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810020_1993.txt

810020_1993

1993

810020

ITEM 1. Business Trans-Resources, Inc., a privately owned Delaware corporation ("the Company"), is a multinational manufacturer of specialty plant nutrients, organic chemicals, industrial chemicals and potash and distributes its products in over 80 countries. The Company is the world's largest producer of potassium nitrate, which is marketed by the Company principally under the brand names K-Power domestically and Multi-K internationally (collectively, referred to as K-Power). The Company is also the world's largest producer of propanil, the leading rice herbicide. In addition, the Company is the largest United States producer of potash. During 1993, specialty plant nutrients, organic chemicals, industrial chemicals and potash contributed approximately 45%, 12%, 26% and 17%, respectively, of the Company's total revenues. The following table sets forth the primary markets and applications for each of the Company's principal products: Of the Company's total revenues for the year ended December 31, 1993, approximately 37% and 36% were derived from sales in the United States and Europe, respectively, with the remainder derived from sales in many other countries. On February 7, 1994, the smaller of the two potassium nitrate production units of the Company's Israeli subsidiary, Haifa Chemicals Limited ("HCL"), was damaged by a fire, causing a temporary reduction of the Company's potassium nitrate production capacity. The Company is currently reviewing various alternatives concerning the most effective and timely replacement of the damaged production unit and expects to replace the damaged unit within approximately twelve months. The Company believes that the impact of the loss of the facility, including the effect of business interruption, will be substantially covered by insurance. While the ultimate amount of the insurance recovery has not yet been determined, the Company expects that the insurance proceeds relating to the property damage will be for replacement value, which substantially exceeds the recorded carrying value of the damaged assets. Management is not aware of any independent, authoritative source of information about sizes, growth rates or shares for the Company's markets. The market size, market growth rate and market share estimates contained herein have been developed by the Company from internal sources and reflect the Company's current estimates. However, no assurance can be given regarding the accuracy of such estimates. The Company's operations are conducted through its direct and indirect wholly-owned subsidiaries which include HCL, and HCL's wholly- owned subsidiary, Haifa Chemicals South, Ltd., an Israeli corporation; Cedar Chemical Corporation, a Delaware corporation ("Cedar"), and Cedar's wholly-owned subsidiaries, Vicksburg Chemical Company, a Delaware corporation ("Vicksburg"), and New Mexico Potash Corporation, a New Mexico corporation ("NMPC"); and Eddy Potash, Inc., a Delaware corporation ("Eddy"). The Company was incorporated in Delaware in 1971 under the name Trans-Pacific Resources, Inc. ("Trans-Pacific"). SPECIALTY PLANT NUTRIENTS The Company is a multinational manufacturer of a range of specialty plant nutrients, which contributed approximately $146,000,000 to the Company's revenues for the fiscal year ended December 31, 1993, of which K-Power contributed a substantial portion. Products and Markets. K-Power, Polyfeed (a fully soluble plant nutrient containing nitrogen, phosphate and potassium), Magnisal (magnesium nitrate), Multi-MAP (monoammonium phosphate) and Multi-MKP (monopotassium phosphate) are suitable for intensive high value crops such as fresh fruit and vegetables, flowers, cotton and tobacco, since they are fully soluble, easily absorbed and leave no harmful residues such as chloride, sodium or sulfate. Because of their solubility, these products can be used with modern drip irrigation systems, which are increasingly being employed to conserve water. The Company produces several grades of agricultural potassium nitrate, including standard and prilled. The Company is the world's largest producer of potassium nitrate. Worldwide demand for potassium nitrate has been growing steadily since potassium nitrate was introduced in the 1960s. The market for K-Power has enjoyed steady volume growth because it increases plant yields, improves crop quality and shortens growing cycles. As a result, potassium nitrate commands a price premium over other potassic plant nutrients such as potassium sulfate and sulfate of potash magnesia, used in combination with ammonium nitrate. After a multi-year research and development effort, the Company developed a technology for the coating of potassium nitrate and other specialty plant nutrients which promotes the controlled release of nutrients over time. These products increase nutrient uptake by plants while minimizing fertilizer runoff into the soil, thus satisfying growing environmental concerns, and reducing labor requirements. The Company is marketing these controlled release plant nutrients products under the Multicote brand name. Marketing and Sales. As part of the Company's market development and sales efforts, resident agronomists are located in the United States, Italy, France, the United Kingdom, Greece, Mexico, South Africa, Japan and the Benelux countries. The steady growth in demand for the Company's specialty plant nutrients has been supported by agronomic activities in many countries which have demonstrated the benefits of using K-Power. Horticultural and agricultural growers generally require substantial testing under their own specific climatic, soil and growing conditions before they will adopt a new plant nutrient. The Company has developed application expertise which has produced a growing number of applications and users. To market its specialty plant nutrients, the Company has established a worldwide network of agents and distributors and uses storage facilities in certain countries to provide prompt and responsive customer service. However, depending on the conditions prevailing in the particular market, certain large users are serviced directly and certain products are covered by product managers who have worldwide responsibility for such products. In order to further improve service to its customers in Western Europe, the Company has established subsidiaries in the United Kingdom, Belgium, Spain and Italy. A French subsidiary engaged in the fertilizer business and having its own sales and distribution network also markets the Company's specialty plant nutrients. For United States sales, the Company utilizes its own sales force and also works in selected areas through brokers. In general, in the United States, the Company sells K-Power to blenders who produce mixed fertilizers containing potassium nitrate, which is then sold to growers. Internationally, the Company's distributors usually sell directly to growers. Manufacturing. The Company believes it accounts for approximately 65% of the world's production of potassium nitrate and its current annual potassium nitrate production capacity is approximately 410,000 metric tons. This capacity has been temporarily reduced by the February 1994 fire at HCL, but is scheduled to be restored within approximately twelve months. To meet the anticipated continued growing demand of the market, the Company is expanding its production capacity by constructing a new facility (the "K3 Plant") in Israel, with capacity to produce by 1995 approximately 100,000 metric tons of potassium nitrate annually. Capacity of the K3 Plant may be expanded in subsequent years. See "Facilities and Suppliers" below. Competition. The Company's only significant competitor in the production and sale of potassium nitrate is Sociedad Quimica Y Minera De Chile, S.A., a Chilean company. The principal methods of competition are product quality, customer service, agronomic expertise and price. ORGANIC CHEMICALS The Company's organic chemicals business has grown by building upon its capabilities in specialized areas of complex organic synthesis. Its sales have grown from approximately $20,000,000 in 1989 to approximately $38,000,000 in 1993, with sales of propanil representing approximately 70% of 1993 sales. Products and Markets. The Company's organic chemicals products include propanil (the leading rice herbicide, which Cedar markets principally under the Cedar label and the brand name "Wham! EZ"), dichloroanaline ("DCA," the principal raw material for the production of propanil), Butoxone (a peanut herbicide) and Diuron (a broad use herbicide used on food crops, alfalfa and cotton). The Company is also the exclusive United States distributor for Tough (a corn and peanut herbicide). The Company estimates that it currently produces approximately 95% of the propanil sold in the United States. The Company has also developed several new propanil formulations which offer various advantages in terms of ease of application and improved environmental impact in an effort to expand the propanil market. Although the United States is currently the largest propanil market, representing approximately 35% of the world market, the United States contains only a small proportion of the world's rice acreage. Accordingly, the Company believes there is significant potential for propanil growth internationally. The Company has established an international market development program to introduce propanil to additional markets around the world. As the largest propanil producer in the world and a low cost producer, the Company believes it is positioned to benefit from growth in the international propanil market. The Company also produces other organic chemicals as a contract manufacturer for various chemical companies. Through this contract manufacturing, the Company has developed certain techniques for the synthesis of complex organic chemicals which has been beneficial to it in both its contract manufacturing activities as well as its own developmental efforts for proprietary products. Marketing and Sales. The Company produces and sells propanil under its own brand name and supplies propanil to other agrichemical companies under long-term supply contracts. Sales by the Company of propanil and DCA under a long-term supply contract with the company that, prior to 1992, was the world's largest producer of propanil, represented approximately 17% of the Company's sales of organic chemicals in 1993. The Company sells propanil and its other organic chemical products through its own sales force and a network of distributors, regional dealers, cooperatives and international brokers. Manufacturing. The Company is a low cost producer of propanil as a result of its 1991 acquisition, relocation and upgrading of a DCA manufacturing plant. The Company intends to continue to expand its organic chemicals business by developing and/or distributing new products that draw upon its skills in organic chemical synthesis and/or its sales organization. In particular, the Company is pursuing new manufacturing opportunities which capitalize on its capabilities in chloronitrobenzene technology. Competition. In the United States market, the Company primarily competes with one other propanil supplier while in international markets the Company competes with several producers. Propanil competes with several other rice herbicides, but is currently the most commonly used rice herbicide. Diuron and Tough compete with other products supplied by several multi-national companies. In contract manufacturing, the Company competes with various other producers and the basis of competition is generally the quality and range of production capabilities, service and price. INDUSTRIAL CHEMICALS The Company's industrial chemical products include technical grade potassium nitrate, technical and food grade sodium tripolyphosphate ("STPP"), technical and food grade phosphoric acid, technical grade monoammonium phosphate and diammonium phosphate ("MAP" and "DAP"), technical and food grade monopotassium phosphate ("MKP"), food grade sodium acid pyrophosphate ("SAPP"), chlorine, nitrogen tetroxide and food grade salts. Industrial chemicals contributed approximately $84,000,000 to the Company's revenues for the fiscal year ended December 31, 1993. The Company intends to begin production of potassium carbonate by the end of 1994 at a new plant being constructed for this purpose by Vicksburg. Products and Markets. Technical grade potassium nitrate is used in the glass industry for making fine tableware glass, TV tubes and crystal glass; in the metal industry for heat treatment; in the ceramics industry for the glazing process; for making explosives and for the production of heat transfer salts in the petrochemical industry; and for solar energy systems. Phosphoric acid is used in metal treatment, industrial cleaning solutions, fermentation processes and for carbonated drinks in the food industry. STPP is used primarily in the manufacturing of detergents and specialty cleaning compounds and in the textile and ceramic clay industry; MAP and DAP are used for fire extinguishing powders and fire retardant functions; MKP is used for the fermentation process; and SAPP is an ingredient in baking powders and is used for potato processing. Chlorine is used in the pulp and paper industry and as a swimming pool disinfectant. Nitrogen tetroxide is an aerospace fuel additive. Food grade salts are used in food processing. Potassium carbonate produced at Vicksburg's new plant will be used primarily in the glass industry. Marketing and Sales. The Company sells its industrial chemicals through its own sales force and brokers in the United States and internationally through a worldwide network of agents and distributors. Nitrogen tetroxide is primarily sold under a long-term contract to the United States Government. The Company utilizes storage facilities in certain countries. Production. Many of these industrial products are co-products of the Company's potassium nitrate manufacturing process. Given its production flexibility, the Company can vary the relative proportion of the various phosphate chemicals (STPP, MAP, MKP, DAP and SAPP) to optimize its product mix in light of then prevailing market conditions. Competition. Certain of the Company's industrial chemicals products, such as STPP and phosphoric acid, compete in large industrial chemical markets in which the Company has a small position. Others, such as technical grade potassium nitrate, MAP, MKP and nitrogen tetroxide have relatively significant competitive positions in their respective niche markets. The nature of competition for the various industrial chemicals sold by the Company varies by product. However, in general, the principal methods of competition are product quality, customer service and price. POTASH The Company is the largest United States producer of potash, producing approximately 900,000 short tons in 1993, primarily for agricultural use as fertilizer. During 1993, the Company's share of total potash production in the United States was approximately 47% and its share of total North American potash production was approximately 6%. Potash provides potassium, an essential nutrient for a wide range of crops, including wheat, soybeans and corn. The Company, through Eddy and NMPC, mines, refines and distributes potash from two mines and related refineries located in New Mexico. Potash sales in 1993, excluding intercompany sales to Vicksburg, amounted to approximately $57,000,000. Products and Markets. During 1993, approximately 78% of the Company's potash production was sold as fertilizer and the balance was sold for industrial uses or used by Vicksburg as a raw material in the production of potassium nitrate. The Company does not view these operations as a source of growth. Marketing and Sales. In the United States, the Company's sales force sells potash to blenders for fertilizer material and to industrial customers. Export sales are handled by a sales subsidiary of Potash Corporation of Saskatchewan. During 1993, the Company sold approximately 77% of its potash production domestically and 23% internationally. Although average selling prices for potash in the United States have declined over the last year, they continue to be above the 1987 price levels, at least in part as a result of the United States Government's preliminary findings in a Canadian potash antidumping investigation and the subsequent Canadian potash antidumping agreement. If such agreement is terminated or violated by the Canadian producers, then depending on the actions taken by the United States Government, the production and pricing decisions of Canadian producers, and other market factors, it is possible that the current price levels for potash could decline substantially, which would adversely affect the Company's results of operations. See Item 3 - "Legal Proceedings" below. Production. The Company's potash is mined from approximately 89,000 acres which are under long-term lease, principally from the United States Government and the State of New Mexico. Such leases cover estimated ore reserves, as of December 31 1993, of approximately 70,000,000 short tons of recoverable ore, at thicknesses ranging from four to eight feet. At average recovery rates these ore reserves are estimated to be sufficient to yield approximately 15,000,000 short tons of potash concentrate with an average grade of 60% to 62% "K2O" (a common standard of measurement established by the industry by defining a product's potassium content in terms of equivalent percentages of potassium oxide). As of December 31, 1993 and based on current rates of production (aggregating approximately 940,000 short tons annually), these ore reserves are estimated to be sufficient to support the mining operations of NMPC for approximately 31 years and of Eddy, depending on market conditions, for approximately two to three years. By the time Eddy suspends operations, which the Company currently expects will be during 1996, depending on market conditions, the Company may expand production at NMPC from its present level of approximately 420,000 short tons per year. Competition. Potash is available from several sources, both domestic and foreign, including very large Canadian sources of supply. As a result, the market is highly competitive. Since potash is a commodity product, the most significant competitive factor affecting sales is price. FACILITIES AND SUPPLIERS Vicksburg owns the property, plant and equipment located at its Vicksburg, Mississippi site and Cedar owns the property, plant and equipment located at its West Helena, Arkansas site. The Vicksburg plant consists of two adjacent manufacturing plants situated on 600 contiguous acres. Vicksburg is constructing a third manufacturing plant on its property, to be completed during 1994, which will be used for the production of potassium carbonate. The West Helena plant is located on a 60 acre site. The plants are encumbered by first mortgages and security interests securing long-term indebtedness. Cedar's corporate offices are located in leased premises in Memphis, Tennessee. The major raw materials required by Vicksburg for production of potassium nitrate are potash supplied by NMPC and nitric acid which is produced at the Vicksburg plant. Ammonia, the principal raw material required for production of nitric acid, is supplied from two plants owned by a third party in close proximity to the Vicksburg facility. The major raw material for the production of propanil is DCA. The principal raw material for the production of DCA is provided to the Company under a supply contract. Such raw material is available from multiple sources. NMPC owns the property, plant and equipment located at its 320 acre site near Hobbs, New Mexico. The property, plant and equipment is encumbered by a first mortgage and security interest securing long-term bank indebtedness. Eddy owns the property, plant and equipment located at its 680 acre site in Eddy County, New Mexico. HCL owns its machinery and equipment and leases its land and buildings from Oil Refineries Ltd. ("ORL"), a corporation which is majority-owned by the Israeli Government. The leases expire at various dates, principally in 22 years. Substantially all of the assets of HCL are subject to security interests in favor of the State of Israel or banks. HCL also has a contract with ORL for steam and processed water which expires on December 31, 1996 and a lease from ORL of a pipeline which transports ammonia from the port in Haifa to HCL's plant. HCL is expanding its production capacity by constructing the K3 Plant, with the capacity to produce annually approximately 100,000 metric tons of potassium nitrate and 15,000 metric tons of phosphoric acid. The K3 Plant is being built in the southern part of Israel, on land leased on a long-term basis from the Government of Israel, and is anticipated to cost approximately $88,000,000. HCL expects to receive from the Government of Israel an investment grant of approximately $32,000,000 (which is non-refundable unless the Company does not comply with the terms of the certificate of approval). In addition, it is expected that the Government of Israel will contribute approximately $5,000,000 for infrastructure, so that the net investment of HCL in the K3 Plant is anticipated to be approximately $51,000,000. Construction commenced in 1993 and production is planned to start in late 1994. Capacity of the K3 Plant may be expanded in subsequent years. Provided it completes the K3 Plant and complies with the conditions specified in the applicable certificate of approval, HCL will receive, with respect to taxable income derived from the K3 Plant, certain benefits accorded under Israel's Investments Law. On February 7, 1994, the smaller of HCL's two potassium nitrate production units was damaged by a fire, causing a temporary reduction of the Company's potassium nitrate production capacity. The Company is currently reviewing various alternatives concerning the most effective and timely replacement of the damaged production unit and expects to replace the damaged unit within approximately twelve months. The Company believes that the impact of the loss of the facility, including the effect of business interruption, will be substantially covered by insurance. While the ultimate amount of the insurance recovery has not yet been determined, the Company expects that the insurance proceeds relating to the property damage will be for replacement value, which substantially exceeds the recorded carrying value of the damaged assets. HCL obtains its major raw materials, potash and phosphate rock, in Israel. HCL purchases potash solely from Dead Sea Works, Ltd. ("DSW") in accordance with a supply contract expiring December 31, 1999. The contract provides for prices to be established quarterly, based on the weighted average of the FOB Israeli port prices paid to DSW by its overseas customers during the preceding quarter plus certain adjustments thereto. HCL purchases phosphate rock solely from Negev Phosphates, Ltd. ("Negev Phosphates") pursuant to a supply agreement expiring on June 30, 1994. Based on a letter of intent between Negev Phosphates and HCL, a long-term contract is currently being negotiated. DSW and Negev Phosphates are companies that are majority-owned by the Israeli Government and the sole suppliers in Israel of potash and phosphate rock, respectively. While HCL views its current relationships with both of its principal suppliers to be good, the loss of supply from either of these sources would have an adverse effect on the Company. Ammonia, which is used to produce nitric acid (which in turn is used to produce potassium nitrate), is manufactured in Israel as well as imported. The ammonia used by HCL is currently imported from a producer under supply agreements expiring on December 31, 1994. HCL owns ammonia terminal facilities located on leased property in the port of Haifa which have the capacity to store an amount of ammonia sufficient to meet HCL's requirements. Management believes that, except for the HCL unit damaged by the fire in February, 1994, its facilities are in good operating condition and adequate for its current needs. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Expenditures" and Note P of Notes to Consolidated Financial Statements. RESEARCH AND DEVELOPMENT The Company has developed and patented certain manufacturing processes and has submitted other applications for patents for additional processes. As of December 31, 1993, the Company employed 81 research and development scientists, engineers and technicians, who are involved in the development and evaluation of process technologies, efficiencies and quality control. For the years ended December 31, 1991, 1992, and 1993, the Company spent approximately $2,860,000, $2,945,000 and $3,206,000, respectively, on these efforts, which have been charged to current operations. PERSONNEL AND LABOR RELATIONS As of December 31, 1993 the Company employed approximately 1,500 people. Approximately 260 employees have advanced technical and academic qualifications. None of Cedar's, Vicksburg's or NMPC's employees are represented by any collective bargaining unit. Eddy's hourly work force is represented by three labor unions. Eddy's collective bargaining agreements covering the hourly work force expire in July 1995. Eddy has enjoyed good relations with its labor unions and has not had a significant work stoppage for many years. Technicians and engineers of HCL are members of the Union of Technicians and Engineers, which operates throughout Israel, and substantial terms of their employment (e.g. salaries and promotions) are governed by a general collective agreement which HCL does not negotiate directly with such employees. The other employees of HCL are members of the "Histadrut", the dominant labor union in Israel, and their terms of employment are governed by a Specific Collective Agreement ("SCA") negotiated by HCL with the Histadrut and the representatives of the employees. The contractual terms of the most recent labor agreements with both employee groups expired on December 31, 1992, with the result that they remain statutorily in effect until terminated by either party thereto at any time upon two months prior written notice. HCL is currently negotiating new labor agreements with the respective employee groups with the objective being to arrive at agreements for the three year period ending December 31, 1995. HCL's last major labor dispute took place in July 1991 and related to negotiations of the SCA for 1990 and 1991. As a result of this dispute, HCL's employees went on strike for approximately four weeks during the third quarter of 1991. Prior to that, the last major labor dispute took place in 1983, which resulted in a strike of approximately two weeks. ENVIRONMENTAL MATTERS Cedar and Vicksburg Vicksburg's plant located in Vicksburg, Mississippi and Cedar's West Helena, Arkansas plant discharge process waste water and storm water pursuant to permits issued in accordance with the Federal Clean Water Act and related state statutes. Air emissions at each plant are regulated by permits issued pursuant to the Federal Clean Air Act and related state statutes. While the plants have generated solid waste regulated by the Federal Resource Conservation and Recovery Act of 1976, as amended by the Hazardous and Solid Waste Amendments of 1984 ("RCRA") and related state statutes, the Company believes that such waste is currently handled and disposed of in a manner which does not require the Company to have permits under RCRA or any related state statute. The Environmental Protection Agency's (the "EPA") Regional Office in Atlanta notified Cedar in 1989 that unspecified corrective action will be required to protect against the release of contaminants allegedly present at the Vicksburg plant as a result of previous pesticide manufacturing operations. As a result of the notice, Cedar reached agreement with the EPA and the Department of Justice on the terms of a Consent Decree which was filed in the United States District Court at Jackson, Mississippi in January 1992. Pursuant to the Consent Decree, Cedar submitted a report of current conditions. Upon agency approval of this report and of the facility investigation work plan to be thereafter submitted for the Vicksburg plant, Vicksburg will undertake a site investigation and corrective measures study, followed by implementation of appropriate corrective action. Compliance with the Consent Decree is expected to occur over a five to six year period. Cedar's West Helena plant utilizes a surface impoundment for biological treatment of non-hazardous waste streams which was the subject of an enforcement proceeding initiated by the Arkansas Department of Pollution Control and Ecology (the "ADPCE") in 1986. The proceeding resulted in a Consent Administrative Order which required Cedar to carry out various studies, ultimately leading to the implementation of a groundwater monitoring system. Based in part on the results of groundwater monitoring and in part on the discovery of a drum burial area on the West Helena plant site, the ADPCE requested Cedar to initiate an expanded plant-wide investigation pursuant to a Consent Administrative Order. The Order was entered in the third quarter of 1991. Implementation is expected to occur over a five year period. Cedar removed the buried drums from the West Helena site in accordance with a work plan incorporated in the Consent Administrative Order and, shortly thereafter, filed a suit against a former operator of the plant site for contribution for the costs incurred. In July 1992, Cedar obtained partial summary judgment in the suit against the former operator in an amount equal to the cost Cedar incurred in removing the buried drums. The judgment, in the amount of $1,725,000 plus interest, has been appealed by the former operator. The Company believes that the future costs required to complete the site investigation and corrective measures studies at Vicksburg and the plant-wide investigation at West Helena will be between $500,000 and $1,000,000 and will be expended over two to three years. Until these investigations are completed, it is not possible to definitively determine the costs for any corrective actions which will be required. Any such corrective action costs will be expended over a period of years. There can be no assurance that such costs will not be material. In November 1992, Cedar entered into an agreement with the ADPCE to resolve alleged violations of Cedar's National Pollutant Discharge Elimination System permit (issued to its West Helena Plant in accordance with the Federal Clean Water Act and related state statutes) by agreeing to enter into an additional Consent Administrative Order which will require implementation of additional corrective measures (which could cost up to $500,000 over a period of two to three years) intended to assure future compliance with the requirements of the permit and which required the payment of a penalty of $80,000. In 1987, Cedar entered into a cost sharing agreement with 55 other companies to fund costs associated with the clean-up of an abandoned waste disposal site located near Bayou Sorrel, Louisiana. The sharing agreement was the basis for a consent decree to which Cedar and the other companies are parties, settling claims brought by the EPA pursuant to the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended. The sharing agreement allocates approximately 4% of the clean-up costs to Cedar. After credits and payments through December 31, 1993, Cedar's remaining share is not expected to exceed an aggregate of $480,000 over approximately the next 25 years. Appropriate provisions have been made in the consolidated financial statements with respect to the above matters. Eddy and NMPC The Company's potash operations are subject to various Federal, state and local environmental laws. The Company does not believe significant expenditures will be required for the potash operations in the near future or that its ongoing environmental operating costs will be material. HCL As a result of the chemicals and processes used by HCL in the course of production, nitrous oxide ("NOX") gases, potassium nitrate and STPP dusts are emitted into the air. In 1986, the Israeli Ministry of Interior issued an order (the "Order") under the Law for the Prevention of Hazards of 1961 directing HCL to avoid unreasonable air pollution and to take certain remedial actions, including the installation of measuring devices. In response to the Order, HCL installed analyzers for the continuous measuring of the NOX content of the tail gases in its two nitric acid plants and opacity meters for the measurement of dust content in the air emitted from potassium nitrate dryers. An additional absorption tower for the recovery of NOX from the tail gases of the larger nitric acid plant was installed in 1989 as well as two ventury scrubber units for the reduction of the dust content in the air emitted from the dryers of both potassium nitrate plants. As a result of these actions, HCL complied with the Order. As part of a 1990 nitric acid capacity increase, an NOX abatement unit was installed in the smaller nitric acid plant. As a result of the production of phosphoric acid, HCL generates acid sludge and liquid acid effluent. HCL had previously disposed of its acid sludge in designated approved sites. In accordance with a permit issued by the Israeli Agency for Environmental Preservation of the Ministry of Interior pursuant to the Law for the Prevention of Sea Pollution (Disposing of Wastes) of 1983 and 1984, HCL is now disposing of the acid sludge in a designated site in the Mediterranean Sea, situated 20 nautical miles from the Israeli coast. The permit allows for the disposal of a quantity which is sufficient to satisfy HCL's needs. The permit is valid until December 31, 1994. HCL currently disposes of its liquid acid effluents in a local river. Local authorities have advised HCL that it must find an alternative site for such disposal. The present solution proposed by HCL is to dispose of the liquid acid waste four kilometers into Haifa Bay utilizing a marine pipeline. This proposal, accepted in principle by both the local authorities for environmental protection and the Haifa port authorities, was submitted for approval to the Ministry of Environmental Protection in Jerusalem. The Ministry gave HCL permission to proceed with the design of the marine pipeline, subject to HCL fulfilling certain requirements. Studies of sea conditions in the area for the proposed pipeline and of the effect of the acid waste on the sea environment were performed by the Israel Oceanographic & Lakes Research Institute. Based on these studies, an environmental impact statement of the proposed system is currently being prepared. The Company estimates that HCL will be required to invest approximately $8,000,000 over the next three years if this proposed solution is adopted and annual operating costs, after completion of the project, will be approximately $800,000. ITEM 2. ITEM 2. Properties. Reference is made to "Facilities and Suppliers" in Item 1 above, "Business," for information concerning the Company's properties. See also Notes D and P of Notes to Consolidated Financial Statements for additional information. ITEM 3. ITEM 3. Legal Proceedings. 1. On or about December 20, 1991, Peter N. Zachary together with fifteen other persons, claiming to be shareholders of Sylvan Learning Centers, Inc., The Enstar Group, Inc. ("Enstar"), Kinder-Care, Inc. and Kinder-Care Learning Centers, Inc., filed a complaint in the Circuit Court for Montgomery County, Alabama against Richard J. Grassgreen ("Grassgreen") and Perry Mendel ("Mendel") (each a former indirect stockholder and director of the Company), another former indirect stockholder and director of the Company, TPR Investment Associates, Inc. ("Associates," which is a former parent corporation of the Company), Trans-Pacific (the former name of the Company) and various other named persons and entities and certain unnamed entities. The complaint alleges that in January 1986, Grassgreen and Mendel became part owners of Associates along with the other former indirect stockholder and director of the Company and certain employees of Drexel Burnham Lambert Incorporated. The complaint also alleges that in January 1986, Grassgreen caused Enstar, through its subsidiary, Care Investors, Inc., to purchase a one-third interest in Associates for $3,000,000 and to loan Associates $10,000,000 to permit it to acquire Trans-Pacific, which would substantially increase the profits Grassgreen and Mendel could make on their investments in Trans-Pacific. The complaint does not explain how these allegations are actionable against Associates or Trans-Pacific. The Company filed a motion to dismiss the complaint. On or about May 27, 1993, the Court entered an order dismissing substantially the entire complaint. Plaintiffs thereafter filed a second amended complaint, against which the Company also filed a motion to dismiss. On or about August 10, 1993 the Court entered an order dismissing four of the five Counts of the amended complaint. The Company has interposed an answer to the remaining Count in the complaint. 2. On or about December 3, 1993 an action was commenced in the United States Bankruptcy Court, Middle District of Florida, Jacksonville Division by Grassgreen (as debtor in his personal bankruptcy proceeding) against the Company, its current parent corporation, TPR Investment Associates, Inc. ("TPR"; which is a different corporation than Associates) and Arie Genger (see Item 10 - "Directors and Executive Officers of the Registrant" and Item 12 - - "Security Ownership of Certain Beneficial Owners and Management"). The complaint alleges that Grassgreen's November 1991 sale to TPR of his 250 shares of TPR common stock (1,000 shares were then outstanding) in exchange for a non- negotiable note constitutes a fraudulent conveyance voidable under state and bankruptcy law, fraud, a breach by TPR of a 1988 Shareholder Agreement among TPR and its then shareholders, and that TPR retains property owing to Grassgreen's bankruptcy estate. The complaint seeks recision of the sale, damages and costs, and that Mr. Genger be enjoined from issuing any new or treasury stock of TPR or changing the ownership of TPR or the Company. On or about February 14, 1994 the defendants filed an answer to the complaint, denying all of the allegations of the complaint, interposing additional defenses and asserting a counterclaim against Grassgreen pursuant to his indemnification obligations under the agreement governing his November 1991 sale of his TPR shares. On or about December 30, 1993 Enstar moved to intervene in the suit, contending that it, rather than Grassgreen, should prosecute it. On or about February 16, 1994, in connection with the then proposed settlement with Grassgreen, Enstar moved to continue indefinitely (i.e., defer) its intervention motion until it or one of the other parties requests otherwise. During March 1994 the parties entered into an agreement (the "Settlement"), which is subject to Bankruptcy Court approval and confirmation of Mr. Grassgreen's plan of reorganization, providing for dismissal with prejudice of the action and releases to the defendants. Pursuant to the Settlement, TPR will make certain payments in exchange for surrender to TPR of Grassgreen's non-negotiable note and the Company's outstanding $9,000,000, 9 1/2% junior subordinated debenture due 2005. In addition, the Settlement provides for the release of the current holder's liability under a $4,000,000 note due 2005 payable to the Company and secured by the $9,000,000 debenture. TPR will thereafter be the obligor on the $4,000,000 note. 3. On or about April 1, 1993 an action was commenced in the United State District Court for the District of Minnesota, Minneapolis Division, by Blomkest Fertilizer, Inc., Meadowland Farmers Corp., and Cobden Grain & Feed against the major Canadian and United States potash producers, including Eddy and NMPC. The action is purportedly a class action on behalf of all purchasers of potash from any of the defendants or their respective affiliates, at any time during the period April 1987 to the present, and alleges that the defendants conspired to fix, raise, maintain and stabilize the prices of potash in the United States purchased by the plaintiffs and the other member of the class in violation of the United States anti-trust laws. The complaint seeks unspecified damages together with injunctive relief against the defendants. A total of fourteen related actions (in ten of which Eddy and NMPC were named defendants) were subsequently filed in the United State District Courts for the District of Minnesota, the Northern District of Illinois and the Western District of Virginia, all containing allegations similar to those made by the plaintiffs in the Blomkest action. The actions pending in Federal court in Minnesota were consolidated and an amended and consolidated complaint was served; several of the plaintiffs named in the original complaints are no longer parties to the amended and consolidated complaint. On or about May 27, 1993 a purported class action was filed against the major potash producers, including Eddy and NMPC, in the Superior Court of the State of California for the County of Los Angeles on behalf of Angela Coleman and a class consisting of all California indirect purchasers of potash. The complaint in the Coleman action alleges a price fixing conspiracy in the potash industry between April 1987 and the present in violation of specified California statutes. On July 6, 1993 the defendants removed the Coleman case to the United States District Court for the Central District of California. Pursuant to an order of the Judicial Panel for Multidistrict Litigation, all of the pending Federal actions have been consolidated for pretrial purposes in the United States District Court for Minnesota. The defendants filed a joint motion to disqualify plaintiffs' counsel and dismiss their complaints ("Motion to Disqualify"). Additionally, certain of the defendants, including Eddy and NMPC, filed a Joint Motion, pursuant to stipulated Federal statutes, to dismiss ("Motion to Dismiss"). On December 8, 1993 the Court granted the Motion to Disqualify with respect to certain of the plaintiffs' counsel, including all of the plaintiffs' lead counsel, and ordered that the plaintiffs, using non-disqualified counsel who submit an affidavit attesting to facts establishing that they should not be disqualified, could file amended complaints within 30 days (subsequently extended to January 28, 1994), failing which the complaints would be dismissed without prejudice. The Court denied the Motion to Dismiss as moot. The Court also ruled that the Motion to Disqualify and the Motion to Dismiss and its rulings with respect thereto did not apply to the case transferred from the California Court. The plaintiffs filed a motion for reconsideration of the Court's December 8, 1993 decision on the Motion to Disqualify or, in the alternative, for certification ("Motion for Certification") allowing plaintiffs to appeal the Court's interlocutory decision to the Eighth Circuit Court of Appeals. On January 4, 1994 the Court ruled that two of the twelve disqualified law firms should not have been disqualified and granted plaintiffs' Motion for Certification. The Court also ruled that upon plaintiffs filing an application for appeal, all proceedings would be stayed pending further order of the Court or the Eighth Circuit. On February 4, 1994 the Eight Circuit Court of Appeals denied the plaintiffs' petitions for permission to appeal the District Court's interlocutory order. Accordingly, on February 14, 1994, the District Court vacated the stay and ordered that plaintiffs (using non-disqualified counsel) could file amended complaints on or before March 1, 1994. Certain of the plaintiffs filed amended complaints on or about March 1, 1994 and other plaintiffs obtained an extension from the District Court to file amended complaints until April 21, 1994. On March 14, 1994, the Court scheduled the trial to begin on or about January 1, 1996. On or about February 18, 1994 certain of the plaintiffs filed with the Eighth Circuit a petition for rehearing and suggestion for rehearing en banc of the Eighth Circuit's denial of plaintiffs' petition for permission to appeal the District Court's interlocutory decision. This petition has not yet been decided. Management has no knowledge of any conspiracy of the type alleged in these complaints. There are several other legal proceedings pending against the Company and certain of its subsidiaries arising in the ordinary course of its business which management does not consider material. Management of the Company believes, based upon its assessment of the actions and claims outstanding against the Company and certain of its subsidiaries, and after discussion with counsel, that the eventual disposition of the matters described or referred to above should not have a material adverse effect on the financial position or future operations of the Company. On or about November 26, 1993 Eddy and NMPC (and other major United States potash producers) were served with subpoenas issued by the United States District Court for the Northern District of Ohio to produce documents to a grand jury authorized by the U.S. Department of Justice Antitrust Division ("DOJ") to investigate possible violations of the antitrust laws in connection with the allegations made in the civil actions describe above. Eddy and NMPC are cooperating with DOJ in connection with providing documents sought by the subpoena. For information relating to certain environmental proceedings affecting the Company, see "Environmental Matters" in Item 1 above, "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 quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters. All of the Company's equity securities are owned by TPR. See Item 12 - - "Security Ownership of Certain Beneficial Owners and Management." In addition, see Note H of Notes to Consolidated Financial Statements for information regarding certain restrictions on the Company's payment of dividends. During 1991, 1992 and 1993 the Company paid or declared dividends on its Common Stock in the amounts of $2,850,000, $13,136,000 and $7,508,000, respectively. ITEM 6. ITEM 6. Selected Financial Data. The following table presents selected consolidated financial data of the Company for the five year period ended December 31, 1993. This data has been derived from the consolidated financial statements of the Company and should be read in conjunction with the notes thereto. _______________________ (1) Includes (a) security losses of $6,381,000 and $15,490,000 (which $15,490,000 relates principally to the Company's investment in Enstar) in the years ended December 31, 1989 and 1990, respectively, (b) a gain of $10,000,000 in the year ended December 31, 1991, representing the excess of insurance proceeds over the carrying value of certain HCL property destroyed in a fire, and (c) security gains of $2,865,000 and $2,261,000 in the years ended December 31, 1992 and 1993, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note L of Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. RESULTS OF OPERATIONS The following table sets forth as a percentage of revenues and the percentage change of those items as compared to the prior period, certain items appearing in the Consolidated Financial Statements. 1993 Compared with 1992 Revenues decreased by 5.5% to $326,315,000 in 1993 from $345,356,000 in 1992, a decrease of $19,041,000, resulting from decreased sales of potash and chlorine ($9,600,000), specialty plant nutrients and industrial chemicals ($2,600,000) and organic chemicals (primarily contract manufacturing activities) ($6,800,000). Cost of goods sold as a percentage of revenues increased to 78.3% in 1993 compared with 77.2% in 1992 primarily due to higher costs associated with contract manufacturing activities in the Company's organic chemicals business and lower potash prices. During the 1993 period margins on specialty plant nutrients, industrial chemicals and the organic chemicals' pesticide business increased, but were offset by reduced margins in contract manufacturing activities and in the potash business. Gross profit was $70,752,000 in 1993 compared with $78,586,000 in 1992, a decrease of $7,834,000, principally the result of a decrease in potash gross profit. General and administrative expense increased to $38,375,000 in 1993 from $36,270,000 in 1992 (11.8% of revenues in 1993 compared with 10.5% in 1992), with the increase of $2,105,000 principally due to increased selling and marketing expenses for specialty plant nutrients and organic chemicals. As a result of the matters described above, the Company's operating income decreased by $9,939,000 to $32,377,000 in 1993 as compared with $42,316,000 in 1992. Interest expense decreased by $137,000 ($27,405,000 in 1993 compared with $27,542,000 in 1992). While the Company's outstanding debt at December 31, 1993 exceeded the outstanding debt at December 31, 1992 primarily as a result of the Company's issuance of its 11 7/8% Senior Subordinated Notes due 2002 (see Note H of Notes to Consolidated Financial Statements), interest expense declined as a result of scheduled debt repayments and lower interest rates in the 1993 period. Interest and other income - net decreased in 1993 by $2,462,000, principally as the result of reduced interest and dividend income and security gains in 1993 and other non-recurring income earned in 1992. As a result of the above factors, income before income taxes, extraordinary item and change in accounting principle decreased by $12,264,000 in 1993. The provision for income taxes increased to 72.1% of pre-tax income in 1993 from 48.3% of pre-tax income in 1992. The Company's provisions for income taxes are impacted by the mix between domestic and foreign earnings and vary from the U.S. Federal statutory rate principally due to the impact of foreign operations and certain losses for which there is no current tax benefit. See Note K of Notes to Consolidated Financial Statements for information regarding effective tax rates. In the 1993 period the Company acquired $65,497,000 principal amount of its 13 1/2% Senior Subordinated Debentures due 1997 (the "13 1/2% Debentures") and $21,500,000 principal amount of its Senior Subordinated Reset Notes due 1996 (the "Reset Notes"), which resulted in a loss of $8,830,000. Such loss (which has no current tax benefit) is classified as an extraordinary item in the accompanying Consolidated Statement of Operations. No debt was acquired in the 1992 period. See the Note H of Notes to Consolidated Financial Statements. 1992 Compared with 1991 Revenues increased by 11.7% to $345,356,000 in 1992 from $309,068,000 in 1991, an increase of $36,288,000, mainly the result of increased sales of specialty plant nutrients, organic chemicals and potash. Cost of goods sold as a percentage of revenues was 77.2% in both 1991 and 1992. During 1992 margins on specialty plant nutrients and industrial chemicals improved slightly, partially offset by higher volumes of propanil sold at lower margins pursuant to a supply agreement commencing in 1992. See "Business - Organic Chemicals - Marketing and Sales." Gross profit was $78,586,000 in 1992 compared with $70,579,000 in 1991, an increase of $8,007,000, with increases occurring in each of the Company's product lines. General and administrative expense increased to $36,270,000 in 1992 from $33,262,000 in 1991 (10.5% of revenues in 1992 compared with 10.7% in 1991) principally due to increased labor costs, selling and marketing expenses. As a result of the matters described above, the Company's operating income increased by $4,999,000 to $42,316,000 in 1992 as compared with $37,317,000 in 1991. Interest expense decreased from $31,210,000 in 1991 to $27,542,000 in 1992, mainly resulting from scheduled debt repayments, lower interest rates and senior subordinated debt repurchased by the Company in 1991, partially offset by exchange rate differences on certain HCL long-term loans denominated in European currencies. Interest and other income - net decreased by $5,683,000 in 1992 principally as the result of the prior year including a gain of $10,000,000 relating to the excess of insurance proceeds over the carrying value of certain HCL property damaged in a fire, partially offset by increased security gains in 1992 (see Notes D and L of Notes to Consolidated Financial Statements). As a result of the above factors, income before income taxes, extraordinary item and change in accounting principle increased by $2,984,000 in 1992. The provision for income taxes increased to 48.3% of pre-tax income in 1992 from 12.7% of pre-tax income in 1991 since during 1991 HCL received an income tax refund relating to prior years of $7,100,000. These effective tax rates are impacted by the mix between domestic and foreign earnings and vary from the U.S. Federal statutory rate principally due to the impact of foreign operations and certain losses for which there is no current tax benefit. See Note K of Notes to Consolidated Financial Statements for information regarding effective tax rates. In 1991 the Company repurchased $10,153,000 principal amount of 13 1/2% Debentures and Reset Notes. Such repurchases resulted in a gain to the Company, net of income taxes, of $1,186,000, with this gain being classified as an extraordinary item. There were no repurchases of public indebtedness in 1992. Effective January 1, 1992, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109 "Accounting For Income Taxes". In connection with such change in accounting, net income in 1992 was impacted by a net charge of $1,170,000. See Note A of Notes to Consolidated Financial Statements. CAPITAL RESOURCES AND LIQUIDITY The Company's consolidated working capital at December 31, 1993 and 1992 was $103,694,000 and $99,297,000, respectively. See "Other Matters" and Notes H and P of Notes to Consolidated Financial Statements. CAPITAL EXPENDITURES During 1993 (excluding the K3 Plant) the Company invested approximately $13,000,000 in capital expenditures. The Company currently anticipates that capital expenditures for the year ending December 31, 1994 (excluding the K3 Plant and the reconstruction of the production unit damaged by a fire in February 1994) will aggregate approximately $35,000,000, which will be used for increasing production capacity and product diversification. During 1993 the Company commenced construction of the K3 Plant, which is estimated to cost approximately $88,000,000, with $37,000,000 of such cost being provided by grants and other entitlements from the Israeli Government. Capital expenditures in connection with the K3 Plant (net of Israeli Government grants) amounted to approximately $16,000,000 in 1993. The Company anticipates completing the construction of the K3 Plant in late 1994. See "Business - Facilities and Suppliers" and Notes D and P of Notes to Consolidated Financial Statements. The Company expects to be able to finance its capital expenditures from internally generated funds, borrowings from traditional lending sources and, where applicable, Israeli Government grants and entitlements. EXCHANGE RATE INSURANCE In 1981, HCL joined a program of exchange rate insurance of the Israeli Government designed to protect participating Israeli exporters from losses resulting from the widening of the gap between the inflation rate in Israel and the rate of devaluation of the New Israeli Shekel ("NIS") against a weighted basket of currencies of Israel's major trading partners. The net benefits received by HCL for the years ended December 31, 1991, 1992 and 1993 were $4,599,000, $4,056,000 and $1,616,000, respectively, which benefits have been included in revenues. As part of various economic measures adopted in Israel subsequent to December 31, 1988, the Israeli Government has gradually reduced the insurance proceeds granted under its program of exchange rate insurance, with the program having been fully eliminated on August 31, 1993. See Note A of Notes to Consolidated Financial Statements. INFLATION Inasmuch as only approximately $36,000,000 of HCL's annual operating costs are denominated in NIS, HCL is exposed to inflation in Israel to a limited extent. The combination of price increases coupled with devaluation of the NIS have in the past generally enabled HCL to avoid a material adverse impact from inflation in Israel. However, HCL's earnings could increase or decrease to the extent that the rate of future NIS devaluation differs from the rate of Israeli inflation. In December 1991, the Central Bank of Israel announced a program whereby the lag between the inflation rate in Israel and devaluation of the NIS, compared to the weighted average exchange rate of a "basket of currencies" (the currencies most commonly traded with Israel, including the U.S. Dollar), will not exceed the average inflation rate (about 3 to 4%) of the countries represented in the "basket of currencies". For the years ended December 31, 1992 and 1993, the devaluation rate of the NIS as compared to the U.S. Dollar exceeded (or was less than) the inflation rate in Israel by 11.7% and (3.2)%, respectively. OTHER MATTERS On January 27, 1994, HCL filed a registration statement with the Israeli Securities Authority (the "ISA") pursuant to which HCL would publicly offer in Israel, in an underwritten offering, units consisting of (i) shares of HCL common stock (the "HCL Shares") and (ii) options exercisable for HCL Shares. The terms of the proposed offering have not been finalized, and there can be no assurance that the ISA will declare the offering effective or that the offering will be consummated (considering, among other things, prevailing stock market conditions in Israel). If the proposed offering is consummated, the Company has determined that it would maintain beneficial ownership of not less than 90% of the HCL Shares upon issuance of the units and not less than 80% on a fully diluted basis. The Company anticipates that the net proceeds to be realized for the HCL Shares in the proposed offering, if consummated, would be substantially in excess of the Company's corresponding carrying value for the equity interest represented by such shares. The net proceeds of the proposed offering may be used for any purpose authorized by the Board of Directors of HCL, including, without limitation, internal growth or the acquisition of new businesses. HCL does not currently have any agreements, commitments or understandings for acquiring any particular businesses and does not anticipate using any of the net proceeds to finance the construction of the K3 Plant. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. See Index to Consolidated Financial Statements and Schedules 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. The directors and executive officers of the Company are as follows: The By-laws of the Company provide for at least one director. Directors hold office until the next annual meeting of stockholders or until their successors are elected and qualified. There are no arrangements or understandings between any director or executive officer of the Company and any other person pursuant to which such person was elected as a director or executive officer. The executive officers serve at the discretion of the Board of Directors. There are no family relationships among any directors or executive officers of the Company. The following are descriptions of the directors and executive officers of the Company and the members of the Financial Advisory Committee. The Financial Advisory Committee advises the Board of Directors regarding financial matters and, when the Committee deems appropriate, make recommendations to the Board of Directors. Arie Genger has been a director and Chairman of the Board of Directors and Chief Executive Officer of the Company since 1986, the sole member of the Executive Committee since June 1988, and was President of the Company from 1986 to December 1993. Thomas G. Hardy has been President and Chief Operating Officer of the Company since December 1993, was Executive Vice President of the Company from June 1987 to December 1993 and has been a director and member of the Financial Advisory Committee since October 1992. He has been a director of Laser Industries Limited (a manufacturer and distributor of surgical lasers and other medical technology in which the Company has an ownership interest) since January 1990. Martin A. Coleman has been a director since March 1993. Since January 1991 he has been a private investor and of counsel to the law firm of Rubin Baum Levin Constant & Friedman, general counsel to the Company. Prior to that, he was a member of such law firm for more than five years. Sash A. Spencer has been a director since October 1992 and a member of the Financial Advisory Committee since March 1993. He has been a private investor and Chairman of Holding Capital Management Corp., a private investment firm, for more than five years. He has been a director of Empire Gas Corp., a corporation engaged in the propane gas business, since 1983. Lester W. Youner has been Vice President, Treasurer and Chief Financial Officer of the Company since October 1987. From June 1979 until October 1987 he was a Partner of Deloitte & Touche, a public accounting firm. Martin A. Eichen has been a Vice President of the Company since June 1988. From June 1978 to June 1988 he was a Manager at Deloitte & Touche. Bernard J. Blaney has been a Vice President of the Company since January 1987. Kenneth H. Traub has been a Vice President of the Company since December 1993. Prior thereto, from July 1989, he was Assistant to the Chairman of the Board of the Company. Lawrence M. Small, 52, has been Chairman of the Financial Advisory Committee of the Board of Directors since October 1992. Mr. Small is President and Chief Operating Officer of Fannie Mae (Federal National Mortgage Association) headquartered in Washington, DC, which he joined in September 1991. Prior to that, he was Vice Chairman and Chairman of the Executive Committee of the Boards of Directors of Citicorp and Citibank, N.A., where he was employed for 27 years. He serves as a director of Fannie Mae and of the Chubb Corporation (an insurance company). ITEM 11. ITEM 11. Executive Compensation The following table sets forth the aggregate compensation paid or accrued by the Company for the past three fiscal years to its Chief Executive Officer and to other executive officers whose annual compensation exceeded $100,000 for the fiscal year ended December 31, 1993: SUMMARY COMPENSATION TABLE ____________________ (1) During the period covered by the table, the Company did not make any restricted stock awards, did not have in effect any stock option or stock appreciation rights plans, and did not make any payments under any long-term incentive plan. See "Compensation Agreement" for Mr. Hardy's bonus arrangement. (2) Does not include in the case of Messrs. Genger, Hardy and Youner $500,000, $275,000 and $20,000, respectively, of 1994 salary which was prepaid in 1993. (3) For 1993, consists of: (i) in the case of Mr. Genger, $250,000 for an annual premium on ordinary life insurance, $258,000 for related income tax gross-up, $6,000 for the Company's matching contribution to a profit sharing thrift plan, and $5,000 for the premium on term life insurance; (ii) in the case of Messrs. Hardy, Youner, Eichen and Traub $6,000, $6,000, $5,000 and $4,000, respectively, for the Company's matching contribution to a profit sharing thrift plan; and (iii) $2,000 each for Messrs. Hardy, Youner and Eichen for the premium on term life insurance. For 1992, consists of: (i) in the case of Mr. Genger, $241,000 for an annual premium on ordinary life insurance, $183,000 for related income tax gross-up, $9,000 for the Company's matching contribution to a profit sharing thrift plan, and $4,000 for the premium on term life insurance; (ii) in the case of Messrs. Hardy, Youner, Eichen and Traub $9,000, $9,000, $7,000 and $6,000, respectively, for the Company's matching contribution to a profit sharing thrift plan; and (iii) $2,000 each for Messrs. Hardy, Youner and Eichen for the premium on term life insurance. COMPENSATION AGREEMENT Pursuant to an Agreement entered into in March 1994 (the "New Agreement"), the Company and Thomas G. Hardy modified and superseded a bonus arrangement entered into on January 15, 1988, as amended (the "Old Agreement"), under which no payments had been made. The Old Agreement provided for a payment upon termination of Mr. Hardy's employment in an amount equal to 2% of the Company's average annual after-tax consolidated net income (as defined) available to the common stockholders for the three years ending on December 31st of the year immediately prior to the termination of Mr. Hardy's employment, multiplied by either the multiple of the market price to such net income of the Company's common stock if it is publicly traded or, if the Company's common stock continues to be privately held at the time of such termination, by a multiple of eleven. Pursuant to the New Agreement, the Company is required to irrevocably deposit in trust for the benefit of Mr. Hardy an aggregate of $2,800,000, of which $1,400,000 was deposited upon execution of the New Agreement, with the remaining $1,400,000 to be deposited in 1996 (or under certain circumstances, including a change in control of the Company, earlier). The deposited funds are held by the trustees under a Trust Agreement (the "Trust Agreement"), which provides that the assets held thereunder are subject to the claims of the Company's general creditors in the event of insolvency of the Company. The Trust Agreement provides that the assets are payable in a lump sum to Mr. Hardy or his beneficiaries upon the earlier of December 1, 2001 or the termination of his employment with Company. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Board of Directors does not have a Compensation Committee. Executive officer compensation matters were determined by the Board of Directors, whose four members currently include Mr. Genger, Chairman of the Board and Chief Executive Officer of the Company, and Mr. Hardy, President and Chief Operating Officer of the Company. COMPENSATION OF DIRECTORS Officers of the Company who serve as directors do not receive any compensation for serving as directors. Martin A. Coleman and Sash A. Spencer each receive $15,000 annually for serving as directors. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. The following table sets forth certain information as of March 23, 1994, as to the beneficial ownership of the Common Stock of the Company, which is the only outstanding class of voting security of the Company: ___________________ (1) All of the shares of the Common Stock of the Company are pledged to secure an outstanding TPR note of $7,000,000 issued to a former indirect stockholder and director of the Company. (2) Mr. Genger and members of his family own all of the capital stock of TPR. ITEM 13. ITEM 13. Certain Relationships and Related Transactions. The Company is, for Federal income tax purposes, a member of a consolidated tax group of which TPR is the common parent. The Company, TPR, Eddy, Cedar and certain other subsidiaries are parties to a tax sharing agreement, dated as of December 30, 1991, under which, among other things, the Company and such other parties have each agreed to pay TPR amounts equal to the amounts of Federal income taxes that each such party would be required to pay if it filed a Federal income tax return on a separate return basis (or in the case of Cedar, a consolidated Federal income tax return for itself and its eligible subsidiaries), computed without regard to net operating loss carrybacks and carryforwards. However, TPR may, at its discretion, allow tax benefits for such losses. See Note A of Notes to Consolidated Financial Statements. See Item 3 - "Legal Proceedings" for a description of the proposed settlement of an action brought by Grassgreen as debtor in his personal bankruptcy proceeding, which will result in, among other things, TPR acquiring the Company's outstanding $9,000,000, 9 1/2% junior subordinated debenture due 2005 and becoming the obligor on an outstanding 8 3/4%, $4,000,000 note due 2005 (which is secured by the $9,000,000 debenture) payable to the Company. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) (1)-(2) See Index to Consolidated Financial Statements and Schedules on Page. (3) See Index to Exhibits on Page E-1. Management contracts or compensatory plans and arrangements required to be filed as exhibits are as follows: (i) Agreement between the Company and Thomas G. Hardy, dated March 22, 1994, concerning incentive bonus compensation, including, as Exhibit A thereto, the related Trust Agreement. (ii) Split Dollar Insurance Agreement, entered into as of August 26, 1988, between the Company and Arie Genger. (b) No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. Trans-Resources, Inc. (Registrant) By LESTER W. YOUNER Lester W. Youner Vice President, Treasurer and Chief Financial Officer 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 DATE INDICATED: PRINCIPAL EXECUTIVE OFFICER: ARIE GENGER Chairman of the Board and Chief Executive Officer PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER: LESTER W. YOUNER Vice President, Treasurer and Chief Financial Officer By LESTER W. YOUNER Lester W. Youner For Himself and As Attorney-In-Fact Directors: Arie Genger Thomas G. Hardy Dated: March 23, 1994 Martin A. Coleman Sash A. Spencer ORIGINAL POWERS OF ATTORNEY AUTHORIZING LESTER W. YOUNER TO SIGN THIS REPORT AND ANY AMENDMENTS HERETO ON BEHALF OF THE PRINCIPAL EXECUTIVE OFFICER AND THE DIRECTORS ARE BEING FILED WITH THE SECURITIES AND EXCHANGE COMMISSION WITH THIS REPORT. 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 or proxy materials have been sent to the Company's security holders. This Annual Report on Form 10-K will be furnished to the holders of the Company's 11 7/8% Notes and Reset Notes. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Certain schedules, other than as listed above, are omitted because of the absence of the conditions under which they are required or because the information required therein is set forth in the financial statements or the notes thereto. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholder of Trans-Resources, Inc. New York, New York We have audited the accompanying consolidated financial statements and financial statement schedules of Trans-Resources, Inc. (a wholly-owned subsidiary of TPR Investment Associates, Inc.) and Subsidiaries listed in the foregoing Index. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We did not audit the consolidated financial statements of Cedar Chemical Corporation, a wholly-owned subsidiary, which statements reflect total assets constituting 26 percent and 27 percent of consolidated total assets as of December 31, 1993 and 1992, respectively, and total revenues constituting 35 percent, 35 percent and 32 percent of consolidated total revenues for the years ended December 31, 1993, 1992 and 1991, respectively. Such financial statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Cedar Chemical Corporation, is based solely on the report of such other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based upon our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Trans-Resources, 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. Also, in our opinion, based on our audits and the report of other auditors, 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 A to the Consolidated Financial Statements, the Company changed its method of accounting for income taxes during the year ended December 31, 1992. Deloitte & Touche New York, New York March 16, 1994 Report of Independent Accountants To the Board of Directors and Shareholder of Cedar Chemical Corporation: In our opinion, the consolidated balance sheets and the related consolidated statements of income and retained earnings and of cash flows (not presented separately herein) present fairly, in all material respects, the financial position of Cedar Chemical Corporation (a wholly-owned subsidiary of Trans-Resources, Inc.) and its subsidiaries ("Cedar") at December 31, 1992 and 1993, and the 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. These financial statements are the responsibility of Cedar'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. Price Waterhouse Memphis, Tennessee February 11, 1994 TRANS-RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. TRANS-RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1991, 1992 and 1993 See notes to consolidated financial statements. TRANS-RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDER'S EQUITY For the Years Ended December 31, 1991, 1992 and 1993 See notes to consolidated financial statements. TRANS-RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1991, 1992 and 1993 See notes to consolidated financial statements. TRANS-RESOURCES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements of Trans-Resources, Inc. ("TRI" or the "Company"), include the Company and its subsidiaries, after elimination of intercompany accounts and transactions. The Company's principal subsidiaries are Cedar Chemical Corporation ("Cedar"), and Cedar's two wholly-owned subsidiaries -New Mexico Potash Corporation ("NMPC") and Vicksburg Chemical Company ("Vicksburg"); Eddy Potash, Inc. ("Eddy"); and Haifa Chemicals Ltd. ("HCL") and HCL's wholly-owned subsidiary, Haifa Chemicals South, Ltd. ("HCSL"). The Company is a wholly-owned subsidiary of TPR Investment Associates, Inc. ("TPR"). Substantially all of the companies' revenues, operating profits and identifiable assets are related to the chemical industry. The Company is a multinational manufacturer of specialty plant nutrients, organic chemicals, industrial chemicals and potash and distributes its products internationally. The Company is the world's largest producer of potassium nitrate, and the world's largest producer of propanil, the leading rice herbicide, and is the largest United States producer of potash. Operating Data The Company's revenues by region for the years ended December 31, 1991, 1992 and 1993 are set forth below: As of December 31, 1992 and 1993, the Company's assets were located in the United States (44% and 49%, respectively) and abroad (principally Israel) (56% and 51%, respectively). The Company has no single customer accounting for more than 10% of its revenues. Contracts and Revenue Recognition Under the terms of a long-term U.S. Government contract for the manufacture of an industrial chemical, revenues are recognized ratably for the duration of the contract and billings are rendered as product is shipped. Current deferred revenue of $2,772,000 at December 31, 1992 and 1993 and non-current deferred revenue of $5,416,000 and $2,645,000 at December 31, 1992 and 1993, respectively, represent billings in excess of revenues recognized under the contract. Such current and non-current amounts are classified within "accrued expenses and other current liabilities" and "other liabilities", respectively, in the accompanying Consolidated Balance Sheets. Functional Currency and Transaction Gains and Losses Approximately 90% of HCL's sales are made outside of Israel in various currencies, of which approximately 35% are in U.S. dollars, with the remainder principally in Western European currencies. The Company has a policy of hedging contracted foreign sales denominated in Western European currencies against fluctuations in the U.S. dollar rates of exchange. Accordingly, the Company has entered into forward exchange contracts. At December 31, 1992 and 1993, there were outstanding contracts to purchase $166 million and $167 million, respectively, in various European currencies, principally Deutsche Marks. In addition, at December 31, 1993 there were outstanding contracts to sell $56 million in various Western European currencies, principally Deutsche Marks. Unrealized gains and losses arising from forward exchange contracts which qualify as hedges pursuant to Statement of Financial Accounting Standards No. 52 have been deferred and are accounted for in the subsequent year as part of sales. Gains of approximately $3,900,000 and $2,400,000 were deferred at December 31, 1992 and 1993, respectively, for forward exchange contracts which qualify as hedges. During the years ended December 31, 1991, 1992 and 1993, the Company recorded a gain of approximately $3,100,000, a loss of approximately $7,000,000 and a gain of approximately $6,100,000, respectively, relating to foreign currency transactions. Raw materials purchased in Israel are mainly quoted at prices linked to the U.S. dollar. The U.S. dollar is the functional currency and accordingly the financial statements of HCL are prepared, and the books and records of HCL (except for a subsidiary described below) are maintained, in U.S. dollars. The assets, liabilities and operations of one of HCL's foreign subsidiaries are measured using the currency of the primary economic environment in which the subsidiary operates. Assets and liabilities are translated at the exchange rate as of the balance sheet date. Revenues, expenses, gains and losses are translated at the weighted average exchange rate for the period. Translation adjustments, resulting from the process of translating such subsidiary's financial statements from its currency into U.S. dollars, are recorded directly as a separate component of stockholder's equity. Exchange Rate Insurance In 1981, HCL joined a program of exchange rate insurance of the Israeli Government designed to protect participating Israeli exporters from losses resulting from the widening of the gap between the inflation rate in Israel and the rate of devaluation of the New Israeli Shekel against a weighted basket of currencies of Israel's major trading partners. The net benefits received by HCL for the years ended December 31, 1991, 1992 and 1993 were $4,599,000, $4,056,000 and $1,616,000, respectively, which benefits have been included in revenues. As part of various economic measures adopted in Israel subsequent to December 31, 1988, the Israeli Government has gradually reduced the insurance proceeds granted under its program of exchange rate insurance, with the program having been fully eliminated on August 31, 1993. Inventories Inventories are carried at the lower of cost or market. Cost is determined on the first-in, first-out method. Property, Plant and Equipment Property, plant and equipment are carried at cost. Depreciation is recorded under the straight-line method at generally the following annual rates: Expenditures for maintenance and repairs are charged to expense as incurred. Investment grants from the Israeli Government are initially recorded as a reduction of the capitalized asset and are recognized in income over the estimated useful life of the respective asset. HCL recorded investment grants for the years ended December 31, 1991, 1992 and 1993 amounting to $4,029,000, $846,000 and $10,952,000, respectively. Effective January 1, 1992 and 1993, Eddy revised the estimate of depreciable lives of its property, plant and equipment to more closely approximate the economic lives of those assets. The effect of these changes in estimate was to decrease depreciation expense in 1992 and 1993 by approximately $960,000 and $630,000, respectively. Non-Current Investments In Marketable Securities The Company carries its investments in marketable equity securities at the lower of cost or market. To the extent that the quoted market value is less than cost, an unrealized loss on marketable equity securities would be recorded and classified as a reduction of common stockholder's equity. At December 31, 1992 and 1993 the aggregate quoted market value of the marketable equity securities owned by the Company exceeded the aggregate cost. The Company's other investments (principally short-term investments) are carried at cost. Should declines in the carrying value of any of these securities (as well as the marketable equity securities described above) be considered to be other than temporary, such declines are recognized by an appropriate charge in the Consolidated Statements of Operations. 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"). The adoption of this Statement, which is not required until 1994, will require the Company to classify its equity and fixed maturity securities as available-for-sale and reported at fair value, with unrealized gains and losses included as a separate component of stockholder's equity. The adoption of SFAS No. 115 is not expected to have a material effect on the Company's consolidated financial position or results of operations. Income Taxes The Company is included in the consolidated Federal income tax return of TPR. Under the tax allocation agreement entered into with TPR in 1991, the annual current Federal income tax liability for the Company and each of its domestic subsidiaries reporting profits is determined as if such entity had filed a separate Federal income tax return; no tax benefits are given for companies reporting losses. However, TPR may, at its discretion, allow tax benefits for such losses. For purposes of the consolidated financial statements, taxes on income have been computed as if the Company and its domestic subsidiaries filed its own consolidated Federal income tax return without regard to the tax allocation agreement. Payments to TPR, if any, representing the excess of amounts determined under the tax allocation agreement over amounts determined for the purposes of consolidated financial statements have been charged to retained earnings. Effective January 1, 1992, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires a change from the deferred method to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Under SFAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The Company has reported the cumulative effect on prior years of the change in the method of accounting for income taxes as of the beginning 1992 in the Consolidated Statement of Operations. The effect of adopting SFAS 109 in 1992 was to decrease net income by approximately $1,170,000, representing an increased income tax provision of $2,300,000 and an increase in income for the cumulative effect of the change in accounting principle of $1,130,000. Research and Development Costs Research and development costs are charged to expense as incurred and amounted to $2,860,000, $2,945,000 and $3,206,000 for the years ended December 31, 1991, 1992 and 1993, respectively. Statements of Cash Flows Investments with original maturities of three months or less are classified as cash equivalents by the Company. Reclassifications Certain prior year amounts have been reclassified to conform to the manner of presentation in the current year. B. OTHER CURRENT ASSETS Other current assets consist of the following at December 31, 1992 and 1993: C. INVENTORIES Inventories consist of the following at December 31, 1992 and 1993: D. PROPERTY, PLANT AND EQUIPMENT - NET Property, plant and equipment at December 31, 1992 and 1993 consists of the following: The Company, through HCSL, is in the process of expanding its production capacity by constructing a new facility in Israel to produce annually approximately 100,000 metric tons of potassium nitrate and 15,000 metric tons of phosphoric acid. The new plant is anticipated to cost approximately $88,000,000 and construction commenced in the second quarter of 1993. The Company expects to receive from the Government of Israel an aggregate investment grant of approximately $32,000,000 and contributions for infrastructure of approximately $5,000,000, so that the Company's net investment in the new plant is anticipated to be approximately $51,000,000. The Company incurred capital expenditures for the new plant during 1993 (net of investment grants) of approximately $16,000,000. Plant production is planned to start in late 1994. The capacity of the new plant may be expanded in subsequent years. The Company capitalized interest costs aggregating $144,000, $200,000 and $352,000 during the years ended December 31, 1991, 1992 and 1993, respectively, with respect to the financing of several construction projects. Certain property, plant and equipment has been pledged as collateral for long-term debt - see Note H. In September 1991, a unit within one of two production lines located in the Company's Israeli manufacturing facility was damaged by a fire. Such damage resulted in a temporary reduction of the Company's phosphoric acid production capacity. Costs of replacement of the damaged assets have been reimbursed by insurers. Insurance proceeds exceeded the recorded carrying value of the damaged assets by approximately $10 million. Accordingly, a gain has been recorded in that amount - see Note L. The effect of business interruption was likewise covered by insurers and the related compensation received has been reflected in the accompanying Consolidated Statements of Operations. See Note P to Consolidated Financial Statements. E. INVESTMENTS IN SECURITIES Investments in securities consist of the following at December 31, 1992 and 1993: During the years ended December 31, 1991, 1992 and 1993 the Company recorded net gains (losses) relating to investments in securities in the caption "interest and other income - net" in the Consolidated Statements of Operations (see Note L) in the amounts of $(30,000), $2,865,000 and $2,261,000, respectively. In March 1992, the Company purchased from a former indirect stockholder and director of the Company a 30% limited partnership interest in American Recreation Group, a New York limited partnership ("ARG"). The purchase price for the 30% limited partnership interest was $7,500,000. In March 1992, in open market purchases, the Company acquired approximately $11,000,000 principal amount of Riviera, Inc. ("Riviera") Floating Rate First Mortgage Notes (the "Riviera Notes"). The Riviera Notes were purchased at a cost of approximately $5,100,000. The above-mentioned former indirect stockholder and director of the Company was the sole owner of the capital stock of Riviera. In September 1992, the Company sold its investments in both ARG and the Riviera Notes for an aggregate of $14,500,000 (of which $10,000,000 was received in October, 1992, and the balance was received during January, 1993) and recognized a gain of approximately $1,900,000. Shortly after the receipt of the respective sale proceeds, the Company dividended these amounts to TPR. F. SHORT-TERM DEBT The weighted average interest rates and weighted average amounts of short-term debt outstanding during the years ended December 31, 1991, 1992 and 1993 were 10.6% and $7,921,000; 7.7% and $10,235,000; and 6.7% and $14,066,000, respectively. The highest amount owed during such years were $14,786,000, $15,163,000 and $22,481,000, respectively. The average amount outstanding was determined by the average of month-end balances. The weighted average interest rate was determined by dividing interest expense on short-term debt by the average amount outstanding during the year. Cedar has a revolving loan commitment from two banks aggregating $25,000,000 for 1993 (approximately $3,000,000 unused at December 31, 1993) and $28,000,000 and $33,000,000 for 1994 and 1995, respectively. HCSL has a $10,000,000 revolving loan commitment from two banks through December 31, 1997, which permits borrowings commencing January 1, 1995. G. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities consist of the following at December 31, 1992 and 1993: H. LONG-TERM DEBT - NET Long-term debt consists of the following at December 31, 1992 and 1993: ____________________ * As prevailing on respective balance sheet dates. Such rates (other than the subordinated debt) generally "float" according to changes in the Prime or LIBOR rates. At December 31, 1993 such rates were approximately 6.0% and 3.5%, respectively. 1. On February 26, 1988, the Company entered into a loan agreement with a bank, pursuant to which the Company borrowed $12,000,000. Subsequently, such agreement was amended and the Company borrowed an additional $700,000. One-half of the outstanding principal amount of the loans is due on February 28, 1994 and the balance is due on February 28, 1995. 2. The senior subordinated debentures (the "Debentures") were redeemable at the option of the Company at any time after May 1, 1992 at stipulated redemption prices. As described below, on March 30, 1993, the Company privately placed $115,000,000 principal amount of 11 7/8% Senior Subordinated Notes due 2002, Series A (the "11 7/8% Notes"). The Company used a portion of the net proceeds from the issuance of the 11 7/8% Notes to acquire all of the Company's $60,997,000 then outstanding principal amount of the Debentures. 3. The Senior Subordinated Reset Notes (the "Reset Notes") bear interest at 14.5% and mature on September 30, 1996. The Reset Notes are not subject to any mandatory sinking fund requirement. 4. On March 30, 1993, the Company privately placed $115,000,000 principal amount of the 11 7/8% Notes at 99% of principal amount (the "Offering"). The net proceeds to the Company from the Offering were approximately $109,700,000. Approximately $24,200,000 of such proceeds were used to acquire $21,500,000 principal amount of the Company's Reset Notes. In addition, approximately $63,900,000 of the proceeds were used in May, 1993 to acquire all of the Company's $60,997,000 then outstanding principal amount of the Debentures through utilization of the applicable sinking fund and optional redemption provisions of the Debentures. As a result of the redemptions and purchases described above, as well as the Company's acquisition of $4,500,000 principal amount of the Debentures in January 1993, the Company has recorded an extraordinary loss of $8,830,000 during 1993, including the write-off of applicable deferred debt issuance costs. Such loss has no current tax benefit. On May 6, 1993, to satisfy its obligations with respect to the registration of the 11 7/8% Notes, the Company commenced an offer (the "Exchange Offer") to exchange up to $115,000,000 principal amount of its registered 11 7/8% Senior Subordinated Notes due 2002, Series B (the "New 11 7/8% Notes") for a like principal amount of the 11 7/8% Notes. The terms of the 11 7/8% Notes and the New 11 7/8% Notes were identical in all material respects. Pursuant to the Exchange Offer, which expired on June 9, 1993, all outstanding 11 7/8% Notes were tendered and exchanged for New 11 7/8% Notes. The New 11 7/8% Notes mature on July 1, 2002 and are redeemable at the option of the Company at any time after July 1, 1998 at stipulated redemption prices. There are no mandatory sinking fund requirements. 5. On November 28, 1986, the Company issued the junior subordinated debentures (the "9.5% Debentures") in the aggregate principal amount of $9,000,000, with interest payable from October 1, 1987 and quarterly thereafter. Such 9.5% Debentures were initially recorded at $6,700,000, the estimated value on the date of issue, and mature in 1998. During 1991, as described in Note M, the Company's redeemable preferred stock was converted into $9,000,000 principal amount of the Company's 9.5% Debentures. Subsequently, during 1991, the then holder of this $9,000,000 principal amount of 9.5% Debentures agreed to extend the maturity date of such principal amount by seven years to the year 2005. The carrying value of the 9.5% Debentures issued upon conversion of the redeemable preferred stock was equivalent to the previous carrying value of the preferred stock. 6. Industrial Revenue Bond financing permits an $11,250,000 term loan commitment in connection with the construction of a new plant in Vicksburg. As of December 31, 1993, $495,000 was outstanding relating to such facility. In addition, as of December 31, 1993 certain subsidiaries of the Company have unused bank credit lines of approximately $37,000,000. Such credit lines permit borrowings through December 31, 1995. Any amounts borrowed must be repaid over a ten year period ending in the year 2005. The Reset Notes are pari passu with the New 11 7/8% Notes and are subordinated in right of payment to all Senior Indebtedness (as defined) of the Company and senior to the 9.5% Debentures. Certain of the Company's and its subsidiaries' loan agreements and Indentures require the Company and/or the respective subsidiary to, among other things, maintain various financial ratios including minimum net worth, ratios of debt to net worth, interest and fixed charge coverage tests and current ratios. In addition, there are certain limitations on the Company's ability make certain Restricted Payments and Restricted Investments (each as defined), etc. The Company is also required to offer to purchase a portion of the New 11 7/8% Notes and the Reset Notes if it fails to maintain minimum amounts of Junior Subordinated Capital (as defined). In the event of a Change in Control (as defined), the Company is required to offer to purchase all the New 11 7/8% Notes and Reset Notes as well as to repay certain bank loans. Certain of the respective instruments also limit the payment of dividends, capital expenditures and the incurring of additional debt and liens. As of December 31, 1993, the Company and its subsidiaries are in compliance with the covenants of each of the respective loan agreements and Indentures. The aggregate maturities of long-term debt are set forth below. Substantially all of the assets of HCL are subject to security interests in favor of the State of Israel and/or banks. In addition, substantially all of Cedar's, Vicksburg's and NMPC's assets are subject to security interests in favor of banks pursuant to loan agreements. The capital stock of HCL, Cedar, Vicksburg and NMPC has also been pledged to the banks pursuant to these agreements. The Company's common stock is pledged to secure the repayment obligations of TPR under a note issued by it to a former indirect shareholder of the Company. During 1991, the Company acquired $10,153,000 principal amount of Debentures and Reset Notes, at a cost of $8,127,000, resulting in a net gain (pre-tax) to the Company, after the elimination of certain deferred costs, of $1,482,000. Such gain is reported as an extraordinary item in the accompanying Consolidated Statement of Operations. Interest paid on the long-term debt obligations, net of capitalized interest, totaled $30,136,000, $26,386,000 and $21,852,000 for the years ended December 31, 1991, 1992 and 1993, respectively. I. OTHER LIABILITIES Under Israeli law and labor agreements, HCL is required to make severance and pension payments to dismissed employees and to employees leaving employment in certain other circumstances. These liabilities are covered by regular deposits to various severance pay funds and by payment of premiums to an insurance company for officers and non-factory personnel under approved plans. "Other liabilities" in the Consolidated Balance Sheets as of December 31, 1992 and 1993 include accruals of $2,097,000 and $2,116,000, respectively, for the estimated unfunded liability of complete severance of all HCL employees. Cost incurred was approximately $2,531,000, $1,673,000 and $1,857,000 for the years ended December 31, 1991, 1992 and 1993, respectively. No information is available regarding actuarial present value of HCL's pension plans and the plans' net assets available for benefits, as these plans are multi-employer, external and independent of HCL. Cedar has a defined benefit pension plan which covers all of the full-time employees of Cedar and Vicksburg. Funding of the plan is made through payment to various funds managed by a third party and is in accordance with the funding requirements of the Employee Retirement Income Security Act of 1974 ("ERISA"). Cedar's net pension cost for the years ended December 31, 1991, 1992 and 1993 included the following benefit and cost components: The funded status and the amounts recognized in the Company's December 31, 1992 and 1993 Consolidated Balance Sheets for Cedar's benefit plan is as follows: At December 31, 1992 and 1993 the actuarial present value of Cedar's vested benefit obligation was $6,036,000 and $7,115,000 and the accumulated benefit obligation was $6,329,000 and $7,533,000, respectively. Actuarial assumptions used at December 31, 1992 and 1993 were as follows: The unrecognized net transition obligation is being amortized on a straight-line basis over fifteen years beginning January 1, 1987. Cedar and its subsidiaries and Eddy have profit sharing thrift plans designed to conform to Internal Revenue Code Section 401(k) and to the requirements of ERISA. The plans, which cover all full-time employees (and one of which includes Company headquarters employees), allow participants to contribute as much as 15% of their annual compensation, up to a maximum permitted by law, through salary reductions. The companies' contributions to the plans are based on a percentage of the participant's contributions, and the companies may make additional contributions to the plans at the discretion of their respective Boards of Directors. The contribution expense relating to the profit sharing thrift plans totaled $631,000, $653,000 and $595,000 for the years ended December 31, 1991, 1992 and 1993, respectively. J. COMMITMENTS AND CONTINGENCIES Operating Leases The Company and its subsidiaries are obligated under non-cancelable operating leases covering principally land and office facilities. At December 31, 1993, minimum annual rental commitments under these leases are: Rent expense for 1991, 1992 and 1993 was $3,154,000, $3,637,000 and $3,835,000, respectively, covering land, office facilities and equipment. Purchase Commitment HCL has an agreement for the purchase of potash which expires in 1999. The terms of the agreement require HCL to purchase a minimum quantity at the weighted average of the FOB Israeli port prices received by the seller for the immediately preceding quarter plus certain adjustments thereto. Based upon current prices and at current capacity, the annual commitment is approximately $15,000,000. There are currently no purchase commitments in excess of market prices. K. INCOME TAXES The Company's income tax provision for the years ended December 31, 1991, 1992 and 1993 consist of the following: Deferred income taxes (benefits) included in the Company's income tax provision consisted of the following: The provision for income taxes for the years ended December 31, 1991, 1992 and 1993 amounted to $2,582,000, $11,231,000 and $7,920,000, respectively, representing effective income tax rates of 12.7%, 48.3% and 72.1%, respectively. These amounts differ from the amounts of $6,890,000, $7,905,000 and $3,845,000, respectively, computed by applying the statutory Federal income tax rates to income before income taxes. The reasons for such variances from statutory rates were as follows: At December 31, 1992 and 1993, deferred taxes (liabilities) consisted of the following: At December 31, 1992, deferred tax assets of $2,382,000 are classified as "other current assets" and deferred tax liabilities of $13,878,000 are classified as "other liabilities". At December 31, 1993, deferred tax assets of $2,100,000 are classified as "other current assets" and deferred tax liabilities of $13,276,000 are classified as "other liabilities". At December 31, 1993, the Company had various tax loss and credit carryovers which expire as follows: Income tax has not been provided on unrepatriated earnings of HCL as it is the intention of the Company to reinvest such foreign earnings for indefinite periods in HCL's operations. The cumulative amount of such unrepatriated earnings at December 31, 1993 approximates $38 million. Income taxes paid totalled approximately $3,300,000, $7,800,000 and $11,600,000, respectively, during the years ended December 31, 1991, 1992 and 1993. The amount paid for 1991 excludes an Israeli tax refund received by HCL relating to prior years amounting to $7,100,000. L. INTEREST AND OTHER INCOME - NET Interest and other income - net for the years ended December 31, 1991, 1992 and 1993 consists of the following: M. REDEEMABLE PREFERRED STOCK Redeemable preferred stock was issued to a then related party, Care Investors, Inc., on November 28, 1986. The dividend on the preferred stock was cumulative at the rate of $9.50 per share per annum and the preferred stock was convertible into 9.5% junior subordinated debentures due 1998, at the option of the Company or the holder. The preferred shares were initially recorded at $6,700,000, the estimated value on the date of issue. During January 1991 the preferred stock was converted into $9,000,000 principal amount of the Company's 9.5% junior subordinated debentures (see Note H). N. FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments." The estimated fair value amounts have been determined by the Company, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Cash and Cash Equivalents, Accounts Receivable, Short-Term Debt, and Accounts Payable - The carrying amounts of these items are a reasonable estimate of their fair value. Investments in Securities - The fair value of these securities (including short-term investments classified within "other current assets" in the accompanying Consolidated Balance Sheets) are estimated based on quoted market prices or recent sales for those or similar investments. Long-Term Debt - Interest rates that are currently available to the Company for issuance of debt with similar terms and remaining maturities are used on a discounted cash flow basis to estimate fair value for debt issues for which no market quotes are available. Foreign Currency Contracts - The fair value of foreign currency contracts (used for hedging purposes) is estimated by obtaining quotes from brokers. The contractual amount of these contracts totals approximately $67,000,000 and $35,000,000 as of December 31, 1992 and 1993, respectively. 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. O. CONTINGENT LIABILITIES For a description of certain legal proceedings pending against the Company, see Item 3 - "Legal Proceedings", which is an integral part of these financial statements. The Company is vigorously defending against the allegations described therein. Management of the Company believes, based upon its assessment of the actions and claims outstanding against the Company and certain of its subsidiaries, and after discussion with counsel, that the eventual disposition of the matters referred to above should not have a material adverse effect on the financial position or future operations of the Company. Also see "Environmental Matters" in Item 1 - "Business". P. SUBSEQUENT EVENTS On January 27, 1994, HCL filed a registration statement with the Israeli Securities Authority (the "ISA") pursuant to which HCL would publicly offer in Israel, in an underwritten offering, units consisting of (i) shares of HCL common stock (the "HCL Shares") and (ii) options exercisable for HCL Shares. The terms of the proposed offering have not been finalized, and there can be no assurance that the ISA will declare the offering effective or that the offering will be consummated (considering, among other things, prevailing stock market conditions in Israel). If the proposed offering is consummated, the Company has determined that it would maintain beneficial ownership of not less than 90% of the HCL Shares upon issuance of the units and not less than 80% on a fully diluted basis. The Company anticipates that the net proceeds to be realized for the HCL Shares in the proposed offering, if consummated, would be substantially in excess of the Company's corresponding carrying value for the equity interest represented by such shares. The net proceeds of the proposed offering may be used for any purpose authorized by the Board of Directors of HCL, including, without limitation, internal growth or the acquisition of new businesses. HCL does not currently have any agreements, commitments or understandings for acquiring any particular businesses and does not anticipate using any of the net proceeds to finance the construction of the K3 Plant. On February 7, 1994, the smaller of the two potassium nitrate production units located in the Company's Haifa, Israel manufacturing facility was damaged by a fire, causing a temporary reduction of the Company's potassium nitrate production capacity. The Company is currently reviewing various alternatives concerning the most effective and timely replacement of the damaged production unit and expects to replace the damaged unit within approximately twelve months. The Company believes that the impact of the loss of the facility, including the effect of business interruption, will be substantially covered by insurance. While the ultimate amount of the insurance recovery has not yet been determined, the Company expects that the insurance proceeds relating to the property damage will be for replacement value, which substantially exceeds the recorded carrying value of the damaged assets. CONDENSED FINANCIAL INFORMATION OF REGISTRANT SCHEDULE III TRANS-RESOURCES, INC. BALANCE SHEETS ____________________ Note - The aggregate maturities of long-term debt during the next five years is approximately as follows: 1994 - $9,810,000; 1995 - $9,810,000; 1996 - $30,210,000; 1997 - $3,460,000 and 1998 - $9,000,000. Also, see Note H of Notes to Consolidated Financial Statements. S-1 CONDENSED FINANCIAL INFORMATION OF REGISTRANT SCHEDULE III (continued) TRANS-RESOURCES, INC. STATEMENTS OF OPERATIONS For the Years Ended December 31, 1991, 1992 and 1993 S-2 CONDENSED FINANCIAL INFORMATION OF REGISTRANT SCHEDULE III (concluded) TRANS-RESOURCES, INC. STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1991, 1992 and 1993 S-3 TRANS-RESOURCES, INC. SCHEDULE V PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (in thousands) S-4 TRANS-RESOURCES, INC. SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (in thousands) S-5 TRANS-RESOURCES, INC. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (in thousands) S-6 TRANS-RESOURCES, INC. INDEX TO EXHIBITS E-1 E-2 ____________________ * Incorporated by reference E-3

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1993

92195

Item 1. BUSINESS GENERAL Southern Indiana Gas and Electric Company (Company) is an operating public utility incorporated June 10, 1912, under the laws of the State of Indiana, engaged in the generation, transmission, distribution and sale of electric energy and the purchase of natural gas and its transportation, distribution and sale in a service area which covers ten counties in southwestern Indiana. The Company has a wholly-owned nonutility investment subsidiary, Southern Indiana Properties, Inc. (refer to Note 3 of the Notes To Consolidated Financial Statements, page 35, for further discussion). Electric service is supplied directly to Evansville and 74 other cities, towns and communities, and adjacent rural areas. Wholesale electric service is supplied to an additional nine communities. At December 31, 1993, the Company served 118,163 electric customers, and was also obligated to provide for firm power commitments to the City of Jasper, Indiana, and to maintain spinning reserve margin requirements under an agreement with the East Central Area Reliability Group (ECAR). At December 31, 1993, the Company supplied gas service to 100,398 customers in Evansville and 63 other nearby communities and their environs. Since 1986, the Company has purchased its natural gas supply requirements from numerous suppliers. During 1993, twenty-five suppliers were used; however, Texas Gas Transmission Corporation (TGTC) remained the Company's primary contract supplier. In November 1993, TGTC restructured its services so that its gas supplies are sold separately from its interstate transportation services. TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See subsequent reference under "Gas Business" to the restructuring of interstate pipelines.) During 1993, eighteen of the Company's major gas customers took advantage of the Company's gas transportation program to procure a portion of their gas supply needs from suppliers other than the Company. The principal industries served by the Company include aluminum smelting and recycling, aluminum sheet products, polycarbonate resin (Lexan) and plastic products, appliance manufacturing, pharmacuetical and nutritional products, automotive glass, gasoline and oil products, and coal mining. The only property the Company owns outside of Indiana is approximately eight miles of 138,000 volt electric transmission line which is located in Kentucky and which interconnects with Louisville Gas and Electric Company's transmission system at Cloverport, Kentucky. The original cost of the property is less than $425,000. The Company does not distribute any electric energy in Kentucky. LINES OF BUSINESS The percentages of operating revenues and operating income before income taxes attributable to the electric and gas operations of the Company for five years ended December 31, 1993, were as follows: ELECTRIC BUSINESS The Company supplies electric service to 118,163 customers, including 103,318 residential, 14,645 commercial, 177 industrial, 19 public street and highway lighting and four municipal customers. The Company's installed generating capacity as of December 31, 1993 was rated at 1,238,000 kilowatts (Kw). Coal-fired generating units provide 1,023,000 Kw of capacity and gas or oil-fired turbines used for peaking or emergency conditions provide 215,000 Kw. In addition, the Company has interconnections with Louisville Gas and Electric Company, Public Service Company of Indiana, Inc., Indianapolis Power & Light Company, Hoosier Energy Rural Electric Cooperative, Inc., Big Rivers Electric Corporation, and the City of Jasper, providing an ability to simultaneously interchange approximately 750,000 Kw. Record-breaking peak conditions occurred on July 28, 1993, when the Company's system summer peak load of 1,012,700 Kw was 6.5% greater than the previous record system summer peak load of 951,200 Kw established August 17, 1988. The Company's total load obligation for each of the years 1989 through 1993 at the time of the system summer peak, and the related capacity margin, are presented below. The Company's other load obligations at the time of the peak included firm power commitments to Alcoa Generating Corporation (AGC) except as noted, the City of Jasper, Indiana, and the Company's reserve margin requirements under the ECAR agreement. The all-time record system winter peak load of 771,900 Kw occurred during the 1989-1990 season on December 22, 1989, and was 10.8% greater than the 1992-1993 winter season system peak (the second highest winter peak) reached on February 18, 1993 at 696,800 Kw. The Company, primarily as agent of AGC, operates the Warrick Generating Station, a coal-fired steam electric plant which interconnects with the Company's system and provides power for the Aluminum Company of America's Warrick Operations, which includes aluminum smelting and fabricating facilities. Of the four turbine generators at the plant, Warrick Units 1, 2 and 3, with a capacity of 144,000 Kw each, are owned by AGC. Warrick Unit 4, with a rated capacity of 270,000 Kw, is owned by the Company and AGC as tenants in common, each having shared equally in the cost of construction and sharing equally in the cost of operation and in the output. The Company (a summer peaking utility) has an agreement with Hoosier Energy Rural Electric Cooperative, Inc. (Hoosier Energy) for the sale of firm power to Hoosier Energy during the annual winter heating season (November 15- March 15). The contract made available 100 Mw during the 1993-1994 winter season, and allows for a possible increase to 250 Mw by November 15, 1998. The contract will terminate March 15, 2000. Electric generation for 1993 was fueled by coal (99.8%) and natural gas (.2%). Oil was used only to light fires and stabilize flames in the coal-fired boilers and for testing of gas/oil fired peaking units. Historically, coal for the Company's Culley Generating Station and Warrick Unit 4 has been purchased from operators of nearby Indiana strip mines pursuant to long-term contracts. During 1991, the Company pursued negotiations for new contracts with these mine operators and while doing so, purchased coal from the respective operators under interim agreements. In October 1992, the Company finalized a new supply agreement effective through 1995 and retroactive to 1991, with one of the operators under which coal is supplied to both locations. Included in the agreement was a provision whereby the contract could be reopened by the Company for modification of certain coal specifications. In early 1993, the Company reopened the contract for such modifications. Effective July 1, 1993, the Company bought out the remainder of its contractual obligations with the supplier, enabling the Company to acquire lower priced spot market coal. The Company estimates the savings in coal costs during the 1991-1995 period, net of the total buyout costs, will approximate $56 million. The net savings are being passed back to the Company's electric customers through the fuel adjustment clause. The coal supplier retained the right of first refusal to supply Warrick Unit 4 and the Culley plant during the years 1996-2000. (See "Rate and Regulatory Matters" of Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15, for further discussion of the contract buyout.) The Indiana coal used in these plants is blended by the vendor and delivered to the plants to meet quality specifications set in conformance with the requirements of the Indiana State Implementation Plan for sulfur dioxide. Approximately 1,572,000 tons of coal were used during 1993 in the generation of electricity at the Culley Station and Warrick Unit 4. (See discussion under "Environmental Matters", page 7.) For supplying the A. B. Brown Generating Station, the Company has a contested agreement, possibly extending to 1998, with an area producer. (See Item 3, LEGAL PROCEEDINGS, page 10 for discussion of litigation with this producer regarding the coal supply agreement.) The amount of coal burned at A. B. Brown Generating Station during 1993 was approximately 862,000 tons. Both units at the generating station are equipped with flue gas desulfurization equipment so that coal with a higher sulfur content can be used. There are substantial coal reserves in the southern Indiana area. The average cost of coal consumed in generating electrical energy for the years 1989 through 1993 was as follows: The Broadway Turbine Units 1 and 2, Northeast Gas Turbines and A. B. Brown Gas Turbine, when used for peaking, reserve or emergency purposes, use natural gas for fuel. Number 2 fuel oil can also be used in the Broadway Turbine Units and the Brown Gas Turbine. All metered electric rates contain a provision for adjustment in charges for electric energy to reflect changes in the cost of fuel and the net energy cost of purchased power through the operation of a fuel adjustment clause unless certain criteria contained in the regulations are not met. The principal restriction to recovery of fuel cost increases is that such recovery is not allowed to the extent that operating income for the twelve month period provided in the fuel cost adjustment filing exceeds the operating income authorized by the Indiana Utility Regulatory Commission (IURC) in the latest general rate case of the Company. During 1991-1993, this restriction did not affect the Company. As prescribed by order of the IURC, the adjustment factor is calculated based on the estimated cost of fuel and the net energy cost of purchased power in a designated future quarter. The order also provides that any over- or underrecovery caused by variances between estimated and actual cost in a given quarter will be included in the second succeeding quarter's adjustment factor. This continuous reconciliation of estimated incremental fuel costs billed with actual incremental fuel costs incurred closely matches revenues to expenses. The Company's primary goal in the area of research and development is cost savings through the use of new technologies. This is accomplished, in part, through the efforts of the Electric Power Research Institute (EPRI). In 1993, the Company paid $893,000 to EPRI to help fund research and development programs such as advanced clean coal burning technology. The Company is participating with 14 other electric utility companies, through Ohio Valley Electric Corporation (OVEC) in arrangements with the United States Department of Energy (DOE), to supply the power requirements of the DOE plant near Portsmouth, Ohio. The sponsoring companies are entitled to receive from OVEC, and are obligated to pay for the right to receive, any available power in excess of the DOE contract demand. The proceeds from the sale of power by OVEC are designed to be sufficient to meet all of its costs and to provide for a return on its common stock. During 1993, the Company's participation in the OVEC arrangements was 1.5%. The Company participates with 32 other utilities, located in eight states comprising the east central area of the United States, in the East Central Area Reliability Group, the purpose of which is to strengthen the area's electric power supply reliability. GAS BUSINESS The Company supplies natural gas service to 100,398 customers, including 91,476 residential, 8,682 commercial, 236 industrial and four public authority customers, through 2,520 miles of gas transmission and distribution lines. The Company owns and operates three underground gas storage fields with an estimated ready delivery from storage of 3.9 million Dth of gas. Natural gas purchased from the Company's suppliers is injected into these storage fields during periods of light demand which are typically periods of lower prices. The injected gas is then available to supplement the normal contract volume from the pipeline during periods of peak requirements. It is estimated that approximately 119,000 Dth of gas per day can be withdrawn from the three storage fields during peak demand periods on the system. The gas procurement practices of the Company and several of its major customers have been altered significantly during the past eight years as a result of changes in the natural gas industry. In 1985 and prior years, the Company purchased nearly its entire gas requirements from Texas Gas Transmission Corporation (TGTC) compared to 1993 when a total of 25 suppliers sold gas to the Company. In total, the Company purchased 17,270,415 Dth in 1993. Of this amount, 5,046,509 Dth, or 29%, was purchased from TGTC, which continued to be the Company's largest supplier and its major pipeline. In November 1993, TGTC restructured its services so that its gas supplies are sold separately from its interstate transportation services. TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See subsequent reference under "Gas Business" to the restructuring of interstate pipelines.) During 1993, eighteen of the Company's major gas customers took advantage of the Company's gas transportation program to procure a portion of their gas supply needs from suppliers other than the Company. A total of 11,370,542 Dth was transported for these major customers in 1993 compared to 9,497,059 Dth transported in 1992. The Company received fees for the use of its facilities in transporting such gas, allowing it to offset a portion of the loss of its customary sales margin with respect to these customers. (See "Rate and Regulatory Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15 of this report, for discussion of the Company's general adjustment in gas rates and for discussion of the FERC Order No. 636 which requires interstate pipelines to restructure their services so that gas supplies will be sold separately from interstate transportation services.) The all-time record send out occurred during the 1989- 1990 winter season on December 22, 1989, when 223,489 Dth of gas was delivered to the Company's customers. Of this amount, 89,614 Dth was purchased, 104,358 Dth was taken out of the Company's three underground storage fields, and 29,517 Dth was transported to customers under transportation agreements. The 1992-1993 winter season peak day send out was 189,717 Dth on February 17, 1993. The average cost per Dth of gas purchased by the Company during the past five calendar years was as follows: 1989, $2.84; 1990, $2.84; 1991, $2.71; 1992, $2.77; and 1993 $2.85. The State of Indiana has established procedures which result in the Company passing on to its customers the changes in the cost of gas sold unless certain criteria contained in the regulations are not met. The principal restriction to recovery of gas cost increases is that such recovery is not allowed to the extent that operating income for the twelve month period provided in the gas cost adjustment filing exceeds the operating income authorized by the IURC in the latest general rate case of the Company. During 1991-1993, this restriction did not affect the Company. Additionally, these procedures provide for scheduled quarterly filings and IURC hearings to establish the amount of price adjustments for a designated future quarter. The procedures also provide for inclusion in a later quarter of any variances between estimated and actual costs of gas sold in a given quarter. This reconciliation process with regard to changes in the cost of gas sold closely matches revenues to expenses. The Company's rate structure does not include a weather normalization-type clause whereby a utility would be authorized to recover the gross margin on sales established in its last general rate case, regardless of actual weather patterns. Natural gas research is supported by the Company through the Gas Research Institute in cooperation with the American Gas Association. Since passage of the Natural Gas Act of 1978, a major effort has gone into promoting gas exploration by both conventional and unconventional sources. Efforts continue through various projects to extract gas from tight gas sands, shale and coal. Research is also directed toward the areas of conservation, safety and the environment. On December 23, 1993, the Company entered into a definitive agreement to acquire Lincoln Natural Gas Company, Inc., a small gas distribution company of approximately 1,300 customers contiguous to the eastern boundary of the Company's gas service territory. The acquisition is expected to be completed by mid-1994, subject to necessary regulatory and shareholder approvals. NONUTILITY SUBSIDIARY During 1986, the Company formed a wholly-owned subsidiary, Southern Indiana Properties, Inc., which owns and/or operates certain nonutility assets. Currently included in the holdings of the subsidiary are an industrial park, investments in several leveraged-lease financing arrangements, investments in several tax oriented limited partnerships, a portfolio of financial investments (principally adjustable rate preferred stocks and municipal bonds), and other nonutility property. (See Note 3 of the Notes To Consolidated Financial Statements, page 35, for further discussion of Southern Indiana Properties, Inc.) PERSONNEL The Company's network of gas and electric operations directly involves 774 employees with an additional 190 employed at Alcoa's Warrick Power Plant. Alcoa reimburses the Company for the entire cost of the payroll and associated benefits at the Warrick Plant, with the exception of one-half of the payroll costs and benefits allocated to Warrick Unit 4, which is jointly owned by the Company and Alcoa. The total payroll and benefits for Company employees in 1993 (including all Warrick Plant employees) were $46.1 million, including $4.1 million of accrued postretirement benefits other than pensions which the Company is deferring as a regulatory asset until inclusion in rates. (See Note 1 of the Notes To Consolidated Financial Statements, page 29, for further discussion of the new financial accounting standard requiring recognition of these costs effective January 1, 1993 and related regulatory treatment.) In 1992, total payroll and benefits were $40.1 million. On July 3, 1991, the Company signed a new three-year contract with Local 702 of the International Brotherhood of Electric Workers. The contract provided for a 4% general wage increase each of the three years of the contract. Certain cost-containment measures related to health care coverage were adopted. Improvements in productivity, work practices and the pension plan are also provided. Additionally, the Company's Hoosier Division signed a three- year labor contract with Local 135 of the Teamsters, Chauffeurs, Warehousemen and Helpers effective January 14, 1992. The contract provided for a 4% general wage increase each of the first and second years of the contract and a 3.75% general wage increase the third year of the contract. Also provided are improvements in health care coverage costs, pension benefits, sick pay, work practices and productivity. CONSTRUCTION PROGRAM AND FINANCING A total of $80,109,000 was spent in 1993 on the Company's construction program, of which $68,840,000 was for the electric system, $5,772,000 for the gas system, $967,000 for common utility plant facilities, and $4,530,000 for the Demand Side Management (DSM) Program. (See "Demand Side Management" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 19.) Major construction project expenditures in 1993 included $49.2 million of the originally projected $115 million (including Allowance for Funds Used During Construction) Culley Unit 2 and 3 scrubber project which is scheduled to be completed by 1995. (See "Clean Air Act" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 18.) On May 11, 1993, the Company issued two series of adjustable rate first mortgage bonds totaling $45.0 million in connection with the sale of Warrick County, Indiana environmental improvement revenue bonds. The proceeds of the revenue bonds have been placed in trust are being used to finance a portion of the Culley scrubber project. (See "Liquidity and Capital Resources" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, page 20 for further discussion of this financing and discussion of the issuance of $110 million of first mortgage bonds used to refinance existing long-term debt.) No other securities were issued by the Company during 1993 for the purpose of funding its construction program. For 1994, construction expenditures are presently estimated to be $92.2 million which includes $8.7 million for DSM programs. Expenditures in the power production area are expected to total $55.8 million and include $41.7 million for the construction of the Culley scrubber project. The balance of the 1994 construction program consists of $14.9 million for additions and improvements to other electric system facilities, $8.1 million of additions and improvements to the gas system and $4.7 million for the final phase of the $27 million Norman P. Wagner operations complex and miscellaneous common utility plant buildings, fixtures and equipment. In keeping with the Company's objective to bring new facilities on line as needed, the construction program and amount of scheduled expenditures are reviewed periodically to factor in load growth projections, system balance requirements, environmental compliance and other considerations. As a result of this program of periodic review, construction expenditures may change in the future from the program as presented herein. For the five-year period of 1994-1998, it is estimated that construction expenditures will total about $270 million as follows: 1994 - $92 million; 1995 - $41 million; 1996 - $44 million; 1997 - $48 million; and 1998 - $45 million. This construction program reflects approximately $51 million for the Company's DSM programs and $44 million to meet the Phase I requirements of the Clean Air Act Amendments of 1990. While the Company expects the majority of the construction requirements and an estimated $48 million in debt security redemptions and other long-term obligations to be provided by internally generated funds, external financing requirements of $50-70 million are anticipated. The aforementioned amounts relating to the Company's construction program are in all cases inclusive of Allowance for Funds Used During Construction. REGULATION Operating as a public utility under the laws of Indiana, the Company is subject to regulation by the Indiana Utility Regulatory Commission as to its rates, services, accounts, depreciation, issuance of securities, acquisitions and sale of utility properties or securities, and in other respects as provided by the laws of Indiana. In addition, the Company is subject to regulation by the Federal Energy Regulatory Commission with respect to the classification of accounts, rates for its sales for resale, interconnection agreements with other utilities, and acquisitions and sale of certain utility properties as provided by the laws of the United States. See "Electric Business" and "Gas Business" for further discussion regarding regulatory matters. The Company is subject to regulations issued pursuant to federal and state laws, pertaining to air and water pollution control. The economic impact of compliance with these laws and regulations is substantial, as discussed in detail under "Environmental Matters." The Company is also subject to multiple regulations issued by both federal and state commissions under the Federal Public Utility Regulatory Policies Act of 1978. As a result of the Company's ownership of 33% of Community Natural Gas Company, the Company is a "Holding Company" as such term is defined under the Public Utility Holding Company Act of 1935 (the 1935 Act). The Company is exempt from all provisions of the 1935 Act except for the provisions of Section 9(A)(2), which pertains to acquisitions of other utilities. COMPETITION The Company does not presently compete for electric or gas customers with the other utilities within its assigned service areas. As a result of changes brought about by the National Energy Policy Act of 1992, the Company may be required to compete (or have the opportunity to compete) with other utilities and wholesale generators for sales of electricity to existing wholesale customers of the Company and other potential wholesale customers. (See subsequent reference to discussion of this recent legislation.) The Company currently competes with other utilities in connection with intersystem bulk power rates. Some of the Company's customers have, or in the future could acquire, access to energy sources other than those available through the Company. (See "Gas Business", page 4, for discussion of gas transportation.) Although federal statute allows for bypass of a local distribution (gas utility) company, Indiana law disallows bypass in most cases and the Company would likely litigate such an attempt in the Indiana courts. Additionally, the Company's geographical location in the corner of the state, surrounded on two sides by rivers, limits customers' ability to bypass the Company (by running long pipelines). There is also increasing interest in research on the development of sources of energy other than those in general use. Such competition from other energy sources has not been a material factor to the Company in the past. The Company is unable, however, to predict the extent of competition in the future or its potential effect on the Company's operations. As part of its efforts to develop a National Energy Strategy, Congress has amended the Public Utility Holding Company Act and the Federal Power Act by enacting the National Energy Policy Act of 1992 (the Act), which will affect the traditional structure of the electric utility industry. (Refer to "National Energy Policy Act of 1992" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 18 of this report, for discussion of the major changes in the electric industry effected by the Act.) ENVIRONMENTAL MATTERS The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. Refer to "Environmental Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 17 of this report, for discussion of the Company's actions regarding the investigation. The Company is subject to federal, state and local regulations with respect to environmental matters, principally air, solid waste and water quality. Pursuant to environmental regulations, the Company is required to obtain operating permits for the electric generating plants which it owns or operates and construction permits for any new plants which it might propose to build. Regulations concerning air quality establish standards with respect to both ambient air quality and emissions from the Company's facilities, including particulate matter, sulfur dioxide and nitrogen oxides. Regulations concerning water quality establish standards relating to intake and discharge of water from the Company's facilities, including water used for cooling purposes in electric generating facilities. Because of the scope and complexity of these regulations, the Company is unable to predict the ultimate effect of such regulations on its future operations, nor is it possible to predict what other regulations may be adopted in the future. The Company intends to comply with all applicable valid governmental regulations, but will contest any regulation it deems to be unreasonable or impossible to comply with or which is otherwise invalid. The implementation of federal and state regulations designed to protect the environment, including those hereinafter referred to, involves or may involve review, certification or issuance of permits by federal and state agencies. Compliance with such regulations may limit or prevent certain operations or substantially increase the cost of operation of existing and future generating installations, as well as seriously delay or increase the cost of future construction. Such compliance may also require substantial investments above those amounts stated under "Construction Program and Financing", page 5. All existing Company facilities have operating permits from the Indiana Air Board. In order to secure approval for these permits, the Company has installed electrostatic precipitators on all coal-fired units and is operating flue gas desulfurization (FGD) units to remove sulfur dioxide from the flue gas at its A. B. Brown Units 1 and 2 generating facilities. The FGD units at the Brown Station remove most of the sulfur dioxide from the flue gas emissions by way of a scrubbing process, thereby allowing the Company to burn high sulfur southern Indiana coal at the station. Under the Federal Clean Air Act (the Act), states are authorized to adopt implementation plans to fulfill the requirements of the Act. These state plans are subject to approval by the U. S. Environmental Protection Agency (EPA). In 1972, Indiana adopted stringent regulations which comprise the State Implementation Plan (SIP) for attaining ambient air standards for particulates, sulfur dioxide and nitrogen oxides. The EPA approved that part of the SIP which sets forth emission standards, fixes time schedules for compliance with such standards and designates air quality regions for the State. The SIP was revised in 1979 to reflect revision of the Act and the State submitted the revised plan to the EPA for approval. On August 10, 1986, the Sierra Club filed a lawsuit against the EPA under Civil No. NA86-194-C seeking declaratory and injunctive relief to compel the EPA to take action pursuant to the Act to reduce sulfur dioxide emissions from power plants in Indiana including the Company's Warrick Unit 4 and Culley Generating Station. In settlement of this suit, the EPA agreed that there would be a SIP for the State by November 1988. The EPA gave final approval on December 16, 1988 to the Warrick County sulfur dioxide emission limits which had been approved by the Indiana Air Pollution Control Board. The ruling provided for the reduction of sulfur dioxide emissions from the two Warrick County generating stations, Warrick and Culley, to take place in two phases. The first reduction, required by December 31, 1989, provided that sulfur dioxide emissions from all units at both stations be reduced to 5.41 lb/MMBTU from 6.00 lb/MMBTU. Under the second phase, which was effective August 1, 1991, sulfur dioxide emissions from Culley Units 1 and 2 had to be decreased to 2.79 lb/MMBTU, Culley Unit 3 was allowed to remain at 5.41 lb/MMBTU, and emissions from all units at the Warrick Generating Station had to be reduced to 5.11 lb/MMBTU. The Company is currently in compliance with these provisions. In October 1990, the U.S. Congress adopted major revisions to the Act. The revisions impose significant restrictions on future emissions of sulfur dioxide (SO2) and nitrogen oxide (NOX) from coal-burning electric generating facilities, including those owned and operated by the Company. The legislation severely affects electric utilities, especially those in the Midwest. Two of the Company's principal coal-fired facilities (A. B. Brown Units 1 and 2, totaling 500 megawatts of capacity) are presently equipped with sulfur dioxide removal equipment (scrubbers) and are not expected to be severely affected by the new legislation. However, 523 megawatts of the Company's coal- fired generating capacity will be significantly impacted by the lower emission requirements. The Company will be required to reduce total emissions from Culley Unit 3 (250 megawatts), Warrick Unit 4 (135 megawatts) and Culley Unit 2 (92 megawatts) by approximately 50% to 2.5 lb/MMBTU by January 1995 (Phase I) and to 1.2 lb/MMBTU by January 2000 (Phase II). In addition, Unit 1 at Culley Station (46 megawatts) is also subject to the 1.2 lb/MMBTU restriction by January 2000. The legislation includes various incentives to promote the installation of scrubbers on units affected by the 1995 deadline. Current regulatory policy allows for the recovery through rates of all authorized and approved pollution control expenditures. (Refer to "Clean Air Act" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 18 of this report, for discussion of the Company's Clean Air Act Compliance Plan, which was filed with the IURC on January 3, 1992 and approved October 14, 1992, and the associated estimated costs.) In connection with the use of sulfur dioxide removal equipment at the A. B. Brown Generating Station, the Company operates a solid waste landfill for the disposal of approximately 200,000 tons of residue per year from the scrubbing process. Renewal of the landfill operating permit was granted in March 1992 by the Indiana Department of Environmental Management (IDEM). The permit expires in January 1997. Additionally, IDEM granted the Company's request for modification (expansion) of the landfill, issuing the construction permit in March 1992. Under the Federal Water Pollution Control Act of 1972 and Indiana law and regulations, the Company is required to obtain permits to discharge effluents from its existing generating stations into the navigable waterways of the United States. The State of Indiana has received authorization from the EPA to administer the Federal discharge permits program in Indiana. Variances from effluent limitations may be granted by permit on a plant-by- plant basis where the utility can establish the limitations are not necessary to assure the protection of aquatic life and wildlife in and on the body of water into which the discharge is to be made. The Company has been granted National Pollution Discharge Elimination System (NPDES) permits covering miscellaneous waste water and thermal discharges for all its generating facilities to which the NPDES is applicable, namely the Culley Station, A. B. Brown Station and Warrick Unit 4. Such discharge permits are limited in time and must be renewed at five-year intervals. During 1989, the Company was granted renewed five-year permits for effluent discharge for such generating facilities, which are required to be renewed again in 1994. At present there are no known enforcement proceedings concerning water quality pending or threatened against the Company. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company are elected at the annual organization meeting of the Board of Directors, held immediately after the annual meeting of stockholders, and serve until the next such organization meeting, unless the Board of Directors shall otherwise determine, or unless a resignation is submitted. Item 2. Item 2. PROPERTIES The Company's installed generating capacity as of December 31, 1993 was rated at 1,238,000 Kw. The Company's coal-fired generating facilities are: the Brown Station with 500,000 Kw of capacity, located in Posey County about eight miles east of Mt. Vernon, Indiana; the Culley Station with 388,000 Kw of capacity, and Warrick Unit 4 with 135,000 Kw of capacity. Both the Culley and Warrick Stations are located in Warrick County near Yankeetown, Indiana. The Company's gas-fired turbine peaking units are: the 80,000 Kw Brown Gas Turbine located at the Brown Station; two Broadway Gas Turbines located in Evansville, Vanderburgh County, Indiana, with a combined capacity of 115,000 Kw; and, two Northeast Gas Turbines located northeast of Evansville in Vanderburgh County, Indiana with a combined capacity of 20,000 Kw. The Brown and Broadway turbines are also equipped to burn oil. Total capacity of the Company's five gas turbines is 215,000 Kw and are generally used only for reserve, peaking or emergency purposes due to the higher per unit cost of generation. The Company's transmission system consists of 871 circuit miles of 138,000, 69,000 and 36,000 volt lines. The transmission system also includes 26 substations with an installed capacity of 3,874,724 kilovolt amperes (Kva). The electric distribution system includes 3,177 pole miles of lower voltage overhead lines and 180 trench miles of conduit containing 987 miles of underground distribution cable. The distribution system also includes 86 distribution substations with an installed capacity of 1,306,508 Kva and 45,057 distribution transformers with an installed capacity of 1,771,152 Kva. The Company owns and operates three underground gas storage fields with an estimated ready delivery from storage capability of 3.9 million Dth of gas. The Oliver Field, in service since 1954, is located in Posey County, Indiana, about 13 miles west of Evansville. The Midway Field is located in Spencer County, Indiana, about 20 miles east of Evansville near Richland, Indiana, and was placed in service in December 1966. The third field is the Monroe City Field, located in Knox County, about 10 miles east of Vincennes, Indiana. The field was placed in service in 1958. The Company's gas transmission system includes 324 miles of transmission mains, and the gas distribution system includes 2,196 miles of distribution mains. The Company's properties, but not those of its subsidiary, are subject to the lien of the First Mortgage Indenture dated as of April 1, 1932 between the Company and Bankers Trust Company, New York, as Trustee, as supplemented by various supplemental indentures, all of which are exhibits to this report and collectively referred to as the "Mortgage". Item 3. Item 3. LEGAL PROCEEDINGS. On January 27, 1993, a coal supplier filed a complaint in the Federal District Court for the Southern District of Indiana alleging that the Company breached a coal supply contract between the Company and that supplier. The Company had notified the supplier that it would not require any delivery of coal under the contract for at least some part of 1993. The supplier claims that this action violates certain minimum purchase requirements imposed by the contract, and asked the court to require specific performance of the contract by the Company and for unspecified monetary damages. The complaint alleges that the Company is obligated to purchase coal at a minimum rate of 50,000 tons per month under the contract and at any event to purchase all of the coal consumed at the Company's A. B. Brown generating plant below 1,000,000 tons per year. The contested contract may run until December 31, 1998. The Company filed counterclaims and disputes that its actions have violated the terms of the contract. On March 26, 1993, the Company and the coal supplier agreed to resume coal shipments but with the invoiced price per ton substantially lower than the contract price and subject to final outcome of the litigation. (Refer to "Rate and Regulatory Matters" in Item 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, page 15 of this report, for discussion of the pricing of this coal to inventory and the associated ratemaking treatment.) On June 6, 1993, the coal supplier won a summary judgement to require the Company to take a minimum of 600,000 tons annually, more or less in equal weekly shipments. The decision cannot be appealed until resolution of other contract provisions still before the court. There are no other pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant is a party. No material legal proceedings were terminated during the fourth quarter of 1993. Item 4. Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS. None PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The principal market on which the registrant's common stock (Common Stock) is traded is the New York Stock Exchange, Inc. where the Common Stock is listed. The high and low sales prices for the stock as reported in the consolidated transaction reporting system for each quarterly period during the two most recent fiscal years are: As of February 4, 1994 there were 9,445 holders of record of Common Stock. Dividends declared and paid per share of Common Stock during the past two years were: Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION Earnings per share of $2.45 in 1993 were the highest in Company history, following 1992 earnings of $2.26. The record 1993 earnings exceeded the previous all-time high of $2.37 in 1991 by 3%. The 1993 earnings were favorably impacted by higher operating revenues due to weather-related increases in retail gas and electric sales. Greater maintenance and nonfuel-related operating expenses and fewer sales to wholesale electric customers partially offset the impact of the higher retail sales. Increased allowance for funds used during construction resulting from the Company's expanded construction program also contributed to the higher earnings. For the thirty-fifth consecutive year, the Board of Directors declared a dividend increase to common shareholders at its January 1994 meeting. Payable in March 1994, the Company's new quarterly dividend is 41-1/4cents per share, increasing the indicated annual rate to $1.65 per share. ELECTRIC OPERATIONS. The table below compares changes in operating revenues, operating expenses, and electric sales between 1993 and 1992, and between 1992 and 1991, in summary form. Higher weather-related sales to the Company's retail customers was the primary reason for the 6.3% ($15.3 million) rise in electric operating revenues. Effective October 1, 1993, the Company implemented the first step (about 1% overall) of a three-step increase in its base electric rates to recover the cost of complying with the Clean Air Act Amendments of 1990 (see "Rate and Regulatory Matters"), however, the rate increase had little impact on electric revenues during 1993. In 1992, operating revenues declined 7.9% ($20.8 million) due to fewer sales to retail and wholesale customers. Cooler winter weather and much warmer summer temperatures, when cooling degree days were 30% greater than the prior year and about 17% above normal, were responsible for the 12.1% and 6.3% increases in residential and commercial sales, respectively. Following flat sales in 1992, industrial sales rose 5.7% during the current year due to increased manufacturing activity. Total system sales were up 7.6% over 1992. The Company experienced a 3.1% overall decline in system sales in 1992 when cooling degree days were down 30%. During 1993, the Company's electric customer base grew by 1,276, or 1%, totaling 118,163 at year end. In addition to greater system sales, 1993 system revenues increased approximately $2.7 million due to the recovery of higher unit fuel costs (see subsequent discussion of changes in the cost of fuel for electric generation), following a $4.7 million reduction in electric revenues in 1992 due to lower unit costs. Changes in the cost of fuel for electric generation and purchased power are reflected in customer rates through commission approved fuel cost adjustments. Because of the current worldwide oversupply of primary aluminum and softening demand for rolled can sheet aluminum in the United States, the Aluminum Company of America (Alcoa) shut down several older potlines at various manufacturing facilities. Alcoa Generating Corporation (AGC), a wholly-owned subsidiary of Alcoa, provides the energy requirements for five potlines at Alcoa's Warrick County, Indiana facility from its Warrick Generating Station. Since 1987, the Company has provided electric energy to AGC (a wholesale customer) for a sixth potline. On July 20,1993, Alcoa shut down the oldest of the six potlines at the Warrick County manufacturing operation. The Company estimates that the decline in electric sales related to the potline for 1993 represented approximately $4.8 million in nonsystem revenues and approximately $.8 million in operating income compared to the prior year. Greater sales to other nonsystem customers, due in part to the region's warmer summer temperatures, partially offset the decline in sales to AGC. Total nonsystem sales by the Company declined 8.3% during the year. On an annual basis, the decline in revenue related to the reduced sales to AGC is estimated at $14.4 million with a corresponding $2.4 million decline in operating income. The Company anticipates that a portion of the decline in operating income will be offset in the future by increases in sales to other nonsystem customers made possible by the reduced commitment to AGC. Most sales to nonsystem customers, including AGC, are on an "as available" basis under interchange agreements which provide for significantly lower margins than sales to system customers. Due to the much warmer summer temperatures, and to the increased demand by industrial customers, a new all-time peak load obligation of 1,100 megawatts was reached on July 28, 1993. The previous record peak, 1,054 megawatts, was set in 1988. The 1992 peak of 992 megawatts was held down by the unseasonably cool summer weather. The Company's total generating capacity at the time of the 1993 peak was 1,238 megawatts, representing an 11% capacity margin. Fuel for electric generation, the most significant electric operating cost, was comparable to 1992. Slightly (2.8%) higher costs of coal per MMBtu consumed due to less favorable volume-related pricing, higher average per unit mine production costs, and the amortized cost of the buyout of one of the Company's long-term coal contracts (see "Rate and Regulatory Matters"), were offset by a decline in generation. The Company continues to pursue further reductions in coal prices as a key component of its strategy to remain a low-cost provider of electricity. The decline in 1992 fuel cost reflected a 6.2% decrease in generation and a lower average cost of coal consumed. The greater energy requirements of the Company's customers and favorably priced power were the primary reasons for the increased purchases of electricity from other utilities, up substantially (220%) during 1993. Purchased electric energy costs decreased 48% in 1992 due to fewer purchases and lower average rates paid for such power. After a 4.1% decrease in 1992, other operation expenditures rose 8.2% ($2.3 million) during the current year chiefly due to increased provisions for injuries and damages, consulting and legal expenditures related to a coal contract buyout (see "Rate and Regulatory Matters") and ongoing coal contract negotiations and litigation, and increases in various administrative and general costs. Greater production plant maintenance activity was the primary reason for the 20% ($4 million) increase in electric maintenance expense. The Company performed a scheduled major turbine generator overhaul on A.B. Brown Unit 2 during the year and completed a major overhaul on the Culley Unit 1 turbine generator begun in late 1992. The Culley Unit 1 turbine generator overhaul was the only major maintenance project during 1992, when electric maintenance expenditures were down $4.5 million. Depreciation and amortization expense increased slightly in 1993 reflecting normal additions to utility plant and the completion of the warehouse and operations building at the Company's new Norman P. Wagner Operations Center. A decline in depreciation and amortization occurred in 1992 when amortization provisions related to the deferred return on the phasein of A. B. Brown Unit 2 expired. While inflation has a significant impact on the replacement cost of the Company's facilities, under the rate-making principles followed by the Indiana Utility Regulatory Commission (IURC), under whose regulatory jurisdiction the Company is subject, only the historical cost of electric and gas plant investment is recoverable in revenues as depreciation. With the exception of adjustments for changes in fuel and gas costs and margin on sales lost under the Company's demand side management programs (see "Demand Side Management"), the Company's electric and gas rates remain unchanged until a rate application is filed and a general rate order is issued by the IURC. In addition to the impact of higher 1993 pretax income on income tax expense, the Company provided approximately $.5 million of additional federal income tax expense to reflect the higher tax rates enacted under the Omnibus Budget Reconciliation Act of 1993. (See Note1 of the Notes to Consolidated Financial Statements for further discussion.) Decreased income tax expense in 1992 was chiefly attributable to lower pretax income. The decrease in taxes other than income taxes during the current year resulted from a 1992 increase in property tax expense reflecting the general reassessment of the Company's property. GAS OPERATIONS. The following table compares changes in operating revenues, operating expenses, and gas sold and transported between 1993 and 1992, and between 1992 and 1991, in summary form. Greater sales of natural gas and higher gas costs recovered through retail rates led to an 11.5% ($7.2 million) increase in gas operating revenues. Effective August 1, the Company implemented the first step (about 4% overall) of a two-step increase in its base gas rates (see "Rate and Regulatory Matters"), however, the impact on gas revenues during 1993 was not significant. A 5.6% rise in the Company's gas sales in 1993 reflected increased sales to residential and commercial customers, up 12.8% and 10.2%, respectively. Although heating degree days during the period were about normal, they were 10% greater than those recorded in 1992. Deliveries to industrial customers under the Company's sales and transportation tariffs were up 7.6%, reflecting the increased manufacturing activity of several of the Company's largest industrial customers. In 1992, residential sales were flat and commercial sales were up only 3.1% due to milder winter weather; industrial sales and transportation volumes increased 6.7% during the same period. During 1993, 1,402 new gas customers were added to the Company's system, raising the year end total 1.4% to 100,398. On December 23, 1993, the Company entered into a definitive agreement to acquire Lincoln Natural Gas, a small gas distribution company of approximately 1,300 customers contiguous to the eastern boundary of the Company's gas service territory. The acquisition is expected to be completed by mid-1994, subject to necessary regulatory and shareholder approvals. The recovery of higher unit gas costs, up 6.1%, through retail rates in 1993 raised revenues $2.7 million following a $1.3 million increase in revenues related to the recovery of higher unit costs in the prior year. During the past two years, the market for purchase of natural gas supply has been very volatile with the average price ranging from a low of $1.34 per Dth in February 1992 to the peak of $2.58 per Dth in May 1993. Prices have declined somewhat since May but remain above the February low reflecting a general tightening of the balance between available supply and demand after several years of excess supply. Changes in the cost of gas sold are passed on to customers through IURC approved gas cost adjustments. Cost of gas sold, the major component of gas operating expenses, was up 9.7% ($4.5 million) in 1993, following a 13.2% ($5.4 million) increase in 1992. The higher costs in both 1993 and 1992 reflected the increased deliveries to customers and higher unit costs. Although the Company's primary pipeline supplier, Texas Gas Transmission Corporation (TGTC), implemented revised tariffs November 1, 1993 to reflect certain changes required by Federal Energy Regulatory Commission (FERC) Order 636, the Company's 1993 purchased gas costs were relatively unaffected by the new tariffs. As of November 1,1993, TGTC ceased to be a supplier of natural gas to the Company, and the Company assumed full responsibility for the purchase of all its natural gas supplies. (See "Rate and Regulatory Matters" for further discussion of FERC Order No. 636 and of the impact on future purchased gas costs and procurement practices of the Company.) Other operation and maintenance expenses were 31% ($3.1 million) greater than the prior year due to increased provisions for injuries and damages (see "Environmental Matters" for discussion of the Company's investigation of the possible existence of facilities utilized for the manufacture of gas), abnormally low distribution maintenance expenses in 1992, and increases in various administrative and general costs. Depreciation expense for 1993 and 1992 reflected increased gas plant additions during the past several years due to new business requirements and various improvements made to the distribution system. Partially offsetting the impact of increased gas plant additions were lower depreciation rates implemented during 1993 as a result of the Company's recent gas rate case. Income tax expense for the current year was comparable to 1992, following a substantial decrease in income tax expense in 1992 resulting from lower pretax operating income. OTHER INCOME AND INTEREST CHARGES. Other income was $2.5million greater during 1993 due to increased allowance for equity funds used during construction, resulting primarily from the construction of the Company's new sulfur dioxide scrubber. (See "Clean Air Act" for further discussion.) Following a significant increase in nonutility income in 1991, nonutility income declined in 1992. The decline was largely due to lower fees from AGC for operation of its Warrick Generating Station. Interest expense during the current year was relatively unchanged. The impact of an additional $45 million of long- term debt issued during the second quarter was offset by savings from refinancing $105 million of long-term debt in the second quarter, which reduced annual interest expense by $1 million, and by additional interest capitalized due to the increased construction program. RATE AND REGULATORY MATTERS. In November 1992, the Company petitioned the IURC requesting a general increase in gas rates, the first such adjustment since 1982. On July 21,1993, the IURC approved an overall increase of approximately 8%, or $5.5 million in revenues, in the Company's base gas rates. The increase is to be implemented in two equal steps. The first step of the rate adjustment, approximately 4%, took place August 1, 1993; the second step will become effective August 1, 1994. In addition to seeking relief for rising operating and maintenance costs and substantial investment in utility plant over the past decade, the Company sought to restructure its tariffs, make available additional services, and "unbundle" existing services to better serve its gas customers and strategically position itself to address the changes brought about by the continued deregulation of the natural gas industry. (See subsequent discussion of FERC Order No. 636 in this section.) On May 24, 1993, the Company petitioned the IURC for an adjustment in its base electric rates representing the first step in the recovery of the financing costs on its investment through March 31, 1993 in the Clean Air Act Compliance project presently being constructed at the Culley Generating Station. The majority of the costs are for the installation of a sulfur dioxide scrubber on Culley Units 2 and 3. (See "Clean Air Act" for further discussion of the project and previous approval of ratemaking treatment of the incurred costs.) On September 15,1993, the IURC granted the Company's request for a 1% revenue increase, approximately $1.8 million on an annual basis, which took effect October 1, 1993. The Company anticipates petitioning the IURC in February 1994 for a 2-3% increase for financing costs related to the project construction expenditures incurred since April 1,1993, with implementation of the new rates effective mid-1994. On December 22, 1993, the Company filed a request with the IURC for the third of the three planned general electric rate increases. This final adjustment, expected to occur in early 1995, is estimated to be 6-9% and is necessary to recover financing costs related to the balance of the project construction expenditures, costs related to the operation of the scrubber, and certain nonscrubber-related costs such as additional costs incurred for postretirement benefits other than pensions beginning in 1993 and the recovery of demand side management program expenditures (see "Demand Side Management"). Over the past several years, the Company has been actively involved in intensive contract negotiations and legal actions to reduce its coal costs and thereby lower its electric rates. During 1992, the Company was successful in negotiating a new coal supply contract with one of its major coal suppliers. The new agreement, effective through 1995, was retroactive to 1991. Included in the agreement was a provision whereby the contract could be reopened by the Company for modification of certain coal specifications. In early 1993, the Company reopened the contract for such modifications. In response, the coal supplier elected to terminate the contract enabling the Company to buy out the remainder of its contractual obligations and acquire lower priced spot market coal. The cost of the contract buyout in 1993, which was based on estimated tons of coal to be consumed during the agreement period, and related legal and consulting services, totaled approximately $18 million. The Company anticipates that $2 million in additional buyout costs for actual tons of coal consumed above the previously estimated amount may be incurred during the 1994-1995 period. On September 22, 1993, the IURC approved the Company's request to amortize all buyout costs to coal inventory during the period July 1,1993 through December 31, 1995 and to recover such costs through the fuel adjustment clause beginning February 1994. The Company estimates the savings in coal costs during the 1991-1995 period, net of the total buyout costs, will approximate $56 million. The net savings are being passed back to the Company's electric customers through the fuel adjustment clause. The Company is currently in litigation with another coal supplier in an attempt to restructure an existing contract. Under the terms of the original contract, the Company was allegedly obligated to take 600,000 tons of coal annually. In early 1993, the Company informed the supplier that it would not require shipments under the contract until later in 1993. On March 26, 1993, the Company and the supplier agreed to resume coal shipments under the terms of their original contract except the invoiced price per ton would be substantially lower than the contract price. As approved by the IURC, the Company has charged the full contract price to coal inventory for subsequent recovery through the fuel adjustment clause. The difference between the contract price and the invoice price has been deposited in an escrow account with an offsetting accrued liability which will be paid either to the Company's ratepayers or its coal supplier upon settlement of the litigation. The escrowed amount was $8,749,000 at December 31, 1993. This litigation is scheduled for trial in June of 1994. Since the litigation arose due to the Company's efforts to reduce fuel costs, management believes that any related costs should be recoverable through the regulatory ratemaking process. In late 1993, in a further effort to reduce coal costs, the Company and the supplier entered into a letter agreement, effective January 1, 1994, and until the litigation is settled, whereby the Company will purchase an additional 50,000 tons monthly above the alleged base requirements at a price lower than the original contract price for tons over 50,000 per month. In April 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (the Order) which required interstate pipelines to restructure their services. In August 1992, the FERC issued Order No. 636-A which substantially reaffirmed the content of the original Order. Under the Order, the stated purpose of which is to improve the competitive structure of the natural gas pipeline industry, existing pipeline sales service was "unbundled" so that gas supplies are sold separately from interstate transportation services. This restructuring has occurred through tariff filings by pipelines after negotiations with their customers. Customers, such as the Company and ultimately its gas customers, could benefit from enhanced access to competitively priced gas supplies as well as from more flexible transportation services. Conversely, customer costs will rise because the Order requires pipelines to implement new rate design methods which shift additional demand-related costs to firm customers; additionally, the FERC has authorized the pipelines to seek recovery of certain "transition" costs associated with restructuring from their customers. On November 2, 1992, the Company's major pipeline supplier, Texas Gas Transmission Corporation (TGTC), filed a recovery implementation plan with the FERC as part of its revised compliance filing regarding the Order. On October 1, 1993, the FERC accepted, subject to certain conditions, the TGTC recovery implementation plan (the Plan). The Plan, which addresses numerous issues related to the implementation of the requirements of the Order, became effective November 1, 1993. Under new TGTC transportation tariffs, which reflect the Plan's provisions, the Company will incur additional annual demand-related charges of approximately $1.9 million. Savings from lower volume-related transportation costs will partially offset the additional charges. TGTC has not yet determined the Company's allocation of transition costs, however, an estimate of such costs and implementation of revised TGTC tariffs to recover such costs are expected during the first quarter of 1994. Due to the anticipated regulatory treatment at the state level, the Company does not expect the Order to have a detrimental effect on its financial condition or results of operations. ENVIRONMENTAL MATTERS. The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. These facilities, if they existed, would have been operated from the 1850's through the early 1950's under industry standards then in effect. Operations at these facilities would have ceased many years ago. However, due to current environmental regulations, the Company and other responsible parties may be required to take remedial action if certain materials are found at the sites of these former facilities. The Company has just recently initiated its investigation, and preliminary assessments have not yet been performed on any sites. However, based on its research, the Company has identified the existence and general location of four sites at which contamination may be present. The Company intends to perform preliminary assessments of all four sites during 1994 and, more than likely, will perform comprehensive investigations of some, or all, of these sites to determine if remedial action is required and to estimate the extent of such action and the associated costs. The Company has notified all known insurance carriers providing coverage during the probable period of operation of these facilities of potential claims for coverage of environmental costs. The Company has not, however, recorded any receivables representing future recovery from insurance carriers. Additionally, the Company is attempting to identify all potentially responsible parties for each site. The Company has not been named a potentially responsible party by the Environmental Protection Agency for any of these sites. While the Company intends to seek recovery from other responsible parties or insurance carriers, the Company does not presently anticipate seeking recovery of these investigation costs from its ratepayers. Therefore, the Company has expensed the $.5 million of anticipated cost of performing preliminary site assessments and the more comprehensive specific site investigations of all four sites. If, however, the specific site investigations indicate that significant remedial action is required, the Company will seek recovery of all related costs in excess of amounts recovered from other potentially responsible parties or insurance carriers through rates. Although the IURC has not yet ruled on a pending request for rate recovery by another Indiana utility of such environmental costs, the IURC did grant that utility authority to utilize deferred accounting for such costs until the IURC rules on the request. NATIONAL ENERGY POLICY ACT OF 1992. In late 1992, the National Energy Policy Act of 1992 (the Act) was signed into law, enacting the first comprehensive energy legislation since the National Energy Act of 1978. Key provisions contained in the Act, specifically Title VII (Electricity), are expected to cause some of the most significant changes in the history of the electric industry. The primary purpose of Title VII is to increase competition in electric generation by enabling virtually nonregulated entities, such as exempt wholesale generators, to develop power plants, and by providing the FERC authority to require a utility to provide transmission services, including the expansion of the utility's transmission facilities necessary to provide such services, to any entity generating electricity. Although the FERC may not order retail wheeling, the transmission of electricity directly to an ultimate consumer, it may order wheeling of electricity generated by an exempt wholesale generator or another utility to a wholesale customer of a regulated utility. The changes brought about by the Act may require, or provide opportunities for, the Company to compete with other utilities and wholesale generators for sales to existing wholesale customers of the Company and other potential wholesale customers. The Company has long-term contracts with its five wholesale customers which mitigate the opportunity for other generators to provide service to them. Many observers of the electric utility industry, including major credit rating agencies, certain financial analysts, and some industry executives, have expressed an opinion that retail wheeling to large retail customers and other elements of a more competitive business environment will occur in the electric utility industry, similar to developments in the telecommunications and natural gas industries. The timing of these projected developments is uncertain. In addition, the FERC has adopted a position, generically and on a case- by-case basis, that it will pursue a more competitive, less regulated, electric utility industry. Although the Company is uncertain of the final outcome of these developments, it is committed to pursuing, and is moving rapidly to implement, its corporate strategy of positioning itself as a low-cost energy producer and the provider of high quality service to its retail as well as wholesale customers. The Company already has some of the lowest per unit administrative, operation, and maintenance costs in the nation, and is continuing its efforts to further reduce its coal costs (see previous discussion of coal contract renegotiation in "Rates and Regulatory Matters"). CLEAN AIR ACT. Revisions to federal clean air laws were enacted in 1990 which have a significant impact on all of American industry. Electric utilities, especially in the Midwest, were severely impacted by Title IV (acid rain provisions) of the Clean Air Act Amendments of 1990. Title IV mandates utilities to significantly reduce emissions of sulfur dioxide (SO2) and nitrogen oxide (NOx) from coal-burning electric generating facilities in two steps. The Company is required to reduce annual emissions of SO2 on a Company-wide basis by approximately 50% by 1995 (Phase I). By the year 2000 (PhaseII), the Company must reduce emissions of SO2 by approximately 50% from the allowed 1995 level. Since the Company's two newest coal- fired generating units, A.B. Brown Units 1 and2 (500 MW total), are equipped with SO2 removal equipment (scrubbers), the impact of the law, although significant, is not as great for the Company as for some other midwestern utilities. To meet the Phase I requirements and nearly all of the Phase II requirements, the Company's Clean Air Act Compliance Plan (the Compliance Plan), which was developed as a least-cost approach to compliance, proposed the installation of a single scrubber at the Culley Generating Station to serve both Culley Unit 2 (92MW) and Culley Unit 3 (250 MW) and the installation of state of the art low NOx burners on these two units. In January 1992, the Company filed a petition with the IURC, requesting preapproval of the Compliance Plan and proposing recovery of financing costs to be incurred during the construction period. In October 1992, the IURC approved a stipulation and settlement agreement between the Company and intervenors pertaining to the petition, which essentially granted the request. Construction of the facilities, originally projected to cost approximately $115 million including the related allowance for funds used during construction, began during 1992 with completion and testing expected to occur in late 1994. Construction costs are currently running under budget. Commercial operation will begin about January 1, 1995 to comply with requirements of the Clean Air Act Amendments of 1990. Under the settlement agreement, the maximum capital cost of the compliance plan to be recovered from ratepayers is capped at approximately $107 million, plus any related allowance for funds used during construction. The estimated cost to operate and maintain the facilities, including the cost of chemicals to be used in the process, is $4-6 million per year, beginning in 1995. By installing a scrubber, the Company was entitled to apply for extra allowances, called "extension allowances", to the federal EPA. However, because utilities applied for more extension allowances than the Act made available, the federal EPA established a lottery procedure to determine which utilities would actually receive the extension allowances. In order to ensure receipt of a majority of the extension allowances, the Company, and nearly all of the other applying utilities, formed an allowance pooling group. As a result, the Company will receive about 88,000 extension allowances, which it has sold to another party under a confidential agreement. The Company will credit the proceeds to customers over 1995-1999, reducing the rate impact of the Compliance Plan. With the addition of the scrubber, the Company expects to exceed the minimum compliance requirements of Phase I of the Clean Air Act and have available unused allowances, called "overcompliance allowances", for sale to others. Proceeds from sales of overcompliance allowances will also be passed through to customers. The scrubbing process utilized by the Culley scrubber produces a salable by-product, gypsum, a substance commonly used in wallboard and other products. In December 1993, the Company finalized negotiations for the sale of an estimated 150,000 to 200,000 tons annually of gypsum to a major manufacturer of wallboard. The agreement will enable the Company to reduce certain operating costs and to credit ratepayers with the proceeds from the sale of the gypsum, further mitigating the rate impact of the Compliance Plan. The rate impact related to the Compliance Plan, estimated to be 7-10%, is being phased in over a three year period beginning in October 1993. (See "Rate and Regulatory Matters" for further discussion.) DEMAND SIDE MANAGEMENT. In October 1991, the IURC issued an order approving expenditures by the Company for development and implementation of demand side management (DSM) programs. The primary purpose of the DSM programs is to reduce the demand on the Company's generating capacity at the time of system peak requirements, thereby postponing or avoiding the addition of generating capacity. Thus, the order of the IURC provided that the accounting and ratemaking treatment of DSM program expenditures should generally parallel the treatment of construction of new generating facilities. Most of the DSM program expenditures are being capitalized per the IURC order and will be amortized over a 15 year period beginning at the time the Company reflects such costs in its rates. The Company is requesting recovery of these costs in its general electric rate increase request filed December 22, 1993 (see "Rates and Regulatory Matters" for further discussion). In addition to the recovery of DSM program costs through base rate adjustments, the Company is collecting, through a quarterly rate adjustment mechanism, most of the margin on sales lost due to the implementation of DSM programs. The Company expects to incur costs of approximately $51 million on DSM programs during the 1994-1998 period. By 1998, approximately 108 megawatts of capacity are expected to be postponed or eliminated due to these programs. Based on the latest projections, the expenditures for DSM programs, as approved by the IURC, will total an estimated $195 million through the year 2012 and result in overall savings of $160 million to ratepayers due to deferring the construction of about 156 megawatts of new generating capacity. INTEGRATED RESOURCE PLAN. In November 1993, the Company filed with the IURC a biannual update to its Integrated Resource Plan (IRP), including the DSM program expenditures referred to above. The IRP process is a least-cost approach to determining the combination of new generating facilities and conservation and load management options that will best meet customers' future energy needs. The 1993 IRP update was the result of a nine month evaluation of detailed technology costs, customer energy use patterns, and market information, and includes natural gas conservation options not in the initial 1991 IRP. If the new IRP is approved by the IURC, the Company will implement several new DSM programs recommended by the IRP, including a residential weatherization pilot project. Supply side options recommended by the IRP include strategies to diversify the Company's natural gas suppliers, maximize the use of economical purchased power during peak usage periods, and expand the strategic use of the Company's gas storage fields. While the Company intends to aggressively utilize various DSM programs to help delay the need for additional power sources, the 1993 IRP forecasts the need of a 125 megawatt base-load generating plant in the early 21st century to meet the future electricity needs of the Company's customers. POSTEMPLOYMENT BENEFITS. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective for years beginning after December 15, 1993, which will require the Company to accrue the estimated cost of benefits provided to former or inactive employees after employment but before retirement age. Postemployment benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including workers' compensation), and continuation of benefits such as health care and life insurance coverage. The Company will adopt SFAS No. 112 on January 1, 1994. The impact of the new statement will not have a material impact on financial position or results of operations. LIQUIDITY AND CAPITAL RESOURCES. The Company experienced record earnings per share during 1993, and financial performance continued to be solid. Internally generated cash, bolstered by the increased retail sales, provided over 74% of the Company's construction and DSM program expenditures, despite the requirements of the Culley scrubber project. Earnings continued to be of high quality, of which 11.4% represented allowance for funds used during construction. The ratio of earnings to fixed charges (SEC method) was 3.8:1, the embedded cost of long-term debt is approximately 6.6%, and the Company's long-term debt continues to be rated AA by major credit rating agencies. The Company has access to outside capital markets and to internal sources of funds that together should provide sufficient resources to meet capital requirements. The Company does not anticipate any changes that would materially alter its current liquidity. On April 30, 1993, the Company called $84.5 million of its first mortgage bonds at a premium, plus accrued interest. The bonds called were the 8% due 2001, the 8% due 2002, the 8.35% due 2007, the 9-1/4% due 2016, and the 8-5/8% due 2017. The bonds called, having a weighted average interest rate of 8.5%, were refunded with two $45 million issues carrying interest rates of 6% and 7.6%, due 1999 and 2023, respectively. On May 11, 1993, the Company issued two series of adjustable rate first mortgage bonds in connection with the sale of Warrick County, Indiana environmental improvement revenue bonds. The proceeds of the bonds have been placed in trust and are being used to finance a portion of the Culley scrubber project. The first series of bonds was for $22.2 million due 2028, the interest rate of which is fixed at 4.65% through April 30, 1998. The second series of bonds was for $22.8 million due 2023; the interest rate of this series is fixed at 6% through maturity. On June 15, 1993, the Company retired $20 million of 8.50% first mortgage bonds maturing in June of 1993 with $20 million of 7-5/8% first mortgage bonds due 2025. The only financing activity during 1992 was in December when the Company called 75,000 shares of 8.75% series cumulative preferred stock at $102 per share, plus accrued dividends, with the issuance of 75,000 shares of 6.50% series redeemable cumulative preferred stock, at $100 per share. During the five year period 1994-1998, the Company anticipates that a total of $47.7 million of debt securities will be redeemed. Construction expenditures, including $4.5 million for DSM programs, totaled $80.1 million during 1993, compared to the $52.1 million expended in 1992. As discussed in "Clean Air Act", construction of the new scrubber continued in 1993, requiring $49.2 million. The remainder of the 1993 construction expenditures consisted of the normal replacements and improvements to gas and electric facilities. The Company expects that construction requirements for the years 1994-1998 will total approximately $270 million. Included in this amount is approximately $44 million to comply with the Clean Air Act amendments by 1995 and approximately $51 million of capitalized expenditures to develop and implement DSM programs. While the Company expects the majority of the construction program and debt redemption requirements to be provided by internally generated funds, external financing requirements of $50-70 million are anticipated. At year end, the Company had $11 million in short-term borrowings, leaving unused lines of credit and trust demand note arrangements totaling $16 million. The Company is confident that its long-term financial objectives, which include maintaining a capital structure near 45-50% long-term debt, 3-7% preferred stock, and 43-48% common equity, will continue to be met, while providing for future construction and other capital requirements. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page No. 1. Financial Statements: Report of Independent Public Accountants 23 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 24 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 25 Consolidated Balance Sheets - December 31, 1993 and 1992 26 - 27 Consolidated Statements of Capitalization - December 31, 1993 and 1992 28 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 29 Notes to Consolidated Financial Statements 29 - 39 2. Supplementary Information: Selected Quarterly Financial Data 40 3. Supplemental Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 44 - 46 Schedule VI - Accumulated Provision for Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 47 - 49 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991 50 Schedule IX - Short-Term Borrowings 51 Schedule X - Supplementary Income Statement Information 52 Schedule XIII - Other Investments 53 All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Consolidated Financial Statements or the accompanying Notes to Consolidated Financial Statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of Southern Indiana Gas and Electric Company: We have audited the consolidated balance sheets and consolidated statements of capitalization of SOUTHERN INDIANA GAS AND ELECTRIC COMPANY (an Indiana corporation) AND SUBSIDIARY as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the supplemental schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and supplemental schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Indiana Gas and Electric Company and Subsidiary 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, effective January 1, 1993, 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 supplemental schedules listed under Item 8 (3) 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 supplemental 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. Chicago, Illinois January 24, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary Southern Indiana Properties, Inc. All significant intercompany transactions and balances have been eliminated. CUSTOMER RECEIVABLES, SALES, AND TRANSPORTATION REVENUES The Company's customer receivables, gas and electric sales, and gas transportation revenues are primarily derived from supplying electricity and natural gas to a broadly diversified base of residential, commercial, and industrial customers located in a southwestern region of Indiana. The Company serves 118,163 electric customers in the city of Evansville and 74 other communities and serves 100,398 gas customers in the city of Evansville and 63 other communities. UTILITY PLANT Utility plant is stated at the historical original cost of construction. Such cost includes payroll-related costs such as taxes, pensions, and other fringe benefits, general and administrative costs, and an allowance for the cost of funds used during construction (AFUDC), which represents the estimated debt and equity cost of funds capitalized as a cost of construction. While capitalized AFUDC does not represent a current source of cash, it does represent a basis for future cash revenues through depreciation and return allowances. The weighted average AFUDC rate (before income tax) used by the Company was 10.5% in 1993, 11.5% in 1992, and 11.2% in 1991. DEPRECIATION Depreciation of utility plant is provided using the straight-line method over the estimated service lives of the depreciable plant. Provisions for depreciation, expressed as an annual percentage of the cost of average depreciable plant in service, were 4.0% for electric and 3.7 % for gas in 1993, 4.0% for electric and 3.9% for gas in 1992, and 4.0% for both electric and gas in 1991. INCOME TAXES The Company utilizes a comprehensive interperiod income tax allocation policy, providing deferred taxes on temporary timing differences. Investment tax credits recorded have been deferred and are amortized through credits to income over the lives of the related property. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". SFAS No. 109 requires an asset and liability approach for financial accounting and reporting for income taxes rather than the deferred method. The new standard requires the Company to establish deferred tax assets and liabilities, as appropriate, for all temporary differences and to adjust deferred tax balances to reflect changes in tax rates expected to be in effect during the periods the temporary differences reverse. In the first quarter of 1993, because of the effects of rate regulation, the Company recorded an increase of $4,987,000 in deferred tax assets and a decrease of $8,551,000 in deferred tax liabilities, and established a corresponding regulatory liability of $13,538,000, primarily to recognize the probable future reduction in rates to flow back to customers deferred taxes previously collected in excess of current tax rates. The adoption of this standard did not have a material impact on results of operations, cash flow, or financial position. The components of the net deferred income tax liability at January 1, 1993 and December 31, 1993 are as follows: Of the $17,668,000 increase in the net deferred income tax liability from January 1, 1993 to December 31, 1993, $11,263,000 is due to current year deferred federal and state income tax expense and the remaining $6,405,000 increase is primarily a result of the decrease in the net regulatory liability. The components of current and deferred income tax expense for the years ended December 31 are as follows: The components of deferred federal and state income tax expense for the years ended December 31 are as follows: As a result of the Omnibus Budget Reconciliation Act of 1993, signed into law on August 10, 1993, the Company provided additional income tax expense of $524,000 in 1993 to recognize the impact of the 1% increase in federal income tax rates. A reconciliation of the statutory tax rates to the Company's effective income tax rate for the years ended December 31 is as follows: PENSION PLANS The Company has trusteed, noncontributory defined benefit plans which cover eligible full-time regular employees. The plans provide retirement benefits based on years of service and the employee's highest 60 consecutive months' base compensation during the last 120 months of employment. The funding policy of the Company is to contribute amounts to the plans equal to at least the minimum funding requirements of the Employee Retirement Income Security Act of 1974 (ERISA) but not in excess of the maximum deductible for federal income tax purposes. The plans' assets as of December 31, 1993 consist of investments in interest bearing obligations and common stocks of 51% and 49%, respectively. The components of net pension cost for the years ended December 31 are as follows: Part of the pension cost is charged to construction and other accounts. The funded status of the retirement plans at December 31 is as follows: The projected benefit obligation at December 31, 1992 was determined using an assumed discount rate of 8%. Due to the decline in yields on high quality fixed income investments, a discount rate of 7% was used to determine the projected benefit obligation at December 31, 1993. For both periods, the long-term rate of compensation increases was assumed to be 5%, and the long-term rate of return on plan assets was assumed to be 8%. The transitional asset is being recognized over approximately 15, 18, and 14 years for the Salaried, Hourly, and Hoosier plans, respectively. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides certain postretirement health care and life insurance benefits for retired employees and their dependents through fully insured plans. Retired employees are eligible for lifetime medical and life insurance coverage if they retire on or after attainment of age 55, regardless of length of service. Their spouses are eligible for medical coverage until age 65. Prior to age 65, retirees are covered by the same insured health care plans provided to active employees. After attaining age 65, the retirees are covered by insured Medicare supplement plans. Additionally, the Company reimburses the retirees for Medicare Part B premiums incurred. The health care plans pay stated percentages of covered medical expenses incurred, after subtracting payments by Medicare or other providers and after a stated deductible has been met. Prior to 1993, the cost of retiree health care and life insurance benefits was recognized as insurance premiums were paid, which was consistent with current ratemaking practices. The costs for retirees totaled $670,000 and $598,000 in 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" which requires the expected cost of these benefits be recognized during the employees' years of service. The actuarial assumptions and calculations involved in determining the recognized costs closely parallel pension accounting requirements. As authorized by the Indiana Utility Regulatory Commission in a December 30, 1992 generic ruling, the Company is deferring as a regulatory asset the additional SFAS No. 106 costs accrued over the costs of benefits actually paid after date of adoption, but prior to inclusion in rates. As required by the generic order, the Company anticipates including the additional costs of the benefits in rates within four years after date of adoption of SFAS No. 106. The components of the net periodic other postretirement benefit cost for the year ended December 31, 1993, is as follows: The 1993 cost determined under the new standard includes the amortization of the discounted present value of the obligation at the adoption date, $29,400,000, over a 20 year period. Reconciliation of the accumulated postretirement benefit obligation to the accrued liability for postretirement benefits as of January 1, 1993 and December 31, 1993, is as follows: The assumptions used to develop the accumulated postretirement benefit obligation at January 1, 1993 included a discount rate of 8.5% and a health care cost trend rate applicable to gross eligible charges of 14% in 1993 declining to 6% in 2008, and remaining level thereafter. Due to the decline in yields on high quality fixed income investments and general inflation, a discount rate of 7.25% and a health care cost trend rate of 13.5% in 1994 declining to 5.5% in 2008 were used to determine the accumulated postretirement benefit obligation at December 31, 1993. The estimated cost of these future benefits could be significantly impacted by future changes in health care costs, work force demographics, interest rates, or plan changes. A 1% increase in the assumed health care cost trend rate each year would increase the aggregate service and interest costs for 1993 by $900,000 and the accumulated postretirement benefit obligation by $4,700,000. The Company currently anticipates continuing its policy of funding postretirement benefits costs other than pensions as incurred. POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits", which will require the Company to accrue the estimated cost of benefits provided to former or inactive employees after employment but before retirement. The Company will adopt SFAS No. 112 on January 1, 1994. The impact of the new statement will not have a material impact on financial position or results of operations. CASH FLOW INFORMATION For the purposes of the Consolidated Balance Sheets and the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. The Company, during 1993, 1992, and 1991, paid interest (net of amounts capitalized) of $18,359,000, $17,890,000, and $18,502,000, respectively, and income taxes of $10,248,000, $14,291,000, and $18,289,000, respectively. The Company is involved in several partnerships which are partially financed by partnership obligations amounting to $16,730,000 and $16,114,000 at December 31, 1993 and 1992, respectively. INVENTORIES The Company accounts for its inventories under the average cost method except for gas in underground storage which is accounted for under two inventory methods: the average cost method for the Company's Hoosier Division (formerly Hoosier Gas Corporation) and the last-in, first- out (LIFO) method for all other gas in storage. Inventories at December 31 are as follows: Based on the December 1993 price of gas purchased, the cost of replacing the current portion of gas in underground storage exceeded the amount stated on a LIFO basis by approximately $12,400,000 at December 31, 1993. OPERATING REVENUES AND FUEL COSTS Revenues include all gas and electric service billed during the year except as discussed below. All metered gas rates contain a gas cost adjustment clause which allows for adjustment in charges for changes in the cost of purchased gas. As ordered by the IURC, the calculation of the adjustment factor is based on the estimated cost of gas in a future quarter. The order also provides that any under- or overrecovery caused by variances between estimated and actual cost in a given quarter, as well as refunds from its pipeline suppliers, will be included in adjustment factors of four future quarters beginning with the second succeeding quarter's adjustment factor. All metered electric rates contain a fuel adjustment clause which allows for adjustment in charges for electric energy to reflect changes in the cost of fuel and the net energy cost of purchased power. As ordered by the IURC, the calculation of the adjustment factor is based on the estimated cost of fuel and the net energy cost of purchased power in a future quarter. The order also provides that any under- or overrecovery caused by variances between estimated and actual cost in a given quarter will be included in the second succeeding quarter's adjustment factor. The Company also collects through a quarterly rate adjustment mechanism, the margin on electric sales lost due to the implementation of demand side management programs. Reference is made to "Demand Side Management" in Management's Discussion and Analysis of Operations and Financial Condition for further discussion. The Company records monthly any under- or overrecovery as an asset or liability, respectively, until such time as it is billed or refunded to its customers. The IURC reviews for approval the adjustment clauses on a quarterly basis. The cost of gas sold is charged to operating expense as delivered to customers and the cost of fuel for electric generation is charged to operating expense when consumed. 2. REGULATORY AND OTHER MATTERS The IURC has jurisdiction over all investor-owned gas and electric utilities in Indiana. The FERC has jurisdiction over those investor-owned utilities that make wholesale energy sales. These agencies regulate the Company's utility business operations, rates, accounts, depreciation allowances, services, security issues, and the sale and acquisition of properties. On July 21, 1993, the IURC approved an overall increase of approximately 8%, or $5.5 million in revenues, in the Company's base gas rates. The increase is to be implemented in two equal steps. The first step of the rate adjustment, approximately 4%, took place August 1, 1993; the second step will become effective August 1, 1994. On May 24, 1993, the Company petitioned the IURC for an adjustment in its base electric rates representing the first step in the recovery of the financing costs on its investment through March 31, 1993 in the Clean Air Act Compliance project presently being constructed at the Culley Generating Station. The majority of the costs are for the installation of a sulfur dioxide scrubber on Culley Units 2 and 3. On September 15, 1993, the IURC granted the Company's request for a 1% revenue increase (approximately $1,800,000 on an annual basis), which took effect October 1, 1993. The Company anticipates petitioning the IURC in February 1994 for a 2-3% increase for financing costs related to project construction expenditures incurred since April 1, 1993, with implementation of the new rates effective mid-1994. On December 22, 1993, the Company filed a request with the IURC for a general electric rate increase. This adjustment, expected to occur in early 1995, is estimated to be 6-9% and is necessary to recover financing costs related to the balance of the scrubber project construction expenditures, costs related to the operation of the scrubber, and certain nonscrubber-related costs such as additional costs incurred for postretirement benefits other than pensions beginning in 1993 and the recovery of demand side management program expenditures. In April 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (the Order) which required interstate pipelines to restructure their services. In August 1992, the FERC issued Order No. 636-A which substantially reaffirmed the content of the original Order. On November 2, 1992, the Company's major pipeline , Texas Gas Transmission Corporation (TGTC), filed a recovery implementation plan with the FERC as part of its revised compliance filing regarding the Order. On October 1, 1993, the FERC accepted, subject to certain conditions, the TGTC recovery implementation plan. Under the new TGTC transportation tariffs, which became effective November 1, 1993, the Company will incur additional annual demand-related charges of approximately $1.9 million. Savings from lower volume-related transportation costs will partially offset the additional charges. TGTC has not yet determined the Company's allocation of transition costs, however, an estimate of such costs and implementation of revised TGTC tariffs to recover such costs, are expected during the first quarter of 1994. Due to the anticipated regulatory treatment at the state level, the Company does not expect the Order to have a detrimental effect on its financial condition or results of operations. Over the past several years, the Company has been involved in contract negotiations and legal actions to reduce its coal costs. During 1992, the Company successfully negotiated a new coal supply contract with a major supplier which was retroactive to 1991 and effective through 1995. In 1993, the Company exercised a provision of the agreement which allowed the Company to reopen the contract for the modification of certain coal specifications. In response, the coal supplier elected to terminate the contract enabling the Company to buy out the remainder of its contractual obligations and acquire lower priced spot market coal. The cost of the contract buyout in 1993, which was based on estimated tons of coal to be consumed during the agreement period, and related legal and consulting services, totaled approximately $18 million. The Company anticipates that $2 million in additional buyout costs for actual tons of coal consumed above the previously estimated amount may be incurred during the 1994-1995 period. On September 22, 1993, the IURC approved the Company's request to amortize all buyout costs to coal inventory during the period July 1, 1993 through December 31, 1995 and to recover such costs through the fuel adjustment clause beginning February 1994. As of December 31, 1993, $13,295,000 of settlement costs paid to date had not yet been amortized to coal inventory. The Company is currently in litigation with another coal supplier in an attempt to restructure an existing contract. Under the terms of the contract, the Company was allegedly obligated to take 600,000 tons of coal annually. In early 1993, the Company informed the supplier that it would not require shipments under the contract until later in 1993. On March 26, 1993, the Company and the supplier agreed to resume coal shipments under the terms of their original contract except the invoiced price per ton would be substantially lower than the contract price. As approved by the IURC, the Company has charged the full contract price to coal inventory for subsequent recovery through the fuel adjustment clause. The difference between the contract price and the invoice price has been deposited in an escrow account with an offsetting accrued liability which will be paid to either the Company's ratepayers or its coal supplier upon resolution of the litigation. The escrowed amount was $8,749,000 at December 31, 1993. This litigation is scheduled for trial in June of 1994. Since the litigation arose due to the Company's efforts to reduce fuel costs, management believes that any related costs should be recoverable through the regulatory ratemaking process. In late 1993, in a further effort to reduce coal costs, the Company and the supplier entered into a letter agreement, effective January 1, 1994, and until the litigation is settled, whereby the Company will purchase an additional 50,000 tons monthly above the alleged base requirements at a price lower than the original contract price for tons over 50,000 per month. Reference is made to "Rate and Regulatory Matters" in Management's Discussion and Analysis of Operations and Financial Condition for further discussion. 3. SOUTHERN INDIANA PROPERTIES, INC. Southern Indiana Properties, Inc. (SIPI), a wholly- owned subsidiary, was formed to conduct nonutility investment activities while segregating such activities from the Company's regulated utility business. Net income for the years 1993, 1992, and 1991 was $2,525,000, $2,321,000, and $1,936,000, respectively, and is included in "Other, net" in the Consolidated Statements of Income. SIPI investment activities consist principally of investments in partnerships (primarily in real estate), leveraged leases, and marketable securities. SIPI is a lessor in four leveraged lease agreements under which an office building, a part of a reservoir, an interest in a paper mill, and passenger railroad cars are leased to third parties. The economic lives and lease terms vary with the leases. The total equipment and facilities cost was approximately $101,200,000 and $83,400,000 at December 31, 1993 and 1992, respectively. The cost of the equipment and facilities was partially financed by nonrecourse debt provided by lenders, who have been granted an assignment of rentals due under the leases and a security interest in the leased property, which they accept as their sole remedy in the event of default by the lessee. Such debt amounted to approximately $78,700,000 and $63,700,000 at December 31, 1993 and 1992, respectively. The Company's net investment in leveraged leases at those dates was $8,184,000 and $7,191,000, respectively, as shown: 4. SHORT-TERM FINANCING The Company has trust demand note arrangements totaling $17,000,000 with several banks, of which $11,000,000 was utilized at December 31, 1993. Funds are also borrowed from time to time from banks on a short-term basis, made available through lines of credit. These available lines of credit totaled $10,000,000 at December 31, 1993 of which none was utilized at that date. 5. LONG-TERM DEBT The annual sinking fund requirement of the Company's first mortgage bonds is 1% of the greatest amount of bonds outstanding under the Mortgage Indenture. This requirement may be satisfied by certification to the Trustee of unfunded property additions in the prescribed amount as provided in the Mortgage Indenture. The Company intends to meet the 1994 sinking fund requirement by this means and, accordingly, the sinking fund requirement for 1994 is excluded from current liabilities on the balance sheet. At December 31, 1993, $106,887,000 of the Company's utility plant remained unfunded under the Company's Mortgage Indenture. Several of the Company's partnership investments have been financed through obligations with such partnerships. Additionally, the Company's investments in leveraged leases have been partially financed through notes payable to banks. Of the amount of first mortgage bonds, notes payable, and partnership obligations outstanding at December 31, 1993, the following amounts mature in the five years subsequent to 1993: 1994 - $4,612,000; 1995 - $11,143,000; 1996 - $12,394,000; 1997 - $2,672,000; and 1998 - $16,577,000. In addition, $41,475,000 of adjustable rate pollution control series first mortgage bonds could, at the election of the bondholder, be tendered to the Company in 1994 on certain interest payment dates. If the Company's agent is unable to remarket any bonds tendered at that time, the Company would be required to obtain additional funds for payment to bondholders. For financial statement presentation purposes those bonds subject to tender in 1994 are shown as current liabilities. First mortgage bonds, notes payable, and partnership obligations outstanding and classified as long-term at December 31 are as follows: 6. CUMULATIVE PREFERRED STOCK The amount payable in the event of involuntary liquidation of each series of the $100 par value preferred stock is $100 per share, plus accrued dividends. The nonredeemable preferred stock is callable at the option of the Company as follows: 4.8% Series at $110 per share, plus accrued dividends; and 4.75% Series at $101 per share, plus accrued dividends. 7. CUMULATIVE REDEEMABLE PREFERRED STOCK On December 8, 1992, the Company issued $7,500,000 of its Cumulative Redeemable Preferred Stock to replace a like amount of 8.75% of Cumulative Preferred Stock. The new series has an interest rate of 6.50% and is redeemable at $100 per share on December 1, 2002. In the event of involuntary liquidation of this series of $100 par value preferred stock, the amount payable is $100 per share, plus accrued dividends. 8. CUMULATIVE SPECIAL PREFERRED STOCK The Cumulative Special Preferred Stock contains a provision which allows the stock to be tendered on any of its dividend payment dates. On April 1, 1992, the Company repurchased 850 shares of the Cumulative Special Preferred Stock at a cost of $85,000 as a result of a tender within the provision of the issuance. On March 8, 1991, the Company repurchased 100 shares at a cost of $10,000 as a result of the same provision. 9. COMMITMENTS AND CONTINGENCIES The Company presently estimates that approximately $90,000,000 will be expended for construction purposes in 1994, including those amounts applicable to the Company's Clean Air Act Compliance Plan and demand side management (DSM) programs. Commitments for the 1994 construction program are approximately $44,000,000 at December 31, 1993. Reference is made to "Clean Air Act" and "Demand Side Management" in Management's Discussion and Analysis of Operations and Financial Condition for discussion of the impact of the Federal Clean Air Act and implementation of the Company's DSM programs. The Company is currently investigating the possible existence of facilities once owned and operated by the Company, its predecessors, previous landowners, or former affiliates of the Company utilized for the manufacture of gas. Based on its investigations, the Company has identified the existence and general location of four sites at which contamination may be present. The Company is attempting to identify all potentially responsible parties for each site. The Company has not been named a potentially responsible party by the Environmental Protection Agency for any of these sites. While the Company intends to seek recovery from other responsible parties or insurance carriers, the Company does not presently anticipate seeking recovery of these investigation costs from its ratepayers. Therefore, the Company has expensed the $500,000 anticipated cost of performing preliminary and comprehensive specific site investigations of all four sites. If the specific site investigations indicate that significant remedial action is required, the Company will seek recovery of all related costs in excess of amounts recovered from other potentially responsible parties or insurance carriers through rates. Although the IURC has not yet ruled on a pending request for rate recovery by another Indiana utility of such environmental costs, the IURC did grant that utility authority to utilize deferred accounting for such costs until the IURC rules on the request. 10. COMMON STOCK Since 1986, the Board of Directors of the Company authorized the repurchase of up to $25,000,000 of the Corporation's common stock. As of December 31, 1993, the Company had accumulated 1,110,177 common shares with an associated cost of $24,540,000 under this plan. On January 21, 1992, the Board of Directors of the Company approved a four-for-three common stock split effective March 30, 1992. The stock split was authorized by the IURC on March 18, 1992. Average common shares outstanding, earnings per share of common stock and dividends per share of common stock as shown in the accompanying financial statements have been adjusted to reflect the split. Shares issued during 1992 as a result of the stock split were 3,923,706. No shares of common stock were issued during 1993 and 1991. Each outstanding share of the Company's stock contains a right which entitles registered holders to purchase from the Company one one-hundredth of a share of a new series of the Company's Redeemable Preferred Stock, no par value, designated as Series 1986 Preferred Stock, at an initial price of $120.00 (Purchase Price) subject to adjustment. The rights will not be exercisable until a party acquires beneficial ownership of 20% of the Company's common shares or makes a tender offer for at least 30% of its common shares. The rights expire October 15, 1996. If not exercisable, the rights in whole may be redeemed by the Company at a price of $.01 per right at any time prior to their expiration. If at any time after the rights become exercisable and are not redeemed and the Company is involved in a merger or other business combination transaction, proper provision shall be made to entitle a holder of a right to buy common stock of the acquiring company having a value of two times such Purchase Price. 11. OWNERSHIP OF WARRICK UNIT 4 The Company and Alcoa Generating Corporation (AGC), a subsidiary of Aluminum Company of America, own the 270 MW Unit 4 at the Warrick Power Plant as tenants in common. Construction of the unit was completed in 1970. The cost of constructing this unit was shared equally by AGC and the Company, with each providing its own financing for its share of the cost. The Company's share of the cost of this unit at December 31, 1993 is $30,733,000 with accumulated depreciation totaling $17,846,000. AGC and the Company also share equally in the cost of operation and output of the unit. The Company's share of operating costs is included in operating expenses in the Consolidated Statements of Income. 12. SEGMENTS OF BUSINESS The Company is primarily a public utility operating company engaged in distributing electricity and natural gas. The reportable items for electric and gas departments for the years ended December 31 are as follows: 13. TAXES OTHER THAN INCOME TAXES The items comprising property and other taxes for the years ended December 31 are as follows: 14. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND TEMPORARY INVESTMENTS The carrying amount approximates fair value because of the short maturity of those investments. The fair value of temporary investments were based on current market values. LONG-TERM DEBT The fair value of the Company's long-term debt was estimated based on the current quoted market rate of utilities with a comparable debt rating. Nonutility long- term debt was valued based upon the most recent debt financing. PARTNERSHIP OBLIGATIONS The fair value of the Company's partnership obligations was estimated based on the current quoted market rate of comparable debt. REDEEMABLE PREFERRED STOCK Fair value of the Company's redeemable preferred stock was estimated based on the current quoted market of utilities with a comparable debt rating. The carrying amount and estimated fair values of the Company's financial instruments at December 31 are as follows: At December 31, 1993 and 1992, approximately $19,100,000 and $11,200,000, respectively, represent the excess of fair value over carrying amounts of the Company's long-term debt relating to utility operations. Anticipated regulatory treatment of the excess of fair value over carrying amounts of the Company's long-term debt, if in fact settled at amounts approximating those above, would dictate that these amounts be used to reduce the Company's rates over a prescribed amortization period. Accordingly, any settlement would not result in a material impact on the Company's financial position or results of operations. Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Identification of Directors The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. (b) Identification of Executive Officers The information required by this item is included in Part I, Item 1. - BUSINESS on page 9, to which reference is hereby made. Item 11. Item 11. EXECUTIVE COMPENSATION AND TRANSACTIONS The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is included in the Company's Proxy Statement, definitive copies of which were filed with the Commission pursuant to Regulation 14A. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1) The financial statements, including supporting schedules, are listed in the Index to Financial Statements, page 22, (a) 2) filed as part of this report. (a) 3) Exhibits: EX-2(a) Merger Agreement - Plan of Reorganization and Agreement of Merger, by and among: Southern Indiana Gas and Electric Company; Southern Indiana Group, Inc.; Horizon Investments, Inc.; and MPM Investment Corporation, dated August 27, 1987. (Physically filed and designated as Exhibit A in Form S-4 Registration Statement filed November 12, 1987, File No. 33-18475.) EX-3(a) Amended Articles of Incorporation as amended March 26, 1985. (Physically filed and designated in Form 10-K, for the fiscal year 1985, File No. 1-3553, as Exhibit 3-A.) Articles of Amendment of the Amended Articles of Incorporation, dated March 24, 1987. (Physically filed and designated in Form 10-K for the fiscal year 1987, File No. 1-3553, as Exhibit 3-A.) Articles of Amendment of the Amended Articles of Incorporation, dated November 27, 1992. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 3-A). EX-3(b) By-Laws as amended through December 18, 1990. (Physically filed in Form 10-K for the fiscal year 1990, File No. 1-3553, as Exhibit 3-B.) By-Laws as amended through September 22, 1993. (Physically filed herewith as EX-3(b).) EX-4(a)*Mortgage and Deed of Trust dated as of April 1, 1932 between the Company and Bankers Trust Company, as Trustee, and Supplemental Indentures thereto dated August 31, 1936, October 1, 1937, March 22, 1939, July 1, 1948, June 1, 1949, October 1, 1949, January 1, 1951, April 1, 1954, March 1, 1957, October 1, 1965, September 1, 1966, August 1, 1968, May 1, 1970, August 1, 1971, April 1, 1972, October 1, 1973, April 1, 1975, January 15, 1977, April 1, 1978, June 4, 1981, January 20, 1983, November 1, 1983, March 1, 1984, June 1, 1984, November 1, 1984, July 1, 1985, November 1, 1985, June 1, 1986. (Physically filed and designated in Registration No. 2-2536 as Exhibits B-1 and B-2; in Post-effective Amendment No. 1 to Registration No. 2-62032 as Exhibit (b)(4)(ii), in Registration No. 2-88923 as Exhibit 4(b)(2), in Form 8-K, File No. 1-3553, dated June 1, 1984 as Exhibit (4), File No. 1-3553, dated March 24, 1986 as Exhibit 4-A, in Form 8-K, File No. 1-3553, dated June 3, 1986 as Exhibit (4).) July 1, 1985 and November 1, 1985 (Physically filed and designated in Form 10-K, for the fiscal year 1985, File No. 1-3553, as Exhibit 4-A.) November 15, 1986 and January 15, 1987. (Physically filed and designated in Form 10-K, for the fiscal year 1986, File No. 1-3553, as Exhibit 4-A.) December 15, 1987. (Physically filed and designated in Form 10-K, for the fiscal year 1987, File No. 1-3553, as Exhibit 4-A.) December 13, 1990. (Physically filed and designated in Form 10-K, for the fiscal year 1990, File No. 1-3553, as Exhibit 4-A.) April 1, 1993. (Physically filed and designated in Form 8-K, dated April 13, 1993, File 1-3553, as Exhibit 4.) June 1, 1993 (Physically filed and designated in Form 8-K, dated June 14, 1993, File 1-3553, as Exhibit 4.) May 1, 1993. (Physically filed herewith as EX-4(a).) EX-10.1 Agreement, dated, January 30, 1968, for Unit No. 4 at the Warrick Power Plant of Alcoa Generating Corporation ("Alcoa"), between Alcoa and the Company. (Physically filed and designated in Registration No. 2-29653 as Exhibit 4(d)-A.) EX-10.2 Letter of Agreement, dated June 1, 1971, and Letter Agreement, dated June 26, 1969, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-41209 as Exhibit 4(e)-2.) *Pursuant to paragraph (b)(4)(iii)(a) of Item 601 of Regulation S-K, the Company agrees to furnish to the Commission on request any instrument 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 has therefore not filed such documents as exhibits to this Form 10-K. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) EX-10.3 Letter Agreement, dated April 9, 1973, and agreement dated April 30, 1973, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-53005 as Exhibit 4(e)-4.) EX-10.4 Electric Power Agreement (the "Power Agreement"), dated May 28, 1971, between Alcoa and the Company. (Physically filed and designated in Registration No. 2-41209 as Exhibit 4(e)-1.) EX-10.5 Second Supplement, dated as of July 10, 1975, to the Power Agreement and Letter Agreement dated April 30, 1973 - First Supplement. (Physically filed and designated in Form 12-K for the fiscal year 1975, File No. 1-3553, as Exhibit 1(e).) EX-10.6 Third Supplement, dated as of May 26, 1978, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1978 as Exhibit A-1.) EX-10.7 Letter Agreement dated August 22, 1978 between the Company and Alcoa, which amends Agreement for Sale in an Emergency of Electrical Power and Energy Generation by Alcoa and the Company dated June 26, 1979. (Physically filed and designated in Form 10-K for the fiscal year 1978, File No. 1- 3553, as Exhibit A-2.) EX-10.8 Fifth Supplement, dated as of December 13, 1978, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-3.) EX-10.9 Sixth Supplement, dated as of July 1, 1979, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-5.) EX-10.10 Seventh Supplement, dated as of October 1, 1979, to the Power Agreement. (Physically filed and designated in Form 10-K for the fiscal year 1979, File No. 1-3553, as Exhibit A-6.) EX-10.11 Eighth Supplement, dated as of June 1, 1980 to the Electric Power Agreement, dated May 28, 1971, between Alcoa and the Company. (Physically filed and designated in Form 10- K for the fiscal year 1980, File No. 1-3553, as Exhibit (20)-1.) EX-10.12* Agreement dated May 6, 1991 between the Company and Ronald G. Reherman for consulting services and supplemental pension and disability benefits. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A- 12.) EX-10.13* Agreement dated July 22, 1986 between the Company and A. E. Goebel regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-13.) EX-10.14* Agreement dated July 25, 1986 between the Company and Ronald G. Reherman regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-14.) EX-10.15* Agreement dated July 22, 1986 between the Company and James A. Van Meter regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-15.) EX-10.16* Agreement dated February 22, 1989 between the Company and J. Gordon Hurst regarding continuation of employment. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553 as Exhibit 10-A-16.) EX-10.17* Summary description of the Company's nonqualified Supplemental Retirement Plan (Physically filed and designated in Form 10- K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-17.) * Filed pursuant to paragraph (b)(10)(iii)(A) of Item 601 of Regulation S-K. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) EX-10.18* Supplemental Post Retirement Death Benefits Plan, dated October 10, 1984. (Physically filed and designated in Form 10-K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-18.) EX-10.19* Summary description of the Company's Corporate Performance Incentive Plan. (Physically filed and designated in Form 10- K for the fiscal year 1992, File No. 1-3553, as Exhibit 10-A-19.) EX-10.20* Company's Corporate Performance Incentive Plan as amended for the plan year beginning January 1, 1994. (Physically filed herewith as Exhibit 10-A-20.) * Filed pursuant to paragraph (b)(10)(iii)(A) of Item 601 of Regulation S-K. (b) Reports on Form 8-K No Form 8-K reports were filed by the Company during the fourth quarter of 1993. SCHEDULE V Page 1 of 3 SOUTHERN INDIANA GAS AND ELECTRIC COMPANY PROPERTY, PLANT AND EQUIPMENT Year 1993 SCHEDULE IX SOUTHERN INDIANA GAS AND ELECTRIC COMPANY SHORT-TERM BORROWINGS Reference is made to Note 4 of the Notes to Consolidated Financial Statements, page 35, regarding short- term borrowings. SCHEDULE X SOUTHERN INDIANA GAS AND ELECTRIC COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION Reference is made to Note 13 of the Notes to Consolidated Financial Statements, page 39, regarding taxes other than income taxes. Maintenance and depreciation, other than set forth in the "Consolidated Statements of Income," rents, advertising costs, research and development and royalties during the periods were not significant. SCHEDULE XIII SOUTHERN INDIANA GAS AND ELECTRIC COMPANY OTHER INVESTMENTS 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. Date: March 28, 1994 SOUTHERN INDIANA GAS AND ELECTRIC COMPANY By R. G. Reherman, Chairman, President and Chief Executive Officer BY (R. G. Reherman) R. G. Reherman 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 R. G. Reherman Chairman, President, Chief Executive Officer (Principal Executive Officer) March 28, 1994 A. E. Goebel* Senior Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial Officer) March 28, 1994 S. M. Kerney* Controller (Principal Accounting Officer) March 28, 1994 Melvin H. Dodson* ) ) Walter B. Emge* ) ) Robert L. Koch II* ) ) Jerry A. Lamb* ) ) Donald A. Rausch* ) Directors March 28, 1994 ) John H. Schroeder* ) ) Richard W. Shymanski*) ) Donald E. Smith* ) ) James S. Vinson* ) ) N. P. Wagner* ) *By (R. G. Reherman, Attorney-in-fact) SIGECO 10-K EXHIBIT INDEX Sequential Page Number Exhibits incorporated by reference are found on 42-44 EX-3(b) By-Laws as amended through September 22, 1993 63-79 EX-4(a) Supplemental Indentures dated May 1, 1993 81-108 EX-10.20 Company's Corporate Performance Incentive Plan as amended for the plan year beginning January 1, 1994 110-114 EX-12 Computation of ratio of earnings to fixed charges 55 EX-21 Subsidiary of the Registrant 56 EX-24 Power-of-Attorney 60-61

19584_1993.txt

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1993

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ITEM 1. BUSINESS GENERAL Chemed Corporation was incorporated in Delaware in 1970 as a subsidiary of W. R. Grace & Co. and succeeded to the business of W. R. Grace & Co.'s Specialty Products Group as of April 30, 1971 and remained a subsidiary of W. R. Grace & Co. until March 10, 1982. As used herein, "Company" refers to Chemed Corporation, "Chemed" refers to Chemed Corporation and its subsidiaries and "Grace" refers to W. R. Grace & Co. and its subsidiaries. On March 10, 1982, the Company transferred to Dearborn Chemical Company, a wholly-owned subsidiary of the Company, the business and assets of the Company's Dearborn Group, including the stock of certain subsidiaries within the Dearborn Group, plus $185 million in cash, and Dearborn Chemical Company assumed the Dearborn Group's liabilities. Thereafter, on March 10, 1982 the Company transferred all of the stock of Dearborn Chemical Company to Grace in exchange for 16,740,802 shares of the capital stock of the Company owned by Grace with the result that Grace no longer has any ownership interest in the Company. On December 31, 1986, the Company completed the sale of substantially all of the business and assets of Vestal Laboratories, Inc., a wholly-owned subsidiary ("Vestal"). The Company received cash payments aggregating approximately $67.4 million over the four-year period following the closing, the substantial portion of which was received on December 31, 1986. On April 2, 1991, the Company completed the sale of DuBois Chemicals, Inc. ("DuBois"), a wholly-owned subsidiary, to the Diversey Corporation ("Diversey"), a subsidiary of The Molson Companies Ltd. Under the terms of the sale, Diversey agreed to pay the Company net cash payments aggregating $223,386,000, including deferred payments aggregating $32,432,000. As of December 31, 1993, the Company had received cash payments totaling $203,580,000. On December 21, 1992, the Company acquired The Veratex Corporation and related businesses ("Veratex Group") from Omnicare, Inc., a publicly traded affiliate in which Chemed maintains a 25.7%-ownership interest (27% ownership interest at December 31, 1993). The purchase price was $62,120,000 in cash paid at closing, plus a post-closing payment of $1,514,000 (paid in April 1993) based on the net assets of Veratex. During 1993, the Company conducted its business operations in three segments: National Sanitary Supply Company ("National Sanitary Supply"), Roto-Rooter, Inc. ("Roto-Rooter"), and Veratex Group ("Veratex"). Effective January 1, 1994, the Company acquired all the capital stock of Patient Care, Inc. ("Patient Care"), for cash payments aggregating $20,582,000, including deferred payments with a present value of $6,582,000, plus 17,500 shares of the Company's Capital Stock. Additional cash payments of up to $10,400,000 may be made, the amount being contingent upon the earnings of Patient Care during the three-year period ending December 31, 1995. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The required segment and geographic data for the Company's continuing operations (as described below) for the three years ended December 31, 1991, 1992 and 1993, are shown in the "Sales and Profit Statistics by Business Segment" and the "Additional Segment Data" on pages 32, 33 and 36 of the 1993 Annual Report to Stockholders and are incorporated herein by reference. DESCRIPTION OF BUSINESS BY SEGMENT The information called for by this item is included within Note 1 of the Notes to Financial Statements appearing on page 23 of the 1993 Annual Report to Stockholders and is incorporated herein by reference. PRODUCT AND MARKET DEVELOPMENT Each segment of Chemed's business engages in a continuing program for the development and marketing of new products. While new product and new market development are important factors for the growth of each active segment of Chemed's business, Chemed does not expect that any new product or marketing effort, including those in the development stage, will require the investment of a material amount of Chemed's assets. RAW MATERIALS The principal raw materials needed for each active segment of Chemed's United States manufacturing operations are purchased from United States sources. No segment of Chemed experienced any material raw material shortages during 1993, although such shortages may occur in the future. Products manufactured and sold by Chemed's active business segments generally may be reformulated to avoid the adverse impact of a specific raw material shortage. PATENTS, SERVICE MARKS AND LICENSES The Roto-Rooter(R) trademark and service mark have been used and advertised since 1935 by Roto-Rooter Corporation, a wholly-owned subsidiary of Roto-Rooter, Inc., a 59%-owned subsidiary of the Company. The Roto-Rooter(R) marks are among the most highly recognized trademarks and service marks in the United States. Chemed considers the Roto-Rooter(R) marks to be a valuable asset and a significant factor in the marketing of Roto-Rooter's franchises, products and services and the products and services provided by its franchisees. INVENTORIES Chemed maintains local warehousing and delivery arrangements throughout the United States to provide prompt delivery service to its customers. Inventories on hand for each active segment are not considered high in relation to industry standards for the business involved. In general, terms and conditions of sale for each segment follow usual and customary industry standards. COMPETITION NATIONAL SANITARY SUPPLY Chemed considers National Sanitary Supply (with its subsidiaries Century Papers, Inc. and NSS Development) to be a leader in the janitorial maintenance supply distribution market in the western, southwestern and midwestern United States (Arizona, California, Colorado, Indiana, Louisiana, Michigan, Mississippi, Missouri, Nevada, New Mexico, Ohio, Oklahoma, Oregon, Tennessee, Texas, Utah and Washington). This subsidiary markets a broad line of cleaning chemicals, paper goods, plastic products, waste handling products and other janitorial supplies to a wide range of customers. The market for sanitary maintenance and paper supplies is highly competitive and entry is relatively easy. Competition is, however, highly fragmented in most geographic markets. In the United States, approximately 9,000 firms compete in the sanitary maintenance supply distribution business on a local or regional basis. The principal competitive factors in this market are the level of service provided; range of products offered; speed, efficiency and reliability of delivery; and price. There are a number of local janitorial supply companies that compete with National Sanitary Supply in its market. The principal competitive factors in the janitorial supply market in order of importance are breadth of product line, prompt delivery and price. While remaining price competitive, National Sanitary Supply maintains a product line that is generally broader than its competitors and has earned an excellent reputation for prompt delivery and customer service. Federal, state and local governmental agencies accounted for approximately 6 percent of National Sanitary Supply's total sales for 1993. These sales are attributable to over 4,000 different agencies whose purchasing decisions are made separately. While it is believed that the loss of the sales to these agencies in the aggregate would be material, the decentralized purchasing decisions make the loss of a significant number of such accounts at any given time unlikely. National Sanitary Supply also had sales to one customer, Sonic Corporation, which comprised approximately 13 percent of sales in 1993. This customer is a fast-food restaurant chain consisting of approximately 1,150 franchises and 120 company-owned restaurants. Sales to this customer consisted primarily of low-margin food-service products such as paper napkins, plates and cups. Other than sales to the aforementioned entities, no one customer accounts for more than two percent of net sales. ROTO-ROOTER All aspects of the sewer, drain, and pipe cleaning, and appliance and plumbing repair businesses are highly competitive. Competition is, however, fragmented in most markets with local and regional firms providing the primary competition. The principal methods of competition are advertising, range of services provided, speed and quality of customer service, service guarantees, and pricing. No individual customer or market group is critical to the total sales of this segment. VERATEX In distributing medical and dental products, Veratex competes with numerous mail-order businesses; medical, dental and veterinary supply houses; and manufacturers of disposable paper, cotton and gauze products. Veratex competes in this market on the basis of customer service, product quality and price. At times, its pricing policy has been subject to considerable competitive pressures, limiting the ability to implement price increases. No individual customer or market group is critical to the total sales of this segment. RESEARCH AND DEVELOPMENT Chemed engages in a continuous program directed toward the development of new products and processes, the improvement of existing products and processes, and the development of new and different uses of existing products. The research and development expenditures from continuing operations have not been nor are they expected to be material. ENVIRONMENTAL MATTERS Chemed's operations are subject to various federal, state and local laws and regulations regarding the environmental aspects of the manufacture and distribution of chemical products. Chemed, to the best of its knowledge, is currently in compliance in all material respects with the environmental laws and regulations affecting its operations. Such environmental laws, regulations and enforcement proceedings have not required Chemed to make material increases in or modifications to its capital expenditures and they have not had a material adverse effect on sales or net income. In connection with the sale of DuBois to the Diversey Corporation, the Company contractually assumed for a period of ten years the estimated liability for potential environmental cleanup and related costs arising from the sale of DuBois up to a maximum of $25,500,000. The Company has accrued $15,500,000 with respect to these potential liabilities. Prior to the sale of DuBois, DuBois had been designated as a Potentially Responsible Party ("PRP") at fourteen Superfund sites by the U.S. Environmental Protection Agency ("USEPA"). With respect to all of these sites, the Company has been unable to locate any records indicating it disposed of waste of any kind at such sites. Nevertheless, it settled claims at five such sites at minimal cost. In addition, because there were a number of other financially responsible companies designated as PRPs relative to these sites, management believes that it is unlikely that such actions will have a material effect on the Company's financial condition or results of operations. With respect to one of these sites, the Company's involvement is based on the location of one of its manufacturing plants. Currently, the USEPA and the state governmental agency are attempting to resolve jurisdictional issues, and action against PRPs is not proceeding. Capital expenditures for the purposes of complying with environmental laws and regulations during 1994 and 1995 with respect to continuing operations are not expected to be material in amount; there can be no assurance, however, that presently unforeseen legislative or enforcement actions will not require additional expenditures. EMPLOYEES On December 31, 1993, Chemed had a total of 4,834 employees; 4,796 were located in the United States and 38 were in Canada. ITEM 2. ITEM 2. PROPERTIES Chemed has plants and offices in various locations in the United States. The major facilities operated by Chemed are listed below by industry segment. All "owned" property is held in fee and is not subject to any major encumbrance. Except as otherwise shown, the leases have terms ranging from one year to thirteen years. Management does not foresee any difficulty in renewing or replacing the remainder of its current leases. Chemed considers all of its major operating properties to be maintained in good operating condition and to be generally adequate for present and anticipated needs. (4) Comprising locations in Pennsauken and North Brunswick, New Jersey; Jacksonville, Medley, Pompano Beach, Ft. Myers, St. Petersburg, Boca Raton, Deerfield Beach, Daytona Beach and Orlando, Florida; Virginia Beach and Fairfax, Virginia; Levittown, Pennsylvania; Raleigh, North Carolina; and Newark, Delaware. (5) Comprising locations in Houston and San Antonio, Texas; Addison, Elk Grove Village and Posen, Illinois; Denver, Colorado; Pearl City, Hawaii; Minneapolis, Minnesota; Tacoma, Washington; and Phoenix, Arizona. (6) Comprising locations in Delta, British Columbia and Boucherville, Quebec. (7) Comprising of former office, manufacturing and warehouse facilities that are presently under lease to an outside third party. (8) Excludes 88,000 square feet in current Cincinnati, Ohio, office facilities that are sublet to an outside party -- portions of this space may revert to the Company beginning in 1998. Includes 31,000 square feet leased for the Company's corporate office facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. (3) Mr. P. C. Voet is an Executive Vice President of the Company and has held this position since May 1991. From May 1988 to November 1993, he served the Company as Vice Chairman. Mr. Voet is President and Chief Executive Officer of National Sanitary Supply. (4) Mr. T. S. O'Toole is an Executive Vice President and the Treasurer of the Company and has held these positions since May 1992 and February 1989, respectively. From May 1988 to February 1989, he served as Vice President and a Director of Taxes of the Company. (5) Mr. K. J. McNamara is an Executive Vice President, Secretary and General Counsel of the Company and has held these positions since November 1993, August 1986 and August 1986, respectively. He previously held the positions of Vice Chairman of the Company, from May 1992 to November 1993, and Vice President of the Company, from August 1986 to May 1992. (6) Ms. S. E. Laney is Senior Vice President and the Chief Administrative Officer of the Company and has held these positions since November 1993 and May 1991, respectively. Previously, from May 1984 to November 1993, she held the position of Vice President of the Company. (7) Mr. A. V. Tucker is a Vice President and Controller of the Company and has held these positions since February 1989. From May 1983 to February 1989, he held the position of Assistant Controller of the Company. Each executive officer holds office until the annual election at the next annual organizational meeting of the Board of Directors of the Company which is scheduled to be held on May 16, 1994. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Capital Stock (par value $1 per share) is traded on the New York Stock Exchange under the symbol CHE. The range of the high and low sale prices on the New York Stock Exchange and dividends paid per share for each quarter of 1992 and 1993 are set forth below. Future dividends are necessarily dependent upon the Company's earnings and financial condition, compliance with certain debt covenants and other factors not presently determinable. As of March 18, 1994, there were approximately 6,096 stockholders of record of the Company's Capital Stock. This number only includes stockholders of record and does not include stockholders with shares beneficially held for them in nominee name or within clearinghouse positions of brokers, banks or other institutions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information called for by this Item for the five years ended December 31, 1993 is set forth on pages 34 and 35 of the 1993 Annual Report to Stockholders and the information for such five years is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information called for by this Item is set forth on pages 37 through 40 of the 1993 Annual Report to Stockholders and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, together with the report thereon of Price Waterhouse dated February 1, 1994, appearing on pages 17 through 30 of the 1993 Annual Report to Stockholders, along with the Supplementary Data (Unaudited Summary of Quarterly Results) appearing on page 31, 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 of the Company are: J. Peter Grace Jon D. Krahulik Edward L. Hutton Sandra E. Laney James A. Cunningham Kevin J. McNamara James H. Devlin John M. Mount Charles H. Erhart, Jr. Timothy S. O'Toole Joel F. Gemunder D. Walter Robbins, Jr. Neal Gilliatt Arthur V. Tucker William R. Griffin Paul C. Voet Will J. Hoekman Hugh A. Westbrook Thomas C. Hutton Except with respect to the age and business experience of Messrs. Gilliatt, Hoekman, and Tucker, the information required under this Item with respect to directors is set forth in the Company's 1994 Proxy Statement which is incorporated herein by reference. The information with respect to Messrs. Gilliatt and Hoekman is set forth below and the information with respect to Mr. Tucker is in footnote (7) under "Executive Officers of the Company" in Part I of this Annual Report on Form 10-K. (1) Mr. Gilliatt is President of Neal Gilliatt/Stuart Watson, Inc., New York, New York (Management Consulting) and has held this position since April 1982. On April 1, 1982, he retired as Chairman of the Executive Committee of the Interpublic Group of Companies, Inc., New York, New York (advertising and related communications), having held that position since February 1980. Mr. Gilliatt is a director of Consolidated Products, Inc., National Sanitary Supply, Omnicare and Roto-Rooter. Mr. Gilliatt is 76. (2) Mr. Hoekman is a Senior Vice President of Firstar Bank, Des Moines, Iowa, and has held this position since November 1980. Mr. Hoekman is a director of Roto-Rooter. Mr. Hoekman is 48. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required under this Item is set forth in the Company's 1994 Proxy Statement, which is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required under this Item is set forth in the Company's 1994 Proxy Statement, which is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required under this Item is set forth in the Company's 1994 Proxy Statement, which is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. EXHIBITS 3.1 Certificate of Incorporation of Chemed Corporation.* 3.2 By-Laws of Chemed Corporation.* 10.1 Agreement and Plan of Merger among Diversey U.S. Holdings, Inc., D. C. Acquisition Inc., Chemed Corporation and DuBois Chemicals, Inc., dated as of February 25, 1991.* 10.2 Stock Purchase Agreement between Omnicare, Inc. and Chemed Corporation, dated as of August 5, 1992.* 10.3 1978 Stock Incentive Plan, as amended through May 20, 1991.*,** 10.4 1981 Stock Incentive Plan, as amended through May 20, 1991.*,** 10.5 1983 Incentive Stock Option Plan, as amended through May 20, 1991.*,** 10.6 1986 Stock Incentive Plan, as amended through May 20, 1991.*,** 10.7 1988 Stock Incentive Plan, as amended through May 20, 1991.*,** 10.8 1993 Stock Incentive Plan.** 10.9 Executive Salary Protection Plan, as amended through November 3, 1988.*,** 10.10 Excess Benefits Plan, as amended effective November 1, 1985.*,** 10.11 Non-Employee Directors' Deferred Compensation Plan.*,** 10.12 Directors Emeriti Plan.*,** 10.13 Employment Contracts with Executives.*,** 10.14 Amendment No. 5 to Employment Contracts with Executives.** 11. Statement re: Computation of Earnings Per Common Share. 13. 1993 Annual Report to Stockholders. 21. Subsidiaries of Chemed Corporation. 23. Consent of Independent Accountants. 24. Powers of Attorney. * This exhibit is being filed by means of incorporation by reference (see Index to Exhibits on page E-1). Each other exhibit is being filed with this Annual Report on Form 10-K. ** Management contract or compensatory plan or arrangement. FINANCIAL STATEMENT SCHEDULES See Index to Financial Statements and Financial Statement Schedules on page S-1. 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. CHEMED CORPORATION March 29, 1994 By /s/ Edward L. Hutton -------------------- Edward L. Hutton 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. March 29, 1994 /s/ Kevin J. McNamara - ----------------------- -------------------------------- Date Kevin J. McNamara (Attorney-in-Fact) - ------------------------ The consolidated financial statements of Chemed Corporation listed above, appearing in the 1993 Annual Report to Stockholders, are incorporated herein by reference. The Financial Statement Schedules should be read in conjunction with the consolidated financial statements listed above. Schedules not included have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto as listed above. S-1 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Chemed Corporation Our audits of the consolidated financial statements referred to in our report dated February 1, 1994 appearing on page 17 of the 1993 Annual Report to Stockholders of Chemed 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 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Cincinnati, Ohio February 1, 1994 S-2 S-3 S-4 S-5

201493_1993.txt

201493_1993

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ITEM 1. BUSINESS. Coltec Industries Inc and its consolidated subsidiaries (together referred to as "Coltec") manufacture and sell a diversified range of highly-engineered aerospace, automotive and industrial products in the United States and, to a lesser extent, abroad. Coltec's operations are conducted through three principal segments: Aerospace/Government, Automotive and Industrial. Set forth below is a description of the business conducted by the respective divisions within Coltec's three industry segments. The tabular five-year presentation of financial information in respect of each industry segment under the caption "Industry Segment Information" of Coltec's 1993 Annual Report to its shareholders and the information in Note 11 of the Notes to Financial Statements of Coltec's 1993 Annual Report to its shareholders are incorporated herein by reference. AEROSPACE/GOVERNMENT Through its Aerospace/Government segment, Coltec is a leading manufacturer of landing gear systems, engine fuel controls, turbine blades, fuel injectors, nozzles and related components for commercial and military aircraft, and also produces high-horsepower diesel engines for naval ships and diesel, gas and dual-fuel engines for electric power plants. The divisions, principal products and principal markets of the Aerospace/Government segment are as follows: With reductions in domestic military spending, Coltec has placed an increasing emphasis on sales by its Aerospace/Government segment to commercial aircraft manufacturers. In addition to producing landing gear for various Boeing, McDonnell Douglas and other aircraft, Coltec has been awarded a contract to supply main landing gear for the Boeing 737-700 aircraft. In the case of Coltec's successful bid to become the supplier of landing gear for the Boeing 777 aircraft, Coltec developed and delivered the first landing gear set ahead of schedule in August 1993. Coltec has also been successful in increasing its penetration of the commercial aircraft engine market, including the commuter aircraft and general aviation markets, through its Chandler Evans Control Systems, Walbar and Delavan Gas Turbine Divisions. See "Aerospace Controls", "Aircraft Engine Components" and "Gas Turbine Products" below. In most of the divisions in this segment, Coltec is a leading manufacturer in the markets it services and has focused its efforts on manufacturing quality products involving a high engineering content or proprietary technology. In many cases in which Coltec developed components for use in a specific aircraft, Coltec has become the primary source for replacement parts and, in some cases, service for these products in the aftermarket. Many of the programs for which Coltec has been awarded a contract or for which Coltec has been selected as a manufacturer are subject to termination or modification. See "--Contract Risks". LANDING GEAR SYSTEMS Coltec, through its Menasco Aerosystems and Menasco Overhaul Divisions and its Canadian subsidiary, Menasco Aerospace Ltd. (collectively referred to as "Menasco"), designs, manufactures and markets landing gear systems, parts and components for medium-to-heavy commercial aircraft and for military aircraft and provides spare parts and overhaul services for these products. Menasco is one of the leading suppliers of landing gear for medium-to-heavy commercial and military aircraft. It also designs and manufactures aircraft flight control actuation systems and is a team leader in a flight control systems research and development program directed toward the design, validation and implementation of advanced "fly-by-wire/fly-by-light" flight control technology. Landing gear, including components, parts, and overhaul services for landing gear, accounted for approximately 87% of Menasco's sales and 11% of Coltec's sales during 1993. For the years 1993, 1992 and 1991, commercial sales accounted for 62%, 73% and 70%, respectively, of Menasco's total sales. Menasco has been awarded contracts to supply the main and nose landing gear for the Boeing 777 aircraft. Delivery of landing gear for the Boeing 777 aircraft commenced in 1993. The Boeing Company ("Boeing") has announced that 147 firm orders and options for an additional 108 of its 777 aircraft have been placed as of December 31, 1993. Menasco has been selected to replace a competitor as the supplier of the main landing gear for the Fokker Fo-100 aircraft as well as to supply the main landing gear and flight controls for the Fokker Fo-70. Menasco has supplied most of the flight controls for the Fo-100 since this aircraft was introduced. Other commercial programs for which Menasco is currently producing landing gear and flight controls include the main and nose landing gear for the Boeing 757 aircraft, the main landing gear for the Boeing 737 aircraft, the nose landing gear for the Boeing 767 aircraft, the main landing gear for the McDonnell Douglas MD-80/90 aircraft, the flight controls for the Canadair RJ-601 aircraft and landing gear components for the Airbus Industrie A-320 and A-330/340 aircraft. Menasco is supplying the main and nose landing gear for the Taiwanese Indigenous Defense Fighter being built for the Taiwanese government and is developing the main and nose landing gear for the Lockheed/Boeing Advanced Tactical Fighter. Other military programs for which Menasco is currently producing landing gear and flight controls include the main and tail landing gear for the McDonnell Douglas AH-64 Apache helicopter, the nose landing gear and flight controls for the McDonnell Douglas C-17 military transport, the main and nose landing gear for the aircraft produced by Lockheed Corp. ("Lockheed") and the Lockheed C-130 military transport. Landing gear and flight controls are designed for specific aircraft and produced by a single manufacturer. Menasco has been the sole supplier of this equipment for each program it has been awarded. The price of landing gear constitutes approximately 2% of the total cost of an aircraft. Menasco joined with Messier-Bugatti for the development and production of landing gear for the Boeing 777 and the Airbus 330/340 aircraft and has agreed to cooperate on future ventures where appropriate, which may include Airbus and McDonnell Douglas programs, although no major commercial programs are currently formalized. In addition to manufacturing and marketing aircraft landing gear and flight controls, Menasco provides complete overhaul services on a worldwide basis for landing gear and actuation systems through its overhaul facilities in the United States and Canada. In view of the relatively small number of medium-to-heavy aircraft manufacturers, Menasco's commercial sales of landing gear have historically been concentrated among a limited number of purchasers, primarily Boeing, McDonnell Douglas and Lockheed in the United States and Fokker in Europe. The market for landing gear is highly competitive, with a small number of airframe manufacturers evaluating potential suppliers based on design, price and record of past performance. Menasco has made significant investments in long-term marketing to promote working relationships with customers and to enhance Menasco's engineering department's understanding of customer requirements. Menasco believes it is this engineering expertise, together with its record of on-time delivery, quality and price, which has made Menasco one of the leading producers of medium-to heavy-aircraft landing gear worldwide. Menasco's primary domestic competitors are Cleveland Pneumatic Division of The B.F. Goodrich Company and Bendix Brake and Strut Division of Allied-Signal Inc. ("Allied-Signal"). Foreign competitors include Messier-Bugatti, Dowty of England and Dowty Canada Ltd. The overhaul business has become increasingly competitive. Menasco believes its competitive strengths in the overhaul business include its name, which carries a reputation for quality and service. Raw materials and finished products essential to Menasco's manufacturing operations are available in sufficient quantity from various sources. AEROSPACE CONTROLS Coltec, through its Chandler Evans Control Systems Division ("Chandler Evans"), manufactures a variety of aircraft engine fuel control systems and fuel pumps and engine and aircraft components for the aerospace industry. Chandler Evans' products are highly engineered and contain proprietary technology. Principal customers for these products include gas turbine engine manufacturers, aircraft manufacturers, domestic and foreign airlines, commercial fleet operators and the military services. For the years 1993, 1992 and 1991, commercial sales accounted for 67%, 71% and 63%, respectively, of Chandler Evans' total sales. Chandler Evans produces for sale to the commercial aircraft engine market the main fuel pump for certain models of the General Electric CF-6 and CF-34 engines, both used on various commercial aircraft, and the Textron Lycoming LF-507 engine used on the British Aerospace BAe 146 aircraft. Chandler Evans also produces for sale to the military aircraft engine market the main fuel pump for certain models of the United Technologies engine used on the McDonnell Douglas aircraft, the main and afterburner fuel pumps for the General Electric engine used on the McDonnell Douglas aircraft and fuel control systems for the Textron Lycoming T-53 engine used on the Bell UH-1 Utility and Cobra attack helicopters. The main and afterburner pump for the GE-414 engine is currently in development. Except for the General Electric CF-6 and the United Technologies (for which different manufacturers supply components for specific engine versions having different thrust), Chandler Evans is the sole source of the pumps and fuel control systems that it supplies for the engine programs described above. Chandler Evans was selected to develop and manufacture a full authority digital electronic control ("FADEC") for the Allison 250 engine. Delivery of this system is scheduled to begin in late 1994. Also, Chandler Evans has developed a FADEC for the T800-LHT helicopter engine, a joint venture of Allison Engine Company and Allied-Signal Garrett, which has commercial and military applications. Chandler Evans is likely to remain the sole source of these components for the life of these programs. Chandler Evans also supports its products with aftermarket sales of spare units, parts and overhaul service. For the year 1993, 52% of Chandler Evans' revenues were attributable to the aftermarket. Aftermarket sales are very significant, since proprietary programs allow Chandler Evans to realize favorable operating margins. Chandler Evans competes with Argo-Tech and the Aviation Division of Sundstrand Corporation in fuel pumps and with the Bendix Control Division of Allied-Signal and the Hamilton Standard Division of United Technologies Corporation in fuel controls. Due to the highly engineered, proprietary nature of its products, Chandler Evans maintains a substantial portion of aftermarket sales, with competition limited to a small number of imitation parts manufacturers. AIRCRAFT ENGINE COMPONENTS Coltec, through its Walbar Inc subsidiary and its Canadian subsidiary, Walbar Canada Inc. (together referred to as "Walbar"), manufactures turbine components, compressor airfoils, and turbine and compressor rotating parts primarily for aircraft gas turbine engines and, to a lesser extent, for land-based, marine and industrial gas turbine applications, and performs services including repairs and protective coatings for these products. Coltec believes that Walbar is one of the leading independent manufacturers of blades, impellers and rotating components for jet engines. Although Walbar does not typically design the products it manufactures, its manufacturing processes are highly sophisticated. Walbar manufactures products for commercial engines including the Pratt & Whitney 100 used on the deHavilland Dash 8, Alenia ATR 40 and Alenia ATR 72 aircraft, the Pratt & Whitney 200 used on the McDonnell Douglas Helicopter MDX, the Pratt & Whitney 300 used on the British Aerospace BAe 1000 aircraft, the Pratt & Whitney PT6 used on various commercial and military aircraft, and the Garrett Auxiliary Power Units used on various commercial aircraft. Walbar's original equipment and replacement components are also utilized in a number of other commercial aircraft, including the Boeing 727, 737, 747, 757 and 767; the Airbus A300, A310 and A320; and the McDonnell Douglas DC-8, DC-9, DC-10 and MD-80. Walbar's blades, vanes and discs are employed on many of the leading models of turboprop, business jet and commuter aircraft currently in service. Walbar supplies a number of different compressor and turbine blades for the new Allison 3007/2100/T406 engine family. These engines are designed for use on several business and regional commuter aircraft and also have military applications. Targeting the commuter aircraft market is part of Walbar's strategy of emphasizing the production of turbine engine components for commercial aircraft applications. Turbine blades for Rolls Royce engines are produced for commercial and military aircraft. For the years 1993, 1992 and 1991, commercial sales accounted for approximately 85%, 74% and 60%, respectively, of Walbar's total sales. Walbar manufactures products for military engines, including the General Electric used on the McDonnell Douglas aircraft, the General Electric used on the Grumman aircraft, the McDonnell Douglas aircraft and the Lockheed aircraft, the GE LM 2500 used on the U.S. Navy's Spruance class destroyers, the Textron Lycoming AGT 1500 used on the U.S. Army M-1 Abrams main battle tank, the Volvo RM12 engine for the SAAB JAS39 aircraft and Turbo Union RB199 engine for the Panavia Tornado aircraft. Walbar's market has become increasingly competitive over the past several years as airlines have sought to limit parts inventories and defense procurement has been reduced. Although Walbar does not typically design its own products, management believes that its highly sophisticated applied manufacturing technology, responsive production capabilities and focus on cost reduction have made Walbar one of the leading independent manufacturers of blades, impellers and rotating components for jet engines. Chromalloy American Corporation and Howmet Turbine Components Corporation provide competition in all aspects of this industry. In addition, Walbar's principal customers possess, in varying degrees, integrated production capacity for producing and servicing the components that Walbar supplies. GAS TURBINE PRODUCTS Coltec, through its Delavan Inc subsidiary operating as the Delavan Gas Turbine Products Division ("Delavan"), manufactures highly engineered fuel injectors, spraybars and other components for commercial and military aircraft gas turbine engines. Coltec believes that Delavan is the leading producer of these products for small-to-medium size aircraft engines. These products are made to design specifications using sophisticated production processes and are marketed directly to engine manufacturers pursuant to production contracts. The principal customers include General Electric Company, Allied-Signal Engines, Pratt & Whitney Canada Inc., Textron Lycoming and the Allison Engine Company. Delavan also supports its products with aftermarket sales of spare units and overhaul services. For the years 1993, 1992 and 1991, commercial sales accounted for 69%, 58% and 66%, respectively, of Delavan's total sales. The market for Delavan products is considered highly competitive. Competitive pressure is focused on price at the manufacturing level and on service and price in the aftermarket segment. Coltec believes that Delavan has achieved its leading position as a supplier of fuel injectors, spraybars and other components to producers of small-to-medium size aircraft engines due essentially to superior product performance, development support and a leadership role in the use of computer modeling in the design of nozzles. Delavan competes worldwide with Textron Fuel Systems Division of Textron Inc. and Parker-Hannifin Corporation. AIRCRAFT INSTRUMENTATION Coltec, through its Lewis Engineering Operation, designs, develops and produces electro-mechanical and electronic instrumentation for aircraft cockpits and temperature sensors for aircraft and engine systems. Lewis competes with several manufacturers of aircraft instruments. ENGINES Coltec, through its Fairbanks Morse Engine Division ("Fairbanks Morse"), manufactures and markets large, heavy-duty diesel, gas and dual-fuel engines and parts for such engines. Fairbanks Morse manufactures engines in conventional "V" and in-line opposed piston configurations which are used as power drives for compressors, large pumps and other industrial machinery, for marine propulsion and for stationary and marine power generation. Engines are offered from 4 to 18 cylinders, ranging from 640 to 29,320 horsepower. Such products are sold in the domestic market primarily through regional sales offices and field sales engineers and in foreign markets through the domestic sales network and foreign sales representatives. Parts are sold primarily through factory and regional sales offices. Approximately 50% of Fairbanks Morse's sales are for replacement parts and service for Fairbanks Morse engines. Large heavy-duty diesel engines are sold to the U.S. Navy and Coast Guard and to electric utilities, municipal power plants, oil and gas producers, firms engaged in ship and tug operations, offshore drilling activities and local, state and federal governments. Under a license agreement with Societe d'Etudes de Machines Thermiques, S.A. groupe Alsthom, a French company, Fairbanks Morse has the right to manufacture the Colt-Pielstick PC2 and PC4 lines of large diesel engines, which operate on oil fuel (including heavy oil) and, in the case of the PC2, dual-fuel, and range in size from 4,400 to 29,320 horsepower. Engines manufactured under this license are used for primary power by electric utilities, standby power for nuclear electric generating plants and ship propulsion. Over the last several years, Fairbanks Morse has supplied each of the ships in the U.S. Navy Landing Ship Dock ("LSD") program with four 16-cylinder PC2.5 engines, each delivering 8,500 horsepower for main propulsion, and four 12-cylinder opposed piston engines for shipboard power generation. The LSD ships hold amphibious craft and troops for close deployment in emergencies. Engines for 11 LSD and LSD Cargo Variant ships have been delivered and engines for one additional ship are scheduled for delivery in 1995. Another major program for Fairbanks Morse is the TAO fleet oiler program. These ships are powered by two 10-cylinder PC4.2 engines, each delivering 16,290 horsepower. A total of 15 ships of this series have been ordered by the U.S. Navy. Engines for 14 ships have been delivered and the remaining shipset is in production. Fairbanks Morse has also received a firm order to produce four 10-cylinder PC4.2 engines for the first new ship in the nation's Sealift Program with options for an additional five to eight ships. The four engines for the first ship are scheduled to be delivered in 1995. If the options are converted to firm orders by the U.S. Navy, four engines would be delivered each year beginning in 1996. Contracts are awarded in the heavy-duty diesel engine market based on price and successful operation in similar applications. Coltec attributes its strong position in this market to its history as a supplier to the U.S. Navy in a variety of propulsion and generator set applications and its ability to meet the U.S. Navy's military specification requirements. Management believes that Fairbanks Morse and its primary competitor, the Cooper-Bessemer Reciprocating Division of Cooper Industries, Inc., lead the field of four domestic manufacturers serving the market for heavy-duty diesel engines in power ranges from 5,000 to 30,000 horsepower. Fairbanks Morse competes with six domestic manufacturers in the medium speed (1,000 to 5,000 horsepower) engine market, dominated by General Motors Corporation ("General Motors") and Caterpillar Inc., and with several foreign manufacturers. Numerous domestic and foreign manufacturers compete in the under 1,500 horsepower engine market. In the first quarter of 1994, Fairbanks Morse acquired equipment and other assets related to the Alco engine business from General Electric Transportation Systems ("GE Transportation"). Under the terms of the agreement, Fairbanks Morse will manufacture and sell engines and aftermarket parts for Alco diesel engines used in power plants and marine markets. GE Transportation will retain the rights to sell and market Alco engines and aftermarket parts for its locomotive markets. Fairbanks Morse has been issued a preferred supplier contract to manufacture these engines and parts for General Electric's locomotive needs. Fairbanks Morse expects to begin producing Alco engines and aftermarket parts in April 1994. AUTOMOTIVE Coltec's Automotive segment manufactures and markets a selected line of high value-added products, including fuel injection system assemblies and components, transmission controls, suspension controls, emission control air pumps, oil pumps and seals for domestic original equipment manufacturers and the replacement parts market. The divisions, principal products and principal markets of the Automotive segment are as follows: Coltec's principal automotive products have strong brand name recognition. Coltec has targeted the development of highly-engineered components for fuel injection systems, transmission controls, suspension controls and air and oil pumps. By forming close, interactive relationships with the domestic automotive manufacturers, Coltec has taken advantage of a shift by these manufacturers from internal sourcing to procurement of components from outside suppliers. AUTOMOTIVE PRODUCTS Coltec, through its Holley Automotive Division, designs and manufactures fuel injection components, electrohydraulic control devices for transmissions and suspensions, transmission modulators and other automotive products used in passenger cars and trucks. Holley has been recognized for its engineering excellence and has strategically changed its structure and product line to accommodate the evolving automotive market. These products are sold directly to original equipment manufacturers, Chrysler Corporation ("Chrysler"), Ford Motor Company ("Ford") and General Motors. Holley currently produces all of the multi-point throttle bodies used on Chrysler imported 3.0 liter engines and the Chrysler-manufactured 3.3 liter engines. These six-cylinder engines propel the LeBaron Convertible, Shadow, Sundance and Acclaim, as well as the Minivan. Holley also is the sole source of the upper intake module and throttle body for the Chrysler 3.5 liter engine used on the Chrysler LH mid-size sedans (the Chrysler Concorde, Dodge Intrepid and Eagle Vision) and also the Chrysler New Yorker and LHS. In the non-fuel area, significant business has been established in transmission control devices. Holley supplies high volumes of aneroid and non-aneroid modulators to the General Motors Powertrain Division. Holley has expanded its design capabilities to include electronic solenoids for automatic transmission control. Holley's first electronic transmission solenoid application was introduced by Chrysler in 1989. Applications were expanded to Saturn in 1991, and to Ford and General Motors in 1992 with additional applications for Ford for the 1994 model year. Holley has increased design and manufacturing capabilities further in development and sales of suspension solenoids to a major suspension manufacturer selling to Ford. Coltec, through its Coltec Automotive Division, produces a mechanical air pump that supplies additional air to the exhaust system which enhances the oxidation process and reduces pollutants emitted into the atmosphere. Coltec Automotive is the sole independent domestic supplier of automotive mechanical air pumps. Major customers are Ford and Chrysler and, with the acquisition of the assets of the General Motors air pump manufacturing business, Coltec Automotive will become the sole source of these components to General Motors' North American operations. Coltec Automotive has also developed an advanced electric air pump designed to cope with increasingly stringent emission standards. In early 1994, Coltec Automotive began supplying mechanical air pumps to Isuzu Motors Limited for use in its Rodeo and Trooper sport utility models and one of its truck models. Coltec expects to ship 30,000 air pumps a year to Isuzu, half for the Japanese market, and half for the U.S. market. Coltec Automotive has also developed a line of engine oil pumps for use in many of Ford's cars and light trucks. Applications have expanded to Ford's Modular and Zetec engines. Coltec, through its Holley Replacement Parts Division, manufactures and markets fuel injection components and other fuel metering devices and controls such as intake manifolds, electric fuel pumps, emission control devices, and engine and road speed governors, new and remanufactured automotive and marine carburetors, remanufactured automotive air conditioning compressors, carburetor parts and repair kits, mechanical fuel pumps, valve covers and related engine components under the Holley name. Holley carburetors and components are used in domestic and foreign vehicles and marine engines and are sold directly to original equipment manufacturers, principally Chrysler, Ford, General Motors and Outboard Marine Corporation, and, through distributors and mass merchandisers to the parts and replacement market. In the domestic market, this segment competes principally with Ford, General Motors and several independent manufacturers. To date, Coltec has not been a significant supplier to foreign vehicle manufacturers. TRUCK PRODUCTS AND SEALING SYSTEMS Coltec, through its Stemco Inc subsidiary operating as the Stemco Truck Products Division ("Stemco"), is one of the leading domestic manufacturers of wheel lubrication systems for heavy-duty trucks. Stemco also produces mileage recording devices (hubodometers) and exhaust systems for the heavy-duty truck, medium-duty truck and school bus markets and manufactures moisture ejectors and other related products for vehicle and stationary air systems. Approximately 80% of Stemco revenues are derived from replacement parts. Stemco, through its Performance Friction Products Operation, manufactures a line of asbestos-free fluorocarbon friction materials, a line of carbon-based friction materials and synchronizers and clutch plates for transmissions, transfer cases and wet brakes for use in trucks, off highway equipment and passenger cars. Coltec, through its Farnam Sealing Systems Division, manufactures and markets automotive and industrial gaskets, seals and other sealing system products for engines, fuel systems and transmissions. Stemco's truck products and Coltec's sealing systems include highly-engineered proprietary products. INDUSTRIAL In the Industrial segment, Coltec, through its Garlock Inc subsidiary ("Garlock"), is a leading manufacturer of industrial seals, gaskets, packing products and self-lubricating bearings and, through its Delavan-Delta, Inc. subsidiary, is a producer of technologically advanced spray nozzles for agricultural, home heating and industrial applications. Coltec also produces air compressors for manufacturers. The divisions, principal products and principal markets of the Industrial segment are as follows: Coltec's Industrial segment manufactures and markets a wide range of products for use in various industries. In this segment, Coltec's strategy has involved developing high quality products, capitalizing on brand name recognition, targeting specific, well-defined markets and building good distribution systems. In January 1994, Coltec sold its Central Moloney Transformer Division. SEALS, PACKINGS AND GASKETING MATERIAL Coltec, under the Garlock name, is a leading manufacturer of industrial seals, gasketing material and gasket assemblies and packing products. Through its France Compressor Products Division of Garlock ("France"), Coltec manufactures and markets rod packings, piston rings, valves and components for reciprocating gas and air compressors used primarily in the hydrocarbon processing industry. These products withstand high temperature, corrosive environments, prevent leakage and exclude contaminants from rotating and reciprocating machinery and seal joints. Manufacturing processes involve plastics, rubbers, metals, textiles, chemicals, aramid fibers, carbon fibers, or a combination of the same. Garlock has been a leader in using advancements in materials technology to develop new products, including its GYLON line of products, and in converting to asbestos-free products. Approximately 95% of the gasketing and packing materials currently manufactured by Garlock worldwide are asbestos-free. Because the raw materials for Garlock's products are widely available, the seals, gasketing materials and packings business of Garlock is not dependent on a limited number of suppliers. Garlock's seals, gasketing material and packings are marketed through sales personnel, sales representatives, agents and distributors to numerous industrial customers involved principally in the petroleum, steel, chemical, food processing, power generation and pulp and paper industries. Most seals, gasketing material and packings wear out during the life of the product in which they are incorporated. Accordingly, the service and replacement market for these products is significant. In 1993, the service and replacement market accounted for approximately 80% of Garlock's sales of seals, gasketing material and packings. Manufacturers in this market compete on the basis of price and aftermarket services. Garlock's extensive distribution network, and its leadership in product development, have contributed to the establishment of what Coltec believes to be its leading position in the market for seals, gasketing products and packings. France believes it is a leading supplier of premium components in the aftermarket, where it competes primarily with C. Lee Cook and Cook Manley, subsidiaries of Dover Corporation, and Hoerbinger Corporation of America Inc. BEARINGS, VALVES, PLASTICS, NOZZLES, CYLINDERS, FORMING TOOLS, IGNITION SYSTEMS AND LEVEL CONTROLS Coltec, through Garlock, is a leading manufacturer of steel-backed and fiberglass-backed self-lubricating bearings and bearing materials primarily for the automotive, truck, agricultural and construction markets. Garlock also manufactures polytetrafluoroethylene ("PTFE") lined butterfly and plug valves and components and PTFE tapes. Coltec, through its Delavan-Delta, Inc. subsidiary operating as the Delavan Commercial Products Division, manufactures and markets spray nozzles and accessories for the agricultural, industrial and home heating markets. These products are sold to original equipment manufacturers, distributors and other end-users throughout the world. Coltec, through Garlock's Ortman Fluid Power operation, manufactures hydraulic and pneumatic cylinders in bore diameter sizes from 1 1/2 to 24 inches. Coltec, under the Sterling and Haber names, manufactures and markets a wide variety of metal cutting and metal forming tools. Sales of these products are primarily made directly to consumers. Competition for such products is provided by numerous companies. Coltec, through its FMD Electronics Operation, manufactures magnetos, ignition systems and level control instruments. These products are sold to original equipment manufacturers and through factory and regional sales forces to various accounts for resale. AIR COMPRESSORS Coltec, through its Quincy Compressor Division ("Quincy"), manufactures and markets reciprocating and helical screw air compressors and vacuum pumps. Helical screw air compressors are manufactured and sold under a non-exclusive license and technical assistance agreement with Svenska Rotor Maskiner Aktiebolag, a Swedish licensor. Reciprocating and helical screw air compressors have a wide range of industrial applications, providing compressed air for general plant services, pneumatic climate and instrument control, dry-type sprinkler systems, air loom weaving, paint spray processes, diesel and gas engine starting, pressurization, pneumatic tools and other air-actuated equipment. Engine-driven skid-mounted models of helical screw air compressors are used in energy related services, such as air-assisted deep-hole drilling, both on offshore drilling platforms and in tertiary recovery schemes involving on-site combustion approaches. Quincy air compressors are marketed through a well-developed distribution network consisting of field sales personnel and distributors to original equipment manufacturers located in major industrial centers throughout the United States, Canada, Mexico and the Pacific Rim. In the domestic market for small, industrial and reciprocating air compressors, management believes that Ingersoll-Rand is the major competitor, with Champion Pneumatic Machinery Co., Inc. and the Campbell-Hausfeld division of Scott Fetzer as other competitors. In the domestic market for helical screw air compressors, management believes that Ingersoll-Rand and Sullair are the dominant competitors, with Gardner-Denver Division of Cooper Industries, Inc. and Atlas Copco Corporation as other competitors. INTERNATIONAL OPERATIONS Coltec's international operations, mainly in Canada, are conducted through foreign-based manufacturing or sales subsidiaries, or both, and by export sales of domestic divisions to unrelated foreign customers. Export sales of products of the Automotive segment and diesel engines are made either directly or through foreign representatives. Compressors are sold through foreign distributors. Certain products of the Industrial segment are sold in foreign countries through salesmen and sales representatives or sales agents. Coltec's manufacturing and marketing activities in Canada are carried on through subsidiaries. Menasco Aerospace Ltd., an indirect wholly owned subsidiary of Coltec, manufactures landing gear systems and aircraft flight controls and provides overhaul service for Canadian and other customers. Walbar Canada Inc., a wholly owned subsidiary of Walbar, manufactures jet engine compressor blades, vanes and turbine components in Canada. Garlock of Canada Ltd., a wholly owned subsidiary of Garlock, manufactures and markets seals, gasketing material, packings and truck products. It also markets parts for Fairbanks Morse diesel engines and accessories as well as other products for use in Canada and for export to other countries. Through wholly owned or majority controlled foreign subsidiaries, Coltec operates 15 plants in Canada, Mexico, France, the United Kingdom, Australia and Germany. In addition, Coltec occupies leased office and warehouse space in various foreign countries. Devaluations or fluctuations relative to the United States dollar in the exchange rates of the currency of any country where Coltec has foreign operations could adversely affect the profitability of such operations in the future. For financial information on operations by geographic segments, see Note 11 of the Notes to Financial Statements of Coltec's 1993 Annual Report to its shareholders incorporated herein by reference. Coltec's contracts with foreign nations for delivery of military equipment, including components, are subject to deferral or cancellation by United States Government regulation or orders regulating sales of military equipment abroad. Any such action on the part of the United States Government could have a material effect on Coltec's results of operations and financial condition. SALES TO THE MILITARY AND BY CLASS OF PRODUCTS Sales to the military and other branches of the United States Government, primarily in the Aerospace/Government segment, were 14%, 15% and 16% of total Coltec sales in 1993, 1992 and 1991, respectively. During the last three fiscal years, landing gear systems was the only class of similar products that accounted for at least 10% of total Coltec sales. In 1993, 1992 and 1991, sales of landing gear systems constituted 11%, 12% and 14%, respectively, of total Coltec sales. BACKLOG At December 31, 1993, Coltec's backlog of firm unfilled orders was $669.7 million compared with $709.1 million at December 31, 1992. Of the $669.7 million backlog at December 31, 1993, approximately $255.2 million is scheduled to be shipped after 1994. CONTRACT RISKS Coltec, through its various divisions, primarily Menasco, Chandler Evans, Walbar and Delavan Gas Turbine Products, produces products for manufacturers of commercial aircraft pursuant to contracts that generally call for deliveries at predetermined prices over varying periods of time and that provide for termination payments intended to compensate for certain costs incurred in the event of cancellation. In addition, certain commercial aviation contracts contain provisions for termination for convenience similar to those contained in United States Government contracts described below. Longer-term agreements normally provide for price adjustments intended to compensate for deferral of delivery depending upon market conditions. A significant portion of the business of Coltec's Menasco, Chandler Evans, Walbar and Delavan Gas Turbine Products divisions has been as a subcontractor and as a prime contractor in supplying products in connection with military programs. Substantially all of Coltec's government contracts are firm fixed-price contracts. Under firm fixed-price contracts, Coltec agrees to perform certain work for a fixed price and, accordingly, realizes all the benefit or detriment occasioned by decreased or increased costs of performing the contracts. From time to time, Coltec accepts fixed-price contracts for products that have not been previously developed. In such cases, Coltec is subject to the risk of delays and cost over-runs. Under United States Government regulations, certain costs, including certain financing costs, portions of research and development costs, and certain marketing expenses related to the preparation of competitive bids and proposals, are not allowable. The Government also regulates the methods under which costs are allocated to Government contracts. With respect to Government contracts that are obtained pursuant to an open bid process and therefore result in a firm fixed price, the Government has no right to renegotiate any profits earned thereunder. In Government contracts where the price is negotiated at a fixed price rather than on a cost-plus basis, as long as the financial and pricing information supplied to the Government is current, accurate and complete, the Government similarly has no right to renegotiate any profits earned thereunder. If the Government later conducts an audit of the contractor and determines that such data were inaccurate or incomplete and that the contractor thereby made an excessive profit, the Government may take action to recoup the amount of such excessive profit, plus treble damages, and take other enforcement actions. United States Government contracts are, by their terms, subject to termination by the Government either for its convenience or for default of the contractor. Fixed-price-type contracts provide for payment upon termination for items delivered to and accepted by the Government, and, if the termination is for convenience, for payment of the contractor's costs incurred plus the costs of settling and paying claims by terminated subcontractors, other settlement expenses, and a reasonable profit on its costs incurred. However, if a contract termination is for default, (a) the contractor is paid such amount as may be agreed upon for completed and partially-completed products and services accepted by the Government, (b) the Government is not liable for the contractor's costs with respect to unaccepted items, and is entitled to repayment of advance payments and progress payments, if any, related to the terminated portions of the contracts, and (c) the contractor may be liable for excess costs incurred by the Government in procuring undelivered items from another source. In addition to the right of the Government to terminate, Government contracts are conditioned upon the continuing availability of Congressional appropriations. Congress usually appropriates funds on a fiscal-year basis even though contract performance may take many years. Consequently, at the outset of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress for future fiscal years. A substantial portion of Coltec's automotive products are sold pursuant to the terms and conditions (including termination for convenience provisions) of the major domestic automotive manufacturers' purchase orders, and deliveries are subject to periodic authorizations which are based upon the production schedules of such automotive manufacturers. RESEARCH AND PATENTS Most divisions of Coltec maintain staffs of manufacturing and product engineers whose activities are directed at improving the products and processes of Coltec's operations. Manufactured and development products are subject to extensive tests at various divisional plants. Total research and development cost, including product development, was $22.1 million for 1993, $22.9 million for 1992 and $23.8 million for 1991. Coltec presently has approximately 370 employees engaged in research, development and engineering activities. Coltec owns a number of United States and other patents and trademarks and has granted licenses under some of such patents and trademarks. Management does not consider the business of Coltec as a whole to be materially dependent upon any patent, patent right or trademark. EMPLOYEE RELATIONS As of December 31, 1993, Coltec had approximately 10,000 employees, of whom approximately 4,000 were salaried. Approximately 40% of the hourly employees are represented by unions for collective bargaining purposes. Union agreements relate, among other things, to wages, hours and conditions of employment, and the wages and benefits furnished are generally comparable to industry and area practices. Nine collective bargaining agreements covering approximately 2,500 hourly employees which expired in 1993 have been renegotiated. In 1994, four collective bargaining agreements covering approximately 400 hourly employees are due to expire. Coltec considers the labor relations of Coltec to be satisfactory, although Coltec does experience work stoppages from time to time. Coltec is subject to extensive Government regulations with respect to many aspects of its employee relations, including increasingly important occupational health and safety and equal employment opportunity matters. Failure to comply with certain of these requirements could result in ineligibility to receive Government contracts. These conditions are common to the various industries in which Coltec participates and entail the risk of financial and other exposure. For litigation relating to labor and other matters, see Item 3. "Legal Proceedings.--Other Litigation." ITEM 2. ITEM 2. PROPERTIES. Coltec operates 60 manufacturing plants in 21 states and in Canada, Mexico, France, the United Kingdom, Australia and Germany. In addition, Coltec has other facilities throughout the United States and in various foreign countries, which include sales offices, repair and service shops, light manufacturing and assembly facilities, administrative offices and warehouses. Certain information with respect to Coltec's principal manufacturing plants that are owned in fee, all of which (other than Palmyra, New York) are encumbered pursuant to the 1994 Credit Agreement between Coltec and certain banks and related security documents, is set forth below: In addition to above facilities, certain manufacturing activities of some industry segments are conducted within leased premises, the largest of which is approximately 173,000 square feet. The Automotive segment has significant manufacturing facilities on leased premises in Water Valley, Mississippi (lease expires in 1994) and Longview, Texas (lease expires in 1997). The Industrial segment has leased facilities located in Quincy, Illinois (lease expires in 1998). Some of these leases provide for options to purchase or to renew the lease with respect to the leased premises. Coltec's total manufacturing facilities presently being utilized aggregate approximately 6,500,000 square feet of floor area of which approximately 5,800,000 square feet of area are owned in fee and the balance is leased. Coltec leases approximately 39,000 square feet at 430 Park Avenue, New York, New York, for its executive offices, and has renewal options under such lease through 2001. In the opinion of management, Coltec's principal properties, whether owned or leased, are suitable and adequate for the purposes for which they are used and are suitably maintained for such purposes. See Item 3. ITEM 3. LEGAL PROCEEDINGS. ASBESTOS LITIGATION As of December 31, 1993, two subsidiaries of Coltec were among a number of defendants (typically 15 to 40) in approximately 68,500 actions (including approximately 6,100 actions in advanced stages of processing) filed in various states by plaintiffs alleging injury or death as a result of asbestos fibers. As of December 31, 1992, the number of such actions approximated that as of December 31, 1993. Through December 31, 1993, approximately 94,600 of the approximately 163,100 total actions brought have been settled or otherwise disposed of. The damages claimed for personal injury or death vary from case to case and in many cases plaintiffs seek $1 million or more in compensatory damages and $2 million or more in punitive damages. Although the law in each state differs to some extent, management believes that liability for compensatory damages would be shared among all responsible defendants, thus limiting the potential monetary impact of such judgments on any individual defendant. Following a decision of the Pennsylvania Supreme Court, in a case in which neither Coltec nor any of its subsidiaries were parties, that held insurance carriers are obligated to cover asbestos-related bodily injury actions if any injury or disease process, from first exposure through manifestation, occurred during a covered policy period (the "continuous trigger theory of coverage"), Coltec settled litigation with its primary and most of its first level excess insurance carriers, substantially on the basis of the Court's ruling. Coltec is currently negotiating with its remaining excess carriers to determine, on behalf of its subsidiaries, how payments will be made with respect to such insurance coverage for asbestos claims. Coltec believes that agreement can be achieved without litigation, and on substantially the same basis that it has resolved the issues with its primary and first-level excess carriers. On this basis, Coltec will have available to it a significant amount of coverage from its solvent carriers for asbestos claims. Settlements are generally made on a group basis with payments made to individual claimants over periods of one to four years. In 1993, two subsidiaries of Coltec received approximately 27,400 new lawsuits with a comparable number of lawsuits received in 1992 and 1991. The subsidiaries made payments with respect to asbestos liability and related costs aggregating $38.7 million in 1993, $39.8 million in 1992 and $48.4 million in 1991, substantially all of which were covered by insurance. In accordance with Coltec's internal procedures for the processing of asbestos product liability actions and due to the proximity to trial or settlement, certain outstanding actions have progressed to a stage where Coltec can reasonably estimate the cost to dispose of these actions. As of December 31, 1993, Coltec estimates that the aggregate remaining cost of the disposition of the settled actions for which payments remain to be made and actions in advanced stages of processing, including associated legal costs, is approximately $52.6 million and Coltec expects that this cost will be substantially covered by insurance. With respect to the 62,400 outstanding actions as of December 31, 1993 which are in preliminary procedural stages, Coltec lacks sufficient information upon which judgments can be made as to the validity or ultimate disposition of such actions, thereby making it difficult to estimate with reasonable certainty the liability or costs to Coltec. When asbestos actions are received they are typically forwarded to local counsel to ensure that the appropriate preliminary procedural response is taken. The complaints typically do not contain sufficient information to permit a reasonable evaluation as to their merits at the time of receipt, and in jurisdictions encompassing a majority of the outstanding actions, the practice has been that little or no discovery or other action is taken until several months prior to the date set for trial. Accordingly, Coltec generally does not have the information necessary to analyze the actions in sufficient detail to estimate the ultimate liability or costs to Coltec, if any, until the actions appear on a trial calendar. A determination to seek dismissal, to attempt to settle or to proceed to trial is typically not made prior to the receipt of such information. It is also difficult to predict the number of asbestos lawsuits that Coltec's subsidiaries will receive in the future. Coltec has noted that, with respect to recently settled actions or actions in advanced stages of processing, the mix of the injuries alleged and the mix of the occupations of the plaintiffs are changing from those traditionally associated with Coltec's asbestos-related actions. Coltec is not able to determine with reasonable certainty whether this trend will continue. Based upon the foregoing, and due to the unique factors inherent in each of the actions, including the nature of the disease, the occupation of the plaintiff, the presence or absence of other possible causes of a plaintiff's illness, the availability of legal defenses, such as the statute of limitations or state of the art, and whether the lawsuit is an individual one or part of a group, management is unable to estimate with reasonable certainty the cost of disposing of outstanding actions in preliminary procedural stages or of actions that may be filed in the future. However, Coltec believes that it is in a favorable position compared to many other defendants because, among other things, the asbestos fibers in its asbestos-containing products were encapsulated. Considering the foregoing, as well as the experience of Coltec's subsidiaries and other defendants in asbestos litigation, the likely sharing of judgments among multiple responsible defendants, and the significant amount of insurance coverage that Coltec expects to be available from its solvent carriers, Coltec believes that pending and reasonably anticipated future claims are not likely to have a material effect on Coltec's results of operations and financial condition. Although the insurance coverage that Coltec has is substantial, insurance coverage for asbestos claims is not available to cover exposures initially occurring on and after July 1, 1984. In addition to claims for personal injury, the subsidiaries were among 40 named defendants in a class action seeking recovery of the cost of asbestos removal from school buildings. Twenty-nine similar school building cases have been dismissed without prejudice to the plaintiffs and without payment by Coltec's subsidiaries. Coltec's subsidiaries continue to be named as defendants in new cases. ENVIRONMENTAL REGULATIONS Coltec and its subsidiaries are subject to numerous federal, state and local environmental laws, many of which are becoming increasingly stringent, giving rise to increased compliance costs. For example, the Clean Air Amendments will require abatement of chemical air emissions that were previously unregulated and will require certain existing, and many newly constructed or modified, facilities to obtain air emission permits that were not previously required. Because many of the regulations under the Clean Air Amendments have not yet been promulgated, Coltec cannot estimate their impact at this time. Coltec, however, believes that it will not be at a competitive disadvantage in complying with the Clean Air Amendments and that any increase in costs to comply with the Clean Air Amendments will not have a material effect on its results of operations and financial condition. Coltec's annual expenditures (including capital expenditures) relating to environmental matters over the three years ended December 31, 1993 ranged from $4 million to $6 million, and Coltec expects such expenditures to range from $8 million to $11 million in each of 1994 and 1995. Many of the facilities of Coltec and its subsidiaries are subject to the federal Resource Conservation and Recovery Act of 1976 ("RCRA"), and its analogous state statutes. Although the costs under RCRA for the treatment, storage and disposal of hazardous materials generated at Coltec's facilities are increasing, Coltec does not believe that such costs will have a material effect on Coltec's results of operations and financial condition. Coltec has been notified that it is among the Potentially Responsible Parties ("PRPs") under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), or similar state laws, for the costs of investigating and in some cases remediating contamination by hazardous materials at several sites. CERCLA imposes joint and several liability for the costs of investigating and remediating properties contaminated with hazardous materials. Liability for these costs can be imposed on present and former owners or operators of the properties or on parties who generated the wastes that contributed to the contamination. The process of investigating and remediating contaminated properties can be lengthy and expensive. The process is also subject to the uncertainties occasioned by changing legal requirements, developing technological applications and liability allocations among PRPs. Among the sites where Coltec or its subsidiaries have been designated a PRP are: Acme Solvents, Winnebago, Illinois; Clare Water Supply, Clare, Michigan; Stringfellow Acid Pits, Riverside, California; Quincy Municipal Landfill #2 and #3, Quincy, Illinois; Water Valley, Mississippi; Byron Barrel and Drum, Byron, New York; Operating Industries, Monterey Park, California; Fulton Terminal Site, Oswego, New York; Parker Landfill, Lyndonville, Vermont; Solvents Recovery Service of New England, Southington, Connecticut; San Fernando Valley Site, Glendale, California; Acqua-Tech Site, Greer, South Carolina; and Hardage, Criner, Oklahoma. Based on the progress to date in the investigation, cleanup and allocation of responsibility for these sites, Coltec does not believe that its costs in connection with these sites will have a material effect on Coltec's results of operations and financial condition. Progress toward the investigation, cleanup and responsibility allocation at the Liberty Industrial Finishing site, Farmingdale, New York has not been sufficient to allow Coltec at this time to determine the extent of any potential financial responsibility for this site; however, Coltec does not believe that its costs in connection with Liberty Industrial Finishing will have a material effect on Coltec's results of operations and financial condition. OTHER LITIGATION In September 1983, the local employees' union at Menasco Canada Ltee. (now Menasco Aerospace Ltd.) ("Menasco Canada"), a federation of trade unions and several member-employees filed a complaint in the Province of Quebec Superior Court against Menasco Canada, alleging, among other things, an illegal lock-out, failure to negotiate in good faith, interference with the affairs of the union and various violations of local law. The plaintiffs are collectively seeking approximately Cdn. $14 million in damages, and Menasco Canada has filed a cross-claim for Cdn. $21 million and has closed its operations in Quebec Province. Coltec does not believe that this action will have a material effect on Coltec's results of operations and financial condition. On September 24, 1986, approximately 150 former salaried employees of Crucible Inc (a former subsidiary of Coltec) commenced an action claiming benefits under a plant shutdown plan that had been created in 1969 (George Henglein v. Colt Industries Operating Corporation Informal Plan for Plant Shutdown Benefits for Salaried Employees, U.S. District Court for the Western District of Pennsylvania, C.A. 86-2021). Future eligibility of any employee for such Plan was eliminated by Crucible Inc in November 1972. Plaintiffs claim that they did not receive notice of such termination and therefore were entitled to benefits in 1982 when the Midland steel-making facility closed. Following a non-jury trial in the U.S. District Court for the Western District of Pennsylvania, defendant's motion to dismiss was granted and the plaintiffs appealed. The Court of Appeals for the Third Circuit remanded the case to the District Court directing it to make specific findings of fact and conclusions of law and also found for the defendant on the jurisdiction of the District Court. The defendants' motion to dismiss was granted by the District Court, appealed to the Third Circuit Court of Appeals and remanded to the District Court for additional findings of fact. On February 10, 1994, the District Court dismissed the plaintiffs' complaint and the plaintiffs have appealed to the Third Circuit Court of Appeals. Coltec does not believe that this action will have a material effect on Coltec's results of operations and financial condition. In an alleged class action filed in June 1984, a group of former salaried employees whose employment had been terminated due to the closing of the Midland steelmaking facility have asserted claims for damages in amounts equal to the present value of the collective bargaining unit's pension plan, insurance and unemployment benefits (Donald A. Nobers v. Crucible Inc, Court of Common Pleas of Beaver County, Pennsylvania, Civil Action No. 843-1984). The case was dismissed by the Common Pleas Court due to the preemptive provisions of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). The Pennsylvania Superior Court reversed the lower court and held that the plaintiffs' claim was based upon an alleged contract. The Pennsylvania Supreme Court refused to hear the appeal and reinstated the case in the Court of Common Pleas. On February 16, 1993, the Court of Common Pleas granted defendants' motion for summary judgment because the Court concluded that it lacked jurisdiction of the subject matter. On January 19, 1994, the Superior Court of Pennsylvania affirmed the Court of Common Pleas grant of defendant's motion for summary judgment. The plaintiffs have appealed to the Supreme Court of Pennsylvania. Coltec does not believe that this action will have a material effect on Coltec's results of operations and financial condition. On January 19, 1993, the Official Committee of Unsecured Creditors of Colt's Manufacturing Company, Inc. filed a fraudulent conveyance action against Coltec and other defendants (The Official Committee of Unsecured Creditors of Colt's Manufacturing Company, Inc., Plaintiff, v. Coltec Industries Inc et al., U.S. Bankruptcy Court for the District of Connecticut, Case No. 93-2020) in connection with the sale on March 22, 1990 of substantially all the assets of the Colt Firearms Division to a company formed by a group of private investors. Coltec does not believe that this action will have a material effect on Coltec's results of operations and financial condition. In addition to the litigation described above, there are various pending legal proceedings involving Coltec which are routine in nature and incidental to the business of Coltec. Some product liability cases pending against Coltec involve claims for large amounts of compensatory damages (the coverage for which is subject to substantial deductibles) as well as, in some instances, punitive damages (which insurance carriers uniformly contend are not covered by product liability insurance). The United States Government conducts investigations into procurement of defense contracts as a part of a continuing process. Under current federal law, if such investigations establish such improper activities, among other matters, debarment or suspension of a company from participating in the procurement of defense contracts could result. These conditions are common to the aerospace and government industries in which Coltec participates and entail the risk of financial and other exposure. Coltec is not aware of any such investigation, nor is Coltec aware of any facts which, if known to investigators, might prompt any investigation. PRODUCT LIABILITY INSURANCE Coltec has product liability insurance coverage for liabilities arising from aircraft products which Coltec believes to be in adequate amounts. In addition, with respect to other products, (exclusive of liability for exposure to asbestos products) Coltec has product liability insurance in amounts exceeding $2.5 million per occurrence, which Coltec believes to be adequate. Coltec has been self-insured with respect to liability for exposure to asbestos products since third party insurance became unavailable in July 1984. 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. Coltec's Common Stock (symbol COT) is listed on the New York and Pacific Stock Exchanges. The high and low prices of the stock since it began trading on March 25, 1992, based on the Composite Tape, were as follows: At December 31, 1993, there were 591 shareholders of record. No dividends were paid in 1993 and 1992, and no dividends are expected to be paid in 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The five year tabular presentation under the caption "Selected Financial Data" of Coltec's 1993 Annual Report to its shareholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information under the caption "Financial Review" of Coltec's 1993 Annual Report to its shareholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The "Quarterly Sales and Earnings" information in Note 14 of the Notes to Financial Statements of Coltec's 1993 Annual Report to its shareholders and the Consolidated Balance Sheet, the Consolidated Statement of Earnings, the Consolidated Statement of Cash Flows, the Consolidated Statement of Shareholders' Equity, the Notes to Financial Statements and the Report of Independent Public Accountants of Coltec's 1993 Annual Report to its shareholders 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 following table provides certain information about each of the current directors and executive officers of Coltec. Directors are indicated by an asterisk. Unless otherwise indicated, each occupation set forth opposite an individual's name refers to employment with Coltec. The initial dates of election of the directors are as follows: Mr. Brennan, November 1991; Mr. Cozzolino, May 1985; Mr. Guffey, May 1991; Dr. Hilton, May 1985; Mr. Hoffen, March 1990; Mr. Margolis, May 1963; Messrs. J. Bradford Mooney, Jr. and Joel Moses, June 1992; and Mr. Sica, November 1991. Pursuant to a Registration and Management Rights Agreement, among other things, The Morgan Stanley Leveraged Equity Fund II, L.P. is permitted to designate a person to be nominated for election to the Board of Directors of Coltec. All officers serve at the pleasure of the Board. None of the executive officers or directors of Coltec is related to any other executive officer or director by blood, marriage or adoption. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. SUMMARY OF CASH AND CERTAIN OTHER COMPENSATION The following table provides certain summary information concerning compensation of Coltec's Chief Executive Officer and each of the four other most highly compensated executive officers of Coltec (determined as of December 31, 1993) (hereinafter referred to as the "named executive officers") for the fiscal years ended December 31, 1993, 1992 and 1991: SUMMARY COMPENSATION TABLE STOCK OPTIONS The following table contains information concerning 1993 grants of stock options under Coltec's 1992 Stock Option and Incentive Plan to the named executive officers and the potential realizable value of these option grants based on assumed rates of stock appreciation of 5% and 10% per year over the 10-year term of the options. OPTION GRANTS IN 1993 OPTION EXERCISES AND HOLDINGS The following table provides information with respect to the named executive officers concerning the options held as of December 31, 1993 (none of the named executive officers exercised options during 1993): AGGREGATED OPTION EXERCISES IN 1993 AND DECEMBER 31, 1993 OPTION VALUES PENSION PLAN The following table shows the estimated annual pension benefits payable to a covered participant at normal retirement age (age 65) on a single life annuity basis under Coltec's qualified defined benefit plan, as well as nonqualified supplemental pension plans that provide benefits that would otherwise be denied participants by reason of certain Internal Revenue Code limitations on qualified plan benefits, based for the most part on five-year average final compensation (salary and bonus during the 60 highest-paid consecutive months out of the last 120 months) and years of service with Coltec and its subsidiaries and not subject to deduction for Social Security or other payments: PENSION PLAN TABLE As of December 31, 1993, the five-year average final compensation and current years of credited service for each of the following persons were: Mr. Margolis, $2,620,816 and 31 years; Mr. Guffey, $877,655 and 15 years (including 7 years of additional credited service as an employee of one of Coltec's subsidiary corporations); Mr. Cozzolino, $1,363,302 and 24 years; Dr. Hilton, $1,363,302 and 31 years; and Mr. diBuono, $722,680 and 23 years. Compensation covered under the pension plans includes amounts reported in columns (c) and (d) of the Summary Compensation Table (other than accrued but unpaid amounts under the Performance Plan reported in column (d) of the table). Coltec has agreed to calculate Mr. Guffey's pension benefits as if his prior credited service with the subsidiary were provided under the plan (the benefits of which are set forth in the above table) with payments to be made to him from the qualified plan, non-qualified plans and from Coltec. DESCRIPTION OF THE 1994 INCENTIVE PLAN. On January 12, 1994, the Compensation Committee and the Board of Directors adopted the 1994 Long-Term Incentive Plan (the "1994 Incentive Plan"), subject to the approval of the 1994 Incentive Plan by the shareholders of Coltec. The 1994 Incentive Plan will be submitted to the shareholders of Coltec for approval at the 1994 annual meeting of shareholders. The summary of the 1994 Incentive Plan which follows is not intended to be complete and is qualified in its entirety by reference to the text of the 1994 Incentive Plan which has been filed as Exhibit 10.16 to this Form 10-K. The 1994 Incentive Plan provides for annual grants of performance units ("Units") to officers and senior operations management employees of Coltec who are selected for grants of Units by the Compensation Committee. Approximately 15 officers and senior operations management employees of Coltec and its subsidiaries are eligible to participate in the 1994 Incentive Plan. The 1994 Incentive Plan is intended to replace the 1977 Long-Term Performance Plan. The value of each Unit is determined on the basis of Coltec's cumulative operating profit measured over a three-year performance cycle. Operating profit for each fiscal year in a performance cycle is generally defined as the net earnings of Coltec and its consolidated subsidiaries, plus interest expense and provisions for income taxes, minus interest income and excluding nonrecurring items, extraordinary items, accounting principle changes and discontinued operations (as such terms are defined under United States generally accepted accounting principles). For each three-year performance cycle, the threshold target for cumulative operating profit is $600 million. If that target is achieved, each Unit will have an award value of $36.00 (for the performance cycle beginning January 1, 1994) and $12.00 (for each performance cycle beginning after 1994 (the "1994 Cycle")). The award value of each Unit granted for a performance cycle will increase by $.10 (with respect to the 1994 Cycle) and by $.0333 (with respect to later cycles) for each $1 million that cumulative operating profit for the award cycle exceeds $600 million. There is no maximum limit on the award value which may be earned for a Unit. No amounts are payable for a Unit if cumulative operating profit for the performance cycle is less than $600 million. The 1994 Incentive Plan provides that no more than 300,000 Units may be awarded for any performance cycle, and that no more than 50,000 Units may be awarded to any participant for a given cycle. The 1994 Incentive Plan is administered by the Compensation Committee which has responsibility for the selection of participants, for construing the terms of the 1994 Incentive Plan and for certifying that the targets for each performance cycle have been achieved. Under the terms of the 1994 Incentive Plan, the Compensation Committee also has the discretion to adjust the targets for operating profit prior to the inception of a performance cycle or to adjust the targets after the inception of a cycle to take into account extraordinary corporate transactions. The award value earned in respect of Units is generally payable following the press release announcing Coltec's unaudited annual financial results for the last fiscal year in the applicable performance cycle. Two-thirds of the award value of the Units will generally be paid in cash; and one-third of such award value will be paid in shares of Common Stock (the "Restricted Shares"). The 1994 Incentive Plan permits participants to elect, prior to the start of the third year of a performance cycle, to have some or all of the portion of the award value that would otherwise be paid in cash be paid in Restricted Shares. As an incentive to encourage participants to make share elections, the 1994 Incentive Plan increases by 15% the number of Restricted Shares which would otherwise have been awarded to a participant in lieu of the foregone cash payment. The 1994 Incentive Plan limits the number of Restricted Shares that may be awarded in any calendar year to .5% (1% for 1997) of the number of shares of Common Stock issued and outstanding on January 1 of such year. Performance Units are forfeited if a participant's employment ends for any reason other than death, disability or retirement. In the event a participant's employment ends as a result of death, disability or retirement, a pro rata portion of the award value will generally be paid to the participant (or, in the event of death, the participant's beneficiary) following the completion of the performance cycle (although, in appropriate circumstances, the Compensation Committee may accelerate the payment in settlement of these outstanding Units). Restricted Shares awarded in payment of Units vest in one third increments on each of the first through third anniversaries of the end of the applicable performance cycle. Unvested Restricted Shares are forfeited if a participant's employment ends for any reason other than death, disability or retirement. Subject to certain limited exceptions set forth in the 1994 Incentive Plan, a participant will be fully vested in all Restricted Shares in the event the participant's employment ends as a result of death, disability or retirement. DESCRIPTION OF THE 1992 STOCK PLAN. On January 12, 1994, the Board of Directors authorized an amendment to the 1992 Stock Option and Incentive Plan (the "1992 Stock Plan") to increase the number of shares of Common Stock that may be issued under the 1992 Stock Plan from 3,000,000 to 7,360,000. The amendment further provides that no employee may be awarded in any 36-month period beginning on or after January 1, 1994 options or stock appreciation rights in excess of 15% of the number of shares of Common Stock which are authorized for awards under the 1992 Stock Plan immediately after the 1994 annual meeting of shareholders. Both such changes are subject to the approval of the amendment to the 1992 Stock Plan by the shareholders of Coltec. The amendment to the 1992 Stock Plan will be submitted to the shareholders of Coltec for approval at the 1994 annual meeting of shareholders. The full text of the amendment has been filed as Exhibit 10.15 to this Form 10-K. The 1992 Stock Plan is administered by the Compensation Committee. The Compensation Committee has authority under the 1992 Stock Plan to adopt rules and regulations with respect thereto, to select the employees to whom awards will be made, to determine the nature and size of each award and to interpret, construe and implement the 1992 Stock Plan. Approximately 250 employees of Coltec and its subsidiaries are eligible to participate in the 1992 Stock Plan. The 1992 Stock Plan provides for grants of stock options, restricted shares, incentive stock rights, stock appreciation rights and dividend equivalents, the making of loans to participants to accomplish the purposes of the 1992 Stock Option Plan and other equity incentive awards established under the plan. The number of stock options, restricted shares, incentive stock rights, stock appreciation rights, dividend equivalents or other incentive benefits granted to any individual, the periods during which they vest or otherwise become exercisable or remain outstanding, and the other terms and conditions with respect to awards under the 1992 Stock Plan are set by the Compensation Committee. Shares issued under the 1992 Stock Plan may be in whole or in part, as the Compensation Committee shall from time to time determine, authorized and unissued shares or issued shares that may have been reacquired by Coltec. Awards under the 1992 Stock Plan may be made only to salaried employees who are officers or who are employed in an executive, administrative, operations, sales or professional capacity by Coltec or its subsidiaries or to those other employees with potential to contribute to the future success of Coltec or its subsidiaries. Such awards may be made to a director of Coltec provided that the director is also an officer or salaried employee of Coltec or a subsidiary thereof. The 1992 Stock Plan provides for equitable adjustments with respect to awards made thereunder upon the occurrence of any increase in, decrease in or exchange of the outstanding shares of Common Stock through merger, consolidation, recapitalization, reclassification, stock split, stock dividend or similar capital adjustment. In addition, the 1992 Stock Plan allows the Compensation Committee, in the event of a Change in Control (as defined in the 1992 Stock Plan), to protect the holders of awards granted under the 1992 Stock Plan by taking certain actions which it deems equitable and in the best interests of Coltec. DESCRIPTION OF THE ANNUAL INCENTIVE PLAN. On March 15, 1994, the Compensation Committee and the Board of Directors adopted an amended and restated version of the Coltec Annual Incentive Plan (the "Annual Incentive Plan"), subject to the approval of the Annual Incentive Plan by the shareholders of Coltec. The Annual Incentive Plan will be submitted to the shareholders of Coltec for approval at the 1994 annual meeting of shareholders. The summary of the Annual Incentive Plan which follows is not intended to be complete and is qualified in its entirety by reference to the text of the Annual Incentive Plan which has been filed as Exhibit 10.17 to this Form 10-K. The Annual Incentive Plan is an amended and restated version of the prior Coltec annual incentive plan which was previously approved by the shareholders of Coltec in 1965 and, as amended, in 1986. The principal purpose of the amended and restated version of the Annual Incentive Plan is to permit amounts paid under the plan to qualify as performance-based compensation which is deductible for federal income tax purposes. Under recently enacted federal tax law changes, a public company is generally precluded from deducting annual compensation in excess of $1 million that is paid to an executive officer named in the summary compensation table of the proxy statement for that year unless, among other things, the compensation qualifies as performance-based compensation. Amounts paid under the amended and restated Annual Incentive Plan are generally intended to qualify as performance-based compensation, which is excluded from the $1 million limit on deductible compensation. The Annual Incentive Plan provides for an annual bonus pool for cash incentive awards for any year equal to 6% of operating profit of Coltec and its consolidated subsidiaries. For purposes of the Annual Incentive Plan, operating profit is generally defined in the same manner as in the 1994 Incentive Plan. SEE "Description of the 1994 Incentive Plan." The Annual Incentive Plan provides that no award may be paid to executive officers of Coltec unless operating profit for the year exceeds $100 million and that the two executive officers at the end of such year who have the highest base salary for such year may each receive no more than 20% of the bonus pool for any year. As the bonus pool is determined as a percentage of operating profit, there is no maximum limit on the size of the pool for any year. Only officers of Coltec and senior executive employees who are not covered by an annual incentive plan of one of Coltec's divisions or subsidiaries are eligible to participate in the Annual Incentive Plan. Approximately 50 officers and senior executive employees of Coltec and its subsidiaries are eligible to participate in the Annual Incentive Plan. The Annual Incentive Plan is administered by the Compensation Committee which has discretion under the plan to select plan participants from among the class of eligible persons and, subject to the limits noted above, to determine the amount of the award paid to plan participants. The Compensation Committee may require that the payment of some or all of an award be deferred until a later date or dates specified by the committee. Amounts paid under the Annual Incentive Plan (as in effect on December 31, 1993) are included in column (d) of the Summary Compensation Table. COMPENSATION OF DIRECTORS Directors who are not also employees of Coltec or of Morgan Stanley receive a retainer at the annual rate of $25,000 ($30,000 if Chairperson of a Committee) and receive $1,250 per meeting for attendance at meetings of the Board of Directors and its committees with a maximum of $2,000 for more than one meeting on the same day ($2,500 if Chairperson of one of the meetings). The Board of Directors of Coltec has established a retirement age policy which provides that a director shall not be eligible for nomination to the Board of Directors if such person has attained the age of 70. In connection therewith, the Board of Directors also established a pension arrangement for directors who are not affiliated with Morgan Stanley or not entitled to a pension from Coltec or any subsidiary thereof, with payments for life commencing at the later of retirement or age 70. The annual amount of such payment is calculated on the basis of the number of years of service as a director and would equal $10,000 for five years of service plus an additional $2,000 for each additional year of service up to a maximum annual amount of $20,000. A director may defer payment of any portion of any retainer, committee or attendance fees in any year, upon advance notice to Coltec, to such time as he or she may determine. Balances of such deferred compensation accrue additional compensatory amounts quarterly at the average cost of United States borrowings of Coltec and its consolidated subsidiaries during the preceding calendar year. Such borrowing cost in 1992 was 7.2%. There are no amounts being deferred at the present time. In addition to the foregoing amounts, on March 15, 1994, the Board of Directors adopted the 1994 Stock Option Plan for Outside Directors (the "1994 Directors Option Plan"), subject to the approval of the 1994 Directors Option Plan by the shareholders of Coltec. The 1994 Directors Option Plan will be submitted to the shareholders of Coltec for approval at the 1994 annual meeting of shareholders. The summary of the 1994 Directors Option Plan which follows is not intended to be complete and is qualified in its entirety by reference to the text of the 1994 Directors Option Plan which has been filed as Exhibit 10.18 to this Form 10-K. The 1994 Directors Option Plan provides for automatic grants of stock options to each member of the Board of Directors who is not an employee of Coltec or any of its subsidiaries ("Outside Directors"). Each individual elected as an Outside Director at the 1994 annual shareholders meeting (or who is initially elected as a director by the shareholders at an annual or special meeting of shareholders occurring after the 1994 annual meeting) will be granted an option to purchase 10,000 shares of Common Stock (an "Initial Option"). On each subsequent Alternate Re-Election Date, as defined in the 1994 Directors Option Plan, each Outside Director will be granted an additional option to purchase 2,000 shares of Common Stock (a "Subsequent Option"). The date of grant of each Initial or Subsequent Option will be the date of the applicable annual or special meeting. The per share exercise price of each option will be the average closing price of a share of Common Stock as reported on the New York Stock Exchange Composite Tape for the date of grant and the four preceding trading days. The Initial Options will vest 20% per year beginning on the first anniversary date of the date of grant. The Subsequent Options will vest 50% per year beginning on the first anniversary date of the date of grant. Each option granted under the 1994 Directors Option Plan will terminate on the tenth anniversary of the date of grant of the option. In the event of an Outside Director's resignation, removal (other than for cause) or termination as a member of the Board, the unvested portion of any option granted to an Outside Director will terminate as of the date of such event, but the vested portion of the option will remain exercisable until the first anniversary of the date of such event. In the event of the removal of the Outside Director from the Board of Directors for cause, the option (including the vested portion thereof) will terminate in its entirety as of the date of such removal. The maximum number of shares of Common Stock that may be awarded under the 1994 Directors Option Plan will not exceed 108,000 shares. The 1994 Directors Option Plan is administered by the Chief Executive Officer ("CEO") of Coltec. The CEO has authority under the 1994 Directors Option Plan to interpret, administer and apply the Plan, and to execute and deliver option certificates on behalf of Coltec. Subject to certain limitations set forth in the plan document, the Board of Directors has the right to amend or terminate the 1994 Directors Option Plan at any time. Unless earlier terminated by the Board of Directors, the 1994 Directors Option Plan will terminate on July 1, 2004 and no further options under the plan will be awarded after that date. EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL ARRANGEMENTS All currently outstanding agreements granting restricted stock or stock options to the named executive officers in the Summary Compensation Table above contain change-in-control provisions. In the case of the restricted stock, in the event of a change-in-control, all restrictions on assignment, transfer or other disposition of the restricted stock lapse. In the case of stock options, in the event of a change-in-control, the options become fully exercisable or, in the alternative, the executive officer may surrender all or part of the option to Coltec during a one-year period after the change-in-control in exchange for a cash payment for each option surrendered equal to the excess of the fair market value of the Common Stock on the date of surrender over the option price. Fair market value for this purpose equals the last sales price of the Common Stock on the exercise date on the New York Stock Exchange Composite Tape (or, if no such sale occurred on such date, the last date preceding such date on which a sale was reported), except that in the case of a change of ownership of more than 35% of the outstanding shares of Common Stock, it shall mean the amount of cash and fair market value of other consideration tendered for such outstanding shares. As of June 10, 1988, Coltec entered into an employment contract (the "Employment Contract") with Mr. Margolis which by its terms is scheduled to terminate on January 24, 1995. The Employment Contract provides for certain severance payments and continuation of benefits for the remaining term of the Employment Contract following termination of employment. The amount of the payments that may be made will vary depending upon the level of compensation and benefits at the time employment terminates and whether such employment is terminated prior to the end of the term by Coltec for "cause" or by Mr. Margolis for "good reason" or otherwise during the term of the contract. In the event that termination of employment is by Mr. Margolis for "good reason" or by Coltec without "cause", such payments are to consist of amounts equal to full salary, bonus payments on each January based on an average of the three prior annual bonus payments pro rated for partial years, an additional one-time payment at the time of termination of the bonus amount pro rated for a partial year, either continuation of participation in compensation and benefit plans or the provision of comparable benefits, reimbursement for any legal fees expended in connection with the termination of employment and gross-up payments for any golden parachute excise taxes paid. Mr. Margolis is required to seek other employment and any amounts paid as a result of such employment offset amounts otherwise payable under the Employment Contract. The Employment Contract includes multi-year non-compete provisions. As of July 1, 1991, Coltec entered into employment agreements with Messrs. Guffey and diBuono. Mr. Guffey's agreement expires on July 1, 1996 and Mr. diBuono's agreement expires on October 13, 1995. Compensation payable thereunder is at salary rates not less than those in effect on July 1, 1991 and with comparable participation in incentive and employee benefit plans at the discretion of the Board of Directors. However, if during the term of the agreement a change of control (as defined in the agreement) occurs, (a) the executive's functions, duties and responsibilities shall not be subject to change, (b) in the event the executive in good faith determines that his functions, duties or responsibilities or any aspect of his employment has been changed adversely, he may elect to serve for a terminal employment period of two years or, if earlier, until the executive attains age 65, and (c) the terminal employment period is followed by a consulting period of two years. During the terminal employment period, the executive is entitled to salary not less than that in effect prior to this period and comparable participation in benefits plans. During the consulting period, the executive is entitled to consulting fees at an annual rate no less than the annual rate of his salary on July 1, 1991 and to participation in all Coltec life and medical insurance programs or comparable benefits. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Set forth below is certain information (as of February 25, 1994) with respect to persons known to Coltec to be the beneficial owners of more than five percent of the Common Stock. This information is based on statements on Schedules 13D or 13G filed by beneficial owners with the Securities and Exchange Commission and other information available to Coltec. Set forth below is information as of February 25, 1994, concerning ownership of Common Stock by all directors, individually, the executive officers named in the Summary Compensation Table above and all present executive officers and directors of Coltec as a group: ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The members of the Stock Option and Compensation Committee are Joel Moses (Chairman), Donald P. Brennan, Howard I. Hoffen and J. Bradford Mooney, Jr. None of the members was formerly an officer of Coltec or any of its subsidiaries. Mr. Brennan was an officer and director and Mr. Hoffen was a director of Coltec Holdings Inc. ("Holdings") before it became a wholly owned subsidiary of Coltec in November 1993. Mr. Brennan is a managing director and Mr. Hoffen is a vice president of Morgan Stanley and they along with another managing director of Morgan Stanley, Frank V. Sica, constituted all of the directors of Holdings, the owner of 100% of the outstanding shares of Common Stock from June 1988 to the recapitalization of Coltec effected in April 1992, which included the public offering by Coltec of 44,275,000 shares of Common Stock (the "1992 Recapitalization"). At the time of the 1992 Recapitalization, Holdings owned 36.1% of the outstanding shares of Common Stock. In the 1992 Recapitalization, Morgan Stanley was sole underwriter of a debt offering for which it received an underwriting commission of $11,250,000 and was one of several underwriters of an equity offering for which it received a portion of the total underwriting commission of $36,527,000. Also, as one of the dealer managers for a tender offer by Holdings for the outstanding Holdings 14 3/4% senior discount debentures, a part of the 1992 Recapitalization, Morgan Stanley received fees of $1,049,000 from Holdings. In October 1992, Morgan Stanley acted as sole underwriter in connection with the issuance by Coltec of $150 million of its 9 3/4% Senior Notes due 1999 for which it received an underwriting commission of $2,625,000. In connection with an industrial revenue bond refinancing in 1993, Morgan Stanley received a fee of $309,000. As of November 18, 1993, pursuant to a Reorganization Agreement, Coltec and Holdings completed a stock-for-stock exchange that resulted in Holdings' stockholders holding directly shares of Coltec Common Stock and Holdings became a wholly owned subsidiary of Coltec. 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: (b) Coltec filed a Form 8-K dated October 13, 1993 reporting under Item 1. Changes in Control of Registrant, the approval of a stock-for-stock exchange between Coltec and Coltec Holdings Inc. (c) Exhibits 4.7, 4.8, 4.9, 4.10, 4.11, 4.12, 4.13, 4.14, 10.3, 10.13, 10.15, 10.16, 10.17, 10.18, 12.1, 13.1, 21.1 and 23.1 are filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Coltec Industries Inc (Registrant) Date: March 22, 1994 By: ________/s/_PAUL G. SCHOEN_______ Paul G. Schoen Executive 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 in the capacities noted on March 22, 1994. INDEX TO EXHIBITS I-1 I-2 I-3 INDEX TO FINANCIAL STATEMENT SCHEDULES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF COLTEC INDUSTRIES INC: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Coltec Industries Inc and subsidiaries' annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 24, 1994. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to 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 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. January 24, 1994 S-1 SCHEDULES V AND VI COLTEC INDUSTRIES INC AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-2 SCHEDULES V AND VI COLTEC INDUSTRIES INC AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (IN THOUSANDS) S-3 SCHEDULES V AND VI COLTEC INDUSTRIES INC AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (IN THOUSANDS) S-4 SCHEDULE VII COLTEC INDUSTRIES INC AND SUBSIDIARIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 (IN THOUSANDS) S-5 SCHEDULE VIII 1993, 1992 AND COLTEC INDUSTRIES INC AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-6

54502_1993.txt

54502_1993

1993

54502

ITEM 1: BUSINESS _________________ As used in this report, the term "K N" means K N Energy, Inc. and the term "Company" means collectively K N Energy, Inc. and its subsidiaries, unless the context requires a different meaning. (See "Subsidiaries of the Registrant" in Exhibit 22.) (A) General Development of Business _______________________________ K N was incorporated in Kansas on May 18, 1927. The Company's principal operations are the sale, marketing, transportation, processing and gathering of natural gas and the exploration, development and production of oil and natural gas. The Company has operated as a natural gas pipeline and utility since 1937 and has been involved in oil and gas exploration and development since 1951. Since 1989, K N subsidiaries have engaged in nonregulated gas marketing and gathering activities. This segment is experiencing significant growth through acquisitions, joint ventures and the transfer of substantially all of K N's existing gathering and processing facilities to this nonregulated segment as part of its restructuring. (See "Restructuring and Reorganization" below.) On October 1, 1993, K N implemented its unbundling of pipeline services in response to the Federal Energy Regulatory Commission's Order No. 636 ("Order 636"). The Order is designed to stimulate competition in the interstate transportation and sale of natural gas. Of the many elements that make up Order 636, the central feature involves the unbundling of gas sales and transportation services. Unbundling means that traditional pipeline customers, such as wholesale customers, direct end- users and shippers, have new options when contracting for various pipeline services such as transportation and storage. In response to Order 636, K N no longer operates its interstate operations as a single entity that purchases, gathers, processes, transports, stores and sells natural gas at retail and wholesale. Instead, K N has restructured its operations and now operates its interstate transmission pipeline as a separate subsidiary business unit, K N Interstate Gas Transmission Co. ("KNI"). K N's local distribution operation is being operated as a separate business unit ("K N Retail") within the parent company. K N also provides retail natural gas services through two intrastate divisions, Rocky Mountain Natural Gas in Colorado and Northern Gas of Wyoming. Substantially all of the gathering and processing facilities that were previously part of K N's regulated transmission operation are now being operated as nonregulated facilities by K N Gas Gathering, Inc. ("KNGG"), a wholly-owned subsidiary which also operates a number of other gathering and processing facilities acquired during the past two years. On April 1, 1993, the Company completed the $48 million acquisition of the Wattenberg natural gas gathering and transportation system. The transmission segment of the system is a Federal Energy Regulatory Commission ("FERC")-regulated interstate pipeline system operated by K N Wattenberg Transmission Limited Liability Company ("KNWTLLC"), a second- tier subsidiary of K N. The nonregulated gathering portion of the system is operated by K N Front Range Gathering Company ("KNFRGC"), a wholly-owned subsidiary of KNGG. (B) Financial Information About Industry Segments _____________________________________________ The Business Segment Information in Note 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 52 and 53 provides the operating profit, identifiable assets and other information for each segment. The Consolidated Statements of Income in the 1993 Annual Report to Shareholders as shown on page 32 show sales to unaffiliated customers (operating revenues) for each segment. (C) Narrative Description of Business _________________________________ (1) Regulated Gas Services ______________________ Markets and Sales _________________ The Company's FERC-regulated interstate pipeline systems (operated by KNI and KNWTLLC) provide transportation and storage services to K N Retail and other local natural gas distribution utilities and shippers. K N Retail provides retail natural gas services to residential, commercial, agricultural and industrial customers in Kansas, Nebraska, Colorado and Wyoming. Approximately 151,000 retail customers are served by K N Retail. The interstate pipeline systems provide transportation and storage services for a portion of the system supply of Public Service Company of Colorado ("PSCo"), Western Resources, Inc. and the City of Colorado Springs, Colorado, as well as for other local utilities serving 92,000 gas consumers in Colorado, Kansas and Nebraska. As of December 31, 1993, the interstate systems provided transportation and storage services to utilities serving 293 communities, as follows: (1) Principal cities served by K N Retail include: Alliance, Chadron, Holdrege, McCook, Ogallala, Scottsbluff, Sidney and a portion of Kearney, Nebraska; Colby, Phillipsburg and Scott City, Kansas; Julesburg and Wray, Colorado; and Douglas and Torrington, Wyoming. (2) Principal cities served by other local distribution utilities include: Grand Island, Hastings, Norfolk, North Platte, and Kearney, Nebraska; Hays, Kansas; and Sterling and the metropolitan areas of Colorado Springs and Denver, Colorado. The Company operates intrastate gas pipeline systems serving industrial customers and K N's distribution divisions in Wyoming and Colorado. The Northern Gas of Wyoming Division of K N provides retail gas service to approximately 50,000 customers in 25 communities in central, south central and northeastern Wyoming. Principal cities served at retail by the Wyoming intrastate system include Casper, Gillette, Lander, Laramie, Rawlins and Riverton, Wyoming. The Rocky Mountain Natural Gas Division of K N ("RMNG") serves approximately 31,500 retail customers in 26 communities in western Colorado. Aspen, Delta, Glenwood Springs, Montrose, Snowmass Village and Telluride are the principal cities served. RMNG continues to experience significant growth in the resort areas of Colorado. During 1993, the division experienced a six percent growth in the number of residential and commercial customers. Because of the demands of this continued growth, RMNG and an affiliate, in conjunction with PSCo, have received a favorable order from the Colorado Public Utilities Commission to build a 90-mile transmission pipeline from Rifle to Avon, Colorado. The pipeline will connect natural gas production areas near Rifle to K N's Colorado intrastate pipeline system. Agriculture is the dominant factor in the economies of the Company's historical service areas. The Company supplies natural gas for irrigation, crop drying, processing of agricultural products and the manufacture of agriculture-related goods. The following table sets forth the percentage of total natural gas sales revenues for each class of customer for each of the three years in the period ended December 31, 1993, as follows: (1) Regulated sales of natural gas to other gas utilities ended on September 30, 1993, due to the Company's implementation of Order 636. Natural gas sales accounted for 51.6, 69.4 and 78.0 percent of consolidated revenues for the years ended December 31, 1993, 1992 and 1991, respectively. The transfer of substantially all of K N's gathering and processing facilities to KNGG effective January 1, 1994, will result in a significant shift in operating revenues, expenses and operating income. The cessation of the merchant function as a FERC-regulated service will substantially reduce this segment's operating revenues and gas purchase expenses; however, this will not impact operating income. Results of this business segment have historically been seasonal in nature due to fluctuating needs for natural gas for space heating and irrigation. However, Order 636 mandated the use of straight fixed-variable rate design ("SFV") for FERC-regulated services. This rate methodology will result in this business segment collecting a significant portion of its revenues from customers through demand charges collected evenly throughout the year. Accordingly, fluctuations in operating revenues resulting from seasonal variations in weather temperatures should be reduced. Transportation ______________ KNI, under its menu of services, provides not only firm and interruptible transportation, but also storage and no-notice services to its customers. Under no-notice service, customers are able to meet their peak day requirements without making specific nominations as required by firm and interruptible transportation services tariffs. Under Order 636, the local distribution companies ("LDCs") and other shippers may release their unused firm transportation capacity rights to other shippers. It is anticipated that this released capacity will, to a large extent, replace interruptible transportation on the Company's system. Interruptible transportation is charged on the basis of volumes shipped. The Company's Wyoming and Colorado intrastate systems have blanket certificates which allow them to transport gas to be delivered in interstate commerce, and both systems also provide intrastate transportation services. Marketing _________ The Company is continuing its efforts to expand its transportation business through expanded capacity and new interconnects, as well as by adding new transportation services. While there is considerable competition for this business, the Company has certain strategic advantages to enable it to be a successful competitor. These include favorable geographic pipeline locations providing access to both major gas supply areas and potential new markets. The Company will continue developing its role as an operator of transportation hubs, facilitating market-center services. A K N subsidiary is a one-third joint venture partner in the TransColorado Gas Transmission Pipeline Project. This pipeline is expected to provide increased flexibility in accessing multiple natural gas basins in the Rocky Mountain region. TransColorado is in its final preconstruction stage and regulatory work is nearing completion. To focus marketing activities, the partner companies have opened a TransColorado marketing office to secure supply and transportation commitments. Construction is anticipated to begin in 1995. Gas Supply __________ With the implementation of Order 636, gas purchasing is now the responsibility of each LDC. To meet this new responsibility, K N Retail formed a new Gas Supply Department. K N Retail has contracted with KNI and other pipelines for transportation and storage services required to serve its markets. K N Retail's gas supply requirements are being met through a combination of purchases from a wholly-owned subsidiary, K N Gas Supply Services, Inc. ("KNGSSI"), and third party suppliers. K N Retail's gas supply comes from five major geological areas, as follows: (1) Anadarko Basin, including the Hugoton, Bradshaw and Panoma fields in Kansas; (2) Barton Arch area of central Kansas; (3) Denver-Julesburg Basin in northeast Colorado, northwest Kansas and western Nebraska; (4) Wind River Basin in central Wyoming; and (5) Bowdoin area in north central Montana. The Company's intrastate system in Wyoming purchases its gas supply principally from producers in the Wind River Basin in central Wyoming. The Company's Colorado intrastate system purchases approximately 12 percent of its system supply from a K N oil and gas subsidiary and the remainder from a number of western Colorado fields. Underground storage facilities are used to provide deliverabilities for peak system demand. Four underground storage facilities are located on the interstate systems, five are on the Wyoming intrastate system and one is on the Colorado intrastate system. In connection with Order 636, K N received FERC approval to reclassify, as of October 1, 1993, 54.9 billion cubic feet ("Bcf") of working gas to cushion gas. As part of the corporate restructuring, all cushion gas (88.1 Bcf) was transferred to KNI at that time. The remaining working gas of 11.1 Bcf at October 1, 1993, was purchased in-place by K N's former wholesale customers; K N Retail retained 4.3 Bcf of this working gas. On the interstate systems, a net injection of 2.7 Bcf in 1993 increased the total year-end gas inventory owned by all parties to 95.1 Bcf. The approximate unused working gas capacity at December 31, 1993, was 9.7 Bcf. On the Wyoming intrastate system, 11.3 Bcf of working gas was available in storage at year-end after a net withdrawal of 2.5 Bcf during the year. On the Colorado intrastate system, 2.3 Bcf of working gas was available in storage at year-end after a net withdrawal of 98 million cubic feet ("MMcf") during the year. Restructuring and Reorganization ________________________________ As authorized by FERC, K N implemented Order 636 restructured services on October 1, 1993. K N requested FERC approval, as a result of Order 636, to transfer all of its interstate transmission and storage facilities to KNI, a wholly-owned jurisdictional subsidiary of K N, and substantially all of its gathering and processing facilities to KNGG, a nonjurisdictional wholly-owned subsidiary of K N. In its May 5, 1993 order, FERC approved the transfer of K N's gathering, processing, transmission and storage facilities to KNI effective October 1, 1993. On November 1, 1993, FERC authorized the transfer of substantially all gathering and processing facilities from KNI to KNGG. Through discussions with its former wholesale customers, K N was able to formulate and implement a plan which resulted in the transition to Order 636 services and which avoided the necessity of any Gas Supply Realignment ("GSR") cost recovery filings with FERC. As a part of its action on K N's restructuring proposal, on January 13, 1994, FERC approved the offer of settlement which implemented K N's GSR crediting mechanism. Regulation __________ KNI's and KNWTLLC's facilities for the transportation of natural gas in interstate commerce, and in the case of KNI, for storage services in interstate commerce, are subject to regulation by FERC. In addition, KNI is subject to the requirements of FERC Order Nos. 497, et al., the Marketing Affiliate Rules, which govern the provision of information by an interstate pipeline to its marketing affiliates. The subsidiaries of K N currently identified as marketing affiliates are K N Gas Marketing, Inc. and KNGSSI. The Company's distribution facilities and retail sales in Kansas, Colorado and Wyoming are under the regulatory authority of each state's utility commission. The Wyoming and Colorado commissions also may review the Company's issuance of securities. In Nebraska, retail gas sales rates for residential and commercial customers are regulated by each municipality served since there is no state utility commission. In the incorporated communities in which K N sells natural gas at retail, K N operates under franchises granted by the applicable municipal authorities. K N is seeking to renew its franchises in: Casper and Laramie, Wyoming; Eagle and Wellington, Colorado; and Atkinson and Gothenburg, Nebraska. Sales are currently being made during the renewal process. In Colorado, these franchises must also be approved by the state regulatory commission. The duration of franchises varies with applicable law. In unincorporated areas, K N's direct sales of natural gas are not subject to franchise, but, in all states except Nebraska, are "certificated" by the state regulatory commissions. Regulatory Matters __________________ See Note 3 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 39 and 40. In March 1994, RMNG filed an application for a "make whole" rate change with the Colorado Public Utilities Commission ("CPUC") proposing to increase annual revenues $2.5 million effective April 2, 1994. This matter is currently pending before the CPUC. In February and March 1994, K N filed suits for injunctive relief against 20 municipalities in Nebraska, seeking the Court to enjoin the effectiveness of ordinances which attempt to make certain gas utility rates retroactive for the period of October 1, 1990, through May 1, 1993. These lawsuits are currently pending in the District Court of Lancaster County, Nebraska. Purchased Gas Adjustment Clauses ________________________________ K N Retail has gas supply cost adjustment clauses in its Kansas, Colorado and Wyoming tariffs and in its rate ordinances for Nebraska residential and commercial customers. These gas supply cost adjustment clauses provide for the pass-on of increases or decreases in upstream delivery costs and the recovery of under- or refund of over-collected purchased gas costs (including carrying charges thereon in certain jurisdictions) from prior periods. Order 636 eliminated the gas supply cost adjustment clause in KNI's FERC tariff. K N's Wyoming and Colorado intrastate regulated utilities' tariffs also contain purchased gas adjustment clauses. Competition ___________ The Company's pipeline systems face competition from other transporters. In addition, natural gas competes with fuel oil, coal, propane and electricity in the areas served by the Company's pipeline systems and local distribution businesses. (2) Gas Marketing and Gathering ___________________________ K N Gas Marketing, Inc. ("KNGM") was formed in March 1989 to provide gas marketing and supply services to various natural gas resellers and end-users on K N pipeline systems. KNGM works with producers and end- users on the pipeline systems to arrange the purchase and transportation of producers' excess or uncommitted gas to end-users, acting as shipper or agent for the end-users, administering nominations and providing balancing assistance when needed. During 1993, KNGM continued efforts to expand its markets both on and off K N's pipelines through the reorganization of its existing staff and K N's former gas supply staff. These growth activities are expected to continue under K N's post Order 636 reorganization activities. KNGSSI began operations in September 1993 to facilitate K N's transition from a provider of bundled pipeline sales service to a provider of Order 636 restructured services. In performing this function, KNGSSI buys gas from K N's former gas suppliers, aggregates these supplies and sells gas to former wholesale customers. K N Trading, Inc. ("KNTI"), another wholly-owned subsidiary of K N, was formed in November 1991 to engage in risk management activities in the gas commodities futures market. KNTI buys and sells gas commodity futures positions on the New York Mercantile Exchange ("NYMEX") and through the use of over-the-counter gas commodity derivatives for the purpose of reducing adverse price exposure for gas supply costs or specific market margins. KNGG was formed in November 1989 to provide gathering and mainline connection services for existing and new gas supply customers. KNGG operates gathering systems whose operations and rates of return are not currently regulated by FERC. Acquisitions and Capital Expenditures _____________________________________ On April 1, 1993, the Company completed its acquisition of the Wattenberg natural gas gathering and transportation system. KNFRGC is the operator of the gathering portion of the system. This system gathers and transports gas from approximately 1,800 receipt points in northeast Colorado, and transports up to 250,000 million British thermal units ("MMBtus") of gas per day. On June 1, 1993, Wind River Gathering Company acquired approximately 110 miles of natural gas pipeline and facilities in Wyoming's Wind River Basin. Wind River Gathering Company is a joint venture between KNGG and a subsidiary of Tom Brown, Inc., a Wind River Basin producer. This system connects area producers with major markets served by K N and other interstate pipeline systems. KNGG manages the operations of the gathering system. The system gathers and transports up to 30,000 MMBtus of gas per day. KNGM and KNGG incurred 1993 capital expenditures of $7.0 million. 1994 capital expenditures are budgeted at $4.7 million. Restructuring and Reorganization ________________________________ In conjunction with its Order 636 reorganization filing, K N applied for and received FERC permission to transfer substantially all of its regulated gathering and processing assets to KNGG. This transfer was effective January 1, 1994. The assets are located in K N's traditional gas supply areas in Kansas, Wyoming, Colorado, Texas and Oklahoma. Regulation __________ To the extent the gas marketing subsidiaries make sales for resale in interstate commerce, they are subject to FERC regulations and rulemaking related to affiliated marketers. Under the Natural Gas Act, facilities used for and operations involving the production and gathering of natural gas are exempt from FERC jurisdiction, while facilities used for and operations involving interstate transmission are not. However, FERC's determination of what constitutes exempt gathering facilities as opposed to jurisdictional transmission facilities has evolved over time. Under current law, facilities which otherwise are classified as gathering may be subject to ancillary FERC rate and service jurisdiction when owned by an interstate pipeline company and used in connection with interstate transportation or jurisdictional sales. Respecting facilities owned by noninterstate pipeline companies, such as KNGG and KNFRGC's gathering facilities, FERC has historically distinguished between these types of activities on a very fact-specific basis. FERC has initiated a rulemaking to consider issues relating to gathering services performed by interstate pipelines or their affiliates. FERC intends to use information obtained to reevaluate the appropriateness of its traditional gathering criteria in light of Order 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 and its potential effect on KNGG and KNFRGC. As part of its corporate reorganization, K N requested and was granted authority to transfer substantially all of its gathering facilities to KNGG. The Commission determined that after the transfer, the gathering facilities would be nonjurisdictional, but FERC reserved the right to reassert jurisdiction if KNGG was found to be operating the facilities in an anti-competitive manner or contrary to open access principles. Competition ___________ The gas marketing and gathering subsidiaries operate in a competitive environment for the purchase, sale and gathering of natural gas. The general availability of competitively priced gas supplies, the availability and price of alternative fuels and the availability and price of gathering and transportation services in their market areas all have an impact on these subsidiaries' competitive position for new markets. (3) Oil and Gas Production ______________________ K N owns and participates in the development and production of oil and gas reserves through two wholly-owned subsidiaries, K N Production Company ("KNPC") and GASCO, Inc. ("Gasco"). KNPC was formed in 1983 and currently owns oil and gas properties mainly in Colorado, Oklahoma, Texas and Wyoming. All KNPC production is sold either to unaffiliated purchasers or nonjurisdictional affiliated purchasers. Gasco was formed in 1966 and acquired by K N in 1986. Gasco owns properties in Colorado and Wyoming, selling much of its production to affiliated purchasers. During 1993, KNPC participated in the drilling and completion of 16 development wells in the Denver-Julesburg Basin, and in the drilling and completion of one exploratory well in the Oklahoma panhandle. Gasco participated in working over ten wells on the Western Slope and in the drilling and completion of one development well in Colorado. At December 31, 1993, KNPC had approximately 30,000 net undeveloped acres under lease and owned interests in 84 producing wells (35 net), of which it operated 20 (14 net). Gasco had approximately 140,000 net undeveloped acres under lease and owned interests in 139 producing wells (107 net), operating 117 (105 net). In addition to oil and gas properties, Gasco owns the Wolf Creek gas storage field in Colorado, and also owns interests in three small gathering systems, all in Colorado. Acquisitions and Capital Expenditures _____________________________________ In February 1994, KNPC and Gasco finalized the acquisition of gas reserves and production from Fuel Resources Development Company, a wholly- owned subsidiary of PSCo. The properties are located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming. Total net reserves approximate 50 billion cubic feet equivalent of natural gas. The Company is discussing the possible sharing of ownership interests and non-recourse financing with other parties. The Company will continue to focus on the acquisition and development of natural gas reserves in the Mid-Continent and Rocky Mountain regions, emphasizing areas contiguous to current and future Company pipeline operations. Capital expenditures in 1993 were $4.8 million. Capital expenditures for 1994 are budgeted at $6.7 million. Regulation __________ Oil and gas operations are primarily subject to the regulation of the Minerals Management Service ("MMS") and the Bureau of Land Management on the Federal level. Each state in which the Company's oil and gas subsidiaries operate regulates the volume and manner of production of natural gas in that state under laws directed toward conservation and the prevention of waste of natural resources. Competition ___________ Oil and gas exploration and development are subject to competition from not only numerous other companies in the industry, but also from alternative fuels, including coal and nuclear energy. (4) General _______ Gas Purchases _____________ Prior to Order 636, gas was purchased by the interstate pipeline for resale to its wholesale customers. As a result of the restructuring and reorganization pursuant to Order 636, each LDC, including K N Retail, now has the responsibility for its gas purchases. Under K N's Supply Transition Program, KNGSSI administers purchases from a portfolio of gas purchase contracts that existed prior to the reorganization. Order 636 has not significantly impacted gas purchasing for K N's intrastate systems. Gas purchase prices for certain categories of gas have been deregulated over a period of time beginning January 1, 1985, pursuant to the Natural Gas Policy Act of 1978 ("NGPA"). The final total deregulation of all gas at the wellhead occurred on January 1, 1993, under terms of the Natural Gas Wellhead Decontrol Act of 1989. The deregulation of gas at the wellhead is intended to bring the prices paid for gas to a "market clearing" level. Those contracts which have a deregulation clause allow the purchaser to redetermine the price to a competitive level and the Company has exercised these rights as deregulation has occurred. The natural gas futures contract, actively traded on the NYMEX, has brought significant price discovery to the natural gas market. Various indices and regional natural gas hubs have changed the method of pricing from long-term annual redeterminations to short-term, daily or monthly, pricing of gas at current market levels. As such, gas prices now quickly react to supply and demand as any other commodity market. Gas purchase contracts also may contain a take-or-pay clause which requires that a certain purchase level be attained each contract year, or the purchaser must make a payment equal to the contract price multiplied by the deficient volume. At December 31, 1993, the level of outstanding payments was $11.7 million. All such payments are fully recoupable under the terms of the gas purchase contracts and the existing regulatory rules and regulations. To date, the Company has not made any buy-out or buy-down payments relating to take-or-pay contracts. Certain gas purchase contracts containing market-out clauses were redetermined to a competitive price for 1993, reflecting an increase in gas prices from the 1992 redetermined price. Environmental Regulation ________________________ The Company's operations and properties are subject to extensive and changing Federal, state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous governmental departments issue rules and regulations to implement and enforce such laws which are often difficult and costly to comply with and which carry substantial penalties for failure to comply. Moreover, the recent trends toward stricter standards in environmental legislation and regulation are likely to continue. The United States Oil Pollution Act of 1990 (the "OPA") and regulations promulgated thereunder by the MMS impose a variety of requirements on persons who are or may be responsible for oil spills in waters of the United States. The term "waters of the United States" has been broadly defined to include inland waterbodies, including wetlands, playa lakes and intermittent streams. The Company has oil and gas facilities that could affect "waters of the United States." The Federal Water Pollution Control Act, also known as the Clean Water Act, and regulations promulgated thereunder, require containment of potential discharges of oil or hazardous substances and preparation of oil spill contingency plans. The Company currently is implementing programs that address containment of potential discharges and spill contingency planning. The failure to comply with ongoing requirements or inadequate cooperation during a spill event may subject a responsible party to civil or criminal enforcement actions. The Comprehensive Environmental Response, Compensation and Liability Act, as amended ("Superfund"), imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons who are considered to have contributed to the release of a "hazardous substance" into the environment. Under Superfund, such persons may be subject to joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment and for damages to natural resources. Furthermore, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment. Federal and state regulations have recently been changed as a result of the 1990 Amendments to the Clean Air Act. This affects the Company's operations in several ways. Natural gas compressors for both gathering and transmission activity are now required to meet stricter air emission standards. Additionally, states in which the Company operates are adopting new regulations under the authority of the "Operating Permit Program" under Title V of these 1990 Amendments. These Operating Permits will require operators of certain facilities to obtain individual site- specific air permits containing stricter operational and technological standards of operation in order to achieve compliance with this section of the 1990 Clean Air Act Amendments and associated state air regulations. Compliance with Federal, state and local provisions with respect to the protection of the environment has had no material effect upon capital expenditures, earnings, or the competitive position of the Company, except as described in Item 3 "Mystery Bridge Road Environmental Matters" and "Other Environmental Matters." Safety Regulation _________________ The operations of certain of the Company's gas pipelines are subject to regulation by the United States Department of Transportation (the "DOT") under the Natural Gas Pipeline Safety Act of 1968 (the "NGPSA"), as amended. The NGPSA establishes safety standards with respect to the design, installation, testing, construction, operation and management of natural gas pipelines, and requires entities that own or operate pipeline facilities to comply with the applicable safety standards, to establish and maintain inspection and maintenance plans and to comply with such plans. The NGPSA was amended by the Pipeline Safety Act of 1992 to require the DOT's Office of Pipeline Safety to consider, among other things, protection of the environment when developing minimum pipeline safety regulations. Management believes the Company's operations, to the extent they may be subject to the NGPSA, comply in all material respects with the NGPSA. The Company is also subject to laws and regulations concerning occupational health and safety. Although the Company is unable to predict the ultimate cost of compliance, it is not anticipated that the Company will be required in the near future to expend material amounts to comply with these laws and regulations. Other _____ Amounts spent by the Company during 1993, 1992 and 1991 on research and development activities were not material. Sales were not made to any individual customer in 1993 in an amount which equaled ten percent or more of the Company's consolidated revenues. At December 31, 1993, the Company had 1,735 employees. (D) Financial Information About Foreign and Domestic Operations and _______________________________________________________________ Export Sales ____________ All of the Company's operations are in the contiguous 48 states. ITEM 2: ITEM 2: PROPERTIES ___________________ (A) Location and Character of Property __________________________________ The Registrant maintains its principal place of business in Lakewood, Colorado. Other major offices are in: Hastings, Nebraska; Phillipsburg, Kansas; Casper, Wyoming; and Glenwood Springs, Colorado. At December 31, 1993, the principal properties of the Company were as set forth below. Gas Service ___________ As of December 31, 1993, the Company's gas service properties included transmission, gathering and storage lines of 8,239 miles in the interstate systems, 675 miles in the Wyoming intrastate system and 766 miles in the Colorado intrastate system. (Effective January 1, 1994, 1,691 miles of gathering lines were transferred to KNGG as part of the corporate reorganization. See "Restructuring and Reorganization" on pages 9 and 10.) Distribution lines totaling 6,159 miles were in the interstate system, 1,072 miles in the Wyoming intrastate system and 1,423 miles in the Colorado intrastate system at December 31, 1993. The Company has four underground gas storage facilities in operation in the interstate systems, five in the Wyoming intrastate system and one in the Colorado intrastate system. Its major interstate facilities are the Huntsman Storage Field in Cheyenne County, Nebraska and the Big Springs Storage Field in Deuel County, Nebraska. The interstate systems also included two products extraction plants and 185 compressor units with an aggregate 175,171 rated compressor horsepower at December 31, 1993. (Effective January 1, 1994, 29 compressor units with an aggregate 5,482 rated compressor horsepower and the Scott City products extraction plant were transferred to KNGG as part of the corporate reorganization.) The Wyoming intrastate system included eight compressor units and the Colorado intrastate system included 13 compressor units with aggregate rated compressor horsepower of 3,204 and 5,995, respectively, at December 31, 1993. The Company's other gas service properties include measuring and regulating stations, garages, warehouses and other land and buildings necessary and useful in the conduct of its business. Gas Marketing and Gathering ___________________________ The Company's gas marketing and gathering properties are discussed in Item 1 (C)(2). As of December 31, 1993, KNGG and its subsidiaries operated gathering systems with 2,918 miles of gathering lines and 75 compressors with an aggregate 43,150 rated compressor horsepower. (Effective January 1, 1994, 1,691 miles of gathering lines, 29 compressor units with an aggregate 5,482 rated compressor horsepower and the Scott City products extraction plant were transferred to KNGG as part of the corporate reorganization.) For additional information relating to gas marketing and gathering properties see Notes 1(H), 2, 4 and 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 37, 39, 40-41 and 52-53. Oil and Gas Production ______________________ The Company's oil and gas producing properties are discussed in Item 1(C)(3). For additional information relating to oil and gas production properties see Notes 1(I), 4 and 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 37, 40-41 and 52-53. (B) Oil and Gas Reserves, Properties and Activities _______________________________________________ Not material. ITEM 3: ITEM 3: LEGAL PROCEEDINGS __________________________ Mystery Bridge Road Environmental Matters _________________________________________ K N is named as one of four potentially responsible parties ("PRPs") at a U.S. Environmental Protection Agency ("EPA") Superfund site, pursuant to Superfund. The site is known as the Mystery Bridge Road/U.S. Highway 20 site located near Casper, Wyoming (the "Brookhurst Subdivision"). The EPA's remedy consists of two parts, "Operating Unit One," which addresses the groundwater cleanup and "Operating Unit Two," which addresses cleanup procedures for the soil and free-phase petroleum product. A Consent Decree between the Company, the EPA and another PRP was entered on October 2, 1991, in the Wyoming Federal District Court. Groundwater cleanup under Operating Unit One has been proceeding since 1990. On September 14, 1993, the EPA certified that the remedial action for Operating Unit One was "operational and functional." This is the last step in the Superfund process prior to remedy completion. In July 1992, the EPA approved the Company's Operating Unit Two workplan and the Company received an EPA "Statement of Work." The work required to be performed for Operating Unit Two commenced during the third quarter of 1992 and is expected to continue through 1995. (United States _____________ of America v. Dow Chemical Company, Dowell Schlumberger, Inc., and K N ______________________________________________________________________ Energy, Inc., Civil Action No. 91CV1042, United States District Court for ____________ the District of Wyoming; formerly reported as Administrative Orders for Removal Action on Consent, October 15, 1987, and Amendment to Administrative Order for Removal Order on Consent, October 10, 1989, Docket No. CERCLA VII-88-01, United States Environmental Protection Agency; Judicial Entry of Consent Decree, United States v. Dow Chemical Company, ______________________________________ et al. (D. Wyo) USDC-WY-91CV1042B, Superfund Site Number 8T83, Natrona _________________________________ County, Wyoming; EPA Docket Number CERCLA-VIII.) With regard to this same Superfund site, in 1987 the State of Wyoming filed suit against several parties (including K N) for injunctive relief, penalties and unquantified damages claimed to have resulted from alleged pollution of groundwater and soils in the Brookhurst Subdivision. On April 1, 1993, the Wyoming District Court dismissed the lawsuit, finding that K N had diligently remedied the alleged pollution. (Wyoming v. Little _________________ America Refining Co., K N Energy, Inc. and Dowell Schlumberger, Civil ______________________________________________________________ Action No. 62325, Wyoming District Court [Natrona County].) On October 20, 1989, a lawsuit was filed against the Company and 18 other defendants on behalf of a group of 268 individuals who reside or resided in the Brookhurst Subdivision, seeking damages for alleged releases of certain chemicals to the soil, groundwater and air. On February 5, 1993, the Company reached agreement to settle the above-described dispute. The settlement, which was approved by the Wyoming District Court, resolved all disputes between the parties and closed the lawsuit. A reserve for the settlement amount and related matters had been established in the Company's financial statements prior to 1993 and, accordingly, such settlement did not have any material adverse impact on the Company's financial position or results of operations. (Albertson, et al., v. Dow Chemical Co., K N ___________________________________________ Energy, Inc., et al., Civil Action No. 65212, 7th Judicial District, ____________________ Natrona County District Court, State of Wyoming.) On November 30, 1990, the Company initiated an action against a number of its insurance carriers for a declaration of the carriers' contractual obligations to provide insurance coverage for all sums associated with the alleged losses under the state, Federal and toxic tort claims related to the Brookhurst Subdivision. The Company entered into formal settlements with all of the defendants in the lawsuit in 1993, and received settlement proceeds associated therewith. (K N v. Allianz ______________ Insurance Company, et al., Civil Action No. 90CV301-J, United States ________________________ District Court for the District of Wyoming.) Other Environmental Matters ___________________________ An environmental audit performed by the Company in autumn 1991 revealed that a grease known as Rockwell 860 had been used as a valve sealant at several of the Company's locations in Nebraska. Rockwell 860 is a solid clay-like material which does not easily spill into the environment, but contains approximately ten percent polychlorinated biphenyls ("PCBs"). Based on the Company's initial studies, the PCBs are contained within the pipeline and valves at the subject locations. PCBs are regulated by the EPA under the Toxic Substances Control Act. On March 31, 1993, the Company filed suit against Rockwell International Corporation manufacturer of the valve sealant; and two other related defendants, claiming under contractual, statutory, tort and strict liability theories that the defendants share responsibility for the Company's environmental expenses and commercial losses resulting from any EPA or state required PCB cleanup or mitigation. The Company reached a settlement in principal with Rockwell, et al. in March 1994. The Company submitted a proposed PCB remediation plan to the EPA in November 1991. To date, no enforcement action or penalties have been issued or discussed by the EPA. The Company currently cannot estimate the extent of the remediation nor costs, though such costs are not expected to exceed the settlement amounts or to have any material adverse impact on the Company's financial position or results of operations. The PCB cleanup program is not expected to interrupt or diminish K N's operational ability to gather or transport natural gas. Certain used pipe reclaimed at the Company's Holdrege, Nebraska pipeyard was wrapped with asphalt-saturated asbestos felt, which was commonly removed in accordance with Company practices. The removed wrap contains friable asbestos fibers above the regulatory standard. The Nebraska Department of Environmental Control ("DEC"), the agency having jurisdiction over this matter, was notified and approved the Company's remediation plan. Remediation is effectively complete, at a total cost not to exceed $600,000. The asbestos cleanup program did not interrupt or diminish K N's operational ability to gather or transport natural gas. Grynberg v. K N et al. ______________________ On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, Rocky Mountain Natural Gas Company and Gasco (the "K N Entities") alleging that the K N Entities as well as KNPC and KNGG, have violated Federal and state antitrust laws. In essence, Grynberg asserts that the companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and illegally have attempted to monopolize or to enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. No specific monetary damages have been claimed, although Grynberg has requested that any actual damages awarded be trebled. In addition, Grynberg has requested that the K N Entities be ordered to divest all interests in natural gas exploration, development and production properties, all interests in distribution and marketing operations, and all interests in natural gas storage facilities, separating these interests from the Company's natural gas gathering and transportation system in northwest Colorado. On August 13, 1993, the United States District Court, District of Colorado, stayed this proceeding pending exhaustion of appeals in a related state court action involving the same plaintiff. (Grynberg v. K N, et al., _______________________ Civil Action No. 92-2000, United States District Court for the District of Colorado.) ITEM 4: ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ____________________________________________________________ None. EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________ (A) Identification and Business Experience of Executive Officers ____________________________________________________________ Name Age Position and Business Experience __________________________ _____ _________________________________ Charles W. Battey. . . . . 62 Chairman and Chief Executive Offi- cer since January 1989 and Director since 1971. Larry D. Hall. . . . . . . 51 President and Chief Operating Offi- cer since May 1988 and Director since 1984. Leland L. Hurst. . . . . . 63 Senior Vice President since May 1993. Previously Senior Vice President, Operations from June 1988 to May 1993. Judith A. Aden . . . . . . 52 Vice President and Treasurer since March 1991, Treasurer since January 1981 and Assistant Secretary since March 1989. William E. Asbury. . . . . 41 Vice President, Gas Service since 1988. Eugene B. Bade . . . . . . 47 Vice President and Controller since May 1993. Previously Vice Pres- ident K N Gas Marketing from January 1990 to May 1993, Vice President from April 1989 to January 1990 and Director of Internal Audit from November 1985 to April 1989. Richard M. Buxton. . . . . 45 Vice President, Strategic Planning and Financial Services since March 1991. Director, Financial Services from 1986 to March 1991. William S. Garner, Jr. . . 44 Vice President, General Counsel and Secretary since April 1992. Vice President and General Counsel since January 1991. Previously Vice Pres- ident and Deputy General Counsel from September 1989 through 1990 and Vice President, Law from June 1988 to September 1989. S. Wesley Haun . . . . . . 46 Vice President, Marketing and Supply since May 1993. Previously Vice President, Gas Supply from March 1990 to May 1993 and Vice President, Gas Acquisition from November 1988 to March 1990. E. Wayne Lundhagen . . . . 57 Vice President, Finance and Accounting since May 1988. Arnold R. Madigan. . . . . 55 Vice President, Interstate Transportation since May 1993. Previously Vice President, Marketing and Transportation from September 1989 to May 1993 and Vice President and General Counsel from June 1988 to September 1989. John W. Simonton . . . . . 48 Vice President, Administration and Human Resources since May 1988. H. Rickey Wells. . . . . . 37 Vice President, Operations since June 1988. These officers generally serve until March of each year. (B) Involvement in Certain Legal Proceedings ________________________________________ None. PART II ITEM 5: ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER _________________________________________________________________________ MATTERS _______ The Company's common stock is listed for trading on the New York Stock Exchange under the symbol KNE. Dividends paid and the price range of the Company's common stock by quarters for the last two years, restated for an October 1993 three-for-two stock split, are provided below. ITEM 6: ITEM 6: SELECTED FINANCIAL DATA ________________________________ FIVE-YEAR REVIEW Selected Financial Data (Dollars in Thousands Except Per Share Amounts) (1) Restated to reflect a three-for-two common stock split in 1993. ITEM 7: ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ________________________________________________________________________ RESULTS OF OPERATIONS _____________________ CONSOLIDATED FINANCIAL RESULTS Continuing Operations Income from continuing operations and the applicable earnings per share and return on beginning of year common equity for the three years ended December 31, 1993, were as follows: Earnings per share for 1993 exceeded 1992 results by 23 percent, despite the negative effects of record low gas sales to irrigation customers. The impact of lower irrigation sales was more than offset by positive contributions from acquisitions of natural gas facilities, expense controls, favorable resolution of rate cases, and insurance settlements. In addition, 1993 first quarter gas sales, transportation and natural gas liquids revenues were significantly greater than those in the first quarter of 1992 due to colder weather. The decline in 1992 earnings, in comparison with 1991, reflected the impact of unfavorable weather on natural gas sales and natural gas liquids revenues, and higher interest expense which resulted, in part, from reduced operating cash flows. These negative earnings factors were partially offset by increased transportation revenues, rate increases, lower operating costs as a result of expense controls and reduced litigation expense provisions. Discontinued Operations In 1991, the Company recorded an after-tax loss of $17.3 million resulting from the sale of its coal subsidiaries and the discontinuance of this business segment. RESULTS OF CONTINUING OPERATIONS Discussion of operating results by business segment and consolidated other income and (deductions) and income taxes follows. Segment operating revenues, gas purchases, operations and maintenance expenses, and volumetric data cited here are before intersegment eliminations (dollars in millions). Revenues and expenses of the Federal Energy Regulatory Commission ("FERC")-regulated Wattenberg transmission system, acquired on April 1, 1993, are included in this segment's 1993 operating results. The decline in gas sales and transportation revenues (and related gas purchases) primarily reflects FERC Order No. 636 ("Order 636") implementation and the resultant elimination of the gas cost component from FERC-regulated service revenues. An additional cause for the decline in 1993 gas sales and transportation revenues was the record low sales to irrigation customers due to the abnormally wet summer. Irrigation sales were 3.1 Bcf below 1992 volumes. However, revenues from the Wattenberg transmission system, rate increases in essentially all K N retail jurisdictions (including resolution of the 1990 rate case in Nebraska), and increases in 1993 residential and commercial sales volumes (4.3 Bcf above 1992 due to colder weather) substantially offset the decline in irrigation sales. Greater systems throughput, costs and expenses of the Wattenberg transmission system and higher costs related to increased natural gas liquids recoveries impacted 1993 operations and maintenance expenses. These increases were partially mitigated by insurance settlements related to the Brookhurst Subdivision Superfund site near Casper, Wyoming. Gas service's 1992 operating revenues were ten percent below 1991 as a result of unfavorable weather. Most notably impacted by the adverse 1992 weather were gas sales to irrigation customers, which were 7.2 Bcf below 1991. Gas sales revenues were positively affected in 1992 by rate increases, including $3.8 million collected in prior years but reserved from earnings for the 1990 eastern and central Nebraska rate case. Transportation revenues in 1992 were $3.4 million higher than 1991 as off-system transport volumes increased by 13.3 Bcf. Natural gas liquids revenues in 1992 were $2.9 million below 1991 as the unfavorable weather affected both prices and volumes. Operating costs and expenses for 1992 were 11 percent below 1991 due principally to reduced on-system throughput and expense controls. Gas purchases declined significantly as a result of lower 1992 gas sales and processing of volumes for natural gas liquids recoveries. In addition, 1992 operations and maintenance expenses were affected by lower provisions for litigation issues. The increase in 1992 taxes, other than income taxes, primarily results from state property tax legislation in Nebraska. In addition to continued growth in nonregulated gas marketing activities, this segment's 1993 and 1992 operating results reflect the Douglas gathering and processing acquisition beginning in October 1992 and the Wattenberg gathering facilities acquisition beginning in April 1993. Additionally, with Order 636 restructuring effective October 1, 1993, this segment assumed the gas sales function previously provided by K N for its wholesale customers as part of its bundled services. The increases in 1993 and 1992 oil and gas revenues and production result from the July 1992 acquisition of producing properties in western Colorado and successful drilling in the Denver-Julesburg Basin in northeastern Colorado. The increase in interest expense primarily reflects the Company's issuance of $195 million of long-term debt during the last three years. The majority of the net proceeds from these debt issues were used to fund capital expenditures and acquisitions; however, $65 million was used to refund higher coupon debt in 1993 and 1992. As a result, the Company's year end 1993 weighted-average embedded cost of long-term debt was 8.3 percent compared with a cost of 9.6 percent at December 31, 1990. The effect of the one percent increase in the Federal tax rate, resulting from enactment of the Revenue Reconciliation Act of 1993, was more than offset by increased 1993 tax credits on gas production from wells qualifying for non-conventional fuel credit under Section 29 of the Internal Revenue Code. The 1991 effective tax rate reflects higher state income tax provisions. LIQUIDITY AND CAPITAL RESOURCES The primary sources of cash during 1993 included cash generated from operations, short-term borrowings and the issuance of long-term debt. Principal cash outflows were capital expenditures and acquisitions, redemptions of long-term debt and preferred stock, and payment of interest and dividends. Cash Flows from Operating Activities Net cash flows from continuing operations were $43.3 million, $33.2 million and $72.1 million for 1993, 1992 and 1991, respectively. In addition to the factors discussed previously, which affect cash generation as well as operating results, net cash flows have been impacted by litigation settlements (including recoupable take-or-pay payments) and environmental costs. In both 1993 and 1992, actual cash disbursements exceeded expense provisions for litigation and environmental issues. Net operating cash flows for 1993 were also reduced by repayments to gas service customers for previous years' over-recovery of gas costs. Capital Expenditures and Commitments Excluding acquisitions, 1993 capital expenditures were $63.1 million compared with expenditures of $60.1 million in 1992 and $59.4 million in 1991. (Refer to Note 13 of Notes to Consolidated Financial Statements for business segment expenditures.) The increased 1993 spending includes approximately $9.0 million of Order 636 transition costs (measurement facilities and systems) and $11.0 million for construction of a new corporate office building. The regulated portion of the Wattenberg system and the Company's portion of the Wind River gathering system primarily account for the $26.8 million of capital expenditures for acquisitions in 1993. Consolidated 1994 capital expenditures are budgeted at $54.5 million, excluding acquisitions. This includes $7.6 million for the first phase of the Rifle to Avon pipeline being jointly constructed by the Company's subsidiary, Rocky Mountain Natural Gas Company, and Public Service Company of Colorado. The second phase of this pipeline will be constructed in 1995; the Company's portion of estimated costs is approximately $5.0 million. In February 1994, K N's oil and gas subsidiaries completed the acquisition of gas reserves and production in western Colorado and southwestern Wyoming. During the first half of 1994, the Company plans to bring in one or more partners to participate in this acquisition and to assist in further development of the properties. The Company has no substantial disagreements related to take-or-pay matters. The Company monitors contractual obligations, including obligations to pay above-market prices under certain contracts, and at the end of each contract year pays those producers to whom take-or-pay amounts are payable. All amounts paid by the Company for take-or-pay are fully recoupable from future gas production. Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employers' Accounting for Postemployment Benefits," 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. SFAS 112 is effective for fiscal years beginning after December 15, 1993. Implementation of SFAS 112 is not expected to have a material effect on the Company's financial position or results of operations. Capital Resources Short-term debt was $47.0 million at December 31, 1993, compared with $2.0 million of borrowings at December 31, 1992. The Company has credit agreements with eight banks to either borrow or use as commercial paper support up to $90 million. In November 1993, K N filed a shelf registration statement with the Securities and Exchange Commission for the sale of $200 million of debt securities in anticipation of long-term financing needs over the next three years. In January 1994, the Company received $41.0 million from the sale of contract demand receivables to a financial institution. The demand receivables resulted from gas sales contracts between some of K N's former wholesale customers and a K N subsidiary. Proceeds were used to reduce short-term debt. The Company expects that 1994 cash requirements for debt service, preferred stock redemptions, dividends and capital expenditures will be provided by internal cash flows, short-term borrowings, and the issuance of common stock for dividend reinvestment and employee benefit plans. OUTLOOK Restructuring and Reorganization The Company's implementation of Order 636 and the related corporate reorganization are discussed in other sections of this annual report. This discussion will focus on the expected 1994 financial implications of these events. As a result of recent acquisitions and the transfer of substantially all of K N interstate's gathering and processing facilities to a nonregulated subsidiary, the composition of 1994's operating income will differ significantly from the past. Historically, the Company's gas service segment has accounted for more than 90 percent of consolidated operating income. The expectation for 1994 is that this segment will account for approximately 65 to 70 percent of operating income. Secondly, Order 636 mandated the use of SFV rate design for FERC- regulated services. Accordingly, fluctuations in operating revenues resulting from significant variations in weather temperatures should be reduced. Revenues from the Company's important summer irrigation load will remain vulnerable to abnormal weather patterns, such as those experienced in 1993 and 1992. Finally, the effect of both of the above items is expected to change the Company's historical quarterly earnings distribution. The 1994 first and fourth quarters will account for a smaller percentage of annual earnings, while the second and third quarters will be higher. Gas Service The Company's Order 636 implementation and reorganization will significantly impact this business segment's future operating results. The transfer of substantially all of K N interstate's gathering facilities and the principal processing plant to a subsidiary within the gas marketing and gathering segment will result in a significant shift in operating revenues, expenses and operating income. Additionally, with the elimination of the merchant function from FERC-regulated services, this segment's operating revenues and gas purchases will be substantially lower than prior periods; however, this elimination should not impact operating income. Operating results for 1994 should benefit from a full year's operation of the Wattenberg transmission system and from rate increases placed into effect during 1993. As a result of the unbundling and the diverse services offered under the post-Order 636 environment, competition will increase. The Company believes that its interstate and intrastate systems are well-positioned to capitalize on opportunities resulting from future development of natural gas reserves in the Rocky Mountain region. The Company expects continued moderate growth in its retail distribution operations due, principally, to the continued customer additions being realized by its Colorado intrastate system. Gas Marketing and Gathering On January 1, 1994, substantially all of the gathering facilities and the principal processing plant, which were previously a part of the K N interstate system, were transferred to a subsidiary within the gas marketing and gathering business segment. This segment's 1993 operating results included only partial year activity of the Wattenberg nonregulated gathering system and the Wind River gas gathering joint venture. Accordingly, this segment's 1994 operating revenues, expenses and operating income are expected to be significantly higher than in 1993. Oil and Gas Production The February 1994 acquisition of producing properties and undeveloped gas reserves in western Colorado and southwestern Wyoming is expected to have a positive impact on 1994 operating results of this business segment. The Company also believes that its involvement in oil and gas development and production provides opportunities to enhance the value of its associated gas service, gathering and processing businesses. Litigation During the last three years, the Company has resolved or settled four major cases or environmental matters -- three cases related to the Brookhurst Subdivision Superfund site near Casper, Wyoming, and long-standing litigation with FM Properties Inc. and other parties. Refer to Note 5 of Notes to Consolidated Financial Statements for additional information on the Company's pending litigation. Management believes it has established adequate reserves such that resolution of pending litigation or environmental matters will not have a material adverse effect on the Company's financial position or results of operations. INFLATION Current ratemaking practices allow the Company to recover through revenues the historical cost, rather than the current replacement cost, of utility plant and equipment. In the past three years, the rate of inflation has not had a material impact on the Company's costs. ITEM 8: ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ____________________________________________________ Report of Independent Public Accountants To K N Energy, Inc.: We have audited the accompanying consolidated balance sheets of K N Energy, Inc. (a Kansas corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of K N Energy, 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 explained in Notes 1(D) and 9 of Notes to Consolidated Financial Statements, the Company changed its method of accounting for income taxes effective January 1, 1992, and its method of accounting for postretirement benefits other than pensions effective January 1, 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of 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 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. Denver, Colorado, February 10, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these balance sheets. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies (A) Principles of Consolidation The consolidated financial statements include the accounts of K N Energy, Inc. ("K N") and all of its subsidiaries (the "Company"). All material intercompany items and transactions have been eliminated. (B) Basis of Accounting The accounting policies of the Company conform to generally accepted accounting principles. For the regulated public utilities in the Company, these accounting principles are applied in accordance with Statement of Financial Accounting Standards No. 71, which prescribes the circumstances in which the application of generally accepted accounting principles is affected by the economic effect of regulation. (C) Gas Service Revenues Natural gas revenues are recorded on the basis of gas delivered to customers to the end of each accounting period. This includes unbilled revenues representing the estimated amount customers will be billed for gas delivered from the time meters were last read to the end of the accounting period, net of cost of gas where applicable. Gas transportation revenues are recorded on the basis of capacity reserved on and gas transported through the pipeline systems. The Company receives a fee for its transportation services; however, there are no purchased gas expenses associated with the transportation function. (D) Income Taxes The Company implemented Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes," effective as of January 1, 1992. SFAS 109 requires recognition of deferred income tax assets and liabilities based on enacted tax laws for all temporary differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets are reduced by a valuation allowance for the amount of any tax benefit that, more likely than not, is expected to not be realized. The adoption of SFAS 109 had an insignificant effect on the Company's financial position and results of operations, since the Company had already adopted the liability method of accounting under Statement of Financial Accounting Standards No. 96. (E) Earnings Per Share Earnings per share are computed based on the monthly weighted average number of common shares outstanding during the periods. There are no other securities or common stock equivalents which have a material dilutive effect on earnings per share. On August 10, 1993, K N's Board of Directors declared a three-for-two common stock split which was distributed on October 4, 1993, to common shareholders of record on September 15, 1993. The par value of the common stock did not change. All weighted average and per share amounts in the accompanying financial statements have been restated to reflect the stock split. The weighted average number of common shares outstanding was 14,913,000 in 1993, 14,580,000 in 1992 and 14,459,000 in 1991. (F) Nonutility Gas Marketing Subsidiaries Gas marketing subsidiaries' revenues are included in "Gas Marketing and Gathering," and their gas purchase costs are included in "Gas Purchases." (G) Prepaid Gas Prepaid gas represents payments made in lieu of taking delivery of (and purchasing) natural gas under the take-or-pay provisions of the Company's gas purchase contracts, net of any subsequent recoupments in kind from producers. All funds paid by the Company for take-or-pay are fully recoupable from future production, and are recorded as an asset (Prepaid Gas). When recoupment is made in kind in a subsequent contract year, natural gas purchase expense is recorded and the asset is reduced. (H) Property, Plant and Equipment Utility plant is stated at the original cost of construction, which includes indirect costs such as payroll taxes, fringe benefits, administrative and general costs and an allowance for funds used during construction. Expenditures which increase capacities or extend useful lives are capitalized. Routine maintenance, repairs and renewal costs are expensed as incurred. The cost of depreciable utility property, plant and equipment retired, plus the cost of removal less salvage, is deducted from accumulated depreciation with no effect on current period earnings. (I) Exploration and Development Costs K N's oil and gas subsidiaries follow the "successful efforts" method of accounting. Under this method, acquisition costs, successful exploration costs and development costs are capitalized and unsuccessful exploration costs, lease rentals and evaluation costs are expensed. (J) Depreciation, Depletion and Amortization Depreciation is computed based on the straight-line method over the estimated useful life for most utility property, plant and equipment. The unit-of-production method is used for computing depreciation, depletion and amortization for oil and gas properties. (K) Gas in Underground Storage K N's regulated interstate retail distribution business and Northern Gas Company record storage injections at the average cost of purchased gas for the year. Storage withdrawals are priced on the last-in first-out ("LIFO") method. K N Gas Supply Services, Inc., a nonjurisdictional subsidiary, prices storage injections at the average cost of purchased gas each month. Storage withdrawals are priced at the average cost of storage gas at the beginning of each month. Rocky Mountain Natural Gas Company prices storage injections at the average cost of purchased gas for the year. Storage withdrawals are priced on the first-in first-out ("FIFO") method. The Company also maintains gas in its underground storage facilities on behalf of certain third parties. The Company receives a fee for its storage services but does not reflect the value of third party gas in the accompanying financial statements. (L) Deferred Revenues In January 1994, contract demand receivables with a face amount of $41 million were sold to a financial institution. No gain or loss was recorded on the sale. The Company is deferring revenues from certain gas sales agreements associated with these receivables pending final disposition of related gas purchase contracts. (M) Reclassification of Prior Year Amounts Certain prior year amounts have been reclassified to conform with the 1993 presentation. (N) Cash Flow Information The Company considers all highly-liquid investments purchased with an original maturity of three months or less to be cash equivalents. Changes in Other Working Capital Items Summary, Supplemental Disclosures of Cash Flow Information and Supplemental Schedule of Noncash Investing and Financing Activities are as follows: (B) In connection with the exchange and lease of gathering and processing facilities described in Note 4(D), the Company exchanged its interest in the Tyrone Gas Gathering system as a portion of the consideration. 2. Restructuring and Reorganization On April 8, 1992, the Federal Energy Regulatory Commission ("FERC") issued Order No. 636 ("Order 636") which requires a fundamental restructuring of interstate natural gas pipelines. A separate restructuring docket was established for each interstate pipeline, including K N (Docket No. RS92-19-000). On November 2, 1992, K N made its compliance filing reflecting K N's proposal for its restructured services to implement Order 636. K N's proposal was revised in response to subsequent FERC orders. As authorized by FERC, K N implemented Order 636 restructured services on October 1, 1993. As a part of its action on K N's restructuring proposal, FERC approved implementation of K N's gas supply realignment ("GSR") crediting mechanism. K N requested FERC approval, as a result of Order 636, to transfer all of its interstate transmission and storage facilities to K N Interstate Gas Transmission Co. ("KNI"), a wholly-owned jurisdictional subsidiary of K N, and substantially all of its gathering and processing facilities to K N Gas Gathering, Inc. ("KNGG"), a nonjurisdictional wholly-owned subsidiary of K N. In its May 5, 1993 order, FERC approved the transfer of K N's interstate gas transmission and storage facilities to KNI effective October 1, 1993. On November 1, 1993, FERC authorized the transfer of gathering and processing facilities from KNI to KNGG. The transfer was effective January 1, 1994, and included approximately $70 million of gross property, plant and equipment. Order 636 required pipelines to unbundle sales and transportation services. KNI has complied with FERC's directive to mitigate its GSR costs caused by this restructuring. KNI's GSR process allows for the assignment of its above-market contracts. Under KNI's tariff, every shipper has a right to take assignment of these above- market contracts. Shippers may either take assignment of these above- market contracts or enter into a negotiated exit fee. This should obviate the need to make any GSR cost recovery filing with FERC. 3. Regulatory Matters On December 30, 1993, KNI made a rate filing with FERC requesting a $12.0 million annual increase in revenues. The new rates will become effective July 1, 1994, subject to refund. In February 1992, K N filed a rate restatement with FERC pursuant to FERC's purchased gas adjustment regulations. The filing proposed no change in K N's current rates. K N submitted an offer of Settlement and Stipulation ("Settlement") in August 1993. FERC approved the Settlement on November 17, 1993. Terms of the Settlement did not have a material effect on K N's financial position or results of operations. In February 1993, K N filed general rate applications in all 177 retail Nebraska communities it serves, requesting an increase in aggregate annual revenues of $2.2 million. Pursuant to Nebraska statute, the new rates became effective May 2, 1993, subject to refund. An agreement was reached in August 1993, between the Company and representatives of the 10 rate areas in Nebraska. Under the terms of the agreement, K N received a $1.4 million annual rate increase. Revenues collected above the settlement rates were refunded to the customers in December 1993. In June 1990, K N filed general rate applications in 147 central and eastern Nebraska communities requesting an increase in aggregate annual revenues of $6.7 million. Pursuant to Nebraska statute, the new rates were put into effect on October 1, 1990, subject to refund. The majority of the communities adopted a lower rate increase. K N filed for injunctions against these communities. On August 27, 1993, the Nebraska Supreme Court ruled that natural gas rates placed into effect by K N as interim rates on October 1, 1990, were properly justified and should be allowed to stand. In 1992, K N reduced the deferred portion of the increased revenues resulting from these rate applications and recorded as revenue $3.8 million of amounts previously deferred in 1990 and 1991. The remaining deferred revenues relating to this matter, totaling $1.6 million, were recorded as revenue in 1993. In June 1992, K N filed an application for a "make whole" rate increase with the Colorado Public Utilities Commission ("CPUC"). The new rates, which resulted in increased annual revenues of $0.7 million, were approved by the CPUC and became effective August 1, 1992. In December 1992, K N filed an application with the Wyoming Public Service Commission ("WPSC") for an annualized general rate increase of $1.2 million. In April 1993, the WPSC issued an order granting K N a $1.1 million annual rate increase effective May 1, 1993. In March 1993, K N filed an application with the Kansas Corporation Commission ("KCC") for an annualized general rate increase of $3.3 million. On October 28, 1993, the KCC issued an order approving a settlement agreement between K N and the interested parties which granted K N a $2.4 million annual rate increase effective October 1, 1993. 4. Acquisitions (A) Wattenberg On April 1, 1993, the Company completed the $48 million acquisition of the Wattenberg natural gas gathering and transmission system. The system has both regulated and nonregulated components. The regulated transmission segment, approximately $18 million of the acquisition, was financed with corporate funds, and the balance of the system was financed through an operating lease. The system gathers and transports gas from approximately 1,800 receipt points in northeastern Colorado. (B) Oil and Gas Reserve Acquisition On February 1, 1994, the Company's oil and gas development subsidiaries, K N Production Company and GASCO, Inc., acquired gas reserves and production properties located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming for a total purchase price of approximately $30 million. The acquired properties have total net reserves of approximately 50 billion cubic feet equivalent of natural gas. The Company is discussing the possible sharing of ownership interests and non-recourse financing with other parties. (C) Wind River Effective June 1, 1993, Wind River Gathering Company acquired approximately 110 miles of natural gas pipeline and facilities in Wyoming's Wind River Basin. Wind River Gathering Company is a joint venture between KNGG and a subsidiary of Tom Brown, Inc., a Wind River Basin producer. KNGG manages the operations of the gathering system. KNGG paid approximately $2 million for its interest in the joint venture. (D) Exchange and Lease of Gathering and Processing Facilities On October 1, 1992, K N exchanged its Tyrone gas gathering system located in the Oklahoma panhandle for a natural gas processing plant and gathering system located near Douglas, Wyoming. KNGG is operator of the Douglas system, and entered into an operating lease for the facilities with a financial institution. (E) Distribution Systems On March 31, 1992, K N acquired the stock of two corporations for $3.7 million in net cash. The acquired corporations owned two gas utility distribution systems serving approximately 7,000 customers, mainly in northeastern Wyoming. The acquisition was accounted for as a purchase, and the corporations were merged into K N effective April 1, 1992. 5. Litigation K N is named as one of four potentially responsible parties ("PRPs") at a U.S. Environmental Protection Agency ("EPA") Superfund site, pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"). The site is known as the Mystery Bridge Road/U.S. Highway 20 site located near Casper, Wyoming (the "Brookhurst Subdivision"). The EPA's remedy consists of two parts, "Operating Unit One," which addresses the groundwater cleanup and "Operating Unit Two," which addresses cleanup procedures for the soil and free-phase petroleum product. A Consent Decree between the Company, the EPA and another PRP was entered on October 2, 1991, in the Wyoming Federal District Court. Groundwater cleanup under Operating Unit One has been proceeding since 1990. On September 14, 1993, the EPA certified that the remedial action for Operating Unit One was "operational and functional." This is the last step in the Superfund process prior to remedy completion. In July 1992, the EPA approved the Company's Operating Unit Two workplan and the Company received an EPA "Statement of Work." The work required to be performed for Operating Unit Two commenced during the third quarter of 1992 and is expected to continue through 1995 at a total cost estimated not to be more than $1.0 million. With regard to this same Superfund site, in 1987 the State of Wyoming filed suit against several parties (including K N) for injunctive relief, penalties and unquantified damages claimed to have resulted from alleged pollution of groundwater and soils in the Brookhurst Subdivision. On April 1, 1993, the Wyoming District Court dismissed the lawsuit, finding that K N had diligently remedied the alleged pollution. On October 20, 1989, a lawsuit was filed against the Company and 18 other defendants on behalf of a group of 268 individuals who reside or resided in the Brookhurst Subdivision, seeking damages for alleged releases of certain chemicals to the soil, groundwater and air. On February 5, 1993, the Company reached agreement to settle the above- described dispute. The settlement, which was approved by the Wyoming District Court, resolved all disputes between the parties and closed the lawsuit. A reserve for the settlement amount and related matters had been established in the Company's financial statements prior to 1993 and, accordingly, such settlement did not have any material adverse impact on the Company's financial position or results of operations. On November 30, 1990, the Company initiated an action against a number of its insurance carriers for a declaration of the carriers' contractual obligations to provide insurance coverage for all sums associated with the alleged losses under the state, Federal and toxic tort claims related to the Brookhurst Subdivision. The Company entered into formal settlements with all of the defendants in the lawsuit in 1993, and received settlement proceeds associated therewith. On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, Rocky Mountain Natural Gas Company and GASCO, Inc. (the "K N Entities") alleging that the K N Entities as well as K N Production Company and KNGG, have violated Federal and state antitrust laws. In essence, Grynberg asserts that the companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and illegally have attempted to monopolize or to enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. No specific monetary damages have been claimed, although Grynberg has requested that any actual damages awarded be trebled. In addition, Grynberg has requested that the K N Entities be ordered to divest all interests in natural gas exploration, development and production properties, all interests in distribution and marketing operations, and all interests in natural gas storage facilities, separating these interests from the Company's natural gas gathering and transportation system in northwest Colorado. On August 13, 1993, the United States District Court, District of Colorado, stayed this proceeding pending exhaustion of appeals in a related state court action involving the same plaintiff. The Company believes it has meritorious defenses to all lawsuits and legal proceedings in which it is a defendant and will vigorously defend against them. Based on its evaluation of the above matters, and after consideration of reserves established, management believes that the resolution of such matters will not have a material adverse effect on the Company's financial position or results of operations. 6. Income Taxes See Note 1(D) regarding the method of accounting for income taxes. Components of the income tax provision applicable to Federal and state income taxes are as follows (in thousands): The difference between the statutory Federal income tax rate and the Company's effective income tax rate is summarized as follows: The Company has recorded deferred regulatory assets of $1.5 million and $2.1 million, and deferred regulatory liabilities of $4.4 million and $7.3 million at December 31, 1993 and 1992, respectively, which are expected to result in cost-of-service adjustments. These amounts reflect the "gross of tax" presentation required under SFAS 109. T he Company reduced its deferred regulatory liability by $2.2 million as a result of the Federal tax rate increase from 34 percent to 35 percent. The deferred tax assets and liabilities and deferred regulatory assets and liabilities for rate-regulated entities computed according to SFAS 109 at December 31, 1993 and 1992 result from the following (in thousands): 7. Financing (A) Notes Payable The Company has credit agreements with eight banks to either borrow or use as commercial paper support, up to a total of $90.0 million at December 31, 1993. At December 31, 1993, $10.0 million was outstanding under the credit agreements at an interest rate of 3.27 percent. No amounts were outstanding under the credit agreements at December 31, 1992. Borrowings are made at prime or a rate less than prime negotiated on the borrowing date and for a term of not more than one year. The Company pays the banks a fee of one quarter of one percent per annum of the unused commitment. Commercial paper issued by the Company represents unsecured short-term notes with maturities up to 270 days from the date of issue. Rates at which commercial paper was issued during the year ranged from 3.2 percent to 3.7 percent. At December 31, 1993 and 1992, $37.0 million and $2.0 million of commercial paper, respectively, were outstanding. (B)Long-Term Debt Long-term debt at December 31, 1993 and 1992 was as follows (in thousands): Maturities of long-term debt for the five years ending December 31, 1998, are as follows (in thousands): (A) Class A $8.50 Preferred Stock The Class A $8.50 Preferred Stock is subject to mandatory redemption through a sinking fund (at $100 per share, plus accrued and unpaid dividends) of $500,000 in 1994. At the option of the Company, this stock is redeemable, in whole or in part, at $100.85 per share during 1994. In each of the years 1993 and 1992, the Company redeemed 10,000 shares subject to mandatory redemption. In 1991, the Company redeemed 10,000 shares subject to mandatory redemption and an additional 25,000 shares at $102.13 per share. (B) Class B $8.30 Preferred Stock The Class B $8.30 Preferred Stock is subject to mandatory redemption through a sinking fund (at $100 per share, plus accrued and unpaid dividends) of $571,400 annually from 1995 through 1998 and $572,000 in 1999. At the option of the Company, this stock is redeemable, in whole or in part, at $101.74 per share prior to January 2, 1995; such redemption price is reduced annually thereafter until January 2, 1998, when it becomes $100 per share. Also, at the option of the Company, 5,714 shares of this stock may be redeemed in each of the years 1994 through 1998, inclusive, at $100 per share. In each of the years 1993, 1992 and 1991, the Company redeemed 5,714 shares subject to mandatory redemption, and an additional 5,714 shares at $100 per share. (C) Class A $5.00 Preferred Stock The Class A $5.00 Preferred Stock is redeemable, in whole or in part, at the option of the Company at any time on 30 days' notice at $105 per share plus accrued dividends. This series has no sinking fund requirements. (D) Rights of Preferred Shareholders All outstanding series of preferred stock have voting rights. If, for any class of preferred stock, the Company (i) is in arrears on dividends, (ii) has failed to pay or set aside any amounts required to be paid or set aside for all sinking funds, or (iii) is in default on any of its redemption obligations, then no dividends shall be paid or declared on any junior stock nor shall any junior stock be purchased or redeemed by the Company. Also, if dividends on any class of preferred stock are sufficiently in arrears, the holders of that stock may elect one-third of the Company's Board of Directors. (E) Combined Aggregate Redemption Requirements The combined aggregate amount of mandatory redemption requirements for all preferred issues for the five years ending December 31, 1998, are as follows (in thousands): (F) Fair Value At December 31, 1993, both the carrying amount and the estimated fair value of K N's outstanding preferred stock subject to mandatory redemption were $3.4 million, compared with $5.5 million and $5.6 million, respectively, at December 31, 1992. The fair value of K N's preferred stock is estimated based on an evaluation made by an independent security analyst. 9. Employee Benefits (A) Retirement Plans The Company has defined benefit pension plans covering substantially all full-time employees. These plans provide pension benefits that are based on the employees' compensation during the period of employment. These plans are tax qualified subject to the minimum funding requirements of ERISA. The Company's funding policy is to contribute annually the recommended contribution using the actuarial cost method and assumptions used for determining annual funding requirements. Plan assets consist primarily of pooled fixed income and equity funds. Net pension cost for 1993, 1992 and 1991 included the following components (in thousands): The following table sets forth the plans' funded status and amounts recognized in the Company's financial statements at December 31, 1993 and 1992 (in thousands): The rate of increase in future compensation and the expected long-term rate of return on assets were 4.5 percent and 8.5 percent, respectively, for 1993, and 5.0 percent and 9.25 percent, respectively, for 1992 and 1991. The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5 percent for all three periods. The Company also contributes the lesser of ten percent of the Company's net income or ten percent of normal employee compensation to the Employees Retirement Fund Trust Profit Sharing Plan (a defined contribution plan). Contributions by the Company were $2,588,000, $2,090,000 and $464,000 for 1993, 1992 and 1991, respectively. (B) Other Postretirement Employee Benefits The Company has a defined benefit postretirement plan providing medical care benefits upon retirement for all eligible employees with at least five years of credited service as of January 1, 1993, and their eligible dependents. Retired employees are required to contribute monthly amounts which depend upon the retired employee's age, years of service upon retirement and date of retirement. This plan also provides life insurance benefits upon retirement for all employees with at least ten years of credited service who are age 55 or older when they retire. The Company pays for a portion of the life insurance benefit; employees may at their option increase the benefit by making contributions from age 55 until age 65 or retirement, whichever is earlier. In 1993, the Company began funding the future expected postretirement benefit costs under the plan by making payments to Voluntary Employee Benefit Association trusts. The Company's funding policy is to contribute amounts within the deductible limits imposed on Internal Revenue Code Sec. 501(c)(9) trusts. Plan assets consist primarily of pooled fixed income funds. Effective January 1, 1993, the Company prospectively adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106") which requires the accrual of the expected costs of postretirement benefits other than pensions during the years that employees render service. The Accumulated Postretirement Benefit Obligation ("APBO") of the plan at January 1, 1993, was approximately $18.8 million. The Company has elected to amortize this transition obligation to expense over a 20- year period. Net postretirement benefit cost for the defined benefit plan in 1993 included the following components (in thousands): Prior to 1993, the cost of providing medical care benefits to retired employees was recognized as expense as claims were paid, and the cost of life insurance benefits for retirees was not accrued. Instead, life insurance claims were paid from a trust fund resulting from termination of third party coverage. The Company's net cost of medical care claims for retirees was approximately $1.2 million and $1.1 million in 1992 and 1991, respectively. In 1993, the incremental effect on postretirement cost as a result of adopting SFAS 106 was a $1.3 million increase. The following table sets forth the plan's funded status and the amounts recognized in the Company's financial statements at December 31, 1993(in thousands): The weighted average discount rate used in determining the actuarial present value of the APBO was 7.5 percent; the assumed health care cost trend rate was 11 percent for 1993, nine percent for 1994 and seven percent for 1995 and beyond. A one-percentage-point increase in the assumed health care cost trend rate for each future year would have increased the aggregate of the service and interest cost components of the 1993 net periodic postretirement benefit cost by $0.1 million and would have increased the APBO as of December 31, 1993, by $0.1 million. K N's interstate retail distribution business, in connection with rate filings described in Note 3 for Kansas, Nebraska and Wyoming, has received regulatory approval to include in the cost-of-service component of its rates the cost of postretirement benefits as measured by application of SFAS 106. In addition, KNI has requested similar regulatory treatment from FERC in connection with its rate filing, also described in Note 3. At December 31, 1993, no SFAS 106 costs were deferred as regulatory assets. (C) Other Postemployment Benefits In November 1992, FASB issued SFAS 112, which 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. SFAS 112 is effective for fiscal years beginning after December 15, 1993. Implementation of SFAS 112 is not expected to have a material effect on the Company's financial position or results of operations. 10. Common Stock Option and Purchase Plans The Company has incentive stock option plans for key employees and nonqualified stock option plans for its nonemployee directors. Under the plans, options are granted at not less than 100 percent of the market value of the stock at the date of grant. Pursuant to amendments to the plans' provisions, options granted after 1989 vest over three to five years and expire ten years after date of grant. Under earlier grants, all options vested immediately or within three years and are exercisable for ten years from date of grant. At December 31, 1993, 91 employees, officers and directors held options under the plans. The changes in stock options outstanding during 1993, 1992 and 1991 are as follows, restated to reflect the three-for-two common stock split described in Note 1(E): Unexercised options outstanding at December 31, 1993, expire at various dates between 1994 and 2003. Effective April 1, 1990, and for each succeeding year, the Company established an Employee Stock Purchase Plan under which eligible employees may purchase the Company's common stock through voluntary payroll deductions at a 15 percent discount from the market value of the common stock, as defined in the plan. Under the Company's Stock Option, Dividend Reinvestment, Employee Stock Purchase and Employee Benefit Plans, 2,111,299 shares were reserved for issuance at December 31, 1993. 11. Commitments and Contingent Liabilities (A) Leases In 1993, K N Front Range Gathering Company began to lease gas gathering equipment and facilities under a ten-year operating lease. Also in 1993, K N and certain subsidiaries began to lease various furniture, fixtures and vehicles under various operating leases with terms from three to seven years. In 1992, KNGG began to lease gas gathering facilities and processing equipment under a seven-year operating lease. All of these operating leases contain purchase options at the end of their lease terms. Payments made under operating leases were $5.2 million in 1993, $2.4 million in 1992 and $1.9 million in 1991. Future minimum commitments under major operating leases for the five years ending December 31, 1998 and thereafter are as follows (in thousands): (B) Capital Expenditure Budget The consolidated capital expenditure budget for 1994 is approximately $54.5 million, excluding acquisitions. Approximately $2.0 million had been committed for the purchase of plant and equipment at December 31, 1993. 12. Discontinued Operations On June 1, 1991, K N sold its wholly-owned coal mining subsidiaries, Wyoming Fuel Company and North Central Energy Company. The Company received cash proceeds of $7.2 million, and receives a royalty interest on all future coal mined and sold from the southern Colorado properties. The results of operations of the coal mining subsidiaries have been accounted for as discontinued operations in the financial statements. Following is a summary of revenues, loss from operations and loss on sale of this discontinued business (in thousands): 13. Business Segment Information The Company's principal operations are the sale and transportation of natural gas ("Gas Service"), nonregulated gas marketing and gathering ("Gas Marketing and Gathering") and exploration, development and production of oil and gas ("Oil and Gas Production"). Total revenues by segment include sales to unaffiliated customers. General corporate income and expenses, interest expense and income taxes are not included in the computation of operating income. Identifiable assets by segment are those assets used in the Company's operations in each segment. Corporate assets are principally cash and investments. (1) Restated to reflect a three-for-two common stock split in 1993. ITEM 9: ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING _____________________________________________________________________ AND FINANCIAL DISCLOSURE ________________________ There were no such matters during 1993. PART III ITEM 10: ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________________________________ (A) Identification of Directors ___________________________ For information regarding the Directors, see pages 2-3 of the 1994 Proxy Statement. (B) Identification of Executive Officers ____________________________________ See Executive Officers of the Registrant under Part I. (C) Identification of Certain Significant Employees _______________________________________________ None. (D) Family Relationships ____________________ None. (E) Business Experience ___________________ See Executive Officers of the Registrant under Part I. (F) Involvement in Certain Legal Proceedings ________________________________________ See Executive Officers of the Registrant under Part I. (G) Promoters and Control Persons _____________________________ None. ITEM 11: ITEM 11: EXECUTIVE COMPENSATION ________________________________ See "Executive Compensation", "Stock Options", "Pension Benefits" and "Director Compensation" on pages 4-5, 8-10, 12 and 13 of the 1994 Proxy Statement. ITEM 12: ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________________________________________________________________________ See the following pages of the 1994 Proxy Statement: (i) pages 2-3 relating to common stock owned by directors; (ii) page 11, "Executive Stock Ownership"; and (iii) pages 18-19, "Principal Shareholders". ITEM 13: ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ________________________________________________________ (A) Transactions with Management and Others _______________________________________ See "Relationship Between Certain Directors and the Company" on page 4 of the 1994 Proxy Statement. (B) Certain Business Relationships ______________________________ See "Relationship Between Certain Directors and the Company" on page 4 of the 1994 Proxy Statement. (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) See the index for a listing and page numbers of financial statements, financial statement schedules and exhibits included herein or incorporated by reference. Executive Compensation Plans and Arrangements _____________________________________________ Form of Key Employee Severance Agreement (Exhibit 10.2, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1982 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 10.3, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1982 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.4, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1986 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.5, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1988 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.6, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* Form of Grant Certificate for Employee Stock Option Plans (Exhibit 10.7, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* Directors' Deferred Compensation Plan Agreement (Exhibit 10.8, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1987 Directors' Deferred Fee Plan and Form of Participation Agreement regarding the Plan (Exhibit 10.9, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1992 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 4.1, File No. 33-46999)* K N Energy, Inc. 1993 Executive Incentive Plan (Exhibit 10(k) to the Annual Report on Form 10-K for the Year Ended December 31, 1992)* K N Energy, Inc. 1994 Executive Incentive Plan (attached hereto as Exhibit 10(k))** 1994 K N Energy, Inc. Long-Term Incentive Plan (Attachment A to the K N Energy, Inc. 1994 Proxy Statement on Schedule 14-A)* (b) Reports on Form 8-K On February 3, 1994, the Company filed a Form 8-K which disclosed that on February 1, 1994, K N's gas reserves development subsidiaries, K N Production Company and GASCO, Inc., acquired gas reserves and production properties located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming from Fuel Resources Development Co., a subsidiary of Public Service Co. of Colorado.* * Incorporated herein by reference. ** Included in SEC and NYSE copies only. 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. K N ENERGY, INC. (Registrant) March 23, 1994 By /s/ E. Wayne Lundhagen ______________________________________ E. Wayne Lundhagen Vice President - Finance and Accounting 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, Chief Executive Officer and Director /s/ Charles W. Battey (Principal Executive Officer) March 23, 1994 ___________________________ Charles W. Battey /s/ Stewart A. Bliss Director March 23, 1994 ___________________________ Stewart A. Bliss /s/ David W. Burkholder Director March 23, 1994 ___________________________ David W. Burkholder /s/ Robert H. Chitwood Director March 23, 1994 ___________________________ Robert H. Chitwood /s/ Howard P. Coghlan Director March 23, 1994 ___________________________ Howard P. Coghlan /s/ Robert B. Daugherty Director March 23, 1994 ___________________________ Robert B. Daugherty /s/ Jordan L. Haines Director March 23, 1994 ___________________________ Jordan L. Haines /s/ Larry D. Hall Director March 23, 1994 ___________________________ Larry D. Hall /s/ William J. Hybl Director March 23, 1994 ___________________________ William J. Hybl Vice President - Finance and Accounting (Principal Financial and Accounting /s/ E. Wayne Lundhagen Officer) March 23, 1994 ___________________________ E. Wayne Lundhagen /s/ H. A. True, III Director March 23, 1994 ___________________________ H. A. True, III SCHEDULE VI SCHEDULE IX K N ENERGY, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 The Company has credit agreements with eight banks to either borrow or use as commercial paper support, up to a total of $90.0 million at December 31, 1993. Borrowings are made at prime or a rate less than prime negotiated on the borrowing date and for a term of not more than one year. The Company pays the banks a fee of one-quarter of one percent per annum of the unused commitment. Commercial paper issued by the Company represents unsecured short-term notes with maturities up to 270 days from the date of issue. Rates at which commercial paper was issued during the year ranged from 3.2 percent to 3.7 percent. Amounts outstanding during the year and at year-end, and related interest rates, were as follows: (A) The average borrowings were determined based on the total of daily outstanding principal balances divided by the number of days in the year. (B) The weighted average interest rates during the period were computed by dividing the actual interest expense by the average short-term debt outstanding. SCHEDULE X K N ENERGY, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 The amounts of depreciation and amortization of intangible assets, preoperating costs and similar deferrals, and advertising costs are not considered to be significant. The amount of taxes, other than payroll and income taxes, maintenance and repairs, and royalties for 1993, 1992 and 1991, are as follows: EXHIBIT 12 EXHIBIT 13 K N ENERGY, INC. ________________ 1993 ANNUAL REPORT TO SHAREHOLDERS __________________________________ Interested persons may receive a copy of the Company's 1993 Annual Report to Shareholders without charge by forwarding a written request to: K N Energy, Inc., Securities Services Department, P. O. Box 281304, Lakewood, Colorado 80228-8304. EXHIBIT 22 K N ENERGY, INC. AND SUBSIDIARIES SUBSIDIARIES OF THE REGISTRANT State of Name of Company Incorporation __________________________________________________ _____________ Colorado Gasmark, Inc. (inactive). . . . . . . . . Colorado GASCO, Inc.. . . . . . . . . . . . . . . . . . . . Colorado KNE Acquisition Corporation. . . . . . . . . . . . Delaware K N Dakota Company (inactive). . . . . . . . . . . Colorado K N Front Range Operating Company. . . . . . . . . Colorado K N Gas Gathering, Inc.. . . . . . . . . . . . . . Colorado *K N Front Range Gathering Company . . . . . . . Colorado K N Gas Marketing, Inc.. . . . . . . . . . . . . . Colorado K N Gas Supply Services, Inc.. . . . . . . . . . . Colorado K N Interstate Gas Transmission Co.. . . . . . . . Colorado K N Optima Company (inactive). . . . . . . . . . . Colorado K N Production Company . . . . . . . . . . . . . . Delaware K N Trading, Inc.. . . . . . . . . . . . . . . . . Delaware K N TransColorado, Inc.. . . . . . . . . . . . . . Colorado K N Wattenberg Company . . . . . . . . . . . . . . Colorado *K N Wattenberg Transmission Limited Liability Company . . . . . . . . . . . . . . . . . . . . Colorado Midlands Transportation Company. . . . . . . . . . Kansas Northern Gas Company . . . . . . . . . . . . . . . Wyoming R M N G Gathering Co.. . . . . . . . . . . . . . . Colorado Rocky Mountain Natural Gas Company . . . . . . . . Colorado *T C P Gathering Co. . . . . . . . . . . . . . . Colorado Slurco Corporation . . . . . . . . . . . . . . . . Colorado Slurco, Inc. (inactive). . . . . . . . . . . . . . Kansas Sunflower Pipeline Company . . . . . . . . . . . . Kansas Wyoming Gasmark, Inc. (inactive) . . . . . . . . . Delaware *Second tier subsidiary of K N; subsidiary of entity listed directly above. All of the subsidiaries named above are included in the consolidated financial statements of the Registrant included herein. EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation by reference in (i) Registration Statements on Form S-16, File Nos. 2-51894, 2-55664, 2-63470 and 2-75654; (ii) Registration Statements on Form S-8, File Nos. 2-77752, 33-10747, 33-24934 and 33- 33018; and (iii) Registration Statements on Form S-3, File Nos. 2-84910, 33-26314, 33-23880, 33-42698, 33-44871, 33-45091, 33-46999 and 33-51115 of our report dated February 10, 1994, on the consolidated financial statements of K N Energy, Inc. and subsidiaries and on supplemental Schedules V, VI, IX and X included in this Form 10-K for the year ended December 31, 1993. /s/ Arthur Andersen & Co. Denver, Colorado. March 23, 1994.

908603_1993.txt

908603_1993

1993

908603

ITEM 1. BUSINESS Ford Credit Auto Receivables Corporation ("FCARC") established the Ford Credit 1993-B Grantor Trust (the "Trust") as of July 1, 1993 by selling and assigning to Chemical Bank, as Trustee (the "Trustee"), property including a pool of retail installment sale contracts secured by new and used automobiles and light trucks (the "Receivables"), certain monies due thereunder, security interests in the vehicles financed thereby and certain other property in exchange for certificates representing fractional undivided interests in the Trust (the "Certificates") consisting of two Classes of Certificates: a) the Class A Certificates evidencing in the aggregate an undivided ownership interest of 92.50% of the Trust, which were sold to the public, and b) the Class B Certificate evidencing in the aggregate an undivided ownership interest of 7.5% of the Trust, which were retained by FCARC. The Trust does not intend to acquire additional retail installment sale contracts and therefore the Receivable portfolio will continue to liquidate. Ford Motor Credit Company ("Ford Credit") services the Receivables pursuant to a Pooling and Servicing Agreement dated as of July 1, 1993 (the "Agreement") and is compensated for acting as the Servicer. In order to facilitate its servicing functions and minimize administrative burdens and expenses, Ford Credit, as Servicer, retains physical possession of the Receivables and documents relating thereto as custodian for the Trustee. The rights of the holders of the Class B Certificates to receive distributions with respect to the Receivables are subordinated, to the extent described in the Agreement, to the rights of the holders of the Class A Certificates. ITEM 2. ITEM 2. PROPERTIES The property of the Trust includes retail installment sale contracts originated on or after July 1, 1992 between dealers (the "Dealers") and retail purchasers (the "Obligors") secured by new and used automobiles and light trucks (the "Financed Vehicles") and, in general, all payments due thereunder on or after July 1, 1993 (the "Cutoff Date"). The Receivables were originated by Dealers in accordance with Ford Credit's requirements under agreements with Dealers, for assignment to Ford Credit, have been so assigned and were sold to FCARC by Ford Credit pursuant to a Purchase Agreement dated July 1, 1993 ("Purchase Agreement), are serviced by Ford Credit, and evidence the indirect financing made available by Ford Credit to the Obligors. The property of the Trust also includes (i) such amounts as from time to time may be held in separate trust accounts established and maintained pursuant to the Agreement, and the proceeds of such accounts, (ii) security interests in the Financed Vehicles and any accessions thereto, (iii) any Dealer Recourse, (iv) the right to proceeds of credit life, credit disability, and physical damage insurance policies covering the Financed Vehicles, (v) the rights of FCARC under the Purchase Agreement and (vi) certain rebates of premiums and other amounts relating to certain insurance policies and other items financed under the Receivables in effect as of the July 1, 1993 (the "Cutoff Date"). Additionally, pursuant to agreements between Ford Credit and the Dealers, the Dealers are obligated to repurchase from Ford Credit Receivables which do not meet certain representations made by the Dealers, as well as those covered by recourse plans ("Dealer Recourse"). The Receivables were purchased by Ford Credit in the ordinary course of business in accordance with Ford Credit's underwriting standards, which emphasize the Obligor's ability to pay and creditworthiness, as well as the asset value of the Financed Vehicle. The Receivables were selected from Ford Credit's portfolio by several criteria, including the following: each Receivable (i) was originated in the United States, (ii) has a contractual Annual Percentage Rate ("APR") that equals or exceeds 6.8%, (iii) provides for level monthly payments which provide interest at the APR and fully amortize the amount financed over an original term no greater than 60 months, (iv) was not more than 30 days past due as of the Cutoff Date and has never been extended, (v) is attributable to the purchase of a new or automobile or light truck, and (vi) was originated on or after July 1, 1992. The Receivables were selected at random from Ford Credit's retail installment sale contracts meeting the criteria described above, and no selection procedures believed to be adverse to the Certificateholders were utilized in selecting the Receivables from qualifying retail installment sale contracts. In addition to required repurchases by the Dealers in cases of misrepresentations as stated above, on July 1, 1992, 1.8% of the Receivables provided recourse to the Dealer which originated the Receivables. Dealers are generally obligated under these recourse plans for payment of the unpaid principal balance of a defaulted contract, unless Ford Credit fails to repossess the vehicle and deliver it to the Dealer within 90 days after default. The Dealer's obligation generally terminates after the first 24 monthly payments are made under the related contract. All the Receivables are prepayable at any time. If prepayments are received on the Receivables, the actual weighted average life of the Receivables will be shorter than that scheduled weighted average life, which is based on the assumptions that payments will be made as scheduled, and that no prepayments will be made. (For this purpose the term "prepayments" includes liquidations due to default, as well as receipt of proceeds from credit life, credit disability, and casualty insurance policies.) Weighted average life means the average amount of time during which each dollar of principal on a receivable is outstanding. The rate of prepayments on the Receivables may be influenced by a variety of economic, social and other factors, including the fact that an Obligor may not sell or transfer a Financed Vehicle without the consent of Ford Credit. Ford Credit believes that the actual rate of prepayments will result in a substantially shorter weighted average life than the scheduled weighted average life of 27.25 months. Based on the historical performance of Ford Credit's portfolio of U. S. retail installment sale contracts for new and used automobiles and light trucks (including previously sold contracts which Ford Credit continues to service), the average effective term of such contracts in approximately two-thirds of their scheduled contractual term. As of December 31, 1993, the pool consisted of 90,881 Receivables, of which 1,507, representing payments of $645,726.08, were delinquent 30 - 59 days; 99, representing payments of $75,028.60, were delinquent 60 - 89 days; 10, representing payments of $12,467.87, were delinquent 90 - 119 days; and 6, representing payments of $9,085.97 were delinquent over 120 days. Additional information concerning the pool balance, payment of principal and interest, prepayments, the servicing fee, the weighted average maturity and seasoning, the pool factor, the remaining limited guaranty amount and other information relating to the pool of Receivables may be obtained in the monthly reports provided to Chemical Bank by Ford Credit as Servicer (Exhibits 19-B through 19-G). ITEM 3. ITEM 3. LEGAL PROCEEDINGS Nothing to report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Nothing to report. ITEM II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS There were 57 Class A Certificateholders as of March 3, 1994. There is no established public trading market for the Certificates. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Nothing to report. PART III ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (3) Amount and nature of (2) Name and Address beneficial (1) Title of of beneficial ownership (4) Percent of Class owner* (in thousands) of Class - ---------------------------------------------------------------------- 4.30% Asset Bankers Trust Company $142,050 12.9% Backed 16 Wall Street Certificates, New York, NY 10015 Class A 4.30% Asset The Chase Manhattan $129,250 11.8% Backed Bank, N. A. Certificates, 1 Chase Manhattan Plaza Class A New York, NY 10081 4.30% Asset Citibank N. A. $ 59,500 5.4% Backed 111 Wall Street Certificates, New York, NY 10043 Class A 4.30% Asset Bank of New York $ 67,170 6.1% Backed 925 Patterson Plank Rd. Certificates, Secaucus, NJ 07094 Class A 4.30% Asset Chemical Bank $269,800 24.6% Backed 270 Park Avenue Certificates, 31st Floor Class A New York, NY 10017 4.30% Asset Shawmut Bank $ 73,016 6.6% Backed Connecticut, N. A./ Certificates, Investment Dealer Class A 777 Main Street, MSN 371 New York, NY 06115 4.30% Asset U. S. Trust Co. of $ 60,500 5.5% Backed New York Certificates, 770 Broadway Class A New York, NY 10003 *As of March 3, 1994 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Nothing to report. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)3. Exhibits Designation Description Method of Filing - ----------- ----------- ---------------- Exhibit 3-A Restated Certificate of Filed as Exhibit 3.1to Incorporation of Ford Ford Credit Auto Credit Auto Receivables Receivables Corporation's Corporation. Registration Statement on Form S-1 (33-39027) and incorporated herein by reference. Exhibit 3-B By-Laws of Ford Credit Filed as Exhibit 3.2 to Auto Receivables Corpora- Ford Credit Auto Receiv- tion. ables Corporation's Registration Statement on Form S-1 (No. 33-39027) and incorporated herein by reference. Exhibit 4-A Form of Pooling and Filed as Exhibit 4 to Servicing Agreement dated Ford Credit 1993-B as of July 1, 1993 Grantor Trust's Current between Ford Credit Auto Report on Form 8-K dated Receivables Corporation, August 10, 1993 and as seller, Ford Credit as incorporated herein by Servicer and Chemical Bank reference. as Trustee. Exhibit 4-B Prospectus dated July Filed as Exhibit 99 to 15, 1993, relating to sale Ford Credit 1993-B of Ford Credit 1993-B Grantor Trust's Current Grantor Trust 4.30% Asset Report on Form 8-K dated Backed Certificates. August 10, 1993 and incorporated herein by reference. Exhibit 19-A Selected Information Filed with this report. Relating to the Receivables. Exhibit 19-B Report for the month ended Filed as Exhibit 19 to July 31, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. August 16, 1993 and incorporated herein by reference. Exhibit 19-C Report for the month ended Filed as Exhibit 19 to August 31, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. September 20, 1993 and incorporated herein by reference. Exhibit 19-D Report for the month ended Filed as Exhibit 19 to September 30, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. October 20, 1993 and incorporated herein by reference. Exhibit 19-E Report for the month ended Filed as Exhibit 19 to October 31, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. November 15, 1993 and incorporated herein by reference. Exhibit 19-F Report for the month ended Filed as Exhibit 19 to November 30, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. December 15, 1993 and incorporated herein by reference. Exhibit 19-G Report for the month ended Filed as Exhibit 19 to December 31, 1993 provided Ford Credit 1993-B to Chemical Bank, as Grantor Trust's Current Trustee under Ford Credit Report on Form 8-K dated 1993-B Grantor Trust. January 12, 1994 and incorporated herein by reference. (b) REPORTS ON FORM 8-K The Ford Credit 1993-B Grantor Trust filed a Current Report on Form 8-K dated August 10, 1993 regarding the pool of Receivables in the Trust and the servicing thereof as described in the Pooling and Servicing Agreement dated as of July 1, 1993 among Ford Credit Auto Receivables Corporation, as Seller, Ford Motor Credit Company, as Servicer and Chemical Bank, as Trustee filed as Exhibit 4, and the Prospectus dated July 15, 1993 relating to the issuance of $1,097,416,687.49 aggregate principal amount of Ford Credit 1993-B Grantor Trust 4.30% Asset Backed Certificates, Class A filed as Exhibit 99. Also, see Exhibits 19-B through 19-G. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FORD CREDIT 1993-B GRANTOR TRUST -------------------------------- (Registrant) March 18, 1994 By: /s/Richard P. Conrad ----------------------------- Richard P. Conrad (Assistant Secretary of Ford Credit Auto Receivables Corporation originator of Trust) EXHIBIT INDEX Exhibit Number Description of Exhibit Page - ------- ---------------------- ---- Exhibit 3-A Restated Certificate of * Incorporation of Ford Credit Auto Receivables Corporation. Exhibit 3-B By-Laws of Ford Credit * Auto Receivables Corpora- tion. Exhibit 4-A Form of Pooling and * Servicing Agreement dated as of July 1, 1993 between Ford Credit Auto Receivables Corporation, as seller, Ford Credit as Servicer and Chemical Bank as Trustee. Exhibit 4-B Prospectus dated July * 15, 1993, relating to sale of Ford Credit 1993-B Grantor Trust 4.30% Asset Backed Certificates. Exhibit 19-A Selected Information Filed with this Report. Relating to the Receivables. Exhibit 19-B Report for the month ended * July 31, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. Exhibit 19-C Report for the month ended * August 31, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. Exhibit 19-D Report for the month ended * September 30, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. Exhibit 19-E Report for the month ended * October 31, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. Exhibit 19-F Report for the month ended * November 30, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. Exhibit 19-G Report for the month ended * December 31, 1993 provided to Chemical Bank, as Trustee under Ford Credit 1993-B Grantor Trust. - ------------------ * Previously filed

701221_1993.txt

701221_1993

1993

701221

Item 1. BUSINESS A. Description of Business With shareholders' equity of $6.6 billion, revenues of $18.4 billion and assets of $85.0 billion as of December 31, 1993, CIGNA Corporation and its subsidiaries constitute one of the largest investor-owned insurance organizations in the United States and one of the principal United States companies in the financial services industry. Unless the context otherwise indicates, the terms "CIGNA" and the "Company," when used herein, refer to one or more of CIGNA Corporation and its consolidated subsidiaries. Although CIGNA Corporation is not an insurance company, its subsidiaries are major providers of group life and health insurance, managed care products and services, retirement products and services, individual financial services, and property and casualty insurance. CIGNA is one of the largest international insurance organizations based in the United States, measured by international revenues, and the largest investor-owned health maintenance organization ("HMO") in the United States, measured by number of enrollees. CIGNA's major insurance subsidiaries, Connecticut General Life Insurance Company ("CG Life") and Insurance Company of North America ("ICNA"), are among the oldest insurance companies in the United States, with ICNA tracing its origins to 1792 and CG Life to 1865. CIGNA Corporation was incorporated in the State of Delaware in 1981. CIGNA's revenues are derived principally from premiums and fees and investment income. CIGNA conducts its business through the following operating divisions, the financial results of which are reported in the following segments: Employee Life and Health Benefits Segment (beginning on page 3) CIGNA HealthCare CIGNA Group Insurance - Life-Accident-Disability(1) Employee Retirement and Savings Benefits Segment (beginning on page 6) CIGNA Retirement & Investment Services Individual Financial Services Segment (beginning on page 9) CIGNA Individual Insurance CIGNA Reinsurance - Life-Accident-Health Property and Casualty Segment (beginning on page 13) CIGNA Property & Casualty CIGNA International CIGNA Reinsurance - Property & Casualty - --------------- (1) Portions of this division are reported in the Individual Financial Services and Property and Casualty Segments. Investment results produced by CIGNA Investment Management on behalf of CIGNA's insurance operations are reported in each segment's results or in Other Operations. The other businesses of CIGNA Investment Management are described on page 32 and financial results for these businesses are reported in Other Operations. CIGNA and its major insurance subsidiaries are rated by nationally recognized rating agencies. Insurance company ratings represent the opinions of the rating agencies of the financial strength of the Company and its capacity to meet the obligations of insurance policies. Corporate credit ratings are assessments of the likelihood that a borrower will make timely payments of principal and interest. As of March 25, 1994, the principal ratings obtained through a contractual relationship with the agencies were as follows: - --------------- * Not rated. (1) A group of subsidiaries rated on a combined basis. Rating agencies generally assign ratings to insurance companies along a scale. While the significance of individual ratings varies from agency to agency, companies assigned ratings at the top end of the scale have, in the opinion of the rating agency, the strongest capacity for repayment of debt or payment of claims, while companies at the bottom end of the scale have the weakest capacity. Insurance company rating scales of the principal agencies that rate the Company's insurance subsidiaries are characterized as follows: A.M. Best Company, Inc. ("A.M. Best"), A++ to F ("Superior" to "In Liquidation"); Duff & Phelps, AAA ("Highest") to Substantial Risk; Moody's Investor Services ("Moody's"), Aaa to C ("Exceptional" to "Lowest"); and Standard & Poor's ("S&P"), AAA to R ("Superior" to "Regulatory Action"). The scales of corporate credit ratings of the principal agencies that rate CIGNA are characterized as follows: Moody's, Aaa to C ("Best" to "Lowest"); and S&P, AAA to D ("Extremely Strong" to "Default"). Commercial paper ratings for Moody's range from Prime 1 to Not Prime ("Superior" to "Speculative"). S&P's commercial paper ratings run from A-1+ to D ("Highest" to "Default"). The ratings of CG Life are characterized as "superior", "highest" or "excellent" and the property and casualty ratings as "excellent" or "good" by the rating agencies. The corporate credit ratings are characterized as "upper medium" or "strong" by the rating agencies, and allow CIGNA ready access to the capital markets. The ratings are reviewed routinely by the rating agencies and may be changed at their discretion. In February 1994, Moody's informed CIGNA that it is reviewing for possible downgrade the credit ratings of CIGNA Corporation and the insurance company ratings of CG Life and the Property & Casualty Domestic Pool Group. The outcome of this review is not expected to have a material adverse effect on CIGNA's financial condition. B. Financial Information about Industry Segments All financial information in the tables that follow is presented in conformity with generally accepted accounting principles ("GAAP"), unless otherwise indicated. Certain reclassifications have been made to 1992 and 1991 financial information to conform with the 1993 presentation. Industry rankings and percentages set forth below are for the year ended December 31, 1992, unless otherwise indicated. Unless otherwise noted, statements set forth in this document concerning CIGNA's rank or position in an industry or particular line of business have been developed internally based on publicly available information. Revenues; income (loss) before income taxes, extraordinary item and cumulative effect of accounting changes; and identifiable assets attributable to each of CIGNA's business segments, other operations and foreign operations are set forth in Notes 12 and 13 to CIGNA's 1993 Financial Statements and are incorporated by reference from pages 45 and 46 of CIGNA's 1993 Annual Report. C. Employee Life and Health Benefits Principal Products and Markets CIGNA's Employee Life and Health Benefits operations offer a wide range of traditional indemnity insurance products and are a leading provider of managed care and cost containment products and services. The following table sets forth the principal products of this segment and their related net earned premiums and fees. ------------------- Amounts in table do not include "premium equivalents," which are the industry's measure of the additional premiums that would have been earned under minimum premium and ASO contracts (described below under "Principal Products and Markets") if they had been written as traditional indemnity or health maintenance organization ("HMO") programs. CIGNA's Employee Life and Health Benefits customers range in size from some of the largest United States corporations to small enterprises, and include employers, multiple employer groups, unions, professional and other associations, and other groups. Products are marketed in all 50 states, the District of Columbia and Puerto Rico. Most of the indemnity products listed in the above table are sold on an experience-rated basis and all are provided through traditional insurance arrangements, in which CIGNA assumes the full insurance risk for a set premium. Certain group indemnity coverages, primarily medical and dental, also are provided through alternative funding programs under which the customer assumes all or a portion of the responsibility for funding claims, with CIGNA providing combinations of administrative and claim services and insurance for a fee or premium charge. These alternative funding programs, primarily consisting of "minimum premium" arrangements and administrative services only ("ASO") plans, constituted 57% of business volume (premiums and fees plus premium equivalents) in 1993. In minimum premium business, the policyholder funds claims up to a predetermined aggregate amount and CIGNA funds claims exceeding that amount. Under ASO plans, the policyholder is responsible for funding all claims and CIGNA provides administrative services for a fee; CIGNA may also provide stop-loss insurance for claims in excess of a predetermined amount. Alternative funding programs and their effect on CIGNA's results are more fully described on page 16 of the Management's Discussion and Analysis ("MD&A") section of CIGNA's 1993 Annual Report. CIGNA markets various disability products, including long-term and short-term disability, in all states and statutorily required disability plans in certain states. These products generally provide a fixed level of income to replace a portion of earned income lost because of disability. Personal accident coverages, which consist primarily of accidental death and dismemberment and travel accident insurance, are provided to employers, associations and other groups. Disability management and medical cost containment services provided by CIGNA help insurers and employers reduce the cost of their benefit programs. CIGNA also provides managed mental health and substance abuse coverage and services to HMOs, insurers and employers through a national network of mental health specialists, some of whom are employees of CIGNA. CIGNA had outstanding approximately 8,100 group life insurance policies covering approximately 14 million lives as of December 31, 1993. The following table shows group life insurance in force and termination data. To control their health care costs, many employers have changed and others are changing their benefit plan design by introducing or expanding managed care features. Managed care products promote effective, efficient use of health care services by coordinating utilization of care and controlling unit costs through provider contracts. While HMOs are generally the most cost-efficient form of managed care, many employers offer their employees a choice of benefit and cost options. CIGNA provides these options through HMOs, preferred provider organizations ("PPOs") and traditional indemnity coverage as well as through integrated products, which include all three. Integrated products are available under alternative funding as well as traditional insurance arrangements. These products may include contract provisions that provide that costs to the customer will not exceed specified levels. In the aggregate, there was essentially no net effect on CIGNA's 1993 results associated with these contract provisions. CIGNA's prepaid health care operations provide medical services through HMOs. CIGNA's HMOs include (1) staff models, in which physicians and other providers are employees of the HMO, (2) individual practice association ("IPA") models, in which independent physicians and hospitals are under contract with CIGNA to provide services and (3) mixed models, in which attributes of IPA and staff model HMOs are combined. Staff model HMOs offer a greater opportunity for direct control of medical costs, quality and service, but require more capital investment. IPAs may cover wider geographic areas with lower fixed costs, but must rely on cost-effective contracts with providers and appropriate utilization management to control medical costs. Staff models generally offer lower costs to the consumer, whereas IPAs may offer broader provider choice and greater accessibility. CIGNA had 48 HMO networks serving approximately 2.7 million members as of December 31, 1993, 48 serving approximately 2.3 million members as of December 31, 1992, and 44 serving approximately 2.2 million members as of December 31, 1991. As of December 31, 1993, 40 of CIGNA's HMO networks were IPA models (with 60% of total members); 3 were staff models (with 24% of total members); and 5 were mixed models (with 16% of total members). CIGNA's indemnity business includes contracts with doctors, hospitals and other independent providers to form PPOs in 71 networks as of December 31, 1993 and 53 as of December 31, 1992. Under a PPO arrangement, CIGNA reimburses PPO participants for the costs of medical care obtained from contracted providers, who charge on a discounted rate basis. CIGNA's PPOs served approximately 900,000 individuals as of December 31, 1993 and approximately 780,000 individuals as of December 31, 1992. CIGNA also offers prepaid dental coverage, using networks of independent providers in most states, serving approximately 1.7 million, 1.3 million and 1.1 million participants as of December 31, 1993, 1992 and 1991, respectively. Distribution The products of this segment are distributed primarily by employed group sales representatives through national and other insurance brokers and insurance consultants and, to a lesser extent, by CIGNA's career agents. Sales of prepaid health care products are made primarily to employers by CIGNA's sales representatives and also through insurance brokers. During 1993, a new direct sales force began marketing HMOs on a guaranteed-cost basis to smaller companies. Salaried marketing representatives sell disability management, medical and disability cost containment, and managed mental health and substance abuse services directly to insurance companies, HMOs and employer groups. Salaried enrollment specialists enroll employees in group life insurance, HMOs and related programs at the worksite. As of December 31, 1993, the field sales force for the products of this segment consisted of approximately 540 sales representatives in 106 field locations. Pricing and Reserves Premiums and fees charged for group indemnity and prepaid products reflect assumptions about future claims, expenses, credit risk, investment returns, competitive considerations and target profit margins. Premiums and fees charged for HMOs and PPOs also reflect assumptions about the impact of provider contracts and utilization management. Most of the premium volume for the indemnity business is established on an experience-rated basis, in which premiums may be adjusted to reflect actual claims experience, administrative expenses and income from investable funds attributable to a given policyholder. All other premiums are based on a guaranteed-cost method, for which there is no retrospective adjustment for actual experience. Both guaranteed-cost and experience-rated contracts generally permit annual rate adjustments. In addition to paying current benefits and expenses, CIGNA establishes reserves in amounts estimated to be sufficient to discharge reported claims not yet paid, as well as claims incurred but not yet reported. Also, reserves are established for estimated experience refunds based on the results of experience-rated policies. Interest on reserve and fund balances is credited to experience-rated policyholders through rates that are either set at the Company's discretion or based on actual investment performance. For rates set at the Company's discretion, several interest-crediting rates are in effect on different types of reserves; generally, higher rates are credited to long-term funds than to short-term funds, reflecting the fact that higher yields are generally available on investments of longer maturities. For 1993, the rates of interest credited ranged from 2.9% to 8.5%. Approximately one-third of the reserves comprise liabilities that will be paid within one year, primarily for group life and medical and prepaid health claims. The remainder primarily include liabilities for long-term disability benefits and group life insurance benefits for disabled individuals. The profitability of medical and dental indemnity and prepaid health care products is largely dependent upon the accuracy of projections for health care cost inflation and utilization, and the adequacy of fees charged for administration and risk assumption. The profitability of other indemnity products depends on the adequacy of premiums charged relative to claims and expenses. Also, particularly in the case of prepaid health care products, control of claim costs can significantly affect profitability. CIGNA reduces its exposure to large individual and catastrophe losses under group life, disability and accidental death contracts by purchasing reinsurance from unaffiliated insurers. Competition Group indemnity insurance and prepaid health care are highly competitive, and no one competitor or small number of competitors is dominant across the country, although some regions are dominated by local HMOs. A large number of insurance companies and other entities compete in offering similar products. Competition exists both for employer-policyholders and for the employees in those instances where the employer offers the products of more than one company. Most group policies are subject to Company review and renewal on an annual basis, and policyholders may seek competitive quotations from several sources prior to renewal. The principal competitive factors that affect this segment are: (i) price; (ii) quality of service; (iii) scope, cost-effectiveness and quality of provider networks; (iv) product responsiveness to customers' needs; (v) cost-containment services; and (vi) effectiveness of marketing and sales. The principal competitors of group insurance and prepaid health care businesses are the large life and health insurance companies that provide group insurance, numerous Blue Cross and Blue Shield organizations, stand-alone HMOs, and HMOs sponsored by major insurance companies and hospitals. Competition also arises from smaller regional or specialty companies with strength in a particular geographic area or product line, administrative service firms and self-insurers. Addressing the needs of employee-consumers as well as of employers is increasingly important for success in these markets. CIGNA is one of the largest investor-owned insurance company providers of group life and health indemnity insurance, based on premiums and premium equivalents. It is the largest investor-owned HMO, based on the number of members. CIGNA is the second largest provider of group long-term disability coverages, based on premiums. Health Care Reform Reform of the United States health care system to address issues of cost, access, universal coverage and quality is widely predicted for 1994. A number of proposals are on the federal and state legislative agendas that would change the way health care is financed and delivered. Many reform proposals contain elements of managed competition. Some include global budgets or some form of price controls as a short-term means to restrain health care costs. Managed competition is a market-based approach to the delivery of health care and health insurance. Other reform proposals include a national standard benefit package, limits on the use of pre-existing conditions to exclude coverage, limits on the tax deductibility of health insurance, and provisions for purchasing pools that are intended to give employers and employees greater purchasing power for health insurance and health care. Certain proposals, including the Clinton Administration's, would create increased levels of regulation to accomplish the goal of health care reform. Reform may provide flexibility for the states to adopt their own programs, which would result in multiple layers of regulation. The proposals are complex and will be actively debated by Congress and the individual states. Health care reform could cause some companies to leave health care-related markets and enter or increase their commitment to other markets, such as for life, accident or disability insurance. Because the reform measures that will ultimately be adopted are not known, CIGNA cannot predict the effect that health care reform will have on its business operations. AIDS The impact of Acquired Immune Deficiency Syndrome ("AIDS") claims to date has not been material for CIGNA. However, the U.S. Center for Disease Control has projected substantial increases in the number of AIDS cases and related deaths in the general population. If such projected increases occur, they will result in higher life and health benefits claims. CIGNA anticipates that most AIDS claims in its Employee Life and Health Benefits business should be recoverable through the experience-rating process and appropriate rate increases for guaranteed-cost and prepaid products. D. Employee Retirement and Savings Benefits General CIGNA's Employee Retirement and Savings Benefits businesses provide investment products and professional services primarily to sponsors of qualified pension, profit-sharing and retirement savings plans. These products and services are marketed through CG Life and certain other subsidiaries. Net earned premiums and fees for, and deposits to, general, separate and investment advisory accounts for this segment for the year ended December 31, were as follows: Assets under management for this segment as of December 31 were as follows: - --------------- (1) General Account assets under management increased $521 million as a result of implementing SFAS No. 115. Principal Products and Markets CIGNA offers a broad range of products to both defined benefit and defined contribution pension plans, profit-sharing plans and retirement savings plans. CIGNA's primary marketing emphasis is on defined contribution plans, which provide for participant accounts with benefits based upon the value of contributions to, and investment returns on, the individual's account. This has been the fastest growing portion of the pension marketplace in recent years. Defined contribution plan assets amounted to approximately $15.9 billion or 46% of assets under management for this segment as of December 31, 1993, compared with $13.8 billion or 42% as of December 31, 1992. The balance of this segment's assets under management relate primarily to defined benefit plans, under which annual retirement benefits are fixed or defined by a benefit formula. CIGNA is increasing its marketing efforts for defined benefit plans. CIGNA sells investment products and investment management services, either separately or as full-service packages with administrative and other professional services, to pension plan sponsors. Traditionally, CIGNA's marketing emphasis has been on sales of full-service products that include investment management and pension services to middle market customers with plan assets of $500,000 to $50 million. In recent years, however, this emphasis has expanded to include sales to sponsors of larger plans that look to more than one entity to provide actuarial, administrative or investment services and products, or combinations thereof. For defined contribution plans, principally 401(k) plans, CIGNA markets products that provide both investment management services and plan level and participant recordkeeping, as well as employee communications, enrollment, plan design and other consulting services. For defined benefit plans, CIGNA provides investment, administrative and professional services, including recordkeeping, plan documentation, and actuarial valuation and consulting. In addition, CIGNA offers single premium annuities, both on guaranteed and experience-rated bases; and guaranteed investment contracts ("GICs"), which provide guarantees of principal and interest with a fixed maturity date. Pension products are supported by the general asset account ("General Account") and segregated accounts ("Separate Accounts") of CG Life. The General Account supports both guaranteed and experience-rated contracts. Guaranteed contracts comprise single premium annuities and GICs. As of December 31, 1993, guaranteed single premium annuities accounted for $2.9 billion, and GICs accounted for $1.5 billion, of General Account assets under management for the Employee Retirement and Savings Benefits segment. For 1993, the interest rate on reserves for guaranteed single premium annuities ranged from 3.25% to 12.75%, with a weighted average of 8.6%. The rate of interest credited in 1993 on CIGNA's GICs ranged from 5% to 13%, with a weighted average rate of 9.6%. CIGNA's GICs and single premium annuities generally do not permit withdrawal by the plan sponsor prior to maturity, except that GICs permit withdrawal at market value in the event of plan termination. None of the GICs include renewal clauses. Payouts associated with GICs have not been material to the Company's liquidity and capital resources. Experience-rated contracts that are supported by the General Account ("policyholder contracts") have no fixed maturity dates and provide for transfer of net investment experience (including impairments and non-accruals) to policyholders through credited interest and termination provisions. Credited interest rates on policyholder contracts are generally declared annually in advance and may be changed prospectively by the Company from time to time. Credited interest rates reflect investment income and realized gains and losses. Credited interest rates on policyholder contracts for 1993 ranged from 6% to 10%, with a weighted average rate of 7.4%. The termination provisions of $4.8 billion, or 100%, of the Company's defined benefit policyholder contract liabilities that are subject to withdrawal, and the termination provisions of $3.8 billion, or 38%, of the Company's liability for defined contribution policyholder contracts, provide the policyholder with essentially two options for withdrawal of assets upon election to terminate: (a) a lump sum at market value; or (b) annual installments. Under the market value method, the Company approximates the market value of the underlying investments by discounting expected future investment cash flows from investment income (including the effect of non-accruals) and repayment of principal, including the effect of impaired assets. The discount rate assumed is based on current market interest rates. Under the installment method, 100% of the contractholder book value is paid, usually over not more than 10 years. Interest is credited over the installment period under a formula derived to pass investment gains and losses (reflecting non-accruals and impairments) through to policyholders. Withdrawals under the installment method have been insignificant to the Company. The termination provisions of $6.2 billion, or 62%, of the Company's liability for defined contribution policyholder contracts contain a book value mechanism for withdrawals at policyholder termination. Under certain circumstances, payout of book value is subject to deferral and the rate of interest credited may be reduced for the recovery of investment losses (including non-accruals and impairments). The Separate Accounts allow customers the flexibility to invest in specific portfolios and participate directly in the investment results. Investment options include publicly traded bonds, private placement bonds, equities, real estate, mutual funds and short-term securities. Approximately $7.4 billion, or 60%, of the assets in the Separate Accounts support experience-rated contracts under which the risks and benefits of investment performance are borne entirely by the customers. The remaining assets in the Separate Accounts are held under experience-rated contracts that guarantee a minimum level of benefits. As of December 31, 1993 and 1992, the amount of minimum benefit guarantees under these contracts was $4.9 billion and $4.5 billion, respectively. Reserves in addition to the Separate Account liabilities are established when CIGNA believes a payment will be required under one of these guarantees. As of December 31, 1993, reserves of $6 million had been established to provide for the cost of interest guarantees. For additional information, see Note 17 to CIGNA's 1993 Financial Statements. CIGNA monitors contract termination experience on an ongoing basis. Of those assets subject to withdrawal, persistency for 1993 was 94%, compared with 93% and 85% in 1992 and 1991, respectively. The lower persistency rate in 1991 primarily reflected the termination of a large defined benefit plan by a single customer. Distribution CIGNA's retirement products and services are distributed primarily through CG Life salaried group pension representatives both directly and through career agents, independent insurance agents and brokers, pension plan consultants, investment advisors, and other service providers. As of December 31, 1993, CG Life had a field organization consisting of 51 pension sales representatives and 155 service consultants and administrative personnel located in 25 sales and service offices throughout the United States. Pricing and Reserves CIGNA establishes reserves for experience-rated contracts in an amount equivalent to the contractholder funds on deposit with it, including liability for estimated experience refunds based upon the results of each contract. Profitability on these contracts is based primarily on margins included in charges for investment and administrative services and risk assumption. Premiums and fees for annuity products are based on assumptions as to mortality experience, investment returns, expenses and target profit margins. For guaranteed-cost contracts, the reserve established is the present value of expected future obligations based on these assumptions, with a margin for adverse deviation. Profitability on guaranteed-cost contracts is affected by the degree to which future experience deviates from these assumptions. Competition The pension marketplace is highly competitive. CIGNA's competitors include other insurance companies, banks, investment advisors, certain service and professional organizations, and increasingly, mutual funds. No one competitor or small number of competitors is dominant. Competition focuses on service, technology, cost, variety of investment options, investment performance and, more recently, vendor financial condition as indicated by ratings issued by nationally recognized rating agencies. Business growth may be constrained by withdrawals and lower deposits resulting from decisions by pension plan sponsors to diversify assets and fund management. The largest single pension manager holds less than a 5% market share, as measured by assets under management. According to a survey published in "Pensions & Investments," CIGNA ranked 5th among insurers, and 15th among pension managers overall, in terms of pension and employee retirement savings plan assets under management. E. Individual Financial Services General CIGNA's Individual Financial Services businesses market a broad range of insurance and investment products and services to individuals and corporations. CIGNA also assumes reinsurance of certain risks under policies written by other insurance companies. The following table sets forth the net earned premiums and fees, and deposits, for this segment. The following table provides data on sales and additions, terminations and life insurance in force for this segment, including assumed reinsurance, and reinsurance ceded to other companies. - --------------- (1) For 1993, $17 billion of sales and additions were participating, with the remainder non-participating. For 1992 and 1991, substantially all sales and additions were non-participating. As of December 31, 1993, total life insurance in force for this segment included assumed reinsurance of approximately $16.6 billion, compared with $16.4 billion as of December 31, 1992 and $15.9 billion as of December 31, 1991. In 1993, assumed reinsurance (included in sales and additions) totaled $3.6 billion compared with $3.9 billion and $2.7 billion in 1992 and 1991, respectively. Individual Products CIGNA's individual insurance products include term and permanent life insurance, disability insurance, and annuities. Term life insurance provides coverage for a stated period and pays a death benefit only if the insured dies within the period. Permanent life insurance, offered on a participating or non-participating basis, provides coverage that does not expire after a term of years and builds a cash value that equals the full policy amount if the insured is alive on the policy maturity date. In participating insurance, policyholders directly participate in policy earnings through dividends. Non-participating insurance does not pay dividends, but deviations from assumed experience may be reflected in the policyholder's future premium payments. Products that provide permanent coverages include whole life, universal life and variable universal life. Whole life provides fixed benefits and level premium payments. Universal life provides benefits that fluctuate with the amount of variable premiums paid, and interest credits, mortality and expense charges made, to the policy. Premiums and benefits in universal life products vary with the design of the benefits being funded. Variable universal life provides benefits that also fluctuate, but with the performance of one or more investment accounts. CIGNA offers both fixed and variable annuity products. Fixed annuities accumulate value at a fixed rate of interest on the invested premium (less applicable expenses and contract charges). Variable annuities accumulate value at levels determined by the contractholder's allocation of premium among a portfolio of mutual funds and fixed rate accounts, and the underlying investment performance of the selected funds (less applicable expenses and contract charges). CIGNA also markets a number of individual investment products and services, including mutual funds, and fee-based financial planning. Principal markets for products and services sold to individuals are affluent executives, professionals and small business owners (typically with incomes above $100,000 and net worths of $1.5 million or more). Individual insurance products are also sold to corporations to provide coverage on the lives of certain of their employees. Principal markets for corporate-owned life insurance ("COLI") are Fortune 1000 companies. The COLI market, and sales volume for COLI products, tend to be volatile. During 1993 the face amount of new sales (as shown in the preceding tables) of COLI universal life business issued on a participating basis was approximately $17 billion, accounting for the increases in deposits, permanent sales and in force, and the number and average size of participating policies. As of December 31, 1993 and 1992, approximately 64% and 85%, respectively, of CIGNA's individual life insurance in force was non-participating permanent, which includes interest-sensitive products such as universal life. The year-over-year decline was due to the large COLI sales mentioned above. Interest credited on whole life products is at a minimum guaranteed rate. For interest-sensitive products, credited interest rates vary with the characteristics of each product and the anticipated investment results of the assets backing these products. Where credited interest exceeds the guaranteed rate, the excess is used to purchase additional insurance or increase cash values. Credited interest rates on interest-sensitive products for 1993 ranged from 4% to 9.5%. Interest rates for policy loans on individual life insurance products are defined in the contract and are either variable or fixed. Variable interest rates are tied to an external index specified in the contract and are subject to a specified minimum rate. The interest rates charged to the policyholder on borrowed funds ("loan rates") are generally greater than the interest rates credited to the policyholder on those funds, and such loan rates and the related credited interest rates tend to move in tandem as interest rates fluctuate. A large portion of the contracts that provide for fixed rates also provide for a relatively constant spread between the policy loan rate and the related credited interest rate. Most individual life insurance products have surrender charges to recover policy acquisition costs and to encourage persistency. Persistency for these products was approximately 95% in 1993, 1992 and 1991. Reinsurance Products Reinsurance products sold through this segment include coverages for part or all of the risks under policies written by other insurance companies for group life and health, individual life and health, and special risks, such as travel accident and workers' compensation catastrophe coverages. The principal markets for these products are individual and group life and health insurers and special risk and workers' compensation units of property-casualty insurers. Reinsurance coverages generally extend for the same duration as the underlying direct policies: from one year or less for group, special risk and individual life term policies, to time of lapse or expiration at death for permanent individual life and individual health policies. Most permanent reinsurance coverages have recapture charges to recover policy acquisition costs and to encourage persistency. Distribution As of December 31, 1993, CG Life sold individual insurance products primarily through approximately 875 full-time career agents and through brokers specializing in COLI products. Investment products are sold through the career agents, who are also registered representatives of a CIGNA broker-dealer. Annuities are distributed through stockbrokers and banks as well as through career agents. The COLI marketplace is dominated by a limited number of brokers. The volume of business from each of the brokers with whom CIGNA has a relationship tends to fluctuate over time. The participating COLI sales in 1993 were placed through one broker, the loss of which would have a significant adverse effect on new sales of corporate-owned participating universal life insurance. Reinsurance products are sold in the United States, Canada and Europe through a small sales force and through domestic and foreign brokers. Pricing, Reserves and Reinsurance Premiums for life and disability insurance, annuities and assumed reinsurance are based on assumptions about mortality, morbidity, persistency, expenses and target profit margins as well as interest rates and competitive considerations. The long-term profitability of individual products is affected by the degree to which future experience deviates from these assumptions. Fees for universal life insurance products consist of mortality, administration and surrender charges assessed against the policyholder's fund balance. Interest credits and mortality charges for universal life, and mortality charges on variable premium products, may be adjusted prospectively to reflect expected interest and mortality experience. Dividends on participating insurance products may be adjusted to reflect prior experience. For individual disability, annuity, traditional and variable premium life insurance and individual life and health reinsurance in force, CIGNA establishes policy reserves that reflect the present value of expected future obligations less the present value of expected future premiums. For universal life insurance, CIGNA establishes reserves for deposits received and investment income credited to the policyholder, less mortality, administration and surrender charges assessed against the policyholder's fund balance. In addition, for all individual and reinsurance products, CIGNA establishes claim reserves for claims received but not yet paid, based on the amount of the claim received, and for claims incurred but not reported, based on prior claim experience. CIGNA maintains a variety of reinsurance agreements with non-affiliated insurers to limit its exposure to large life and health losses and to multiple losses arising out of a single occurrence. Although such reinsurance does not discharge CIGNA from its obligations on insured risks, CIGNA's exposure to losses is reduced by the amount of reinsurance ceded, provided that reinsurers meet their obligations. Competition The individual insurance, annuity and investment business is highly competitive. No one competitor or small number of competitors dominates. More than 1,000 domestic life insurance companies may offer one or more individual insurance and annuity products, and approximately 40 companies may offer one or more reinsurance products, similar to those offered by CIGNA. In addition, some of CIGNA's individual financial businesses compete with non-insurance organizations, including commercial and savings banks, investment advisory services, investment companies and securities brokers. Competition focuses on product, service, price, distribution method and, more recently, the financial strength of the vendor as indicated by ratings issued by nationally recognized rating agencies. CIGNA has benefited competitively from CG Life's financial strength and stability, and from the quality of its distribution systems. The COLI marketplace is also highly competitive. The Company principally competes with approximately half of the 25 largest domestic life insurance companies that may offer one or more COLI products. Competition in this market focuses primarily on product design, underwriting, price and administrative servicing capabilities, as well as vendor financial strength. Based on information published by A.M. Best, CG Life was the 32nd largest individual life insurer in terms of aggregate individual life insurance in force, and the 7th largest in terms of direct premiums, in the United States. Other Matters CIGNA does not expect AIDS claims, discussed on page 6, to have a significant effect on the results of operations of this segment. Where appropriate, CIGNA tests for AIDS antibodies and considers AIDS information in underwriting coverages and setting rates. Legislation may be proposed that could change the policyholder tax treatment of certain of the Company's interest-sensitive products and, thus, adversely affect future sales and persistency of such products. F. Property and Casualty Principal Products and Markets CIGNA provides property and casualty insurance and reinsurance for customers in the United States and international markets, primarily Europe, Canada, the Pacific region and Latin America. During 1993, United States and international markets constituted approximately 56% and 44%, respectively, of the total earned premiums and fees for this segment. CIGNA provides insurance coverage under standard risk transfer arrangements and provides coverages and services for customers who wish to increase their levels of risk retention or to self-insure. Principal product lines include workers' compensation, commercial packages, casualty (including commercial automobile and general liability), property, and marine and aviation. CIGNA also markets life, accident and health insurance coverages in a number of international markets. CIGNA also reinsures risks written by other insurance companies. It offers treaty reinsurance on both a full risk and finite risk basis. Treaty reinsurance is the reinsurance of a specified type, category or class of risks defined in a reinsurance agreement (a "treaty") between a primary insurer or other reinsured and a reinsurer. CIGNA also writes facultative reinsurance, which is the reinsurance of all or a portion of the insurance provided by a single policy. During 1993, approximately 90% of reinsurance premiums in the Property and Casualty segment were written on a treaty basis and 10% on a facultative basis. Approximately 77% of CIGNA's treaty reinsurance premium and all of its facultative reinsurance premium currently written is for property coverage. In recent years and increasingly during 1993, CIGNA has implemented strategies to change the business mix of its domestic operations. In the specialty insurance market, CIGNA has discontinued writing domestic-based airlines and most professional liability coverages and has divested its contract surety bond business. In this market, CIGNA is focusing on excess casualty and homeowners business. In the medium-sized risk market, CIGNA intends to reduce the number of individual risks written, and increase production of group business, such as through affinity groups, associations and national broker blocks of business. In addition, CIGNA is focusing on writings of workers' compensation business that involves standard risk transfer in states with regulatory climates in which the Company believes it can operate profitably. Since 1990, CIGNA has implemented more restrictive risk selection and raised prices for its international property coverages. Also, CIGNA has withdrawn substantially from the domestic voluntary personal automobile insurance market and the London property and casualty assumed reinsurance market. The Company routinely re-evaluates the regulatory and reserving environment associated with these automobile and London reinsurance lines of business, and future changes in related reserves could occur. CIGNA generally attempts to protect itself from economic loss arising from foreign exchange exposure in its international operations by maintaining invested assets abroad that are currency specific in support of its foreign obligations. For information on the effect of foreign exchange exposure on CIGNA, see Notes 1(N) and 13 to CIGNA's 1993 Financial Statements. Until recently, CIGNA wrote financial guarantees on municipal bonds and certain corporate debt obligations (which are reported in the Property and Casualty segment) and on industrial revenue bonds (which are reported in other segments). For additional information, see Note 17 to CIGNA's 1993 Financial Statements. CIGNA's domestic subsidiaries are members of, or participate in, various voluntary associations and syndicates that facilitate the underwriting of large or highly concentrated risks. The associations distribute the risks assumed among the members, provide specialized inspection and engineering services and may use special forms of coverage to control overall exposures. In addition, regulatory authorities require the participation of CIGNA's domestic subsidiaries in various joint underwriting associations and pools, including workers' compensation pools that are unprofitable and represent a cost of conducting business in certain jurisdictions. Underwriting losses in these pools are the result of inadequate rate levels, the failure of states to institute workers' compensation reforms and reduced levels of voluntary writings by the industry. The following table sets forth geographic distribution of GAAP net earned premiums and fees for the products of this segment. - --------------- For 1993 and 1992, earned premiums and fees were substantially the same as written premiums. CIGNA's property and casualty insurance subsidiaries provide loss protection to insureds in exchange for premiums. If earned premiums exceed the sum of losses, commissions to agents or brokers, other operating expenses and policyholders' dividends, underwriting profits are realized. The "combined ratio" is a frequently used measure of property and casualty underwriting performance. On a GAAP basis, this ratio is the sum of (i) the ratio of incurred losses and associated loss expenses to earned premiums (the "loss and loss expense ratio"), (ii) the ratio of expenses incurred for sales commissions, premium taxes, administrative and other operating expenses to earned premiums (the "expense ratio") and (iii) the ratio of policyholders' dividends to earned premiums (the "policyholder dividend ratio"), each of these three ratios being expressed as a percentage. The statutory combined ratio differs from the GAAP ratio primarily in that the expense ratio and the policyholder dividend ratio are calculated as a percent of written premiums, rather than earned premiums. When the combined ratio is over 100%, underwriting results are not profitable. The combined ratios for CIGNA's property and casualty product lines and total property and casualty operations are shown in the table on page 16. Because time normally elapses between the receipt of premiums and the payment of claims and certain related expenses, funds become available for investment by CIGNA. The combined ratio does not reflect investment income from these funds, investment gains and losses, results of non-insurance business, or federal income tax expenses or benefits. Such investment income, when added to underwriting profits or losses, other items (including federal income tax expenses or benefits), investment income from accumulated earnings and capital, and realized investment gains and losses, produces net income or loss. For information concerning investment income, see "Investments and Investment Income -- Property and Casualty Investments" on pages 31 and 32. The following tables set forth GAAP net earned premiums and fees, underwriting results, combined ratios and net investment income for the products of this segment. The above table is presented on a GAAP basis. Industry results are more readily available on a statutory basis. CIGNA's statutory combined ratio after policyholders' dividends was 126.5 for 1993. CIGNA's 1993 statutory ratio was favorably affected by 9 points due to changes in the discounting of certain workers' compensation reserves. CIGNA's results have been adversely affected in recent years by a highly competitive pricing environment, which has resulted in general deterioration in its combined ratio. (The significance of the combined ratio is explained on page 15.) CIGNA's statutory combined ratio for 1993 was adversely affected by 9.0 points for environmental pollution losses and 3.9 points for asbestos-related losses, with the remainder primarily attributable to price deterioration and unfavorable underwriting. It is not known to what extent the types of losses reflected in CIGNA's combined ratio are also reflected in the combined ratios of other companies. The average statutory combined ratio for the nine months ended September 30, 1993 for companies that write at least 70% commercial coverage and file data with the Insurance Services Office was 112.5%. However, caution should be exercised in using this data because it is not possible to compare meaningfully an individual company's combined ratio with an industry average due to numerous variables, including product mix and amounts of fee for service business, which differ between companies. Competition The principal competitive factors that affect the property and casualty products of this segment are (i) pricing; (ii) underwriting; (iii) quality of claims and policyholder services; (iv) operating efficiencies; and (v) product differentiation and availability. In the highly competitive environment of the past several years, CIGNA has reduced its premium volume rather than maintain business at inadequate prices, and its share of domestic and international markets has declined. Competition has intensified due to increased capacity in the direct insurance market resulting from growing capital supporting the industry. In international markets, particularly western Europe, price competition is intense as companies compete for market share. Perception of financial strength, as reflected in the ratings assigned to an insurance company, especially by A.M. Best, is also a factor in the Company's competitive position. Continued pressure on ratings of the domestic Pool Group is expected because of continued losses. If the A.M. Best rating of the Pool Group drops from its current A- level, the Company's ability to write the domestic lines at present levels would be adversely affected, although the effects cannot be reasonably estimated. In its international life insurance operations, CIGNA focuses on those market segments where it can compete effectively based on service levels and product design, and achieve an adequate level of profitability in the long term. It generally does not attempt to compete with large, entrenched local companies. Property and casualty insurance can be obtained through national and regional companies that use an agency distribution system, direct writers (who may have an employed agency force) or brokers, or through self-insurance, including the use by corporations of subsidiary captive insurers. Approximately 3,900 companies compete for this business in the United States and no single company or group of affiliated companies is dominant. In 1993 and 1992, CIGNA's domestic property and casualty statutory net written premiums amounted to approximately 1.1% and 1.2%, respectively, of the total market. Internationally, CIGNA competes directly with foreign insurance companies as well as with other U.S.-based companies. CIGNA's reinsurance operations compete with over 100 reinsurers around the world. Based on information published by A.M. Best, CIGNA's domestic property and casualty insurance subsidiaries rank 16th in annual net premiums written, CIGNA is the 3rd largest U.S. writer of commercial multi-peril coverages, 13th largest of workers' compensation coverages and 12th largest of commercial auto coverages. Based on revenues, CIGNA's international operations are the second largest U.S.-based provider of insurance products and services. CIGNA's reinsurance operations rank 14th domestically and 24th worldwide in annual net premiums written. Distribution In the United States, CIGNA markets its insurance products principally through independent agents and brokers. CIGNA is reducing the number of producers through which it markets its products to focus on those producers who historically have provided more profitable business, to better manage the change in business mix described on pages 13 and 14 and to reduce expenses associated with writing the business. The current producer force of approximately 3,000 is expected to be reduced to about 2,500 during 1994. In addition, CIGNA is increasing the use of brokers in the medium-sized risk market in an effort to increase the amount of group business that is written. Property and casualty direct coverage is sold in the international marketplace primarily through brokers. A network of offices in about 50 jurisdictions provides claims and account services to international customers and brokers. Life, accident and health insurance products are sold in the international marketplace through approximately 7,000 brokers and agents. Reinsurance products are sold worldwide, with approximately 52% of 1993 business volume sold directly to client companies and the remainder through reinsurance brokers. About 56% of the brokered reinsurance business was sold through 30 broker organizations. Ceded Reinsurance To protect against losses greater than the amount that it is willing to retain on any one risk or event, CIGNA purchases reinsurance from unaffiliated insurance companies. The Company is not substantially dependent upon any single reinsurer. The Company's largest aggregation of reinsurance recoverables as of December 31, 1993 and 1992, at approximately 9% and 6%, respectively, was with syndicates affiliated with Lloyd's of London, with such recoverables spread over in excess of 100 syndicates. Although reinsurance does not discharge CIGNA from its obligations on insured risks, CIGNA's exposure to losses is reduced by the amount ceded, and thus will be limited to the amount of risk retained, provided that reinsurers meet their obligations. In recent years, in order to improve the long-term cost effectiveness of its reinsurance program, CIGNA has generally purchased less reinsurance and retained more risk. Changes in CIGNA's property catastrophe reinsurance program for domestic and international business are described on page 19 of the MD&A section of its 1993 Annual Report. The collectibility of reinsurance is largely a function of the solvency of reinsurers. CIGNA cedes risk to reinsurers who meet certain financial security standards and monitors their quality and financial condition. In its selection and monitoring process, CIGNA examines its reinsurers' financial performance and reserve adequacy; considers factors such as the quality of their management; and considers ratings and reviews of them by independent sources. When deemed appropriate, CIGNA seeks collateral from reinsurers; reassumes, in return for a settlement, risks for which it had previously purchased reinsurance; and establishes allowances for potentially unrecoverable reinsurance. Reinsurance disputes can delay recovery of reinsurance and, in some cases, affect its collectibility. Disputes resulting in such delays have increased in recent years, particularly on larger and more complex claims, such as those related to professional liability, asbestos and London reinsurance market exposures. Losses for unrecoverable reinsurance were $28 million, $89 million and $28 million for 1993, 1992 and 1991, respectively. Of the loss for 1992, $62 million related to CIGNA's London reinsurance market exposures. Additional losses from unrecoverable reinsurance are likely to affect CIGNA's future results adversely, although the amounts and timing cannot be reasonably estimated. Reserves General Significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer and the insurer's payment of that loss. To recognize liabilities for unpaid losses, insurers establish "reserves," which are liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events that have occurred, including events that have not been reported to the insurer. After a claim is reported, except for a class of very small claims that typically are settled quickly, a "case reserve" is established by claims personnel for the estimated amount of the ultimate payment. The estimate reflects the informed judgment of such personnel, based on their experience and knowledge regarding the nature and value of the specific claim. Claims personnel review and update their estimates as additional information becomes available and claims proceed toward resolution. "Bulk reserves" are established on an aggregate basis (i) to provide for losses incurred but not yet reported to and recorded by the insurer; (ii) to provide for the estimated expenses of settling claims, including legal and other fees and general expenses of administering the claims adjustment process; and (iii) to adjust for the fact that, in the aggregate, case reserves may not accurately estimate the ultimate liability for reported claims. As part of the bulk reserving process, CIGNA's historical claims data and other information are reviewed and consideration is given to the anticipated impact of various factors such as legal developments, economic conditions and changes in social attitudes. Insurance industry experience is also considered. With respect to asbestos-related, environmental pollution and certain other long-term exposure claims, CIGNA does not establish bulk reserves, except for the estimated expenses of settling reported claims and except for claims related to certain major asbestos manufacturers' policies. See below for a more detailed discussion of reserving for these claims. The reserving process relies on the basic assumption that past experience is an appropriate basis for predicting future events. The probable effects of current developments, trends and other relevant matters are also considered. Because the eventual deficiency or redundancy of reserves is affected by many factors, some of which are interdependent, there is no precise method for evaluating the adequacy of the consideration given to inflation or to any other specific factor affecting claims payments. However, the reserving process provides implicit recognition of the impact of inflation and other factors by taking into account changes in historic claims reporting and payment patterns. A number of analytical reserving techniques are used, which often yield differing results. Accordingly, estimating future claims costs is a complex and uncertain process. Because available claims data and other information are rarely definitive, the evaluation of such data's implications with respect to future losses requires the use of informed estimates and judgments. As additional experience and other data become available and are reviewed, the Company's estimates and judgments are revised and appropriate action is taken, which may include increases or decreases in CIGNA's estimate of ultimate liabilities for insured events of prior years. These increases or decreases, net of reinsurance, are reflected in results for the period in which the estimates are changed. CIGNA continually attempts to improve its loss estimation process by refining its ability to analyze loss development patterns, claims payments and other information, but there remain many reasons for adverse development of estimated ultimate liabilities. For example, the uncertainties inherent in the loss estimation process have grown in the last decade as loss estimates have become increasingly subject to changes in social and legal trends that expand the liability of insureds, establish new liabilities, and reinterpret insurance contracts to provide unanticipated coverage long after the related policies were written. As noted in the discussion below of asbestos-related, environmental pollution, and other long-term exposure claims, such changes from past experience significantly affect the ability of insurers to estimate liabilities for unpaid losses and related expenses. In management's judgment, information currently available has been appropriately considered in estimating CIGNA's loss reserves. However, future changes in estimates of claims costs will adversely affect results in future periods, although such effects cannot be reasonably estimated. Prior Year Development The adverse pre-tax effects during 1993, 1992 and 1991 on CIGNA's results of operations from insured events of prior years (prior year development) were $789 million, $656 million and $341 million, respectively. Of the prior year loss development during 1993, 82% was attributable to asbestos-related, environmental pollution and other long-term exposure claims, which are discussed below. The remaining development is discussed on pages 20 and 21 of the MD&A section of CIGNA's 1993 Annual Report. Asbestos-related, Environmental Pollution and Other Long-term Exposure Claims CIGNA continues to receive claims related to asbestos, environmental pollution and other long-term exposure claims asserting a right to recovery under insurance policies issued by the Company. Liabilities for these claims cannot be estimated using standard actuarial methods because developed case law and adequate claim history do not exist for such claims. In addition, these claims differ from almost all others in that it is generally not clear that an insured loss has occurred and which, if any, of multiple policy years and insurers may be liable. These uncertainties prevent identification of applicable policies and policy limits until after a claim is reported to the Company and substantial time is spent (many years in some cases), resolving contract issues and determining facts necessary to evaluate the claim. Estimating liabilities and recoveries for claims that will be asserted under assumed and ceded reinsurance policies is also subject to uncertainties similar to those affecting claims under direct policies. CIGNA expects recoveries from ceded reinsurance to reduce its future losses, although the amount of recoveries cannot be reasonably estimated. Under current law, CIGNA expects these types of claims will continue to be reported for the foreseeable future. The claims to be paid, if any, and timing of any such payments depend on resolution of the uncertainties associated with them, which are expected to extend over several decades. For the reasons discussed above, and further elaborated on below, CIGNA expects that its future results will continue to be adversely affected by losses and legal expenses for these types of claims. Because of the significant uncertainties involved, and the likelihood that they will not be resolved in the near future, CIGNA is unable to reasonably estimate the additional losses and expenses and therefore is unable to determine whether such amounts will be material to its future results of operations, liquidity or financial condition. Asbestos-related Claims Since 1985, CIGNA has carried reserves related to certain insurance policies issued for certain major asbestos manufacturers ("targets"), under which CIGNA expects to pay the limits of liability. These reserves (which include amounts for unreported claims and associated legal expenses) are equal to the policy limits of liability, minus payments made to date, plus an estimate of the associated future legal expenses. More recent asbestos bodily injury litigation has been filed against manufacturers and suppliers of diverse products that either contain asbestos or used it in the manufacturing process, as well as against contractors and building owners. There is inadequate history from which the Company can predict the number or types of policyholders that will receive asbestos-related claims, how many claims they will receive, the amounts of those future claims, the insurance coverages that might be called upon for defense and indemnification or the likelihood of those coverages having to respond to claims. Because the date of event for which insurance coverage might be determined is unclear, numerous policies with varying terms over many years may be involved. In addition to bodily injury cases, damage suits have been brought seeking reimbursement for the diminution in value of buildings containing asbestos materials and for the expense of removing and replacing asbestos insulation material and other building components made of asbestos. The Company and the insurance industry generally dispute that coverage applies to these asbestos-in-building claims. Within the various state and federal court systems, there have been conflicting decisions regarding the extent, if any, of the obligation of insurers to provide coverage and the method of allocation of costs among involved insurers. Additional uncertainties are created by efforts to create novel dispute resolution procedures in response to the burden of asbestos litigation on the courts, such as the proposed global settlement of future asbestos bodily injury claims brought against certain asbestos producers, which is being contested in the courts. The majority of CIGNA's losses and legal expenses for asbestos-related claims arise from its domestic property and casualty operations. As of December 31, 1993, 1992 and 1991, respectively, approximately 1,200, 950 and 900 policyholders had asbestos-related claims outstanding with the domestic operations. The 1993 amount includes 140 policyholders for which data had not previously been available. The number of policyholders with claims pending increased during 1993, 1992 and 1991 reflecting policyholders filing claims for the first time. During those years, there were no policyholders for which all pending claims were either dismissed or settled. CIGNA continues to litigate certain asbestos-related coverage issues, with 39 lawsuits involving 27 policyholders pending as of December 31, 1993. It is not possible to determine the Company's potential liability for asbestos-related claims based on the number of policyholders with claims outstanding. Additional information (which is not known for unreported claims) would be needed for such determination, including the extent of coverage, the policyholder's liability for claims tendered to it, the injuries allegedly sustained by the policyholder's claimants, and the number of claims pending against a policyholder. As discussed above, the lack of information on these and other matters prevents the estimation of liabilities for unreported asbestos-related claims. CIGNA establishes case reserves for reported asbestos-related claims as information permits and, during 1993, also established reserves for future legal and associated expenses for such reported claims. However, except for claims under the target manufacturers' policies discussed above, CIGNA does not establish reserves for unreported claims or for legal and associated expenses related to unreported claims because of the uncertainties described above. Reserve changes for asbestos-related claims before ("Gross") and after ("Net") the effects of reinsurance for the periods indicated are as follows: During 1993 CIGNA was able to segregate and separately report asbestos-related reserves for certain of its excess and surplus and reinsurance contracts that were previously included in prior year development for lines of business such as casualty, commercial packages and reinsurance. The above table reflects this change for all periods presented. Excess and surplus business is generally subject to a significant amount of reinsurance; as a result, the effect on net reserves of losses for this business was not significant. The incurred claims and claim adjustment expenses for 1993 reflect the establishment in the third quarter of reserves of $72 million, net of reinsurance ($106 million gross), for future legal and associated expenses for reported claims. Environmental Pollution Claims The principal federal statute that requires cleanup of environmental damage is the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"), passed in 1980. It imposes liability on "Potentially Responsible Parties" ("PRPs"), subjecting them to liability for clean-up costs regardless of fault, time period and relative contribution of pollutants. Superfund is subject to reauthorization by Congress in 1994; any changes in Superfund's system of allocating responsibility or funding clean-up costs could affect the liabilities of policyholders and insurers. The proposals being considered by Congress to reform Superfund are in the early stages of development, therefore, CIGNA is not able to determine what effect, if any, such enacted reform would have on its future results. In addition to Superfund, other federal environmental statutes exist, and state environmental statutes are, in some cases, stricter than the federal statutes. In addition to clean-up costs, environmental pollution may give rise to claims for bodily injury and property damage. Those identified as potentially responsible for environmental pollution typically assert that their liability is insured. As a result, CIGNA's environmental pollution claims have escalated rapidly since 1985, and a substantial and growing number of legal actions that involve insurers, including CIGNA, have been brought to determine insurance coverage issues. CIGNA and other insurers dispute coverage for the environmental liabilities of policyholders. Fundamental legal questions that will ultimately determine whether or not insurers have an obligation to provide coverage are being vigorously litigated and there is no consistency among the court decisions nationwide on these questions. Additional uncertainty arises because of the varying types and terms of policies, which may or may not provide for the costs of defense or contain pollution exclusions. Pollution exclusions may be absolute or may allow coverage for certain sudden and accidental events. The estimation of reserves for reported environmental pollution claims is difficult and likely to change as additional information emerges. Even if coverage issues on a particular claim are ultimately resolved in favor of the policyholder, that result may not be useful in setting reserves on other claims because of complex factual variations between sites, policyholders and policies. For example, at any given Superfund site, the allocation of liability varies greatly, depending on such factors as the amount and relative toxicity of the material contributed, extent of impairment to the environment and ability to pay. A PRP may have no liability, may share responsibility with others or may bear the cost alone. According to the Environmental Protection Agency, the average time period between issuance of initial notice of PRP status and determination of the method and cost of a site clean-up now averages about ten years. The issues have been resolved for relatively few waste sites. The majority of CIGNA's losses and expenses for environmental pollution claims arise from its domestic property and casualty operations. As of December 31, 1993, 1992 and 1991, respectively, the domestic operations had approximately 13,300, 9,200 and 7,000 environmental pollution files outstanding. During 1993, 1992 and 1991, new claim files opened were approximately 4,500 (including approximately 1,300 files for which data had not previously been available), 2,500 and 2,100, respectively, and pending claim files dismissed, settled or otherwise resolved were approximately 400, 300 and 200, respectively. A file represents each policyholder involved at a site, regardless of the number or type of claims asserted against the policyholder or the number or type of insurance policies (primary or excess) under which coverage is asserted. CIGNA disputes coverage for essentially all environmental pollution claims, and is involved in 493 coverage lawsuits as of December 31, 1993, compared with 449 as of December 31, 1992. Accordingly, and because of the many unresolved legal and factual issues described above, liabilities cannot be estimated from the number of environmental pollution files outstanding. CIGNA establishes case reserves for reported environmental pollution claims as information permits and, during 1993, also established reserves for future legal and associated expenses for such reported claims. However, CIGNA does not establish reserves for unreported claims or for legal and associated expenses related to unreported claims because of the uncertainties described above. Reserve changes for environmental pollution claims before ("Gross") and after ("Net") the effects of reinsurance for the periods indicated are as follows: During 1993, CIGNA was able to segregate and separately report environmental pollution reserves for certain of its excess and surplus contracts that were previously included in prior year development for lines of business such as casualty and commercial packages. The above table reflects this change for all periods presented. Excess and surplus contracts are generally subject to a significant amount of reinsurance; as a result, the effect on net reserves of losses for this business was not significant. The incurred claims and claim adjustment expenses for 1993 reflect the establishment in the third quarter of reserves of $268 million net of reinsurance ($335 million gross) for future legal and associated expenses for reported claims. Other Long-term Exposure Claims Other long-term exposure claims typically assert injuries from a substance, such as DES, lead or breast implants, which are manifested over an extended period of time. These claims may involve multiple policies, policyholders and insurers, with uncertainties similar to those affecting asbestos-related claims, in resolving whether, and which, insurers may be liable. In addition, there are questions as to which, if any, injuries or damages are caused by the particular product or substance. CIGNA's losses and legal expenses for other long-term exposure claims primarily arise from its domestic property and casualty operations. As of December 31, 1993 and 1992, respectively, approximately 1,000 and 700 policyholders had other long-term exposure claims outstanding with the domestic operations. The 1993 amount includes approximately 250 policyholders for which data had not previously been available. CIGNA continues to litigate other long-term exposure coverage disputes, with 49 lawsuits involving 48 policyholders pending as of December 31, 1993. CIGNA establishes case reserves for reported long-term exposure claims and, during 1993, also established reserves for future legal and associated expenses for such reported claims. However, CIGNA does not establish reserves for certain classes of unreported claims or for legal and associated expenses related to certain classes of unreported claims because of the uncertainties described above. The incurred claims and claim adjustment expenses, net of reinsurance, for other long-term exposures were $76 million, $16 million and $21 million for 1993, 1992 and 1991, respectively. The incurred claims and claim adjustment expenses in 1993 for other long-term exposure claims reflect the establishment in the third quarter of reserves of $35 million, net of reinsurance, for future legal and associated expenses for reported claims. Reserve Analysis The following table presents a reconciliation of total beginning and ending reserve balances of the Property and Casualty segment for unpaid claims and claim adjustment expenses for the periods indicated. The table on page 25 presents the subsequent development of the estimated year-end property and casualty reserve, net of reinsurance ("net reserve") for the ten years prior to 1993. The first section of the table shows the estimated net reserve that was recorded at the end of each of the indicated years for all current and prior year unpaid claims and claim adjustment expenses. The second section shows the cumulative percentages of such previously recorded net reserve paid in succeeding years. The third section shows, as a percentage of such net reserve, the re-estimates of the net reserve made in each succeeding year. The indicated deficiency as shown in the table represents the aggregate change in the reserve estimates from the original balance sheet dates through 1993. The amounts noted are cumulative; that is, an increase in a loss estimate that related to a prior year occurrence generates a deficiency in each intermediate year. For example, a deficiency recognized in 1993 relating to losses incurred in 1987 would be included in the indicated deficiency amount for the years 1987 through 1992. Yet, the deficiency would be reflected in operating results in 1993 only. The effects on income in the past three years due to changes in estimates of net reserve are shown as "Increase in provision for insured events of prior years" in the above table. Conditions and trends that have affected the reserve development reflected in the table may continue to change, and care should be exercised in extrapolating future reserve redundancies or deficiencies from such development. - --------------- The liability for foreign subsidiaries was excluded for 1983 because claims and claim adjustment expenses by accident year for foreign subsidiaries were not available that year. On a GAAP basis, which is before the effects of reinsurance, CIGNA's 1993 year-end reserves totaled $17.7 billion. For GAAP purposes, CIGNA's reserves are generally carried at the full value of the estimated liabilities, except for certain workers' compensation liabilities assumed in pre-1984 reinsurance agreements. The discount for these liabilities, based on an assumed interest rate of 9%, was approximately $22 million as of December 31, 1993, and approximately $2 million was amortized in 1993. For state regulatory purposes, reserves are reported in accordance with statutory accounting procedures ("SAP"), which is net of the effects of reinsurance, and, on that basis, totaled $9.6 billion. The following table reconciles, as of year end, liabilities for unpaid claims and claim adjustment expenses determined for state regulatory purposes in accordance with SAP to those determined in accordance with GAAP: - --------------- (1) Primarily for workers' compensation reserves. For SAP purposes workers' compensation reserves are discounted at rates ranging from 3.5% to 6%. During 1993, CIGNA expanded the use of discounting for certain statutory loss reserves and modified the assumptions used to discount other reserves, in accordance with state insurance regulations, which decreased statutory reserves by $388 million. (2) Prior to 1992, SAP did not generally allow for the recognition of estimated recoverable salvage and subrogation. Beginning in 1992, both SAP and GAAP included an adjustment for salvage and subrogation recoverables. NAIC and Other Property and Casualty Regulatory Matters The National Association of Insurance Commissioners ("NAIC") has adopted risk-based capital rules effective for property and casualty companies as of December 31, 1994. Additional information about the rules and their effect on CIGNA's property and casualty subsidiaries is contained on page 33 below and on page 15 of the MD&A section of CIGNA's 1993 Annual Report. The NAIC calculates annually 12 financial ratios to assist state insurance regulators in monitoring the financial condition of insurance companies. Departure from the benchmark "usual range" on four or more of the ratios could lead to inquiries from individual state insurance commissioners as to certain aspects of a company's business. For 1993, CIGNA's consolidated domestic property and casualty insurance subsidiaries fell outside the usual ranges for four of the ratios, as discussed below. Management believes that this departure from the usual ranges reflects the unfavorable insurance environment and will not result in any regulatory actions that would have a material adverse effect on the results of operations or financial condition of CIGNA. The consolidated subsidiaries fell outside the usual ranges for the two year overall operating ratio (118%), the one and two year reserve development to surplus ratios (38% and 49%, respectively) and the liabilities to liquid assets ratio (109%). The two year operating ratio measures a company's overall profitability by relating cumulative underwriting losses net of investment income for the current and prior year to premium for that period. A ratio in excess of 100% falls outside the usual range. Significant factors contributing to this result include losses from catastrophes and asbestos and environmental pollution claims as well as a highly competitive pricing environment. Underwriting losses and steps taken to improve results are discussed on page 19 of the MD&A section of the Company's 1993 Annual Report. The one and two year reserve development to surplus ratios relate a company's loss reserve development for insured events of prior years for the most recent calendar year to 1992 surplus (for the one year ratio) and for the two most recent calendar years to 1991 surplus (for the two year ratio). A company falls outside the usual ranges if such development exceeds 20% of such surplus. The reasons for the Company's adverse loss development are discussed beginning on page 19 above and on pages 20 and 21 of the MD&A section of the Company's 1993 Annual Report. The liabilities to liquid assets ratio measures a company's ability to pay its liabilities with cash, investment assets or receivables. A ratio in excess of 105% falls outside the usual range. As stated above on page 13, CIGNA provides coverages and services for customers who wish to increase their levels of risk retention or to self-insure. The receivables associated with certain of these products (with respect to which the Company typically obtains collateral) are separately classified in the financial statements and are not included in the NAIC definition of liquid assets. The inclusion of the liabilities associated with such products without the related receivables results in the Company falling outside the usual range. As a result of property and casualty underwriting losses, CIGNA contributed $150 million of capital in 1993 to enhance the capital base of the domestic property and casualty operations. Also during 1993, CIGNA expanded the use of discounting for certain statutory loss reserves and modified the assumptions used to discount other reserves, in accordance with state insurance regulations, which increased statutory surplus by approximately $290 million. Additional capital contributions may be needed as a result of continued property and casualty losses; however, such amounts are not reasonably estimable at this time. CIGNA's property and casualty insurance subsidiaries are members of regulated advisory organizations that provide certain statistical, rate-making, policy audit and similar services on a fee basis. In most states, these subsidiaries may use rate filings developed by advisory organizations. They also use filings developed by themselves, or combinations of both, thus enabling them to pursue an independent course in certain areas while using advisory organization services in others. The continued operation of advisory organizations and their authority to set advisory rates is the subject of a variety of proposed regulatory restraints and legal challenges. G. Investments and Investment Income CIGNA's investment operations primarily provide investment management and related services in the United States and certain other countries for CIGNA's corporate and insurance-related assets. Assets under management at year-end 1993 totaled $67.4 billion, comprising CIGNA corporate and insurance-related investment assets ("investment assets") of $50.7 billion and advisory portfolios of $16.7 billion. Advisory portfolios included $13.7 billion in Separate Accounts of CIGNA's life insurance subsidiaries. For information about Separate Accounts, see "Employee Retirement and Savings Benefits-- Principal Products and Markets" on page 7. As of December 31, 1993, CIGNA implemented Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, certain fixed maturities were classified as available for sale and are now carried at fair value, rather than amortized cost. The effect of implementing SFAS No. 115 was to increase investment assets by $1.6 billion. CIGNA invests in a broad range of asset classes, including domestic and international fixed maturities and common stocks, mortgage loans, real estate, and short-term investments. In 1993, CIGNA ceased active management of the bulk of its domestic equity holdings in favor of an index approach primarily based on the Standard & Poor's 500 Index. The major portfolios under management consist of the combined assets of the Employee Life and Health Benefits, Employee Retirement and Savings Benefits, and Individual Financial Services segments (collectively, "Employee Benefits and Individual Financial portfolios") and the assets of the Property and Casualty segment. CIGNA's investment assets are generally managed to reflect the underlying characteristics of related insurance and contractholder liabilities, as well as regulatory and tax considerations pertaining to those liabilities. CIGNA's insurance and contractholder liabilities as of December 31, 1993 comprised the following: property and casualty 37%; fully guaranteed 13%, experience-rated 27%, interest-sensitive 10%, and other life and health 13%. Property and casualty claim demands are somewhat unpredictable in nature and require liquidity from the underlying investment assets, which are structured to emphasize current investment income to the extent consistent with maintaining appropriate portfolio quality and diversity. The liquidity requirements for shorter-term liabilities are met primarily through cash flows and shorter-term investments (less than two years) and, to a lesser extent, through publicly traded fixed maturities. For longer-term liabilities, liquidity requirements are met primarily through private fixed maturity investments. During 1993, equity holdings were sold from the Property and Casualty portfolios and replaced with fixed maturity holdings with the objective of reducing future volatility of investments supporting CIGNA's property and casualty reserves. Fully guaranteed products primarily include GICs, settlement annuities and single premium annuity products. Because these products generally do not permit withdrawal by policyholders prior to maturity, the amount and timing of future benefit cash flows can be reasonably estimated. Funds supporting these products are invested in fixed income investments that generally match the aggregate duration of the investment portfolio with that of the related benefit cash flows. As of December 31, 1993, the duration of assets and liabilities for GICs, single premium annuities and settlement annuities was 3 years, 8 years and 12 years, respectively. Experience-rated products include defined benefit and defined contribution pension products. The principal and liquidity requirements of experience-rated liabilities are met by investments that emphasize current yield, primarily fixed income investments. Investment assets for interest-sensitive products, which include universal life insurance, primarily include fixed income investments, which emphasize investment yield while meeting the liquidity requirements of the related liabilities. Other life and health products consist of various group and individual life and health products. The supporting investment assets are structured to emphasize investment income, and the necessary liquidity is provided through cash flow, short-term investments and common stocks. Investment strategy and results are affected by the amount and timing of cash available for investment, economic conditions and interest rates. For example, cash flows have increased in the past two years due to higher principal repayments, primarily from prepayments of mortgage-backed securities. Reinvestment of this cash in high quality fixed maturities at prevailing interest rates has reduced investment income. Increased competition for quality investments could reduce the availability of such investments and adversely affect future investment results. CIGNA routinely monitors and evaluates the status of its investments in light of current economic conditions, trends in capital markets and other factors. Such factors include industry segment considerations for fixed maturity investments, and geographic and property-type considerations for mortgage loan investments. CIGNA's fixed maturity investments as of December 31, 1993 constituted approximately 54% of the Employee Benefits and Individual Financial portfolios and approximately 87% of the Property and Casualty portfolios, respectively. As of that date, approximately 33% of fixed maturity investments was attributable to experience-rated contracts. CIGNA reduces credit risk for the portfolios as a whole by investing primarily in investment grade securities rated by rating agencies (for public investments), by CIGNA (for private investments) or by the Securities Valuation Office of the NAIC (for both public and private investments). For information about below investment grade holdings and NAIC and agency ratings, see page 24 of the MD&A section of CIGNA's 1993 Annual Report. Adverse economic conditions in particular industry sectors have impaired certain borrowers' abilities to pay debt service on fixed maturities. This resulted in additional write-downs, delinquencies and restructured bonds in 1993. Despite signs of overall economic growth, continuing adverse conditions in various industry segments are expected to result in additional problem fixed maturities and write-downs and valuation reserves. CIGNA's mortgage loan investments constituted approximately 26% of the Employee Benefits and Individual Financial portfolios and approximately 4% of the Property and Casualty portfolios as of December 31, 1993. As of that date, approximately 59% of mortgage loan investments was attributable to experience-rated contracts. Mortgage loan investments are subject to underwriting criteria addressing loan-to-value ratio, debt service coverage, cash flow, tenant quality, leasing, market, location and financial strength of the borrower. Such investments consist primarily of first mortgage loans on commercial properties and are diversified relative to property type, location, borrower and loan size. The Company invests in fully completed and substantially leased commercial properties. Virtually all of the Company's mortgage loans are bullet or balloon loans, under which all or a substantial portion of the loan principal is due at the end of the loan term. Conditions in certain economic sectors and the real estate markets generally, have impaired certain borrowers' abilities to pay debt service on mortgage loans. As a result, CIGNA experienced additional delinquencies, restructurings and, in particular, foreclosures in 1993, as well as an increase in valuation reserves. Continuing adverse conditions, in particular in California and the office building sector, are expected to result in additional problem mortgage loans, foreclosures and valuation reserves. In addition, in 1993 the Company refinanced approximately $900 million of mortgage loans in good standing that related to borrowers unable to obtain alternative financing and extended the maturities of certain mortgage loans. CIGNA manages properties obtained through foreclosure of mortgage loans ("foreclosure properties") until such properties are sold. The Company's general policy is to sell foreclosure properties after rehabilitating the properties, re-leasing them, and managing them for two to four years, although CIGNA may hold certain foreclosure properties for immediate sale if circumstances indicate that to do so is in the best financial interests of the Company or policyholders. The amounts and timing of future write-downs and changes in valuation reserves for bonds, mortgage loans and foreclosure properties cannot be reasonably estimated. However, CIGNA currently does not expect a significant decline in the aggregate carrying value of its assets or a material adverse effect on its financial condition. See pages 23 through 29 of the MD&A section of CIGNA's 1993 Annual Report and Notes 1, 3 and 4 to CIGNA's 1993 Financial Statements for additional information about CIGNA's investments. Employee Benefits and Individual Financial Investments The following tables summarize the distribution of investments attributable to CIGNA's Employee Benefits and Individual Financial portfolios and the related net investment income from such investments. Approximately 53% of the investments in the Employee Benefits and Individual Financial portfolios is attributable to experience-rated contracts with policyholders. - --------------- See Note 1 of Notes to Financial Statements on page 34 of CIGNA's 1993 Annual Report for a discussion of the method of valuation of investments. The above amounts do not include Separate Account assets. (1) Comprises fixed maturities of sovereign foreign governments. (2) Amount reflects an increase of $732 million related to the adoption of SFAS No. 115. See Note 1 of Notes to Financial Statements on page 33 of CIGNA's 1993 Annual Report. - --------------- (1) In accordance with rules prescribed by the NAIC, the earned interest rate for any given year is equal to (a) net investment income multiplied by two, divided by (b) the sum, at the beginning and end of the year (excluding the effects of SFAS No. 115), of cash, invested assets and investment income due and accrued, less borrowed money, less net investment income. Property and Casualty Investments The following tables summarize the distribution of investments attributable to CIGNA's Property and Casualty segment and the related net investment income from such investments. - ------------ See Note 1 of Notes to Financial Statements on page 34 of CIGNA's 1993 Annual Report for a discussion of the method of valuation of investments. The above table does not reflect purchase accounting adjustments relating to the 1982 business combination of Connecticut General Corporation ("CGC") and INA Corporation ("INA"), which are made in consolidation. In addition, the above amounts do not include Separate Account assets. (1) Comprises fixed maturities of sovereign foreign governments. (2) Amount reflects an increase of $548 million related to the adoption of SFAS No. 115. See Note 1 of Notes to Financial Statements on page 33 of CIGNA's 1993 Annual Report. Fixed maturities carried at fair value prior to adoption of SFAS No. 115 approximated $2.3 billion as of December 31, 1993 and are reflected in the appropriate bond categories presented above. (3) Includes fixed maturities that are carried at market value of approximately $2.1 billion and $1.9 billion, respectively, as of December 31, 1992 and 1991. - --------------- (1) The above table does not reflect purchase accounting adjustments relating to the 1982 business combination of CGC and INA, which are made in consolidation. Portfolio Management and Advisory Services CIGNA's investment operations primarily focus on providing investment services to CIGNA and its insurance subsidiaries. In addition, the investment operations provide fee-based investment management and advisory services to advisory clients, including large group pension sponsors, institutions and international investors. CIGNA acquires or originates, directly or through intermediaries, various investments including private placements, public securities, mortgage loans, real estate and leveraged capital funds. Other Investments and Operations Assets for CIGNA's Other Operations include fixed maturities, mortgage loans and investments maturing in less than two years. These assets support the settlement annuity and non-insurance businesses, and also supported, until January 1994 when they were sold, the California personal automobile and homeowners insurance businesses that CIGNA retained from the 1989 sale of the Horace Mann insurance companies. Net investment income for these investments was $217 million for 1993, $218 million for 1992 and $215 million for 1991. In addition, CIGNA has non-strategic equity investments in operating businesses, including oil and gas, drilling rig and real estate operations. H. Regulation CIGNA's insurance subsidiaries are licensed to do business in, and are subject to regulation and supervision by, the states of the United States, the District of Columbia, certain U.S. territories and various foreign jurisdictions. Although the extent of regulation varies, most jurisdictions have laws and regulations governing rates, solvency, standards of business conduct, and various insurance and investment products. Licensing of insurers and their agents and the approval of policy forms are usually required. The form and content of statutory financial statements and the type and concentration of investments are also regulated. Each insurance subsidiary is required to file annual financial reports with supervisory agencies in most of the jurisdictions in which it does business, and its operations and accounts are subject to examination by such agencies at regular intervals. Most states and the District of Columbia require licensed insurance companies to support guaranty associations, which are organized to pay claims on behalf of insolvent insurance companies. These associations levy assessments on member insurers in a particular state to pay such claims on the basis of their proportionate shares of the lines of business of the insolvent insurer. Maximum assessments permitted by law in any one year generally range from 1% to 2% of annual premiums written by each member in a particular state with respect to the categories of business involved, and in some cases may be offset against premium taxes payable to the state. The assessments against CIGNA's subsidiaries were $28 million, $23 million and $32 million for 1993, 1992 and 1991, respectively, before giving effect to premium tax offsets. The amounts of future assessments are not expected to have a material adverse effect on CIGNA's financial condition. The increase in the number of insurance companies that are impaired or insolvent has prompted state and federal initiatives to enhance solvency regulation. For example, the NAIC has developed model solvency-related laws that it is encouraging states to adopt. In addition, effective for life insurance companies in 1993 and property and casualty companies in 1994, risk-based capital rules have been adopted that recommend a specified level of capital depending on the types and quality of investments held, the types of business written and the types of liabilities maintained. Depending on the ratio of the insurer's surplus to its risk-based capital, the insurer could be subject to various regulatory actions ranging from increased scrutiny to conservatorship. See page 15 of the MD&A section of CIGNA's 1993 Annual Report for additional information. Also, the NAIC is addressing risk-based capital guidelines for HMOs and a proposal that would limit the types and amounts of investment assets that an insurance company can hold. In the past, federal oversight of insurer solvency has also been proposed. Among proposals that have been discussed are optional federal chartering, which would preempt most state insurance regulations; minimum federal solvency standards, which would be supervised by the states; federal licensing of all reinsurers; and establishment of a national guaranty fund. Recent state and federal regulatory scrutiny of life insurers' sales and advertising tactics, including the adequacy of disclosure regarding products and their future performance, may result in increased regulations in this area. In December 1993, the U.S. Supreme Court issued the John Hancock Mutual Life Insurance Company v. Harris Trust decision, which held that certain funds held under a general account group annuity contract were subject to ERISA fiduciary standards. The Department of Labor is addressing compliance issues raised by the decision and, depending on the outcome, CIGNA may make future changes to its group annuity contracts or the operation of its general account. CIGNA's insurance subsidiaries are subject to state laws regulating insurers that are subsidiaries of insurance holding companies. Under such laws, which are generally becoming more stringent, certain dividends, distributions and other transactions between an insurance subsidiary and the holding company or its other subsidiaries may require notification to, or be subject to the approval of, one or more state insurance commissioners. Proposals to reform the United States health care system could change the way health care is financed and delivered. Such proposals are discussed on page 6. CIGNA's HMOs and mental health and substance abuse clinics are subject to regulation and supervision by various government agencies in the states in which they do business. The extent of regulation varies, but most jurisdictions regulate licensing, solvency, contracts and rates. Regulation of these entities may also include standards for quality assurance, minimum levels of benefits that must be offered and requirements for availability and continuity of care. A few states require HMOs to participate in guaranty funds, and several state legislatures have recently considered insolvency and guaranty fund legislation, a trend that is expected to continue. Regulatory concerns with insurance risk selection have increased significantly in recent years. For example, there is continuous legislative, regulatory and judicial activity regarding the use of gender in determining insurance benefits and rates. Also, some states have imposed restrictions on the use of underwriting criteria related to AIDS. Property and casualty insurers are required to participate in assigned risk plans, joint underwriting associations and other residual market mechanisms to write coverages on risks not acceptable under normal underwriting standards. In addition, states have responded to concerns about the availability and affordability of commercial casualty insurance by proposing or adopting legislation, regulations or positions to, among other things, limit rate increases, require rate reductions or refunds, restrict nonrenewal and cancellation with respect to commercial lines coverages or require the refunding of "excess" profits, and by expanding regulatory examination of the appropriateness of rates, non-renewals and cancellations. The extent of insurance regulation varies significantly among the countries in which CIGNA conducts its international operations. As a foreign insurer, CIGNA is, in many countries, faced with greater restrictions than domestic competitors. Trade barriers include discriminatory licensing procedures, compulsory cessions of reinsurance, required localization of records and funds, higher premium and income taxes, and requirements for local participation in an insurer's ownership. Where appropriate, CIGNA has incorporated insurance subsidiaries locally to improve its position. Depending upon their nature, CIGNA's investment management activities and products with United States contacts are subject to the federal securities laws, ERISA and other federal and state laws governing investment management activities and products. Investments made by United States insurance companies are subject to state insurance laws. Investment management activities and products outside the United States, and investments made by non-United States insurance companies outside the United States, are subject to local regulation. Often, the investments of individual insurance companies are subject to regulation by multiple jurisdictions. Federal initiatives can have an impact on the insurance business in a variety of ways. In addition to proposals discussed above related to Superfund, health care reform and federal oversight of insurer solvency, current and proposed federal measures that may significantly affect the insurance business include: (a) pension and other employee benefit regulation; (b) Social Security legislation; (c) financial services regulation; (d) amendment to the antitrust exemption provided for the business of insurance by the McCarran-Ferguson Act; and (e) tax legislation. The economic and competitive effects of the legislative and regulatory proposals discussed above would depend upon the final form such legislation or regulation might take. I. Miscellaneous Portions of CIGNA's insurance business are seasonal in nature. Reported claims under group health and certain property and casualty products are generally higher in the first quarter. Sales, particularly of individual life products, are generally lowest in the first quarter and highest in the fourth quarter. CIGNA and its principal subsidiaries are not dependent on business from one or a few customers. No customer accounted for 10% or more of CIGNA's consolidated revenues in 1993. CIGNA and its principal subsidiaries are not dependent on business from one or a few brokers or agents, except as noted on page 12 in connection with sales of certain corporate-owned life insurance. In addition, CIGNA's insurance businesses are generally not committed to accept a fixed portion of the business submitted by independent brokers and agents, and generally all such business is subject to its approval and acceptance. CIGNA had approximately 50,600, 52,300 and 56,000 employees as of December 31, 1993, 1992 and 1991, respectively. Item 2. Item 2. PROPERTIES CIGNA's headquarters are located in approximately 90,240 total square feet of leased office space at One Liberty Place, Philadelphia, Pennsylvania. CIGNA Property & Casualty, CIGNA Reinsurance -- Property & Casualty, CIGNA Group Insurance -- Life - Accident - Disability, and CIGNA International are located in a leased building of approximately 1.25 million total square feet at Two Liberty Place, Philadelphia. CIGNA HealthCare, CIGNA Individual Insurance, CIGNA Reinsurance -- Life - Accident - Health and CIGNA Investment Management are located in a complex of buildings owned by CIGNA, aggregating approximately 1.15 million total square feet of office space, located at 900-950 Cottage Grove Road, Bloomfield, Connecticut. CIGNA's Retirement & Investment Services operations are located in approximately 230,000 total square feet of leased office space at Metro Center One, Hartford, Connecticut. In addition, CIGNA owns or leases office buildings, or parts thereof, throughout the United States and in other countries. For additional information concerning leases and property, see Notes 1(H) and 15 to CIGNA's 1993 Consolidated Financial Statements, which are incorporated herein by reference from pages 35 and 46, respectively, of CIGNA's 1993 Annual Report. This paragraph does not include information on investment properties. CIGNA's information processing resources include large mainframe computers in major data centers, a multitude of personal computers connected through local area networks and a nationwide backbone network that provides desktop computing and office automation to CIGNA employees. CIGNA's policies regarding the safeguarding of critical corporate data are disseminated to all employees. The policies require data security through the use of appropriate identification and password practices and data backup through appropriate offsite storage techniques. Protection of CIGNA's major data centers, which house large amounts of critical corporate data, involves access controls, fire detection and suppression systems, and other hazard elimination processes. In addition, CIGNA maintains a formal disaster contingency plan, which includes recovery services in the event of a disaster in a CIGNA data center. Critical files are stored offsite, to be available for recovery in the event of a disaster. Item 3. Item 3. LEGAL PROCEEDINGS CIGNA is continuously involved in numerous lawsuits arising, for the most part, in the ordinary course of its business either as a liability insurer defending third-party claims brought against its insureds or as an insurer defending coverage claims brought against it by its policyholders or other insurers. During 1988, a number of state attorneys general and private plaintiffs filed lawsuits against a number of insurance companies and others, including CIGNA, alleging violations of federal and state antitrust laws. One of the lawsuits, filed in Texas, was settled in March 1991 for an insignificant amount. All of the remaining lawsuits were dismissed by the trial court in 1989. The United States Court of Appeals reversed the trial court and the United States Supreme Court reversed in part and modified in part the ruling of the Court of Appeals and remanded the cases to the Court of Appeals for further proceedings in accordance with its opinion. The Supreme Court ruled that the insurance companies did not forfeit their McCarran-Ferguson protection when they acted with reinsurers to produce acceptable policy terms and defined the boycott exception to the McCarran-Ferguson exemption in a manner favorable to the insurance industry. The cases are now in the trial court for further proceedings, having been remanded by the Court of Appeals. While the outcome of litigation involving CIGNA cannot be determined, such litigation (other than that related to asbestos, environmental pollution and other long-term exposure claims, which is discussed below), net of reserves and giving effect to reinsurance, is not expected to have a material effect on CIGNA. CIGNA is involved in lawsuits regarding policy coverage and judicial interpretation of legal liability for asbestos-related, environmental pollution and other long-term exposure claims. As discussed beginning on page 19, reserving for these claims is subject to significant uncertainties, such as lack of developed case law or adequate claim history. Future results of the Company are expected to continue to be affected adversely by losses and expenses for asbestos-related, environmental pollution and other long-term exposure claims. Because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved in the near future, CIGNA is unable to reasonably estimate the additional losses and expenses and therefore is unable to determine whether such amounts will be material to its future results of operations, liquidity or financial condition. 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 STOCKHOLDER MATTERS The information under the caption "Quarterly Financial Data--Stock and Dividend Data" on page 51 and under the caption "Stock Listing" on the inside back cover of CIGNA's 1993 Annual Report is incorporated by reference, as is the information from Note 7 to CIGNA's Consolidated Financial Statements on page 41 and the number of shareholders of record as of December 31, 1993 under the caption "Highlights" on page 1 of CIGNA's 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA The five-year financial information under the caption "Highlights" on page 1 of CIGNA's 1993 Annual Report is incorporated by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information on pages 14 through 29 of CIGNA's 1993 Annual Report is incorporated by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CIGNA's Consolidated Financial Statements on pages 30 through 49 and the report of its independent accountants on page 50 of CIGNA's 1993 Annual Report are incorporated by reference, as is the unaudited information set forth under the caption "Quarterly Financial Data--Consolidated Results" on page 51. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT A. Directors of the Registrant The information under the captions "Nominees for Election" and "Incumbent Directors to Continue in Office" on pages 5 through 7, and the information in the final paragraph under the caption "Certain Transactions" on page 9 of CIGNA's proxy statement dated March 21, 1994 are incorporated by reference. B. Executive Officers of the Registrant Reference is made below to CG Life and ICNA, which are indirect subsidiaries of CIGNA. All officers are elected to serve for a one-year term or until their successors are elected. Principal occupations and employment during the past five years are listed. LAWRENCE P. ENGLISH, 53, President of CIGNA HealthCare since March 1992; President of CIGNA's Individual Financial Services Division from April 1986 until March 1992; and President of CG Life from January 1991 until February 1992. H. EDWARD HANWAY, 42, President of CIGNA International beginning March 7, 1994; President of CIGNA International -- Property & Casualty from February 1989 until March 7, 1994; Senior Vice President of ICNA since February 1989; and Vice President of CIGNA with responsibility for Operational Planning and Business Control from December 1986 until February 1989. GERALD A. ISOM, 55, President of CIGNA Property and Casualty beginning March 1993. Group Vice President of Transamerica Corporation from 1990 until March 1993; and Chief Executive Officer and President of Transamerica Insurance Group from January 1985 until March 1993. Transamerica Insurance Group is a major provider of property and casualty insurance products. JOHN K. LEONARD, 45, President of CIGNA Group Insurance - Life-Accident-Disability since March 1992; and Senior Vice President of CIGNA from March 1989 until March 1992 (Vice President from December 1986 until March 1989) with responsibility for Corporate Marketing and Strategy. DONALD M. LEVINSON, 48, Executive Vice President of CIGNA since March 1988, with responsibility for Human Resources and Services. BYRON D. OLIVER, 51, President of CIGNA Retirement & Investment Services since February 1988. ARTHUR C. REEDS, III, 49, President of CIGNA Investment Management since March 1992; and Managing Director and Head of Portfolio Management, CIGNA's Investment Division, from May 1986 until March 1992. JAMES G. STEWART, 51, Executive Vice President and Chief Financial Officer of CIGNA since 1983. WILSON H. TAYLOR, 50, Chairman of CIGNA since November 1989; and Chief Executive Officer of CIGNA since November 1988 and President of CIGNA since May 1988. GEORGE R. TRUMBULL, 49, President of CIGNA Individual Insurance since March 1992; Executive Vice President of CIGNA from January 1988 until April 1992; President of CG Life since February 1992; and President of CIGNA's Investment Division from July 1988 until March 1992. THOMAS J. WAGNER, 54, Executive Vice President and General Counsel of CIGNA since January 1992; Corporate Secretary of CIGNA from January 1988 until April 1992; and Senior Vice President of CIGNA from January 1988 until January 1992. C. Compliance with Section 16(a) of the Securities Exchange Act The information under the caption "Compliance with Section 16(a) of the Securities Exchange Act" on page 18 of CIGNA's proxy statement dated March 21, 1994 is incorporated by reference. Item 11. Item 11. EXECUTIVE COMPENSATION The information under the captions "Executive Compensation" on pages 11 through 14 and "Compensation of Directors" on pages 8 and 9 of CIGNA's proxy statement dated March 21, 1994 is incorporated by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the captions "Ownership of CIGNA Corporation Common Stock by Directors and Executive Officers" on pages 2 and 3 and "Ownership of CIGNA Corporation Common Stock by Certain Beneficial Owners" on page 4 of CIGNA's proxy statement dated March 21, 1994, relating to security ownership of certain beneficial owners and management, is incorporated by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Certain Transactions" on page 9 of CIGNA's proxy statement dated March 21, 1994 is incorporated by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. (1) The following financial statements have been incorporated by reference from the pages indicated below of CIGNA's 1993 Annual Report: Consolidated Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991--page 30. Consolidated Balance Sheets as of December 31, 1993 and 1992--page 31. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991--page 32. Notes to Financial Statements--pages 33 through 49. Report of Independent Accountants, Price Waterhouse--page 50. (2) The financial statement schedules are listed in the Index to Financial Statement Schedules on page FS-1. (3) The exhibits are listed in the Index to Exhibits beginning on page E-1. B. During the last quarter of the fiscal year ended December 31, 1993, the registrant filed (1) a Report on Form 8-K dated December 21, 1993 regarding legal proceedings; (2) a Report on Form 8-K dated December 14, 1993 restating the registrant's 1992 Form 10-K financial information to reflect the effects of implementing SFAS 113; (3) a Report on Form 8-K dated November 19, 1993 regarding a revised rating by Standard & Poor's; and (4) a Report on Form 8-K dated November 1, 1993 containing a copy of a press release reporting its third quarter 1993 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 by its undersigned duly authorized officer, on its behalf and in the capacity indicated. 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 indicated on March 25, 1994. [THIS PAGE INTENTIONALLY LEFT BLANK] CIGNA CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules other than those listed above are omitted because they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto, which are incorporated by reference from CIGNA's 1993 Annual Report. FS-1 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of CIGNA Corporation Our audits of the consolidated financial statements referred to in our report dated February 14, 1994 appearing on page 50 of the 1993 Annual Report to Shareholders of CIGNA 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 the index on page FS-1 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. The Company implemented certain new accounting pronouncements as discussed in Note 1 to the consolidated financial statements. /S/ PRICE WATERHOUSE Philadelphia, Pennsylvania February 14, 1994 FS-2 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE I SUMMARY OF INVESTMENTS-- OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1993 (IN MILLIONS) - --------------- (1) Amount reflects an increase of approximately $1.6 billion related to the adoption of SFAS No. 115. See Note 1 of Notes to Financial Statements on page 33 of CIGNA's 1993 Annual Report. FS-3 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF CIGNA CORPORATION (REGISTRANT) STATEMENTS OF INCOME (IN MILLIONS) See Notes to Condensed Financial Statements on FS-7. FS-4 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF CIGNA CORPORATION (REGISTRANT) BALANCE SHEETS (IN MILLIONS) See Notes to Condensed Financial Statements on FS-7. FS-5 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF CIGNA CORPORATION (REGISTRANT) STATEMENT OF CASH FLOWS (IN MILLIONS) See Notes to Condensed Financial Statements on FS-7. FS-6 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF CIGNA CORPORATION (REGISTRANT) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto in the Annual Report. Note 1-- As of December 31, 1993, CIGNA implemented Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The effect of implementing SFAS No. 115 resulted in an increase in net assets and shareholders' equity of approximately $900 million resulting from the classification of certain fixed maturities previously classified as held to maturity (carried at amortized cost) to available for sale (carried at fair value). In the fourth quarter of 1992, CIGNA implemented SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions"; No. 109, "Accounting for Income Taxes"; and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." These accounting changes were implemented as of January 1, 1992 through cumulative effect adjustments. Prior year financial statements were not restated. The cumulative effect of implementing these accounting standards as of January 1, 1992 resulted in a non-cash after-tax charge to net income of $26 million. In addition, the implementation of these accounting standards decreased 1992 net income by $5 million. Note 2-- Long-term debt, net of current maturities, consists of CIGNA's 7.4% Notes, due 2003; 7.65% Notes, due 2023; 8% Notes, due 1996; 8.2% Convertible Subordinated Debentures, due 2010; 8 1/4% Notes, due 2007; 8.3% Notes due 2023; 8 3/4% Notes, due 2001; and Medium-term Notes with interest rates ranging from 5 3/4% to 10%, and original maturity dates from approximately two to ten years. Maturities of long-term debt for each of the next five years are as follows: 1994--$43 million; 1995--$2 million; 1996--$157 million; 1997--$39 million; 1998--$82 million. In 1993, CIGNA issued $100 million of unsecured 7.4% Notes due in 2003; $100 million of unsecured 7.65% Notes due in 2023; $100 million of unsecured 8.3% Notes due in 2023 and $27 million of medium-term notes. In 1992, CIGNA issued $100 million of unsecured 8 1/4% Notes due in 2007 and $11 million of medium-term notes. As of December 31, 1993, CIGNA had approximately $950 million remaining under effective shelf registration statements filed with the Securities and Exchange Commission that may be issued as debt and equity securities, depending upon market conditions and CIGNA's capital requirements. In January 1994, CIGNA issued $100 million of unsecured 6 3/8% Notes due in 2006 under one of the shelf registration statements. Interest paid on short-and long-term debt amounted to $95 million, $88 million and $84 million, for 1993, 1992 and 1991, respectively. Note 3-- CIGNA Corporation files a consolidated U.S. federal income tax return with its domestic subsidiaries. Net income taxes paid in connection with the consolidated return were $75 million, $287 million and $122 million during 1993, 1992 and 1991, respectively. FS-7 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE V SUPPLEMENTARY INSURANCE INFORMATION (IN MILLIONS) - ------------ (1) Amounts presented are shown net of the effects of reinsurance. (2) The allocation of net investment income is based upon the investment year method, the identification of certain portfolios with specific segments, or a combination of both. FS-8 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE V SUPPLEMENTARY INSURANCE INFORMATION (IN MILLIONS) - ------------ (1) Amounts presented are shown net of the effects of reinsurance. (2) The allocation of net investment income is based upon the investment year method, the identification of certain portfolios with specific segments, or a combination of both. FS-9 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE VI REINSURANCE (IN MILLIONS) FS-10 CIGNA CORPORATION SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN MILLIONS) - --------------- (1) Change in valuation reserves attributable to policyholder contracts. (2) Reflects transfer of reserves to other investment asset categories as well as charge-offs upon sales, repayments and other. (3) The Company adopted SFAS No. 109 effective January 1, 1992. FS-11 CIGNA CORPORATION SCHEDULE IX SHORT-TERM BORROWINGS (IN MILLIONS) - --------------- (1) Method of computation -- the sum of the daily amount outstanding for each day divided by the number of days in the year. (2) Method of computation -- the sum of the weighted average rate for each month times the sum of the daily amount outstanding during the month, divided by the sum of the daily amount outstanding during the year. FS-12 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE X SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS (IN MILLIONS) - --------------- (1) Discounts were computed using an annual interest rate of 9%. (2) Amounts presented are shown net of the effects of reinsurance. FS-13 CIGNA CORPORATION AND SUBSIDIARIES SCHEDULE X SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS (IN MILLIONS) - --------------- (1) Discounts were computed using an annual interest rate of 9%. (2) Amounts presented are shown net of the effects of reinsurance. FS-14 INDEX TO EXHIBITS - --------------- * Refiled in electronic format. E-1 INDEX TO EXHIBITS - --------------- * Refiled in electronic format. E-2 INDEX TO EXHIBITS The registrant will furnish to the Commission upon request a copy of any of the registrant's agreements with respect to its long-term debt. Shareholders may obtain copies of exhibits by writing to CIGNA Corporation, Shareholder Services Department, Two Liberty Place, 1601 Chestnut Street, P.O. Box 7716, Philadelphia, Pennsylvania 19192-2378. - --------------- * Refiled in electronic format. E-3

806031_1993.txt

806031_1993

1993

806031

Item 1. Business The principal objectives of Polaris Aircraft Income Fund III (PAIF-III or the Partnership) are to purchase and lease used commercial jet aircraft in order to provide quarterly distributions of cash from operations, to maximize the residual values of aircraft upon sale and to protect Partnership capital through experienced management and diversification. PAIF-III was organized as a California limited partnership on June 27, 1984 and will terminate no later than December 2020. PAIF-III has many competitors in the aircraft leasing market, including airlines, aircraft leasing companies, other limited partnerships, banks and several other types of financial institutions. This market is highly competitive and there is no single competitor who has a significant influence on the industry. In addition to other competitors, the general partner, Polaris Investment Management Corporation (PIMC), and its affiliates, including Polaris Aircraft Leasing Corporation (PALC), Polaris Holding Company and GE Capital Corporation (GE Capital), acquire, lease, finance and sell aircraft for their own accounts and for existing aircraft-leasing programs sponsored by them. Accordingly, in seeking to re-lease and sell its aircraft, the Partnership may be in competition with the general partner and its affiliates. A brief description of the aircraft owned by the Partnership is set forth in Item 2, on page 4. The following table describes the material terms of the Partnership's leases to Continental Airlines, Inc. (Continental) and Trans World Airlines, Inc. (TWA) as of December 31, 1993: Number Aircraft of Lease Renewal Lessee Type Aircraft Expiration Options Continental B727-200 3 4/94 (1) none B727-200A 5 10/96 (1) none TWA DC-9-30 13 2/98 (2) none (1) The Continental leases were modified in 1991; the leases for the Boeing 727-200 aircraft were extended for seven months beyond the initial lease expiration date in September 1993 at approximately 64% of the original lease rates. Continental may terminate the leases for these aircraft at the earlier of April 1994 or 60,000 cycles. The leases for the Boeing 727-200 Advanced aircraft were extended for 37 months beyond the initial lease expiration date in September 1993 at approximately 90% of the original lease rates. The Partnership also agreed to pay for certain aircraft maintenance, modification and refurbishment costs, not to exceed approximately $3.2 million, a portion of which will be recovered with interest through payments from Continental over the extended lease terms. (2) TWA may specify a lease expiration date for each aircraft up to six months before the date shown, provided the average date for the 13 aircraft is February 1998. The TWA leases were modified in 1991; the leases were extended for an aggregate of 75 months beyond the initial lease expiration date in November 1991 at approximately 46% of the original lease rates. The Partnership also agreed to share in the costs of certain Airworthiness Directives (ADs). If such costs are incurred by TWA, they will be credited against rental payments, subject to annual limitations with a maximum of $500,000 per aircraft over the lease terms. On January 31, 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code and subsequently emerged from bankruptcy protection in August 1993 as discussed further in Note 4 to the financial statements of the Partnership's 1993 Annual Report to the Securities and Exchange Commission on Form 10-K (Form 10 -K) (Item 8). The Partnership also owns 3 McDonnell Douglas DC-9-10 aircraft formerly leased to Midway Airlines, Inc. (Midway) which have been transferred to aircraft inventory and have been disassembled for sale of their component parts and six Boeing 727-100 aircraft formerly leased to Continental which have been transferred to aircraft inventory and are being remarketed for sale. Approximately 700 commercial aircraft are currently available for sale or lease. The current surplus has negatively affected market lease rates and fair market values of both new and used aircraft. Current depressed demand for air travel has limited airline expansion plans, with new aircraft orders and scheduled delivery being cancelled or substantially deferred. As profitability has declined, many airlines have opted to downsize, liquidate assets or file for bankruptcy protection. The Partnership has been forced to adjust its estimates of the residual values realizable from its aircraft and aircraft inventory, which resulted in an increase in depreciation expense in 1993, 1992 and 1991, as discussed in Note 3 to the financial statements of the Form 10-K (Item 8). A discussion of the current market condition for the type of aircraft owned by the Partnership follows: Boeing 727-100 The Boeing 727 was the first tri-jet introduced into commercial service. The Boeing 727-100 is a short to medium range jet carrying approximately 125 passengers on trips of up to 1,500 miles. The operating characteristics of the aircraft, as well as the cost of aging aircraft and corrosion control ADs, have significantly reduced the possibility of re-leasing this type of aircraft. Boeing 727-200 and Boeing 727-200 Advanced The Boeing 727 was the first tri-jet introduced into commercial service. The Boeing 727 is a short to medium range jet used for trips of up to 1,500 miles. The Boeing 727-200 aircraft was introduced in 1967 and 299 were built between 1967 and 1972. In 1972, Boeing introduced the Boeing 727-200 Advanced model, a higher gross weight version with increased fuel capacity. Noise suppression hardware, commonly known as a "hushkit," has been developed which, when installed on the aircraft, bring the Boeing 727-200 and the Boeing 727-200 Advanced into compliance with Federal Aviation Administration (FAA) Stage 3 noise limits. The cost of the hushkit is approximately $1.75 million for the Boeing 727-200 aircraft and approximately $2.5 million for the Boeing 727-200 Advanced aircraft. However, while technically feasible, hushkits may not be cost effective on all aircraft due to the age of some of the aircraft and the time required to fully amortize the additional investment. Certain ADs applicable to all models of the Boeing 727 have been issued to prevent fatigue cracks and control corrosion. Demand for Boeing 727-200 aircraft is currently very soft due to the general oversupply of narrowbody aircraft. McDonnell Douglas DC-9-10/30 The McDonnell Douglas DC-9-10, a short to medium range twin-engine jet, was introduced in 1965. The DC-9-30, which is a stretched version of the DC-9-10, was introduced in 1967. This model offered improved performance when carrying heavier loads. Over 970 DC-9 aircraft were produced and there are approximately 56 operators worldwide. Providing reliable, inexpensive lift, these aircraft fill thin niche markets, mostly in the United States. Hushkits costing approximately $1.6 million are available to bring these aircraft into compliance with Stage 3 requirements. The market for this type of aircraft, as for all Stage 2 narrowbody aircraft, is currently soft. It is expected that the FAA will continue to propose and adopt ADs similar to those discussed above for the Boeing 727s, which will require modifications at some point in the future to prevent fatigue cracks and control corrosion. Likewise demand, and hence value, of the aircraft is expected to continue to diminish to the extent that the costs of bringing DC-9 aircraft into compliance with any ADs reduces the economic efficiency of operating these aircraft. The general partner believes that the current soft market reflects, in addition to the factors cited above, the airline industry's reaction to the significant expenditures potentially necessary to bring these aircraft into compliance with certain ADs issued by the FAA relating to aging aircraft, corrosion prevention and control and structural inspection and modification. Item 2. Item 2. Properties PAIF-III owns a portfolio of 27 commercial jet aircraft out of its original portfolio of 38 aircraft. The portfolio includes 13 McDonnell Douglas DC-9-30 aircraft leased to TWA and eight Boeing 727 (Series 200 and 200 Advanced) aircraft leased to Continental. All leases are operating leases. The Partnership also owns 3 McDonnell Douglas DC-9-10 aircraft formerly leased to Midway which were transferred to aircraft inventory and have been disassembled for sale of their component parts and six Boeing 727-100 aircraft formerly leased to Continental which are being remarketed for sale. The following table describes the Partnership's aircraft portfolio in greater detail: Cycles Year of As of 10/31/93 Aircraft Type Serial Number Manufacture (1) Boeing 727-100 18329 1965 47,689 Boeing 727-100 18331 1965 47,626 Boeing 727-100 18848 1965 47,200 Boeing 727-100 18852 1965 46,960 Boeing 727-100 18854 1965 45,877 Boeing 727-100 18860 1965 45,772 Boeing 727-200 19804 1968 56,817 Boeing 727-200 20243 1969 54,558 Boeing 727-200 20384 1970 53,515 Boeing 727-200A 21247 1976 28,909 Boeing 727-200A 21248 1976 28,505 Boeing 727-200A 21249 1976 28,343 Boeing 727-200A 21363 1977 26,971 Boeing 727-200A 21366 1977 26,770 McDonnell Douglas DC-9-10 45737 1966 (2) McDonnell Douglas DC-9-10 45741 1966 (2) McDonnell Douglas DC-9-10 45779 1967 (2) McDonnell Douglas DC-9-30 47028 1967 76,411 McDonnell Douglas DC-9-30 47029 1967 75,497 McDonnell Douglas DC-9-30 47030 1967 75,602 McDonnell Douglas DC-9-30 47095 1967 71,249 McDonnell Douglas DC-9-30 47109 1968 74,369 McDonnell Douglas DC-9-30 47134 1967 70,639 McDonnell Douglas DC-9-30 47136 1968 70,826 McDonnell Douglas DC-9-30 47172 1968 71,660 McDonnell Douglas DC-9-30 47173 1968 74,595 McDonnell Douglas DC-9-30 47248 1968 78,219 McDonnell Douglas DC-9-30 47250 1968 75,803 McDonnell Douglas DC-9-30 47344 1969 72,367 McDonnell Douglas DC-9-30 47491 1970 67,761 (1) Cycle information as of 12/31/93 is not yet available. (2) Aircraft disassembled for sale of component parts. Item 3. Item 3. Legal Proceedings Continental - On August 23, 1991, the court overseeing Continental's bankruptcy case approved the negotiated agreement reached by Continental and the Partnership as discussed in Note 6 to the financial statements of the Form 10-K (Item 8). Continental emerged from bankruptcy under a plan of reorganization approved by the Bankruptcy Court effective April 28, 1993. The Bankruptcy Court retains jurisdiction over Continental for the purpose of approving the terms of a stipulated settlement in which Continental would continue to operate certain of the Partnership's aircraft under lease. Midway As discussed in the Partnership's 1991 Form 10-K, the Partnership had previously filed a proof of claim in the Midway bankruptcy proceeding to recover damages for lost rent and for Midway's failure to meet return conditions with respect to four of the Partnership's aircraft. In light of Midway's cessation of operations, on April 30, 1992, the Partnership amended and restated its prior proof of claim and filed an additional proof. To date no action has been taken to pay or settle the Partnership's bankruptcy claims. TWA Bankruptcy TWA submitted a plan of reorganization which has been approved by the Bankruptcy Court and became effective November 3, 1993. TWA has affirmed all of the Partnership's aircraft leases. Prudential Securities Incorporated (Prudential) Settlement - On October 21, 1993, the U.S. Securities and Exchange Commission announced a settlement with Prudential of an administrative proceeding alleging violations of the anti-fraud provisions of the federal securities laws. It is our understanding that, in connection with this settlement, Prudential has agreed to establish certain claim resolution procedures and expedited arbitration procedures for persons with claims against Prudential arising from their purchase of various limited partnership interests through Prudential. Information regarding the Prudential settlement and claims procedures may be obtained by calling toll-free 1-800-774- 0700. Other Proceedings - Item 10 discusses certain actions which have been filed against the general partner in connection with certain public offerings, including that of the Partnership. With the exception of Novak, et al v. Polaris Holding Company, et al, where the registrant is named as a nominal defendant, the registrant is not a party to these actions. 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 a) PAIF-III's units representing assignments of limited partnership interest (Units) are not publicly traded. The Units are held by Polaris Depositary III on behalf of the Partnership's investors (Unit Holders). Currently there is no market for PAIF-III's Units and it is unlikely that any market will develop. b) Number of Security Holders: Number of Record Holders Title of Class as of December 31, 1993 Limited Partnership Interest: 18,139 General Partnership Interest: 1 c) Dividends: The Partnership distributed cash to partners on a quarterly basis beginning April 1987. Cash distributions to Unit Holders totalled $12,500,000, or $25.00 per limited partnership unit, and $10,000,000, or $20.00 per unit, in 1993 and 1992, respectively. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Polaris Aircraft Income Fund III (the Partnership) owns a portfolio of 27 commercial jet aircraft out of its original portfolio of 38 aircraft. The portfolio includes 13 McDonnell Douglas DC-9-30 aircraft leased to Trans World Airlines, Inc. (TWA) and eight Boeing 727 (series 200 and 200 Advanced) aircraft leased to Continental Airlines, Inc. (Continental). The Partnership also owns six Boeing 727-100 aircraft formerly leased to Continental which have been transferred to aircraft inventory and are being remarketed for sale. Three McDonnell Douglas DC-9-10 aircraft formerly leased to Midway Airlines, Inc. (Midway) have been transferred to aircraft inventory and disassembled for sale of their component parts. The Partnership sold one former Continental DC-9-10 aircraft in December 1992, one former Midway DC-9-10 aircraft in January 1993, the former Aero California S.A. de C.V. (Aero California) DC-9-10 aircraft in September 1993 and five of the former Continental DC-9-10 aircraft at varying dates in 1993. Partnership Operations For the year ended December 31, 1993, the Partnership recorded net income of $2,707,789, or $2.86 per limited partnership unit, a significant improvement over net losses of $4,800,779 and $20,128,461, or $11.51 and $42.48 per limited partnership unit, for the years ended December 31, 1992 and 1991 respectively. The losses in 1992 and 1991 resulted primarily from adjustments to depreciation expense for declines in estimated future values of aircraft and aircraft inventory, as discussed in the Industry Update section. Depreciation adjustments for 1992 and 1991 were approximately $10.1 million and $19.0 million, respectively, compared to approximately $825,000 in 1993. Rental revenues, net of related management fees, were higher during 1993 in comparison to the previous two years. Continental began making deferred rent payments in July 1992 on rents deferred and not previously recognized as revenue in 1990 and 1991. Continental also began making deferred rent payments in October 1993 on rents deferred and not previously recognized in 1992. The increase in rent due primarily to the commencement of rent payments by Continental on previously deferred rent was partially offset by lower TWA rental rates (1992 revenues included two months at the higher pre-bankruptcy rates, whereas all rent from TWA in 1993 is at the lower renegotiated rates) and the absence of rental revenue from the Aero California lease. Interest income also increased for 1993 as additional interest was earned on the rent deferral and modification advances with Continental. Revenues for 1993 include the gain on the sale of two aircraft totalling $233,387 as discussed below and income from a forfeited deposit of $25,000. Partially offsetting the higher revenues for 1993 were increased operating expenses incurred in the remarketing of off-lease aircraft and disassembling of the former Midway aircraft as discussed below. During the off-lease period, the Partnership bears the operating costs of all routine expenses associated with the aircraft, including storage, insurance and maintenance. When the aircraft are on lease, the lessee bears these costs. Liquidity and Cash Distributions As discussed in the Industry Update section, the airline industry in general is facing tremendous economic adversities which have impacted all of the Partnership's lessees. In order to keep the Partnership's aircraft on lease and generating revenue, the Partnership has entered into leases with lower rental rates on all its aircraft, with the exception of those aircraft that were previously off-lease and later sold. Liquidity The Partnership has received all lease payments due from TWA and Continental under the respective modified agreements. In addition, Aero California has made all payments due on the financed sale of the DC-9-10 aircraft as discussed below. The agreement with Continental stipulates that the Partnership pay for the costs of certain maintenance work, Airworthiness Directive (AD) compliance, aircraft modification and refurbishment costs, which are not to exceed approximately $3.2 million, a portion of which will be recovered with interest through payments from Continental over the extended lease terms. In accordance with the cost sharing agreement, the Partnership financed $165,937 for new image modifications during 1993. The Partnership's balance sheets, in the financial statements of the Form 10-K (Item 8), reflect as notes receivable such reimbursable costs financed through December 31, 1993. The Partnership will use a portion of its cash reserves of approximately $25.6 million as of December 31, 1993 to finance additional costs to Continental. Cash Distributions Distributions of cash available from operations commenced in the second quarter of 1987. Cash distributions to Limited Partners totalled $12,500,000, $10,000,000, and $13,125,000 in 1993, 1992 and 1991, respectively. Cash distributions per limited partnership unit totalled $25.00, $20.00 and $26.25 in 1993, 1992 and 1991, respectively. The amount of future cash distributions will depend on the Partnership's future cash requirements, continued receipt of the renegotiated rental payments from Continental and TWA, proceeds from the sale of parts from the Partnership disassembled aircraft and the general partner's success in selling the six Boeing 727-100 aircraft formerly on lease to Continental and the three Boeing 727-200 aircraft scheduled to be returned from lease with Continental in April 1994. TWA Lease Modification During 1991, TWA defaulted under its leases with the Partnership when it failed to pay its lease payments due on March 5, 1991. On March 28, 1991, TWA and the Partnership entered into lease amendments which specified (i) renegotiated lease rates equal to approximately 71% of the original rates; (ii) payment of the March and April lease payments at the renegotiated rates on March 27, 1991; and (iii) an advance lump sum payment on March 29, 1991 representing the present value of the remaining lease payments due through the end of the leases in November 1991 at the renegotiated rate. The Partnership recorded the lump sum payment from TWA as deferred income, and recognized the rental revenue as it was earned over the lease term. The Partnership also recognized interest expense equal to the difference between the cash received and the rental revenue earned over the lease term. In December 1991, the leases for all 13 aircraft were amended further to extend the terms to February 1998, at approximately 46% of the initial lease rates. In addition, the Partnership agreed to share in the costs of certain ADs. If such costs are incurred by TWA, they will be credited against rental due to the Partnership, subject to annual limitations with a maximum of $500,000 per aircraft over the term of the leases. In January 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. TWA has made all payments due under the leases. TWA received court approval to emerge from bankruptcy protection effective November 3, 1993. TWA notified the partnership of its intention to affirm its leases for all 13 DC-9 aircraft. In addition, while the court had originally granted TWA an additional 90-day period subsequent to its emergence from bankruptcy during which it could exercise its right to reject the Partnerships's leases, TWA has elected to waive that right with respect to the Partnership's aircraft. As previously agreed with TWA, August and September 1993 rentals were drawn from a security deposit held by the Partnership, which had been posted for this purpose by TWA prior to its bankruptcy filing. In accordance with the cost sharing arrangement described above, in 1993, TWA submitted to the Partnership invoices for expenses paid to date by TWA to meet the ADs. These expenses were offset against rental payments totalling $1.95 million that were due the Partnership in 1993. TWA may offset rental payments up to an additional $4.55 million subject to limitations over the lease term. Midway Bankruptcy In March 1991, Midway commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. In August 1991, the Bankruptcy Court approved Midway's proposal to discontinue use of the Partnership's aircraft, and the aircraft were subsequently returned to the Partnership. The aircraft were not in compliance with the return conditions specified under the lease. The general partner has retained counsel on behalf of the Partnership to pursue all legal remedies available to protect the interests of the limited partners. Although Midway remains liable for expenses for which it was responsible under its lease, including the costs of complying with return conditions, the Partnership is unlikely to recover material damages resulting from Midway's failure to meet its obligations under the leases, as Midway's bankruptcy estate is minimal. The Partnership sold one of these aircraft in January 1993 and has disassembled the remaining three aircraft for sale of their component parts as discussed later. Continental Lease Modification As discussed in the Partnership's Form 10-K for the year ended December 31, 1990, Continental filed for Chapter 11 bankruptcy protection in December 1990. Continental terminated the leases on the six 727-100s and has returned these aircraft to the Partnership. The leases for the seven McDonnell Douglas DC-9-10 aircraft expired from April through June 1991. During the off-lease period, the Partnership bears the cost of all operating expenses associated with the aircraft including storage, insurance, maintenance and remarketing costs. Continental will be entitled, under certain circumstances related to a possible future substantial downsizing by Continental, which is not currently anticipated, to reject the remaining existing leases. The terms of the modified agreement are described below. For the Partnership's Boeing aircraft, the agreement approved by the Bankruptcy Court in 1991 specifies (i) extension of the leases for the three 727-200s to the earlier of April 1994 or 60,000 cycles, and for the five 727-200 Advanced aircraft to October 1996; (ii) renegotiated rental rates averaging approximately 73% of the original lease rates; (iii) payment of ongoing rentals at the reduced rates beginning in October 1991; (iv) payment of deferred rentals with interest beginning in July 1992; and (v) payment by the Partnership of certain aircraft maintenance, modification and refurbishment costs, expected not to exceed approximately $3.2 million, a portion of which will be recovered with interest through payments from Continental over the extended lease terms. The Partnership's balance sheets reflect the net reimbursable costs incurred of $456,308 and $413,832 as of December 31, 1993 and 1992, respectively, as notes receivable. The Partnership's share of such costs will be capitalized and depreciated over the remaining lease term. The Partnership recognized rent receivable from Continental of $1,511,750 in its financial statements for the year ended December 31, 1990. As a result of the terms of the above agreement, which included an extended deferral of the dates when Continental will remit its rental payments for the period from December 3, 1990 through September 30, 1991 (the Deferred Amount), the Partnership has not recognized the Deferred Amount as rental revenue until it is received, or until the contingencies regarding collectability are removed. Accordingly, the rent receivable recognized at December 31, 1990 was reversed during the first quarter of 1991. The unrecognized Deferred Amounts as of December 31, 1993 and 1992 were $4,148,922 and $6,862,417, respectively. In accordance with the aforementioned agreement, Continental began making supplemental payments for accrued unpaid rent plus interest on July 1, 1992. During 1993 and 1992, the Partnership received supplemental payments of $3,946,788 and $1,973,394, of which $2,713,495 and $1,202,583 was recognized as rental income in 1993 and 1992, respectively. Additional Continental Deferral Agreement As part of its reorganization plan, Continental requested additional concessions from its aircraft lessors. As a result, the Partnership and Continental reached an agreement to defer rental payments for a period of three months, beginning in November 1992, for a total of $1,852,500 (Additional Deferred Amount), with repayment over the shorter of three and one-half years or the remaining lease term. Repayment with interest began October 1, 1993. The unrecognized Additional Deferred Amount as of December 31, 1993 was $1,733,100. During 1993, the Partnership received supplemental payments of $162,819, of which $119,400 was recognized as rental income in 1993. Continental continues to pay all other amounts due under the prior agreement. The Partnership's rights to receive payments under the agreements fall into various categories of priority under the Bankruptcy Code. In general, the Partnership's claims are administrative claims, with the exception of certain deferred amounts. If Continental's reorganization is not successful, it is likely that a portion of the Partnership's claims will not be paid in full. Disassembly of Aircraft In an attempt to maximize the economic return from three of the four aircraft formerly leased to Midway (the fourth aircraft was sold in 1993 as discussed below), the Partnership entered into an agreement with Soundair, Inc. (Soundair) in 1992 for the disassembly and sale of these aircraft. It is anticipated that the disassembly and sales process will take at least three years. The Partnership has borne the cost of disassembly of approximately $50,000 per aircraft, and will receive the proceeds from the sale of such parts net of commission paid to Soundair. During 1993, the Partnership paid $141,630 for aircraft disassembly costs and received net proceeds from the sale of aircraft inventory of $593,923. These aircraft have been recorded as aircraft inventory in the Partnership's balance sheet as of December 31, 1992. Upon transferring the aircraft to inventory, the Partnership recorded downward adjustments of $1,050,000. During 1993, the Partnership recorded additional downward adjustments of $801,590 to reflect the current estimate of net realizable aircraft inventory value. These adjustments are included in depreciation expense in the statement of operations in the Form 10-K (Item 8). Aircraft Sale to Lear 25, Inc. (Lear 25) In December 1992, the Partnership reached an agreement with Lear 25 for the installment sale of one of the ex-Continental DC-9-10 aircraft which had been off lease since it was returned to the Partnership in early 1991. Under the terms of the sale, Lear 25 made a non-refundable $200,000 down payment and paid the remaining $825,000 in March 1993. The total proceeds of $1,025,000 are approximately 26% of the original acquisition price. The Partnership recorded a $1,000 loss on the sale in 1992. Lear 25 is the owner of several charter operators (passenger and freight) based in Las Vegas, Nevada. Aircraft Sale to Target Airways, Ltd. (Target) One ex-Midway DC-9-10 aircraft was sold to Target for $925,000 in January 1993, which resulted in a gain on sale of $146,500. This aircraft was recorded in aircraft inventory as of December 31, 1992. Aircraft Sale to Aero California In January 1993, the Partnership agreed to sell to Aero California the DC-9-10 aircraft it was leasing. The Partnership applied the existing security deposit and maintenance reserves toward the purchase price of approximately $1.1 million, and the remainder was paid in monthly installments through September 1993, when title was transferred to Aero California. The Partnership recognized a gain of $86,887 on the sale. Aircraft Sale to Intercontinental De Aviacion, S.A. (Intercontinental) In March 1993, the Partnership agreed to sell to Intercontinental five of the six DC-9-10 aircraft formerly on lease to Continental, which had been off-lease since they were returned to the Partnership in early 1991. Two aircraft were sold in March 1993, a third aircraft was sold in April 1993, a fourth aircraft was sold in June 1993, and a fifth aircraft was sold in October 1993 for total proceeds of $3.4 million for the five aircraft. The Partnership recorded no gain or loss on the sales, as the aircraft sales values equalled book values. Hushkit Options On August 30, 1990, the Partnership acquired options to purchase up to nine hushkits for Boeing 727 aircraft from Federal Express Corporation (Federal Express). The Partnership's deposit of $90,000 was refunded with interest of $6,587 in 1992, as the Partnership elected not to exercise these options. Reconciliation of Book Income to Taxable Loss The following is a reconciliation between net income per limited partnership unit reflected in the financial statements of the Form 10-K (Item 8) and information provided to unit holders for federal income tax purposes: The differences between the net income for book purposes and net loss for tax purposes result from the timing differences of certain income and deductions. The Partnership computes depreciation using the straight line method for financial reporting and tax purposes; however, the aircraft are depreciated using a shorter life for tax purposes. Thus, the current year tax depreciation expense is greater than the book depreciation expense and provides unit holders with the benefit of deferring taxation on a portion of their cash distributions. The Partnership also periodically evaluates the ultimate recoverability of the carrying values and the economic lives of its aircraft for book purposes and, accordingly, recognized adjustments which increased depreciation expense. The adjustments also resulted in a larger tax loss on the aircraft sale than for book. Certain aircraft have been disassembled and held in inventory until their component parts can be sold. A net tax loss resulted from the sale of these component parts along with a writedown of aircraft to tax basis inventory value. For book purposes, such assets are reflected at estimated net realizable value. Certain costs were capitalized for tax purposes and expensed for book purposes. In addition, there are differences between the recognition of certain deferred rental income for book and tax. As previously discussed, one of the Partnership's lessees, Continental, filed for Chapter 11 bankruptcy protection. The Partnership and Continental subsequently reached agreement as to the payment of deferred and future rentals. The original deferred rentals were converted into promissory notes bearing interest at a 12% rate, to be repaid by Continental over periods of up to 52 months beginning in July 1992. The additional deferred rentals were converted to notes under a similar agreement. For book purposes, the Partnership will not recognize any of these deferred rentals, or the related interest, as income, nor will it accrue management fee expense on such rentals, until the amounts due are received from Continental. However, for tax purposes, these amounts have been accrued over the period in which they were earned. Industry Update Maintenance of Aging Aircraft The process of aircraft maintenance begins at the aircraft design stage. For aircraft operating under Federal Aviation Administration (FAA) regulations, a review board consisting of representatives of the manufacturer, FAA representatives and operating airline representatives is responsible for specifying the aircraft's initial maintenance program. This program is constantly reviewed and modified throughout the aircraft's operational life. Since 1988, the FAA, working with the aircraft manufacturers and operators, has issued a series of ADs which mandate that operators conduct more intensive inspections, primarily of the aircraft fuselages. The results of these mandatory inspections may uncover the need for repairs or structural modifications that may not have been required under existing maintenance programs. In addition, an AD adopted in 1990 requires replacement or modification of certain structural items on a specific timetable. These structural items were formerly subject to periodic inspection, with replacement when necessary. The FAA estimates the cost of compliance with this AD to be approximately $1.0 million per Boeing 727 aircraft, if none of the required work had been done previously. In general, the new maintenance requirements must be completed by the later of March 1994, or 60,000 cycles for each Boeing 727. A similar AD was adopted on September 24, 1990, applicable to McDonnell Douglas aircraft. The AD requires specific work to be performed at various cycle thresholds between 50,000 and 100,000 cycles, and on specific date or age thresholds. The estimated cost of compliance with all of the components of this AD is $1.0 million per aircraft. The Partnership's existing leases require the lessees to maintain the Partnership's aircraft in accordance with an FAA-approved maintenance program during the lease term. At the end of the leases, each lessee is generally required to return the aircraft in airworthy condition, including compliance with all ADs for which action is mandated by the FAA during the lease term, except for certain instances. In negotiating subsequent leases, market conditions generally require that the Partnership bear some or all of the costs of compliance with future ADs or ADs that have been issued, but which did not require action during the previous lease term. The ultimate effect on the Partnership of compliance with the FAA maintenance standards is not determinable at this time and will depend on a variety of factors, including the state of the commercial aircraft market, the timing of the issuance of ADs, and the status of compliance therewith at the expiration of the current leases. Aircraft Noise Another issue which has affected the airline industry is that of aircraft noise levels. The FAA has categorized aircraft according to their noise levels. Stage 1 aircraft, which have the highest noise level, are, with few exceptions, no longer allowed to operate from civil airports in the United States. Stage 2 aircraft meet current FAA requirements. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all new aircraft. On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2 aircraft by the end of this decade. The current U.S. fleet is comprised of approximately 51% Stage 3 aircraft and 49% Stage 2 aircraft. The key features of the rule include: Compliance can be accomplished through a gradual process of phase-in or phase-out (see below) on each of three interim compliance dates: December 31, 1994, 1996 and 1998 (with waivers available in certain specific cases to December 31, 2003). All operators have the option of achieving compliance through a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25% of its Stage 2 fleet on each of the compliance dates noted above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%, 65% and 75% of an operator's fleet must consist of Stage 3 aircraft by the respective compliance dates noted above). Carryforward credits will be awarded to operators for early additions of Stage 3 aircraft to their fleets. These credits may be used to reduce either the number of Stage 2 aircraft it must phase-out or the number of Stage 3 aircraft it must phase-in by the next interim compliance date. The credits must be used by that operator, however, and cannot be transferred or sold to another operator. The federal rule does not prohibit local airports from issuing more stringent phase-out rules. In fact, several local airports have adopted more stringent noise requirements which restrict the operation of Stage 2 and certain Stage 3 aircraft. Other countries have also adopted noise policies. The European Economic Community (EEC) adopted a non-addition rule in 1989, which directed each member country to pass the necessary legislation to prohibit airlines from adding Stage 2 aircraft to their fleets after November 1, 1990. The rule has specific exceptions for leased aircraft and does allow the continued use of Stage 2 aircraft which were in operation before November 1, 1990, although adoption of rules requiring the eventual phase-out of Stage 2 aircraft is anticipated. The Partnership's entire fleet consists of Stage 2 aircraft. Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3 requirements, are currently available for the Partnership's aircraft. However, while technically feasible, hushkits may not be cost effective on all models due to increasing maintenance and operation costs. The general partner will evaluate, as appropriate, the potential benefits of hushkitting some or all of the Partnership's aircraft. It is unlikely, however, that the Partnership will incur such costs unless they can be recovered through a lease. Implementation of the Stage 3 standards have adversely affected the value of Stage 2 aircraft, as these aircraft will require eventual modification to be operated in the U.S. or other countries with Stage 3 standards. Demand for Aircraft Approximately 700 commercial aircraft are currently available for sale or lease. The current surplus has negatively affected market lease rates and fair market values of both new and used aircraft. Current depressed demand for air travel has limited airline expansion plans, with new aircraft orders and scheduled delivery being cancelled or substantially deferred. As profitability has declined, many airlines have opted to downsize, liquidate assets, or file for bankruptcy protection. Effects on the Partnership's Aircraft The Partnership has made downward adjustments to its estimates of aircraft value for certain of its on-lease aircraft. To ensure that the carrying value of each asset equals its estimated residual value at the end of its expected holding period, where appropriate the Partnership has increased depreciation expense. The Partnership also made downward adjustments to the carrying values of certain of its off-lease aircraft and aircraft inventory where depreciated cost exceeded the estimated net realizable value. During 1993, 1992 and 1991, the Partnership recognized downward adjustments totalling approximately $825,000, $10.1 million and $19.0 million, respectively, for certain of its aircraft and, with respect to 1993, the adjustment also included aircraft inventory. These adjustments are included in depreciation expense in the statement of operations. The Partnership's leases expire between April 1994 and February 1998. Current market studies indicate that the Partnership's non-advanced Boeing and McDonnell Douglas aircraft continue to be significantly affected by industry events. Therefore, the Partnership will evaluate each aircraft as it comes off lease to determine whether a re-lease or a sale at the then current market rates would be most beneficial for unit holders. Other Event Effective October 18, 1993, James F. Walsh resigned as Senior Vice President and Chief Financial Officer of Polaris Investment Management Corporation to assume new responsibilities at GE Capital Corporation. Bobbe V. Sabella has assumed the position of Vice President and Chief Financial Officer. Ms. Sabella has served the general partner in various capacities since September 1986, most recently as Vice President-Finance of Polaris Investment Management Corporation. Item 8. Item 8. Financial Statements and Supplementary Data POLARIS AIRCRAFT INCOME FUND III (A California Limited Partnership) FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 AND 1992 TOGETHER WITH AUDITORS' REPORT REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Polaris Aircraft Income Fund III: We have audited the accompanying balance sheets of Polaris Aircraft Income Fund III (a California Limited Partnership) as of December 31, 1993 and 1992, and the related statements of operations, changes in partners' capital (deficit) and cash flows for each of the three years ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the general partner. 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 the general partner, 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 Polaris Aircraft Income Fund III 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to the 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. ARTHUR ANDERSEN & CO. San Francisco, California, January 21, 1994 [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. [FN] The accompanying notes are an integral part of these statements. POLARIS AIRCRAFT INCOME FUND III (A California Limited Partnership) NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 1. Accounting Principles and Policies Accounting Method Polaris Aircraft Income Fund III (PAIF-III or the Partnership), a California Limited Partnership, maintains its accounting records, prepares financial statements and files its tax returns on the accrual basis of accounting. Aircraft and Depreciation The aircraft are recorded at cost, which includes acquisition costs. Depreciation to an estimated salvage value is computed using the straight-line method over the estimated economic life of the aircraft which was originally estimated to be 30 years from the date of manufacture. Depreciation in the year of acquisition is calculated based upon the number of days that the aircraft are in service. The Partnership periodically reviews the estimated realizability of the residual values at the end of each aircraft's economic life. For any downward adjustment in estimated residual, or change in the estimated remaining economic life, the depreciation expense over the remaining life of the aircraft is increased. If the expected net income generated from the lease (rental revenue, net of management fees, less adjusted depreciation and an allocation of estimated administrative expense) results in a net loss, that loss will be recognized currently. Off-lease aircraft are carried at the lower of depreciated cost or estimated net realizable value. A further adjustment is made for those aircraft, if any, that require substantial maintenance work. Capitalized Costs Aircraft modification and maintenance costs which are determined to increase the value or extend the useful life of the aircraft are capitalized and amortized using the straight-line method over the appropriate period. These costs are also subject to the periodic evaluation discussed above. Aircraft Inventory Aircraft held in inventory for sale are reflected at the lower of depreciated cost or estimated net realizable value. Proceeds from sales are applied against inventory until book value is fully recovered. Operating Leases The aircraft leases are accounted for as operating leases. Lease revenues are recognized in equal installments over the terms of the leases. Other Assets Lease acquisition costs are capitalized as other assets and amortized using the straight-line method over the term of the lease. Income Taxes The Partnership files federal and state information income tax returns only. Taxable income or loss is reportable by the individual partners. Net Income (Loss) Per Limited Partnership Unit Net income (loss) per limited partnership unit is based on the limited partners' share of net income or loss and the number of units outstanding for the years ended December 31, 1993, 1992 and 1991. Short-Term Investments The Partnership classifies all liquid investments with original maturities of three months or less as short-term investments. Operating Expenses Operating expenses include costs incurred to maintain, insure and lease the Partnership's aircraft, including costs related to lessee defaults and costs of disassembling aircraft inventory. 2. Organization and the Partnership The Partnership was formed on June 27, 1984 for the purpose of acquiring and leasing aircraft. The Partnership will terminate no later than December 2020. Upon organization, both the general partner and the depositary contributed $500 to capital. The Partnership recognized no profits and losses during the periods ended December 31, 1984 and 1985. The offering of depositary units (Units), representing assignments of limited partnership interest, terminated on September 30, 1987 at which time the Partnership had sold 500,000 Units of $500, representing $250,000,000. All unit holders were admitted to the Partnership on or before September 30, 1987. Polaris Investment Management Corporation (PIMC), the sole general partner of the Partnership, supervises the day-to-day operations of the Partnership. Polaris Depositary Company III (PDC) serves as the depositary. PIMC and PDC are wholly owned subsidiaries of Polaris Aircraft Leasing Corporation (PALC). Polaris Holding Company (PHC) is the parent company of PALC. GE Capital Corporation (GE Capital), an affiliate of General Electric Company, owns 100% of PHC's outstanding common stock. Allocations to affiliates are described in Note 10. 3. Aircraft The Partnership originally owned a portfolio of 38 used commercial jet aircraft, which were acquired, leased and sold as discussed below. All aircraft were acquired from an affiliate and purchased within one year of the affiliate's acquisition at the affiliate's original price paid. The aircraft leases are generally net leases, requiring the lessees to pay all operating expenses associated with the aircraft during the lease term including Airworthiness Directives (ADs) which have been or may be issued by the Federal Aviation Administration (FAA) and require compliance during the lease term. The leases generally state a minimum acceptable return condition for which the lessee is liable under the terms of the lease agreement. Certain leases also provide that if the aircraft are returned at a level above the minimum acceptable level, the Partnership must reimburse the lessee for the related excess, subject to certain limitations. The related liability, if any, is currently inestimable and therefore is not reflected in the financial statements. Of its original portfolio of 38 aircraft, the Partnership sold one aircraft in December 1992, and another seven aircraft in 1993, as discussed in Note 8. Thirteen McDonnell Douglas DC-9-30s These aircraft were acquired for $86,163,046 during 1986 and 1987, and leased to Ozark Air Lines, Inc. (Ozark). In 1987, Trans World Airlines, Inc. (TWA) merged with Ozark and assumed the leases. The leases were modified and extended prior to TWA's bankruptcy filing as discussed in Note 4. Four McDonnell Douglas DC-9-10s These aircraft were acquired for $15,768,766 in 1987 and leased to Midway Airlines, Inc. (Midway). Midway defaulted under its leases in January 1991 and returned the aircraft to the Partnership as described in Note 5. The Partnership has disassembled three of the aircraft for sale of their component parts (Note 7). One aircraft was sold to Target Airways, Ltd. during January 1993 as described in Note 8. Fourteen Boeing 727s (Series 100, 200 and 200 Advanced) and Seven McDonnell Douglas DC-9-10s These aircraft were acquired for $111,830,728 in 1987 and leased to Continental Airlines, Inc. (Continental) for terms of 72 months for the Boeing aircraft and 42 months for the McDonnell Douglas aircraft. Continental filed for Chapter 11 bankruptcy protection in December 1990. In 1991, the Partnership and Continental entered into an agreement for Continental's continued lease of eight of the Partnership's Boeing aircraft; however, Continental rejected the leases on six Boeing 727-100s and the seven McDonnell Douglas DC-9-10s. Note 6 contains a detailed discussion of the Continental events. Six of the seven McDonnell Douglas DC-9-10 aircraft were sold in 1993 and 1992 as discussed in Note 8. During 1993, the six Boeing 727- 100s were transferred to aircraft inventory and are being remarketed for sale. Upon transferring the aircraft to aircraft inventory, the Partnership recorded downward adjustments to the aircraft value, which are included in the adjustment discussed in Note 7. In June 1991, one of the DC-9-10 aircraft formerly leased to Continental was leased to Aero California S.A. de C.V. (Aero California) for a lease term of 18 months at approximately 76% of the original lease rate with Continental. The aircraft was subsequently sold to Aero California in September 1993, as discussed in Note 8. The following is a schedule by year of future minimum rental income under the existing leases including the deferred rental payments specified in the Continental lease modifications (Note 6): (1) Rental payments for the period from December 1990 through September 1991 are payable with interest commencing in July 1992 according to the Continental lease modification agreement. Rental payments for the period from November 1992 through January 1993 are payable with interest commencing in October 1993 according to the additional lease modification agreement with Continental. These payments are shown separately from regular rental payments because of contingencies regarding collectability as discussed in Note 6. Future minimum rental payments may be offset or reduced by future costs as described in Notes 4 and 6. During 1992 and 1991, the Partnership made downward adjustments to its estimates of aircraft value for certain of its on-lease aircraft. To ensure that the carrying value of each asset equals its estimated residual value at the end of its expected holding period, where appropriate, the Partnership has increased depreciation expense as described in Note 1. The Partnership also made downward adjustments to the carrying values of certain of its off-lease aircraft and aircraft inventory where depreciated cost exceeded the estimated net realizable value. During 1993, 1992 and 1991, the Partnership recognized downward adjustments totalling approximately $825,000, $10.1 million and $19.0 million, respectively, for certain of its off-lease and on-lease aircraft and, with respect to 1993, the adjustment also included aircraft inventory. These adjustments are included in depreciation expense in the statements of operations. 4. TWA Lease Modification During 1991, TWA defaulted under its leases with the Partnership when it failed to make its lease payments due on March 5, 1991. On March 28, 1991, TWA and the Partnership entered into lease amendments which specified (i) renegotiated lease rates equal to approximately 71% of the original rates; (ii) payment of the March and April lease payments at the renegotiated rates on March 27, 1991; and (iii) an advance lump sum payment on March 29, 1991 representing the present value of the remaining lease payments due through the end of the leases in November 1991 at the renegotiated rate. The Partnership recorded the lump sum payment from TWA as deferred income, and recognized the rental revenue as it was earned over the lease term. The Partnership also recognized interest expense equal to the difference between the cash received and the rental revenue earned over the lease term. In December 1991, the leases for all 13 aircraft were extended further to extend the terms to February 1998 at approximately 46% of the initial lease rates. In addition, the Partnership agreed to share in the costs of certain ADs. If such costs are incurred by TWA, they will be credited against rental due to the Partnership, subject to annual limitations with a maximum of $500,000 per aircraft over the term of the leases. In January 1992, TWA commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. TWA has made all payments due under the leases. TWA received court approval to emerge from bankruptcy protection effective November 3, 1993. TWA notified the partnership of its intention to affirm its leases for all 13 DC-9 aircraft. In addition, while the court had originally granted TWA an additional 90-day period subsequent to its emergence from bankruptcy during which it could exercise its right to reject the Partnerships's leases, TWA has elected to waive that right with respect to the Partnership's aircraft. As previously agreed with TWA, August and September 1993 rentals were drawn from a security deposit held by the Partnership, which had been posted for this purpose by TWA prior to its bankruptcy filing. In accordance with the cost sharing arrangement described above, in 1993, TWA submitted to the Partnership invoices for expenses paid to date by TWA to meet the ADs. These expenses were offset against rental payments totalling $1.95 million that were due the Partnership in 1993. TWA may offset rent up to an additional $4.55 million subject to limitations over the lease term. 5. Midway Bankruptcy In March 1991, Midway commenced reorganization proceedings under Chapter 11 of the federal Bankruptcy Code. In August 1991, the Bankruptcy Court approved Midway's proposal to discontinue use of the Partnership's aircraft, and the aircraft were subsequently returned to the Partnership. The aircraft were not in compliance with the return conditions specified under the lease. The general partner has retained counsel on behalf of the Partnership to pursue all legal remedies available to protect the interests of unit holders. Although Midway remains liable for expenses for which it was responsible under its lease, including the costs of complying with return conditions, the Partnership is unlikely to recover material damages resulting from Midway's failure to meet its obligations under the leases, as Midway's bankruptcy estate is minimal. The Partnership sold one of these aircraft in January 1993 (Note 8), and has disassembled the remaining three aircraft for sale of their component parts (Note 7). 6. Continental Lease Modification As discussed in the Partnership's Form 10-K for the year ended December 31, 1990, Continental filed for Chapter 11 bankruptcy protection in December 1990. Continental terminated the leases on the six 727-100s and has returned these aircraft to the Partnership. The leases for the seven McDonnell Douglas DC-9-10 aircraft expired during the period of April through June 1991. During the off-lease period, the Partnership must bear the cost of all operating expenses associated with the aircraft including storage, insurance, maintenance and remarketing costs. Continental will be entitled, under certain circumstances related to a possible future substantial downsizing by Continental, which is not currently anticipated, to reject the remaining existing leases. The terms of the modified agreement are described below. For the Partnership's Boeing aircraft, the agreement approved by the Bankruptcy Court in 1991 specifies (i) extension of the leases for the three 727-200s to the earlier of April 1994 or 60,000 cycles, and for the five 727-200 Advanced aircraft to October 1996; (ii) renegotiated rental rates averaging approximately 73% of the original lease rates; (iii) payment of ongoing rentals at the reduced rates beginning in October 1991; (iv) payment of deferred rentals with interest beginning in July 1992; and (v) payment by the Partnership of certain aircraft maintenance, modification and refurbishment costs, not to exceed approximately $3.2 million, a portion of which will be recovered with interest through payments from Continental over the extended lease terms. The Partnership's balance sheets reflect the net reimbursable costs incurred of $456,308 and $413,852 as of December 31, 1993 and 1992, respectively, as notes receivable. The Partnership's share of such costs will be capitalized and depreciated over the remaining lease term. The Partnership recognized rent receivable from Continental of $1,511,750 in its financial statements for the year ended December 31, 1990. As a result of the terms of the agreement, which includes an extended deferral of the dates when Continental will remit its rental payments for the period from December 3, 1990 through September 30, 1991 (Deferred Amount), the Partnership will not recognize the Deferred Amount as rental revenue until it is received, or until the contingencies regarding collectability are removed. Accordingly, the rent receivable recognized at December 31, 1990 was reversed during the first quarter of 1991. The unrecognized Deferred Amounts as of December 31, 1993 and 1992 were $4,148,922 and $6,862,417, respectively. In accordance with the aforementioned agreement, Continental began making supplemental payments for accrued unpaid rent plus interest on July 1, 1992. During 1993 and 1992, the Partnership received supplemental payments of $3,946,788 and $1,973,394, of which $2,713,495 and $1,202,583 was recognized as rental income in 1993 and 1992, respectively. Additional Continental Deferral Agreement As part of its reorganization plan, Continental requested additional concessions from its aircraft lessors. As a result, the Partnership and Continental reached an agreement to defer rental payments for a period of three months, beginning in November 1992, for a total of $1,852,500 (Additional Deferred Amount), with repayment over the shorter of three and one-half years or the remaining lease term. Repayment with interest began October 1, 1993. During 1993, the Partnership received supplemental payments of $162,819, of which $119,400 was recognized as rental income in 1993. The unrecognized Additional Deferred Amount as of December 31, 1993 was $1,733,100. Continental continues to pay all other amounts due under the prior agreement. The Partnership's rights to receive payments under the agreements fall into various categories of priority under the Bankruptcy Code. In general, the Partnership's claims are administrative claims, with the exception of certain deferred amounts. If Continental's reorganization is not successful, it is likely that a portion of the Partnership's claims will not be paid in full. 7. Disassembly of Aircraft In an attempt to maximize the economic return from three of the remaining four aircraft formerly leased to Midway (Note 5), the Partnership entered into an agreement with Soundair, Inc. (Soundair) on October 31, 1992, for the disassembly and sale of these aircraft. It is anticipated that the disassembly and sales process will take approximately three years. The Partnership has borne the cost of disassembly of approximately $50,000 per aircraft, and will receive the proceeds from the sale of such parts net of commission paid to Soundair. During 1993, the Partnership paid $141,630 for aircraft disassembly costs and received net proceeds from the sale of aircraft inventory of $593,923. These aircraft have been recorded as aircraft inventory in the accompanying balance sheet as of December 31, 1993 and 1992 as described in Note 3. Upon transferring the aircraft to inventory, the Partnership recorded downward adjustments of $1,050,000. During 1993, the Partnership recorded additional downward adjustments of $801,590 to reflect the current estimate of net realizable aircraft inventory value. These adjustments are included in depreciation expense in the statement of operations. 8. Aircraft Sales Lear 25, Inc. (Lear 25) - In December 1992, the Partnership sold one of the ex-Continental DC-9-10 aircraft to Lear 25 for $1,025,000. The aircraft had been off lease since it was returned to the Partnership in early 1991. Under the terms of the sale, Lear 25 made a non-refundable $200,000 down payment and paid the remaining $825,000 in March 1993. The total proceeds of $1,025,000 were approximately 26% of the original acquisition price. The Partnership recorded a $1,000 loss on the sale in 1992. Target Airways, Ltd. (Target) - One ex-Midway DC-9-10 aircraft was sold to Target for $925,000 in January 1993, resulting in a gain on sale of $146,500. This aircraft was recorded in aircraft inventory as of December 31, 1992. Aero California - In January 1993, the Partnership agreed to sell to Aero California the DC-9-10 aircraft it was leasing. The Partnership applied the existing security deposit and maintenance reserves toward the purchase price of approximately $1.1 million, and the remainder was paid in monthly installments through September 1993, when title was transferred to Aero California. The Partnership recognized a gain of $86,887 on the sale. Intercontinental De Aviacion S.A. (Intercontinental) - In March 1993, the Partnership agreed to sell to Intercontinental five of the six DC-9-10 aircraft formerly on lease to Continental, which had been off-lease since they were returned to the Partnership in early 1991. Two aircraft were sold in March 1993, a third aircraft was sold in April 1993, a fourth aircraft was sold in June 1993, and a fifth aircraft was sold in October 1993 for total proceeds of $3.4 million for the five aircraft. The Partnership recorded no gain or loss on the sales, as the aircraft sales prices equalled book values. 9. Hushkit Options On August 30, 1990, the Partnership acquired options to purchase up to nine hushkits for Boeing 727 aircraft from Federal Express Corporation (Federal Express). The Partnership's deposit of $90,000 was refunded with interest of $6,587 in 1992, as the Partnership elected not to exercise these options. 10. Related Parties Under the Limited Partnership Agreement (Partnership Agreement), the Partnership paid or agreed to pay the following amounts to PIMC and/or its affiliates in connection with services rendered: a. An aircraft management fee equal to 5% of gross rental revenues with respect to operating leases or 2% of gross rental revenues with respect to full payout leases of the Partnership, payable upon receipt of the rent. b. Reimbursement of certain out-of-pocket expenses incurred in connection with the management of the Partnership and supervision of its assets. In 1993, 1992 and 1991, the Partnership reimbursed PIMC for expenses of $754,345, $703,756 and $943,571, respectively. Reimbursements totalling $190,747 and $110,661 were payable to PIMC at December 31, 1993 and 1992, respectively. c. A 10% interest in all cash distributions and sales proceeds, gross income in an amount equal to 9.09% of distributed cash available from operations and 1% of net income or loss and taxable income or loss, as such terms are defined in the Partnership Agreement. d. A subordinated sales commission of 3% of the gross sales price of each aircraft for services performed upon disposition and reimbursement of out-of-pocket and other disposition expenses. Subordinated sales commissions shall be paid only after unit holders have received distributions in an aggregate amount equal to their capital contributions plus a cumulative non-compounded 8% per annum return on their adjusted capital contributions, as defined in the Partnership Agreement. The Partnership did not pay or accrue a sales commission on any aircraft sales to date as the above subordination threshold has not been met. 11. Income Taxes Federal and state income tax regulations provide that taxes on the income or loss of the Partnership are reportable by the partners in their individual income tax returns. Accordingly, no provision for such taxes has been made in the accompanying financial statements. In 1993, the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). One of the requirements of SFAS 109 is for a public enterprise that is not subject to income taxes, because its income is taxed directly to its owners, to disclose the net difference between the tax basis and the reported amounts of the enterprise's assets and liabilities. The net differences between the tax basis and the reported amounts of the Partnership's assets and liabilities at December 31, 1993 are as follows: Reported Amounts Tax Basis Net Difference Assets $114,953,271 $89,815,206 $ 25,138,065 Liabilities 1,126,528 514,819 611,709 PART III Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 10. Item 10. Directors and Executive Officers of the Registrant PAIF-III has no directors or officers. PIMC is the General Partner of the Partnership and as such manages and controls the business of the Partnership. The directors and officers of PIMC are: Name Position Herbert D. Depp Chairman of the Board; President; Director Howard L. Feinsand Senior Vice President; Director John E. Flynn Senior Vice President Aircraft Marketing Richard J. Adams Senior Vice President Aircraft Sales and Leasing James T. Caleshu Senior Vice President and General Counsel; Secretary Bobbe V. Sabella Vice President and Chief Financial Officer Robert M.J. Ward Vice President International James R. Weiland Vice President Technical James W. Linnan Vice President Financial Management Robert W. Dillon Vice President Aviation Legal and Insurance Affairs; Assistant Secretary Mr. Depp, 49, assumed the position of the President effective April 1991, previously having served as Executive Vice President of PIMC and PALC since July 1989, Vice President Aircraft Marketing since June 1986, Vice President Commercial Aircraft since August 1984, and Director of Marketing Aircraft since November 1980. Mr. Depp assumed the position of Chairman effective April 1991. He has been a director of PIMC and of PHC since May 1990 and a director of PALC since April 1991. Mr. Feinsand, 46, joined PIMC and PALC as Vice President and General Counsel; Assistant Secretary in April 1989. Effective July 1989, Mr. Feinsand assumed the positions of Senior Vice President which he continues to hold, and previously served as General Counsel and Secretary from July 1989 to August 1992. Mr. Feinsand also serves as a director of PIMC. Mr. Feinsand, an attorney, was a partner in the New York law firm of Golenbock and Barell from 1987 through 1989. In his previous capacities, Mr. Feinsand served as counsel to PIMC and PALC. Mr. Feinsand also serves as a director on the board of Duke Realty Investments, Inc. Mr. Flynn, 53, was elected Senior Vice President Aircraft Marketing effective April 1991, having previously served as Vice President North America of PIMC and PALC since July 1989. Mr. Flynn joined PALC in March 1989 as Vice President Cargo. For the two years prior to the time he joined PALC, Mr. Flynn was a Transportation Consultant. Mr. Adams, 60, serves as Senior Vice President Aircraft Sales and Leasing of PIMC and PALC effective August 1992; having previously served as Vice President Aircraft Sales & Leasing, Vice President North America, and Vice President Corporate Aircraft since he joined PALC in August 1986. Mr. Weiland, 50, joined PIMC and PALC in September 1990 as Vice President Technical. Prior to joining PIMC and PALC, Mr. Weiland had been President and Chief Executive Officer of RAMCO, a company organized to build and operate an aircraft maintenance facility, since 1986. Mr. Caleshu, 54, joined PIMC and PALC in August 1992 as Senior Vice President and General Counsel. Prior to joining PIMC and PALC, Mr. Caleshu, an attorney, was a partner in the San Francisco firm of Pettit and Martin from 1966 to 1992. Ms. Sabella, 37, was elected Vice President and Chief Financial Officer effective October 1993, having previously served as Vice President - Finance since April 1992, Vice President and Controller since January 1990 and Corporate Controller of PIMC and PALC since September 1986. Mr. Ward, 50, has served as Vice President International of PIMC and PALC since October 1987, with responsibility for Asia, Central America, Pacific and Latin America. Mr. Linnan, 52, was elected Vice President Financial Management effective April 1991, having previously served as Vice President Investor Marketing of PIMC and PALC since July 1986. Mr. Dillon, 52, was elected Vice President Aviation Legal and Insurance Affairs effective April 1989. Previously, he has served as General Counsel of PIMC and PALC since January 1986. Disclosure pursuant to Section 16, Item 405 of Regulation S-K: Based solely on its review of the copies of such forms received or written representations from certain reporting persons that no Forms 3, 4, or 5 were required for those persons, the Partnership believes that, during 1993 all filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were met. As reported in the Partnership's 1990 Form 10-K, on June 8, 1990, a purported class action entitled Harner, et al, v Prudential Bache Securities, (to which the Partnership was not a party) was filed by certain purchasers of units in a 1983 and 1984 public offering in several corporate aircraft public partnerships. PALC and PIMC were named as two of the defendants in this action. On September 24, 1991, the court entered an order in favor of PALC and PIMC granting their motion for summary judgement and dismissing the plaintiffs' complaint with prejudice. On March 13, 1992, Plaintiff filed a notice of appeal to the United States Court of Appeals for the Sixth Circuit. On August 21, 1992, the court of Appeals ordered consolidation of the Appellants' causes for the purposes of briefing and submission. This appeal was fully briefed and oral argument was held. Parties are waiting for the Court to issue a decision. On October 27, 1992, a Class Action Complaint entitled Edwin Weisl, Jr. et al, Plaintiffs, v the General Partner of the Partnership, its affiliates and others, Defendants, Index No. 29239/92 was filed in the Supreme Court of the State of New York for the County of New York. The Complaint sets forth various causes of action which include allegations against certain or all of the defendants (i) for alleged fraud in connection with certain public offerings, including that of the Partnership, on the basis of alleged misrepresentation and alleged omissions contained in the written offering materials and all presentations allegedly made to investors; (ii) for alleged negligent misrepresentation in connection with such offerings; (iii) for alleged breach of fiduciary duties; (iv) for alleged breach of third party beneficiary contracts; (v) for alleged violations of the NASD Rules of Fair Practice by certain registered broker dealers; and (vi) for alleged breach of implied covenants in the customer agreements by certain registered brokers. The Complaint seeks an award of compensatory and other damages and remedies. On January 19, 1993, Plaintiff's filed a motion for class certification. On March 1, 1993, Defendants filed motions to dismiss Complaint on numerous grounds, including failure to state a cause of action and statute of limitations. The court has not ruled on the motion for class certification or the motions to dismiss the complaint. The Partnership is not named as a defendant in this action. On or around February 17, 1993, a civil action entitled Einhorn, et al v Polaris Public Income Funds, et al, was filed in the Circuit Court of the 11th Judicial Circuit in and for Dade County, Florida against, among others, PIMC and Polaris Depositary Company. Plaintiffs seek class action certification on behalf of a class of investors in the Polaris Aircraft Income Funds IV, V and VI who purchased their interests while residing in Florida. Plaintiffs allege the violation of Section 517.301, Florida Statutes, in connection with the offering and sale of the Partnerships. Among other things, Plaintiffs assert that the Defendants sold interests in the Partnerships while "omitting and failing to disclose the material facts questioning the economic efficacy of" the Partnerships. Plaintiffs seek rescission or damages, in addition to interest, costs, and attorneys' fees. On April 5, 1993, defendants filed a motion to stay this action pending the final determination of a prior filed action in the Supreme Court for the State of New York entitled Weisl v Polaris Holding Company. On that date, defendants also filed a motion to dismiss the Complaint on the grounds of failure to attach necessary documents, failure to plead fraud with particularity and failure to plead reasonable reliance. On April 13, 1993, the court denied the defendants' motion to stay. On May 7, 1993, the Court stayed the action pending an appeal of the denial of the motion to stay. Defendants subsequently filed with the Third District Court of Appeal a petition for writ of certiorari to review the Circuit Court order denying the motion to stay. On October 19, 1993, the Court of Appeal granted the writ of certiorari, quashed the order, and remanded the action with instruction to grant the stay. On or around May 14, 1993, a purported class action entitled Michael Moross, et al, v Polaris Holding Company, et al, was filed in the United States District Court for the District of Arizona. This purported class action was filed on behalf of investors in the Polaris Aircraft Income Funds I - VI by nine investors in the Polaris Aircraft Income Funds. The Compliant alleges that defendants violated Arizona state securities statues and committed negligent misrepresentation and breach of fiduciary duty by misrepresenting and failing to disclose material facts in connection with the sale of limited partnership units in the above-named funds. An Amended Compliant was filed on September 17, 1993, but has not been served upon defendants. On or around October 4, 1993, defendants filed a notice of removal to the United States District Court for the district of Arizona. Defendants also filed a motion to stay the action pending the final determination of a prior filed action in the Supreme Court for the State of New York entitled Weisl v. Polaris Holding Company ("Weisl") and to defendants' time to respond to the Complaint until 20 days after disposition of the motion to action pending resolution of the motions for class certification and motions to dismiss pending in Weisl. On January 20, 1994, the court stayed the action and required defendants to file status reports every sixty days setting forth the status of the motions in Weisl. On September 21, 1993, a purported derivative action entitled Novak, et al, v. Polaris Holding Company, et al, was filed in the Supreme Court of the State of New York, County of New York. This action was brought on behalf of Polaris Aircraft Income Funds I - III (the "Partnerships"). The Complaint names as defendants Polaris Holding Company, its affiliates and others. Polaris Aircraft Income Funds I - III are named as nominal defendants. The Complaint alleges, among other things, that defendants mismanaged the Partnerships, engaged in self-dealing transactions that were detrimental to the Partnerships and failed to make required disclosure in connection with the sale of the Partnership units. The Complaint alleges claims of breach of fiduciary duty and constructive fraud and seeks, among other things an award of compensatory and punitive damages in an unspecified amount, re-judgment interest, and attorneys' fees and costs. On January 13, 1994, certain of the defendants, including Polaris Holding Company, filed motions to dismiss the Complaint on the grounds of, among others, failure to state a cause of action and failure to plead the alleged wrong in detail. On or around March 13, 1991, a purported class action entitled Kahn v Polaris Holding Company, et al, was filed in the Supreme Court of the State of New York, County of New York. This purported class action on behalf of investors in Polaris Aircraft Income Fund V ("PAIF V") was filed by one investor in the above named fund. The Complaint names as defendants the Company, Polaris Holding Company, its affiliates and others. The Complaint charges defendants with common law fraud, negligent misrepresentation and breach of fiduciary duty in connection with certain misrepresentations and omissions allegedly made in connection with the sale of interest in PAIF V. Plaintiffs seek compensatory and consequential damages in an unspecified amount, plus interest, disgorgement and restitution of all earnings, profits and other benefits received by defendants as a result of their alleged practices, and attorneys' fees and costs. Defendants' time to move, answer or otherwise plead with respect to the Complaint has been extended by stipulation up to and including 30 days after the Court rules on the pending motions to dismiss, or the motions are otherwise resolved, in Weisl v Polaris Holding Company, et al. The Partnership is not named as a defendant in this action. Item 11. Item 11. Management Remuneration and Transactions PAIF-III has no directors or officers. PAIF-III is managed by PIMC, the General Partner. In connection with management services provided, management and advisory fees of $893,701 were paid to PIMC in 1993. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management a) No person owns of record, or is known by PAIF-III to own beneficially more than five percent of any class of voting securities of PAIF-III. b) The General Partner of PAIF-III owns the equity securities of PAIF-III as set forth in the following table: c) There are no arrangements known to PAIF-III, including any pledge by any person of securities of PAIF-III, the operation of which may at a subsequent date result in a change in control of PAIF-III. 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 1. Financial Statements. The following are included in Part II of this report: Page No. Report of Independent Public Accountants 19 Balance Sheets 20 Statements of Operations 21 Statements of Changes in Partners' Capital (Deficit) 22 Statements of Cash Flows 23 Notes to Financial Statements 24 2. Financial Statement Schedules. a) The following are included in Part II of this report: Page No. Schedule V Property, Plant and Equipment 33 Schedule VI Accumulated Depreciation, Depletion; and Amortization of Property, Plant, and Equipment 33 All other schedules are omitted because they are not applicable, not required or because the required information is included in the financial statements or notes thereto. 3. Exhibits required to be filed by Item 601 of Regulation S-K and Reports on Form 8-K. a) Reports on Form 8-K: None. b) Exhibits required to be filed by Item 601 of Regulation S-K: None.

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1993

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ITEM 1. BUSINESS (a) General Development of Business. The general development -------------------------------- of the registrant's business for the fiscal year ended October 31, 1993, is set out in the registrant's 1993 Annual Report to Stockholders on pages 10 through 13 and is incorporated by reference herein. No material changes in the registrant's mode of doing business occurred during the five years ended October 31, 1993. (b) Financial information about Industry Segments. Industry ---------------------------------------------- segment data is set out in the registrant's 1993 Annual Report to Stockholders on pages 14-17 under the caption "1993 Operating Results", page 18 under the caption "Industry Segment Data", page 19 under the caption "Worldwide Operations" and page 28 under the caption "Segment Information", and is incorporated by reference herein. (c) Narrative Description of Business. ---------------------------------- 1) Specialty Chemical Segment. Specialty chemicals are --------------------------- produced primarily from petrochemicals and petroleum derived raw materials, and include demulsifiers, corrosion inhibitors, drilling fluids, polymers and waxes, water treating chemicals, and fuel and other additives. Sales for the three major product groupings within the specialty chemical segment (oil field chemicals, industrial chemicals, and industrial polymers and waxes) for each of the three years in the period ended October 31, 1993, are provided in the 1993 Annual Report to Stockholders on page 18 under the caption "Industry Segment Data" which is incorporated by reference herein. Registrant markets its products and services primarily to producers and transporters of crude oil and natural gas, related service companies and petroleum refineries throughout the world through the registrant's own field staff and a limited number of agents and distributors. The registrant also serves other major markets, such as adhesives, agribusiness, coatings, packaging, petrochemicals, plastics fabrication, power utilities, and printing inks. During the fiscal year ended October 31, 1993, there have been no significant changes in the kinds of products or services rendered, or in the markets or methods of distribution by registrant. It is the continuing nature of the business for a number of new or improved products to be introduced annually; typically, no individual new product or service by itself is expected to be significant immediately in sales or earnings. Registrant's joint business alliance with Energy BioSystems Corporation continues to make steady progress in its efforts to commercialize a breakthrough biocatalytic desulfurization (BDS) process for hydrocarbons. Registrant's participation has expanded to worldwide coverage at 22% of gross profits from biodesulfurization unit sales and fees. In return, registrant will provide development resources, separation technology, engineering know-how and ongoing customer service for all BDS units, worldwide. Registrant is dependent on the availability of petrochemicals and petroleum-derived raw materials and supplies, which have been available in the past in adequate quantities. In the past year, registrant's operations were not affected materially by any raw material shortages. Registrant presently does not foresee any shortage of materials in the near future. Registrant has numerous patents, patent applications, and licenses under patents, of various durations which, in the aggregate, are material to the operation of the registrant. The registrant, however, does not believe that expiration of any particular patent or group thereof would have a material adverse effect upon its business as a whole. The specialty chemical business is not considered to be seasonal. The registrant traditionally has carried sufficient inventory at various stages of production in order to respond quickly to the needs of its customers. Accounts receivable generally are due within thirty days of invoicing, and letters of credit are employed when deemed appropriate. The registrant believes that its practices are consistent with industry standards. Registrant's customers are located throughout the world and no one customer constitutes more than 10% of the registrant's business. Foreign operations account for a significant portion of the registrant's specialty chemical business. Non-U.S. revenues were approximately 32% of total specialty chemical revenues during each of the last three years. Orders from customers for specialty chemical products generally are filled from stock or manufactured within a few days or weeks after receipt of the order and, as a result, backlog of orders is not significant in relation to total annual dollar volume of sales. The registrant's specialty chemical product lines, oil field chemicals, industrial chemicals, and industrial polymers and waxes are in competition with a number of manufacturers. Competitive companies vary in size from large international companies to small companies which may compete with the registrant in the sale of one product or a line of products. All aspects of this business are considered to be very competitive. Registrant is recognized as a leader in providing services and products to the oil field chemical market. In the registrant's opinion, registrant's overall competitive position in the market has not changed materially in the past fiscal year, although registrant is unable to predict the extent to which its business may be affected by future competition or by consolidations within the industry. Information on acquisitions made by the registrant in fiscal 1993 is set out in the registrant's 1993 annual report on page 25 under the caption "Acquisitions" and is incorporated by reference herein. 2. Equipment Segment - The equipment segment designs, ----------------- installs and services processing equipment for petroleum, petrochemical and electrical power generating industries. Products and services are marketed both domestically and in foreign countries through the registrant's own field staff and a limited number of agents and distributors. During the past year the registrant has not had, and in the foreseeable future does not anticipate, any shortage of raw materials. Certain products of the equipment segment are covered under patents, patent applications, and licenses under patents. Registrant does not believe that expiration of any particular patent or group thereof would have a material adverse effect upon its business as a whole. The equipment segment business is not seasonal, but is subject to the business cycles of the industries which it serves. This segment primarily produces processing equipment upon order from customers. Accounts receivable generally are due within thirty days of invoicing, and letters of credit are employed when deemed appropriate. The registrant believes that its practices are consistent with industry standards. Registrant's customers are located throughout the world and no one customer constitutes a significant portion of the registrant's business on a continuing basis. However, one or several equipment contracts may represent a significant portion of the equipment segment revenues in a particular year. Foreign operations account for a significant portion of the registrant's equipment business. Non-U.S. revenues ranged from 40% to 67% of total equipment revenues during the last three years. The amount of backlog orders for the equipment segment at October 31, 1993, approximates $11.5 million. Substantially all of these orders are expected to be completed in fiscal 1994. Backlog orders as of October 31, 1992 were $8.7 million. The equipment segment is in competition with similar equipment and services offered by other competitors. Although, in registrant's opinion, registrant's competitive position in its equipment business has not changed materially in the past year, the registrant is unable to predict the extent to which its business may be affected by future competition. 3. Registrant's Business in General - The registrant expended -------------------------------- $13,587,000, $12,224,000, and $11,431,000, in fiscal years 1993, 1992 and 1991, respectively, on research activities relating to development of new products and services, and on improvement of existing products and services. Approximately 95% was applicable to the registrant's specialty chemical products segment. The registrant also continued its strong commitment to technology by continuing to increase its emphasis on field applications support which, when combined with the research and development amounts, resulted in total technology expenditures of $24,444,000, $21,764,000, and $20,474,000 in fiscal years 1993, 1992 and 1991, respectively. The registrant directly sponsors substantially all of its research activities. The registrant is subject to various federal, state and local laws and regulations concerning environmental matters. The registrant maintains a separate Safety, Health and Environmental Affairs Department charged with the responsibility of monitoring compliance with these various laws and regulations. For fiscal year 1993, these efforts did not result in any material capital expenditure or material charges to income, and it is not likely that these efforts will result in any material capital expenditure or material charges to income during fiscal year 1994. Approximately 2,012 persons are employed worldwide by registrant and its subsidiaries. (d) Financial Information About Foreign and Domestic ------------------------------------------------ Operations and Export Sales. Information under this caption is - ---------------------------- included in the registrant's 1993 Annual Report to Stockholders for each of the three years ended October 31, 1993, 1992, and 1991, respectively, on page 19 under the caption "Worldwide Operations" and is incorporated by reference herein. Substantially all of the registrant's non-U.S. sales are made to major international companies, national oil companies and utilities, and contractors and distributors of long standing. Letters of credit are required when and where appropriate. The risk attendant to the foreign business conducted by registrant and its subsidiaries is believed to be slightly greater than the risk involved in doing business within the United States. The registrant protects itself from potential losses due to foreign currency fluctuations through pricing adjustments, maintenance of offsetting asset and liability balances, and utilization of foreign currency futures contracts when deemed appropriate. ITEM 2. ITEM 2. PROPERTIES All properties are owned by the registrant, except for the following: Sales office facilities located at 16010 Barker's Point Lane, Houston, Texas, are leased under an agreement which expires April 14, 1997. Petrolite Saudi Arabia Ltd. blending facilities are located on leased properties with the lease expiring 2002. Petrolite Pacific Pte. Ltd. blending facilities are located on leased properties with the lease expiring 2009. P.T. Petrolite Indonesia Patrama manufacturing facilities are located on leased property with the lease expiring in October, 2015. In addition to the foregoing properties, the registrant and its subsidiaries occupy a number of small general and sales offices under short- term leases and its subsidiaries occupy a number of distribution warehouses located on small sites owned in fee. Although facilities are of varying ages, the registrant considers them generally to be well maintained, equipped with modern and efficient equipment, and in good operating condition. Current productive capacity is adequate to meet demands for the immediate future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Neither the registrant nor any of its subsidiaries is a party to, nor is any of their property subject to, any material pending legal proceedings, other than routine litigation incidental to the business. The registrant is subject to various laws and governmental regulations concerning employee safety and environmental matters. The registrant maintains a separate Safety, Health and Environmental Affairs Department charged with the responsibility of monitoring compliance with these various laws and regulations. The registrant currently participates, as a potentially responsible party and otherwise, with various governmental agencies concerning certain environmental cleanup sites. After consultation with environmental and engineering advisors, and legal counsel, the registrant does not believe that the registrant's participation at these sites, individually and collectively, is likely to result in the payment of any material sanctions, capital expenditures or charges to income. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of fiscal 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information regarding registrant's common stock appears on page 17 of the registrant's 1993 Annual Report to Stockholders under the caption "Stockholders' Equity/Capital Stock" and is incorporated by reference herein. As of January 7, 1994 the registrant has 2,093 stockholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA A summary of selected financial data for the five years ended 10/31/93 appears on pages 30 and 31 of the registrant's 1993 Annual Report to Stockholders under the caption "11-Year Summary", and is incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information under this caption is in the registrant's 1993 Annual Report to Stockholders on pages 14 through 19, under the caption "Financial Review", and on pages 25 and 26 under the captions "Acquisitions, Short-Term Borrowings and Lines of Credit, and Long-Term Debt" and is incorporated by reference herein. The registrant continued its program to cease manufacturing operations at its Webster Groves, Missouri facility to coincide with an expansion of its La Porte, Texas facility. As and when such operations cease, the registrant expects that appropriate reserves will be established. This program will increase manufacturing capacity, efficiency and flexibility, and ultimately will allow for any necessary additions to sales, administrative and research facilities at Webster Groves. On January 27, 1993, the registrant announced that it adopted Statement of Financial Accounting Standard No. 106 related to medical and other postretirement benefits. The adoption of this rule resulted in a one-time, non-cash charge of $6.5 million, or $0.58 per share, to net income in fiscal 1993's first quarter ending January 31. During the first quarter of fiscal 1994, the registrant will adopt Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." Statement 109 will change the company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. The estimated cumulative effect of implementing the new standard, using current tax rates, will be a one-time, non-cash credit of $2.0 million, or $0.18 per share, to net income in fiscal 1994's first quarter ending January 31. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated Financial Statements of the registrant and its subsidiaries, and the Notes to Consolidated Financial Statements, together with the report thereon of Price Waterhouse dated November 30, 1993, appearing on pages 20 through 29, the Quarterly Results on pages 15 and 16, Industry Segment Information on page 18, and Worldwide Operations Information on page 19 in the registrant's 1993 Annual Report to Stockholders, are incorporated by reference in this Form 10-K Annual Report. Marketable securities are stated at their approximate market value at October 31, 1993. The registrant's provision for bad debts was $395,000, $338,000, and $281,000, for fiscal years 1993, 1992, and 1991, respectively. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the registrants three most recent fiscal years, there were no changes in or disagreements with the registrants independent accountants on accounting or financial disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT a) Identification of directors - Information regarding identification --------------------------- of directors, on pages 3 through 7 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. Also see information on page 32 of the registrant's Annual Report to Stockholders under the caption "Corporate Organization" which is incorporated by reference herein. c) Identification of certain significant employees - S. Monro joined ------------------------------------------------ the registrant in January 1978. After having served in various sales and managerial positions within International operations, in March of 1989 he was appointed Managing Director of Petrolite Ltd. In June 1991, he was also appointed to the position of General Manager of the newly created EuroChem Division. He holds various diplomas and degrees including a Licentiate in Chemistry, a chartered engineer and an M.B.A. degree in Management from the City University in London. David Winslett joined Petrolite in December of 1982 with 15 years of Refinery and Speciality Chemical experience. From 1982 to 1989 Winslett was Operations Manager for the European Industrial Chemicals business based in Kirkby, England. Since 1989, he has served in various capacities in Petrolite's St. Louis office as Vice President in the Industrial Chemicals Division until June 16, 1993 when he was promoted to General Manager of the Industrial Chemicals Division. Winslett is a graduate of the University of Wales with a B.Sc. (Honors) in Chemistry. d) Business experience - Information regarding business experience of ------------------- directors, on pages 5 and 6 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. Officers are elected to serve until removed or until a successor has been elected or appointed. Except as noted below, each of the officers in Item 10 (b) has served in his present office for at least five years. The following is a brief description of past positions of those officers who were elected to their present position within the last five years. Mr. W.E. Nasser has been an employee of the registrant since 1962. He served as Vice President and General Manager of Petrolite's Specialty Polymers from March 1980 until May 1988, when he was elected President and Chief Operating Officer. In February 1992, he also was elected Chairman of the Board and Chief Executive Officer. Dr. R.J. Churchill returned to the registrant July 1, 1989 as Vice President-Corporate Development. In June 1990, he became Vice President of Technology and in January 1993, he also was named to the position of Vice President, Marketing. In December, 1993, he was appointed Vice President-Special Projects. He served the registrant in various research and management positions before leaving in 1981 to head his own management consulting firm. He holds a Ph.D. in sanitary engineering. Dr. T.R. Graves has been an employee of the registrant since 1972, and served as technical director of the registrant's Specialty Polymers Group from 1980 until June 1988,when he was elected Vice President and General Manager of such Group (now the Polymers Division). He holds a Ph.D in chemical engineering. Mr. J.F. McCartney has served as Assistant General Counsel since joining the registrant in 1973, managing legal aspects of the registrants international operations, primarily working to establish subsidiaries, affiliates and joint venture companies worldwide. He was named Vice President in August 1989. During July 1992, he also assumed responsibility for the administration of the Law Department and now is Vice President, General Counsel. Mr. E.E. Schooling joined the Registrant in February 1968, and has served in various plant manager positions. Most recently he was manufacturing manager before his July 1, 1991 promotion to the position of Vice President - Manufacturing/Distribution. Mr. W.F. Haberberger joined the Registrant in October 1977, as an internal auditor. Since 1980, he has served in various financial managerial positions of the registrant's international operations until his election to Controller on March 4, 1991. He holds a B.S. degree in Business from the University of Missouri - St. Louis and is a certified public accountant. Mr. S.F. Schaab joined the registrant in November 1992, and was elected Treasurer effective January 1, 1993. He has 19 years of experience in financial and treasury management, most recently with Peabody Holding Company, Inc. A certified public accountant, he holds a B.S.B.A. degree in accounting from the University of Missouri-Columbia. Mr. C.R. Miller joined the registrant in May 1990, as an attorney, and was elected Secretary on August 12, 1992. His title now is Corporate Secretary, Associate General Counsel. He has twelve years experience in the public and private practice of law, most recently as an attorney in the executive branch of Missouri state government. Derek Redmore joined Petrolite as a research chemist in 1965 and was promoted to group Leader in 1966. From 1972 to 1993, he held various managerial positions with increasing responsibility in Research and Development, most recently Director of Technology Support. In December 1993, he was elected Vice President, Technology. Redmore earned his B.Sc. and Ph.D. degrees in Organic Chemistry at the University of Nottingham. e) Compliance with Section 16(a) of the Exchange Act. Information -------------------------------------------------- regarding compliance with Section 16(a) of the Exchange Act, on page 14 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, hereby is incorporated by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information appearing under Compensation of Executive Officers, Retirement Benefits, and Compensation of Directors' on pages 10 through 14 of the registrant's Notice of Annual Meeting and Proxy statement dated January 20, 1994 is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership is set out on pages 3 and 4 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994, under the heading "Security Ownership of Certain Beneficial Owners and Management", is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information appearing under Certain Transactions on page 7 of the registrant's Notice of Annual Meeting and Proxy Statement dated January 20, 1994 is incorporated by reference herein. PART IV b) No form 8-K's were filed with SEC during the fourth quarter of fiscal 1993. Individual financial statements of the registrant's subsidiaries have been omitted since the registrant is primarily an operating registrant and the operating subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interest and/or indebtedness to any person other than the registrant or its consolidated subsidiaries in amounts which together exceed 5 percent of total consolidated assets at October 31, 1993. Separate financial statements of subsidiaries not consolidated, and 50% or less owned entities (accounted for by the equity method) have been omitted because, if considered in the aggregate, they would not constitute a significant subsidiary. 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. PETROLITE CORPORATION --------------------- (Registrant) By s/ Herbert F. Eggerding, Jr. ------------------------------ Herbert F. Eggerding, Jr. Executive Vice President and Chief Financial Officer Dated: January 26, 1994 ---------------------------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By s/ William E. Nasser By s/ Herbert F. Eggerding, Jr. -------------------------------------- ------------------------------- William E. Nasser Herbert F. Eggerding, Jr. Principal Executive Officer Principal Financial Officer and Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Andrew B. Craig * By s/ William F. Haberberger --------------------------------------- ------------------------------- Andrew B. Craig, Director William F. Haberberger Principal Accounting Officer Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Paul F. Cornelsen* By s/ Louis Fernandez* -------------------------------------- ------------------------------- Paul F. Cornelsen, Director Louis Fernandez, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ Michael V. Janes* By s/ James E. McCormick* -------------------------------------- ------------------------------ Michael V. Janes, Director James E. McCormick, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- By s/ William E. Maritz* By s/ Thomas P. Reidy* --------------------------------------- ----------------------------- William E. Maritz, Director Thomas P. Reidy, Director Dated: January 26 , 1994 Dated: January 26 , 1994 --------------------- --------------------- *By: s/ Charles R. Miller ------------------------------------- Charles R. Miller Attorney-In-Fact REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- ON FINANCIAL STATEMENTS SCHEDULES --------------------------------- To the Directors of Petrolite Corporation Our audits of the consolidated financial statements referred to in our report dated November 30, 1993 appearing on page 29 of the Petrolite Corporation 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 in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. s/ Price Waterhouse PRICE WATERHOUSE St. Louis, Missouri November 30, 1993 CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We hereby consent to the incorporation by reference in the Prospectuses constituting part of the registration statements on Form S-8 (Nos. 2-80631, 33- 20553, 33-21962, 33-24261, 33-63108, 33-47814, 33-47815, and 33-63108) of Petrolite Corporation of our report dated November 30, 1993 appearing on page 29 of the Petrolite Corporation 1993 Annual Report to Stockholders 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 on page 19 of this Form 10-K. s/ Price Waterhouse PRICE WATERHOUSE St. Louis, Missouri January 26, 1994 ***************** Major capital expenditures in fiscal 1993, 1992, and 1991 included property, plant and equipment from the Welchem acquisition, a new information system principally to serve the Tretolite and Industrial Chemicals Divisions, continuing expansion and upgrading of the Bayport Chemical manufacturing plant, investments in bulk containers and related distribution facilities, and a new EuroChem Division office building in Kirkby, England. Depreciation is generally provided on a straight-line basis at rates based on estimated useful lives of properties.

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1993

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ITEM 1. BUSINESS NIPSCO INDUSTRIES, INC. AND ITS SUBSIDIARIES. NIPSCO Industries, Inc. (Industries) was incorporated in Indiana on September 22, 1987, as a wholly- owned subsidiary of Northern Indiana Public Service Company (Northern Indiana). Industries became the parent of Northern Indiana on March 3, 1988, after the shareholders of Northern Indiana approved the formation of a holding company in December, 1987. Northern Indiana's outstanding common shares were exchanged on a share-for-share basis with common shares of Industries effective March 3, 1988. The other securities of Northern Indiana, including its First Mortgage Bonds, pollution control notes and bonds, other debt securities and each series of preferred stock, were not changed by the restructuring and continue to be outstanding obligations and securities of Northern Indiana. Northern Indiana is a public utility operating company supplying electricity and gas to the public in the northern third of Indiana. At December 31, 1993, Industries had five direct, wholly-owned subsidiaries in addition to Northern Indiana, which are all Indiana corporations: NIPSCO Development Company, Inc. (Development), NIPSCO Energy Services, Inc. (Services), NIPSCO Capital Markets, Inc. (Capital Markets), Kokomo Gas and Fuel Company (Kokomo Gas) and Northern Indiana Fuel and Light Company, Inc. (NIFL). Northern Indiana, Industries' largest and dominant subsidiary, is a public utility operating company, incorporated in Indiana on August 2, 1912, engaged in supplying natural gas and electric energy to the public. It operates in 30 counties in the northern part of Indiana, serving an area of about 12,000 square miles with a population of approximately 2,188,000. At December 31, 1993, Northern Indiana serves approximately 622,500 customers with gas and approximately 395,100 with electricity. Northern Indiana has two subsidiaries, Shore Line Shops, Inc. (Shore Line) and NIPSCO Exploration Company, Inc. (Exploration). Shore Line undertakes the purchase and sale of transferred employees' residences on behalf of Northern Indiana. Exploration has investment interests, which are subject to Indiana Utility Regulatory Commission (Commission) rate treatment, in off-shore Gulf of Mexico oil and gas leases. Kokomo Gas is a public utility operating company incorporated in Indiana in 1917, engaged in supplying natural gas to the public. It operates in the city of Kokomo, Indiana and the surrounding area in 6 counties having a population of approximately 100,000, and serves approximately 31,000 customers at December 31, 1993. The Kokomo Gas service territory is contiguous to Northern Indiana's gas service territory. On March 31, 1993, Industries acquired NIFL, a natural gas utility headquartered in Auburn, Indiana, that serves approximately 28,700 customers at December 31, 1993, in the northeast corner of the state, contiguous to Northern Indiana's service territory. Industries issued 1,112,862 common shares and $26,311 cash in exchange for all of the common shares of NIFL. Development makes various investments, including real estate. Services coordinates the energy-related diversification ventures and has four wholly- owned subsidiaries: NIPSCO Fuel Company, Inc. (Fuel) which makes investments in gas and oil exploration and development ventures; NIPSCO Energy Trading Corp. (NETCO) which is engaged in gas and other energy brokering businesses; NI-TEX, Inc. (NI-TEX) which is an intrastate natural gas transmission and supply company and Crossroads Pipeline Company (Crossroads), a natural gas transmission company. Capital Markets handles financing for ventures of Industries and its subsidiaries other than Northern Indiana. Development is a 95% shareholder in Elm Energy and Recycling (UK) Ltd. (Elm Energy), which was formed to develop, own and operate a waste-to-energy generating plant in Wolverhampton, England. The 30 megawatt tire-fueled generating station is expected to use about 8-10 million automobile and truck tires a year and began operations in late 1993. The majority of the "Business" discussion of this report relates to Northern Indiana, Kokomo Gas, NIFL and Crossroads (Utilities). See "Selected Supplemental Information--Gas Statistics and Electric Statistics" in the 1993 Annual Report to Shareholders, which information is incorporated by reference, (see Exhibit 13) regarding classes of customers served. BUSINESS OF THE COMPANY. ELECTRIC OPERATIONS. Northern Indiana owns and operates four coal fired electric generating stations with net capability of 3,179,000 kilowatts (kw). Northern Indiana also owns and operates two hydroelectric generating plants with rated net capability of 10,000 kw, and four gas fired combustion turbine generating units with net capability of 203,000 kw. During the year ended December 31, 1993, Northern Indiana generated 92% and purchased 8% of its electric energy requirements. Northern Indiana's 1993 electric control area peak of 2,953,600 kw, which includes Wabash Valley Power Association, Inc. (WVPA) and Indiana Municipal Power Agency (IMPA) for which Northern Indiana controls interchange operation, was set on August 27, 1993. The 1993 peak established a new all-time peak, exceeding the old peak of 2,738,550 kw established on September 6, 1990. The electric system 1993 peak internal load, which excludes WVPA and IMPA, was 2,736,100 kw on August 27, 1993. This also established a new internal peak for Northern Indiana. Northern Indiana's electric system is interconnected with that of Indiana Michigan Power Company, Commonwealth Edison Company, PSI Energy, Inc., Consumers Power Company, WVPA, IMPA, and Central Illinois Public Service Company. Electric energy is purchased from, sold to, or exchanged with these and other utilities. Northern Indiana provides WVPA with transmission and distribution service, operating reserve requirements and capacity deficiency service, and provides IMPA with transmission, operating reserve requirements and capacity deficiency service, in Northern Indiana's control area. Northern Indiana also engages in sales and services under the interconnection agreements with WVPA and IMPA. WVPA provides service to twelve Rural Electric Membership Corporations (REMC's) located in Northern Indiana's control area. IMPA provides service to the municipal electric system of the city of Rensselaer located in Northern Indiana's control area. Northern Indiana and WVPA executed a supplemental agreement in 1990 which provides WVPA with intermediate-term capacity and energy service, and unit peaking capacity and energy service. Under the unit peaking capacity and energy service, WVPA purchased 90,000 kw per month beginning January, 1992, which purchases will extend through December 2001. Northern Indiana has full requirements agreements with each of its eight municipal wholesale customers. These full requirements contracts became effective October 1, 1987, and extend through January 31, 1998. Northern Indiana is a member of the East Central Area Reliability Coordination Agreement (ECAR). ECAR is one of nine regional electric reliability councils established to coordinate planning and operations of member companies regionally and nationally. FUEL SUPPLY. The generating units of Northern Indiana are located at Bailly, Mitchell, Michigan City and Schahfer Generating Stations. Thirteen steam generating units have a net capability of 3,179,000 kw. Coal is the primary source of fuel for all units, except for three, which utilize natural gas. In addition, Northern Indiana's four combustion turbine generating units with a net capability of 203,000 kw are fired by gas. Fuel requirements for Northern Indiana's generation for 1993 were supplied as follows: In 1993, Northern Indiana used approximately 7.1 million tons of coal at its generating stations. Northern Indiana has established a normal level of coal stock which provides adequate fuel supply during the year under all conditions. Annual coal requirements for Northern Indiana's electric generating units through 1998 are estimated to range from 7.1 million tons to 8.5 million tons, depending from year to year upon anticipated sales levels, scheduled maintenance and other variables. These requirements are being or will be met in part under long-term contracts as follows: - -------- (a) Contract calls for requirements up to 1.0 million tons. The average cost of coal consumed in 1993 was $32.90 per ton or 16.65 mills per kilowatt-hour (kwh) generated as compared to $33.66 per ton or 16.82 mills per kwh generated in 1992. Northern Indiana's forecasts indicate that its coal costs will remain at the current level or be slightly lower over the next two years. COAL RESERVES. Included in the previous table of coal contracts is a coal mining contract with Cyprus Shoshone Coal Corporation (Cyprus) under which Cyprus is mining Northern Indiana's coal reserves in the Cyprus mine through the year 2001. The costs of the reserves are being recovered through the rate making process as the coal is burned to produce electricity. FUEL ADJUSTMENT CLAUSE. See "Fuel Adjustment Clause" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (see Exhibit 13). GAS OPERATIONS. Northern Indiana supplies natural gas of about 1,000 Btu per cubic foot. In a 24-hour period ending February 18, 1993, Northern Indiana's 1993 maximum day sendout was 1,444,714 dekatherms (dth). The maximum day's sendout of gas to date in 1994, is preliminarily estimated to be 1,775,227 dth during the 24-hour period ending at noon, January 19, 1994. In 1993, most of the gas supplied by Northern Indiana was purchased from Natural Gas Pipeline Company of America (Natural), Midwestern Gas Transmission Company (Midwestern), Panhandle Eastern Pipe Line Company (Panhandle), Trunkline Gas Company (Trunkline), ANR Pipeline Company (ANR) and various producers under separate service agreements with each of these suppliers. Approximately 28% of Northern Indiana's 1993 gas supply was purchased on the spot market, generally on a 30-day agreement. The average price per dth (including take-or-pay charges) in 1993 decreased from $3.32 to $3.25, and the average cost of purchased gas, after adjustment for take-or-pay charges billed to transport customers, was $3.21 per dth as compared to $3.16 per dth in 1992. The wholesale rates of Natural, Midwestern, Panhandle, Trunkline and ANR to Northern Indiana are subject to change either in accordance with purchased gas adjustment procedures established by the Federal Energy Regulatory Commission (FERC), or in rate proceedings filed with the FERC, or both. Northern Indiana has had service agreements with the pipeline suppliers which provide for daily purchases of natural gas in specified quantities. New agreements have been negotiated with the natural gas suppliers to replace former pipeline supplier contracts pursuant to the requirements of FERC Order No. 636 (See "Rate Matters--FERC Order No. 636" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference, see Exhibit 13.) Northern Indiana also has firm transportation agreements with the pipelines, which allow Northern Indiana to move third party gas through a pipeline's transmission system. Northern Indiana also has producer agreements which allow for the purchase of gas either from gas marketers or directly from companies that drill and process gas for commercial use. Northern Indiana has a curtailment plan approved by the Commission. Effective on August 11, 1981, the plan allows unrestricted gas sales by Northern Indiana. In 1993, Northern Indiana added 8,971 new gas customers. There were no firm sales curtailments in 1993 and none are expected during 1994. Northern Indiana has in operation an underground gas storage field at Royal Center, Indiana, which currently has a storage capacity of 6.75 million dth. Withdrawals have been made in the 1993-94 winter of up to 73,586 dth per day. In addition, Northern Indiana and NI-TEX have several gas storage service agreements which make possible the withdrawal of substantial quantities of gas from other storage facilities. All of the storage agreements have limitations on daily withdrawal volumes and the timing thereof. These contracts provide in the aggregate for approximately 32,287,004 dth of annual stored volume, and allow for approximately 637,529 dth of maximum daily withdrawal. Northern Indiana has a liquefied natural gas plant in LaPorte County which is designed for peak shaving and has the following capacities: maximum storage of 4,000,000 dth; maximum liquefaction rate (gas to liquid), 20,000 dth per day; maximum vaporization rate (output to distribution system), 400,000 dth per day. GAS EXPLORATION. Northern Indiana has participated in successful gas exploration projects which have produced additional gas supplies. NIPSCO Exploration Company, Inc., a wholly-owned subsidiary of Northern Indiana, was formed in 1973. As of December 31, 1993, Northern Indiana had a remaining investment of $1,400,000 in the subsidiary for two projects. The first project is participation by Exploration with others in the acquisition of interests in leases sold by the Department of Interior in the Gulf of Mexico. Exploration originally invested $7.6 million, of $16.8 million authorized by the Commission, in this project and has an interest in several tracts. The second project is participation by Exploration in an off-shore oil and gas development venture with Natural, Chevron U.S.A., Inc. and other distribution customers of Natural. This venture also involves exploring and developing oil and gas leases in the Gulf of Mexico. Exploration was authorized to invest $15 million in this project and has invested $8.4 million. KOKOMO GAS. Kokomo Gas' total gas send-out for 1993 was 8,122,208 dth, compared to 7,586,788 dth for 1992. Total transportation volumes handled for industrial customers in 1993 were 1,785,329 dth, compared to 1,675,546 dth in 1992. Kokomo Gas purchased gas on the spot market from a number of suppliers including NI-TEX, a subsidiary of Services, to satisfy some of its system requirements; the balance was purchased from Panhandle. Spot market purchases accounted for 99% of total system requirements in 1993. The wholesale rates of Panhandle to Kokomo Gas are subject to change either in accordance with purchased gas adjustment procedures established by the FERC, in rate proceedings filed with the FERC, or both. NIFL. NIFL's total gas send-out for 1993 was 7,881,513 dth. Total transportation volumes handled for industrial customers in 1993 were 3,227,853 dth. NIFL purchased gas on the spot market from a number of suppliers including NI-TEX, a subsidiary of Services, to satisfy some of its system requirements; the balance was purchased from ANR and Panhandle. Spot market purchases accounted for 50% of total system requirements in 1993. The wholesale rates of ANR and Panhandle to NIFL are subject to change either in accordance with purchased gas adjustment procedures established by the FERC, in rate proceedings filed with the FERC, or both. GAS COST ADJUSTMENT CLAUSE. See "Gas Cost Adjustment Clause" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (see Exhibit 13). TAKE-OR-PAY PIPELINE GAS COSTS. See "Take-or-Pay Pipeline Gas Costs" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (see Exhibit 13). FERC ORDER NO. 636. See "FERC Order No. 636" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (see Exhibit 13). BUSINESS OF OTHER SUBSIDIARIES CAPITAL MARKETS. Capital Markets was formed in 1989 to serve as the funding agent for ventures of Industries and its subsidiaries other than Northern Indiana. Capital Markets has a $150 million revolving Credit Agreement, which provides short-term financing flexibility to Industries and also serves as the back up instrument for a commercial paper program. As of December 31, 1993, there were no borrowings outstanding under this agreement. Capital Markets also has $50 million of money market lines of credit. As of December 31, 1993, there were no borrowings under these lines of credit. As of December 31, 1993 Capital Markets had $47.0 million in commercial paper outstanding, having a weighted average interest rate of 3.48%. The obligations of Capital Markets are subject to a Support Agreement between Industries and Capital Markets, under which Industries has committed to make payments of interest and principal on Capital Markets' securities in the event of a failure to pay by Capital Markets. Restrictions in the Support Agreement prohibit recourse on the part of Capital Markets' investors against the stock and assets of Northern Indiana which are owned by Industries. Under the terms of the Support Agreement, in addition to the cash flow of cash dividends paid to Industries by any of its consolidated subsidiaries, the assets of Industries, other than the stock and assets of Northern Indiana, are available as recourse to holders of Capital Markets' securities. The carrying value of those assets, other than Northern Indiana, reflected in the consolidated financial statements of Industries, is approximately $299.1 million at December 31, 1993. DEVELOPMENT. Development looks for partnerships with customers on energy projects, seeks environmental project opportunities and coordinates the real estate diversification of Industries. Development is a 95% shareholder in Elm Energy and Recycling (UK) Ltd. (Elm Energy), which was formed to develop, own and operate a waste-to-energy generating plant in Wolverhampton, England. The 30 megawatt tire-fueled generating station is expected to use about 8-10 million automobile and truck tires a year and began operations in late 1993. In conjunction with EER, Ltd., Development is evaluating similar tires-to- energy projects in Scotland and Belgium. In 1993, Development, through its various real estate partnerships, completed three multiple-family residential housing communities in Hammond, Fort Wayne and Mishawaka, while similar joint projects are being considered in Portage, East Chicago and other communities in Northern Indiana's service territories. These projects are part of a commitment by Development to provide high-quality, energy efficient, affordable housing to the residents of a variety of geographic and economic regions served by Northern Indiana. Harbor Coal Company (Harbor Coal), a wholly-owned subsidiary of Development, has invested in a partnership to finance, construct, own and operate a $65 million pulverized coal injection facility which began commercial operation in August, 1993. The facility receives raw coal, pulverizes it and delivers it to Inland Steel Company blast furnaces for use in the operation of their blast furnaces. Harbor Coal is a 50% partner in the project with an Inland Steel affiliate. Industries has guaranteed the payment and performance of the partnership's obligations under a sale and leaseback of a 50% undivided interest in the facility. Development is also evaluating potential partnerships with Northern Indiana customers for using waste gases from steelmaking and other processes for power generation. Low BTU blast furnace gases and other fuels, in amounts which could fuel up to 250 megawatts of new generation, are produced at industries served by Northern Indiana. SERVICES. Services coordinates energy-related diversification and has four wholly-owned subsidiaries: NETCO. NETCO provides natural gas brokering and transportation management services to customers within Northern Indiana's service territory. During the last quarter of 1993, NETCO expanded its transportation management services to include imbalance exchange services for its customers. Operating revenues for the year totalled $1.9 million. NI-TEX. NI-TEX is an intrastate natural gas transmission and supply company providing gas sales, transportation and storage services. NI-TEX continues to provide flexible city gate gas supply to Northern Indiana, Kokomo Gas and NIFL under term contracts. NI-TEX, through joint ventures with industry partners, also owns natural gas transmission and storage facilities located in Texas. Its Laredo-Nueces pipeline affiliate transported 16.2 million dth of natural gas in 1993. Its Coastline Gas Storage Company affiliate operates a salt dome gas storage facility with a Phase I operating capacity of 2.9 billion cubic feet, and provides contract storage services to Northern Indiana and other third parties. Phase II, which is projected to increase total storage capacity to 5.3 billion cubic feet, is expected to be completed during the fourth quarter of 1995. Operating income from NI-TEX sales arrangements, combined with joint venture earnings, totalled $3.0 million for the year. FUEL. Fuel is an oil and gas exploration and production company with activities concentrated in the mid-continent region of the United States and offshore in the Gulf of Mexico. As of December 31, 1993, $35.8 million has been invested in exploration and development projects. Fuel's share of estimated proved reserves at year-end totalled 1.2 million barrels of oil and 23.8 million dth of natural gas. CROSSROADS. In April 1993, NI purchased a 20-inch crude-oil pipeline that extends from the Illinois-Indiana state line east 202 miles to Cygnet, Ohio. The Crossroads line has been converted from oil to natural gas and was approved by the Commission as an intrastate pipeline. The line provides: (1) access to major gas supplies in the United States; (2) enhanced ability to negotiate for gas supplies at the most competitive price; (3) a northern hub in the Midwest gas market; and (4) increased reliability for customers in extreme weather conditions such as those occurring in January 1994. TRIUMPH NATURAL GAS, INC. (TRIUMPH). Services also owns a 51 percent interest in Triumph, a Dallas-based full service natural gas marketing company. Triumph specializes in the purchase, transportation and sale of natural gas to utility, industrial and commercial customers in the upper midwest region of the United States, as well as supply and transportation management services to Northern Indiana. Triumph also owns interests in gas gathering facilities in Oklahoma. In December 1993, Services entered into a Letter of Intent with Eastex Energy Inc. (Eastex) to sell its entire ownership interest in NETCO and its 51 percent ownership interest in Triumph in exchange for a combination of Eastex common and preferred stock, representing an equity ownership of approximately 25 percent. Eastex is a nationwide natural gas merchant specializing in purchase, gathering, transportation, storage and sale of natural gas, and related services. On March 4, 1994, Services entered into a definitive agreement with Eastex for the sale and exchange of its ownership interests in NETCO and Triumph, subject to certain conditions precedent to closing. Services was unable to meet the conditions precedent to closing and, as a result, the definitive agreement will expire March 31, 1994. REGULATION Holding Company Act. Industries is exempt from registration with the Securities and Exchange Commission (the "SEC") as a "registered holding company" under the Public Utility Holding Company Act of 1935, as amended (the "Holding Company Act"). Prior approval of the SEC under the Holding Company Act is, however, required if Industries proposes to acquire, directly or indirectly, additional utility securities. There may also be limits on the extent to which Industries and its non-utility subsidiaries can enter into businesses which are not "functionally related" to the electric and gas businesses without raising questions about Industries' exempt status under the Holding Company Act. SEC guidelines established in prior decisions of the SEC require Industries to remain engaged primarily and predominantly in the electric and gas businesses and to limit the size of its activities outside of such businesses relative to Industries as a whole. Industries has no present intention of becoming a registered holding company subject to regulation by the SEC under the Holding Company Act. Indiana Utility Regulatory Commission. Northern Indiana and Industries have been advised by their counsel that Industries will not be subject to regulation by the Commission as long as it is not a public utility. Under existing law, Industries and its non-utility subsidiaries are subject to Commission regulation with respect to transactions and contracts with the Utilities, and are subject to certain reporting and information access requirements under Indiana law. The Utilities are subject to regulation by the Commission as to rates, service, accounts, issuance of securities, and in other respects. See "Rate Matters" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (see Exhibit 13). The Utilities are also subject to limited regulation by local public authorities. Federal Energy Regulatory Commission. Industries is not regulated by the FERC, but any subsidiary, including Northern Indiana, that engages in FERC jurisdictional sales or activities will continue to be subject to such regulation. Northern Indiana's restructuring under Industries was approved by a February 29, 1988 order of the FERC. The FERC's February 29, 1988 order is conditioned upon the FERC's continuing authority to examine the books and records of Industries and its subsidiaries, upon further order of the FERC, and to make such supplemental orders, for good cause, as it may find necessary or appropriate regarding the restructuring. In 1993, about 3% of Northern Indiana's electric revenues were derived from electric service it furnished at wholesale in interstate commerce to other utility companies, municipalities and WVPA (see Item 1. Business--Electric Operations regarding WVPA). Northern Indiana's wholesale rates and operations are subject to the jurisdiction of the FERC. The jurisdiction of the FERC does not extend to the issuance of securities by Northern Indiana since it is a public utility organized and operating in the State of Indiana, under the laws of which its security issues are regulated by the Commission. The FERC on October 21, 1954, declared Northern Indiana exempt from the provisions of the Natural Gas Act. Kokomo Gas, NIFL and Crossroads are also exempt from the provisions of the Natural Gas Act. RATE MATTERS. For information regarding Northern Indiana's gas rates, and the Utilities' take-or-pay pipeline gas costs and potential gas transition costs, see "Rate Matters" and "FERC Order No. 636" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which notes are incorporated herein by reference (see Exhibit 13). CONSTRUCTION BUDGET. The Utilities 1994-98 construction budget (including allowance for funds used during construction) is estimated at approximately $748 million, including $178 million in 1994, $160 million in 1995, $137 million in 1996, $132 million in 1997 and $141 million in 1998. The Utilities construction estimates include adjustments for anticipated inflation. No new electric generating units are planned in the 1994-98 budget. Northern Indiana does not have, and has no plans to construct, a nuclear generating unit. COMPETITION. In municipalities where Northern Indiana renders electric service to the general public as a public utility, no other utility renders electric or gas service, except in Angola, DeMotte, Rome City, Wanatah and Waterloo. In certain municipalities where electric service is supplied by Northern Indiana, NIFL provides competing gas utility service. In localities where Northern Indiana renders gas service only, it competes with electric utilities, municipal or private, for the business for which they render alternative electric service. Kokomo Gas and NIFL service territories are contiguous to Northern Indiana's gas service territory, but Northern Indiana, Kokomo Gas and NIFL do not compete for any of the same customers. Kokomo Gas and NIFL compete with other electric utilities serving customers in their respective service territories. All electric service territories within the State of Indiana are assigned to the existing suppliers, and boundaries of new territories outside existing municipalities are assigned to the utility having the nearest existing electric distribution lines. Only existing municipal electric utilities may expand their service areas and then only into areas that have been annexed by the municipality, subject to the approval of the Commission and certain other conditions. Northern Indiana makes no representation as to the possible effect upon its business of present or future competition by private or municipal utilities or governmental agencies, instrumentalities or authorities within the territory now served. Northern Indiana is also subject to competition for gas sales to industrial customers through their ability, under Northern Indiana's rate provisions, to make their own purchases of gas and have Northern Indiana transport the gas to the customers. During 1993, gas transportation represented 59% of Northern Indiana's total gas sendout. Indiana law requires Commission approval before a gas customer of a utility may bypass the utility and make other arrangements for gas service. Any entity which transports gas from outside Indiana for direct sale or delivery to itself or other end-users within the state will be considered a public utility and must obtain a necessity certificate from the Commission in order to engage in such activities. EMPLOYEE RELATIONS. Northern Indiana had 4,417 employees at December 31, 1993. Approximately 65% of the Company's employees (physical and clerical workers) are represented by two local unions of the United Steelworkers of America, AFL-CIO-CLC. Effective June 1, 1993, the bargaining unit employees ratified new four-year agreements which continue until June 1, 1997. The new agreements provide for base wage increases of two percent in 1993, three percent in 1994 and 1995, and three and one-half percent in 1996. Additional economic provisions include an early signing bonus of four percent and a variable compensation plan linked to improvements in productivity. Certain officers of Northern Indiana are also officers of Industries. Industries currently has 30 employees in its diversified operations. Kokomo Gas had 75 full-time employees at December 31, 1993. Of these, 55 employees are represented by the Oil, Chemical and Atomic Workers International Union, AFL-CIO. New collective bargaining agreements covering these employees were negotiated in early 1992 and will expire February 15, 1995. NIFL had 80 full-time employees at December 31, 1993. ENVIRONMENTAL MATTERS. Northern Indiana is subject to regulation with regard to environmental matters by various federal, state and local authorities. Northern Indiana cannot forecast the effect of all such regulation upon its generating, transmission and other facilities, or its operations. Northern Indiana intends to comply with all applicable governmental requirements but also intends to contest any it deems to be unreasonable or impossible of compliance or otherwise invalid or contrary to the public interest. The application of federal and state restrictions to protect the environment, including but not limited to those hereinafter described, involves or may involve review, certification or issuance of permits by various federal, state and local authorities. Such restrictions, particularly in regard to emissions into the air and water, and disposal of solid wastes, may limit or prevent operations, or substantially increase the cost of operation of Northern Indiana's facilities, and may also require substantial investments above the amounts presently estimated for proposed new projects and may delay or prevent authorization and completion of the projects. Northern Indiana's total capital expenditures from January 1, 1989, through December 31, 1993, for pollution control facilities were approximately $75 million, which have been financed in part by the sale of Pollution Control Notes and Bonds--Jasper County. Northern Indiana anticipates expenditures of approximately $40 million for pollution control equipment in the 1994-98 period which includes anticipated expenditures of $8 million for the year 1994 and $8 million for the year 1995. Air. The Indiana Department of Environmental Management (IDEM) Office of Air Management has submitted to the U.S. Environmental Protection Agency (EPA) a State Implementation Plan (SIP) in accordance with the requirements of the Clean Air Act Amendments of 1977. As part of the sulfur dioxide SIP, the IDEM adopted a short-term compliance methodology that could make compliance with the applicable standards more difficult from time to time. The result could be the potential increase in costs of fuel incurred by Northern Indiana. Attainment-Nonattainment. Under the Clean Air Act Amendments of 1977, the State has identified various areas which are in compliance with the National Ambient Air Quality Standards (NAAQS) (attainment areas), and those that are not (nonattainment areas), with respect to sulfur dioxide, particulate matter and other pollutants. Portions of Lake, Porter and LaPorte Counties in which Northern Indiana operates electric generating facilities remain designated as nonattainment for sulfur dioxide. The control plans for each county are being implemented. Any reductions required by Northern Indiana have been made and no increased costs are anticipated for compliance. Lake County, Indiana, is designated as a nonattainment area for particulate or PM-10. The State of Indiana promulgated a new PM-10 SIP rule, which became effective on June 11, 1993. The regulations require reduced opacity and mass emissions limits at Dean H. Mitchell Station as well as the establishment of a fugitive dust control and continuous compliance plans. Northern Indiana invested $2.8 million to rebuild the Unit 5 electrostatic precipitator during 1993 to help meet the new PM-10 emission limits. The cost of compliance with the fugitive dust control requirements in the PM-10 rules cannot be firmly established at this time, but is expected to require minimal additional cost beyond those incurred for fugitive dust control measures historically undertaken at the Mitchell Generating Station. Porter County has been determined to have an unclassified status for PM-10. According to state requirements, the area will be monitored for PM-10 impacts to determine the appropriate classification with respect to the NAAQS. All other counties where Northern Indiana operates electric production facilities have an unclassified status for PM-10. Under Title I of the Clean Air Act Amendments of 1990 (CAAA) Lake and Porter Counties are classified as severe nonattainment areas for ozone. Passage of the CAAA results in new provisions applicable to mobile and stationary sources in Lake and Porter Counties. Transportation control measures required by the Employee Commute Options (ECO) rules will affect seven Northern Indiana facilities by late 1996. These measures will include plans to reduce the number of vehicles used by employees during their daily commutes to work and programs that promote the use of alternative fuel vehicles. Control measures requiring reduction of emissions of nitrogen oxides from the Mitchell and Bailly Generating Stations as a consequence of the Lake Michigan Ozone Control Program have yet to be determined. Northern Indiana is proactively undertaking efforts to evaluate potential least-cost methods to reduce emissions of nitrogen oxides from the generating stations. Northern Indiana cannot determine the cost impact of the future provisions. Acid Rain. Title IV of the CAAA addresses the acid rain issue by targeting large sources of sulfur dioxide and nitrogen oxides for significant reductions. The core acid rain rules for sulfur dioxide were promulgated by the EPA January 11, 1993. According to the regulations, Bailly Units 7 and 8 and Michigan City Unit 12 will be required to reduce their sulfur dioxide emissions below 2.5 pounds per million British thermal units (lbs/mmBtu) by January 1, 1995. These units, along with the remainder of Northern Indiana's coal-fired units, will require sulfur dioxide reductions below 1.2 lbs/mmBtu by January 1, 2000. Presently, all of Northern Indiana's eleven coal-fired generating units except Unit 12 utilize low sulfur fuel or flue gas desulfurization units to control sulfur dioxide emissions below the 1.2 lbs/mmBtu level. The EPA approved Northern Indiana's Acid Rain permits for the Bailly and Michigan City Generating Stations on August 31, 1993. The Phase I Acid Rain permits for the stations are effective from January 1, 1995 through December 31, 1999. One component of the permit is the Phase I extension plan for Bailly. Northern Indiana was eligible for and received the extension because of the construction and operation of the Bailly scrubber. This extension plan allocates additional allowances above the basic allowances applicable to Bailly and Michigan City Generating Stations. Northern Indiana has successfully tested the use of low sulfur coal at Unit 12 and expects that unit to be able to meet the limits with low sulfur coal. Northern Indiana estimates that total costs of compliance with the CAAA sulfur dioxide regulations will impact electric rates by less than 5% in the future. Additional Air Issues. The CAAA contain provisions that could lead to strict limitations on emissions of nitrogen oxides and "air toxics," which may require significant capital expenditures for control of these emissions. Northern Indiana cannot predict the costs of complying with them, but Northern Indiana believes that any such mandated costs would be recoverable through the rate making process. The EPA has promulgated a permit program to meet the requirements of Title V of the CAAA. The IDEM, on November 3, 1993, proposed an Air Operating permit program to meet the requirements of Title V to the Air Pollution Control Board. The program contains fee increases which will be charged when the program is promulgated during the first half of 1994. Water. The Clean Water Act, as amended, subjects point source dischargers to technology and water quality based controls through the National Pollution Discharge Elimination System (NPDES) permit program. Northern Indiana is required to have NPDES permits for discharges from its generating stations into the waters of the United States. The IDEM Office of Water Management has issued renewal NPDES permits effective as follows: Schahfer Station, November 1, 1993; Mitchell Station, November 1, 1993 and Michigan City Generating Station, November 1, 1993. The renewed Bailly Station NPDES permit is expected to be issued in the early portion of 1994. Northern Indiana received NPDES permit modifications for intermittent chemical treatment of the main discharge at the Mitchell and Michigan City Stations for zebra mussel control. Bailly Station utilizes thermal treatment in its water systems to control zebra mussels. Schahfer Station has not presently experienced operational impacts due to zebra mussels. Rather, Schahfer Station has experienced equipment problems due to an asiatic clam infestation. Alternate forms of control are being investigated by Northern Indiana in an effort to prevent any impact on plant operations relating to these infestations, while also minimizing the environmental impact of the controls. Superfund Sites. Northern Indiana has received notices from the EPA that it is a "potentially responsible party" (PRP) under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA) and the Superfund Amendment and Reauthorization Act (SARA) and may be required to share in the cost of cleanup of several waste disposal sites identified by the EPA. The sites are in various stages of investigation and analysis to determine the amount of remedial costs necessary to clean up the sites. At each of the sites Northern Indiana is one of several PRP's, and it is expected that remedial costs, as provided under CERCLA and SARA, will be shared among them. At some sites Northern Indiana and/or the other named PRP's are presently working with the EPA to clean up the site and avoid the imposition of fines or added costs. While remedial costs at these sites are not presently determinable, Northern Indiana's preliminary analysis indicates its share of such costs should not have a significant impact on the results of future operations. Manufactured Gas Plant Sites. Northern Indiana was notified by IDEM of the release of a petroleum substance into the St. Mary's River in Fort Wayne, Indiana, from the site of a former manufactured gas plant formerly owned by Northern Indiana. In cooperation with IDEM, Northern Indiana has taken steps to investigate and contain the substance. Northern Indiana is continuing to monitor and investigate the site to determine what further remedial action, if any, is required to be taken by it. Northern Indiana was notified by Indiana Gas Company, Inc. (Indiana Gas) that the site of a former manufactured gas plant in Lafayette, Indiana, believed to have been formerly owned by Northern Indiana, was being investigated and partially remediated by Indiana Gas pursuant to an administrative order issued by IDEM. Northern Indiana is investigating its potential liability and evaluating appropriate action. Northern Indiana has commenced a voluntary program of investigating its former manufactured gas plant sites in order to determine what, if any, remediation of any potential remaining waste materials may be required. Since this program is in its early stages, it is not possible at this time to estimate what, if any, remediation costs may be incurred. Electric And Magnetic Fields. The possibility that exposure to electric and magnetic fields emanating from power lines, household appliances and other electric sources may result in adverse health effects has been the subject of increased public, governmental and media attention. A considerable amount of scientific research has been conducted on this topic without definitive results. Research is continuing to resolve scientific uncertainties. ---------------- The Utilities have an ongoing program to remain aware of laws and regulations involved with hazardous waste. It is the Utilities' intent to continue to evaluate their facilities and properties with respect to these rules and identify any sites that would require corrective action. It is not possible to predict the scope, enforceability or financial impact of other environmental regulations or standards which may be established in the future. ITEM 2. ITEM 2. PROPERTIES. The physical properties of the Utilities are located in the State of Indiana. Crossroads owns a 202-mile natural gas pipeline running from northwest Indiana to Cygnet, Ohio. Only the Indiana portion of the line is presently in service as an intrastate gas pipeline. The only significant properties owned by other subsidiaries of Industries are: the Southlake Complex, a 325,000 square foot office building in Merrillville, Indiana, leased to Northern Indiana and owned by Development; a 36-mile intrastate natural gas pipeline, located in southern Texas and half- owned by NI-TEX, Inc.; a golf course and surrounding residential development in Chesterton, Indiana, owned by Lake Erie Land Company (a subsidiary of Development); a waste-to-energy generating plant in Wolverhampton, England owned by Elm Energy; and commercial real estate joint ventures, half-owned by KOGAF Enterprises, located in Kokomo, Indiana. ELECTRIC. Northern Indiana owns and operates four electric generating stations, with generating units using fossil fuels, with net capability of 3,179,000 kw. Northern Indiana also owns and operates two hydroelectric generating plants with rated net capability of 10,000 kw, and four gas fired combustion turbine generating units with net capability of 203,000 kw, an aggregate of 3,392,000 kw. Northern Indiana has 290 substations with an aggregate transformer capacity of 22,449,000 kva. Its transmission system with voltages from 34,500 to 345,000 consists of approximately 3,050 circuit miles of line, of which 2,073 miles are on wood poles, 823 miles are on steel towers, 133 miles are on steel poles, 19 miles are on concrete poles and 2 miles are in underground conduits. The electric distribution system extends into 21 counties and consists of approximately 7,669 circuit miles of overhead and approximately 1,108 cable miles of underground primary distribution lines operating at various voltages from 2,400 to 12,500 volts. Of approximately 306,097 poles on which Northern Indiana has transmission and distribution circuits, about 49,502 poles are owned by other utilities. Northern Indiana has distribution transformers having an aggregate capacity of approximately 10,597,576 kva and 425,031 electric watt-hour meters. GAS. Northern Indiana has an underground storage field at Royal Center and a liquefied natural gas plant in LaPorte County both described under "Item 1. Business--Gas Operations." Northern Indiana has approximately 12,266 miles of gas mains. Kokomo Gas has a liquified natural gas plant in Howard County which has the following capacities: maximum storage of 400,000 mcf; maximum liquefaction rate (gas to liquid), 2,850 mcf per day; maximum vaporization rate (output to distribution system), 30,000 mcf per day. Kokomo Gas also has a gas holder with a storage capacity of 12,000 mcf. Kokomo Gas has approximately 709 miles of gas mains. NIFL has approximately 732 miles of gas mains. OTHER PROPERTIES. Northern Indiana owns offices and service buildings, salesrooms, garages, repair shops, motor vehicles, construction equipment and tools, and office furniture and equipment, and also leases offices in various localities. It also owns miscellaneous parcels of real estate not now used in utility operations. PENDING DONATION OF PROPERTY. Northern Indiana announced during 1991 the planned donation of approximately 2,150 acres of land, including 60 miles of lake and river frontage, to the Indiana Natural Resources Foundation. The property frames and includes the resort areas of Lake Shafer and Lake Freeman in White and Carroll Counties, near the cities of Monticello and Delphi in central Indiana. Northern Indiana acquired the property in 1944 as part of the purchase of dams and two small hydroelectric plants and has maintained the area since that time. Northern Indiana is continuing to pursue the donation of this property to ensure the land is managed to enhance its preservation and recreational value. The dams and hydroelectric plants will be retained for Northern Indiana operations. CHARACTER OF OWNERSHIP. The properties of Northern Indiana are subject to the lien of its First Mortgage Indenture. The principal offices and properties are held in fee and are free from other encumbrances, subject to minor exceptions, none of which is of such a nature as substantially to impair the usefulness to Northern Indiana of such properties. Many of the offices in the various communities served are occupied by Northern Indiana under leases. All properties are subject to liens for taxes, assessments and undetermined charges (if any) incidental to construction, which it is Northern Indiana's practice regularly to pay, as and when due, unless contested in good faith. In general, the electric and gas lines and mains are located on land not owned in fee but are covered by necessary consents of various governmental authorities or by appropriate rights obtained from owners of private property. These consents and rights are deemed adequate for the purposes for which they are being used. Northern Indiana does not, however, generally have specific easements from the owners of the property adjacent to public highways over, upon or under which its electric and gas lines are located. At the time each of the principal properties was purchased a title search was made. In general, no examination of titles as to rights-of-way for electric and gas lines and mains was made, other than examination, in certain cases, to verify the grantors' ownership and the lien status thereof. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Industries and Northern Indiana are parties to various pending proceedings, including suits and claims against it for personal injury, death and property damage, but, in the opinion of their counsel, the nature of such proceedings and suits, and the amounts involved, do not depart from the routine litigation and proceedings incident to the kind of business conducted by Northern Indiana, except as set forth above under "Item 1. Business--subcaption Environmental Matters," and as described under the captions "Pending Tax Matter" and "Environmental Matters" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which notes are incorporated herein by reference (see Exhibit 13). No other proceedings against Industries, Northern Indiana or their subsidiaries are contemplated by governmental authorities to the knowledge of Industries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. SUPPLEMENTAL ITEM--EXECUTIVE OFFICERS OF THE REGISTRANT. Throughout the past five years, each of the executive officers of Industries has been continuously active in the business of Industries or Northern Indiana except as follows: Prior to August 15, 1989, Gary L. Neale was Chairman, President and Chief Executive Officer of Planmetrics, Inc., a consulting and computer software firm; prior to July 30, 1990, Owen C. Johnson was Senior Vice President, Administration of LIT America, Inc. and prior to December 31, 1991, David A. Kelly was Partner, Tax Division of Arthur Andersen & Co. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS. Industries' common shares are listed and traded on both the New York and Chicago stock exchanges. The table below indicates the high and low sales price of Industries' common shares, on the composite tape, during the periods indicated. As of February 28, 1994, Industries had 40,793 common shareholders of record. The policy of the Board of Directors has been to declare dividends on a quarterly basis payable on or about the 20th day of February, May, August and November. Industries paid quarterly common dividends of $0.31 per share during 1992; and quarterly common dividends of $0.33 per share during 1993. At its December 20, 1993 meeting Industries' Board of Directors increased the quarterly common dividend to $0.36 per share, payable February 18, 1994. Holders of Industries' common shares will be entitled to receive dividends when, as and if declared by the Board of Directors out of funds legally available therefor. Although the Board of Directors of Industries currently intends to consider the payment of regular quarterly cash dividends on common shares, the timing and amount of future dividends will depend on the earnings of Northern Indiana and other subsidiaries, their financial condition, cash requirements, any restrictions in financing agreements and other factors deemed relevant by the Board of Directors. During the next few years, it is expected that the great majority of earnings available for distribution of dividends will depend upon dividends paid to Industries by Northern Indiana. The following limitations on payment of dividends and issuance of preferred stock applies to Northern Indiana: When any bonds are outstanding under its First Mortgage Indenture, Northern Indiana may not pay cash dividends on its stock (other than preferred or preference stock) or purchase or retire common shares, except out of earned surplus or net profits computed as required under the provisions of the maintenance and renewal fund. At December 31, 1993, Northern Indiana had approximately $144.1 million of retained earnings (earned surplus) available for the payment of dividends. Future common share dividends by Northern Indiana will depend upon adequate retained earnings, adequate future earnings and the absence of adverse developments. So long as any shares of Northern Indiana's cumulative preferred stock are outstanding, no cash dividends shall be paid on its common shares in excess of 75% of the net income available therefor for the preceding calendar year unless the aggregate of the capital applicable to stocks subordinate as to assets and dividends to the cumulative preferred stock plus the surplus, after giving effect to such dividends, would equal or exceed 25% of the sum of all obligations evidenced by bonds, notes, debentures or other securities, plus the total capital and surplus. At December 31, 1993, the sum of the capital applicable to stocks subordinate to the cumulative preferred stock plus the surplus was equal to 41% of the total capitalization including surplus. In connection with the foregoing discussion, see "Common Share Dividend" in the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which note is incorporated herein by reference (See Exhibit 13). ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - -------- (a) Earnings per share were reduced by $0.72 due to the $82.0 million refund, less associated tax benefits of $30.3 million, related to the Bailly N1 generating unit. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information regarding results of operations, liquidity and capital resources and environmental matters is reported in the 1993 Annual Report to Shareholders under "Management's Discussion and Analysis of Financial Condition and Results of Operations," which information is incorporated herein by reference (see Exhibit 13). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following Consolidated Financial Statements and Supplementary Data are included in the 1993 Annual Report to Shareholders and are hereby incorporated by reference and made a part of this report (see Exhibit 13). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding executive officers is included as a supplemental item at the end of Item 4 of Part I of this Form 10-K. Information regarding directors is included at pages 2-5 in the Notice of Annual Meeting and Proxy Statement dated March 11, 1994, for Annual Meeting to be held April 13, 1994, which information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information regarding executive compensation is included at pages 11-17 in the Notice of Annual Meeting and Proxy Statement dated March 11, 1994, for Annual Meeting to be held April 13, 1994, which information 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 at pages 6-7 in the Notice of Annual Meeting and Proxy Statement dated March 11, 1994, for Annual Meeting to be held April 13, 1994, which information 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) The Financial Statements filed herewith as a part of this report on Form 10-K are listed on the Index to Financial Statements under Item 8 on page 16. (2) The following is a list of the Financial Statement Schedules filed herewith as part of this report on Form 10-K: (3) Exhibits-- The exhibits filed herewith as a part of this report on Form 10-K are listed on the Exhibit Index included on pages 35-37. Each management contract or compensatory plan or arrangement of Industries listed on the Exhibit Index is separately identified by an asterisk. (b) Reports on Form 8-K: None. NIPSCO INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET The accompanying notes to condensed financial statements are an integral part of this statement. NIPSCO INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME The accompanying notes to condensed financial statements are an integral part of this statement. NIPSCO INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS The accompanying notes to condensed financial statements are an integral part of this statement. NIPSCO INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL STATEMENTS 1. DIVIDENDS FROM SUBSIDIARIES Cash dividends paid to NIPSCO Industries, Inc. (Industries) by its consolidated subsidiaries were (in thousands of dollars): $155,224, $138,676 and $155,813 in 1993, 1992 and 1991, respectively. 2. SUPPORT AGREEMENT The obligations of NIPSCO Capital Markets, Inc. (Capital Markets) are subject to a Support Agreement between Industries and Capital Markets, under which Industries has committed to make payments of interest and principal on Capital Markets' securities in the event of a failure to pay by Capital Markets. Restrictions in the Support Agreement prohibit recourse on the part of Capital Markets' investors against the stock and assets of Northern Indiana Public Service Company (Northern Indiana) which are owned by Industries. Under the terms of the Support Agreement, in addition to the cash flow of cash dividends paid to Industries by any of its consolidated subsidiaries, the assets of Industries, other than the stock and assets of Northern Indiana, are available as recourse to holders of Capital Markets' securities. The carrying value of those assets other than Northern Indiana, reflected in the consolidated financial statements of Industries, is approximately $299.1 million at December 31, 1993. 3. CONTINGENCIES No proceedings against Industries or any of its subsidiaries other than Northern Indiana are pending or contemplated to the knowledge of Industries. The Company is a party to various pending proceedings, including suits and claims against it for personal injury, death and property damage, but, in the opinion of counsel for Northern Indiana, the nature of such proceedings and suits, and the amounts involved, do not depart from the routine litigation and proceedings incident to the kind of business conducted by Northern Indiana. 4. CHANGES IN ACCOUNTING PRINCIPLES Effective January 1, 1993, Industries adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes". The adoption of these standards did not have a significant impact on the condensed financial statements. - -------- See also Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders, which are incorporated herein by reference. (See Exhibit 13). SCHEDULE V NIPSCO INDUSTRIES, INC. SCHEDULE V--UTILITY PLANT AND OTHER PROPERTY AT ORIGINAL COST TWELVE MONTHS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (a) Northern Indiana Fuel and Light Company, Inc. purchased on March 31, 1993. (b) Includes acquisition and construction expenditures related to Crossroads Pipeline Company of $24,361,000. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE V NIPSCO INDUSTRIES, INC. SCHEDULE V--UTILITY PLANT AND OTHER PROPERTY AT ORIGINAL COST TWELVE MONTHS ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES: (a) Kokomo Gas and Fuel Company purchased on February 10, 1992. (b) Reconstruction costs associated with Bailly Generating Station pipe collapse, net of insurance recoveries. (c) Office building transferred to non-utility property. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE V NIPSCO INDUSTRIES, INC. SCHEDULE V--UTILITY PLANT AND OTHER PROPERTY AT ORIGINAL COST TWELVE MONTHS ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VI NIPSCO INDUSTRIES, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION TWELVE MONTHS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Northern Indiana Fuel and Light Company, Inc. purchased on March 31, 1993. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VI NIPSCO INDUSTRIES, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION TWELVE MONTHS ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Kokomo Gas and Fuel Company purchased on February 10, 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VI NIPSCO INDUSTRIES, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION TWELVE MONTHS ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII NIPSCO INDUSTRIES, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS TWELVE MONTHS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (a) Northern Indiana Fuel and Light Company, Inc. purchased on March 31, 1993. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII NIPSCO INDUSTRIES, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS TWELVE MONTHS ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (a) Kokomo Gas and Fuel Company purchased on February 10, 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII NIPSCO INDUSTRIES, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS TWELVE MONTHS ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE IX NIPSCO INDUSTRIES, INC. SCHEDULE IX--SHORT-TERM BORROWINGS TWELVE MONTHS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- NOTE: (1) Commercial paper is generally issued for short-term working capital requirements. Individual issues of commercial paper generally remain outstanding for less than thirty days. Bank notes represent borrowing under Credit Agreements and Lines of Credit with a consortium of local, domestic and international banks. (2) The average amount of short-term borrowing is determined by a weighted monthly average based on number of days outstanding. (3) The weighted average interest rates, except for commercial paper, represent the actual fixed rates applicable during the time period the borrowings were outstanding. The commercial paper interest rate was determined by dividing the aggregate annualized commercial paper interest expense by the actual aggregate principal outstanding during the period. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- SCHEDULE X NIPSCO INDUSTRIES, INC. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION TWELVE MONTHS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The amounts of maintenance and repairs and depreciation which are charged to expenses, other than those set forth in the Consolidated Statement of Income, or are charged to other accounts, are not significant. Advertising is not considered to be significant, and Northern Indiana pays no royalties. Provisions for taxes, other than payroll and income taxes, are summarized as follows: - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of NIPSCO Industries, Inc.: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in NIPSCO Industries, Inc.'s annual report to shareholders for the year ended December 31, 1993, 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 consolidated financial statements taken as a whole. The schedules listed on Page 17, Item 14(a)(2) are the responsibility of NIPSCO Industries, Inc.'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. As discussed in the notes to consolidated financial statements, effective January 1, 1993, NIPSCO Industries, Inc. and subsidiaries changed their methods of accounting for postretirement benefits other than pensions and income taxes. 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. NIPSCO Industries, Inc. (Registrant) March 28, 1994 /s/ Gary L. Neale Date_______________________________ By_________________________________ Gary L. Neale, Its 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 AND IN THE CAPACITIES AND ON THE DATES INDICATED. EXHIBIT INDEX - -------- *Management contract or compensatory plan arrangement of NIPSCO Industries, Inc.

352947_1993.txt

352947_1993

1993

352947

Item 1. Business Engelhard Corporation and its Subsidiaries (collectively referred to as the Company) are the successors to the businesses previously operated by Engelhard Minerals & Chemicals Corporation (EMC) through its Engelhard Industries and Minerals & Chemicals Divisions. In 1981, the Company's Common Stock was distributed, as a spin-off, to the shareholders of EMC, and the Company became a separate, publicly-held corporation. The Company's principal executive offices are located at 101 Wood Avenue, Iselin, New Jersey, 08830 (telephone number (908) 205-5000). The Company develops, manufactures and markets technology-based specialty chemical products and engineered materials for a wide spectrum of industrial customers and provides services to precious metals customers. The Company recently announced a plan to realign and consolidate businesses, concentrate resources and better position itself to achieve its strategic growth objectives. See Note 2 "Special charge" to the Consolidated Financial Statements on page 30 of the 1993 Annual Report to Shareholders. This plan resulted in a special charge of $148.0 million ($91.8 million after tax or $.95 per share) which covered a $118.0 million pretax restructure provision for asset writedowns related to product lines or sites being exited together with provisions for facility shutdown, rundown and relocation and for employee reassignment, severance and related benefits and a $30.0 million pretax environmental reserve for sites directly affected by this plan and for the most recent assessment of continuing environmental developments. The plan provides for the closure, relocation or consolidation of five facilities in the U.S. and two sites in Europe currently operated by the Chemical Catalysts and Engineerd Materials Groups. These actions are being taken to ensure that certain product lines stay competitive despite changing market conditions. Further, the plan covers one Specialty Minerals and Colors facility in the U.S. which will be rationalized or idled. The Company expects that these restructuring activities will impact approximately 600 employees. The plan also provides for assets of the Petroleum Catalysts, Paper Pigments and Chemicals and Specialty Minerals and Colors Groups which will become obsolete as a result of the development of new production processes and the reconfiguration of existing production processes or because certain product lines have become uneconomic. A special team has been designated by the Management Committee of the Company to implement the changes and programs contemplated by this plan within the year 1994. The Company employed approximately 5,750 people as of January 1, 1994 and operates on a worldwide basis with corporate and operating headquarters and principal manufacturing facilities and mineral reserves in the United States with other operations conducted in the European Community, the Russian Federation and the Pacific Rim. The Company's businesses are organized into three segments -Catalysts and Chemicals, Pigments and Additives, and Engineered Materials and Precious Metals Management. Information concerning the Company's net sales, operating earnings and identifiable assets by industry segment and by geographic area; inter-area transfers by geographic area; and export sales is included in Note 13 "Industry segment and geographic area data" to the Consolidated Financial Statements on pages 37 and 38 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Catalysts and Chemicals The Catalysts and Chemicals segment is comprised of three principal product groups: the Environmental Catalysts Group, serving the automotive, off-road vehicle, aircraft, industrial power generation and process industries; the Petroleum Catalysts Group, serving the petroleum refining industries; and the Chemical Catalysts Group, serving the chemical, petrochemical, pharmaceutical and food processing industries. Environmental catalysts are used in applications such as the abatement of carbon monoxide, oxides of nitrogen and hydrocarbons from gasoline, diesel and alternate fueled vehicle exhaust gases to meet emission control standards. These catalysts are also used for the removal of odors, fumes and pollutants generated by a variety of process industries including but not limited to the painting of automobiles, appliances and other equipment; printing processes; the manufacture of nitric acid and tires, in the curing of polymers; and power generation sources. The Company also participates in the manufacture and supply of automobile exhaust emissions control catalysts through affiliates serving the Pacific Rim: N.E. Chemcat Corporation (Japan) - 38.8 percent owned; and Hankuk- Engelhard (South Korea) - 49 percent owned, both of which also produce other catalysts and products. In the third quarter of 1992, the Company and Salem Industries, Inc., formed Salem Engelhard, a jointly owned partnership to produce and market products and services to abate, by catalytic and non- catalytic methods, emissions of volatile organic chemicals and other pollutants generated by a variety of process industries. The petroleum refining catalyst products consist of a variety of catalysts and processes used in the petroleum refining industry. The principal products are zeolitic fluid cracking catalysts which are widely used to provide economies in petroleum processing. The Company offers commercially a full line of fluid cracking catalyst based on patented technology including the DYNAMICS (registered trademark) line which can be used to control selectivity and cracking activity virtually independently of one another. This characteristic permits custom catalysts formulation for essentially all users. The Company manufactures petroleum catalysts used for catalytic reforming and isomerization of hydrocarbons to produce higher octane gasoline, for isomerization of xylenes to produce paraxylene and orthoxylene and for selective hydrogenation of alkylation feed stocks. The Company also manufactures hydrotreating catalysts which are used in viscosity improvement and aromatics saturation of lube oil feedstocks and for the removal of contaminant sulfur, nitrogen and metals. These reforming, isomerization and hydrotreating catalysts are marketed in North America and the Caribbean by Acreon Catalysts, a jointly owned partnership formed by the Company and Procatalyse. Process technologies developed by the Company are also offered for license to the petroleum industry. In March 1994, the Company completed its purchase of the assets of the sorbents and moving bed catalysts businesses of Solvay Catalysts, GmbH, in Nienburg Germany. This acquisition expands the Company's moving bed catalysts business and provides complementary product lines serving adsorbents applications. The chemical catalysts products consist of catalysts and sorbents used in the production of a variety of products or intermediates, including synthetic fibers, fragrances, antibiotics, vitamins, polymers, plastics, detergents, fuels and lube oils, solvents, oleochemicals and edible products. These catalysts are generally used in both batch and continuous operations requiring special catalysts for each application. Chemical catalysts utilize the Company's proprietary technology and many times are developed in close cooperation with specific customers. Sorbents are used to purify and decolorize naturally occurring fats and oils for manufacture into shortenings, margarines and cooking oils. In early 1994, the Company and ICC Technologies, Inc. formed Engelhard/ICC, a jointly owned partnership, to develop and commercialize air conditioning and air-treatment systems based on a proprietary new desiccant developed by Engelhard. The partnership will market these systems worldwide. The products of the Catalysts and Chemicals segment compete in the marketplace on the basis of product performance, technical service and price. No single competitor is dominant in the markets in which the Company operates. The manufacturing operations of the Catalysts and Chemicals segment are carried out in seven states in the United States. Wholly-owned foreign facilities are located in Italy, The Netherlands, Germany and the United Kingdom with equity investments located in the U.S., Japan and South Korea. The products are sold principally through the Company's sales organizations or its equity investments, supplemented by independent distributors and representatives. The principal raw materials used by the Catalysts and Chemicals segment include precious metals, procured by the Engineered Materials and Precious Metals Management Segment; kaolin, supplied by the Pigments and Additives Segment; and a variety of minerals and chemicals which are generally readily available. As of January 1, 1994 the Catalysts and Chemicals segment had approximately 1,860 employees worldwide, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Pigments and Additives The Pigments and Additives segment is comprised of two principal product groups: the Paper Pigments and Chemicals Group, serving the paper industry and the Specialty Minerals and Colors Group, serving the plastics, coatings, paint and allied industries. Paper pigments and chemicals products consist primarily of coating and extender pigments. The coating pigments provide whiteness, opacity and improved printing properties for high-quality paper and paperboard. Other products are used as extenders and/or combined with fibers during the manufacture of paper or paperboard. Products for the paper market include Ultra White 90 (registered trademark) pigment, a high-brightness material for high-quality paper coating; Ansilex (registered trademark) pigments that provide the desired opacity, brightness, gloss and printability in paper products; Nuclay (registered trademark) specialized coating pigment for lightweight publication papers; EXSILON (trademark) structured pigment that improves the printability of lightweight coated paper and carbonless forms; and Spectrafil (trademark) pigments for the newsprint and groundwood specialties markets. Specialty minerals and colors kaolin based products are used as pigments and extenders for a variety of purposes in the manufacture of plastic, rubber, ink, ceramic, adhesive products and in paint. Principal products include Satintone (registered trademark) products, ASP (registered trademark) pigments and Translink (registered trademark) surface modified reinforcements. Other specialty minerals and colors products which serve essentially the same end markets as the Company's kaolin-based pigments and extenders comprise a variety of organic and inorganic color pigments. The Group also produces gellants and sorbents for a wide range of applications. The products of the Pigments and Additives segment compete with similar products as well as products made from other materials on the basis of product performance and price. No single competitor is dominant in the markets in which the Company operates. Pigments and Additives operations are carried out in four states in the United States and in Finland. The products are sold principally through the Company's sales organization supplemented by independent distributors and representatives. The principal raw materials used by the Pigments and Additives segment include kaolin and attapulgite from mineral reserves owned or leased by the Company and a variety of minerals and chemicals which are generally readily available. As of January 1, 1994 the Pigments and Additives segment had approximately 1,840 employees worldwide, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Engineered Materials and Precious Metals Management The Engineered Materials and Precious Metals Management segment includes the Engineered Materials Group, serving a broad spectrum of industries and the Precious Metals Management Group, which is responsible for precious metals sourcing and dealing and for managing the precious metals requirements of the Company and its customers. The products of the Engineered Materials Group consist primarily of metal- based materials such as temperature-sensing devices, crucibles, bushings, gauze, precious metals coating and electroplating materials, conductive pastes and powders, brazing alloys and precious metal wire, sheet, and tubing. These products are used in the manufacture of automotive components, industrial devices, glass and glass fiber, ceramics, chemicals, instruments, control devices, fine jewelry, dental and medical supplies, hardware, furniture and air conditioners. The Group also provides refining services to internal and external customers. The products of the Engineered Materials Group compete with similar products as well as products made from other materials on the basis of product performance, technical service and price. No single competitor is dominant in the markets in which the Company operates. Engineered Materials manufacturing and refining operations are carried out in four states in the United States and in facilities located in the United Kingdom, France and Italy. The products are sold principally through the Company's sales organization, supplemented by independent distributors and representatives. The principal raw materials used by these operations are precious metals including those of the platinum group (platinum, palladium, rhodium, iridium and ruthenium), silver and gold, all of which are generally available. In January, 1993 the Company sold its 40 percent interest in M&T Harshaw, an affiliate through which the Company had participated in the base metal plating industry. In the fourth quarter of 1992, the Company formed Heraeus Engelhard Electrochemistry Corp., a venture with Heraeus Inc. The venture, 46 percent owned, markets electrochemical products in the Western Hemisphere. The Precious Metals Management Group is responsible for procuring precious metals requirements of the Company's operations and its customers. Supplies of newly mined platinum group metals are obtained primarily from South Africa and the Russian Federation and to a lesser extent from the United States and Canada, which four regions are the only known significant sources. Most of these platinum group metals are obtained pursuant to a number of contractual arrangements with different durations and terms. Management believes that available supplies of such metals will be adequate to meet the needs of the Company for the foreseeable future. Gold and silver are purchased from various sources. In addition, in the normal course of business, certain customers and suppliers deposit significant quantities of precious metals with the Company under a variety of arrangements. Equivalent quantities of precious metals are returnable as product or in other forms. The Precious Metals Management Group also engages in precious metal dealing operations with industrial consumers, dealers, central banks, miners and refiners. The group does not routinely speculate in the precious metals market. Offices are located in the United States, the United Kingdom, Switzerland, Japan and the Russian Federation. As of January 1, 1994 the Engineered Materials and Precious Metals Management segment had approximately 1,470 employees throughout the world, many of whom are hourly employees covered by collective bargaining agreements. Employee relations have generally been good. Major Customer Approximately 12 percent and 10 percent of the Company's net sales for the years ended December 31, 1992 and 1991, respectively, were generated from a customer of both the Catalysts and Chemicals and Engineered Materials and Precious Metals Management segments. Sales to this customer included both fabricated products and precious metal and were therefore significantly influenced by fluctuations in precious metal prices as well as the quantity of metal purchased. In such cases, the market price fluctuations and quantities purchased can result in material variations in sales reported but do not usually have a direct or substantive effect on earnings. Research and Patents The Company currently employs approximately 300 scientists, technicians and auxiliary personnel engaged in research and development in the field of chemistry and metallurgy. These activities are conducted in the United States and abroad. The Company spent approximately $45 million on research and development in each of the last three years. Research facilities include fully staffed instrument analysis laboratories, which the Company maintains in order to achieve the high level of precision necessary for its various businesses and to assist customers in understanding the performance of Engelhard products in their specific application. The Company owns or is licensed under numerous patents which have been secured over a period of years. It is the policy of the Company to apply for patents whenever it develops new products or processes considered to be commercially viable and, in appropriate circumstances, to seek licenses when such products or processes are developed by others. While the Company deems its various patents and licenses to be important to certain aspects of its operations, it does not consider any significant portion or its business as a whole to be materially dependent on patent protection. Environmental Matters The Company devotes considerable attention to the requirements of environmental compliance. Management believes that compliance programs in effect at all major operations satisfactorily meet the requirements of local, state and federal environmental agencies. However, risks of increased costs and liabilities relating to environmental matters are inherent in certain Company operations, as they are with most other industrial companies. See Note 15 "Environmental costs" in the Notes to the Consolidated Financial Statements on pages 39 and 40 of the 1993 Annual Report to Shareholders. The Company is preparing, has under review, or is implementing with the oversight of cognizant environmental agencies, studies and cleanup plans at several locations, including Salt Lake City, Utah and Plainville, Massachusetts. In addition, the Company is in the process of implementing a cleanup plan approved by the New Jersey Department of Environmental Protection and Energy for the Company's Newark, New Jersey site. In December 1993 in connection with obtaining its operating permit under the Utah Solid and Hazardous Waste Act, the Company entered into an agreement with the Utah Solid and Hazardous Waste Control Board to assess the environmental status of its Salt Lake facility. With respect to the Plainville site, in September 1993, the United States Environmental Protection Agency (EPA) and the Company entered into a Consent Order under which the Company will conduct stabilization measures and further study contamination at the site. This site is also included on the Nuclear Regulatory Commission's (NRC) "Existing Site Decommissioning Management Plan Sites" list and the NRC has approved the Company's proposed plans for additional investigation of the site and an interior cleanup of the plant. The Company is currently identified as a potentially responsible party (PRP) at 16 sites by the EPA under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA) or by a state or local equivalent under analogous laws. Subject to outstanding state claims or the reopening of existing settlement agreements for extraordinary circumstances or natural resource damages, the Company has settled a number of other cleanup proceedings. In several additional instances, PRPs named by the EPA or its state equivalent have notified or sued the Company claiming that the Company should have been named a PRP and allocated a share of clean-up costs. The Company has also responded to information requests from the EPA at other CERCLA sites. The Company believes it is a de minimis contributor at most of the sites referenced above and that there is no legal or factual basis for the Company's alleged responsibility for any hazardous substances present at certain of these sites. While it is not possible at this time to predict with certainty the ultimate outcome of all of the matters discussed above, it is the opinion of management, after consultation with counsel and based on existing information, that the resolution of these lawsuits and other matters in the aggregate will not have a material adverse effect on the Company or its business. Item 2. Item 2. Properties The Company owns approximately 15 acres of land and three buildings with a combined area of approximately 168,000 square feet in Iselin, New Jersey. These buildings serve as the major research and development facilities for the Company's operations. The Company also owns a research facility in the Cleveland, Ohio area. In 1990, the Company entered into a 15 year lease for a 271,000 square foot building in Iselin, New Jersey, proximate to its owned facilities, which serves as the principal executive and administrative offices of the Company and its operating segments. This lease provides for three consecutive five-year-period extensions. The building is owned by a partnership in which the Company holds a significant interest. The Catalysts and Chemicals segment owns and operates a complex of plants in Georgia that manufactures petroleum cracking catalysts, and other domestic plants located in Union, New Jersey; Huntsville, Alabama; Seneca, South Carolina; Little Rock, Arkansas; Elyria, Ohio and Jackson, Mississippi. Foreign manufacturing operations are conducted at owned facilities in Italy, The Netherlands, Germany and the United Kingdom. In addition, the segment owns a mine in Mississippi and leases a mine in Arizona. The Pigments and Additives segment owns and operates five kaolin mines and five milling facilities in middle Georgia which serve an 85 mile network of pipelines to four processing plants. It also owns land containing kaolin clay and leases, on a long-term basis, kaolin mineral rights to additional acreage. The segment also owns and operates an attapulgite processing plant in Attapulgus, Georgia near the area containing its attapulgite reserves. Management believes that the Company's crude kaolin and attapulgite reserves will be sufficient to meet its needs for the foreseeable future. The segment also owns and operates color pigments manufacturing facilities in Louisville, Kentucky, Sylmar, California and Elyria, Ohio. Foreign operations are conducted at owned facilities in Finland. In addition, the segment owns mines in Florida. The Engineered Materials and Precious Metals Management segment owns and operates manufacturing facilities in Carteret and East Newark, New Jersey, Anaheim and Fremont, California, Lincoln Park, Michigan and Warwick, Rhode Island. Other manufacturing operations are conducted at owned facilities in the United Kingdom, France and Italy. The Company announced a plan to realign and consolidate businesses, concentrate resources and better position itself to achieve its strategic growth objectives. (See Item 1 "Business" above and Note 2 "Special charge" in the Notes to the Consolidated Financial Statements on page 30 of the 1993 Annual Report to Shareholders.) Management believes that the resulting configuration will be suitable and have sufficient capacity to meet its normal operating requirements for the foreseeable future. Item 3. Item 3. Legal Proceedings The Company is a defendant in a number of lawsuits covering a wide range of matters. In some of these pending lawsuits, the remedies sought or damages claimed are substantial. The Company has also received a demand for indemnification from a distributor of the Company's talc products. The Company is vigorously defending against these claims. See also "Environmental Matters" for a discussion about lawsuits and matters concerning environmental compliance. While it is not possible at this time to predict with certainty the ultimate outcome of these lawsuits or the resolution of the environmental contingencies, it is the opinion of management, after consultation with counsel and based on available information that the disposition of these matters should not have a material adverse effect on the Company or its business. Submission of Matters to a Vote of Item 4. Item 4. Participating Employees At December 31, 1993, there were approximately 2,127 employees participating in the Plan. Item 5. Item 5. Administration of the Plan (a) The Plan is administered by the Pension and Employee Benefit Plans Committee of the Company (the Committee), the members of which are appointed by the Company to serve until their successors are appointed or until death, resignation or removal. The Committee has full power to determine questions relating to the eligibility of employees to participate in the Plan, to interpret the provisions of the Plan and to adopt regulations for its administration. Any or all members of the Committee who are employees of the Company may be participants in the Plan. The current members of the Committee and their addresses are as follows: James V. Napier 3343 Peachtree Road Chairman of the Committee and East Tower Director of the Company - Suite 1420 Atlanta, GA 30326 Marion H. Antonini 225 High Ridge Road Director of the Company Stamford, CT 06905 Robert L. Guyett Engelhard Corporation Senior Vice President, 101 Wood Avenue Chief Financial Officer and Iselin, NJ 08830 Director of the Company L. Donald LaTorre Engelhard Corporation Senior Vice President, 101 Wood Avenue Chief Operating Officer Iselin, NJ 08830 and Director of the Company Gerald E. Munera One DTC Director of the Company 5251 DTC Parkway Suite 700 Englewood, CO 80111 Norma T. Pace 100 East 42nd Street Director of the Company New York, NY 10017 Reuben F. Richards 250 Park Avenue Chairman of the Board, New York, NY 10177 Director of the Company Orin R. Smith Engelhard Corporation President, Chief Executive 101 Wood Avenue Officer and Director of Iselin, NJ 08830 the Company (b) All expenses of the Plan incidental to its administration are paid by the Company. Effective January 1, 1994, certain administrative fees and brokerage commissions will be charged against each participant's fund unit value. Item 6. Item 6. Custodian of Investments (a) The Committee has appointed Vanguard Fiduciary Trust Company, P.O. Box 1101 Vanguard Financial Center, Valley Forge, Pennsylvania 19482, as independent Plan Trustee. The Trustee and the Company have entered into a trust agreement setting forth the Trustee's responsibilities under the Plan including maintaining custody of the Plan's investments and records of accounts for participants. (b) The Trustee receives no compensation from the Plan. (c) Vanguard Fiduciary Trust Company meets certain ERISA financial criteria and the Company is not required to secure or provide bonds as evidence of financial guarantee. Item 7. Item 7. Reports of Participating Employees During each quarter of the plan year, each participant receives an individual participant statement disclosing the status of his or her account during the preceding quarter. Item 8. Item 8. Investment of Funds The Company pays brokerage commissions only on investments in Engelhard Corporation common stock. Page Item 9. Item 9. Financial Statements and Exhibits No. (a) Financial Statements Report of Independent Public Accountants 103 Statements of Financial Condition 104 - 105 at December 31, 1993 and 1992 Statements of Income and Changes in Plan Equity 106 - 108 for the three years in the period ended December 31, 1993 Notes to Financial Statements 109 - 112 Supplemental Schedule 113 - 114 Schedule I Schedules II and III have been omitted because the required information is shown in the financial statements or the notes thereto. (b) Exhibits Engelhard Corporation Savings Plan for Hourly * Paid Employees (incorporated by reference to the Engelhard Corporation Registration Statement on Form S-8 dated September 6, 1990). First, Second, Third, and Fourth Amendments * to the Engelhard Corporation Savings Plan for Hourly Paid Employees (Incorporated by reference to the Engelhard Corporation Annual Report Form 10-K for the fiscal year ended December 31, 1992). Fifth, Sixth and Seventh Amendments to the 115 - 118 Engelhard Corporation Savings Plan for Hourly Paid Employees. * Incorporated by reference as indicated Report of Independent Public Accountants To the Pension and Employee Benefit Plans Committee of Engelhard Corporation: We have audited the financial statements and the financial statement schedule of the Engelhard Corporation Savings Plan for Hourly Paid Employees listed in the index on Page 129 of this Form 11-K. These financial statements and the financial statement schedule are the responsibility of the Plan's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule 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 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 the Engelhard Corporation Savings Plan for Hourly Paid Employees as of December 31, 1993 and 1992, and the results of its operations for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND New York, New York March 24, 1994 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Financial Condition at December 31, 1992 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1993 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1992 See Accompanying Notes to Financial Statements Engelhard Corporation Savings Plan for Hourly Paid Employees Statement of Income and Changes in Plan Equity for the year ended December 31, 1991 Notes to Financial Statements Note 1 - Description of the Plan The Engelhard Corporation Savings Plan for Hourly Paid Employees (the Plan), effective as of January, 1991, is designed to provide eligible employees of Engelhard Corporation (the Company) an opportunity to save part of their income by having the Company reduce their compensation and contribute the amount of the reduction to the Plan on a tax deferred basis. The following plan description is provided for general information purposes. Participants of the Plan should refer to the plan document for more detailed and complete information. Eligibility Except as specifically included or excluded by the Board of Directors of the Company (the Board), the hourly paid employees of Engelhard Corporation represented by Locals 223, 237 and 238, Independent Workers of North America, Locals 1668, 1668A and 1668B of the United Automobile Workers, Local 170 of the United Steelworkers of America, and, as of January 1, 1994, Local 8-406 of the Oil, Chemical and Atomic Workers International Union who have completed at least one year of service, as defined, are eligible to participate in the Plan as of the first day of the month in which they meet the year of service requirement. Contributions The Plan permits eligible employees participating in the Plan (the Participants) to elect to reduce their compensation, as defined, by a whole percentage thereof, subject to limitations, and to have that amount contributed to the Plan and the related taxes deferred. Matching Contributions The Company will contribute, on a monthly basis and subject to limitations and exclusions, either cash or common stock of the Company in an amount equal to 10 percent of the amount contributed by the Participants. Investments All contributions to the Plan are held and invested by Vanguard Fiduciary Trust Company (the Trustee). The Trustee maintains four separate investment funds within the Trust: a) The Company Stock Fund, which consists of assets invested or held for investment in the common stock of the Company. In the event the assets cannot be immediately invested in Company common stock, the funds are invested in short- term securities pending investments in Company common stock. b) The Fixed Income Fund, which consists of assets invested in shares of the Vanguard Variable Rate Investment Contract Trust. In the event the assets cannot be immediately invested in such shares or deposited as specified above, the assets are invested in short-term investments at the discretion of the Pension and Employee Benefit Plans Committee (the Committee). c) The Balanced Fund, which consists of assets invested in the Vanguard Asset Allocation Fund, which invests in stocks, bonds and cash reserves for the purpose of maximizing long- term total return with less volatility than a portfolio of common stock. d) The Equity Index Fund, which consists of assets invested in the Vanguard Quantitative Portfolio, which invests primarily in common stocks for the purpose of realizing a total return greater than the Standard & Poor's 500 Index while maintaining fundamental investment characteristics similar to such Index. Participants have the right to elect, subject to restrictions, in which investment fund or funds their contributions are invested. All matching contributions are invested in the Company Stock Fund. The number of Participants in each fund was as follows at December 31: Participants 1993 1992 --------- --------- Common Stock Fund 599 462 Fixed Income Fund 396 342 Balanced Fund 136 104 Equity Index Fund 145 118 The total number of Participants in the Plan was less than the sum of the number of Participants shown above because many were participating in more than one fund. The number of units representing Participant interests in each fund and the related net asset value per unit were as follows at December 31: Vesting Participants at all times have a fully vested and non-forfeitable interest in their contributions and in the matching contributions allocated to their account. Termination Although it expects and intends to continue the Plan indefinitely, the Company has reserved the right of the Board to terminate or amend the Plan. Distributions and Withdrawals All distributions and withdrawals from the Plan are made to Participants in a lump sum cash payment except those amounts distributed from the Company Stock Fund which may, at the Participant's election, be paid in full shares of the Company's Common Stock with cash paid in lieu of fractional shares. Note 2 - Accounting Policies The accounts of the Plan are maintained on an accrual basis. Purchases and sales of investments are reflected on a trade date basis. Assets of the Plan are valued at fair value. Gains and losses on distributions to participants and sales of investments are based on average cost. Certain prior year amounts have been reclassified to conform with the current year presentation. Note 3 - Income Tax Status The Plan and the Trust created thereunder are intended to qualify under Section 401(a) and 501(a) of the Internal Revenue Code of 1986, as amended (the Code) and the Plan includes a cash or deferred arrangement intended to meet the requirements of Section 401(k) of the Code. The Internal Revenue Service has issued a favorable determination letter as to the Plan's qualified status under the Code. Amounts contributed to and earned by the Plan are not taxed to the employee until a distribution from the Plan is made. In addition, any unrealized appreciation on any shares of common stock of the Company distributed to an employee is not taxed until the time of disposition of such shares. Note 4 - Administrative Expenses All expenses of the Plan are paid for by the Company. Investment advisory fees for portfolio management of Vanguard funds are paid directly from fund earnings. Advisory fees are included in the fund expense ratio and will not reduce the assets of the Plan. Brokerage commissions paid to purchase Engelhard Corporation common stock are paid for by the Company. Effective January 1, 1994, certain administrative fees and brokerage commissions will be charged against each participant's unit value. Note 5 - Concentrations of Credit Risk Financial instruments which potentially subject the Plan to concentrations of credit risk consist principally of investment contracts with insurance and other financial institutions. The Plan places its investment contracts with high-credit quality institutions and, by policy, limits the amount of credit exposure to any one financial institutions. Note 6 - Investments Investments in the Common Stock of the Company are valued at the readily-available, quoted market price as of the valuation date and investments in the Vanguard Funds are valued based on the quoted net asset value (redemption value) of the respective investment company as of the valuation date. Schedule I Engelhard Corporation Savings Plan for Hourly Employees Schedule of Investments at December 31, 1993 Approximate Cost Market Value ---------- ------------- Company Stock Fund - ------------------- Common Stock of $1,096,878 $1,308,182 Engelhard Corporation (53,669 shares) Cash equivalents 11,824 11,824 Fixed Income Fund - ------------------ Vanguard Variable Rate 1,285,061 1,285,061 Investment Contract Trust Balanced Fund - -------------- Vanguard Asset Allocation 215,508 224,821 Fund Equity Index Fund - ------------------ Vanguard Quantitative 256,478 254,653 Portfolio ---------- ------------- Total $2,865,749 $3,084,541 ========== ============= Schedule I Engelhard Corporation Savings Plan for Hourly Employees Schedule of Investments at December 31, 1992 Approximate Cost Market Value ---------- ------------- Company Stock Fund - ------------------- Common Stock of $ 481,064 $ 686,469 Engelhard Corporation (19,970 shares) Cash equivalents 3,601 3,601 Fixed Income Fund - ------------------ Vanguard Variable Rate 743,477 743,477 Investment Contract Trust Balanced Fund - -------------- Vanguard Asset Allocation 109,724 113,823 Fund Equity Index Fund - ------------------ Vanguard Quantitative 132,316 135,602 Portfolio ---------- ------------- Total $1,470,182 $1,682,972 =========== ============= FIFTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereby amended in the following respects, effective as of January 1, 1993: 1. Appendix A to the Plan is amended by adding the following at the end thereof: "4. Hourly-paid employees of Engelhard Corporation represented by Local 170 of the United Steelworkers of America. a. Effective Date (Section 1.13). January 1, 1993. b. Eligibility Requirement (Section 2.01). Employees in the employ of the Employer on or before November 24, 1992 are eligible as of the Effective Date; individuals hired after November 24, 1992 are eligible following completion of one year of Eligibility Service. c. Maximum Deferral Percentage (Section 3.01). 15% d. Matching Percentage (Section 3.02). 0% -- No Matching Contribution. e. Investment Funds (Section 5.02). Fixed Income Fund, Balanced Fund, Equity Index Fund. f. Withdrawals (Section 7.01). Permitted. g. Loans (Section 7.04). Not Permitted." SIXTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereb amended in the following respects, effective as of the dates set forth below: 1. Effective as of January 1, 1994, Section 5.03 is amended by adding the following sentence at the end thereof: "The Trustee shall be obligated to comply with a Participant's instructions as to investment elections made in accordance with this Section 5.03, except as otherwise provided in Department of Labor Regulations S 2550.404c-1(b) (2) (ii) (B) and (d) (2) (ii), and a Participant shall be given an opportunity to obtain written confirmation of telephonic instructions to the Trustee." 2. Effective as of January 1, 1994, Section 5.05 is amended by adding the following sentence at the end thereof: "The Trustee shall be obligated to comply with a Participant's instructions as to investment elections made in accordance with this Section 5.05, except as otherwise provided in Department of Labor Regulations S 2550.404c-1(b) (2) (ii) (B) and (d) (2) (ii), and a Participant shall be given an opportunity to obtain written confirmation of telephonic instructions to the Trustee." 3. Effective as of August 5, 1993, Section 10.01 is amended by adding at the end thereof the following: "Payments pursuant to a qualified domestic relations order may be made to an alternate payee prior to the Participant's earliest retirement age, within the meaning of Section 414(p) (4) (B) of the Code." 4. Effective as of August 5, 1993, Article XV is amended by adding at the end thereof the following new Section 15.07: "15.07. If a Participant transfers to a position with the Company or an Affiliate which is not covered by the Plan and the Participant, after the transfer, is qualified for participation in the Salary Deferral Savings Plan of Engelhard Corporation (or any other qualified plan maintained by the Company or an Affiliate), then such Participant's entire Account balance may be transferred to the Salary Deferral Savings Plan of Engelhard Corporation (or such other qualified plan), at the sole discretion of the Committee or its delegate, and after such transfer the Participant shall have no further interest in this Plan." 5. Effective as of January 1, 1994, Appendix A to the Plan is amended by adding the following at the end thereof: "5. Hourly-paid employees of Engelhard Corporation represented by Local 8-406 of the Oil, Chemical & Atomic Workers International Union. a. Effective Date (Section 1.13). January 1, 1994 b. Eligibility Requirement (Section 2.01). Employees in the employ of the Employer on or before March 26, 1993 are eligible as of the Effective Date; individuals hired after March 26, 1993 are eligible following completion of one year of Eligibility Service. c. Maximum Deferral Percentage (Section 3.01). 10% d. Matching Percentage (Section 3.02). 10% of Tax Deferred Contributions, up to 0.6% of Compensation. e. Investment Funds (Section 5.02). Fixed Income Fund, Balanced Fund, Equity Index Fund. f. Withdrawals (Section 7.01). Permitted. g. Loans (Section 7.04). Not Permitted." SEVENTH AMENDMENT TO THE ENGELHARD CORPORATION SAVINGS PLAN FOR HOURLY PAID EMPLOYEES The Engelhard Corporation Savings Plan for Hourly Paid Employees is hereby amended in the following respects, effective as of January 1, 1994: 1. Section 1.10 is amended by deleting the last sentence thereof and inserting the following in its place: "Notwithstanding the foregoing, an Employee's Compensation for any Plan Year in excess of $150,000, as such amount shall be increased due to cost of living increases in accordance with regulations issued from time to time by the Secretary of the Treasury under Section 401(a) (17) of the Code, shall be disregarded for all purposes of the Plan." 2. Section 3.03 is amended by adding the following sentence at the end of paragraph (c) (vii) thereof: "Total Compensation taken into account for any Plan Year shall not include any amounts in excess of $150,000, as adjusted for increases in the cost of living in accordance with regulations issued from time to time by the Secretary of the Treasury under Section 401 (a) (17) of the Code." 3. Appendix A to the Plan is amended by deleting part c. of paragraph 5 thereof and inserting the following in its place: "c. Maximum Deferral Percentage (Section 3.01). 15%."

812708_1993.txt

812708_1993

1993

812708

Item 1. Business Recent Developments In March 1993, the Company sold its 44% ownership interest in Wellstar Holding B.V. ("Wellstar"), a Netherlands-based manufacturer of PET beverage bottles, for a total consideration of approximately $33 million. The transaction resulted in a net gain, before applicable income taxes, of $12.4 million. The sale of Wellstar increased 1993 net earnings by approximately $7.3 million or $.22 per share. See Note 2 of the Notes to the Consolidated Financial Statements. General The principal business of Wellman, Inc. (which, together with its subsidiaries, is herein referred to as the "Company") is the manufacture and sale of polyester and nylon fibers and resins. The Company's Fibers Group manufactures and markets polyester and nylon staple fibers and partially-oriented yarn ("POY"). Polyester staple and POY production is sold under the Fortrel/ brand to major domestic yarn processors and integrated fabric mills for use in apparel, home furnishings and industrial applications. The Fibers Group also manufactures polyester and nylon staple fibers from waste raw materials, including fiber producer wastes, postconsumer PET soft drink bottles and film producer wastes, for use in the fiberfill, furniture, home furnishings, carpet, and industrial markets in the United States and Europe. The Company believes it is the largest recycler in the United States of post-consumer plastics and the largest producer of polyester staple fiber made from recycled feedstocks. The Company's Manufactured Products Group ("MPG") manufactures and markets PET resins, a portion of which is used in the Company's POY production, for use in polyester fibers and PET packaging. Prior to 1993, sales of PET resin were reported by the Company under the Fibers Division (which consists of the domestic operations of the Fibers Group). MPG also processes raw wool to produce wool top for worsted fabric manufacturing; anhydrous lanolin is a by-product of this production. MPG also manufactures nylon engineering resins, primarily from producer waste raw materials, for automotive, consumer and industrial uses. MPG converts polyester fiber into high-loft nonwoven battings which are used as filling primarily for the home furnishings industry, and manufactures needle-punched fabrics primarily for geotextile applications. In addition, MPG processes postconsumer plastics and certain producer wastes into suitable raw materials for the Company. It also markets recycled high density polyethylene ("HDPE") resins produced from the basecups of soft drink bottles. The Company manufactures and markets PET and other plastic thermoformed packaging products and PET sheet. New England CR Inc. ("CRInc") designs, equips, constructs and operates materials recovery facilities ("MRFs"). MRFs separate and process commingled recyclables reclaimed from households and commercial establishments through curbside recycling programs. CRInc holds the exclusive North American rights to distribute the patented Bezner automated materials sorting process, a German MRF sortation technology. CRInc also sells the recyclables from its MRFs and brokers recyclables for other parties. CRInc also operates glass beneficiation facilities in California and a polystyrene recycling facility in New Jersey. Raw Materials Fibers Group. The major raw materials used by the Company in the manufacture of polyester staple fiber and POY are purified terephthalic acid ("PTA") and monoethylene glycol ("MEG"), two petrochemicals, and various waste raw materials. The Company believes it is the largest producer of polyester staple fiber made from recycled feedstocks. The Company purchases PTA under an exclusive supply contract which expires December 31, 1995 with Amoco Chemical Corporation ("Amoco"). The Company purchases MEG under an exclusive supply contract with Oxy Chem Inc. which expires December 31, 1997. The prices of PTA and MEG have fluctuated in the past and may continue to do so in the future. Three categories of wastes are also utilized in the production of staple fibers: fiber producer waste, PET bottle waste and PET film waste. A material portion of fiber producer waste is purchased from fiber manufacturers that compete with the Company in the sale of fiber. The Company believes it is the largest U.S. recycler of postconsumer PET bottles, which are obtained from deposit return and curbside recycling programs. PET film waste is obtained from various audio, video, photographic, packaging and X-ray film producers. Fiber producer and film wastes represent off-quality production, trim and other wastes. The Company also uses virgin PET resin in polyester fiber production. The Company's Recycling Division is responsible for the procurement and processing of the waste raw materials. The availability of its petrochemical and waste raw materials is essential to the Company's fiber operations. While historically suppliers have provided adequate quantities of raw materials, the unavailability, scarcity or significantly increased cost of certain raw materials could have a material adverse effect on the Company. Manufactured Products Group. MPG utilizes PTA and MEG to manufacture PET resins and utilizes recycled PET bottles and producer waste feedstocks to produce nylon engineering and recycled HDPE resins. MPG utilizes raw wool and wool grease for the production of wool top and anhydrous lanolin, respectively. MPG also uses polyester fiber, supplied by the Company's Fibers Group and other polyester fiber producers, to manufacture nonwoven products. MPG utilizes virgin and recycled PET in the production of PET thermoformed packaging products and sheet. Products and Markets The following table presents the combined net sales (in millions) and percentage of net sales by business of the Company for the periods indicated. For purposes of this data, intercompany transactions have been eliminated and with respect to its Irish fiber subsidiary, Wellman International Limited ("WIL"), historical exchange rates have been applied to the data for the periods indicated. 1993 1992 1991 Net % of Net % of Net % of Sales Total Sales Total Sales Total Fibers Grp(1) $655.2 77.8% $674.5 81.5% $651.2 80.8% MPG(1)(2) $163.1 19.4 134.3 16.2 124.3 15.4 CRInc 23.8 2.8 19.4 2.3 30.2 3.8 TOTAL $842.1 100.0% $828.2 100.0% $805.7 100.0% (1) 1991 and 1992 sales were restated to include sales of PET resins, which were previously reported under the Fibers Division, in MPG. (2) Includes sales of Creative Forming, Inc. ("CFI") from November 18, 1992, the date of its acquisition by the Company. Fibers Group. Fibers Division. The Fibers Division produces polyester and nylon staple fibers and POY. Staple, the primary product produced, is multi-strand fiber cut into short lengths to simulate certain properties found in natural fibers such as cotton and wool and/or to meet the end product needs of the Company's customers. In 1993, approximately 35% of the Company's domestic polyester staple sales were to the apparel industry, approximately 22% to the home furnishings industry, 19% as fiberfill, 12% to the carpet industry, and the balance to nonwovens and industrial markets. The Company's domestic nylon staple production was utilized primarily by the carpet industry, with the balance used in specialty applications. The Fiber Division's staple products are manufactured at facilities in Darlington (Palmetto), Johnsonville and Marion, SC. Polyester textile staple, the Division's largest staple product, is produced at Palmetto from PTA and MEG and is sold primarily to textile mills and spinners for processing into fabric for a variety of applications, including apparel, home furnishings and industrial uses. The stated annual fiber production capacity of the Palmetto plant is approximately 450 million pounds. All other domestic polyester staple production occurs at the Johnsonville and Marion facilities. The primary end market for the production from these facilities is the fiberfill market, followed by the carpet and industrial markets. The Johnsonville plant, site of all domestic nylon staple fiber production, has approximately 255 million pounds of annual fiber production capacity, based on a product mix of 80% polyester and 20% nylon staple. The Marion facility has approximately 32 million pounds of annual polyester staple fiber production capacity. POY, a continuous polyester filament product, is sold by the Company to integrated textile mills and texturizers for further processing for use primarily in apparel, home furnishings and industrial applications. POY is produced at the Company's Fayetteville, NC plant from PET resin manufactured by the Company at its Palmetto plant. The Company's Fayetteville plant increased its stated annual POY production capacity to approximately 130 million pounds, or by 30%, in the first quarter of 1994. The Company's polyester textile staple and POY production is sold under the Fortrel/ brand. Wellman International Limited. The fiber production process of WIL, a wholly-owned subsidiary based in Mullagh, Republic of Ireland, is similar to that of the Company's Johnsonville plant. WIL also uses recycled raw materials, including producer fiber and film wastes and, to a lesser extent, postconsumer PET soft drink bottles, to produce polyester and nylon staple fibers. The majority of WIL's raw materials are producer wastes, some of which are obtained from suppliers who compete with it in the fibers business in Europe. Postconsumer PET bottles procured by WIL are processed at the Company's European PET bottle recycling facility, located in Spijk, the Netherlands. The maximum annual fiber production capacity of WIL is approximately 154 million pounds, based on a product mix of approximately 90% polyester and 10% nylon staple. WIL's polyester fibers are used primarily in fiberfill, nonwovens and industrial applications, while its nylon fibers are used mainly by the carpet industry. WIL exports, primarily to the United Kingdom and Europe, virtually all of its fiber production. Manufactured Products Group. Polymer Products Division. Located at the Palmetto plant, this Division utilizes PTA and MEG to produce approximately 220 million pounds of PET resin, the commodity bulk form in which pure polyester is transported and utilized. In 1993, approximately 47% of the Division's resin was used by the Fayetteville plant to produce POY. The remainder was sold to Hoechst Celanese Corp. ("HCC"), pursuant to the terms of a take or pay supply arrangement which expired in the second half of 1993, and to other customers. In the first quarter of 1994, the Company commenced operation of new solid stating equipment at Palmetto which will enable it to upgrade approximately 80 million pounds per year of its current PET resin production to higher-value PET bottle resin, which is used to manufacture PET packaging such as soft drink bottles. In addition, the new solid stating unit has capacity to upgrade an additional 80 million pounds per year of PET resin when the monomer and polymerization capacity at the Palmetto plant increases as described below. Monomer is the PET feedstock derived from PTA and MEG from which polyester textile staple fiber and PET resin is produced. The Company plans to expand monomer capacity by 400 million pounds, or over 55%, in late 1994. The Company also plans to add 160 million pounds of PET resin capacity in the second quarter of 1995. Wool Division. At the Wool Division's facility in Johnsonville, SC, raw wool is processed through sorting and blending operations, scoured, carded, combed, and packaged as wool top primarily for use in worsted fabric applications for apparel. The Wool Division's plant has the flexibility to process and blend various wool grades and to simultaneously run several different wool blends. As a by-product of the wool scouring process, wool grease is recovered which, in combination with wool grease purchased in the open market, is processed to produce anhydrous lanolin. The Company believes that it is the largest U.S. producer of anhydrous lanolin, which it sells to the pharmaceutical, cosmetics and industrial markets. Engineering Resins Division. The Engineering Resins Division, located in Johnsonville, SC, manufactures and markets nylon engineering resins to the injection molding industry. These resins, chiefly Nylon 6 and 66 and co-polymers of these types, are produced primarily from producer wastes and compounded and combined with various additives (glass, minerals, fire retardant, etc.) to impart desired performance characteristics. The Company serves a variety of markets with these compounded engineering resins, with the largest being automotive, followed by consumer products, industrial and other. Nonwovens Business. The Nonwovens business, located in Charlotte, NC, and Commerce, CA, utilizes polyester fiber to produce high-loft battings, primarily for the home furnishings industry, and needle-punched fabrics primarily for geotextile applications. High-loft battings are used for their cushioning and insulating properties in bedspreads, comforters, quilts and other similar products and are sometimes sold under the Fortrel/ brand. The largest customers of this product are vertically-integrated textile mills and independent bedspread and comforter manufacturers. Geotextile fabrics are used for soil reinforcement and filtration in various civil engineering applications, including landfill and pond linings and railroad and road stabilization. The Nonwovens business utilizes polyester staple fiber produced by the Fibers Group, as well as other fiber manufacturers, as raw material. Recycling Division. The Recycling Division processes postconsumer PET soft drink bottles and producer fiber and film wastes into usable raw materials for the Fibers and Engineering Resins Divisions and CFI. It also markets recycled HDPE resins, primarily to manufacturers of basecups for soft drink bottles. The Division consists of PET bottle and producer waste recycling operations in Johnsonville, SC and PET bottle recycling operations in Bridgeport, NJ, which was acquired in May 1993. In the third quarter of 1993, the Recycling Division expanded its annual capacity to recycle PET bottles at its Johnsonville location by over 70%, from 110 million pounds to 190 million pounds. Annual PET bottle recycling capacity in Bridgeport is approximately 50 million pounds. Creative Forming, Inc. Utilizing PET as well as other materials, Creative Forming, Inc. custom designs, manufactures and markets thermoformed plastic packaging products for the consumer products industry. It also produces PET sheet, utilizing both virgin and recycled raw materials, for use in its own thermoforming operations and for sale in the open market. CFI, which is based in Ripon, WI, expanded its capacity to produce sheet by 33% and installed coextrusion equipment in early 1994. New England CR Inc. CRInc designs, equips, constructs and operates materials recovery facilities ("MRFs"). MRFs separate and process commingled recyclables reclaimed from households and commercial establishments through curbside recycling programs. CRInc holds exclusive North American, United Kingdom and Irish rights to distribute the patented Bezner automated materials sorting process, a German MRF sortation technology. CRInc commenced operation of three MRFs in 1993 so that at year-end 1993, CRInc had 13 full-service MRFs operational. CRInc also sells the recyclables from its MRFs and brokers recyclables for other parties. CRInc also operates glass beneficiation facilities in California and a polystyrene recycling facility in New Jersey. Capital Investment Program Pursuant to its on-going long-term capital investment program, the Company's 1993 capital expenditures totaled approximately $105 million. The capital projects included in the 1993 expenditures were the installation of solid-stating equipment, expansion of PET bottle recycling and POY production capacity and equipment modernization at the Company's domestic fiber operations. The Company's 1994 capital expenditures are expected to total approximately $90 million, which will include the expansion of monomer and PET resin production capacity and continued equipment upgrades at the domestic fiber operations. Marketing The Company markets the majority of its products through a direct sales force consisting of approximately 50 sales personnel. For certain sales outside the United States, the Company utilizes representatives or agents. The Company also markets its polyester fibers through various activities, such as advertising, sales promotion, market analysis, product development and fashion forcasting directed to its customers and organizations downstream from its customers. As part of this effort, the Company's marketing personnel encourage downstream purchasers of apparel, home furnishings and other products to specify to their suppliers the use of Fortrel/ brand polyester in their products. Competitors Each of the Company's major fiber markets is highly competitive. The Company competes primarily on the basis of quality, service, brand identity and price. Several competitors are substantially larger than the Company and have substantially greater economic resources. The Company's primary competitors are E.I. DuPont de Nemours & Co.and the Hoechst Celanese division of Hoechst A.G. The Company believes it is currently the third-largest producer of polyester staple and POY in the United States, representing approximately 26% and 13%, respectively, of U.S. production capacity for these products. The Company also competes with Nan Ya Plastics Corp., which completed construction of a facility in 1993 to sell polyester staple and POY. The polyester staple fiber and POY markets have historically displayed price and volume cyclicality. The domestic polyester textile fiber markets are subject to changes in, among other factors, polyester fiber and/or textile product imports and consumer preferences, spending and retail sales patterns, which are driven by general economic conditions. Consequently, a downturn in either the domestic or global economy or an increase in imports of textile or polyester fiber products could adversely affect the Company's business. Research and Development The Company has approximately 75 U.S. employees devoted to research and development activities. The Company has entered into technology sharing arrangements from time to time with various parties. Foreign Activities Primarily through WIL, its Irish fiber subsidiary, the Company operates in international markets, primarily the United Kingdom and Western Europe. Since substantially all of WIL's sales are for export, changes in exchange rates may affect WIL's profit margins and sales levels. In addition, fluctuations between the United States dollar and Irish pound may also affect reported results. The Company's foreign business is subject to certain risks customarily attendant upon foreign operations and investments in foreign countries, including restrictive action by local governments, limitations on repatriating funds and changes in currency exchange rates. See Note 11 of the Notes to the Consolidated Financial Statements for additional information relating to the Company's foreign activities. Employees As of December 31, 1993, the Company employed approximately 3,600 persons in the United States and Europe. At December 31, 1993, approximately 790 U.S. employees were members of The Amalgamated Clothing and Textile Workers Union ("ACTWU"). The Company's contract with the ACTWU expires in July, 1996. In addition, approximately 351 of its Irish employees were represented by four unions. The wage agreements with these unions each expire on April 30, 1994. The Company believes that its relations with its employees are satisfactory. Environmental Matters The Company has determined that groundwater contamination exists at certain of its facilities. In 1986 contamination involving chlorinated solvents and hydrocarbon derivatives was found at its Johnsonville, SC facility, principally associated with a former drum storage site and an underground storage tank. In 1987, the Company entered into a consent order with the South Carolina Department of Health and Environmental Control ("SCDHEC") for remediation of the Johnsonville site. In September 1989, nitrate contamination of groundwater at the Johnsonville facility, primarily resulting from a wool dust stockpile, was also confirmed. Varying levels of groundwater contamination at the Palmetto plant, believed to have been the result of a leak in the chemical sewers and emergency ponds, were reported to SCDHEC by HCC prior to the acquisition of the plant by Fiber Industries, Inc. ("FI") in January 1988. Although no formal action to require remediation or penalties has been taken by the SCDHEC, the underground sewer lines have been replaced with a pumped above-ground system. HCC and Celanese Fibers Inc. ("Celanese") have completed at their expense the sewer line replacement and the replacement of two emergency waste ponds and a storm water pond at the Palmetto plant in order to prevent further groundwater contamination. Extraction systems for removal of groundwater contamination by the sewer lines and old emergency ponds and new emergency holding facilities have been installed at the expense of HCC and are presently in operation. In April 1991, the Company entered into a consent order with the SCDHEC over nitrate contamination of groundwater at the Company's Palmetto plant. Additional groundwater contamination, resulting from the leakage of 1,4 dioxane, a process by-product, was discovered at Palmetto in 1992. The Company has requested that SCDHEC defer action on the nitrate consent order based on the limited extent of the nitrate contamination. In September 1993, the Company entered into a second consent order with the SCDHEC over 1,4 dioxane contamination discovered at Palmetto in 1992. All requirements of this consent order (continued monitoring of the nitrate contamination, definition of the 1,4 dioxane plume, assessment of risk from the dioxane plume and development of a plan for groundwater remediation) have been met to date. The Company is also evaluating whether to repair or replace its wastewater treatment plant. In January 1994 the Company determined that its Palmetto plant was in violation of its wastewater permit with respect to biological oxygen demand parameters and toxicity. The Company has notified the SCDHEC of such violation and is undertaking remediation action. The cost of such remediation is not expected to be material. The Fayetteville plant was notified in 1987 of an "event of noncompliance" by the North Carolina Department of Environment, Health and Natural Resources ("NCDEHNR"), formerly the Department of Natural Resources and Community Development, due to an increase in total organic carbon levels in two of its six groundwater monitoring wells. On October 25, 1991 the Company received a Notice of Violation from the NCDEHNR with regard to groundwater monitoring results shared with them, showing chlorinated hydrocarbon contamination. One on-site source, a chemical wastewater sump, was identified and removed. Additional off-site sources are suspected. In August 1992, SCDHEC requested that the Palmetto plant submit a plan for compliance with the National Ambient Air Quality Standards ("NAAQS") for sulphur dioxide. The Company plans to install a new tall stack and related equipment at Palmetto in late 1994 or early 1995. Assessment of and remedial plans at the Company's sites are on-going. While it is often difficult to reasonably quantify future environmental-related expenditures, the Company currently estimates its non-capital expenditures related to environmental matters to range between $13.0 million and $25.0 million. Such expenditures are expected to occur over a significant number of future years. In connection with these expenditures, the Company has accrued $15.5 million at December 31, 1993, representing management's best estimate of probable non-capital environmental expenditures. In addition, capital expenditures aggregating approximately $10.0 million to $15.0 million may be required over the next several years related to currently existing environmental matters. See Notes 1 and 8 of the Company's Notes to Consolidated Financial Statements. The Company's plants are subject to numerous existing and proposed laws and regulations designed to protect the environment from wastes, emissions and hazardous substances. Except as discussed in the preceding paragraphs, the Company believes it is either in material compliance with all currently applicable regulations or is operating in accordance with the appropriate variances and compliance schedules or similar arrangements. The Company believes that compliance with current laws and regulations will not require significant capital expenditures other than as identified above or have a material adverse effect on its operations. Executive Officers of the Registrant The current executive officers of the Company are as follows: Name and Age Position Thomas M. Duff, 46 President, Chief Executive Officer and Director Clifford J. Christenson, 44 Executive Vice President Keith R. Phillips, 39 Vice President, Chief Financial Officer and Treasurer C.W. Beckwith, 62 Vice President and Director; Chief Executive Officer of WIL James P. Casey, 53 Vice President; President, Fibers Division Paul D. Apostol, 48 Vice President, Manufactured Products Group, Strategic Planning and Business Development Richard J. Kattar, 61 Vice President; President, New England CR Inc. Mark J. Rosenblum, 40 Vice President, Controller Ernest G. Taylor, 43 Vice President, Administration Officers are elected annually by the Board of Directors. Set forth below is certain information with respect to the Company's executive officers. Thomas M. Duff. Mr. Duff has been President of the Company since its inception in 1985. Clifford J. Christenson. Mr. Christenson has been Executive Vice President since October 4, 1993. Prior to that time he was Chief Financial Officer and Treasurer since he joined the Company in 1985 and Vice President since 1986. Keith R. Phillips. Mr. Phillips has been Vice President, Chief Financial Officer and Treasurer since October 4, 1993. Prior to joining the Company on October 1, 1993 he was a partner in Ernst & Young. C.W. Beckwith. Mr. Beckwith has been Vice President of Wellman and Chief Executive Officer of WIL since the acquisition of WIL in 1987. Prior to such time, he was managing director of WIL since 1972. James P. Casey. Mr. Casey has been President of the Fibers Division since October 4, 1993; prior to such time he was Vice President, Marketing since March 25, 1991. Prior to that time, he was Vice President of Marketing of FI and its predecessor companies. Paul D. Apostol. Mr. Apostol has been Vice President, Manufactured Products Group and Strategic Planning and Business Development since March 15, 1991. Prior to such time, Mr. Apostol was Vice President of Marketing of FI and its predecessor companies. Richard J. Kattar. Mr. Kattar has been Vice President since May 21, 1991. He has been President of CRInc since its inception in 1982. Mark J. Rosenblum. Mr. Rosenblum has been Vice President, Controller since September 1, 1989 and Controller since he joined the Company in 1985. Mr. Rosenblum is a certified public accountant. Ernest G. Taylor. Mr. Taylor has been Vice President in charge of Administration since January 1991. From November 1989 until 1991 he was Manager of Administration. Prior to such time, he was a manager of information systems for FI and its predecessor companies. Section 16 Compliance. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and persons who own more than 10% of a registered class of the Company's equity securities ("insiders"), to file reports of ownership and changes in ownership with the Securities and Exchange Commission ("SEC"). Insiders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on review of the copies of such forms furnished to the Company, the Company believes that during 1993 all Section 16(a) filing requirements applicable to its insiders were complied with, except that a trust for which Mr. Apostol serves as trustee inadvertently failed to timely file an initial report of its holdings as required by Section 16. Item 2. Item 2. Properties The location and general description of the principal properties owned or leased by the Company are set forth in the table below: Principal Square Location Function Footage Ownership Shrewsbury, NJ Corporate 7,600 Leased Johnsonville, SC Manufacturing 2,291,000 Owned and Warehouse Darlington, SC Manufacturing 1,015,000 Owned (Palmetto) and Warehouse Mullagh, Ireland (1) Manufacturing 340,633 Owned and Warehouse Fayetteville, NC Manufacturing 295,048 Owned and Warehouse Commerce, CA Fiber Converting 90,000 Leased Facility Marion, SC Manufacturing 247,500 Owned and Warehouse Charlotte, NC Fiber Converting 75,000 Owned Facility Administrative 55,020 Leased and Research Chelmsford, MA Sales and 13,750 Leased Administrative Ripon, WI Manufacturing and 106,000 Owned Warehouse Bridgeport, NJ Plastic Bottle Re- 80,000 Leased cycling Facility Spijk, The Neth- Plastic Bottle Re- 55,812 Leased erlands cycling Facility (1) WIL's lenders currently have a lien on this facility. Item 3. Item 3. Legal Proceedings Not applicable. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's Common Stock is listed on the New York Stock Exchange under the symbol WLM. The following table shows the high and low sales prices on the New York Stock Exchange as reported on its Composite Tape and the cash dividends paid on its Common Stock for the last two fiscal years. Year High Low Dividend First Quarter $23-3/4 $19-3/4 $0.03 Second Quarter $24-7/8 $18-1/8 $0.05 Third Quarter $22 $17-3/8 $0.05 Fourth Quarter $19-3/8 $16-1/4 $0.05 First Quarter $31-1/2 $22-1/8 $0.03 Second Quarter $30-7/8 $20 $0.03 Third Quarter $24-5/8 $20 $0.03 Fourth Quarter $22-3/8 $16-1/2 $0.03 The Company had approximately 1,657 stockholders of record of Common Stock as of March 16, 1994. ## ## ## ## Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ACCOUNTING CHANGES During 1993, the Company adopted the provisions of the Financial Accounting Standards Board's Emerging Issues Task Force (EITF) Abstract No. 93-5. EITF 93-5 provides that an environmental liability should be evaluated independently from any potential claim for recovery and that the loss arising from the recognition of an environmental liability should be reduced only when a claim for recovery is probable of realization. Current accounting standards provide a general presumption that disputed claims for recovery are not probable of realization. Under practice prior to the issuance of EITF 93-5, some companies, including the Company, offset reasonably possible recoveries against probable losses. As a result of the issuance of EITF 93-5, this accounting treatment is no longer permitted. The Company is obligated to remediate environmental problems which existed at some of its manufacturing facilities prior to their acquisition by the Company. The Company has escrow funds and indemnification agreements with the prior owners of these facilities, which may result in reimbursement of a significant portion of the environmental liabilities. However, as discussed above, the new accounting standards generally permit companies to record only uncontested claims for reimbursement of environmental liabilities. The change in accounting for environmental liabilities resulted in an after-tax cumulative effect charge of $6.8 million ($0.20 per share), net of the related income tax effect of $4.2 million. See Note 1 to the Consolidated Financial Statements. During 1993, the Company changed its method of applying the lower of cost or market rule to certain slow-moving and discontinued waste raw material inventory which is valued using the last in-first out (LIFO) dollar value method. In prior years, the Company used the aggregate method in applying the lower of cost or market rule to such inventories and in 1993 changed to the item-by-item method. The Company believes the new method of accounting is preferable because it provides a better matching of costs and revenue and results in a more conservative valuation of slow-moving and discontinued waste raw material inventory. This change in accounting for certain slow-moving and discontinued inventory resulted in an after-tax cumulative effect charge of $2.2 million ($0.07 per share), net of the related income tax effect of $1.3 million. In addition, this change decreased operating income in 1993 by approximately $4.0 million. See Note 1 to the Consolidated Financial Statements. RESULTS OF OPERATIONS -- 1993 COMPARED TO 1992 Net sales increased from $828.2 million in 1992 to $842.1 million in 1993. Increased sales at the Manufactured Products Group (MPG) more than offset lower sales of the Company's fiber businesses. The increase in sales at the MPG was primarily the result of the contribution of Creative Forming, Inc. (CFI), acquired in November 1992, and, to a lesser extent, higher sales at the Wool and Engineering Resins Divisions. Domestic fiber sales decreased due to lower polyester fiber selling prices, which more than offset higher domestic sales volumes. At Wellman International Limited (WIL), the Company's Irish fiber subsidiary, sales in U.S. dollars decreased due to the unfavorable impact of the decrease in value of the Irish punt against the U.S. dollar, which more than offset modest improvements in selling prices expressed in terms of local currency and sales volumes. At New England CRInc. (CRInc.), revenues increased primarily due to an increase in the number of operating material recovery facilities. Gross profit amounted to $162.9 million in 1993 compared to $188.5 million in 1992. Gross profit at the Company's fiber businesses decreased primarily due to lower domestic polyester fiber selling prices, and, to a lesser extent, higher costs of the Company's waste-based fiber business. At the MPG, gross profit increased primarily due to the contribution of CFI and an increase in gross profit at the Polymer Products Division. As a result of the foregoing, the Company's gross margin was approximately 19% in 1993 compared to 23% in 1992. In addition to the effect on 1993 earnings of the change in accounting for certain slow-moving and discontinued inventory mentioned earlier, gross profit was also adversely affected by unusual items, primarily related to inventory, development of a prototype materials recovery facility and expenses associated with the Company's on-going capital investment program, aggregating $11.6 million. Selling, general and administrative expenses were $86.5 million, or approximately 10% of sales, in 1993 compared to $77.4 million, or approximately 9% of sales in 1992. The increase was primarily due to the inclusion of CFI, including the amortization of intangible assets arising from the acquisition, and a decline in earnings from unconsolidated subsidiaries due to the sale of the Company's equity interest in Wellstar Holding, B.V. (Wellstar) in the first quarter of 1993. In addition, certain unusual charges aggregating $2.9 million were included in selling, general and administrative expenses in 1993. As a result of the foregoing, operating income was $76.4 million in 1993 compared to $111.1 million in 1992. Net interest expense for 1993 was $15.7 million compared to $23.0 million in 1992. This decrease was primarily the result of the decline in the Company's average interest rates on outstanding borrowings and, to a lesser extent, an increase in the amount of interest capitalized to property, plant and equipment commensurate with the Company's on-going capital investment program. In the first quarter of 1993, the Company sold its ownership interest in Wellstar for $33.0 million, resulting in a pre-tax gain of $12.4 million. The transaction resulted in an increase in 1993 net earnings of $7.3 million, or approximately $0.22 per share. In the third quarter of 1993, the Revenue Reconciliation Act of 1993 (the Act) was enacted, which included an increase in the maximum corporate tax rate from 34% to 35%. The provisions of Statement of Financial Accounting Standards No. 109 require that the impact of changes in tax legislation, including changes in tax rates, be recognized in the period of the change. Accordingly, the provision for income taxes reflects an increase in income tax expense of $2.7 million, representing a negative effect on net earnings of approximately $0.08 per share. As discussed above, 1993 net earnings were adversely effected by $15.9 million, or $0.48 per share, due to the net effect of changes in accounting principles and unusual and nonrecurring events. As a result of the foregoing, net earnings in 1993 were $31.4 million, or $0.96 per share, compared to $52.3 million, or $1.60 per share in 1992. OUTLOOK Demand for the Company's domestic polyester fiber products remained relatively stable in 1993. The previously announced expansion at the Company's Fayetteville plant should result in increased shipments of POY in 1994 as compared to 1993. Demand for the Company's other polyester fiber products is expected to remain stable in 1994. Domestic fiber selling prices declined, primarily in the last half of 1993, due to price competition from Far Eastern and domestic fiber producers and the start-up of a new Taiwanese-owned U.S. polyester fiber plant and the resultant pricing strategies of the Company's domestic competitors. Selling prices in the first quarter of 1994 appear to have stabilized at approximately year-end 1993 levels. RESULTS OF OPERATIONS -- 1992 COMPARED TO 1991 Net sales increased 3% from $805.7 million in 1991 to $828.2 million in 1992. This increase was primarily the result of higher domestic sales at the Fibers Division due to an increase in sales volumes for the Company's polyester fibers. At WIL, sales increased due to increased sales volumes and the favorable impact of an increase in the value of the Irish punt against the U.S. dollar, which more than offset lower selling prices in terms of local Irish currency. Sales at the MPG increased primarily due to the increase in direct wool sales activities at the Wool Division. The increases in sales discussed above were partially offset by lower revenues at CRInc. due to reduced construction activities. Gross profit amounted to $188.5 million in 1992 compared to $182.1 million in 1991. Gross profit increased for the Company's fiber businesses due to the increase in sales of polyester fiber discussed above, which more than offset higher costs. The increase in costs reflects the Company's on-going expansion and modernization of its Recycling Division, which processes waste raw materials for two of the Company's domestic fiber plants. Gross profit at the MPG was essentially unchanged in 1992 compared to 1991. The increase in gross profit at CRInc. was due to the increase in the number of operating material recovery facilities which resulted in higher margins. The Company's gross margin was approximately 23% in both 1992 and 1991. Selling, general and administrative expenses were $77.4 million in 1992 compared to $73.2 million in 1991, or approximately 9% of sales in each of the two years. The 6% increase in 1992 resulted primarily from increased costs associated with recycling activities, increased general and administrative expenses and increased expenses at CRInc., all of which more than offset the favorable impact of the sale of Wellman Machinery of Michigan in December 1992 and the increase in earnings from the Company's joint venture, Wellstar. As a result of the foregoing, operating income was $111.1 million in 1992 compared to $108.9 million in 1991. Net interest expense for 1992 was $23.0 million compared to $29.4 million in 1991. This decrease was the result of the decline in the Company's average amount of outstanding borrowings and lower weighted average interest rates on outstanding borrowings. As a result of the forgoing, net earnings in 1992 were $52.3 million, or $1.60 per share, compared to $46.6 million, or $1.43 per share, in 1991. LIQUIDITY AND CAPITAL RESOURCES The Company generated cash from operations of $95.3 million in 1993 compared to $95.9 million in 1992. Net cash used in investing activities amounted to $62.2 million in 1993 compared to $102.5 million in 1992. Capital spending amounted to $105.7 million in 1993, indicative of the Company's on-going capital investment program. In 1993, investing activities included proceeds of $33.0 million from the sale of Wellstar. Net cash used in financing activities amounted to $15.7 million for 1993 compared to $8.2 million of cash provided by financing activities in 1992. The Company's financing agreements contain normal financial and restrictive covenants, including restrictions on the payment of dividends and requirements with respect to working capital, net worth and debt to capitalization. The Company's capital investment program includes approximately $90.0 million in planned expenditures in 1994. The exact amount and timing of the capital spending is difficult to predict, however, as certain projects may extend into 1995 or beyond depending upon equipment delivery and construction schedules. The 1994 capital plan includes expansion of monomer and PET resin capacity at the Palmetto plant, and equipment upgrades at the Company's domestic fiber operations. See "Item 1. Business - Products and Markets" and "- Capital Investment Program". The Company believes that the financial resources available to it, including approximately $58.2 million available at December 31, 1993 under its $176.8 million bank credit facility, approximately $12.4 million of restricted cash resulting from the issuance of economic development revenue bonds (included in "Other assets, net" in the Company's balance sheet and earmarked to recycling-related capital expenditures) and internally generated funds, will be sufficient to meet its foreseeable working capital, capital expenditure and dividend payment requirements. ENVIRONMENTAL MATTERS The Company's operations are subject to extensive and changing federal and state environmental regulations governing air emissions, waste water discharges and solid and hazardous waste management activities. As discussed in Note 1 to the Company's Consolidated Financial Statements, the Company's policy is to accrue environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and the amount can be reasonably estimated. While it is often difficult to reasonably quantify future environmental related expenditures, the Company currently estimates its non-capital expenditures related to environmental matters will range between $13.0 million and $25.0 million. Such expenditures are expected to occur over a significant number of future years. In connection with these expenditures, the Company has accrued $15.5 million at December 31, 1993 ($2.5 million at December 31, 1992), representing management's best estimate of probable non-capital environmental expenditures. In addition, capital expenditures aggregating approximately $10.0 million to $15.0 million may be required over the next several years related to currently existing environmental matters. During 1993, costs associated with environmental remediation and on-going assessment were not significant. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In November 1992, the Financial Accounting Standards Board issued new rules that require accrual accounting over the employees' service period for post-employment benefits that accumulate, such as severance benefits, instead of recognizing an expense for those benefits when the termination decision is made. The Company does not provide these types of benefits and accordingly, will not be affected by these new rules. Item 8. Item 8. Financial Statements and Supplementary Data WELLMAN, INC. and Financial Statement Schedules Page Consolidated Statements of Income for the years 24 ended December 31, 1991, 1992 and 1993 Consolidated Balance Sheets at December 31, 1992 and 25 Consolidated Statements of Stockholders' Equity 26 for the years ended December 31, 1991, 1992, and 1993 Consolidated Statements of Cash Flows for the years 27 ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements 28 Consolidated schedules for the years ended December 31, 1991, 1992 and 1993: V -- Property, plant and equipment 45 VI -- Accumulated depreciation of plant and equipment 46 VIII -- Valuation and qualifying accounts 47 X -- Supplementary income statement information 48 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements and notes thereto. ## ## CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, (In thousands, except per share data) 1991 1992 1993 Net sales. . . . . . . . . . . . . . . . . . . $805,664 $828,200 $842,064 Cost of sales. . . . . . . . . . . . . . . . . 623,546 639,664 679,182 Gross profit . . . . . . . . . . . . . . . . 182,118 188,536 162,882 Selling, general and administrative expenses . 73,194 77,439 86,511 Operating income . . . . . . . . . . . . . . . 108,924 111,097 76,371 Interest expense . . . . . . . . . . . . . . . 29,387 23,012 15,736 Gain on sale of Wellstar . . . . . . . . . . . -- -- 12,386 Earnings before income taxes and cumulative effect of changes in accounting principles . 79,537 88,085 73,021 Provision for income taxes (Note 3): Current. . . . . . . . . . . . . . . . . . . 20,979 25,805 35,655 Deferred . . . . . . . . . . . . . . . . . . 11,975 9,996 (3,088) 32,954 35,801 32,567 Earnings before cumulative effect of changes in accounting principles . . . . . . . . . . 46,583 52,284 40,454 Cumulative effect of changes in accounting principles, net of income taxes (Note 1) . . . . . . . . . . . . . . . -- -- (9,010) Net earnings . . . . . . . . . . . . . . . . . $46,583 $52,284 $31,444 Earnings (loss) per common share: Before cumulative effect of changes in accounting principles . . . . . . . . . $1.43 $1.60 $1.23 Cumulative effect of changes in accounting principles (Note 1). . . . . -- -- (0.27) Net earnings . . . . . . . . . . . . . . . . $1.43 $1.60 $0.96 Average common shares. . . . . . . . . . . . . 32,632 32,728 32,857 Pro forma amounts assuming the effect of the changes in accounting principles are applied retroactively: Net earnings . . . . . . . . . . . . . . . $46,583 $43,759 $40,454 Net earnings per share . . . . . . . . . . $1.43 $1.34 $1.23 See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS December 31, (Dollar amounts in thousands) 1992 1993 Assets Current assets: Cash and cash equivalents. . . . . . . . . . . . . . . . $1,749 $18,751 Accounts receivable, less allowance of $4,443 in 1992 and $4,232 in 1993.. . . . . . . . . . . . . . 89,798 96,599 Inventories (Note 5) . . . . . . . . . . . . . . . . . . 152,152 133,391 Prepaid expenses and other current assets. . . . . . . . 7,579 4,995 Total current assets. . . . . . . . . . . . . . . . . 251,278 253,736 Investment in unconsolidated partially-owned companies (Note 2). . . . 17,584 -- Property, plant and equipment, at cost: Land, buildings and improvements . . . . . . . . . . . . 79,581 94,652 Machinery and equipment. . . . . . . . . . . . . . . . . 405,439 489,516 485,020 584,168 Less accumulated depreciation. . . . . . . . . . . . . . 129,010 163,627 Net property, plant and equipment . . . . . . . . . . 356,010 420,541 Cost in excess of net assets acquired. . . . . . . . . . . 318,258 309,395 Other assets, net. . . . . . . . . . . . . . . . . . . . . 53,453 31,575 $996,583 $1,015,247 Liabilities and Stockholders' Equity Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . $55,218 $51,882 Accrued liabilities (Note 6) . . . . . . . . . . . . . . 25,756 27,019 Deferred taxes on income (Note 3). . . . . . . . . . . . 3,470 482 Current portion of long-term debt (Note 7) . . . . . . . 24,688 18,594 Total current liabilities . . . . . . . . . . . . . . 109,132 97,977 Long-term debt (Note 7). . . . . . . . . . . . . . . . . . 299,860 294,173 Deferred taxes on income and other liabilities (Note 3). . 104,323 116,591 Total liabilities . . . . . . . . . . . . . . . . . . 513,315 508,741 Commitments and contingencies (Note 8) Stockholders' equity (Notes 4, 7, and 10): Common stock, $0.001 par value; 55,000,000 shares authorized, 32,523,650 shares issued and outstanding in 1992, 32,780,018 in 1993. . . . . . . . . . . . . . . 33 33 Class B common stock, $0.001 par value; 5,500,000 shares authorized; no shares issued . . . . . . . . . . -- -- Paid-in capital. . . . . . . . . . . . . . . . . . . . . 210,180 215,179 Foreign currency translation adjustments . . . . . . . . 7,416 96 Retained earnings. . . . . . . . . . . . . . . . . . . . 265,639 291,198 Total stockholders' equity. . . . . . . . . . . . . . 483,268 506,506 $996,583 $1,015,247 See notes to consolidated financial statements. ## ## Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The consolidated financial statements include the accounts of Wellman, Inc. and all wholly and majority-owned subsidiaries (the Company). All material intercompany transactions have been eliminated. Investments in unconsolidated partially-owned companies are accounted for using the equity method. Certain 1992 amounts have been reclassified to conform to the 1993 presentation. Revenue Recognition Sales to customers are recorded when goods are shipped. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for approximately $101,000,000 and $79,000,000 of inventory at December 31, 1992 and 1993, respectively, and the first-in, first-out (FIFO) and average cost methods for the remainder. Property, Plant and Equipment Property, plant and equipment is carried at cost. Depreciation is provided based on the estimated useful lives of the related assets and is computed on the straight-line method. Cost in Excess of Net Assets Acquired Cost in excess of net assets acquired is amortized on the straight-line method over 40 years. Accumulated amortization amounted to approximately $29,803,000 and $38,505,000 at December 31, 1992 and 1993, respectively. The carrying value of goodwill is reviewed if the facts and circumstances suggest that it may be impaired. 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. Other Assets Other assets are comprised primarily of organization costs, deferred charges related to the Company's debt agreements and other intangible assets that are amortized over periods ranging from one to twenty years. Additionally, other assets include cash restricted for use obtained from borrowings under economic development revenue bonds in the amount of approximately $31,600,000 and $12,400,000 at December 31, 1992 and 1993, respectively. See Note 7. Environmental Expenditures Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when environmental assessments and/or remedial efforts are probable and the costs can be reasonably estimated. Income Taxes Income taxes have been provided using the liability method in accordance with the Financial Accounting Standards Board's Statement No. 109, "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. Deferred income taxes resulting from such differences are recorded based on the enacted tax rates that are currently expected to be in effect when the differences are expected to reverse. Cash and Cash Equivalents The carrying amounts reported in the balance sheets for cash and cash equivalents approximate their fair value. The Company considers all short term investments purchased with a maturity of three months or less to be cash equivalents for purposes of the consolidated statements of cash flows. Foreign Currency Translation The financial statements of foreign entities have been translated into U.S. dollar equivalents in accordance with Statement of Financial Accounting Standards No. 52. Adjustments resulting from the translation of the financial statements of foreign entities are excluded from the determination of income and accumulated in a separate component of stockholders' equity. Earnings Per Common Share Earnings per common share is based on the weighted average number of common and common equivalent shares outstanding. Accounting Changes Environmental Liabilities During 1993, the Financial Accounting Standards Board's Emerging Issues Task Force (EITF) issued EITF Abstract No. 93-5, "Accounting For Environmental Liabilities" (EITF 93-5). The Company adopted the provisions of EITF 93-5 in its 1993 Consolidated Financial Statements effective January 1, 1993. EITF 93-5 provides that an environmental liability should be evaluated independently from any potential claim for recovery (a two-event approach) and that the loss arising from the recognition of an environmental liability should be reduced only when a claim for recovery is probable of realization. Current accounting standards provide a general presumption that disputed claims for recovery are not probable of realization. Under practice prior to the issuance of EITF 93-5, some companies, including the Company, offset reasonably possible recoveries against probable losses. As a result of the issuance of EITF 93-5, this accounting treatment is no longer permitted. The cumulative effect as of January 1, 1993 of adopting the provisions of EITF 93-5 was a charge to net income of $6,820,000 ($0.20 per share), net of the income tax effect of $4,180,000. Excluding the cumulative effect, the impact of this change on 1993 net earnings and earnings per share was not material. The pro forma effect of applying this change retroactively would be a decrease in 1992 net earnings of approximately $6,300,000 ($0.19 per share). This change in accounting did not impact 1991 net earnings or earnings per share. Inventory Valuation During 1993, the Company changed its method of applying the lower of cost or market rule to certain slow-moving and discontinued waste raw material inventory which is valued using the LIFO dollar value method. In prior years, the Company used the aggregate method in applying the lower of cost or market rule to such inventories and in 1993 changed to the item-by-item method. The Company believes the new method of accounting is preferable because it provides a better matching of costs and revenue and results in a more conservative valuation of slow-moving and discontinued waste raw material inventory. The cumulative effect as of January 1, 1993 of this change in accounting is a charge to net earnings of $2,190,000 ($0.07 per share), net of the related income tax effect of $1,342,000. Excluding the cumulative effect, this change decreased net earnings for 1993 by approximately $2,500,000 ($0.08 per share). The pro forma effect of applying this change retroactively to 1992 would be a decrease in net earnings of approximately $2,225,000 ($0.07 per share). The pro forma effect on 1991 net earnings and earnings per share is not material. 2. INVESTMENT IN UNCONSOLIDATED PARTIALLY-OWNED COMPANIES In 1992 the investment in unconsolidated partially-owned companies consisted of the Company's 43.7% equity interest in Wellstar Holding, B.V. (Wellstar). Wellstar's subsidiary companies in The Netherlands, France and the United Kingdom are engaged in manufacturing plastic beverage bottles and other plastic containers. In March 1993, the Company sold its ownership interest in Wellstar for a total consideration of $33,000,000. The transaction resulted in a gain, before applicable income taxes, of approximately $12,386,000. The sale of Wellstar increased 1993 net earnings by approximately $7,300,000 or $0.22 per share. 3. INCOME TAXES For financial reporting purposes, earnings before income taxes and the cumulative effect of changes in accounting principles are as follows (in thousands): Years Ended December 31, 1991 1992 1993 United States. . . . . . . . . . . . $75,784 $82,647 $54,535 Foreign. . . . . . . . . . . . . . . 3,753 5,438 18,486 $79,537 $88,085 $73,021 Significant components of the provision for income taxes before the cumulative effect of the changes in accounting principles are as follows (in thousands): Years Ended December 31, 1991 1992 1993 Current: Federal. . . . . . . . . . . . . $15,985 $20,828 $30,310 State. . . . . . . . . . . . . . 4,070 4,057 4,357 Foreign. . . . . . . . . . . . . 924 920 988 $20,979 $25,805 $35,655 Deferred: Federal. . . . . . . . . . . . . $11,799 $9,700 $(2,566) State. . . . . . . . . . . . . . 314 296 (522) Foreign. . . . . . . . . . . . . (138) -- -- 11,975 9,996 (3,088) Total . . . . . . . . . . . . . . . . $32,954 $35,801 $32,567 As discussed in Note 1, deferred income tax benefits relating to the cumulative effect of changes in accounting principles in 1993 amounted to $5,522,000. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The tax effects of these differences are as follows (in thousands): Years Ended December 31, 1992 1993 Inventory . . . . . . . . . . . . . . . . . . $4,116 $ 2,618 Depreciation. . . . . . . . . . . . . . . . . 82,925 81,310 Basis in foreign subsidiaries . . . . . . . . 2,167 3,248 Other . . . . . . . . . . . . . . . . . . . . 5,677 4,232 Total deferred tax liabilities. . . . . . . . 94,885 91,408 Pension . . . . . . . . . . . . . . . . . . . 4,285 4,601 State taxes . . . . . . . . . . . . . . . . . 4,212 3,743 Long-term liabilities . . . . . . . . . . . . 1,535 6,771 Other . . . . . . . . . . . . . . . . . . . . 4,089 4,139 Total deferred tax assets . . . . . . . . . . 14,121 19,254 Net deferred tax liabilities. . . . . . . . . $80,764 $72,154 Deferred income taxes have not been provided for approximately $56,118,000 of undistributed earnings of foreign entities which are considered to be permanently reinvested. Upon repatriation of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes. Determination of the amount of unrecognized deferred U. S. income tax liability is not practicable because of the complexities associated with its hypothetical calculation. The difference between the provision for income taxes before the cumulative effect of changes in accounting principles and income taxes computed at the statutory U. S. federal income tax rate is explained as follows: Years Ended December 31, 1991 1992 1993 Computed at statutory rate. . . 34.0% 34.0% 35.0% State taxes, net of federal benefit . . . . . . . . . . . 3.6 3.3 3.4 Differences in income tax rates between the United States and foreign countries . . . . . . (0.2) (0.4) (1.8) Amortization of cost in excess of net assets acquired. . . . 3.6 3.2 4.1 Effect of tax rate change on net deferred tax liabilities. -- -- 2.6 Other, net. . . . . . . . . . . 0.4 0.5 1.3 Effective tax rate. . . . . 41.4% 40.6% 44.6% 4. STOCKHOLDERS' EQUITY In 1991, 1992 and the first quarter of 1993, the Company paid quarterly cash dividends of $0.03 per share. In the second quarter of 1993, the quarterly dividend was increased to $0.05 per share. Approximately 375,000 and 3,588,000 common shares have been reserved for issuance in connection with certain of the Company's employee benefit plans and the Company's stock option plans, respectively. Of the 3,588,000 common shares reserved for issue in connection with stock option plans, 1,500,000 are subject to approval at the Company's Annual Meeting to be held in May 1994. See Notes 9 and 10. On August 6, 1991, the Board of Directors declared a dividend of one common stock purchase right (a Right) for each outstanding share of common stock. Each Right, when exercisable, will entitle the registered holder to purchase from the Company one share of common stock at an exercise price of $90 per share (the Purchase Price), subject to certain adjustments. The Rights are not represented by separate certificates and are only exercisable when a person or group of affiliated or associated persons acquires or obtains the right to acquire 15% or more of the Company's outstanding common shares (an Acquiring Person) or announces a tender or exchange offer that would result in any person or group beneficially owning 15% or more of the Company's outstanding common shares. In the event any person becomes an Acquiring Person, the Rights would give holders the right to buy, for the Purchase Price, common stock with a market value of twice the Purchase Price. The Rights expire on August 5, 2001, unless extended by the Board of Directors or redeemed earlier by the Company at a redemption price of $0.01 per Right. Although the Rights should not interfere with a business combination approved by the Board of Directors, they may cause substantial dilution to a person or group that attempts to acquire the Company on terms not approved by the Board, except pursuant to an offer conditioned on a substantial number of Rights being acquired. 5. INVENTORIES Inventories consist of the following (in thousands): December 31, 1992 1993 Finished and semi-finished goods. . $ 52,933 $ 53,083 Raw materials . . . . . . . . . . . 86,289 72,723 Supplies. . . . . . . . . . . . . . 12,930 12,467 152,152 138,273 Less adjustments of certain inventories to a LIFO basis . . . -- 4,882 Total . . . . . . . . . . . . . . . $152,152 $133,391 The replacement cost of the Company's inventories amounted to approximately $152,000,000 and $138,000,000 at December 31, 1992 and 1993, respectively. 6. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands): December 31, 1992 1993 Payroll and other compensation. . . $ 4,776 $ 3,800 Benefit plans . . . . . . . . . . . 9,442 9,931 Property and other taxes. . . . . . 2,885 2,733 Insurance . . . . . . . . . . . . . 2,297 1,112 Interest. . . . . . . . . . . . . . 2,303 2,347 Other . . . . . . . . . . . . . . . 4,053 7,096 Total . . . . . . . . . . . . . . . $25,756 $27,019 7. LONG-TERM DEBT Long-term debt consists of the following (in thousands): December 31, 1992 1993 Reducing revolving credit and term loan facilities and loan note participations . . . . . . . $115,932 $118,559 Serialized senior unsecured notes . 100,000 100,000 Economic development revenue bonds . . . . . . . . . . . . . . 54,500 54,500 8.41% senior note payable, due on July 31, 2000. . . . . . . 30,000 30,000 14.5% senior promissory notes due through July 1, 1994. . . . . 8,700 2,900 Wellman International Limited debt. . . . . . . . . . . . . . . 14,706 6,099 Other . . . . . . . . . . . . . . . 710 709 324,548 312,767 Less amount due within one year . 24,688 18,594 Total . . . . . . . . . . . . . . . $299,860 $294,173 The reducing revolving credit and term loan facilities originally consisted of a $222,000,000 Reducing Revolving Credit Loan and a $178,000,000 Term Loan (collectively, the Facilities). The reducing revolving credit and term loan facilities mature on December 31, 1996 and June 30, 1995, respectively. As of December 31, 1993, the Company reduced the aggregate commitment on the Facilities from $400,000,000 to $176,759,000. Borrowings under each of the Facilities bear interest, at the Company's option, at the prime rate, the LIBOR or CD rate plus margins ranging from 0.50% to 0.75% on LIBOR loans and 0.625% to 0.875% on CD rate loans, determined on the basis of the Company's leverage ratio, as defined in the Facilities. The terms of the Reducing Revolving Credit Loan provide the Company the ability to borrow under competitive bid loans. Such borrowings, as well as borrowings under loan note participations (LNPs), reduce the availability under the Reducing Revolving Credit Loan and bear interest at the offering bank's prevailing interest rate. At December 31, 1993, the average interest rate on borrowings under the Facilities and LNPs was approximately 3.70%. The $100,000,000 of Serialized Senior Unsecured Notes bear interest at rates ranging between 9.02% and 9.26% (averaging 9.18%) and mature between May 1997 and May 1999. The WIL debt consists primarily of funds borrowed under multi-currency term loan facilities, of which approximately $750,000 is due in 1994 and the remainder in 2000. The interest rate floats based upon the banks' cost of funds and the currencies borrowed. At December 31, 1993, the average rate on WIL borrowings approximated 6.00%. The WIL debt is secured by assets of WIL. The economic development revenue bonds (the Bonds) bear interest at variable rates which cannot exceed 12.00% for certain issues and 15.00% for one issue. The Bonds mature as follows: $8,000,000 on December 1, 2010; $32,000,000 on December 1, 2012; $5,000,000 on April 1, 2017; and $9,500,000 on June 1, 2022. The Bonds are tenderable by the holders and are secured by letters of credit aggregating approximately $55,800,000 at December 31, 1993. The weighted average interest rate on the Bonds at December 31, 1993 was approximately 2.50%. The Bonds and certain borrowings under the Facilities and LNPs are classified as long term in accordance with the Company's intention and ability to refinance such obligations on a long term basis. The Company's financing agreements contain normal financial and restrictive covenants, including restrictions on the payment of dividends and requirements with respect to working capital, net worth and debt to capitalization. Under the most restrictive covenant, approximately $131,300,000 of retained earnings at December 31, 1993 is not restricted as to the payment of dividends. The carrying amounts of the Company's borrowings under its variable rate credit agreements approximate their fair value. The fair values of the Company's fixed rate credit agreements are estimated using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair value of the Company's fixed rate debt exceeded its carrying value by approximately $15,000,000 at December 31, 1993. Prepayment of the fixed rate debt would result in significant penalties. The approximate annual maturities of long term debt, including the current portion, during each of the next five years and thereafter are as follows: 1994 -- $18,594,000; 1995 -- $46,410,000; 1996 -- $112,137,000; 1997 -- $20,148,000; 1998 -- $40,183,000; and thereafter -- $75,295,000. Although maturities of the Bonds range from 2010 to 2022, they have been included as maturities in 1995 and 1996 as they are tenderable by the holders, and the Company's present long term facilities mature during those years. During 1991, 1992 and 1993, the Company capitalized interest of $809,000, $304,000 and $2,375,000, respectively, as part of the cost of capital projects under construction. 8. COMMITMENTS AND CONTINGENCIES The Company's operations are subject to extensive and rapidly changing federal and state environmental regulations governing air emissions, waste water discharges and solid and hazardous waste management activities. As discussed in Note 1, the Company's policy is to accrue environmental and clean-up-related costs of a non-capital nature when it is both probable that a liability has been incurred and the amount can be reasonably estimated. While it is often difficult to reasonably quantify future environmental related expenditures, the Company currently estimates its non-capital expenditures related to environmental matters will range between $13,000,000 and $25,000,000. Such expenditures are expected to occur over a significant number of future years. In connection with these expenditures, the Company has accrued $15,500,000 at December 31, 1993 ($2,500,000 at December 31, 1992) representing management's best estimate of probable non-capital environmental expenditures. In addition, capital expenditures aggregating approximately $10,000,000 to $15,000,000 may be required over the next several years related to currently existing environmental matters. The Company believes that it is entitled to recover a portion of these expenditures under indemnification and escrow agreements. In connection with the 1992 acquisition of Creative Forming, Inc. (CFI), the Company may be required to make an additional payment in 1997 based primarily on CFI's 1995 and 1996 average earnings, as defined. The contingent payment, if any, will increase cost in excess of net assets acquired. At December 31, 1993, the Company had approximately $63,127,000 of outstanding letters of credit of which approximately $55,800,000 were outstanding as security for the Bonds, as discussed in Note 7. Approximate minimum rental commitments under non-cancelable leases (principally for buildings and equipment) during each of the next five years and thereafter are as follows: 1994 -- $4,235,000; 1995 -- $3,759,000; 1996 -- $2,976,000; 1997 -- $2,788,000; 1998 -- $2,773,000; and thereafter -- $5,832,000. Rent expense for cancelable and non-cancelable operating leases was $5,049,000, $4,797,000, and $6,295,000 for the years ended December 31, 1991, 1992 and 1993, respectively. 9. RETIREMENT PLANS The Company has defined benefit and defined contribution pension plans and an employee stock ownership plan (the ESOP) covering substantially all employees. Payments upon retirement or termination of employment under the defined contribution plans are based on vested amounts credited to individual accounts. The plans provide for Company contributions based on the earnings of eligible employees. Such contributions, excluding amounts contributed to the ESOP, amounted to approximately $3,556,000, $6,442,000 and $7,553,000 for the years ended December 31, 1991, 1992 and 1993, respectively. Company contributions to the ESOP amounted to approximately $1,847,000 and $2,249,000 for the years ended December 31, 1992 and 1993, respectively. The increase in total contributions in 1992 and 1993 compared to prior years is primarily due to the formation of the Wellman, Inc. Retirement Plan (WIRP) and the ESOP. The WIRP effectively consolidates retirement benefits for certain domestic employees. Accordingly, amendments to certain provisions of a domestic defined benefit plan were made effective on January 1, 1992. Benefits under the WIL defined benefit plan are based on employees' compensation and length of service, while benefits under defined benefit plans covering domestic employees are based on employees' compensation and length of service or at stated amounts based on length of service. The Company's policy is to fund amounts which are actuarially determined to provide the plans with sufficient assets to meet future benefit payment requirements. Assets of the plans are invested primarily in equity securities and commingled trust funds. The pension costs of the defined benefit plans consist of the following (in thousands): Years Ended December 31, 1991 1992 1993 Service cost. . . . . . . . . . $3,391 $ (706) $ (370) Interest cost on projected benefit obligations . . . . . 3,908 4,113 4,336 Less actual return on assets. . 3,236 (1,697) 7,512 Net amortization and deferral . 345 (5,009) 4,621 Total $4,408 $ 95 $1,075 The following table sets forth the funded status and amounts included in the Company's Consolidated Balance Sheets at December 31, 1992 and 1993 for its defined benefit pension plans (in thousands): December 31, 1992 1993 Actuarial present value of benefit obligations: Vested benefit obligations. . . . $ 27,600 $ 33,502 Accumulated benefit obligations . $ 27,907 $ 33,952 Projected benefit obligations . . $ 51,585 $ 52,913 Plan assets at fair market value. . 38,564 45,063 Funded status . . . . . . . . . . . (13,021) (7,850) Unrecognized net (gain) loss. . . . 1,990 (1,875) Unrecognized net asset at transition . . . . . . . . . . (50) (5) Unrecognized prior service cost . . (1,083) (1,395) Accrued pension costs . . . . . . . $(12,164) $(11,125) The unrecognized prior service cost relates primarily to amendments to the early retirement provisions of a domestic plan. Such amendments became effective January 1, 1992. At December 31, 1992 and 1993, assumed discount rates of 8% and 7.25%, respectively, and rates of increase in future compensation levels of 6% and 4.5%, respectively, were used in determining the actuarial present value of benefit obligations for the domestic plans. The assumed long-term rates of return on domestic plan assets were 8%. The assumptions used in calculating the actuarial present value of benefit obligations for WIL were discount rates of 9% and 7% and rates of increases in future compensation levels of 6.5% and 5% at December 31, 1992 and 1993, respectively. The assumed long-term rates of return on plan assets for WIL were 9%, 9% and 7% at December 31, 1991, 1992 and 1993, respectively. 10. STOCK OPTION PLANS The Company has stock option plans (the Plans) which authorize the grant of non-qualified stock options (NQSOs). The maximum number of common shares authorized for grant under the Plans is 3,588,000. Of the 3,588,000 common shares, 1,500,000 are subject to shareholder approval at the Company's Annual Meeting to be held in May 1994. For substantially all options granted in connection with the Plans, the option period extends for either ten years and one day from the date of grant, or 11 years from the date of grant, and the shares vest at 20% per year over the first five years. The option price at which options are granted under the Plans must be at least equal to the fair market value at the date of grant. Information regarding the NQSOs is as follows: 1991 1992 1993 Options outstanding at January 1 943,169 1,185,073 1,481,735 Options granted at prices of $19.875 in 1991, $20.625 in 1992 and $17.375 in 1993. . . . . 346,500 366,300 223,714* Options exercised at average prices of $3.83 in 1991, $12.28 in 1992 and $12.32 in 1993. . . . (35,456) (54,138) (54,748) Options canceled at average prices of $24.99 in 1991, $22.36 in 1992 and $20.42 in 1993 . . . (69,140) (15,500) (5,590) Options outstanding at December 31 at average prices of $19.38 in 1991, $19.92 in 1992 and $19.63 in 1993. . . . . . . . . . 1,185,073 1,481,735 1,645,111* Options exercisable at December 31 . . . . . . . . . . . 390,458 558,380 768,960 Options available for grant at December 31. . . . . . . . . . 568,924 218,124 -0-* *The options granted in 1993 and options outstanding at December 31, 1993 exclude options relating to 136,286 common shares. These options were granted by the Board of Directors pending shareholder authorization of additional common shares to the Plans. 11. BUSINESS SEGMENT AND GEOGRAPHIC AREAS The Company operates in one business segment: principally the manufacture and sale of polyester and nylon fibers and resins primarily for use in the apparel, home furnishings and other consumer products markets. Revenues and operating income for the years ended December 31, 1991, 1992 and 1993 and identifiable assets at the end of each year, classified by the major geographic areas in which the Company operates, are as follows (in thousands): Years Ended December 31, 1991 1992 1993 Net sales U.S. . . . . . . . . . . . . $711,862 $728,733 $ 754,882 Western Europe . . . . . . . 93,802 99,467 87,182 Total net sales. . . . . . $805,664 $828,200 $ 842,064 Operating income U.S. . . . . . . . . . . . . $103,733 $105,943 $ 69,305 Western Europe . . . . . . . 5,191 5,154 7,066 Total operating income. . . . . . . . . . 108,924 111,097 76,371 Interest expense . . . . . . . 29,387 23,012 15,736 Gain on sale of Wellstar . . . -- -- 12,386 Earnings before income taxes . . . . . . . . $ 79,537 $ 88,085 $ 73,021 Identifiable assets U.S. . . . . . . . . . . . . $834,020 $913,384 $ 927,330 Western Europe . . . . . . . 91,269 83,199 87,917 Total. . . . . . . . . . . $925,289 $996,583 $1,015,247 UNAUDITED QUARTERLY FINANCIAL DATA Quarterly financial information for the years ended December 31, 1992 and 1993 is summarized as follows: REPORT OF INDEPENDENT AUDITORS Board of Directors Wellman, Inc. We have audited the accompanying consolidated balance sheets of Wellman, Inc. 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 8. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements and schedules of a wholly-owned subsidiary of the Company, which statements reflect total assets constituting 6% in 1993 and 8% in 1992 and total revenues constituting 10% in 1993 and 11% in 1992 and 1991 of the related consolidated totals. Those statements and schedules were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for the Company's wholly-owned subsidiary, is based solely on the report of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Wellman, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, based on our audits and the report of other auditors, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, in 1993 the Company changed its method of accounting for recoveries related to environmental liabilities and its method of valuing certain inventories. ERNST & YOUNG Charlotte, North Carolina February 15, 1994 SCHEDULE X WELLMAN, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION For The Years Ended December 31, 1991, 1992, and 1993 (In thousands) ================================================================= 1991 1992 1993 - ----------------------------------------------------------------- Maintenance and repairs $33,479 $36,721 $37,959 ======= ======= ======= Amortization of intangible assets $11,967 $12,764 $16,313 ======= ======= ======= Other amounts are less than 1 percent of sales. 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 "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission on or before April 30, 1994 is hereby incorporated by reference herein. Item 11. Item 11. Executive Compensation "Compensation of Directors and Officers" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission on or before April 30, 1994 is hereby incorporated by reference herein. 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 "Introduction" and "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission on or before April 30, 1994 is hereby incorporated by reference herein. Item 13. Item 13. Certain Relationships and Related Transactions "Compensation of Directors and Officers" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission on or before April 30, 1994 is hereby incorporated by reference herein. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements The financial statements included in Item 8 are filed as part of this annual report. 2. Financial Statement Schedules The financial statement schedules included in Item 8 are filed as part of this annual report. 3. Exhibits Exhibit Number Description 3(a)(1) Restated Certificate of Incorporation (Exhibit 3.1 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 3(a)(2) Certificate of Amendment to Restated Certificate of Incorporation (Exhibit 3(a)(2) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) 3(a)(3) Certificate of Amendment to Restated Certificate of Incorporation (Exhibit 28 of the Company's Registration Statement on Form S-8, File No. 33-38491, incorporated by reference herein) 3(a)(4) Certificate of Amendment to Restated Certificate of Incorporation 3(b) By-Laws, as amended 4(a) Loan Agreement dated December 7, 1990 by and between the Company and Fleet National Bank, as agent, and certain other financial institutions (Exhibit 4(a) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 4(b) Note and Stock Purchase Agreement dated July 31, 1985, among the Company, the Prudential Insurance Company of Amer ("Prudential") and Teachers Insurance and Annuity Association of America ("Teachers") (Exhibit 4.6 of the Company's Registration Statement on Form S-1, File No. 33-23988, incorporated by reference herein) 4(c) Letter Agreement dated June 10, 1987 between the Company and Teachers (Exhibit 19.2 of the Company's Form 10-Q for the Quarter ended June 30, 1987 incorporated by reference herein) 4(d) Letter Agreement dated October 2, 1989 between the Company and Teachers (Exhibit 4(c) of the Company's Form 8-K for the event dated November 1, 1989 incorporated by reference herein) 4(e) Letter Agreement dated June 10, 1987 between the Company and Prudential (Exhibit 19.3 of the Company's Form 10-Q for the Quarter ended June 30, 1987 incorporated by reference herein) 4(f) Letter Agreement dated October 2, 1989 between the Company and Prudential (Exhibit 4(d) of the Company's Form 8-K for the event dated November 1, 1989 incorporated by reference herein) 4(g) Letter Agreement dated March 20, 1990 between the Company and Prudential (Exhibit 4(g) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(h) Letter Agreement dated March 20, 1990 between the Company and Teachers (Exhibit 4(h) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(i) Letter Agreement dated December 7, 1990 between the Company and Prudential (Exhibit 4(i) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(j) Letter Agreement dated December 7, 1990 between the Company and Teachers (Exhibit 4(j) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(k) Amendment Agreement dated February 27, 1992 between the Company and Prudential (Exhibit 4(k) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(l) Amendment Agreement dated February 27, 1992 between the Company and Teachers (Exhibit 4(l) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(m) Facilities dated December 19, 1991 between WIL and Ulster Investment Bank Limited (Exhibit 4(m) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(n) Registration Rights Agreement dated as of August 12, 1985 by and among the Company, Teachers, Prudential, Narragansett First Fund, Thomas M. Duff, John L. Dings, Alex Holder, Calvin Hughes, and Frank McGuire (Exhibit 4.7 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 4(o) Loan Agreement between South Carolina Jobs - Economic Development Authority (the "Authority") and the Company dated as of December 1, 1990 (Exhibit 4(n) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 4(p) First Supplemental Loan Agreement between the Authority and the Company dated as of April 1, 1991 (Exhibit 4(a) of the Company's Form 10-Q for the quarter ended June 30, 1991 incorporated by reference herein) 4(q) Note Purchase Agreement dated as of June 14, 1991 between the Company and the Purchasers named in Schedule I thereto (Exhibit 4(b) of the Company's Form 10-Q for the quarter ended June 30, 1991 incorporated by reference herein) 4(r) Rights Agreement dated as of August 6, 1991 between the Company and First Chicago Trust Company of New York, as Rights Agent (Exhibit 1 to the Company's Form 8-K dated as of August 6, 1991 incorporated by reference herein) 4(s) Loan Agreement between the Authority and the Company, dated as of June 1, 1992 (Exhibit 4(u) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(t) Note Purchase Agreement between the Company and Teachers dated July 28, 1992 (Exhibit 4(v) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(u) Loan Agreement between the Authority and the Company, dated as of December 1, 1992 (Exhibit 4(w) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 4(v) Promissory Note dated May 15, 1992 of the Company to the City of Florence, SC (Exhibit 4(x) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 4(w) Loan note participations with the Sumitomo Bank, Limited, dated July 27, 1992, Buliner Handels-und Frankfurter Bank dated June 15, 1992, Banco di Napoli dated September 14, 1992, Istituto Bancario San Paolo di Torino S.p.A. dated January 4, 1992, Continental Bank N.A. dated November 26, 1991 (Exhibit 4(y) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 4(x) Promissory Note dated August 9, 1993 of the Company to First Fidelity Bank, National Bank (Exhibit 4(z) of the Company's Form 10-Q for the quarter ended September 30, 1993 incorporated by reference herein) 4(y) Commercial Purpose Loan Note dated August 11, 1993 to Chemical Bank New Jersey, National Association 4(z) Promissory Note dated June 18, 1993 of the Company to Fleet National Bank Executive Compensation Plans and Arrangements 10(a) Wellman, Inc. 1985 Incentive Stock Option Plan, as amended (Exhibit 4(a) of the Company's Registration Statement on Form S-8/S-3, File No. 33-17196, incorporated by reference herein) 10(b)(1) Employment Agreement dated as of January 1, 1990 between the Company and Thomas M. Duff (Exhibit 10(e) of the Company's Form 10-K for the year ended December 31, 1989 incorporated by reference herein) 10(b)(2) Amendment to Employment Agreement dated as of January 1, 1993 between the Company and Thomas M. Duff (Exhibit 19 to the Company's Form 10-Q for the quarter ended March 31, 1993 incorporated by reference herein) 10(c)(1) Employment Agreement dated as of January 1, 1990 between the Company and Clifford J. Christenson (Exhibit 10(f) of the Company's Form 10-K for the year ended December 31, 1989 incorporated by reference herein) 10(c)(2) First Amendment to Employment Agreement dated as of January 1, 1993 between the Company and Clifford J. Christenson (Exhibit 10(c)(2) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 10(d) Service Agreement dated as of June 26, 1991 between Wellman International Investments Limited and Charles William Beckwith (Ehibit 10(g) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 10(e) Employment Agreement dated as of October 1, 1991 between the Company and James P. Casey (Ehibit 10(j) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 10(f) Employment Agreement dated as of April 1, 1992 between the Company and Paul D. Apostol (Exhibit 10(f) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 10(g) Directors Stock Option Plan dated as of December 2, 1991 (Exhibit 4(a) of the Company's Registration Statement on Form S-8, File No. 33-44822 incorporated by reference herein) 10(h) Management Incentive Compensation Plan 10(i) Summary of Executive Life Insurance Plan (Exhibit 10.22 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 10(j)(1) Amended and Restated Restricted Stock Agreement dated November 17, 1988 between the Company and Peter H. Conze (Exhibit 10(x)(1) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(2) Amended and Restated Restricted Stock Agreement dated December 5, 1988 between the Company and Richard F. Heitmiller (Exhibit 10(x)(2) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(3) Restricted Stock Agreement dated March 31, 1989 between the Company and Jonathan M. Nelson (Exhibit 10(w)(4) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) 10(j)(4) Restricted Stock Agreement dated March 31, 1989 between the Company and Roger A. Vandenberg (Exhibit 10(w)(5) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) 10(j)(5) Restricted Stock Agreement dated as of August 9, 1990 between the Company and Allan R. Dragone (Exhibit 10(x)(5) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(6) Restricted Stock Agreement dated as of August 9, 1990 between the Company and Raymond C. Tower (Exhibit 10(x)(6) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(7) Restricted Stock Agreement dated September 21, 1993 between the Company and James E. Rogers Other Material Agreements 10(k) Environmental Agreement dated as of August 8, 1985, by and among the Company, Arthur O. Wellman, Jr., and Edward R. Sacks (Exhibit 10.12 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 10(l) Post-Closing Escrow Agreement dated August 12, 1985 by and among the Company, Arthur O. Wellman, Jr., Edward R. Sacks and certain other parties (Exhibit 10.2 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 10(m) Guarantee of indebtedness of Wellman Fibers Limited to National Westminster Bank PLC (Exhibit 10(r) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 10(n) Letter Agreement, relating to certain environmental matters, dated August 17, 1987, by and among FI, HCC and Celanese (Exhibit 10.3 of FI's Registration Statement on Form S-1, File No. 33-20626, incorporated herein by reference) 10(o) Trademark Assignment and License, dated January 28, 1988, by and among FI, HCC and Celanese (Exhibit 10.14 of FI's Registration Statement on Form S-1, File No. 33-20626, incorporated herein by reference) 18 Letter of Ernst & Young re change in accounting principles 21 Subsidiaries of the Company 23(a) Consent of Ernst & Young 23(b) Consent of KPMG Stokes Kennedy Crowley 99 Report of KPMG Stokes Kennedy Crowley (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, on March 24, 1994. WELLMAN, INC. By /s/ Thomas M. Duff 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 indicated on March 24, 1994. Signatures Title /s/ Thomas M. Duff President, Chief Executive Officer Thomas M. Duff and Director (Principal Executive Officer) /s/ Keith R. Phillips Vice President, Chief Financial Keith R. Phillips Officer and Treasurer (Principal Financial Officer) /s/ Mark J. Rosenblum Vice President, Controller Mark J. Rosenblum (Principal Accounting Officer) /s/ C. William Beckwith Director C. William Beckwith /s/ Peter H. Conze Director Peter H. Conze /s/ Allan R. Dragone Director Allan R. Dragone /s/ Richard F. Heitmiller Director Richard F. Heitmiller /s/ Jonathan M. Nelson Director Jonathan M. Nelson /s/ James E. Rogers Director James E. Rogers /s/ Raymond C. Tower Director Raymond C. Tower /s/ Roger A. Vandenberg Director Roger A. Vandenberg EXHIBIT INDEX Exhibit Number Description 3(a)(1) Restated Certificate of Incorporation (Exhibit 3.1 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 3(a)(2) Certificate of Amendment to Restated Certificate of Incorporation (Exhibit 3(a)(2) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) 3(a)(3) Certificate of Amendment to Restated Certificate of Incorporation (Exhibit 28 of the Company's Registration Statement on Form S-8, File No. 33-38491, incorporated by reference herein) 3(a)(4) Certificate of Amendment to Restated Certificate of Incorporation 3(b) By-Laws, as amended 4(a) Loan Agreement dated December 7, 1990 by and between the Company and Fleet National Bank, as agent, and certain other financial institutions (Exhibit 4(a) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 4(b) Note and Stock Purchase Agreement dated July 31, 1985, among the Company, the Prudential Insurance Company of America ("Prudential") and Teachers Insurance and Annuity Association of America ("Teachers") (Exhibit 4.6 of the Company's Registration Statement on Form S-1, File No. 33-23988, incorporated by reference herein) Exhibit Number Description 4(c) Letter Agreement dated June 10, 1987 between the Company and Teachers (Exhibit 19.2 of the Company's Form 10-Q for the Quarter ended June 30, 1987 incorporated by reference herein) 4(d) Letter Agreement dated October 2, 1989 between the Company and Teachers (Exhibit 4(c) of the Company's Form 8-K for the event dated November 1, 1989 incorporated by reference herein) 4(e) Letter Agreement dated June 10, 1987 between the Company and Prudential (Exhibit 19.3 of the Company's Form 10-Q for the Quarter ended June 30, 1987 incorporated by reference herein) 4(f) Letter Agreement dated October 2, 1989 between the Company and Prudential (Exhibit 4(d) of the Company's Form 8-K for the event dated November 1, 1989 incorporated by reference herein) 4(g) Letter Agreement dated March 20, 1990 between the Company and Prudential (Exhibit 4(g) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(h) Letter Agreement dated March 20, 1990 between the Company and Teachers (Exhibit 4(h) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(i) Letter Agreement dated December 7, 1990 between the Company and Prudential (Exhibit 4(i) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) Exhibit Number Description 4(j) Letter Agreement dated December 7, 1990 between the Company and Teachers (Exhibit 4(j) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(k) Amendment Agreement dated February 27, 1992 between the Company and Prudential (Exhibit 4(k) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(l) Amendment Agreement dated February 27, 1992 between the Company and Teachers (Exhibit 4(l) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 4(m) Facilities dated December 19, 1991 between WIL and Ulster Investment Bank Limited (Exhibit 4(m) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(n) Registration Rights Agreement dated as of August 12, 1985 by and among the Company, Teachers, Prudential, Narragansett First Fund, Thomas M. Duff, John L. Dings, Alex Holder, Calvin Hughes, and Frank McGuire (Exhibit 4.7 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 4(o) Loan Agreement between South Carolina Jobs - Economic Development Authority (the "Authority") and the Company dated as of December 1, 1990 (Exhibit 4(n) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) Exhibit Number Description 4(p) First Supplemental Loan Agreement between the Authority and the Company dated as of April 1, 1991 (Exhibit 4(a) of the Company's Form 10-Q for the quarter ended June 30, 1991 incorporated by reference herein) 4(q) Note Purchase Agreement dated as of June 14, 1991 between the Company and the Purchasers named in Schedule I thereto (Exhibit 4(b) of the Company's Form 10-Q for the quarter ended June 30, 1991 incorporated by reference herein) 4(r) Rights Agreement dated as of August 6, 1991 between the Company and First Chicago Trust Company of New York, as Rights Agent (Exhibit 1 to the Company's Form 8-K dated as of August 6, 1991 incorporated by reference herein) 4(s) Loan Agreement between the Authority and the Company, dated as of June 1, 1992 (Exhibit 4(u) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(t) Note Purchase Agreement between the Company and Teachers dated July 28, 1992 (Exhibit 4(v) of the Company's Form 10-Q for the quarter ended June 30, 1992 incorporated by reference herein) 4(u) Loan Agreement between the Authority and the Company, dated as of December 1, 1992 (Exhibit 4(w) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) Exhibit Number Description 4(v) Promissory Note dated May 15, 1992 of the Company to the City of Florence, SC (Exhibit 4(x) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 4(w) Loan note participations with the Sumitomo Bank, Limited, dated July 27, 1992, Buliner Handels-und Frankfurter Bank dated June 15, 1992, Banco di Napoli dated September 14, 1992, Istituto Bancario San Paolo di Torino S.p.A. dated January 4, 1992, Continental Bank N.A. dated November 26, 1991 (Exhibit 4(y) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 4(x) Promissory Note dated August 9, 1993 of the Company to First Fidelity Bank, National Bank (Exhibit 4(z) of the Company's Form 10-Q for the quarter ended September 30, 1993 incorporated by reference herein) 4(y) Commercial Purpose Loan Note dated August 11, 1993 to Chemical Bank New Jersey, National Association 4(z) Promissory Note dated June 18, 1993 of the Company to Fleet National Bank Executive Compensation Plans and Arrangements 10(a) Wellman, Inc. 1985 Incentive Stock Option Plan, as amended (Exhibit 4(a) of the Company's Registration Statement on Form S-8/S-3, File No. 33-17196, incorporated by reference herein) Exhibit Number Description 10(b)(1) Employment Agreement dated as of January 1, 1990 between the Company and Thomas M. Duff (Exhibit 10(e) of the Company's Form 10-K for the year ended December 31, 1989 incorporated by reference herein) 10(b)(2) Amendment to Employment Agreement dated as of January 1, 1993 between the Company and Thomas M. Duff (Exhibit 19 to the Company's Form 10-Q for the quarter ended March 31, 1993 incorporated by reference herein) 10(c)(1) Employment Agreement dated as of January 1, 1990 between the Company and Clifford J. Christenson (Exhibit 10(f) of the Company's Form 10-K for the year ended December 31, 1989 incorporated by reference herein) 10(c)(2) First Amendment to Employment Agreement dated as of January 1, 1993 between the Company and Clifford J. Christenson (Exhibit 10(c)(2) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 10(d) Service Agreement dated as of June 26, 1991 between Wellman International Investments Limited and Charles William Beckwith (Ehibit 10(g) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 10(e) Employment Agreement dated as of October 1, 1991 between the Company and James P. Casey (Ehibit 10(j) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) Exhibit Number Description 10(f) Employment Agreement dated as of April 1, 1992 between the Company and Paul D. Apostol (Exhibit 10(f) of the Company's Form 10-K for the year ended December 31, 1992 incorporated by reference herein) 10(g) Directors Stock Option Plan dated as of December 2, 1991 (Exhibit 4(a) of the Company's Registration Statement on Form S-8, File No. 33-44822 incorporated by reference herein) 10(h) Management Incentive Compensation Plan 10(i) Summary of Executive Life Insurance Plan (Exhibit 10.22 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 10(j)(1) Amended and Restated Restricted Stock Agreement dated November 17, 1988 between the Company and Peter H. Conze (Exhibit 10(x)(1) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(2) Amended and Restated Restricted Stock Agreement dated December 5, 1988 between the Company and Richard F. Heitmiller (Exhibit 10(x)(2) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(3) Restricted Stock Agreement dated March 31, 1989 between the Company and Jonathan M. Nelson (Exhibit 10(w)(4) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) Exhibit Number Description 10(j)(4) Restricted Stock Agreement dated March 31, 1989 between the Company and Roger A. Vandenberg (Exhibit 10(w)(5) of the Company's Registration Statement on Form S-4, File No. 33-31043, incorporated by reference herein) 10(j)(5) Restricted Stock Agreement dated as of August 9, 1990 between the Company and Allan R. Dragone (Exhibit 10(x)(5) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(6) Restricted Stock Agreement dated as of August 9, 1990 between the Company and Raymond C. Tower (Exhibit 10(x)(6) of the Company's Form 10-K for the year ended December 31, 1990 incorporated by reference herein) 10(j)(7) Restricted Stock Agreement dated September 21, 1993 between the Company and James E. Rogers Other Material Agreements 10(k) Environmental Agreement dated as of August 8, 1985, by and among the Company, Arthur O. Wellman, Jr., and Edward R. Sacks (Exhibit 10.12 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) 10(l) Post-Closing Escrow Agreement dated August 12, 1985 by and among the Company, Arthur O. Wellman, Jr., Edward R. Sacks and certain other parties (Exhibit 10.2 of the Company's Registration Statement on Form S-1, File No. 33-13458, incorporated by reference herein) Exhibit Number Description 10(m) Guarantee of indebtedness of Wellman Fibers Limited to National Westminster Bank PLC (Exhibit 10(r) of the Company's Form 10-K for the year ended December 31, 1991 incorporated by reference herein) 10(n) Letter Agreement, relating to certain environmental matters, dated August 17, 1987, by and among FI, HCC and Celanese (Exhibit 10.3 of FI's Registration Statement on Form S-1, File No. 33-20626, incorporated herein by reference) 10(o) Trademark Assignment and License, dated January 28, 1988, by and among FI, HCC and Celanese (Exhibit 10.14 of FI's Registration Statement on Form S-1, File No. 33-20626, incorporated herein by reference) 18 Letter of Ernst & Young regarding change in accounting principles 21 Subsidiaries of the Company 23(a) Consent of Ernst & Young 23(b) Consent of KPMG Stokes Kennedy Crowley 99 Report of KPMG Stokes Kennedy Crowley

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1993

200155

ITEM 1. BUSINESS. INTRODUCTION Colorado is a Delaware corporation organized in 1927. All of Colorado's outstanding common stock is owned by Coastal Natural Gas, which is a wholly- owned subsidiary of Coastal. Colorado owns and operates an interstate natural gas pipeline system and also has gas and oil exploration and production operations. At December 31, 1993, the Company had 1,129 employees. The revenues and operating profit of the Company by industry segment for each of the three years in the period ended December 31, 1993, and the related identifiable assets as of December 31, 1993, 1992 and 1991, are set forth in Note 12 of Notes to Consolidated Financial Statements included herein. NATURAL GAS SYSTEM OPERATIONS GENERAL The Company is involved in all phases of the production, gathering, processing, transportation, storage and sale of natural gas. Colorado purchases and produces natural gas and makes sales of such gas principally to local gas distribution companies for resale. Separately, Colorado contracts to gather, process, transport and store natural gas owned by third parties. Colorado's gas transmission system extends from gas production areas in the Texas Panhandle, western Oklahoma and western Kansas, northwesterly through eastern Colorado to the Denver area, and from production areas in Montana, Wyoming and Utah, southeasterly to the Denver area. The Company's gas gathering and processing facilities are located throughout the production areas adjacent to its transmission system. Most of the Company's gathering facilities connect directly to its transmission system, but some gathering systems are connected to other pipelines. The Company also has certain gathering facilities located in New Mexico. Colorado owns four underground gas storage fields; three located in Colorado, and one in Kansas. The Company's principal pipeline facilities at December 31, 1993 consisted of 6,347 miles of pipeline and 65 compressor stations with approximately 346,000 installed horsepower. At December 31, 1993, the design peak day delivery capacity of the transmission system was approximately 2.0 Bcf per day. The underground storage facilities have a working capacity of approximately 29 Bcf per year and a peak day delivery capacity of approximately 769 MMcf. GAS SALES, STORAGE AND TRANSPORTATION Beginning in October, 1993, Colorado implemented Order 636 on its system and as required by the Order, Colorado's gas sales are now made at "upstream" locations (typically the wellhead). Colorado's gas sales contracts extend through September 30, 1996, but provide for reduced customer purchases to be made each year. Under Order 636, Colorado's certificate to sell gas for resale allows sales to be made at negotiated prices and not at prices established by FERC. Colorado is also authorized to abandon all sales for resale at such time as the contracts expire and without prior FERC approval. Effective October 1, 1993, Colorado formed an unincorporated Merchant Division to conduct most of the Company's sales activity in the Order 636 environment. The gas sales volumes reported include those sales which continue to be made by Colorado together with those of its Merchant Division. Effective October 1, 1993, Colorado assigned an undivided interest in a portion of its company-owned leases (representing approximately 20% of Company owned reserves) to a new subsidiary. The subsidiary has entered into a contract to sell the production to the Company's Merchant Division, which utilizes the gas primarily for its sales to Colorado's traditional customers. The reserve volumes reported represent those interests retained by Colorado together with those assigned to the new subsidiary. Gas sales revenues were $223 million in 1993, compared to $261 million in 1992. This decrease is due largely to the fact that prior to the mandated restructuring under Order 636 the costs of providing gathering, storage and transportation services for sales customers were recovered as part of the total resale rate and were classified as part of gas sales revenue. Subsequent to restructuring, these costs are now recovered under separate rates for each service. Colorado has engaged in "open access" transportation and storage of gas owned by third parties for several years. In addition, prior to October 1, 1993, Colorado provided storage and transportation services as part of its "bundled" sales service. As a result of Order 636, the Company has "unbundled" these services from its sales services and will continue to provide these services to third parties under individual contracts. Such services will be at negotiated rates that are within minimum and maximum levels established by the FERC. Also, pursuant to Order 636, the Company, on September 30, 1993, sold all of its working gas except for 3.8 Bcf which it retained for operational needs. Colorado's deliveries for the years 1993, 1992 and 1991 are as follows: GAS GATHERING AND PROCESSING Prior to Order 636, the Company gathered and processed gas incident to its "bundled" sales service (which also included storage and transportation activities). However, in compliance with the FERC mandated restructuring, Colorado now provides gathering and processing services on an "unbundled" or stand-alone basis. The Company contracts for these services under terms which are negotiated. With respect to gathering, the Company is limited to charging rates which are between minimum and maximum levels approved by FERC. Processing terms are not subject to FERC approval, but Colorado is required to provide "open access" to its processing facilities. Colorado has 2,994 miles of gathering lines and 110,500 horsepower of compression in its gathering operations. Colorado owns and operates six gas processing plants which recovered approximately 86 million gallons of liquid hydrocarbons in 1993, compared to 77 million gallons in 1992 and 61 million gallons in 1991, and 4,400 long tons of sulfur in 1993 and 3,600 long tons in both 1992 and 1991. Additionally, in 1993, Colorado processed approximately 12 million gallons of liquid hydrocarbons owned by others compared to 10 million in 1992 and 11 million in 1991. These plants, with a total operating capacity of approximately 697 MMcf daily, recover mainly propane, butanes, natural gasoline, sulfur and other by-products, which are sold to refineries, chemical plants and other customers. COMPETITION Colorado has historically competed with interstate and intrastate pipeline companies in the sale, storage and transportation of gas and with independent producers, brokers, marketers and other pipelines in the gathering, processing and sale of gas within its service areas. On October 1, 1993, the Company implemented Order 636 on its system. Order 636 also mandated implementation of capacity release and secondary delivery point options allowing a pipeline's firm transportation customers to compete with the pipeline for interruptible transportation, which may result in reduced interruptible transportation revenue of pipelines. Additional information on this subject is included under "Regulations Affecting Gas System" included herein. Natural gas competes with other forms of energy available to customers, primarily on the basis of price. These competitive forms of energy include electricity, coal, propane and fuel oils. Changes in the availability or price of natural gas or other forms of energy, as well as changes in business conditions, conservation, legislation or governmental regulations, capability to convert to alternate fuels, changes in rate structure, taxes and other factors may affect the demand for natural gas in the areas served by Colorado. GAS SYSTEM RESERVES AND AVAILABILITY GENERAL The following information about gas system reserves of Colorado and the current and future availability of these reserves is based on data as of December 31, 1993, 1992 and 1991, prepared by Huddleston, Colorado's independent engineers. Based on annual requirements of 109 Bcf, the Company's reserve life index at January 1, 1994 is approximately 12 years. See a further discussion of estimated future sales requirements under "Gas System Reserves and Availability - - Availability" included herein. RESERVES The table below presents the independent engineers' estimates of the Company's gas system reserves as of December 31, 1993, 1992 and 1991 (Bcf): The estimates of controlled gas reserves include: (a) quantities economically recoverable over the productive life of existing wells and quantities estimated to be recoverable in the future, either from completions in other productive zones of existing wells or from additional wells to be drilled in proven reservoirs currently covered by existing gas purchase contracts and (b) reserves attributable to gas in storage fields. The independent engineers' estimates of reserves are based upon new analyses or upon a review of earlier analyses updated by production and field performance. At December 31, 1993, Colorado maintained under its own account 3 Bcf of natural gas in underground working storage for system balancing and no-notice storage services. The Company has an additional 38 Bcf of base gas in its four owned storage fields. AVAILABILITY The table below presents the independent engineers' estimates of the Company's aggregate daily volumes of gas available for sale for the next three years (MMcf): The independent engineers' estimates of the current availability of gas from Colorado's existing controlled gas reserves exceed the anticipated total requirements for 1994 of 272 MMcf per day. The availability of future gas volumes for years 1995 and 1996, including those available volumes from the future development of the non-producing and undeveloped reserves, is greater than the future total requirements of 227 MMcf per day averaged over that time period. Future requirements have been estimated utilizing the projected effects of Order 636 on future sales. Over the remaining life of Colorado's current gas sales contracts (most of which expire October 1, 1996), it is expected that customers will continue to reduce their contractual sales entitlements pursuant to the provisions of Order 636. At this time, however, the magnitude of those conversions cannot be estimated with reasonable certainty. See a further discussion under "Regulations Affecting Gas System" included herein. The independent engineers' estimates of gas available for sale in future years are not firm, unconditional projections, but are calculations based on reviews of historical data and estimates of the future availability of gas from contracted gas reserves. In preparing the estimates of gas available for sale, the independent engineers assumed pipeline availability at levels similar to 1993 purchases and did not make projections as to the volumes of gas which Colorado may temporarily release from contract as being in excess of its purchase requirements. Colorado's ability to supply gas on a daily and annual basis to meet the demands of its customers is subject to limiting factors in addition to the quantities of gas available for sale. Such factors include, but are not limited to, conservation, regulations by governmental agencies, a producer's right to exercise prudent control of operations and maintenance of wells or leases, mechanical operation of equipment, weather, the ability of wells to deliver gas of pipeline quality and pressure, new production technology, unpredictable declines of production, varying peakload demands, availability of alternate fuels, gas storage capacity and pipeline capacity in particular areas. RESERVES DEDICATED TO A PARTICULAR CUSTOMER Colorado is committed to provide gas to Mesa Operating Company, formerly Mesa Operating Limited Partnership ("Mesa"), a customer, from specific owned gas reserves in the West Panhandle Field of Texas. Production from this area contributed approximately 46% of Colorado's total supply in 1993. Approximately 68% of those volumes were delivered to Mesa. Under an agreement which was effective January 1, 1991, as amended, Colorado has the right to take a cumulative 23% of the total net production from such reserves for its customers other than Mesa. RECONCILIATION WITH FERC FORM 15 REPORT The FERC Form 15 Annual Report of Gas Supplies is no longer required pursuant to FERC Order No. 554 issued July 13, 1993. REGULATIONS AFFECTING GAS SYSTEM GENERAL Under the NGA, the FERC has jurisdiction over Colorado as to rates and charges for the transportation and storage of natural gas and the construction of new facilities, extension or abandonment of service and facilities, accounts and records, depreciation and amortization policies and certain other matters. In addition, FERC has certificate authority over gas sales for resale in interstate commerce, but under Order 636, had determined that it will not regulate sales rates. Additionally, FERC has asserted rate-regulation (but not certificate regulation) over gathering. Colorado is challenging the FERC's assertion of rate jurisdiction over gathering, but has agreed in a settlement that for three years beginning October 1, 1993, Colorado will post in its tariff the minimum and maximum gathering rates which will be established and approved by FERC. Colorado, where required, holds certificates of public convenience and necessity issued by the FERC covering its jurisdictional facilities, activities and services. Colorado is also subject to regulation with respect to safety requirements in the design, construction, operation and maintenance of its interstate gas transmission and storage facilities by the Department of Transportation. Operations on United States government land are regulated by the Department of the Interior. FERC Order Nos. 500 and 528 allowed regulated pipelines, including Colorado, to recover, through a fixed charge, from 25% to 50% of the cost of payments made to producers to extinguish outstanding claims under existing gas purchase contracts or to secure reformation of existing contracts. Fixed charges are paid by pipeline sales customers without regard to volumes of gas purchased. Under this election, however, an amount equivalent to the amount included in the fixed charge must be borne by the pipeline. Colorado has incurred costs related to contract reformation and settlements of take-or-pay claims, a portion of which have been recovered under Order Nos. 500 and 528. On April 8, 1992, the FERC issued Order No. 636 ("Order 636"), which required significant changes in the services provided by interstate natural gas pipelines. The Company and numerous other parties have sought judicial review of aspects of Order 636. On July 2, 1993, the Company submitted to the FERC an unanimous offer of settlement which resolved all the Order 636 restructuring issues which had been raised in its restructuring proceedings. That settlement was ultimately approved (except for minor issues), and the Company's restructured services became effective October 1, 1993. Under that settlement, Colorado has "unbundled" its gas sales from its other services. Separate gathering, transportation, storage, no notice transportation and storage and other services are available on a "stand-alone" basis to any customers desiring them. Colorado's Order 636 transition costs are not expected to be material and are expected to be recovered through Colorado's rates. RATE MATTERS Under the NGA, Colorado continues to be required to file with the FERC to establish or adjust certain of its service rates. The FERC may also initiate proceedings to determine whether Colorado's rates are "just and reasonable." On March 31, 1993, the Company filed at FERC to increase its rates by approximately $26.5 million annually. Such rates (adjusted to reflect the Company's Order 636 program) became effective subject to refund on October 1, 1993. Certain regulatory issues remain unresolved among Colorado, its customers, its suppliers, and the FERC. The Company has made provisions which represent management's assessment of the ultimate resolution of these issues. While Colorado estimates the provisions to be adequate to cover potential adverse rulings on these and other issues, it cannot estimate when each of these issues will be resolved. GAS AND OIL EXPLORATION AND PRODUCTION The Company has domestic gas and oil production operations. The gas is delivered primarily to Colorado's interstate gas pipeline system while the crude oil and condensate are sold at the wellhead to oil purchasing companies at prevailing market prices. The production of gas and oil is subject to regulation in states in which the Company operates. The following table shows gas, oil and condensate production volumes of the Company, including quantities attributable to its natural gas system, for the three years ended December 31, 1993: The following table summarizes sales price and unit cost information of the Company's exploration and production operations for the three years ended December 31, 1993: At December 31, 1993, the gas and oil properties of the Company included leasehold interests covering 475,622 acres (357,281 net acres), of which 388,012 acres (323,262 net acres) were producing and 87,610 acres (34,019 net acres) were undeveloped. The net producing acreage, held by production, is concentrated principally in Texas (77%), Oklahoma (9%), Wyoming (6%) and Utah (6%). The net undeveloped acreage, not held by production, is principally in Wyoming (42%), Colorado (20%) and Montana (22%). The Company drilled 22 gross (12.53 net) gas wells, 39 gross (34.41 net) gas wells and 24 gross (21.52 net) gas wells in 1993, 1992 and 1991, respectively. Information on Company-owned reserves of oil and gas is included herein under "Supplemental Information on Oil and Gas Producing Activities (Unaudited)" in Item 14(a)1 included herein. ENVIRONMENTAL The Company's operations are subject to extensive federal, state and local environmental laws and regulations which may affect such operations and costs as a result of their effect on the construction and maintenance of its pipeline facilities as well as its gas and oil exploration and production operations. Appropriate governmental authorities may enforce the laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties and remediation requirements. Compliance with all applicable environmental protection laws is not expected to have a material adverse impact on the Company's liquidity or financial position. Future information and developments will require the Company to continually reassess the expected impact of all applicable environmental laws. The Comprehensive Environmental Response, Compensation and Liability Act, also known as "Superfund", as reauthorized, imposes liability, without regard to fault or the legality of the original act, for disposal of a "hazardous substance." The Company is not presently, and has not been in the past, a potentially responsible party in any "Superfund" waste disposal sites. There are additional areas of environmental remediation responsibilities which may fall upon the Company. OTHER DEVELOPMENTS Colorado owns approximately 20% of Natural Fuels Corporation ("NFC") which is headquartered in Denver, Colorado. NFC's business is to develop compressed natural gas ("CNG") as an alternative vehicular fuel. Major services provided by NFC include vehicle conversions to CNG, fuel sales, CNG equipment sales, maintenance services, and training. Besides operating a full service conversion center which converts vehicles to CNG, NFC has installed 44 stations in Colorado, 26 of which are open to the public. NFC, in joint partnership with Total Petroleum, installs natural gas refueling facilities at selected Total Petroleum stores along the Colorado Front Range. This project is one of the largest public fueling station development commitments in the United States. As of January 1994, seven stations were operational and one was under construction. Also, Colorado is a co-sponsor in the testing of two Colorado Springs buses that are powered by dual-fueled engines modified to run on up to 90% natural gas. ITEM 2. ITEM 2. PROPERTIES. Information on properties of Colorado is included in Item 1, "Business," included herein. The real property owned by the Company in fee consists principally of sites for compressor and metering stations and microwave and terminal facilities. With respect to the four owned storage fields, the Company holds title to gas storage rights representing ownership of, or has long-term leases on, various subsurface strata and surface rights and also holds certain additional mineral rights. Under the NGA, the Company may acquire by the exercise of the right of eminent domain, through proceedings in United States District Courts or in state courts, necessary rights-of-way to construct, operate and maintain pipelines and necessary land or other property for compressor and other stations and equipment necessary to the operation of pipelines. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In December 1992, certain of Colorado's natural gas lessors in the West Panhandle Field filed a complaint in the U.S. District Court for the Northern District of Texas, claiming underpayment, breach of fiduciary duty, fraud and negligent misrepresentation. Management believes that Colorado has numerous defenses to the lessors' claims, including (i) that the royalties were properly paid, (ii) that the majority of the claims were released by written agreement, and (iii) that the majority of the claims are barred by the statute of limitations. Other lawsuits and other proceedings which have arisen in the ordinary course of business are pending or threatened against Colorado or its subsidiaries. Although no assurances can be given and no determination can be made at this time as to the outcome of any particular lawsuit or proceeding, the Company believes there are meritorious defenses to substantially all of the above claims and that any liability which may finally be determined should not have a material adverse effect on the Company's consolidated financial position. Additional information regarding legal proceedings is set forth in Notes 3 and 10 of Notes to Consolidated Financial Statements included herein. 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. All common stock of Colorado is owned by Coastal Natural Gas. Certain preferred stock resolutions restrict the payment of dividends on common stock. Under the most restrictive of these provisions, approximately $311.5 million was available for dividends on the common stock of the Company at December 31, 1993. Additional information relating to dividends is set forth under the "Statement of Consolidated Retained Earnings and Additional Paid-In Capital" included herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data (in thousands of dollars) is derived from the Consolidated Financial Statements included herein and Item 6 of the Company's Annual Report on Form 10-K for the year ended December 31, 1992. The Notes to Consolidated Financial Statements included herein contain information relating to this data. All of the outstanding common stock of Colorado is owned by Coastal Natural Gas; therefore, earnings and cash dividends per common share have no significance and are not presented. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The Management's Discussion and Analysis of Financial Condition and Results of Operations is presented on pages through herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Financial Statements and Supplementary Data required hereunder are included in this Annual Report as set forth in Item 14(a) 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. The directors and executive officers of Colorado as of March 16, 1994, were as follows: The above named persons bear no family relationship to each other. Their respective terms of office expire coincident with Colorado's Annual Meeting of the Sole Stockholder and Annual Meeting of the Board of Directors to be held in May 1994. Each of the directors and officers named above have been officers or employees of Colorado, ANR Pipeline and/or Coastal for five years or more except for the following: Mr. Anderson was elected to the Board of Directors of Colorado in April 1989. He is a General Partner of Anderson Development Associates. Mr. Coffin was elected a Vice President of Colorado in June 1990. Before joining the Company, he practiced law with the Denver law firms of Holland & Hart from 1986 to 1988 and Brownstein Hyatt Farber & Madden from 1988 to 1990. Prior thereto, he served as Deputy Administrative Assistant to a United States congressman. Mr. Gillet was elected Vice President of Colorado in July 1993. Prior thereto he served as Vice President of ANR Pipeline Company from 1985 to 1991 and as a Vice President of Coastal States Management Corporation since 1983. Mr. King was elected to Colorado's Board of Directors in April 1989. Prior thereto, he served in various executive capacities with the Company. Mr. Ogden was elected to the Board of Directors of Colorado in April 1989. He has been President and General Manager of KCNC-TV, Denver, Colorado since 1983. Mr. Powers was elected to Colorado's Board of Directors in April 1989. He served as a Colorado State Senator from 1978 through 1988. He currently is a member of the Board of Directors of the Vail National Bank and President of Hanover Realty Corporation. Mr. Sparger was elected a Vice President of Colorado in June 1992. Before joining the Company, he served in various capacities with Transcontinental Gas Pipe Line Corporation since 1967. Mr. Tutt was elected to the Board of Directors of Colorado in April 1989. He is Chairman of the Olympic Festival Committee, Chairman Emeritus of the Colorado Springs Sports Corporation, Vice Chairman of the United States Space Foundation and a member of the Boards of Directors of Norwest Bank of Colorado and US West Communications/Colorado. He has also been past President of the Broadmoor Management Company and past Vice President of the United States Olympic Committee. Mr. Zuckweiler was elected a Vice President of Colorado in August 1991. He held the position of Director, Transportation and Exchange for the Company from July 1981 to September 1988, at which time he was elected Assistant Vice President. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Colorado is an indirectly wholly-owned subsidiary of Coastal. Information concerning the cash compensation and certain other compensation of directors and officers of Coastal is contained in this section. The following table sets forth information for the fiscal years ended December 31, 1993, 1992 and 1991 as to cash compensation paid by Coastal and its subsidiaries, as well as certain other compensation paid or accrued for those years, to Coastal's Chief Executive Office ("CEO") and its four most highly compensated executive officers other than the CEO (the "Named Executive Officers"). The table also sets forth the cash compensation paid to James R. Paul, CEO through July 20, 1993, including Long Term Incentive Plan ("LTIP") cash compensation. SUMMARY COMPENSATION TABLE /(1)/ Does not include the value of perquisites and other personal benefits because the aggregate amount of such compensation, if any, does not exceed the lesser of $50,000 or 10 percent of annual salary and bonus for any named individual. (2) Due to Coastal's practice of paying bi-weekly, there is one extra pay period reflected in the 1992 salary. Normally there are 26 pay periods, but approximately once every 11 years there are 27 pay periods; 1992 was such a year. (3) The bonuses shown in the table represent the amount awarded for performance in the year indicated. With the exception of Mr. Burrow, bonuses for 1993 will not be finalized until after preliminary results for the 1994 first quarter are known. These bonuses will be reported in the Coastal Proxy Statement for the 1995 Annual Meeting. Mr. Burrow's bonus was paid in full in 1993. Bonuses for 1992 were paid or are payable in equal installments over a three-year period, provided the employee is still employed on the anniversary date of the award. The 1991 bonuses were payable in equal installments in 1992 and 1993. (4) The options do not carry any stock appreciation rights. (5) All Other Compensation for 1993 consists of: (i) directors' fees paid by Coastal, ANR and Colorado (O. S. Wyatt, Jr. $66,375; David A. Arledge $18,000; James R. Paul $51,625; James F. Cordes $66,375; Sam F. Willson, Jr. $-0-; and Harold Burrow $56,624); (ii) cash payments for relinquishing certain stock appreciation rights (O. S. Wyatt, Jr. $ -0-; David A. Arledge $5,625; James R. Paul $9,375; James F. Cordes $3,750; Sam F. Willson, Jr. $1,875; and Harold Burrow $-0-); (iii) Coastal contributions to the Coastal Thrift Plan (O. S. Wyatt, Jr. $15,000; David A. Arledge $15,000; James R. Paul $15,000; James F. Cordes $15,000; Sam F. Willson, Jr. $15,000; and Harold Burrow $15,000); and (iv) certain payments in lieu of Thrift Plan contributions (O. S. Wyatt, Jr. $56,690; David A. Arledge $21,417; James R. Paul $-0-; James F. Cordes $29,664; Sam F. Willson, Jr. $11,725; and Harold Burrow $8,409). Mr. Cordes is employed pursuant to a five-year employment contract expiring in 1995, which provides that if he is terminated for a reason not permitted by the employment contract, he will be entitled to receive for the remainder of the term the salary, employee benefits, perquisites, salary increases, bonuses and other incentive compensation which he would have received had he not been terminated. Such reasons are a significant change in title, duties, authorities or reporting responsibilities, a reduction in salary or benefits or a move of the location of his office to a location not acceptable to him. STOCK OPTIONS The following table sets forth information with respect to stock options granted on November 4, 1993 and December 8, 1993 for the fiscal year ended December 31, 1993 to the Named Executive Officers. OPTION/SAR GRANTS IN LAST FISCAL YEAR (1993) (1) Options expire ten years from the date of issuance and are granted at the fair market value of the Common Stock of Coastal on the date of grant. Options granted on November 4, 1993 vested in full immediately. Options granted on December 8, 1993, vest in full on the second anniversary of the date of grant. (2) Granted November 4, 1993 as a one-time grant for relinquishment of directors fees. (3) Granted December 8, 1993. (4) The options do not carry any stock appreciation rights. The option information included in the table does not include grants made on March 4, 1993 for the fiscal year ended December 31, 1992 which (except for Mr. Willson) were reported in the Coastal 1993 Proxy Statement. These grants were at $26.06 per share as follows: O. S. Wyatt, Jr. -0-; David A. Arledge 35,000 shares; James R. Paul 40,000 shares; James F. Cordes 25,000 shares; Sam F. Willson, Jr. 15,000 shares; and Harold Burrow -0-. (5) Based on the Black-Scholes option pricing model expressed as a ratio (.425 for options granted on November 4, 1993; .399 for options granted on December 8, 1993) x exercise price x number of shares. The actual value, if any, an executive may realize will depend on the excess of the stock price over the exercise price on the date the option is exercised, so that there is no assurance the value realized by an executive will be at or near the value estimated by the Black-Scholes model. The estimated values under that model are based on assumptions that include (i) a stock price volatility of .2786, calculated using monthly stock prices for the three years prior to the grant date, (ii) an interest rate of 6.10%, (iii) a dividend yield of 1.44% and (iv) an option exercise term of ten years. No adjustments were made for the non-transferability of the options or to reflect any risk of forfeiture prior to vesting. The Securities and Exchange Commission requires disclosure of the potential realizable value or present value of each grant. The Company's use of the Black-Scholes model to indicate the present value of each grant is not an endorsement of this valuation, which is based on certain assumptions, including the assumption that the option will be held for the full ten-year term prior to exercise. Studies conducted by the Company's independent consultants indicate that options are usually exercised before the end of the full ten-year term. OPTION/SAR EXERCISES AND HOLDINGS The following table sets forth information with respect to the Named Executive Officers, concerning the exercise of options during the last fiscal year and unexercised options and SARs held as of the fiscal year ("FY") ended December 31, 1993. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES (1993) (1) $-based on the market price of $28.00 at December 31, 1993. PENSION PLAN The following table shows for illustration purposes the estimated annual benefits payable under the Pension Plan and Coastal's Replacement Pension Plan described below upon retirement at age 65 based on the compensation and years of credited service indicated. PENSION PLAN TABLE (A) Compensation covered under the Pension Plan for Employees of Coastal and the Coastal Replacement Pension Plan generally includes only base salary and is limited to $235,840 for 1993. (B) At December 31, 1993 each of the individuals named in the Summary Compensation Table had covered salary of $235,840 and the following years of credited service: Mr. Wyatt, 38 years; Mr. Arledge, 13 years; Mr. Paul, 20 years; Mr. Cordes, 16 years; Mr. Willson, 21 years; and Mr. Burrow, 19 years. (C) The normal form of retirement income is a straight life annuity. Benefits payable under the Pension Plan are subject to offset by 1.5% of applicable monthly social security benefits multiplied by the number of years of credited service (up to 33 1/3 years). The Employee Retirement Income Security Act of 1974, as amended by subsequent legislation, limits the retirement benefits payable under the tax-qualified Pension Plan. Where this occurs, Coastal will provide to certain executives, including persons named in the Summary Compensation Table, additional nonqualified retirement benefits under a Coastal Replacement Pension Plan. These benefits, plus payments under the Pension Plan, will not exceed the maximum amount which Coastal would have been required to provide under the Pension Plan before application of the legislative limitations, and are reflected in the above table. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Security ownership of certain beneficial owners. The following is information, as of March 16, 1994, on each person known or believed by Colorado to be the beneficial owner of 5% or more of any class of its voting securities: (b) Security ownership of management. Colorado is an indirectly wholly-owned subsidiary of Coastal. Information concerning the security ownership of certain beneficial owners and management of Coastal is contained in this section. The total number of shares of stock of Coastal outstanding as of March 16, 1994 is 112,832,796: consisting of 64,403 shares of $1.19 Cumulative Convertible Preferred Stock, Series A (the "Series A Preferred Stock"), 87,398 shares of $1.83 Cumulative Convertible Preferred Stock, Series B (the "Series B Preferred Stock"), 35,252 shares of $5.00 Cumulative Convertible Preferred Stock, Series C (the "Series C Preferred Stock"), and 8,000,000 non-voting shares of $2.125 Cumulative Preferred Stock, Series H (the "Series H Preferred Stock"), 104,218,335 shares of Common Stock, and 427,408 shares of Class A Common Stock. Each voting share of Common Stock or Preferred Stock entitles the holder to one vote with respect to all matters to come before a shareholders' meeting while each share of Class A Common Stock entitles the holder to 100 votes. However, 25% of Coastal's directors standing for election at each annual meeting will be determined solely by holders of the Common Stock and voting Preferred Stock voting as a class. The following table sets forth information, as of March 16, 1994, with respect to each person known or believed by Coastal to be the beneficial owner, who has or shares voting and/or investment power (other than as set forth below), of more than five percent (5%) of any class of its voting securities. _____________________ (1) Class includes presently exercisable stock options held by directors and executive officers. (2) Includes 7,354 shares of Class A Common Stock owned by the spouse and a son of Mr. Wyatt, as to which shares beneficial ownership is disclaimed. (3) The Trustee/Custodian is the record owner of these shares; and also is the record owner of 969 shares of the Series B Preferred Stock, each of which is convertible into 3.6125 shares of Common Stock and 0.1 share of Class A Common Stock. Voting instructions are requested from each participant in the Thrift Plan and ESOP and from the trustees under a Pension Trust. Absent voting instructions, the Trustee is permitted to vote Thrift Plan shares on any matter, but has no authority to vote ESOP shares or Pension Plan shares. Nor does the Trustee/Custodian have any authority to dispose of shares except pursuant to instructions of the administrator of the Thrift Plan and ESOP or pursuant to instructions from the trustees under the Pension Trust. (4) Members of the DeZurik family acquired the Series C Preferred Stock in connection with a 1972 Agreement of Merger involving the acquisition of Colorado, a subsidiary of Coastal. The following table sets forth information, as of March 16, 1994, regarding each of the then current directors, including Class II directors standing for election, and all directors and executive officers as a group. Each director has furnished the information with respect to age, principal occupation and ownership of shares of stock of Coastal. As of such date, Messrs. Bissell, Burrow, Chapin, Cordes, Gates and Katzin were the Class I directors whose terms expire in 1996; Messrs. Arledge, Brundrett, Wooddy and Wyatt were the Class II directors whose terms expire in 1994; and Messrs. Buck, Johnson, Marshall and McDade were the Class III directors whose terms expire in 1995. * Less than one percent unless otherwise indicated. Class includes outstanding shares and presently exercisable stock options held by directors and executive officers. Excluding presently exercisable stock options, directors and executive officers as a group would own 187,501 shares of Class A Common Stock, which would constitute 43.9% of the shares of such class. (1) Except for the shares referred to in Notes 2 and 3 below, and the shares represented by presently exercisable stock options, the holders are believed by Coastal to have sole voting and investment power as to the shares indicated. Amounts include shares in Coastal ESOP and Thrift plans, and presently exercisable stock options held by Messrs. Burrow (14,189 shares of Common Stock), Arledge (140,960 shares of Common Stock and 13,412 shares of Class A Common Stock), Cordes (89,786 shares of Common Stock), and Johnson (60,415 shares of Common Stock). (2) Includes shares owned by the spouse and a son of Mr. Wyatt (266,295 shares of Common Stock and 7,354 shares of Class A Common Stock), by the spouse of Mr. Burrow (5,000 shares of Common Stock), by the spouse of Mr. Chapin (1,000 shares of Common Stock) and by the spouse of Mr. Katzin (928 shares of Common Stock), as to which shares beneficial ownership is disclaimed; also includes shares owned by the estate of the late Mrs. Marshall (4,362 shares of Common Stock and 100 shares of Class A Common Stock). (3) Includes presently exercisable stock options to purchase 629,038 shares of Common Stock and 14,628 shares of Class A Common Stock; also includes 280,239 shares of Common Stock and 7,354 shares of Class A Common Stock owned by spouses and children, as to which shares beneficial ownership is disclaimed; also includes 4,362 shares of Common Stock and 100 shares of Class A Common Stock owned by the estate named in Note 2 above. In addition, one executive officer owns 8 shares of Series B Preferred Stock, each of which is convertible into 3.6125 shares of Common Stock and 0.1 share of Class A Common Stock. No incumbent director is related by blood, marriage or adoption to another director or to any executive officer of Coastal or its subsidiaries or affiliates. Except as hereafter indicated, the above table includes the principal occupation of each of the directors during the past five years. The listed executive officers have held various executive positions with Coastal, ANR, ANR Pipeline and/or Colorado during the five-year period. Mr. Bissell is a member of the Boards of Directors of Old Kent Financial Corporation and Batts Inc. Mr. Cordes is a member of the Boards of Directors of Comerica Inc. and Royal Group, Inc. Mr. Katzin is a member of the Board of Directors of Qualcomm Incorporated. Mr. Marshall is a member of the Boards of Directors of Missouri-Kansas-Texas Railroad Company and Presidio Oil Company. Mr. McDade is a trial lawyer and the founding senior partner of the Houston law firm of McDade & Fogler. Prior to forming McDade & Fogler he was a senior partner in the Houston law firm of Fulbright & Jaworski. Messrs. Arledge, Burrow, Cordes and Wyatt are directors of Colorado. Mr. Cordes is a director of ANR Pipeline. Both of these subsidiaries of Coastal are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). (c) Coastal knows of no arrangement which may, at a subsequent date, result in a change in control of Coastal. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. (a) Transactions with management and others. Colorado participates in a program which matches short-term cash excesses and requirements of participating affiliates, thus minimizing total borrowings from outside sources. At December 31, 1993 the Company had advanced $107.5 million to an associated company at a market rate of interest. Such amount is repayable on demand. Additional information called for by this item is set forth under Item 11, "Executive Compensation" and Notes 9 and 13 of Notes to Consolidated Financial Statements included herein. (b) Certain business relationships. None. (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) The following documents are filed as part of this Annual Report or incorporated herein by reference: 1. Financial Statements and Supplemental Information. The following Consolidated Financial Statements of Colorado and Subsidiaries and Supplemental Information are included in response to Item 8 hereof on the attached pages as indicated: 2. Financial Statement Schedules. The following schedules of Colorado and Subsidiaries are included on the attached pages as indicated: Schedules other than those referred to above are omitted as not applicable or not required, or the required information is shown in the Consolidated Financial Statements or Notes thereto. 3. Exhibits. (3.1)+ Certificate of Incorporation of the Company (Exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1980). (3.2)+ By-laws of the Company (Filed as Module CIGBY-LAWS on March 29, 1994). (3.3)+ Certificate of Amendment of Certification of Incorporation of the Company (Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). (4) With respect to instruments defining the rights of holders of long-term debt, the Company will furnish to the Securities and Exchange Commission any such document on request. (21)* Subsidiaries of the Company. (24)* Power of Attorney (included on signature pages herein). Note: + Indicates documents incorporated by reference from the prior filing indicated. * Indicates documents filed herewith. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the quarter ended December 31, 1993. POWER OF ATTORNEY Each person whose signature appears below hereby appoints David A. Arledge, Dan A. Homec and Austin M. O'Toole and each of them, any one of whom may act without the joinder of the others, as his attorney-in-fact to sign on his behalf and in the capacity stated below and to file all amendments to this Annual Report on Form 10-K, which amendment or amendments may make such changes and additions thereto as such attorney-in-fact may deem necessary or appropriate. 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. COLORADO INTERSTATE GAS COMPANY (Registrant) By: JON R. WHITNEY ------------------------------ Jon R. Whitney President 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 dates indicated. By: HAROLD BURROW ------------------------------ Harold Burrow Chairman of the Board March 29, 1994 By: JON R. WHITNEY ------------------------------ Jon R. Whitney President, Chief Executive Officer and Director March 29, 1994 By: DAVID A. ARLEDGE ------------------------------ David A. Arledge Principal Financial Officer and Director March 29, 1994 By: DAN A. HOMEC ------------------------------ Dan A. Homec Principal Accounting Officer March 29, 1994 * * * By: RICHARD L. ANDERSON By: ROGER L. OGDEN ------------------------------ ------------------------------ Richard L. Anderson Roger L. Ogden Director Director March 29, 1994 March 29, 1994 By: JAMES F. CORDES By: PAUL W. POWERS ------------------------------ ------------------------------ James F. Cordes Paul W. Powers Director Director March 29, 1994 March 29, 1994 By: By: WILLIAM B. TUTT ------------------------------ ------------------------------ Peter J. King, Jr. William B. Tutt Director Director March , 1994 March 29, 1994 By: REBECCA H. NOECKER By: ------------------------------ ------------------------------ Rebecca H. Noecker O. S. Wyatt, Jr. Director Director March 29, 1994 March , 1994 --- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Notes to Consolidated Financial Statements contain information that is pertinent to the following analysis. LIQUIDITY AND CAPITAL RESOURCES The Company uses the following consolidated ratios to measure liquidity and ability to meet future funding needs and debt service requirements. The Company's primary needs for cash are capital expenditures and debt service requirements. Capital expenditures, debt retirements and other cash needs in each of the years 1991 through 1993 and the sources of capital used to finance these expenditures are summarized in the Statement of Consolidated Cash Flows. Management believes the Company's stable financial position and earnings capability will enable it to continue to generate and obtain capital for financing needs in the foreseeable future. Cash flow from operating activities amounted to $77.6 million in 1993 and $169.1 million in 1992. Prepayments for gas supply and settlement of natural gas contract disputes required investments of $7.1 million in 1993 and $2.4 million in 1992. Liquidity needs were met in 1993 by internally generated funds and a $249.7 million repayment of a note due from an associated company. The Company has adopted a guideline capital expenditure budget of approximately $51.6 million for 1994, a decrease from the capital additions of $72.4 million in 1993. The anticipated decrease in 1994 is the result of a $19.0 million decrease for natural gas projects and a $1.8 million decrease for exploration and production projects. Alternatives to finance capital expenditures and other cash needs are primarily limited by the terms of a Coastal Natural Gas debt instrument. As of December 31, 1993, the Company and certain affiliates could incur approximately $916.8 million of additional indebtedness. For the Company and such affiliates to incur indebtedness for borrowed money in excess of $916.8 million, approximately $400 million of indebtedness under this agreement would need to be retired. The Company participates in a program which matches short-term cash excesses and requirements of participating affiliates, thus minimizing borrowings from outside sources. At December 31, 1993, the Company had advanced $107.5 million to an associated company at a market rate of interest. Such amount is repayable on demand. The Company is responding to the extensive changes in the natural gas industry by continuing to take steps to operate its facilities at their maximum efficient capacity, renegotiating many gas purchase contracts to lower its cost of gas and reduce take-or-pay obligations, pursuing innovative marketing strategies and applying strict cost-cutting measures. In 1993, the Company adopted changes in accounting for postretirement benefits as required by FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." See Note 8 of Notes to Consolidated Financial Statements. In 1994, the Company adopted FAS No. 112, "Employers' Accounting for Postemployment Benefits." This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. The effect of this new standard is not expected to have a significant effect on the Company's results of operations or financial position. Order 636, issued in 1992, required significant changes in natural gas pipeline services. See Note 10 of Notes to Consolidated Financial Statements. The Company's operations are subject to extensive federal, state and local environmental laws and regulations which may affect such operations and costs as a result of their effect on the construction and maintenance of its pipeline facilities as well as its gas and oil exploration and production operations. Appropriate governmental authorities may enforce laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties and remediation requirements. Compliance with all applicable environmental protection laws is not expected to have a material adverse impact on the Company's liquidity or financial position. Future information and developments will require the Company to continually reassess the expected impact of all applicable environmental laws. The Comprehensive Environmental Response, Compensation and Liability Act, also known as "Superfund", as reauthorized, imposes liability, without regard to fault or the legality of the original act, for disposal of a "hazardous substance." The Company is not presently, and has not been in the past, a potentially responsible party in any "Superfund" waste disposal sites. There are additional areas of environmental remediation responsibilities which may fall upon the Company. RESULTS OF OPERATIONS OPERATING REVENUES The following table reflects the increase (decrease) in operating revenues experienced by segment during the past two years (millions of dollars): NATURAL GAS 1993 Versus 1992. Revenues from natural gas operations increased in 1993 due to the $35 million sale of storage gas inventory pursuant to the implementation of Order 636, increased transportation and gathering revenues of $34 million and increased extracted products revenue of $4 million offset by lower sales prices of $23 million and decreased sales volumes for $15 million. 1992 Versus 1991. Revenues from natural gas operations increased in 1992 as a result of higher sales volumes for a $10 million increase, a net $16 million increase related to decreased reservations and an outstanding rate related matter and increased transportation and gathering revenues of $5 million offset by lower sales prices of $1 million and other decreases of $3 million. The daily average volumes of natural gas sold were 272 MMcf, 287 MMcf and 278 MMcf for 1993, 1992 and 1991, respectively. However, over the remaining life of Colorado's current gas sales contracts (most of which expire October 1, 1996), it is expected that customers will reduce their contractual sales entitlement pursuant to the provisions of Order 636. At this time, however, the magnitude of those conversions cannot be estimated with reasonable certainty. Transportation volumes increased by 16% in 1993 over the 1992 level and are expected to increase slightly in 1994. EXPLORATION AND PRODUCTION 1993 Versus 1992. Revenues from exploration and production increased in 1993 as natural gas volumes generated a $4 million increase and natural gas prices increased by $1 million, partially offset by decreases of $1 million. 1992 Versus 1991. Revenues from exploration and production increased in 1992 as natural gas volumes generated a $2 million increase. The prices for natural gas also increased slightly. OTHER INCOME - NET The decreases in 1993 and 1992 reflect changes in interest income, primarily from loans to affiliated companies. COST OF GAS SOLD 1993 Versus 1992. The increase in 1993 was due primarily to increased transportation, gathering and exchange gas costs of $17 million and storage gas costs associated with the sale of storage gas inventory pursuant to Order 636, net of injection/withdrawals in the amount of $11 million, partially offset by other increases and decreases of $1 million. 1992 Versus 1991. The increase in 1992 was due primarily to higher average gas purchase rates for $11 million and an increase of $11 million for storage gas due to larger withdrawal levels partially offset by decreased gas purchase volumes for $10 million and other decreases of $2 million. OPERATION AND MAINTENANCE 1993 Versus 1992. Operation and maintenance expenses increased in 1993 due primarily to increased property and production taxes of $3 million, increased professional services of $2 million, increased gas used costs of $2 million and other increases of $1 million. 1992 Versus 1991. Operation and maintenance expenses increased in 1992 due primarily to an $8 million increase for gas and gas liquids handling and other increases of $2 million. DEPRECIATION, DEPLETION AND AMORTIZATION 1993 Versus 1992. Depreciation, depletion and amortization increased $8 million in 1993 due primarily to an increase in the natural gas segment's depreciable plant and increased production volumes in the exploration and production segment. 1992 Versus 1991. Depreciation, depletion and amortization increased $4 million in 1992 due primarily to an increase in the natural gas segment's depreciable plant and increased production volumes in the exploration and production segment. OPERATING PROFIT The following table reflects the increase (decrease) in operating profit experienced by segment during the past two years (millions of dollars): NATURAL GAS 1993 Versus 1992. The natural gas segment's operating profit decrease in 1993 is due to increased gas related costs of $27 million, increased operation and maintenance expenses of $6 million, increased depreciation, depletion and amortization expenses of $6 million and other increases of $3 million partially offset by increased operating revenues of $35 million. 1992 Versus 1991. The natural gas segment's operating profit increase in 1992 is due to increased operating revenues of $27 million partially offset by increased gas related costs of $12 million, increased operation and maintenance expenses of $9 million and increased depreciation, depletion and amortization expenses of $3 million. EXPLORATION AND PRODUCTION 1993 Versus 1992. The exploration and production segment's operating profit was unchanged from 1992 as increased revenues of $4 million were offset by increases of $2 million for operation and maintenance expenses and $2 million for depreciation, depletion and amortization. 1992 Versus 1991. The exploration and production segment's operating profit was unchanged from 1991 as increased revenues of $2 million were offset by increases of $1 million for operation and maintenance expenses and $1 million for depreciation, depletion and amortization. INTEREST EXPENSE The slight decrease in 1993 is primarily due to lower average debt outstanding partially offset by increases in other financial expenses. The decrease in 1992 is primarily due to decreased interest expense related to rate refund provisions and lower average debt outstanding. TAXES ON INCOME Income taxes fluctuated primarily as a result of changing levels of income before taxes and changes in the effective income tax rate. The effective federal income tax rate for the Company was 32% in 1993, 32% in 1992 and 33% in 1991. The Omnibus Budget Reconciliation Act of 1993 enacted in August 1993 included, among other things, an increase in the corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. In September 1993, the Company recorded a change in its deferred income tax balances reflecting this change in corporate federal income tax rates. The cumulative impact of the tax rate increase did not materially affect the Company's consolidated earnings and financial position. The Company has mitigated the impact of this tax rate increase in its rates effective October 1, 1993, subject to refund. INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders Colorado Interstate Gas Company Colorado Springs, Colorado We have audited the accompanying consolidated balance sheets of Colorado Interstate Gas Company (a wholly-owned subsidiary of The Coastal Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, retained earnings and additional paid-in capital 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 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 Colorado Interstate 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. 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, in 1993 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 Denver, Colorado February 3, 1994 COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Thousands of Dollars) See Notes to Consolidated Financial Statements. COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Thousands of Dollars) See Notes to Consolidated Financial Statements. COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES STATEMENT OF CONSOLIDATED EARNINGS (Thousands of Dollars) STATEMENT OF CONSOLIDATED RETAINED EARNINGS AND ADDITIONAL PAID-IN CAPITAL (Thousands of Dollars) See Notes to Consolidated Financial Statements. COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES STATEMENT OF CONSOLIDATED CASH FLOWS (Thousands of Dollars) See Notes to Consolidated Financial Statements. COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies - - Basis of Presentation Colorado is a subsidiary of Coastal Natural Gas, a wholly-owned subsidiary of Coastal. The stock of the Company was contributed by Coastal to Coastal Natural Gas effective April 30, 1982. The financial statements presented herewith are presented on the basis of historical cost and do not reflect the basis of cost to Coastal Natural Gas. The Company is regulated by and subject to the regulations and accounting procedures of the FERC. Colorado meets the criteria and, accordingly, follows the reporting and accounting requirements of FAS No. 71 for regulated enterprises. - - Principles of Consolidation The Consolidated Financial Statements include the accounts of the Company and its subsidiaries after eliminating all significant intercompany transactions. The equity method of accounting is used for investments in which the Company has approximately 20% interests and exercises significant influence. - - Statement of Cash Flows For purposes of this Statement, cash equivalents include time deposits, certificates of deposit and all highly liquid instruments with original maturities of three months or less. The Company made cash payments for interest, net of amounts capitalized, of $20.3 million, $20.7 million and $29.4 million in 1993, 1992 and 1991, respectively. Cash payments for income taxes amounted to $40.5 million, $22.5 million and $49.6 million in 1993, 1992 and 1991, respectively. - - Inventories Materials and supplies inventories are carried principally at average cost. Gas stored underground is carried at last-in, first-out cost ("LIFO"), and the current portion is included under the caption "Current portion of gas stored underground and prepaid expenses." At December 31, 1993 there was no current gas stored underground and the carrying value of current gas stored underground was $25.9 million at December 31, 1992. Pursuant to FERC Order 636, on September 30, 1993, the Company sold all of its working gas except for 3.8 Bcf which it was allowed to retain for operational needs. The excess of replacement cost over the carrying value of gas in underground storage carried by the LIFO method, including long-term amounts which are classified as Plant, Property and Equipment, was $52.6 million and $47.8 million at December 31, 1993 and 1992, respectively. - - Plant, Property and Equipment Property additions and betterments are capitalized at cost. In accordance with accounting requirements of the FERC, an allowance for equity and borrowed funds used during construction is included in the cost of property additions and betterments. This cost amounted to $1.2 million, $2.4 million and $.7 million in 1993, 1992 and 1991, respectively. All costs incurred in the acquisition, exploration and development of gas and oil properties, including unproductive wells, are capitalized under the full-cost method of accounting. The Company generally provides for depreciation on a straight-line basis, although the unit-of-production method is used for depreciation, depletion and amortization of certain natural gas properties. The average amortization rate per equivalent unit of a thousand cubic feet of gas production for oil and gas properties was $1.00 for the years 1993, 1992 and 1991. The cost of minor property units replaced or retired, net of salvage, is credited to plant accounts and charged to accumulated depreciation, depletion and amortization. Since provisions for depreciation, depletion and amortization expense are made on a composite basis, no adjustments to accumulated depreciation, depletion and amortization are made in connection with retirements or other dispositions occurring in the ordinary course of business. Gain or loss on sales of major property units is credited or charged to income. - - Income Taxes The Company follows the liability method of accounting for deferred federal income taxes as required by the provisions of FAS 109 "Accounting for Income Taxes." The Company is a member of a consolidated group which files a consolidated federal income tax return. Members of the consolidated group with taxable income are charged with the amount of income taxes as if they filed separate federal income tax returns, and members providing deductions and credits which result in income tax savings are allocated credits for such savings. - - Gain or Loss on Reacquired Debt As required by the FERC, gain or loss on reacquired debt is deferred and amortized over the remaining life of the related long-term indebtedness. - - Revenue Recognition The Company recognizes revenues for the sale of their products in the period of delivery. Revenue for services are recognized in the period the services are provided. - - Reclassification of Prior Period Statements Certain minor reclassifications of prior period statements have been made to conform with current reporting practices. The effect of the reclassifications was not material to the Company's consolidated results of operations or financial position. Balances at December 31 were as follows (thousands of dollars): The 9.875% Notes due in 1998 were redeemed in part through the exercise of the doubling option on the annual installment due date of October 1, 1993, and in part through an early redemption at a premium on October 6, 1993. The $8.4 million previously outstanding on the 9% Notes due 1994 were redeemed through the exercise of a doubling option on the November 1, 1993 installment due date. The 10% Series debentures, due 2005, are not redeemable prior to maturity and have no sinking fund provisions. There are no maturities of long-term debt in the next five years. Alternatives to finance capital expenditures and other cash needs are primarily limited by the terms of a Coastal Natural Gas debt instrument. As of December 31, 1993, the Company and certain affiliates could incur approximately $916.8 million of additional indebtedness. For the Company and such affiliates to incur indebtedness for borrowed money in excess of $916.8 million, approximately $400 million of indebtedness under this agreement would need to be retired. 3. Take-or-Pay Obligations The Consolidated Balance Sheet includes assets of $13.2 million and $22.3 million at December 31, 1993 and 1992, respectively, relating to prepayments for gas under gas purchase contracts with producers and settlement payment amounts relative to the restructuring of gas purchase contracts as negotiated with producers. As a result of the implementation of Order 636 on October 1, 1993 (see Note 10 of Notes to Consolidated Financial Statements), future gas sales will be made at negotiated prices and will not be subject to regulatory price controls. This will not affect the recoverability or the results of pending take-or-pay litigation or any take-or-pay or contractual reformation settlements that the Company may achieve with respect to periods before October 1, 1993. A portion of the costs associated with take-or-pay incurred prior to October 1, 1993, may continue to be recovered pursuant to FERC's Order No. 528. A few producers have instituted litigation arising out of take-or-pay claims against the Company. In the Company's experience, producers' claims are generally vastly overstated and do not consider all adjustments provided for in the contract or allowed by law. The Company has resolved the majority of the exposure with its suppliers for approximately 11% of the amounts claimed. At December 31, 1993, the Company estimated that unresolved asserted and unasserted producers' claims amounted to approximately $22.9 million. The remaining disputes will be settled where possible and litigated if settlement is not possible. At December 31, 1993, the Company was committed to make future purchases under certain take-or-pay contracts with fixed, minimum or escalating price provisions. Based on contracts in effect at that date, and before considering reductions provided in the contracts or applicable law, such commitments are estimated to be $1.2 million, $1.0 million, $1.0 million, $.9 million and $.8 million for the years 1994-1998, respectively, and $4.8 million thereafter. Such commitments have not been adjusted for all amounts which may be assigned or released, or for the results of future litigation or negotiation with producers. The Company has made provisions, which it believes are adequate, for payments to producers that may be required for settlement of take-or-pay claims and restructuring of future contractual commitments. In determining the net loss relating to such provisions, the Company has also made accruals for the estimated portion of such payments which would be recoverable pursuant to FERC approved settlements with customers. 4. Common Stock and Other Stockholders' Equity All of the Company's common stock is owned by Coastal Natural Gas. Certain provisions of the preferred stock resolutions restrict the payment of dividends on common stock; however, all $311.5 million of retained earnings were available for dividends on the common stock of the Company at December 31, 1993. 5. Mandatory Redemption Preferred Stock The Company's Mandatory Redemption Preferred Stock consists of the following: 5.50% Cumulative Preferred Stock (Third Series) - Of the 150,000 shares authorized and issued, 5,560 were outstanding as of December 31, 1993. The shares are callable at the option of the Company at a price of $100 per share. The sinking fund requirements have annual provisions which will retire all shares of this series on or before July 1, 1997. Required share redemptions during the remaining years are: The outstanding series of the Company's Mandatory Redemption Preferred Stock is a $100 par value, cumulative, non-convertible and non-voting issue. If at any time dividends on the Mandatory Redemption Preferred Stock shall be in arrears in an amount equal to six quarterly dividends, holders of the Mandatory Redemption Preferred Stock, voting as a class, will have the right to elect not less than one-fourth of the Company's Board of Directors until all accrued and unpaid dividends on the Mandatory Redemption Preferred Stock are paid in full. In addition, if at any time dividends shall be in arrears in an aggregate amount equal to eight full quarterly dividends, holders of these securities, voting as a class, will have the right to elect such number of Directors as shall be necessary to constitute a minimum majority of the Board of Directors until all accrued and unpaid dividends on the Mandatory Redemption Preferred Stock are paid in full. 6. Fair Value of Financial Instruments The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. Considerable judgment is required to develop the estimates of fair value, thus, the estimates provided herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The carrying values of cash and the note receivable from affiliate are reasonable estimates of their fair values. The estimated value of the Company's long-term debt and mandatory redemption preferred stock is based on interest rates at December 31, 1993 and 1992, respectively, for new issues with similar remaining maturities. 7. Taxes On Income Provisions for income taxes are composed of the following (thousands of dollars): The Company and the Internal Revenue Service ("IRS") Appeals Office have concluded a tentative settlement of all contested adjustments to federal income tax returns filed for the years 1982 through 1984. The settlement is in the process of being finalized. The Company's federal income tax returns filed for the years 1985 through 1987 have been examined by the IRS, and the Company has received notice of proposed adjustments to the returns for each of those years. The Company currently is contesting certain of these adjustments with the IRS Appeals Office. Examinations of the Company's federal income tax returns for 1988, 1989 and 1990 are currently in progress. It is the opinion of management that adequate provisions for federal income taxes have been reflected in the consolidated financial statements. Provisions for federal income taxes were different from the amount computed by applying the statutory United States federal income tax rate to earnings before tax. The reasons for these differences are (thousands of dollars): Deferred tax liabilities (assets) which are recognized for the estimated future tax effects attributable to temporary differences are (thousands of dollars): The Omnibus Budget Reconciliation Act of 1993 enacted in August 1993 included, among other things, an increase in the corporate federal income tax rate from 34% to 35% retroactive to January 1, 1993. In September 1993, the Company recorded a change in its deferred income tax balances reflecting this change in corporate federal income tax rates. The cumulative impact of the tax rate increase did not materially affect the Company's consolidated earnings and financial position. The Company has mitigated the impact of this tax rate increase in its rates effective October 1, 1993, subject to refund. 8. Benefit Plans The Company participates in the non-contributory pension plan of Coastal (the "Plan") which covers substantially all employees. The Plan provides benefits based on final average monthly compensation and years of service. As of December 31, 1993, the Plan did not have an unfunded accumulated benefit obligation. Colorado made no contributions to the Plan for 1993, 1992 or 1991. Assets of the Plan are not segregated or restricted by participating subsidiaries and pension obligations for Company employees would remain the obligation of the Plan if the Company were to withdraw. The Company also makes contributions to a thrift plan, which is a trusteed, voluntary and contributory plan for eligible employees of the Company. The Company's contributions, which match the contributions made by employees, amounted to approximately $2.8 million for 1993 and $2.6 million for each of 1992 and 1991. - - Postretirement/Postemployment Benefits Other Than Pensions The Company provides certain health care and life insurance benefits for retired employees. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). FAS 106 requires the Company to accrue the estimated cost of retiree 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 106 allows recognition of the cumulative effect of the liability in the year of the adoption or the amortization of the obligation over a period of up to twenty years. The Company has elected to recognize the initial postretirement benefit obligation of approximately $18.2 million over a period of twenty years. The impact on the Company's results of operations for the nine months ended September 30, 1993 of $1.8 million has been deferred and will be amortized over three years consistent with rates effective October 1, 1993, subject to refund. The impact on the Company's results of operations for three months ended December 31, 1993 was approximately $.8 million. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 16.0% in 1993, declining gradually to 7.0% by the year 2004. 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 4.29%. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. The Company adopted FAS No. 112, "Employers' Accounting for Postemployment Benefits" effective January 1, 1994. This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. The effect of the new standard will not have a material effect on the Company's results of operations or financial position. 9. Commitments The Company and its subsidiary had rental expense of approximately $9.0 million, $9.7 million and $8.3 million in 1993, 1992 and 1991, respectively (excluding leases covering natural resources). The aggregate minimum lease payments under existing noncapitalized long-term leases are estimated to be $5.9 million, $3.1 million, $2.2 million, $.3 million and $.2 million for the years 1994-1998, respectively, and $1.1 million thereafter. The Company has executed a service agreement with WIC, an affiliate, providing for the availability of pipeline transportation capacity through January 1, 2004. Under the service agreement, the Company is required to make minimum payments on a monthly basis. The estimated amounts of minimum annual payments are as follows (thousands of dollars): The Company made minimum payments of approximately $3.6 million under this agreement in 1993. The Company has and will continue to pay additional amounts based on the actual quantities shipped. 10. Litigation and Regulatory Matters - - Litigation In December 1992, certain of Colorado's natural gas lessors in the West Panhandle Field filed a complaint in the U.S. District Court for the Northern District of Texas, claiming underpayment, breach of fiduciary duty, fraud and negligent misrepresentation. Management believes that Colorado has numerous defenses to the lessors' claims, including (i) that the royalties were properly paid, (ii) that the majority of the claims were released by written agreement, and (iii) that the majority of the claims are barred by the statute of limitations. Other lawsuits and other proceedings which have arisen in the ordinary course of business are pending or threatened against the Company or its subsidiaries. Although no assurances can be given and no determination can be made at this time as to the outcome of any particular lawsuit or proceeding, the Company believes there are meritorious defenses to substantially all of the above claims and that any liability which may finally be determined should not have a material adverse effect on the Company's consolidated financial position. - - Rate Matters On April 8, 1992, the FERC issued Order No. 636 ("Order 636"), which required significant changes in the services provided by interstate natural gas pipelines. The Company and numerous other parties have sought judicial review of aspects of Order 636. On July 2, 1993, the Company submitted to the FERC an unanimous offer of settlement which resolved all the Order 636 restructuring issues which had been raised in its restructuring proceedings. That settlement was ultimately approved (except for minor issues), and the Company's restructured services became effective October 1, 1993. Effective October 1, 1993, Colorado has separated all of its services and separately contracts for each service on a stand-alone or "unbundled" basis. Gathering, storage and transportation services are provided at negotiated rates established between minimum and maximum levels approved by FERC, while gas processing rates are not subject to FERC regulations. Effective October 1, 1993, Colorado formed an unincorporated Merchant Division to conduct most of the Company's sales activity in the Order 636 environment. The gas sales volumes reported include those sales which continue to be made by Colorado together with those of its Merchant Division. Colorado's gas sales contracts extend through September 30, 1996, but provide for reduced customer purchases to be made each year. Under Order 636, Colorado's certificate to sell gas for resale allows sales to be made at negotiated prices and not at prices established by FERC. Colorado is also authorized to abandon all sales for resale at such time as the contracts expire and without prior FERC approval. On March 31, 1993, the Company filed at FERC to increase its rates by approximately $26.5 million annually. Such rates (adjusted to reflect the Company's Order 636 program) became effective subject to refund on October 1, 1993. The Company is regulated by the FERC. Certain rate issues remain unresolved between the Company, its customers, its suppliers, and the FERC. The Company has made provisions which represent management's assessment of the ultimate resolution of these issues. While the Company estimates the provisions to be adequate to cover potential adverse rulings on these issues, it cannot estimate when each of these issues will be resolved. 11. Quarterly Results of Operations (Unaudited) The results of operations by quarter for the years ended December 31, 1993 and 1992 were (thousands of dollars): 12. Segment Reporting Natural gas system operations and gas and oil exploration and production are the two segments of the Company's operations. Natural gas system operations involve the production, purchase, gathering, storage, transportation and sale of natural gas, principally to and for public utilities, industrial customers, other pipelines, and other gas customers, as well as the operation of natural gas liquids extraction plants. Gas and oil exploration and production operations involve primarily the development and production of natural gas, crude oil, condensate and natural gas liquids. Operating revenues by segment include both sales to unaffiliated customers, as reported in the Company's statement of consolidated earnings, and intersegment sales, which are accounted for on the basis of contract, current market, or internally established transfer prices. The intersegment sales are from the exploration and production segment to the natural gas segment. Operating profit is total revenues less interest income from affiliates and operating expenses. Operating expenses exclude income taxes, corporate general and administrative expenses and interest. Identifiable assets by segment are those assets that are used in the Company's operations in each segment. The Company's operating revenues and operating profit for the years ended December 31, 1993, 1992 and 1991, and identifiable assets as of December 31, 1993, 1992 and 1991, by segment, are shown below (thousands of dollars): Capital expenditures and depreciation, depletion and amortization expense by segment for the years ended December 31, 1993, 1992 and 1991, were (thousands of dollars): Revenues from sales and transportation of natural gas to individual customers amounting to 10% or more of the Company's consolidated revenues were as indicated below (thousands of dollars): Revenues from sales and transportation of natural gas to any other single customer did not amount to 10% or more of the Company's consolidated revenues for the years ended December 31, 1993, 1992 and 1991, respectively. The Company does not have any foreign operations. Gas sales from the Company's transmission system are made primarily to public utilities which resell the gas to residential, commercial and industrial customers and to end-users in Colorado and southeastern Wyoming. Deliveries from the Company's field system are made to markets in the Texas Panhandle region. Transportation services are provided for brokers, producers, marketers, distributors, end-users and other pipelines. The Company extends credit for sales and transportation services provided to certain qualifying companies. 13. Transactions with Affiliates The Statement of Consolidated Earnings includes the following major transactions with affiliates (thousands of dollars): - ---------------------------- /1/ The 1991 and 1992 amounts were immaterial. /2/ The 1991 Gathering, Transportation and Compression amount for WIC includes the result of a transportation rate refund in the amount of $15.6 million, inclusive of interest, for the period June 1, 1985 through August 31, 1991. Services provided by the Company at cost for affiliated companies were $7.9 million for 1993, $8.1 million for 1992 and $4.4 million for 1991. Services provided by affiliated companies for the Company at cost were $8.1 million for 1993, $7.9 million for 1992 and $7.3 million for 1991. The services provided by the Company to affiliates, and by affiliates to the Company, primarily reflect the allocation of costs relating to the sharing/operating of facilities and general and administrative functions. Such costs are allocated to the Company using a three factor formula consisting of revenue, property and payroll, or other methods which have been applied on a reasonable and consistent basis. In 1989, the Company entered into two separate five-year lease agreements with ANR Western Storage Company, an affiliate, for the rental of certain pipeline facilities. Rental expense of approximately $1.5 million for 1993 and $1.6 million was recorded in both 1992 and 1991, in conjunction with the terms of the lease agreements. In 1992, the Company entered into a five-year lease agreement with ANR Production Company, an affiliate, for the rental of certain pipeline facilities. Rental expense of approximately $.2 million was recorded in 1993 and 1992 in conjunction with the terms of the lease agreement. The Company participates in a program which matches short-term cash excesses and requirements of participating affiliates, thus minimizing total borrowings from outside sources. At December 31, 1993, the Company had advanced $107.5 million to an associated company at a market rate of interest. Such amount is repayable on demand. SUPPLEMENTAL INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES (UNAUDITED) Reserves, capitalized costs, costs incurred in oil and gas acquisition, exploration and development activities, results of operations and the standardized measure of discounted future net cash flows are presented for the exploration and production segment. Natural gas systems reserves and the related standardized measure of discounted future net cash flows are presented separately for natural gas operations. All reserves are located in the United States. Most of the Company-owned gas reserves are dedicated to Colorado's system. Changes in proved reserves since the end of 1990 are shown in the following table: Total proved reserves for natural gas systems exclude storage gas and liquids volumes. The natural gas systems storage gas volumes are 41,012, 55,284 and 57,346 MMcf and storage liquids volumes are approximately 150, 159 and 207 thousand barrels at December 31, 1993, 1992 and 1991, respectively. The 1991 "Revisions of previous estimates and other" for Colorado's company- owned reserves of natural gas are related to the Company's independent engineers' interpretation of an agreement, effective January 1, 1991, as amended, between Colorado and Mesa Operating Company, formerly Mesa Operating Limited Partnership, which is discussed under Item 1, "Business - Gas System Reserves and Availability-Reserves Dedicated to a Particular Customer" herein. Such revisions are not due to any change in gross reserve estimates for the affected properties. CAPITALIZED COSTS RELATING TO EXPLORATION AND PRODUCTION ACTIVITIES (thousands of dollars) As described in Note 1 of Notes to Consolidated Financial Statements, the Company follows the full-cost method of accounting for oil and gas properties. COSTS INCURRED IN OIL AND GAS ACQUISITION, EXPLORATION AND DEVELOPMENT ACTIVITIES (thousands of dollars) Property acquisition costs consist of amounts paid for unproved reserves. RESULTS OF OPERATIONS FOR EXPLORATION AND PRODUCTION ACTIVITIES (thousands of dollars) The average amortization rate per equivalent Mcf was $1.00 in 1993, 1992 and 1991. STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVE QUANTITIES Future cash inflows from the sale of proved reserves and estimated production and development costs, as calculated by the Company's independent engineers, are discounted at 10% after they are reduced by the Company's estimate for future income taxes. The calculations are based on year-end prices and costs, statutory tax rates and nonconventional fuel source tax credits that relate to existing proved oil and gas reserves in which the Company has mineral interests. The standardized measure is not intended to represent the market value of reserves and, in view of the uncertainties involved in the reserve estimation process, including the instability of energy markets, may be subject to future revisions (thousands of dollars): Principal sources of change in the standardized measure of discounted future net cash flows during each year are as follows (thousands of dollars): None of the amounts include any value for storage gas and liquids which were approximately 41 Bcf and 150 thousand barrels, respectively, at the end of 1993. COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (Thousands of Dollars) - ---------------------------- 1 The note receivable is a promissory note due from an affiliate on demand and bears a market rate of interest. S-1 COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT (Thousands of Dollars) - --------------- (A) Reclassifications and other miscellaneous adjustments. (B) Amortization of exploration cost charged to income. The Company generally provides for depreciation on a straight-line basis, although the unit-of-production method is used for depreciation, depletion and amortization of gas and oil properties. The depreciation rates for production and gathering, products extraction, storage, and transmission plant are 1.55%, 3.85%, 2.90% and 2.60%, respectively. S-2 COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (Thousands of Dollars) - --------------- (A) Charged to clearing and other accounts. (B) Reclassification and other miscellaneous adjustments. S-3 COLORADO INTERSTATE GAS COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Thousands of Dollars) - --------------------------------- /1/ Amounts are not presented as such amounts are less than 1% of revenues. /2/ Production taxes for exploration and production operations are charged against operating revenues. S-4 EXHIBIT INDEX Exhibit Number Document - ------ ------------------------------------------------------------------------ (3.1)+ Certificate of Incorporation of the Company (Exhibit to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1980). (3.2)+ By-laws of the Company (Filed as Module CIGBY-LAWS on March 29, 1994). (3.3)+ Certificate of Amendment of Certification of Incorporation of the Company (Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). (4) With respect to instruments defining the rights of holders of long-term debt, the Company will furnish to the Securities and Exchange Commission any such document on request. (21)* Subsidiaries of the Company. (24)* Power of Attorney (included on signature pages herein). __________________________________ Note: + Indicates documents incorporated by reference from prior filing indicated. * Indicates documents filed herewith.

64605_1993.txt

64605_1993

1993

64605

Item 1. The Business General Medical Monitors, Inc. (the "Registrant"), is a corporation organized under Delaware law in February, 1975. The Registrant previously developed an automated electronic blood pressure measuring device that can be used by individuals to measure their own blood pressure without training or assistance. The Registrant has experienced significant operating losses since inception, and at February 28, 1993 had an accumulated deficit of $1,960,211. The Registrant has been without any material funds to develop and expand its business since the Fall of 1981 when management determined that the Registrant should remain in an inactive status pending the development of an improved AES Unit. No such improve of the AES Unit was undertaken by the Registrant and the has been no active business operations. Since that time, Harry Shuster, the sole officer and director of the Registrant has personally financed the maintenance of the Registrant by making non-interest bearing loans to the Registrant. There can be no assurance that Mr. Shuster will be willing or able to continue personally finance the Registrant's operations or maintenance of the Registrant in the future. At present, the Registrant has no active business. The Registrant proposes to combine with an existing, privately-held Registrant which is profitable and, in management's view, has growth potential (irrespective of the industry in which it is engaged). A combination may be structured as a merger, consolidation, exchange of the Registrant's Common Stock for stock or assets or any other form which will result in the combined enterprise's being a publicly-held corporation. The Registrant will pursue a combination with a Registrant or business enterprise that satisfies its combination suitability standards by advertising in one or more newspapers or magazines to establish contact with, or by otherwise contacting, selected privately-held companies which are profitable and are believed to have growth potential. There are no assurances that management of the Registrant will be able to locate a suitable combination partner or that a combination can be structured on terms acceptable to the Registrant. Pending negotiation and consummation of a combination, the Registrant anticipates that it will have limited business activities, will have no significant sources of revenue and will incur no significant expenses or liabilities. If expenses are incurred and funds are necessary the Registrant may undertake a private placement of its common stock or borrow the necessary capital from its officers and directors. Should necessary funds be available, the Registrant will engage attorneys, accountants and/or other consultants to evaluate and assist in completing a potential combination. Capital Expenditures The Registrant plans no significant expenditures. Employees The Company currently has one employee, Harry Shuster, who is the sole officer and director of the Company. The Company is not a party to any collective bargaining agreement. Item 2. Item 2. Properties The Company owns no real property or other materially important physical facilities. The Company uses offices maintained personally by Harry Shuster, the sole officer and director of the Company, at no cost to the Company. Item 3. Item 3. Legal Proceedings There are no material pending legal proceedings to which the Company is a party or of which any of its property is subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted to a vote of security holders of the Company during the fourth quarter of the fiscal year ended February 28, 1993 through the solicitation of proxies, or otherwise. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Common Stock, $.01 par value, or the Company is very thinly traded in over-the-counter market with the bid and ask ranging between $.01 and $.02. There were approximately 1,746 holders of record of the Common Stock, $.0l par value, of the Company as of February 28, 1993. The Company has paid no cash dividends on its Common Stock, $.001 par value, in the past and does not contemplate paying dividend in the foreseeable future. Future declaration of dividends, if any, will be determined by the Board of Directors in its discretion and will depend upon conditions then existing, including the availability of funds, requirements for working capital expenditures and debt retirement, general business condition and prospects, and other factors. The General Corporation Law of the State of Delaware provides that dividends may be declared and paid only out of surplus, as defined in such statute, or it there is no such surplus, only out of net profits for the fiscal year in which the dividend is paid and/or the preceding fiscal year. The Company has no surplus, as defined in the statute, and has not had any net profits in either of its last two fiscal years. Accordingly, any future dividends can only be declared and paid out of current earnings, if any. Item 6. Item 6. Selected Financial Data See the Financial Statements of the Registrant in Item 8. Item 7. Item 7. Management's Discussion And Analysis Of Financial Condition and Results Of Operations. General The Company has experienced severe working capital shortages during most of the period since 1976, primarily because of its prolonged experience in its research and development stage and its subsequent inability to obtain delivery of product from its manufactured. The Registrant had been primarily a one product company, engaged in the development of its automated electronic blood pressure measuring device known as the AES Unit. Since February 28, 1985, the Company has had no active business operations of any kind. All risk inherent in new and inexperienced enterprises are inherent the Company's business. The Company has not made a formal study of the economic potential of any business. At the present, the Company has not identified any assets or business opportunities for acquisition. As of February 28, 1993 the Company has no liquidity and no presently available capital resources, such as credit lines, guarantees, etc. and should a merger or acquisition prove unsuccessful, it is possible that the Company may be dissolved by the State of Delaware for failing to file reports, at which point the Company would no longer be a viable corporation under Delaware law and would be unable to function as a legal entity. Should management decide not to further pursue its acquisition activities, management may abandon its activities asked the shares of the Company would become worthless. However, the Company's officers, directors and majority shareholder, have made an oral undertaking to make loans to the Company in amounts sufficient to enable it to satisfy its reporting requirements and other obligations incumbent on it as a public company, and to commence, on a limited basis, the process of investigating possible merger and acquisition candidates. The Company's status as a publicly-held corporation may enhance its ability to locate potential business ventures. The loans will be interest free and are intended to be repaid at a future date, or when the Company shall have received sufficient funds through any business acquisition. The loans are intended to provide for the payment of filing fees, professional fees, printing and copying fees and other miscellaneous fees. Based on current economic and regulatory conditions, Management believes that it is possible. if not probable, for a company like the Company, without assets or liabilities, to negotiate a merger or acquisition with a viable private company. The opportunity arises principally because of the high legal and accounting fees and the length of time associated with the registration process of "going public". However, should any of these conditions change, it is very possible that there would be little or no economic value for anyone taking over control of the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Balance Sheets - for the Years ended February 28, 1993 and 1992.......... 6 Statement of Operations and Accumulated Deficit.......................... 7 Statement of Cash Flows.................................................. 8 Notes to Financial Statements............................................ 9-10 All other schedules are not submitted because they are not applicable or not required or because the information is included in the financial statements or notes thereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. MEDICAL MONITORS BALANCE SHEETS FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT FOR THE YEARS ENDED FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS NOTES TO FINANCIAL STATEMENTS FEBRUARY 28, 1993 AND 1992 (UNAUDITED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. Description of Business - Medical Monitors, Inc. (the "Company") was incorporated in Delaware in February 1975. Initially, its purpose was to develop and market blood pressure measuring devices. In April 1980, the Company raised $884,000 from the initial public offering of its common stock. Because the Company was unable to raised additional capital to continue developing and marketing its product, in the Fall of 1981, it ceased its operations. In 1986, the Company ceased making the required public filings under the Securities and exchange Act of 1934, as amended. The Board of Directors of the Company is currently investigating the possibility of a new business direction and searching for viable acquisition or merger candidates which would enable the Company to maximize value to its shareholders. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Income Taxes - Income taxes are provided using the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis (i.e., temporary differences). Net Income (Loss) Per Share - Net Income (loss) per share is calculated using the weighted average number of common shares outstanding. Common share equivalents are included to the extent they are dilutive. 2. GOING CONCERN. The Company ceased its operations in the Fall of 1981. The Company's ability to continue as a going concern will be dependent upon obtaining a viable business through merger or acquisition. There can be no assurance that the Company will be able to find a business to acquire or merge with. 3. NOTES PAYABLE. Notes payable consisted of the following at February 28, 1993 and 1992: 1993 1992 ----------- ---------- Non-interest bearing advances payable To H. Shuster $ 84,865 $ 84,865 Non-interest bearing notes payable to Loma Vista, Ltd. 379,833 379,833 Non-interest bearing note payable to European Diamond trading Corporation 20,750 20,750 ----------- --------- $ 485,448 $485,448 =========== ========= A portion of the notes payable to Loma Vista, Ltd. In the amount of $304,000 is secured by all assets of the Company. Harry Shuster, the President of the Company, is the sole general partner of Loma Vista, Ltd. Harry Shuster is an officer and majority shareholder of European Diamond Trading Corporation. All of the above notes are in default. 4. ACCRUED OFFICER'S SALARIES. Accrued officer's salaries consisted of amounts due Harry Shuster under his employment agreement which expired in December 1981. PART III Item 10. Item 10. Directors and Executive officers of the Registrant. The following table sets forth certain information concerning the Directors and executive officers of the Company. A Age Principal Occupation and all Director Name Positions With the Company Since - ------------------------------------------------------------------------------- Harry Shuster Director and Chief Executive Officer 1975 President, Secretary and Chief Financial Officer 1986 Harry Shuster is a founder of the Company and has been its Chairman of the Bard, President and a Director since its inception in February, 1975. Mr. Shuster was also Treasurer of the Company until August, 1981. In 1967, Mr. Shuster founded Lion Country Safari, Inc. a publicly-held corporation whose Common Stock is registered under Section 12(g) of the Securities Exchange Act of 1934, which operates an African wildlife preserve and theme amusement park in Irvine, California. Mr. Shuster has served as Lion Country Safari, Inc.'s chief executive officer and a director since 1967, in which capacity he has directed the marketing and promotional efforts relating to the Lion Country Safari operations. Since March, 1976, Mr. Shuster has served under a consulting agreement which does not require his full-time services in such capacities for Lion Country Safari, Inc. It is estimated that approximately 20% of Mr. Shuster's business working hours were devoted to his position as Chief Executive Officer of the Company during the fiscal year ended February 28, 1985. Since the Company moved into an inactive status in late 1981, Mr. Shuster has only spent so much of his time on the business and affairs of the Company as his duties as Chief Executive Officer have required. Accordingly, Mr.. Shuster's services to Lion Country Safari Inc. have occupied more and more of his working time and, from time-to-time will likely continue to restrict the amount of time which Mr. Shuster can make available to the Company's business. See "Management Compensations" and "Certain Relationships and Related Transactions" in items 11 and 13, respectively, of this Annual Report on Form 10-K. Mr. Shuster is an attorney admitted to the Supreme Court of South Africa. The present term of each Director will expire at the time of the next Annual Meeting of Stockholders of the Company. Executive officers are elected each year at the Annual Meeting of the Board of Directors held immediately following the Annual Meeting of Stockholders and hold office until the next Annual Meeting of the Board of Directors or until their successors are duly elected and qualified. The Company has held no Annual Meeting of Shareholders since August 26, 1980. There are no arrangements or understandings known to the Company between any of the Directors or executive officers of the Company and any other person pursuant to which any of such persons was or is to be selected as a Director or an executive officer. There are no family relationships between any Director or executive officer and any other Director or executive officer of the Company. The Board of Directors has held no formal meetings since 1983. The Company has no standing audit, nominating or compensation committees of the Board of Directors. Item 11. Item 11. Management Compensation Management Compensation No officer or Director of the Company either received or had accrued on the books of the Company any remuneration with respect to the fisca1 year ended February 28, 1993. There was no health or life insurance provided to officers or Directors by the Company which discriminates in favor of officers or Directors and which is not available generally to all salaried employees of the Company. The Company has no employee incentive, bonus or benefit plans, profit sharing plans, retirement plans, deferred compensation plans or similar arrangements. No fees are paid Directors for attendance at meetings of the Board of Directors, although out-of-pocket expenses incurred in connection therewith are reimbursed. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth certain information with respect to all persons, or groups of persons, known by the Company to own beneficially more than five percent of the Common Stock, $.01 par value, of the Company, its only outstanding class of voting securities, and as to the beneficial ownership thereof of the Directors of the Company, individually, and all Directors and officers as a group, all as at February 28, 1993. Name and Address of Amount and Nature or Beneficial Owner (a) Beneficial Ownership Percentages(b) - -------------------- -------------------- -------------- Harry Shuster 1900 Westwood Blvd. Los Angeles, California 90025 16,082,088 32.16% Loma Vista, Ltd. c/o Harry Shuster 1900 Westwood Blvd. Los Angeles, California 90025 3,318,985 (c) 6.64%(c) Richard Weisman 16200 Ventura Blvd. Suite 201 Encino, California 91436 2,631,745 (d) 5.26%(d) All officers and Directors as A Group (One person) 19,401,073 (e) 38.80%(e) - ---------------- (a) Addresses are shown only for the beneficial owners of at least five-percent of the Common Stock of the Company. (b) Percentages are determined on the basis of 50,000,000 shares of outstanding Common Stock. (c) Loma Vista Ltd. is a limited partnership of which Harry Shuster, Chairman of the Board, President and Chief Executive Officer of the Company, is the general partner and through which Mr. Shuster has an interest in shares of the Company's Common Stock. A portion of the shares originally issued to Loma Vista, Ltd. were subsequently distributed to several of its limited partners. All of the shares now owned by Loma Vista, Ltd. are allocated to Mr. Shuster's general partner's interest in such limited partnership. (d) Mr. Weisman, a former Director of the Company, holds 545,106 of these shares directly, 86,000 as executor of his father's estate, and a total of 800,151 shares as trustee for his adult sons. As to all of these shares, Mr. Weisman can be said to have sole investment and voting power. The remaining shares are owned by Mr. Weisman's wife, sister and mother and Mr. Weisman disclaims any beneficial ownership thereof. (e) Includes shares owned by Loma Vista, Ltd. PART IV. Item 13. Item 13. Certain Relationship and Related Transactions. The following table outlines certain information with respect to obligations of the Company to its present principal stockholders and their affiliates as of February 28, 1993. Accrued Purchase Loans for Total Due AES to the Services At End of Obligee Rights Company Rendered year - ------------------------------------------------------------------------------ Loma Vista, Ltd. $ 75,833(1) $304,000 (1) $ - $379,833 European Diamond Trading Corporation (2) 20,750 20,750 Harry Shuster 84,865 - 84,865 - ------------------------------------------------------------------------------ $ 75,833 $409,615 $283,464 $ 768,912 ======== ======== ======== ========== (1) This note is secured by a pledge of all assets of the Company. These notes are presently in default, but payment "thereof has not been demanded by Loma Vista, Ltd. See Note 3 of "Notes to Financial Statements". (2) These demand notes are payable to European Diamond Trading Corporation, a corporation controlled by Harry Shuster, Chairman of the Board, President and Chief Executive Officer of the Company. All of the above notes are in default. 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 of the Registrant. set forth under Item 8 are filed as part of this report. (2) The Financial Statement Schedules other than those listed above have been omitted because they are either not required, not applicable, or the information is otherwise included. (b) Information filed as part of this report from Form 8-K: (1) No reports on Form 8-K were filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MEDICAL MONITORS, INC. (Registrant) Date: March 12, 1998 /S/ Harry Shuster ------------------------------ By: Harry Shuster Its: President, Secretary and Chief Financial Officer

92116_1993.txt

92116_1993

1993

92116

Item 1. Business General Southern California Water Company (the "Registrant") is a public utility company engaged principally in the purchase, production, distribution and sale of water. The Registrant also distributes electricity in one community. The Registrant, regulated by the California Public Utilities Commission ("CPUC"), was incorporated in 1929 under the laws of the State of California as American States Water Services Company of California as the result of the consolidation of 20 water utility companies. From time to time additional water companies and municipal water districts have been acquired and properties in limited service areas have been sold. The Registrant's present name was adopted in 1936. At December 31, 1993, the Registrant provided service in 17 separate operating districts, 16 of which were water districts and one an electric district, located in 75 communities in ten counties throughout the State of California. Total population of the service areas on December 31, 1993 was approximately 1,000,000. As of that date, about 73% of the Registrant's water customers were located in the greater metropolitan areas of Los Angeles and Orange Counties. The Registrant provided electric service to the City of Big Bear Lake and surrounding areas in San Bernardino County. All electric energy sold is purchased from Southern California Edison Company ("SCE") on a resale rate schedule. The Registrant served 236,985 water customers and 20,131 electric customers at December 31, 1993, or a total of 257,116 customers compared with 255,966 total customers at December 31, 1992. For the year ended December 31, 1993, approximately 90% of the Registrant's operating revenues were derived from water sales and approximately 10% from the sale of electricity, ratios which are generally consistent with prior years. Operating income before taxes on income of the electric district was 9.2% of the Registrant's total operating income before taxes. The material contained in Note 12 of the Notes to Financial Statements included in the 1993 Annual Report to Shareholders provides additional information on business segments while Note 13 provides information regarding the seasonal nature of the Registrant's business. Page 15 of the 1993 Annual Report to Shareholders lists the geographical distribution of customers. During 1993, the Registrant supplied, from all sources, a total of 178,196 acre feet of water compared with 172,500 acre feet for the previous year. Of the total water supplied in 1993, approximately 43% was purchased from others, principally from member agencies of the Metropolitan Water District of Southern California ("MWD"), and 1% was furnished by the Bureau of Reclamation under contract, at no cost, for the Registrant's Arden-Cordova District and to the Registrant's Clearlake district by prescriptive right to water extracted from Clear Lake. These amounts reflect a continued reduction in reliance on imported water supplies. The MWD is a water district organized under the laws of the State of California for the purpose of delivering imported water to areas within its jurisdiction which includes most of coastal Southern California from the County of Ventura south to and including San Diego County. The Registrant has 52 connections to the water distribution facilities of MWD and other municipal water agencies. MWD imports water from two principal sources: the Colorado River and the State Water Project ("SWP"). Available water supplies from the Colorado River and the SWP have historically been sufficient to meet most of MWD's requirements even though the State's major reservoirs were significantly impacted by six years of drought. The drought officially ended in February, 1993. The price of water purchased from MWD, however, is expected to continue to increase. MWD announced a 7% rate adjustment on March 8, 1994, effective for the 1994-1995 fiscal year. In those districts of the Registrant which pump groundwater, overall groundwater conditions continue to maintain at adequate levels. The Registrant drilled six new wells during 1993 in order to improve the Registrant's ability to use more groundwater in its resource mix and further decrease its dependence on purchased water. The Registrant is continuing its efforts to become a participant in the Coastal Aqueduct extension of the State Water Project (the "Project"). The Registrant believes that participation in the Project is necessary in order to provide another source of water for its Santa Maria water district. Should the Registrant be allowed to participate in the Project at a 500 acre-foot level, the Registrant will prepare a filing with the CPUC in order to recover costs associated with that participation under normal rate-making methods. A final decision of the CPUC on the application would not be anticipated until late 1994 or early 1995. Rates and Regulation The Registrant is subject to regulation by the CPUC as to its water and electric business and properties. The CPUC has broad powers of regulation over public utilities with respect to service and facilities, rates, classifications of accounts, valuation of properties and the purchase, disposition and mortgaging of properties necessary or useful in rendering public utility service. It also has authority over the issuance of securities, the granting of certificates of convenience and necessity as to the extension of services and facilities and various other matters. Water rates of the Registrant vary from district to district due to differences in operating conditions and costs. Each operating district is considered a separate entity for rate-making purposes. The Registrant continuously monitors its operations in all of its districts so that applications for rate changes may be filed, when warranted, on a district-by-district basis in accordance with CPUC procedure. Under the CPUC's practices, rates may be increased by three methods - general rate increases, offsets for certain expense increases and advice letter filings related to certain plant additions. General rate increases typically are for three year periods and include "step" increases in rates for the second and third years. General rate increases are established by formal proceedings in which the overall rate structure, expenses and rate base of the district are examined. Rates are based on estimated expenses and capital costs for a forward two-year period. A major feature of the proceeding is the use of an attrition mechanism for setting rates for the third of the three year test cycle assuming that the costs and expenses will increase in the same proportion over the second year as the increase projected for the second test year increased over the first test year. The step rate increases for the second and third years are allowed to compensate for the projected cost increases, but are subject to tests including a demonstration that earnings levels in the district did not exceed the latest rate of return authorized for the Registrant. Formal general rate proceedings typically take about twelve months from the filing of a Notice of Intent to increase rates to the authorization of new rates. Rate increases to offset increases in certain expenses such as costs of purchased water, energy costs to pump water, costs of power purchased for resale and groundwater production assessments are accomplished through an abbreviated "offset" procedure that typically takes about two months. CPUC regulations require utilities to maintain balancing accounts which reflect differences between specific offset cost increases and the rate increases authorized to offset those costs. The balancing accounts are subject to amortization through the offset procedure or through general rate decisions. An advice letter, or rate base offset, proceeding is generally undertaken on an order of the CPUC in a general rate proceeding wherein the inclusion of certain projected plant facilities in future rates is delayed pending notification that such facilities have actually been placed in service. The advice letter provides such notification and, after CPUC approval, permits the Registrant to include the costs associated with the facilities in rates. During 1993, 1992 and 1991, the Registrant's rates for all water districts were increased, among other reasons, to directly offset increases in certain expenses, principally purchased water, as well as increased levels of capital improvements. The Registrant decreased rates in its Bear Valley electric district by approximately 28% in November, 1991 as a result of amortizing large refunds from the Registrant's wholesale power supplier. The following table lists information related to the Registrant's rate increases for the last three years: The Registrant filed an application for general rate increases in six of its water operating districts in May, 1992. In June, 1993, the CPUC issued its decision and the Registrant requested rehearing on two matters - the rate of return on rate base and an authorized rate increase for the Registrant's Bay Point water district. The CPUC granted the Registrant's request for rehearing on the two issues and established an interim rate of return on rate base of 9.5% applicable for certain attrition, step rate filings and other earnings test filings with respect to the Registrant's other operating districts. For further information, please see the caption "Rates and Regulation" under Management's Discussion and Analysis herein and Note 10 of the Notes to Financial Statements in the 1993 Annual Report to Shareholders. The Registrant has filed its case on the two matters set for rehearing, which was held on March 15, 1994. Prior to commencement of hearings, the Registrant and the Division of Ratepayer Advocates ("DRA") of the CPUC had stipulated to a rate of return on common equity of 10.10%. In addition, DRA had agreed that an increase in rates applicable to the Registrant's Bay Point water district was appropriate with certain modifications as to the level of rate base. A final decision on these matters, however, is still subject to the CPUC and is not expected until the Summer of 1994. The Registrant anticipates filing applications with the CPUC in July, 1994 for rate increases, effective in 1995, in all of its operating districts for certain cost-effective recommendations resulting from the recently completed Management Audit of the Registrant conducted under the auspices of the CPUC. In addition, the Registrant will file a general rate case in one of its water operating districts. The requested annual increase in rates will also seek step increases for 1996 and 1997. No assurance can be given that the CPUC will authorize any or all of the rates for which the Registrant applies. Industrial Relations The Registrant had 486 paid employees as of December 31, 1993. Seventeen employees in the Bear Valley Electric District were members of the International Brotherhood of Electrical Workers. Their present labor agreement is effective through June 30, 1994. Seventy-three of the Registrant's water utility employees, unionized under the Utility Workers of America ("UWA"), are covered by a contract which expires March 31, 1996. The Registrant has no other unionized employees. Environmental Matters The Environmental Protection Agency ("EPA"), under provisions of the Safe Drinking Water Act, as amended, is required to establish Maximum Contaminant Levels ("MCL's") for the 83 potential drinking water contaminants initially listed in the Act, and for an additional 25 contaminants every three years thereafter. The California Department of Health Services ("DOHS"), acting on behalf of the EPA, administers the EPA's program. The Registrant continues to test its wells and water systems for more than 90 contaminants. Water from wells found to contain levels of contaminants above the established MCL's has either been treated or blended before it is delivered to customers. Only 2 of the Registrant's 306 wells have been permanently taken out of service due to high levels of contamination. The Registrant is aware of two new rules pending implementation by the EPA which may significantly affect the Registrant: the Radon Rule and the Arsenic Rule. The EPA did not meet the October 1, 1993 deadline for establishing an MCL for radon. Because of this inaction, the rule is presently in the hands of the United States Congress where it is believed that an MCL will be established primarily to implement the regulation. However, the 1994 budget as drafted by the Appropriations Committee has specifically excluded funds for further work on radon regulation, basically setting a moratorium on the regulation. The EPA is continuing its review of data on the Arsenic Rule although the Registrant anticipates an MCL will be proposed by September, 1994. The Registrant is unable to predict, until the MCL's are established, what effects, if any, these new rules will have on its financial condition or results of operation. The Registrant has experienced increased operating costs for testing to determine the levels (if any) of the contaminants in the Registrant's source of supply and costs to lower the level of any contaminants found to a level that meets standards. Such costs and the control of any other pollutants may include capital costs as well as increased operating costs. The rate-making process provides the Registrant with the opportunity to recover capital and operating costs associated with water quality, and management believes that such costs are properly recoverable. Item 2 Item 2 - Properties Franchises, Competition, Acquisitions and Condemnation of Properties The Registrant holds the required franchises from the incorporated communities and the counties which it serves. The Registrant holds certificates of public convenience and necessity granted by the CPUC in each of the 17 districts it serves. The business of the Registrant is substantially free from direct competition with other public utilities, municipalities and other public agencies. The Registrant's certificates, franchises and similar rights are subject to alteration, suspension or repeal by the respective governmental authorities having jurisdiction over such matters. The laws of the State of California provide for the acquisition of public utility property by governmental agencies through their power of eminent domain, also known as condemnation. The Registrant has been, within the last three years, involved in activities related to the condemnation of its Big Bear and Bay Point water districts. The Registrant continues to oppose the condemnation actions with respect to its Bay Point water district initiated by the Contra Costa Water District in 1992. Note 8 of the Notes to Financial Statements contained in the 1993 Annual Report to Shareholders herein describes condemnation actions related to the Registrant's properties in greater detail. Water Properties As of December 31, 1993, the Registrant's physical properties consisted of water transmission and distribution systems which included over 2,560 miles of pipeline together with services, meters and fire hydrants and approximately 438 parcels of land (generally less than 1 acre each) on which are located wells, pumping plants, reservoirs and other utility facilities. The Registrant's operating properties have been maintained and improved in the ordinary course of business. As of December 31, 1993, the Registrant owned and operated 306 wells equipped with pumps with an aggregate capacity of 265.7 million gallons per day ("MGD"). Other production facilities include filter plants with an aggregate capacity of 29.4 MGD and 52 connections to the water distribution facilities of the MWD and other municipal water agencies. The Registrant's storage reservoirs and tanks have an aggregate capacity of 156.6 million gallons. There are no dams in the Registrant's system. Electric Properties The Registrant's electric properties are all located in the Big Bear area of San Bernardino County. As of December 31, 1993, the Registrant operated 28.8 miles of overhead 34.5 KV transmission lines, 0.6 miles of underground 34.5 KV transmission lines, 172.7 miles of 4.16 KV or 2.4 KV distribution lines, 41.7 miles of underground cable and 14 sub-stations. There are no generating plants in the Registrant's system. Other Properties The Registrant's general offices are housed in a single-story office building located in San Dimas, California. The land and the building, which was completed and occupied in early 1990, are owned by the Registrant. Certain of the Registrant's district offices are housed in leased premises. During 1993, the Registrant refinanced a significant portion of its then outstanding debt in order to lower interest costs. In doing so, the Registrant redeemed all outstanding First Mortgage Bonds. In early 1994, the Trustee filed for release of the lien of an indenture securing the previously outstanding First Mortgage Bonds. As of December 31, 1993, the Registrant had no mortgage debt outstanding. Financing of Construction Expenditures The Registrant's construction program is designed to ensure its customers with high quality service. The Registrant has an ongoing distribution main replacement program, throughout its service areas, based upon the priority of leaks detected, fire protection enhancement and a reflection of the underlying replacement schedule. In addition, the Registrant upgrades its electric and water supply facilities and is aggressively scheduling meter replacements. The Registrant anticipates gross capital expenditures of $26,700,000, $17,500,000 and $34,500,000 in 1994, 1995 and 1996, respectively. During 1993, the Registrant issued 1,107,000 Common Shares (on a post-split basis) in two separate public offerings for aggregate net proceeds of $23,935,000. The net proceeds were applied against then outstanding short-term bank borrowing incurred to temporarily finance construction expenditures. The Registrant issued additional common equity through its Dividend Reinvestment and Common Share Purchase Plan and its 401-k Plan. The Registrant issued 47,828, 28,416 and 29,146 shares under the Dividend Reinvestment and Common Share Purchase Plan in the three years ended December 31, 1993, 1992 and 1991, respectively. The Registrant issued 7,741 and 7,102 Common Shares under the 401-k Plan in the two years ended December 31, 1993 and 1992. The Registrant did not issue any Common Shares through its 401-k Plan in the year ended December 31, 1991. During 1993 and 1992, the Registrant did not undertake any long-term debt financing to provide additional funds for construction. In 1993, however, the Registrant did refinance $37 million of its long-term debt, in order to reduce interest expense, through its Medium Term Note Program. In 1992, the Registrant entered into a $2,247,000 fixed rate obligation due 2013 for financing construction of a new reservoir serving one of the Registrant's water operating districts. In May, 1991, the Registrant completed the sale of $28,000,000 in long-term Notes Due 2031, $13,500,000 of which was used to repay then outstanding short-term bank loans which had been used to fund the Registrant's construction program. In addition, in December, 1991, the Registrant redeemed, at a premium, $6,000,000 principal amount of 11-3/4% Notes. The remainder of the proceeds from the May, 1991 issue was utilized to fund the Registrant's capital expansion program. Item 3. Item 3. Legal Proceedings On October 20, 1993, the Registrant and the Internal Revenue Service ("IRS") reached a tentative settlement on the results of the IRS examination of the Registrant's 1987, 1988 and 1989 tax returns. Based on the settlement, the Registrant remitted an additional $438,000 in taxes. The Registrant anticipates signing the final agreement in late March, 1994. On March 8, 1994, the Registrant and the Contra Costa County Board of Supervisors (the "County") reached a tentative settlement of issues related to the County's taking on the Registrant's Madison Treatment plant in its Bay Point water district. The County's Highway Department had taken possession of the property on June 24, 1993. The tentative settlement of $2.3 million includes remuneration to the Registrant for the value of the property taken, severance damages, if any, and reimbursement for treated water purchased from the City of Pittsburg. The amount determined as remuneration for the value of the property taken is to be applied against the value of the Registrant's Bay Point district, currently under condemnation by the Contra Costa Water District ("CCWD"). The Registrant and CCWD, however, are continuing their negotiations concerning the CCWD's condemnation of the Registrant's Bay Point water district. At this time, however, the Registrant is unable to predict the final outcome of these negotiations. In 1993, water revenues from the Registrant's Bay Point water district were approximately $2.7 million or 2.75% of its total annual water revenues. There are no other material pending legal proceedings, other than litigation incidental to the ordinary course of business, to which the Registrant is a party or of which any of its properties is the subject. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (a) Market Price for Common Shares Information responding to Item 5(a) is included in the 1993 Annual Report to Shareholders, under the caption "Trading of Stock" located on the inside back cover, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein pursuant to General Instruction G(2). (b) Approximate Number of Holders of Common Shares As of February 28, 1994, there were 4,342 holders of record of Common Shares. (c) Frequency and Amount of Any Dividends Declared and Dividend Restrictions Information responding to Item 5(c) is included in the 1993 Annual Report to Shareholders, under the caption "Trading of Stock" located on the inside back cover, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(2). For the last three years, the Registrant has paid dividends on its Common Shares on March 1, June 1, September 1 and December 1. Additional information responding to Item 5(c) is included in the 1993 Annual Report to Shareholders, under Note 3 of the Notes to Financial Statements captioned "Common Share Dividend Restriction" on page 31, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 6. Item 6. Selected Financial Data Information responding to Item 6 is included in the 1993 Annual Report to Shareholders, in the section entitled "Financial Information" under the caption "Statistical Review from 1989 to 1993" on Page 36, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation Information responding to Item 7 is included in the 1993 Annual Report to Shareholders, under the caption "Management's Discussion and Analysis" on Pages 17 through 23, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 8. Item 8. Financial Statements and Supplementary Data Information responding to Item 8 is included in the 1993 Annual Report to Shareholders, under the captions contained on Pages 24 through 35, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Balance Sheets - December 31, 1993 and 1992 Statements of Capitalization - December 31, 1993 and 1992 Statements of Income for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Common Shareholders' 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 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 Information responding to Item 10 was included in the Proxy Statement, under the caption "Executive Officers Experience and Compensation", filed by the Registrant with the Commission on or about March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 11. Item 11. Executive Compensation Information responding to Item 11 was included in the Proxy Statement, under the captions "Executive Officers Experience and Compensation" and "Board Report on Executive Compensation", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information responding to Item 12 was included in the Proxy Statement, under the captions "Election of Directors" and "Executive Officers Experience and Compensation", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 13. Item 13. Certain Relationships and Related Transactions Information responding to Item 13 was included in the Proxy Statement, under the caption "Election of Directors", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K _____________________ * Filed herewith REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON THE SUPPLEMENTAL SCHEDULES To the Shareholders and the Board of Directors Of Southern California Water Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in Southern California Water Company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 15, 1994. Our audit was made for the purpose of forming an opinion on those basic financial statements taken as a whole. The supplemental schedules listed in Part IV of this Form 10-K, which are the responsibility of the company's management, are presented for purposes of complying with the Securities and Exchange Commission's rules and regulations 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. ARTHUR ANDERSEN & CO. Los Angeles, California February 15, 1994 SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (1) Includes property added under install and convey contracts of $819,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (1) Includes property added under install and convey contracts of $3,119,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (1) Includes property added under install and convey contracts of $1,398,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1993 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .01% to a maximum of 27.73%, for 1993. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1992 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .05% to a maximum of 27.73%, for 1992. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1991 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .05% to a maximum of 26.91%, for 1991. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VIII - RESERVES FOR UNCOLLECTIBLE ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHERN CALIFORNIA WATER COMPANY By : s/ JAMES B. GALLAGHER . ----------------------------- James B. Gallagher Secretary, Treasurer and Chief Financial Officer 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.

813672_1993.txt

813672_1993

1993

813672

ITEM 1. BUSINESS Cadence Design Systems, Inc. ("Cadence" or the "Company") develops, markets, and supports electronic design automation ("EDA") software products that automate, enhance and accelerate the design and verification of integrated circuits ("ICs") and electronic systems. Cadence's product lines are composed of suites of software packages or tools, integrated through Cadence's proprietary software architecture. Cadence was formed as a result of the merger of SDA Systems, Inc. ("SDA") into ECAD, Inc. ("ECAD") in May 1988. ECAD commenced operations in 1982. SDA commenced operations in 1983. The Company's name was changed to Cadence Design Systems, Inc. in June 1988. In March 1989, Cadence acquired Tangent Systems Corporation ("Tangent"). In December 1989, Cadence merged with Gateway Design Automation Corporation ("Gateway"), a leading EDA supplier of digital logic simulation software. In July 1990 Cadence merged with Automated Systems, Inc. ("ASI"), a company that marketed products and services related to the design and manufacture of electronic printed circuit boards ("PCBs") to the aerospace, defense, computer and telecommunications industries. In December 1991 Cadence merged with Valid Logic Systems Incorporated ("Valid"), a company that developed and supported EDA software used to design electronic systems, PCBs and applications for electronic product designs involving advanced packaging technology such as hybrids and multi-chip modules ("MCMs"). In June 1993 Cadence acquired the business and certain assets of Comdisco Systems, Inc. ("Comdisco") a subsidiary of Comdisco, Inc. Comdisco develops, markets and supports digital signal processing software products in the electronic systems applications area. In December 1993 the Company sold its ASI division and reported the operating results of ASI as discontinued operations for all prior years. Valid had acquired two companies by merger in February 1989: Integrated Measurements Systems, Inc. ("IMS"), a company that manufactured and marketed verification systems used in testing prototype application specific integrated circuits ("ASICs"), and Analog Design Tools, Inc. ("ADT"), a supplier of computer-aided engineering ("CAE") software for the design of analog electronic circuits. THE ELECTRONIC PRODUCT DEVELOPMENT CYCLE ELECTRONIC DESIGN AUTOMATION EDA refers to the use of engineering software to design electronic circuits and systems. A critical and enabling technology for the global electronics industry, EDA allows engineers to develop complex and high quality electronic products within accelerated time-to-market schedules. EDA software is one of the key forces driving electronics innovation and production. Virtually all complex computer, telecommunication, aerospace and semiconductor projects depend on advanced EDA solutions to handle the large amounts of data associated with these designs. In addition, the short product life cycles of consumer electronics products depend on the accelerated design schedules that EDA software allows. EDA software can literally cut months from a production schedule, allowing design teams to complete projects in a timeframe that would be impossible if done manually. Electronics manufacturing has a synergistic relationship with EDA. Without EDA simulation software to verify design performance, the design quality required for profitable high volume production of ICs and PCBs would be compromised. EDA technology has also enabled the quick production time and enormous market growth of semi-custom circuits and subsystems such as ASICs, Programmable Logic Devices ("PLDs"), Field Programmable Gate Arrays ("FPGAs") and MCMs. EDA systems address two major functions in the electronic product development cycle: electrical design, often referred to as CAE, and physical design, often referred to as computer-aided design ("CAD"). Together, CAE and CAD address the major phases in the design of electronic systems, PCBs, MCMs, ASICs, PLDs, FPGAs and full-custom ICs. CAE DESIGN PROCESSES The electrical design process involves design description, model development and simulation of the design's behavior and timing performance. Additional design automation technologies, such as architectural design and logic and test synthesis, can simplify the design entry process; IC floorplanning can provide greater accuracy in simulation. Design description (called design entry, design capture or schematic capture) is the first step in the electronic design process. To handle the complexity of large designs, design entry often consists of several levels of design description. At the highest level of abstraction, a design can be expressed in a behavioral description, a convention that allows engineers to describe large and complex designs quickly. Behavioral design description typically involves the use of equations, or a special design description language called a Hardware Description Language ("HDL"). For digital designs, the most common HDLs are Verilog(R) HDL, a language developed by Cadence that is now in the public domain, and VHDL, a language standardized and backed by the U.S. Department of Defense and supported by Cadence as well as many other EDA vendors. A similar standard is emerging for analog design. Cadence is developing an analog hardware description language ("AHDL") which it will seek to make an industry-standard. Much as a sketch is detailed into a blueprint before building a house, behavioral descriptions must be detailed into lower-level descriptions (also called structural designs) before the IC or PCB can be manufactured. This process can be done manually, or in an automated fashion using a process called logic synthesis and a software tool such as the Cadence Synergy(TM) synthesizer. In structural design, the engineer specifically defines components, their interconnections, and associated physical properties. This description can be the text file produced by logic synthesis, or a graphical drawing called a schematic. In structural design, critical design time is saved by pulling components from an electronic library and including them in the design, rather than recreating symbols and data for each design. A database, containing the design's electrical characteristics, interconnections and specific design rules, is automatically created and used as the foundation for subsequent design steps. Simulation is used to verify the design electronically before it is manufactured, enabling engineers to explore design alternatives quickly and to catch costly design errors before the design is manufactured. Simulation can be performed with different levels of design description: behavioral, structural and mixed-level. These levels allow designers to test their design concept, actual structure and performance, and a combination of concept and structure. A key element in the simulation process is the use of component libraries containing software models of commonly used parts. These are either developed and supplied by Cadence, or are provided by third-parties such as ASIC vendors or independent modeling companies that have certified their libraries for use with Cadence's simulation products. When the functionality and timing are determined to be correct, the engineer generates a netlist. A netlist is a non-graphic description, in list form, of all design components and interconnects. The netlist is the link between the CAE design environment and the CAD process. CAD DESIGN PROCESSES An electronic product's physical design process varies depending on whether the final product is a full-custom IC, an ASIC or a PCB. However, the physical design process typically includes the placement of devices or components, electrical routing or wiring between those devices and components, analysis of the layout to check for compliance with design rules and performance specifications and the generation of data for use in manufacturing and test activities. If the design is a full custom IC, the process includes chip-level architectural design, creation of cells and blocks, floorplanning, placement, routing and compaction of the cells/blocks, analysis of conformance to electrical and physical design rules, analysis of wire lengths, load factors and timing performance, and generation of mask data for chip fabrication. If the design is produced as a PCB or MCM incorporating off-the-shelf components, full custom ICs and/or ASICs, physical design typically includes floorplanning and pre-placement of critical components, automatic or interactive component placement, analysis of thermal conditions and high-frequency transmission line characteristics, analysis of testability and generation of test documentation, pre-manufacturing clean-up or "glossing" of the board design, and generation of a wide range of manufacturing data and artwork. CADENCE'S EDA PRODUCT FAMILY Cadence's full line of integrated EDA software solutions has been developed to support engineers at two levels. At one level, individual engineers need solutions to solve their specific design needs. A second level is to support teams of engineers working on larger projects. These engineers need to share information across the entire company and can do so effectively with a variety of solutions from Cadence. Cadence offers a full line of integrated EDA solutions for three basic design areas: IC design for digital, analog and mixed-signal devices; system design for both digital and analog systems; and ASIC design, particularly for high-performance sub-micron ASICs. These three areas include solutions for the electrical and physical design of all types of systems, subsystems, and ICs, including PCBs, MCMs, hybrids, ASICs, PLDs, FPGAs, and full custom and semi-custom ICs. The major advantages of Cadence products are in the areas of design methodologies and integration of electrical and physical design tools. Cadence's commitment to industry standard hardware platforms, operating systems and networking protocols allows users to configure an open design environment tailored to their specific needs. As design needs grow, the Cadence design environment can be expanded to include additional Cadence tools or third-party tools. Customizing environments can be handled through Cadence's Spectrum Services Group, responsible for working with customers to define and implement design environments optimized for customer project or product needs. PRODUCT STRATEGY AND PRODUCTS Cadence's goal is to provide technology that accelerates the creation of innovative electronic products, enabling designers to bring complex products to market quickly and reliably. To meet this goal consistently, Cadence has adopted the following core product strategies: o Focus development efforts on collapsing the most complex and time-consuming aspects of the design process o Provide full integration of leading-edge tools into a unified environment o Deliver solutions that combine software tools and advanced design methodologies to streamline the overall design process CORE PRODUCT TECHNOLOGY Cadence believes that within its integrated solutions approach, customers still demand high performance point tools for certain functions. By focusing technology development efforts to address the most complex and time-consuming aspects of the design process, Cadence has delivered a suite of individual design tools that has become well known in the industry. These tools, which address all major areas of the design process, include: o Allegro(TM) and Prance-XL(TM) for board and MCM layout, along with integrated layout analysis tools, DF/SigNoise(TM), DF/Thermax(TM), and DF/Viable(TM) o Analog Artist(TM) and Analog Workbench(TM) for analog IC and system design, respectively o Composer(TM) and Concept(TM) design entry environments o Design Framework II(TM) framework technology o Dracula(R) and Diva(TM) for verification o Gate Ensemble(TM), Cell Ensemble(TM) and Block Ensemble(TM) for place and route o Preview(TM) for ASIC and IC floorplanning o Profile(TM) analog behavioral language o Spectre(TM), Cadence Spice(TM) and SpicePlus(TM) for analog simulation o Synergy(TM) family for circuit synthesis and optimization o Verilog-XL(TM) and Leapfrog(TM) VHDL for top-down digital simulation o Virtuoso(TM) products for custom IC layout and library development OPEN ENVIRONMENT Cadence pioneered the ability to link and manage a variety of design tools under a consistent graphical user interface with the introduction of its Design Framework(TM) in 1985. In 1990 Cadence delivered Design Framework II, so that designers can work with multiple tools more efficiently. Through its communication and design management features, Design Framework II also improves project and data management, critical for today's large designs and design teams. Design Framework II gives users an easy-to-use EDA software system, which can easily be customized, combined with third party tools, and ported to new computer platforms as they become available. Cadence's software operates on industry standard workstations from Digital Equipment Corporation, Hewlett-Packard/Apollo, International Business Machines Corporation and Sun Microsystems, Inc. Cadence believes that it is well positioned to port its systems quickly to other UNIX-based workstations that may gain broad customer acceptance in the future. The CAD Framework Initiative (CFI), a standards committee comprised of EDA vendors and customers, has developed a reference architecture as an initial step towards a universal framework definition. As a founding member, Cadence works closely with CFI to develop this standard, and is advancing Design Framework II to adhere to CFI's evolving guidelines. INTEGRATED DESIGN SOLUTIONS Cadence offers a full line of EDA software combined with framework technology and advanced design methodologies to provide complete EDA solutions that enhance productivity. IC DESIGN Cadence's products have been used in every major electronic product design ranging from microprocessors that are at the heart of personal computers and workstations, to mixed signal chips that are driving the telecommunications and networking industries. Cadence's IC solutions feature proven tools for custom library development and editing, automated custom design, advanced digital and analog simulation, and IC physical verification. Building on this full-line of IC tools, Cadence offers complete, front-to-back solutions for designing digital, analog, mixed-signal and microwave ICs. These solutions streamline the design of complex chips and help design teams get to market with innovative, high quality products. For each step in the IC design process Cadence provides a complete design environment to meet individual design tasks. Cadence's solution includes the Virtuoso(TM) product family of custom layout tools supporting polygon layout, symbolic layout and layout synthesis; the Ensemble(TM) product family providing automatic place and route for both ASIC and custom cell-based design styles; Chip Assembly Solution for multi-layered block placement and routing; the Diva(TM) product family of interactive verification tools; and the DRACULA product family of physical verification tools. For analog designers, Cadence offers complete front-to-back solutions for analog, mixed-signal and microwave circuits. The Analog Artist for IC design provides advanced simulation, layout and verification, featuring products like the Profile(TM) behavioral modeling and simulation software and the Spectre(TM) high-speed circuit simulator. This solution supports design teams with productive tools for fast, early evaluation of design alternatives on complex analog designs, allowing teams to manage the critical interdependencies between electrical design and physical layout. Cadence's front-to-back IC solution includes a unique timing-driven design methodology to minimize costly downstream iterations. All tools, from synthesis and simulation to floorplanning and place and route, share critical timing information to maintain consistency and ensure that key performance requirements are met. SYSTEM DESIGN Cadence provides complete front-to-back digital and analog system design solutions built around the Concept design entry system; the Verilog-XL and Leapfrog VHDL simulators; and the Allegro PCB/MCM physical design system. Allegro, one of the industry's most comprehensive and production-proven systems design environments includes: the DF/Viable(TM) reliability analyzer, the DF/SigNoise(TM) and signal integrity analysis modules, the DF/Thermax(R) thermal analysis software, and the Prance- XL(TM) routers. For analog board and system design, Cadence provides the Analog Workbench, for top-down, front-to-back analog design. The Analog Workbench provides simulation tools, integrated physical layout, extensive analog model libraries and advanced analysis tools for tasks such as thermal analysis and post-layout simulation with extracted temperatures. Cadence's system design tools, combined with design methodologies such as rules-driven design and correct-by-design, allow engineers to shorten design cycles and improve the product quality of high-speed PCBs, MCMs, hybrids and multiwire boards. With Cadence's solutions, important design or technology considerations are defined in advance and are automatically checked and enforced throughout the design process to shorten design cycles and optimize designs for performance, quality and cost. For additional accuracy, flexibility and overall process control, Cadence's unique "synchronized" library approach and in-process analysis tools cover electrical, thermal, reliability, testability, manufacturing and design management constraints. ASIC DESIGN Cadence helped pioneer the use of top-down design by ASIC designers with its Verilog-XL simulator and Verilog(R) HDL design language. Building on what is now the most broadly used top-down method in the industry, Cadence offers a complete and production- proven top-down design system. Included is a flexible environment with Composer(TM) mixed-level design entry using either Verilog HDL or VHDL; large-capacity, high- performance logic synthesis and optimization with the Synergy and Optimizer(TM) synthesis software; fully integrated mixed-level logic simulation with Verilog-XL(TM) and Leapfrog(TM) VHDL verification tools; and the Preview(TM) floorplanner that enable the sharing of consistent timing data from design entry through place and route. Completing the ASIC design process is Cadence's Gate Ensemble place and route system. A new series of design-for-test tools, offering advanced test synthesis and test pattern generation capabilities, helps to shorten ASIC design cycles and improve yields. In addition, Cadence's extensive list of over 185 ASIC libraries and endorsements from major ASIC vendors help ensure a production path for the most complex, leading-edge ASIC designs. MARKETING AND CUSTOMERS CUSTOMERS AND MARKETING STRATEGY Cadence's customers and target markets include computer manufacturers, consumer electronics companies, defense electronics companies, merchant semiconductor manufacturers, ASIC foundries and telecommunications companies. In addition, Cadence licenses its products to international distributors in certain countries (see "International Sales" below in this "Business" section). In 1993, 1992 and 1991 one customer, Cadence's distributor in Japan, Innotech Corporation ("Innotech"), accounted for 13%, 14% and 13% of total revenue, respectively. Cadence's principal marketing objectives are: o Offer high quality, complete and integrated design solutions o Provide best-in-class technologies in critical design areas o Deliver a standards-driven, open design environment o Utilize Cadence's worldwide resources to solve customers' complex design challenges and serve global customers CUSTOMER SUPPORT Cadence's support group helps tailor new tools to a customer's existing design environment, train designers on how to best utilize their EDA software and provide ongoing software updates to enhance product capabilities. The backbone of the global customer support process is the customer response center program. These centers give Cadence customers worldwide access to solution and product experts. A dedicated team of application engineers is available to address customer applications issues as well as provide links between customers and Cadence's product developers. CADENCE SPECTRUM SERVICES Customizing design automation systems can require a major time and resource investment from the customer. Spectrum Services provides a structured consultative approach to analyzing the design process. After an extensive review of a customer's business and technical objectives and design processes, a comprehensive plan is developed for an advanced custom design environment. By integrating Cadence's solutions with the customer's software tools and third-party and custom-designed tools and augmenting the software with expert advice on streamlining the design process, customers benefit from a custom optimized design environment. CUSTOMER PARTNERSHIPS Cadence has established close working relationships with a number of semiconductor manufacturers and electronic systems companies based on a business partnership model that has become a central business model for the Company. To ensure that research and development activities are properly prioritized, and also that finished products meet customers' needs, major new product developments begin after collaboration with a Cadence customer/partner. There are presently several variations of Cadence partnerships: four groups of technology partnerships (involving Cadence's IC, HDL, Systems Design and Systems Physical Design Groups, respectively) and a fifth group that focuses on development of specific products ("Product Development Partnerships"). These technology partnerships allow Cadence to work with customers' designers in defining and developing state-of-the-art solutions for current and emerging design approaches. Through an engineer exchange program, customers will often work on-site at Cadence facilities, giving Cadence valuable insight into customer product planning. Product Development Partnerships are generally directed at the development and refinement of specific tools. INDUSTRY ALLIANCES Cadence cooperates with other design automation vendors to deliver full-scope technology to its customers. Through Cadence's Connections(TM) Program, participating companies can integrate their products and technologies more easily into Cadence's design framework. This provides customers with the flexibility to mix and match third-party and proprietary tools to specifically meet their design automation needs. Today over 70 companies have integrated their tools into Cadence's design framework. UNIVERSITY SOFTWARE PROGRAM Cadence supports EDA research by sharing its design automation technology and expertise with universities. More than 500 universities worldwide participate, including the University of California at Berkeley, Duke University, the Massachusetts Institute of Technology and Stanford University. SALES As of December 31, 1993, Cadence had 796 employees engaged in field sales and sales support, representing approximately 32% of its total employees. Cadence's sales people present Cadence and its products for licensing to prospective customers, while applications engineers provide technical pre-sales as well as post-sales support. Due to the complexity of EDA products, the selling cycle is generally long, with three to six months being typical. Activities during this sales cycle typically consist of a technical presentation, a product demonstration, a design benchmark and often, an on-site customer evaluation of Cadence software. NORTH AMERICAN SALES In the domestic market Cadence uses a direct sales force, utilizing both sales people and applications engineers in each territory to license its products. As of December 31, 1993, Cadence had 419 regional sales people and applications engineers licensing and supporting Cadence's products in the United States and Canada. Cadence maintains domestic sales and support offices at various locations across the United States. INTERNATIONAL SALES In Europe and Asia Cadence markets and supports its products primarily through 12 majority owned subsidiaries, which, as of December 31, 1993, employed 86 salespeople and 291 other sales and support personnel. Cadence licenses its products in Japan through three distributors: Innotech, Kanematsu Electronics and Sony Tektronics. Cadence's systems products are marketed in Japan through a wholly-owned subsidiary and, until 1992, through a distributor, CIC, Inc. In March 1992 Cadence reached an agreement to acquire CIC, Inc. and consolidated its systems product marketing in Japan utilizing its subsidiary in Japan, Cadence Design Systems K.K. ("Cadence K.K."). Cadence also serves its international customers through a manufacturer's representative in Europe, European Silicon Structures B.V. ("ES2"). The Company also uses distributors in various countries. In Singapore, Hong Kong, Brazil, Australia, India and The People's Republic of China, Cadence uses CAD/CAM Systems, Modern Devices Ltd., Quick Chip Eng. E. Projectos Ltd., Cadence Design Systems Pty Ltd., Wipro Information Technology and IMAG Industries, Inc. and ReMA Ltd., respectively, as its distributors. Revenue from international sources was $183.6 million, $215.4 million and $197.6 million or approximately 50%, 51% and 52% of total revenue for the years ended December 31, 1993, 1992 and 1991, respectively. Prices for international customers are quoted from an international price list. The list is maintained in U.S. dollars but reflects the higher cost of doing business outside the United States. International customers are invoiced in U.S. dollars using current exchange rates or the local currency. In light of the large portion of Cadence's revenue derived from international sales, if the dollar strengthens in relation to the Japanese yen or certain European currencies, Cadence's revenue from international sales may be adversely affected. Cadence enters into forward exchange contracts to reduce the impact of foreign currency fluctuations resulting from transaction gains and losses. Cadence is required to have United States Department of Commerce export licenses for shipment of its products outside the United States. Although to date Cadence has not encountered any material difficulty in obtaining these licenses, any difficulty in obtaining necessary export licenses in the future could have an adverse effect on revenue. Foreign subsidiaries' marketing and support expenses are incurred in local currency and license fees paid by the subsidiaries to Cadence are paid in local currency or U.S. dollars. Cadence is subject to the currency conversion risks inherent in international transactions. It is Cadence's policy to manage and minimize its foreign exchange risks. SERVICE AND SUPPORT STANDARD SERVICE AND SUPPORT Cadence believes that customer support is a key factor in successfully marketing EDA products and generating repeat orders. A majority of Cadence's customers have purchased one-year renewable maintenance contracts. Product maintenance contracts entitle the customers to product updates, documentation and ongoing support. Cadence tracks all service reports using an on-line database that provides a mechanism for tracking progress in solving any reported problem from first report to final software solution. ENHANCED SERVICE AND SUPPORT Installing a new design automation system, tailoring it to a customer's design environment and training designers in the efficient use of this new system requires a major time and resource investment from the customer. In response to customer requests, Cadence has developed an enhanced consulting service capability. The Cadence consulting services team is a group of Cadence employees whose services can be retained by customers to provide a wide range of engineering activities from specialized training to custom programming projects or contract design. These services are intended to assist customers in becoming productive quickly through use of Cadence's products, thereby improving customer satisfaction and increasing the likelihood of follow-on sales. PRODUCT DEVELOPMENT AND ENGINEERING As of December 31, 1993, Cadence's product development was performed by 750 employees, 476 employees located at its research and development facilities in San Jose, Foster City, Santa Cruz and San Diego, California, 106 employees in Chelmsford, Massachusetts, 59 employees in India, 13 employees in Taiwan, 15 employees in Lawrence, Kansas, 2 employees in Ohio and 5 employees in Albany, New York. The development group includes experts in database structures and industry specific algorithm technology. In June 1990, the Company entered into a joint venture ("EuCAD") as majority owner with ES2. During 1992, the Company acquired the minority interest in the joint venture. EuCAD has 26 employees in the U.K. and 3 employees in France and specializes in research and development activities in the EDA and ASIC design markets. The Company also has 45 employees in Beaverton, Oregon at its IMS subsidiary. For the years ended December 31, 1993, 1992 and 1991 Cadence's research and development expenses were approximately $84.3 million, $81.2 million and $84.3 million (before capitalizing approximately $15.2 million, $14.7 million and $16.2 million of software development costs in 1993, 1992 and 1991), respectively. Cadence began capitalizing certain of its software development costs in 1986 in accordance with Statement of Financial Accounting Standards No. 86. See Note 3 of Notes to Consolidated Financial Statements at December 31, 1993 for a more complete description of Cadence's capitalization of certain software development costs. Certain faculty members from the University of California at Berkeley, considered to be a leading university for IC design software research, have served as consultants to Cadence since its inception. These consultants have helped Cadence to stay abreast of the latest developments and directions in the rapidly changing IC design software industry. COMPETITION Cadence competes with a number of companies in each of Cadence's tool categories, as well as with internal CAD development groups of potential customers. The EDA software industry is characterized by rapid technological change and is intensely competitive. In Cadence's opinion, the principal competitive factors in its markets include performance, ease of use, breadth of tool offering, open system architecture, software portability, pre-sales and post-sales support and price. PROPRIETARY RIGHTS Cadence relies principally upon a combination of copyright and trade secret laws and license agreements to protect Cadence's proprietary interest in its products. Cadence's products are generally licensed to end users pursuant to a license agreement that restricts the use of the products to the customer's internal purposes. Cadence protects the source code version of its products as a trade secret and as an unpublished copyrighted work. Cadence has made portions of its source code available to certain customers under very limited circumstances, subject to confidentiality, use and other restrictions. Despite these precautions, it may be possible for third parties to copy aspects of Cadence's products or to obtain and use information that Cadence regards as proprietary without authorization. In addition, effective copyright and trade secret protection for software products may be unavailable in certain foreign countries. Cadence believes that patent, trade secret and copyright protection are less significant to Cadence's success than factors such as the knowledge, ability and experience of Cadence's personnel, new product development, frequent product enhancements, name recognition and ongoing reliable product maintenance. Cadence does not believe that its products or processes infringe on existing proprietary rights of others. DRACULA(R), Verilog(R), Prance(R), Verifault-XL(R) and Thermax(R) are registered trademarks of Cadence and substantially all of the other Cadence product and product family names used herein are trademarks of Cadence. MANUFACTURING AND BACKLOG Cadence's software production operations consist of configuring the proper version of a product, recording it on magnetic tape or other recording media and producing user manuals and other documentation. Shipments are generally made within two weeks of receiving an order. In light of the short time between order and shipment of Cadence's products, Cadence generally has relatively little backlog at any given date. Cadence's product line includes a series of design verification systems offered by IMS. Logic Master is a family of design verification systems designed to work with most computer systems, workstations, or terminals to receive and execute test commands and report the results of test procedures. These systems are designed to match varying customer requirements. Generally, they differ from one another as to speed, size of the device to be verified, flexibility in the number and variety of applications in which a system can be used and price. EMPLOYEES As of December 31, 1993, Cadence employed 2,476 persons, including 1,449 in sales, marketing, support and manufacturing activities, 750 in product development and 277 in management, administration and finance. Of these employees, 1,949 were located in the United States and 527 were located in 15 other countries. None of Cadence's employees are represented by a labor union and Cadence has experienced no work stoppages. Cadence believes that its employee relations are good. Competition in recruiting of personnel in the software industry is intense. Cadence believes that its future success will depend in part on its continued ability to recruit and retain highly skilled management, marketing and technical personnel. ITEM 2. ITEM 2. PROPERTIES Cadence leases approximately 692,000 square feet of facilities comprised of four buildings located at 535-575 River Oaks Parkway (the "555 Facility"), three buildings at Seely Road and three buildings at Plumeria Drive in San Jose, California for an annual rental of approximately $10,600,000. Cadence also leases approximately 100,000 square feet of facilities in Chelmsford, Massachusetts at an annual rate of approximately $450,000. Cadence leases additional facilities for its sales offices in the United States and various foreign countries, and research and development facilities in San Diego, Foster City and Santa Cruz, California, Lawrence, Kansas, Albany, New York, United Kingdom, France, Taiwan and India at an aggregate annual rental of approximately $7,000,000. Cadence leases design center facilities in Blue Bell, Pennsylvania and Torrance, California, of approximately 11,700 and 13,700 square feet, respectively, at a combined annual rate of approximately $500,000. Cadence has contracted for the early termination of the Torrance facility lease and expects this transaction will close by April 1994 for approximately $600,000. In connection with its sales of ASI, Cadence has entered into a sublease agreement with ASI for the rental of the Blue Bell facility. Cadence also leases approximately 75,000 square feet in a building in Beaverton, Oregon, at a current annual rental of approximately $540,000, which houses manufacturing, engineering, marketing and administrative operations for its IMS subsidiary. During June 1989 Cadence acquired a 49% interest as a limited partner in a real estate partnership. Also in 1989, the Company signed agreements to lease the four buildings of the 555 Facility from the limited partnership that is the owner of the 555 Facility for a period of ten years. During June 1991 the Company acquired a 46.5% interest as a limited partner in an additional real estate partnership, and signed agreements to lease upon completion of construction three buildings proximate to the 555 Facility in San Jose, California from the limited partnership for a period of fifteen years, which commenced during the second quarter of 1992. During June 1991 the Company acquired an 80% interest in a third real estate partnership which has purchased land for future expansion. This third partnership is consolidated in the accompanying financial statements. In March 1994 the Company acquired all third-party interests in two real estate partnerships in which it is a 46.5% and 80% limited partner, respectively, for approximately $9 million in cash and the assumption of a secured construction loan of approximately $23.5 million. The Company expects it will refinance the construction loan with permanent financing when it comes due in June 1994, although it may elect to pay off the construction loan with its cash reserves. Cadence believes that these facilities are adequate for its current needs and that suitable additional or substitute space will be available as needed to accommodate expansion of Cadence's operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Stockholder class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the Northern District of California, San Jose Division, on April 8 and 9, 1991. The suits were subsequently consolidated into a single lawsuit and the class period changed to include purchasers of the Company's common stock during the period from October 18, 1990 through April 3, 1991. The lawsuit alleges violation of certain federal securities laws by maintaining artificially high market prices for the Company's common stock through alleged misrepresentations and nondisclosures regarding the Company's financial condition. The plaintiff in the suit seeks compensatory damages unspecified in amount. On June 2, 1993 the District Court granted in part and denied in part the Company's motion to dismiss the complaint in the class action originally filed in April 1991. The effect of the ruling was to limit the class period to include purchasers of the Company's common stock between January 29, 1991 and April 3, 1991. Trial of this matter is scheduled to commence on August 8, 1994. The Company is vigorously defending against the litigation. On March 23, 1993 a separate class action lawsuit was filed against the Company and certain of its directors and officers in the United States District Court, Northern District of California, San Jose Division. Two additional complaints, identical to the complaint filed on March 23, 1993 except for the identities of the plaintiffs, were filed later in March and in April 1993. All three complaints were consolidated into a single lawsuit which seeks unspecified damages on behalf of all purchasers of the Company's common stock between October 12, 1992 and March 19, 1993. The lawsuit alleges violation of certain federal securities laws by maintaining artificially high market prices for the Company's common stock through alleged misrepresentations and nondisclosures regarding the Company's financial condition. On November 18, 1993, the District Court granted the Company's motion to dismiss the 1993 complaint. The effect of the ruling was to dismiss the complaint except as to a statement allegedly made on January 28, 1993, but plaintiffs were granted leave to further amend their complaint. The Company is vigorously defending against the litigation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS NONE EXECUTIVE OFFICERS OF THE REGISTRANT The executive corporate officers of Cadence are as follows: Executive corporate officers are appointed by the Board of Directors and serve at the discretion of the Board. JOSEPH B. COSTELLO was appointed as President and a director of Cadence in May 1988 and as Chief Executive Officer in June 1988 . He is also a director of Oracle Corporation, Microelectronics and Computer Technology Corporation and Pano Corporation Display Systems. DR. LEONARD Y.W. LIU was appointed to serve on the Board in June 1989. Dr. Liu was appointed as Chief Operating Officer of the Company in February 1993. From April 1989 until March 1992, Dr. Liu was Chairman and Chief Executive Officer of Acer America Corporation and President of Acer, Inc., two personal computer suppliers. From 1969 until 1989, Dr. Liu held various technical and general management positions at IBM Corporation, most recently Manager of its Santa Teresa Laboratory. Dr. Liu is a director of Pano Corporation Display Systems, Network Application Technology, Omni Science Corporation and CIMIC Corporation. W. DOUGLAS HAJJAR was Chief Executive Officer and a director of Valid from May 1987 and Chairman of the Board of Valid from February 1988 until Valid's merger with and into Cadence in December 1991, at which time he was appointed as Vice Chairman and a director of Cadence. He also served as President of Valid from February 1987 to September 1989 and as Chief Financial Officer from May 1987 until August 1989. Mr. Hajjar was Chairman of the Board, President and Chief Executive Officer of Telesis, a manufacturer of EDA workstations and related software, from 1985 until the acquisition of Telesis by Valid in 1987. Mr. Hajjar is a director of Control Data Corporation, Frame Technology and Lasersight, Inc. H. RAYMOND BINGHAM joined Cadence in June 1993 as Executive Vice President and Chief Financial Officer. From June 1985 to May 1993 he served as Executive Vice President and Chief Financial Officer of Red Lion Hotels and Inns, which owns and operates a chain of 54 hotels. From 1981 to 1985 Mr. Bingham was the Managing Director of Agrico Overseas Investment Company, a subsidiary of the Williams Companies and was responsibile for developing and managing international manufacturing joint ventures. M. ROBERT LEACH joined Cadence in June 1993 as Senior Vice President of Consulting. From September 1981 to June 1993 Mr. Leach served as a partner in the worldwide electronics industry consulting practice for Andersen Consulting. SCOTT W. SHERWOOD joined Cadence in July 1990 as Vice President Human Resources and was appointed Senior Vice President, Human Resources in February 1992. From 1983 to 1990, he was Vice President Human Resources of Mead Data Central, a division of Mead Corporation and provider of information services to the legal community. JAMES E. SOLOMON, a founder of SDA, served as its Chief Executive Officer from its inception in July 1983 to May 1988 and as its President from July 1983 to March 1987, at which time he was appointed Chairman of the Board. He became a director of Cadence in 1988 and was Co-Chairman of Cadence's Board of Directors from May 1988 until May 1989. He was appointed President of the Company's Analog Division in December 1988, Senior Vice President of the IC Design Group of Cadence in February 1993 and Vice President and Principal Technologist in February 1994. DOUGLAS J. MCCUTCHEON joined Cadence in January 1991 as its Director, Financial Planning and Analysis, and in July 1991 became its Vice President, Corporate Finance. From November 1989 to November 1990, Mr. McCutcheon was President of Toshiba America Medical Credit, Inc., the wholly-owned captive financing subsidiary of Toshiba America Medical Systems, Inc., which sells and provides maintenance services for diagnostic and therapeutic medical systems. From November 1980 to November 1989, Mr. McCutcheon held various positions with Diasonics, Inc., a medical equipment company, most recently as Vice President and Treasurer. WILLIAM PORTER joined Cadence in February 1994 as Vice President, Corporate Controller and Assistant Secretary. From September 1988 to February 1994 Mr. Porter served as Technical Accounting and Reporting Manager and most recently as Controller of Cupertino Operations with Apple Computer Corporation, a worldwide manufacturer of computer equipment. From 1976 until 1988 Mr. Porter held various positions with Arthur Andersen & Co., most recently as a Senior Audit Manager. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock was traded on the NASDAQ National Market System under the NASDAQ symbol ECAD from the Company's initial public offering at $7.83 per share on June 10, 1987 until June 1, 1988 when it began trading under the NASDAQ symbol CDNC. Since September 17, 1990 the Company's Common Stock has traded on the New York Stock Exchange under the symbol CDN. The Company has not paid cash dividends in the past and none are planned to be paid in the future. As of December 31, 1993, the Company had approximately 2,400 stockholders of record. The following table sets forth the high and low bid prices for the Common Stock for each calendar quarter in the two year period ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA For the years ended December 31, (In thousands, except per share amounts) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Cadence (the "Company") designs, develops, markets and supports electronic design automation ("EDA") software products primarily used to automate, enhance and accelerate the design, verification and testing of integrated circuits, electronic systems and printed circuit boards ("PCBs"). In December 1991 the Company merged with Valid Logic Systems Incorporated ("Valid"). Valid commenced operations in 1981 and was involved in the development, marketing and support of EDA products primarily used to design electronic systems and PCBs. The merger was accounted for by the pooling of interests method and all financial information prior to the merger has been restated to combine the results of the Company and Valid. In connection with the merger, the Company recorded $49.9 million of restructuring costs and $1.7 million of merger costs in the fourth quarter of 1991. In June 1993 the Company acquired the business and certain assets of Comdisco Systems, Inc. ("Comdisco"), a subsidiary of Comdisco, Inc. Comdisco develops, markets and supports digital signal processing software products in the electronic systems applications area. The acquisition was accounted for as a purchase. Accordingly, the results of Comdisco from the date of the acquisition forward have been recorded in the Company's consolidated financial statements. In December 1993 the Company sold its Automated Systems ("ASI") division. ASI manufactures and provides design services for complex printed circuit boards. The operating results of ASI have been reported as discontinued operations in the consolidated statements of income for all years presented. Results of Operations The following table sets forth for the years indicated (a) the percentage of total revenue represented by each item reflected in the Company's consolidated statements of income and (b) the percentage increase (decrease) in each such item from the prior year. * Not meaningful (1) The Company capitalizes software development costs in accordance with SFAS No. 86. Total research and development expenses incurred prior to capitalization represented 23%, 19% and 22% of total revenue for 1993, 1992 and 1991, respectively. The percentage change from 1992 to 1993 and from 1991 to 1992 was an increase of 4% and a decrease of 4%, respectively, on a pre-capitalization basis. Revenue Total revenue was approximately $368.6 million, $418.7 million and $379.5 million for the years ended December 31, 1993, 1992 and 1991, respectively. Total revenue decreased approximately $50.1 million for the year ended December 31, 1993 as compared to the prior year and increased approximately $39.2 million in 1992 as compared to 1991. The decrease in total revenue in 1993 was primarily due to a $74.0 million decrease in product revenue due to weak economic conditions in certain areas and lower sales volume for the Company's products, as well as a shift in the Company's systems product strategy. This decrease in product revenue was offset somewhat by the acquisition of Comdisco. While product revenue decreased in 1993, maintenance revenue increased by $23.9 million due to increased focus on customer renewals, combined with a larger customer base. The growth in total revenue in 1992 compared to 1991 was comprised of $22.9 million in product revenue due to increased demand for the Company's products, including the new Valid products as a result of the merger, and improved economic conditions in 1992 as compared to 1991, and a $16.3 million increase in maintenance revenue. Maintenance revenue continued to increase each year as the Company's installed base of products has increased, growing by approximately $23.9 million in 1993 compared to 1992 and by approximately $16.3 million in 1992 compared to 1991. As a percentage of total revenue, maintenance revenue has grown over the last three years from approximately 23% to approximately 35% of total revenue. The increase in maintenance revenue as a percentage of total revenue is due in part to the Company's continued effort toward obtaining customer renewals of maintenance coverage as well as the decrease in total product revenue in 1993. Revenue from international sources was approximately $183.6 million, $215.4 million and $197.6 million or 50%, 51% and 52% of total revenue for each of the three years ended December 31, 1993, 1992 and 1991, respectively. The decrease in 1993 was principally related to decreased sales volume in Japan. It is anticipated that international revenue will continue to constitute a significant portion of total revenue. International revenues are subject to certain additional risks normally associated with international operations, including, among others, adoption and expansion of government trade restrictions, currency conversion risks, limitations on repatriation of earnings and reduced protection of intellectual property rights. Due to the continuing adverse business conditions in Japan, the Company has experienced and can expect to experience a reduced level of activity from this important market. A continued low level or further reduction of orders from Japan could have a material adverse impact on the Company's results of operations. Cost of Revenue Total cost of revenue was approximately $89.4 million, $94.0 million and $87.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Total cost of revenue decreased $4.6 million in 1993 compared to 1992 and increased $6.4 million in 1992 compared to 1991. The decrease in 1993 consisted of a $2.5 million decrease in product cost of revenue due to the decrease in product revenue and related costs, reduced costs due to restructure actions including related headcount reductions as well as the discontinuance in 1992 of sales of third- party hardware. This decrease was slightly offset by an increase in cost of product associated with the newly acquired Comdisco operations and a $4.0 million increase in amortization of software development costs, purchased software and other intangibles. Cost of maintenance also decreased $2.1 million in 1993 as compared to 1992 even though revenue increased due to the streamlining of the maintenance renewal process which includes a more cost-effective update program and lower cost media. The increase in total cost of revenue in 1992 as compared to 1991 consisted of an $11.7 million increase in cost of product, which was offset by a $5.4 million decrease in cost of maintenance. The increase in cost of product was primarily due to an increase in royalties of approximately $2.4 million and other related software product costs. The increase in software costs in 1992 was primarily a result of the expansion-related increase in personnel and capital expenditures in the Company's operations departments, which include software tape duplication, technical documentation and support, training and consulting services. The decrease in cost of maintenance in 1992 was primarily due to post-merger restructure and efficiencies, including the reduction of personnel and other duplicate costs in 1992 due to the merger of the Company with Valid, streamlining of the maintenance renewal process and a decrease in hardware maintenance contracts and costs related to Valid. As a percentage of total revenue, cost of maintenance revenue has remained in the range of approximately 4% to 6% and cost of product revenue has been at approximately 17% to 20%. Gross Margin Gross margin was 76%, 78% and 77% for the years ended December 31, 1993, 1992 and 1991, respectively. Marketing and Sales Marketing and sales expenses increased $1.2 million in 1993 compared to 1992 and $11.8 million in 1992 compared to 1991. The increase in 1993 is primarily due to increased costs associated with the acquired Comdisco operations. This increase was partially offset by reduced costs related to restructure actions, including headcount reduction. The increase in 1992 was due to the establishment and continued growth of foreign subsidiaries and domestic field offices, and increased personnel and related expenses. As a result of the merger with Valid, there were a number of duplicate sales locations which were consolidated during 1992. Notwithstanding this, during 1992 the Company continued to focus on expanding its selling efforts. The costs associated with the consolidation of sales offices were included in the restructuring costs recorded in 1991. Marketing and sales expenses have increased as a percentage of revenue from 39% in 1991 to 43% in 1993. The higher percentage in 1993 is due primarily to the decrease in total revenue in 1993. Research and Development Total research and development expenditures incurred prior to capitalization of software development costs increased 4% in 1993 as compared to 1992 and decreased 4% in 1992 as compared to 1991, an increase of approximately $3.1 million and a decrease of approximately $3.2 million, respectively. The increase in 1993 is primarily due to increased expenses due to the addition of Comdisco's operations. The decrease in total research and development expenditures in 1992 compared to 1991 is due primarily to post-merger restructure and efficiencies, including the reduction of personnel and other duplicate costs in 1992 related to the merger with Valid. Prior to the deduction for capitalization of software development costs, research and development expenses comprised approximately 23%, 19% and 22% of total revenue or approximately $84.3 million, $81.2 million and $84.3 million for the years 1993, 1992 and 1991, respectively. The increase as a percentage of revenue in 1993 is primarily due to the decrease in total revenue in 1993 as compared to 1992. The decrease as a percentage of revenue in 1992 as compared to 1991 is due primarily to the elimination of duplicate costs in 1992 as a result of the merger with Valid. The Company capitalized approximately $15.2 million, $14.7 million and $16.2 million of software development costs in the years 1993, 1992 and 1991, respectively, which represented approximately 18%, 18% and 19% of total research and development expenditures made in those years. The amount of capitalized software development costs in any given period may vary depending on the exact nature of the development performed. General and Administrative General and administrative expenses increased approximately $4.9 million in 1993 compared to 1992 and decreased approximately $2.2 million in 1992 compared to 1991. The increase in 1993 is due to the addition of Comdisco's operations, increased bad debt expense due to the write-off of uncollectible accounts, increased professional services and employee-related expenses. The decrease in 1992 was due primarily to the result of post-merger efficiencies, including the reduction of personnel and related expenses and duplicate facilities in 1992 as a result of the merger with Valid. As a percentage of total revenue, general and administrative expenses have been in the range of approximately 8% to 10%. The higher percentage in 1993 is partially due to the decrease in total revenue in 1993. Restructuring Costs In March 1993 the Company recorded restructuring costs of $13.5 million associated with a planned restructure of certain areas of sales, operations and administration due to business conditions. The restructuring charge primarily reflects costs associated with excess facilities, the write-off of software development costs and purchased software and intangibles and employee terminations resulting from lower revenue levels. In the fourth quarter of 1991 the Company recorded restructuring costs of approximately $49.9 million associated with the merger of Valid with the Company. This amount included accruals for severance and payroll-related payments, costs of closing excess or duplicate facilities and write-offs of equipment, other assets and capitalized software development costs due to the overlap of products. Other Income and Expense Interest income was $3.2 million, $3.6 million and $6.2 million for the years ended December 31, 1993, 1992 and 1991, respectively. The decrease in interest income in 1993 and 1992 was primarily due to a decrease in interest rates which in 1992 was combined with a $20.7 million decrease in cash and cash investments and short-term investments. Interest expense was $.7 million, $.9 million and $2.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. The decrease in 1993 as compared to 1992 is due to a decrease in capital lease borrowings and other debt obligations. The decrease of $1.8 million in 1992 as compared to 1991 was due to the repayment of $18.5 million in notes payable to banks in 1991. In addition, the Company incurred approximately $1.7 million of merger costs in the fourth quarter of 1991 related to the merger of the Company and Valid. Provision for Income Taxes Through December 31, 1992, the Company accounted for income taxes pursuant to Statement of Financial Accounting Standards ("SFAS") No. 96. Effective January 1, 1993, the Company retroactively adopted SFAS No. 109, "Accounting for Income Taxes." This pronouncement requires, among other things, recognition of future tax benefits, measured by enacted tax rates, attributable to (a) deductible temporary differences between the financial statement and income tax basis of assets and (b) liabilities and tax net operating loss carryforwards, to the extent that realization of such benefits is more likely than not. The adoption of this accounting pronouncement did not have a material impact on amounts reported in prior years' financial statements. As of December 31, 1993 the Company had gross deferred tax assets of approximately $67.0 million against which the Company has recorded a valuation allowance of $54.6 million, resulting in a net deferred tax asset of $12.4 million. A significant portion of the net operating loss and credit carryforwards which created the deferred tax asset were generated by Valid prior to its merger with the Company and by restructure charges recorded as a result of the merger. Management has determined, based on the Company's history of prior operating earnings and its expectations for future years, that the recorded net deferred tax asset is realizable. However, no assurances can be given that sufficient taxable income will be generated in future years for the utilization of the net deferred tax asset. The Company's tax provision for 1993 was zero as a result of the operating loss in 1993 and the recording of the benefit of certain foreign withholding and income taxes. In 1992 the Company's effective tax rate was 19%. This rate reflects the utilization of foreign tax credits, Valid's net operating losses and temporary items generated in prior years but benefited currently. The Company provided for income taxes in 1991 even though the Company reflected a pretax loss. This provision was primarily attributable to restructuring costs and foreign tax credits that the Company was not fully able to benefit for financial statement purposes. Net Income (Loss) From Continuing Operations The net loss from continuing operations for 1993 was $.6 million as compared with net income of $55.1 million in 1992 and net loss of $17.1 million in 1991. The net loss from continuing operations in 1993 was due to a decrease in product revenue and $13.5 million recorded for restructuring costs. The net income in 1992 compared to the net loss in 1991 was partially due to increased revenue in 1992. Net income from continuing operations was also favorably impacted by the post-merger restructure and efficiencies, including the reduction of personnel and other duplicate costs in 1992 related to the merger with Valid. The fourth quarter of 1991 also included $49.9 million of restructuring costs and $1.7 million of merger costs associated with the merger of the Company and Valid. Discontinued Operations As previously discussed, the Company sold its ASI division in December 1993 and restated the financial information of prior periods to report discontinued operations of ASI as a separate line item in the consolidated statements of income. The discontinued operations resulted in a loss of $12.2 million, income of $.3 million and a loss of $5.3 million for the years ended December 31, 1993, 1992 and 1991, respectively. The loss for 1993 includes $6.0 million recorded as a loss on disposal, which represents the loss on the sale of the net assets as well as amounts accrued for estimated costs to be incurred in connection with the disposal. In addition, the 1993 loss includes $6.2 million for ASI's operating loss. Quarterly Results of Operations The following table sets forth selected unaudited quarterly financial information for the Company's last eight quarters. This unaudited information has been prepared on the same basis as the audited information and in management's opinion reflects all adjustments (which include only normal recurring adjustments) necessary for the fair presentation of the information for the periods presented. Based on the Company's operating history and factors that may cause fluctuations in the quarterly results, quarter-to-quarter comparisons should not be relied upon as indicators of future performance. Although the Company's revenues are not generally seasonal in nature, the Company from time to time has experienced decreases in first quarter revenue versus the preceding fourth quarter which is believed to result primarily from the capital purchase cycle of the Company's customers. The Company's operating expenses are partially based on its expectations of future revenue. The Company's results of operations may be adversely affected if revenue does not materialize in a period as expected. Since expense levels are usually committed in advance of revenues and because only a small portion of expenses vary with revenue, the Company's net income may be impacted significantly by lower revenue. In addition, the Company's results of operations for a particular quarter or quarters could be materially adversely affected by the ultimate resolution of the disputes and litigation matters discussed in Note 9 of Notes to Consolidated Financial Statements. The Company's revenue decreased in each quarter in 1993 as compared to the same quarter in the prior year. This decrease was due to weak economic conditions and reduced demand for the Company's products as well as a shift in the Company's system product strategy. In addition, the first quarter of 1993 included approximately $13.5 million of restructuring costs related to the Company's planned restructure. The amounts in the table above reflect the results of the Company restated to reflect the sale of ASI in the fourth quarter of 1993 and reclassification of its operations to discontinued operations. The following table represents quarterly information as previously reported for the Company. Inflation To date, the Company's operations have not been impacted significantly by inflation. Liquidity and Capital Resources The Company raised approximately $10.8 million, $13.8 million and $14.9 million through the sale of common stock pursuant to employee benefit plans in 1993, 1992 and 1991, respectively. The Company purchased $52.2 million of treasury stock and repurchased $10.8 million and $1.8 million of common stock for the years ended December 31, 1993, 1992 and 1991, respectively. In addition, the Company realized approximately $90.7 million, $40.4 million and $74.7 million in cash provided by operations in 1993, 1992 and 1991, respectively. The Company's principal investing activities consist of the purchase of property, plant and equipment and the capitalization of software development costs, which in total were $34.5 million, $45.7 million and $44.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. In addition, the other major component of investing activities is the change in short-term investments. Working capital at December 31, 1993 was $105.0 million compared with $153.3 million at December 31, 1992 and $119.0 million at December 31, 1991. The decrease in 1993 as compared to 1992 was primarily due to a decrease of $30.9 million in accounts receivable primarily due to lower revenue, a $12.8 million increase in deferred revenue and a $7.3 million increase in accrued liabilities related to restructuring accruals recorded in 1993. The increase in 1992 as compared with 1991 was primarily due to a $17.0 million increase in accounts receivable due to higher revenue, a $21.4 million decrease in accrued liabilities related to restructuring accruals recorded in 1991 associated with the Company's merger with Valid and an $11.9 million decrease in deferred revenue. These increases were offset by a decrease of $20.7 million in cash and cash investments and short-term investments. Long-term obligations decreased $1.7 million in 1993 as compared to 1992 due to a decrease in capital lease borrowings and increased $1.9 million in 1992 as compared to 1991 due to an increase in capital lease borrowings and other debt obligations. At December 31, 1993 the Company had available $15.0 million under equipment lease lines for future capital expenditures and $17.5 million under two bank lines, which had not been drawn upon at December 31, 1993 (see Notes 7 and 8 of Notes to Consolidated Financial Statements for further discussion). Anticipated cash requirements in 1994 are payments related to the purchase of treasury stock, contemplated additions of capital equipment and restructure costs accrued at December 31, 1993. Prior to 1993, the Company authorized the repurchase of up to 2.8 million shares of common stock in the open market over the next several years to satisfy its estimated requirements for shares to be issued under its employee stock option and stock purchase plans. In April 1993 the Company authorized the repurchase of an additional 4.0 million shares of common stock from time to time in the open market. In total, as of December 31, 1993, approximately 5.5 million shares had been repurchased. In addition, in February 1994 the Company authorized the repurchase of an additional 2.9 million shares. In March 1994 the Company acquired all third-party interests in two real estate partnerships in which it is a 46.5% and 80% limited partner for approximately $9 million in cash and the assumption of a secured construction loan of approximately $23.5 million. The Company leases buildings from one of the limited partnerships and the second limited partnership owns unencumbered land adjacent to the leased property (see Note 3 of Notes to Consolidated Financial Statements). The Company expects it will refinance the construction loan with permanent financing when it comes due in June 1994, although it may elect to pay off the construction loan with its cash reserves. The Company anticipates that current cash balances, cash flow from operations and unused balances on capital lease lines and lines of credit will be sufficient to meet its working capital and capital expenditure requirements for at least the next year. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The quarterly supplementary data is included as part of Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." The financial statements required by this item are submitted as a separate section of this Form 10-K. See Item 14. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not required pursuant to Instruction 1 to Item 304 of Regulation S-K. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 as to directors is incorporated by reference from the section entitled "Election of Directors" in the Company's Proxy Statement for its annual stockholders' meeting to be held May 17, 1994. The information required by this Item as to executive officers is included in Part I under "Executive Officers of the Registrant." Pursuant to Item 405 of Regulation S-K, the Company has reviewed all Forms 3, 4 and 5 required to be filed with respect to 1993 and has determined that there are no delinquencies in filing reports required by Section 16(a) of the Exchange Act for 1993 or prior years at the time of the filing of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated by reference from the Company's Proxy Statement for its annual stockholders' meeting to be held May 17, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated by reference from the Company's Proxy Statement for its annual stockholders' meeting to be held May 17, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated by reference from the Company's Proxy Statement for its annual stockholders' meeting to be held May 17, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K _ PAGE (a)1. Financial Statements (a)2. Financial Statement Schedules All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto. (a)3. Exhibits The following exhibits are filed herewith: EXHIBIT NUMBER EXHIBIT TITLE EXHIBIT NUMBER EXHIBIT TITLE EXHIBIT NUMBER EXHIBIT TITLE REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Cadence Design Systems, Inc.: We have audited the accompanying consolidated balance sheets of Cadence Design Systems, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements 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 did not audit the financial statements of Valid Logic Systems Incorporated, a company acquired during 1991 in a transaction accounted for as a pooling of interests, as discussed in Note 1. Such statements are included in the consolidated financial statements of Cadence Design Systems, Inc. and reflect total revenues of 40 percent of the consolidated total for the year ended December 31, 1991. These statements were audited by other auditors whose report has been furnished to us and our opinion, insofar as it relates to amounts included for Valid Logic Systems Incorporated, is based solely upon the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the financial position of Cadence Design Systems, 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. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14. (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 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. San Jose, California Arthur Andersen & Co. January 26, 1994 INDEPENDENT AUDITORS' REPORT Cadence Design Systems, Inc. San Jose, California We have audited the consolidated statements of operations, stockholders' equity, and cash flows of Valid Logic Systems Incorporated (a wholly- owned subsidiary of Cadence Design Systems, Inc.) and subsidiaries for the year ended December 31, 1991. These financial statements (which are not presented separately herein) 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 results of operations and cash flows of Valid Logic Systems Incorporated and subsidiaries for the year ended December 31, 1991 in conformity with generally accepted accounting principles. /s/ Deloitte & Touche DELOITTE & TOUCHE San Jose, California January 27, 1992 CADENCE DESIGN SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ASSETS The accompanying notes are an integral part of these balance sheets. CADENCE DESIGN SYSTEMS, INC. CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The accompanying notes are an integral part of these financial statements CADENCE DESIGN SYSTEMS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of these financial statements. CADENCE DESIGN SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of these financial statements. CADENCE DESIGN SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ORGANIZATION OF THE COMPANY Cadence Design Systems, Inc. (the "Company") develops, markets and supports computer-aided design software products that automate, enhance and accelerate the design, verification and testing of integrated circuits and complex electronic circuits and systems. In December 1991 the Company acquired all of the outstanding common and preferred stock of Valid Logic Systems Incorporated ("Valid") in exchange for approximately 10,816,000 shares of the Company's common stock and 86,133 shares of the Company's preferred stock. Valid was involved in the design, development, marketing and support of electronic design automation software products primarily used to design electronic systems and printed circuit boards ("PCBs"). In connection with the merger, each share of Valid common and preferred stock was converted into .323 shares of the Company's common and preferred stock, respectively. The Company also issued approximately 199,000 shares of common stock in exchange for an outstanding warrant to purchase common stock of Valid. The Company also assumed Valid's outstanding stock options and all other outstanding warrants. Each such option and warrant to purchase one share of Valid common stock was converted into an option and warrant, respectively, to purchase .323 shares of the Company's common stock. The merger was accounted for as a pooling of interests and, accordingly, the financial statements for periods prior to the merger have been restated to include the results of Valid. In June 1993 the Company acquired the business and certain assets of Comdisco Systems, Inc. ("Comdisco"), a subsidiary of Comdisco, Inc. in exchange for 1,050,000 shares of the Company's common stock and a warrant to purchase 1,300,000 shares of the Company's common stock. The acquisition was accounted for as a purchase. Accordingly, the results of Comdisco from the date of acquisition forward have been recorded in the Company's consolidated financial statements. Comparative pro forma financial information has not been presented as the results of operations for Comdisco are not material to the Company's consolidated financial statements for 1993, 1992 and 1991. The acquisition costs of $10,903,000 include amounts paid for the net tangible assets of Comdisco and purchased software and other intangibles. 2. DISCONTINUED OPERATIONS In December 1993 the Company sold its Automated Systems ("ASI") division. ASI was sold for a nominal amount of cash and future royalties amounting to 5% of gross revenues of ASI for the period from January 1, 1994 through December 31, 2003, up to maximum royalties of $12,000,000. The royalties will be recorded in future periods as earned. The sale of ASI resulted in a loss on disposal of $6.0 million (the income tax effect of which was not material). This loss includes the loss on the sale of the net assets, as well as amounts accrued for estimated costs to be incurred in connection with the disposal. As of December 31, 1993, the Company has recorded $1.4 million in accrued liabilities and $2.0 million in other noncurrent liabilities for liabilities associated with the discontinued division. The operating results of the discontinued division have been reported as discontinued operations in the consolidated statements of income for all years presented. The prior year balance sheet has also been adjusted to reflect the net current assets of ASI as of December 31, 1992 of $4.8 million as a single line item in other current assets and to reflect the net noncurrent assets of $3.0 million as a single line item in other assets. There were no remaining assets related to ASI on the Company's balance sheet as of December 31, 1993. Revenue of the discontinued division was $11,165,000, $15,776,000 and $12,079,000 for the years ending December 31, 1993, 1992 and 1991, respectively. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries after elimination of intercompany accounts and transactions. The ownership interest of minority participants in subsidiaries that are not wholly owned was approximately $725,000 and $946,000 at December 31, 1993 and 1992, respectively, and is included in other noncurrent liabilities in the accompanying balance sheets. Minority interest income was approximately $134,000 and $196,000 and minority interest expense was $268,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and is included in other income and expense in the accompanying statements of income. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Depreciation and amortization are provided over the following estimated useful lives, by the straight-line method. CASH AND CASH INVESTMENTS For purposes of the statements of cash flows, the Company considers all commercial paper, medium-term notes, bankers' acceptances, certificates of deposit, municipal bonds, Euro certificates of deposit and money market accounts with an original maturity of ninety days or less to be cash and cash investments. SHORT-TERM INVESTMENTS Short-term investments are stated at cost, which approximates market value, and consist principally of Euro certificates of deposit, medium-term notes, money market accounts, commercial paper, bankers' acceptances and certificates of deposit with an original maturity of greater than ninety days that the Company intends to sell within one year. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out method) or market. Cost includes labor, material and manufacturing overhead. Inventories include testing equipment and accelerators. Inventories consisted of the following (in thousands): REAL ESTATE PARTNERSHIPS During 1989 and 1991 the Company acquired a 49% and 46.5% interest as a limited partner in two real estate partnerships and signed agreements to lease buildings from the limited partnerships. Both of the above commitments are included in future operating lease commitments in Note 7. The investment in these partnerships of approximately $5.2 million at December 31, 1993 and 1992 is included in other assets in the accompanying balance sheets. The Company accounts for these investments under the equity method of accounting. During June 1991 the Company acquired an 80% interest in a third real estate partnership which has purchased land for future expansion. This partnership is consolidated in the accompanying financial statements. REVENUE RECOGNITION Product revenue consists principally of revenue earned under software license agreements. Revenue earned under license agreements to end users is generally recognized when a customer purchase order has been received, the software has been shipped, the Company has a right to invoice the customer and there are no significant obligations remaining. Design services revenue and test equipment revenue are recognized upon delivery of the final design or shipment of the test equipment. Nonrefundable revenue earned under guaranteed revenue commitments from products relicensed through OEMs, system integrators and software value-added relicensors is recognized at the latter of the beginning of the commitment period or shipment of the initial product master. Additional revenue under these agreements is recognized at the time such amounts are reported to the Company. Maintenance revenue consists of fees for providing system updates, user documentation and technical support for software products. Maintenance revenue is recognized ratably over the term of the agreement. In 1993, 1992 and 1991 one customer (a distributor) accounted for 13%, 14% and 13% of total revenue, respectively. SOFTWARE DEVELOPMENT COSTS The Company capitalizes internally generated software development costs in compliance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Capitalization of software development costs begins upon the establishment of technological feasibility for the product. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future gross product revenue, estimated economic life and changes in software and hardware technology. Software development costs capitalized were $15,207,000, $14,741,000 and $16,188,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Amortization of capitalized software development costs begins when the products are available for general release to customers and is generally computed on a straight-line basis over the remaining estimated economic life of the product (three to five years). Amortization, which is included in cost of revenue in the accompanying statements of income, amounted to $13,065,000, $11,043,000 and $11,904,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company wrote off $1,495,000 of capitalized software in 1993 for projects discontinued during the year. In connection with the merger with Valid, the Company also wrote off $2,794,000 and $10,896,000 of capitalized software in 1992 and 1991, respectively, due to an overlap of products. PURCHASED SOFTWARE AND INTANGIBLES Purchased software and intangibles are stated at cost less accumulated amortization. Amortization is generally computed on a straight-line basis over the remaining estimated economic life of the underlying product (two to seven years). The cost and related accumulated amortization of purchased software and intangibles were as follows (in thousands): INCOME TAXES Through December 31, 1992 the Company accounted for income taxes pursuant to Statement of Financial Accounting Standards ("SFAS") No. 96, "Accounting for Income Taxes." Effective January 1, 1993 the Company retroactively adopted the provisions of SFAS No.109, "Accounting for Income Taxes." This statement provides for a liability approach under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. The adoption of this accounting pronouncement did not have a material impact on the prior years' financial statements (see Note 11). FOREIGN CURRENCY TRANSLATION As of December 31, 1991 the functional currency of certain of the Company's foreign subsidiaries was the U.S. dollar, whereas the functional currency of the former Valid subsidiaries was the local currency. During 1992, the Company made certain changes in the manner in which the subsidiaries' operations were conducted to conform more closely to the Valid business model. Accordingly, the functional currency of the U.S. dollar foreign subsidiaries was changed to the respective local currency effective for the first quarter of 1992. Gains and losses resulting from the translation of the financial statements for the subsidiaries are reported as a separate component of stockholders' equity. MERGER COSTS Total costs incurred by the Company and Valid in 1991 in connection with the merger of the two companies were $1,660,000. These costs, consisting primarily of legal, accounting and other related expenses, were charged to operations in the fourth quarter of 1991. NET INCOME (LOSS) PER SHARE Net income per share for each period is calculated by dividing net income attributable to common stockholders by the weighted average number of common stock and common stock equivalents outstanding during the period. Common stock equivalents consist of dilutive shares issuable upon the exercise of outstanding common stock options and warrants and the conversion of Series A-1 preferred stock. Net loss per share is calculated by dividing net loss attributable to common stockholders by the weighted average number of common shares. Fully diluted net income (loss) per share is substantially the same as primary net income (loss) per share. SUPPLEMENTAL STATEMENTS OF CASH FLOWS DISCLOSURES Cash paid for interest and income taxes, including foreign withholding taxes, was as follows (in thousands): DISCLOSURE OF NONCASH FINANCING AND INVESTING ACTIVITIES Notes payable and capital lease obligations incurred for property, plant and equipment placed into service in 1993, 1992 and 1991 were $4,441,000, $5,498,000 and $2,195,000, respectively. As discussed in Note 1, in June 1993 the Company acquired the business and certain assets of Comdisco in exchange for 1,050,000 shares of the Company's common stock and a warrant to purchase 1,300,000 shares of the Company's common stock. The cost in excess of net assets acquired was $6,500,000 which is being amortized over seven years and is included in purchased software and intangibles in the accompanying balance sheet. The accumulated amortization as of December 31, 1993 was approximately $436,000. In connection with the acquisition, net assets acquired were as follows (in thousands): In March 1992 the Company acquired a distributorship in Japan, which, as its sole operation, had distributed the Company's system products. As part of this transaction, the Company paid approximately $400,000 in cash and issued a note for $3,100,000 in exchange for stock and a consulting agreement. This acquisition was accounted for as a purchase. The cost in excess of the net assets acquired was approximately $5.2 million which is being amortized over five years and is included in other assets in the accompanying balance sheets. The accumulated amortization as of December 31, 1993 and 1992 was approximately $2,079,000 and $854,000, respectively. During 1992 all of the Company's outstanding Series A-1 preferred stock was converted to approximately 861,000 shares of the Company's common stock. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. The carrying amount of cash and cash investments and short-term investments is a reasonable estimate of fair value because of the short maturity of those instruments. The fair value of the Company's long-term obligations, excluding capital leases, 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. The carrying amount of the Company's long-term debt at December 31, 1993 approximates its fair value. The Company enters into forward exchange contracts to reduce the impact of foreign currency fluctuations on those accounts that give rise to transaction gains or losses. As of December 31, 1993 the Company had entered into forward exchange contracts in the amount of $33,058,000, maturing January 31, 1994. The fair value of foreign currency contracts is estimated by obtaining quotes from banks. The market value was approximately the same as the carrying value as of December 31, 1993. CONCENTRATION OF CREDIT RISK Financial instruments which may potentially subject the Company to concentrations of credit risk consist principally of cash and cash investments, short-term investments and accounts receivable. The Company's investment policy limits investments to short-term, low-risk instruments. Concentration of credit risk related to accounts receivable is limited due to the varied customers comprising the Company's customer base and their dispersion across geographies. RESTRUCTURING COSTS In March 1993 the Company recorded restructuring costs of $13,450,000 associated with a planned restructure of certain areas of sales, operations and administration due to business conditions. The restructuring charge primarily reflects costs associated with excess facilities, the write-off of software development costs and purchased software and intangibles and employee terminations resulting from the change in product strategy and lower revenue levels. In December 1991 the Company recorded restructuring costs of $49,901,000 associated with the merger of Valid with the Company. This amount included approximately $5,530,000 for excess fixed assets and other assets, $13,385,000 for severance and payroll-related payments, $16,475,000 for closing of excess and duplicate facilities, $10,896,000 for write-offs of capitalized software due to overlap of products and $3,615,000 for other items. POST RETIREMENT BENEFITS Statement of Financial Accounting Standards No. 106, "Accounting for Post Retirement Benefits other than Pensions," which was effective for the Company in fiscal 1993, has no effect on the Company as the Company has not offered such post retirement benefits. INVESTMENTS IN DEBT AND EQUITY SECURITIES Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which will be effective for the Company in fiscal 1994, is not expected to have a material impact on the Company. 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consisted of (in thousands): The cost of equipment, furniture and fixtures under capital leases included in property, plant and equipment at December 31, 1993 and 1992 was $22,178,000 and $25,622,000, respectively. Accumulated amortization of the leased equipment, furniture and fixtures at such dates was $16,199,000 and $19,568,000, respectively. 5. ACCRUED LIABILITIES Accrued liabilities consisted of (in thousands): Accrued merger and restructuring costs consist principally of severance obligations and the current portion of lease obligations for closing of excess facilities. 6. LONG-TERM OBLIGATIONS Long-term obligations consisted of (in thousands): At December 31, 1993 future principal payments on long-term obligations, excluding capital lease obligations, were $620,000 for each of the years ending December 31, 1994, 1995 and 1996, respectively. 7. LEASES Facilities and equipment are leased under various capital and operating leases expiring on different dates through the year 2008. Certain of these leases contain renewal options. The terms of several of the facilities agreements, accounted for as operating leases, provide for the deferral of several months' rental payments or scheduled rent increases. Rental expense under these agreements is recognized on a straight-line basis. Rental expense was approximately $19,983,000, $21,287,000 and $16,798,000 for the years ended December 31, 1993, 1992 and 1991, respectively. In connection with the merger with Valid and planned restructure, the Company has closed certain excess and duplicate facilities. Accordingly, the Company has accrued for estimated future minimum rent and maintenance costs related to these facilities. Total costs accrued at December 31, 1993 were $8,557,000, of which $1,193,000 is included in accrued liabilities and $7,364,000 is included in lease liabilities in the accompanying balance sheet. In connection with the disposition of ASI, the Company has accrued for estimated future rent on facilities not assumed by the purchaser. Total costs accrued at December 31, 1993 were $1,911,000, of which $102,000 is included in accrued liabilities and $1,809,000 is included in other noncurrent liabilities in the accompanying balance sheet. At December 31, 1993 future minimum lease payments under capital and operating leases and the present value of the capital lease payments were as follows (in thousands): As of December 31, 1993 the Company had $15.0 million available for future borrowings under capital lease agreements which expire in September 1994. 8. LINES OF CREDIT The Company has unsecured lines of credit with two banks allowing for combined maximum borrowings of $17,500,000 in the form of (a) domestic rate revolving loans with interest at the banks' prime lending rate, (b) Eurodollar rate loans with interest that exceeds three- quarters of one percent of the banks' current Eurodollar rate quoted for the same amount and maturity, or (c) issuances of letters of credit. There were no outstanding borrowings at December 31, 1993 or 1992 under these agreements. Certain financial covenants and restrictions are included in these agreements. As a result of its treasury stock purchase activity during 1993, the Company was not in compliance with certain covenants related to one of its lines of credit, with a borrowing amount of $10,000,000, as of December 31, 1993. The Company subsequently obtained a waiver of the noncompliance from the bank. These lines of credit will expire in May 1994 and June 1994. 9. COMMITMENTS AND CONTINGENCIES The Company has entered into an executive compensation agreement with one of its executive officers. This agreement provides severance benefits to the executive in the event that within 120 days before or two years after any change in control, or sale of all or substantially all assets of the Company, the executive's employment is terminated by the Company or the executive, in circumstances described in the agreement. The severance benefits are a cash payment of two times the executive's base salary, plus accelerated vesting of all outstanding stock options. The Company assumed as part of the ASI acquisition an agreement dated April 22, 1985 under which the Company is obligated to pay to a former ASI officer a monthly annuity for a fifteen-year period after his retirement date or a lump sum payment subject to the terms of the agreement. The Company has accrued an amount equal to the present value of the estimated future payments at the eligible retirement date. Such accrual amount is included in accrued liabilities in the accompanying balance sheet. The Company is involved in various disputes and litigation matters which have arisen in the ordinary course of business. These include disputes and lawsuits related to intellectual property, contract law and employee relations matters and the stockholder class action lawsuits described below, which allege violation of certain federal securities laws by maintaining artificially high market prices for the Company's common stock through alleged misrepresentations and nondisclosures regarding the Company's financial condition. Stockholder class action lawsuits were filed against the Company and certain of its officers and directors in the United States District Court for the Northern District of California, San Jose Division, on April 8 and 9, 1991. The suits were subsequently consolidated into a single lawsuit and the class period changed to include purchasers of the Company's common stock during the period from October 18, 1990 through April 3, 1991. The plaintiff in the suit seeks compensatory damages unspecified in amount. On June 2, 1993 the District Court granted in part and denied in part the Company's motion to dismiss the Complaint in the class action originally filed in April 1991. The effect of the ruling was to limit the class period to include purchasers of the Company's common stock between January 29, 1991 and April 3, 1991. Trial of this matter is scheduled to commence on August 8, 1994. The Company is vigorously defending against the litigation. On March 23, 1993 a separate class action lawsuit was filed against the Company and certain of its directors and officers in the United States District Court, Northern District of California, San Jose Division. Two additional complaints, identical to the complaint filed on March 23, 1993 except for the identities of the plaintiffs, were filed later in March and in April 1993. All three complaints were consolidated into a single lawsuit which seeks unspecified damages on behalf of all purchasers of the Company's common stock between October 12, 1992 and March 19, 1993. On November 18, 1993, the District Court granted the Company's motion to dismiss the 1993 complaint. The effect of the ruling was to dismiss the complaint except as to a statement allegedly made on January 28, 1993, but plaintiffs were granted leave to further amend their complaint. The Company is vigorously defending against the litigation. Management believes that the ultimate resolution of the disputes and litigation matters discussed above will not have a material adverse impact on the Company's financial position or results of operations. 10. STOCKHOLDERS' EQUITY REDEEMABLE CONVERTIBLE PREFERRED STOCK The Company has 2,000,000 shares of authorized and unissued preferred stock at $.01 par value per share. At December 31, 1993 and 1992 there were no shares of preferred stock outstanding. In 1990 a corporation acquired a minority interest in Valid through an initial investment of $10,998,000, in exchange for 86,133 shares of newly issued Series A-1 voting, convertible preferred stock, convertible into 861,330 common shares, at a purchase price equivalent to $13.00 per common share. All of the preferred stock was converted to common stock during 1992. In 1990 the corporation also purchased, for $1,187,500, a warrant to acquire up to 4,750,000 shares of Valid's common stock. This warrant was exchanged for approximately 199,000 shares of common stock upon the merger of Valid with the Company. Each share of Series A-1 preferred stock was entitled to receive cumulative annual dividends. The dividends were payable in cash. In 1992 and 1991 the Company recorded $559,000 and $1,344,000, respectively, for dividends paid to the corporation. EMPLOYEE STOCK OPTION PLANS The Company's Employee Stock Option Plan (the "Plan") provides for employees to be granted options to purchase up to 13,637,800 shares of common stock. The Plan provides for the issuance of either incentive or nonqualified options at an exercise price not less than fair market value of the stock on the date of grant. Options granted under the Plan become exercisable over periods of one to four years and expire five to ten years from the date of grant. At December 31, 1993 options to purchase 8,320,101 shares were outstanding under the Plan, of which options for 1,317,646 shares were exercisable at prices ranging from $2.00 to $28.75. Options to purchase 1,284,864 shares were available for future grant under the Plan. During 1993 holders of the Company's options were given the opportunity to exchange previously granted stock options for new common stock options exercisable at $8.81 per share, the fair market value of the common stock on the date of exchange. Under the terms of the new options, one-third of the shares vest one year from the date of grant and the remaining shares vest in 24 equal monthly installments. Options to purchase 4,856,026 shares were exchanged. Options to purchase 4,032,835 shares of common stock have been exercised as of December 31, 1993. During 1993 the Company adopted a Non-Statutory Stock Option Plan (the "Non-Statutory Plan"). The Company has reserved 2,500,000 shares of common stock for issuance under the Non-Statutory Plan. Since directors and officers of the Company are not eligible to receive options under the Non-Statutory Plan, stockholder approval is not required nor will it be sought. Options granted under the Non-Statutory Plan become exercisable over a four-year period, with one-fourth of the shares vesting one year from the vesting commencement date and the remaining shares vesting in 36 equal monthly installments. The Non-Statutory options generally expire ten years from the date of grant. At December 31, 1993 options to purchase 1,230,225 shares were outstanding, none of which were exercisable. Options to purchase 1,269,775 shares were available for future grant under the Non-Statutory Plan. STOCK OPTION PLANS - COMPANIES ACQUIRED The Company has reserved a total of 1,313,996 shares of its authorized common stock for issuance upon the exercise of options granted to former employees of companies acquired (the "Acquired Options"). The Acquired Options were assumed by the Company outside the Plan, but all are administered as if assumed under the Plan. All of the Acquired Options have been adjusted to effectuate the conversion under the terms of the Agreements and Plans of Reorganization between the Company and the companies acquired. The Acquired Options generally become exercisable over a four-year period and generally expire either five or ten years from the date of grant. At December 31, 1993 Acquired Options to purchase a total of 1,313,996 shares were outstanding, of which 1,128,756 were exercisable at prices ranging from $.41 to $21.52. No additional options will be granted under any of the acquired companies' plans. Combined activity with respect to the Employee Stock Option Plans and Stock Option Plans - Companies Acquired was as follows: OPTION AGREEMENTS The Company occasionally has issued options outside of the Plan. As of December 31, 1993 options to purchase 70,313 shares were outstanding under these agreements, of which 21,250 were exercisable at prices ranging from $18.25 to $20.94 per share. DIRECTORS STOCK OPTION PLANS The Company's Board of Directors has adopted the 1988 and 1993 Directors Stock Option Plans (the "Directors Plans") in the indicated years. The Company has reserved 445,000 shares of common stock for issuance under the Directors Plans. The Directors Plans provide for the issuance of nonqualified stock options to nonemployee directors of the Company with an exercise price equal to the fair market value of the common stock on date of grant. Options granted under the Directors Plans have a term of up to ten years and vest one-third one year from the date of grant and two-thirds ratably over the subsequent two years. As of December 31, 1993 options to purchase 265,000 shares of common stock at $9.31 to $29.88 per share were outstanding under the Directors Plans, of which options for 99,717 shares were exercisable at prices ranging from $16.25 to $29.88 per share. Options to purchase 87,223 shares are available for future grant under the Directors Plans. Options to purchase 92,777 shares of common stock have been exercised as of December 31, 1993 under the Directors Plans. No additional options will be granted under the 1988 Directors Plan. EMPLOYEE STOCK PURCHASE PLANS The Company has reserved 1,500,000 shares of common stock for issuance under the 1990 Employee Stock Purchase Plan (the "ESPP"). Under the ESPP the Company's employees may purchase shares of common stock at a price per share that is 85% of the lesser of the fair market value as of the beginning or the end of the semiannual option periods. In addition, Valid had a similar plan for which shares were approved for issuance in 1983. For the years ended December 31, 1993, 1992 and 1991 shares issued under the combined plans were 487,941, 324,183 and 286,586, respectively. As of December 31, 1993, 449,668 shares were available for future purchase under the ESPP. No additional shares will be issued under the Valid stock purchase plan. WARRANT In connection with the purchase of Comdisco, the Company issued a warrant to purchase 1,300,000 shares of the Company's common stock at $14.50 per share. The warrant expires in June 2003 and can be exercised at any time in increments of not less than 50,000 shares. The warrant was valued at approximately $1,847,000 which was included as part of the total purchase price of Comdisco. RESERVED FOR FUTURE ISSUANCE As of December 31, 1993 the Company has reserved the following shares of authorized but unissued common stock for future issuance: STOCKHOLDER RIGHTS PLAN During 1989 the Company adopted a Stockholder Rights Plan. As part of this plan the Company's Board of Directors declared a dividend of one Common Share Purchase Right (the "Right") for each share of the Company's common stock outstanding on July 20, 1989. The Board also authorized the issuance of one such Right for each share of the Company's common stock issued after July 20, 1989 until the occurrence of certain events. Each Right entitles the holder thereof to purchase one share of the Company's common stock for $100, subject to adjustment in certain events. The Rights are not exercisable until the occurrence of certain events related to a person acquiring, or announcing the intention to acquire, 20% or more of the Company's common stock. Upon such acquisition, each Right (other than those held by the acquiring person) will be exercisable for that number of shares of the Company's common stock having a market value of two times the exercise price of the Right. If the Company subsequently enters into certain business combinations, each Right (other than those held by the acquiring person) will be exercisable for that number of shares of common stock of the other party to the business combination having a market value of two times the exercise price of the Right. The Rights currently trade with the Company's common stock. The Rights are subject to redemption at the option of the Board of Directors at a price of $.01 per Right until the occurrence of certain events, and are exchangeable for the Company's common stock, at the discretion of the Board of Directors, under certain circumstances. The Rights expire on May 30, 1999. 11. INCOME TAXES Through December 31, 1992 the Company accounted for income taxes pursuant to Statement of Financial Accounting Standards ("SFAS") No. 96, "Accounting for Income Taxes." Effective January 1, 1993 the Company retroactively adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." The adoption of this accounting pronouncement did not have a material impact on amounts reported in prior years' financial statements. The provision for income taxes for the year ended December 31, consisted of the following components (in thousands): Income (loss) from continuing operations before income taxes for the years ended December 31, 1993, 1992 and 1991 included income (loss) of $9,166,000, $5,478,000 and $(4,493,000), respectively, from the Company's foreign subsidiaries. The provision for income taxes at December 31, differs from the amount estimated by applying the statutory federal income tax rate to income (loss) from continuing operations before taxes as follows (in thousands): The components of deferred tax assets and liabilities consisted of the following (in thousands): The deferred assets which will affect equity or intangibles and which will not be available to offset future provisions for income taxes are stated in the above table as "Valuation allowance-equity/intangibles." The net operating losses will expire at various dates from 1998 through the year 2006 and tax credit carry forwards will expire at various dates from 1997 through the year 2008. 12. RELATED PARTY TRANSACTIONS During 1993 a customer of the Company entered into a consulting joint venture with the Company. Revenue related to this customer was approximately $5,928,000 for the year ended December 31, 1993. Outstanding trade accounts receivable from this related party were $2,268,000 at December 31, 1993. A minority interest participant in a subsidiary of the Company is also a major customer of the Company. Revenue related to this customer (a distributor) was approximately $48,655,000, $57,133,000 and $49,672,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Outstanding trade accounts receivable from this related party were approximately $10,304,000 and $17,021,000 as of December 31, 1993 and 1992, respectively. During 1990 a customer of the Company entered into a research and development joint venture with the Company. During 1992 the Company acquired the minority interest in the joint venture. Revenue related to this customer was approximately $777,000 and $1,276,000 for the years ended December 31, 1992 and 1991, respectively. There were no accounts receivable outstanding for this customer at December 31, 1992. 13. OPERATIONS BY GEOGRAPHIC AREA The Company operates primarily in one industry segment -- the development and marketing of computer-aided design software. The Company's products have been marketed internationally through distributors and through the Company's subsidiaries in Europe, Japan and the Far East. Intercompany revenue results from licenses that are based on a percentage of the subsidiaries' revenue from unaffiliated customers. The following table presents a summary of operations by geographic area (in thousands): (1) Domestic operations revenue includes export revenue of approximately $10,137,000, $11,500,000 and $4,900,000 to Europe for the years ended December 31, 1993, 1992 and 1991, respectively, and approximately $48,971,000, $75,400,000 and $71,700,000 to Asia/Pacific for the years ended December 31, 1993, 1992 and 1991, respectively. SCHEDULE VIII CADENCE DESIGN SYSTEMS, INC. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS) (1) Uncollectible accounts written-off (2) Inventory costs written-off (3) Incurred severance and facilities costs relating to the Company's restructuring and a reclassification of $3,500 and $13,135 in 1993 and 1991, respectively, from accrued operating lease obligations to lease liabilities. (4) Reflects a reclassification of $2,009 from accrued liabilities to other noncurrent liabilities. SCHEDULE IX CADENCE DESIGN SYSTEMS, INC. SHORT-TERM BORROWINGS (DOLLARS IN THOUSANDS) (1) Computed by dividing the average month-end balance (2) Computed by averaging month-end balance interest rates SCHEDULE X CADENCE DESIGN SYSTEMS, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Cadence Design Systems, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, March 30, 1994. CADENCE DESIGN SYSTEMS, INC. /s/ Joseph B. Costello --------------------------------- Joseph B. Costello President & Chief Executive 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 capabilities and on the date indicated. INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS

92275_1993.txt

92275_1993

1993

92275

Item 1. Business. - ------ -------- and Item 2. Item 2. Properties. - ------ ---------- GENERAL. Norfolk Southern Railway Company (Norfolk Southern Railway) was incorporated in 1894 under the name Southern Railway Company (Southern) in the Commonwealth of Virginia and, together with its consolidated subsidiaries (collectively, NS Rail), is primarily engaged in the transportation of freight by rail. On June 1, l982, Southern and Norfolk and Western Railway Company (NW) became subsidiaries of Norfolk Southern Corporation (NS), a transportation holding company. Effective December 31, 1990, NS transferred all the common stock of NW to Southern, and Southern's name was changed to Norfolk Southern Railway Company. Accordingly, all the common stock of NW, which is its only voting security, is owned by Norfolk Southern Railway, and all the common stock of Norfolk Southern Railway (16,668,997 shares) is owned directly by NS. NS common stock is publicly held and listed on the New York Stock Exchange. There remain issued and outstanding as of February 28, 1994, 1,197,027 shares of Norfolk Southern Railway's $2.60 Cumulative Preferred Stock, Series A (Series A Stock), of which 1,096,907 shares (including 74 shares not entitled to vote) were held by other than subsidiaries. The Series A Stock is entitled to one vote per share, is nonconvertible, and is traded on the New York Stock Exchange. STOCK PURCHASE PROGRAM. On June 2, 1989, NS announced that it intended to purchase up to 250,000 shares of Norfolk Southern Railway's Series A Stock during the subsequent two-year period. In May 1991, NS extended the previously announced stock purchase program through 1993. In March 1994, NS announced that it would continue purchasing up to 250,000 shares of the Series A Stock through 1996. As of February 28, 1994, NS had purchased 77,626 shares of preferred stock at a total cost of approximately $2.67 million. Consequently, as of February 28, 1994, NS held 94.3 percent of the voting stock of Norfolk Southern Railway. OPERATIONS. As of December 3l, l993, NS Rail operated 14,589 miles of road in the states of Alabama, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Missouri, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia and West Virginia, and the Province of Ontario, Canada. Of this total, 12,761 miles are owned, 677 miles are leased and 1,151 miles are operated under trackage rights. Of the operated mileage, 11,870 miles are main line and 2,719 miles are branch line. In addition, NS Rail operates approximately 11,266 miles of passing, industrial, yard and side tracks. NS Rail has major leased lines in North Carolina and between Cincinnati, Oh., and Chattanooga, Tn. The North Carolina leases, covering approximately 300 miles, expire at the end of 1994, and NS Rail is discussing possible renewals with the lessor. If these leases are not renewed, NS Rail could be required to continue using the lines subject to conditions prescribed by the Interstate Commerce Commission (ICC) or might find it necessary ultimately to operate over an alternate route or routes. It is not expected that the resolution of this matter, whether resulting in renewal of the leases, continued use of the leased lines under prescribed conditions or operation over one or more alternate routes, will have a material effect on NS Rail's consolidated financial position. The Cincinnati-Chattanooga lease, also covering about 335 miles, expires in 2026, subject to an option to extend the lease for an additional 25 years at terms to be agreed upon. NS Rail's lines carry raw materials, intermediate products and finished goods primarily in the Southeast and Midwest and to and from the rest of the United States and parts of Canada. These lines also transport overseas freight through several Atlantic and Gulf Coast ports. Atlantic ports served by NS Rail include: Norfolk, Va.; Morehead City, N.C.; Charleston, S.C.; Savannah and Brunswick, Ga.; and Jacksonville, Fl. Gulf Coast ports served include: Mobile, Al., and New Orleans, La. NS Rail's lines reach most of the larger industrial and trading centers of the Southeast and Midwest, with the exception of those in central and southern Florida. Atlanta, Birmingham, New Orleans, Memphis, St. Louis, Kansas City (Missouri), Chicago, Detroit, Cincinnati, Buffalo, Norfolk, Charleston, Savannah and Jacksonville are among the leading centers originating and terminating freight traffic on the system. In addition to serving other established centers, its lines reach many industries, mines (in western Virginia, eastern Kentucky and southern West Virginia) and businesses located in smaller communities in its service area. The traffic corridors carrying the heaviest volumes of freight include those from the Appalachian coal fields of Virginia, West Virginia and Kentucky to Norfolk and Sandusky, Oh.; Buffalo to Chicago and Kansas City; Chicago to Jacksonville (via Cincinnati, Chattanooga and Atlanta); and Washington, D.C./Hagerstown, Md., to New Orleans (via Atlanta and Birmingham). Buffalo, Chicago, Hagerstown, Jacksonville, Kansas City, Memphis, New Orleans and St. Louis are major gateways for interterritorial system traffic. REVENUES. NS Rail's railway operating revenues were $3.7 billion in 1993. These revenues were received for the transportation of 262.3 million tons of revenue freight of which approximately 210.4 million tons originated on line, approximately 222.8 million tons terminated on line (including 177.1 million tons of local traffic -- originating and terminating on line) and approximately 6.2 million tons was overhead traffic (neither originating nor terminating on line). Revenue and revenue ton mile (one ton of freight moved one mile) contributions by principal railway operating revenue sources for the period 1989 through 1993 are set forth in the following table: COAL TRAFFIC - The commodity group moving in largest tonnage volume over NS Rail is coal, coke and iron ore, most of which is bituminous coal. NS Rail originated 112.1 million tons of coal, coke and iron ore in 1993 and handled a total of 118.0 million tons. Originated tonnage decreased 5 percent from 118.0 million tons in 1992, and total tons handled decreased 5 percent from 124.4 million tons. Revenues from coal, coke and iron ore, which accounted for 33 percent of NS Rail's total railway operating revenues and 37 percent of total revenue ton miles in 1993, were $1.21 billion, a decrease of 6 percent from $1.30 billion in 1992. The following table shows total coal tonnage originated on NS Rail, received from connections and handled for the five years ended December 31, 1993: Of the 109.8 million tons of coal originating on NS Rail in 1993, the approximate breakdown is as follows: 37.9 million tons from West Virginia, 37.6 million tons came from Virginia, 22.9 million tons from Kentucky, 7.6 million tons from Alabama, 1.7 million tons from Tennessee, 1.1 million tons from Illinois, and 1.0 million tons from Indiana. Of this NS Rail-origin coal, approximately 25.3 million tons moved for export, principally through NS Rail's pier facilities at Norfolk (Lamberts Point), Virginia; 20.1 million tons moved to domestic and Canadian steel industries; 55.6 million tons of steam coal moved to electric utilities; and 8.8 million tons moved to other industrial and miscellaneous users. NS Rail moved 9.7 million tons of originated coal to various docks on the Ohio River for further movement by barge and 5.1 million tons to various Lake Erie ports. Other than coal moving for export, virtually all coal tonnage handled by NS Rail was terminated in states situated east of the Mississippi River. Total NS Rail coal tonnage handled through all system ports in 1993 was 42.4 million. Of this total, 65 percent moved through the pier facilities at Lamberts Point. In 1993, total tonnage handled at Lamberts Point, including coastwise traffic, was 27.6 million tons, a 20 percent decrease from the 34.7 million tons handled in 1992. The quantities of NS Rail coal handled for export only through Lamberts Point for the five years ended December 31, 1993, were as follows: The recession in Europe and high stockpiles of coal overseas continued to affect NS Rail's export coal shipments in 1993, as did the UMWA strike at several mines served by NS Rail. Domestic coal was essentially flat, compared with 1992, although the market for utility coals increased slightly because of the hot weather in our service region and continued spot tonnage purchases. Increased shipments to steel producers were attributed to strike-related problems encountered by suppliers served by other carriers; the industrial market stayed even with the previous year. MERCHANDISE RAIL TRAFFIC - The merchandise traffic group consists of Intermodal and five major commodity groupings (Paper/ Forest; Chemicals; Automotive; Agriculture; and Metals/Construction). Total NS Rail merchandise revenues increased in 1993 to $2.39 billion, a 4 percent increase over 1992. Merchandise carloads handled in 1993 were 2.82 million, compared with 2.66 million handled in 1992, an increase of 6 percent. In 1993, 97.8 million tons of merchandise freight, or approximately 68 percent of total merchandise tonnage handled by NS Rail, originated on line. The balance of NS Rail's merchandise traffic was received from connecting carriers (mostly railroads, with some intermodal, water and highway as well), usually at interterritorial gateways. The principal interchange points for NS Rail-received traffic included Chicago, Memphis, New Orleans, Cincinnati, Kansas City, Detroit, Hagerstown, St. Louis/East St. Louis, and Louisville. The economy improved in 1993, but the pace of recovery was still below the average of post-war recoveries. All merchandise commodity groups showed improvement over 1992. The biggest gains were in Intermodal, up $30.9 million; Automotive, up $28.0 million; Metals/ Construction, up $19.8 million and Agriculture, up $18.3 million. There were smaller gains in Paper/Forest and Chemicals. PAPER/FOREST traffic (including paper, paperboard, wood pulp, pulpwood, wood chips, lumber, kaolin clay and waste paper) accounted for 13 percent of NS Rail's total operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, Paper/Forest revenues increased 1 percent and revenue ton miles increased 3 percent. Weak domestic and overseas demand for paper depressed NS Rail shipments for much of the year. Lumber, however, posted a 4 percent gain in revenue due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic (including petroleum products, plastics, fertilizers, nonmetallic minerals, sulfur, chloral-alkali chemicals, rubber, miscellaneous chemicals and waste/hazardous chemicals) accounted for 13 percent of NS Rail's total operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, NS Rail's total revenue for chemicals was up 0.3 percent and revenue ton miles increased 3 percent. The lower gain in revenue was due to a change in the mix of traffic. Gains in general chemicals and plastics were offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail-truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic (including motor vehicles, vehicle parts, miscellaneous transportation and ordnance, and tires) accounted for 11 percent of NS Rail's total operating revenues and 4 percent of revenue ton miles during 1993. Compared with 1992, NS Rail Automotive revenues increased 7 percent and revenue ton miles increased 14 percent. The gain was due to strong demand for vehicles produced at plants served by NS Rail. NS Rail's largest customer, Ford Motor Company, produced the top-selling automobile and truck in 1993. In addition, NS Rail benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the gain. Further growth in Automotive is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. Within this growing market, NS Rail will pursue innovative marketing programs and aggressive industrial development. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS Rail--the second Toyota Plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes- Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic (including grains and soybeans, feed and feed ingredients, sweeteners, beverages, consumer products, and various other agricultural and food commodities) accounted for 9 percent of NS Rail's total operating revenues and 12 percent of total revenue ton miles during 1993. Compared with 1992, agricultural revenues increased 6 percent and revenue ton miles increased 8 percent. In the early part of the year, NS Rail benefited from a record harvest, that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS Rail's sourcing areas and poor conditions elsewhere produced strong NS Rail traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenue is expected, driven by growth in poultry production in the Southeast, a prime NS Rail feed grain market. METALS/CONSTRUCTION traffic (including aluminum ore, iron and steel, aluminum products, scrap metal, machinery, sand and gravel, cement, brick, miscellaneous construction, and nonhazardous waste) accounted for 8 percent of NS Rail's total operating revenues and 9 percent of total revenue ton miles during 1993. Compared with 1992, NS Rail's total revenues for Metals/Construction were up 7 percent and revenue ton miles were up 13 percent. Most of the revenue gain was in shipments of iron and steel, where strong industry production and new plants located on NS Rail's lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years. NS Rail has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. INTERMODAL traffic (including trailers, containers, and Triple Crown) accounted for 10 percent of NS Rail's total operating revenues and 12 percent of total revenue ton miles during 1993. Compared with 1992, intermodal revenues increased 9 percent, and revenue ton miles increased 9 percent. Intermodal growth in 1993 was led by a 21 percent increase in services provided to Triple Crown Services Company (a partnership between subsidiaries of NS and Consolidated Rail Corporation which provides RoadRailer (Registered Trademark) (RT) and domestic container services) due to strong automotive shipments and expansion of service to the Northeast. Container revenues were up 6 percent, a smaller increase than previous years due to less international traffic caused by the continuing recession in Europe and Japan. Trailer revenue was up 11 percent, boosted by gains from haulage arrangements with truckload carriers. Strong growth is expected in 1994 and for the next several years. Container traffic is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. RAIL OPERATING STATISTICS. The following table sets forth certain statistics relating to NS Rail's operations during the periods indicated: FREIGHT RATES. In the pricing of freight services, NS Rail continued in 1993 to increase its reliance on private contracts which, coupled with traffic that has been exempted from regulation by the ICC (e.g., boxcar and intermodal traffic), presently account for over 80 percent of freight operating revenues. Thus, a major portion of NS Rail's freight business is not economically regulated by the government. In general, market forces have been substituted for government regulation and now are the primary determinant of rail service prices. In 1993, the ICC found NS Rail "revenue adequate" based on results for the year 1992. A railroad is "revenue adequate" under the Interstate Commerce Act when its return on net investment exceeds the rail industry's cost of capital. The condition of "revenue adequacy" determines whether a railroad can take advantage of a provision in the Interstate Commerce Act allowing freedom to increase regulated rates by a specific percentage. However, with the decreasing importance of regulated tariff traffic to NS Rail, the ICC's "revenue adequacy" findings have less impact than formerly. PASSENGER OPERATIONS. Regularly scheduled passenger operations on NS Rail's lines consist of Amtrak trains operating between Alexandria and New Orleans, and between Charlotte and Selma, N.C. Former Amtrak operations between East St. Louis and Centralia, Il., were discontinued by Amtrak November 3, 1993. Commuter trains continued operations on the NS Rail line between Manassas and Alexandria under contract with two transportation commissions of the Commonwealth of Virginia, providing for reimbursement of related expenses incurred by NS Rail. During 1993, a lease of the Chicago to Manhattan, Il., line to the Commuter Rail Division of the Regional Transportation Authority of Northeast Illinois replaced a purchase of service agreement by which NS Rail had provided commuter rail service for the Authority. OTHER RAILWAY OPERATIONS. Revenues from switching, demurrage and miscellaneous services amounted to $121.5 million, or approximately 3 percent of total railway operating revenues, during 1993 and $121.7 million, or approximately 3 percent of total railway operating revenues, in 1992. The average age of the freight car fleet at December 31, 1993, was 20.8 years. During 1993, NS Rail retired 5,576 freight cars. As of December 31, 1993, the average age of the locomotive fleet was 14.6 years. During 1993, NS Rail retired 37 locomotives, the average age of which was 24.7 years. Since 1989, NS Rail has rebodied over 14,000 coal cars. As a result, the remaining serviceability of the freight car fleet is greater than is indicated by the percentage of freight cars built in earlier years. NS Rail continues freight car and locomotive maintenance programs to ensure the highest standards of safety, reliability, customer satisfaction and equipment marketability. In recent years, as illustrated in the table below, the bad order ratio has risen or remained fairly stable primarily due to the storage of certain types of cars which are not in high demand. Funds were not spent to repair certain types of cars for which present and future customers' needs could be adequately met without such repair programs. Also, NS Rail's own standards of what constitutes a "serviceable" car have risen, and NS continues a rational disposition program for underutilized, unserviceable and overage cars. TRACKAGE - All NS Rail trackage is standard gauge, and the rail in approximately 95 percent of the main line trackage (including first, second, third and branch main tracks, all excluding trackage rights) is heavyweight rail ranging from 90 to 155 pounds per yard. Of the 23,512 miles of track maintained by NS Rail as of December 31, 1993, 15,621 miles were laid with welded rail. The density of traffic on NS Rail running track (main line trackage plus passing track) during 1993 was as follows: MICROWAVE SYSTEM - The NS Rail microwave system, consisting of 6,584 radio path miles, 374 active stations and 7 passive repeater stations, provides communication services between Norfolk, Buffalo, Detroit, Fort Wayne, Chicago, Kansas City, St. Louis, Washington, D.C., Atlanta, New Orleans, Jacksonville, Memphis, Cincinnati and most operating locations between these cities. The microwave system provides approximately 2,152,600 individual voice channel miles of circuits, and NS Rail began a conversion of the system from analog to digital technology in 1993. Conversion is under way on all microwave facilities between St. Louis, Mo., and Danville, Ky.; the process is also under way between Roanoke and Norfolk, Va. The microwave communication system is used principally for voice communications, VHF radio control circuits, data and facsimile transmissions, traffic control operations, AEI data transmissions, and relay of intelligence from defective equipment detectors. Extension of microwave communications to low density or operations support facilities is accomplished via microwave interface to buried fiber-optic or copper cables. TRAFFIC CONTROL - Of a total of 13,438 road miles operated by NS Rail, excluding trackage rights over foreign lines, 5,274 road miles are governed by centralized traffic control systems and 2,734 road miles are equipped for automatic block system operation. COMPUTERS - Data processing facilities connect the yards, terminals, transportation offices, rolling stock repair points, sales offices and other key locations on NS Rail to the central computer complex in Atlanta, Ga. System operating and traffic data are compiled and stored to provide customers with information on their shipments throughout the system. Data processing facilities are capable of providing current information on the location of every train and each car on line, as well as related waybill and other train and car movement data. Additionally, this facility affords substantial capacity for, and is utilized to assist management in the performance of, a wide variety of functions and services, including payroll, car and revenue accounting, billing, material management activities and controls, and special studies. OTHER - NS Rail has extensive facilities for support of railroad operations, including freight depots, car construction shops, maintenance shops, office buildings, and signals and communications facilities. ENCUMBRANCES. Most of NS Rail's properties are subject to liens securing as of December 31, 1993, and 1992, approximately $74.8 million and $146.6 million of mortgage debt, respectively. In addition, certain of the rolling stock is subject to the prior lien of equipment financing obligations amounting to approximately $521.8 million as of December 31, 1993, and $558.2 million as of December 31, 1992. CAPITAL EXPENDITURES. During the five calendar years ended December 31, 1993, capital expenditures for road, equipment and other property were as follows: NS Rail's capital spending and maintenance programs are and have been designed to assure the Corporation's ability to provide safe, efficient and reliable transportation services. For 1994, NS Rail is planning $627 million of capital spending and anticipates new equipment financing of approximately $72 million. Looking further ahead, capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However, because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to boosting capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. ENVIRONMENTAL MATTERS. Compliance with federal, state and local laws and regulations relating to the protection of the environment is a principal NS Rail goal. To date, such compliance has not affected materially NS Rail's capital additions, earnings, liquidity or competitive position. Costs for environmental protection for 1993 were approximately $32.9 million, of which $28.9 million were operating expenses and $4.0 million were capitalized. Such NS Rail expenditures historically have been associated with the cleanup of real estate used for operating and nonoperating purposes, solid/hazardous waste handling and disposal, water pollution control, asbestos removal projects and removal/remediation work related to underground tanks. To promote achievement of NS Rail's environmental objectives and to assure continuous improvement in its programs, environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded (and expensed or capitalized, as appropriate). Evaluations of other sites are ongoing. NS Rail also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives and undertake environmental awareness programs through which NS Rail employees will receive training. Norfolk Southern Railway and certain subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) which generally imposes joint and several liability for cleanup costs. State agencies also have notified Norfolk Southern Railway and certain subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS Rail has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Although the estimated liability usually is expensed in the year it is recorded, certain expenditures relating to real estate development projects have been capitalized. Claims, if any, against third parties for recovery of remediation costs incurred by NS Rail are reflected as receivables in the balance sheet and not netted against the associated NS Rail liability. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS Rail's traffic mix can pose special risks, which NS Rail works diligently to minimize. In addition, NS Rail has land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS Rail ultimately may bear some financial responsibility, there can be no assurance that NS Rail will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which NS Rail is aware. At year end, a grand jury investigation was under way regarding possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A more detailed report of this incident, including information concerning its resolution since year end, is set forth under the heading "Item 3. Item 3. Legal Proceedings - ------ ----------------- New Orleans, Louisiana - Tank Car Fire. A number of lawsuits have been filed as a result of a tank car fire which occurred in New Orleans, La., on September 9, 1987, and resulted in the evacuation of many residents of the surrounding area. Plaintiffs allege that they were injured and sustained other economic loss when a chemical called butadiene leaked from a tank car under the control of either CSX Transportation, Inc., or New Orleans Terminal Company (a subsidiary of Norfolk Southern Railway) or both. In addition to the rail defendants, defendants in one or more of the suits include the City of New Orleans, the owner of the tank car (General American Transportation Corporation), the loader of the tank car (GATX Terminals Corporation), and the shipper (Mitsui & Co. (USA Inc.)). The suits, which are pending in the Civil District Court for the parish of Orleans, seek damages ranging from $10,000 to $20,000,000,000. Management, after consulting with its legal counsel, is of the opinion that ultimate liability will not materially affect the consolidated financial position of NS Rail. This matter has been reported previously by NS Rail in Part II, Item 1, of its Form 10-Q Reports for the quarters ending September 30, 1987, and March 31, 1990; and in Part I, Item 3, of its Form 10-K Annual Reports for 1987, 1988, 1989, 1990, 1991 and 1992. Moberly, Missouri - Burial of Paint and Solvent. On or about May 16 and May 23, 1991, respectively, certain employees and NW were served with subpoenas duces tecum requiring production of various documents and information, all related to a federal grand jury's investigation of possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A search warrant also was served on NW at Moberly, and various company records were seized. A second subpoena duces tecum was served on September 19, 1991, concerning the relationship between NS and NW. The investigation resulted from employees' having buried containers of paint and one container of solvent. NW management first learned of the incident in June 1990 from the Missouri Department of Natural Resources ("DNR"). Promptly thereafter, NW initiated appropriate remediation efforts and notified the National Response Center. The burial of paint and solvent violated long-standing NW policy and instructions. NW cooperated fully with the DNR; at year end 1993, the grand jury's investigation was continuing. The paint and paint cans (along with the single drum which contained a solvent and appears not to have leaked) and any associated contaminated dirt have been excavated and properly disposed of under the DNR's direction. On February 23, 1994, NW settled this matter with the federal and state governments by pleading guilty to a single violation of the federal Resource Conservation and Recovery Act and by making or committing to make penalty and restitution payments of up to $4,400,000. Of that amount, $1.7 million is to purchase equipment for state environmental enforcement purposes and, in line with NW's suggestion, $1.0 million is for the Katy Trail State Park which was damaged severely in the 1993 Missouri River flood. In addition, NW made certain commitments with respect to an organization-wide environmental awareness program. Management believes the February 23 settlements conclude this matter and expects to make no further reports about it. This matter has been reported previously by NS Rail in Part II, Item 1, of its Form 10-Q Report for the quarter ending June 30, 1991, and in Part I, Item 3, of its Form 10-K Annual Reports for 1991 and 1992. 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. Executive Officers of the Registrant. - ------------------------------------ Norfolk Southern Railway's officers are elected annually by the Board of Directors at its first meeting held after the annual meeting of stockholders, and they hold office until their successors are elected. There are no family relationships among the officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of March 1, 1994, relating to these officers: Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- David R. Goode, 53, Present position since September 1992. President and Chief Also, Chairman, President and Chief Executive Officer Executive Officer of Norfolk Southern Corporation since September 1992, President from October 1991 to September 1992, and Executive Vice President-Administration from January to October 1991. Served as Vice President-Administration of Norfolk Southern Railway from January 1991 to February 1992, Vice President from February to September 1992, and prior thereto as Vice President-Taxation of Norfolk Southern Railway and NS. William B. Bales, 59, Vice Present position since August 1993. President-Coal Marketing Also, Vice President-Coal Marketing of Norfolk Southern Corporation since August 1993. Served prior thereto as Vice President-Coal and Ore Traffic of Norfolk Southern Railway and NS. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- R. Alan Brogan, 53, Vice Present position since December 1992. President-Transportation Also, Executive Vice President- Logistics Transportation Logistics of Norfolk Southern Corporation since December 1992, Vice President- Quality Management from April 1991 to December 1992, Vice President- Material Management and Property Services from July 1990 to April 1991, and prior thereto as Vice President of Material Management. Served as Vice President-Quality Management of Norfolk Southern Railway from June 1991 to December 1992, and prior thereto as Vice President-Material Management. Thomas L. Finkbiner, 41, Vice Present position since August 1993. President-Intermodal Also, Vice President-Intermodal of Norfolk Southern Corporation since August 1993. Served as Senior Assistant Vice President- International and Intermodal of NS from April to August 1993, and prior thereto as Assistant Vice President- International and Intermodal. James A. Hixon, 40, Vice Present position since June 1993. President-Taxation Also, Vice President-Taxation of Norfolk Southern Corporation since June 1993. Served as Assistant Vice President-Tax Counsel of NS from January 1991 to June 1993, and prior thereto as General Tax Attorney. Harold C. Mauney, Jr., 55, Present position since December 1992. Vice President-Quality Also, Vice President-Quality Management Management of Norfolk Southern Corporation since December 1992. Served as Assistant Vice President- Quality Management of NS from April 1991 to December 1992, and prior thereto as General Manager- Intermodal Transportation Services. Donald W. Mayberry, 50, Vice Present position since October 1987. President-Mechanical Also, Vice President-Mechanical of Norfolk Southern Corporation since October 1987. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- James W. McClellan, 54, Vice Present position since October 1993. President-Strategic Planning Also, Vice President-Strategic Planning of Norfolk Southern Corporation since October 1993. Served as Assistant Vice President- Corporate Planning of NS from March 1992 to October 1993, and prior thereto as Director-Corporate Development. Kathryn B. McQuade, 37, Vice Present position since December 1992. President-Internal Audit Also, Vice President-Internal Audit of Norfolk Southern Corporation since December 1992. Served as Director-Income Tax Administration of NS from May 1991 to December 1992, and prior thereto as Director-Federal Income Tax Administration. Charles W. Moorman, 42, Vice Present position since October 1993. President-Information Also, Vice President-Information Technology Technology of Norfolk Southern Corporation since October 1993. Served as Vice President-Employee Relations of Norfolk Southern Railway and NS from December 1992 to October 1993, Vice President-Personnel and Labor Relations from February to December 1992, Assistant Vice President-Stations, Terminals and Transportation Planning of NS from March 1991 to February 1992, Senior Director Transportation Planning from March 1990 to March 1991, and prior thereto as Director, Transportation Planning. Phillip R. Ogden, 53, Vice Present position since December 1992. President-Engineering Also, Vice President-Engineering of Norfolk Southern Corporation since December 1992. Served as Assistant Vice President-Maintenance of NS from November 1990 to December 1992, Chief Engineer-Line Maintenance North from February 1989 to November 1990, and prior thereto as Chief Engineer-Program Maintenance. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- L. I. Prillaman, Jr., 50, Present position since December 1992. Vice President-Properties Also, Vice President-Properties of Norfolk Southern Corporation since December 1992. Served prior thereto as Vice President and Controller of Norfolk Southern Railway and NS. John P. Rathbone, 42, Vice Present position since December 1992. President and Controller Also, Vice President and Controller of Norfolk Southern Corporation since December 1992. Served as Assistant Vice President- Internal Audit of NS from January 1990 to December 1992, and prior thereto as Director-Internal Audit. William J. Romig, 49, Present position since December 1992. Vice President Also, Vice President and Treasurer of Norfolk Southern Corporation since December 1992. Served prior thereto as Assistant Vice President-Finance of NS. Paul R. Rudder, 61, Vice Present position since March 1990. President-Operations Also, Executive Vice President- Operations of Norfolk Southern Corporation since March 1990. Served as Vice President of Norfolk Southern Railway and Senior Vice President-Operations of NS from October 1989 to March 1990, and prior thereto as Vice President- Engineering of Norfolk Southern Railway and NS. Donald W. Seale, 41, Vice Present position since August 1993. President-Merchandise Also, Vice President-Merchandise Marketing Marketing of Norfolk Southern Corporation since August 1993. Served as Assistant Vice President- Sales and Service of NS from May 1992 to August 1993, Director- Metals, Waste and Construction from March 1990 to May 1992, and prior thereto as Director-Marketing Development. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- John S. Shannon, 63, Vice Present position since May 1984. President-Law Also, Executive Vice President- Law of Norfolk Southern Corporation since June 1982. Thomas C. Sheller, 63, Vice Present position since February 1992. President-Administration Also, Executive Vice President- Administration of Norfolk Southern Corporation since October 1991. Served prior thereto as Vice President-Personnel and Labor Relations of Norfolk Southern Railway and NS. Powell F. Sigmon, 54, Vice Present position since October 1993. President-Safety, Environ- Also, Vice President Safety, mental and Research Environmental and Research Development Development of Norfolk Southern Corporation since October 1993. Served as Assistant Vice President- Mechanical (Car) of NS from January 1991 to October 1993, and prior thereto as General Manager- Mechanical Facilities. Stephen C. Tobias, 49, Present position since October 1993. Vice President Also, Senior Vice President- Operations of Norfolk Southern Corporation since October 1993. Served as Vice President-Strategic Planning of Norfolk Southern Railway and NS from December 1992 to October 1993, Vice President- Transportation from October 1989 to December 1992, and prior thereto as General Manager-Western Lines. John R. Turbyfill, 62, Vice Present position since June 1993. President Also, Vice Chairman of Norfolk Southern Corporation since June 1993. Served prior thereto as Executive Vice President-Finance of NS since June 1982, and Vice President-Finance of Norfolk Southern Railway since March 1984. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- -------------------------------------- D. Henry Watts, 62, Vice Present position since July 1986. President and Chief Also, Executive Vice President- Traffic Officer Marketing of Norfolk Southern Corporation since July 1986. Henry C. Wolf, 51, Vice Present position since June 1993. President-Finance Also, Executive Vice President- Finance of Norfolk Southern Corporation since June 1993. Served as Vice President-Taxation of Norfolk Southern Railway and NS from January 1991 to June 1993, and prior thereto as Assistant Vice President-Tax Counsel. Dezora M. Martin, 46, Present position since October 1993. Corporate Secretary Served prior thereto as Assistant Corporate Secretary of Norfolk Southern Railway and NS. Ronald E. Sink, 51, Present position since September Treasurer 1987. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related - ------ ---------------------------------------------------- Stockholder Matters. ------------------- COMMON STOCK - ------------ Since June 1, 1982, NS has owned all the common stock of Norfolk Southern Railway Company. The common stock is not publicly traded. SERIAL PREFERRED STOCK - ---------------------- There are 10,000,000 shares of no par value serial preferred stock authorized. This stock may be issued in series from time to time at the discretion of the Board of Directors with any series having such voting and other powers, designations, dividends and other preferences as deemed appropriate at the time of issuance. The $2.60 Cumulative Preferred Stock, Series A (Series A Stock), of which 1,197,027 shares were issued and 1,096,907 shares were held other than by subsidiaries as of February 28, 1994, has no par value but has a $50 per share stated value. As indicated in the title, the stock pays a dividend of $2.60 per share annually, payable quarterly on March 15, June 15, September 15 and December 15. Dividends on this stock are cumulative and in preference to dividends on all other classes of stock. Except for any shares held by Norfolk Southern Railway Company subsidiaries and/or in a fiduciary capacity, each share is entitled to one vote per share on all matters, voting as a single class with holders of other stock. Should dividends become delinquent for six quarters, this class of stock, voting as a class, may elect two directors so long as any default in dividend payments continues. The stock is redeemable at the option of Norfolk Southern Railway Company at $50 per share plus accrued dividends. On liquidation, the stock is entitled to $50 per share plus accrued dividends before any amounts are paid on any other class of stock. In June 1989, NS announced that it intended to purchase up to 250,000 shares of the outstanding Series A Stock during the subsequent two-year period. In May 1991, NS extended the previously announced stock purchase program through 1993. In March 1994, NS announced that it would continue purchasing up to 250,000 shares of the Series A Stock through 1996. As of February 28, 1994, NS had purchased 77,626 shares of Series A Stock at a total cost of $2,671,986; as of the same date, NS held a total of 77,721 shares. Item 6. Item 6. Selected Financial Data. - ------ ----------------------- Item 7. Item 7. Management's Discussion and Analysis of Financial - ------ ------------------------------------------------- Condition and Results of Operations. ------------------------------------ See pages 39-50 for "Management's Discussion and Analysis of Financial Condition and Results of Operations." Item 8. Item 8. Financial Statements and Supplementary Data. - ------ -------------------------------------------- Item 8. Financial Statements and Supplementary Data. (continued) - ------ -------------------------------------------- The Index to Financial Statements follows, and the Index to Financial Statement Schedules appears in Item 14 on page 34. The financial statements and related documents for Norfolk Southern Railway Company and Subsidiaries are as follows: Index to Financial Statements: Page ----------------------------- ---- Consolidated Statements of Income Years ended December 31, 1993, 1992 and 1991 51 Consolidated Balance Sheets As of December 31, 1993 and 1992 52 Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992 and 1991 53-54 Consolidated Statements of Changes in Stockholders' Equity Years ended December 31, 1993, 1992 and 1991 55 Notes to Consolidated Financial Statements 56-75 Independent Auditors' Report 76 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting - ------ ----------------------------------------------------------- and Financial Disclosure. ------------------------ None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. - ------- -------------------------------------------------- Item 11. Item 11. Executive Compensation. - ------- ---------------------- Item 12. Item 12. Security Ownership of Certain Beneficial Owners - ------- ----------------------------------------------- and Management. -------------- and Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- In accordance with General Instruction G(3), the information called for by Part III is incorporated herein by reference from Norfolk Southern Railway's definitive Proxy Statement, to be dated April 19, 1994, for the Norfolk Southern Railway Annual Meeting of Stockholders to be held on May 24, 1994, which definitive Proxy Statement will be filed electronically with the Commission pursuant to Regulation 14A. The information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I beginning on page 23 under "Executive Officers of the Registrant." PART IV Item l4. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. -------- (a) The following documents are filed as part of this report: 1. Financial Statement Schedules: The following consolidated financial statement schedules should be read in connection with the consolidated financial statements: Index to Consolidated Financial Statement Schedules Page --------------------------------------------------- ---- Schedule I - Marketable Securities-Other Investments 77 Schedule V - Property, Plant and Equipment 78 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 79 Schedule VII - Guarantees of Securities of Other Issuers 80 Schedule VIII - Valuation and Qualifying Accounts 81 Schedule IX - Short-Term Borrowings 82 Schedule X - Supplementary Income Statement Information 83 Schedules other than those listed above are omitted for reasons that they are not required, are not applicable or the information is included in the consolidated financial statements or related notes. 2. Exhibits Exhibit Number Description - ------- ------------------------------------------------- 3 Articles of Incorporation and Bylaws - 3(a) The amended Restated Articles of Incorporation of Norfolk Southern Railway Company are incorporated herein by reference from Exhibit 3(a) of Norfolk Southern Railway's 1990 Annual Report on Form 10-K. 3(b) The Bylaws of Norfolk Southern Railway Company, as last amended March 3, 1993, are incorporated herein by reference from Exhibit 3(b) of Norfolk Southern Railway's 1992 Annual Report on Form 10-K. Item l4. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- 4 Instruments Defining the Rights of Security Holders, Including Indentures - In accordance with Item 601(b)(4)(iii) of Regulation S-K, copies of instruments of Norfolk Southern Railway and its subsidiaries with respect to the rights of holders of long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10 Material Contracts - (a) The Agreement of Merger and Reorganization dated as of July 31, 1980, among Southern Railway Company (name changed to Norfolk Southern Railway Company by Certificate of Amendment issued by the State Corporation Commission of Virginia as of December 31, 1990), Southern Railroad Company of Virginia, NWS Enterprises, Inc. (name changed to Norfolk Southern Corporation by Certificate of Amendment issued by the State Corporation Commission of Virginia on November 2, 1981), Norfolk and Western Railway Company, and Norfolk and Western Railroad Company of Virginia, and the related Plans of Merger (Exhibits B and C to the Agreement) are incorporated herein by reference from Appendix A to NW's and Southern's definitive Proxy Statements dated October 1, 1980, for NW's and Southern's Special Meetings of Stockholders held on November 7, 1980. (b) The lease between The Cincinnati, New Orleans and Texas Pacific Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, and the Trustees of the Cincinnati Southern Railway, as lessor, dated as of October 11, 1881, is incorporated herein by reference from Exhibit 5 of Southern's 1980 Annual Report on Form 10-K. The Supplementary Agreement to the lease, dated as of January 1, 1987, is incorporated herein by reference from Exhibit 10(b) of Southern's 1987 Annual Report on Form 10-K. Item l4. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- (c) The lease between The North Carolina Railroad Company, as lessor, and Norfolk Southern Railway, as lessee, dated as of January 1, 1896, is incorporated herein by reference from Exhibit 6 of Southern's 1980 Annual Report on Form 10-K. (d) The lease between Atlantic and North Carolina Railroad Company (The North Carolina Railroad Company, successor by merger, September 29, 1989), as lessor, and Atlantic and East Carolina Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, dated as of April 20, 1939, is incorporated herein by reference from Exhibit 7 of Southern's 1980 Annual Report on Form 10-K. 21 Subsidiaries of the Registrant. (b) Reports on Form 8-K. No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)2 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial statements specified by this Item are included in Item 14(a)1 or are otherwise not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" hereby authorizes Henry C. Wolf and John S. Shannon, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints Henry C. Wolf and John S. Shannon, or either of them, as attorneys-in-fact to sign on his behalf, individually and in each capacity stated below, and to file, any and all amendments to this report. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Norfolk Southern Railway Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 22nd day of March, 1994. NORFOLK SOUTHERN RAILWAY COMPANY By /s/ David R. Goode ----------------------------------------- (David R. Goode, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 22nd day of March, 1994, by the following persons on behalf of Norfolk Southern Railway Company and in the capacities indicated. Signature Title --------- ----- /s/ David R. Goode - -------------------------- President and Chief Executive (David R. Goode) Officer and Director (Principal Executive Officer) /s/ John P. Rathbone - -------------------------- Vice President and Controller (John P. Rathbone) (Principal Accounting Officer) /s/ Henry C. Wolf - -------------------------- Vice President-Finance (Henry C. Wolf) (Principal Financial Officer) Signature Title --------- ----- /s/ Paul R. Rudder - -------------------------- Director (Paul R. Rudder) /s/ John S. Shannon - -------------------------- Director (John S. Shannon) /s/ Thomas C. Sheller - -------------------------- Director (Thomas C. Sheller) /s/ John R. Turbyfill - -------------------------- Director (John R. Turbyfill) /s/ D. Henry Watts - -------------------------- Director (D. Henry Watts) (ITEM 7) NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes beginning on page 51 and the Five-Year Financial Review on page 30. The Condensed Summary provides a brief overview of results of operations, and the text beginning under "Results of Operations" is a more detailed analytical discussion. CONDENSED SUMMARY OF RESULTS OF OPERATIONS 1993 Compared with 1992 - ----------------------- Net income was $782.0 million in 1993, a substantial increase over the $606.5 million reported in 1992. Results for 1993 were significantly affected by required accounting changes (see Note 1 on page 56) and by an increase in the federal income tax rate (see Note 3 on page 59). Excluding the impact of the accounting changes and the federal tax rate increase related to prior years, 1993 earnings would have been $585.8 million, a $20.7 million decrease from 1992. Total railway operating revenues increased less than 1%, compared with 1992, as gains in merchandise traffic were substantially offset by lower coal traffic levels. Total railway operating expenses increased 1%, compared with 1992. Nonoperating income reflected in the Consolidated Statements of Income as "Other income-net" rose $8.1 million due to gains from property sales (see Note 4 on page 63). 1992 Compared with 1991 - ----------------------- Net income was $606.5 million in 1992, a significant increase over the $230.6 million reported in 1991. Earnings in 1991 were adversely affected by a $483 million special charge (see Note 14 on page 72). Excluding the impact of the special charge in 1991, 1992 earnings increased by $72.9 million, or 14%, compared with 1991. Railway operating revenues were up 3%, compared with 1991, despite a decline in coal traffic. Railway operating expenses were down 1%, compared with 1991 (excluding the special charge). Nonoperating income declined $20.7 million, reflecting lower interest income on less cash available to invest, lower interest rates and reduced gains from stock sales (see Note 4 on page 63). NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Railway Operating Revenues - -------------------------- Railway operating revenues were $3.73 billion in 1993, compared with $3.71 billion in 1992 and $3.60 billion in 1991. The following table presents a three-year comparison of revenues by market group. Most NS Rail traffic, particularly coal traffic, moves under contractually negotiated rates as opposed to the typically higher regulated tariff rates. In 1993, 91% of NS Rail origin coal moved under contract, compared with 88% in 1992 and 90% in 1991. Traffic volume increased for all market groups except coal. The reduction in the revenue per unit/mix was due to the decline in coal traffic and to new business that was short-haul and lowered overall average revenue. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations COAL (which includes coke and iron ore) traffic volume in 1993 decreased 6%, and revenues, which represented 33% of total railway operating revenues, were down 6% from 1992. Coal accounted for about 97% of this market group's volume, and 95% of coal shipments originated on NS Rail's lines. As shown in the following table, small tonnage gains in utility and steel coal were more than offset by declines in export coal, down 22%, compared with 1992. The export coal market continues to be weak. The recession in Europe deepened as the year progressed. Additionally, stockpiles remain at high levels in the United Kingdom, and two Italian coal-fired generating stations that closed in 1992 remained closed for all of 1993. The UMWA strike, which was settled in December 1993, also had an adverse effect on the export market, as some U.S. producers deferred export shipments to take advantage of higher domestic spot market prices. Although the strike was not widespread at mines served by NS Rail, it idled four operations that are heavily oriented toward export shipments. NS Rail's export coal business is expected to remain somewhat depressed in 1994. Expanded coal output and export capacity by foreign producers may make this market very competitive, especially for steam coal. Export coal opportunities for NS Rail are expected to continue to be greatest in Europe, and moderate growth is expected over the next five- year period. In contrast to the export market, domestic coal remained steady. Extended periods of warmer-than-usual temperatures in the Southeast resulted in increased business for a number of utility customers. NS Rail was able to provide coal service to some whose customary carriers were adversely affected by flooding in the Midwest and the UMWA strike. NS Rail continued to do well in domestic steel markets, especially in the Midwest. While total volumes in the domestic steel market remained relatively flat, compared with 1992, NS Rail was able to increase its market share. The outlook for domestic NS Rail coal traffic remains promising. New movements of western coal to an eastern utility began late in 1993 and are expected to reach 3 million tons in 1994 and to grow to nearly 7 million tons annually in the next few years. Changes in emissions regulations for sulfur dioxide included in the Clean Air Act Amendments of 1990 may increase NS Rail utility traffic. Coal volume in 1992 decreased 2%, compared with 1991, and revenues were down 3% from 1991. Traffic volume in 1991 represented NS Rail's second best year since the 1982 consolidation. As shown in the table on the previous page, NS Rail had mixed results in 1992 in the four basic coal market segments it serves. The largest decline in coal tonnage was in export coal, down 8%, compared with 1991. Beginning in 1992, the European economies slumped badly, reducing demand for U.S. coal in both steel and electricity production. Domestic utility tonnages showed the second greatest decline, 2% below 1991, reflecting weakness in the overall economy and unusually mild weather in NS Rail's service region. On the positive side, coal traffic to domestic steel companies in 1992 showed improvement. Compared with 1991, tonnage increased 15%, and NS Rail increased its market share. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations MERCHANDISE TRAFFIC volume in 1993 increased 6%, and revenues increased by $101.4 million, or 4%, compared with 1992. Merchandise carloads handled in 1993 were 2.8 million, compared with 2.7 million in 1992. Despite the slow economic recovery, all six market groups comprising merchandise traffic showed revenue improvement over 1992. The largest gains were in intermodal, up $30.9 million, or 9%; automotive, up $28.0 million, or 7%; and metals/construction, up $19.8 million, or 7%. PAPER/FOREST traffic was about even with 1992, and revenues increased 1%. Weak domestic and overseas demand for paper depressed NS Rail's shipments for much of the year. Lumber, however, posted a solid 4% revenue gain due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic rose 4% over 1992; however, revenues increased less than 1% due to a change in the mix of the traffic. There were solid gains in general chemicals and plastics, but this was offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail- truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic rose 8% and revenues increased 7%, compared with 1992. The gain was due to strong demand for vehicles produced at plants served by NS Rail. NS Rail's largest customer, Ford Motor Company, produced the top-selling automobile and truck in 1993. In addition, NS Rail benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the higher traffic levels. Further growth in automotive traffic is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS Rail's lines: the second Toyota plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes-Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic rose 4%, and revenues increased 6%, compared with 1992. In the early part of the year, NS Rail benefited from a record harvest that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS Rail's sourcing areas and poor conditions elsewhere produced strong NS Rail traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenues is expected, driven by growth in poultry production in the Southeast, a prime NS Rail feed grain market. METALS/CONSTRUCTION traffic rose 9%, and revenues increased 7%, compared with 1992. Most of the revenue gain was in shipments of iron and steel; strong industry production and new plants located on NS Rail's lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years, as NS Rail has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. NORFOLK-SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations INTERMODAL traffic rose 9%, and revenues increased 9%, compared with 1992. Intermodal revenue growth in 1993 was led by a 21% increase in services provided to Triple Crown Services Company (a partnership between subsidiaries of NS and Consolidated Rail Corporation) due to strong automotive shipments and expansion of service to the Northeast. Container revenues were up 6%, a smaller increase than previous years, reflecting reduced international traffic caused by the continuing recessions in Europe and Japan. Trailer revenues were up 11%, boosted by gains from haulage arrangements with truckload carriers. Strong growth in intermodal traffic is expected in 1994 and for the next several years. Container traffic is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. During 1992, all six merchandise market groups showed improvement over 1991. Traffic volume increased 6%, and revenues increased $147.5 million, or 7%. The largest revenue increases were in the automotive group, up $75.6 million, or 23%, over a weak 1991. The intermodal group was up $16.4 million, or 5%, over 1991, and the paper/forest and chemicals groups each reported 5% revenue gains. The growth in the automotive group was the result of a national rise in automobile production, especially increased production of popular models at plants which NS Rail serves. All segments of intermodal traffic showed growth during 1992. Triple Crown(RT), the fastest growing segment, which accounted for 24% of the intermodal traffic, began a new domestic container service in the eastern part of the NS Rail system, in addition to its RoadRailer(RT) business. Paper/forest revenues improved as the result of increased housing starts and greater paper production. Chemical revenues were higher because of a general recovery in chemical production over the recessionary levels of 1991. Railway Operating Expenses - -------------------------- Railway operating expenses increased 1% in 1993, compared with 1992, and decreased 15% in 1992, compared with 1991. Included in 1991's expenses was a $483.0 million special charge discussed below. Excluding the 1991 special charge, railway operating expenses decreased 1% in 1992, compared with 1991. SPECIAL CHARGE IN 1991 (see Note 14 on page 72): By the end of 1991, after several years of negotiations and a brief nationwide strike, new rail labor agreements were in place that allowed NS Rail to begin operating trains with reduced crew sizes. The agreements also provide for future crew size reductions. To achieve the reductions in employment and other labor savings permitted by the new agreement, NS Rail recorded a special charge that included $450 million to cover the cost of future separation payments, protective payments and amounts to buy out productivity funds. The special charge, which totalled $483 million, also included a $33 million write-down of certain properties to be sold or abandoned. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations The following table compares, on a year-to-year basis, railway operating expenses summarized by major classifications. The special charge also is summarized, as well as comparative railway operating expenses, excluding the special charge. The narrative expense analysis presented in the following paragraphs focuses on the major factors contributing to changes in railway operating expenses, excluding the effects of the 1991 special charge discussed above and in Note 14 on page 72. COMPENSATION AND BENEFITS, which includes salaries, wages and fringe benefits, represents about half of total railway operating expenses and increased 1% in 1993, compared with 1992, and declined 2% in 1992, compared with 1991. The higher expenses in 1993 were mainly due to accruals for postretirement and postemployment benefits which were previously accounted for on a pay-as-you-go basis (see "Required Accounting Changes" in Note 1 on page 56) and higher costs for stock- based compensation plans. A voluntary early retirement program was completed in 1993, which resulted in a $42.4 million charge in compensation and benefits expense (see Note 12 on page 68). Also in 1993, a $46 million credit was recorded in compensation and benefits, reflecting a partial reversal of the 1991 special charge (see Note 14 on page 72). Labor expenses were favorably affected by a lower average train crew size, which was 2.6 in 1993, a moderate decline compared with 1992. The lower expenses in 1992, compared with 1991, were mainly due to savings associated with reduced train crew sizes. The average train crew size in 1992 was 2.7 compared with 3.5 in 1991. MATERIALS, SERVICES AND RENTS consists of items used for maintenance of road (rail line and related structures) and equipment (locomotives and freight cars); equipment rents representing the cost to NS Rail of using freight equipment owned by other railroads or private owners, less the rent paid to NS Rail for the use of its equipment; and the cost of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads. This category was up less than 1%, compared with 1992, but was up 9% in 1992, compared with 1991. The increase in 1992 largely was a result of that year's greatly expanded equipment maintenance program. Also contributing to the 1992 increase were higher roadway maintenance activity, increased gross ton miles and accruals related to a lease with Canadian National Railway. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations DEPRECIATION expense (see Note 1 "Properties" on page 56 for NS Rail's depreciation policy) was up 5% in 1993, compared with 1992, and up 4% in 1992, compared with 1991. The increases in both periods were due to property additions, reflecting substantial levels of capital spending during the three-year period ended December 31, 1993. DIESEL FUEL costs declined 2% in 1993, compared with 1992, and declined 5% in 1992, compared with 1991. NS Rail consumes substantial quantities of diesel fuel; therefore, changes in price per gallon or consumption have a significant impact on the cost of providing transportation services. The lower costs in 1993 were due to a lower price per gallon, offset in part by a 2% increase in consumption related to the 3% increase in gross ton miles. Expenses declined in 1992, compared with 1991, mainly due to a lower price per gallon offset partially by increased consumption. CASUALTIES AND OTHER CLAIMS (which includes insurance costs, estimates of costs related to personal injury, property damage and environmental- related costs) declined 2% in 1993, compared with 1992, and decreased 22% in 1992, compared with 1991. By far the largest component, personal injury expenses, which relate primarily to the cost of on-the-job employee injuries, has shown favorable trends since 1990, reflecting both success in reducing accidental employee injuries and effective claims handling. Unfortunately, the favorable trend in accidental injury claims has been more than offset by increased costs of nonaccidental "occupational" claims. The rail industry remains uniquely susceptible to both accidental injury and occupational claims because of an outmoded law, the Federal Employers' Liability Act (FELA), originally passed in 1908 and applicable only to railroads. This law provides the sole basis for compensating railroad employees who sustain job-related injuries. Under the FELA, claimants unable to reach an agreement with the railroad concerning compensation may file a civil suit to recover damages. In most cases, a jury must then determine whether the claimant is entitled to any damages and, if so, the amount. The system produces results that are unpredictable, inconsistent and frequently unfair, at a cost to the rail industry that is two or three times greater than the no-fault workers' compensation systems to which nonrail competitors are universally subject. The railroads have been unsuccessful so far in efforts to persuade Congress to replace the FELA with a no-fault workers' compensation act. OTHER expenses decreased 3% in 1993, compared with 1992, and 7% in 1992, compared with 1991. These decreases were largely the result of favorable settlements of issues related to property and other state taxes. The NS Rail operating ratio (the percentage of operating revenues consumed by operating expenses) continues to be the best among the major railroads in the United States. NS Rail will continue to pursue cost- containment efforts to assure that its rail subsidiaries are operated efficiently. The operating ratios for past six years were as follows: Other Income-Net - ---------------- Nonoperating income increased $8.1 million, or 16%, in 1993, compared with 1992, but decreased $20.7 million, or 29%, in 1992, compared with 1991 (see Note 4 on page 63). The 1993 increase arose from gains on property sales, partially offset by declines in interest income and rental income (see also Note 2 "Noncash Dividend" on page 58). The 1992 decline was a result of an absence of stock sales in 1992, coupled with a decline in interest income due to lower cash and short-term investments balances and lower rates. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations Interest Expense on Debt - ------------------------ Interest expense on debt decreased 28% in 1993, compared with 1992, and 8% in 1992, compared with 1991, due principally to lower levels of equipment debt and lower interest rates. Income Taxes - ------------ Income tax expense in 1993 was $412.8 million for an effective rate of 43.6%, compared with an effective rate of 34.9% in 1992 and 34.6% in 1991, excluding the special charge. Income tax expense in 1993 was accrued under SFAS 109, rather than under the prior accounting rules (see Note 1 on page 56). Absent the federal income tax rate increase imposed by the Revenue Reconciliation Act of 1993, income tax expense in 1993 would have been $352.0 million for an effective rate of 37.2%. Current income tax expense increased from $249.0 million in 1992 to $319.9 million in 1993, primarily due to tax payments made in anticipation of Revenue Agent Reports for the 1988-1989 federal income tax audit. Deferred tax expense for 1993, compared with 1992, decreased primarily for the same reason. Current and deferred tax expenses for 1991 were affected significantly by the special charge. Much of the tax benefit resulting from this charge was not deductible in 1991 and therefore was recorded as a deferred tax benefit. Excluding the payment discussed above and the federal tax rate increase, the portion of the special charge that reversed in 1993 and 1992, combined with property-related adjustments, including depreciation, were the principal causes for the increase in deferred tax expense over the 1991 level. As a result of changes in tax law that limit or defer the timing of deductions and recent tax rate increases, NS Rail expects current taxes to remain high in relation to pretax earnings (see Note 3 on page 59 for the components of income tax expense). Required Accounting Changes - --------------------------- Effective January 1, 1993, NS Rail adopted required accounting for postretirement benefits other than pensions, postemployment benefits and income taxes (see Note 1 on page 56 for a discussion of these accounting changes). The net cumulative effect of these noncash adjustments increased 1993's net income by $247.8 million. The balance sheet effects of these accrual adjustments are reflected primarily in "Other liabilities" for the postretirement and postemployment benefits and in "Deferred income taxes" for the income tax accounting change. Impact of New Accounting Pronouncements - --------------------------------------- In May 1993, the Financial Accounting Standards Board issued a new standard, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. This standard will require NS Rail to increase the recorded carrying value for its investment in NS stock to fair value, with a corresponding increase, net of taxes, as a separate component of stockholders' equity (see Note 1 "New Statement of Financial Accounting Standards" on page 56 for further details.) NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES FINANCIAL CONDITION refers to the assets, liabilities and stockholders' equity of an organization, including the value of those individual elements in relation to each other. Generally, financial condition is evaluated at a point in time using an organization's balance sheet (see page 52). LIQUIDITY refers to the ability of an organization to generate adequate amounts of cash, principally from operating results or through borrowing power (based on net income or financial condition), to meet its short-term and long-term cash requirements. CAPITAL RESOURCES refers to the ability of an organization to attract investors through the sale of either debt or equity (stock) securities. CASH PROVIDED BY OPERATING ACTIVITIES, which is NS Rail's principal source of liquidity, declined 9% in 1993, compared with 1992, but was up 32% in 1992, compared with 1991. These fluctuations were primarily due to the timing of income tax payments. In 1993, tax payments were $146.0 million higher than in 1992 due to payments related to the 1988-1989 federal income tax audit, higher 1993 earnings and the fact that 1992's tax payments were low. In 1992, tax payments were $70.8 million less than 1991 primarily due to the higher tax payments in 1991 related to the federal income tax audit for 1986 and 1987, and to estimated tax payments in 1991 utilized in 1992. In addition, net income in 1992, excluding the special charge in 1991, was up $72.9 million, and depreciation increased $13.4 million. Implementation of the labor portion of the 1991 special charge also contributed to the fluctuations in cash provided by operations. In 1993, only $36.1 million was used for labor costs related to the special charge, compared with $134.7 million in 1992 and $108.0 million in 1991. The decline in 1993 was partly due to the failure to reach agreement on terms for certain further labor savings. This situation also led to a partial reversal of the 1991 special charge (see discussion in Note 14). Looking ahead, the labor portion of the special charge is expected to continue to require the use of cash to achieve productivity gains permitted by the agreements, although at a level somewhat lower than previously anticipated. NS Rail regards this cash outflow as an investment because, in view of the high cost of labor and fringe benefits, these payments are expected to produce significant future labor savings. It is estimated that NS Rail's labor-related payments will be reduced by about $150 million per year upon full implementation of the new labor agreements. Since consolidation, cash provided by operating activities has been sufficient to fund dividend requirements, debt repayments and a significant portion of capital spending (see Consolidated Statements of Cash Flows on page 53). NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations CASH USED FOR INVESTING ACTIVITIES declined 22% in 1993, compared with 1992, but was up 6% in 1992, compared with 1991. Repayment received from NS on short-term advances (see Note 2 on page 58) and higher proceeds from property sales were primarily responsible for the improvement in 1993. An absence of investment sales caused the 1992 over 1991 increase. Although the high level of property sales that occurred in 1993 is not expected to continue, efforts to hold down capital spending will be ongoing as NS Rail seeks to maximize utilization of all its assets. In this connection, NS Rail continues to review its route network to identify areas where efficiency can be enhanced by coordinated agreements with other railroads, or through sale or abandonment. The following table summarizes capital spending over the last five years, as well as track maintenance statistics and the average ages of railway equipment. The average age of locomotives retired during 1993 was 24.7 years. In recent years, NS Rail has rebodied over 14,000 coal cars and plans to continue that program at the rate of about 3,000 cars per year for the next several years. This process, performed at NS Rail's Roanoke Car Shop, converts hopper cars into high-capacity steel gondolas or hoppers. As a result, the remaining serviceability of the freight car fleet is greater than indicated by the increasing average age of the freight car fleet. Construction of two surge silos at the coal transloading facility in Norfolk was completed in 1993. The silos, which have a total capacity of 8,150 tons, allow for continuous dumping which reduces operating costs and loading time. For 1994, NS Rail is planning $627 million of capital spending. NS Rail anticipates new equipment financing of approximately $72 million in 1994. Rail capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to adding capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. Investments and advances (see Note 5 on page 63) decreased $110.1 million in 1993, compared with 1992. This decline reflects a $220 million reclassification to "Other current assets" for the cash surrender value of certain corporate owned life insurance (COLI) which is expected to be borrowed in April 1994, and accounts for the increase in working capital. Absent this reclassification, "Investments" would have increased almost $110 million, principally reflecting premium payments on COLI, which increase the cash surrender value of the underlying insurance policies. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations CASH USED FOR FINANCING ACTIVITIES increased 16% in 1993, compared with 1992, and 45% in 1992, compared with 1991. These increases were principally a result of lower borrowing. Debt activity over the past five years was as follows: Debt requirements for 1994 are expected to remain moderate partly because another source of cash, borrowing on the cash surrender value of COLI, will satisfy some of 1994's cash requirements (see Note 5 on page 63). ENVIRONMENTAL MATTERS NS Rail is subject to various jurisdictions' environmental laws and regulations. NS Rail and certain subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified NS Rail and certain subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS Rail has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS Rail are reflected as receivables in the balance sheet and are not netted against the associated NS Rail liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS also established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS Rail's traffic mix can pose special risks that NS Rail and its subsidiaries work diligently to minimize. In addition, several NS Rail subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS Rail ultimately may bear some financial responsibility, there can be no assurance that NS Rail will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Company is aware. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Management's Discussion and Analysis of Financial Condition and Results of Operations INFLATION Generally accepted accounting principles require the use of historical costs in preparing financial statements. This approach disregards the effects of inflation on the replacement cost of property and equipment. NS Rail, a capital-intensive company, has approximately $12.1 billion invested in such assets. The replacement costs of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical costs. RAIL INDUSTRY TRENDS NS Rail and other railroads are continuing to seek opportunities to share traffic routes and facilities, furthering the goals of providing seamless service to customers, making railroads more competitive with trucks and maximizing efficiency of the respective railroads. NS Rail is responding to concerns regarding the emission of coal dust from in-transit coal trains. Testing is under way of various methods of controlling such emissions. However, at this time final results of the testing and estimated costs that may be incurred to implement the conclusions resulting therefrom are not available. NS Rail and the rail industry are continuing their efforts to replace the FELA with a no-fault workers' compensation system, which we strongly believe to be fairer both to the rail industry and to its employees. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements The following notes are an integral part of the consolidated financial statements. 1. Summary of Significant Accounting Policies Principles of Consolidation - --------------------------- The consolidated financial statements include Norfolk Southern Railway Company, Norfolk and Western Railway Company (NW) and their majority- owned and controlled subsidiaries (collectively, NS Rail). All significant intercompany balances and transactions have been eliminated in consolidation (see Note 15 for NW's summarized consolidated financial information). Cash Equivalents - ---------------- Cash equivalents are highly liquid investments purchased three months or less from maturity. The carrying value approximates fair value because of the short maturity of these investments. Materials and Supplies - ---------------------- Materials and supplies, which consist mainly of fuel oil and items for maintenance of property and equipment, are stated at average cost. The cost of materials and supplies expected to be used in capital additions or improvements is included in properties. Properties - ---------- Properties are stated principally at cost and are depreciated using group depreciation. Rail is primarily depreciated on the basis of use measured by gross ton miles. The effect of this method is to write off these assets over 42 years on average. Other properties are depreciated generally using the straight-line method over estimated service lives at annual rates that range from 1% to 20%. The overall depreciation rate averaged 2.6% for roadway and 4.0% for equipment. NS Rail capitalizes interest on major capital projects during the period of their construction. Maintenance expense is recognized when repairs are performed. When properties other than land are sold or retired in the ordinary course of business, the cost of the assets less the sale proceeds or salvage is charged to accumulated depreciation rather than recognized through income. Gains and losses on disposal of land, which is a nondepreciable asset, are included in other income. Revenue Recognition - ------------------- Revenue is recognized proportionally as a shipment moves from origin to destination. Balance Sheet Classification - ---------------------------- Beginning with 1991, the balance sheet classification of certain revenue-related balances appears on an actual (net) basis rather than an estimated (gross) basis due to the earlier availability of certain settlement data with other railroads. This modification, which had no income statement effect, resulted in large offsetting declines in accounts receivable and accounts payable as illustrated in the Statement of Cash Flows for 1991. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (continued) Required Accounting Changes - --------------------------- Effective January 1, 1993, NS Rail adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS 112). SFAS 106 requires NS Rail to accrue the cost of specified health care and death benefits over an employee's active service period rather than, as was the previously prevailing practice, accounting for such expenses on a pay-as-you-go basis. SFAS 112 requires corporations to recognize the cost of benefits payable to former or inactive employees after employment but before retirement on an accrual basis. For NS Rail, such postemployment benefits consist principally of benefit obligations related to participants in the long-term disability plan. NS Rail recognized the effects of these changes in accounting on the immediate recognition basis. The cumulative effects on years prior to 1993 of adopting SFAS 106 and 112 increased pretax expenses $336.3 million ($208.4 million after-tax), and $22.8 million ($14.2 million after-tax), respectively (see Note 13). The impact on 1993 expenses is not material. The pro forma effects of applying SFAS 106 and SFAS 112 on individual prior years is not presented, as the effect on each separate year also is not material. Also effective January 1, 1993, NS Rail adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 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 future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, which applied for 1992 and prior years, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation, and deferred taxes were not adjusted for subsequent changes in tax rates. The cumulative effect on years prior to 1993 of adopting SFAS 109 increased net income by $470.4 million (see also Note 3). New Statement of Financial Accounting Standards - ----------------------------------------------- "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115) was issued in May 1993. This standard, which is effective for 1994, addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Investments are to be categorized as one of the following types of securities: "held-to-maturity," "trading" or "available-for-sale." The carrying value and timing of gain/loss realization is dependent upon the categorization of the investment. For NS Rail, the only significant effect will be a change in the carrying value of its investments in NS stock. As described in Note 5, NS Rail owns approximately 7.3 million shares of NS stock, the fair market value of which far exceeds the original cost. Under SFAS 115, NS Rail will report this investment at fair value with the unrealized gain reported, net of taxes, as a separate component of stockholders' equity. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 2. Related Parties General - ------- NS is the parent holding company of NS Rail. The costs of functions performed by NS are allocated among its rail operating subsidiaries. Rail operations are coordinated at the holding company level by the NS Executive Vice President-Operations. Noncash Dividend - ---------------- On April 1, 1993, NS Rail declared and issued to NS a $104.7 million noncash dividend representing the net assets of several nonrailroad subsidiaries. These subsidiaries, principally involved in real estate, produce a small amount of rental income which will no longer be part of NS Rail's results. Noncash dividends are excluded from the Consolidated Statements of Cash Flows. Assets Acquired - --------------- During 1991, NS Rail acquired $66.6 million of assets from a related party (see Note 6). During 1993, NW issued a demand note for $112.6 million to an NS subsidiary for the purchase of a portfolio of short-term investments. This noncash transaction was excluded from the Consolidated Statement of Cash Flows. Interest is applied to short-term advances at the average NS yield on short-term investments. Intercompany Federal Income Tax Accounts - ---------------------------------------- In accordance with the NS Tax Allocation Agreement, intercompany federal income tax accounts are recorded between companies in the NS consolidated group. At December 31, 1993 and 1992, NS Rail had intercompany federal income tax payables (which are included in "Deferred income taxes" in the Consolidated Balance Sheets) of $175.1 million and $139.5 million, respectively. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 2. Related Parties (continued) Cash Required for NS Stock Purchase Program and NS Debt - ------------------------------------------------------- Since 1987, the NS Board of Directors has authorized the purchase and retirement of up to 65 million shares of NS common stock. Purchases under the programs initially were made with internally generated cash. Beginning in May 1990, NS financed some purchases with proceeds from the sale of commercial paper notes. As of December 31, 1993 and 1992, NS had recorded $521.8 million and $520.5 million, respectively, of notes under this program. In March 1991, NS issued $250 million of long-term notes and, in February 1992, NS issued an additional $250 million of long-term notes in part to repay a portion of the commercial paper notes, as well as to fund additional stock purchases. On January 29, 1992, NS announced that, primarily related to issues surrounding the 1991 special charge (see Note 14), the purchase program would continue, but at a slower pace and over a longer authorized period, with actual purchases dependent on market conditions, the economy, cash needs and alternative investment opportunities. Since the first purchases in December 1987 and through December 31, 1993, NS has purchased and retired 53,615,800 shares of its common stock under these programs at a cost of $2.2 billion. Consistent with the earlier cash purchases, a significant portion of the funding for future NS stock purchases, either in the form of direct cash or cash used for debt service, will come from NS Rail through intercompany advances or dividends to NS. Cash required to service NS debt issued to fund labor costs related to the special charge (see Note 14) also will come principally from NS Rail. Included in interest income is $6.7 million, $7.7 million and $8.8 million in 1993, 1992 and 1991, respectively, related to amounts due from NS. Transfers of Investment from NS - ------------------------------- In August 1991, NS transferred its $15.2 million equity interest in a railroad equipment leasing subsidiary to Norfolk Southern Railway Company. This transfer was recorded at historical cost and reflected as a contribution to capital. 3. Income Taxes Federal Income Tax Rate Increase - -------------------------------- In August 1993, Congress enacted the Revenue Reconciliation Act of 1993, which increased the federal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. The tax rate increase had two components which, as required by SFAS 109, were recognized in 1993's earnings. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 3. Income Taxes (continued) The first component relates to the increased income tax rate's effect on 1993's earnings, which increased the provision for income taxes and reduced net income by $9.2 million. The second component increased the provision for the net deferred tax liability in the Consolidated Balance Sheet, which reduced net income by $51.6 million. Inclusion in Consolidated Return - -------------------------------- NS Rail is included in the consolidated federal income tax return of NS. The provision for current income taxes in the Consolidated Statements of Income reflects NS Rail's portion of NS' consolidated tax provision. Tax expense or tax benefit is recorded on a separate company basis whether or not such benefit would be currently available on a separate company basis. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 3. Income Taxes (continued) Deferred Income Tax Expense - --------------------------- Some income and expense items are reported differently for financial reporting and income tax purposes. Provisions for deferred income taxes were made in recognition of these differences in accordance with APB Opinion No. 11 for years prior to 1993, and SFAS 109 for 1993 (see Note 1 for an explanation of this required accounting change). For 1993, the components of deferred income tax expense were as follows: (1) $51.6 million in adjustments to deferred tax assets and liabilities for the enacted tax rate increase; (2) $1.4 million decrease in the valuation allowance for deferred tax NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 3. Income Taxes (continued) assets, and (3) $42.7 million net for all other deferred tax expense items, for a total of $92.9 million. The significant components of deferred income tax expense for 1992 and 1991 were as follows: NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 3. Income Taxes (continued) Except for amounts for which a valuation allowance is provided, Management believes the other deferred tax assets will be realized. The valuation allowance for deferred tax assets as of January 1, 1993, was $3.4 million. The net change in the total valuation allowance for the year ended December 31, 1993, was a decrease of $1.4 million. Internal Revenue Service (IRS) Reviews - -------------------------------------- Consolidated federal income tax returns have been examined and Revenue Agent Reports have been received for all years up to and including 1989. The consolidated federal income tax returns for 1990 through 1992 are being audited by the IRS. Management believes that adequate provision has been made for any additional taxes and interest thereon that might arise as a result of these examinations. Corporate Owned Life Insurance - ------------------------------ The cash surrender value of certain corporate owned life insurance, amounting to approximately $220 million, which is expected to be borrowed in April 1994, has been reclassified in the Consolidated Balance Sheet from "Investments and advances" to "Other current assets." NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 5. Investments and Advances (continued) Fair Values - ----------- At December 31, 1993, the fair value of investments approximated $904 million. The fair values of marketable securities were based on quoted market prices. At December 31, 1993 and 1992, the market value of marketable equity securities, which consist principally of 7,252,634 shares of NS common stock, was $511.9 million and $444.6 million, respectively. The fair values of stock in nonmarketable securities were estimated based on the underlying net assets. For the remaining investments and advances, consisting principally of corporate owned life insurance and long-term advances to NS, the carrying value approximates fair value. Noncash Property Transactions Excluded from the Consolidated Statements - ----------------------------------------------------------------------- of Cash Flows - ------------- Additions to "Other property" in 1991 included $66.6 million for assets acquired from a real estate partnership in which an NS Rail subsidiary owned an equity interest. Of this transaction, $10.6 million was noncash and related to amounts invested in or advanced to that partnership which previously had been classified in "Investments and advances." Capitalized Interest - -------------------- Total interest cost incurred on long-term debt for 1993, 1992 and 1991 was $53.9 million, $62.5 million and $66.0 million, respectively, of which $21.6 million, $17.9 million and $17.6 million was capitalized. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 8. Debt Short-Term Debt - --------------- Short-term debt consists of $27.2 million of notes assumed in connection with the 1990 acquisition of a coal terminal facility. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 8. Debt (continued) A substantial portion of NS Rail's properties and certain investments in affiliated companies are pledged as collateral for much of the secured debt. Fair Values - ----------- The carrying value of short-term debt approximates fair value. The fair value of long-term debt, including current maturities, approximated $670 million at December 31, 1993. The fair values of debt were estimated based on quoted market prices or discounted cash flows using current interest rates for debt with similar terms, company rating and remaining maturity. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 9. Lease Commitments Among NS Rail's leased properties are approximately 300 miles of road in North Carolina. The leases expire in 1994, and NS Rail is discussing renewals with the lessor (see also page 5). NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 11. Stock Preferred - --------- There are 10,000,000 shares of no par value serial preferred stock authorized. This stock may be issued in series from time to time at the discretion of the Board of Directors with any series having such voting and other powers, dividends and other preferences as deemed appropriate at the time of issuance. At December 31, 1993 and 1992, 1,197,027 and 1,197,131 shares of $2.60 Cumulative Preferred Stock, Series A (Series A Stock) were issued, and 1,096,907 and 1,097,011 shares were held other than by subsidiaries. The Series A Stock has a $50 per share stated value. The Series A Stock is callable at any time at $50 per share plus accrued dividends and has one vote per share on all matters, voting as a single class with holders of other stock. On June 2, 1989, NS announced that it intended to purchase up to 250,000 shares of the outstanding Series A Stock during the subsequent two-year period. In May 1991, NS extended the previously announced stock purchase program through 1993. In March 1994, NS announced that it would continue purchasing up to 250,000 shares of the Series A Stock through 1996. NS had purchased 77,626 shares at a total cost of approximately $2.7 million as of December 31, 1993. NS purchased the shares in regular brokerage transactions on the open market at prevailing prices. At year end 1993 and 1992, NS held 77,721 shares and 75,721 shares, respectively. Preference - ---------- There are 10,000,000 shares of no par value serial preference stock authorized. None of these shares has been issued. Common - ------ There are 50,000,000 shares of no par value common stock with a stated value of $10 per share authorized. NS owns all 16,668,997 shares issued and outstanding at December 31, 1993 and 1992. 12. Pension Plans NS Rail's defined benefit pension plans, which principally cover salaried employees, are part of NS' retirement plans. Pension benefits are based primarily on years of creditable service with NS and its participating subsidiary companies and compensation rates near retirement. Contributions to the plans are made on the basis of not less than the minimum funding standards set forth in the Employee Retirement Income Security Act of 1974, as amended. Assets in the plans consist mainly of common stocks. The following data relate principally to NS Rail's portion of the combined NS plans, since no separate NS Rail data are available. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 12. Pension Plans (continued) NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 12. Pension Plans (continued) Early Retirement Program - ------------------------ During 1993, NS Rail completed a voluntary early retirement program for salaried employees that resulted in a $42.4 million charge in compensation and benefits expense. The principal benefit for those who participated in the program was enhanced pension benefits which are reflected in the accumulated benefit obligation at December 31, 1993. Transfer of Pension Plan Assets - ------------------------------- During 1991, the NS Retirement Plan was amended to establish a Section 401(h) account for the purpose of transferring a portion of pension plan assets in excess of the projected actuarial liability to fund current- year medical payments for retirees. In December 1993, 1992 and 1991, $13.0 million, $15.0 million and $14.5 million, respectively, were transferred from this account to reimburse NS for such payments. NS contributed equal amounts to a Voluntary Employee Beneficiary Association account in those years to fund future benefit costs for retirees (see Note 13). 401(k) Plan - ----------- NS Rail provides a 401(k) savings plan for salaried employees. Under the plan, NS Rail matches a portion of the employee contributions, subject to applicable limitations. NS Rail's expenses under this plan were $5.1 million, $4.7 million and $4.4 million in 1993, 1992 and 1991, respectively. 13. Postretirement Benefits Other Than Pensions NS Rail provides specified health care and death benefits to eligible retired employees, principally salaried employees. Under the present plans, which may be amended or terminated at NS Rail's option, a defined percentage of health care expenses is covered, reduced by any deductibles, co-payments, Medicare payments and, in some cases, coverage provided by other group insurance policies. The cost of such health care coverage to a retiree may be determined, in part, by the retiree's years of creditable service with NS Rail prior to retirement. Death benefits are determined based on various factors, including, in some cases, salary at time of retirement. NS Rail continues to fund benefit costs principally on a pay-as-you-go basis. However, in 1991, NS Rail established a Voluntary Employee Beneficiary Association (VEBA) account to fund a portion of the cost of future health care benefits for retirees (see "Transfer of Pension Plan Assets" in Note 12). NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 13. Postretirement Benefits Other Than Pensions (continued) For measurement purposes, a 12% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate was assumed to decrease gradually to an ultimate rate of 6% for 2005 and remain at that level thereafter. The health care cost trend rate has a significant effect on the amounts reported in the financial statements. 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 about $53 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year 1993 by about $4.7 million. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 13. Postretirement Benefits Other Than Pensions (continued) The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. A 6% salary increase assumption was used for death benefits based on salary at the time of retirement. The VEBA trust holding the plan assets is not expected to be subject to federal income taxes as the assets are invested entirely in trust- owned life insurance. The long-term rate of return on plan assets, as determined by the growth in cash surrender value of the life insurance policies, is expected to be 9%. Under collective bargaining agreements, NS Rail and certain subsidiaries participate in a multi-employer benefit plan, which provides certain postretirement health care and life insurance benefits to eligible union employees. Premiums under this plan are expensed as incurred and amounted to $6.4 million, $6.2 million and $6.2 million in 1993, 1992 and 1991, respectively. 14. Special Charge in 1991 and Subsequent Partial Reversal in 1993 Included in 1991 results was a $483 million special charge for labor force reductions and asset write-downs. The special charge reduced net income by $303 million. The principal components of the special charge were as follows: Labor - ----- Significant new labor agreements were reached late in 1991 following a Presidential Emergency Board's recommendations that railroads be permitted to modify long-standing unproductive work rules. The principal feature of the new agreements concerned a change in crew consist (the required number of crew members on a train) from four to two members to be implemented over a five-year period across most of NS Rail's system. Surplus employees whose positions were eliminated as a result of the restructured crew size are entitled to protective pay and may be offered voluntary separation incentives. Related to crew-consist changes, separate agreements were reached concerning the buy out of certain productivity funds (payments to train service employees whenever a train operates with a reduced crew). The labor portion of the special charge amounted to $450 million and represented the estimated costs of achieving the productivity gains provided by these new agreements. Property - -------- The property portion of the special charge, which amounted to $33 million, was for marginally productive railroad property that was scheduled for sale or abandonment. Special Charge Reversal - ----------------------- Based on NS Rail's success in eliminating reserve board positions in 1992 and 1993, and on events occurring in the third quarter of 1993, the accrual included in the 1991 special charge related to labor was reduced by $46 million and was reflected as a credit in compensation and benefits expenses. The principal factor contributing to the reversal was that, in 1993, agreement on terms for certain further labor savings could not be reached. Accordingly, it became apparent that a surplus existed in the labor portion of the provision established in the 1991 special charge. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 15. Norfolk and Western Railway Company and Subsidiaries (NW)-- Summarized Consolidated Financial Information NW is operated as an integral part of NS Rail. Revenues are allocated to NW based on actual traffic movements as determined by revenue ton miles within market groups. Expenses are allocated to NW based on criteria considered appropriate for the type of expense. The costs of functions performed by NS, the parent holding company of NS Rail, are also allocated to its rail operating subsidiaries. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 15. Norfolk and Western Railway Company and Subsidiaries (NW)-- Summarized Consolidated Financial Information (continued) 16. Contingencies Lawsuits - -------- Norfolk Southern Railway Company and certain subsidiaries are defendants in numerous lawsuits relating principally to railroad operations. While the final outcome of these lawsuits cannot be predicted with certainty, it is the opinion of Management, after consulting with its legal counsel, that ultimate liability will not materially affect the consolidated financial position of NS Rail. Debt Guarantees - --------------- As of December 31, 1993, NS Rail and certain subsidiaries are contingently liable as guarantors with respect to $37 million of indebtedness of related entities. NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES (A Majority-Owned Subsidiary of Norfolk Southern Corporation) Notes to Consolidated Financial Statements 16. Contingencies (continued) Environmental Matters - --------------------- NS Rail is subject to various jurisdictions' environmental laws and regulations. NS Rail and certain subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified NS Rail and certain subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS Rail has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS Rail are reflected as receivables in the balance sheet and are not netted against the associated NS Rail liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS Rail also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS Rail's traffic mix can pose special risks that NS Rail and its subsidiaries work diligently to minimize. In addition, several NS Rail subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS Rail ultimately may bear some financial responsibility, there can be no assurance that NS Rail will not incur liabilities or costs, the amount of and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Company is aware. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Norfolk Southern Railway Company: We have audited the consolidated financial statements of Norfolk Southern Railway Company and subsidiaries (a majority-owned subsidiary of Norfolk Southern Corporation) as listed in Item 8. In connection with our audits of the consolidated financial statements, we also have audited the consolidated financial statement schedules as listed in Item 14(a)1. These consolidated financial statements and consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Norfolk Southern Railway 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 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. As discussed in Note 1, the Company changed its methods of accounting in 1993 by adopting the provisions of the Financial Accounting Standards Board's Statement 109, Accounting for Income Taxes; Statement 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; and Statement 112, Employers' Accounting for Postemployment Benefits. /s/ KPMG Peat Marwick Norfolk, Virginia January 25, 1994, except as to Note 11, which is as of March 3, 1994 EXHIBIT INDEX ------------- Electronic Submission Exhibit Number Description Page Number - ---------- -------------------------------------------- ----------- Subsidiaries of Norfolk Southern Railway. 85

789570_1993.txt

789570_1993

1993

789570

ITEM 1. BUSINESS GENERAL MGM Grand, Inc. (the "Company") was organized as a Delaware corporation on January 29, 1986. Through its wholly-owned subsidiary, MGM Grand Hotel, Inc. ("MGM Grand Hotel"), the Company commenced operations on December 18, 1993 of the MGM Grand Hotel and Theme Park, a large-scale integrated hotel/casino entertainment complex. The new resort is located on approximately 112 acres on Las Vegas Boulevard South (the "Strip") in Las Vegas, Nevada, across the street from Excalibur and the Tropicana Hotel/Casino. MGM Grand Hotel Finance Corp. ("MGM Finance"), a wholly-owned subsidiary of the Company, was formed to issue First Mortgage Notes to the public, to incur bank debt (the "Bank Loan") if required and to lend the aggregate proceeds thereof to MGM Grand Hotel to finance the construction and opening of the MGM Grand Hotel and Theme Park. Through its wholly-owned subsidiary, MGM Grand Air, Inc. ("MGM Grand Air"), the Company provides service as an all charter airline. MGM Grand Air operated a scheduled airline service between New York and Los Angeles through December 1992. In January 1990, the Company acquired the Marina Hotel and Casino (the "Marina") located on the project site for $80 million consisting of $50 million in cash and 1,764,706 shares of common stock. In February 1990, the Company acquired the Tropicana Country Club and adjacent land which, along with the Marina, constitutes the 112 acre project site, for $38 million in cash. During November 1990, the Marina and the Tropicana Country Club were closed to prepare for construction of the MGM Grand Hotel and Theme Park. Formal ground breaking occurred in October 1991, and the facility opened in December 1993. In February 1988, the Company through its wholly-owned subsidiaries, MGM Desert Inn, Inc. ("MGM Desert Inn") and MGM Sands, Inc. ("MGM Sands"), acquired the Desert Inn Hotel and Casino (the "Desert Inn") and the Sands Hotel and Casino (the "Sands") together with the assets (excluding cash and receivables) used in their operations, as well as certain adjacent undeveloped property, for $167 million. In April 1989, the Sands was sold for $110 million in cash, realizing a pre-tax gain of approximately $26.5 million. In January 1990, MGM Desert Inn purchased for $28 million in cash 143 acres of previously leased land on which the Desert Inn is located. In December 1991, the Desert Inn was sold to a subsidiary of Tracinda Corporation ("Tracinda") for $130 million in cash. The net sales proceeds in excess of the book value of the assets sold of $11.8 million net of taxes were credited to Capital in Excess of Par Value. For certain information about the Company's industry segments, see Note 17 to the Company's Consolidated Financial Statements. The Company's principal executive offices are currently located at 3799 Las Vegas Boulevard South, Las Vegas, Nevada 89109. The Company's telephone number is (702) 891-3333. HOTELS AND GAMING MGM Grand Hotel and Theme Park MGM Grand Hotel opened the MGM Grand Hotel and Theme Park on December 18, 1993, more than three months ahead of the originally scheduled opening date of April 1, 1994. The new resort is located on approximately 112 acres on the Strip in Las Vegas Nevada, across the street from Excalibur and the Tropicana Hotel/Casino. MGM Grand Hotel is a multi-themed destination resort which management believes is a "must see" attraction for visitors to Las Vegas. The resort has over 350 feet of frontage on the Strip and 1,450 feet on Tropicana Avenue. The complex is easily accessible from McCarran International Airport and from interstate 15 via Tropicana Avenue. MGM Grand Hotel creates an exciting and unique gaming and entertainment experience which is intended to appeal to all segments of the Las Vegas market. The entrance to the hotel and casino on the Strip is highlighted by a seven story lion through which visitors proceed to a 70 foot high reproduction of the Emerald City inspired by "The Wizard of Oz". The casino is approximately 171,500 square feet in size, and is one of the largest casinos in the world. The casino has 3,500 slot machines and 155 table games, a state of the art baccarat pit, a poker room, a race and sports book, and a keno lounge. The casino features four separate themed areas: Emerald City, Hollywood, Monte Carlo, and Sports which enhance the entertainment experience of the casino patron. The hotel has 5,005 rooms, which management believes is the largest in the world. The hotel includes approximately 4,254 typical guest rooms decorated in five different themes: Deep South, Hollywood, Monte Carlo, Emerald, and Casablanca. The hotel also has 751 luxury suites, more than any other Las Vegas hotel. These suites range in size from 650 to 6,000 square feet. The hotel provides guests with a state of the art health spa, a swimming pool, and four lighted tennis courts. MGM Grand Hotel has Las Vegas' only full scale theme park. Situated on 33 acres, the park has 12 rides and attractions, extensive food and beverage outlets, ten retail shops, and a large craft area where visitors can view handcrafts being made. Other entertainment facilities include: a 31,000 square foot Midway containing 30 carnival games of skill; an extensive video arcade including virtual reality simulators; two showrooms providing celebrity entertainment; eight restaurants and a food court; a 15,200 seat special events center, providing a venue for great entertainers such as Barbra Streisand and Luther Vandross, as well as sporting events. MGM Grand Hotel uses the unique characteristics of the property to target the following segments of the Las Vegas market: (i) free and independent travelers; (ii) tour and travel; (iii) special events/conventions; (iv) high end gaming; and (v) local. Las Vegas Market The MGM Grand Hotel and Theme Park operates in the Las Vegas market, and is located on the Strip. Las Vegas is the largest city in Nevada, with a population in excess of 900,000, and one of the largest resort destinations in the world with over 23.5 million visitors in 1993, an increase of 7.5% over 1992. Gaming has continued to be a strong and growing business in Las Vegas. Since 1982, Las Vegas Strip gaming revenues have increased at a compound annual growth rate of 7.5% from $1.3 billion in 1982 to $2.9 billion in 1993. The hotel industry in Las Vegas is highly competitive. In 1993 two other major themed resort hotels opened on the Strip; the Luxor with 2,500 rooms and 100,000 square feet of gaming space, and Treasure Island with 3,000 rooms and 90,000 square feet of gaming space. While all of the large themed resorts pose direct competition with the MGM Grand Hotel and Theme Park, Las Vegas Visitors and Convention Authority ("LVCVA") statistics show that tourism growth more than offset the increased capacity as visitor volume for 1993 increased 16% over 1992 levels. MGM Grand Hotel competes with gaming and resort facilities in their respective markets as well as gaming and resort facilities elsewhere in the world. To some extent, state lotteries and state-authorized card rooms such as those present in California compete with the Company's casino/hotels. Gambling, with various limitations and conditions, is now legal in numerous locations throughout the United States. The proliferation of such limited gaming facilities on riverboats and elsewhere is increasing. Also, as a result of certain legislative and court decisions, casino-type operations are being established at various Native American reservations throughout the country. The development of fully operating casinos in California would likely have a negative effect on MGM Grand Hotel's operations in Nevada. Insurance The MGM Grand Hotel carries insurance of the type customary in the hotel and casino industry and in amounts deemed adequate by management to protect the properties. The policies provide customary business and commercial coverages, including workers' compensation, third party liability, property damage, boiler and machinery and business interruption. Government Regulation The ownership and operation of casino gaming facilities in Nevada are subject to: (i) the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, the "Nevada Act"); and (ii) various local regulation. The Company's gaming operations are subject to the licensing and regulatory control of the Nevada Gaming Commission (the "Nevada Commission"), the Nevada State Gaming Control Board (the "Nevada Board"), and the Clark County Liquor and Gaming Licensing Board (the "CCLGLB"). The Nevada Commission, the Nevada Board, and the CCLGLB are collectively referred to as the "Nevada Gaming Authorities." The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy that are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (iv) the prevention of cheating and fraudulent practices; and (v) to provide a source of state and local revenues through taxation and licensing fees. Change in such laws, regulations and procedures could have an adverse effect on the Company's gaming operations. MGM Grand Hotel operates the casino and is required to be licensed by the Nevada Gaming Authorities. The gaming license requires the periodic payment of fees and taxes and is not transferable. MGM Grand Hotel is also licensed as a manufacturer and distributor of gaming devices. Another wholly-owned subsidiary of the Company, MGM Dist., Inc. ("MGM Dist."), is also licensed by the Nevada Gaming Authorities as a manufacturer and distributor of gaming devices, subject to certain conditions and limitations imposed by the Nevada Commission. The Company is required to be registered by the Nevada Commission as a publicly traded corporation ("Registered Corporation") and as such, it is required periodically to submit detailed financial and operating reports to the Nevada Commission and furnish any other information that the Nevada Commission may require. No person may become a stockholder of, or receive any percentage of profits from, MGM Grand Hotel or MGM Dist. without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Company, MGM Grand Hotel and MGM Dist. have obtained from the Nevada Gaming Authorities the various registrations, approvals, permits and licenses required in order to engage in gaming activities in Nevada. The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, the Company, MGM Grand Hotel or MGM Dist. in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of MGM Grand Hotel and MGM Dist. must file applications with the Nevada Gaming Authorities and may be required to be licensed or found suitable by the Nevada Gaming Authorities. Officers, directors and key employees of the Company who are actively and directly involved in the gaming activities of MGM Grand Hotel or MGM Dist. may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada Gaming Authorities and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a change in a corporate position. If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with the Company, MGM Grand Hotel or MGM Dist., the companies involved would have to sever all relationships with such person. In addition, the Nevada Commission may require the Company, MGM Grand Hotel or MGM Dist. to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada. The Company, MGM Grand Hotel and MGM Dist. are required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar financing transactions by MGM Grand Hotel and MGM Dist., must be reported to or approved by the Nevada Commission. If it was determined that the Nevada Act was violated by MGM Grand Hotel or MGM Dist., the gaming licenses they held could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, MGM Grand Hotel, MGM Dist., the Company and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Further, a supervisor could be appointed by the Nevada Commission to operate the Company's gaming property and, under certain circumstances, earnings generated during the supervisor's appointment (except for the reasonable rental value of the Company's gaming property) could be forfeited to the State of Nevada. Limitation, conditioning or suspension of any gaming license or the appointment of a supervisor could (and revocation of any gaming license would) materially adversely affect the Company's gaming operations. Any beneficial holder of the Company's voting securities, regardless of the number of shares owned, may be required to file an application, be investigated, and have his suitability as a beneficial holder of the Company's voting securities determined if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation. The Nevada Act requires any person who acquires more than 5% of the Company's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of the Company's voting securities apply to the Nevada Commission for a finding of suitability within thirty days after the Chairman of the Nevada Board mails the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10% but not more than 15% of the Company's voting securities, may apply to the Nevada Commission for a Waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the Company, any change in the Company's corporate charter, bylaws, management, policies or operations of the Company or any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the Company's voting securities for investment purposes only. Activities that are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation. Any person who fails or refuses to apply for a finding of suitability or a license within thirty days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board, may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request, fails to identify the beneficial owner. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock of a Registered Corporation beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Company is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Company, MGM Grand Hotel or MGM Dist., the Company (i) pays that person any dividend or interest upon voting securities of the Company, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) pays remuneration in any form to that person for services rendered or otherwise, or (iv) fails to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities for cash at fair market value. Additionally, the CCLGLB has taken the position that they have the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming license. The Nevada Commission may, in its discretion, require the holder of any debt security of a Registered Corporation to file applications, be investigated and be found suitable to own the debt security of a Registered Corporation. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction. The Company is required to maintain a current stock ledger in Nevada that may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable. The Company is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require the Company's stock certificates to bear a legend indicating that such securities are subject to the Nevada Act. However, to date, the Nevada Commission has not imposed such a requirement on the Company. The Company may not make a public offering of any securities without the prior approval of the Nevada Commission if the securities or the proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. Such approval, if given, does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities. Any representation to the contrary is unlawful. On July 29, 1993, the Nevada Commission granted the Company prior approval to make public offerings for a period of one year, subject to certain conditions (the "Shelf Approval"). However, the Shelf Approval may be rescinded for good cause without prior notice upon the issuance of an interlocutory stop order by the Chairman of the Nevada Board. The Shelf Approval does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities offered. Any representation to the contrary is unlawful. Changes in control of the Company through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and the Nevada Commission concerning a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process of the transaction. The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada gaming licensees, and Registered Corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate gaming operators and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and(iii) promote a neutral environmental for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Company can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the Company's board of directors in response to a tender offer made directly to the Registered Corporation's stockholders for the purposes of acquiring control of the Registered Corporation. License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to Clark County, Nevada. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually and are based upon either: (i) a percentage of the gross revenues received; (ii) the number of gaming devices operated; or (iii) the number of table games operated. A casino entertainment tax is also paid by MGM Grand Hotel where entertainment is furnished in connection with the selling of food or refreshments. Nevada licensees that hold a license as an operator of a slot machine route, a manufacturer or a distributor, such as MGM Grand Hotel and MGM Dist., also pay certain fees and taxes to the State of Nevada. Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada, is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation of the Nevada Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are also required to comply with certain reporting requirements imposed by the Nevada Act. Licensees are also subject to disciplinary action by the Nevada Commission if they knowingly violate any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fail to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engage in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employ a person in the foreign operation who has been denied a license or a finding of suitability in Nevada on the ground of personal unsuitability. The sale of alcoholic beverages by MGM Grand Hotel is subject to licensing, control and regulation by the applicable local authorities. All licenses are revocable and are not transferable. The agencies involved have full power to limit, condition, suspend or revoke any such license, and any such disciplinary action could (and revocation would) have a material adverse effect upon the operations of MGM Grand Hotel. Pursuant to a 1985 agreement between the State of Nevada and the United States Department of the Treasury (the "Treasury"), the Nevada Commission and the Nevada Board have authority to enforce their own cash transaction reporting laws applicable to casinos and that substantially parallel the federal Bank Secrecy Act. Thus, the Nevada Act requires most gaming licensees to file reports related to cash purchases of chips, cash wagers, cash deposits or cash payment of gaming debts, if any such transactions aggregate more than $10,000 in a 24-hour period. Casinos are required to monitor receipts and disbursements of currency in excess of $10,000 and report them to the Treasury. Although it is not possible to quantify the full impact of these requirements on the Company's business, the changes are believed to have had some adverse effect on results of operations since 1985. The Treasury has proposed amendments to the federal regulations promulgated under the Bank Secrecy Act. The most significant proposed regulatory amendment is a reduction in the threshold at which customer identification data must be obtained and documented by the casino, from $10,000 to $3,000 (which may include the aggregation of smaller denominations). The amendments would substantially increase the record-keeping requirements imposed upon casinos relative to customer data, currency and non-currency transactions. The Company's management believes the proposed amendments, if enacted in their current form, could adversely affect future income if middle and upper-level play is reduced as a result thereof and operating costs are increased due to the more extensive record-keeping requirements. While these proposed amendments were issued as a final rule in 1993 and were scheduled to go into effect in September 1993, the Treasury has agreed to delay implementation of these amendments until at least December 1, 1994. Additionally, two bills are currently pending before Congress that could potentially affect Nevada's ability to enforce its own cash transaction reporting laws. While the bill before the House of Representatives includes a section that would revoke the Secretary of the Treasury's ability to allow Nevada to enforce its own cash transaction reporting laws, the bill before the Senate does not include such a section and would allow Nevada to continue to enforce its own cash transaction reporting laws applicable to casinos. In the past, the Internal Revenue Service (the "IRS") had taken the position that gaming winnings from table games by non-resident aliens were subject to a 30% withholding tax; however, the IRS subsequently adopted a practice of not collecting such tax. In response to this ambiguity, Congress enacted as part of the Technical and Miscellaneous Revenue Act of 1988, a provision that exempts from tax withholding game winnings from table games by non-resident aliens, unless the Secretary of the Treasury determines by regulation that such collections have become administratively feasible. When Congress enacted this legislation, it stated its intent that future regulations imposing a withholding tax would be formulated only when future developments permit withholding that would not be disruptive to the operation of the games. Currently, casino operators withhold tax from non-resident aliens only on large wins from slot machines, keno and other high odds wins, and do not withhold from table game winnings. Competition The hotel industry is highly competitive. Hotels located on or near the strip ("Strip Hotels") compete primarily with other Strip Hotels and with a few major hotels in downtown Las Vegas. Strip Hotels offering similar prices compete with each other primarily on the basis of quality of rooms, restaurants and facilities, entertainment offered, complimentary goods and services given, credit limits and quality of personal attention offered to guests and casino customers. The Company's hotel/casino operations will also compete with a large number of hotels and motels, and gaming facilities not related to hotels or motels, located in and near Las Vegas. The Theme Park will compete with all other forms of entertainment, lodging and recreational activities, including other theme parks, especially those located in southern California. Some of the Company's competitors are larger than the Company and may have greater resources. According to the LVCVA, as of December 31, 1993, there were approximately 86,000 hotel and motel rooms in the Las Vegas area. In addition, the LVCVA reports proposals to construct approximately 29,000 more hotel and motel rooms. The Company cannot make any prediction as to how many additional rooms will be constructed in Las Vegas. The Company's future operating results could be adversely affected by excess Las Vegas room and gaming capacity. In addition to competing with hotel/casino facilities elsewhere in Nevada (i.e., the Reno/Lake Tahoe area and the rapidly expanding Laughlin area) and in Atlantic City, the Company competes with hotel/casino facilities elsewhere in the world and with state lotteries. Certain states have recently legalized, and several other states are currently considering, legalizing casino gaming in specific geographic areas, including Colorado, Illinois, Iowa, Louisiana, Mississippi, Missouri, Oregon, South Dakota and Tennessee. Legalized casino gambling in other states could adversely affect the Company's activities in Las Vegas, particularly if such legalization were to occur in areas close to Nevada, such as California. Additionally, certain gaming operations are conducted or have been proposed on federal Indian reservations, including those located in the primary market to be served by the MGM Grand Hotel. In addition, with respect to group bookings, the Company's hotel/casino facilities in Las Vegas also compete with hotels and resorts, which do not include casinos, throughout the United States. MGM GRAND AIR Operating Strategy The first element of MGM Grand Air's strategy is to promote its quality reputation and name recognition in order to provide a distinctive alternative to the current service offered by other airlines and charter operators to professional sports teams, touring entertainers, upscale tour operators and certain upscale travelers. Management of MGM Grand Air believes that these travelers will continue to select MGM Grand Air for their travel needs because of the convenience and premium service offered by MGM Grand Air. The second element of MGM Grand Air's strategy is to reconfigure its markets in order to derive a significant portion of its revenue from track flying (i.e., regularly scheduled flying between the same destinations). Through December 31, 1992, MGM Grand Air provided regularly scheduled service between Los Angeles and New York. This service was discontinued in order to concentrate on the upscale charter market. This decision was a direct result of the low prices established by competitors, over-capacity in the Los Angeles-- New York market, and the on-going recession in the scheduled airline business. MGM Grand Air's charter service is available using either its Boeing 727-100 or DC-8-62 aircraft. The combination of aircraft allows MGM Grand Air to offer flexibility in size and destinations with virtual worldwide capabilities. The aircraft are configured to offer passengers as much as 60 inches of leg room, with a premium cabin service. MGM Grand Air has a separate private terminal facility at Los Angeles International Airport. At other airports, MGM Grand Air usually contracts with fixed base operators which are separate from the main terminal. Pricing and Marketing Strategy MGM Grand Air's marketing strategy operates on the premise that sports teams, touring entertainers and certain upscale travelers will be attracted to MGM Grand Air due to the convenience, privacy and premium service offered by MGM Grand Air. MGM Grand Air markets its services directly to potential customers and also through charter brokers and tour operators. Direct sales efforts are supported by targeted media advertising, public relations and promotional activities and direct mail contact with selected potential customers. Flight Equipment Prior to commencement of operations, MGM Grand Air acquired three specially- configured Boeing 727-100 aircraft for an aggregate cost of approximately $11,000,000 and incurred additional expenses of approximately $8,500,000 to repair, refurbish and equip the aircraft. The aircraft seats 36 passengers. In December 1987, MGM Grand Air acquired three DC-8-62 aircraft for a total purchase price of approximately $16,000,000 and subsequently incurred additional expenses of approximately $38,300,000 to repair, refurbish, equip and hush kit the aircraft. The aircraft seats 70 passengers. These aircraft have been modified to conform to FAA Stage III noise standards. Ground Facilities and Services At Los Angeles International Airport, MGM Grand Air is currently operating under a twenty year lease expiring in March 2007 for its passenger service facilities, flight operations and other office space. MGM Grand Air believes that its current Los Angeles location is unique and enhances its appeal to the travel customer. MGM Grand Air contracts for major maintenance, passenger and ground handling and pre-boarding security services. Maintenance management personnel, quality assurance personnel and airport station management personnel are MGM Grand Air employees. Competition The airline industry is intensely competitive and has become more competitive due to the enactment of the Airline Deregulation Act of 1978 (the "Deregulation Act"). The Deregulation Act has increased competition with respect to both routes and fares among currently certificated carriers, and reduced the barriers to entry in the air transport industry. MGM Grand Air competes with commercial airlines and private charter carriers, some of whom are larger with greater resources than MGM Grand Air. Fuel Jet fuel accounts for the most significant portion of MGM Grand Air's operating costs. MGM Grand Air purchases fuel on standard airline trade terms, which do not provide protection against price increases or assure availability of supplies. Since February 25, 1979, jet fuel has been exempted from the price control and allocation rules under the Emergency Petroleum Allocation Act of 1973. The Department of Energy has adopted special standby pricing and allocation rules applicable to jet fuel in the event of a petroleum supply shortage, but, because of the recent adequacy of supply of petroleum products, these special rules have not yet been imposed. The future availability of fuel and the impact of fuel costs on MGM Grand Air cannot be predicted with certainty. Substantial increases in fuel prices, such as occurred during the mid east conflict of 1990-1991, or the unavailability of adequate supplies could have a material adverse effect on the operations and operating results of MGM Grand Air. In addition, MGM Grand Air's ability to pass on increased fuel costs to its passengers through price increases may be limited. Summary Operating Data for Passenger Service The following table (unaudited) sets forth selected operating data relating to MGM Grand Air's passenger service for the periods indicated. - -------- (1) Excludes 1993 fourth quarter aircraft carrying value adjustment--see also (2). (2) Includes 1993 fourth quarter aircraft carrying value adjustment of $68,948,000. (3) The average revenues per block hour flown. Insurance MGM Grand Air carries insurance of the type customary in the airline industry and in amounts deemed adequate to protect MGM Grand Air and its property. The policies provide customary business and commercial coverages, including workers' compensation, public liability, aircraft liability, airport liability, passenger liability, baggage and cargo liability, shippers risk, property damage and loss of or damage to flight equipment. Government Regulation Economic. Under the Federal Aviation Act of 1958, as amended (the "Aviation Act"), interstate air carriers are subject to regulation by the United States Department of Transportation (the "DOT") and the Federal Aviation Administration (the "FAA"). The DOT has jurisdiction over the issuance of Certificates of Public Convenience and Necessity (the "401 Certificates"), pursuant to which air carriers are permitted to operate. The DOT has the power to amend, modify, suspend or revoke such 401 Certificates. In addition, 401 Certificates are not transferable without DOT approval. MGM Grand Air has received a 401 Certificate to operate as a scheduled and charter interstate air carrier and has been certified by the FAA. Environmental. Under federal law and regulations pertaining to aircraft noise promulgated under the Noise Control Act of 1972 and the Aviation Safety and Noise Abatement Act of 1979, commercial jet aircraft are classified in three categories, Stage I, II and III, with Stage III being the quietest and Stage I being the noisiest. Stage I aircraft were banned from use in the United States, effective January 1, 1986. MGM Grand Air's Boeing 727-100 aircraft are classified as Stage II aircraft and currently comply with applicable noise regulations. Hush kits can be purchased to enable these aircraft to comply with Stage III. MGM Grand Air's DC-8-62 aircraft, which have hush kits installed, are classified as Stage III. Because of the mix of Stage II and Stage III aircraft in the MGM Grand air fleet, all six aircraft are qualified to operate until January 1, 1999. The legislatures and other governmental bodies in several states have from time to time considered noise-reduction measures including limitations on hours of operation of jet aircraft generally or of specific types of aircraft. Any such regulations affecting the aircraft utilized by MGM Grand Air could substantially increase costs or curtail operations. Under the Federal Clean Air Act, the Environmental Protection Agency (the "EPA") has been given authority to promulgate aircraft emission standards, and the adoption or enforcement of site or local aircraft emission standards is expressly barred. The EPA has not yet promulgated emission standards affecting any of the aircraft which it is anticipated will be operated by MGM Grand Air. Other Regulations. The FAA has jurisdiction to regulate flight operations generally, including the licensing of pilots and maintenance personnel, the establishment of minimum standards for training and maintenance and technical standards for flight, communications and ground equipment. All of MGM Grand Air's aircraft must have and maintain airworthiness certificates issued by the FAA. The FAA must also approve MGM Grand Air's pilot and flight attendant training programs. MGM Grand Air's flight personnel procedures, aircraft, maintenance facilities and other procedures are subject to inspection by the FAA. The FAA has the authority to suspend temporarily or revoke permanently the authority of an air carrier or its licensed personnel for failure to comply with federal aviation regulations promulgated by the FAA and to levy civil penalties for such failures. The FAA may also suspend or revoke airworthiness certificates of such aircraft which the FAA determines are or may be unsafe or which do not meet applicable regulations. The Federal Communications Commission has jurisdiction over certain aspects of the operations of airlines involving the use of radio-facilities and in- flight telephone service. In addition, the National Mediation Board has jurisdiction over the labor relations of MGM Grand Air under the Railway Labor Act, as amended. The Food and Drug Administration has regulatory authority over airplane galleys, and various government agencies regulate the sale of alcoholic beverages aboard aircraft. EMPLOYEES As of December 31, 1993, the Company employed approximately 8,500 full time equivalent employees at its corporate offices, MGM Grand Air, MGM Grand Laundry, Inc., and MGM Grand Hotel. None of the Company's employees are covered by collective bargaining agreements. ITEM 2. ITEM 2. PROPERTIES The Company's principal executive offices are located at 3799 Las Vegas Boulevard South, Las Vegas, Nevada 89109, where it rents approximately 7,028 square feet from MGM Grand Hotel. In January and February 1990, the Company acquired approximately 112 acres of real property in Las Vegas, Nevada, consisting of the Marina land and the Tropicana land and adjacent land thereto, for approximately $88 million in cash and 1,764,706 shares of Common Stock which together, constitute the MGM Grand Hotel, Casino and Theme Park property. (See Item 1. Business.) MGM Grand Hotel's principal executive offices are also located at 3799 Las Vegas Boulevard South, Las Vegas, Nevada, 89109. Pursuant to a lease expiring in March 1999, certain other office and warehouse space is leased by MGM Grand Hotel consisting of approximately 112,000 square feet at 3155 W. Harmon, Las Vegas, Nevada, 89103, for an annual rent of approximately $372,000. MGM Grand Air maintains its headquarters at 1500 Rosecrans Avenue, Suite 350, Manhattan Beach, California 90266. Pursuant to a lease which expires in January 1999, MGM Grand Air leases approximately 12,300 square feet, 3,100 of which is sublet to an unrelated party. MGM Grand Air's annual aggregate rent payments for its office, terminal and other facilities are approximately $405,000. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In October, 1992, the Los Angeles Superior Court issued a minute order favorable to the Company in the litigation between the Company and Walt Disney Co. ("Disney"). Disney sought unspecified compensatory and punitive damages from the Company, and an injunction prohibiting the Company from using the MGM or MGM Grand names in connection with the new theme park in Las Vegas. The court found in favor of the Company on every count of Disney's claim. The Company has been informed that Disney has determined not to appeal the decision, which is now final. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT FRED BENNINGER (age 77) has served as a Director of the Company since February 1986, and as Chairman of the Board since August 1987. He also served as President of the Company from August 1987 to March 1990. He served as Chairman of the Executive Committee on the Board of Directors of MGM/UA Communications Co. from July 1988 to January 1990. He was President of Tracinda from March 1982 to July 1987 and Chairman of the Executive Committee of MGM Grand Hotels, Inc. from 1971 to April 1986. He was Director and Chairman of the Executive Committee of MGM/UA Entertainment Co. from June 1980 to March 1986. ROBERT R. MAXEY (age 56) has served as President, Chief Executive Officer and Director of the Company since January 1991. From May 1989 to January 1991, he was President and Chief Executive Officer of MarCor Resort Properties, Inc. a hotel/casino operator. Prior thereto, from October 1985 to May 1989, he was a Consultant to Golden Nugget, a hotel/casino operator. ALEX YEMENIDJIAN (age 38) has served as Executive Vice President of the Company since June 1992, as Chairman of the Executive Committee from January 1991 to June 1992, and as President and Chief Operating Officer of the Company from March 1990 to January 1991. Since January 1990, he has also served as an executive of Tracinda. Chairman of the Executive Committee and Director of MGM/UA from January to November 1990. For more than five years prior thereto, he served as managing partner of Parks, Palmer, Turner and Yemenidjian, a public accounting firm to December 1989. K. EUGENE SHUTLER (age 55) has served as Executive Vice President and General Counsel and Director of the Company since February 1991. For more than 5 years prior thereto, he was a member of the law firm of Troy and Gould Professional Corporation. JOSEPH T. MURPHY (age 53) has served as Vice President and Chief Financial Officer since July 1987. Prior thereto he served in various capacities with Transamerica Airlines from October 1968 to June 1987, most recently as Senior Vice President Finance and Administration. SCOTT LANGSNER (age 40) has served as Secretary/Treasurer of the Company since July 1987. For more than five years prior to July 1987, he served as Controller of Tracinda. 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 Stock Exchange. For price information with respect to such Common Stock, see page 31 of the Company's 1993 Annual Report to Stockholders, which information is incorporated herein by this reference. As of March 14, 1993, there were approximately 2,800 record holders of the Company's Common Stock. The Company has not paid any dividends to date on the Common Stock. The declaration of dividends (which is within the discretion of the Company's Board of Directors) will depend on the earnings, financial position and capital requirements of the Company and other relevant factors existing at the time. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information set forth on page 1 of the Company's 1993 Annual Report to Stockholders is incorporated herein by this reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth on pages 16 to 18 of the Company's 1993 Annual Report to Stockholders is incorporated herein by this reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information set forth on pages 19 to 31 of the Company's 1993 Annual Report to Stockholders is incorporated herein by this 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 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information called for by PART III (Items 10, 11, 12 and 13) has been omitted, as the Company intends to file with the Securities and Exchange Commission not later than 120 days after the end of its fiscal year a definitive Proxy Statement pursuant to Regulation 14A, except that the information regarding the Company's executive officers called for by Item 10 of PART III has been included in PART I of this Form 10-K under the heading "Executive Officers of the Registrant." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The financial statements and schedules listed in the accompanying Index to Financial Statements at page 17 herein are filed as part of this Form 10-K. (b) Exhibits The exhibits listed in the accompanying Exhibit Index on pages 23-24 are filed as part of this Form 10-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. MGM GRAND, INC. Robert R. Maxey By: _________________________________ Robert R. Maxey President and Chief Executive Officer (Principal Executive Officer) Joseph T. Murphy By: _________________________________ Joseph T. Murphy Vice President and Chief Financial Officer Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. (ITEM 14(A)) All other schedules have been omitted either as inapplicable or not required under the instructions contained in Regulation S-X or because the information is included in the financial statements or the notes thereto. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To MGM Grand, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in MGM Grand, Inc.'s Annual Report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 24, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules V, VI, VIII and X as shown on pages 17 through 20 are the responsibility of the Company's management, 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. Las Vegas, Nevada February 24, 1994 MGM GRAND, INC. AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------- (A)Amounts in 1991 represent Desert Inn assets sold. The amounts in 1993 represent the reclassification of MGM Grand Hotel assets from construction costs due to completion of construction on December 18, 1993. MGM GRAND, INC. AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------- (A)Amounts in 1991 represent Desert Inn assets sold. (B) The accumulated depreciation and amortization at December 31, 1993 includes the $68,948,000 reduction in the carrying value of aircraft and related equipment. MGM GRAND, INC. AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) MGM GRAND, INC. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) EXHIBIT INDEX - -------- * Management contract. ** Except for those portions which are expressly incorporated herein by reference, such Annual Report is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of the Report.

79166_1993.txt

79166_1993

1993

79166

Item 1. Business -------- The Registrant is and for many years has been engaged in the business of publishing and distributing advanced scientific and technical material. The Registrant publishes and distributes books and journals and creates and maintains databases for which it receives royalties from unrelated organizations providing access to such materials throughout the world under the imprints of Plenum Press, Consultants Bureau, DaCapo Press, IFI/Plenum Data, J.S. Canner & Company, and Human Sciences Press. The Registrant and its subsidiaries maintain offices in New York, New York; Wilmington, Delaware; Boston, Massachusetts; Wilmington, North Carolina; London, England; and Moscow, Russia; and warehouse facilities in Edison, New Jersey. The Registrant's principal markets are public and private libraries, technically oriented corporations, research organizations and individual scientists, engineers, research workers, other professionals and graduate students throughout the world. Except as to the sale of reprints and trade books, the Registrant does not generally sell to book stores. The Registrant's principal methods of marketing are by direct mail and by advertising in scientific publications, including its own journals. The Registrant makes a wide distribution of its catalogs of published material, as well as plans for new publications. In certain foreign markets, the Registrant utilizes the services of independent distributors and agents. The Registrant generally secures copyrights on its publications in its own name or in the name of its subsidiaries. In some cases, pursuant to written agreement, the copyright is secured in the name of the author of the publication or a learned society or other organization. Copyrights on translations of foreign journals are limited to English language translations and do not cover the original foreign language works. Those translations of Russian journals as to which the Registrant is the distributor but not the publisher are copyrighted in the name of the publisher. Most publications printed by the Registrant's DaCapo Press subsidiary are reprints of works in the public domain which are not subject to copyright protection or are works published by others who have sold to the Registrant certain rights for publication, either for a fixed payment or under a royalty agreement. The Registrant does not perform any printing operations. It uses outside printing and binding services, with much of the material being prepared by the Registrant for printing. Preparations by the Registrant include editing, creation of a suitable design and typesetting. The following table sets forth the total revenues contributed by each class of similar products and services, and the income (loss) generated from securities owned by the Registrant. Subscription Journals - --------------------- During 1993, the Registrant published a total of 243 journals, of which 97 were translations of Russian language scientific journals which represented a substantial portion of the Registrant's subscription income. The Russian journals are in the fields of physical sciences, mathematics, engineering and life sciences. In December 1993, the Registrant entered into a Journal Production and Distribution Agreement (the "Distribution Agreement") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and Registrant's role as publisher and distributor of certain of such journals was altered. The Distri- bution Agreement extends from 1994 through 2006. In the lawsuit, the Registrant had alleged a conspiracy by certain competing entities to procure the breach of its translation contract with the Copyright Agency of the former Soviet government ("VAAP") by entering into agreements to obtain translation rights to certain journals. Pursuant to the Distribution Agreement, in 1994 the Registrant will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Registrant had translated, published and distributed these journals under a con- tract with VAAP, and under contracts with the individual insti- tutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Registrant will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing its function. In 1994, the Registrant will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Revenue from such 21 journals in the 1993 journal year constituted 6.7% of the Registrant's overall journal revenue and 16.2% of its Russian journal revenue. Nine of such journals were being published by both the Registrant and the predecessor of MN under conflicting contracts and were the subject of the above-mentioned litigation. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Registrant, representing a total of an additional 13.7% of the Registrant's 1993 Russian journal revenue and 5.6% of its total journal revenue. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Regis- trant. The total revenue to the Registrant from these 23 jour- nals equals 29.2% of Registrant's 1993 Russian journal revenue and 11.9% of its total journal revenue. As to each additional journal which is published by MN and distributed by the Registrant under the Distribution Agreement, the Registrant will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Regis- trant will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Registrant's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. The translation journals published by MN will be distributed by the Registrant under the MAIK Nauka/Interperiodica imprint, and it will be indicated that they are distributed worldwide by Plenum/Consultants Bureau. Those translation journals translated and published by the Registrant will continue to be published under the Registrant's "Consultant's Bureau" imprint. Management expects that in 1994 and thereafter, reve- nues and net income from subscription journals will decrease as a result of the Registrant's modified relationship to the transla- tion journals covered by the Distribution Agreement, and also as a result of the political and economic situation in Russia and in the other republics of the former Soviet Union. The translation work required for the publication of the Registrant's Russian language material is done primarily by scientists and technical persons in the United States and else- where who have other principal occupations. The Registrant maintains relationships with approximately 130 such persons, most of whom have been rendering translation services to the Regis- trant for several years. The Registrant has been able to obtain the required translators to enable it to meet its needs. The number of translators reflects a reduction from previous years since the Registrant, under the Distribution Agreement, will be translating fewer journals. In addition to the Russian Language Translation Jour- nals, the Registrant published 96 journals in its English Lan- guage Journal Program in 1993. The journals are published under the Registrant's "Plenum Press" imprint, and include titles in chemistry, physics, mathematics, computer science, engineering, biology, medicine, psychiatry, social sciences and law. Each journal is published under the direction of an editorial board composed of professionals specializing in the fields of research covered by the journal. The Registrant's subsidiary, Human Sciences Press, Inc., publishes 50 journals, under the "Human Sciences Press" imprint. These journals are primarily in the health, behavioral and social science fields. Outside Journals - ---------------- In April 1993, an American learned society with which the Registrant had a contract to produce English translations of 11 Russian language journals for publication by that society gave notice that it would not exercise the option of renewing the contract beyond the term ending with the 1993 volume year. For 1993, the amount of revenue generated from the production of these 11 journals was approximately $1,261,000; however, such revenue will cease during 1994. The Registrant, through its Boston-based J.S. Canner & Company, Inc. subsidiary, engages in the purchase and sale of backissue periodicals to libraries, colleges, universities and other users. Books - ----- The Registrant's Plenum Press division publishes scientific, technical and medical books for use by scientists, engineers, research workers, other professionals and graduate students, and their supporting libraries, research laboratories and institutions. During 1993, the division published 288 new titles as part of this program, and had an active backlist of approximately 3,800 titles as of December 31, 1993. During 1992, 305 new titles were published. Titles include comprehensive treatises, monographs and other advanced text-reference works, as well as proceedings of meetings reporting original scientific research, works surveying the state of the art in various scientific fields and specialized bibliographies and data compilations. In recent years, a number of books treating scientific topics of interest to the general reader have also been published. The Registrant's DaCapo Press, Inc. subsidiary publishes reprints of books in music, dance, visual arts and the social sciences. These books are sold mainly to libraries and specialists in these fields. DaCapo also publishes a line of academic/trade paperbacks in the arts, biography and history. During 1993, this subsidiary published 40 titles compared to 43 titles in the prior year. As of December 31, 1993, this subsidiary had an active backlist of approximately 1,500 titles. The Registrant's Human Sciences Press, Inc. subsidiary had an active backlist of approximately 400 titles as of December 31, 1993. The Registrant has no immediate plans to publish new titles under the Human Sciences imprint, but will continue to publish the backlist under such imprint. The Human Sciences books are primarily in the health, behavioral and social science fields, and are sold mainly to libraries and professionals in these fields. Database Products - ----------------- The Registrant's IFI/Plenum Data Corporation subsidiary ("IFI") is primarily involved in providing to major industrial users on-line access to the IFI Comprehensive Data Base of Patents, a computerized index file containing references to all United States chemical and chemical related patents issued since January 1950. The Registrant's customers generally use terminals at their own facilities to obtain the information through several international database networks. The file is further utilized by IFI in its performance of patent searches for law firms and other customers. IFI produces other on-line databases for searching chemical, general, electrical and mechanical United States patents, and publishes in book format the Patent Intelligence and Technology Report and The Assignee Index, all of which are patent information publications. IFI also offers other online database products including Mental Health Abstracts and Information Science Abstracts. The Registrant through its subsidiary, Career Placement Registry, Inc. ("CPR"), has developed a database system of infor- mation concerning college graduates and experienced personnel who are seeking employment opportunities. The information had been made available to the approximately 150,000 subscribers to the Dialog Information Services of Knight-Ridder, Inc. Effective March 1, 1994, Dialog discontinued carrying the database due to insufficient use. CPR is currently seeking another carrier. Since its creation in 1981, the operations of CPR have not had a significant impact on the Registrant's earnings. Other Publishing Activities - --------------------------- Plenum Publishing Company Limited, the Registrant's English subsidiary, provides sales representation for the Registrant in the United Kingdom and European markets. Plenum Publishing Company Limited also performs editorial procurement services for the scientific book and journal publishing programs of the Registrant. Competition - ----------- The market in which the Registrant operates both for the procurement of manuscripts and the sale of its products is highly competitive. The Registrant is one of the leading publishers and distributors of English translations of Russian scientific journals. However, several other companies with English translation capabilities have relationships with individuals and entities responsible for the publication of scientific and technical material in the former Soviet Union. In addition, other publishers in the United States and abroad with greater financial resources than the Registrant are engaged in the publication of original English language scientific materials and database products, as well as the reprint of out-of-print books and other books generally not available. Export Sales - ------------ The Registrant's sales derived from customers outside the United States aggregated approximately $23,217,000 in 1993 (approximately 43% of consolidated sales). Sales derived from customers outside the United States were approximately $21,214,000 in 1992 and $21,453,000 in 1991 (approximately 39% and 40%, respectively, of consolidated sales). The Registrant generally prices its products sold abroad in U.S. dollars. Investments in Securities - ------------------------- In 1993, the Registrant's dividends, interest income, net realized and unrealized gains/losses on marketable securities, and equity in the net income (loss) of Gradco Systems, Inc. (the foregoing items net of interest expense and other investment-related expenses) represented 3.2% of the Registrant's pre-tax income. In 1992, such items (net of interest expense and other investment-related expenses) represented 18.4% of pre-tax income. The Registrant's excess cash is invested principally in a portfolio of marketable securities. Market conditions and the nature of the investments have an impact on the performance of the portfolio. Excess cash is also invested in part, from time to time, in short-term investments such as time deposits, money market funds and commercial paper, and in the past has been invested in U.S. Government securities. The investments of ex- cess cash are available for corporate purposes, and have been so used periodically. On April 30, 1993 the Registrant's outstand- ing 6-1/2% convertible subordinated debentures due 2007 were re- deemed, requiring an expenditure of $40,734,793 which was funded principally from liquidation of a portion of such investments. The Registrant owns 913,000 shares of Common Stock of Gradco Systems, Inc. ("Gradco"), an office automation company, which were acquired by the Registrant during the period October, 1989 through August, 1991. The acquisitions by the Registrant have been reported in a Statement on Schedule 13D and amendments thereto filed jointly with the Securities and Exchange Commission by the Registrant and by its Chairman, Martin E. Tash, and his wife, who as of the date hereof had acquired a total of 250,672 shares. Mr. Tash also has currently exercisable options to purchase 50,000 additional shares. The filings are required because the Registrant and Mr. and Mrs. Tash as a group (the "Group") beneficially own more than 5% of the outstanding shares of Gradco (11.7% by the Company and 3.8% by Mr. and Mrs. Tash, inclusive of his currently exercisable options, as of the date hereof, for a total of 15.5%). In October 1990, in a proxy contest, a five-person slate of directors was nominated by the Group in opposition to the nominees of Gradco's then current management. The slate consisted of Martin E. Tash (Registrant's Chairman of the Board and Chief Executive Officer), Bernard Bressler (Secretary and a director of Registrant) and three other individuals not affiliated with Registrant. Three nominees of the Group (including Messrs. Tash and Bressler) were elected to directorships, constituting a majority of the Board. The newly named Board named Mr. Tash as Gradco's Chairman and Chief Executive Officer. The Group may be deemed to have obtained control of Gradco in October 1990, as a result of the fact that its nominees were elected as a majority of Gradco's Board of Directors. Gradco's current five-person Board, elected without any opposing nominees at its October 1993 Annual Meeting, consists of Messrs. Tash and Bressler, and three other persons. All of the nominees were designated as such at the request of the Group, which there- fore may be deemed to continue to have control of Gradco. Registrant has not undertaken any obligations in connection with Gradco's operations or advanced any funds to it and does not otherwise engage in business through Gradco. The Registrant's investment in Gradco is reflected in the Financial Statements included herein using the equity method of accounting. Gradco, the Registrant and Mr. Tash are defendants in a lawsuit which has been brought by certain former management employees of Gradco. See Item 3, Legal Proceedings. ----------------- In view of the securities investments described above, the Registrant evaluates its status under the Investment Company Act of 1940, as amended (the "Company Act"), on an annual basis. (Prior to the redemption of the Debentures, such evaluation had been performed on a quarterly basis, but in view of the signifi- cant reduction of investments resulting from the redemption, the Registrant now considers an annual analysis to be sufficient.) The Company Act requires the registration with the Securities and Exchange Commission of, and imposes various substantive restric- tions on, any "investment company." The Company Act defines the term "investment company" to include a company that engages primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. An "investment company" may also include a company which engages or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and which owns or proposes to acquire investment securities (which for this purpose excludes U.S. Government securities) having a value that exceeds 40% of the value of such company's total assets (excluding cash items and U.S. Government securities), unless the company is primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities. The Registrant's principal business continues to be publishing and distributing advanced scientific and technical material, and the Registrant is not primarily engaged in invest- ing, reinvesting or trading in securities. As of December 31, 1993, investment securities represented less than 40% of the value of the Registrant's total assets (exclusive of U.S. Govern- ment securities and cash items), and in any event the Registrant continued to be exempt from status as an investment company pursuant to Rule 3a-1 under the Company Act because less than 45% of the value of its total assets (exclusive of U.S. Government securities and cash items) consisted of, and less than 45% of its net income after taxes for the last four fiscal quarters combined was derived from, securities (other than U.S. Government securi- ties). Miscellaneous Information - ------------------------- The Registrant currently employs approximately 300 full time employees. Backlog is not significant in the Registrant's business because orders are filled on a current basis. The Registrant does receive payments and on occasion records receivables from journal subscribers in advance of the issuance of journals, and the amounts appearing on the Registrant's Consolidated Balance Sheets as "Deferred Subscription Income" represent these items. See Note 1 of Notes to Consolidated Financial Statements. The business of the Registrant is not seasonal. No material portion of the business of the Registrant is subject to renegotiation of profits or termination of contracts at the election of the Government. Compliance with the provisions enacted regulating the discharge of materials into the environ- ment or otherwise relating to the protection of the environment does not have an effect upon the Registrant. Item 2. Item 2. Properties ---------- As of December 31, 1993, the Registrant had leases at the following principal locations: Various of the leases referred to above provide for additional payments or increases in rent over the base rental specified above under different circumstances. In addition to the leases referred to above, the Registrant or its subsidiaries have leases on space at various locations with a total annual rental of approximately $22,450. The Registrant's warehouse operations are conducted at a 69,000 square foot warehouse in Edison, New Jersey which is owned by Registrant. Item 3. Item 3. Legal Proceedings ----------------- (a) Plenum Publishing Corporation v. Interperiodica, ----------------------------------------------- et al. - ------ This litigation, which was previously reported in the Registrant's Report on Form 10-K for the fiscal year ended Decem- ber 31, 1992, was discontinued with prejudice and without costs in December 1993, pursuant to the Journal Production and Distrib- ution Agreement described in Item 1, Business, under "Subscrip- -------- tion Journals." (b) Stewart, et al. v. Gradco Systems, Inc., --------------------------------------- Plenum Publishing Corporation, et al. - ------------------------------------ As the result of the proxy contest in October 1990, described above in Item 1, Business, under "Investments in Securities", the composition of the Board of Directors of Gradco Systems, Inc. ("Gradco") was changed. Among such changes were the election of Martin E. Tash, the Registrant's Chief Executive Officer, to the Gradco Board, and the non-renewal of Keith Stewart as a member of the Gradco Board. Mr. Tash succeeded Mr. Stewart as Chief Executive Officer of Gradco. In December 1990, Gradco asserted claims in the Superi- or Court of California against Mr. Stewart and others, alleging a conspiracy on their part to defraud Gradco of a substantial part of its assets. Mr. Stewart was charged with converting Gradco funds to satisfy his personal obligations and other wrongful actions, including defaulting on a promissory note in Gradco's favor. The aggregate of the allegedly converted funds exceeds $1,000,000. The complaint, among other things, also seeks a declaration that no payments are due under "golden parachute" agreements which are claimed to have been wrongfully obtained. Certain of Gradco's former employees, including Mr. Stewart, have instituted actions in the Superior Court of Cali- fornia against Gradco, Mr. Tash and the Registrant, claiming, among other things, the breach of the above-referenced "golden parachute" agreements. The stated aggregate claims for compensa- tory damages by said former employees exceeds $20,000,000. Of that sum, approximately $2,500,000 is attributable to the afore- said alleged breach of the "golden parachute" agreements. The balance is principally attributed to various causes of action arising from the same set of facts, including such claims as bad faith denial of contract existence, conspiracy to induce breach of contract, and intentional infliction of emotional distress. Gradco, the Registrant and Mr. Tash have denied all liability and have interposed various affirmative defenses. The claims by one of the former employees have been settled, with Gradco being responsible for the settlement payments. Pre-trial discovery is being conducted with respect to the aforesaid matters in dispute, and the discovery cutoff date is June 30, 1994. A trial date has not yet been set. Management of the Registrant, after consultation with counsel, believes that the action will not result in a material loss to the Registrant and intends to vigorously defend against it. 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 ------------------- The Common Stock of the Registrant is traded on the NASDAQ National Market System. The following table sets forth, for the calendar quarters indicated, information furnished by the NASD, Inc. as to the high and low sale prices for the Registrant's Common Stock as reported on the NASDAQ National Market System under the symbol PLEN. The table also sets forth dividends declared during such periods. There were approximately 638 record holders of the Registrant's Common Stock on March 14, 1994. The number of holders as so stated does not include individual participants in security position listings. Dividends Calendar Year Ended December 31, High Low Per Share - -------------------------------- ---- --- --------- - ---- First Quarter.................... 30-1/2 25-3/4 $ .27 Second Quarter................... 30 25-1/2 .27 Third Quarter.................... 27-3/4 22-3/4 .27 Fourth Quarter................... 26-1/4 22-1/2 .27 Dividends Calendar Year Ended December 31, High Low Per Share - -------------------------------- ---- --- --------- - ---- First Quarter.................... 22-7/8 19-1/2 $ .26 Second Quarter................... 21-3/4 20-1/2 .26 Third Quarter.................... 23-1/2 20-3/4 .26 Fourth Quarter................... 26-3/8 22-3/4 .26 The Registrant has paid cash dividends on its Common Stock in each year since 1974. The payment and amount of future dividends are dependent upon the Registrant's earnings, general financial condition and the requirements of the business and upon declaration of the dividend from time to time by the Board of Directors. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -------------------------------------------------- Results of Operations - --------------------- 1993 Compared to 1992 - --------------------- Revenues from the Company's publishing operations in- creased by 0.7% to $54,098,246. Revenues from subscriptions and outside journals increased by 2.4%, primarily attributable to more journal issues being published and higher selling prices, offset by non-renewals of subscriptions partially due to the reduced buying power of libraries. Revenues from book sales decreased by 6.2% primarily due to fewer book titles being published. In December 1993, the Company entered into a Journal Production and Distribution Agreement (the "Distribution Agree- ment") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and the Company's role as publisher and distributor of certain of such journals was altered. The Distri- bution Agreement extends from 1994 through 2006. Pursuant to the Distribution Agreement, in 1994 the Company will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Company had translated, published and distributed these journals under a con- tract with the Copyright Agency of the former Soviet government, and under contracts with the individual institutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Company will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing its function. In 1994, the Company will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Revenue from such 21 journals in the 1993 journal year constituted 6.7% of the Company's overall journal revenue and 16.2% of its Russian journal revenue. Nine of such journals were being published by both the Company and the predecessor of MN under conflicting contracts and were the subject of the above-mentioned litigation. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Company, representing a total of an additional 13.7% of the Company's 1993 Russian journal revenue and 5.6% of its total journal revenue. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Company. The total revenue from these 23 journals equals 29.2% of the Comp- any's 1993 Russian journal revenue and 11.9% of its total journal revenue. As to each additional journal which is published by MN and distributed by the Company under the Distribution Agreement, the Company will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Company will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Company's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. Management expects that in 1994 and thereafter, revenues and net income from subscription journals will decrease as a result of the Company's modified relationship to the translation journals covered by the Distribution Agreement, and also as a result of the political and economic situation in Russia and in the other republics of the former Soviet Union. In April 1993, an American learned society with whom the Company had a contract to produce English translations of 11 Russian language journals for publication by that society gave formal notice that they would not exercise the option of renewing the contract beyond the term ending with the 1993 volume year. For fiscal 1993, the amount of revenue generated from the produc- tion of these 11 journals was approximately $1,261,000; however, such revenue will cease during fiscal 1994. The cost of sales as a percentage of revenues increased from 39.82% to 40.08%, primarily due to higher salaries and employee benefit costs, offset by a more favorable mix of reve- nues from subscriptions and outside journals and book sales. The increase in royalty expenses was principally due to increased royalty rates. The decrease in selling, general and administra- tive expenses was primarily attributable to decreased profession- al fees and bad debt expense, offset by higher salaries, employee benefit costs and sales commissions. The decrease in interest income was principally due to lower interest rates and decreased investments in Government securities, time deposits and money market funds, arising in large part because of the decrease in investment assets utilized for redemption of the Company's 6-1/2% Convertible Subordinated Debentures on April 30, 1993. The increase in dividend income resulted from the increase in average investment in marketable securities in 1993. The Company had a net realized gain of $801,387 on marketable securities and recorded a provision of $1,713,197 for net unrealized losses on marketable securities for 1993, as compared to a net realized gain of $2,476,916 on marketable securities for 1992. The decrease in interest expense was primarily due to the redemption of the Debentures. The decrease in net income was principally attributable to the decrease in investment income as discussed in the preceding paragraph and the extraordinary loss from early retirement of 6-1/2% Convertible Subordinated Debentures. The provision for income taxes as a percentage of income decreased in 1993 as compared to 1992 because in 1992 the Company recorded an additional provision for state and local income taxes for assessments of such taxes expected with respect to prior years. 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," effective for fiscal years beginning after December 15, 1993. Under the new rules, which the Company will adopt effective January 1, 1994, the Company will classify its marketable equity securities held as trading securities on the basis of its intent to trade such securities. Accordingly, all marketable equity securities classified as trading securities will be carried at fair market value. Unrealized gains and losses applicable to these securities will be reported as a component of current earnings. Presently, the Company values marketable equity securities as trading securities and reports such securities at the lower of aggregate cost or market, with unrealized losses reported as a component of current earnings. 1992 Compared to 1991 - --------------------- Revenues from the Company's publishing operations increased by 0.7% to $53,725,999. Revenues from subscriptions and outside journals increased by 2.3%, primarily attributable to higher selling prices, offset by non-renewals of subscriptions partially due to the impact of the recession on the buying power of libraries and individuals, and fewer journal issues being published. Revenues from book sales decreased by 5.3% primarily due to fewer book titles being published. Revenues from database products increased by 9.7%, primarily due to increased prices. The cost of sales as a percentage of revenues increased from 39.56% to 39.82%, primarily due to higher salaries and employee benefit costs, offset by a more favorable mix of revenues from subscriptions and outside journals and book sales, and increased prices of database products. The increase in royalty expense was principally due to increased royalty rates and higher costs associated with extended English translation and publication agreements with Institutes publishing scientific journals in Russia. The insignificant decrease in selling, general and administrative expenses was primarily attributable to lower sales commissions, advertising expenditures, computer expenses and mailing expenses, offset by higher salaries and employee benefit costs and increased professional fees. The decrease in interest income was principally due to lower interest rates. The increase in dividend income was due to increased investment in marketable securities. The Company had a net realized gain of $2,476,916 on marketable securities for 1992, as compared to a net realized gain of $19,714 and a reversal of the provision of $6,544,417 for net unrealized loss on marketable securities for 1991. The decrease in interest expense resulted from the repurchase of $6,808,000 of 6 1/2% Convertible Subordinated Debentures due April 15, 2007. The decrease in net income was principally due to the decrease in investment income discussed in the preceding paragraph, decreased income from publishing operations and an increase in the provision for income taxes as a percentage of income, offset by the cumulative effect on prior years of accounting change for deferred income taxes and extraordinary credit arising from the repurchase of 6 1/2% Convertible Subordinated Debentures. The provision for income taxes as a percentage of income increased because the reversal of net unrealized losses on marketable securities in 1991 was exempt from income taxes to the extent that said losses, when incurred in 1990, had no deferred tax benefits recognized, and in 1992 the Company recorded an additional provision for state and local income taxes for assessments of such taxes expected with respect to prior years. Liquidity and Sources of Capital - -------------------------------- The ratio of current assets to current liabilities is 6.3 to 1 at December 31, 1993 compared to 2.1 to 1 at December 31, 1992. Management anticipates that internally generated funds will exceed requirements of the operations of the business. The Company also has funds of approximately $53,855,000 at December 31, 1993 invested in marketable securities and in cash, which are available for corporate purposes. On April 30, 1993 (the "Redemption Date"), pursuant to a notice of election to redeem which had been given to the holders on March 24, 1993, the Company redeemed the Debentures which were outstanding on the Redemption Date. In accordance with the terms of the Debentures and the applicable Trust Indenture, the redemp- tion required a total payment of $40,734,793 (representing the redemption price of 102.60% of the principal amount of outstanding Debentures and accrued interest from April 15 to April 30, 1993). This amount was funded by liquidating a portion of the Company's investments of its excess cash, and from short-term borrowing on the Company's margin account with a broker. Item 8. Item 8. Financial Statements and Supplementary Data --------------------------------------------------- Response to this Item is contained in Item 14(a). Item 9. Item 9. Changes in and Disagreements with Accountants on Ac- counting and Financial Disclosure ---------------------------------------------------- Not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant --------------------------------------------------- (a) The following table sets forth the name of each director and executive officer of the Registrant, the date on which his present term as a director will expire, and the nature of all positions and offices with the Registrant held by him at present. The term of office of all executive officers expires at the next annual meeting of stockholders of the Registrant, which is to be held in June 1994. Present Term as Director Name Expires Position - ---- ------------- -------- Martin E. Tash 1994 President and Chairman of the Board of Directors Mark Shaw 1994 Executive Vice President and Director Bernard Bressler 1994 Secretary and Director Earl Ubell 1995 Director N. Bruce Hannay 1995 Director Howard F. Mathiasen 1995 Director Ghanshyam A. Patel ---- Treasurer and Chief Financial Officer; Assistant Secretary (b) The following is a brief account of the recent business experience of each director and executive officer, and directorships held with other companies which file reports with the Securities and Exchange Commission. Name Business Experience - ---- ------------------- Martin E. Tash, Mr. Tash has been actively engaged in the age 53 the Registrant's business since 1971. He has been Chairman of the Board and President since July 15, 1977, and served as Treasurer and Chief Financial Officer from 1971 until September 29, 1986. Mr. Tash is also Chairman of the Board and Chief Executive Officer of Gradco Systems, Inc. Mark Shaw, Mr. Shaw has been actively engaged in the age 55 Registrant's business since 1963. He has been Executive Vice President since July 15, 1977, and manages the Registrant's book and journal publication program. Bernard Bressler, Mr. Bressler has been a practicing age 66 attorney since 1952, and is presently a member of the firm of Bressler, Amery & Ross, counsel to the Registrant. Mr. Bressler is also a director of Gradco Systems, Inc. Earl Ubell, Mr. Ubell has been the Health and Science age 67 Editor of WCBS-TV since September 11, 1978. Between August 1976 and September 1978, Mr. Ubell was the Producer of Special Events and Documentaries for NBC News. For more than three years prior to that time, Mr. Ubell was the Director of News of WNBC-TV. N. Bruce Hannay, Dr. Hannay has been a business and age 73 technical consultant since his retire- ment, as of April 10, 1982, from Bell Telephone Laboratories, Incorporated where he had held the position of Vice President - Research and Patents for the preceding ten years. Dr. Hannay had been employed by Bell Laboratories since 1944 and had been engaged in a variety of re- search programs. Dr. Hannay performs consulting services for several comp- anies, and is a director of General Sig- nal Corp., and of a group of mutual funds sponsored by Alex. Brown & Sons, Inc. Howard F. Mathiasen, Mr. Mathiasen is retired. From age 56 July 1982 to June 1987 Mr. Mathiasen was Senior Vice President of National West- minster Bank U.S.A. (formerly known as The National Bank of North America). Between June 1979 and July 1982 he was Vice President of that Bank. Between May 1, 1978 and April 1979, Mr. Mathiasen was Senior Vice President of Nassau Trust Company. Between January 1975 and May 1978, Mr. Mathiasen was Vice President of Chemical Bank. Ghanshyam A. Patel, Mr. Patel has been Treasurer and age 57 Chief Financial Officer of the Registrant since September 29, 1986. Prior to that he was with the accounting firm of Ernst & Whinney (predecessor to Ernst & Young) from April 1970 and served in the capacity of Senior Manager commencing June 1977. Item 11. Item 11. Executive Compensation ---------------------- (a) Summary Compensation Table. The following table sets forth all compensation awarded to, earned by or paid to the following persons through March 14, 1994 for services rendered in all capacities to the Registrant and its subsidiaries during each of the fiscal years ended December 31, 1993, 1992 and 1991: (1) the Registrant's Chief Executive Officer, and (2) each of the other executive officers whose total compensation for the fiscal year ended December 31, 1993 required to be disclosed in column (c) and (d) below exceeded $100,000. SUMMARY COMPENSATION TABLE -------------------------- (a) (b) (c) (d)1 (e)2 Name and All Other Principal Position Year Salary ($) Bonus ($) Compensation ($) - ------------------ ---- ---------- --------- ---------------- Martin E. Tash 1993 290,000 295,400 30,000 Chairman of the 1992 275,000 335,650 30,000 Board and President 1991 250,000 287,350 30,000 (Chief Executive Officer) Mark Shaw 1993 290,000 211,000 30,000 Executive Vice 1992 275,000 239,750 30,000 President 1991 250,000 205,250 30,000 Ghanshyam A. Patel 1993 136,000 33,000 22,868 Treasurer and Chief 1992 130,000 37,500 20,839 Financial Officer 1991 120,000 32,000 18,196 Footnotes to Summary Compensation Table - --------------------------------------- (1)Represents amounts paid to the named executive officer, for the applicable fiscal year, under the Registrant's Incentive Compensation Plan. For each fiscal year an amount equal to 5% of the Registrant's Income from Operations as reported in the Registrant's year-end financial statements (together with, when applicable, 5% of the excess of cumulative Investment Profit over cumulative Investment Loss) is distributed to key employees. Thirty-five percent of such amount is distributed to the chief executive officer and 25% is distributed to the next senior officer. The balance of such amount is distributed as determined by the chief executive officer. Since cumulative Investment Profit (as defined) earned after 1990, through December 31, 1992, exceeded Investment Loss (as defined) incurred in 1990, the excess was added to Income from Operations for the purpose of calculating incentive compensation for 1992. Since there was Investment Profit (as defined) in 1993, the amount of such Profit was added to Income from Operations for the purpose of calculating incentive compensation for 1993. (2)Represents amount of contribution made to or accrued for the account of the named executive officer, in respect of the applicable fiscal year, in the Registrant's Profit Sharing Plan (a defined contribution plan qualified under the Internal Revenue Code). The Plan is maintained for all full-time employees who have completed certain minimum periods of service. The Registrant contributes to the Plan specified amounts based upon its after tax income as a percentage of gross revenue. The Registrant's contribution to the Plan for each employee is determined by his salary level and length of service. Contributions are invested by the Plan Trustee in stock of the Registrant and/or in a variety of other investment options, depending upon the employee's election. Interests in the Plan become vested to the extent of 20% after three years of service and vest at the rate of an additional 20% for each year of service thereafter and in any event become 100% vested at death or at the "normal retirement age" of 55 as specified in the Plan. Each employee (or his beneficiary) is entitled to receive the value of his vested interest upon his death or retirement. He may also receive the value of such interest upon prior termination of his services with the Registrant, or if he elects at any time to withdraw his interest. The interests of Messrs. Tash, Shaw, and Patel are fully vested. The aggregate contributions made or accrued by the Registrant through the end of fiscal 1993 for Messrs. Tash, Shaw and Patel under this Plan are $405,650, $425,525 and $109,694, respectively; these contributions have been invested in the manner set forth above, and (as to Mr. Shaw) a portion of the investments was transferred from the Plan into a private profit sharing plan of which Mr. Shaw is the beneficiary. (b) Compensation of Directors. ------------------------- Directors fees for Dr. N. Bruce Hannay and Messrs. Earl Ubell and Howard F. Mathiasen are currently at the rate of $9,500 per annum each. Directors of the Registrant who are also officers of the Registrant receive no additional compensation for their services as directors. (c) Termination of Employment and Change of Control Arrangements Regarding Named Executive Officers. ------------------------------------------------ (i) See footnote (2) to table in Item 11(a) for information as to entitlement of Messrs. Tash, Shaw and Patel to receive certain distributions under the Registrant's Profit Sharing Plan upon termination of their employment. (ii) On September 22, 1989, the Registrant adopted Amended Contingent Compensation Agreements with Martin Tash and Mark Shaw (executive officers of the Registrant named in the table in item 11(a)) and with Harry Allcock and Marshall Lebowitz (officers of subsidiaries of the Registrant). The Amended Agreements supersede the Contingent Compensation Agreements, adopted on October 8, 1986, and provide that if (a) during the officer's employment or within six months after his employment terminates, there is a sale of 75% of the book value of the Registrant's operating assets (as defined), or if any person or group becomes the owner of over 25% of the Registrant's outstanding stock, and (b) the officer's employment is terminated at or prior to the end of the sixth month after such event, then the Registrant shall pay the terminated officer cash equal to 290% of the officer's average annual taxable compensation over the preceding five calendar years. The Amended Agreements add a provision specifying that a successor in interest to the Registrant would remain liable thereunder. They are otherwise substantially identical to the original Agreements. On December 14 1993, the Registrant entered into Contingent Compensation Agreements with Ghanshyam Patel (an executive officer of the Registrant named in the table in item 11(a)) and Ken Derham (an officer of a subsidiary of the Registrant) on the same terms as the Amended Agreements described above. (d) Indemnification Agreements. -------------------------- In September 1987, the Registrant's liability insurance for its directors and officers expired and was not renewed due to the significantly increased cost. In light of this development, and to provide increased protection, the Registrant's By-Laws were amended on November 18, 1987 to require the Registrant to advance expenses of directors or officers in defending a civil or criminal action as such expenses are incurred, subject to certain conditions. Furthermore, on that date the Registrant entered into a contract with each of its directors and executive officers, requiring indemnification for expenses, judgments, fines and amounts paid in settlement, in accordance with the By-Laws as ameded, or any future By-Laws which provide greater indemnification. (On December 14, 1993, the Registrant entered into a substantially identical contract with an officer of one of its subsidiaries.) The present By-Laws provide for such indemnification, in connection with claims arising from service to the Registrant, or to another entity at Registrant's request, except where it would be prohibited under applicable law. (e) Compensation Committee Interlocks and Insider Participation --------------------------------------------- The Registrant's Board of Directors has no compensation committee (or other Board committee performing equivalent functions); compensation policies applicable to executive officers are determined by the Board. During the fiscal year ended December 31, 1993, the officers of the Registrant participating in the Board's deliberations concerning executive compensation were Martin E. Tash, Mark Shaw and Bernard Bressler (who are members of the Board). During the fiscal year ended December 31, 1993, Martin E. Tash (an executive officer of the Registrant) served as a member of the Board of Directors of Gradco Systems, Inc. ("Gradco"). Gradco has no compensation committee (or other Board committee performing equivalent functions); compensation policies applicable to executive officers are determined by its Board. Mr. Tash is an executive officer of Gradco and is the only such executive officer who also served on Registrant's Board. Bernard Bressler (Secretary and a director of Registrant) is an officer and director of Gradco, but he is not an executive director of either entity. During the period since January 1, 1993, there were no transactions between the Registrant and Gradco of the type required to be disclosed under Item 13, Certain Relationships and Related Transactions. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management ---------------------------------------------------- (a) The following table sets forth information regarding persons known to the Registrant to be the beneficial owners of more than 5% of the Registrant's voting securities as of March 14, 1994, based on 4,498,940 shares of Common Stock, $.10 par value, outstanding as of such date. Amount and Nature of Name and Address of Beneficial Percentage Title of Class Beneficial Owner Ownership of Class - -------------- ------------------- ---------- ---------- Common Stock Martin E. Tash 423,402 $.10 par value 233 Spring Street shares(1) 9.41% New York, NY 10013 Arlene S. Tash 298,229 17049 Northway Circle shares(2) 6.63% Boca Raton, FL 33496 Southeastern Asset 328,000 Management, Inc. shares(3) 7.29% 860 Ridgelake Boulevard Memphis, TN 38120 Quest Advisory Corp. 456,150 and Quest Management shares(4) 10.14% Company as a Group 1414 Avenue of the Americas New York, NY 10019 Footnotes - --------- (1) Includes 112,253 shares held by the Registrant's Profit Sharing Plan, as to which Mr. Tash has voting and investment power. Of the aggregate of 423,402 shares shown, Mr. Tash has sole voting and investment power as to 125,173, and shared voting and investment power with his wife as to 298,229. (2) Shares are owned jointly by Mrs. Tash with her husband, Martin E. Tash, and she shares voting and investment power with him. Shares are included in the 423,402 shares shown as owned by Mr. Tash. (3) Number of shares as shown in beneficial owner's Amendment No. 2 to Schedule 13G dated February 11, 1994, filed with the Securities and Exchange Commission, reporting ownership as of December 31, 1993. According to such Schedule 13G, Southeastern Asset Management, Inc. is an Investment Adviser registered under the Investment Advisers Act of 1940. It has sole voting power and no dispositive power as to 218,000 of the shares shown, and shared voting and dispositive power as to 110,000 of said shares. According to the Schedule 13G, all of the aforesaid securities "are owned legally by Southeastern's investment advisory clients and none are owned directly or indirectly by Southeastern. As permitted by Rule 13d-4, the filing of this statement shall not be construed as an admission that Southeastern is the beneficial owner of any of [such] securities." The Schedule 13G was also filed by O. Mason Hawkins, Chairman of the Board and President of Southeastern "in the event he could be deemed to be a controlling person of that firm as the result of his official position with or ownership of voting securities. The existence of such control is expressly disclaimed. Mr. Hawkins does not own directly or indirectly any securities covered by this statement for his own account. As permitted by Rule 13d-4, the filing of this statement shall not be construed as an admission that Mr. Hawkins is the beneficial owner of any of the securities covered by this statement." The Schedule 13G reflects that Mr. Hawkins has voting or dispositive power as to none of the Registrant's shares. (4) Number of shares as shown in beneficial owner's Amendment No. 1 to Schedule 13G dated February 8, 1994, reporting ownership as of December 31, 1993. According to such Schedule 13G, each of Quest Advisory Corp. ("Quest") and Quest Management Company ("QMC") is an Investment Adviser registered under the Investment Advisers Act of 1940. Quest has sole voting and dispositive power as to 418,650 of the shares shown above, representing 9.31% of the outstanding Common Stock, and QMC has sole voting and dispositive power as to 37,500 of the shares shown above, representing 0.83% of the outstanding Common Stock. The Schedule 13G also includes Charles M. Royce as part of the Group and indicates that he may be deemed to be a controlling person of Quest and QMC, and as such may be deemed to beneficially own the shares of the Registrant beneficially owned by Quest and QMC. Mr. Royce owns no shares of the Registrant outside of Quest and QMC and has disclaimed beneficial ownership of the shares reported above. (b) The following table sets forth information regarding the voting securities of the Registrant beneficially owned by each director of the Registrant, each of the executive officers named in the Summary Compensation table in item 11, Executive Compensation, and all executive officers and directors as a group, without naming them (7 persons), as of March 14, 1994. Amount and Nature of Name and Address of Beneficial Percentage Title of Class Beneficial Owner Ownership of Class - -------------- ------------------- ---------- ---------- Common Stock Martin E. Tash 423,402 $.10 par value 233 Spring Street shares (1) 9.41% New York, NY 10013 Mark Shaw 80,667 233 Spring Street shares (2) 1.79% New York, NY 10013 Earl Ubell 1,000 WCBS-TV shares * 524 West 57th Street New York, NY 10019 Howard F. Mathiasen 28,125 10276 Totem Run shares * Littleton, CO 80125 Bernard Bressler 12,809 Bressler, Amery & shares (3) * Ross 90 Broad Street New York, NY 10004 N. Bruce Hannay 1,000 201 Condon Lane shares(4) * Port Ludlow, WA 98365 Ghanshyam A. Patel 9,801 * 233 Spring Street shares(5) New York, NY 10013 All Executive 556,804 12.38% Officers and Directors shares as a Group (7 persons, comprising all those shown above) * Less than 1%. (1) See footnote (1) to table in Item 12(a). (2) Includes 50,625 shares held in trust for adult children. Of the aggregate of 80,667 shares shown, Mr. Shaw has sole voting and dispositive power as to 67,085 and shared voting and dispositive power with his wife as to 13,582. (3) Includes 572 shares held by a trustee for Mr. Bressler under an Individual Retirement Account. Does not include 12,497 shares held by Mr. Bressler's wife as to which he disclaims beneficial ownership. (4) Shares are held in the name of Dr. Hannay's wife and comprise community property. Dr. Hannay therefore has a direct beneficial ownership interest in the shares. He and his wife have shared voting and dispositive power. (5) Includes 4,451 shares held by the Registrant's Profit Sharing Plan, as to which Mr. Patel has sole voting and dispositive power. As to the balance of 5,350 shares, Mr. Patel shares voting and dispositive power with his wife. Item 13. Item 13. Certain Relationships and Related Transactions ---------------------------------------------- Bernard Bressler, Secretary and a director of the Registrant, is a member of the law firm of Bressler, Amery & Ross, counsel to the Registrant. During the 1993 fiscal year, the Registrant paid legal fees of $192,899, to such firm. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K -------------------------------------------- (a) See index to financial statements and financial statement schedules. See list of exhibits in paragraph (c) below. (b) 8-K reports - During the quarter ended December 31, 1993 (the last quarter of the period covered by this Report), the Registrant filed a Report on Form 8-K to report the completion on December 13, 1993 of the execution of the Journal Production and Distribution Agreement dated November 29, 1993 with the Russian Academy of Sciences and other interested parties. (c) Exhibits - 3.1 Certificate of Incorporation of the Registrant has been filed as part of Exhibit 3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986.(1) 3.2 By-Laws of the Registrant, as amended November 18, 1987, have been filed as Exhibit 3.2 to the Registrant's Annual Report on Form 10-k for the fiscal year ended December 31, 1987.(1) 10.1 Journal Production and Distribution Agreement dated November 29, 1993 among the Registrant, MAIK Nauka, Interperiodica, Pleiades Publishing, Inc., the Russian Academy of Sciences and Vo Nauka, has been filed as Exhibit 99 to the Registrant's Report on Form 8-K dated December 13, 1993.(1) 10.2 Incentive Compensation Plan for Executive Officers and Key Employees of Registrant as amended on June 18, 1985 has been filed as part of Exhibit 10 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985.(1) 10.3 Amendment adopted on December 5, 1990 to Plan referred to in Item 10.3 has been filed as exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990.(1) 10.4 Amended Contingent Compensation Agreements dated September 22, 1989 between the Registrant and Martin Tash, Mark Shaw, Harry Allcock and Marshall Lebowitz have been filed as Exhibit 10.4 to the Registrant's Annual Report on form 10-K for the fiscal year ended December 31, 1989.(1) The Registrant has entered into identical agreements as of December 14, 1993, with Ghanshyam Patel and Ken Derham. To avoid unnecessary duplication, such additional agreements have been omitted from the exhibit filing. 10.5 Indemnification Agreement dated as of November 18, 1987 between the Registrant and Martin E. Tash has been filed as Exhibit 10.6 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987.(1) The Registrant has entered into identical agreements as of the same date with each of the following persons: Howard F. Mathiasen, Mark Shaw, Earl Ubell, Dr. N. Bruce Hannay, and Bernard Bressler. The Registrant entered into a substantially identical agreement dated March 9, 1988 with Ghanshyam A. Patel and dated December 14, 1993 with Ken Derham. To avoid unnecessary duplication, such additional agreements have been omitted from the exhibit filing. 10.6 Amendment dated March 9, 1988 to Indemnification Agreements referred to in Item 10.6 between the Registrant and Martin E. Tash has been filed as Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987.(1) The Registrant has entered into identical amendments of the same date with Mark Shaw and Bernard Bressler. To avoid unnecessary duplication, such identical amendments were omitted from the exhibit filing. 11 Statement re: computation of per share earnings - filed herewith. 21 Subsidiaries of Registrant (i) Plenum Publishing Co., Ltd. (United Kingdom) (ii) Da Capo Press, Incorporated (New York) (iii) Career Placement Registry, Inc. (Delaware) (iv) J.S. Canner & Company, Inc. (Massachusetts) (v) Plenum International Sales Corporation (Virgin Islands) (vi) IFI/Plenum Data Corporation (Delaware) (vii) Human Sciences Press, Inc. (Delaware) (1) Not filed with this report but incorporated by reference herein. 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. PLENUM PUBLISHING CORPORATION (Registrant) By:s/Martin E. Tash ---------------- Martin E. Tash Chairman of the Board of Directors and President Dated: 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: By:s/Martin E. Tash ---------------- Martin E. Tash Chairman of the Board of Directors and President (Principal Executive Officer) Dated: March 28, 1994 By:s/Mark Shaw --------------------- Mark Shaw Executive Vice President and a Director Dated: March 28, 1994 By:s/Ghanshyam A. Patel --------------------- Ghanshyam A. Patel Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Dated: March 28, 1994 By:s/Bernard Bressler --------------------- Bernard Bressler Secretary and a Director Dated: March 28, 1994 By:s/Earl Ubell --------------------- Earl Ubell Director Dated: March 28, 1994 By:s/N. Bruce Hannay --------------------- N. Bruce Hannay Director Dated: March 28, 1994 By:s/Howard F. Mathiasen --------------------- Howard F. Mathiasen Director Dated: March 28, 1994 Plenum Publishing Corporation and Subsidiary Companies Form 10-K Item 14(a)(1) and (2) and Financial Statement Schedules The following consolidated financial statements of Plenum Publishing Corporation and subsidiary companies are included in Item 8: Report of Independent Auditors S- 1 Consolidated Balance Sheets - December 31, 1993 and 1992 S- 2 Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991 S- 4 Consolidated Statements of Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 S- 6 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 S- 7 Notes to Consolidated Financial Statements S- 9 The following consolidated financial statement schedules of Plenum Publishing Corporation and subsidiary companies are included in Item 14(d): Schedules: I Marketable Securities - Other Investments S-22 VIII Valuation and Qualifying Accounts S-23 IX Short-Term Borrowings S-24 X Supplementary Income Statement Information S-25 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 Stockholders and Board of Directors Plenum Publishing Corporation We have audited the accompanying consolidated balance sheets of Plenum Publishing Corporation and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Plenum Publishing Corporation and subsidiary companies 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. ERNST & YOUNG New York, New York March 14, 1994 Plenum Publishing Corporation and Subsidiary Companies Notes to Consolidated Financial Statements December 31, 1993 1. Summary of Significant Accounting Policies - --------------------------------------------- Basis of Presentation - --------------------- The accompanying financial statements include the accounts of the Plenum Publishing Corporation (the "Company") and its domestic and foreign subsidiaries, which are wholly-owned. The accounts of the foreign subsidiaries are not material. Intercompany items and transactions are eliminated in consolidation. The Company accounts for its investment in Gradco Systems, Inc. under the equity method (see Note 5). The Company and its subsidiaries are engaged in the publishing and distri- bution of advanced scientific and technical materials in the United States and in foreign countries. Export sales aggregated approximately $23,217,000 (1993), $21,214,000 (1992) and $21,453,000 (1991). Inventories - ----------- Inventories are stated at the lower of cost (principally average cost or specific invoice cost) or market (based on selling market). Depreciation and Amortization - ----------------------------- Depreciation is provided for by the straight-line method or by the declining- balance method over estimated useful lives ranging from 3 to 35 years. Amortization of leasehold improvements is provided for by the straight-line method generally over the terms of the related leases or the estimated useful lives of the improvements, whichever period is shorter. The excess of cost of assets acquired over book amount thereof (which arose in connection with various acquisitions by the Company in prior years, other than Gradco Systems, Inc.) is being amortized by the straight-line method principally over forty years. Deferred expenses relating to issuance of long-term debt are being amortized by the straight-line method over the term of the related debt (see Note 6). The cost of the subscription lists of Human Sciences Press and Agathon journals is being amortized by the straight-line method over estimated useful lives ranging from 12 to 20 years. Other assets include the cost of rights to produce and distribute certain journals, which is being amortized by the straight-line method, primarily over a period of fifteen years. Deferred Subscription Income - ---------------------------- The Company bills subscribers to certain publications and patent information services in advance of issuance thereof. The publications are generally issued over a one-year period and subscription revenues are taken into income by the straight-line method based on the relationship of the number of publications issued to the number ordered by subscribers. Patent information service revenues are taken into income when published. The portion of advance billings which will require use of financial resources within one year is not practicable to determine and, accordingly, no portion thereof is included in current liabilities; expenditures at balance sheet dates in respect of such advance billings have similarly been excluded from current assets. Marketable Securities - --------------------- Marketable securities are valued at the lower of aggregate cost or market. Gains and losses on marketable securities are determined based on specific identification. See Note 2. Cash Equivalents and Supplemental Cash Flow Information - ------------------------------------------------------- The Company considers all highly liquid financial instruments with a maturity of three months or less when purchased to be cash equivalents. As of December 31, 1993, the Company had time deposits and money market accounts totalling approximately $1,442,000 on deposit with five financial institutions. As of December 31, 1992, the Company had time deposits and money market accounts of approximately $10,057,000 on deposit with four financial institutions. The Company paid income taxes in 1993, 1992 and 1991 of approximately $6,029,000, $5,962,000 and $6,915,000 (net of income tax refunds received of approximately $1,218,000 in 1991), respectively. In addition, the Company paid interest in 1993, 1992 and 1991 of approximately $1,565,000, $3,023,000 and $3,200,000, respectively. 2. Accounting Change - -------------------- In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes" (the "Statement"). The Company adopted the provisions of the new standard in its financial statements for the year ended December 31, 1992. As permitted by the Statement, prior year financial statements have not been restated to reflect the change in accounting method. The cumulative effect as of January 1, 1992 of adopting the Statement increased net income by $1,179,950 or $.25 per share ($.19 per share on a fully diluted basis). Under the Statement, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of the Statement, income tax expense was determined using the liability method prescribed by Financial Accounting Standards Board Statement No. 96 ("Statement 96"), which is superseded by the Statement. Among other matters, the Statement changes the recognition and measurement criteria for deferred tax assets included in Statement 96. In accordance with the Statement, all of the income tax benefits on the excess of book over tax deductions (for example, depreciation, allowance for doubtful accounts, etc.) are deferred (see Note 7). The cumulative effect on prior years of the change has been shown in the income statement for 1992. 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," effective for fiscal years beginning after December 15, 1993. Under the new rules, which the Company will adopt effective January 1, 1994, the Company will classify its marketable equity securities held as trading securities on the basis of its intent to trade such securities. Accordingly, all marketable equity securities classified as trading securities will be carried at fair market value. Unrealized gains and losses applicable to these securities will be reported as a component of current earnings. Presently, the Company values marketable equity securities as trading securities and reports such securities at the lower of aggregate cost or market, with unrealized losses reported as a component of current earnings. 3. U.S. Government Securities - ----------------------------- The cost and market value of U.S. Government securities at December 31, 1992 are as follows: Cost $31,896,181 =========== Market Value $33,255,846 =========== 4. Inventories - -------------- Inventories at December 31 are comprised of: 1993 1992 -------------------------------- Finished publications $3,612,257 $3,841,520 Work in process 566,928 644,175 -------------------------------- $4,179,185 $4,485,695 ================================ 5. Investment in Gradco Systems, Inc. - ------------------------------------- As of December 31, 1993 and 1992, the Company owned 913,000 common shares of Gradco Systems, Inc. ("Gradco"), a company engaged in the development and marketing of photocopier machine technology, representing approximately 11.7% of its outstanding common stock. Gradco stock is publicly traded on the NASDAQ National Market System. The aggregate market value of this investment as of December 31, 1993 and 1992 amounted to approximately $2,739,000 and $1,480,000, respectively. Selected financial data of Gradco as of and for the 12 months ended December 31, 1993, 1992 and 1991 is as follows and has been extracted from unaudited financial information as filed by Gradco with the Securities and Exchange Commission (in thousands): 1993 1992 1991 ---------------------------------- Balance sheet data Total assets $38,863 $44,019 $40,962 Working capital 9,147 7,198 6,721 Noncurrent liabilities, including minority interest and excluding current installments 15,669 12,387 12,275 Shareholders' equity 9,767 10,914 11,825 Statement of operations data Net revenues 55,773 55,635 58,719 Net income (loss) 43 (863) (753) The President and Chairman of the Board of the Company, Mr. Martin E. Tash, is also the President and Chairman of the Board of Gradco. 6. Long-Term Debt - ----------------- Long-term debt at December 31, 1992 consisted of 6-1/2% Convertible Subordinated Debentures (the "Debentures") due April 15, 2007. The Debentures were issued in April and May 1987. In 1993, 1992 and 1991, the Company purchased Debentures in the principal amount of $1,149,000, $6,808,000 and $1,300,000, respectively, for an aggregate cost (including the write-off of related deferred issuance costs of approximately $28,000, $173,000 and $34,000, respectively) of approximately $1,143,000, $6,149,000 and $1,134,000, respectively. On April 30, 1993 (the "Redemption Date"), pursuant to a notice of election to redeem which had been given to the holders on March 24, 1993, the Company redeemed the Debentures which were outstanding on the Redemption Date. In accordance with the terms of the Debentures and the applicable Trust Indenture, the redemption price was equal to 102.60% of the principal amount of outstanding Debentures, and the holders were also paid accrued interest for the period from April 15, 1993 (the date on which the last semiannual installment of interest was paid) to the Redemption Date. Prior to the Redemption Date, Debentures in the aggregate principal amount of $80,000 were converted into 2,560 shares of Common Stock at the applicable conversion rate of $31.25 per $1,000 of principal amount. On the Redemption Date, Debentures in the aggregate principal amount of $39,598,000 were outstanding, requiring a total payment to the holders of approximately $40,735,000 (including accrued interest). This amount was funded by liquidating a portion of the Company's investments of its excess cash, and from short-term borrowing on the Company's margin account with a broker. The premium paid for the Debentures, and the write-off of related deferred issuance costs of approximately $956,000, net of applicable income tax benefit of $675,000 totalled approximately $1,310,000, which has been accounted for as an extraordinary loss. 7. Income Taxes - --------------- Effective January 1, 1992, the Company changed its method of accounting for income taxes to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes" (see Note 2-"Accounting Change"). Income taxes for the years ended December 31 consist of the following: -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,424,809 $ (874,809) $4,550,000 State and local 1,652,470 (266,470) 1,386,000 -------------------------------------- $7,077,279 $(1,141,279) $5,936,000 ====================================== -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,084,206 $ (84,206) $5,000,000 State and local 2,871,540 (21,540) 2,850,000 -------------------------------------- $7,955,746 $ (105,746) $7,850,000 ====================================== -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,117,300 $ 642,700 $5,760,000 State and local 1,419,158 109,842 1,529,000 -------------------------------------- $6,536,458 $ 752,542 $7,289,000 ====================================== Deferred income taxes result from the recognition of the income tax effect of timing differences in reporting transactions for financial and tax purposes. A description of the differences and the related tax effect follow: 1993 1992 1991 --------------------------------------------- Valuation of inventories $ (337,711) $ (95,457) $154,305 Depreciation ( 77,000) (102,600) 4,600 Allowance for doubtful accounts, etc. ( 26,768) 92,311 - Adjustments applicable to net unrealized losses (699,800) - 593,637 --------------------------------------------- $(1,141,279) $(105,746) $752,542 ============================================= Significant components of the Company's deferred tax assets as of December 31 are as follows: 1993 1992 ----------- ----------- Valuation of inventories $ 2,117,711 $ 1,780,000 Depreciation 1,047,721 970,721 Allowance for doubtful accounts, etc. 135,768 109,000 Allowance for net unrealized losses 699,800 - Equity in losses of Gradco 1,998,400 2,000,000 ----------- ----------- Total deferred tax assets 5,999,400 4,859,721 Valuation allowance (1,998,400) (2,000,000) ----------- ----------- Net deferred tax assets $ 4,001,000 $ 2,859,721 =========== =========== The Company has recorded a valuation allowance for the entire value of the deferred tax asset attributable to the equity in losses of Gradco, since management believes the realization of such asset is not reasonably assured. 8. Leases - --------- The Company leases certain real properties. Certain leases provide for the payment of real estate taxes and escalation of rentals based on increases in real estate taxes. Rental expense for the years ended December 31 is as follows: 1993 $758,226 1992 804,728 1991 823,848 Approximate future minimum rentals under all noncancelable operating leases for real property at December 31, 1993 are as follows: 1994 $ 506,000 1995 512,000 1996 459,000 1997 301,000 1998 289,000 Subsequent to 1998 2,648,000 --------------- $4,715,000 =============== 9. Profit Sharing and Incentive Compensation Plans - -------------------------------------------------- The Company has a profit sharing plan for its employees which provides for annual contributions based upon the Company's net income as a percentage of gross revenue and the employees' salary level and length of service. Such contributions, which are placed in a trust fund, are invested at the employees' discretion. Contributions under the plan aggregated approximately $1,121,000 (1993), $1,126,000 (1992) and $1,006,000 (1991). Other accrued expenses and sundry liabilities include accrued contributions under the plan of $1,121,000 (1993) and $1,126,000 (1992). The Company has an incentive compensation plan for executive officers and key employees of the Company providing for 5% of the Company's income from operations to be distributed (as provided) to participants of the plan. In addition to the amounts payable as set forth above, since cumulative investment income (as defined) earned after 1990 through December 31, 1992 exceeded investment loss (as defined) incurred in 1990, the excess was added to income from operations for the purpose of calculating incentive compen- sation for 1992. Since there was investment income (as defined) in 1993, the amount of such income was added to income from operations for the purpose of calculating incentive compensation for 1993. Distributions under the plan aggregated $844,000 (1993), $959,000 (1992) and $821,000 (1991). Other accrued expenses and sundry liabilities include accrued incentive compensation of $339,000 (1993) and $464,200 (1992). The Company has the right to change, modify or terminate the above plans at any time. 10. Per Share Amounts - --------------------- Primary net income per share of Common Stock is computed on the basis of weighted average number of common shares outstanding (4,607,458 (1993), 4,727,714 (1992) and 5,030,844 (1991)). Amounts per share of Common Stock assuming full dilution are computed on the basis of the weighted average number of shares set forth in the preceding paragraph adjusted for shares issuable upon conversion of the Convertible Subordinated Debentures, after elimination from net income of related debt expense thereon, less applicable income taxes. The number of shares used in this computation is 5,003,791 (1993), 6,166,436 (1992) and 6,592,579 (1991). Fully diluted net income per share is not presented for the periods where the result of the computation is antidilutive. 11. Marketable Securities - ------------------------- December 31 1993 1992 ------------------------------ Aggregate market value $ 48,825,213 $54,502,745 Cost 50,538,410 51,636,161 ------------------------------ Net unrealized (loss) gain $ (1,713,197) $ 2,866,584 ============================== The net unrealized gain at December 31, 1992 has not been recognized in the accompanying consolidated financial statements; such amount consisted of unrealized gains of $5,885,284 and unrealized losses of $3,018,700. The net unrealized loss at December 31, 1993 has been provided for in the accompanying consolidated financial statements; such amount consisted of unrealized gains of $796,126 and unrealized losses of $2,509,323. The Company's portfolio of marketable securities is substantially invested in a limited number of issuers, operating principally in the pharmaceutical industry at December 31, 1993 and in the pharmaceutical and electric utility industries at December 31, 1992. At December 31, 1993, the cost and market value of the Company's largest holding (invested in a company operating in the pharmaceutical industry) were $21,000,000 and $21,749,000, respectively ($18,422,000 and $23,154,000, respectively, at December 31, 1992). Subsequent to December 31, 1993 and through March 14, 1994, the Company realized net losses aggregating approximately $904,000 on sales of marketable securities. At March 14, 1994, the market value of marketable securities aggregated approximately $39,844,000 (cost $41,635,000). 12. Quarterly Financial Information (Unaudited) - ----------------------------------------------- 13. Distribution Agreement - -------------------------- In December 1993, the Company entered into a Journal Production and Distribution Agreement (the "Distribution Agreement") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and the Company's role as publisher and distributor of certain of such journals was altered. The Distribution Agreement extends from 1994 through 2006. Pursuant to the Distribution Agreement, in 1994 the Company will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Company had translated, published and distributed these journals under a contract with the Copyright Agency of the former Soviet government, and under contracts with the individual institutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Company will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing these functions. In 1994, the Company will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Pursuant to the Distribution Agreement, the Company advanced the Academy $1,000,000 during 1993, of which, $750,000 was outstanding at December 31, 1993. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Company. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Company. As to each additional journal which is published by MN and distributed by the Company under the Distribution Agreement, the Company will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Company will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Company's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. 14. Contingencies - ----------------- The Company has contingent compensation agreements with certain key personnel. Each agreement provides for the cash payment of an amount equal to 290% of average annual compensation (as defined), in the event of termination of employment, under certain conditions which include, among other matters, (a) the sale of 75% of the book value of the Company's operating assets (as defined) or (b) any person (as defined) becoming the owner of more than 25% of the issued and outstanding shares of the Company's voting stock. In 1991, the Company was named as a co-defendant in an action brought by former executives of Gradco, seeking compensatory and other damages of a material amount. Management of the Company, after consultation with counsel, believes the action will not result in a material loss to the Company and intends to vigorously defend against it. S-22 S-23 S-24 Plenum Publishing Corporation and Subsidiary Companies Schedule X-Supplementary Income Statement Information Column A Column B - ----------------------------------------------------------------------- Charged to Costs Item and Expenses - ----------------------------------------------------------------------- Year ended December 31, 1993 Advertising Costs $2,069,627 Year ended December 31, 1992 Advertising Costs $2,081,552 Year ended December 31, 1991 Advertising Costs $2,071,546 Note: Items not shown above are omitted because the amounts charged to costs and expenses for such items are less than one percent of total revenues, except for royalties which are shown in the consolidated statements of income. S-25

6474_1993.txt

6474_1993

1993

6474

Item 1. Business (a) General Development of Business The Andersons (the "Partnership" or "Company") is engaged in grain merchandising and operates grain elevator facilities located in Ohio, Michigan, Indiana and Illinois. The Partnership is also engaged in the distribution of agricultural products such as fertilizers, seeds and farm supplies. The Partnership operates retail general stores; produces, distributes and markets lawn care products and corncob products; and repairs and leases rail cars. The Partnership is the successor to other Ohio limited partnerships which have operated as "The Andersons" continuously since 1947. Except where the context otherwise requires, the terms "Partnership," "Company" and "The Andersons" include The Andersons and all predecessor and successor entities. The Andersons Management Corp. (the "Corporation") was formed in 1987 and is the sole General Partner of the Partnership. All of the common shares of the Corporation are owned by Limited Partners of the Partnership. The Corporation's Board of Directors has overall responsibility for the management of the Corporation, including its responsibilities as General Partner of the Partnership. The Corporation provides all management and labor services required by the Partnership in its operations under a Management Agreement entered into between the Partnership and the Corporation. See "Item 13. Certain Relationships and Related Transactions - Management Agreement." (b) Financial Information About Industry Segments See Note 11 to the Partnership's Consolidated Financial Statements for information regarding the Partnership's business segments. (c) Narrative Description of Business Grain Operations The Partnership's grain operations involve merchandising grain and operating terminal grain elevator facilities, which includes purchasing, handling, processing and conditioning grain, storing grain purchased by the Partnership as well as grain owned by others, and selling grain. The principal grains sold by the Partnership are yellow corn, yellow soybeans and soft red and white wheat. The Partnership's total grain storage capacity aggregates approximately 51 million bushels. Virtually all grain merchandised by the Partnership is grown in the midwestern part of the United States and is acquired from country elevators, dealers and producers. The Partnership effects grain purchases at prices related to Chicago Board of Trade quotations. The Partnership competes for the purchase of grain with grain processors and feeders, as well as with other grain merchandisers. The Partnership's grain business may be adversely affected by unfavorable weather conditions, disease, insect damage, the total acreage planted by farmers, government regulations and policies, and commodity price levels as they affect grower incentive or a supplier's decision when to deliver grain for sale. See "Government Regulation." The grain business is seasonal coinciding with the harvest of the principal grains purchased and sold by the Partnership. During 1993, approximately 77% of the grain sold by the Partnership was purchased domestically by grain processors and feeders and approximately 23% was exported. Most of the exported grain was purchased by exporters for shipment to foreign markets. Some grain is shipped directly to foreign countries, mainly Canada. Almost all grain shipments are by rail or boat. Rail shipments are made primarily to grain processors and feeders, with some rail shipments made to exporters on the Gulf or east coast. All boat shipments are from the Toledo, Ohio port elevator. The Partnership competes in the sale of grain with other grain merchants, other private elevator operators and farmer cooperatives which operate elevator facilities. Competition is based primarily on price, service and reliability. The Partnership believes that it is the largest terminal elevator operator in the Maumee/Toledo area and that it accounts for substantial portions of the grain elevator business done in its other principal geographic areas of operations. Some of the Partnership's competitors are also its customers and many of its competitors have substantially greater financial resources than the Partnership. Grain sales are effected on a negotiated basis by the Partnership's merchandising staff. As with agricultural commodities generally, the volume and pricing of the Partnership's sales are sensitive to changes in supply and demand relationships, which in turn are affected by factors such as weather, crop disease and government programs, including subsidies and acreage allotments. The Partnership's business also is affected by factors such as conditions in the shipping industry, currency exchange fluctuations, government export programs and the relationships of other countries with the United States and similar considerations. Since the Partnership does not know the ultimate destination of the grain it sells for export, it is unable to determine the relative importance, in terms of sales, of the various countries to which grain is shipped by its customers. The Partnership hedges virtually all grain transactions through offsetting sales or purchases of grain for future delivery. These hedging transactions customarily involve trading in grain futures on the Chicago Board of Trade, a regulated commodity futures exchange which maintains futures markets for virtually all grains merchandised by the Partnership. Hedging transactions are designed to provide protection against changes in the market prices of the grain purchased and sold by the Partnership. Agricultural Products The Partnership's agricultural products operations involve purchasing, storing, formulating, and selling dry and liquid fertilizers; providing fertilizer warehousing and services to manufacturers and customers; wholesale distribution of seeds and various farm supplies; and retail sales of seeds, farm supplies and fertilizer. The major fertilizer ingredients sold by the Partnership are nitrogen, phosphate and potassium, all of which are readily available from various sources. The Partnership's market area primarily includes Illinois, Indiana, Michigan and Ohio and customers for the Partnership's agricultural products are principally retail dealers. Sales of agricultural products are heaviest in the spring and fall. The Partnership's aggregate storage capacity for dry fertilizer is 13 million cubic feet. The Partnership reserves 5 million cubic feet of this space for various fertilizer manufacturers and customers. The Partnership's aggregate storage capacity for liquid fertilizer is 21 million gallons and 6 million gallons of this space is reserved for manufacturers and customers. The agreements for reserved space provide the Partnership storage and handling fees and, generally, are for one year and are renewed at the end of each term. In its agricultural products business, the Partnership competes with regional cooperatives; fertilizer manufacturers; multi-state retail/wholesale chain store organizations; and other independent wholesalers of agricultural products. Many of these competitors have considerably larger resources than the Partnership. Competition in the agricultural products business of the Partnership is based principally on price, location and service. The Partnership believes that it is a strong competitor in these areas. Retail Store Operations The Partnership's retail store operations consist of six general stores located in the Columbus, Lima and Toledo, Ohio areas, which serve urban, rural and suburban customers. A smaller store is located in Delphi, Indiana. Major product categories in the general stores include: hardware, home remodeling and building supplies; automotive accessories and parts; small appliances, electronics and houseware products; work clothes and footwear; wine, specialty meats and cheeses, baked goods and produce; pet care products; lawn and garden supplies, nursery stock and Christmas decorations and trim; toys, sporting goods, bicycles and marine accessories. The general store concept features self-selection of a wide range and variety of brand name, quality merchandise. Each general store carries more than 70,000 different items, has over 100,000 square feet of in-store display space plus 40,000 square feet of outdoor garden center space, and has a center aisle that features do-it-yourself clinics, special promotions and varying merchandise displays. The retail merchandising business is highly competitive. The Partnership competes with a variety of retail merchandisers, including numerous mass retailers, department and hardware stores, and farm equipment and supply companies. The principal competitive factors are quality of product, price, service and breadth of selection. In each of these areas the Partnership is an effective competitor. Its wide selection of brand names and other quality merchandise is attractively displayed in the Partnership's general stores. Each store is located on landscaped property with ample well- lit parking facilities. The Partnership's retail business is affected by seasonal factors with significant sales occurring during the Christmas season and in the spring. Other Activities The Partnership produces more than 2000 granular retail and professional lawn care products which are distributed in the snowbelt states from the Rocky Mountains to the east coast. The retail granular products are sold to mass merchandisers, small independent retailers and other lawn fertilizer manufacturers. The professional granular products are sold both direct and through distributors to lawn service applicators and to golf courses. The principal raw materials for the lawn care products are nitrogen, potash and phosphate, which are available from the Partnership's agricultural products division. The lawn care industry is highly seasonal, with the majority of the sales occurring from early spring to early summer. Competition is based principally on merchandising ability, service and quality. The Partnership is one of the largest producers of processed corncob products in the United States. These products serve the chemical carrier, animal bedding, industrial and sorbent markets and are distributed throughout the United States and Canada and into Europe and Asia. The unique absorption characteristics of the corncob has led to the development of "sorbent" products. Sorbents include products made from corncobs as well as synthetic and other materials and are used to absorb spilled industrial lubricants and other waste products. The principal sources for the corncobs are the Partnership's grain operations and seed corn producers. The Partnership produces dog and cat foods, which are marketed through a joint venture partnership. The Partnership is also involved in repairing, buying, selling and leasing rail cars, the operation of six auto service centers, a steel fabrication shop, a restaurant and an outdoor power equipment sales and service shop. Research and Development The Partnership's research and development program is mainly concerned with the development of improved products and processes, primarily lawn care products and corncob products. Approximately $450,000, $380,000 and $220,000 was expended on research and development during 1993, 1992 and 1991, respectively, including materials, salaries and outside consultants. Working Capital, Lines of Credit and Secured Borrowings The Partnership finances part of its inventories through short-term borrowings under lines of credit which are also used from time to time for other Partnership purposes. Generally, the highest borrowings occur in the spring and are related to payments of grain payables, credit sales of agricultural products related to spring planting and a seasonal peak in credit sales of lawn care products. The amount of borrowings outstanding during the year, and from one year to another, may fluctuate widely. The Partnership has available lines of credit for unsecured short-term debt with banks aggregating $117,000,000. The credit arrangements, the amounts of which are adjusted from time to time to meet the Partnership's needs, do not have termination dates but are reviewed at least annually for renewal. At December 31, 1993, the Partnership was, and it believes that it continues to be, in compliance with the conditions of its lines of credit. See Note 6 to the Partnership's Consolidated Financial Statements for additional information relating to the lines of credit. The Partnership also has a $10 million long-term revolving line of credit. See Note 7 to the Partnership's Consolidated Financial Statements. Certain of the Partnership's long-term indebtedness is secured by first mortgages on various facilities of the Partnership. Some of the Partnership's long-term borrowings include provisions that impose minimum levels of working capital and partnership equity (as defined); limit the amount of cash distributions and other payments to partners; limit the addition of new long- term debt; restrict the Partnership from certain sale, lease, merger and consolidation transactions; require the Partnership to be substantially hedged in its grain transactions; and certain other requirements. At December 31, 1993, the Partnership was, and it believes it continues to be, in compliance with all terms and conditions of the secured borrowings and lines of credit. See Note 7 to the Partnership's Consolidated Financial Statements for further information with respect to long-term financing. Employees All management and labor services are provided to the Partnership by the employees of the Corporation. The Partnership pays a management fee to the Corporation for these services. At December 31, 1993, there were 939 full- time and 1,972 part-time or seasonal employees of the Corporation providing services to the Partnership, which does not have any of its own employees. Government Regulation Grain sold by the Partnership must conform to official grade standards imposed under a federal system of grain grading and inspection administered by the United States Department of Agriculture ("USDA"). The production levels, markets and prices of the grains which the Partnership merchandises are materially affected by United States government programs, including acreage control and price support programs of the USDA. Also, under federal law, the President may prohibit the export of any product, the scarcity of which is deemed detrimental to the domestic economy, or under circumstances relating to national security. Because a portion of the Partnership's grain sales are to exporters, the imposition of such restrictions could have an adverse effect upon the Partnership's operations. The Partnership, like other companies engaged in similar businesses, is subject to a multitude of federal, state and local environmental protection laws and regulations including, but not limited to, laws and regulations relating to air quality, water quality, pesticides and hazardous materials. The provisions of these various regulations could require modifications of certain of the Partnership's existing plant and processing facilities and could restrict future facilities expansion or significantly increase their cost of operation. To date, none of these requirements has had a materially adverse impact on the Partnership's operations. Possible Environmental Proceeding In October 1992, the Partnership was notified by the Ohio Environmental Protection Agency (the "Agency") that a water contamination discharge issue had been referred to the Ohio Attorney General. The issue involves the Partnership's Toledo, Ohio river elevator facility, built during the 1960's and 1970's on low lying land that had, in part, been filled by an unrelated corporation with material from its manufacturing operations. This material is the apparent source of the alleged contamination at issue. No proceedings have yet been instituted against the Partnership, but the Partnership has been advised that it may become the subject of an action seeking injunctive relief and monetary penalties. The Partnership is diligently working to resolve this matter and has had continuing discussions with the Agency and the Ohio Attorney General's office in that regard. Although no representation can be made as to the outcome, it is management's opinion that the resolution of this matter will not have a material adverse effect on the consolidated financial position of the Partnership. Item 2. Item 2. Properties The Partnership's principal grain, agricultural products, retail store and other properties are described below. Except as otherwise indicated, all properties are owned by the Partnership. Grain Facilities Bushel Bushel Location Capacity Location Capacity Maumee, OH 17,500,000 Poneto, IN 550,000 Toledo, OH 6,300,000 Albion, MI 1,600,000 Champaign, IL 12,000,000 Potterville, MI 800,000 Delphi, IN 4,900,000 White Pigeon, MI 1,500,000 Dunkirk, IN 5,700,000 The Partnership's grain facilities have an aggregate storage capacity of approximately 51 million bushels. The grain facilities are mostly concrete and steel tanks, with some flat storage. The Partnership also owns grain inspection buildings and driers, a corn sheller plant, maintenance buildings and truck scales and dumps. Agricultural Products Facilities Dry Storage Liquid Storage Location (in cu. ft.) (in gallons) Maumee, OH 5,667,000 Toledo, OH 2,000,000 2,857,000 Clymers, IN (1) 7,000 900,000 Delphi, IN 1,500,000 Dunkirk, IN 817,000 Logansport, IN (1) 37,000 3,274,000 Poneto, IN 4,700,000 Walton, IN (1) 247,000 5,867,000 Champaign, IL 800,000 Webberville, MI 1,833,000 3,250,000 (1) Leased facilities - lease expires in 1994, contains a five-year renewal option and an option to purchase the facilities. Agricultural products properties consist mainly of fertilizer warehouse and distribution facilities for dry and liquid fertilizers. The dry fertilizer storage capacity totals approximately 13 million cubic feet and the liquid fertilizer storage capacity totals approximately 21 million gallons. The Maumee, Ohio and Walton, Indiana locations have fertilizer mixing, bagging and bag storage facilities. The Partnership owns a seed processing facility in Delta, Ohio. The Partnership also leases four retail supply and sales facilities in Michigan. Retail Store Properties Name Location Sq. Ft. Maumee General Store Maumee, OH 128,000 Toledo General Store Toledo, OH 134,000 Woodville General Store (1) Northwood, OH 105,000 Lima General Store (1) Lima, OH 103,000 Brice General Store (1) Columbus, OH 140,000 Sawmill General Store Columbus, OH 134,000 Delphi Store Delphi, IN 28,000 Warehouse (1) Maumee, OH 245,000 (1) Leased The leases for the three general stores and the warehouse facility are long-term leases with several renewal options and provide for minimum aggregate annual lease payments approximating $1,750,000. The general store leases provide for contingent lease payments based on achieved sales volume. With respect to the Brice General Store lease, see "Item 13. Certain Relationships and Related Transactions - Alshire-Columbus." Lawn, Pet, Cob and Other Properties The Partnership owns lawn fertilizer production facilities and automated pet food production and storage facilities in Maumee, Ohio. It also owns corncob processing and storage facilities in Maumee, Ohio and Delphi, Indiana. The Partnership leases a lawn fertilizer production facility, a warehouse facility and two lawn products sales outlets. In its rail car leasing business, the Partnership owns or leases approximately 700 covered hopper cars with lease terms ranging from one to five years and annual lease payments aggregating approximately $1,900,000. The Partnership also owns a rail car repair facility, a steel fabrication facility, a service and sales facility for outdoor power equipment and the Partnership owns or leases six auto service centers. The Partnership's administrative office building is leased at an annual rental of $631,000 under a net lease expiring in 2000. See "Item 13. Certain Relationships and Related Transactions - Management Agreement." The Partnership owns approximately 488 acres of land on which various of the above properties and facilities are located; approximately 485 acres of farmland and land held for future use; approximately 105 acres of improved land in an office/industrial park held for sale; and certain other meeting and recreational facilities, dwellings and parcels. The Partnership also owns or leases a number of switch engines, cranes and other equipment. Real properties, machinery and equipment of the Partnership were subject to aggregate encumbrances of approximately $23,150,000 at December 31, 1993. In addition, a general store that was previously leased was purchased in early 1994 and is subject to an encumbrance of $5,217,000. Additions to property for the years ended December 31, 1993, 1992 and 1991, amounted to $10,808,521, $6,590,045 and $6,770,883, respectively. See Note 8 to the Partnership's Consolidated Financial Statements for information as to the Partnership's leases. The Partnership believes that its properties, including its machinery, equipment and vehicles, are adequate for its business, well maintained and utilized, suitable for their intended uses and adequately insured. Item 3. Item 3. Legal Proceedings The Partnership is not involved in any material legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters (a) Because of the form of its organization that includes restrictions on the transfer of Limited Partnership Interests, there is no market for the Limited Partnership Interests. (b) The number of holders of Limited Partnership Interests as of March 1, 1994, was 205. (c) The Partnership makes cash distributions and allocations of net income to Limited Partners, and to the General Partner in accordance with the terms of the Partnership Agreement. See "Item 6. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Working capital at December 31, 1993 was $47 million, up $6.9 million from last year. Inventories were up $63 million, with grain inventories accounting for $50 million of the increase. The number of bushels owned at December 31, 1993 were about the same as the prior year, but prices were up. The average price of corn was up almost 50% and the average price of soybeans was up about 25%. In addition, the mix of the grain inventories changed, with approximately 3.7 million more bushels of soybeans in grain inventories at December 31, 1993, at an average price of $6.99 per bushel compared to corn at $2.96 per bushel and red wheat at $3.69. Lawn products inventories were up $8 million as a result of a build up of inventory to better meet the heavy spring demand. Retail (merchandise) inventories were up about $6 million, mostly due to an additional general store opened in 1993. The grain commodity price increases resulted in additional margin deposits at December 31, 1993, as well as an increase in accounts payable for grain. Accounts receivable were up $19 million, with most of the increase in grain and agricultural products receivables due to year end sales. Short-term borrowings were up to fund the inventory and accounts receivable increases. Partners' capital at December 31, 1993 totalled $55.4 million, up $4.3 million from December 31, 1992. During 1993 the Partnership offered limited partnership interests and received $424,000 of proceeds. The offering is continuing in 1994 and $750,000 of additional proceeds has been received. Any additional amounts received in 1994 are not expected to be significant. Withdrawals of capital by partners in 1993 totalled $828,000. Withdrawals in 1994 are not expected to be significant. Quarterly cash distributions to partners totaled $1.5 million in 1993 and are expected to be approximately $1.3 million in 1994. Tax distributions are made to partners to assist them in making federal, state and local tax payments since the taxable income of the Partnership is taxable to the partners and not to the Partnership. Tax distributions can fluctuate widely from year to year (see "Item 6. Selected Financial Data") due to changes in the amount and in the components of partnership taxable income and due to the timing of required tax payments by partners. In the years 1989, 1990 and 1991, tax distributions were made in April based on the previous year's taxable income. Tax distributions made in 1989, 1990 and 1991 were $336,000, $278,000 and $3.7 million, respectively. Tax distributions were higher in 1991 due to a significant increase in taxable (and book) income and due to a change in policy whereby the Partnership began making tax distributions on a quarterly basis coinciding with the dates estimated tax payments are due by partners. In 1992, tax distributions dropped to $418,000 as a result of the quarterly tax distributions paid in 1991. In 1993, tax distributions totalled $4.2 million. Of this amount, $2.2 million was paid in January and April as tax distributions on 1992 taxable income. The remainder of the 1993 tax distributions were made in April, June and September for 1993 estimated tax payments by partners. In 1994, a tax distribution of $660,000 was made in January. The final tax distribution of $900,000 for 1993 taxable income is expected to be made April. Quarterly tax distributions of $700,000 are expected to be paid in April, June and September 1994 and January 1995. During 1993 the Partnership issued $3.5 million of Five-Year and $2.3 million of Ten-Year debentures and additional debentures are being offered in 1994. Proceeds from the issuance of the debentures in 1993 were used to fund current maturities of long-term debt and for capital expenditures. The amount of proceeds to be realized in 1994 from the sale of debentures is unknown since the offering is not underwritten. Any proceeds realized will be added to working capital and used for such purposes as the funding of current maturities of long-term debt and for capital expenditures. Unused short-term lines of credit were $29.1 million at December 31, 1993, and unused long-term lines of credit were $2.5 million. The Partnership's liquidity is enhanced by the fact that grain inventories are readily marketable. In management's opinion, the Partnership's liquidity is adequate to meet short and long-term needs. The Partnership's short-term lines of credit have been higher in the past and early in 1994 were increased by $25 million on a temporary basis. Capital expenditures totaled $10.8 million in 1993 and are expected to be approximately $26 million in 1994. Anticipated capital expenditures in 1994 include $12 million for two general stores previously leased and $1 million for facilities in the Agricultural Products area subject to a lease expiring in 1994. Funding for capital expenditures in 1994 is expected to come from additional long-term debt of approximately $14 million and cash generated from operations. If cash generated from operations is not sufficient, capital expenditures will be curtailed or additional long-term borrowings could be obtained. Results of Operations Years ended December 31, 1993 and 1992: Income from continuing operations was $11 million in 1993 compared to $10 million in 1992. Operating, administrative and general expenses were up $12 million or about 12%. Included is an increase of $5.7 million (10%) in the management fee paid to the general partner. The more significant items comprising the increase are additional salaries, wages and benefits for the new general store, as well as an expanded work force in several other operating areas and additional cash profit sharing and management performance payments as a result of improved net income. The management fee also increased as a result of the Corporation's adoption of Statement of Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Corporation has elected to recognize the $8.4 million of accrued benefits as of January 1, 1993 (transition obligation) prospectively as a component of annual postretirement benefit cost over approximately 20 years. The additional annual cost incurred by the Corporation and passed on to the Partnership as part of the management fee was approximately $850,000 for 1993 and is expected to be about the same in future years. By major business segment the results were as follows. Sales in the grain area were $416 million, down 2% from 1992. The average selling price was down 4%, from $3.39 per bushel in 1992 to $3.25 per bushel in 1993. Bushels sold increased by 2%. Gross profit on grain sales decreased by 9%, due to the average price decrease and a decrease in margins. Most of these changes were a result of an increase in yields in 1993 as well as an improvement in the quality of the crops in the eastern corn belt. Merchandising revenues were up $6.4 million. Income earned in 1993 from holding owned grain was up from the depressed levels in 1992, due in part to the effects of the floods in 1993 and to a shortage of wheat in the first half of 1993. Income from drying and blending grain was also up in 1993, with most of the increase coming in the first six months of the year. This is a result of the high moisture content in the 1992 corn crop carried into 1993 and due to the depressed level of drying and blending income in the first six months of 1992. As a result of the increase in merchandising revenues, coupled with an increase in operating expenses, operating profit in the grain area was up $3.8 million, or 52% from 1992. In the agricultural products area, sales were $105 million in 1993, up 11% from a year ago. Wholesale sales of fertilizer products accounted for most of the sales increase as a result of a 19% increase in sales volume. Average selling prices were down and margins were also down. Sales of other agricultural products were mixed, as sales of seeds and supplies were down and retail sales were up. Storage income continued to decrease, due to an industry oversupply of warehouse space, although the level of decrease seems to have slowed down. As a result of the increased volume in wholesale fertilizer sales, gross profit in the agricultural products area was up 13% and operating profit was up $1 million, or 44% from 1992. Sales in the retail area were $155 million in 1993, up 4% from 1992. Sales in the Columbus market were up 5%, sales in the Toledo market were down 2% and sales from a new store opened in Lima, Ohio, in the fourth quarter of 1993 accounted for the remainder of the sales increase. Gross profit was up about $1.2 million, or 3%, as a result of the sales increase along with a small decrease in margins due to the competitive pressures in the retail market. As a result of a $3.7 million (10%) increase in operating expenses, due to increased advertising and the costs associated with opening the new general store, operating profit decreased from $4 million in 1992 to $1.6 million in 1993. Sales of lawn products totalled $38 million, up 7% from a year ago. Volume increased 2% and average selling prices increased 5%. Margins were up about 11%. In the industrial products area sales were $14.2 million, up 1%. Sales of sorbent products were up, due to volume increases, and sales of corncob products were down, due to a decrease in volume. Sales from the Partnership's auto service centers were up, as were steel fabrication sales. Railcar leasing activity improved, while railcar repairs for external customers were down due to utilizing the shop capacity for repairs to cars owned by the Partnership. Sales from the Partnership's outdoor power equipment and service shop were $4 million. In total, the operating profits of lawn and corn cob products and other businesses of the Partnership improved by $470,000. During 1993, as a result of lower prevailing interest rates, the Corporation decreased the discount rate used to determine its projected benefit obligation for its pension plan and for its postretirement health care benefits. The change in the discount rate, from 8% to 7.5%, is expected to increase the management fee charged by the Corporation to the Partnership in future years by approximately $365,000. Years ended December 31, 1992 and 1991: Income from continuing operations was $10 million in 1992, more than double the results of 1991, with almost every major business segment showing improvement. Interest expense was down, due in general to lower interest rates. During 1992 the Partnership disposed of its pet products distribution business. See Note 3 to the Partnership's Consolidated Financial Statements. Sales from discontinued operations were approximately $9.8 million and $18.7 million in 1992 and 1991, respectively. Sales in the grain area were $424 million, up 24% from 1991. The average selling price was $3.39 per bushel compared to $3.03 in the previous year and the number of bushels sold also increased. Due to the higher volume, higher average selling prices and an increase in margins, gross profit on grain sales improved by $2.9 million. Merchandising revenues, however, were down by $3.1 million. The largest decrease was in the income earned from holding and storing grain, which decreased by 50%. Fewer bushels were received during the first nine months of the year due to a smaller harvest in the fall of 1991 and a smaller wheat harvest in the summer of 1992 and the prevailing grain market during 1992 did not allow the Partnership to earn as much income from holding grain as in the prior year. In addition, fewer bushels of grain were held in storage during most of 1992. On the other hand, income from drying grain and blending high quality grain with lower quality grain was up about 90% from 1991. The entire increase occurred in the fourth quarter as a result of the high moisture content in the 1992 corn crop due to the wet growing season. Operating expenses increased by about 2.5%. Operating profit in the grain area was $7.4 million, down about $637,000 from 1991 as a result of the decrease in merchandising revenues. In the agricultural products area, sales totalled $94 million, down $3 million from 1991. Wholesale sales of fertilizer products were down $4.7 million, as a result of a 5% decrease in average selling prices. Retail sales were up $960,000 and sales of agricultural supplies were up $425,000. As a result of an increase in margins on wholesale sales and the increases in retail sales and sales of agricultural products, gross profit was up 7%. Storage income, however, was down 40%. An industry oversupply of warehouse space in the last five years has resulted in shorter lease terms with fertilizer producers and reduced storage prices. Some of the reduced storage income is offset by an increase in handling fees. Although total gross profit in the agricultural products area was down in 1992, due to the decrease in storage income, a reduction in operating expenses resulted in an improvement in operating profit from $1.8 million in 1991 to $2.3 million in 1992. Sales in the retail area were $149 million in 1992, up $9.7 million from 1991. The Columbus market accounted for 60% of the sales increase and the Toledo market accounted for 40%. As a result of the sales increase and an improvement in margins, operating profit was $4.1 million, an increase of $2.4 million. Sales of lawn products totalled $35 million, up $8 million from 1991. Volume increased 24% and average selling prices increased 4%. Margins were up about 1.5%. In the industrial products area sales were $14 million, up $1.4 million. Volume was up in both corncob products and sorbent products. Sales at the Partnership's auto service centers were about $7 million, while sales in the rail car repair and leasing business were $5 million, up $3.8 million. In total, the operating profits of lawn and corn cob products and other businesses of the Partnership were $4.5 million, an increase of $2 million. Impact of Inflation: Although inflation has slowed in recent years, it is still a factor in the economy and the Partnership continues to seek ways to cope with its impact. To the extent permitted by competition, the Partnership passes increased costs on through increased selling prices. Grain inventories are valued at the current replacement market price and substantially all purchases and sales of grain are hedged as a result of buying or selling commodity futures contracts. Consequently, grain inventories and cost of goods sold are not directly affected by inflation but rather by market supply and demand. If adjusted for inflation, net income would be lower than reported due primarily to increased depreciation costs resulting from the replacement costs associated with property, plant and equipment. Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Auditors Partners The Andersons We have audited the accompanying consolidated balance sheets of The Andersons (a partnership) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in partners' capital 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 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 consolidated financial position of The Andersons 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 Toledo, Ohio February 7, 1994 The Andersons and Subsidiaries Consolidated Statements of Income Year ended December 31 1993 1992 1991 Sales and merchandising revenues $776,457,070 $753,166,752 $643,063,190 Other income 3,763,737 3,834,457 3,824,408 780,220,807 757,001,209 646,887,598 Costs and expenses: Cost of sales and revenues 650,143,742 639,754,086 541,906,184 Operating, administrative and general expenses (Note 2) 112,829,334 100,791,991 93,167,633 Interest expense 6,168,371 6,325,440 7,297,735 769,141,447 746,871,517 642,371,552 Income from continuing operations 11,079,360 10,129,692 4,516,046 Discontinued operations (Note 3): Loss from discontinued operations - (396,177) (1,690,737) Loss on sale of discontinued operations - (2,097,767) - Net income $ 11,079,360 $ 7,635,748 $ 2,825,309 Net income (loss) was allocated to: General partner: From continuing operations $ 145,526 $ 124,871 $ 55,353 From discontinued operations - (30,743) (20,723) 145,526 94,128 34,630 Limited partners: From continuing operations 10,933,834 10,004,821 4,460,693 From discontinued operations - (2,463,201) (1,670,014) 10,933,834 7,541,620 2,790,679 $ 11,079,360 $ 7,635,748 $ 2,825,309 Net income (loss) allocation per $1,000 of partners' capital: Weighted average capital for allocation purposes $ 47,405,022 $ 43,101,473 $ 41,938,671 Allocation per $1,000: From continuing operations $ 234 $ 235 $ 107 From discontinued operations - (58) (40) $ 234 $ 177 $ 67 See accompanying notes. The Andersons and Subsidiaries Consolidated Balance Sheets December 31 1993 1992 Assets Current assets: Cash and cash equivalents $ 3,936,955 $ 1,365,906 Accounts receivable: Trade accounts, less allowance for doubtful accounts of $1,178,000 in 1993; $775,000 in 1992 60,036,382 40,826,103 Margin deposits 15,320,979 3,123,451 75,357,361 43,949,554 Inventories (Note 4) 211,023,651 148,268,898 Prepaid expenses 858,941 543,492 Total current assets 291,176,908 194,127,850 Other assets: Investments in and advances to affiliates 942,053 1,069,591 Investments and other assets 3,965,729 3,463,679 4,907,782 4,533,270 Property, plant and equipment (Notes 5 and 7) 60,417,088 56,839,517 $356,501,778 $255,500,637 Liabilities and partners' capital Current liabilities: Notes payable (Note 6) $ 87,900,000 $ 23,000,000 Accounts payable for grain 83,712,076 64,745,380 Other accounts payable 58,896,317 54,033,898 Amounts due General Partner (Note 2) 4,173,287 2,669,529 Accrued expenses 7,496,181 6,720,978 Current maturities of long-term debt 1,992,000 2,860,000 Total current liabilities 244,169,861 154,029,785 Amounts due General Partner (Note 2) 2,413,041 1,756,451 Long-term debt (Note 7) 52,259,120 46,077,319 Deferred gain 1,145,151 1,492,949 Minority interest 1,103,892 1,024,326 Partners' capital: General partner 761,839 622,659 Limited partners 54,648,874 50,497,148 55,410,713 51,119,807 $356,501,778 $255,500,637 See accompanying notes. The Andersons and Subsidiaries Consolidated Statements of Cash Flows Year ended December 31 1993 1992 1991 Operating activities Net income $ 11,079,360 $ 7,635,748 $ 2,825,309 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 7,109,223 7,010,579 7,053,977 Amortization of deferred gain (385,956) (373,238) (386,200) Minority interest in net income of subsidiaries 236,224 154,392 88,879 Payments to minority interests (166,198) (132,896) (114,139) Equity in undistributed loss of affiliates - 4,255 133,439 Provision for losses on receivables, investments and other assets 909,724 763,677 930,456 (Gain) loss on sale of property, plant and equipment (1,107,707) (1,645,421) 3,293 Loss on sale of discontinued operations - 1,582,630 - Changes in operating assets and liabilities: Accounts receivable (32,109,849) (5,866,574) (4,250,862) Inventories (61,137,730) 37,905,112 (55,339,694) Prepaid expenses and other assets (1,255,649) (501,424) (230,024) Accounts payable for grain 18,966,696 (3,086,492) 6,542,586 Other accounts payable and accrued expenses 6,719,097 5,074,170 (696,159) Net cash provided by (used in) operating activities (51,142,765) 48,524,518 (43,439,139) Investing activities Purchases of property, plant and equipment (10,808,521) (6,590,045) (6,670,883) Proceeds from sale of property, plant and equipment 1,696,989 2,586,539 43,662 Proceeds from sale of discontinued operations - 1,299,340 - Payments received from affiliates 149,999 5,145 330,200 Net cash used in investing activities (8,961,533) (2,699,021) (6,297,021) Financing activities Net increase (decrease) in short-term borrowings 64,150,000 (45,330,000) 57,000,000 Proceeds from issuance of long-term debt 22,753,656 16,022,652 30,216,000 Payments of long-term debt (17,439,855) (17,887,109) (33,555,721) Payments to partners and other deductions from capital accounts (7,212,084) (3,177,162) (6,250,492) Capital invested by partners 423,630 4,153,500 121,250 Net cash provided by (used in) financing activities 62,675,347 (46,218,119) 47,531,037 Increase (decrease) in cash and cash equivalents 2,571,049 (392,622) (2,205,123) Cash and cash equivalents at beginning of year 1,365,906 1,758,528 3,963,651 Cash and cash equivalents at end of year $ 3,936,955 $ 1,365,906 $ 1,758,528 See accompanying notes. The Andersons and Subsidiaries Consolidated Statements of Changes in Partners' Capital Year ended December 31 1993 1992 1991 General partner capital Balance at beginning of year $ 622,659 $ 531,322 $ 546,453 Amounts credited (charged) to capital: Net income for the year 145,526 94,128 34,630 Charitable contributions (6,346) (2,791) (442) Distributions - - (49,319) 139,180 91,337 (15,131) Balance at end of year $ 761,839 $ 622,659 $ 531,322 Limited partners' capital Balance at beginning of year $50,497,148 $41,976,399 $45,265,201 Amounts credited (charged) to capital: Net income for the year 10,933,834 7,541,620 2,790,679 Increase in invested capital 423,630 4,153,500 121,250 Charitable contributions (476,772) (223,623) (35,597) Withdrawals (827,573) (899,793) (1,016,214) Distributions (5,901,393) (2,050,955) (5,148,920) 4,151,726 8,520,749 (3,288,802) Balance at end of year $54,648,874 $50,497,148 $41,976,399 Total partners' capital --at end of year $55,410,713 $51,119,807 $42,507,721 See accompanying notes. The Andersons and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 1. Significant Accounting Policies Principles of Consolidation and Related Matters: The consolidated financial statements include the accounts of The Andersons (the Partnership) and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Other affiliated entities are not material. Cash and Cash Equivalents: The Partnership considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The carrying value of these assets approximate their fair value. Inventories: Inventories of grain are valued on the basis of replacement market prices prevailing at the end of the year. Such inventories are adjusted for the amount of gain or loss (based on year-end market price quotations) on open grain contracts at the end of the year. Contracts in the commodities futures market, maintained for hedging purposes, are valued at market at the end of the year and income or loss to that date is recognized. Grain contracts maintained for other merchandising purposes are valued in a similar manner and net margins from these transactions are included in sales and merchandising revenues. All other inventories are stated at the lower of cost or market. Cost is determined by the average cost or retail methods. Property, Plant and Equipment: Land, buildings and equipment are carried at cost. For assets acquired subsequent to 1983, depreciation is provided over the estimated useful lives of the individual assets by the straight-line method. For assets acquired prior to 1984, depreciation is provided over the estimated useful lives of the individual assets by accelerated methods. Accounts Payable for Grain: The liability for grain purchases on which price has not been established (delayed price), has been computed on the basis of replacement market at the end of the year, adjusted for the applicable premium or discount. Income Taxes: No provision has been made for federal income taxes on the Partnership's net income since such amounts are includable in the federal income tax returns of its partners. At December 31, 1993, the Partnership's net assets for financial reporting purposes were approximately $3,800,000 greater than their corresponding tax bases, as a result of temporary differences in when revenues and expenses are recognized for financial reporting purposes and in determining taxable income. Preopening Expenses: Preopening expenses are charged to income when incurred. Deferred Gain: The deferred portion of a gain from the sale and leaseback of a retail store is being amortized into income over the ten-year leaseback period by the straight-line method. Income Allocations and Cash Distributions to Partners: The Partnership Agreement reflects each partner's capital account as of the beginning of each year. Partners' capital, used in determining the allocation of net income or loss to each partner, is weighted to reflect cash and tax distributions made to partners and additional investments made by partners during the year. The general partner and each limited partner receive the same allocation of net income or loss per $1,000 of partners' capital. Partners may elect to receive quarterly cash distributions as declared by the general partner. Partners may also elect to receive quarterly tax distributions or an annual tax distribution. The final 1993 tax distributions of approximately $1,500,000 will be paid to partners in 1994 from the year end partners' capital balances. Charitable Contributions: Provision is made in the Partnership Agreement for contributions to various charitable, educational and other not-for-profit institutions. It is the policy of the Partnership to account for charitable contributions as charges to partners' capital, and they are not deducted in determining Partnership net income. Reclassifications: Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform with the 1993 presentation. These reclassifications had no effect on net income. 2. Transactions with General Partner The Andersons Management Corp. (the Corporation) is the sole general partner of the Partnership and provides all management and labor services to the Partnership. In exchange for providing these services, the Corporation charges the Partnership a management fee equal to: a) the salaries and cost of all employee benefits and other normal employee costs, paid or accrued for services performed by the Corporation's employees on behalf of the Partnership, b) reimbursable expenses incurred by the Corporation in connection with its services to the Partnership, or on the Partnership's behalf, and c) an amount based on an achieved level of return on partners' capital to cover the Corporation's general overhead and to provide an element of profit to the Corporation. Employee benefit costs include the cost of pension and other postretirement benefits. In 1993, the Corporation changed its method of accounting for postretirement health insurance benefits. The Corporation now accrues for the cost of providing these benefits during the employees' working career rather than recognizing the cost of these benefits as claims are paid. The Corporation has elected to recognize the accrued benefits earned by employees as of January 1, 1993 (transition obligation) prospectively, which means this cost will be recognized as a component of annual postretirement benefit costs over a period of approximately 20 years. The change in the method of accounting for these benefits increased management fees charged to the Partnership by approximately $850,000 in 1993. The Partnership generally pays the Corporation for salaries and employee benefits as those costs are paid by the Corporation. Amounts owed to the Corporation relating to postretirement benefits that will not be paid within one year have been classified as a long-term liability. The Partnership leases office space from the Corporation under a lease expiring May 1, 2000. Net lease payments amounted to $529,982, $516,344 and $498,699 in 1993, 1992 and 1991, respectively. The components of the management fee and rent incurred by the Partnership consisted of the following: Year Ended December 31 1993 1992 1991 Salaries and wages $47,706,731 $43,356,247 $41,103,580 Employee benefits 14,619,453 13,426,059 13,721,230 Rent for office space and other reimbursable expenses 641,491 516,344 498,699 Achieved level of return of the Partnership 139,656 89,618 34,090 Totals $63,107,331 $57,388,268 $55,357,599 3. Discontinued Operations In April 1992, the Partnership decided to dispose of its pet products distribution business, which was represented by a majority investment in B&R Pet Supplies, Inc. (B&R). During 1992, the Partnership sold the operations of B&R for approximately $1,300,000, which resulted in a loss of $1,582,630. Losses from operations from April 1, 1992 to the date of sale amounted to $515,137. This transaction has been accounted for as a discontinued operation. Sales from discontinued operations were approximately $9,780,000 and $18,700,000 for the years ended December 31, 1992 and 1991, respectively. 4. Inventories Major classes of inventory are as follows: December 31 1993 1992 Grain $135,346,670 $ 85,587,197 Agricultural products 16,170,908 20,994,809 Merchandise 32,497,574 26,726,585 Lawn and corn cob products 20,579,022 12,904,099 Supplies and other 6,429,477 2,056,208 $211,023,651 $148,268,898 5. Property, Plant and Equipment The components of property, plant and equipment are as follows: December 31 1993 1992 Land $ 9,457,460 $ 9,687,951 Land improvements and leasehold improvements 19,378,810 17,493,509 Buildings and storage facilities 62,022,387 60,809,927 Machinery and equipment 80,141,615 75,377,099 Construction in progress 1,707,564 1,331,205 172,707,836 164,699,691 Less allowances for depreciation and amortization 112,290,748 107,860,174 $ 60,417,088 $ 56,839,517 6. Banking and Credit Arrangements The Partnership has available lines of credit for unsecured short-term debt with banks aggregating $117,000,000. The Partnership can exceed certain of these base lines of credit as needed on a temporary basis without additional fee costs. The credit arrangements, the amounts of which are adjusted from time to time to meet the Partnership's needs, do not have termination dates but are reviewed at least annually for renewal. The terms of certain of these lines of credit provide for annual commitment fees. The following information relates to borrowings under short-term lines of credit during the years indicated. 1993 1992 1991 Maximum borrowed $100,500,000 $104,000,000 $84,000,000 Average daily amount borrowed (total of daily borrowings divided by number of days in period) 60,404,384 50,341,667 41,650,972 Average interest rate (computed by dividing interest expense by average daily amount outstanding) 4.15% 5.20% 6.48% At December 31, 1993, the Partnership had an interest rate swap agreement and an interest rate cap agreement with notional amounts of $10,000,000 and $10,000,000, respectively. These financial instruments are used to convert the variable interest rate of its short-term borrowings to intermediate-term fixed interest rates of 4.99% and 4.86%, respectively. These agreements were entered into to reduce the risk (hedge) to the Partnership of rising interest rates and expire in April 1994. 7. Long-Term Debt Long-term debt consists of the following: December 31 1993 1992 Notes payable relating to revolving credit facility $ 7,500,000 $ 5,000,000 Note payable, variable rate (5.00% at December 31, 1993), payable $800,000 annually, due 1997 6,800,000 7,600,000 Other notes payable 888,409 910,512 Industrial development revenue bonds: 6.0%, due 1993 - 500,000 6.5%, due 1999 5,000,000 5,000,000 Variable rate (4.02% at December 31, 1993), due 1995 to 2004 8,114,000 8,514,000 Variable rate (2.37% at December 31, 1993), due 2025 3,100,000 3,100,000 Debenture bonds: 8.5% to 9.6%, due 1993 - 1,007,000 9.2% to 11.4%, due 1995 and 1996 7,586,000 7,667,000 6.5% to 7.2%, due 1997 and 1998 4,894,000 1,482,000 10% to 10.5%, due 1997 and 1998 2,849,000 2,852,000 10%, due 2000 and 2001 2,774,000 2,780,000 7.5% to 8.5%, due 2002 and 2003 4,061,000 1,803,000 Other bonds, 4% to 9.6% 684,711 721,807 54,251,120 48,937,319 Less current maturities 1,992,000 2,860,000 $52,259,120 $46,077,319 The Partnership has a $10,000,000 revolving line of credit with a bank which bears interest based on the LIBOR rate (4.25% to 4.345% at December 31, 1993). Borrowings under this agreement totalled $7,500,000 at December 31, 1993. This revolving line of credit replaced the $5,000,000 revolving line of credit with a bank and bearing interest based on the LIBOR rate that was outstanding at December 31, 1992. The current revolving line of credit expires on June 30, 1996. The variable rate note payable and the industrial development revenue bonds are collateralized by first mortgages on certain facilities and related property with a cost aggregating approximately $42,700,000. The various underlying loan agreements, including the Partnership's revolving line of credit, contain certain provisions which require the Partnership to, among other things, maintain minimum working capital of $28,000,000 and net Partnership equity (as defined) of $40,000,000, limit the addition of new long-term debt, limit its unhedged grain position to 2,000,000 bushels, and restrict the amount of certain payments to partners. The aggregate annual maturities, including sinking fund requirements, through 1998 of long-term debt are as follows: 1994--$2,539,000; 1995--$3,300,000; 1996--$18,070,000; 1997--$13,169,000 and 1998--$6,184,000. These amounts include annual maturities of long-term debt relating to the purchase of a retail store on February 1, 1994 as discussed in Note 8. Long-term debt maturing in 1994 excluding this purchase is $1,992,000. Interest paid (including short-term lines of credit) amounted to $5,425,491, $6,595,883 and $6,594,646 in 1993, 1992 and 1991, respectively. 8. Leases The Partnership and subsidiaries lease certain equipment and real property under operating leases. Rental expense for all operating leases amounted to $7,095,276, $7,400,356 and $7,695,639 in 1993, 1992 and 1991, respectively. The leases for three retail stores and one agricultural facility contain provisions for contingent lease payments based on sales volume. One lease is for a retail store which is owned by a partnership in which certain directors and executive officers of the General Partner hold limited partnership interests. Rental expense for this lease amounted to $742,108, $741,523 and $1,034,245 in 1993, 1992 and 1991, respectively. On February 1, 1994 the Partnership purchased a retail store under lease for $5,200,000 and eliminated future minimum rentals amounting to $2,631,600 at December 31, 1993. Future minimum rentals under operating leases, after excluding the lease for the retail store, are as follows: 1994 $ 6,054,590 1995 5,047,777 1996 4,191,547 1997 3,534,500 1998 3,326,495 Future years 4,842,676 $26,997,585 9. Fair Values of Financial Instruments Most of the Partnership's short and long-term debt is borrowed under instruments which provide for variable interest rates, or the Partnership has agreements which fix the rate for intermediate periods. The Partnership considers the carrying value of these liabilities to approximate their fair value. Debenture bonds are generally issued at fixed rates of interest for periods of five or ten years. Based upon current interest rates offered by the Partnership on similar bonds, the Partnership believes that debenture bonds outstanding at December 31, 1993 and 1992, with aggregate principal balances of $22,241,000 and $17,636,000, respectively, have a fair value of approximately $23,750,000 and $18,640,000, respectively. 10. Commitments The Partnership has, in the normal course of its business, entered into contracts to purchase and sell certain items of inventory in future periods and has interest in other commodity contracts requiring performance in future years. Management does not anticipate any significant net losses resulting from such contracts. 11. Segments of Business The Partnership's business includes grain merchandising and the operation of terminal grain elevator facilities. Another significant part of the business involves the distribution of agricultural products, primarily fertilizer. The Partnership also is engaged in the operation of retail stores, the production and distribution of lawn and corn cob products and rail car leasing and repair. The segment information includes the allocation of expenses shared by one or more segments. Although management believes such allocations are reasonable, the operating information does not necessarily reflect how such data might appear if the segments were operated as separate businesses. Year Ended December 31 1993 1992 1991 Revenues: Grain operations: Sales to unaffiliated customers $416,242,442 $423,722,972 $342,223,031 Intersegment sales 37,893 241,145 73,447 Merchandising revenue and other income 23,599,472 16,975,690 14,781,082 439,879,807 440,939,807 357,077,560 Agricultural products: Sales to unaffiliated customers 104,648,079 93,875,811 96,905,378 Intersegment sales 3,067,592 2,468,205 2,388,643 Merchandising revenue and other income 3,750,561 3,032,268 4,310,214 111,466,232 99,376,284 103,604,235 Retail stores: Sales to unaffiliated customers 155,424,855 149,090,921 139,398,055 Other income 118,337 82,344 73,452 155,543,192 149,173,265 139,471,507 Lawn and corn cob products and other: Sales to unaffiliated customers 71,668,255 64,976,326 43,839,610 Intersegment sales 730,135 819,310 677,195 Other income 678,710 553,502 323,944 73,077,100 66,349,138 44,840,749 Other income 4,090,096 4,691,375 5,032,832 Eliminations--intersegment sales (3,835,620) (3,528,660) (3,139,285) Total revenues $780,220,807 $757,001,209 $646,887,598 Operating profit: Grain operations $ 11,206,499 $ 7,382,088 $ 8,019,496 Agricultural products 3,365,102 2,337,950 1,762,059 Retail stores 1,639,953 4,062,370 1,643,177 Lawn and corn cob products and other 4,985,651 4,517,401 2,562,221 Total operating profit 21,197,205 18,299,809 13,986,953 Other income 2,063,567 2,533,177 2,328,942 Interest expense (6,168,371) (6,325,440) (7,297,735) General expenses (6,013,041) (4,377,854) (4,502,114) Income from continuing operations $ 11,079,360 $ 10,129,692 $ 4,516,046 Identifiable assets: Grain operations $197,352,136 $121,316,208 $164,811,996 Agricultural products 46,712,717 47,601,783 32,150,375 Retail stores 56,558,711 48,174,786 46,332,580 Lawn and corn cob products and other 44,091,096 29,021,506 27,874,702 General assets 11,787,118 9,386,354 18,940,824 Total assets $356,501,778 $255,500,637 $290,110,477 Depreciation and amortization expense: Grain operations $ 2,129,988 $ 2,259,243 $ 2,345,425 Agricultural products 1,122,163 1,105,530 1,102,502 Retail stores 1,957,190 1,882,966 1,829,175 Lawn and corn cob products and other 1,512,000 1,211,566 938,859 General 387,882 551,274 838,016 Total depreciation and amortization expense $ 7,109,223 $ 7,010,579 $ 7,053,977 Capital expenditures: Grain operations $ 2,735,570 $ 1,578,192 $ 1,359,805 Agricultural products 1,037,201 842,645 557,074 Retail stores 4,228,566 728,538 1,522,244 Lawn and corn cob products and other 2,209,646 2,917,100 558,348 General 597,538 523,570 2,673,412 Total expenditures $ 10,808,521 $ 6,590,045 $ 6,670,883 Intersegment sales are made at prices comparable to normal, unaffiliated customer sales. Operating profit is sales and merchandising revenues plus interest and other income attributable to the operating area less operating expenses, excluding interest and general expenses. Identifiable assets by segment include accounts receivable, inventories, advances to suppliers, property, plant and equipment and other assets that are directly identified with those operations. General assets consist of cash, investments, land held for investment, land and buildings and equipment associated with administration and Partnership services, assets of discontinued operations and other assets not directly identified with segment operations. An unaffiliated customer accounted for grain operations sales of $85,900,000 and $77,200,000 in 1992 and 1991, respectively. No unaffiliated customer accounts for more than 10% of sales and merchandising revenues in 1993. Grain sales for export to foreign markets amounted to approximately $88,300,000 and $101,300,000 in 1993 and 1992, respectively. Sales for export to foreign markets did not exceed 10% of consolidated sales and merchandising revenues in 1991. 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 Partnership is managed by the Corporation acting in its capacity as sole General Partner. The Board of Directors of the Corporation has overall responsibility for the management of the Corporation's affairs, including its responsibilities as General Partner of the Partnership. Day-to-day operating decisions, relative to the Partnership, have been delegated by the Board to the Corporation's Chief Executive Officer. The directors and executive officers of the Corporation are: Name Age Position Thomas H. Anderson 70 Chairman of the Board (1) (2) Richard P. Anderson 64 Director; President and Chief Executive Officer Christopher J. Anderson 39 Vice President Business Development Group (3) Daniel T. Anderson 38 Director; General Merchandise Manager Retail Group (3) Donald E. Anderson 67 Director; Science Advisor Michael J. Anderson 42 Director; Vice President and General Manager Retail Group (2) Richard M. Anderson 37 Director; Vice President and General Manager Industrial Products Group (2) John F. Barrett 44 Director Joseph L. Braker 43 Vice President and General Manager Ag Group (3) Dale W. Fallat 49 Director; Vice President Corporate Services Richard R. George 44 Corporate Controller and Principal Accounting Officer (1) Paul M. Kraus 61 Director (2) Peter A. Machin 46 Vice President and General Manager Lawn Products Group (1) Beverly J. McBride 52 General Counsel and Corporate Secretary (2) Rene C. McPherson 69 Director (1) (2) Donald M. Mennel 75 Director (1) (3) Larry D. Rigel 52 Vice President Marketing (1) Janet M. Schoen 34 Director (2) Gary L. Smith 48 Corporate Treasurer (3) (1) Member of Nominating and Advisory Committee (2) Member of Compensation Committee (3) Member of Audit Committee Thomas H. Anderson - Held the position of Manager-Company Services of The Andersons for several years and was named Senior Partner in 1987. When the Corporation was formed in 1987, he was named Chairman of the Board. He served as a General Partner of The Andersons and a member of its Managing Committee from 1947 through 1987. Richard P. Anderson - He was Managing Partner of The Andersons from 1984 to 1987 when he was named Chief Executive Officer. Served as a General Partner of The Andersons and a member of its Managing Committee from 1947 through 1987 and has been a Director of the Corporation since its inception in 1987. He is also a director of Centerior Energy Corporation, First Mississippi Corp. and N-Viro, International Corp. Christopher J. Anderson - Began full-time employment with the Partnership in 1983. He held several positions in the Grain Group, including Planning Manager and Administrative Services Manager, until 1988 when he formed a private consulting business. He returned to the Company in 1990 in his present position. Daniel T. Anderson - Began full-time employment with The Andersons in 1979. He has served in various positions in the Retail Group since 1984, including Store Manager and Retail Operations Manager. In 1990, he assumed the position of General Merchandise Manager for the Retail Group. He was elected a Director in 1990. Donald E. Anderson - In charge of scientific research for the Partnership since 1980, he semi-retired in 1992. He served as a General Partner of The Andersons from 1947 through 1987 and has served the Corporation as a Director since its inception in 1987. Michael J. Anderson - Began his employment with The Andersons in 1978. He has served in several capacities in the Grain Group and he held the position of Vice President and General Manager Grain Group from 1990 to February 1994 when he was named Vice President and General Manager of the Retail Group. He has served as a Director of the Corporation since 1988. Richard M. Anderson - Began his employment with The Andersons in 1986 as Planning Analyst and was named the Manager of Technical Development in 1987. In 1990, he assumed his present position. He has served as a Director since 1988. John F. Barrett - He has served in various capacities at The Western and Southern Life Insurance Company, including Executive Vice President and Chief Financial Officer and President and Chief Operating Officer, and currently serves as Chief Executive Officer. He is a director of Cincinnati Bell, Inc. and Fifth Third Bancorp. He was elected a Director of the Corporation in December 1992. Joseph L. Braker - Began his employment with the Partnership in 1968. He held several positions within the Grain area and in 1988, he was named Group Vice President Grain. In 1990, he was named Vice President and General Manager Ag Products Group and in February 1994 he was named Vice President and General Manager Ag Group. He served as a General Partner of The Andersons from 1985 to 1987. Dale W. Fallat - Began his employment with The Andersons in 1967 and in 1988 was named Senior Vice President Law and Corporate Affairs. He assumed his present position in 1990. He served as a General Partner of The Andersons from 1983 through 1987 and a member of its Managing Committee in 1986 and 1987. He has served as a Director of the Corporation since its inception in 1987. Richard R. George - Began his employment with the Partnership in 1976 and has served as Controller since 1979. Paul M. Kraus - General partner in the law firm of Marshall & Melhorn. He has been a Director of the Corporation since 1988. Peter A. Machin - Began his employment with The Andersons in the Lawn Products Group in 1987 as Sales Manager of Professional Products. In 1988 he was promoted to Sales and Marketing Manager and assumed his present position in 1990. Beverly J. McBride - Began her employment with The Andersons in 1976. She has served as Assistant General Counsel, Senior Counsel and since 1987 as General Counsel and Corporate Secretary. Rene C. McPherson - He has been a Director of the Corporation since 1988 and currently serves as a director of BancOne Corporation, Dow Jones & Company, Inc., Mercantile Stores Company, Inc., Milliken & Company, and Westinghouse Electric Corporation. Donald M. Mennel - Retired Chairman of the Board and Chief Executive Officer of the Mennel Milling Company. He began a private law practice in 1986. Elected as a Director in 1990. Larry D. Rigel - Began his employment with the Partnership in 1966. From 1987 to February 1994 was in charge of the Partnership's Retail operations and currently serves as Vice President Marketing for the Company. Janet M. Schoen - A former school teacher, she is currently a full-time homemaker. She was elected a Director of the Corporation in 1990. Gary L. Smith - Began his employment with the Partnership in 1980 and has served as Treasurer since 1985. Donald E., Richard P. and Thomas H. Anderson are brothers; Paul M. Kraus is a brother-in-law. Christopher J. and Daniel T. Anderson are sons of Richard P. Anderson and Janet M. Schoen is a daughter of Thomas H. Anderson. Michael J. and Richard M. Anderson are nephews of the three brothers. Item 11. Item 11. Executive Compensation The Corporation provides all management services to the Partnership pursuant to a Management Agreement entered into between the Partnership and the Corporation as further described under "Item 13. Certain Relationships and Related Transactions - Management Agreement." The fee paid to the Corporation includes an amount equal to the salaries and cost of all employee benefits, and other normal employee costs, paid or accrued on behalf of the Corporation's employees who are engaged in furnishing services to the Partnership. The following table sets forth the compensation paid by the Corporation to the Chief Executive Officer and the four highest paid executive officers. Summary Compensation Table Annual Compensation All Other Name and Position Year Salary Bonus Compensation (a) Richard P. Anderson 1993 $308,333 $150,000 $4,497 President and Chief 1992 286,666 60,000 4,300 Executive Officer 1991 280,008 4,200 Thomas H. Anderson 1993 206,669 90,000 4,497 Chairman of the Board 1992 190,004 35,000 4,364 1991 185,004 4,238 Joseph L. Braker 1993 194,634 70,000 4,497 Vice President and General 1992 181,408 30,000 4,364 Manager Ag Products Group 1991 175,106 15,000 4,238 Larry Rigel 1993 162,558 15,000 4,497 Vice President and General 1992 151,924 30,000 4,364 Manager Retail Group 1991 146,876 4,238 Michael J. Anderson 1993 161,962 100,000 4,497 Vice President and General 1992 146,978 30,000 4,364 Manager Grain Group 1991 136,238 41,000 4,087 (a) Corporation's matching contributions to its 401(k) retirement plan. Pension Plan The Corporation has a Defined Benefit Pension Plan (the "Pension Plan") which covers substantially all permanent and regular part-time employees. The amounts listed in the table below are payable annually upon retirement at age 65 or older. A discount of six percent per year is applied for retirement before age 65. The pension benefits are based on a single-life annuity and have been reduced for Social Security covered compensation. The compensation covered by the Pension Plan is equal to the employees' base pay, which in the Summary Compensation Table is the executive's salary, but beginning in 1989, was limited by the Internal Revenue Code to $200,000, adjusted for inflation, and beginning in 1994 is limited to $150,000, which will also be adjusted for inflation in future years. Each of the named executives has six years of credited service. Average Approximate Annual Retirement Benefit Based Five-Year Upon the Indicated Years of Service Compensation 5 Years 10 Years 15 Years 25 Years $ 50,000 $ 3,292 $ 6,584 $ 9,877 $ 16,461 100,000 7,042 14,084 21,127 35,211 150,000 10,792 21,584 32,377 53,961 200,000 14,542 29,084 43,627 72,711 250,000 18,292 36,584 54,877 91,461 Directors' Fees Directors who are not employees of the Corporation and who are not members of the Anderson family receive an annual retainer of $10,000. Directors who are not employees of the Corporation receive a fee of $600 for each Board Meeting attended. There are three committees of the Board of Directors: the Audit Committee; the Nominating and Advisory Committee; and the Compensation Committee. The chairman of these committees receives a retainer of $2,000 provided they are not an employee of the Corporation, and members of the committees who are not employees of the Corporation receive $400 for each meeting attended. Compensation Committee Interlocks and Insider Participation The Compensation Committee includes the following executive officers and directors: Michael J. Anderson, Richard M. Anderson, Richard P. Anderson (ex officio), Thomas H. Anderson (ex officio), Dale W. Fallat, Paul M. Kraus, Beverly J. McBride, Rene C. McPherson (chairman), and Janet M. Schoen. In addition, Charles E. Gallagher, Director of Personnel, is an ex officio member of the committee. Certain Transactions - Alshire-Columbus: The Partnership and certain of the directors and executive officers of the Corporation are limited partners in Alshire-Columbus Limited Partnership ("Alshire-Columbus"), an Ohio limited partnership, which owns the Partnership's Brice General Store in Columbus, Ohio. The store is leased to the Partnership by Alshire-Columbus at an annual base rental of $732,000. Additional rental payments are due if net sales exceed $35 million. The lease is a "net lease" and has an initial term expiring in 2000, with three five- year renewal periods and options to purchase the building, land and improvements at the end of the initial term and each renewal period. The Partnership believes that the terms of the Brice General Store lease are at least as favorable to the Partnership as terms obtainable from other third parties. The Partnership contributed the land, at its cost ($1,367,000), for its original limited partner interest. As original limited partner, the Partnership has no economic interest in the income from operations of Alshire- Columbus but will receive a preferential distribution upon any sale of the real estate equal to the cost of the land plus an amount equal to the aggregate cash distributions received by the limited partners in excess of their capital contributions. The remaining cash proceeds from any sale of the Brice General Store will be distributed to the limited partners - 75%; the Partnership, as original limited partner - 24%; and the general partner - 1%. The other limited partners of Alshire-Columbus contributed $1,450,000, representing 35 limited partnership units. None of the directors and executive officers of the Corporation or their family members own more than one limited partnership unit, except for Richard P. Anderson, who owns two units. In the aggregate, 8 3/4 units are owned by directors and executive officers of the Corporation, and their family members own an additional four units. The limited partners, other than the Partnership, have 99% of the economic interest in the income from operations of Alshire-Columbus and the general partner has a 1% economic interest. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No Limited Partner beneficially owns as much as 5% of the Partnership's total capital. As of March 1, 1994, the descendants of Harold and Margaret Anderson, founders of the Partnership, beneficially held Partnership capital in the aggregate amount of $39,349,105, constituting 72% of the Partnership's total capital of $54,880,282 as of that date. All capital amounts as of March 1, 1994 are before the allocation of Partnership income for 1994. The Anderson family members also own a total of 80% of the Class A (non-voting) Shares and 79% of the outstanding Class B (voting) Shares of the Corporation. (c) The Partnership knows of no arrangements which may at a subsequent date result in a change in control of the Partnership. Item 13. Item 13. Certain Relationships and Related Transactions Management Agreement The Corporation provides all personnel and management services to the Partnership pursuant to a Management Agreement. The fee paid to the Corporation for its services is an amount equal to (a) the salaries and cost of all employee benefits, and other normal employee costs, paid or accrued on behalf of the Corporation's employees who furnish services to the Partnership, (b) reimbursable expenses incurred by the Corporation in connection with its services to the Partnership, or on the Partnership's behalf, and (c) an amount equal to $5,000 for each 1% of return on partners' capital up to a 15% annual return on partners' capital, plus $7,500 for each 1% of return on partners' capital between 15% and 25%, plus $10,000 for each 1% of return on partners' capital greater than a 25% annual return to cover that part of the Corporation's general overhead which is attributable to Partnership services and to provide an element of profit to the Corporation. The management fee incurred by the Partnership in 1993 totaled $63,107,331. See Note 2 to the Partnership's Consolidated Financial Statements. Management believes that the amount of the management fee paid to the Corporation is as favorable to the Partnership as it would be if paid to an unaffiliated third party providing similar management services. In this connection, approximately 88% of the limited partners in the Partnership are also shareholders in the Corporation and no one may own shares in the Corporation unless they are a limited partner in the Partnership. In addition to the fee payable to the Corporation, the Management Agreement also provides for certain other customary terms and conditions, including termination rights, and requires the Corporation to make its books and records available to the Partnership for inspection at reasonable times. Sublease Arrangement The office building utilized by the Partnership is leased by the Corporation from an unaffiliated lessor under a net lease expiring in 2000. The Partnership subleases approximately 80% of the building from the Corporation and pays the Corporation rent for the space it occupies. Under the terms of the sublease, the Partnership also is responsible for insurance, utilities, taxes, general maintenance, snow removal, lawn care and similar upkeep expenses for the entire building. The Corporation reimburses the Partnership for management and maintenance of the building, including the space it does not occupy. The amount paid by the Partnership to the Corporation for the portion of the building occupied by the Partnership is designed to reimburse the Corporation for its equivalent cost under the Corporation's lease. In 1993, the rental payments made by the Partnership to the Corporation, net of the reimbursement for management and maintenance of the building was $529,982, which is included in the total management fee referred to under "Management Agreement" above. See Note 2 to the Partnership's Consolidated Financial Statements. Alshire-Columbus See "Item 11. Executive Compensation - Compensation Committee Interlocks and Insider Participation - Certain Transactions - Alshire- Columbus." PART IV Item 14. Item 14. Financial Statement Schedules and Reports on Form 8-K (a) (1) The following consolidated financial statements of the registrant are included in Item 8: Page Report of Independent Auditors.............................. Consolidated Statements of Income - years ended December 31, 1993, 1992 and 1991.......................... Consolidated Balance Sheets - December 31, 1993 and 1992.... Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991.......................... Consolidated Statements of Changes in Partners' Capital - years ended December 31, 1993, 1992 and 1991............ Notes to Consolidated Financial Statements.................. (2) The following consolidated financial statement schedules are included in Item 14(d): V. Consolidated Property, Plant and Equipment - years ended December 31, 1993, 1992 and 1991.......................... VI. Consolidated Accumulated Depreciation of Property, Plant and Equipment - years ended December 31, 1993, 1992 and 1991............................................. VIII. Consolidated Valuation and Qualifying Accounts - years ended December 31, 1993, 1992 and 1991.................... All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (3) Exhibits: 3(a) Amendment No. 18 to Restated Certificate of Limited Partnership filed by the Partnership January 24, 1994 with the Clerk of the Court of Common Pleas of Lucas County, Ohio. 3(b) The Andersons Partnership Agreement, dated as of January 1, 1994. 4(a) Form of Indenture dated as of October 1, 1985, between the Registrant and Ohio Citizens Bank, as Trustee. (Incorporated by reference to Exhibit 4(a) in Registration Statement No. 33-819.) 4(b)(i) The Thirteenth Supplemental Indenture dated as of January 1, 1994, between The Andersons and Fifth Third Bank of Northwestern Ohio, N.A., successor Trustee to an Indenture between The Andersons and Ohio Citizens Bank, dated as of October 1, 1985. 10(a) Management Performance Program.* (Incorporated by reference to Exhibit 10(a) to the Partnership's Form 10-K dated December 31, 1990.) * Management contract or compensatory plan. 10(b) Amended and Restated Limited Partnership Agreement of Alshire-Columbus Limited Partnership effective July 1, 1986. (Incorporated by reference to Exhibit 10(a) in Registration Statement No. 33-7017.) 10(c) Purchase Agreement effective June 30, 1986, between Alshire-Columbus Limited Partnership and The Andersons. (Incorporated by reference to Exhibit 10(b) in Registration Statement No. 33-7017.) 10(d) Lease Agreement effective July 1, 1986, between Alshire-Columbus Limited Partnership and The Andersons. (Incorporated by reference to Exhibit 10(c) in Registration Statement No. 33-7107.) 10(f) Management Agreement between The Andersons and The Andersons Management Corp., effective as of January 1, 1988. (Incorporated by reference to Exhibit 10(f) in Registration Statement No. 33-13538.) 10(h) Business Property Sublease effective January 1, 1993, between The Andersons Management Corp. and The Andersons. (Incorporated by Reference to Exhibit 10(h) in Registration Statement 33-42680.) 22 Subsidiaries of The Andersons. 24(a) Consent of Independent Auditors 28 Anderson Foundation Declaration of Trust, as amended. (Incorporated by reference to Exhibit 28 to Registrants Form 10-K dated December 31, 1992.) The Partnership agrees to furnish to the Securities and Exchange Commission a copy of any long-term debt instrument or loan agreement that it may request. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the last quarter of the year. (c) Exhibits: The exhibits listed in Item 14(a)(3) of this report, and not incorporated by reference, follow "Financial Statement Schedules" referred to in (d) below. (d) Financial Statement Schedules: The financial statement schedules listed in 14(a)(2) follow "Signatures". 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 Maumee, Ohio, on the 29th day of March, 1994. THE ANDERSONS (Registrant) By The Andersons Management Corp (General Partner) By /s/Richard P. Anderson Richard P. Anderson 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 as Directors of the General Partner and on behalf of the Registrant on the 29th day of March, 1994. Signature Title* Signature Title* /s/Richard P. Anderson Director Director Richard P. Anderson John F. Barrett /s/Daniel T. Anderson Director /s/Dale W. Fallat Director Daniel T. Anderson Dale W. Fallat /s/Donald E. Anderson Director Director Donald E. Anderson Paul M. Kraus /s/Michael J. Anderson Director Director Michael J. Anderson Rene C. McPherson /s/Richard M. Anderson Director /s/Donald M. Mennel Director Richard M. Anderson Donald M. Mennel /s/Thomas H. Anderson Director Director Thomas H. Anderson Janet M. Schoen *Titles with The Andersons Management Corp. No proxy statement of the Partnership is furnished to Limited Partners. Audited financial statements will be distributed to Limited Partners at a later date. EXHIBIT INDEX THE ANDERSONS Exhibit Number 3(a) Amendment No. 18 to Restated Certificate of Limited Partnership filed by the Partnership January 24, 1994 with the Clerk of the Court of Common Pleas of Lucas County, Ohio. 3(b) The Andersons Partnership Agreement, dated as of January 1, 1994. 4(b)(i) The Thirteenth Supplemental Indenture dated as of January 1, 1994, between The Andersons and Fifth Third Bank of Northwestern Ohio, N.A., successor Trustee to an Indenture between The Andersons and Ohio Citizens Bank, dated as of October 1, 1985. 22 Subsidiaries of The Andersons 24(a) Consent of Independent Auditors

701546_1993.txt

701546_1993

1993

701546

Item 1. Business Union Bancshares, Inc. (UBI) is a bank holding company formed in 1982 under the laws of the State of Kansas. In connection with this formation, UBI acquired all of the common stock of Union National Bank of Wichita (UNB) by exchange for UBI Class A common stock on a share for share basis. In 1987, UBI formed Union Boulevard National Bank (UBNB), a wholly-owned subsidiary, to acquire from the Federal Deposit Insurance Corporation certain assets and liabilities previously owned by Boulevard State Bank. UBNB was merged into UNB in 1989. In April 1990, UBI acquired certain assets and liabilities from the Resolution Trust Corporation (RTC) of the former First Federal Savings and Loan Association of Hutchinson. UBI acquired two branch locations in this purchase. One of these branches was closed on January 12, 1991. In November 1990, UBI acquired certain assets and liabilities from the RTC of the former Valley Savings, A Federal Savings and Loan Association of Hutchinson. UBI began operations from two branch locations in this purchase. One branch location was closed on January 12, 1991. The second branch was moved from its initial operational site to a new site on June 30, 1992. On February 16, 1991, UBI acquired from the RTC, certain assets and liabilities of the Derby branch of the former Mid Kansas Savings and Loan, F.A. of Wichita. UBI purchased the Derby branch location from the RTC on June 21, 1991. At December 31, 1993, UBI had three active, wholly-owned subsidiaries: UNB, UBI Growth Capital, Inc. (UBIGC), a venture capital company, and UBI Financial Services, Inc. (UBIFS), a community development company. In addition, UNB owns all of the outstanding common stock of Union Center, Inc. (UCI), a Kansas corporation formed in 1956 to purchase and operate the building mainly occupied by UNB. At December 31, 1993, UBI and its subsidiaries had 352 FTE (full-time equivalent) employees. UBI and its subsidiaries are engaged primarily in commercial banking and related activities authorized by the Bank Holding Company Act of 1956, as amended, or determined by the Board of Governors of the Federal Reserve System to be so closely related to the business of banking as to be proper incident thereto. UBI and its subsidiaries, therefore, did not engage in material operations in separate reportable industry segments for the last three years. Union Bancshares, Inc. and Subsidiaries Item 1. Business (Continued) UBI offers a wide range of financial services in the Wichita and Derby, Sedgwick County, and Hutchinson, Reno County, Kansas, areas through UNB, its subsidiary bank. These services include deposit accounts; commercial, installment and real estate loans; trust, investment and escrow services; and a network of automated teller machines. UNB has ten locations and 17 ATMs situated within the city limits of Wichita, Hutchinson, and Derby. UNB is the third largest bank in Wichita and the largest bank in Hutchinson and Derby. In addition, customers may also access UNB services at 479 ATMs throughout the State of Kansas and at over 101,280 ATMs throughout the United States and Canada through UNB participation in Kansas Electronic Transfer Systems, Inc. (KETS), VIA, Cirrus, and Plus ATM switching companies. UNB faces competition from banks and other financial institutions located in Sedgwick and Reno County, Kansas. There are approximately 87 other financial institutions within the Sedgwick and Reno County areas. UBI and its subsidiary bank are principally affected by the monetary policy of the Board of Governors of the Federal Reserve System and other federal banking regulators. UBI, being a bank holding company, is primarily regulated by the Federal Reserve Bank. UNB, being a national bank, is primarily regulated by the Comptroller of the Currency. UNB is also subject to regulation by the Federal Deposit Insurance Corporation because of deposit insurance. The bank operates under the guidance of its board and officers, implementing policies as to lending practices, interest rates, service charges, and other banking functions. These policies guide the bank in serving the communities in which it operates. In 1989, Congress enacted the "Financial Institutions Reform, Recovery, and Enforcement Act" (FIRREA), which allowed bank holding companies to acquire savings and loan associations, either in or outside of Kansas. It also allowed the acquisition of savings and loan associations by out-of-state bank holding companies. The FIRREA Act also abolished the Federal Savings and Loan Insurance Corporation, making the Federal Deposit Insurance Corporation (FDIC) the single insurer of deposits for financial institutions. This resulted in higher insurance premium rates, which had a negative impact on noninterest expense of UBI starting in 1991. An analysis of noninterest expense is discussed in greater detail starting on page A-38. Union Bancshares, Inc. and Subsidiaries Item 1. Business (Continued) Beginning July 1, 1992, bank holding companies located in Arkansas, Colorado, Iowa, Missouri, Nebraska, and Oklahoma were permitted to acquire banks and bank holding companies located in Kansas after obtaining the approval of the Kansas State Banking Board. No applications can be approved unless the laws of the state, or jurisdiction in which the applicant bank holding company is located, permit Kansas bank holding companies to acquire banks and bank holding companies in that state or jurisdiction on substantially the same terms as established under Kansas law. This has brought greater competition to Kansas and potentially to the communities in which UBI and its subsidiaries operate. There have been several institutions that have made acquisitions in the state, but none in the Wichita area. UBI and its subsidiaries are evaluating these changes as well as other legislation pending before the federal and state governments which may have an effect on its business. At this time it is difficult to predict what pending proposals might be adopted and what, if any, effect they may have on UBI and its subsidiaries. UBI is currently implementing changes as a result of Regulation DD, Truth in Savings, which UBI believes will add costs beyond the perceived benefits to its customers. The regulatory burden on financial institutions continues without any sign of easing. The regulatory burden has a negative impact on financial institutions' ability to meet customers' needs. UBI is not currently aware of any pending proposals that would have a materially adverse impact on UBI and its subsidiaries. The principal source of UBI's cash revenues is dividends from UNB. The ability of UNB to pay such cash dividends is limited by federal regulations. Approval of the Comptroller of the Currency is required if total dividends declared by a national bank in any calendar year exceed the bank's net profits for that year combined with its retained profits for the preceding two years. At December 31, 1993, dividends of approximately $7,839,000 were available from the bank subsidiary without such approval. Item 2. Item 2. Properties UBI uses the main offices of Union National Bank, 200 Union Center Building, 150 North Main, Wichita, Kansas, for its offices. Presently, UBI pays no rental to UNB, although UBI may pay to UNB a fair and reasonable charge for all facilities and services furnished by UNB at such time as UBI requires separate facilities. Union Bancshares, Inc. and Subsidiaries Item 2. Properties (Continued) The Union Center Building is a 10-story structure which was completed and occupied by UNB in 1956. The building is owned by UNB's subsidiary, UCI. Approximately 81,508 square feet, or 68.0%, of the rentable space in the building is leased by UNB at a monthly rent of $77,760 for 1993. UNB owns two of the thirteen lots comprising the site of the Union Center Building, and leases two others for a term expiring no earlier than the year 2053. UCI owns three of the lots comprising the Union Center Building site, and leases the remaining six lots for terms expiring no earlier than 2047. There are no mortgages or liens outstanding. UNB owns nine separate bank facilities and the land on which they are located. These are at the following locations in Wichita, Hutchinson and Derby Kansas: Aggregate annual rental paid during 1993 with respect to all leased real estate to third party lessors amounted to $142,000. Item 3. Item 3. Legal Proceedings There were no legal proceedings pending during the last fiscal year to which UBI or its subsidiaries was a party, other than ordinary routine litigation incidental to their business. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No information is required in response to this Item as no matters were submitted to a vote of UBI's security holders during the fourth quarter of 1993. Union Bancshares, Inc. and Subsidiaries PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters There is no established public trading market for UBI Common Stock, Class A. Therefore, the high and low bid prices for UBI stock cannot be determined. The number of stockholders on record for the Company as of December 31, 1993 was 347. Dividend information for the stock is as follows: UNB, the principal subsidiary of UBI, must follow regulatory guidelines on the payment of dividends. See the last paragraph of Item 1. Business. Item 6. Item 6. Selected Financial Data The information required by Item 301 of Regulation S-K is contained on page A-51 of the attached Appendix under the caption "Five-Year Summary of Operations". Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required by Item 303 of Regulation S-K is contained on pages A-29 thru A-31 of the attached Appendix under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations". Item 8. Item 8. Financial Statements and Supplementary Data Set forth below are the consolidated financial statements of UBI and its subsidiaries appearing on pages A-4 to A-27 of the attached Appendix A. a. Consolidated Statement of Condition b. Consolidated Statement of Income c. Consolidated Statement of Stockholders' Equity d. Consolidated Statement of Cash Flows e. Notes to Consolidated Financial Statements f. Independent Auditors' Reports Union Bancshares, Inc. and Subsidiaries Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure UBI filed a Form 8-K dated October 20, 1993, under Item 4., "Change in Registrant's Certifying Accountants". This discussed the change from Coopers & Lybrand as UBI's independent accountants to Allen, Gibbs & Houlik effective for the fiscal year ending December 31, 1993. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required by Item 401 of Regulation S-K appears on pages 2 and 3 of the 1993 Proxy Statement under the caption "Election of Directors" and is hereby incorporated by reference. Item 11. Item 11. Executive Compensation The information required by Item 402 of Regulation S-K appears on pages 7,8 and 9 of the 1993 Proxy Statement under the caption "Compensation of Directors and Executive Officers" and is hereby incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 403 of Regulation S-K appears on pages 6 and 7 of the 1993 Proxy Statement under the caption "Security Ownership of Management" and is hereby incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information required by Item 404 of Regulation S-K appears on page 10 of the 1993 Proxy Statement under the caption "Transactions with Management" and is hereby incorporated by reference. Union Bancshares, Inc. and Subsidiaries 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 financial statements, notes, and accountant's report are described in Item 8 to which reference is hereby made. (2) Financial Statement Schedules None (3) Exhibits None (b) Reports on Form 8-K During the last quarter of the period covered by this report, UBI filed two Form 8-K's. The first one was dated October 20, 1993, and was filed under Item 4., "Change in Registrant's Certifying Accountants". This discussed the change from Coopers & Lybrand as UBI's independent accountants to Allen, Gibbs & Houlik effective for the fiscal year ending December 31, 1993. The second 8-K dated October 13, 1993 was filed under Item 2., "Acquisition or Disposition of Assets" and discussed the execution of a merger agreement between UBI, UNB and First Community Federal Savings and Loan Association (First Community). This 8-K was later amended with 8-K/A No. 1 filed on December 23, 1993. The amendment changed it from an Item 2., "Acquisition or Disposition of Assets" to an Item 5., "Other Events" because this merger is not expected to be consummated until April of 1994. At that time UBI will file an 8-K with all the required financial and pro forma information. Union Bancshares, Inc. and Subsidiaries SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Union Bancshares, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNION BANCSHARES, INC. /S/ WILLIAM G. WATSON /S/ STEVEN C. WORRELL By: William G. Watson By: Steven C. Worrell President & Chief Vice President, Executive Officer Treasurer & Chief Financial Officer (Principal Executive Officer) (Principal Accounting Officer) March 16, 1994 March 16, 1994 Date Date Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: /S/ JACK B. HINKLE March 16, 1994 Jack B. Hinkle, Director Date /S/ RANDOLPH D. LOVE March 16, 1994 Randolph D. Love, Director Date /S/ ROBERT D. LOVE March 16, 1994 Robert D. Love, Director Date /S/ Derek L. Park March 16, 1994 Derek L. Park Date /S/ DONALD H. PRATT March 16, 1994 Donald H. Pratt, Director Date /S/ WILLIAM G. WATSON March 16, 1994 William G. Watson, Director Date Union Bancshares, Inc. and Subsidiaries Financial Information APPENDIX A FINANCIAL INFORMATION -A1- THIS PAGE LEFT BLANK INTENTIONALLY -A2- Union Bancshares, Inc. and Subsidiaries Index to 1993 Financial Information Page Financial Statements Consolidated Statement of Condition A-4 Consolidated Statement of Income A-5 Consolidated Statement of Stockholders' Equity A-6 Consolidated Statement of Cash Flows A-7 Notes to Consolidated Financial Statements A-8 to A-24 Independent Auditors' Reports A-26 to A-27 Management's Report on Financial Statements and Internal Accounting Control A-28 Management's Discussion and Analysis of Financial Condition and Results of Operations A-29 to A-51 Consolidated Statement of Condition - Average Balances and Interest Rates A-32 to A-33 Five-Year Summary of Operations A-51 -A3- Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Condition [FN] The accompanying notes are an integral part of these financial statements. -A4- Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Income [FN] The accompanying notes are an integral part of these financial statements. -A5- Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Stockholders' Equity [FN] The accompanying notes are an integral part of these financial statements. -A6- Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Cash Flows [FN] The accompanying notes are an integral part of these financial statements. -A7- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements in 1993, 1992 and 1991 include UBI and its wholly-owned subsidiaries, UNB, UBIGC and UBIFS. All significant intercompany accounts and transactions have been eliminated. In addition, adjustments made to the unaudited interim financial statements were of a normal recurring nature. The 1992 and 1991 consolidated financial statements have been reclassified to conform with 1993 presentation. Such reclassifications have no effect on net income. Statement of Cash Flows For purposes of reporting cash flows, cash equivalents include amounts due from banks, federal funds sold, and securities purchased under resale agreements. Generally, federal funds are sold for one-day periods. Investment and Trading Account Securities Investment securities are stated at cost, adjusted for amortization of premium and accretion of discount. Gains or losses on security transactions are recognized upon realization and are reported as a separate component of noninterest income. The specific identification method is used in determining the cost of investment securities sold. Securities are classified as "Investment Securities" when management has the intent and ability to hold the securities for the foreseeable future. Normal operations do not require the sale of investment securities for liquidity purposes. However, on occasion, UBI may decide to sell investment securities prior to maturity for any of the following reasons: (a) to meet unanticipated short-term liquidity needs, (b) to reposition the maturity structure of the portfolio to meet projected liquidity needs, (c) to reposition the rate cycle structure of the portfolio to meet projected asset/liability requirements, or (d) to reposition the relative portion of tax-exempt securities versus taxable securities in response to projected levels of taxable income. UBI sold investment securities during the years ended December 31, 1993, and 1992, due to all the aforementioned reasons. Trading account securities are classified as such primarily based on the intent of management at the time the securities are purchased. The securities are held for resale to customers. Trading account securities are stated at market value. Gains or losses on the sale of trading account securities are considered a normal part of operations and are included in other income. -A8- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (Continued) Investment and Trading Account Securities (Continued) Effective January 1, 1994, UBI adopted Financial Accounting Standard No. 115 (FAS 115) which relates to accounting for certain investments in debt and equity securities. FAS 115 requires that banks classify all securities as "held to maturity", "available for sale" or "trading securities". Any new securities at time of purchase must be placed in one of these three categories for reporting purposes. Any security placed in the "available for sale" or "trading securities" must be marked to its fair value at that time. The fair value adjustment for "available for sale" securities will flow through the equity section on the financial reports. The fair value adjustment for the trading securities will continue to flow through the income statement. Management of UBI has done an extensive evaluation of all of its securities to determine what securities will be placed in each of these categories. Management has considered several factors to determine these securities classifications including liquidity needs, loan demand, tax issues, credit quality, regulatory issues and asset/liability positioning. Meeting the requirements of FAS 115 is not expected to have a significant effect on either the balance sheet or equity of UBI. Loans Loans are stated at principal amount outstanding. Interest income on loans is accrued as earned. Loans are placed on nonaccrual status when principal or interest is due and has remained unpaid for 90 days or more unless the loan is both well secured and in the process of collection. Loans are also placed on nonaccrual status when there is reasonable doubt as to the ability of the borrower to pay interest. At the time a loan is classified as nonaccrual, interest previously recorded but not collected is reversed. Interest payments received on such loans are generally recorded as a reduction in book value unless such book value is deemed to be collectible. -A9- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (Continued) Allowance for Loan Losses UBI's policy is to maintain a valuation allowance adequate to provide for potential losses on loans currently outstanding. The allowance for loan losses is determined by management on the basis of a detailed review of the risk factors affecting the loan portfolio, including changes in the portfolio size and mix, past loan loss experience, the financial condition of the borrowers, and the prevailing economic environment. The result of this review enables management to establish the allowance at a level considered adequate to absorb loan losses. Loan losses are charged to the allowance, and recoveries are credited to the allowance. A provision for loan losses is made to maintain the allowance at a level that, in management's judgment, is adequate to absorb potential losses inherent in the loan portfolio. Loan Fees Loan commitment and origination fees, net of the related direct loan origination costs, are amortized over the life of the related loans as an adjustment of yield. The unamortized balance of these deferred fees is reported as a reduction of total loans. Annual fees on bankcard loans are amortized on a straight-line basis over a twelve month period, and the unamortized balance of these fees is included in other liabilities. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed by straight-line and accelerated methods over the estimated useful lives of the assets. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is reflected in other income for the period. The cost of maintenance and repairs is charged to operating expenses as incurred. Significant renewals and betterments are capitalized. -A10- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (Continued) Income Taxes In January 1993, UBI adopted Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes". FAS 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in UBI's financial statements or tax returns. In estimating future tax consequences, FAS 109 generally takes into consideration all expected future events other than enactments of changes in the tax law or rates. Previously, UBI used the Financial Accounting Standards No. 96 asset and liability approach, which gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. Management has determined that there was no significant financial statement impact to UBI with the implementation of FAS 109. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107 (FAS 107), "Disclosures about Fair Value of Financial Instruments", became effective for financial statements issued for fiscal years ending after December 15, 1992. FAS 107 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. FAS 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of UBI. The following methods and assumptions were used by UBI in estimating the fair value of its financial instruments as noted in Note 16: Cash and cash equivalents: The book values reported in the balance sheet for cash and short-term instruments approximate their fair values. Investment securities (including mortgage-backed securities): Fair value for investment securities is based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. -A11- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (Continued) Fair Value of Financial Instruments (Continued) Trading account assets: Fair values for UBI's trading account assets, which also are the amounts recognized in the balance sheet, are based on quoted market prices where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans receivable: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values approximate their book value. The fair values for fixed rate mortgage loans (primarily one-to-four family residential), are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values for other loans (primarily commercial real estate and rental property mortgage loans, commercial and industrial loans, financial institution loans, agricultural loans, and consumer loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. The fair value of credit card loans is estimated to be the book value due to the short-term nature considered to exist in this portfolio. The book value of accrued interest receivable approximates its fair value. Deposit liabilities: The estimated fair value of noninterest- bearing deposits, NOW accounts, savings accounts and money market accounts is equal to their book value, which represents the amount payable on demand at the reporting date. The book value for variable rate money market and savings accounts approximates their fair values at the reporting date. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of similar remaining maturities to a schedule of aggregated expected monthly maturities on time deposits. Short-term borrowings: The book value of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings approximates their fair values at the reporting date. FHLB advances: The estimated fair value of variable rate FHLB advances is the balance sheet book value. The estimated fair value of fixed rate advances has been determined using rates currently available to UNB for advances with similar terms and remaining maturities. -A12- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (Continued) Fair Value of Financial Instruments (Continued) Long-term borrowings: The fair values of UBI's long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on UBI's current incremental borrowing rates for similar types of borrowing arrangements. 2. Mergers and Acquisition Mid Kansas Savings and Loan Association, F.A., of Wichita On February 16, 1991, UBI assumed certain liabilities and purchased certain assets of the Derby branch of the failed Mid Kansas Savings and Loan Association, F.A., of Wichita, Kansas, from the RTC. UBI paid a premium of $480,000 which was netted out of the cash paid by the RTC to UBI to balance the difference in liabilities assumed and assets purchased. The amount of deposits assumed was $15,681,000. This acquisition was accounted for as a purchase, with the premium allocated to the acquired core deposit as well as other intangibles. First Community Federal Savings and Loan Association, Winfield, Ks. On October 13, 1993, UBI announced the execution of a merger agreement between UBI, UNB and First Community Federal Savings and Loan Association (First Community) of Winfield, Kansas. Under the merger agreement, First Community will be merged with UNB, and each outstanding share of First Community common stock will be converted into $35.00 in cash. The total cost of the transaction is $12,646,520. The transaction will be financed with a $6,800,000 loan from Harris Bank and Trust in Chicago and the remaining $5,846,520 from internal funds. The merger was approved by the First Community shareholders in January 1994 but is still subject to final regulatory approval. The transaction is expected to be completed in the spring of 1994. -A13- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 2. Mergers and Acquisitions (Continued) First Community is a savings and loan institution with total assets at December 31, 1993, of $156,382,000, and offers full service banking from three branches. These facilities are located in Winfield, Arkansas City and Derby, Kansas. All three of these offices will be part of the merger and will be operated as branches of UNB. This acquisition will be accounted for as a purchase, with the premium allocated to various intangible assets. 3. Cash and Due From Banks Federal Reserve Bank regulations require the subsidiary bank to maintain certain reserve balances relating to deposits. The reserves may be maintained in the form of vault cash or balances maintained with a Federal Reserve Bank. For the two-week reserve period inclusive of December 31, 1993, UNB maintained daily average reserves of $10,553,000. For the two-week reserve period inclusive of December 31, 1992, the daily average reserves maintained were $11,009,000. 4. Investment Securities The book value and estimated market values of investments in debt securities are as follows (in thousands): -A14- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 4. Investment Securities (Continued) The book value and estimated market value of debt securities, by contractual maturity, are shown below in thousands. 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. Mortgage-backed securities have been included in the schedule of maturities based upon their estimated average life. Proceeds from sales of investments in debt securities were $121,000, $13,447,000 and $40,462,000 for 1993, 1992 and 1991 respectively. Gross gains of $21,000, $365,000 and $366,000 and gross losses of $1,000, $6,000 and $154,000 for 1993, 1992 and 1991 were realized on those sales respectively. The sales generating these gains and losses were due to adjustments made in the investment portfolio to meet asset/liability management decisions. The decisions were made for various reasons which were all within those noted under Note 1, page A-8, under Investment and Trading Account Securities. Investment securities with a book value of $41,322,000 and $42,136,000 were pledged to secure deposits of public funds at December 31, 1993, and December 31, 1992, respectively. Total pledgings required at December 31, 1993, and December 31, 1992, were $17,038,000 and $7,910,000, respectively. -A15- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 5. Loans Major classifications of loans are summarized as follows (in thousands): Changes in the allowance for loan losses were as follows (in thousands): In the ordinary course of business, UBI and its subsidiary bank has, and expects to have, transactions, including borrowings with its officers, directors, and their affiliates. Loans, net of participations sold, made to such borrowers are summarized as follows (in thousands): The "Other changes" category are loans that were outstanding to directors and their related parties as of December 31, 1992, but who were no longer directors at December 31, 1993. 6. Premises and Equipment Premises and equipment are summarized as follows (in thousands): -A16- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 6. Premises and Equipment (Continued) Depreciation expense amounted to $1,355,000 in 1993, $1,175,000 in 1992 and $1,058,000 in 1991. 7. Short-term Borrowings Short-term borrowings of UBI consist of the following (in thousands): 8. FHLB Advances Federal Home Loan Bank (FHLB) advances outstanding at December 31, 1993, for UBI are detailed below. The advances provide one of many funding alternatives that are used by UBI in its asset/liability management process for acquiring funds to meet customer loan needs and as a source of funds for other asset/liability strategies. One FHLB advance for $15,000,000 maturing March 23, 1994, is tied to the 1-month floating LIBOR rate minus 20 basis points. All other FHLB advances are at a fixed rate to maturity. Maturities and weighted average rates of the FHLB advances are as follows (in thousands): 9. Long-term Borrowings At December 31, 1993, and 1992, UBI had a note payable to Harris Bank for $8,000,000 and $10,000,000 respectively at a fixed rate of 8.28% until March 31, 1995. After this date the rate will float at Harris Bank's base rate. The note is collateralized by stock of UNB. Principal payments of $500,000 per quarter began on March 31, 1993, with final payment due on December 31, 1997. Interest is payable quarterly. Proceeds of the note payable were used to pay off short-term borrowings of UBI at Harris Bank and for the purchase of $8,200,000 of stock in UNB. -A17- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 9. Long-term Borrowings (Continued) The note payable agreement with Harris Bank contains a restriction on the amount of dividends that UBI can declare or pay during any one calendar year without the prior written consent of Harris Bank. Dividends declared or paid may not exceed 25% of consolidated net income for the calendar year. Other restrictions to UBI call for a minimum capital level of $31,500,000 through December 30, 1992, and consolidated nonperforming assets not exceed 3% of consolidated tangible assets. On December 31, 1992, and on the last day of each calendar year thereafter the required minimum capital level will increase by 50% of consolidated net income for the year then ended. Maturities of this note payable are as follows (in thousands): 10. Income Taxes Applicable income taxes include deferred income taxes arising primarily from differences between financial and tax reporting of the provision for loan losses, depreciation, and loan fees. The consolidated provisions for income taxes applicable to net income are as follows (in thousands): The table at the top of the following page is a summary of the source of differences between income tax expense and income taxes computed at the statutory federal income tax rate of 34% (in thousands): -A18- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 10. Income Taxes (Continued) Deferred income taxes arise from temporary differences in the recognition of revenues, expenses, and tax credits for tax and financial reporting purposes. Cumulative temporary differences resulted in a net deferred income tax asset of $339,000 at December 31, 1993. The gross deferred tax asset and the gross deferred tax liability are included in other assets and other liabilities respectively in the 1993 Consolidated Statement of Condition. At December 31, 1992, a $514,000 net deferred tax liability is included in other liabilities in the Consolidated Statement of Condition. Deferred tax liabilities (assets) are comprised of the following (in thousands): For the years ended December 31, 1992, and 1991, deferred income tax expense (benefit) results from timing differences in the recognition of revenue and expense for income tax and financial reporting purposes. The sources of these differences and the related tax effects are as follows: -A19- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 11. Financial Instruments with Off-Balance-Sheet Risk UBI is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. UBI's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. UBI uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Financial instruments whose contract amounts represent credit risk at December 31, 1993, and 1992, include (in thousands): 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. 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 drawn upon, the total commitment amounts do not necessarily represent future cash requirements. UBI evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by UBI upon extension of credit, is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property, plant, equipment, and income- producing commercial properties. Standby letters of credit are a conditional commitment issued by UBI to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Credit card lines represent the unused portion of many different customers that have credit card loans. UBI grants agribusiness, commercial, individual, bankcard, and residential loans to customers throughout the State of Kansas and bankcard loans in the states of Nebraska, Mississippi, and Louisiana. UBI has a diversified loan portfolio, without what it considers undue concentration in any one economic sector. -A20- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 12. Dividend Availability Approval of the Comptroller of the Currency is required if total dividends declared by a national bank in any calendar year exceed the bank's net profits for that year combined with its retained profits for the preceding two years. At December 31, 1993, dividends of approximately $7,839,000 were available from the bank subsidiary without such approval. 13. Retirement Plan UBI's bank subsidiary has an employee thrift plan covering substantially all of its employees after one year of service. Contributions are made based on a percentage of each participant's contribution. The total expense for the years ended December 31, 1993, 1992, and 1991, amounted to $201,000 ,$184,000, and $176,000 respectively. 14. Net Income per Share Net income per share is computed by dividing net income by the weighted average number of shares of stock outstanding during the year. The weighted average number of shares was 350,690 in 1993, 350,190 in 1992 and 349,109 in 1991. 15. Supplementary Income Statement Information Items included on the Consolidated Statement of Income under the captions of other income and other expense which exceed one percent of gross income are as follows (in thousands): -A21- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 16. Disclosures About Fair Value of Financial Instruments The estimated fair values of UNB's financial instruments are as follows (in thousands): The item for "unrecognized financial instruments" was not presented in the above table due to the amount of fees from commitments to extend credit being insignificant in amount. 17. Parent Company Only Financial Statements -A22- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 17. Parent Company Only Financial Statements (Continued) -A23- Union Bancshares, Inc. and Subsidiaries Notes to Consolidated Financial Statements 17. Parent Company Only Financial Statements (Continued) -A24- THIS PAGE LEFT BLANK INTENTIONALLY -A25- Union Bancshares, Inc. and Subsidiaries Independent Auditor's Report ALLEN, GIBBS & HOULIK, L.C. Certified Public Accountants & Consultants Epic Center, 301 N. Main, Suite 1700 Wichita, Kansas 67202-4868 (316) 267-7231, Fax (316) 267-0339 REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors and Stockholders Union Bancshares, Inc. We have audited the consolidated statement of condition of Union Bancshares, Inc. and Subsidiaries as of December 31, 1993, and the related consolidated statements of income, stockholders' equity and cash flows for the period then ended, and the separate financial statements of Union Bancshares, Inc., which are included in Note 17 to the consolidated financial statements. 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 financial positions of Union Bancshares, Inc. and Subsidiaries and Union Bancshares, Inc. as of December 31, 1993, and the results of their respective operations and their respective cash flows for the period ended December 31, 1993, in conformity with generally accepted accounting principles. /S/ Allen, Gibbs & Houlik, L.C. Wichita, Kansas January 28, 1993 AGH Member: The McGladrey Network and RSM International -A26- Union Bancshares, Inc. and Subsidiaries Independent Auditor's Report Coopers certified public accountants &Lybrand REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors and Stockholders Union Bancshares, Inc. We have audited the consolidated statement of condition of Union Bancshares, Inc. and Subsidiaries as of December 31, 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the two years in the period ended December 31, 1992, and the separate financial statements of Union Bancshares, Inc., which are included in Note 17 to the consolidated financial statements. 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 positions of Union Bancshares, Inc. and Subsidiaries and Union Bancshares, Inc. as of December 31, 1992, and the results of their respective operations and their respective cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. /S/ Coopers & Lybrand Omaha, Nebraska January 29, 1993 -A27- PAGE Union Bancshares, Inc. and Subsidiaries Management's Report on Financial Statements and Internal Accounting Control The financial statements, management's discussion and analysis, and statistical data of UBI and subsidiaries contained herein have been prepared in conformity with generally accepted accounting principles at the direction of management, which has the responsibility for these representations. In preparing the financial information, management makes informed judgments and estimates of the expected effects of events and transactions that are currently being accounted for and is cognizant of the materiality of those events and transactions. In meeting its responsibility for the reliability of the financial statements, management depends on UBI's system of internal accounting control. This system is designed to provide reasonable assurance that transactions are executed in accordance with management's authorization and recorded properly to permit the preparation of financial statements in accordance with generally accepted accounting principles and that assets are safeguarded. Such a system includes the communication of policies and procedures to appropriate personnel, the careful selection and training of qualified personnel, the assignment of authority and responsibility, the accountability for performance, and a strong program of internal audits. The concept of reasonable assurance is based on the recognition that the cost of a system of internal accounting control should not exceed the benefits expected to be derived and that the evaluation of those factors requires estimates and judgments by management. Management has confidence that the internal accounting controls currently in place, along with its strong audit programs, provide reasonable assurance that the financial statements presented herein and transactions underlying such statements are in accordance with management's authorization and generally accepted accounting principles. -A28- PAGE Union Bancshares, Inc. and Subsidiaries Management's Discussion and Analysis of Financial Condition and Results of Operations For 1993, UBI's net income was $5,192,000, up 20.7% from the $4,300,000 earned in 1992. The earnings for 1993 produced a return on average assets of .97% compared to .79% the prior year. The return on average equity of 13.50% was up from the 12.45% of the preceding year. The increase in earnings was the result of a higher net interest margin, a lower loan loss provision and lower expenses. The improvement in the net interest margin was the result of liabilities repricing faster than assets in a lowering interest rate environment in 1993. In the fourth quarter the margin leveled out. Management does not see continued improvement in the margin in 1994 as liabilities have appeared to reach a low, while asset rates are still falling. The change in the asset mix of the balance sheet also contributed to the improved margin in 1993. Management anticipates a continued change in the mix of assets during 1994 as more assets are deployed to loans from investments. This should further help the margin in 1994. Overall, management anticipates the net interest margin to be flat in 1994. The reduction in the loan loss provision was directly related to the lowest net charge-off level (.50% of average loans) since 1982. While management believes its systems for monitoring, reviewing and analyzing credits contributed to this low number, it also believes an improved economic environment assisted in holding this number down. Management believes that this number will continue to remain low in 1994. Expenses in 1993 were down from 1992 levels, almost to 1991 levels. This resulted from reduced marketing expenditures, data processing expenses, supply costs and other overhead expenses. A change in UBI's advertising agency and marketing programs helped in reducing marketing expenses for 1993. Management anticipates marketing costs to be up in 1994 from new marketing programs being implemented during 1994. Data processing expenses were down in 1993 as the result of reduced data processing projects. This savings was offset somewhat by increased equipment costs from new systems. These systems are reducing supply costs and helping to position UBI for greater expansion of business without major staff additions. Management anticipates slight increases in other expenses for 1994 as UBI looks to have additional system requirements to meet the demand for products and services of its customers. It also anticipates further pressure on expenses from increased regulatory burdens and the potential for increased employee benefit costs from health care reform. -A29- Union Bancshares, Inc. and Subsidiaries Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) On October 13, 1993, UBI announced the execution of a merger agreement between UBI, UNB and First Community. Under the merger agreement, First Community will be merged with UNB and each outstanding share of First Community common stock will be converted into $35.00 in cash. The total cost of the transaction is $12,646,520. First Community, with total assets of $156,382,000 at December 31, 1993, offers full service banking from three branches located in Winfield, Arkansas City and Derby, Kansas. First Community brings new markets and product offerings to UNB. It has a very strong mortgage banking business that UNB can utilize in its Sedgwick and Reno County markets. UNB will be able to take its commercial and consumer products to the markets served by First Community. Management perceives this as a positive benefit to customers of both institutions. Management believes that this will bring increased profitability to UNB through increased markets, increased sales of products and cost savings from operational efficiencies. In 1992, UBI earned $4,300,000, an increase of 22.8% over the $3,502,000 earned in 1991. This was a .79% return on average assets and a 12.45% return on average equity. This compares to a .63% return on average assets and a 11.59% return on average equity in 1991. The increased earnings in 1992 resulted from a higher net interest margin and some higher noninterest income levels. The net interest margin was up 8.8% in 1992 over 1991 due to increased volumes of earning assets and a change in the mix of assets from investments to loans. Net income for 1991 of $3,502,000 was up 21.4% over the $2,885,000 in 1990. Return on average assets was .63% in 1991 compared to .59% in 1990. Return on average equity was 11.59% compared to 10.25% in the prior year. An increase in the net interest margin of $21,352,000, or 13.8%, was the major contributor to the increased earnings. There were also some higher levels of noninterest income. In 1990 and 1991, UBI acquired certain assets and assumed certain liabilities of three failed savings and loan associations in transactions with the Resolution Trust Corporation (RTC). The liabilities assumed in these transactions consisted mainly of deposits, in particular, certificates of deposit. The assets acquired consisted primarily of performing 1-4 family mortgages. UBI's balance sheet increased by some $170 million from these acquisitions. While the impact to the balance sheet was considered significant, the resulting effect in the initial years to the income statement was not. The effect to the income statement has come over the past three years through the improved net interest margin as identified above and back room operational efficiencies. -A30- PAGE Union Bancshares, Inc. and Subsidiaries Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The improved margin is the result of repricing of liabilities and the change in the asset mix from investments to loans. Management anticipates 1994 to be a very competitive year. Margins will continue to flatten causing management to rely on further deployment of investment assets to loan assets to maintain margins. Management will look to increased sales of products and services in 1994 to improve earnings over 1993. They will also continue to look for technological improvements and efficiencies to take on additional volumes at current costs or to reduce costs where applicable. Management has implemented the new rules on marking to market of securities under FAS 115. It is management's belief that there will not be any major impact to UBI's balance sheet or income statement from this change in accounting procedure. Management is also trying to assess what, if any, effect health care reform may have on earnings in 1994. It cannot be determined at this time what the effect will be, but management believes it will have a negative impact on earnings as costs will most likely increase. Management also has under review various other regulatory issues. It is too early to determine the effect these pending issues might have on UBI and/or its bank subsidiary, UNB. Management continues to look for acquisition opportunities in South Central Kansas. Management believes growth through acquisition will help provide future shareholder value and assist in meeting competition through cost efficiencies. The significant elements of income and expense affecting net income are detailed separately and in greater detail in the ensuing analyses. -A31- PAGE Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Condition - Average Balances and Interest Rates (Tax-equivalent basis in thousands of dollars) -A32- PAGE Union Bancshares, Inc. and Subsidiaries Consolidated Statement of Condition - Average Balances and Interest Rates -A33- Union Bancshares, Inc. and Subsidiaries Analysis of Net Interest Income Net interest income, the most significant element of UBI's earnings, represents the difference between the interest earned on loans and other investments and the interest incurred for deposits and other sources of funds. For purposes of the analysis below, net interest income is adjusted to convert tax-exempt income to a fully taxable equivalent basis. This adjustment does not affect net income since a statement of income prepared on a taxable equivalent basis includes an offsetting amount in income tax expense. The following table reflects net interest income on a taxable equivalent basis (1) for the years 1991 to 1993 (in thousands): On a tax-equivalent basis, net interest income for 1993 was $25,115,000, representing an increase over the previous year of $724,000 or 3.0%. The improvement in net interest income was the result of an increase in interest rate spreads and the mix of earning assets. Average loans in 1993 totaled $284,565,000, an increase of $8,332,000, or 3.0%, over the prior year. This increase contributed to the improved margin, in addition to the interest costing liabilities repriced faster in 1993 at lower rates than did interest earning assets. Interest expense in 1993 decreased by $4,788,000, or 24.5%, from 1992. This decrease was due mainly from lower rates paid on deposits. Average interest costing liabilities were $413,259,000 representing a decrease of $16,481,000, or 3.8%, below 1992. Average time deposits less than $100,000 fell $27,305,000, or 13.9%, in the current year. In 1992, net interest income increased 8.9% over 1991. This increase was primarily the result of an improvement in the mix of interest earning assets. Lower yielding investments were replaced with higher yielding loans. -A34- PAGE THIS PAGE LEFT BLANK INTENTIONALLY -A35- PAGE Union Bancshares, Inc. and Subsidiaries Changes in Tax-equivalent Net Interest Income The following table analyzes the increase in taxable equivalent net interest income in terms of the respective amounts attributable to changes in interest rates, changes in average balances, and changes in both rates and balances. -A36- PAGE Union Bancshares, Inc. and Subsidiaries Changes in Tax-equivalent Net Interest Income (Continued) -A37- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Noninterest Income Noninterest income in 1993 was $7,904,000, representing a decrease of $19,000, or .2%, under the preceding year. The largest decrease came from the security gains category which decreased $339,000 from 1992. This was due to the 1992 sale of collateralized mortgage obligations discussed in the next paragraph. Increases in service charges and trust fees categories for 1993 helped offset the decreases in noninterest income caused by the security gains category. All other categories remained relatively unchanged. Noninterest income in 1992 was $7,923,000, representing a decrease of $438,000, or 5.2%, under the preceding year. This decrease resulted primarily from other income. In 1991 and 1990 there were items of income received from the RTC in the settlement of the acquisition transactions of failed savings and loans from the RTC that did not repeat themselves in 1992. Bankcard fees and service charges were also down in 1992 due to changes in customer uses of these services. During 1992, UNB sold collateralized mortgage obligations because of accelerated repayments and small principal sums remaining in certain issues. This accounted for almost all of the investment sales in 1992, and the security gains noted in the table below. The total par value sold represented approximately 6.6% of the entire investment portfolio. All other categories remained relatively unchanged. Each major category of noninterest income is analyzed in the following table (in thousands): Analysis of Noninterest Expense Noninterest expense in 1993 totaled $22,163,000, a decrease of $403,000, or 1.8%, under 1992. The largest decrease in noninterest expense occurred in marketing expenses. In 1992 there was extensive media advertising that took place that did not occur in 1993. Several other noninterest expense categories decreased in 1993 due to efforts to control costs in UBI. The largest dollar increase in noninterest expense came from salaries and benefits expenses. The increase of $522,000 was due to normal salary and benefits increases. -A38- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Noninterest Expense (Continued) Noninterest expense in 1992 totaled $22,566,000, an increase of $414,000, or 1.9%, over 1991. This increase was significantly less than the increase from 1990 to 1991. There were various increases and decreases in the expense categories resulting in the small 1.9% increase overall. Management continues to look for ways to cut costs. Each major category of noninterest expense is detailed in the following table (in thousands): Analysis of Investment Securities The book value of investment securities at December 31, 1993, 1992, and 1991, is presented below (in thousands): -A39- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Investment Securities (Continued) It is the initial intent of UBI to hold securities to maturity. It may, from time to time, sell securities for reasons as defined in Note 1, page A-9 (Investment and Trading Account Securities) of the Notes to Consolidated Financial Statements. Except for total U.S. Treasury and U.S. Agency Obligations, no investment in a single issuer exceeds 10% of stockholders' equity. State and municipal securities make up approximately 22.3% of the total investment portfolio. UNB's investment policy states that out-of-state municipal securities purchased shall have an A rating or better by either Standard & Poor's or Moody's rating service or be approved by the Investment Committee if municipal securities with less than an A rating are considered. The quality ratings on Kansas municipal bonds shall be left to the investment officer. At December 31, 1993, $10,443,000, or 24.5%, of the state and municipal securities were nonrated with $6,833,000, or 65.4%, of the nonrated municipal securities being Kansas issues. The majority of the nonrated municipal securities are smaller bond issues that are not rated by Standard & Poors or Moody's but are considered to be of appropriate investment quality and actively traded in a liquid market. A complete breakout of the ratings for state and municipal securities at December 31, 1993, is shown below (in thousands): -A40- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Investment Securities (Continued) The maturity distribution of UBI's investment securities at December 31, 1993, is presented below. In addition, the weighted average yield of each maturity range of 1993 is presented on a fully taxable equivalent basis. Analysis of Loans Outstanding loans distinguished by selected categories at December 31 for each of the last five years, their maturities, and interest sensitivity of those loans categories at year-end December 31, 1993, are set forth in the following analyses (in thousands): -A41 PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Loans (Continued) UBI has had a significant increase in installment loans starting in 1991 through 1993. UBI has been aggressively pursuing indirect dealer loan business during this period. UBI will continue to emphasize this area of the retail market in the future because of the potential to generate additional loan growth for UBI. UBI shows a significant increase in mortgage loans in 1990 from prior years. This increase is the result of acquisitions of two failed savings and loans during 1990 from the RTC. Prior to these acquisitions, UBI's bank subsidiary, UNB, began emphasizing home mortgage lending in the latter part of 1988. Prior to that time UNB did not actively promote mortgage loans. In 1988, when UNB began emphasizing mortgage loans, Sedgwick County, Kansas was defined as the market area. The acquisitions in 1990 expanded the mortgage lending market to Reno County, Kansas with a few loans in counties adjacent to Sedgwick and Reno counties. UNB continues to consider Sedgwick and Reno counties as its primary mortgage loan markets. The majority of these loans are 1-4 family residential mortgage loans. At December 31, 1993, approximately 55% are adjustable rate mortgages with the remaining 45% being fixed rate. -A42- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Underperforming Assets UBI continues to place strong emphasis on the close monitoring of underperforming assets. It is UBI's policy to treat as underperforming assets (a) loans that are accounted for on a nonaccrual basis, (b) loans, the terms of which have been renegotiated to provide for a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower, (c) other real estate, and (d) loans which are past due 90 days or more and still accruing interest. Underperforming assets at December 31, 1993, were $2,213,000, an increase of $156,000 from $2,057,000 at December 31, 1992. Nonaccrual loans decreased $402,000, while loans 90 days past due increased $530,000 over the prior year. At December 31, 1992, underperforming assets were $544,000 higher than the $1,513,000 reported at December 31, 1991. The increase at December 31, 1992, was not substantial and the level of underperforming assets to total loans and the allowance for loan losses remain at very acceptable levels. The decrease in 1991, was attributable to reduced levels of past due loans and charge-offs of loans classified as underperforming in 1990. All underperforming loans of $100,000 or more are specifically reviewed by management in analyzing the adequacy of the allowance for loan losses. This is discussed further on page A-10 under Allowance for Loan Losses. Loans are placed on nonaccrual status when principal or interest is due and has remained unpaid for 90 days or more unless the loan is well secured and/or in the process of collection. Loans are also placed on nonaccrual status when there is reasonable doubt as to the ability of the borrower to pay interest or principal. At the time a loan is classified as nonaccrual, interest previously recorded but not collected is reversed. Interest payments received on such loans are generally recorded as a reduction in book value unless such book value is deemed to be collectible. Loans on which the accrual of interest has been discontinued amounted to $685,000 at December 31, 1993. If interest on these loans had been accrued, such income would have approximated $66,000 in 1993. No interest was recognized on these loans after transferring them to non-accrual status. Underperforming assets for five-year period ended December 31, 1993, are set forth in the following table (in thousands): -A43- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Allowance for Loan Losses In the normal course of business, banks recognize that a relatively small percentage of the loans they make will eventually be charged off. These future charge-offs are currently provided for through the allowance for loan losses. Additions made to this allowance are charged to operating expenses under the provision for loan losses. Loans are charged against the allowance when they are deemed to be uncollectible. Recoveries are credited directly to the allowance. The required level for the allowance for loan losses is determined by management on the basis of a detailed review of the risk factors affecting the loan portfolio. In addition to evaluating the financial condition of individual borrowers, management assesses the entire portfolio as to past loan loss experience, volumes, mix and maturity, concentration of credit, prevailing economic conditions, both locally and nationally, and off-balance sheet risk. Management specifically reviews all underperforming assets of $100,000 or more for loan loss adequacy as well as for potential partial or complete charge-off. The results of these reviews along with the other above factors enable management to establish the allowance at a level considered adequate to absorb loan losses. At December 31, 1993, the allowance for loan losses was $4,400,000, or 1.49%, of outstanding loans. This compares with $3,400,000, or 1.21%, of outstanding loans reported at the end of 1992. The provision for loan losses totaled $2,412,000 in the current year, a decrease of $157,000 from the $2,569,000 reported a year earlier. Net charge-offs during 1993 amounted to $1,412,000, or .50%, of average net loans. This compares with net charge-offs of $2,219,000, or .80%, of average net loans for the preceding year. Based upon managements detailed review and analysis of the loan portfolio at December 31, 1993, the allowance for loan losses was set at a level of $4,400,000 as managements best estimate of the potential losses which might be present in the loan portfolio at that point in time. Management believes it is important to take a conservative approach in evaluating the risk profile of the company. -A44- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Allowance for Loan Losses (Continued) The activity in the allowance for loan losses during each of the past five years is presented in the following analysis: (In thousands) -A45- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Allowance for Loan Losses (Continued) The following tables allocate UBI's allowance for loan losses in dollars and percentages among the various loan categories based upon managements review and analysis of the potential risk in the loan portfolio at year-end. Allocation of the allowance for loan losses between loan categories is shown in the following table (in thousands). This allocation is not fixed, and UBI considers the entire allowance available to absorb losses in any category. The following tables compare the percentage of loans in each loan category to total loans and the allocation of the allowance for loan losses by type expressed as a percentage of the total allowance for loan losses: -A46- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Deposits Deposits at December 31, 1993, were $433,816,000, representing a decrease of $41,811,000, or 8.8%, below 1992. On average for the year, deposits were $444,364,000, down $31,280,000 over 1992. Most of the decrease in deposits during 1993 occurred in time deposits. This decrease was the result of lower interest rates in 1993 and 1992, which has caused customers to look for alternative investments at higher yields outside the banking industry. The maturity of time deposits of $100,000 or more is set forth in the following table (in thousands): Analysis of Short-term Borrowings Information for each category of short-term borrowings for which the average balance outstanding for the period was at least 30 percent of stockholders' equity at the end of the period is presented below (in thousands): -A47- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Capital Resources Stockholders' equity increased $4,596,000, or 12.7%, to $40,816,000 at December 31, 1993, from the $36,220,000 reported at December 31, 1992. The ratio of equity capital to total assets was 7.7 % at December 31, 1993, compared to 6.6% for the same period in 1992. This increase was the result of reinvested earnings, which amounted to $4,596,000, or 88.5%, of net income compared with $3,705,000, or 86.2%, of net income a year earlier. The dividend payout ratio of 11.5% is consistent with UBI's policy of maintaining an appropriate balance between earnings returned to stockholders in the form of dividends and earnings retained to provide internal capital growth. Risk-based capital guidelines established by the Federal Reserve Bank (FRB), UBI's primary regulator, started in 1991. These guidelines began phase in on January 1, 1991, with final implementation on December 31, 1992. Under these guidelines, the FRB will monitor three ratios for capital levels. They are Tier I capital, Tier II capital and a Leverage ratio. Currently the FRB is requiring a minimum Tier I capital guideline of 4.00%, a Tier II capital guideline of 8.00%, and a Leverage ratio of 3.00%. At December 31, 1993, UBI had a 11.8% Tier I capital ratio, a 13.1% Tier II capital ratio, and a 7.4% Leverage ratio. All of UBI's capital ratios are above the regulatory guidelines and placed UBI in the "well capitalized" category currently defined by regulators. Well capitalized institutions are defined as those institutions having a Tier I capital level of 6.0%, a Tier II capital level of 10.0% and a Leverage ratio of 5.0%. This is the highest capital level category defined by regulators. -A48- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Liquidity Liquidity for UBI's bank subsidiary, UNB, is represented by UNB's ability to generate a continuing stream of funds to satisfy its financial needs and the credit and deposit demands of its customers. Liquidity and interest sensitivity are managed in a coordinated asset/liability management program within the bank. Asset liquidity is derived from loan repayments and scheduled maturities of loans and other assets, primarily investment securities. At December 31, 1993, loan repayments and scheduled loan maturities within one year or less totaled $86,142,000. At December 31, 1993, investment securities, federal funds sold, FHLB overnight deposits, securities purchased under resale agreements and other investments, all of which are maturing within one year or less, totaled $54,761,000. These short-term investment funds equaled 11.3% of aggregate interest-earning assets. This liquidity provides UNB with a substantial capacity to fund customers' new credit demands, internal financial needs, deposit payouts and to take advantage of other attractive market conditions as they arise. On the liability side, the most significant sources of liquidity for UNB consist of customers' new savings and time deposits under $100,000 and the renewal of customers' maturing deposits. Other sources of liquidity include customers' certificates of deposit of $100,000 or more, FHLB advances, and the purchase of federal funds and securities sold under agreements to repurchase. UBI relies on dividends and tax benefit payments from its subsidiaries and borrowings from unaffiliated banks to generate cash flow. Federal regulations restrict the payment of dividends by national banks by requiring approval of the Comptroller of the Currency if total dividends declared by a national bank in any calendar year exceed the bank's net profits for that year combined with its retained profits for the preceding two years. At December 31, 1993, dividends of approximately $7,839,000 were available from the bank subsidiary without such approval. UBI also has available for cash flow needs a $1,000,000 line of credit with Harris Bank and Trust Company of Chicago. As of December 31, 1993, the line of credit had a $0 balance. Analysis of Interest Sensitivity Interest sensitivity is the cornerstone of UBI's asset/liability margin management system. Key asset and liability decisions are reviewed in the framework of this system with the objective of optimizing long-term profitability at an acceptable level of risk. -A49- PAGE Union Bancshares, Inc. and Subsidiaries Analysis of Interest Sensitivity (Continued) The tables that follow summarize the asset/liability margin management status at December 31, 1993. Yields and rates shown in the table are interest income and expense only. Other factors such as loan fees are not included in the summary. -A50- PAGE Union Bancshares, Inc. and Subsidiaries Five-Year Summary of Operations (In Thousands of Dollars Except Per Share Amounts)

812701_1993.txt

812701_1993

1993

812701

Item 1. Business: The Company: The predecessor of the Company's activated carbon business was formed in 1942. From 1968 until April 1985 it was owned and operated by the previous owner. In April 1985 the Company's predecessor business was purchased by its management in a leveraged buyout. The Company's business is currently conducted by substantially the same management that conducted the business prior to the leveraged buyout. On June 9, 1987 the Company completed its initial public offering of common stock. In May of 1988 the Company acquired Degussa AG's activated carbon and charcoal business located in Germany. The acquisition was accounted for as a purchase. The acquisition provided the Company with two additional manufacturing facilities located in Germany and strengthened its customer base. In September of 1990, the Company purchased the operating assets of TMPC, Inc. (Vara International) in order to strengthen the Company's vapor phase equipment business. Products and Services: Calgon Carbon is engaged in the production and marketing of activated carbons and related services and systems throughout the world. The Company's activities consist of four integrally related areas: (1) activated carbons--the production and sale of a broad range of untreated, impregnated or acid-washed carbons, in either powder, granular or pellet form; (2) services--the provision of carbon reactivation services, as well as on-site purification, filtration and extraction services; (3) systems--the design, assembly and sales of activated carbon purification, filtration and extraction systems; and (4) charcoal--the production and sale of charcoal to consumer markets in Europe. Markets: The Company offers its activated carbon products, equipment and services to the Industrial Process Market, and the Environmental Market and charcoal products to the Consumer Market. The following table sets forth certain data concerning the Company's total net sales by market for the past three years. Industrial Process Market: The Industrial Process Market consists of customers that use the Company's products either for purification of their own products in the manufacturing process or direct incorporation into their own product. The Industrial Process Market includes four significant sub-markets: the food market, the original equipment manufacturers market, the chemical and pharmaceutical market and a group of other sub-markets. Environmental Market: The Environmental Market consists of customers that use the Company's products to control air and water pollutants. The Environmental Market has two sub- markets, the industrial market and the municipal market. Consumer Market: The Consumer Market consists of sales of charcoal (Grillis/R/ and Der Sommer-Hit/R/) for outdoor barbecue grilling. The Company's grill charcoal is primarily sold through distributors principally in Germany. This market is weather dependent, with the majority of the sales in the spring and summer months. Sales and Marketing: The Company sells activated carbons, systems and services throughout the world. In Europe, the Company also sells charcoal. To date, in areas outside of the United States and Europe, the Company's primary activity has been the sale of activated carbons. The Company sells its products and services principally through its own direct sales force, and, to a lesser degree, through agents and distributors. The Company has a direct sales force in the United States in offices located in Pittsburgh, Pennsylvania; San Mateo, California; Carlsbad, California; Lisle, Illinois; Houston, Texas; and Bridgewater, New Jersey. The Company conducts sales in Canada through its wholly owned subsidiary which has a sales office in Mississauga, Ontario. In Europe the Company has sales offices in Brussels, Belgium; Paris, France; Manchester, England; Frankfurt, Germany; and Milan, Italy. The Company also has a network of agents and distributors that conduct sales in certain countries in Europe (including Eastern European countries), the Middle East, Africa, Latin America, the Far East, Australia and New Zealand. The following table sets forth certain data concerning total net sales to customers in geographic areas in the past three years: Refer to Note 14 to the Consolidated Financial Statements for a discussion of certain other financial information classified by major geographic areas in which the Company operates. Sales of the Company's products in Japan, South Korea, Taiwan and the People's Republic of China are conducted exclusively by Calgon Far East Co. Ltd., a joint venture in which the Company is a 50% participant. The joint venture purchases the Company's products for resale in the four designated countries. Sales to the joint venture have not been a significant portion of the Company's total net sales. The Company's products and services were purchased by approximately 3,700 active customers in 1993. Over the past three years, no single customer accounted for more than 10% of the total sales of the Company in any year. Competition: The Company has three principal competitors with respect to the production and sale of activated carbons: Norit, N.V., a Dutch Company; CECA and Atochem, USA, subsidiaries of Elf-Aquitaine, a French company; and Westvaco Corporation, a United States company. Recently, Chinese producers of coal based activated carbon and certain East Asian producers of coconut based activated carbon have entered the market on a worldwide basis and sell principally through resellers. Competition in activated carbons, systems and services is based both on price and performance. Other sources of competition for the Company's activated carbon services and systems are purification, filtration and extraction processes that do not employ activated carbons. A number of other smaller competitors engage in the production and sale of activated carbons in the United States and throughout the world. These companies compete with the Company in the sale of specific types of activated carbons, but do not generally compete with the Company in the worldwide activated carbon business. In the United States the Company competes with several small regional companies for the sale of its reactivation services and equipment. There are a number of competitors in the consumer charcoal market who are located in the Eastern European countries, Spain, Portugal and South Africa. These competitors offer inexpensive, low-quality products to the market. Capital Expenditures: In 1993, the Company invested $15.1 million for capital expenditures. The Company's 1994 capital expenditure budget approximates $21.0 million and includes equipment for adsorption service customers. The Company believes that the funds generated from operations, supplemented as necessary with funds from lines of credit and its cash reserves, will provide sufficient funds required for such capital expenditures. Raw Materials: The principal raw material purchased by the Company is bituminous coal from mines in the Appalachian Region and mines outside the United States, under annual supply contracts. The Company purchases the coal used in its Belgian production facility from a number of European and Western Hemisphere coal companies under similar arrangements. The Company purchases beech wood for its German operations through long-term contracts and on the open market, either as fresh forest wood or as off-cuts from the furniture industry. Most of the wood is sourced in Germany and the supply of wood is adequate. The Company also purchases, through long-term contracts, fly ash, a by-product of the lumber industry, that is used to produce powdered carbon at the Blue Lake, California plant. The Company purchases significant amounts of natural gas from various suppliers for use in its production facilities. In both the United States and Europe, this natural gas is purchased pursuant to various contracts with natural gas companies. The only other raw material that is purchased by the Company in significant quantities is coal tar pitch, which is used as a binder in the manufacturing process. The Company purchases coal tar pitch from various suppliers in the United States and Europe under annual supply contracts. The Company does not presently anticipate any problems in obtaining adequate supplies of any of its raw materials. Research and Development: The Company's research and development activities are conducted at a research center near Pittsburgh, Pennsylvania, under the direction of a Vice President with a staff of 70 employees. A pilot plant located near Pittsburgh is used for the production of experimental activated carbon products for testing and applications development. The principal goals of the Company's research program are maintaining the Company as a technological leader in the production and utilization of granular activated carbon, systems and services; developing new products and services; and providing technical support to the manufacturing and marketing operations of the Company. Results of the Company's new product research programs include: development of a new product line of Centaur/TM/ carbons; development of proprietary specialty activated carbons in industrial and military respirators; commercial introduction of two new solvent recovery carbons, Xtrusorb A754 and Xtrusorb 800, for acetone and toluene recovery; development of an improved potable water carbon; and development of a new process to remove mercury from hydrocarbon liquids. Research and development expenses were $6.5 million, $6.2 million and $5.9 million in 1993, 1992, and 1991, respectively. Expenses were essentially flat between 1993, 1992 and 1991, apart from inflationary cost increases. Patent and Trade Secrets: The Company possesses a substantial body of technical knowledge and trade secrets and owns 47 United States patents and 68 patents in other countries. The technology embodied in these patents, trade secrets and technical knowledge applies to all phases of the Company's business including production processes, product formulations and application engineering. The Company considers this body of technology important to the conduct of its business, although it considers no individual item material to its business. Regulatory Matters: Domestic. The Company is subject to extensive environmental laws and regulations concerning emissions to the air, discharges to waterways and the generation, handling, storage, transportation, treatment and disposal of waste materials and is also subject to other federal and state laws regarding health and safety matters. The Company believes it is presently in substantial compliance with these laws and regulations. These laws and regulations are constantly evolving and it is impossible to predict accurately the effect these laws and regulations may have on the Company in the future. The Environmental Protection Agency (EPA) has issued certain regulations under the Resource Conservation and Recovery Act (RCRA) dealing with the transportation, storage and treatment of hazardous waste that impact the Company in its carbon reactivation services. Once activated carbon supplied to a customer can no longer adsorb contaminating organic substances, it is returned to the Company's facilities for reactivation and subsequent reuse. If the substance(s) adsorbed by the spent carbon is considered hazardous, under these EPA regulations the activated carbon used in the treatment process is also considered hazardous. Therefore, a permit is required to transport the hazardous carbon to the Company's facility for reactivation. The Company possesses the necessary federal and state permits to transport hazardous waste. Once at the Company's reactivation site, the hazardous spent activated carbon is placed in temporary storage tanks. Under the EPA regulations, the Company is required to have a hazardous waste storage permit. The Company has obtained RCRA Part B permits to store hazardous waste at its Neville Island and Catlettsburg facilities. The process of reactivating the spent activated carbon, which destroys the hazardous organic substances, is subject to permitting as a thermal treatment unit under RCRA. The Company does not accept for reactivation carbons containing certain hazardous materials, including PCBs, dioxins and radioactive materials. Each of the Company's domestic production facilities has permits and licenses regulating air emissions and water discharges. All of the Company's domestic production facilities are controlled under permits issued by state and federal air pollution control entities. The Company is presently in substantial compliance with these permits. Continued compliance will require administrative control and will be subject to any new or additional standards. Europe. The Company is also subject to various environmental health and safety laws and regulations at its facilities in Belgium, England and Germany. These laws and regulations address substantially the same issues as those applicable to the Company in the United States. The Company believes it is presently in substantial compliance with these laws and regulations. Indemnification. The Company has a limited indemnification agreement with the previous owner of the Company which will fund certain liabilities in certain limited situations. Employee Relations: As of December 31, 1993, the Company employed 1,320 persons on a full-time basis, 734 of whom were salaried production, office, supervisory and sales personnel. The 275 hourly personnel in the United States are represented by the United Steelworkers of America. The current contracts with the United Steelworkers of America expire on February 1, 1996 with respect to the Pittsburgh facility and on June 6, 1996 with respect to the Catlettsburg facility. The 215 hourly personnel at the Brilon Wald and Bodenfelde plants in Germany are represented by the German Chemical Industry Union. Agreements are reached every two years between the National Chemical Union and the German Chemical Federation. The last agreement expired on November 30, 1993. At this time, no formal agreement exists with the German Chemical Federation, but a proposal is under negotiation. The 70 hourly personnel at the Company's Belgian facility are represented by two national labor organizations with contracts expiring on July 1, 1995. The Company has 26 hourly employees at its United Kingdom facility. Item 2. Item 2. Properties: The Company owns nine production facilities, two of which are located in Pittsburgh, Pennsylvania; and one each in the following locations: Catlettsburg, Kentucky; Pearlington, Mississippi; Blue Lake, California; Feluy, Belgium; Grays, England; Brilon Wald and Bodenfelde, Germany. The Catlettsburg, Kentucky plant is the Company's largest facility, with plant operations occupying approximately 50 acres of a 226-acre site. This plant produces granular activated carbons and powdered activated carbons, acid-washes granular activated carbons and reactivates spent granular activated carbons. The Pittsburgh, Pennsylvania carbon production plant occupies a four-acre site. Operations at the plant include the reactivation of spent granular activated carbons, the impregnation of granular activated carbons, the grinding of granular activated carbons into powdered activated carbons and the production of pelletized carbon. The plant also has the capacity to produce coal-based or coconut-based granular activated carbons. The Pittsburgh, Pennsylvania equipment and assembly plant is located approximately one mile from the carbon production plant and is situated within a 16-acre site that includes 300,000 square feet under roof. The equipment and assembly plant occupies 95,000 square feet under roof, with the remaining under roof space occupied by a centralized warehouse for carbon inventory. The plant assembles fully engineered equipment for purification, filtration and extraction systems. The Pearlington, Mississippi plant occupies a site of approximately 100 acres. The plant, the construction of which was completed in 1992, has one production line that produces granular activated carbons and powdered carbons. The Blue Lake, California plant, located near the city of Eureka, occupies approximately two acres. The operations at the plant include reactivation of spent granular activated carbons and manufacturing of powdered carbon. The Feluy, Belgium plant occupies a site of approximately 21 acres located 30 miles south of Brussels, Belgium. It has one production line which manufactures granular activated carbons. In addition, operations at the plant include the reactivation of spent activated carbons used in the treatment of food products, drinking water, industrial water and the grinding of granular activated carbons into powdered activated carbons. The Grays, England plant occupies a three acre site near London, England. Operations at the plant include the reactivation of spent granular activated carbons used in food or drinking water processing operations and the impregnation of granular activated carbon. The Brilon Wald, Germany plant occupies a site of approximately 40 acres and is situated in the North Rhine-Westphalia Region. Operations at the plant include the manufacture of pellet, granular and powdered carbons, acid washing and impregnation of activated carbon. The Bodenfelde, Germany plant occupies a site of approximately 40 acres and is situated in the State of Lower Saxony. Operations at the plant include the manufacture of charcoal for the consumer market. In addition, the plant produces charcoal tar which is used by the Brilon Wald plant for the production of activated carbon. As a by-product, acetic acid of various grades is produced and sold. 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 of which any of their property is the subject, except proceedings which arise in the ordinary course of business. In the opinion of management, any ultimate liability arising from pending litigation will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company . 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: - -------------------------------------------------------------------------------- Common Shares and Market Information There is no established trading market for Class A stock, but such stock may be converted to common stock. Class A shares are held by four officers or directors and one prior officer and director and are subject to a voting trust. These shares have identical rights with common stock except that holders of Class A stock are entitled to 10 votes per share on matters submitted to a vote of the common shareholders. Common shares are traded on the New York Stock Exchange under the trading symbol CCC. There were 1,470 registered shareholders at year end. Quarterly Common Stock Price Ranges and Dividends Item 6. Item 6. Selected Financial Data: - -------------------------------------------------------------------------------- Eight-Year Summary Selected Financial And Statistical Data (Dollars in thousands except per share data) (a) After extraordinary charges in 1990 and 1987 resulting from prepayment of debt obligations of $1.24 million or $.03 per share net of tax, and $.68 million or $.02 per share, net of tax, respectively. (b) Income per common share for 1987 and 1986 is based upon pro forma net income of $17.71 million and $10.69 million, respectively. (c) After a charge in 1992 of $10.65 million or $.26 per share resulting from the cumulative effect of a change in accounting principle for income taxes. (d) Year of initial public offering. (e) First full year of operations. Item 7. Item 7. Management's Discussion and Analysis: Management's Discussion and Analysis Calgon Carbon Corporation Overview Industry Worldwide recessionary conditions continued to adversely affect the activated carbon industry during 1993. Pricing of activated carbon products was impacted by the lack of demand in relation to increased activated carbon production and reactivation capacity worldwide. The overall United States market showed a slight increase but this was offset by declines in Europe and Japan where recessionary conditions increased. Potential markets in Eastern Europe did not materialize due to lack of funds. Certain trends continue to affect the activated carbon industrial process and environmental markets. First, companies are increasing their efforts to reengineer processes to reduce waste and cost of production, thereby decreasing the demand for activated carbon and service. Second, there has been a delay of major carbon fills particularly in the municipal potable water area. The markets for equipment utilized in the application of activated carbon for water and air purification and industrial processes remain weak. Lack of bid awards and extremely competitive conditions in metal fabrication reduced pricing and lowered margins. The Company The Company experienced recessionary effects in all market and product areas. Reduced volume resulted in significant pricing pressure in most areas of the business. Potential major carbon fills in the United States potable water market did not occur in 1993. Increased activity in the European potable water market, principally by water companies in the United Kingdom offset shortfalls in the United States and other countries. As a result of decreased volume during the year, the Company effectively idled two lines at its Catlettsburg, Kentucky plant in order to control inventory levels. Hourly workers were laid off as a result of this action. In order to match the work force to present activity levels, the worldwide salaried staff was reduced 8% by the end of 1993. Based upon present conditions, the Company has taken steps and will continue to focus its efforts on improving customer satisfaction through a total quality effort. Two new product lines, Filtraform/TM/ (activated carbon in cylindrical and panel shapes) and Centaur/TM/ (activated carbon with greatly enhanced catalytic properties) have been introduced. The activated carbon activities in Germany will be operated at a level in line with their markets and will be required to self-finance investment requirements. The Company continues to believe that the potable water market has significant potential; however, development efforts will be concentrated in industrial process markets as it is anticipated that recovery from recessionary conditions will occur first in these markets. Results of Operations Consolidated net sales in 1993 declined by $28.9 million or 9.7% versus 1992. This decrease was throughout the carbon, service and equipment areas. The overall decrease was the net result of volume and price decreases due to the worldwide recession and excess capacity in the carbon industry and to the effect of unfavorable currency rate changes of $9.4 million. On a market basis, net sales to the industrial process area decreased by 12.4% while net sales in the environmental area declined by 6.2% in 1993 versus 1992. The industrial process decline occurred primarily in the original equipment manufacture and food areas due to significant non-repeat 1992 sales and product selection shifts. The decrease in the environmental market also reflected the non-repeating nature of significant 1992 municipal category sales. Net sales in 1992 decreased by $10.0 million or 3.2% from 1991. Minor increases were experienced in the carbon, service and charcoal/liquid areas offset by a nearly 30% decline in the equipment area. Currency exchange had an overall positive effect of approximately $5.2 million on 1992 sales as compared to 1991. From a market standpoint, sales into the industrial process area declined 2.7% from 1991 to 1992 and sales to the environmental area declined 4.8% for the similar period. Gross profit before depreciation as a percentage of net sales was 39.0%, 40.8% and 40.5% for 1993, 1992 and 1991, respectively. The 1993 decline from 1992 was primarily the combination of lower selling prices and customer shifts to lower margin products. The slight improvement from 1991 to 1992 can generally be attributed to a reduced level of low-margin major equipment sales and improvement in variable gross margins somewhat offset by the impact of higher fixed manufacturing costs in relation to the volume of sales. Depreciation increased by $2.0 million in 1993 versus 1992 and by $3.7 million in 1992 over 1991. The 1993 increase was principally the result of the full year's depreciation rate used for the Pearl River, Mississippi plant in 1993 versus a half year rate for 1992, its first year of operation. The 1992 increase can particularly be associated with the aforementioned start-up of this plant but also resulted from other significant capital spending. Selling, general and administrative expenses decreased by $1.9 million in 1993 versus 1992 while 1992 reflected an increase of $2.1 million over 1991. The 1993 decrease was primarily related to reduced personnel costs resulting from the year-end 1992 voluntary retirement incentive program in the United States, other worldwide staff terminations, 1993 initiated cost control programs including the absence of executive bonuses due to the Company's performance and reductions due to currency rate changes. These decreases were partially offset by inflation. The 1992 increase over 1991 was primarily due to increased sales personnel associated costs in the United States as the Company attempted to maintain momentum and market share. Research and development expenses, as a percentage of sales, were 2.4%, 2.1% and 1.9% in 1993, 1992 and 1991, respectively. Interest income increased by $0.4 million in 1993 over 1992 but decreased by $0.6 million in 1992 from 1991. The 1993 increase was due to increased investable cash resulting from moving from the previous year's borrowing position. Conversely, the decrease in 1992 versus 1991 was the result of borrowings in 1992. Interest expense decreased in 1993 by $0.4 million from 1992 and increased by $0.3 million over 1991. Both changes were the result of borrowing activity in the indicated years. The effective tax rate for 1993 was 37.8% compared to 34.9% in 1992 and 37.2% in 1991. The 1993 increase was primarily the result of the United States passage of the "Omnibus Budget Reconciliation Act of 1993" which was retroactive to January 1, 1993, which not only affected the current year's tax provision, but also required the remeasurement of the Company's deferred tax liability to revised tax rates. The 1992 change versus 1991 was the result of the Company's January 1, 1992, adoption of the Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This also resulted in an unfavorable cumulative adjustment to first quarter 1992 net income of $10.7 million. (See Note 11 to the Consolidated Financial Statements.) The Company does not believe that inflation has had a significant effect on its business during the periods discussed. Working Capital and Liquidity Net cash flows from operating activities totalled $41.1 million in 1993, $45.4 million in 1992 and $47.2 million in 1991. The Company expects to be a net generator of cash, providing sufficient funding on an annual basis for debt service, working capital, payment of dividends and a maintenance level of capital expenditures, short of any major capital expansions. During 1992 and 1991, significant capital was expended in building the Pearl River plant which had a total cost of approximately $68 million. This project is now completed. During the second quarter of 1993 the Company negotiated two new credit facilities, one with a bank in the United States and one in Germany in the amounts of $10 million and approximately $11.5 million (deutsche mark 20 million) respectively. These credit facilities have a duration of one year and "until further notice", respectively. As a result, the Company has two United States credit facilities in the amounts of $10 million each, expiring as of April 30, 1994 and May 30, 1994 and the aforementioned German credit facility. Based upon its present financial position and history of operations, it is contemplated that these credit facilities, coupled with cash flow from operations, will provide sufficient liquidity to cover its debt service and any reasonable foreseeable working capital, capital expenditure, stock repurchase and dividend requirements. In July of 1993, the board of directors authorized the purchase of up to two million shares, or approximately 5% of the Company's common stock. Purchases will be made from time to time at prices that management considers appropriate and the repurchased shares will be held as treasury stock. During the year, the Company began to purchase these shares. During this period, 153,600 shares were purchased at a cost of $1.6 million. It is the current intention of the Company to declare and pay quarterly cash dividends on its common stock. The Company has paid cash dividends since the third quarter of 1987, the quarter succeeding the one in which the Company went public. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The declaration and payment of future dividends and the amounts thereof will be dependent upon the Company's results of operations, financial condition, cash requirements for its business, future prospects and other factors deemed relevant by the Board of Directors. Capital Expenditures and Investments Capital expenditures were $15.1 million in 1993, $24.0 million in 1992 and $70.6 million in 1991. Major expenditures in 1993 were made for production improvements at the Blue Lake, California plant ($3.2 million), a specific new product production capability at the Neville Island, Pennsylvania plant ($1.8 million) and costs associated with domestic service customer capital ($2.7 million). The 1992 and 1991 expenditure amounts included costs associated with the construction of the Pearl River prime carbon production facility. Capital expenditures for the year of 1994 are projected to be approximately $21.0 million. Item 8. Item 8. Financial Statements and Supplementary Data: Index to Consolidated Financial Statements and Supplementary Data: Report of Independent Accountants To the Board of Directors and Shareholders of Calgon Carbon Corporation: In our opinion, the consolidated financial statements listed in the index on page 12 and Item 14.B on page 27 present fairly, in all material respects, the financial position of Calgon Carbon Corporation and its subsidiaries (the Company) at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 11 to the consolidated financial statements, in 1992 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". PRICE WATERHOUSE Pittsburgh, Pennsylvania February 10, 1994 Consolidated Statement of Income Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Balance Sheet Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Statement of Cash Flows Increase (decrease) in Cash and Cash Equivalents Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Consolidated Statement of Shareholders' Equity Calgon Carbon Corporation The accompanying notes are an integral part of these consolidated financial statements. Notes to the Consolidated Financial Statements Calgon Carbon Corporation - -------------------------------------------------------------------------------- 1. Statement of Accounting Policies Operations The Company's operations are conducted in one business segment, the production and marketing of activated carbons and related products and services. Principles of Consolidation The consolidated financial statements include the accounts of Calgon Carbon Corporation and its wholly-owned subsidiaries, Chemviron Carbon GmbH, Calgon Carbon Canada, Inc., Chemviron Carbon Ltd., Calgon Carbon Investments Inc. and the Company's foreign sales corporation. A portion of the Company's international operations in Europe are owned directly by the Company and are operated as branches. The Company's 50% investment in Calgon Far East Co., Ltd. is accounted for by the equity method. Intercompany accounts and transactions have been eliminated. Foreign Currency Translation Substantially all assets and liabilities of the Company's international operations are translated at year-end exchange rates; income and expenses are translated at average exchange rates prevailing during the year. Translation adjustments are accumulated in a separate component of shareholders' equity, net of tax effects. Transaction gains and losses are included in income. Revenue Recognition Revenue and related costs are recognized when goods are shipped or services are rendered to customers. Inventories Inventories are carried at the lower of cost or market. Inventory costs are determined using the last in, first out (LIFO) method except at Chemviron Carbon GmbH and Calgon Carbon Canada, Inc., where cost is determined by the first in, first out (FIFO) method. Property, Plant and Equipment Property, plant and equipment expenditures are recorded at cost. Repair and maintenance costs are expensed as incurred. Depreciation for financial statement purposes is computed on the straight-line method over the estimated remaining service lives of the assets, which are from twenty to thirty years for buildings and land improvements, fifteen years for machinery and equipment and seven years for vehicles. Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." (See Note 11 to the Consolidated Financial Statements.) Pensions Substantially all U.S. employees of the Company are covered by one of three non-contributory defined benefit pension plans. It is the Company's policy to annually fund net pension cost accrued to these plans, subject to minimum and maximum amounts specified by regulations. In Europe, employees are also covered by various defined benefit pension plans or government sponsored defined contribution plans. The Company funds these plans according to local laws and practices. Statement of Cash Flows For the purpose of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. - -------------------------------------------------------------------------------- 2. Restructuring Charges The charge of $1,733,000 in the fourth quarter of 1993 consists of worldwide personnel costs associated with the voluntary retirement incentive program and other staff terminations. The first and fourth quarters of 1992 included charges of $690,000 and $4,507,000, respectively, for the restructuring of operations at the Brilon- Wald, Germany activated carbon plant, for a voluntary retirement incentive program in the United States, and for termination costs at several locations. The total restructuring costs for 1992 included $2,966,000 for employee terminations and net property and spare parts write-offs for operations at the Brilon-Wald plant. The cost of the voluntary retirement incentive program and termination payments at various locations totalled $2,231,000. - -------------------------------------------------------------------------------- 3. Inventories Approximately 62% of total inventories at December 31, 1993 are valued using the LIFO method. The LIFO carrying value of inventories exceeded the related current cost by $2,463,000 and $2,497,000 at December 31, 1993 and 1992, respectively. - -------------------------------------------------------------------------------- 4. Property, Plant and Equipment - ------------------------------------------------------------------------------- 5. Long-Term Debt Pollution Control Debt The City of Ashland, Kentucky Floating Rate Pollution Control Revenue bonds bear interest at a defined floating rate and are due October 1, 2006. During the year ended December 31, 1993, the Company paid interest on these bonds at an average rate of 3.2%. These pollution control bonds are secured by certain pollution control projects located at the Company's Big Sandy, Kentucky plant. The German pollution control loans consist of three loans, due March 31, 1997, 1998 and 2000 and have fixed interest rates of 5.0%, 6.5% and 6.0%,respectively. The German wastewater control loans consist of four loans. Three loans are due February 28, 2016 and one loan is due February 28, 2017. All four loans have a fixed interest rate of 1.5%. United States Credit Facilities The Company's two credit facilities totalling $20 million expire in April and May of 1994. The Company pays annual facility fees of one-eighth percent and one-quarter percent on the unused portion of each credit line. The facilities provide for interest rates based upon prime rates with other interest options available. As of December 31, 1993, no amounts were outstanding related to these credit facilities. German Credit Facility Chemviron Carbon GmbH has a bank credit facility which provides for borrowing up to $11,527,000. The facility has no set maturity date and is made available on an until further notice basis. No commitment fee is required on unborrowed funds. The facility bears interest at the German bank rate with other interest options available. As of December 31, 1993, the weighted average interest rate was 7.2% on loans outstanding. Restrictive Covenants The United States credit facilities' covenants impose financial restrictions on the Company, including maintaining certain ratios of total liabilities to tangible net worth and operating income to interest expense. At December 31, 1993 the Company was in compliance with all financial covenants relating to the credit facilities in the United States. The German credit facility has no covenants. Maturities of Debt The Company is obligated to make principal payments on debt outstanding at December 31, 1993 of $2,516,000 in 1994, $215,000 in 1995 and 1996, respectively, $197,000 in 1997, and $146,000 in 1998. - -------------------------------------------------------------------------------- 6. Lease Commitments The Company has entered into leases covering principally office, research and warehouse space, office equipment and vehicles. Future minimum rental payments required under all operating leases that have remaining noncancelable lease terms in excess of one year are $4,535,000 in 1994, $3,937,000 in 1995, $3,507,000 in 1996, $3,216,000 in 1997, $3,130,000 in 1998 and $20,302,000 thereafter. Total rental expenses on all operating leases were $4,996,000 , $5,075,000 and $5,125,000 for the years ended December 31, 1993, 1992 and 1991, respectively. - -------------------------------------------------------------------------------- 7. Shareholders' Equity The 12,148,508 shares of Class A stock outstanding at December 31, 1993 must be converted to common stock on a share-for-share basis when the Class A stock is released from a voting trust which terminates March 1, 1995. The common stock and the Class A stock have identical rights except that holders of Class A stock are entitled to 10 votes per share with respect to each matter submitted to a vote of the shareholders. On July 13, 1993, the Board of Directors authorized the Company to purchase up to two million shares, or approximately 5% of its common stock. Purchases will be made from time to time at prices management considers appropriate and the repurchased shares will be held as treasury stock. As of December 31, 1993, the Company had purchased 153,600 shares of its common stock at an aggregate cost of $1,615,000. At the Company's annual meeting of shareholders held in April 1990, an amendment to the Certificate of Incorporation was approved which affected the capital structure of the Company and modified the class voting rights of common shareholders. The amendment increased the number of authorized shares of common stock and Class A stock from 30,000,000 shares to 100,000,000 shares and increased the number of shares of preferred stock which the Company is authorized to issue from 1,000,000 shares to 5,000,000 shares. The amendment eliminated the common stock's separate class voting on amending or deleting any provision of Section 4 of the Certificate of Incorporation (relating to the capital stock of the Company) and amending, waiving or deleting provisions of the voting trust agreement. The amendment also permits the issuance of additional shares of Class A stock without a separate class vote of the common stock as long as the number of shares of Class A stock which would be outstanding after such issuance will not exceed 55% of the number of shares of common stock which would be outstanding immediately after such issuance. - -------------------------------------------------------------------------------- 8. 1985 Stock Option Plan The Company has an Employee Stock Option Plan for officers and other key employees of the Company. Stock options may be "nonstatutory," with a purchase price not less than 80% of fair market value on the date of the grant, or "incentive" with a purchase price of not less than 100% of the fair market value on that date. Stock appreciation rights may be granted at date of option grant or at any later date during the term of the option. There were 4,138,640 shares available for issuance under the Plan. In 1985, 2,096,000 options were granted and were exercised in 1985 and 1986. "Incentive" stock options granted since 1986 become exercisable two years after the date of grant in five equal annual installments and are no longer exercisable after the expiration of ten years from the date of grant. Transactions for 1993, 1992 and 1991 are as follows: - -------------------------------------------------------------------------------- 9. Employee Growth Sharing Plan Under the Plan, an employee growth sharing plan pool is calculated as a percentage of the increase in year-to-year pre-tax income plan pool which will be distributed to full time employees not eligible to receive a cash bonus under any other incentive plan of the Company. This plan pool may be adjusted by the Board of Directors at its sole discretion in any plan year in order to reflect any material events that would impact the calculation in either a positive or negative manner. There was no pool for distribution for the years ending December 31, 1993, 1992 and 1991. - -------------------------------------------------------------------------------- 10. Pensions The Company has a number of non-contributory defined benefit pension plans for its U.S. employees which provide benefits based upon the greater of a fixed rate per month or a percentage of average compensation. Prior service and compensation of employees formerly covered by pension plans of the previous owners of the Company's operations are considered in the determination of benefits payable under Company plans. By agreement with previous owners, benefits payable under Company plans are reduced by the benefit amounts attributable to the previous owners which are computed utilizing a 2.5% compensation increase assumption. Domestic plan assets are invested primarily in commingled equity and government security trust funds administered by a bank. Prior service cost for all plans is amortized on a straight-line basis over the remaining average service period of employees expected to receive benefits under the plans. For U.S. plans, net pension costs, amounts recognized in the balance sheet and significant assumptions are as follows: In addition to the above pension cost for the year ended December 31, 1993, the Company recognized $197,000 for pension curtailment and settlement losses associated with the voluntary retirement incentive program. There are several defined benefit plans covering certain employees of Chemviron Carbon GmbH for which the obligations are accrued but not funded in accordance with local practice. Benefits under these plans are generally based on a percentage of average compensation. The European employees in the branches and United Kingdom subsidiary participate in certain contributory defined benefit pension plans which guarantee a pension over the state pension level. These plans are funded by employee contributions calculated as a percentage of their compensation with the balance of the plan funding provided by Company contributions. Funds are managed by an insurance company under a deposit administration contract. Benefits under these plans are generally based upon a percentage of final earnings subject to an upper earnings limit. For European plans, net pension costs, amounts recognized in the balance sheet and significant assumptions are as follows: - -------------------------------------------------------------------------------- 11. Provision for Income Taxes In 1992, the Company adopted SFAS No. 109 which requires an asset and liability approach in accounting for income taxes. Under this method, deferred income taxes are provided to reflect the future tax consequences of carryforwards and differences between the tax bases of assets and liabilities and their financial bases at each year-end. The unfavorable cumulative effect of the change in accounting principle determined as of January 1, 1992 totaled $10,654,000 ($.26 per share). On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 became law. This act changed the United States tax rates retroactively to January 1, 1993. As required by SFAS No. 109, these new income tax rates resulted in a remeasurement of the liability for deferred income taxes of $456,000, increasing "Provision for income taxes". The components of the provision for income taxes were as follows: Income before income taxes for 1993, 1992 and 1991 includes $7,531,000, $9,145,000 and $17,359,000, respectively, generated by operations outside the United States. The difference between the U.S. federal statutory tax rate and the Company's effective income tax rate is as follows: (a) Computed in accordance with Accounting Principles Board Opinion No. 11. The deferred tax provision for 1991 was primarily the result of timing differences related to depreciation. Operating loss and credit carryforwards of $6,545,000 in foreign jurisdictions at December 31, 1993 have no expiration dates. The Company's U.S. income tax returns have been examined by the Internal Revenue Service through 1991. Management believes that adequate provisions for taxes have been made through December 31, 1993. The components of deferred taxes are comprised of the following: - ------------------------------------------------------------------------ 12. Other Information Repair and maintenance expenses were $20,008,000, $21,584,000 and $23,297,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Other (expense)-net includes net foreign currency transaction losses of ($486,000) and ($806,000) for the years ended December 31, 1993 and 1992, respectively, and gains of $294,000 for the year ended December 31, 1991. Also included are taxes other than on income of $1,049,000, $706,000 and $760,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Deferred taxes included in the translation adjustments for 1993, 1992 and 1991 were ($1,528,000), ($1,880,000) and ($281,000), respectively. - ------------------------------------------------------------------------ 13. Supplemental Cash Flow Information - -------------------------------------------------------------------------------- 14. Geographic Information Net sales by the Company's operations in certain geographic areas, transfers between geographic areas and income from operations for 1993, 1992 and 1991 and identifiable assets, at the end of each year, classified by major geographic areas in which the Company operates, were as follows: Transfers between geographic areas are at prices in excess of cost and the resultant income is assigned to the geographic area of manufacture. Interarea income remaining in inventories is eliminated in consolidation. - -------------------------------------------------------------------------------- Quarterly Financial Data - Unaudited (Dollars in thousands except per share data) (a) The cumulative effect of a change in accounting principle for income taxes was ($10,654,000) or ($.26) per share in the first quarter of 1992. See Note 11 to the Consolidated Financial Statements for details of the adoption of SFAS 109. Item 9. Item 9. Disagreements with Accountants: None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant: Information concerning the directors and executive officers of the Corporation required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 11. Item 11. Executive Compensation: Information required by this item is incorporated by reference to the material appearing under the heading "Executive Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management: Information required by this item is incorporated by reference to the material appearing under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. Item 13. Item 13. Certain Relationships and Related Transactions: Information required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Stockholders. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Report on Form 8-K: A. Financial Statements Financial statements filed as part of this report are listed in the index to Consolidated Financial Statements and Supplementary Data on page 12. B. Financial Statement Schedules Schedule V. Property, Plant and Equipment Schedule VI. Accumulated Depreciation of Property, Plant and Equipment All other schedules are omitted because they are not applicable, not material or the required information is shown in the financial statements listed above. Note: The Registrant hereby undertakes to furnish, upon request of the Commission, copies of all instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries. The total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. (a) Incorporated herein by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (b) Incorporated herein by reference to Exhibit 9.1 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (c) Incorporated herein by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (d) Incorporated herein by reference to Exhibit 9.2 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1987. (e) Incorporated herein by reference to Exhibit 22.0 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1988. (f) Incorporated herein by reference to Exhibit 3.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. (g) Incorporated herein by reference to Exhibit 10.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. * Executive compensation plans. D. Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Calgon Carbon Corporation March 4, 1994 By /s/ THOMAS A. MCCONOMY - ------------- --------------------------------------- (Date) Thomas A. McConomy 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 on the dates indicated. Schedule V. Property, Plant and Equipment Calgon Carbon Corporation Notes: Reference is made to the Statement of Accounting Policies in Note 1 to the Consolidated Financial Statements. (a) Includes foreign currency translation of $389,000 increase to property, plant and equipment and an increase of $31,000 from amortization of goodwill. (b) Includes foreign currency translation of ($5,496,000) decrease to property, plant and equipment and an increase of $31,000 from amortization of goodwill. (c) Includes foreign currency translation of ($5,761,000) decrease to property, plant and equipment, an increase of $92,000 from amortization of goodwill. Schedule VI. Accumulated Depreciation of Property, Plant and Equipment Calgon Carbon Corporation - -------------------------------------------------------------------------------- (a) Includes foreign currency translation effect on current year depreciation of $327,000 and $31,000 from amortization of goodwill. (b) Includes foreign currency translation effect on current year depreciation of ($1,542,000) and $31,000 from amortization of goodwill. (c) Includes foreign currency translation effect on current year depreciation of ($1,917,000) and $92,000 from amortization of goodwill. EXHIBIT INDEX Note: The Registrant hereby undertakes to furnish, upon request of the Commission, copies of all instruments defining the rights of holders of long- term debt of the Resgistrant and its consolidated subsidiaries. The total amount of securities authorized thereunder does not exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. (a) Incorporated herein by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (b) Incorporated herein by reference to Exhibit 9.1 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (c) Incorporated herein by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No. 33-13443) effective June 2, 1987. (d) Incorporated herein by reference to Exhibit 9.2 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1987. (e) Incorporated herein by reference to Exhibit 22.0 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1988. (f) Incorporated herein by reference to Exhibit 3.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. (g) Incorporated herein by reference to Exhibit 10.1 to the Company's report on Form 10-K filed for the fiscal year ended December 31, 1990. * Executive compensation plans. CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 (No. 33-34019) of Calgon Carbon Corporation of our report dated February 10, 1994 appearing on page 13 of this report on Form 10-K. PRICE WATERHOUSE 600 Grant Street Pittsburgh, Pennsylvania 15219-2793 March 14, 1994

792863_1993.txt

792863_1993

1993

792863

ITEM 1. BUSINESS BACKGROUND Infinity Broadcasting Corporation (the "Company" or "Infinity") is the largest company in the United States whose business is exclusively devoted to radio broadcasting. It is one of only two companies able to offer advertisers a radio listening audience in each of the nation's top ten radio markets (the other being CBS, Inc.). Based on information contained in Duncan's Radio Market Guide (1994 ed.), and adjusting for the pro forma effect of the 1993 Acquisitions (as defined below), Infinity would have ranked first in total radio revenues in 1993 among all companies owning radio stations in the United States. The Company serves markets accounting for approximately $2.4 billion in radio advertising revenues, representing approximately 27% of the total radio advertising expenditures in the United States in 1993. Upon completion of the acquisitions of WPGC-AM/FM and WXYT-AM referred to below, Infinity would own and operate 26 radio stations serving 13 of the nation's largest radio markets. Since Infinity acquired its first radio station in May 1973, it has expanded by acquiring and developing underperforming stations in the nation's largest media markets, where the greatest proportion of radio advertising dollars is spent. The Company believes that its presence in large markets makes it attractive to advertisers and that the overall diversity of its stations reduces its dependence on any single station, local economy or advertiser. In each of its markets, the Company attracts a specific demographic group by targeting its program format and hiring popular on-air talent. The Company's stations serve diverse target demographics through a broad range of programming formats such as rock, oldies, adult contemporary, all-sports and country. The Company's overall programming strategy in part is to acquire significant on-air talent and broadcasting rights for sports franchises. The diversity of station and market characteristics, combined with the Company's successful acquisition and operating strategies, have enabled the Company to achieve consistent growth in revenues and operating cash flow (as used in this Form 10-K, the term "operating cash flow" means operating income plus depreciation and amortization). The Company was incorporated in 1972 in Delaware and first issued shares of its common stock to the public in June 1986. In August 1988, the Company became privately held as a result of a merger (the "Merger") with a company whose stockholders were the Company's principal stockholders and executive officers at the time. The Company was the surviving corporation in the Merger. On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold 13,788,826 shares of Class A Common Stock through an initial public offering (the "Common Stock IPO"). In addition, on May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold 8,148,814 shares of Class A Common Stock through another public offering (the "Second Common Stock Offering"). RECENT DEVELOPMENTS On February 1, 1993, the Company completed the acquisition of radio stations WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) for a total purchase price of approximately $100 million. On September 1, 1993, the Company completed the acquisition of WIP-AM, an all-sports radio station serving Philadelphia, for approximately $17.4 million (together with the acquisition of radio stations WZGC-FM, WZLX-FM and WUSN-FM described above, the "1993 Acquisitions"). In February 1994, the Company completed the acquisition of KRTH-FM, a radio station serving Los Angeles, for approximately $116 million. On October 4, 1993, the Company entered into an agreement to purchase WPGC- AM/FM in Washington, D.C. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire WXYT-AM, a news/talk radio station serving Detroit for approximately $23 million. In addition, on February 3, 1994 the Company, Unistar Communications Group, Inc. ("UCG") Unistar Radio Networks, Inc. ("Unistar") and Westwood One, Inc. ("Westwood One") consummated the Stock Purchase Agreement dated November 4, 1993 for the purchase by Westwood One of Unistar, an affiliate of the Company, for approximately $101.3 million. In connection with the Westwood One/Unistar transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and a warrant to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company is managing the combined operations of Westwood One and Unistar pursuant to a management agreement, and the Company's Chief Executive Officer, Mel Karmazin, and Chief Financial Officer, Farid Suleman, serve as the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One. The agreement provides for a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price ranging from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. The Company continues to seek opportunities for expansion through the acquisition of additional radio stations, although its ability to make further acquisitions may be limited by certain regulatory requirements. See "Business--Federal Regulation of Radio Broadcasting", appearing elsewhere in this Report. COMPANY STRATEGY The Company's overall strategy is to own and operate radio stations in the nation's largest radio revenue markets. The Company believes that its presence in large markets makes it attractive to advertisers and that the overall diversity of its stations reduces its dependence on any single station, local economy, or advertiser. The Company also believes that by serving major markets, it is able to attract more highly skilled management, employees and on-air talent. In developing its stations, the Company takes a variety of actions to improve a station's operating cash flow, including instituting strict financial reporting requirements and cost controls, directing promotional activities, developing programming to improve the station's appeal to a targeted audience group and enhancing advertising sales efforts. In particular, the Company emphasizes increasing local advertising revenues in order to reduce dependence on national advertising revenues. During the year ended December 31, 1993, the Company generated approximately 74% of its total revenues from local and regional advertising. In operating its stations, the Company concentrates on the development of strong decentralized local management, which is responsible for the day-to-day operations of the station and is compensated based on the station's financial performance. Local management, in cooperation with corporate management, is responsible for developing programming. Corporate management is responsible for long-range planning, establishing policies and procedures, resource allocation and maintaining overall control of the stations. The overall mix of a station's programming is designed to fit each station's specific format and serve its local community. The Company's overall programming strategy includes acquiring significant on-air talent and sports franchises for its radio stations. The Company believes that this strategy, in addition to developing loyal audiences for its radio stations, enables the Company to obtain additional revenues from syndicating such programming franchises to other radio stations. In addition to its regular programming, all of the Company's stations provide non-entertainment programming, such as news and public affairs broadcasts. The Company expects to continue to acquire radio stations with strong growth potential in the Company's current markets, subject to the Communications Act of 1934, as amended (the "Communications Act"), and FCC rules, which impose certain limits on the maximum number of radio stations the Company can own nationwide and the number of stations the Company can own in the same geographic market. Because the Company has historically grown in part through the acquisition of broadcasting properties, limitations imposed by the FCC on the number of broadcasting properties the Company can acquire could limit the Company's ability to grow through acquisitions in the future. In 1992, the FCC adopted changes in its ownership rules that, among other things, increased the number of radio broadcasting properties the Company can own both nationwide and within a single geographic market. See "Business--Federal Regulation of Radio Broadcasting--Ownership Matters", appearing elsewhere in this Report. Other than as described in this Report, the Company has no present agreements or arrangements to acquire or sell any radio stations. The Company's affiliation with Westwood One and Unistar will enable the Company to expand its presence in the radio program distribution business while simultaneously enhancing the programming lineups of Westwood One and Unistar. ADVERTISING The Company believes that radio is one of the most efficient, cost-effective means for advertisers to reach specific demographic groups. Advertising rates charged by radio stations are based primarily on a station's ability to attract audiences in the demographic groups targeted by advertisers (as measured by rating service surveys quantifying the number of listeners tuned to the station at various times), on the number of stations in the market competing for the same demographic group and on the supply of and demand for radio advertising time. Rates are generally highest during morning and evening drive-time hours. Radio station revenues are derived substantially from local, regional and national advertising. Local and regional sales generally are made by a station's sales staff. National sales are made by "national rep" firms, which specialize in radio advertising sales on the national level. These firms are compensated on a commission-only basis. Most advertising contracts are short-term, generally running for only a few weeks. COMPETITION Radio broadcasting is a competitive business. The Company's radio stations compete for listeners and advertising revenues directly with other radio stations within their markets. Radio stations compete for listeners primarily on the basis of program content and by hiring on-air talent which appeals to a particular demographic group. By building a strong listenership base comprised of a specific demographic group in each of its markets, the Company is able to attract advertisers seeking to reach these listeners. Other media, including broadcast television, cable television, newspapers, magazines, direct mail, coupons and billboard advertising also compete with the Company's stations for advertising revenues. SEASONALITY The Company's revenues vary throughout the year. As is the case throughout the radio broadcast industry, the Company's first quarter generally reflects the lowest revenues for each year. EMPLOYEES As of December 31, 1993, the Company had approximately 675 full-time employees and approximately 180 part-time employees. Certain employees at the Company's stations in New York, Chicago, Philadelphia, and Boston, totalling approximately 125, are represented by unions. The Company believes that its relations with its employees and their unions are good. The Company employs several high-profile on-air personalities with large loyal audiences in their respective markets. The Company generally enters into employment agreements with its on-air talent and commissioned sales representatives to protect its interests in those relationships that it believes to be valuable. The Company has entered into employment agreements with three of its four executive officers (see "Executive Compensation--Employment Agreements" appearing in Part III of this Report, which is incorporated by reference) and with all of its high-profile on-air personalities. FEDERAL REGULATION OF RADIO BROADCASTING The ownership, operation and sale of radio stations, including those licensed to the Company, are subject to the jurisdiction of the FCC, which engages in extensive and changing regulation of the radio broadcasting industry under authority granted by the Communications Act. Among other things, the FCC assigns frequency bands for broadcasting; determines the particular frequencies, locations and operating power of stations; issues, renews, revokes and modifies station licenses; determines whether to approve changes in ownership or control of station licenses; regulates equipment used by stations; adopts and implements regulations and policies that directly or indirectly affect the ownership, operation and employment practices of stations; regulates program content (including indecent and obscene program material) and has the power to impose penalties for violations of its rules or the Communications Act. The following is a brief summary of certain provisions of the Communications Act and of specific FCC regulations and policies. Reference should be made to the Communications Act, FCC rules and the public notices and rulings of the FCC for further information concerning the nature and extent of federal regulation of broadcast stations. License Renewal. Radio broadcasting licenses are granted for maximum terms of seven years. They are subject to renewal upon application to the FCC. During certain periods when a renewal application is pending, (1) competing applicants are permitted to file for the radio frequency being used by the renewal applicant; (2) interested parties, including members of the public, are permitted to file petitions to deny license renewal applications; and (3) the transferability of the applicant's license is restricted. The FCC is required to hold evidentiary hearings on renewal applications if a competing application is filed against a renewal application, or if the FCC is unable to determine that renewal of a license would serve the public interest, convenience and necessity, or if a petition to deny raises a "substantial and material question of fact" as to whether the grant of the renewal application would be prima facie inconsistent with the public interest, convenience and necessity. The following table sets forth the date on which each of the Company's radio stations was acquired, the frequency on which each station operates, and the date on which each such station's FCC license expires: EXPIRATION DATE OF DATE OF FCC STATION MARKET(1) ACQUISITION FREQUENCY AUTHORIZATION - - ------- -------------------------- ----------- ----------- ------------- WXRK-FM New York, NY.............. 11/81 92.3 MHz 06/01/98 WZRC-AM New York, NY.............. 11/81 1480 KHz 06/01/98 WFAN-AM New York, NY.............. 04/92 660 KHz 06/01/98 KROQ-FM Los Angeles, CA........... 09/86 106.7 MHz 12/01/97 KRTH-FM(3) Los Angeles, CA........... 02/94 101.1 MHz 12/01/97 WJMK-FM Chicago, IL............... 07/84 104.3 MHz 12/01/96 WJJD-AM Chicago, IL............... 07/84 1160 KHz 12/01/96 WUSN-FM Chicago, IL............... 02/93 99.5 MHz 12/01/96 KOME-FM San Jose/ 05/73 98.5 MHz 12/01/97 San Francisco, CA... WYSP-FM(2) Philadelphia, PA.......... 11/81 94.1 MHz 08/01/91 WIP-AM Philadelphia, PA.......... 09/93 610 KHz 08/01/91 WOMC-FM Detroit, MI............... 04/88 104.3 MHz 10/01/96 WJFK-FM Washington, DC............ 12/86 106.7 MHz 10/01/95 KVIL-FM Dallas/Ft. Worth, TX...... 07/87 103.7 MHz 08/01/97 KVIL-AM Dallas/Ft. Worth, TX...... 07/87 1150 KHz 08/01/97 WBCN-FM Boston, MA................ 02/79 104.1 MHz 04/01/98 WZLX-FM Boston, MA................ 02/93 100.7 MHz 04/01/98 KXYZ-AM Houston, TX............... 06/83 1320 KHz 08/01/97 WLIF-FM Baltimore, MD............. 05/89 101.9 MHz 10/01/95 WJFK-AM Baltimore, MD............. 05/89 1300 KHz 10/01/95 WZGC-FM Atlanta, GA............... 02/93 92.9 MHz 04/01/96 WQYK-FM Tampa/St. Petersburg, FL.. 12/86 99.5 MHz 02/01/96 WQYK-AM Tampa/St. Petersburg, FL.. 11/87 1010 KHz 02/01/96 (1) Some stations are licensed to a different community located within the market which they serve. (2) An application for renewal of the WYSP-FM license was filed on April 1, 1991. Two Petitions to Deny were filed against such renewal application in July 1991. See "Business--Federal Regulation of Broadcasting--Programming and Operation," appearing elsewhere in this Report. One of these petitions has been dismissed by the FCC, and one remains pending. The station's operating authority remains effective during the pendency of the remaining petition. (3) The FCC granted its consent to assignment of the KRTH license to the Company on February 1, 1994. A Petition for Reconsideration of the FCC's grant was filed by Americans for Responsible Television on March 3, 1994. The station's operating authority and the FCC's grant of assignment remain effective during the pendency of this Petition. See "Business--Federal Regulation of Radio Broadcasting--Programming and Operation". Ownership Matters. The Communications Act prohibits the assignment of a license or the transfer of control of a broadcast licensee without the prior approval of the FCC. In determining whether to grant or renew a broadcast license, the FCC considers a number of factors pertaining to the licensee, including compliance with the Communications Act's limitations on alien ownership, compliance with various rules limiting common ownership of broadcast, cable and newspaper properties, and the "character" of the licensee and those persons holding "attributable" interests therein. Under the Communications Act, broadcast licenses may not be granted to any corporation having more than one-fifth of its issued and outstanding capital stock owned or voted by aliens (including non-U.S. corporations), foreign governments or their representatives (collectively, "Aliens") or having an Alien as an officer or director. The Communications Act also prohibits a corporation without FCC waiver, from holding a broadcast license if that corporation is controlled, directly or indirectly, by another corporation, any officer of which is an Alien, or more than one-fourth of the directors of which are Aliens, or more than one-fourth of the issued and outstanding capital stock of which is owned or voted by Aliens. The FCC has issued interpretations of existing law under which these restrictions in modified form apply to other forms of business organizations, including partnerships. As a result of these provisions, in the absence of a waiver (which the FCC has granted in very limited circumstances), the Company, which serves as a holding company for its various radio station subsidiaries, cannot have more than 25% of its stock owned or voted by Aliens, and cannot have an officer who is an Alien, or more than one-fourth of its Board of Directors consisting of Aliens. Certain merchant banking partnerships (the "Lehman Investors") affiliated with Shearson Lehman Brothers Holdings, Inc. ("SLBH") hold shares of the Company's capital stock and warrants exercisable for additional shares. See "Security Ownership of Certain Beneficial Owners and Management," appearing in Part III of this Report which is incorporated by reference. Certain of the Lehman Investors and certain limited partners in the Lehman Investors may be deemed to be Aliens or controlled by Aliens or their representatives under the Communications Act. Approximately 1.51% and .72% of the Company's issued and outstanding capital stock is owned and voted, respectively, by the Lehman Investors. Assuming the exercise of all warrants held by the Lehman Investors, approximately 20.36% and 9.37% of the Company's issued and outstanding capital stock would be owned and voted, respectively, by the Lehman Investors. The warrants held by the Lehman Investors can only be exercised by the Lehman Investors to the extent such exercise would not cause the Company to violate the Communications Act's limitations on Alien ownership or control. Current FCC rules limit the number of radio broadcast stations that can be commonly owned, operated or controlled. These rules prohibit the Company from owning, operating or controlling, directly or indirectly, more than 18 AM and 18 FM radio stations in the United States provided that an entity may have a noncontrolling interest in up to 3 additional FM and 3 additional AM stations that are controlled by members of minority groups or by certain small businesses. The 18 station limitation will increase to 20 in September 1994. The Company currently owns 15 FM radio stations and 8 AM radio stations, and has entered into agreements to acquire Washington, D.C. market radio stations WPGC(AM) and WPGC(FM) and Detroit, Michigan radio station WXYT(AM). The Communications Act and FCC rules also generally limit the common ownership, operation, or control of radio broadcast stations in the same service (AM or FM) serving the same geographic market, of a radio broadcast station and a television broadcast station serving the same geographic market and of a radio broadcast station and a daily newspaper serving the same geographic market. Under these rules, absent waivers, the Company would not be permitted to acquire any newspaper or television broadcast station (other than low-power television) in a geographic market in which it now owns any radio broadcast properties. The FCC's rules provide for the liberal grant of waivers of the rule prohibiting ownership of radio and television stations in the same geographic market in the top 25 television markets if certain other conditions are satisfied. Similar newly- enacted rules provide for liberal grant of waivers of the rule prohibiting common ownership of a radio station and a newspaper in the same market in the nation's 25 largest markets. Until August 1992, the multiple ownership rules permitted the Company to own both an AM and FM station in the same geographic market, but did not allow ownership of two AM or two FM stations in the same market. As a result of the 1992 rule changes, the Company is now permitted to own up to three stations, no more than two of which are FM stations, in markets with fewer than 15 commercial stations, so long as the owned stations represent less than 50% of the stations in the market; the Company may own up to two AM and two FM stations, so long as the combined audience share of those stations does not exceed 25%. The FCC is currently considering other possible changes to some of the FCC rules governing the ownership of broadcast properties. See "Federal Regulation of Radio Broadcasting--Proposed Changes". The Company owns three stations in each of the New York City and Chicago markets, and two FM stations in the Boston and Los Angeles markets, all of which ownership combinations are consistent with the new rules. Completion of the pending Washington, D.C. and Detroit acquisitions will also be consistent with these new rules. The FCC generally applies its ownership limits to "attributable" interests held by an individual, corporation, partnership or other association. In the case of corporations holding broadcast licenses, the interests of officers, directors and those who, directly or indirectly, have the right to vote 5% or more of the corporation's stock (or 10% or more of such stock in the case of insurance companies, mutual funds, bank trust departments and certain other passive investors that are holding stock for investment purposes only) are generally attributable, as are positions of an officer or director of a corporate parent of a broadcast licensee. Currently, none of the Company's officers, directors or stockholders has an attributable interest in any company licensed to operate broadcast stations other than the Company, except that one of the Company's directors has an attributable interest in an FM radio station located in the Denver, Colorado market. Certain stockholders and a director of the Company have a non-attributable interest in another broadcasting company, which is licensed to operate radio stations in some of the markets in which the Company's radio stations are located. Because such interests are non-attributable and have been disclosed repeatedly in ownership reports filed by the Company with the FCC, and in applications filed by the Company with the FCC which were granted, the Company believes that these cross-interests are consistent with FCC rules and policies. Local Marketing Agreements. Over the past several years, a number of radio stations have entered into what have commonly been referred to as "Local Marketing Agreements", or "LMAs". While these agreements may take varying forms, under a typical LMA, separately owned and licensed radio stations agree to enter into cooperative arrangements of varying sorts, subject to compliance with the requirements of the antitrust laws and the FCC's rules and policies, including the requirement that the licensee of each station maintain independent control over the programming and station operations of its own stations. One typical type of LMA is a programming agreement among two separately-owned radio stations serving a common service area, whereby the licensee of one station programs substantial portions of the broadcast day on the other licensee's station, subject to ultimate editorial and other controls being exercised by the latter licensee, and sells advertising time during such program segments. The FCC has held that such agreements are not contrary to the Communications Act, provided that the licensee of the station that is being substantially programmed by another entity maintains complete responsibility for, and control over, the operations of its broadcast station, and assures compliance with applicable FCC rules and policies. During the past year, the Company had such an arrangement with respect to its station WZRC(AM) in New York City. The FCC's rules provide that a station brokering more than 15% of the weekly broadcast time of another station serving of the same market will be considered to have an attributable ownership interest in the brokered station for purposes of the FCC's multiple ownership rules. As a result, under these rules, a broadcast station will not be permitted to enter into an LMA or time brokerage agreement giving it the right to program more than 15% of the broadcast time, on a weekly basis, of another local station that it could not own under the FCC's local ownership rules. The FCC's rules also prohibit a broadcast licensee from simulcasting more than 25% of its programming on another station in the same broadcast service (i.e., AM-AM or FM-FM), whether it owns that other station or has a time brokerage or LMA arrangement, with it where the brokered and brokering stations serve substantially the same geographic area. Programming and Operation. The Communications Act requires broadcasters to serve the "public interest". Since the late 1970s, the FCC gradually has relaxed or eliminated many of the more formalized procedures it developed to promote the broadcast of certain types of programming responsive to the needs of a station's community of license. However, licensees continue to be required to present programming that is responsive to community problems, needs and interests and to maintain certain records demonstrating such responsiveness. Complaints from listeners concerning a station's programming often will be considered by the FCC when it evaluates renewal applications of a licensee, although such complaints may be filed at any time. Stations also must follow various rules promulgated under the Communications Act that regulate, among other things, political advertising, the broadcast of obscene or indecent material, sponsorship identifications, the advertisement of contests and lotteries, and technical operations, including limits on radio frequency radiation. In addition, licensees must develop and implement affirmative action plans designed to promote equal employment opportunities, and must submit reports to the FCC with respect to these matters on an annual basis and in connection with renewal applications. Failure to observe these or other rules and policies can result in the imposition of various sanctions, including monetary forfeitures, the grant of "short" (less than the full seven-year) renewal terms or, for particularly egregious violations, the denial of a license renewal application or the revocation of a license. In a letter dated October 25, 1989, the FCC requested the Company to respond to a complaint that it had received alleging that WXRK-FM, the Company's New York City FM radio station, had broadcast certain programming that contained "indecent" material. On December 29, 1989, the Company submitted a letter to the FCC in which it contended that WXRK-FM had not broadcast "indecent" programming. On November 29, 1990, the FCC issued a Notice of Apparent Liability for Monetary Forfeiture advising WXRK-FM (New York), WYSP-FM (Philadelphia), and WJFK-FM (Washington, D.C.) of apparent liability for forfeitures in the amount of $2,000 each for the broadcast, which was part of the Howard Stern Show and had been originated by WXRK-FM and simulcast over the other two stations. On February 11, 1991, the Company responded to this Notice, opposing the imposition of any fine and again contending that "indecent" programming had not been broadcast. On October 23, 1992, the FCC's Staff issued a Memorandum Opinion and Order in which it determined that the three stations were liable for those forfeitures. Thereafter, the Company sought reconsideration of that Order which the FCC subsequently denied. On December 30, 1993, the Company advised the FCC that it did not intend to pay the forfeiture and that it wished to avail itself of de novo U.S. District Court procedures in the _______ event that the FCC wished to continue to pursue the matter by initiating a collection suit in such court as is required by statute. On December 18, 1992, the same date on which the FCC approved the Company's acquisition of the three Cook Inlet radio stations (see "Business--Recent Developments"), the FCC issued a Notice of Apparent Liability (the "1992 NAL") advising the Company that it may be liable for a $600,000 monetary forfeiture for broadcasts over WXRK-FM, WYSP-FM, and WJFK-FM, of certain material in the Howard Stern Show that the FCC believes may be "indecent". The 1992 NAL related to broadcasts aired after the FCC's October 1989 action. The NAL stated that additional enforcement action would result if additional violations of the FCC's indecency regulations have occurred or should occur, and that further action could include additional monetary forfeitures, renewal of licenses for short terms, or proceedings focusing upon the Company's qualifications to be an FCC licensee. The Company was afforded an opportunity to show why the proposed forfeiture should not be imposed or should be reduced. On February 23, 1993, the Company filed its response with the FCC, which asserted that the cited material is not indecent and set forth several other defenses. The FCC has taken no action on the Company's response and the matter is pending. On August 12,1993, the same date on which the FCC approved the Company's acquisition of Station WIP-AM in Philadelphia, the FCC issued a Notice of Apparent Liability for a Forfeiture (the "1993 NAL") in the amount of $500,000 which was directed to the Company's subsidiaries which operate Stations WJFK-AM/FM, WXRK-FM and WYSP-FM, and which relates to the broadcast of allegedly indecent material on certain dates in November and December 1992 and January 1993. The 1993 NAL stated that if additional violations of the FCC's indecency regulations should occur, further enforcement action could include proceedings focusing upon the Company's qualifications to be a licensee. The Company submitted a response to the 1993 NAL on October 15, 1993, which vigorously asserted its position that the material is not indecent, and advanced other defenses.The FCC has taken no action on the Company's response and the matter remains pending. On August 5, 1993, Americans for Responsible Television filed a Formal Petition to Deny against the Company's application to purchase Station KRTH-FM in Los Angeles, which contended that the Company's pending proceedings at the FCC involving indecency matters should cause the FCC to conclude that the Company is unqualified to purchase KRTH. In addition, an individual filed a late-filed Petition to Deny the KRTH assignment application, which made a similar argument. The Company opposed these Petitions, and on February 1, 1994, the FCC granted the KRTH application and the Company closed the KRTH transaction on February 15, 1994. On March 3, 1994, ART filed a Petition for Reconsideration of the FCC's grant. The Company intends to vigorously oppose ART's Petition, and the current due date for the Company's Opposition is April 13, 1994. On February 1, 1994, the same date on which the FCC granted the KRTH assignment application, the FCC released an NAL in the amount of $400,000 (the"1994 NAL") directed to Stations WXRK-FM, WYSP-FM and WJFK-AM/FM relating to the broadcast of allegedly indecent material within the Howard Stern Show on four dates in August, September and October, 1993. The Company intends to vigorously assert that the material in question is not indecent and will advance other defenses in a response that is currently due on April 4, 1994. On November 15, 1993, the African American Businesses Association (AABA) filed a Petition to Deny against the application for assignment of the WPGC(AM/FM) licenses to the Company. The Petition alleges that the Company, which carries the Howard Stern Show on its Station WJFK-FM in the Washington, DC market, is unqualified to be a licensee because such show contains allegedly racist comments; that the broadcast of such show creates a hostile, racist environment at WJFK-FM in violation of civil rights laws and the FCC's equal employment opportunity rules; and that the marketing environment created by the acquisition at WPGC(AM/FM) will be hostile to African American businesses because purchase of advertising time on WPGC(AM/FM) will purportedly subsidize the broadcast of the Howard Stern Show on WJFK-FM. AABA also requests the FCC to order that the renewal application for WJFK-FM be filed by the Company one year earlier than it would otherwise be due and that the renewal application be designated for hearing and denied. On November 22, 1993, a late-filed pleading styled "Petition to Deny" was filed by an individual which replicates the argument made by the AABA. The Company filed an Opposition to both Petitions on December 2, 1993, which vigorously contested the allegations set forth in the Petitions. The WPGC(AM/FM) assignment application is pending. The Company is involved in pending proceedings at the FCC (including complaints as to which the FCC has not taken any action that were filed after the 1994 NAL) which relate to the broadcast of allegedly indecent material by certain of the Company's stations. The Company is contesting, on an informal basis, the FCC's and complainants' contentions in these proceedings. Changes in FCC policy toward indecent broadcasts or the pending proceedings against the Company or other FCC licensees for allegedly indecent broadcasts could, among other things, result in the FCC calling into question the Company's continuing fitness as a licensee and delaying the grant of, or refusing to grant, its consent to the assignment of licenses to the Company. On July 1, 1991, the Philadelphia Lesbian and Gay Task Force, the National Organization for Women (Pennsylvania Chapter and Philadelphia Chapter), and Aspira, Philadelphia (collectively, the "Petitioners") filed a Petition to Deny the license renewal application of WYSP-FM, Philadelphia, Pennsylvania, and of three other radio stations owned by other companies in the Philadelphia market. The Petition alleges that WYSP-FM's employment of women and minorities during the previous license term was not in compliance with FCC rules. On August 30, 1991, a subsidiary of the Company, Infinity Broadcasting Corporation of Pennsylvania, licensee of WYSP-FM, filed an Opposition to the Petition contesting these allegations. On January 15, 1992, the Petitioners filed a Reply, which raised no new issues. The Company believes that the Petition to Deny would be granted by the FCC only if the Petition established a prima facie case of clearly inadequate equal employment opportunity efforts by WYSP-FM. The Company believes, and its Opposition demonstrates, that WYSP's equal employment opportunity efforts were fully adequate during the previous license term and that the allegations made in the Petition, even if accepted as true, would not warrant grant of the relief requested. Accordingly, while the Company cannot predict the outcome of this matter at this time, the Company believes that the Petition to Deny will not be granted. A second Petition filed by these entities and others against several radio stations in the Philadelphia market which focused upon programming efforts was denied by the FCC in August 1993. Proposed Changes. The Congress and the FCC have under consideration, and may in the future consider and adopt, new laws, regulations and policies regarding a wide variety of matters that could, directly or indirectly, affect the operation and ownership of the Company's radio broadcast properties. Such matters include, for example, the license renewal process; proposals to impose spectrum use or other governmentally imposed fees upon licensees; the FCC's equal employment opportunity rules and other matters relating to minority and female involvement in the broadcasting industry; proposals to change rules relating to political broadcasting; proposals to increase the thresholds or benchmarks for attributing ownership interests in broadcast media; proposals to permit lenders to take a security interest in FCC licenses; technical and frequency allocation matters, including those relative to the implementation of digital audio broadcasting on both a satellite and terrestrial basis; proposals to permit expanded use of FM translator stations; proposals to restrict or prohibit the advertising of beer, wine and other alcoholic beverages on radio; proposals to allow telephone companies to deliver audio and video programming to the home through existing phone lines; and changes to broadcast technical requirements and frequency allocation matters. The Company cannot predict whether any such proposed changes will be adopted nor can it judge in advance what impact, if any, any such proposed changes might have on its business. In addition, the Company cannot predict what other changes might be considered in the future, nor can it judge in advance what impact, if any, such other changes might have on its business. ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters are located in midtown Manhattan. The types of properties required to support each of the Company's radio stations include offices, studios, transmitter sites and antenna sites. A station's studios are generally housed with its offices in downtown or business districts. The transmitter sites and antenna sites are generally located so as to provide maximum market coverage. With the exception of the Company's Houston radio station, the studios and offices of the Company's stations, as well as its corporate headquarters in New York City, are located in leased facilities with lease terms that expire in one to ten years. The Company owns or leases its transmitter and antenna sites, with lease terms that expire in one to eleven years. The Company does not anticipate any difficulties in renewing those leases that expire within the next five years or in leasing other space, if required. No one property is material to the Company's overall operations. The Company believes that its properties are in good condition and suitable for its operations; however, the Company continually looks for opportunities to upgrade its properties. The Company owns substantially all of the equipment used in its radio broadcasting business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a party to certain litigation in the ordinary course of business and also is a party to routine filings with the FCC and customary regulatory proceedings pending in connection with station acquisitions and license renewals, proceedings concerning the broadcast industry generally, and other legal and regulatory proceedings that management does not believe are material to the Company. For a description of certain matters pending before the FCC, see "Business--Federal Regulation of Radio Broadcasting--Programming and Operation", appearing elsewhere in this Report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS As reported in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, the Company's Board of Directors, pursuant to a Proxy Statement dated September 2, 1993, solicited the written consent of its stockholders to amend the Company's Restated Certificate of Incorporation. The amendment was approved by the stockholders of the Company and filed with the Secretary of State of the State of Delaware on October 22, 1993. The above information, together with additional information regarding such amendment, the number of votes cast for or withheld and the number of abstentions with respect to such amendment, is contained in the above-referenced Form 10-Q. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Shares of the Company's Class A Common Stock, par value $.002 per share (the "Class A Shares"), have been quoted on the NASDAQ National Market System under the symbol INFTA since the consummation of the Common Stock IPO in February 1992. See "Business--Background" appearing elsewhere in this Report. The following table sets forth, for the calendar quarters indicated, the high and low sales prices of the Class A Shares on the NASDAQ National Market System, as reported in published financial sources. YEAR HIGH LOW - - ---- ------ ----- 1992: First Quarter (from February 5, 1992)........... 8.33 7.56 Second Quarter.................................. 9.44 7.00 Third Quarter................................... 9.33 8.44 Fourth Quarter.................................. 11.78 8.89 1993: First Quarter................................... 13.89 10.22 Second Quarter.................................. 18.67 13.56 Third Quarter................................... 32.17 20.33 Fourth Quarter.................................. 35.67 24.75 1994: First Quarter (through March 18, 1994).......... 33.75 27.00 The above table gives effect to the stock splits effected by the Company during 1993. See Note 2 of the Notes to Company's Consolidated Financial Statements, appearing elsewhere in this Report. There is no public trading market for the Company's Class B Common Stock, $.002 per share (the "Class B Shares"), or its Class C Common Stock, $.002 per share (the "Class C Shares"). As of March 18, 1994, there were 195 holders of record of the Class A Shares (which number does not include the number of stockholders whose shares are held of record by a broker or clearing agency but does include each such brokerage house or clearing agency as one record holder). As of March 18, 1994, there were six holders of record of the Class B Shares and four holders of record of the Class C Shares. The Company has never paid dividends on its shares of common stock, and the payment of dividends is restricted by the terms of the Credit Agreement and the Indenture. See Note 5 of the Notes to the Company's Consolidated Financial Statements, appearing elsewhere in this Report. It is not anticipated that any dividends will be paid on any shares of any class of the Company's common stock in the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial information for the Company presented below under the captions "Statement of Operations Data" and "Balance Sheet Data" for, and as of the end of, each of the years in the five-year period ended December 31, 1993, is derived from the Company's Consolidated Financial Statements. This selected consolidated financial information should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations", appearing elsewhere in this Report. - - --------------- (1) The historical consolidated financial results for the Company are not comparable from year to year because of the acquisition of various broadcasting properties by the Company during the periods covered. See "Business--Background" and "Management's Discussion and Analysis of Financial Condition and Results of Operations", appearing elsewhere in this Report. (2) See Notes 1(f) and 2 of the Notes to the Company's Consolidated Financial Statements, appearing elsewhere in this Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net revenues for the year ended December 31, 1993 were $204,522,000 as compared to $150,230,000 for the year ended December 31, 1992, an increase of approximately 36%. The increase was due principally to higher advertising revenues at most of the Company's stations and the 1993 Acquisitions and the acquisition of WFAN-AM effective April 16, 1992. On a pro forma basis, assuming the above acquisitions had occurred as of the beginning of 1992, net revenues for the year ended December 31, 1993 would have increased by approximately 14%. Station operating expenses (excluding depreciation and amortization) for the year ended December 31, 1993 were $109,601,000, as compared to $81,707,000, for the year ended December 31,1992 an increase of approximately 34%. The increase was due principally to the above acquisitions, expenses associated with higher revenues and higher programming expenses. On a pro forma basis, assuming the above acquisitions had occurred as of the beginning of 1992, station operating expenses in 1993 would have increased by approximately 12%. Depreciation and amortization expense for the year ended December 31, 1993 was $38,853,000, as compared to $28,926,000 for the year ended December 31, 1992, an increase of approximately $9,927,000 or 34%. The increase was due to the depreciation and amortization expense associated with the above acquisitions, partially offset by lower depreciation and amortization expense at the Company's other radio stations. Operating income for the year ended December 31, 1993 was $51,232,000, as compared to $35,415,000 for the year ended December 31, 1992, an increase of approximately 45%. The increase was due principally to improved results at the Company's radio stations. Net financing expense (defined as interest expense less interest income) for the year ended December 31, 1993 was $36,291,000 as compared to $38,238,000 for the year ended December 31, 1992, a decrease of approximately 5% The decrease was due principally to lower interest rates during 1993. Net earnings before extraordinary items for the year ended December 31, 1993 was $14,335,000 ($0.35 per share) as compared to a net loss of $9,432,000 ($0.30 per share) for the year ended December 31, 1992, an increase of approximately $23,767,000. As a result of the Common Stock IPO in February 1992, the Company recorded in 1992 a non-recurring charge of approximately $6,503,000, resulting from the issuance in 1990 of Common Stock to management. In 1992, the Company recorded extraordinary charges of approximately $12,318,000, including the write-off of deferred financing costs of approximately $7,416,000, as a result of (a) the redemption of all of the remaining, approximately $98,000,000 principal amount of the Company's 14.25% Subordinated Discount Debentures (the "14.25% Subordinated Debentures"), and (b) the refinancing of the Company's then existing bank credit agreement. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net revenues for the year ended December 31, 1992 were $150,230,000, as compared to $117,959,000 for the year ended December 31, 1991, an increase of approximately $32,271,000, or 27%. The increase was due principally to the acquisition of New York radio station WFAN-AM, effective April 16, 1992, revenues associated with the various sports broadcasting rights, and higher local advertising revenues generally at the Company's stations in Los Angeles, New York, Detroit, Tampa/St. Petersburg, Philadelphia, Chicago, and Washington, D.C., partially offset by lower revenues at the Company's stations in Dallas/Fort Worth. On a pro forma basis, assuming the acquisition of WFAN-AM had occurred as of the beginning of 1991, net revenues in 1992, as compared to 1991, would have increased by approximately 8%. Station operating expenses (excluding depreciation and amortization) for the year ended December 31, 1992 were $81,707,000, as compared to $61,207,000 for the year ended December 31, 1991, an increase of approximately $20,500,000, or 33%. The increase was due principally to the acquisition of WFAN-AM and costs associated with various sports broadcasting rights. On a pro forma basis, assuming the acquisition of WFAN-AM had occurred as of the beginning of 1991, station operating expenses in 1992, as compared to 1991, would have increased by approximately 8%. Depreciation and amortization expense for the year ended December 31, 1992 was $28,926,000, as compared to $25,582,000 for the year ended December 31, 1991, an increase of approximately $3,344,000, or 13%. The increase was due to the acquisition of WFAN-AM. Operating income for the year ended December 31, 1992 was $35,415,000, as compared to $27,472,000 for the year ended December 31, 1991, an increase of approximately $7,943,000, or 29%. The increase was due principally to higher net revenues. Net financing expense (defined as interest expense less interest income) for the year ended December 31, 1992 was $38,238,000, as compared to $51,492,000 for the year ended December 31, 1991, a decrease of approximately 26%. The decrease was due principally to lower total borrowings, as well as lower interest rates during 1992. The Company's net financing expenses consist principally of interest on borrowings under its bank credit agreement and of interest on the 10 3/8% Senior Subordinated Notes Due 2002, which were sold to the public in March 1992. The Company redeemed all of its outstanding 14.25% Subordinated Debentures in 1992. Net loss before extraordinary items for the year ended December 31, 1992 was $9,432,000, as compared to a net loss of $24,026,000 for the year ended December 31, 1991, a decrease of approximately 61%. As a result of the Common Stock IPO in February 1992, the Company recorded a non-recurring, non-cash charge of approximately $6,503,000 during the first quarter of 1992, resulting from the issuance in 1990 of approximately 836,107 shares of the Company's common stock to management. Excluding the effect of this non-cash charge, net loss before extraordinary items for the year ended December 31, 1992 would have been $2,929,000, as compared to $24,026,000 for the year ended December 31, 1991, a decrease of approximately 88%. For the year ended December 31, 1992, the Company recorded extraordinary charges of approximately $12,318,000, including the write-off of non-cash deferred financing costs of approximately $7,416,000, as a result of (a) the redemption of all of the remaining, approximately $98,000,000 principal amount of the Company's 14.25% Subordinated Debentures, at a cost of approximately $102,900,000, and (b) the refinancing of the Company's bank credit agreement, in September 1992, in connection with the execution of a new bank credit agreement. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources", appearing elsewhere in this Report. The Company recorded an extraordinary gain of approximately $18,020,000 during 1991, as a result of the purchase of approximately $87 million principal amount of its 14.25% Subordinated Debentures at a discount. LIQUIDITY AND CAPITAL RESOURCES The Company's primary needs for capital are to make acquisitions of radio stations and to cover debt service payments on its indebtedness. The Company's radio stations do not typically require substantial investments in capital expenditures. For the year ended December 31, 1993, net cash flow from operating activities was approximately $45,211,000, as compared to $18,310,000 for the year ended December 31, 1992, an increase of approximately $26,901,000 or 147%. The increase was principally due to improved earnings in 1993 partially offset by higher working capital requirements. In February 1993, the Company borrowed $103 million under the Credit Agreement to finance the acquisition and working capital of radio stations WZGC-FM, WZLX-FM and WUSN-FM. In September 1993, the Company borrowed approximately $18 million under the Credit Agreement to finance the acquisition and working capital of WIP-AM. On May 13, 1993, the Company completed the Second Common Stock Offering for net proceeds to the Company of approximately $100 million (including approximately $10.1 million paid to the Company upon exercise of certain warrants sold in the offering). The net proceeds from the offering were used to pay down borrowings under the acquisition facility under the Credit Agreement. The net cash flow from operating activities of approximately $45.2 million together with total cash from financing activities of approximately $78.1 million were used to finance acquisitions and capital expenditures of $123.3 million. The Credit Agreement contains various covenants and restrictions that impose certain limitations on the Company and its subsidiaries, including, among others, limitations on the incurrence of additional indebtedness by the Company or its subsidiaries, the payment of cash dividends or other distributions, the redemption or repurchase of the capital stock of the Company, the issuance of additional capital stock of the Company, the making of investments and acquisitions, and other similar limitations. Under the terms of a Security Agreement among the Company, its subsidiaries, and one of the banks acting as collateral agent, substantially all of the assets of the Company and its subsidiaries, as well as the stock of the Company's subsidiaries, are pledged to secure borrowings under the Credit Agreement. The Credit Agreement provides for the repayment of borrowings on a quarterly basis through September 2000. See Note 5 of the Notes to the Company's Consolidated Financial Statements. The Credit Agreement also permits voluntary prepayments in whole or in part at any time, and it requires mandatory prepayments under specified circumstances. In February 1994, the Company borrowed approximately $116 million under the Credit Agreement to finance the acquisition of Los Angeles radio station KRTH-FM. The Company is currently negotiating with its Agent Bank under the Credit Agreement to increase its acquisition facility by $150 million. The purchase price of the pending acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by additional bank borrowings. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this Item is included on Pages through of this Report on Form 10-K and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information called for by this Item is not applicable. PART III The information required in this Part is incorporated by reference from the registrant's definitive proxy statement (to be filed pursuant to Regulation 14A). PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements. 2. Financial Statement Schedules. The financial statements and schedules listed in the index to the Consolidated Financial Statements of the Company that appears on Page 31 of this Report on Form 10-K are filed as part of this Report. 3. Exhibits. Exhibit Number Description of Exhibit _______ ______________________ 2(a) Securities Purchase Agreement, dated as of September 30, 1991, by and among the Company, Michael A. Wiener, Gerald Carrus, Mel Karmazin, and Shearson Lehman Hutton Capital Partners II, L.P., Shearson Lehman Hutton Merchant Banking Portfolio Partnership L.P., Shearson Lehman Hutton Offshore Investment Partnership L.P., and Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. (collectively, the "Lehman Investors"). (This exhibit can be found as Exhibit 2(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-14702) and is incorporated herein by reference.) 2(b) Stock Purchase Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and KPWR, Inc. (This exhibit can be found as Exhibit 2(c) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(c) Assignment and Assumption Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and the Company. (This exhibit can be found as Exhibit 2(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(d) Asset Purchase Agreement, dated as of August 15, 1992, between Cook Inlet Radio Partners, L.P., Cook Inlet Radio License Partnership, L.P., Infinity Broadcasting Corporation of Chicago, Infinity Broadcasting Corporation of Atlanta, Infinity Broadcasting Corporation of Boston and the Company. (This exhibit can be found as Exhibit 2(c) to the Company's Quarterly Report on Form 10-Q for the quarter Exhibit Number Description of Exhibit _______ ______________________ ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(e) Asset Purchase Agreement, dated as of September 25, 1992, between Spectacor Broadcasting, L.P. and Infinity Broadcasting Corporation of Philadelphia. (This exhibit can be found as Exhibit 2(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(f) Purchase Agreement, dated as of June 16, 1993, among Beasley FM Acquisition Corp., Infinity Broadcasting Corporation of California and the Company. (This exhibit can be found as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(g) Asset Purchase Agreement, dated as of October 4, 1993, between Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. and Infinity Broadcasting Corporation of Maryland and the Company. (This exhibit can be found as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(h) Asset Purchase Agreement, dated as of March 8, 1994, by and between Fritz Broadcasting, Inc., Infinity Broadcasting Corporation of Detroit and the Company, including a list of omitted schedules and an undertaking by the Company to furnish supplementally a copy of any such omitted schedule to the Securities and Exchange Commission upon request. 3(a) Restated Certificate of Incorporation of the Company, as amended October 22, 1993. (This exhibit can be found as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 3(b) Amended and Restated By-Laws of the Company. (This exhibit can be found as Exhibit 3(b) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(a) Indenture, dated as of March 24, 1992, between the Company and Bank of Montreal Trust Company, as Trustee. (This exhibit can be found as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (Registration No. 33-61348) and is incor- porated herein by reference.) 4(b) Credit Agreement, dated as of September 22, 1992, by and among the Company, Hemisphere Broadcasting Corporation, Sagittarius Broadcasting Corporation, each of the sub- sidiaries of the Company identified under the caption "Subsidiary Guarantors" on the sig- nature page thereof, each of the banks that is a signatory thereto (collectively, the "Banks"), The Chase Manhattan Bank (National Association) as Administrative Agent for the Banks, Bank of Montreal, The Bank of New York, and Chemical Bank as co-agents for the Banks, and Chemical Bank as collateral agent for the Banks. (This exhibit can be found as Exhibit 4(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(c) Amendment No. 1, dated as of December 1, 1992, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4(c) to the Company's Report on Form 8-K filed on February 12, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(d) Amendment No. 2, dated as of May 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signatories thereto. (This exhibit can be found as Exhibit 4(a) to Exhibit Number Description of Exhibit _______ ______________________ the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(e) Amendment No. 3, dated as of August 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (file No. 0-14702) and is incorporated herein by reference.) 4(f) Security Agreement, dated as of September 22, 1992, by and among the Company, each of the subsidiaries of the Company identified under the caption "Subsidiaries" on the signature page thereof, and Chemical Bank, as col- lateral agent for the lenders or other finan- cial institutions or entities party, as lenders, to the Credit Agreement. (This exhibit can be found as Exhibit 4(k) to the Company's Quarterly Report on Form l0-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(g) Amended and Restated Stockholders' Agreement, dated as of February 5, 1992, among the Com- pany, Michael A. Wiener, Gerald Carrus, Mel Karmazin and the Lehman Investors. (This exhibit can be found as Exhibit 4(j) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(h) Warrant Certificate, dated January 28, 1992, certifying that Shearson Lehman Hutton Capital Partners II L.P. is the owner of warrants to purchase 1,051,977 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(l) to the Company's Regis- tration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incor- porated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 4(i) Warrant Certificate, dated January 28, 1992, certifying that Lehman Brothers Merchant Banking Portfolio Partnership L.P. is the owner of warrants to purchase 1,547,373 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(m) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(j) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership L.P. is the owner of warrants to purchase 769,465 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(k) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. is the owner of warrants to purchase 2,317,522 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(l) Securities Exchange Agreement, dated as of January 28, 1992, among the Company and the Lehman Investors. (This exhibit can be found as Exhibit 4(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(a)* Employment Agreement, dated as of December 30, 1985, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(a) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(b)* Employment Agreement, dated as of December 30, 1985, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(b) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(c)* Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 28(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990 (File No. 0-14702) and is incorporated herein by reference.) 10(d)* First Amendment, dated September 30, 1991, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 10(e)* Second Amendment, dated February 4, 1992, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(e) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(f)* Third Amendment, effective as of June 14, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(g)* Fourth Amendment, effective as of August 16, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(h)* Fifth Amendment, effective as of November 19, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(i)* Sixth Amendment to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin, effective as of March 30, 1994 (subject in part to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(j)* The Company's Stock Option Plan, amended and restated as of August 16, 1993. 10(k)* Amendment, effective as of November 19, 1993, to the Company's Stock Option Plan, as amended and restated as of August 16, 1993. 10(l)* Amendment, adopted March 30, 1994 (subject to shareholder approval at the annual meeting of the Company's shareholders to be held June 13, 1994) to the Company's Stock Option Plan. 10(m)* The Company's Deferred Share Plan, amended and restated as of August 16, 1993. ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(n)* Amendment, effective as of November 19, 1993, to the Company's Deferred Share Plan, as amended and restated as of August 16, 1993. 10(o)* The Company's Cash Bonus Compensation Plan, adopted on March 30, 1994 (subject to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(p)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(f) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(q)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(g) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(r)* Indemnity Agreement, dated as of February 7, 1986, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(h) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(s) Indemnity Agreement, dated as of June 22, 1987, between the Company and Farid Suleman. (This exhibit can be found as Exhibit 10(j) to the Company's Registration Statement on Form S-1 (Registration No. 33-15285) and is incorporated herein by reference.) 10(t) Indemnity Agreement, dated as of February 4, 1992, between the Company and Steven A. Lerman. (This exhibit can be found as Exhibit 10(l) to the Company's Registration Statement on Forms S-1 and S-3 (Registration ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ No. 33-46118) and is incorporated herein by reference.) 10(u) Indemnity Agreement, dated as of November 9, 1992, between the Company and Alan R. Batkin. (This exhibit can be found as Exhibit 10(m) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(v)* Indemnity Agreement, dated as of November 9, 1992, between the Company and O.J. Simpson. (This exhibit can be found as Exhibit 10(n) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(w)* Stock Option Agreement, dated as of June 27, 1988, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit (c)(2) to the Statement on Schedule 13E-3 filed pursuant to Rule 13e-3 by WCK, the Management Investors (Michael A. Wiener, Gerald Carrus and Mel Karmazin) and the Company and is incorporated herein by reference.) 10(x)* Amendment Agreement, dated as of August 2, 1988, to Stock Option Agreement dated as of June 27, 1988, between the Company, as suc- cessor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 9(c)(7) to Amendment No. 3 to Schedule 14D-1 filed by the Company as successor to WCK and is incor- porated herein by reference.) 10(y)* Amendment No. 1 to Stock Option Agreement, dated as of October 14, 1988, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 4(l) to the Company's Annual Report on Form 10-K for the year ended ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ December 25, 1988 (File No. 0-14702) and is incorporated herein by reference.) 10(z)* Agreement, dated as of July 26, 1993, between the Company and Mel Karmazin, with respect to the exercise of certain options granted pur- suant to the Stock Option Agreement, dated as of June 27, 1988, as amended, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(aa) Warrant Certificate, dated September 30, 1991, certifying that Mel Karmazin is the owner of warrants to purchase shares of Class A Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 10(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(bb) Management Agreement, dated February 17, 1993, by and among the Company, Unistar Com- munications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A., National Westminster Bank, USA, and Novastar, Inc. (This exhibit can be found as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(cc) Amended and Restated Management Agreement, dated September 29, 1993, among the Company, Unistar Communications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A. and Novastar, Inc. (This exhibit can be found as Exhibit 10(a) to the Com- pany's Quarterly Report on Form 10-Q for the ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ quarter ended September 30, 1993 (File No. 0- 14702) and is incorporated herein by refer- ence.) 10(dd) Amended and Restated Credit Agreement, Pur- chase and Release Agreement, dated as of February 3, 1994, among Unistar Radio Networks, Inc. (formerly known as Unistar Holdings, Inc.), UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), TMRG, Inc. (formerly known as The Market Research Group, Inc.), The Chase Manhattan Bank (National Association), as lender and as agent, the Company and Novastar, Inc. 10(ee) Securities Purchase Agreement, dated as of November 4, 1993, between Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(ff) Stock Purchase Agreement, dated as of November 4, 1993, among UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), Unistar Radio Networks, Inc., the Company and Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(a) to the Company's Report on Form 8-K filed on November 17, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(gg) Management Agreement, dated as of February 3, 1994, between Westwood One, Inc. and the Company. 21 Subsidiaries of the Company. 23 Consent of KPMG Peat Marwick, Independent Certified Public Accountants. (b) Reports on Form 8-K. The Company filed a Report on Form 8-K, dated November 4, 1993, with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. on November 17, 1993, reporting in response to Item 5 of the Form 8-K. The Report on Form 8-K contained the consolidated financial statements at November 30, 1992 of Westwood One, 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, on the 30th day of March, 1994. INFINITY BROADCASTING CORPORATION BY /S/ MICHAEL A. WIENER .................................. Michael Wiener Chairman of the Board of Directors 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. /s/ Michael A. Wiener March 30, 1994 ........................ ............... Michael A. Wiener Date Chairman of the Board of Directors and Secretary /s/ Gerald Carrus March 30, 1994 .................. .............. Gerald Carrus Date Co-Chairman of the Board of Directors and Treasurer /s/ Mel Karmazin March 30, 1994 ........................ ............... Mel A. Karmazin Date Director, President, and Chief Executive Officer /s/ Farid Suleman March 30, 1994 .................. .............. Farid Suleman Date Director, Vice President--Finance, and Chief Financial Officer * /s/ James A. Stern March 30, 1994 ........................ .............. James A. Stern Date Director /s/ James L. Singleton March 30, 1994 ....................... .............. James L. Singleton Date Director /s/ Steven A. Lerman March 30, 1994 ........................ .............. Steven A. Lerman Date Director /s/ Alan R. Batkin March 30, 1994 ........................ .............. Alan R. Batkin Date Director /s/ O.J. Simpson March 30, 1994 ........................ .............. O.J. Simpson Date Director - - --------------- * Mr. Suleman also performs the functions of Chief Accounting Officer INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY INDEPENDENT AUDITORS' REPORT (ITEM 14(A)1) Independent Auditors' Report............................................ Consolidated balance sheets as of December 31, 1992 and 1993............. Consolidated statements of operations for each of the years in the three-year period ended December 31, 1993............................ Consolidated statements of changes in stockholders' equity (deficiency) for each of the years in the three-year period ended December 31,1993.... Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993............................ Notes to consolidated financial statements.............................. Financial statement schedules for each of the years in the three-year period ended December 31, 1993 VIII Valuation and qualifying accounts.................................. X Supplementary income statement information......................... All other schedules have been omitted because the required information either is not applicable or is shown in the consolidated financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Stockholders Infinity Broadcasting Corporation: We have audited the consolidated financial statements of Infinity Broadcasting Corporation 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 Infinity Broadcasting Corporation and subsidiaries as of December 31, 1992 and 1993, 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 New York, New York February 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, which are wholly owned and are all involved in radio broadcasting. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Revenue Recognition Revenues are recognized when advertisements are aired. (c) Property and Equipment Depreciation is provided on a straight line basis for financial statement purposes over the estimated useful lives of the related assets as follows: Buildings........................................ 18 years Machinery and equipment.......................... 3-10 years Leasehold improvements........................... Life of lease Furniture and fixtures........................... 10 years (d) Intangible Assets Intangible assets arising from acquisitions are amortized on a straight-line basis over their useful lives ranging generally from 3 to 40 years. (e) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the asset and liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. (f) Earnings Per Share Earnings (loss) per common share are based on the weighted average number of common shares and common equivalent shares (where inclusion of such equivalent shares would not be anti-dilutive) outstanding during the year. (g) Cash Equivalents Cash equivalents include certificates of deposit and commercial paper with maturities of one month or less. NOTE 2. PUBLIC STOCK OFFERINGS On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock, through an initial public offering (the "Common Stock IPO") sold 13,788,826 shares of Class A Common Stock, resulting in net proceeds to the Company of approximately $100.1 million before expenses of approximately $1.6 million. As a result of the Company's Common Stock IPO, the Company in the First Quarter of 1992 recorded a non-recurring non-cash charge of approximately $6,503,000, resulting from the issuance in 1990 of approximately 836,107 deferred shares of the Company's Common Stock to management. On May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold through a public offering 8,148,814 shares of Class A Common Stock resulting in net proceeds to the Company of approximately $100 million. The net proceeds from this offering were used to pay down bank borrowings under the Company's bank credit agreement (the "Credit Agreement"). Effective August 9, 1993, the Company declared a three-for-two stock split in the form of a stock dividend payable on August 16, 1993 to shareholders of record at the close of business on August 9, 1993. Effective November 12, 1993, the company declared another three-for-two stock split in the form of a stock dividend payable on November 19, 1993 to shareholders of record at the close of business on November 12, 1993. During 1993, in connection with these stock splits, the Company increased the number of authorized shares of its Class A Common Stock to 75,000,000, Class B Common Stock to 17,500,000 and Class C Common Stock to 30,000,000. The accompanying consolidated financial statements reflect the effect of the stock dividends. On December 7, 1993, certain merchant banking partnerships affiliated with Lehman Brothers Inc. and certain officers of the Company sold in a secondary offering 5,550,000 shares of Class A Common Stock. NOTE 3. ACQUISITIONS On April 16, 1992, the Company acquired WFAN-AM, a radio station serving New York City, for approximately $70 million. On February 1, 1993, the Company acquired the assets of WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for a total purchase price of approximately $100 million. On September 1, 1993, the Company acquired WIP-AM, an all-sports radio station serving Philadelphia, from Spectacor Broadcasting, L.P. for approximately $17.4 million. The above acquisitions have been accounted for by the purchase method of accounting. The purchase price has been allocated to the assets acquired, principally intangible assets, including covenants not to compete, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill. The operating results of these acquisitions are included in the Company's consolidated results of operations from the date of acquisition. The following unaudited pro forma summary presents the consolidated results of operations as if the acquisitions had occurred as of the beginning of 1992 and 1993, after giving effect to certain adjustments, including amortization of goodwill and interest expense on the acquisition debt. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or of results which may occur in the future. Years Ended December 31, ------------------------ 1992 1993 ---------- ---------- (Unaudited) Net revenues.................................... $ 183,935 $ 210,317 Net earnings (loss) before extraordinary items.. (23,287) 13,524 Net earnings (loss)............................. (35,605) 13,524 Earnings (loss) per common share: Before extraordinary items...................... (.74) .33 Extraordinary items............................. (.39) -- ---------- ---------- Net earnings (loss) per common share............ (1.13) .33 ========== ========== On October 4, 1993, the Company entered into an agreement to acquire Washington, D.C. radio stations WPGC-AM/FM from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire Detroit radio station WXYT-AM for approximately $23 million from Fritz Broadcasting Inc. The purchase price of the acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by bank borrowings. In February 1994, the Company completed the acquisition of Los Angeles radio station KRTH-FM from Beasley FM Acquisitions Corp. for approximately $116 million. The purchase price of the acquisition was funded by borrowings under the Credit Agreement. On February 17, 1993, the Company entered into an agreement to manage the business and operations of Unistar Communications Group, Inc. ("UCG") and its subsidiaries. UCG is the parent of Unistar Radio Networks, Inc. ("Unistar"), the country's fourth-largest provider of radio network programming services. Under the terms of this agreement, as amended, the Company received at no cost approximately 20.23% of UCG's issued and outstanding capital stock, an option to acquire the remaining capital stock of UCG for a nominal price under certain conditions, and an annual management fee of approximately $2 million. On February 3, 1994, the Company, Unistar and Westwood One, Inc. ("Westwood One") completed the purchase by Westwood One of the radio network business of Unistar for approximately $101.3 million. Westwood One is the nation's largest producer and distributor of nationally sponsored radio programs. In connection with the transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and an option to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company's Chief Executive Officer and Chief Financial Officer became the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One pursuant to a Management Agreement between the Company and Westwood One. Under the management agreement, the Company will receive a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. NOTE 4. DEPRECIATION AND AMORTIZATION - - --------------- (a) At December 31, 1993, the Company's Credit Agreement provided for aggregate borrowings of up to approximately $295 million, including an acquisition facility of $115 million and a working capital facility of $30 million. The Credit Agreement provides for quarterly principal payments through September 30, 2000. Under the Credit Agreement, interest is payable quarterly, based on the (i) prime rate or (ii) London Interbank Offer Rate. In the normal course of business, the Company enters into a variety of interest rate protection agreements, options and swaps, in order to limit its exposure due to adverse fluctuations in interest rates. These instruments are executed with creditworthy financial institutions. As of December 31, 1993, the Company has entered into various interest rate protection agreements under which the Company's interest rate on $80 million of borrowings under the Credit Agreement is fixed at between 4.80% and 5.25% per annum, expiring in the first quarter of 1996. (b) On March 24, 1992, the Company sold $200 million principal amount of its 10 3/8% Senior Subordinated Notes due 2002, through a public offering for net proceeds to the Company of approximately $195 million. At December 31, 1993, the fair value of the Company's 10 3/8% Senior Subordinated Notes was estimated to be $215,000,000 based on the quoted market prices for the same issue. The scheduled maturities of long-term debt for the next five years and after are as follows: YEAR ENDING DECEMBER AMOUNT ------------------------------------------- -------------- (In Thousands) 1994....................................... $ 22,312 1995....................................... 15,170 1996....................................... 20,227 1997....................................... 20,227 1998....................................... 25,478 After 1998................................. 261,648 ------------- $ 365,062 ============= The debt agreements contain, among other things, restrictions on additional borrowings, capital expenditures, leases, sale of assets or common stock of subsidiaries, and payment of cash dividends. As of December 31, 1993, no earnings were available for payment of dividends. Substantially all of the assets of the Company and the common shares of its subsidiaries are pledged as collateral under the Credit Agreement. For years ended 1991, 1992 and 1993, the Company paid cash for interest of $32,066,000, $40,891,000 and $34,625,000, respectively. NOTE 6. EMPLOYEE AND OTHER POST RETIREMENT BENEFIT PLANS The Company has a qualified 401(k) profit sharing plan covering substantially all of its non-union full-time employees. For the years ended December 31, 1991, 1992 and 1993, no contributions to this plan were made by the Company. The Company does not provide any post retirement health care and life insurance benefits to its employees and accordingly, has no liabilities for such benefits. NOTE 7. INCOME TAXES The provision for income taxes for the years ended December 31, 1991, 1992 and 1993, consisting of current state and local taxes, was $6,000, $106,000 and $606,000, respectively. No federal income taxes were provided in 1991, 1992 and 1993 as a result of net losses incurred and available net loss carryforwards for each period. At December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes which expire from 2004 to 2008 of approximately $73 million. As discussed in note 1, the Company adopted FAS No. 109 as of January 1, 1993. There was no effect on the consolidated balance sheet as of December 31, 1993 of implementing FAS 109 as the value of the deferred tax asset resulting from the net operating loss carryforwards was offset by a valuation allowance of equal amount. For the years ended December 31, 1991, 1992 and 1993, the Company paid cash for income taxes of $33,000, $714,000 and $135,000, respectively. NOTE 8. EMPLOYEE STOCK PLANS Employee Stock Option Plan. The Company's 1988 Employee Stock Option Plan as amended provides for a grant of options to purchase 2,664,350 shares of the Company's Class A Common Stock and 187,500 shares of Class B Common Stock. The options are exercisable in equal amounts generally over five years from the date of grant. At December 31, 1992 and 1993, options for 686,700 and 905,981 shares, respectively, of Class A Common Stock were exercisable. Employee Deferred Share Plan. The Deferred Share Plan permits the grant of up to 240,641 Class A Deferred Shares and 782,969 Class B Deferred Shares to executives or other key employees of the Company. The following is a table summarizing the changes during the years ended December 31, 1992 and 1993 in options and deferred shares outstanding: CLASS A COMMON STOCK --------------------------- DEFERRED EXERCISE SHARES AND PRICE PER OPTIONS SHARE ------------ ------------ Outstanding as of December 31, 1991........... 1,203,196 $.001-.1333 Granted/Issued................................ 556,875 7.78 Canceled...................................... (50,076) .04-7.78 Exercised..................................... (58,495) .1333 ---------- Total outstanding as of December 31, 1992....... 1,651,500 Granted/Issued.................................. 963,750 8.78-26.00 Canceled........................................ -- -- Exercised................................ ..... (173,900) .1333-8.78 ----------- Total outstanding as of December 31, 1993....... 2,441,350 =========== NOTE 9. STOCKHOLDERS' EQUITY Each share of Class A Common Stock and each share of Class C Common Stock is entitled to one vote per share. Each share of Class B Common Stock is generally entitled to ten votes per share. Shares of Class B Common Stock and Class C Common Stock, at the option of the holder, may be converted at any time into an equal number of shares of Class A Common Stock. Each share of Class B Common Stock and Class C Common Stock automatically converts into one share of Class A Common Stock upon the sale, gift, or other transfer of such share to any person other than an associate of the Company (as defined) and upon certain other events. During 1988, the Company issued options with an exercise price of $.027 per share to an officer of the Company to purchase 2,107,998 shares of the Company's Class B Common Stock. During 1992 and 1993 options to purchase 33,750 and 134,942 shares were exercised. The Company has reserved 32,439 shares of Class A Common Stock, 2,051,807 shares of Class B Common Stock and 8,935,526 shares of Class C Common Stock for issuance upon the exercise of certain warrants and options outstanding as of December 31, 1993. NOTE 10. RELATED PARTY TRANSACTIONS The Company leases office space from an affiliate which is owned 70% by certain stockholders. The lease expires on December 31, 1998 and provides for an annual rent of $145,380 subject to certain annual adjustments. As of December 31, 1992 and 1993, the Company has loans receivable from certain stockholders amounting to $1,200,000 in the aggregate. Such loans, payable on June 1, 1994, are non-interest bearing and are included as other assets in the accompanying consolidated balance sheets. As of December 31, 1993, the Company had accounts receivable from Unistar amounting to approximately $204,000. NOTE 11. EXTRAORDINARY ITEMS In 1991, the Company purchased approximately $87 million principal amount of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary gain of approximately $18 million. On March 24, 1992, the Company called for the redemption of all of the remaining approximately $98,000,000 of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary loss of approximately $8,277,000. On September 22, 1992, the Company entered into a new credit agreement which replaced its prior bank credit agreement and which resulted in an extraordinary loss of $4,041,000. NOTE 12. COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries occupy certain office space and transmitting facilities under lease agreements expiring at various dates through 2004. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Most leases provide for escalation of rent based on increases in the Consumer Price Index and/or real estate taxes. The following is a summary of the future minimum rental commitments under existing leases: YEAR ENDING DECEMBER 31, AMOUNT ------------------------------------------ -------------- (In Thousands) 1994...................................... $ 3,766 1995...................................... 3,897 1996...................................... 3,740 1997...................................... 2,664 1998...................................... 2,556 After 1998................................ 7,343 -------------- $ 23,966 ============== Rent expense applicable to such leases amounted to approximately $2,049,000, $2,354,000 and $3,079,000 for the years ended December 31, 1991, 1992 and 1993, respectively. At December 31, 1993, the Company is committed to the purchase of broadcast rights for various sports events and other programming including on-air talent, aggregating approximately $62.5 million. The aggregate payments related to these commitments during the next five years are as follows: AMOUNT -------------- (In Thousands) 1994.................................... $ 26,475 1995.................................... 26,721 1996.................................... 6,203 1997.................................... 2,894 1998.................................... 179 -------------- $ 62,472 ============== NOTE 13. INTANGIBLE AND OTHER ASSETS Intangible assets at cost, as of December 31, 1992 and 1993 include: 1992 1993 -------- -------- (In Thousands) Franchise interests................ $214,458 $259,582 Favorable leasehold interest....... 30,708 30,542 Other, principally covenants....... not to complete.................. 45,068 60,000 -------- -------- $290,234 $350,124 ========= ========= Other assets include principally deferred financing costs and are amortized over the term of the financing. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements. 2. Financial Statement Schedules. The financial statements and schedules listed in the index to the Consolidated Financial Statements of the Company that appears on Page 31 of this Report on Form 10-K are filed as part of this Report. 3. Exhibits. Exhibit Number Description of Exhibit _______ ______________________ 2(a) Securities Purchase Agreement, dated as of September 30, 1991, by and among the Company, Michael A. Wiener, Gerald Carrus, Mel Karmazin, and Shearson Lehman Hutton Capital Partners II, L.P., Shearson Lehman Hutton Merchant Banking Portfolio Partnership L.P., Shearson Lehman Hutton Offshore Investment Partnership L.P., and Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. (collectively, the "Lehman Investors"). (This exhibit can be found as Exhibit 2(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991 (File No. 0-14702) and is incorporated herein by reference.) 2(b) Stock Purchase Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and KPWR, Inc. (This exhibit can be found as Exhibit 2(c) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(c) Assignment and Assumption Agreement, dated as of December 16, 1991, between Infinity Broadcasting Corporation of New York and the Company. (This exhibit can be found as Exhibit 2(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 2(d) Asset Purchase Agreement, dated as of August 15, 1992, between Cook Inlet Radio Partners, L.P., Cook Inlet Radio License Partnership, L.P., Infinity Broadcasting Corporation of Chicago, Infinity Broadcasting Corporation of Atlanta, Infinity Broadcasting Corporation of Boston and the Company. (This exhibit can be found as Exhibit 2(c) to the Company's Quarterly Report on Form 10-Q for the quarter Exhibit Number Description of Exhibit _______ ______________________ ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(e) Asset Purchase Agreement, dated as of September 25, 1992, between Spectacor Broadcasting, L.P. and Infinity Broadcasting Corporation of Philadelphia. (This exhibit can be found as Exhibit 2(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 2(f) Purchase Agreement, dated as of June 16, 1993, among Beasley FM Acquisition Corp., Infinity Broadcasting Corporation of California and the Company. (This exhibit can be found as Exhibit 2(e) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(g) Asset Purchase Agreement, dated as of October 4, 1993, between Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. and Infinity Broadcasting Corporation of Maryland and the Company. (This exhibit can be found as Exhibit 2(f) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 2(h) Asset Purchase Agreement, dated as of March 8, 1994, by and between Fritz Broadcasting, Inc., Infinity Broadcasting Corporation of Detroit and the Company, including a list of omitted schedules and an undertaking by the Company to furnish supplementally a copy of any such omitted schedule to the Securities and Exchange Commission upon request. 3(a) Restated Certificate of Incorporation of the Company, as amended October 22, 1993. (This exhibit can be found as Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 3(b) Amended and Restated By-Laws of the Company. (This exhibit can be found as Exhibit 3(b) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(a) Indenture, dated as of March 24, 1992, between the Company and Bank of Montreal Trust Company, as Trustee. (This exhibit can be found as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (Registration No. 33-61348) and is incor- porated herein by reference.) 4(b) Credit Agreement, dated as of September 22, 1992, by and among the Company, Hemisphere Broadcasting Corporation, Sagittarius Broadcasting Corporation, each of the sub- sidiaries of the Company identified under the caption "Subsidiary Guarantors" on the sig- nature page thereof, each of the banks that is a signatory thereto (collectively, the "Banks"), The Chase Manhattan Bank (National Association) as Administrative Agent for the Banks, Bank of Montreal, The Bank of New York, and Chemical Bank as co-agents for the Banks, and Chemical Bank as collateral agent for the Banks. (This exhibit can be found as Exhibit 4(j) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(c) Amendment No. 1, dated as of December 1, 1992, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4(c) to the Company's Report on Form 8-K filed on February 12, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(d) Amendment No. 2, dated as of May 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signatories thereto. (This exhibit can be found as Exhibit 4(a) to Exhibit Number Description of Exhibit _______ ______________________ the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 4(e) Amendment No. 3, dated as of August 31, 1993, to the Credit Agreement, dated as of September 22, 1992, among the Company, its subsidiaries and the banks that are signa- tories thereto. (This exhibit can be found as Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (file No. 0-14702) and is incorporated herein by reference.) 4(f) Security Agreement, dated as of September 22, 1992, by and among the Company, each of the subsidiaries of the Company identified under the caption "Subsidiaries" on the signature page thereof, and Chemical Bank, as col- lateral agent for the lenders or other finan- cial institutions or entities party, as lenders, to the Credit Agreement. (This exhibit can be found as Exhibit 4(k) to the Company's Quarterly Report on Form l0-Q for the quarter ended September 30, 1992 (File No. 0-14702) and is incorporated herein by reference.) 4(g) Amended and Restated Stockholders' Agreement, dated as of February 5, 1992, among the Com- pany, Michael A. Wiener, Gerald Carrus, Mel Karmazin and the Lehman Investors. (This exhibit can be found as Exhibit 4(j) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(h) Warrant Certificate, dated January 28, 1992, certifying that Shearson Lehman Hutton Capital Partners II L.P. is the owner of warrants to purchase 1,051,977 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(l) to the Company's Regis- tration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incor- porated herein by reference.) Exhibit Number Description of Exhibit _______ ______________________ 4(i) Warrant Certificate, dated January 28, 1992, certifying that Lehman Brothers Merchant Banking Portfolio Partnership L.P. is the owner of warrants to purchase 1,547,373 shares of Class C Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 4(m) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 4(j) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership L.P. is the owner of warrants to purchase 769,465 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(k) Warrant Certificate, dated December 14, 1993, certifying that Shearson Lehman Hutton Offshore Investment Partnership Japan L.P. is the owner of warrants to purchase 2,317,522 shares of Class C Common Stock, par value $.002 per share, of the Company. 4(l) Securities Exchange Agreement, dated as of January 28, 1992, among the Company and the Lehman Investors. (This exhibit can be found as Exhibit 4(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(a)* Employment Agreement, dated as of December 30, 1985, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(a) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(b)* Employment Agreement, dated as of December 30, 1985, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(b) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(c)* Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 28(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990 (File No. 0-14702) and is incorporated herein by reference.) 10(d)* First Amendment, dated September 30, 1991, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-44568) and is incorporated herein by reference.) 10(e)* Second Amendment, dated February 4, 1992, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(e) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(f)* Third Amendment, effective as of June 14, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(g)* Fourth Amendment, effective as of August 16, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(h)* Fifth Amendment, effective as of November 19, 1993, to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(i)* Sixth Amendment to the Employment Agreement, dated as of September 10, 1990, between the Company and Mel Karmazin, effective as of March 30, 1994 (subject in part to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(j)* The Company's Stock Option Plan, amended and restated as of August 16, 1993. 10(k)* Amendment, effective as of November 19, 1993, to the Company's Stock Option Plan, as amended and restated as of August 16, 1993. 10(l)* Amendment, adopted March 30, 1994 (subject to shareholder approval at the annual meeting of the Company's shareholders to be held June 13, 1994) to the Company's Stock Option Plan. 10(m)* The Company's Deferred Share Plan, amended and restated as of August 16, 1993. ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ 10(n)* Amendment, effective as of November 19, 1993, to the Company's Deferred Share Plan, as amended and restated as of August 16, 1993. 10(o)* The Company's Cash Bonus Compensation Plan, adopted on March 30, 1994 (subject to share- holder approval at the annual meeting of the shareholders to be held on June 13, 1994). 10(p)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Michael A. Wiener. (This exhibit can be found as Exhibit 10(f) to the Company's Registration Statement on Form S-1 (Registration No. 33- 5190) and is incorporated herein by refer- ence.) 10(q)* Indemnity Agreement, dated as of February 27, 1986, between the Company and Gerald Carrus. (This exhibit can be found as Exhibit 10(g) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(r)* Indemnity Agreement, dated as of February 7, 1986, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 10(h) to the Company's Registration Statement on Form S-1 (Registration No. 33-5190) and is incorporated herein by reference.) 10(s) Indemnity Agreement, dated as of June 22, 1987, between the Company and Farid Suleman. (This exhibit can be found as Exhibit 10(j) to the Company's Registration Statement on Form S-1 (Registration No. 33-15285) and is incorporated herein by reference.) 10(t) Indemnity Agreement, dated as of February 4, 1992, between the Company and Steven A. Lerman. (This exhibit can be found as Exhibit 10(l) to the Company's Registration Statement on Forms S-1 and S-3 (Registration ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ No. 33-46118) and is incorporated herein by reference.) 10(u) Indemnity Agreement, dated as of November 9, 1992, between the Company and Alan R. Batkin. (This exhibit can be found as Exhibit 10(m) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(v)* Indemnity Agreement, dated as of November 9, 1992, between the Company and O.J. Simpson. (This exhibit can be found as Exhibit 10(n) to the Company's Report on Form l0-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(w)* Stock Option Agreement, dated as of June 27, 1988, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit (c)(2) to the Statement on Schedule 13E-3 filed pursuant to Rule 13e-3 by WCK, the Management Investors (Michael A. Wiener, Gerald Carrus and Mel Karmazin) and the Company and is incorporated herein by reference.) 10(x)* Amendment Agreement, dated as of August 2, 1988, to Stock Option Agreement dated as of June 27, 1988, between the Company, as suc- cessor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 9(c)(7) to Amendment No. 3 to Schedule 14D-1 filed by the Company as successor to WCK and is incor- porated herein by reference.) 10(y)* Amendment No. 1 to Stock Option Agreement, dated as of October 14, 1988, between the Company and Mel Karmazin. (This exhibit can be found as Exhibit 4(l) to the Company's Annual Report on Form 10-K for the year ended ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ December 25, 1988 (File No. 0-14702) and is incorporated herein by reference.) 10(z)* Agreement, dated as of July 26, 1993, between the Company and Mel Karmazin, with respect to the exercise of certain options granted pur- suant to the Stock Option Agreement, dated as of June 27, 1988, as amended, between the Company, as successor to WCK, and Mel Karmazin. (This exhibit can be found as Exhibit 10(d) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 (File No. 0-14702) and is in- corporated herein by reference.) 10(aa) Warrant Certificate, dated September 30, 1991, certifying that Mel Karmazin is the owner of warrants to purchase shares of Class A Common Stock, par value $.002 per share, of the Company. (This exhibit can be found as Exhibit 10(p) to the Company's Registration Statement on Forms S-1 and S-3 (Registration No. 33-46118) and is incorporated herein by reference.) 10(bb) Management Agreement, dated February 17, 1993, by and among the Company, Unistar Com- munications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A., National Westminster Bank, USA, and Novastar, Inc. (This exhibit can be found as Exhibit 10(s) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 0-14702) and is incorporated herein by reference.) 10(cc) Amended and Restated Management Agreement, dated September 29, 1993, among the Company, Unistar Communications Group, Inc., Unistar Radio Networks, Inc., The Chase Manhattan Bank, N.A. and Novastar, Inc. (This exhibit can be found as Exhibit 10(a) to the Com- pany's Quarterly Report on Form 10-Q for the ____________________ * Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. Exhibit Number Description of Exhibit _______ ______________________ quarter ended September 30, 1993 (File No. 0- 14702) and is incorporated herein by refer- ence.) 10(dd) Amended and Restated Credit Agreement, Pur- chase and Release Agreement, dated as of February 3, 1994, among Unistar Radio Networks, Inc. (formerly known as Unistar Holdings, Inc.), UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), TMRG, Inc. (formerly known as The Market Research Group, Inc.), The Chase Manhattan Bank (National Association), as lender and as agent, the Company and Novastar, Inc. 10(ee) Securities Purchase Agreement, dated as of November 4, 1993, between Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(ff) Stock Purchase Agreement, dated as of November 4, 1993, among UCGI, Inc. (formerly known as Unistar Communications Group, Inc.), Unistar Radio Networks, Inc., the Company and Westwood One, Inc. and Infinity Network Inc. (This exhibit can be found as Exhibit 10(a) to the Company's Report on Form 8-K filed on November 17, 1993 (File No. 0-14702) and is incorporated herein by reference.) 10(gg) Management Agreement, dated as of February 3, 1994, between Westwood One, Inc. and the Company. 21 Subsidiaries of the Company. 23 Consent of KPMG Peat Marwick, Independent Certified Public Accountants. (b) Reports on Form 8-K. The Company filed a Report on Form 8-K, dated November 4, 1993, with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. on November 17, 1993, reporting in response to Item 5 of the Form 8-K. The Report on Form 8-K contained the consolidated financial statements at November 30, 1992 of Westwood One, 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, on the 30th day of March, 1994. INFINITY BROADCASTING CORPORATION BY /S/ MICHAEL A. WIENER .................................. Michael Wiener Chairman of the Board of Directors 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. /s/ Michael A. Wiener March 30, 1994 ........................ ............... Michael A. Wiener Date Chairman of the Board of Directors and Secretary /s/ Gerald Carrus March 30, 1994 .................. .............. Gerald Carrus Date Co-Chairman of the Board of Directors and Treasurer /s/ Mel Karmazin March 30, 1994 ........................ ............... Mel A. Karmazin Date Director, President, and Chief Executive Officer /s/ Farid Suleman March 30, 1994 .................. .............. Farid Suleman Date Director, Vice President--Finance, and Chief Financial Officer * /s/ James A. Stern March 30, 1994 ........................ .............. James A. Stern Date Director /s/ James L. Singleton March 30, 1994 ....................... .............. James L. Singleton Date Director /s/ Steven A. Lerman March 30, 1994 ........................ .............. Steven A. Lerman Date Director /s/ Alan R. Batkin March 30, 1994 ........................ .............. Alan R. Batkin Date Director /s/ O.J. Simpson March 30, 1994 ........................ .............. O.J. Simpson Date Director - - --------------- * Mr. Suleman also performs the functions of Chief Accounting Officer INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY INDEPENDENT AUDITORS' REPORT (ITEM 14(A)1) Independent Auditors' Report............................................ Consolidated balance sheets as of December 31, 1992 and 1993............. Consolidated statements of operations for each of the years in the three-year period ended December 31, 1993............................ Consolidated statements of changes in stockholders' equity (deficiency) for each of the years in the three-year period ended December 31,1993.... Consolidated statements of cash flows for each of the years in the three-year period ended December 31, 1993............................ Notes to consolidated financial statements.............................. Financial statement schedules for each of the years in the three-year period ended December 31, 1993 VIII Valuation and qualifying accounts.................................. X Supplementary income statement information......................... All other schedules have been omitted because the required information either is not applicable or is shown in the consolidated financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Stockholders Infinity Broadcasting Corporation: We have audited the consolidated financial statements of Infinity Broadcasting Corporation 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 Infinity Broadcasting Corporation and subsidiaries as of December 31, 1992 and 1993, 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 New York, New York February 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, which are wholly owned and are all involved in radio broadcasting. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Revenue Recognition Revenues are recognized when advertisements are aired. (c) Property and Equipment Depreciation is provided on a straight line basis for financial statement purposes over the estimated useful lives of the related assets as follows: Buildings........................................ 18 years Machinery and equipment.......................... 3-10 years Leasehold improvements........................... Life of lease Furniture and fixtures........................... 10 years (d) Intangible Assets Intangible assets arising from acquisitions are amortized on a straight-line basis over their useful lives ranging generally from 3 to 40 years. (e) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the asset and liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. (f) Earnings Per Share Earnings (loss) per common share are based on the weighted average number of common shares and common equivalent shares (where inclusion of such equivalent shares would not be anti-dilutive) outstanding during the year. (g) Cash Equivalents Cash equivalents include certificates of deposit and commercial paper with maturities of one month or less. NOTE 2. PUBLIC STOCK OFFERINGS On February 5, 1992, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock, through an initial public offering (the "Common Stock IPO") sold 13,788,826 shares of Class A Common Stock, resulting in net proceeds to the Company of approximately $100.1 million before expenses of approximately $1.6 million. As a result of the Company's Common Stock IPO, the Company in the First Quarter of 1992 recorded a non-recurring non-cash charge of approximately $6,503,000, resulting from the issuance in 1990 of approximately 836,107 deferred shares of the Company's Common Stock to management. On May 13, 1993, the Company and certain holders of warrants exercisable for shares of the Company's Class A Common Stock sold through a public offering 8,148,814 shares of Class A Common Stock resulting in net proceeds to the Company of approximately $100 million. The net proceeds from this offering were used to pay down bank borrowings under the Company's bank credit agreement (the "Credit Agreement"). Effective August 9, 1993, the Company declared a three-for-two stock split in the form of a stock dividend payable on August 16, 1993 to shareholders of record at the close of business on August 9, 1993. Effective November 12, 1993, the company declared another three-for-two stock split in the form of a stock dividend payable on November 19, 1993 to shareholders of record at the close of business on November 12, 1993. During 1993, in connection with these stock splits, the Company increased the number of authorized shares of its Class A Common Stock to 75,000,000, Class B Common Stock to 17,500,000 and Class C Common Stock to 30,000,000. The accompanying consolidated financial statements reflect the effect of the stock dividends. On December 7, 1993, certain merchant banking partnerships affiliated with Lehman Brothers Inc. and certain officers of the Company sold in a secondary offering 5,550,000 shares of Class A Common Stock. NOTE 3. ACQUISITIONS On April 16, 1992, the Company acquired WFAN-AM, a radio station serving New York City, for approximately $70 million. On February 1, 1993, the Company acquired the assets of WZGC-FM (Atlanta), WZLX-FM (Boston) and WUSN-FM (Chicago) from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for a total purchase price of approximately $100 million. On September 1, 1993, the Company acquired WIP-AM, an all-sports radio station serving Philadelphia, from Spectacor Broadcasting, L.P. for approximately $17.4 million. The above acquisitions have been accounted for by the purchase method of accounting. The purchase price has been allocated to the assets acquired, principally intangible assets, including covenants not to compete, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of purchase price over the estimated fair values of the net assets acquired has been recorded as goodwill. The operating results of these acquisitions are included in the Company's consolidated results of operations from the date of acquisition. The following unaudited pro forma summary presents the consolidated results of operations as if the acquisitions had occurred as of the beginning of 1992 and 1993, after giving effect to certain adjustments, including amortization of goodwill and interest expense on the acquisition debt. These pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisitions been made as of those dates or of results which may occur in the future. Years Ended December 31, ------------------------ 1992 1993 ---------- ---------- (Unaudited) Net revenues.................................... $ 183,935 $ 210,317 Net earnings (loss) before extraordinary items.. (23,287) 13,524 Net earnings (loss)............................. (35,605) 13,524 Earnings (loss) per common share: Before extraordinary items...................... (.74) .33 Extraordinary items............................. (.39) -- ---------- ---------- Net earnings (loss) per common share............ (1.13) .33 ========== ========== On October 4, 1993, the Company entered into an agreement to acquire Washington, D.C. radio stations WPGC-AM/FM from Cook Inlet Radio Partners, L.P. and Cook Inlet Radio License Partnership, L.P. for approximately $60 million. On March 8, 1994, the Company entered into an agreement to acquire Detroit radio station WXYT-AM for approximately $23 million from Fritz Broadcasting Inc. The purchase price of the acquisitions of WPGC-AM/FM and WXYT-AM is expected to be financed by bank borrowings. In February 1994, the Company completed the acquisition of Los Angeles radio station KRTH-FM from Beasley FM Acquisitions Corp. for approximately $116 million. The purchase price of the acquisition was funded by borrowings under the Credit Agreement. On February 17, 1993, the Company entered into an agreement to manage the business and operations of Unistar Communications Group, Inc. ("UCG") and its subsidiaries. UCG is the parent of Unistar Radio Networks, Inc. ("Unistar"), the country's fourth-largest provider of radio network programming services. Under the terms of this agreement, as amended, the Company received at no cost approximately 20.23% of UCG's issued and outstanding capital stock, an option to acquire the remaining capital stock of UCG for a nominal price under certain conditions, and an annual management fee of approximately $2 million. On February 3, 1994, the Company, Unistar and Westwood One, Inc. ("Westwood One") completed the purchase by Westwood One of the radio network business of Unistar for approximately $101.3 million. Westwood One is the nation's largest producer and distributor of nationally sponsored radio programs. In connection with the transaction, an affiliate of the Company received 5 million newly issued shares of common stock of Westwood One for $3 per share (which represents approximately 16.45% of the issued and outstanding capital stock of Westwood One) and an option to purchase an additional 3 million shares of Westwood One's common stock at a purchase price of $3 per share, subject to certain vesting requirements. In connection with the transactions, the Company's Chief Executive Officer and Chief Financial Officer became the Chief Executive Officer and Chief Financial Officer, respectively, of Westwood One pursuant to a Management Agreement between the Company and Westwood One. Under the management agreement, the Company will receive a base management fee and additional warrants to acquire up to 1.5 million shares of Westwood One's Common Stock at a purchase price from $3 to $5 per share in the event that Westwood One's Common Stock trades above certain target price levels. NOTE 4. DEPRECIATION AND AMORTIZATION - - --------------- (a) At December 31, 1993, the Company's Credit Agreement provided for aggregate borrowings of up to approximately $295 million, including an acquisition facility of $115 million and a working capital facility of $30 million. The Credit Agreement provides for quarterly principal payments through September 30, 2000. Under the Credit Agreement, interest is payable quarterly, based on the (i) prime rate or (ii) London Interbank Offer Rate. In the normal course of business, the Company enters into a variety of interest rate protection agreements, options and swaps, in order to limit its exposure due to adverse fluctuations in interest rates. These instruments are executed with creditworthy financial institutions. As of December 31, 1993, the Company has entered into various interest rate protection agreements under which the Company's interest rate on $80 million of borrowings under the Credit Agreement is fixed at between 4.80% and 5.25% per annum, expiring in the first quarter of 1996. (b) On March 24, 1992, the Company sold $200 million principal amount of its 10 3/8% Senior Subordinated Notes due 2002, through a public offering for net proceeds to the Company of approximately $195 million. At December 31, 1993, the fair value of the Company's 10 3/8% Senior Subordinated Notes was estimated to be $215,000,000 based on the quoted market prices for the same issue. The scheduled maturities of long-term debt for the next five years and after are as follows: YEAR ENDING DECEMBER AMOUNT ------------------------------------------- -------------- (In Thousands) 1994....................................... $ 22,312 1995....................................... 15,170 1996....................................... 20,227 1997....................................... 20,227 1998....................................... 25,478 After 1998................................. 261,648 ------------- $ 365,062 ============= The debt agreements contain, among other things, restrictions on additional borrowings, capital expenditures, leases, sale of assets or common stock of subsidiaries, and payment of cash dividends. As of December 31, 1993, no earnings were available for payment of dividends. Substantially all of the assets of the Company and the common shares of its subsidiaries are pledged as collateral under the Credit Agreement. For years ended 1991, 1992 and 1993, the Company paid cash for interest of $32,066,000, $40,891,000 and $34,625,000, respectively. NOTE 6. EMPLOYEE AND OTHER POST RETIREMENT BENEFIT PLANS The Company has a qualified 401(k) profit sharing plan covering substantially all of its non-union full-time employees. For the years ended December 31, 1991, 1992 and 1993, no contributions to this plan were made by the Company. The Company does not provide any post retirement health care and life insurance benefits to its employees and accordingly, has no liabilities for such benefits. NOTE 7. INCOME TAXES The provision for income taxes for the years ended December 31, 1991, 1992 and 1993, consisting of current state and local taxes, was $6,000, $106,000 and $606,000, respectively. No federal income taxes were provided in 1991, 1992 and 1993 as a result of net losses incurred and available net loss carryforwards for each period. At December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes which expire from 2004 to 2008 of approximately $73 million. As discussed in note 1, the Company adopted FAS No. 109 as of January 1, 1993. There was no effect on the consolidated balance sheet as of December 31, 1993 of implementing FAS 109 as the value of the deferred tax asset resulting from the net operating loss carryforwards was offset by a valuation allowance of equal amount. For the years ended December 31, 1991, 1992 and 1993, the Company paid cash for income taxes of $33,000, $714,000 and $135,000, respectively. NOTE 8. EMPLOYEE STOCK PLANS Employee Stock Option Plan. The Company's 1988 Employee Stock Option Plan as amended provides for a grant of options to purchase 2,664,350 shares of the Company's Class A Common Stock and 187,500 shares of Class B Common Stock. The options are exercisable in equal amounts generally over five years from the date of grant. At December 31, 1992 and 1993, options for 686,700 and 905,981 shares, respectively, of Class A Common Stock were exercisable. Employee Deferred Share Plan. The Deferred Share Plan permits the grant of up to 240,641 Class A Deferred Shares and 782,969 Class B Deferred Shares to executives or other key employees of the Company. The following is a table summarizing the changes during the years ended December 31, 1992 and 1993 in options and deferred shares outstanding: CLASS A COMMON STOCK --------------------------- DEFERRED EXERCISE SHARES AND PRICE PER OPTIONS SHARE ------------ ------------ Outstanding as of December 31, 1991........... 1,203,196 $.001-.1333 Granted/Issued................................ 556,875 7.78 Canceled...................................... (50,076) .04-7.78 Exercised..................................... (58,495) .1333 ---------- Total outstanding as of December 31, 1992....... 1,651,500 Granted/Issued.................................. 963,750 8.78-26.00 Canceled........................................ -- -- Exercised................................ ..... (173,900) .1333-8.78 ----------- Total outstanding as of December 31, 1993....... 2,441,350 =========== NOTE 9. STOCKHOLDERS' EQUITY Each share of Class A Common Stock and each share of Class C Common Stock is entitled to one vote per share. Each share of Class B Common Stock is generally entitled to ten votes per share. Shares of Class B Common Stock and Class C Common Stock, at the option of the holder, may be converted at any time into an equal number of shares of Class A Common Stock. Each share of Class B Common Stock and Class C Common Stock automatically converts into one share of Class A Common Stock upon the sale, gift, or other transfer of such share to any person other than an associate of the Company (as defined) and upon certain other events. During 1988, the Company issued options with an exercise price of $.027 per share to an officer of the Company to purchase 2,107,998 shares of the Company's Class B Common Stock. During 1992 and 1993 options to purchase 33,750 and 134,942 shares were exercised. The Company has reserved 32,439 shares of Class A Common Stock, 2,051,807 shares of Class B Common Stock and 8,935,526 shares of Class C Common Stock for issuance upon the exercise of certain warrants and options outstanding as of December 31, 1993. NOTE 10. RELATED PARTY TRANSACTIONS The Company leases office space from an affiliate which is owned 70% by certain stockholders. The lease expires on December 31, 1998 and provides for an annual rent of $145,380 subject to certain annual adjustments. As of December 31, 1992 and 1993, the Company has loans receivable from certain stockholders amounting to $1,200,000 in the aggregate. Such loans, payable on June 1, 1994, are non-interest bearing and are included as other assets in the accompanying consolidated balance sheets. As of December 31, 1993, the Company had accounts receivable from Unistar amounting to approximately $204,000. NOTE 11. EXTRAORDINARY ITEMS In 1991, the Company purchased approximately $87 million principal amount of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary gain of approximately $18 million. On March 24, 1992, the Company called for the redemption of all of the remaining approximately $98,000,000 of the 14.25% Subordinated Discount Debentures, resulting in an extraordinary loss of approximately $8,277,000. On September 22, 1992, the Company entered into a new credit agreement which replaced its prior bank credit agreement and which resulted in an extraordinary loss of $4,041,000. NOTE 12. COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries occupy certain office space and transmitting facilities under lease agreements expiring at various dates through 2004. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Most leases provide for escalation of rent based on increases in the Consumer Price Index and/or real estate taxes. The following is a summary of the future minimum rental commitments under existing leases: YEAR ENDING DECEMBER 31, AMOUNT ------------------------------------------ -------------- (In Thousands) 1994...................................... $ 3,766 1995...................................... 3,897 1996...................................... 3,740 1997...................................... 2,664 1998...................................... 2,556 After 1998................................ 7,343 -------------- $ 23,966 ============== Rent expense applicable to such leases amounted to approximately $2,049,000, $2,354,000 and $3,079,000 for the years ended December 31, 1991, 1992 and 1993, respectively. At December 31, 1993, the Company is committed to the purchase of broadcast rights for various sports events and other programming including on-air talent, aggregating approximately $62.5 million. The aggregate payments related to these commitments during the next five years are as follows: AMOUNT -------------- (In Thousands) 1994.................................... $ 26,475 1995.................................... 26,721 1996.................................... 6,203 1997.................................... 2,894 1998.................................... 179 -------------- $ 62,472 ============== NOTE 13. INTANGIBLE AND OTHER ASSETS Intangible assets at cost, as of December 31, 1992 and 1993 include: 1992 1993 -------- -------- (In Thousands) Franchise interests................ $214,458 $259,582 Favorable leasehold interest....... 30,708 30,542 Other, principally covenants....... not to complete.................. 45,068 60,000 -------- -------- $290,234 $350,124 ========= ========= Other assets include principally deferred financing costs and are amortized over the term of the financing.

732715_1993.txt

732715_1993

1993

732715

ITEM 1. BUSINESS. THE COMPANY Ameritech Corporation (Ameritech or the Company), incorporated in 1983 under the laws of the State of Delaware, with its principal executive offices at 30 South Wacker Drive, Chicago, Illinois 60606 (telephone number 312-750-5000), is a leading supplier of full service communications and advanced information services, primarily to 12 million customers in the Midwest. It also has interests in New Zealand, Hungary, Norway, Poland and other international areas. Ameritech is the parent of Illinois Bell Telephone Company; Indiana Bell Telephone Company, Incorporated; Michigan Bell Telephone Company; The Ohio Bell Telephone Company; and Wisconsin Bell, Inc.; hereinafter referred to as the "landline telephone companies," as well as several other communications businesses. In 1993, Ameritech restructured its five geographically based landline telephone companies and two other related businesses into a structure of customer-specific business units supported by a single, regionally coordinated network unit. The five Bell companies continue to function as legal entities, owning Bell company assets in each state, and continue to be regulated by the individual state public utility commissions. Products and services are now marketed under a single common brand identity, "Ameritech," rather than using the "Bell" name. While the Ameritech logo is now used to identify all the Ameritech companies, the landline telephone companies are sometimes regionally identified and hereinafter referred to by using "Ameritech" with the name of the state in which they operate, for example, "Ameritech Illinois." TELECOMMUNICATIONS Ameritech is engaged in the business of furnishing a wide variety of advanced telecommunications services, including local exchange and toll service, network access and telecommunications products, to 12 million business and residential customers in the Great Lakes region. Exchange telecommunications service refers to intraLATA service, defined below, which includes usage services as well as local service. In connection with the divestiture described below, all Bell System territory within the continental United States was divided into 161 geographical areas which have been termed Local Access and Transport Areas (LATAs). These LATAs are generally centered on a city or other identifiable community of interest, and each LATA marks the boundary within which the former Bell operating communications company subsidiaries (Bell Companies) of American Telephone and Telegraph Company (AT&T) may provide telephone service. Since January 1, 1984, the Bell Companies have provided two basic types of telecommunications services. First, the Bell Companies transport telecommunications traffic between telephones and other customer premises equipment located within the same LATA (intraLATA service), which can include toll service as well as local service. Second, the Bell Companies provide exchange access service, which links a subscriber's telephone or other equipment to the network of transmission facilities of interexchange carriers, which in turn provide telecommunications service between LATAs (interLATA service). AMERITECH'S BUSINESS UNITS AND NETWORK SERVICES The following is a description of the business and network services units at March 30, 1994. Local, regional and national business advertisers seeking to reach businesses or households with information are the customers of the Advertising Services Unit which connects buyers and sellers of goods and services by providing advertising in printed telephone directories, specialized printed guides and electronic advertising services across the United States and Europe. The Cellular Services Unit provides cellular and other wireless communications to customers using Ameritech's nearly 1 million cellular lines and 500,000 paging units in eight Midwestern states and Hawaii. This unit also identifies and pursues new wireless services such as data transmission and personal communications services (PCS). The Consumer Services Unit provides communications services for 10.8 million residential customers. The Custom Business Services Unit offers to 200 of Ameritech's largest and most sophisticated customers custom communications and information technology solutions, as well as the full complement of Ameritech products, through a single, dedicated sales and service account team well versed in the sophisticated business needs of each customer. The Enhanced Business Services Unit offers packaged communications solutions to more than 50,000 medium-sized and large business customers. These innovative solutions are tailored to the needs of specific industries, such as health care, education, manufacturing, government and financial services. The Small Business Services Unit delivers innovative telecommunications solutions for approximately 1 million small businesses in the Ameritech region. Customers of the Information Industry Services Unit are the more than 2,500 communications network and information services providers that buy services from Ameritech and use them as components in offerings to their own customers. This unit assists these customers as they use the Ameritech network and other innovative services that enable them to offer their customers new ways to obtain and share information. The Leasing Services Unit supports the sale of Ameritech products and services by providing competitive, value-added financing, primarily to large and medium-sized businesses and government units. Ameritech has financed more than $1 billion worth of equipment and services since 1984. The Long Distance Industry Services Unit provides network access through switched and special access services, as well as other service options such as end user billing, to approximately 140 long distance companies. The Pay Phone Services Unit makes it easier for "people in motion" to communicate while on the go. Customers are the millions of callers who use Ameritech's more than 200,000 pay phones for coin, calling card and operator assisted calls, and over 100,000 agents who have Ameritech pay phones on their premises. For local exchange carriers, including 263 in the Ameritech region, the Telephone Industry Services Unit provides products and services including access, usage, directory assistance, operator services and 800 data base access. This unit also manages the costs of the services that Ameritech purchases from the independent telephone companies in the region. The International Unit focuses technological and financial strength on business opportunities in communications and information systems around the world. With interests in Poland, Norway, Hungary and New Zealand, this unit invests in entities that provide customers with cellular services, telephone services and pay TV services. Supporting the 12 business units, the Network Services Unit builds and maintains an advanced network and information technology infrastructure to meet business unit service expectations, and those of their customers, while improving overall cost performance. INVESTMENTS IN INTERNATIONAL MARKETS In December 1993, Ameritech, with its partner, Deutsche Bundespost Telekom of Germany (Deutsche Telekom), Europe's largest communications carrier, announced a major expansion of its international presence with an investment in MATAV, the Hungarian telephone company. Ameritech and Deutsche Telekom will have equal ownership totaling approximately 30 percent of the company. The Hungarian government owns the majority of the remaining 70 percent. Ameritech and its partner were selected by the Hungarian government from among several other leading telecommunications companies. MATAV, which is the principal provider of local, long distance and international telephone service and the controlling shareowner in a cellular venture using GSM (Global System for Mobile Communications) digital technology, is the first state-owned telecommunications company to be privatized in Eastern and Central Europe. MATAV has approximately 1.5 million customer lines in a country of 10.5 million people. MATAV plans to double the number of lines by the year 2000. Ameritech may increase its investment in MATAV if the government proceeds with plans to reduce its holdings. In September 1993, Ameritech and its partners in the Norwegian firm NetCom GSM inaugurated service to Oslo, the central and eastern areas of Norway and several other major cities, on the first privately supplied cellular communications system in the country. In 1992, Ameritech and Singapore Telecom, the government-owned telecommunications and postal operator in Singapore, agreed to acquire an equal interest in NetCom totaling an effective 49.9 percent. Their agreement with NetCom includes a management service contract under which Ameritech and Singapore Telecom provide their skills and expertise in constructing and operating the system. Nationwide coverage by the NetCom system is expected within four years. NetCom officials estimate that the usage of GSM service in Norway currently is growing at 35 percent per year and that service could be extended to 700,000 Norwegian customers over the next 10 years. Norway is one of the leaders in Europe in per capita use of mobile telephones. In June 1992, an Ameritech consortium began operating a cellular system in Poland after being selected by that country's government in an international competitive bidding process. Ameritech and France Telecom, in partnership with Telekomunikacja Polska S.A., Poland's state-owned telephone company, created the joint venture, Polska Telefonia Komorkowa (PTK), to build the nationwide cellular system. The government's terms for the cellular license include 51 percent ownership of the joint venture by Telekomunikacja Polska, with Ameritech and France Telecom taking equal shares of the remainder. The cellular network developed by PTK, which markets the system under the name "Centertel," was serving Warsaw and 15 other major cities by the end of 1993 and is expected to cover the entire country within four years. In September 1990, Ameritech and Bell Atlantic Corporation (Bell Atlantic) purchased Telecom Corporation of New Zealand Limited (New Zealand Telecom), New Zealand's state-owned principal supplier of domestic and international telecommunications services, including mobile telephone and directory services, to 1.5 million customers. At the time of the purchase, the New Zealand government required Ameritech and Bell Atlantic to agree to reduce their combined ownership position of New Zealand Telecom to not more than 49.9 percent of the then outstanding shares by September 12, 1994. After stock sales, which were completed by September 1993, Ameritech has a 24.8 percent interest in the company. Ameritech and Bell Atlantic, along with two leading cable television system operators, Tele-Communications, Inc. and Time Warner's American Television and Communications unit, own a 51 percent interest in Sky Network Television Limited of New Zealand (Sky). Sky provides multi-channel pay television services in New Zealand, using three UHF channels for movies, sports and news programming in a number of areas including Greater Auckland, the country's largest metropolitan market, Wellington, the capital of New Zealand, and other cities. Ameritech owns a 24.5 percent interest in the partnership which holds the 51 percent interest in Sky. OTHER BUSINESS DEVELOPMENTS In December 1993, Ameritech entered into an agreement with General Electric Company (GE) under which Ameritech will invest approximately $472 million in a new company that will include the assets of GE Information Services, a global leader in electronic commerce and electronic data interchange (EDI). Ameritech's investment will be in the form of a four-year convertible debenture, which, if legal restrictions are removed, will convert into a 30 percent equity position. The new company will develop and market on a worldwide basis information services products that facilitate intercompany communication and electronic commerce, a business that is growing at a double-digit pace. Electronic commerce links companies and internal organizations to each other and to customers, suppliers, banks, financial services providers and distributors in virtual electronic trading communities to simplify day-to-day transactions. Typical electronic commerce applications involve order entry and processing, invoicing, electronic payment, inventory management, cargo tracking, E-mail, electronic catalogs and point-of-sale data gathering. The transaction is scheduled to close in 1994. Ameritech, in an arrangement with Household International, Inc. (Household), offers a no fee, dual-purpose credit card and calling card, the Ameritech CompleteSM Card. Consumers may use the card to charge telephone calls as well as retail goods and services. The Complete card has no annual fee, competitive interest rates, and a 10 percent cash back offer from Household for all calling card calls made by dialing "0" plus the telephone number. Under the arrangement between the companies, Household owns and finances the credit card receivables and Ameritech funds certain marketing expenses. Since its introduction in 1991, the Complete card has attracted approximately 700,000 cardholders. RESEARCH AND DEVELOPMENT Ameritech owns an equal one-seventh interest in Bell Communications Research, Inc. (Bellcore) with the other six regional holding companies (collectively, the RHCs) formed in connection with the court-ordered divestiture described below. Bellcore furnishes the RHCs with technical assistance, such as network planning, engineering and software development (including applied research), provided most effectively on a centralized basis. Bellcore is also a central point of contact for coordinating the efforts of the RHCs in meeting national security and emergency preparedness requirements of the Federal government. CONSENT DECREE AND LINE OF BUSINESS RESTRICTIONS On August 24, 1982, the U.S. District Court for the District of Columbia (Court) approved and entered a consent decree entitled "Modification of Final Judgment" (Consent Decree), which arose out of antitrust litigation brought by the Department of Justice (DOJ), and which required AT&T to divest itself of ownership of those portions of its wholly owned Bell Companies that related to exchange telecommunications, exchange access and printed directory advertising, as well as AT&T's cellular mobile communications business. On August 5, 1983, the Court approved a Plan of Reorganization (Plan) outlining the method by which AT&T would comply with the Consent Decree. Pursuant to the Consent Decree and the Plan, effective January 1, 1984, AT&T divested itself of, by transferring to Ameritech, its 100 percent ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech landline telephone companies as well as a cellular mobile communications service company. The Consent Decree, as originally approved by the Court in 1982, provided that the Bell Companies could not, directly or through an affiliated enterprise, provide interLATA telecommunications services or information services, manufacture or provide telecommunications products, or provide any product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff. The Consent Decree allowed the 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 to engage in an otherwise prohibited line of business 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 Ameritech's landline telephone companies and the other Bell Companies to engage in various activities. The Court's order approving the Consent Decree provided for periodic reviews of the restrictions imposed by it. Following the first triennial review, in decisions handed down in September 1987 and March 1988, the Court continued the prohibitions against Bell Company manufacturing of telecommunications products and provision of interLATA services. The rulings allowed limited provision of information services by transmission of information and provision of information gateways, but excluded generation or manipulation of information content. In addition, the rulings eliminated the need for a waiver for entry into non-telephone related businesses. In April 1990, a Federal appeals court 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. CAPITAL EXPENDITURES Capital expenditures represent the single largest use of Company funds. By reinvesting in the telecommunications core business, the Company expects to be able to introduce new products and services, respond to ever increasing competitive challenges and increase the operating efficiency and productivity of the network. Capital expenditures by all the Ameritech companies since January 1, 1989, were approximately as follows: Responding to the market needs for cost-effective technology, Ameritech's capital expenditures for landline telephone operations decreased $265 million in 1993. The cellular services portion of the Company's capital expenditures increased $106 million in 1993 resulting from plans to expand service and offer new data and digital services. Network modernization expenditures occurred in all the states where the Company provides service. Expanding on the aggressive deployment plan it began in 1992, in January 1994 Ameritech unveiled a multi-billion dollar plan for a digital network to deliver video services. The Company is launching a digital video network upgrade, subject to certain regulatory approvals, that by the end of the decade will enable 6 million customers in its region to access interactive information and entertainment services, as well as traditional cable TV services, from their homes, schools, offices, libraries and hospitals. The video network upgrade will increase Ameritech's capital spending over the next 15 years by $4.4 billion, to a total of approximately $29 billion. The Company expects to fund most of this amount by reducing capital expenditures in its core landline business. Capital expenditures anticipated in the first three years of the video upgrade total approximately $400 million. The video network concept, along with other competitive concerns, is discussed on page 10. Anticipated capital expenditures for the Company including all subsidiaries approximate $1.9 billion for 1994. This amount excludes any capital expenditures that may occur in 1994 related to the above described video network upgrade program. CUSTOMER LINES As of December 31, 1993, 66 percent of the Company's customer lines were served by digital switches and virtually all its lines had been converted to equal access. In addition, the Company had installed 802,000 miles of fiber-optic lines. The number of customer lines in the Ameritech region served by the Ameritech landline telephone companies increased 3.3 percent from 17.0 million at December 31, 1992 to 17.6 million at December 31, 1993, including business lines, which grew 6.1 percent from 5.1 million to 5.4 million, and residential line service, which increased 2 percent from 11.4 million to 11.6 million. As of December 31, 1993, there were 295 customer lines in service per landline telephone company employee. Sizable areas within the five-state region are served by nonaffiliated telecommunications companies. Ameritech does not furnish local service in those areas or localities served by such companies. The following table sets forth the number of customer lines served by Ameritech at the end of the year: CUSTOMER LINES IN SERVICE REGULATORY ENVIRONMENT FCC Regulatory Jurisdiction The Ameritech landline telephone companies are 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, rules for apportioning costs between regulated and non-regulated services, depreciation rates (for interstate services) and the principles and standard procedures (separations procedures) used to separate property costs, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to services under the jurisdiction of the respective state regulatory authorities. For certain companies, including the Ameritech landline telephone companies, interstate services regulated by the FCC are covered by a price cap plan. The plan creates incentives to improve productivity over benchmark levels in order to retain higher earnings. Price cap regulation sets maximum limits on the prices that may be charged for telecommunications services but also provides for a sharing of productivity gains. Earnings in excess of 12.25 percent 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. Intrastate Rates and Regulation The Ameritech landline telephone companies, in providing communications services, are also subject to regulation by state commissions in all of the states in which they operate with respect to intrastate rates and services, depreciation rates (for intrastate services), issuance of securities and other matters. The increasing effects of competitive market forces are being recognized by state legislatures and state regulatory agencies. Legislation has been passed in the Company's five state region which will permit reduced regulation or deregulation of telephone companies and services as they become competitive. Intrastate rate restructuring and repricing activities have been or are being undertaken by all Ameritech landline telephone companies, which are intended to alter the traditional pricing methods by de-averaging and restructuring rates towards cost-based pricing. In addition, Ameritech has actively pursued a policy of incentive regulation at the state and federal levels. No general intrastate rate increases have been authorized for the landline telephone companies since 1985. Presently, there are no pending requests for general rate increases. Unless otherwise indicated, the changes in revenues resulting from the principal changes in intrastate rates since January 1, 1990, referred to below, are stated on an annual basis and are estimates without adjustment for subsequent changes in volumes of business. In May 1992, the Illinois General Assembly voted to revise the Universal Telephone Service Protection Law of 1985. The new law enables the Illinois Commerce Commission (ICC) to approve alternative regulation of any type, subject to explicit policy goals. In addition, the law transfers authority over intraLATA equal access dialing arrangements to the ICC. In the realm of competitive pricing, the law requires that telephone companies providing essential facilities impute the rate charged for those facilities to themselves and that telephone companies are required to apportion overhead and embedded costs between competitive and noncompetitive services. The law remains in effect until July 1, 1999. In December 1992, Ameritech Illinois filed a petition with the ICC proposing a price regulation plan which features a price cap mechanism under which future rate changes would be subject to a predetermined formula reflecting factors such as inflation and productivity improvement. If the plan is adopted, increases in basic residential rates will be prohibited for a three-year period. A decision by the ICC is expected during the second quarter of 1994. In March 1990, the Michigan Public Service Commission (MPSC) issued an order in which it adopted an incentive regulation plan authorizing Ameritech Michigan a return-on-equity range of 12.25 percent to 13.25 percent. The order also established the following sharing arrangement: earnings between 13.25 percent and 14.25 percent to be shared 25 percent with customers, 25 percent with Ameritech Michigan, and 50 percent dedicated to special construction programs; earnings between 14.25 percent and 17.25 percent to be shared 25 percent with customers, 50 percent with Ameritech Michigan, and 25 percent to construction; earnings above 17.25 percent to be shared 75 percent with customers and 25 percent with Ameritech Michigan. The MPSC action resulted in a revenue reduction of about $18.5 million annually. Of this amount, $14.5 million resulted from the change in authorized return. The Michigan Telecommunications Act of 1991 (Act), which became effective as of January 1, 1992 for a four-year period, removes traditional rate-of-return regulation as of that date. It gives Ameritech Michigan flexibility to adjust prices and introduce new services without regulatory approval. The law capped basic local residential service rates at current levels for two years and allows for expedited approval of increases in such rates after that period if the increase does not exceed a formula related to the Consumer Price Index (CPI). The law allows new usage charges for local calls in excess of a monthly call allowance for most residential customers. Long distance (toll) rates are capped for the four-year life of the Act at those in effect at the end of 1991, unless carrier access charges are increased during that period. The Act instituted a streamlined system for changes to basic rates, depending on the size of the change. Rate changes which do not exceed 1 percent less than the change in the CPI may be put in place after 90 days notice unless the MPSC takes further action, but proposed rate changes greater than 1 percent less than the CPI change require MPSC approval. As a direct response to this new pricing flexibility, Ameritech Michigan immediately reduced intraLATA message toll rates by $20 million effective January 1, 1992. An additional reduction of over $20 million was implemented in December 1992. Two new calling plans were introduced in 1992. Overall, the reductions and discount plans will amount to a cut of more than 12 percent in prices residence and business customers pay for long distance calls within LATAs. In September 1990, Ameritech Wisconsin adopted a Public Service Commission of Wisconsin (PSCW) approved innovative regulatory plan, effective October 1, 1990, under which the rate-of-return on equity is set at 13.75 percent and the company's revenues are not subject to refund. This trial plan, 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. In September 1992, Ameritech Wisconsin eliminated business Touch-Tone charges reducing local service revenues by approximately $4 million annually. In March 1993, the PSCW reached a decision concerning inside wire and moratorium refund issues. In April 1993, Ameritech Wisconsin commenced refunding $22.5 million to residence, business customers and interexchange carriers in the form of credits and rate reductions. In January 1993, the Public Utilities Commission of Ohio (PUCO) adopted new rules governing the rates and services of local exchange companies, including a process to change rates with faster, less tedious PUCO review. The new guidelines established a procedure for companies to file individual plans for alternative regulation. In June 1993, Ameritech Ohio filed its "Advantage Ohio" price regulation plan with the PUCO. Under the plan, future overall rate changes would be subject to price ceilings based on inflation, Ameritech Ohio's productivity and service quality, and significant tax law or accounting rule changes. The plan will also provide for the ability to flexibly price competitive services and discretionary services within the boundary of the price ceilings. The proposed plan will include significant infrastructure investment and pricing commitments. The PUCO's decision on the plan is expected in 1994. As a result of an agreement on a settlement with the Indiana Utility Regulatory Commission (IURC), Touch-Tone rates were reduced by $6 million in 1992. In Indiana, state law permits the IURC to adopt alternatives to rate-of-return regulation. In February 1994, Ameritech Indiana and consumer representatives announced a wide-ranging agreement to speed development of an advanced communications system in Indiana, make Indiana a national leader in the use of technology to improve education, provide Ameritech regulatory flexibility, remove the cap on earnings, reduce local phone charges, and cap basic rates for three years. The agreement, reached in settlement of Ameritech Indiana's "Opportunity Indiana" regulatory reform initiative, which was proposed in May 1993, still requires approval of the IURC. ACCESS CHARGE ARRANGEMENTS Interstate Access Charges The Ameritech landline telephone companies provide access services for the origination and termination of interstate telecommunications. The access charges are of three types: common line, switched access and trunking. The common line portion of interstate revenue requirements are recovered through monthly subscriber line charges and per minute carrier common line charges. The carrier common line rates include recovery of transitional and long-term support payments for distribution to other local exchange carriers. Transitional support payments were made over a four-year period which ended on April 1, 1993. Long-term support payments will continue indefinitely. Effective January 1, 1994, rates for local transport services were restructured and a new "trunking" service category was 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 an Ameritech 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 an Ameritech 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 and the access tandem or end office, 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 landline telephone companies' local serving areas. Separate arrangements govern compensation between Ameritech telephone companies and independent telephone companies for jointly provided communications within Ameritech's 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 and technological advances, as well as heightened customer interest in advanced telecommunications services, have expanded the types of available communications services and products and the number of companies offering such services. Market convergence, already a reality, is expected to intensify. The FCC has taken a series of steps that are expanding opportunities for companies to compete with local exchange carriers in providing services 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 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 serve more than 80 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. This effort is called the Customer First Plan. Ameritech proposes to facilitate competition in the local exchange business by allowing other service providers to purchase components of its network and to repackage them with their own services for resale, in exchange for the freedom to compete in both its existing and currently prohibited businesses. Ameritech has requested regulatory reforms to match the competitive environment as well as support of its efforts to remove restraints, such as the interLATA service restriction, which currently restrict its participation in the full telecommunications marketplace. In addition, the Company 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. The Company 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 ICC that propose specific rates and procedures to open the local network in Illinois. Approval could take up to 11 months. The Company 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. These proposals are discussed on pages 7 and 8 in Intrastate Rates and Regulation. MICHIGAN INTRALATA LONG DISTANCE SERVICE ORDER On July 31, 1992, MCI Telecommunications Corporation (MCI) filed a complaint with the MPSC seeking "1+" intraLATA dialing parity for all toll competitors of Ameritech Michigan alleging that current dialing arrangements violated the Michigan Telecommunications Act. Callers in Michigan must currently dial "10" plus a three digit access code to use the services of Ameritech's intraLATA toll competitors. The MPSC dismissed MCI's complaint finding no statutory violations. However, as a result of subsequent proceedings in the case, on February 24, 1994, the MPSC issued an order requiring implementation of "1+" intraLATA toll dialing parity in Michigan. The effective date of the order is to be concurrent with receipt of relief from the Consent Decree interLATA service restriction sought under the Customers First Plan, but in any event, no later than January 1, 1996. The order also called for establishing an industry task force to consider all factors necessary to establish full intraLATA toll competition. The task force will develop a deployment schedule, identify the costs for deployment and determine the methodology to recover those costs. The task force is required to file its findings with the MPSC by September 23, 1994. Ameritech believes that the MPSC has not considered all relevant factors in rendering its decision. Accordingly, Ameritech Michigan has filed a petition for a rehearing with the MPSC as a first step in bringing further clarification to the issues. In 1993, Ameritech Michigan recorded $695.8 million of long distance revenue, of which approximately $634 million resulted from intraLATA long distance service. Customer response to dialing parity and the effect on Ameritech Michigan's intraLATA long distance revenue is uncertain. However, Ameritech Michigan estimates that approximately 50% of any long distance revenue lost, which could be significant, would be offset by additional access revenue. AMERITECH'S VIDEO NETWORK CONCEPT In January 1994, Ameritech filed plans with the FCC to construct a digital video network upgrade that could reach 6 million customers by the end of the decade. 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, could be expanded to approximately 1 million additional Midwest customers in each of the next five years. Ameritech will be only one of many users of the broadband network. A multitude of competing video information providers, businesses, institutions, interexchange carriers and video telephony customers will also have access to the technology. With the new system, customers will have access to a virtually unlimited variety of programming sources. These will include basic broadcast services, similar to today's cable service, and advanced interactive services such as video on demand, home healthcare, interactive educational software, distance learning, interactive games and shopping, and a variety of other entertainment and information services that can be accessed from homes, offices, schools, hospitals, libraries and other public and private institutions. CABLE/TELCO CROSSOWNERSHIP 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. The Company 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. Only Bell Atlantic has won the right to enter the video services business. The U.S. District Court that permitted entry to Bell Atlantic denied the requests of Ameritech and the other RHCs. Legislation has been introduced in Congress that would repeal the crossownership ban. EMPLOYEE RELATIONS As of December 31, 1993, the Ameritech companies employed 67,192 persons, a decrease from 71,300 at December 31, 1992. During 1993, approximately 1,700 management employees left the payroll as a result of voluntary and involuntary workforce reduction programs and 900 nonmanagement employees took advantage of a Supplemental Income Protection Program (SIPP) established under labor agreements to voluntarily exit the workforce. Additional restructuring was done by normal attrition. Some reductions were partially offset by workforce additions due to acquisitions and growth. On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995. 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 the 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 terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who elect to leave the business before the end of 1995. Reduction of the workforce results from technological improvements, consolidations, and initiatives identified by management to balance its cost structure with emerging competition. Approximately 48,000 employees are represented by unions. Of those so represented, about 71 percent are represented by the CWA and about 29 percent are represented by the IBEW, both of which are affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services, the wholly owned centralized procurement and support subsidiary of the landline telephone companies, reached agreement with the two unions on a workforce transition plan for assigning union-represented employees to the newly established business units. The separate agreements with the CWA and the IBEW extend existing union contracts with the landline telephone companies and Ameritech Services to the new units. The pacts address a number of force assignment, employment security and union representation issues. In 1995, when union contracts are due to expire, the parties will negotiate regional contracts. ITEM 2. ITEM 2. PROPERTIES. The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, central office equipment represented 37 percent of its consolidated investment in telecommunications plant; land and buildings (occupied principally by central offices) represented 11 percent; telecommunications instruments and related wiring and equipment, including private branch exchanges, substantially all of which are on the premises of customers, represented 2 percent; 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 40 percent. Substantially all of the installations of central office equipment and administrative offices are located in buildings owned by the Ameritech landline telephone companies situated on land held in fee. Many garages and business offices and some installations of central office equipment and administrative offices 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 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 Company. 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 COMPANY (AS OF MARCH 1, 1994) The following table sets forth, as to the executive officers of Ameritech, their ages, their offices with Ameritech and the period during which they have held such offices. - ------------------------- * Member of the Board of Directors, Chairman of the Executive Committee ** Member of the Board of Directors and the Finance Committee *** Member of the Board of Directors + Member of the Board of Directors, the Finance Committee and the Executive Committee Prior to the most recent election to office with Ameritech, the above officers held high-level managerial positions within Ameritech for more than the past five years, except for Mr. Bruce, Mr. Edwardson, Mr. Edson, Mr. Welsh and Mr. Campbell. Prior to joining Ameritech, Mr. Bruce was a four-term member of the U.S. House of Representatives from Illinois. Mr. Edwardson was Chief Financial Officer of United (Airlines) Employee Acquisition Corp. from 1990 to 1991 and Executive Vice President and Chief Financial and Administrative Officer of IMCERA Group, Inc. from 1989 to 1990. Mr. Edson was with the Office of the U.S. Trade Representative as chief of staff and counselor and then as general counsel from 1989 to 1993. Mr. Welsh was chief legal officer for the City of Chicago from 1989 to 1993 and, prior to that, was an attorney with Mayer, Brown and Platt, a Chicago-based law firm. Mr. Campbell was President of Columbia TriStar Home Video, a Sony Pictures Entertainment Company, from 1989 to 1994. Mrs. Thornton and Mr. Rutigliano have announced plans to retire in April and June 1994, respectively. Officers are elected annually but may be removed at any time at the discretion of the Board of Directors. PART II ITEMS 5 THROUGH 8. There were 956,338 owners of record of Ameritech Common Stock as of December 31, 1993. Ameritech Common Stock is listed on the New York, Boston, Chicago, Pacific, Philadelphia, London, Tokyo, Amsterdam, Basel, Geneva and Zurich stock exchanges. The rest of the information required by these items is included in the Financial Review section on pages 16 through 22, pages 24 through 37, and on page 40 of the Company's annual report to security holders for the year ended December 31, 1993. Such information is incorporated by reference pursuant to General Instructions G(2). In March 1994, Ameritech announced plans to reduce its nonmanagement workforce by 6,000 employees by the end of 1995. This program, discussed on page 11, will result in a charge to first quarter 1994 earnings of approximately $530 million, or $335 million and $.60 per share on an after-tax basis. A significant portion of the program cost will be funded by the pension plan, whereas financial incentives to be paid by Ameritech will require company funds of approximately $140 million. 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. Ameritech believes this program will reduce its employee-related costs by approximately $300 million on an annual basis upon completion of this program. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. No disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure occurred during the period covered by this annual report. PART III ITEMS 10 THROUGH 13. Information regarding executive officers required by Item 401 of Regulation S-K is furnished in a separate disclosure in Part I of this report since the Company did not furnish such information in its definitive proxy statement dated March 1, 1994, prepared in accordance with Schedule 14A. The other information required by these items is included in the Company's definitive proxy statement in the last two paragraphs on the first page, on pages 2 through 4, in the section on Compensation of Directors on page 6, in the section on Officer and Director Stock Ownership on page 7, and in the section on Executive Compensation on pages 10 through 18, and is incorporated herein by reference pursuant to General Instructions G(3). PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as a part of the report: * Incorporated herein by reference to the appropriate portions of the Company's annual report to security holders for the year ended December 31, 1993 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. Separate financial statements of subsidiaries not consolidated and 50 percent or less owned persons are omitted since no such entity constitutes a "significant subsidiary" pursuant to the provisions of Regulation S-X, Article 3-09. Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Ameritech will furnish, without charge, to a security holder upon request a copy of the annual report to security holders and the proxy statement, portions of which are incorporated by reference, and will furnish any other exhibit at cost. (b) Reports on Form 8-K: On December 29, 1993, the Company filed a Current Report on Form 8-K dated December 15, 1993, to report on Item 5, Other Events, approval of a two-for-one split in the form of a 100 percent stock dividend of the Company's Common Stock, payable to owners of record at the close of business on 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. AMERITECH CORPORATION By /s/ BETTY F. ELLIOTT ---------------------------------- (Betty F. Elliott, Vice President and Comptroller) March 30, 1994 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 date indicated. PRINCIPAL EXECUTIVE OFFICER: R. C. Notebaert* President and Chief Executive Officer PRINCIPAL FINANCIAL OFFICER: J. A. Edwardson* Executive Vice President and Chief Financial Officer PRINCIPAL ACCOUNTING OFFICER: B. F. Elliott *By /s/ BETTY F. ELLIOTT Vice President and -------------------------------- Comptroller (Betty F. Elliott, for herself and as Attorney-in-Fact) DIRECTORS: R. H. Brown* D. C. Clark* R. M. Gillett* H. H. Gray* March 30, 1994 J. A. Henderson* S. B. Lubar* L. M. Martin* J. B. McCoy* R. C. Notebaert* J. D. Ong* A. B. Rand* L. J. Rutigliano* W. L. Weiss* REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Board of Directors Ameritech Corporation We have audited in accordance with generally accepted auditing standards the financial statements included in Ameritech Corporation's annual report to shareowners incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange 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. Chicago, Illinois January 28, 1994 AMERITECH CORPORATION SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) NOTES TO SCHEDULE V (a) Additions, other than to Buildings, include material purchased from Ameritech Services, Inc., a wholly owned centralized procurement subsidiary of the Ameritech landline telephone companies (see Notes to Consolidated Financial Statements in the Company's annual report to security holders for the year ended December 31, 1993). 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 C. (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, for all years, of the reclassification between plant categories. AMERITECH CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION (MILLIONS OF DOLLARS) NOTES TO SCHEDULE VI (a) The Company's 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 plant with similar characteristics. The Company is allowed by regulatory authorities to use reserve deficiency amortization in conjunction with the remaining life method. For years 1993, 1992 and 1991, depreciation expressed as a percentage of average depreciable plant was 7.4 percent, 7.2 percent and 7.3 percent, respectively. (b) The Company's amount for additions charged to expenses (column C above) does not agree with the amounts reported on the face of the consolidated statements of income under the caption "depreciation and amortization." The difference relates primarily to the amortization of intangibles. AMERITECH CORPORATION SCHEDULE VIII -- ALLOWANCE FOR UNCOLLECTIBLES (MILLIONS OF DOLLARS) - ------------------------- (a) Includes principally amounts previously written off which were credited directly to this account when recovered and amounts related to interexchange carrier receivables which are being billed by the Company. (b) Amounts written off as uncollectible. AMERITECH CORPORATION SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (MILLIONS OF DOLLARS) - ------------------------- Note: All other possible applicable items did not meet the one percent sales test and therefore are excluded. EXHIBIT INDEX

356981_1993.txt

356981_1993

1993

356981

ITEM 1 - BUSINESS Overview Suburban Bancorp, Inc. (the "Company") is organized as a multi-bank holding company, with its principal office in Palatine, Illinois. Its princi- pal subsidiaries are thirteen community banks. The banks are located in Cook, DuPage, Lake, Kane, and McHenry counties in suburban areas of metropolitan Chicago. Because most of their market areas are suburban communities, the banks are primarily retail-oriented, providing a wide range of financial services to individuals and small businesses. The market areas of the banks have a diversified economy, with several corporate headquarters and numerous smaller commercial and industrial businesses providing employment, with a large number of residents commuting to work in the City of Chicago. The banks engage in a general full service banking business. The depository and loan products of the banks are generally those offered by competing financial institutions in the communities. Deposit products include several types of interest-bearing transaction accounts and savings and time deposits, including individual retirement accounts. Although numerous types of loans are available, the banks principally make secured commercial loans to small business organizations and secured installment loans to individuals. Additional products and services offered include lock box services, electronic fund transfers, automatic teller machines (ATMs), safe deposit facilities, automatic payroll deposit, cash management and trust services. Although each bank operates under the direction of its own board of directors, the Company has standard operating policies and procedures regard- ing asset/liability management, liquidity, investment, lending and deposit structure management. The Company has historically centralized certain opera- tions where economies of scale can be achieved. Market Information As of March 1, 1994, the Company has 13 bank subsidiaries with 30 offices providing direct service to 31 communities in the Chicago metropolitan area. The combined populations of these communities have grown at a signifi- cantly faster pace than the population of the Chicago metropolitan area over the past two decades. Local planners forecast that growth in communities served by the banks will, on a percentage basis, greatly exceed that of the total metropolitan area. Average household income of the communities served by the Company was greater than the average Chicago metropolitan area income, and the Company believes that average incomes of the households it serves will continue to compare favorably to Chicago metropolitan averages for the fore- seeable future. Subsidiary Banks The Company has made seven acquisitions in the past nine years. The Suburban Bank of Bartlett was purchased in 1985, both the Marengo State Bank and the Suburban Bank of West Brook in 1986, Suburban National Bank/Aurora and The State Bank of Woodstock in 1987, Suburban Bank of Oakbrook Terrace in 1988, and The State Bank of Huntley in 1993. The table below presents certain information regarding the subsidiary banks owned by the Company (dollars in thousands.) December 31, 1993 (1) Name of Bank Number ------------------------------------------- (Year Formed/Year Af- of Total Net Return on Average filiated with Suburban) Locations Assets Equity Income Assets Equity - - ------------------------ -------- -------- ------- ------ -------- ------- (1) The data presented in this table does not aggregate to the Company's consolidated financial results for 1993, since they do not take into account unallocated parent company expenses and other consolidating adjust- ments. Nonbank Subsidiaries The Company also owns 100 percent of three nonbank subsidiaries: Brockway Insurance Agency, Inc., a company organized as an insurance broker; Suburban Mortgage Corp., a company organized as a mortgage banker; and Subur- ban Holdings, Inc., a company organized to hold real estate. Suburban Hold- ings, Inc. is the owner of certain parcels of real estate which are being held for use as bank premises and for sale. Bank Service Corporation Subsidiaries The Company's subsidiary banks own two bank service corporations designed to facilitate certain operations of the banks. Suburban Information Systems, Inc. provides data processing, bookkeeping, and proof of deposit services for the customers of the banks. Suburban Information Systems, Inc. derives substantially all its revenue from the Company's banks. Suburban Remittance Corporation, which is a wholly owned subsidiary of Suburban Infor- mation Systems, processes remittances to large commercial customers requiring specialized services due to high volumes of deposit items. Competition The Company faces intense competition in all phases of its banking business from other banks and financial institutions. In addition to numerous banks in their market area, the Company's banks compete actively with savings and loan institutions, credit unions, insurance companies, investment firms, and retailers. A growing source of local competition comes from out-of-state regional bank holding companies and major Chicago banks which have established themselves in the market areas of the Company's subsidiary banks through loan production offices and affiliated banks. The Company believes that competi- tion for its products and services is based principally on location, conven- ience, quality, and price. The principal pricing factors relate to interest rates charged on loans and paid on deposits. Employees The Company and its subsidiaries employed approximately 575 persons (full time equivalent) on December 31, 1993, of which 21 were employed by the parent company. SUPERVISION AND REGULATION The Company. The Company is a corporation organized in 1981 under the General Corpora- tion Law of the State of Delaware, having its principal place of business in Palatine, Illinois. It holds a certificate of authority to do business as a foreign corporation in the State of Illinois. As a corporation listed for quotation on NASDAQ, it is subject to the Delaware anti-takeover legislation adopted February, 1988. That legislation prevents hostile acquirers from engaging in a wide range of business combinations for three years after ac- quiring a 15% interest in the target corporation. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before merging with or consolidating into another bank holding company, acquiring substantially all the assets of any bank or acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank. The Federal Reserve Board may not approve an acquisition by the Company unless such acquisition has been specifically authorized by Illinois statute. The Bank Holding Company Act prohibits a bank holding company, 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, and controlling banks or furnishing services to banks and their subsidiaries. The Company, however, may engage in, and may own shares of companies engaged in, certain businesses determined by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Bank Holding Company Act does not place territorial restrictions on the activities of bank holding companies or their nonbank subsidiaries. The Banks. Under the Bank Holding Company Act, and the regulations promulgated thereunder, the Company is required to file annual reports of its operations and such additional information as the Federal Reserve Board may require and is subject to examination by the Federal Reserve Board. The Federal Reserve Board has jurisdiction to regulate the terms of certain debt issues of the Company, including the authority to impose reserve requirements. Three of the Company's subsidiaries are national banks and are subject to regulation and regular examinations by the Comptroller of the Currency. All national banks are members of the Federal Reserve System and are subject to applicable provisions of the Federal Reserve Act. The Com- pany's three national banks are the Suburban National Bank of Palatine, Subur- ban National Bank of Elk Grove Village and Suburban National Bank/Aurora. Ten of the Company's banks are state banks, chartered under the Illinois Banking Act. They are subject to regulation and examination by the Illinois Commissioner of Banks and Trust Companies. The Company's state chartered banks are the Suburban Bank of Cary-Grove, Suburban Bank of Hoffman- Schaumburg, Suburban Bank of Barrington, Suburban Bank of Rolling Meadows, Suburban Bank of Bartlett, Suburban Bank of West Brook, Suburban Bank of Oakbrook Terrace, Marengo State Bank, The State Bank of Woodstock and The State Bank of Huntley. All of the banking subsidiaries are members of the Federal Deposit Insurance Corporation ("FDIC") and as such are subject to the provisions of the Federal Deposit Insurance Act. Regulatory Issues The federal and state laws and regulations generally applicable to banks regulate, among other things, the scope of their business, their invest- ments, their reserves against deposits, the nature and amount of and collater- al for loans, and include restrictions on the number of banking offices and activities which may be performed at such offices. Subsidiary banks of a bank holding company are subject to certain restrictions under the Federal Reserve Act and the Federal Deposit Insurance Act on loans and extensions of credit to the bank holding company or to its other subsidiaries, investments in the stock or other securities of the bank holding company or its other subsidiaries, or advances to any borrower collat- eralized by such stock or other securities. Effective December 1, 1990, out-of-state bank holding companies are authorized to acquire banks or bank holding companies having their principal place of business in Illinois. Such out-of-state bank holding companies must have their principal place of business in a state whose interstate banking laws are fully reciprocal with those of Illinois. In 1993, the Illinois General Assembly amended the Illinois Banking Act effectively removing all numeric, geographic and home office protection branching restrictions imposed on banks and savings banks under Illinois law. On December 19, the Federal Deposit Insurance Corporation Improvement act of 1991 ("FDICIA") was enacted. FDICIA provides for, among other things: the recapitalization of the Bank Insurance Fund; several supervisory reforms, inc- luding required annual regulatory examinations of depository institutions, annual independent audits and related management reports on internal controls; the adoption of safety and soundness standards on matters such as loan under writing and documentation, interest rate risk deposit insurance system; and mandated consumer protection disclosure regarding deposit accounts. FDICIA, together with the regulations promulgated pursuant thereto, have increased certain costs related to examination reporting and disclosure. Effective July 1, 1992, banks commonly owned by the same holding company are allowed to establish "affiliate facilities." An affiliate facili- ty is allowed to receive deposits; cash and issue checks drafts and money orders; and receive payments on existing indebtedness. Dividends. The Company uses funds derived primarily from the payment of divi- dends by its subsidiaries for, among other purposes, the payment of dividends to the Company's stockholders. The directors of a national bank may generally declare a dividend of as much of the net profits (as defined in the National Bank Act) of the bank as they deem proper. However, the approval of the Comptroller of the Currency is required for any dividend paid to the Company by national bank subsidiaries if the total of all dividends, including any proposed dividend declared by that bank in any calendar year, exceeds the total of its net profits (as defined in the National Bank Act) for that year and retained net profits (as defined in the National Bank Act) for the preceding two years. Under provisions of the Illinois Banking Act, dividends may not be declared by the Company's state banking subsidiaries except out of each bank's net profit, and unless each bank has transferred to surplus at least one- tenth of its net profits since the date of the declaration of the last preced- ing dividend until the amount of its surplus is at least equal to its capital. Presently, the surplus of each of the Company's state banks equals or exceeds capital. All dividends paid to the Company by its subsidiary banks and by the Company to its stockholders are further restricted by Capital Asset Guide- lines, adopted in substantially the same form by all the relevant Federal regulatory agencies. The Capital Asset Guidelines have been phased in over several years and are currently effective in their entirety. The Capital Asset Guidelines include two measures, a risk-based measure and a leverage measure. Generally a financial institution's capital ratios must meet both measures. The risk-based measure compares an institution's capital with its assets which have been weighted in accordance with the risks associated with them. The minimum ratio established under the risk-based measure is 8.00 percent. The ratio under the risk-based measure for the Company on a consoli- dated basis was 15.77 percent at December 31, 1993. The leverage measure is flexible. The minimum ranges between 4 percent and 5 percent, except for the strongest institutions, which are permitted to operate with a minimum of 3 percent. The Company had a consolidated capital ratio based on the leverage measure of 7.2 percent at December 31, 1993. At December 31, 1993, the Company's banking subsidiaries had $15,656,000 available for the payment of dividends to the Company. Monetary Policy and Economic Conditions. The earnings of bank holding companies and their subsidiary banks are affected by general economic conditions and also by the fiscal and mone- tary policies of governmental authorities, including in particular those of the Federal Reserve Board, which influences conditions in the money and capi- tal markets through, among other means, open market operations. Such opera- tions are designed to affect interest rates and the growth in bank credit and deposits. The above monetary and fiscal policies of the Federal Reserve Board have affected the operating results of all commercial banks in the past and may be expected to do so in the future. The Company cannot predict the nature or the extent of any effects which economic conditions, fiscal, or monetary policies may have on its business and earnings. SELECTED STATISTICAL INFORMATION In accordance with general instruction G(2), the information called for by Item 1 of this Form 10-K and Guide 3, Statistical Disclosure by Bank Holding Companies, is incorporated herein by reference to a section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 24 through 36 of the Company's 1993 Annual Report. ITEM 1(a) - EXECUTIVE OFFICERS OF THE COMPANY The names and ages of the executive officers of the Company, along with a brief account of the business experience of each such person during the past five years, and certain other information follows: Name (Age) and Positions Principal Occupations and Offices with the Company (year with the Company (and subsidiaries) For first elected to office) Past Five Years and Other Information Gerald F. Fitzgerald, Jr. (43) President of Suburban National Bank of director (1981) Palatine from 1980 to 1990; chairman president chief executive of the board of Suburban Bank of West officer (1990) Brook since 1986; of Suburban Bank of of Oakbrook Terrace since 1988; of Suburban Bank of Rolling Meadows since 1990; of Suburban National Bank/ Aurora since 1990; of Suburban National Bank of Elk Grove Village since 1990; of Suburban National Bank of Palatine since 1990; and Suburban Information Systems, Inc. since 1990; president of Brockway Insurance Agency, Inc. since 1990; director Suburban Remittance Corp. since 1987; presi- dent of Suburban Holdings, Inc. since 1990. James G. Fitzgerald (42) Chairman of the board since 1990 and director (1981) president since 1983 of Suburban Bank of treasurer and chief Barrington; chairman of the board of financial officer(1981 Marengo State Bank since 1986; vice vice president (1993) chairman and director of The State Bank of Woodstock since 1987; chairman of the board of Suburban Bank of Bartlett since 1990; of Suburban Bank of Cary-Grove since 1990; of Suburban Bank of Hoffman- Schaumburg since 1990; and The State Bank of Huntley since 1993; director of Suburban Information Systems, Inc. since 1990. Thomas P. MacCarthy (44) President Suburban National Bank of Palatine since 1990; director of Suburban Remittance Corp. since 1993. Francis Catini (48) President Suburban Bank of Cary/Grove director (1981) since 1981; director Suburban Remittance Corp. since 1993; Trustee Suburban Bancorp, Inc. Employee Benefit Plan since 1983. Edward C. Murawski (46) Secretary and treasurer of Brockway senior vice president and Insurance Agency; since 1990; secretary, assistant secretary (1991) treasurer and director of Suburban Holdings comptroller and chief Inc. since 1988; secretary treasurer of accounting officer (1986) Suburban Mortgage Corporation since 1992; treasurer of Suburban Information Systems, Inc.; since 1991. Gerald F. Fitzgerald, Jr. and James G. Fitzgerald are sons of Gerald F. Fitzgerald, current Chairman of the Board of Directors of the Company. No other executive officers of the Company are related. The officers of the Company hold their offices until such time as their successors are chosen by the Board of Directors or their resignations become effective. ITEM 2 ITEM 2 - PROPERTIES The Company occupies a total of approximately 282,000 square feet in 30 locations. The Company's principal offices are located in approximately 10,000 square feet of office space in the Suburban National Bank of Palatine building in Palatine, Illinois. Twenty thousand square feet of the Suburban National Bank of Palatine building, six thousand square feet of the Marengo Bank build- ing, and 4,000 square feet of the Suburban Bank of West Brook building are leased to non-affiliated tenants. Except as discussed above, all facilities are used solely to conduct the Company's banking and bank related businesses. The following table sets forth certain information concerning the main offices and branches of the Company's subsidiary banks and of its nonbank sub- sidiaries. Approximate Own/ Property Main/Branch Square Feet Lease Status ------- ----------- ----------- ----- ------ Certain subsidiary banks have entered into operating leases for banking premises with unaffiliated third parties which resulted in approx- imately $657,000, $587,000, and $565,000 in lease-related expenses in 1993, 1992 and 1991, respectively. The Company does not anticipate material increases in operating lease-related expenses earlier than 1998, except to the extent, if any, addi- tional leased facilities are opened. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS None ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5 ITEM 5 - MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated by reference to a section entitled "Market Price of and Dividends on Company's Common Equity" on page 36 of the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Incorporated by reference to sections entitled "Selected Financial Data" on page 22, "Selected Quarterly Financial Data" on page 23, and "Manage- ment's Discussion and Analysis of Financial Condition and Results of Opera- tions" on page 24 of the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference to a section entitled "Management's Discus- sion and Analysis of Financial Condition and Results of Operations" on pages 24 through 36 of the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Incorporated by reference to the consolidated financial statements set forth on pages 7 through 21 of the Company's Annual Report to Stockholders 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 COMPANY Incorporated herein by reference to sections entitled "Election of Directors" and "Beneficial Ownership of Securities," on pages 1 through 5, of the Company's definitive proxy statement filed with the Securities and Ex- change Commission March 15, 1994, pursuant to Regulation 14A. Information concerning the Executive Officers of the Company is contained in the response to Item 1(a) hereof. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION Incorporated by reference to a section entitled "Executive Compensation" on pages 5 through 11 of the Company's definitive proxy statement filed with the Securities and Exchange Commission March 15, 1994, pursuant to Regula- tion 14A. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to a section entitled "Beneficial Ownership of Securities" on pages 4 and 5 of the Company's definitive proxy statement filed with the Securities and Exchange Commission March 15, 1994, pursuant to Regulation 14A. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference to a section entitled "Management Relation- ships and Related Transactions" on page 12 of the Company's definitive proxy statement filed with the Securities and Exchange Commission March 15, 1994, pursuant to Regulation 14A. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Item 14(a)(1) and (2) SUBURBAN BANCORP, INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENT AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of the Company and its subsidiaries are incorporated by reference to the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993. Page Independent Auditors' Report 7 Consolidated Balance Sheets - December 31, 1993 and 1992 8 Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991 9 Consolidated Statements of Changes in Stockholders' Equity - Years Ended December 31, 1993, 1992 and 1991 10 Consolidated Statements of Changes in Cash Flows - Years Ended December 31, 1993, 1992 and 1991 11 Notes of Consolidated Financial Statements 12 Schedules The following Condensed Financial Information (Parent Company Only) is incorporated by reference to note 15 to the Company's Consolidated Finan- cial Statements as set forth on pages 20 and 21 of the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993. Condensed Balance Sheets - December 31, 1993 and 1992 20 Condensed Statements of Income - Years Ended December 31, 1993, 1992 and 1991 20 Condensed Statements of Changes in Cash Flows - Years Ended December 31, 1993, 1992 and 1991 21 Schedules other than those listed above are omitted for the reason that they are not required or are not applicable or the required information is shown in the financial statements or notes thereto. Item 14(a)(3) and 14(c) - Exhibits (i) See "Index to Exhibits" immediately following signature pages. (ii) The following management contracts and compensatory plans and arrangements are listed as exhibits to this Form 10-K: 10.1 Suburban Bancorp, Inc. Bank Employees Profit Shar- ing Plan - Incorporated by reference to Exhibit 10.8 of Form S-1 of the Company dated June 17, 1986, Registration Number 33-6528 IBRF 10.2 Suburban Bancorp, Inc. Executive Incentive Plan - Incorporated by reference to Exhibit 10.9 of Form S-1 dated July 16, 1986, Registration Number 33-6528 IBRF 10.3 1986 Stock Appreciation Rights Plan - Incorporated by reference to Exhibit 10.5 of Form 10-K of the Company for the year ended December 31, 1986, File Number 0-11138 IBRF 10.4 Deferred Compensation agreement effective as of January 1, 1991 between the Company and Gerald F. Fitzgerald - Incorporated by reference to Exhibit 10.4 of Form 10-K for the year ended December 31, 1991, File Number 0-11138 IBRF 10.5 Employment Agreement between the Company and Gerald F. Fitzgerald - Incorporated by reference to Exhibit 10.5 to Form 10-K for the year ended December 31, 1992, File No-11138 IBRF Item 14(b) - Reports on Form 8-K None Upon written request to the Secretary of Suburban Bancorp, Inc., 50 North Brockway, Drawer A, Palatine, Illinois 60067, copies of exhibits listed on the Index to Exhibits are available to stockholders of Suburban Bancorp, Inc. by specifically identifying each exhibit desired in the request. A fee of $0.20 per page will be charged to stockholders requesting copies of exhibits to cover copying and mailing costs. 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. SUBURBAN BANCORP, INC. (the Registrant) By: /s/ Gerald F. Fitzgerald, Jr. _____________________________ Gerald F. Fitzgerald, Jr. President, Chief Executive Officer, and Director 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 Company and in the capacities indicated, on March 25, 1994. /s/ Gerald F. Fitzgerald ___________________________ ______________________ Gerald F. Fitzgerald John V. Crowe Chairman of the Board Director /s/ James G. Fitzgerald /s/ Gerald F. Fitzgerald, Jr. ____________________________ ___________________________ James G. Fitzgerald Gerald F. Fitzgerald, Jr. Treasurer, Chief Financial President, Chief Executive Officer and Director Officer, and Director /s/ Edward C. Murawski /s/ Thomas G. Fitzgerald ____________________________ ________________________ Edward C. Murawski Thomas G. Fitzgerald Senior Vice President, Secretary and Director Comptroller and Chief Accounting Officer /s/ Francis Catini /s/ James H. Sammons ____________________________ __________________________ Francis Catini James H. Sammons, M.D. Director Director /s/ Richard J. Riordan ____________________________ ___________________________ Donald J. Cooney Richard J. Riordan Director Director /s/ Joseph F. Lizzadro ____________________________ Joseph F. Lizzadro Director INDEX TO EXHIBITS Exhibit Document Number Description Filing* 3.1 Restated Certificate of Incorporation - Incorporated by reference to Exhibit 3.1 of Form S-1 of the Company dated June 17, 1986, under Registration Number 33-6528 IBRF 3.2 By-laws - Incorporated by reference to Exhibit 3.2 of Form 10-K of the Company for the year ended December 31, 1986, File Number 0-11138 IBRF 4.1 Copy of specimen certificate for Class A Common Stock - Incorporated by reference to Exhibit 4.1 of Form S-1 of the Company dated June 17, 1986, Registration Number 33-6528 IBRF 4.2 Copy of specimen certificate for Class B Common Stock - Incorporated by reference to Exhibit 4.2 of Form S-1 of the Company dated June 17, 1986, Registration Number 33-6528 IBRF 10.1 Suburban Bancorp, Inc. Bank Employees Profit Shar- ing Plan - Incorporated by reference to Exhibit 10.8 of Form S-1 of the Company dated June 17, 1986, Registration Number 33-6528 IBRF 10.2 Suburban Bancorp, Inc. Executive Incentive Plan - Incorporated by reference to Exhibit 10.9 of Form S-1 dated July 16, 1986, Registration Number 33-6528 IBRF 10.3 1986 Stock Appreciation Rights Plan - Incorporated by reference to Exhibit 10.5 of Form 10-K of the Company for the year ended December 31, 1986, File Number 0-11138 IBRF 10.4 Deferred Compensation agreement effective as of January 1, 1991 between the Company and Gerald F. Fitzgerald - Incorporated by reference to Exhibit 10.4 of Form 10-K for the year ended December 31, 1991, File Number 0-11138 IBRF 10.5 Employment Agreement between the Company and Gerald F. Fitzgerald - Incorporated by reference to Exhibit 10.5 to Form 10-K for the Year ended December 31, 1992, File No. 0-11138 IBRF Exhibit Document Number Description Filing* 10.6 Form of Directorship Agreement entered into between the Company and each of its Directors - Incorporated by reference to Exhibit 10.5 of Form 10-K for the year ended December 31, 1991 File Number 0-11138 IBRF 13 Annual Report to Stockholders for fiscal year ended December 31, 1993 filed on March 15, 1994 IBRF 21.1 Subsidiaries of Registrant - Incorporated by reference to the definitive proxy statement filed on March 15, 1994 IBRF 23.1 Opinion of Deloitte & Touche concerning financial statements for the year ended December 31, 1993 filed herewith EF * IBRF - Incorporated by Reference EF - Electronically Filed

711083_1993.txt

711083_1993

1993

711083

ITEM 1. BUSINESS OF MID-AMERICA BANCORP Mid-America Bancorp (the "Company") is a Kentucky corporation registered as a bank holding company pursuant to the Bank Holding Company Act of 1956, as amended, and as a savings and loan holding company pursuant to the Home Owners' Loan Act. The Company is registered with, and subject to, the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") and the Office of Thrift Supervision. The Company's banking subsidiary, Mid-America Bank of Louisville and Trust Company (the "Bank") represents the Company's primary subsidiary. The Bank was established as a Kentucky banking corporation on October 14, 1925, under the name "Morris Plan Industrial Bank." On July 2, 1946 the Bank's name was changed to "Bank of Louisville." The Bank merged with "Royal Bank and Trust Company" in 1963 under the name Bank of Louisville-Royal Bank and Trust Co. The Bank's name was changed to Bank of Louisville and Trust Company on March 26, 1980. The present name of the Bank was adopted on March 25, 1983. The Bank is engaged in a wide range of commercial, trust, and personal banking activities including the usual acceptance of deposits for checking, savings and time deposit accounts; making of real estate, construction, commercial, home improvement and consumer loans; issuance of letters of credit; rental of safe deposit boxes; providing financial counseling for institutions and individuals; serving as executor of estates and as trustee under trusts and under various pension and employee benefit plans; serving as escrow agent on bond issues; serving as stock transfer agent, exchange agent, dividend disbursing agent, and registrar with respect to corporate securities; and participation in small business loan and student loan programs. The Company also operates a number of other subsidiaries, including Mid-America Bank, FSB, a federal savings bank (Savings Bank), which was organized and chartered during 1993. The Savings Bank is located in Pewee Valley, Kentucky in Oldham County, and competes on the local level with other commercial banks and financial institutions in Oldham County, Kentucky for all types of deposits and loans. Another subsidiary, Mid-America Money Order Company, is engaged in the issuance and sale throughout the United States of retail money orders and similar consumer-type payment instruments having a face value of not more than $1,000. As of December 31, 1993, Mid-America Money Order Company was licensed to issue money orders in 48 states and the District of Columbia. Competition Competition for banking and related financial services is active in Jefferson County, Kentucky and other geographic areas served by the Company's subsidiaries. The Company's subsidiaries compete with other financial institutions including savings and loan associations, finance companies, mortgage banking companies, credit unions, insurance companies, brokerage firms, mutual funds, and other commercial banks. In addition, large money center banks continue to increase competition in the Company's trade territories through the acquisition of local financial institutions, the establishment of loan production offices and the solicitation of customers for credit cards and related services. At present, both price and product range are critically important in maintaining and expanding financial relationships. On December 31, 1993, the Bank ranked fourth among banks and trust companies in the City of Louisville and in Jefferson County, Kentucky, in terms of total assets and in terms of total deposits. On December 31, 1993 there were 8 commercial banks and trust companies in Jefferson County, including the Bank. Employees As of December 31, 1993, the Company and subsidiaries employed 583 persons on a full-time equivalent basis and 132 on a part-time basis. Government Policies As a financial institution, the earnings of the Company's various operating subsidiaries are affected by state and federal laws and by policies of various federal and state regulatory agencies. These policies include, for example, statutory maximum legal lending rates, domestic monetary policies of the Board of Governors of the Federal Reserve System, United States fiscal policy, and capital adequacy and liquidity constraints imposed by bank regulatory agencies. Supervision And Regulation The Company is a registered bank holding company under the Bank Holding Company Act of 1956, as amended ("BHC Act"), and is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System. Under the BHC Act, a bank holding company is, with limited exceptions, prohibited from (i) acquiring direct or indirect ownership or control of any voting shares of any company which is not a bank or (ii) engaging in any activity other than managing or controlling banks. Notwithstanding this prohibition, a bank holding company may engage in or own shares of a company that engages solely in activities which the Federal Reserve Board has determined to be so closely related to banking, or managing or controlling banks, as to be a proper incident thereto. As a registered bank holding company, the Company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and the business operations of its subsidiaries. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval prior to acquiring, directly or indirectly, ownership or control of any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting stock of such bank unless it already owns a majority of the voting stock of such bank. The Bank is subject to regulation and supervision, of which regular bank examinations are a part, by the Kentucky Department of Financial Institutions, Division of Banking. The Federal Deposit Insurance Corporation ("FDIC") currently insures the deposits of the Bank to a maximum of $100,000 per depositor. For this protection, the Bank pays a semi-annual statutory assessment and is subject to the rules and regulations of the FDIC pertaining to deposit insurance. On July 13, 1989, the Bank became a member bank in the Federal Reserve System. The Federal Reserve Board retains direct supervision of state chartered member banks and their affiliates through periodic examinations, the expense of which is borne by the Bank. The Savings Bank is subject to regulation and supervision, of which regular examinations are a part, by the Office of Thrift Supervision (OTS). The FDIC currently insures the deposits of the Savings Bank to a maximum of $100,000 per depositor. Eton Life Insurance Company, a wholly-owned subsidiary of the Company, is regulated by the Kentucky Department of Insurance and is subject to Kentucky statutes and regulations governing domestic underwriters of credit life, accident, and health insurance. The enactment in August 1989 of the Financial Reform, Recovery and Enforcement Act of 1989 ("FIRREA") placed the savings and loan insurance fund under the control of the FDIC, created the OTS in the U.S. Treasury Department and created the Resolution Trust Corporation to act as receiver to liquidate failed thrift institutions. FIRREA further expanded the power of bank holding companies to allow for the acquisition of savings associations and to operate them as separate thrift subsidiaries. FIRREA enhanced the ability of bank holding companies to expand through thrift acquisitions beyond their present geographic interstate banking region. The tandem restrictions placed upon thrift subsidiaries of bank holding companies have been removed allowing linkage of deposit-taking activities and solicitation of deposits and loans on behalf of affiliate companies. FIRREA led to many structural changes in competition for loans, deposits and other services, affected collateral valuation methods, and the acquisition of financial institutions. In addition to FIRREA, in December 1991 the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDIC Improvement Act") was enacted. The FDIC Improvement Act deals with the recapitalization of the Bank Insurance Fund, deposit insurance reform, including requiring the FDIC to establish a risk-based premium assessment system, and a number of other regulatory and supervisory matters. The following tables set forth selected statistical information with respect to the Company and its subsidiaries and should be read in conjunction with the Company's consolidated financial statements. DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY; INTEREST RATES AND INTEREST DIFFERENTIAL The schedule captioned "Average Balances and Yields/Rates Tax Equivalent Basis" included on page 32 of the Company's annual report to shareholders for the year ended December 31, 1993, which is incorporated herein by reference, shows, for each major category of interest earning asset and interest bearing liability, the average amount outstanding, the interest earned or expensed on such amount and the average rate earned or expensed for each of the years in the three-year period ended December 31, 1993. The schedule also shows the average rate earned on all interest earning assets and the average rate expensed on all interest bearing liabilities and the net interest margin (net interest income divided by total average interest earning assets, where net interest income equals the difference between interest earned and interest expensed) for each of the years in the three-year period ended December 31, 1993. Nonaccrual loans outstanding were included in calculating the rate earned on loans. Total interest income includes the effects of taxable equivalent adjustments using a tax rate of 35% for 1993 and 34% for 1992 and 1991. The changes in interest income and interest expense resulting from changes in volume and changes in rates for the years ended December 31, 1993 and 1992 are shown in the schedule captioned "Interest Income and Interest Expense Volume and Rate Changes for the Years 1993 and 1992 Tax Equivalent Basis" included on page 33 of the Company's annual report to shareholders for the year ended December 31, 1993, which is incorporated herein by reference. Total interest income includes the effects of taxable equivalent adjustments using a tax rate of 35% for 1993 and 34% for 1992 and 1991. SECURITIES PORTFOLIO BOOK VALUE SECURITIES MATURITY DISTRIBUTION AND WEIGHTED AVERAGE YIELDS DECEMBER 31, 1993 The calculation of the weighted average yield is based on the average tax exempt yield, weighted by the respective costs of the securities. The weighted average yields on states and political subdivisions securities are computed on a tax equivalent basis using a marginal federal tax rate of 35%. LOAN PORTFOLIO (In Thousands) Includes domestic loans only as the Company has no foreign loans. The Company has no other category of loans whose concentration exceeds 10% of total loans. SELECTED LOAN MATURITIES AND SENSITIVITY TO INTEREST RATES DECEMBER 31, 1993 (In Thousands) NON-PERFORMING LOANS Information with respect to the Company's non-performing loans is included in the schedule captioned "Non-Performing and Restructured Assets" and footnote C to the consolidated financial statements included on pages 26 and 44, respectively, of the Company's annual report to shareholders for the year ended December 31, 1993, which is incorporated herein by reference. SUMMARY OF LOAN LOSS EXPERIENCE (Dollars In Thousands) The allowance for loan losses is maintained at a level adequate to absorb probable losses. Management determines the adequacy of the allowance based upon reviews of individual credits, evaluation of the risk characteristics of the loan portfolio, including the impact of current economic conditions on the borrowers' ability to repay, past collection and loss experience and such other factors, which, in Management's judgement, deserve current recognition. The allowance for loan losses is increased by charges to operating earnings and reduced by charge-offs, net of recoveries. ALLOCATION OF ALLOWANCE FOR LOAN LOSSES (Dollars In Thousands) MATURITY SCHEDULE OF TIME DEPOSITS OF $100,000 AND OVER DECEMBER 31, 1993 (In Thousands) Certificate Of Deposits Other Total ----------- ---------- --------- Three months or less...................... $5,973 $5,135 $11,108 Over three through six months............. 2,555 -- 2,555 Over six through twelve months............ 5,568 -- 5,568 Over twelve months........................ 12,360 -- 12,360 ---------- ---------- --------- $26,456 $5,135 $31,591 ========== ========== ========= RETURN ON EQUITY AND ASSETS Incorporated by reference herein to page 4 of the Company's annual report to shareholders. FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE (Dollars In Thousands) Federal funds purchased and securities sold under agreements to repurchase generally represent overnight borrowing transactions. Included in repurchase agreements are balances of several institutional customers which are subject to substantial fluctuations, with reductions occurring in the normal course of business after year end. The detail of these short-term borrowings for the years 1993, 1992 and 1991 follows: ITEM 2. ITEM 2. PROPERTIES The Bank maintains a main office, warehouse and 30 branches. The Bank owns 18 branch offices, leases 11 branch offices and the main office, and owns the buildings but leases the land with regard to 1 branch. The Bank also operates 43 automatic teller machines, at various locations in its traditional customer base of Jefferson County, Kentucky. See footnote E to the consolidated financial statements on page 45 of the Company's annual report to shareholders for the year ended December 31, 1993, which is incorporated herein by reference, for additional information on premises, equipment and lease commitments. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information contained in footnote N to the Company's consolidated financial statements included on page 50 of the Company's annual report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. EXECUTIVE OFFICERS OF REGISTRANT. Listed below are the names and ages of the Company's executive officers, positions held, and the year from which held. The Company's executive officers are elected annually by the Board of Directors: Year From Name Age Position Held Which Held Bertram W. Klein 63 Chairman of the Board, 1985 Chief Executive Officer & member of the Executive Committee Orson Oliver 50 President, Director & 1985 member of the Executive Committee Thomas L. Weber 61 Executive Vice President 1984 & member of the Executive Committee Wallace A. Fudold 49 Executive Vice President 1985 & member of the Executive Committee Paul E. Henry 58 Executive Vice President 1989 & member of the Executive Committee David N. Klein 38 Executive Vice President 1991 & member of the Executive Committee Richard B. Klein 35 Executive Vice President 1991 & member of the Executive Committee Gail W. Pohn 58 Executive Vice President 1993 & member of the Executive Committee Robert H. Sachs 54 Executive Vice President, 1993 General Counsel, & member of the Executive Committee Steven A. Small 40 Executive Vice President, 1993 Chief Financial Officer & member of the Executive Committee Mr. Henry joined the Company's subsidiary bank in 1964. He was elected to his current position in 1989, and last held the office of Senior Vice President - Commercial Lending. David N. Klein joined the Company's subsidiary bank in 1978. He was elected to his current position in 1991 and from 1987 to 1991 held the office of Senior Vice President - Retail Banking. He is the son of Bertram W. Klein and the brother of Richard B. Klein. Richard B. Klein joined the Company's subsidiary bank in 1980. He was elected to his current position in 1991 and from 1987 to 1991 held the office of Senior Vice President -Consumer Loans and Credit. He is the son of Bertram W. Klein and the brother of David N. Klein. Mr. Pohn joined the Company and the Company's subsidiary bank in 1993. Prior to joining the Company, from 1981 to 1993, he was Senior Vice President, Chief Counsel and Secretary for National City Bank, Kentucky (and its predecessor), a non-affiliate of the Company. Mr. Sachs joined the Company and the Company's subsidiary bank in 1993. From 1990 to 1993, Mr. Sachs was the President of Legal Services Management, Inc., a consultant to corporations and law firms regarding the effective management and delivery of legal services. From 1989 to 1990 he was Vice President of Law and Corporate Secretary to BATUS Inc., a $13 billion management and holding company for the U.S. interests of BAT Industries, plc, a large publicly held UK conglomerate. Prior to that, Mr. Sachs was Vice President and General Counsel, Product Litigation, to Brown & Williamson Tobacco Corporation. Mr. Small, a CPA, joined the Company and the Company's subsidiary bank in 1993. Prior to joining the Company, from 1986 to 1993, he was a partner of KPMG Peat Marwick, Certified Public Accountants, and worked primarily in serving financial institution clients of that firm. All other executive officers have served the Company or the Bank in executive officer capacities for more than five years. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The information captioned "Market for Mid-America Bancorp's Stock and Related Security Holder Matters" included on page 36 of the Company's annual report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information captioned "Summary of Financial Data" included on page 34 of the Company's annual report to shareholders for the year ended December 31, 1993 is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management's Discussion and Analysis of Financial Condition and Results of Operations included on pages 21 through 33 of the Company's annual report to shareholders 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 Company and report of independent auditors included on pages 37 through 53 in the Company's annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference: 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 changes in 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 The information captioned "Quarterly Financial Data" included on page 35 of the Company's annual report to shareholders 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 ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT; AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by these items, other than the information set forth above under Item I, "Executive Officers of Registrant," is omitted because the Company is filing a definitive proxy statement pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report which includes the required information. The required information contained in the Company's proxy statement is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a-l Financial Statements See Part II, Item 8 for a listing of all financial statements and report of independent auditors. a-2 Financial Statement Schedules All schedules normally required by Form lO-K are omitted since they are either not applicable or the required information is shown in the financial statements or the notes thereto. a-3 Exhibits 3(a) Amended and Restated Articles of Incorporation of Mid-America Bancorp filed with the Secretary of State of Kentucky on May 4, 1989. Exhibit 3(e) to the Company's annual report on Form 10-K for the year ended December 31, 1989 is incorporated by reference herein. (b) By-Laws of Mid-America Bancorp. Exhibit 3 (c) to Registration Statement No. 2-80835 is incorporated by reference herein. 4. Amended and Restated Articles of Incorporation and By-Laws. See Exhibits 3(a) and 3(b). 10. Material Contracts (a) Employment Agreement between the Company and Orson Oliver dated, April 5, 1993 (b) Employment Agreement between the Company and Wallace A. Fudold dated, April 5, 1993 (c) Employment Agreement between the Company and David N. Klein dated, April 5, 1993 (d) Employment Agreement between the Company and Richard B. Klein dated, April 5, 1993 (e) Employment Agreement between the Company and Robert Sachs dated, April 5, 1993 (f) Employment Agreement between the Company and Gail Pohn dated, April 5, 1993 (g) Employment Agreement between the Company and Steven Small. May 3, 1993 (h) Agreement and General Release between the Company and Stanley L. Atlas dated, October 26, 1993 (i) Amended and Restated Mid-America Bancorp Incentive Stock Option Plan is incorporated herein by reference to Post-Effective Amendment Number 1 to Form S-8 Registration Statement No. 2-92270. (j) Mid-America Bancorp 1991 Incentive Stock Option Plan. Exhibit 28 to Registration Statement No. 33-42989 is incorporated by reference herein. (k) Mid-America Bancorp Incentive Compensation Plan. Exhibit 10(d) to the Company's annual report on Form 10-K for the year ended December 31, 1990 is incorporated by reference herein. 11. Statement re Computation of per share earnings. 13. Selected portions of the annual report to shareholders for the year ended December 31, 1993. 21. Subsidiaries of the Company. 23. Consent of independent auditors. 27. Financial Data Schedule. 99. Additional Exhibits Form 11-K b Reports on Form 8-K None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MID-AMERICA BANCORP March 21, 1994 BY: /s/ Bertram W. Klein Bertram W. Klein Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated. /s/ Bertram W. Klein Chairman of the Board & Mar. 21, 1994 Bertram W. Klein Chief Executive Officer /s/ Orson Oliver President & Director Mar. 21, 1994 Orson Oliver /s/ Steven A. Small Executive Vice President Mar. 21, 1994 Steven A. Small & Chief Financial Officer /s/ Stanley L. Atlas Director Mar. 21, 1994 Stanley L. Atlas /s/ Leslie D. Aberson Director Mar. 21, 1994 Leslie D. Aberson /s/ Robert P. Adelberg Director Mar. 21, 1994 Robert P. Adelberg /s/ William C. Ballard, Jr. Director Mar. 21, 1994 William C. Ballard, Jr. /s/ Henry D. Burns Director Mar. 21, 1994 Henry D. Burns /s/ Martha Layne Collins Director Mar. 21, 1994 Martha Layne Collins /s/ Harry S. Frazier, Jr. Director Mar. 21, 1994 Harry S. Frazier, Jr. /s/ Peggy Ann Markstein Director Mar. 21, 1994 Peggy Ann Markstein /s/ Donald G. McClinton Director Mar. 21, 1994 Donald G.McClinton /s/ John D. Palmore Director Mar. 21, 1994 John D. Palmore /s/ Katherine G. Peden Director Mar. 21, 1994 Katherine G. Peden Director Mar. 21, 1994 Woodford R. Porter, Sr. /s/ Benjamin Richmond Director Mar. 21, 1994 Benjamin Richmond /s/ Raymond L. Sales Director Mar. 21, 1994 Raymond L. Sales /s/ Thomas E. Sandefur, Jr. Director Mar. 21, 1994 Thomas E. Sandefur, Jr. Director Mar. 21, 1994 Al J. Schneider /s/ Henry C. Wagner Director Mar. 21, 1994 Henry C. Wagner SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------------- EXHIBITS filed with FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1993 Commission file number 1-10602 __________________________ MID-AMERICA BANCORP INDEX TO EXHIBITS Exhibit Number Page 10. Material Contracts (a) Employment Agreement between the Company and Orson Oliver dated, April 5, 1993 1 (b) Employment Agreement between the Company and Wallace A. Fudold dated, April 5, 1993 9 (c) Employment Agreement between the Company and David N. Klein dated, April 5, 1993 17 (d) Employment Agreement between the Company and Richard B. Klein dated, April 5, 1993 25 (e) Employment Agreement between the Company and Robert Sachs dated, April 5, 1993 33 (f) Employment Agreement between the Company and Gail Pohn dated, April 5, 1993 42 (g) Employment Agreement between the Company and Steven Small dated, May 3, 1993 50 (h) Agreement and General Release between the Company and Stanley L. Atlas dated, October 26, 1993 58 11. Statement re: Computation of per share earnings 62 13. Selected portions of the annual report to shareholders for the year ended December 31, 1993. 63 21. Subsidiaries of the Registrant. 106 23. Consent of independent auditors. 107 27. Financial Data Schedule 108 99. Additional Exhibits Form 11-K 109

34616_1993.txt

34616_1993

1993

34616

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Page Financial Statements Independent Auditors' Report................................31 Consolidated Balance Sheets, August 31, 1993 and 1992.......32 Consolidated Statements of Operations for each of the years in the three-year period ended August 31, 1993................34 Consolidated Statements of Cash Flows for each of the years in the three-year period ended August 31, 1993...............35 Consolidated Statements of Capital Shares and Equities for each of the years in the three-year period ended August 31, 1993.37 Notes to Consolidated Financial Statements...............38 Financial Statement Schedules Farmland Industries, Inc. and Subsidiaries for each of the years in the three-year period ended August 31, 1993: V--Property, Plant and Equipment.........................70 VI--Accumulated Depreciation and Amortization of..........73 Property, Plant and Equipment IX--Short-term Borrowings.................................76 X--Supplementary Income Statement Information............76 All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Board of Directors Farmland Industries, Inc.: We have audited the accompanying consolidated balance sheets of Farmland Industries, Inc. and subsidiaries as of August 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and capital shares and equities for each of the years in the three-year period ended August 31, 1993. 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 Farmland Industries, Inc. and subsidiaries as of August 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 August 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 7 to the consolidated financial statements, the Internal Revenue Service (IRS) has examined the Company's tax returns for the years ended August 31, 1984 and 1983, and has proposed certain adjustments. Should the IRS ultimately prevail, the federal and state income taxes and statutory interest thereon could be significant. Farmland believes it has meritorious positions with respect to such claims and, based upon the opinion of special tax counsel, management believes it is more likely than not that the courts will ultimately conclude that Farmland's treatment of such items was substantially, if not entirely, correct. The ultimate outcome of this matter can not presently be determined. Therefore, no provision for such income taxes and interest has been made in the accompanying consolidated financial statements. KPMG PEAT MARWICK Kansas City, Missouri October 29, 1993 FARMLAND INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) FARMLAND INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Farmland is organized and operated as a cooperative and is intended to be a producer-driven and profitable ag supply to consumer foods cooperative system. Principles of Consolidation --The consolidated financial statements include the accounts of Farmland Industries, Inc. ("Farmland") and all its majority-owned subsidiaries (the "Company"). All significant intercompany accounts and transactions have been eliminated. Certain previously reported amounts have been reclassified to conform to the 1993 presentation. Investments --Investments in cooperatives are stated at cost plus the par value of equity certificates received as payment of patronage refunds less such equity certificates redeemed. Investments in companies owned 20% to 50% by Farmland are accounted for by the equity method. All other investments are stated at cost. Accounts Receivable --The Company uses the allowance method to account for uncollectible accounts and notes. Uncollectible accounts and notes receivable from members are reduced by offsets against the common stock of Farmland held by members prior to charging uncollectible accounts to operations. Inventories --Grain inventories are valued at market adjusted for net unrealized gains or losses on open commodity contracts. Crude oil, refined petroleum products, cattle and beef inventories are valued at the lower of last-in, first-out cost or market. Supplies are valued at cost. All other inventories are valued at the lower of first-in, first-out cost or market. To the extent practical, the Company hedges certain inventories, advance sales and purchase contracts with fixed prices and anticipated purchases of raw materials. Property, Plant and Equipment --Assets are stated at cost and depreciated principally on a straight-line basis over the estimated useful life of the individual asset (3 to 40 years). Leasehold improvements are amortized on a straight-line basis over the terms of the individual leases (15 to 21 years). Upon disposition of these assets any resulting gain or loss is included in income. Major repairs and maintenance costs are capitalized. Normal repairs and maintenance costs are charged to operations. Research and Development Costs --Total research and development costs for the Company for the years ended August 31, 1993, 1992 and 1991 were $3,303,000, $3,338,000 and $3,269,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Goodwill --The excess of cost over net assets of businesses purchased is being amortized on a straight-line basis over a period of 25 to 40 years. Federal Income Taxes --Farmland and its cooperative subsidiaries are subject to income taxes on all income not distributed to patrons as patronage refunds. Farmland and all its subsidiaries, except Farmland Foods, Inc. ("Foods") and National Beef Packing Company, L.P. ("NBPC") file consolidated federal and state income tax returns. Cash and Cash Equivalents --Investments with maturities of less than three months are included in "Cash and cash equivalents." (2) Acquisitions and Dispositions During 1993, Farmland and partners organized NBPC, a limited partnership. Farmland retained a 58% ownership interest in NBPC by investing $10,500,000 in cash. NBPC's purpose is to carry on the business of Idle Wild Foods, Inc. ("Idle Wild"). On April 15, 1993, NBPC acquired Idle Wild's beef packing plant and feedlot located in Liberal, Kansas. NBPC acquired these assets by assuming liabilities of Idle Wild with a fair market value of approximately $130,605,000, including bank loans which are nonrecourse to NBPC's partners. The acquisition has been accounted for as a purchase and, accordingly, the results of operations of NBPC have been included in the Company's consolidated financial statements from April 15, 1993. The liabilities assumed over the fair value of the net identifiable assets acquired ($16,086,000) has been recorded as goodwill and is being amortized on a straight-line basis over 25 years. Effective June 30, 1992, Farmland acquired substantially all the business and assets of Union Equity Co-Operative Exchange ("Union Equity") in exchange for 2,051,880 shares of Farmland common stock with a par value of $51,297,000 and Farmland's assumption of substantially all of Union Equity's liabilities. The acquisition has been accounted for as a purchase and, accordingly, the results of operations of Union Equity have been included in the Company's consolidated financial statements from June 30, 1992. The excess of the purchase price over the fair value of the net identifiable assets acquired ($20,976,000) has been recorded as goodwill and is being amortized on a straight-line basis over 25 years. To establish The Cooperative Finance Association ("CFA") as an independent finance association for its members, CFA purchased 10,113,000 shares of its voting common stock held by Farmland for a purchase price comprised of $1,541,000 in cash, equities of Farmland (with a par value of $2,406,000) held by CFA and a $6,166,000 subordinated promissory note payable to Farmland bearing interest of 5.3%. In addition, CFA: 1) purchased the lending operations and notes receivable of Farmland Financial Services Company ("FFSC"), a wholly-owned subsidiary of Farmland. The purchase price approximated the face amount of FFSC's notes receivable and consisted of $60,505,000 in cash and a $2,128,000 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6% subordinated promissory note payable; 2) repaid its operating loan to Farmland ($25,181,000); and, 3) proposed a recapitalization plan which limits the voting rights of any owner (including Farmland) to 20% or less regardless of the number of voting shares held. Farmland repaid $87,227,000 of its borrowings from National Bank for Cooperatives ("CoBank") with proceeds received from CFA. As a result of CFA's purchase of its stock, Farmland's voting percentage in CFA was reduced to 49%. Accordingly, CFA is not included in the consolidated balance sheet of the Company as of August 31, 1993. The following unaudited financial information, for the years ended August 31, 1993 and 1992, presents pro forma results of operations of the Company as if the disposition of CFA and the acquisitions of Union Equity and NBPC had occurred at the beginning of each period presented. The pro forma financial information includes adjustments for amortization of goodwill, additional depreciation expense and increased interest expense on debt assumed in the acquisitions. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company been a single entity which excluded CFA and included Union Equity and NBPC for the full years 1993 and 1992. August 31 (Unaudited) 1993 1992 (Amounts in Thousands) Net sales............................... $5,357,867 $5,441,303 Income (loss) before extraordinary item..$ (44,040) $ 47,225 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (3) Inventories Major components of inventories are as follows: August 31 1993 1992 (Amounts in Thousands) Grain.................................$ 91,990 $ 67,459 Beef.................................. 27,754 -0- Materials............................. 43,857 42,702 Supplies.............................. 41,388 38,445 Finished and in-process products...... 285,947 258,358 $490,936 $406,964 LIFO adjustment....................... 5,754 1,635 $496,690 $408,599 Earnings for the year ended August 31, 1993 have been reduced by $8,346,000 to recognize the write-down of certain crude oil and refined petroleum inventories to market. Inventories, for these products, stated under the last-in, first-out (LIFO) method at August 31, 1993 and 1992, were $84,088,000 and $92,094,000, respectively. Had the lower of first-in, first-out (FIFO) cost or market been used to value these products, inventories at August 31, 1993 and 1992 would have been lower by $5,754,000 and $1,635,000, respectively. The LIFO valuation method had the effect of increasing income before income taxes and patronage refunds by $4,119,000 in 1993, reducing such income by $1,953,000 in 1992 and increasing such income by $3,588,000 in 1991. Liquidation of prior year inventory layers in 1992 and 1991 reduced income before income taxes and patronage refunds in these years by $3,302,000 and $4,177,000, respectively. The carrying value of beef inventories stated under the LIFO method was $27,754,000 at August 31, 1993. The LIFO method of accounting for beef inventories had no effect on the carrying value of inventories or on the loss reported in 1993, because market value of these inventories was lower than LIFO or FIFO cost. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (4) Investments and Long-Term Receivables The Company's investments accounted for by the equity method consist principally of 50% equity interests in Farmland Hydro L.P., SF Phosphates Limited Company and Hyplains Beef L.C. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) On November 15, 1991, Farmland and Norsk Hydro a.s. ("Hydro") formed a joint venture company, Farmland Hydro, to manufacture phosphate fertilizer products for distribution to international markets. As part of the joint venture agreement, Farmland sold a 50% interest in its Green Bay, Florida phosphate fertilizer plant and certain phosphate rock reserves located in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Hardee County, Florida to Hydro for an amount approximately equal to Farmland's carrying value of the assets. Subsequently, Farmland and Hydro contributed the assets to the joint venture. Farmland operates the plant under a management agreement with the joint venture and Hydro provides international marketing services. See note 15 of the notes to consolidated financial statements. Farmland and J. R. Simplot formed a joint venture (SF Phosphates, Limited Company) to operate a phosphate mine located in Vernal, Utah, a fertilizer plant located in Rock Springs, Wyoming, and a 96-mile pipeline that connects the mine with the fertilizer plant. The purchase of the mine, plant and pipeline from Chevron Corporation was completed in April 1992. Prior to August 31, 1993, CFA was a 99%-owned finance subsidiary of the Company. CFA provides specialized financial services for Farmland's local cooperative members. CFA operates on a fiscal year ending August 31. For the years ended August 31, 1993, 1992 and 1991, interest income of CFA amounting to $7,614,000, $7,840,000 and $7,382,000, respectively, has been included in sales and interest expense of $5,498,000, $6,248,000 and $5,202,000, respectively, has been included in cost of sales in the accompanying consolidated statements of operations. A condensed balance sheet of CFA as of August 31, 1992 and condensed statements of operations for the period ended August 30, 1993 and the years ended August 31, 1992 and 1991 are shown below. See note 2 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," was issued by the Financial Accounting Standards Board ("FASB") in May 1993 and is effective for fiscal years beginning after December 15, 1993 (the Company's 1995 fiscal year). Statement 115 expands the use of fair value accounting and the reporting for certain investments in debt and equity securities. Management expects the adoption of Statement 115 will not have a significant impact on the Company's consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (5) Property, Plant and Equipment A summary of cost for property, plant and equipment is as follows: August 31 1993 1992 (Amounts in Thousands) Land and improvements.................$ 11,825 $ 11,437 Site improvements..................... 26,878 15,308 Buildings............................. 215,420 193,215 Machinery and equipment............... 655,117 593,014 Furniture and fixtures................ 45,405 37,850 Automotive equipment.................. 51,179 46,324 Mining properties..................... 26,786 26,569 Fertilizer properties................. 48,695 48,695 Construction in progress.............. 57,242 53,812 Leasehold improvements................ 15,796 10,215 Total.......................$1,154,343 $1,036,439 Mining properties represent phosphate rock reserves and construction and development costs of a mine in Hardee County, Florida and the surrounding area. The Company has deferred the development of this phosphate mine. See note 4 of the notes to consolidated financial statements. For the years ended August 31, 1993, 1992 and 1991, the Company capitalized construction period interest of $1,611,000, $330,000 and $328,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (6) Bank Loans, Subordinated Debt Certificates and Notes Payable The Company maintains various credit agreements with CoBank that allow the Company to borrow under terms as the Company and CoBank mutually agree upon. These facilities provide for both seasonal and term borrowings. At August 31, 1993, total credit lines available were approximately $508,900,000. Seasonal and term borrowings under these agreements at August 31, 1993 were $156,650,000 and $66,098,000, respectively, and $86,819,000 was used to support letters of credit issued on behalf of Farmland by CoBank. The agreements with CoBank stipulate that by February 15, 1994 the maximum credit available from CoBank to the Company shall be reduced to an amount not in excess of CoBank's then applicable lending limit to a single borrower. Under loan agreements with CoBank, the Company has pledged its investment in CoBank stock carried at $31,824,000. Under industrial revenue bonds and lease agreements, property, plant and equipment with a carrying value of $31,394,000 has been pledged. Under bank loan agreements of NBPC, all of its assets (carried at $152,745,000) are pledged to support its borrowings. Such borrowings of NBPC are nonrecourse to its partners. Farmland's loan agreements with CoBank contain provisions which require the Company to maintain consolidated working NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) capital of not less than $150,000,000 and to maintain consolidated net worth of not less than $425,000,000. In addition, the agreements require the Company to maintain funded indebtedness and senior funded indebtedness of not more than 52% and 43% of capitalization, respectively. All computations are based on consolidated financial data adjusted to exclude nonrecourse subsidiaries (any subsidiary for which Farmland is not directly or indirectly liable for any of such subsidiary's indebtedness). As computed under provisions of the agreement, at August 31, 1993, working capital was $210,744,000, net worth was $561,303,000, funded indebtedness was 45.14%, and senior funded indebtedness was 21.10% of capitalization. Borrowers from CoBank are required to maintain an investment in CoBank stock based on the average amount borrowed from CoBank during the previous five years. At August 31, 1993, the Company's investment in CoBank approximated the requirement. Farmland has credit facilities with various commercial banks. At August 31, 1993, Farmland had $215,000,000 of available credit from commercial banks under committed arrangements and $30,000,000 of credit available under uncommitted arrangements. Borrowings at August 31, 1993 under these committed and uncommitted credit facilities were $131,300,000 and $10,000,000, respectively. In addition, $18,237,000 was used at August 31, 1993 to support letters of credit issued by such banks on Farmland's behalf. Covenants of these arrangements are not more restrictive than Farmland's credit lines with CoBank. Subordinated debt certificates have been issued under several different indentures and therefore the terms of such securities are not identical. Farmland may redeem subordinated certificates of investments and capital investment certificates in advance of scheduled maturities. Farmland will redeem subordinated certificates of investments, capital investment certificates and subordinated monthly interest certificates upon death of the holder. Holders of certificates of investment and capital investment certificates have the right to exchange such securities after a minimum holding period for similar securities. The outstanding subordinated debt certificates are subordinated to senior indebtedness. At August 31, 1993, senior indebtedness included $449,454,000 for money borrowed, and other instruments (principally long-term operating leases) which provide for aggregate payments over ten years of approximately $116,250,000. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Bank loans, subordinated debt certificates and notes payable mature during the fiscal years ending August 31 in the following amounts: (Amounts in Thousands) 1994.......................................$ 31,947 1995....................................... 33,794 1996....................................... 94,075 1997....................................... 51,997 1998....................................... 73,643 1999 and after............................. 232,352 $517,808 (7) Income Taxes On July 28, 1983, Farmland sold the stock of Terra Resources, Inc. ("Terra"), a wholly-owned subsidiary engaged in oil and gas exploration and production operations, and exited its oil and gas exploration and production activities. The gain from the sale of Terra amounted to $237,200,000 for tax reporting purposes. During 1983, and prior to the sale of the Terra stock, Farmland received certain distributions from Terra totaling $24,800,000. For tax purposes, Farmland claimed intercorporate dividends-received deductions for the entire amount of such distributions. On March 24, 1993, the Internal Revenue Service ("IRS") issued a statutory notice to Farmland asserting deficiencies in federal income taxes (exclusive of statutory interest thereon) in the aggregate amount of $70,775,000. The asserted deficiencies relate primarily to the Company's tax treatment of the sale of the Terra stock and the distributions received from Terra prior to the sale. The IRS asserts that Farmland incorrectly treated the Terra sale gain as income against which certain patronage-sourced operating losses could be offset, and that, as a nonexempt cooperative, Farmland was not entitled to an intercorporate dividends-received deduction in respect of the 1983 distribution by Terra. It further asserts that Farmland incorrectly characterized gains for tax purposes aggregating approximately $14,600,000, and a loss of approximately $2,300,000, from the disposition of certain other assets. On June 11, 1993, Farmland filed a petition in the United States Tax Court contesting the asserted deficiencies in their entirety. A trial date has not yet been set. If the IRS ultimately prevails on all of the adjustments asserted in the statutory notice, Farmland would have additional federal and state income tax liabilities aggregating approximately $85,800,000 plus accumulating statutory interest thereon (through October 31, 1993, of approximately NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) $133,500,000). In addition, such adjustments would affect the computation of Farmland's taxable income for its 1989 tax year and, as a result, could increase Farmland's federal and state income taxes for that year by approximately $5,000,000 plus applicable statutory interest thereon. No provision has been made in the consolidated financial statements for federal or state income taxes (or interest thereon) in respect of the IRS claims described above. Farmland believes that it has meritorious positions with respect to all of these claims and will continue to vigorously pursue their favorable resolution through the pending litigation. In the opinion of Bryan Cave, Farmland's special tax counsel, it is more likely than not that the courts will ultimately conclude that (i) Farmland's treatment of the Terra sale gain was substantially, if not entirely, correct; and (ii) Farmland properly claimed a dividends-received deduction in respect of the 1983 distributions which it received from Terra prior to the sale of the Terra stock. Counsel has further advised, however, that none of the issues involved in these disputes is free from doubt, and that there can be no assurance that the courts will ultimately rule in favor of Farmland on any of these issues. Should the IRS ultimately prevail on all of its asserted claims, all claimed federal and state income taxes as well as accrued interest would become immediately due and payable, and would be charged to current operations. In such case, the Company would be required to renegotiate agreements with its banks to maintain compliance with various requirements of such agreements, including working capital and funded indebtedness provisions. However, no assurance can be given that such renegotiation would be successful. Alternatives could include other financing arrangements or the possible sale of assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Income tax expense (benefit) is comprised of the following: Year Ended August 31 1993 1992 1991 (Amounts in Thousands) Federal: Current..................$ (2,502) $ 6,600 $ 6,644 Deferred................. (2,944) 1,490 (205) $ (5,446) $ 8,090 $ 6,439 State: Current..................$ (468) $ 1,106 $ 1,064 Deferred................... (519) 262 (30) $ (987) $ 1,368 $ 1,034 $ (6,433) $ 9,458 $ 7,473 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The current tax benefit for the year ended August 31, 1993 results from the carryback of nonpatronage-sourced losses to reduce the amount of federal and state income taxes paid during prior years. During the year ended August 31, 1992, all of Foods' nonmember-sourced loss carryforwards were utilized and deferred income taxes amounting to $1,294,000 were reinstated. During the year ended August 31, 1992, Farmland utilized nonmember-sourced loss carryforwards amounting to $3,168,000 to reduce income tax expense for financial reporting purposes by $1,267,000. Utilization of these loss carryforwards has been presented as an extraordinary item in the accompanying consolidated statement of operations for the year ended August 31, 1992. In connection with the acquisition of Union Equity, Farmland acquired member-sourced and nonmember-sourced loss carryforwards from Union Equity amounting to approximately $18,600,000 and $10,600,000, respectively. For the year ended August 31, 1992, Farmland was able to utilize member-sourced and nonmember-sourced loss carryforwards amounting to $18,600,000 and $2,800,000, respectively. The benefit of the utilization of the nonmember-sourced loss carryforward amounting to $1,134,000 has been recorded as a reduction of goodwill in the accompanying consolidated balance sheet as of August 31, 1992. See note 2 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) At August 31, 1993, Farmland has nonmember-sourced loss carryforwards amounting to approximately $7,597,000, which expire in 2006 and 2007. At August 31, 1993, Farmland and its consolidated subsidiaries have alternative minimum tax credit carryforwards of approximately $2,502,000. At August 31, 1993, Farmland has patronage-sourced loss carryforwards available to offset future patronage-sourced income of $8,155,000 which expire in 2008. Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," was issued by the FASB in February 1992 and is effective for fiscal years beginning after December 15, 1992 (the Company's 1994 fiscal year). Statement 109 requires a change from the deferred method currently used by the Company, to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The Company has determined that implementation of Statement 109 in the first fiscal quarter of 1994 will not have a significant impact on its consolidated financial statements. (8) Minority Owners' Equity in Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) During the year ended August 31, 1993, Farmland reduced its voting interest in CFA to 49%. See note 2 of the notes to consolidated financial statements. (9) Preferred Stock, Earned Surplus and Other Equities The 5-1/2% and 6% preferred stocks have preferential liquidation rights over the Series F preferred stock. Dividends on the 5-1/2% and 6% preferred stock are cumulative only to the extent earned each year. Series F preferred stock is nondividend bearing. Upon liquidation, holders of all preferred stock are entitled to the par value thereof and, with respect to the 5-1/2% and 6% preferred stock, any declared or unpaid earned dividends. (B) A summary of earned surplus and other equities is as follows: August 31 1993 1992 (Amounts in Thousands) Earned surplus................$123,974 $136,175 Nonmember capital.......... .. 104 104 Capital credits............... 38,105 35,765 Unallocated equity............ 6,021 25,877 Additional paid-in surplus.... 1,603 1,936 $169,807 $199,857 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Nonmember capital represents patronage refunds distributed in the form of book credits. Capital credits are issued: 1) for payment of the portion of patronage refunds distributed in equity to patrons who do not satisfy requirements for membership or associate membership; and, 2) upon conversion of an equal par value amount of common stock or associate member common stock held by persons who no longer meet qualifications for membership or associate membership in Farmland. During the year ended August 31, 1992, Farmland issued $11,110,000 of capital credits to owners of Foods in exchange for an equivalent par value of their ownership of Foods common stock and capital equity fund certificates. Unallocated equity represents the cumulative difference between the amount of member-sourced income determined for financial reporting purposes and the amount of member-sourced income for income tax reporting purposes. The difference in the two income amounts results principally from differences in timing between book expense and tax deductions. Additional paid-in surplus results from members donating Farmland equity to Farmland. None of the aforementioned equities are held by or for the account of Farmland or in any sinking or other special fund of Farmland and none have been pledged by Farmland. The bylaws of Farmland provide that the patronage refund payable for any year be reduced if immediately after the payment of such patronage refund, the amount of retained earnings (defined for this purpose as the sum of earned surplus and unallocated equity) would be less than 30% of the previous year-end balance of members' equity accounts (defined for this purpose as the sum of common stock, associate member common stock, capital credits, nonmember capital and patronage refunds payable in equities). The reduction of patronage refunds would be the lesser of 15% or the amount required to increase the balance of the retained earnings account to the required 30%. As of August 31, 1993, 1992 and 1991, retained earnings exceeded the required amount by approximately $3,874,000, $49,451,000 and $9,623,000, respectively. Farmland established a base capital plan in 1991. The plan's objective is to achieve proportionality between the dollar amount of business a member or associate member of Farmland ("Participant") transacts with Farmland and the par value of Farmland equity which the Participant should hold (hereinafter referred to as the Participants' "Base Capital Requirement"). This plan: 1) provides that the relationship between the par value of a Participant's actual investment in Farmland equity and the Participant's Base Capital Requirement shall influence the cash portion of any patronage refund paid to the Participant; and, 2) provides a method for redemption by Farmland of its NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) equities held by a Participant when the par value of the Participant's investment exceeds his Base Capital Requirement. The Base Capital Requirement shall be determined annually by the Farmland Board of Directors at its sole discretion. No patronage refunds were paid by Farmland for 1993. (10) Contingent Liabilities and Commitments The Company leases various equipment and real properties under long-term operating leases. For the years ended August 31, 1993, 1992 and 1991, rental expenses totaled $41,104,000, $43,300,000 and $43,029,000, respectively. Rental expense is reduced for mileage credits received on leased railroad cars ($1,939,000 in 1993, $663,000 in 1992 and $1,773,000 in 1991). The leases have various remaining terms ranging from over one year to 16 years. Some leases are renewable, at Farmland's option, for additional periods. The minimum amount Farmland must pay for these leases during the fiscal years ending August 31 are as follows: (Amounts in Thousands) 1994....................................$ 38,673 1995.................................... 29,370 1996.................................... 23,532 1997.................................... 21,603 1998.................................... 17,528 1999 and after.......................... 67,881 $198,587 Farmland and its subsidiaries are involved in various lawsuits incidental to the businesses. In the opinion of management, the ultimate resolution of these litigation issues will not have a material adverse effect on the Company's consolidated financial statements. The Company has certain throughput agreements, take-or-pay agreements, minimum quantity agreements, and minimum charge agreements for various raw material supplies and services through 1996. The Company's minimum obligations under such agreements are: $2,548,000 in 1994; $1,248,000 in 1995; and $924,000 in 1996. As a result of regulations by the Environmental Protection Agency, sulfur levels must be reduced in diesel fuels sold after September 30, 1993. To comply with these regulations, the Company has committed to approximately $44,000,000 of improvements to the Coffeyville refinery. As of August 31, 1993, approximately $31,451,000 has been spent. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (11) Employee Benefit Plans The Farmland Industries, Inc. Employee Retirement Plan ("the Plan") is a defined benefit plan covering substantially all employees of Farmland and its subsidiaries who meet minimum age and length-of-service requirements. Benefits payable under the Plan are based on years of service and the employee's average compensation during the highest four of the employee's last ten years of employment. The Company's funding policy is to make the maximum annual contribution that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The assets of the Plan are maintained in a trust fund. The majority of the Plan's assets are invested in common stocks, corporate bonds, United States Government securities and short-term investment funds. Plan assets at August 31, 1993 and 1992 included Farmland subordinated debt certificates and Farmland demand loan certificates totalling $280,000 and $5,832,000, respectively. In connection with Farmland's acquisition of Union Equity, Union Equity's defined benefit plan's assets and actuarial liabilities were transferred to Farmland's retirement plan. The discount rate and the rate of increase in future compensation levels used in determining the actuarial present NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) value of the projected benefit obligations at August 31, 1993 were 8.5% and 5%, respectively (9% and 5% at August 31, 1992 and 1991, respectively). The expected long-term rates of return on assets at August 31, 1993, 1992 and 1991 were 8.5%, 9% and 9.5%, respectively. The Company provides life insurance benefits for retired employees through an insurance company. Any employee hired before January 1, 1988 who reaches normal retirement age while working for the Company is eligible for the benefit. Annual premiums for providing this employee benefit and for providing group life insurance for active employees are based on payments made by the insurance company during the year. Costs of life insurance provided for retired employees are not separable from costs of providing group life insurance for active employees. The Company recognizes costs for providing life insurance for retired and active employees by charging operations for the annual insurance premium paid. For the years ended August 31, 1993, 1992 and 1991, such insurance premiums were $1,178,000, $783,000 and $462,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company will adopt FASB Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" during the first quarter of its 1994 fiscal year. Upon adoption, the cost for providing life insurance during an employee's retirement years will be accrued during the active service period of the employee. Previously unrecognized costs related to the service period already rendered (the transition obligation) will be recognized over 20 years. The annual cost of providing life insurance for retired employees, determined following Statement 106, is estimated to be $1,000,000. Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits", was issued by the FASB in November 1992 and is effective for fiscal years beginning after December 15, 1993 (the Company's 1995 fiscal year). Statement 112 establishes standards of accounting and reporting for the estimated cost of benefits provided to former or inactive employees. Management expects that the adoption of Statement 112 will not have a significant impact on the Company's consolidated financial statements. An Annual Employee Variable Compensation Plan, a Long-Term Management Incentive Plan, and an Executive Deferred Compensation Plan have been established by the Company to meet the competitive salary programs of other companies, and to provide a method of compensation which is based on the Company's performance. Under the Company's Variable Compensation Plan, all regular salaried employees are eligible to receive an annual cash bonus that is based on the employee's position, income before extraordinary items of the Company, and income or other performance criteria of the individual's operating unit. Amounts accrued under this plan for the years ended August 31, 1993, 1992 and 1991 amounted to $-0-, $10,033,000 and $-0-, respectively. Distributions under this plan are made annually after the close of each fiscal year. Under the Long-Term Management Incentive Plan, the Company's executive management employees are paid cash bonus amounts determined by a formula which takes into account the level of management and the average annual net income of the Company over a three-year period. The current Long-Term Management Incentive Plan ends August 31, 1996. The Company's performance did not reach a level where incentive was earned under the Long-Term Management Incentive Plan that covered the three-year period ended August 31, 1993. As a result, operations in 1993 were credited by $2,463,000 to reverse provisions for management incentive awards previously charged against operations in 1992 and 1991 ($1,171,000 and $1,292,000, respectively). The Company's Executive Deferred Compensation Plan permits certain employees to defer part of their salary and/or part or all of their bonus compensation. The amount to be deferred and the period for deferral is specified by an election made NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) semi-annually. Payments of deferred amounts shall begin at the earlier of the end of the specified deferral period, retirement, disability or death. The employee's deferred account balance is credited annually with interest at the highest rate of interest paid by the Company on any subordinated debt certificate sold during the year. Payment of an employee's account balance shall, at the employee's election, be a lump sum or in ten annual installments. At August 31, 1993 and 1992, the Company's obligations under this plan amounted to $8,240,000 and $7,649,000, respectively. (12) Industry Segment Information The Company's business is conducted within three general operating areas: cooperative farm supply operations, cooperative marketing operations, and retail and service operations. As a farm supply cooperative, the Company engages in manufacturing and wholesale distribution of input products of agricultural production. The Company's principal farm supply products are petroleum, fertilizer and agricultural chemicals, and feed. Petroleum products include gasoline, distillate, diesel fuel, propane, lube oils, grease and automotive parts and accessories. Products in the fertilizer and agricultural chemicals area include nitrogen, phosphate and potash fertilizers, herbicides, insecticides and other farm chemicals. Feed products include a complete line of formulated feeds. Supply products are sold primarily at wholesale to local farm cooperatives. Marketing operations include pork and beef processing, marketing and the distribution of fresh meat products, ham, bacon, sausage, deli meats, Italian specialty meats and boxed beef, and the marketing and storage of grain. In 1993, export sales of grain totaled $570,171,000. The retail and service operations include convenience fuel and food stores, farm supply stores, finance company operations and services such as accounting, financial, management, environmental and safety, and transportation. See note 2 of the notes to consolidated financial statements. The operating income (loss) of each industry segment includes the revenue generated on transactions involving products within that industry segment less identifiable and allocated expenses. In computing operating income (loss) of industry segments none of the following items have been added or deducted: other income (deductions) or corporate expenses (included in the accompanying statements of operations as selling, general and administrative expenses), which cannot practicably be identified or allocated by industry segment. Operating income (loss) of industry segments for the years ended August 31, 1992 and 1991 have been restated for comparative purposes to include certain costs which were not identified to business segments in 1992 and 1991 but which were identified to business segments in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Corporate assets include cash, investments in other cooperatives, the corporate headquarters of Farmland and certain other assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (13) Significant Group Concentration of Credit Risk Farmland extends credit to its customers on terms no more favorable than standard terms of the industries it serves. A substantial portion of Farmland's receivables are concentrated in the agricultural industry. Collections on these receivables may be dependent upon economic returns from farm crop and livestock production. The Company's credit risks are continually received and management believes that adequate provisions have been made for doubtful accounts. Farmland maintains investments in and advances to cooperatives, cooperative banks and joint ventures from which it purchases products or services. A substantial portion of the business of these investees is dependent on the agribusiness economic sector. See note 4 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (14) Disclosures About Fair Value of Financial Instruments The estimated fair value of notes receivable has been determined by discounting future cash flows using a market interest rate. The estimated fair value of the subordinated debt certificates was calculated using the discount rate for subordinated debt certificates with similar maturities currently offered for sale. **** Investments in CoBank and other cooperatives' equities which have been purchased are carried at cost and securities received as patronage refunds are carried at par value, less provisions for permanent impairment. The Company believes it is not practicable to estimate the fair value of these securities because there is no established market for these securities and it is inappropriate to estimate future cash flows which are largely dependent on future patronage earnings of the cooperatives. (15) Related Party Transactions Farmland Hydro, L.P. and Hyplains Beef, L.C. (50% owned investees) and National Beef Packing Company, L.P. (a 58% owned NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) consolidated limited partnership) have credit agreements with various banks. Borrowings under these agreements are nonrecourse to the Company. Cash distributions by these entities to their owners are restricted by these credit agreements. In addition, Farmland advances funds and provides management and administrative services for these entities and, in certain instances, on terms less advantageous to Farmland than transactions conducted in the ordinary course of business. At August 31, 1993, Farmland's notes receivable from these entities amounted to $38,368,000. (16) Provision for Loss on Disposition of Assets The Board of Directors authorized management to proceed with negotiations to sell the Company's refinery at Coffeyville, Kansas. Based on terms of the transaction contemplated, a $20,022,000 provision for loss on the sale of the refinery has been included in the accompanying consolidated statement of operations for the year ended August 31, 1993. Accordingly, at August 31, 1993, the net carrying value of property, plant and equipment has been reduced by $17,622,000, and a liability of $2,400,000 has been recorded for completion of capital projects. The transaction is subject to certain conditions including negotiation of final definitive agreements. The Company entered discussions with a potential purchaser of a dragline. Based on these discussions, the Company estimates a loss of $6,155,000 from the sale. Accordingly, at August 31, 1993, the carrying value of the dragline has been written down by $6,155,000 and a provision for this loss is included in the Company's consolidated statement of operations for the year then ended. The carrying value of a pork processing plant at Iowa Falls, Iowa was written down by $3,253,000 to an estimated disposal value. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No disagreement on any matter of accounting principles or practices or financial statement disclosure was reported. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors of Farmland are as follows: Directors are elected for a term of three years by the shareholders of Farmland at its annual meeting. The expiration dates for such three-year terms are sequenced so that about one-third of Farmland's Board of Directors is elected each year. H. D. Cleberg is serving as director-at-large; the remaining twenty-one directors were elected from nine geographically defined districts in Farmland's territory. The executive committee consists of Willard Engel, Robert Merkle, Otis Molz, Paul Ruedinger, Albert Shivley, and H. D. Cleberg. The audit committee consists of Willard Engel, Steven Erdman, Greg Pfenning, Vonn Richardson and Raymond Schmitz. The executive officers of Farmland are: Age as of August 31, Name 1993 Principal Occupation and Other Positions J. F. Berardi 50 Executive Vice President and Chief Financial Officer - Mr. Berardi joined Farmland March 1, 1992 to serve in his present position. Mr. Berardi served as Executive Vice President and Treasurer of Harcourt Brace Jovanovich, Inc., a diversified Fortune 200 company, and was a member of its Board of Directors from 1988 until 1990. From 1986 to 1989 Mr. Berardi served as Senior Vice President and Chief Financial Officer of Harcourt Brace Jovanovich, Inc. H. D. Cleberg 54 President and Chief Executive Officer - Mr. Cleberg has been with Farmland since 1968. He was appointed to his present position effective April 1991. From September 1990 to March 1991 he served as Senior Vice President and Chief Operating Officer. From April 1989 to August 1990 he served as Executive Vice President, Operations. From October 1987 to March 1989 he served as Vice President and General Manager, Fertilizer and Ag Chemicals Operations, and from July 1986 to September 1987 he served as President, Farmland Foods. Prior to July 1986 he held several executive management positions, most recently Vice President, Field Services and Operations Support. S. P. Dees 50 President and General Manager of Farmland Industrias, S.A. de C.V. - Mr. Dees was appointed to his present position in September 1993. From October 1990 to September 1993 he served as Executive Vice President, Administrative Group and General Counsel. Mr. Dees joined Farmland in October 1984, serving as Vice President and General Counsel, Law and Administration until September 1990. He was a partner in the law firm of Stinson, Mag and Fizzell, Kansas City, Missouri, from 1971 until his employment by Farmland. G. E. Evans 49 Senior Vice President, Agricultural Production Marketing/Processing - Mr. Evans has been with Farmland since 1971. He was appointed to his present position in January 1992. From April 1991 to January 1992 he served as Senior Vice President, Agricultural Inputs. He served as Executive Vice President, Agricultural Marketing from October 1990 to March 1991. He served as Executive Vice President, Operations from January 1990 to September 1990. He served as Vice President, Farmland Industries and President, Farmland Foods from October 1987 to December 1989. He served as Vice President and General Manager, Feed Operations from June 1986 to September 1987, and from May 1983 to June 1986 he served as Vice President, Feed Operations. R. W. Honse 50 Executive Vice President, Agricultural Inputs Operations - Mr. Honse has been with Farmland since September 1983. He was appointed to his present position in January 1992, and served as Executive Vice President, Agricultural Operations from October 1990 to January 1992. From April 1989 to September 1990, he served as Vice President and General Manager, Fertilizer and Agricultural Chemicals Operations. From July 1986 to March 1989 he served as General Manager of the Florida phosphate fertilizer complex. B. L. Sanders 52 Vice President and Corporate Secretary - Dr. Sanders has been with Farmland since 1968. He was appointed to his present position in September 1991. From April 1990 to September 1991 he served as Vice President, Strategic Planning and Development. From October 1987 to March 1990 he served as Vice President, Planning. From July 1986 to September 1987 he served as Director, Management Information Services. From July 1984 to June 1986 he served as Executive Director, Corporate Strategy and Research and from 1968 to June 1984, as Executive Director, Economic and Market Research. EXECUTIVE COMPENSATION An Annual Employee Variable Compensation Plan, a Long-Term Management Incentive Plan, and an Executive Deferred Compensation Plan have been established by the Company to meet the competitive salary programs of other companies, and to provide a method of compensation which is based on the Company's performance. Under the Company's Annual Employee Variable Compensation Plan, all regular salaried employees are eligible to receive an annual cash bonus that is based on the employee's position, income before extraordinary items of the Company, and income or other performance criteria of the individual's operating unit. Amounts accrued under this plan for the years ended August 31, 1993, 1992 and 1991 amounted to $-0-, $10,033,000 and $-0-, respectively. Distributions under this plan are made annually after the close of each fiscal year. Under the Long-Term Management Incentive Plan, the Company's executive management employees are paid cash bonus amounts determined by a formula which takes into account the level of management and the average annual net income of the Company over a three-year period. The current Long-Term Management Incentive Plan ends August 31, 1996. The Company's performance did not reach a level where incentive was earned under the Long-Term Management Incentive Plan that covered the three-year period ended August 31, 1993. As a result, operations in 1993 were credited by $2,463,000 to reverse provisions for management incentive awards previously charged against operations in 1992 and 1991 ($1,171,000 and $1,292,000, respectively). The Company's Executive Deferred Compensation Plan permits executive employees to defer part of their salary and/or part or all of their bonus compensation. The amount to be deferred and the period for deferral is specified by an election made semi-annually. Payments of deferred amounts shall begin at the earlier of the end of the specified deferral period, retirement, disability or death. The employee's deferred account balance is credited annually with interest at the highest rate of interest paid by the Company on any subordinated debt certificate sold during the year. Payment of an employee's account balance shall, at the employee's election, be a lump sum or in ten annual installments. Amounts accrued pursuant to the plan for the accounts of the named individuals during the fiscal years 1993, 1992 and 1991 are included in the cash compensation table. The Company established Farmland Industries, Inc. Employee Retirement Plan in 1986 for all employees whose customary employment is at the rate of at least 1000 hours per year. Participation in this plan is optional prior to age 34, but mandatory thereafter. Approximately 6,480 active and 6,900 inactive employees were participants in the plan on August 31, 1993. The plan is funded by employer and employee contributions to provide lifetime retirement income at normal retirement age 65, or a reduced income beginning as early as age 55. The Retirement Plan has been determined qualified under the Internal Revenue Code. The plan is administered by a committee appointed by the Board of Directors of Farmland, and all funds of the plan are held by a bank trustee in accordance with the terms of the trust agreement. It is the present intent to continue this plan indefinitely. Payments to participants in the plan are based upon length of participation and compensation (limited to $235,840 annually for any employee) reported to the plan for the four highest of the last ten years of employment. The plan also contains provisions for death and disability benefits. The Company made no contributions to the plan in 1993, 1992 and 1991. At August 31, 1993 (based upon the Plan's funded status as of May 31, 1993), the present value of the accumulated benefit obligation was $130,163,000 and the estimated fair value of plan assets was $212,647,000. In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) imposed a maximum retirement benefit which may be paid by a qualified retirement plan. At the present time, that limit is $115,641. Subject to the $235,840 maximum limit on annual compensation which may be covered by a qualified pension plan, amounts included in the cash compensation table do not vary substantially from the compensation covered by the pension plan. CERTAIN TRANSACTIONS The Company transacts business in the ordinary course with its directors and with its local cooperative members with which the directors are associated on terms no more favorable than those available to its other local cooperative members. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT No person owns of record or is known to own beneficially more than five percent of Farmland's equity securities. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company transacts business in the ordinary course with its directors and with its local cooperative members with which the directors are associated on terms no more favorable than those available to its other local cooperative members. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) Listing of Financial Statements, Financial Statement Schedules and Exhibits (1) Financial Statements Independent Auditors' Report Consolidated Balance Sheets, August 31, 1993 and Consolidated Statements of Operations for each of the years in the three-year period ended August 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three-year period ended August 31, 1993 Consolidated Statements of Capital Shares and Equities for each of the years in the three-year period ended August 31, 1993 Notes to Consolidated Financial Statements (2) Financial Statement Schedules Farmland Industries, Inc. and Subsidiaries for each of the years in the three-year period ended August 31, 1993: 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 as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. (3) Exhibits Articles of Incorporation and Bylaws: 3.A Articles of Incorporation and Bylaws of Farmland Industries, Inc. effective August 30, 1990. (Incorporated by Reference - Form SE, filed November 21, 1990) Instruments Defining the Rights of Owners of the Debt Securities Being Registered: 4.A(1) Trust Indenture dated November 20, 1981, as amended January 4, 1982, including specimen of Demand Loan Certificates. (Incorporated by Reference - Form S-1, No.2-75071, effective January 7, 1982) 4.A(2) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 20-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(2)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 20-Year Subordinated Capital Investment Certificates (Incorporated by Reference - Form SE, filed December 3-2, 1991) 4.A(3) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 10-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(3)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 10-Year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form SE, filed December 3-3, 1991) 4.A(4) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 5-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(4)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 5-Year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form SE, filed December 3-4, 1991) 4.A(5) Trust Indenture dated November 8, 1984, as amended January 3, 1985 and November 20, 1985, including specimen of 10-year Subordinated Monthly Income Capital Investment Certificates. (Incorporated by Reference - Form S-1, No. 2-94400, effective December 31, 1984) 4.A(6) Trust Indenture dated November 11, 1985 including specimen of the 5-year Subordinated Monthly Income Capital Investment Certificates. (Incorporated by Reference - Form S-1, No. 33-1970, effective December 31, 1985) Instruments Defining Rights of Owners of Indebtedness not Registered: 4.B(1) National Bank for Cooperatives Master Loan Agreement for Farmland Industries, Inc., dated April 23, 1993. (Incorporated by Reference - Form 10-Q, filed July 14, 1993) 4.B(2) List identifying contents of all omitted schedules referenced in and not filed with, the National Bank for Cooperatives Master Loan Agreement for Farmland Industries, Inc. (Incorporated by Reference - Form 10-Q, filed July 14, 1993) Material Contracts: Lease Contracts: 10.A(1) The First National Bank of Chicago, not individually but solely as Trustee for FNBC Leasing Corporation, the First Chicago Leasing Corporation, The Boatmen's National Bank of St. Louis, Firstier Bank, N.A., and Norwest Bank Minnesota, National Association and Farmland Industries, Inc. consummated a leveraged lease in the amount of $73,153,000 dated September 6, 1991. (Incorporated by Reference - Form SE, filed December 3-1, 1991.) 10.A(2) Iowa-Des Moines National Bank as Trustee for Citicorp Lescaman as Owner-Participant and Farmland Industries, Inc. consummated a leveraged lease in the amount of $18,774,476 dated June 15, 1975. (Incorporated by Reference - Form S-1, No.2-57765, effective January 10, 1977) 10.A(3) The First National Bank of Commerce as Trustee for General Electric Credit Corporation as Beneficiary and Farmland Industries, Inc. consummated a leveraged lease in the amount of $51,909,257.90 dated March 17, 1977. (Incorporated by Reference - Form S-1, No.2-60372, effective December 22, 1977) Management Remunerative Plans Filed Pursuant to Item 14C of this Report. 10.(iii)(A)Annual Employee Variable Compensation Plan (September 1, 1993 - August 31, 1994) 10.(iii)(A)Farmland Industries, Inc. Management Long-Term Incentive Plan (Effective September 1993) 10.(iii)(A)Farmland Industries, Inc. Executive Deferred Compensation Plan (Incorporated by Reference - Form SE, filed November 23, 1987) 22. Subsidiaries of the Registrant Farmland Foods, Inc., a 99%-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmland Foods, Inc. has been included in the consolidated financial statements filed in this registration. Farmland Insurance Agency, a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Farmland Insurance Agency has been included in the consolidated financial statements filed in this registration. Farmers Chemical Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmers Chemical Company has been included in the consolidated financial statements filed in this registration. Farmland Securities Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Farmland Securities Company has been included in the consolidated financial statements filed in this registration. Cooperative Service Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Nebraska. Cooperative Service Company has been included in the consolidated financial statements filed in this registration. Double Circle Farm Supply Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Nevada. Double Circle Farm Supply Company has been included in the consolidated financial statements filed in this registration. National Beef Packing Company, L.P., a 58%-owned subsidiary, was incorporated under the laws of the State of Delaware. National Beef Packing Company has been included in the consolidated financial statements included in this registration. Farmland Financial Services Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmland Financial Services Company has been included in the consolidated financial statements included in this registration. Farmland Transportation, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Farmland Transportation, Inc. has been included in the consolidated financial statements included in this registration. Environmental and Safety Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Environmental and Safety Services, Inc. has been included in the consolidated financial statements included in this registration. Penterra, Inc., a 81%-owned subsidiary, was incorporated under the laws of the State of Kansas. Penterra, Inc. has been included in the consolidated financial statements included in this registration. Farmland Industries, Ltd., a wholly-owned subsidiary, was incorporated under the laws of the United States Virgin Islands. Farmland Industries, Ltd. has been included in the consolidated financial statements included in this registration. Heartland Data Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Heartland Data Services, Inc. has been included in the consolidated financial statements included in this registration. Yuma Feeder Pig, Inc., a 72%-owned subsidiary, was incorporated under the laws of the state of Colorado. Yuma Feeder Pig, Inc. has been included in the consolidated financial statements included in this registration. Equity Country, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Equity Country, Inc. has been included in the consolidated financial statements included in this registration. Equity Export Oil and Gas Company, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Oklahoma. Equity Export Oil and Gas Company, Inc. has been included in the consolidated financial statements included in this registration. Uneco Investor Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Uneco Investor Services, Inc. has been included in the consolidated financial statements included in this registration. 24. Power of Attorney (B) Reports on Form 8-K A Form 8-K was filed September 15, 1993, pursuant to Item 2 of the Form 8-K, as a result of the disposition of The Cooperative Finance Association. Financial statements filed with the Form 8-K: a) Unaudited pro forma statements of operations for the year ended August 31, 1992 and the nine months ended May 31, 1993; b) Unaudited pro forma balance sheet as of May 31, 1993; and c) Notes to unaudited pro forma financial statements. (C) Exhibits The exhibits required by Item 601 of Regulation S-K are filed herewith or have been filed with the Securities and Exchange Commission and are incorporated by reference as part of this Form 10-K. See Item 14(A)(3). (D) Financial Statement Schedules required by Regulation are filed herewith: See Item 14(A)(2). SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT, FARMLAND INDUSTRIES, INC. HAS DULY CAUSED THIS FORM 10-K TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED IN THE CITY OF KANSAS CITY, STATE OF MISSOURI ON NOVEMBER 29, 1993. FARMLAND INDUSTRIES, INC. BY H. D. Cleberg H. D. Cleberg President and Chief Executive Officer BY John F. Berardi John F. Berardi Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Act of 1933, this Form 10-K has been signed for the following persons on the date indicated pursuant to valid Power of Attorney executed on October 21, 1993. Signature Title Date ALBERT J. SHIVLEY Chairman of Board, Director November 29, 1993 Albert J. Shivley Vice Chairman of Board, OTIS H. MOLZ Director November 29, 1993 Otis H. Molz LYMAN ADAMS Director November 29, 1993 Lyman Adams RONALD J. AMUNDSON Director November 29, 1993 Ronald J. Amundson BAXTER ANKERSTJERNE Director November 29, 1993 Baxter Ankerstjerne JODY BEZNER Director November 29, 1993 Jody Bezner RICHARD L. DETTEN Director November 29, 1993 Richard L. Detten WILLARD ENGEL Director November 29, 1993 Willard Engel STEVEN ERDMAN Director November 29, 1993 Steven Erdman BEN GRIFFITH Director November 29, 1993 Ben Griffith GAIL D. HALL Director November 29, 1993 Gail D. Hall BARRY JENSEN Director November 29, 1993 Barry Jensen ROBERT MERKLE Director November 29, 1993 Robert Merkle GREG PFENNING Director November 29, 1993 Greg Pfenning VONN RICHARDSON Director November 29, 1993 Vonn Richardson MONTE ROMOHR Director November 29, 1993 Monte Romohr PAUL RUEDINGER Director November 29, 1993 Paul Ruedinger RAYMOND J. SCHMITZ Director November 29, 1993 Raymond J. Schmitz DALE STENERSON Director November 29, 1993 Dale Stenerson THEODORE J. WEHRBEIN Director November 29, 1993 Theodore J. Wehrbein ROBERT ZINKULA Director November 29, 1993 Robert Zinkula

48681_1993.txt

48681_1993

1993

48681

ITEM 1. BUSINESS. Household Finance Corporation ("HFC" or the "Company") is a subsidiary of Household International, Inc. ("Household International"). HFC and its subsidiaries offer a diversified range of financial services. The principal products of HFC's consumer financial services business is the making of cash loans, including home equity loans secured by first and second mortgages and unsecured credit advances (including revolving and closed-end personal loans) to middle-income consumers in the United States and Australia. Loans are made through branch lending offices and through direct marketing efforts. In 1992, HFC launched a new portfolio acquisition business focusing on open-end and closed-end home equity loan products. In 1993, HFC acquired approximately 3,800 new accounts aggregating $430 million in such receivables. In addition, in 1993 HFC acquired the right to service without recourse approximately 1.1 million accounts aggregating approximately $2.0 billion in unsecured loans. The Company believes that the portfolio acquisition business provides an additional source for developing new customer relationships. Through banking subsidiaries located in Salinas, California and Wood Dale, Illinois, the Company issues both VISA* and Mastercard* credit cards. These banks engage only in consumer credit card operations. Household Retail Services ("HRS") is a revolving credit merchant participation business. Through subsidiaries of HFC, HRS provides sales financing and purchases, originates and services merchants' private-label revolving charge accounts. In conjunction with its consumer finance operations and where applicable laws permit, HFC makes available to customers credit life, credit accident and health, and household contents insurance. Credit life and credit accident and health insurance are generally written directly by, or reinsured with, HFC's insurance subsidiary, Alexander Hamilton Life Insurance Company of America ("Alexander Hamilton"). Alexander Hamilton is also engaged in the sale of ordinary life, annuity, and specialty insurance products to the general public through approximately 16,300 independent agents throughout the United States. HFC also is engaged in commercial finance involving leveraged leases, privately-placed, limited-term preferred stocks, and selected commercial financing of equipment or property. At December 31, 1991 the Company discontinued lending in certain commercial product lines. See "Management's Discussion and Analysis" on pages 13 and 14 for further discussion of discontinued commercial product lines. ITEM 2. ITEM 2. PROPERTIES. Substantially all of HFC's branch office and headquarters space is rented with the exception of its corporate headquarters in Prospect Heights, Illinois; Alexander Hamilton's headquarters in Farmington Hills, Michigan; and administration buildings in Northbrook, Illinois and Salinas, California. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There is no litigation pending which management and counsel for the Company consider to be material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All 1,000 shares of HFC's outstanding common stock are owned by Household International. Consequently, there is no market in HFC's common stock. HFC also has outstanding 1 million depositary shares which represent 1/3,000 share of term cumulative preferred stock (with a liquidation value of $.3 million per share) to institutional investors not affiliated with HFC. - ------------ * VISA and MasterCard are registered trademarks of VISA USA, Inc. and MasterCard International Incorporated, respectively. During 1993 HFC did not pay cash dividends on its common stock. During 1992 HFC paid cash dividends on its common stock to Household International totaling $175.3 million. In addition, HFC paid cash dividends on its preferred stock totaling $8.7 and $10.3 million in 1993 and 1992, respectively. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Omitted. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. MANAGEMENT'S DISCUSSION AND ANALYSIS BUSINESS SEGMENT DATA HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES The combination of the Company's consumer and continuing commercial product lines are referred to as Finance and Banking. Assets of liquidating commercial product lines, which are separately managed as receivables are collected or otherwise disposed of, have been disclosed separately in the consolidated balance sheets and as a separate business segment, referred to as Liquidating Commercial Lines. To define and report the results of operations, the Company refers to its Finance and Banking and Individual Life Insurance segments as its Core Business. CONSOLIDATED RESULTS OF OPERATIONS Net income in 1993 was $220.4 million, down from 1992 net income of $239.5 million. Net income in 1992 was 53 percent higher than 1991 earnings of $156.7 million when the Company reported a large loss in the Liquidating Commercial Lines segment associated with its decision to withdraw from the higher-risk portion of its commercial business. During 1993, net income was negatively impacted by the following: - The enactment of new Federal tax legislation which increased the statutory corporate income tax rate from 34 percent to 35 percent retroactive to January 1, 1993 and decreased net income by $5.8 million. - Implementation of Statement of Financial Accounting Standards No. 106 on postretirement benefits, which the Company adopted effective January 1, 1993, which reduced net income by $7 million. The following summarizes key highlights of the Company's operations during 1993: - Domestic consumer finance earnings increased over the prior year primarily due to wider interest spreads on variable rate products and growth in the managed portfolio. This improvement was more than offset by lower earnings in the Company's bankcard and continuing commercial businesses. Lower bankcard earnings were caused by higher provisions related to the strengthening of credit loss reserves and higher operating expenses. Earnings from the continuing commercial business declined due to reduced margin, lower levels of earning assets in the aircraft portfolio and lower gains on the dispositions of assets. - Consumer two-months-and-over contractual delinquency ("delinquency") continued to decline throughout the year due to tighter credit standards implemented in prior years and an improving economic environment. Total consumer delinquency as a percent of managed consumer receivables was 4.33 percent at December 31, 1993, down significantly from 5.37 percent at December 31, 1992 and was at the lowest level since 1988. The full year chargeoff ratio for the managed consumer portfolio declined to 3.61 percent from 3.81 percent in 1992. The Company increased credit loss reserves for Finance and Banking managed receivables by $33.4 million, or 9 percent over 1992, despite a $142.4 million decrease in delinquency. The increase was due to continued caution regarding the uncertainty of the economic outlook, continued relatively high chargeoff levels and more conservative recognition of recourse obligations for receivables serviced with limited recourse. Reserves, as a percent of the managed Finance and Banking receivable portfolio, were at their highest level since the Company adopted the contractual basis of delinquency in 1990. - The Liquidating Commercial Lines ("LCL") segment experienced an increased loss due to the resolution of the Company's largest problem loan in the third quarter. The Company reached a cash settlement on a nonaccrual equipment finance loan which resulted in a higher chargeoff than expected and a complete disposition of the loan, with no continuing involvement on the part of the Company. The Company anticipates that future LCL results will improve. LCL assets totaled $1.6 billion, down $295.5 and $474.8 million from year-end 1992 and 1991, respectively. This trend is consistent with management's strategy to dispose of these assets over several years. Nonperforming LCL assets declined $191.6 million during the year and reached their lowest level since June 1991. Credit loss reserves at December 31, 1993 as a percent of both LCL receivables and nonperforming loans increased over the year-ago period. - Owned assets totaled $19.9 billion at December 31, 1993, up 9 percent from year-end 1992. The increase primarily was due to a 20 percent increase in the investment securities portfolio, principally in the Individual Life Insurance segment, and a 14 percent increase in owned Finance and Banking receivables. Total managed assets (owned assets plus receivables serviced with limited recourse) were $27.0 billion, up 3 percent from year-end 1992. Household International invested an additional $70 million of capital into HFC in 1993. As a result, the Company's debt to equity ratio declined from 6.8 at December 31, 1992 to 6.2 at December 31, 1993. - In July 1993 Standard & Poor's Corporation upgraded its credit rating outlook for the Company, and in November 1993 Moody's Investor Services, Inc. upgraded the Company's credit rating. These upgrades were a result of improving trends in both capital levels and asset quality. CONSOLIDATED CREDIT LOSS RESERVES Total managed credit loss reserves, which include reserves for recourse obligations for receivables serviced, were as follows: The level of reserves for credit losses is based on delinquency and chargeoff experience by product and management's evaluation of economic conditions, including regional considerations. See Note 1, "Summary of Significant Accounting Policies" on pages and in the accompanying financial statements for further description of the basis for establishing such reserves. See Note 5, "Credit Loss Reserves" in the accompanying financial statements for an analysis of credit loss reserves. While management allocates reserves among the Company's various products and segments, all reserves are considered to be available to cover total loan losses. CONSOLIDATED CREDIT LOSS RESERVES (AS A PERCENT OF RECEIVABLES) During 1993 the Company strengthened its managed credit loss reserves for Finance and Banking receivables as described on page 3. Reserves for Liquidating Commercial Lines decreased from year-end 1992 levels primarily due to the continued disposition of LCL receivables, including the resolution of a large nonaccrual equipment finance loan as described earlier. Despite the dollar decrease in LCL reserve levels, credit loss reserves at December 31, 1993 as a percent of both LCL receivables and nonperforming loans increased over December 31, 1992 and 1991. CREDIT MANAGEMENT POLICIES The Company's credit portfolios and credit management policies historically have been divided into two distinct components -- consumer and commercial. For consumer products, credit policies focus on product type and specific portfolio risk factors. The consumer credit portfolio is diversified by product and geographic location. The commercial credit portfolio is monitored by individual transaction as well as being evaluated by overall risk factors. See Note 3, "Finance and Banking Receivables" and Note 4, "Liquidating Commercial Assets" in the accompanying financial statements for receivables by product type. CONSUMER The consumer credit risk management process has four key elements: - Computerized scoring systems to assess the risk characteristics of new applicants and monitor the payment behavior of existing customers for early warning signs of troubled accounts. - A centralized credit system for past due accounts to make the collection process more productive and provide the analytical capability to measure the effectiveness of collection strategies. - A chargeoff policy intended to eliminate problem loans early and improve the quality of the remaining portfolio. - A senior executive position of credit risk manager in each consumer lending operation which places credit management at a high level of priority and provides the means for the credit function to interact more productively with other business functions. Based on this credit risk management process, expected credit losses for each consumer product are estimated on a statistical basis. The Company suspends accrual of interest on all consumer receivables when payments are three months contractually past due, except for bankcards and private-label credit cards. On these credit card receivables, consistent with industry practice, interest continues to accrue until the receivable is charged off. Consumer loans are charged off when an account is contractually delinquent for a pre-established period of time. The period of time is dependent on the terms, collateral and credit loss experience of each consumer product category. This period ranges from 6 to 9 months. The Company's domestic consumer businesses lend funds nationwide, with California accounting for 22 percent of total managed domestic consumer receivables. It is the only state with receivables in excess of 10 percent of domestic managed receivables. The Company's Australian operations accounted for 2 percent of managed consumer receivables at December 31, 1993. Due to its centralized underwriting, collection and processing functions, the Company can quickly revise underwriting standards and intensify collection efforts for specific geographic locations. COMMERCIAL Commercial loans, in continued or discontinued product lines, are underwritten based upon specific criteria by product, which include the following items: borrower's financial strength, underlying value of collateral, ability of the property/business to generate cash flow and pricing considerations. For financing commitments in excess of $1 million, the loan request must be approved by an investment committee consisting of senior management. The financial and operating performance of all borrowers is monitored and reported to management on an ongoing basis. Additionally, the conclusions of this monitoring process are reported to senior management on a quarterly basis. Substantially all commercial chargeoffs have related to the product lines which are being liquidated. The Company administers a classification of assets policy whereby, on a quarterly basis, all commercial credits are reviewed and assigned a rating based on a process similar to that used by bank regulatory authorities. The review process specifically addresses whether any commercial loans need to be charged off and uses the following criteria: (a) ability of the borrower to make loan payments; (b) ability of the property or business to generate cash flow; (c) value of collateral; (d) other debt associated with the property or business; and (e) passage of title or in-substance possession of collateral. The quarterly evaluation of the adequacy of the credit loss reserve is based on this review process and management's evaluation of probable future losses in the portfolio as a whole given its geographic and industry diversification and historical loss experience. Management also evaluates the potential impact of existing and anticipated economic conditions on the portfolio in establishing credit loss reserves. Commercial loans are placed on nonaccrual when they become 90 days past due, or sooner if the Company believes that the loan has experienced significant adverse developments that could result in a loss of interest or principal. There are no commercial loans that are 90 days past due and on full accrual status. Loans are disclosed as renegotiated loans or troubled debt restructurings if the rate of interest has been reduced because of the inability of the borrower to meet the original terms of the loan. Such loans continue to accrue interest at the renegotiated rate, unless they become 90 days past due, because the Company believes the borrowers will be able to meet their obligations following the restructuring. Commercial loans that are modified in the normal course of business, for which additional consideration is received or significant concessions are not made, are not reported as renegotiated loans or troubled debt restructurings. Real estate owned is recorded at the lower of cost or fair value less estimated costs to sell. These values are periodically reviewed and reduced, if appropriate. FINANCE AND BANKING STATEMENTS OF INCOME OVERVIEW Finance and Banking earnings decreased to $196.7 million from $210.1 million in 1992. As described earlier, improved earnings in the domestic consumer finance operations were more than offset by lower earnings in the bankcard and continuing commercial operations. RECEIVABLES Managed receivables at December 31, 1993 were $16.1 billion, up 2 percent compared to December 31, 1992 and up 7 percent from year-end 1991 as all businesses continued to apply conservative underwriting standards because of continued economic uncertainty. In addition, domestic growth was limited by lower market demand than seen in previous years and by additional run-off of second mortgages from customer loan refinancings. Changes in owned receivables and receivables serviced with limited recourse may vary from period to period depending on the timing and significance of securitization transactions in a particular period. The Company securitized and sold with limited recourse approximately $1.7 billion of receivables in 1993 compared to $2.2 billion in 1992. NET INTEREST MARGIN Net interest margin was $799.0 million in 1993, up from $711.3 million in 1992 due to higher levels of interest-earning assets, wider spreads on variable rate products and a shift in product mix towards higher yielding bankcard, merchant participation and other unsecured receivables. Spreads on variable rate products in 1993 exceeded those achieved in the prior year periods. The Company does not anticipate that spreads in 1994 will remain at the level reached in 1993 because of overall conditions in the capital markets. Due to the growth in securitized assets over the past several years, the comparability of net interest margin between years may be affected by the level and type of assets securitized. As receivables are securitized and sold rather than held in portfolio, net interest income is shifted to securitization and servicing fee income. Net interest margin on an owned basis as a percent of average owned interest-earning assets was 8.9 percent, compared to 8.1 percent in 1992 and 7.8 percent in 1991. Net interest margin on a managed basis, assuming receivables securitized and sold were instead held in the portfolio, increased to $1.3 billion in 1993 from $1.2 billion in 1992 and, as a percent of average managed interest-earning assets, increased to 8.1 percent from 8.0 percent in 1992 and 7.8 percent in 1991. Net interest margin on an owned basis was greater than on a managed basis because home equity receivables, which have lower spreads, are a larger portion of the portfolio serviced with limited recourse than of the owned portfolio. OTHER REVENUES SECURITIZATION AND SERVICING FEE INCOME consists of two components: income associated with the securitization and sale of receivables with limited recourse and servicing fee income related to the servicing of unsecured receivables. Securitization income increased in 1993 as the total managed receivables portfolio continued to grow. Securitization income as a percent of average receivables serviced with limited recourse was 4.94 percent in 1993, compared to 5.23 percent in 1992 and 7.16 percent in 1991. This decrease primarily was due to a shift toward home equity loans in the securitized portfolio, resulting in narrower spreads. Servicing fee income increased over 1992 despite little year-over-year change in average receivables serviced with no recourse. This increase primarily was due to a change in the composition of the serviced portfolio which occurred in the third quarter of 1993 when the Company began servicing an unsecured consumer loan portfolio without recourse which provided a higher servicing fee. This portfolio totaled $1.3 billion at December 31, 1993. INSURANCE PREMIUMS AND CONTRACT REVENUES were $114.7 million, up from $109.2 million in 1992, but down slightly from $115.4 million in 1991 due to changes in sales volumes of specialty and credit insurance. INVESTMENT INCOME was $11.7 million, up 11 percent compared to $10.5 million in both 1992 and 1991 due to higher gains on sales of investments from the specialty and credit insurance portfolio. FEE INCOME includes revenues from fee-based products such as bankcards and private-label credit cards. Fee income was $58.9 million, up from $49.6 million in 1992 and $45.3 million in 1991 primarily due to interchange and other fees related to growth in owned bankcard receivables. OTHER INCOME was essentially flat compared to 1992 and 1991. PROVISION FOR CREDIT LOSSES The provision for credit losses for receivables on an owned basis totaled $404.4 million, up 21 percent from $333.0 million in 1992 and up 19 percent from 1991's level due to continued caution regarding the uncertainty of the economic outlook and continued relatively high chargeoff levels. EXPENSES Operating expenses, which the Company defines as salaries and fringe benefits plus other operating expenses, were $673.0 million, up 7 percent over 1992. Operating expenses as a percent of average receivables owned or serviced were 3.96 percent, up slightly from 3.93 percent in 1992 and 3.88 percent in 1991 due to higher costs associated with servicing a larger average managed portfolio and additional expenses related to real estate owned. The effective tax rate in 1993 was 31.3 percent compared to 27.3 percent in 1992 and 29.3 percent in 1991. The increase in the effective tax rate over 1992 primarily was due to the impact of the increase in the statutory Federal income tax rate from 34 percent to 35 percent and a change in the treatment of purchase accounting adjustments resulting from the adoption of FAS No. 109. CREDIT QUALITY The Company generally experienced improved credit quality during 1993. This improvement was a result of better domestic economic conditions and the higher quality of recently originated receivables. At year-end 1993 delinquency had fallen for seven consecutive quarters. Chargeoffs in 1993 were below the prior year. DELINQUENCY Delinquency levels are monitored for both receivables owned and receivables managed. The Company looks at delinquency levels which include receivables serviced with limited recourse because this portfolio is subjected to underwriting standards comparable to the owned portfolio, is managed by operating personnel without regard to portfolio ownership and results in a similar credit loss exposure for the Company. TWO-MONTHS-AND-OVER CONTRACTUAL DELINQUENCIES (AS A PERCENT OF MANAGED CONSUMER RECEIVABLES) Total delinquent receivables at December 31, 1993 were $142 million lower than a year earlier despite higher receivable levels. This improvement consisted of a $124 million decrease in the domestic operations and a $18 million decrease in the Australian operations. Delinquency as a percent of managed consumer receivables fell 19 percent in 1993 and was the lowest since 1988. The Company currently believes the positive trend in delinquency ratios will continue but recognizes the trend may moderate in future periods. Further improvement will depend on the extent and timing of improvement in economic conditions in both countries where the Company operates and the composition of the managed receivables base. DOMESTIC DELINQUENCY HOME EQUITY delinquency declined during the fourth quarter of 1993 and remained below the year-end 1992 level. Home equity delinquency was the lowest since December 1990 and was down approximately 44 percent from the peak in the first quarter of 1992. The improvement was a result of tighter underwriting standards instituted at the start of the recent economic downturn and improvements in the economy. Vintage analysis of home equity loans originated after June 1991 continued to demonstrate the favorable performance of recently underwritten receivables. The delinquency level for OTHER SECURED RECEIVABLES at December 31, 1993 decreased from the prior quarter and prior year, but did not impact total delinquency due to the small size of the portfolio. BANKCARD delinquency declined compared to the prior quarter and was below the December 1992 level. The improvement was due to higher quality bankcard receivables recently underwritten, which have higher credit scores and lower early delinquency. MERCHANT PARTICIPATION delinquency levels continued to decline in the fourth quarter of 1993 and were below the year-end 1992 level. The steady decline during 1993 was the result of an improved economy coupled with tighter underwriting standards and a greater focus on association with low delinquency merchants. The delinquency level for OTHER UNSECURED receivables decreased in the 1993 fourth quarter and has fallen for eight consecutive quarters. This steady decline was due to the improvement of the quality of receivables recently underwritten combined with improved economic conditions. Since chargeoff rates on unsecured receivables are much higher than secured receivables, improvements in delinquency are significant in evaluating potential future credit losses. FOREIGN DELINQUENCY Delinquency levels in AUSTRALIA continued to improve; however, due to the relatively small size of the receivable portfolio, the decrease in delinquency had a relatively small impact on total delinquencies for the Company. NONPERFORMING ASSETS The following table details the components of nonperforming assets for the Finance and Banking segment: The decrease in nonaccrual managed receivables during 1993 primarily was due to improvements in the domestic consumer finance operations. Consumer real estate owned was essentially flat compared to both the 1992 year-end level and third quarter level. As part of continuing commercial activities, the Company held at December 31, 1993 approximately $83 million of aircraft acquired through foreclosure of loans and leases. The Company is actively marketing these aircraft for sale or lease. However, due to the current economic condition of the airline industry, the Company is uncertain about the timing of the disposition of these aircraft. These aircraft were recorded at date of acquisition at the lower of cost or fair value, with such values subsequently being depreciated over their estimated remaining useful lives. CHARGEOFFS Chargeoffs decreased in 1993 as a result of improved delinquency trends and better domestic economic conditions. The following table presents chargeoffs on a full year and quarterly basis, by product: NET CHARGEOFFS OF CONSUMER RECEIVABLES (AS A PERCENT OF AVERAGE CONSUMER RECEIVABLES MANAGED) Net chargeoffs as a percent of average consumer receivables managed were 3.61 percent, down from 3.81 percent in 1992, primarily due to improvements in the unsecured portfolios. Chargeoffs are a lagging indicator of credit quality and generally reflect prior delinquency trends. As previously discussed, overall delinquency levels have continued to decline. The decline has been a result of improved economic conditions and the effect of the Company's strategy to improve overall credit quality by tightened underwriting standards. The Company expects that chargeoff trends will continue to follow the downward trend in consumer delinquency. However, future improvement in net chargeoffs may be impacted by factors such as product mix, economic conditions and the impact of personal bankruptcies. Consequently, the extent and timing of an overall improved chargeoff trend remains uncertain. Domestic net chargeoffs were 3.60 percent for the year, down from 3.83 percent a year ago, due to improvements in the unsecured portfolios. HOME EQUITY chargeoffs increased slightly on both a year-over-year basis and in the fourth quarter as this portfolio continued to be impacted by weak economic conditions in the western region. Net chargeoffs for OTHER SECURED receivables did not significantly impact total chargeoffs as these receivables represented approximately 2 percent of total managed receivables at year end. In the domestic unsecured portfolios, BANKCARD net chargeoffs declined in 1993 compared to the prior year due to improved economic conditions and a decrease in personal bankruptcies. Net chargeoffs of MERCHANT PARTICIPATION and OTHER UNSECURED receivables were below both the 1992 level and the prior quarter. These improvements were consistent with the downward trend in delinquency in these portfolios. Chargeoffs in AUSTRALIA increased year-over-year and during the fourth quarter. However, due to the size of the receivable portfolio, Australia's chargeoffs did not significantly impact the overall chargeoff level of the Company. INDIVIDUAL LIFE INSURANCE Individual Life Insurance net income was $45.2 million, up 8 percent from 1992 due to higher investment income resulting from gains on the sale of available-for-sale investments, a larger investment portfolio and higher levels of contract revenues from individual life and annuity contracts. STATEMENTS OF INCOME Investment securities for the Individual Life Insurance segment totaled $6.4 billion, up from $5.3 billion at December 31, 1992. This portfolio represented 90 percent of the Company's total investment portfolio at December 31, 1993. During 1993 the Company continued to emphasize conservative investment strategies. Higher-risk securities, which include non-investment grade bonds, common and preferred stocks, commercial mortgage loans and real estate, represented 7 percent of the insurance investment portfolio at December 31, 1993, compared to 9 percent at December 31, 1992. Commercial real estate loans totaled less than 2 percent of Individual Life Insurance segment investments at December 31, 1993. At December 31, 1993 there were no significant nonaccrual or renegotiated loans in this portfolio. Commercial real estate acquired through foreclosure, which is included in the investment portfolio, totaled $12.4 million. Underwriting standards and credit monitoring procedures for these residential and commercial real estate loans are similar to those described in the credit management policy section on pages 5 and 6. At December 31, 1993 the market value of the insurance held-to-maturity investment portfolio was 108 percent of the amortized cost. Reductions in market value which are determined to be other than temporary are charged to income as realized losses. There were no unrealized losses in the insurance investment portfolio at December 31, 1993 which would materially impact current or future earnings or the capital position of the Company. Investment and other income was $540.4 million in 1993, a 12 percent increase over 1992. The improvement was primarily due to higher gains on sales of available-for-sale investments. These investments were sold consistent with pre-established interest rate and exchange rate policies. A substantially larger investment portfolio, partially offset by lower yields on investments, also contributed to the increase in investment income. Contract revenues also increased in 1993 due to higher levels of insurance in force. Policyholders' benefits were $456.9 million, a 7 percent increase over 1992 due to increased life insurance and annuity contracts. Operating expenses for 1993 were $140.2 million compared with $102.1 and $95.2 million in 1992 and 1991, respectively. Both the 1993 and 1992 increases were due to higher amortization of deferred insurance policy acquisition costs ("DAC"). The higher levels of DAC amortization resulted from increased gross profits on universal life and deferred annuity products. Amortization rates are based on estimated lifetime gross profits and are periodically adjusted as required by generally accepted accounting principles. Unamortized insurance policy acquisition costs totaled $381.6 million at December 31, 1993. In the event of policy surrender, the write-off of unamortized insurance policy acquisition costs would be offset by surrender charges to the policyholder. Surrender charges on policies for which acquisition costs have been capitalized approximated $490 million at December 31, 1993. The effective income tax rate for 1993 was 36.5 percent compared to 34.0 and 26.5 percent in 1992 and 1991, respectively. The 1993 effective tax rate included the impact of the retroactive increase to January 1, 1993 in the statutory Federal corporate income tax rate from 34 percent to 35 percent. The 1991 income tax rate was favorably impacted as a result of the resolution of prior years' tax matters. LIQUIDATING COMMERCIAL LINES The 1993 net loss for the Liquidating Commercial Lines segment was $21.5 million, compared to a loss of $12.3 million in 1992. The net loss was higher primarily due to the previously described resolution of the Company's largest problem loan. The Company expects future results of operations for this segment to improve. STATEMENTS OF OPERATIONS Interest margin increased over 1992 primarily due to wider spreads and gains on terminating debt and related hedges associated with assets which have been liquidated. Other revenues increased due to the Company's 25 percent equity investment in a commercial joint venture of liquidating assets made in 1993. See pages 5 and 6 for a discussion of factors impacting the determination of provision for credit losses. Operating expenses declined 37 percent due to lower write-downs and net expenses for real estate owned and other expenses. Loans decreased 27 percent in 1993 to $1.2 billion. Commercial real estate and highly leveraged acquisition finance and other loans declined during the year. Highly leveraged acquisition finance receivables at December 31, 1993 totaled $717.3 million and consisted of 27 individual credit extensions. The average credit extension was $27 million and the largest credit extension was $50 million. The Company defines highly leveraged acquisition finance receivables as corporate loans to finance the buyout, acquisition or recapitalization of an existing business, in which the debt and equity subordinated to the Company's claims in a borrower are less than 25 percent of the borrower's total assets. The Company had unfunded secured working capital lines and letters of credit related to these acquisition finance borrowers of $98 million at December 31, 1993. Lending for highly leveraged acquisition finance loans was discontinued in 1991. COMMERCIAL NONPERFORMING LOANS AND REAL ESTATE OWNED Nonperforming commercial assets decreased 27 percent during 1993 to $514.0 million. Nonaccrual loans at December 31, 1993 were down 12 percent compared to the December 31, 1992 level, while renegotiated loans declined by $168.1 million during the year. The previously mentioned problem equipment finance loan was transferred during the year from renegotiated loan status to nonaccrual loan status prior to being resolved. Despite the resolution of this credit, the ratio of reserves to nonperforming loans increased to 67.2 percent at December 31, 1993 from 44.6 percent at December 31, 1992. Real estate owned was flat with the prior year. The Company expects the longer term downward trend in nonperforming assets to continue, although it may stabilize in the near future before decreasing. The future level of nonperforming assets will depend, in part, on the timing and extent of economic recovery. In addition, comparisons between periods may be impacted by individual transactions which mask the overall trend. The Company continues to estimate its ultimate loss exposure for nonperforming assets based upon performance and specific reviews of individual loans and its outlook for economic conditions. Because the portfolio consists of a number of loans with relatively large balances, changes in individual borrower circumstances which currently are unforeseen have the potential to change the estimate of ultimate loss exposure in the future. There were no significant potential problem loans not classified as nonperforming assets at December 31, 1993. Management believes that commercial real estate markets began to stabilize in the second half of 1993. The level of future write-downs will continue to depend heavily on changes in overall market conditions as well as circumstances surrounding individual properties. To preserve value in liquidating the real estate portfolio over time, the Company has segregated its portfolio into two categories. Properties in weak markets or with poor cash flow will be divested in an expeditious, orderly fashion. These properties, which have been written down an average of 51 percent, represent 19 percent of the commercial real estate owned portfolio at December 31, 1993. The average carrying value of a property in this portfolio at December 31, 1993 was $2 million. Properties with positive and/or improved cash flows and in markets which, the Company believes, have potential for improvement are being held for sale at prices which reflect this value and may, therefore, take longer to divest. Net operating income on all commercial real estate properties in 1993 was $17.7 million, up from $8.5 million in 1992. Commercial real estate write-downs and carrying costs on all commercial real estate properties were $30.8 million in 1993, compared to $23.3 million in 1992. LIQUIDITY AND CAPITAL RESOURCES The Company generally is funded independently with cash flows, liquidity and capital resources monitored at both the Company and Household International levels. The decision to invest in or to withdraw capital from specific business segments is based on their profitability, growth potential and target capital structure. Household International invested additional capital in HFC of approximately $70 million in 1993 to strengthen the Company's capital position and to fund asset growth. The Company received no capital contributions from Household International in 1992. HFC paid cash dividends to Household International of $175.3 and $63.0 million in 1992 and 1991, respectively. The Company paid no cash dividends to Household International in 1993. The Company employs an integrated and comprehensive program to manage liquidity and capital resources. The major usage of cash by the Company is the origination or purchase of receivables or investment securities. During 1993 and 1992 the Company purchased $430 and $364 million of home equity loan portfolios, respectively. During 1993 and 1992 the Company purchased $33 and $437 million, respectively, of bankcard portfolios. The main sources of cash for the Company are the collection and sales of receivable balances, maturities or sales of investment securities, proceeds from the issuance of debt, cash received from policyholders and cash provided from operations. The Company obtains a majority of its funding through the issuance of commercial paper and long-term debt as well as through the securitizations and sales of consumer receivables. At December 31, 1993 outstanding commercial paper of the Company was $3.7 billion compared to $3.2 billion at December 31, 1992. HFC markets its commercial paper through an in-house sales force, directly reaching more than 165 investors. HFC also markets medium-term notes through its in-house sales force and investment banks and issued a total of $1.6 billion in 1993. During 1993 HFC also issued $626 million of intermediate and long-term debt to the public through investment banks and brokerage houses. To facilitate liquidity, HFC had committed back-up lines of credit totaling $3.5 billion at December 31, 1993, 76 percent of which did not contain a material adverse change clause which could restrict availability. Securitizations and sales of consumer receivables have been, and will continue to be, an important source of liquidity for HFC. During 1993 the Company securitized and sold, including replenishments of certificate holder interests, approximately $3.8 billion of home equity, merchant participation and bankcard receivables compared to $4.8 billion in 1992. Household International has a comprehensive program which addresses the management and diversification of financial risk, such as interest rate, funding, liquidity and currency risk. Household International manages these risks for the Company through an asset/liability management committee ("ALCO") composed of senior management. Interest rate risk is the exposure of earnings to changes in interest rates. The ALCO sets and monitors policy so that the potential impact on earnings from future changes in interest rates is managed within approved limits. Simulation models are utilized to measure the impact on net interest margin of changes in interest rates. The Company, whenever possible, funds its assets with liability instruments of similar interest rate sensitivity, thereby reducing structural interest rate risk. To manage its liquidity position, the Company may synthetically create liabilities with similar characteristics to its assets. As a result of changing market conditions over the last few years, the Company's balance sheet composition has changed dramatically. This shift primarily has been driven by the conversion of fixed rate credit card receivables to a floating rate and the success of variable rate home equity loan products. At December 31, 1993 the Company owned approximately $6.0 billion of domestic receivables with variable interest rates based on the prime rate. To manage liquidity to acceptable levels, these receivables have been funded with $4.0 billion of short-term debt with the remainder funded by longer duration liabilities creating an asset-sensitive position. Through the use of derivatives, primarily interest rate swaps, the Company has been able to offset the asset sensitivity of its balance sheet and achieve a cost of funds based on shorter-term interest rates, thereby reducing interest rate risk while also preserving liquidity. As a result of this strategy and the change in the pricing characteristics of the receivable portfolio, the Company's portfolio of off- balance sheet risk instruments increased significantly during the year. These instruments also are used to manage basis risk or the risk due to the difference in movement of market rate indices on which assets and liabilities are priced (primarily prime and LIBOR, respectively). The Company does not serve as a financial intermediary to make markets in any off-balance sheet financial instruments. While the notional amount of the Company's synthetic portfolio is large, the economic exposure underlying these instruments is substantially less. The notional amount is used to determine the fixed or variable rate interest payment due by each counterparty but does not result in an exchange of principal payments. The Company's exposure on its synthetic portfolio is counterparty risk, or the risk that a counterparty may default on a contract when the Company is owed money. The potential for economic loss is the present value of the interest rate differential determined by reference to the notional amount, discounted using current interest rates. Counterparty limits have been established and are closely monitored as part of the overall risk management process. At December 31, 1993 approximately 99 percent of the Company's derivative instrument counterparties were rated A-or better, and 56 percent were rated AA-or better. The Company has never suffered a loss due to counterparty failure. While attempting to eliminate structural interest rate risk, the Company also strives to take advantage of the profit opportunities available in short-term interest rate movements principally using exchange-traded options. Limits have been established for each instrument based on potential daily changes in market values due to interest rate movements, volatility and market liquidity. Positions are monitored daily to ensure compliance with established policies and limits. Income from these trading activities has not been, nor is anticipated to be, material to the Company. See Note 8, "Financial Instruments With Off-Balance Sheet Risk and Concentrations of Credit Risk" for additional information related to interest rate risk management. During 1993, the Company's credit rating was upgraded by one nationally recognized rating agency and its credit rating outlook was upgraded by another. At December 31, 1993, the long-term debt of the Company had been assigned an investment grade rating by four "nationally recognized" rating agencies. Furthermore, these agencies included the commercial paper of HFC in their highest rating category. With these ratings the Company believes it has substantial capacity to raise capital from wholesale sources to refinance maturing obligations and fund business growth. Total assets of Australia were $419.6 million at year-end 1993. The Company enters into foreign exchange contracts to partially hedge its investment in Australia. Foreign currency translation adjustments, net of gains and losses on contracts used to hedge foreign currency fluctuations, totaled $5.0 and $10.3 million in net losses in 1993 and 1992, respectively, and are included as a component of common shareholder's equity. The functional currency for Australia is its local currency, and the Australian operation borrows funds in local currency. The Company's net realized gains and losses in foreign currency transactions were not material to results of operations or financial position in 1993 or 1992. The Company's life insurance subsidiary, Alexander Hamilton Life Insurance Company ("Alexander Hamilton"), plans for capital needs based on target leverage ratios determined in consultation with key rating agencies. The target leverage ratios are based on Alexander Hamilton's statutory financial position. At the end of 1993 Alexander Hamilton's operating leverage ratio, as defined statutorily, was consistent with its target. Alexander Hamilton has an A+ (Superior) rating from A.M. Best and has an "AA" claims-paying ability rating from Standard & Poor's Corporation, Duff and Phelps Credit Rating Co. and Fitch Investors Services, Inc. The Company believes that future growth of Alexander Hamilton can be funded through its own operations. During 1993, the Company invested $30.5 million in capital expenditures, compared to the prior year level of $37.5 million. In the accompanying financial statements, Note 10 provides information regarding the fair value of certain financial instruments. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Reference is made to the list of financial statements under Item 14(a) herein for the financial statements required by this Item. 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. Omitted. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Omitted. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements. Report of Independent Public Accountants. Statements of Income 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 Preferred Stock and Common Shareholder's Equity for the Three Years Ended December 31, 1993. Business Segment Data for the Three Years Ended December 31, 1993. Notes to Financial Statements. Selected Quarterly Financial Data (Unaudited). (b) Reports on Form 8-K During the three months ended December 31, 1993, HFC did not file with the Securities and Exchange Commission any Current Report on Form 8-K. (c) Exhibits. 3(i) Restated Certificate of Incorporation of Household Finance Corporation ("HFC"), as amended (incorporated by reference to Exhibit 3(a) of HFC's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 3(ii) Bylaws of Household Finance Corporation (incorporated by reference to Exhibit 3(b) of HFC's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 4(a) Indenture dated as of May 15, 1989, between HFC and Bankers Trust Company, as Trustee (incorporated by reference to Exhibit 4 to HFC's Current Report on Form 8-K dated August 3, 1989), as supplemented by a First Supplemental Indenture dated as of June 15, 1989 (incorporated by reference to Exhibit 4 of HFC's Current Report on Form 8-K dated June 15, 1989), as amended by Amendment No. 1 dated October 18, 1990 to the First Supplemental Indenture dated as of June 15, 1989 (incorporated by reference to Exhibit 4 of HFC's Current Report on Form 8-K dated October 18, 1990). 4(b) The principal amount of debt outstanding under each other instrument defining the rights of holders of long-term debt of HFC and its subsidiaries does not exceed 10 percent of the total assets of HFC and its subsidiaries on a consolidated basis. HFC agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument defining the rights of holders of long-term debt of HFC and its subsidiaries. 12 Statement of Computation of Ratios of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends. 23 Consent of Arthur Andersen & Co. Certified Public Accountants. (d) Schedules. Household Finance Corporation and Subsidiaries: VIII Valuation and Qualifying Accounts. X Supplementary Income Statement Information. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, HOUSEHOLD FINANCE CORPORATION HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. HOUSEHOLD FINANCE CORPORATION Dated: March 29, 1994 By: R. F. ELLIOTT --------------------------------- R. F. Elliott, 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 HOUSEHOLD FINANCE CORPORATION AND IN THE CAPACITIES AND ON THE DATES INDICATED. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS HOUSEHOLD FINANCE CORPORATION: We have audited the accompanying balance sheets of Household Finance Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related statements of income, changes in preferred stock and common shareholder's 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 Household Finance 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 listed in Item 14(d) 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 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. Chicago, Illinois February 1, 1994 HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF INCOME The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES BALANCE SHEETS - ------------ * See the Statements of Changes in Preferred Stock and Common Shareholder's Equity on page for the number of shares authorized, issued and outstanding. The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES STATEMENTS OF CHANGES IN PREFERRED STOCK AND COMMON SHAREHOLDER'S EQUITY The accompanying notes are an integral part of these financial statements. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES PRESENTATION OF INCOME DATA The combination of the Company's consumer and continuing commercial product lines are referred to as Finance and Banking. Assets of the liquidating commercial product lines, which are separately managed as receivables are collected or otherwise disposed of, have been disclosed separately in the consolidated balance sheets and as a separate business segment, referred to as Liquidating Commercial Lines. To better define and report the results of operations, the Company refers to its Finance and Banking and Individual Life Insurance segments as its Core Business. Operating profits represent income before income taxes but include interest expense, as financing costs are integral to the Company's operations. Income by segment assumes each business services its own debt. The segments generally provide for income taxes as if separate tax returns were filed subject to certain consolidated return limitations and benefits. Equity is allocated to the business segments based on the underlying regulatory and business requirements. PRESENTATION OF BUSINESS SEGMENT DATA The Finance and Banking segment markets home equity receivables, other secured consumer receivables, bankcards, merchant participation receivables, other unsecured consumer receivables, equipment and other secured commercial loans and leases, and credit and specialty insurance. The Individual Life Insurance segment provides ordinary life, universal life and annuity insurance products. The Liquidating Commercial Lines segment manages the discontinued product lines which consist of commercial real estate, acquisition finance and other loans and other commercial assets being liquidated. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS Household Finance Corporation ("HFC" or the "Company") is a subsidiary of Household International, Inc. ("Household International" or the "parent company"). 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The financial statements include the accounts of the Company and all subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform with the current year's presentation. INVESTMENT SECURITIES. The Company maintains investment portfolios in both its noninsurance and insurance operations. These portfolios are comprised primarily of debt securities. The insurance portfolio also includes mortgage and policyholder loans and other real estate investments. Effective December 31, 1993 the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("FAS No. 115"). In accordance with FAS No. 115, investment securities in both the noninsurance and insurance operations are classified in three separate categories: trading, available-for-sale or held-to-maturity. Trading investments are bought and held principally for the purpose of selling them in the near term and are carried at fair value. Adjustments to the carrying value of trading investments are included in current earnings. Investments which the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and carried at amortized cost. Investments not classified as trading or held-to-maturity are classified as available-for-sale. They are intended to be invested for an indefinite period but may be sold in response to events reasonably expected in the foreseeable future. These investments are carried at fair value. Unrealized holding gains and losses on available-for-sale investments are recorded as adjustments to common shareholder's equity, net of income taxes and, for certain investments in the insurance operation, related unrealized deferred insurance policy acquisition cost adjustments (see 'Insurance' accounting policies on pages and). Prior to the adoption of FAS No. 115, available-for-sale investments were carried at the lower of aggregate amortized cost or fair value, and any adjustments to carrying value for the noninsurance operations were included in earnings, while any adjustments to carrying value for the insurance operation were included in common shareholder's equity. Any decline in the fair value of available-for-sale or held-to-maturity investments which is deemed to be other than temporary is charged against current earnings. Cost of investment securities sold by the insurance operation generally is determined using the first-in, first-out ("FIFO") method, and cost of noninsurance investment securities sold is determined by specific identification. Interest income earned on the noninsurance investment portfolio is classified in the statements of income in net interest margin. Realized gains and losses from the noninsurance portfolio and investment income from the insurance portfolio are recorded in investment income. Gains and losses on trading investments are recorded in other income. Accrued investment income is classified with investment securities. RECEIVABLES. Receivables are carried at amortized cost. The Company periodically sells receivables from its home equity, bankcard and merchant participation portfolios. Because these receivables were originated with variable rates of interest or rates comparable to those currently offered by the Company for such receivables, carrying value approximates market value. Finance income is earned using the effective yield method and classified on the balance sheets, to the extent not collected, with the related receivables. Origination fees are deferred and amortized to finance income over the estimated life of the related receivables, except to the extent they offset directly related lending costs. Annual fees on bankcards are netted with direct lending costs associated with the issuance of the cards. The net amount is deferred and amortized on a straight-line basis over one year. Net deferred direct lending costs related to bankcard receivables totaled $7 and $8 million at December 31, 1993 and 1992, respectively. Insurance reserves applicable to credit risks on consumer receivables are treated as a reduction of receivables in the balance sheets since payments on such policies generally are used to reduce outstanding receivables. Provisions for credit losses are made in amounts sufficient to maintain reserves at a level considered adequate to cover probable losses of principal and earned interest in the existing portfolio of owned receivables. Probable losses are estimated for consumer receivables based on contractual delinquency status and historical loss experience and, for commercial loans, based on a specific loan review process as well as management's assessment of general reserve requirements. These estimates are reviewed periodically, and adjustments are reported in earnings in the periods in which they become known. The Company's chargeoff policy for all consumer receivables is based on contractual delinquency over periods ranging from 6 to 9 months. Commercial loans are written off when it becomes apparent that an account is uncollectible. LIQUIDATING COMMERCIAL ASSETS. The Company has discontinued selected, high-risk commercial product lines. These assets are managed separately from the continuing core businesses and therefore have been presented separately for financial reporting purposes. Liquidating commercial assets are recorded in the accompanying balance sheets at amortized cost net of reserves for credit losses. The carrying value recorded does not exceed amounts estimated to be recoverable, which is consistent with the current intent to hold these assets and collect or otherwise dispose of them in the normal course of business. These assets are accounted for consistent with accounting policies discussed herein. NONACCRUAL LOANS. Nonaccrual loans are loans on which accrual of interest has been suspended. Interest income is suspended on all consumer and commercial loans when principal or interest payments are more than three months contractually past due, except for bankcards and private-label credit cards, which are included in the merchant participation product line. On these credit card receivables, interest continues to accrue until the receivable is charged off. There were no commercial loans at December 31, 1993 which were 90 days or more past due which remained on accrual status. Accrual of income on nonaccrual consumer receivables is not resumed until such receivables become less than three months contractually past due. Accrual of income on nonaccrual commercial loans is not resumed until such loans become contractually current. RECEIVABLES SOLD AND SERVICED WITH LIMITED RECOURSE AND SECURITIZATION INCOME. Certain home equity, bankcard and merchant participation receivables have been securitized and sold to investors with limited recourse. The servicing rights to these receivables have been retained by the Company. Upon sale, the receivables are removed from the balance sheet, and a gain on sale is recognized for the difference between the carrying value of the receivables and the adjusted sales proceeds. The adjusted sales proceeds are based on a present value estimate of future cash flows to be recognized over the life of the receivables. Future cash flows are based on estimates of prepayments, the impact of interest rate movements on yields of receivables sold and securities issued, delinquency of receivables sold, normal servicing fees, operating expenses and other factors. The resulting gain is reduced by establishing a reserve for estimated probable losses under the recourse provisions. Gains on sale, recourse provisions and servicing cash flows on receivables sold are reported in the accompanying statements of income as securitization and servicing fee income. PURCHASED MORTGAGE SERVICING RIGHTS. In 1993, the Company acquired purchased mortgage servicing rights ("PMSR") from an affiliate (see Note 14, "Transactions With Parent Company and Affiliates" for a description of the transaction). PMSR are amortized in a manner which corresponds to the estimated net servicing revenue stream over their estimated useful life not to exceed 15 years. The Company periodically evaluates the carrying value of its PMSR in light of the actual repayment experience of the underlying loans and makes adjustments to reduce the carrying value where appropriate. Servicing income and amortization of PMSR are included in securitization and servicing fee income in the statements of income. PROPERTIES AND EQUIPMENT. Properties and equipment are recorded at cost and depreciated over their estimated useful lives principally using the straight-line method for financial reporting purposes and accelerated methods for tax purposes. REAL ESTATE OWNED. Real estate owned, which is included in assets acquired through foreclosure on the accompanying balance sheets, is valued at the lower of cost or fair value less estimated costs to sell. Costs of holding this real estate, and related gains and losses on disposition, are credited or charged to operations as incurred. These values are periodically reviewed and reduced, if appropriate. INSURANCE. Premiums for ordinary life policies are recognized when due. Premiums for credit insurance are recognized over the period at risk in relationship to anticipated claims. Premiums received on single premium life, universal life and annuity policies ("interest sensitive policies") are considered insurance deposits. Revenues on interest sensitive insurance policies consist of contract charges against policyholders' accounts and are reported in the period assessed. Costs associated with acquisition of insurance risks are deferred and generally amortized in relation to premium revenues on ordinary and credit insurance and in relation to gross profits on interest sensitive policies. Amortization of deferred insurance policy acquisition costs has been adjusted for unrealized gains or losses on available-for-sale investments on the same basis as if the gains or losses were realized. Such amortization related to unrealized gains or losses has been netted against the unrealized gains or losses as an adjustment to common shareholder's equity. Liability for future contract benefits on interest sensitive policies is computed in accordance with the retrospective deposit method using interest rates which vary with rates credited to policyholders' accounts. Liabilities for future policy benefits on other life insurance products generally are computed using the net level premium method, based upon estimated future investment yields, mortality, and withdrawals appropriate when the policies were issued. Mortality and withdrawal assumptions principally are based on industry tables. Policy and contract claim reserves are based on estimated settlement amounts for both reported and incurred but not reported losses. ACQUIRED INTANGIBLES. Acquired intangibles consist of the cost of investments in excess of net tangible assets acquired and acquired credit card relationships. Acquired credit card relationships are amortized on a straight-line basis over their estimated remaining lives, not to exceed 10 years. Other intangible assets are amortized using straight-line and other methods over their estimated useful lives, not to exceed 15 years. The average remaining amortization period for acquired intangibles was approximately 6, 7 and 8 years at December 31, 1993, 1992 and 1991, respectively. INTEREST RATE CONTRACTS. The Company enters into a variety of interest rate contracts in the management of its interest rate exposure and in its trading activities. For interest rate swaps that are designated as hedges, the interest rate differential to be paid or received is accrued and included in interest expense. For interest rate futures, options, caps and floors, and forward contracts that qualify as hedges, realized and unrealized gains and losses are deferred and amortized over the lives of the hedged items as adjustments to interest expense. Realized and unrealized gains and losses on contracts that do not qualify as hedges are included in other income. FOREIGN CURRENCY TRANSLATION. Foreign subsidiary assets and liabilities are located in Australia. The functional currency for Australia is its local currency. Foreign subsidiary financial data are translated into U.S. dollars at the current exchange rate, and translation adjustments are accumulated as a separate component of common shareholder's equity. The Company enters into forward exchange contracts to hedge its investment in foreign subsidiaries. After-tax gains and losses on contracts to hedge foreign currency fluctuations are included in the foreign currency translation adjustment in common shareholder's equity. Effects of foreign currency translation in the statements of cash flows are offset against the cumulative foreign currency adjustment, except for the impact on cash. Foreign currency transaction gains and losses are included in income as they occur. INCOME TAXES. The Company and its eligible subsidiaries are included in Household International's consolidated Federal income tax return and in various consolidated state income tax returns. In addition, the Company files some unconsolidated state tax returns. Under the tax-sharing agreement with Household International, the Company's Federal and consolidated state tax provisions are determined based on the Company's effect on Household International's consolidated return. Tax benefits are paid to the Company as they are utilized in Household International's consolidated return. Investment tax credits generated by leveraged leases are accounted for by the deferral method. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes" ("FAS No. 109") effective January 1, 1993 which requires that deferred tax assets and liabilities, other than those associated with leveraged leasing transactions, be adjusted to the tax rates expected to apply in the periods in which the deferred tax assets and liabilities are expected to be realized or settled. 2. INVESTMENT SECURITIES Investment securities at December 31 were as follows: The Company's insurance subsidiaries held $6.5 and $5.5 billion of the investment securities at December 31, 1993 and 1992, respectively. Policy loans and mortgage loans on real estate held by the Company's insurance subsidiaries are classified as investment securities, consistent with insurance industry practice. Included in the Company's earnings for 1993, 1992 and 1991 are changes in net unrealized holding gains(losses) of $.7, $(3.4) and $3.1 million, respectively, from trading investments. Proceeds from the sale of available-for-sale investments totaled $448.3 and $235.1 million in 1993 and 1992, respectively. Gross gains of $35.8 and $8.8 million and gross losses of $7.5 and $18.1 million in 1993 and 1992, respectively, were realized on those sales. There were no investments classified as available-for-sale in 1991. The amortized cost of held-to-maturity investments transferred to available-for-sale in 1993 was $2.8 billion. Proceeds from sales of held-to-maturity investments were $756.9 million, $825.4 million and $1.3 billion during 1993, 1992 and 1991, respectively. Sales and transfers of held-to-maturity investments in 1993 were due to restructuring of the investment security portfolio in anticipation of the adoption of FAS No. 115 on December 31, 1993. Approximately $400 and $800 million of sales proceeds in 1992 and 1991 were related to a decision made in 1991 to restructure the held-to-maturity investments to significantly reduce exposure in the Company's non-investment grade bond portfolio. Gross gains of $46.5, $34.9 and $36.7 million and gross losses of $9.6, $15.8 and $27.9 million were realized on sales of held-to-maturity investments in 1993, 1992 and 1991, respectively. The gross unrealized gains (losses) on investment securities were as follows: See Note 10, "Fair Value of Financial Instruments" for further discussion of the relationship between the fair value of the Company's assets, liabilities and off-balance sheet financial instruments. As of December 31, 1993 the Company did not hold any debt or equity securities from a single issuer that exceeded 10 percent of common shareholder's equity. Contractual maturities and yields of investments in debt securities available-for-sale and held-to-maturity were as follows: 3. FINANCE AND BANKING RECEIVABLES Finance and Banking receivables of the Australian operations included in receivables owned were as follows: The Company has securitized and sold certain receivables which it services with limited recourse. Securitizations and sales of receivables, including replenishments of certificate holder interests were as follows: The outstanding balance of receivables serviced with limited recourse consisted of the following: The combination of receivables owned and receivables serviced with limited recourse, which the Company considers its managed portfolio, is shown below: For certain securitizations, wholly-owned subsidiaries were created (HRSI Funding, Inc., HFS Funding Corporation, Household Finance Receivables Corporation II, Household Receivables Funding Corporation, Household Receivables Funding Corporation II, and HFC Funding Corporation) for the limited purpose of consummating such transactions. The amount due and deferred from receivables sales of $675.2 million at December 31, 1993 included unamortized excess servicing assets and funds established pursuant to the recourse provisions and holdback reserves for certain sales totaling $539.0 million. The amount due and deferred also included customer payments not yet remitted by the securitization trustee to the Company. In addition, the Company has made guarantees relating to certain securitizations of $281.3 million plus unpaid interest and has subordinated interests in certain transactions, which are recorded as receivables, for $83.9 million at December 31, 1993. The Company maintains credit loss reserves pursuant to the recourse provisions for receivables serviced with limited recourse which are based on estimated probable losses under such provisions. These reserves totaled $134.5 million at December 31, 1993 and represent the Company's best estimate of probable losses on receivables serviced with limited recourse. Contractual maturities of owned receivables at December 31, 1993 were as follows: A substantial portion of all consumer receivables, based on the Company's experience, will be paid prior to contractual maturity. This tabulation, therefore, is not to be regarded as a forecast of future cash collections. The ratio of annual cash collections of principal to average principal balances, excluding bankcard receivables, approximated 40 and 38 percent in 1993 and 1992, respectively. The following table summarizes contractual maturities of owned receivables at December 31, 1993 due after one year by repricing characteristic: Finance and Banking nonaccrual owned receivables totaled $221.3 million at December 31, 1993 including $29.4 million relating to the foreign operation. Interest income that would have been recorded in 1993 if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $36 million. Interest income that was included in net income for 1993 on those receivables was approximately $19 million. For further information on nonperforming assets, see pages 10 and 11 in Management's Discussion and Analysis of Results of Operations. See Note 5, "Credit Loss Reserves" for an analysis of credit loss reserves for Finance and Banking receivables. 4. LIQUIDATING COMMERCIAL ASSETS At December 31, 1993 contractual maturities of receivables were: Within 1 year--$207.3 million; 1 - 2 years--$99.1 million; 2 - 3 years--$249.1 million; 3 - -4 years--$158.9 million; 4 - 5 years--$129.9 million and over 5 years--$345.6 million. Receivables with predetermined interest rates maturing in over 1 year but within 5 years were $331.1 million, and those maturing in over 5 years were $288.2 million. Receivables with floating or adjustable rates maturing in over 1 year but within 5 years were $305.9 million and those maturing in over 5 years were $57.4 million. See Note 5, "Credit Loss Reserves" for an analysis of credit loss reserves for liquidating commercial assets. Liquidating commercial nonaccrual loans totaled $228.7 million at December 31, 1993. See page14 for nonaccrual data for prior years. Interest income that would have been recorded in 1993 if such nonaccrual receivables had been current and in accordance with contractual terms was approximately $33 million. Interest income that was included in net income in 1993 on those receivables was approximately $2 million. Renegotiated loans included in liquidating commercial assets at December 31, 1993 totaled $28.7 million. The Company recorded $2.5 million of interest earned on such loans in 1993. Had the loans been performing in accordance with their original terms, interest income in 1993 would have been approximately $4 million higher. There were $.7 million of commitments at December 31, 1993 to lend additional funds to borrowers whose loans were renegotiated. See page 14 for further information on nonperforming assets. 5. CREDIT LOSS RESERVES 6. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS Interest expense for commercial paper, bank and other borrowings totaled $151.0, $174.2 and $260.0 million for 1993, 1992 and 1991, respectively. The Company maintains various bank credit agreements primarily to support commercial paper borrowings. At December 31, 1993 the Company had total bank credit agreements of $4.0 billion, of which $3.7 billion were unused. Formal credit lines are reviewed annually and revolving credit agreements expire at various dates from 1994 to 1996. Borrowings under credit agreements generally are available at the prime rate or at a surcharge over the London Interbank Offered Rate (LIBOR). Annual commitment fee requirements to support availability of credit agreements at December 31, 1993 totaled $7.9 million. 7. SENIOR AND SENIOR SUBORDINATED DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) Weighted average interest rates, excluding the impact of interest rate swap agreements, were 7.1, 7.7 and 8.4 percent at December 31, 1993, 1992 and 1991, respectively. Including the impact of interest rate swap agreements, weighted average interest rates were 4.8, 5.5 and 7.6 percent at December 31, 1993, 1992 and 1991, respectively. Maturities of senior and senior subordinated debt at December 31, 1993 were as follows (in millions): At December 31, 1993 there were no significant restrictions on retained earnings in any of HFC's various indentures and agreements. Cash dividends or advances to HFC by certain of its subsidiaries are limited by government or statutory regulation. At December 31, 1993 approximately $1.3 billion of consolidated net assets were so restricted. 8. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK In connection with its asset/liability management program and in the normal course of business, the Company enters into various transactions involving off-balance sheet financial instruments. These instruments are used to reduce the Company's exposure to fluctuations in interest rates and foreign exchange rates, and to a lesser extent for proprietary trading purposes, or to meet the financing needs of its customers. The Company does not serve as a financial intermediary to make markets in any off-balance sheet financial instruments. These financial instruments, which include interest rate contracts, foreign exchange rate contracts, commitments to extend credit, financial guarantees and recourse obligations have varying degrees of credit risk and/or market risk. CREDIT RISK Credit risk is the possibility that a loss may occur because the counterparty to a transaction fails to perform according to the terms of the contract. The Company's exposure to credit loss under commitments to extend credit, financial guarantees and recourse obligations is represented by the contract amount. The Company's credit quality and collateral policies for commitments and guarantees are the same as those for receivables that are recorded on the balance sheet. The Company's exposure to credit loss related to interest rate swaps, cap and floor transactions, forward and futures contracts and options is the amount of uncollected interest or premium related to these instruments. These interest rate related instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties. The Company controls the credit risk of its off-balance sheet financial instruments through established credit approvals, risk control limits and ongoing monitoring procedures. The Company has never experienced nonperformance by any counterparty. MARKET RISK Market risk is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. The Company mitigates this risk by establishing limits for positions and other controls and by entering into counterbalancing positions. OFF-BALANCE SHEET INTEREST RATE AND FOREIGN EXCHANGE CONTRACTS The accompanying tables summarize the notional amounts of the Company's off-balance sheet interest rate and foreign exchange contracts: - --------------- * Bracketed amounts at year end represent net short positions. Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The Company utilizes interest rate swaps to allow it to match fund its receivables, which are primarily floating rate, with its liabilities, which are primarily fixed rate. Credit and market risk exist with respect to these instruments. The following table summarizes the interest rate swaps outstanding: Forwards and futures are contracts for delivery at a future date in which the buyer agrees to take delivery of a specified instrument or cash at a specified price. The Company has both interest rate and foreign exchange rate forward contracts and interest rate futures contracts. Foreign exchange contracts are utilized by the Company to reduce exposure in its Australian operation to fluctuations in exchange rates. Interest rate forward and interest rate futures contracts primarily are used in the Company's proprietary trading activities. Interest rate forward and futures contracts also are used to mitigate basis risk which arises due to the difference in movement of market rate indices (prime and LIBOR) on which a large portion of the Company's assets and liabilities are priced. For futures, the Company's exposure to credit risk is limited as these contracts are traded on organized exchanges and are settled on a daily basis with the exchanges. In contrast, forward contracts have credit risk relating to the performance of the counterparty. These instruments also are subject to market risk. For forward and futures contracts entered into as hedging activities, the Company had commitments to purchase of $3.4 and $197.5 million and commitments to sell of $91.7 and $108.5 million at December 31, 1993 and 1992, respectively. In connection with its trading activities, the Company had commitments to purchase of $332.0 and $2,710.2 million and commitments to sell of $877.0 and $3,108.0 million at December 31, 1993 and 1992, respectively. Options grant the purchaser the right to either purchase or sell a financial instrument at a specified price within a specified period. The Company primarily uses options, both written and purchased, for its proprietary trading activities. Gains and losses from the Company's trading activities were immaterial to the financial results of the Company. For written options, the Company is exposed to market risk but generally not credit risk. The credit risk and market risk associated with purchased options is limited to the premium paid which is recorded on the balance sheet. The Company had options purchased for trading activities of $9.7 and $2.7 billion and options written for trading activities of $16.4 and $10.6 billion at December 31, 1993 and 1992, respectively. The Company also had options purchased for hedging activities of $29.6 million and options written for hedging activities of $40.0 million at December 31, 1993. The Company had no options written or purchased for hedging activities at December 31, 1992. Other risk management instruments consist of caps and floors and foreign currency swaps. Caps and floors written expose the Company to market risk but not to credit risk. Credit and market risk associated with caps and floors purchased is limited to the premium paid which is recorded on the balance sheet. Deferred gains of $9.7 and $14.2 million and deferred losses of $7.8 and $11.1 million were recorded on the balance sheet from interest rate risk management instruments at December 31, 1993 and 1992, respectively. The weighted average amortization periods were 3.8 and 4.0 years associated with the deferred gains and 4.2 and 2.4 years associated with the deferred losses at December 31, 1993 and 1992, respectively. Interest margin was increased by $166.7, $101.4 and $37.9 million in 1993, 1992 and 1991, respectively, through the use of off-balance sheet interest rate risk management instruments. At December 31, 1993 the accrued interest, unamortized premium and other assets recorded for agreements which would be written off should all related counterparties fail to meet the terms of their contracts was $50.7 million. COMMITMENTS AND GUARANTEES The Company enters into various commitments and guarantees to meet the financing needs of its customers. However, the Company expects a substantial portion of these contracts to expire unexercised. The Company's significant commitments and guarantees consisted of the following: Commitments to extend credit to consumers represent the unused credit limits on bank and private-label credit cards and on other lines of credit. Commitments on bank and private-label credit cards are cancelable at any time. The Company does not require collateral to secure credit card agreements. Other consumer lines of credit include home equity lines of credit, which are secured by residential real estate, and other unsecured lines of credit. Commitments on these lines of credit generally are cancelable by the Company when a determination is made that a borrower may not be able to meet the terms of the credit agreement. Other loan commitments include commitments to fund commercial loans and letters of credit and guarantees for the payment of principal and interest on municipal industrial development bonds. Commercial loan commitments, primarily related to the Liquidating Commercial Lines segment, including working capital lines and letters of credit, totaled $150.7 and $168.9 million at December 31, 1993 and 1992, respectively. These commitments are collateralized to varying extents by inventory, receivables, property and equipment and other assets of the borrowers and were entered into prior to the Company's decision to exit these product lines. The Company has issued guarantees of $136 million at both December 31, 1993 and 1992 for the payment of principal and interest on municipal industrial development bonds. The guarantees expire from 1994 through 1997. The Company has security interests in underlying properties for these guarantees, with an average collateral value of 101 percent of the guarantees at both December 31, 1993 and 1992. The Company also has guaranteed payment of all debt obligations issued prior to 1989, excluding deposits, of Household Financial Corporation Limited ("HFCL"), a Canadian affiliate. The amount of guaranteed debt issued by HFCL prior to 1989 and still outstanding was approximately $113 million. OTHER FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Certain receivables securitized and serviced with limited recourse include floating interest rate provisions whereby the underlying receivables pay a fixed (floating) rate and the pass-through rate to the investor is floating (fixed). Further, in other transactions the underlying receivables reprice based on one index while the pass-through rate reprices on another index. The Company manages its exposure to interest rate risk on these financial instruments primarily through the use of interest rate swaps. See Note 3, "Finance and Banking Receivables" for additional information on securitizations and sales of receivables. CONCENTRATIONS OF CREDIT RISK A concentration of credit risk is defined as a significant credit exposure with an individual or group engaged in similar activities or affected similarly by economic conditions. Because the Company primarily lends to consumers, it does not have receivables from any industry group that equal or exceed 10 percent of total managed receivables at December 31, 1993 and 1992. The Company lends nationwide; the following geographic areas comprised more than 10 percent of total managed domestic receivables at December 31, 1993: California--22 percent, Midwest (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)--23 percent, Middle Atlantic (DE, DC, MD, NJ, PA, VA, WV) - 15 percent, Northeast (CT, ME, MA, NH, NY, RI, VT)--14 percent and Southeast (AL, FL, GA, KY, MS, NC, SC, TN)--13 percent. 9. PREFERRED STOCK The Company is authorized to issue up to 1,000 shares of preferred stock, with no stated par value. Preferred stock consisted of the following: The term cumulative preferred stock is non-voting and has a dividend rate of 7.25 percent, is not redeemable at the option of the Company prior to the mandatory redemption date of August 15, 1997, and has a liquidation value of $300,000 per share. On October 1, 1993 the Company's exchangeable money market cumulative preferred stock was redeemed in whole for $500,000 per share plus accrued and unpaid dividends. 10. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company has estimated the fair value of its financial instruments in accordance with Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments" ("FAS No. 107"). The estimates were made as of December 31, 1993 and 1992 based on relevant market information. Financial instruments include cash, receivables, investments, liquidating commercial assets, debt, certain insurance reserves and off-balance sheet instruments. Accordingly, a number of other assets recorded on the balance sheet (such as acquired credit card relationships) and other intangible assets not recorded on the balance sheet (such as the value of consumer lending relationships for originated receivables and the franchise values of the Company's business units) are not required to be valued for purposes of this disclosure. The Company believes there is substantial value associated with these assets based on current market conditions and historical experience. Approximately 30 percent in 1993 and 35 percent in 1992 of the fair value of financial instruments disclosed were determined using quoted market prices. Because no actively traded market exists, however, for a significant portion of the Company's financial instruments, fair values for items lacking a quoted market price were estimated by discounting estimated future cash flows at estimated current market discount rates. Assumptions used to estimate future cash flows are consistent with management's assessments regarding ultimate collectability of assets and related interest and with estimates of product lives and repricing characteristics used in the Company's asset/liability management process. All assumptions are based on historical experience adjusted for future expectations. Assumptions used to determine fair values for financial instruments for which no active market exists are inherently judgmental and changes in these assumptions could significantly affect fair value calculations. The following is a summary of the carrying value and estimated fair value of the Company's financial instruments: The estimated fair value in excess of carrying value (the "Difference") of the Company's financial instruments was $19 million at December 31, 1993 an increase of $6 million from year-end 1992. The adoption of FAS No. 115 on December 31, 1993 reduced the Difference associated with investment securities, as available-for-sale investment securities are now carried at estimated fair value. Excluding the impact of FAS No. 115, the Difference for investment securities at December 31, 1993 would have been approximately $381 million. The excess of carrying value over estimated fair value of liquidating commercial assets declined in 1993, as discussed more fully below. Recently adopted generally accepted accounting principles (FAS No. 115) require recognition of the difference between fair market and carrying values of certain debt and equity securities. As previously disclosed, the differential increased common shareholder's equity by $35.1 million after partially offsetting adjustments for the impact of income taxes and deferred insurance policy acquisition costs. The Company believes it is not meaningful to evaluate the difference between fair market and carrying values for assets without evaluating similar differences for all liabilities and off-balance sheet financial instruments utilized in the Company's asset/liability management process. As market interest rates change, application of this new accounting principle will result in volatility of the reported capital base that is inconsistent with economic value. The analysis presented on the previous page presents a more complete view of the differences between fair market and carrying values of both assets and liabilities. Although the disclosed pretax excess of fair value over carrying value of $19 million at December 31, 1993 covers a substantial portion of the elements of the Company's financial position, it excludes the substantial value associated with other intangible values described earlier. In addition, the disclosures presented previously exclude fair market valuation of certain insurance reserves and leases as prescribed by generally accepted accounting principles. Both the analysis of the fair value information presented previously, as well as the adjustments required by FAS No. 115, therefore have inherent limitations. The following methods and assumptions were used to estimate the fair value of the Company's financial instruments: CASH: The carrying value approximates fair value for this instrument due to its liquid nature. INVESTMENT SECURITIES: Quoted market prices were used to determine fair value for investment securities. FINANCE AND BANKING RECEIVABLES: The fair value of adjustable rate consumer receivables was determined to approximate existing carrying value because interest rates on these receivables adjust with changing market interest rates. The fair value of fixed rate consumer receivables was estimated by discounting future expected cash flows at interest rates approximating those offered by the Company on such products at the respective valuation dates. This approach to estimating fair value for fixed rate consumer receivables results in a disclosed fair value that is less than amounts the Company believes could be currently realizable on a sale of these receivables. These receivables are relatively insensitive to changes in overall market interest rates and therefore have additional value compared to alternative uses of funds in a low interest rate environment. The fair value of consumer receivables included an estimate, on a present value basis, of future excess servicing cash flows associated with securitizations and sales of certain home equity, bankcard and merchant participation receivables. LIQUIDATING COMMERCIAL ASSETS: The fair value of liquidating commercial assets was determined by discounting estimated future cash flows at an estimated market interest rate. The assumptions used in the estimate were consistent with the Company's intention to manage this portfolio of assets separately from the Core Business and to dispose of the assets in the normal course of business. The estimated fair value for liquidating commercial assets was below carrying value due to increases in current market discount rates, adjusted for changes in overall market rates, from rates in effect when assets were originated. This change in discount rates impacts all assets regardless of whether any uncertainty exists over collectability of future principal and interest payments. The Company believes the relative increase in current market discount rates is due to economic conditions and market perceptions towards the types of commercial assets which the Company decided to discontinue in 1991. While these market perceptions improved slightly during 1993, they still remain unfavorable, which has resulted in illiquid and sluggish markets for these assets. Because of these current market conditions, the Company currently intends to collect or otherwise dispose of its liquidating commercial assets over several years. The decrease in the difference between estimated fair value and carrying value in 1993 compared to 1992 reflects the belief that current market conditions, while depressed, have improved and will continue to improve over the next several years. Accordingly, the Company does not believe that the differential between estimated fair and carrying values for liquidating commercial assets represents a permanent impairment of value. COMMERCIAL PAPER, BANK AND OTHER BORROWINGS: The fair value of these instruments was determined to approximate existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. SENIOR AND SENIOR SUBORDINATED DEBT: Quoted market prices where available were used to determine fair value. For those instruments for which quoted market prices were not available, the estimated fair value was computed by discounting future expected cash flows at interest rates offered for similar types of debt instruments. INSURANCE RESERVES: The fair value of insurance reserves for periodic payment annuities and guaranteed investment contracts was estimated by discounting future expected cash flows at interest rates offered by the Company on such products at December 31, 1993 and 1992. The fair value of other insurance reserves is not required to be determined in accordance with FAS No. 107. The Company believes the fair value of such reserves approximates existing carrying value because interest rates on these instruments adjust with changes in market interest rates due to their short-term maturity or repricing characteristics. INTEREST RATE AND FOREIGN EXCHANGE CONTRACTS: Quoted market prices were used to determine fair value of these instruments. See Note 8, "Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk" for a discussion of the nature of these items. COMMITMENTS TO EXTEND CREDIT AND GUARANTEES: These commitments were valued by considering the Company's relationship with the counterparty, the creditworthiness of the counterparty and the difference between committed and current interest rates. 11. LEASES AND OTHER SIMILAR ARRANGEMENTS The Company leases certain offices, buildings and equipment for periods of up to 10 years with various renewal options. The majority of such leases are noncancelable operating leases. Net rental expense under operating leases was $26.6, $25.9 and $27.9 million for 1993, 1992 and 1991, respectively. In the fourth quarter of 1991, the Company purchased credit card receivables of approximately $1 billion from CoreStates Financial Corporation. An unaffiliated third party acquired the rights to the account relationships associated with the receivables. The Company is entitled to utilize the account relationships under a licensing agreement with the third party. This licensing arrangement is noncancelable and has an initial term expiring in 1998. Net expense under this licensing arrangement was $32.9, $32.9 and $2.7 million in 1993, 1992 and 1991, respectively. Future net minimum lease and other commitments under noncancelable operating lease and licensing arrangements were: 12. EMPLOYEE BENEFIT PLANS The Company and its U.S. subsidiaries participate in Household International's Retirement Income Plan ("RIP"), which covers substantially all U.S. full-time employees. No separate actuarial valuation has been made for the Company's participation in RIP. The fair value of plan assets in RIP exceeded Household International's projected benefit obligation by $212.6 and $208.4 million at December 31, 1993 and 1992, respectively. The 1993 and 1992 projected benefit obligations for RIP were determined using an assumed weighted average discount rate of 7.25 and 8.00 percent, respectively, an assumed compensation increase of 3.75 and 4.25 percent, respectively, and an assumed weighted average long-term rate of return on plan assets of 9.50 and 9.75 percent, respectively. At December 31, 1993 and 1992, the Company's estimated share of prepaid pension cost was $113.2 and $101.8 million, respectively. Plan benefits are based primarily on years of service and compensation of participants. The Company's share of total pension income due to the over-funded status of RIP was $11.4, $22.4 and $25.1 million for 1993, 1992 and 1991, respectively. The Company's Australian subsidiary also has a defined benefit pension plan covering substantially all of its employees. The projected benefit obligation, pension income and funded status of the foreign plan is not significant to the Company. The Company participates in Household International's defined contribution plan where each participant's contribution is matched by the Company up to a maximum of 6 percent of the participant's compensation. For 1993, 1992 and 1991 the Company's costs totaled $9.2, $9.2 and $8.5 million, respectively. The Company also participates in Household International's plans which provide medical, dental and life insurance benefits to retirees and eligible dependents. The plans are funded on a pay-as-you-go basis and cover substantially all employees who meet certain age and vested service requirements. Household International has instituted dollar limits on its payments under the plans to control the cost of future medical benefits. Effective January 1, 1993 Household International adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS No. 106"). FAS No. 106 requires the recognition of the expected postretirement costs on an accrual basis, similar to pension accounting. The expected cost of postretirement benefits is required to be recognized over the employees' years of service with the Company instead of the period in which the benefits are paid. Household International is recognizing the transition obligation, which represents the unfunded and unrecognized accumulated postretirement benefit obligation at that date, over 20 years. While no separate actuarial valuation has been made for the Company's participation in Household International's plans for postretirement medical, dental and life benefits, its share of the liability and expense has been estimated. Household International's accumulated postretirement benefit obligation was $152.5 million at December 31, 1993. The Company's estimated share of Household International's accrued postretirement benefit obligation was $10.1 million at December 31, 1993. In addition, the Company's estimated share of postretirement benefit expense recognized in 1993 was $13.9 million. Through 1992, it had been the Company's policy to charge the cost of retiree health care and life insurance benefits to expense when benefits were paid. The cost of these plans to Household International totaled $2.9 and $2.5 million in 1992 and 1991, respectively. The cost of plans which cover retirees and eligible dependents in Australia is not significant to the Company. Household International's accumulated postretirement benefit obligation at December 31, 1993 was determined using an assumed weighted average discount rate of 7.50 percent and an assumed annual compensation increase of 3.75 percent. A 15 percent annual rate of increase in the gross cost of covered health care benefits is assumed for 1993 and 1994. This rate of increase is assumed to decline by 1 percentage point in each year after 1994. The health care cost trend rate assumption has an effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rate by 1 percentage point would have increased the Company's share of the 1993 net periodic postretirement benefit cost by $.7 million and its share of the accumulated postretirement benefit obligation at December 31, 1993 by $8.5 million. A 1 percentage point increase would have increased Household International's accumulated postretirement benefit obligation by $12.3 million. 13. INCOME TAXES Effective January 1, 1993 the Company adopted FAS No. 109. As a result of implementing FAS No. 109, retained earnings for all periods between 1986 and 1992 have been reduced by approximately $62 million from amounts previously reported. The statements of income for those periods subsequent to December 31, 1986 have not been restated as the impact of FAS No. 109 on net income was immaterial to any such year and in total. Total income taxes were allocated as follows: Provisions for income taxes related to operations were: The significant components of deferred income tax provisions attributable to income from operations were: Income before income taxes from foreign operations was $1.0, $14.0 and $6.0 million in 1993, 1992 and 1991, respectively. Effective tax rates are analyzed as follows: In accordance with the Company's accounting policy, provisions for U.S. income taxes had not been made at December 31, 1993 on $85.9 million of undistributed earnings of its U.S. life insurance subsidiary accumulated as policyholders' surplus under tax laws in effect prior to 1984. Because this amount would become taxable only in the event of certain circumstances which the Company does not expect to occur within the foreseeable future, no deferred tax liability has been established for this item. The amount of deferred tax liability not recognized was $30.1 million at December 31, 1993. At December 31, 1993 the Company had net operating loss carryforwards for tax purposes of $39.3 million which have no expiration date. The realization of these carryforwards will reduce future income tax payments. Temporary differences which gave rise to a significant portion of deferred tax assets and liabilities were as follows: 14. TRANSACTIONS WITH PARENT COMPANY AND AFFILIATES HFC periodically advances funds to Household International and affiliates or receives amounts in excess of the parent company's current requirements. Advances to parent company and affiliates consisted of the following: These advances bear interest at various interest rates which approximate market. Interest income on advances to parent company and affiliates is included with interest expense and includes the following: During 1993 and 1992, Household Bank, National Association ("HBNA"), a wholly-owned subsidiary of the Company, borrowed monies from Household Bank, f.s.b. ("the Bank") at arm's length interest rates. The balance at December 31, 1992 was $450 million and was included in commercial paper, bank and other borrowings for financial statement purposes. This loan was paid in full in the first quarter of 1993. HBNA paid approximately $2.6 and $18.2 million of interest expense on this loan during 1993 and 1992, respectively. In November 1993 the Company purchased approximately $133 million of purchased mortgage servicing rights from the Bank. The Bank will continue to act as a subservicer for the Company and will be paid a subservicing fee based on the Bank's estimated costs of servicing the loans. These rights were purchased at net book value which approximated market value. The Company has an agreement with the Bank to originate unsecured nonmortgage consumer loans using the Bank's lending criteria. These loans are originated via direct mail programs, and are serviced by the Company for an arm's length fee. In 1993, the Company originated approximately $73 million of loans for the Bank under this program. Household International has entered into a Regulatory Capital Maintenance/Dividend Agreement with the Office of Thrift Supervision. Under this agreement, as amended, as long as Household International is the parent company of the Bank, Household International and the Company agree to maintain the capital of the Bank at the levels currently required or any subsequent regulatory capital requirements. The agreement also requires that any capital deficiency be cured by Household International and/or the Company within thirty days. In 1993, 1992 and 1991, Household International made cash capital contributions of $70, $54 and $20 million, respectively, to maintain the regulatory capital of the Bank at levels consistent with management's objectives and minimum regulatory capital requirements. During the fourth quarter of 1992 the Company purchased approximately $290 million of home equity loans from the Bank which were subsequently securitized and sold. These loans were purchased by the Bank from a third party. Certain support services of the Company are performed by a wholly-owned subsidiary of Household International. This subsidiary was established to maximize the efficiency and consolidate the back room operating functions of various subsidiaries of Household International. The Company has negotiated an arms-length agreement with this subsidiary for services such as item processing, collections and billings, accounts payable, and payroll processing. Additionally, the Company was allocated and/or billed for costs incurred on its behalf by Household International for expenses including insurance, credit, and legal and other fees. These expenses were recorded in other operating expenses and totaled approximately $261, $207 and $250 million in 1993, 1992 and 1991, respectively. 15. COMMITMENTS AND CONTINGENT LIABILITIES In the ordinary course of business there are various legal proceedings pending against the Company. Management considers that the aggregate liabilities, if any, resulting from such actions would not have a material adverse effect on the consolidated financial position of the Company. See Note 8 for a discussion regarding commitments and contingent liabilities related to off-balance sheet financial instruments. See Note 11 for discussion of lease commitments. HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN MILLIONS) FOURTH QUARTER RESULTS Net income for the 1993 fourth quarter was $71.2 million, up 42 percent from the third quarter but down 6 percent from the prior year fourth quarter. The improvement over the third quarter resulted from higher earnings from the domestic consumer finance and bankcard businesses. The domestic consumer finance operations benefited primarily from wider spreads on variable rate products and growth in the managed portfolio, while the bankcard business benefited from higher revenues associated with seasonality. Earnings in the quarter also benefited from lower losses in the Liquidating Commercial Lines segment due to reduced credit losses. Net interest margin was $217.4 million, essentially flat with the prior quarter and up 9 percent from the prior year fourth quarter primarily due to higher average owned receivables and wider spreads on variable rate products. The level of earning assets is dependent on the timing of securitizations and sales of receivables. The Company securitized and sold $.6 billion of receivables in the fourth quarter of 1993 compared to $2.1 billion in the year-ago period. The provision for credit losses on owned receivables declined by $21.6 million in the fourth quarter of 1993 compared to the third quarter due to lower loss provision on liquidating commercial receivables. The third quarter amount reflected the disposition of the Company's largest problem loan. The increase compared to the prior year was primarily due to higher loss provision associated with increased year-over-year receivable balances. Securitization and servicing fee income declined 11 and 29 percent from 1993 third quarter and 1992 fourth quarter amounts due to lower average receivables serviced with limited recourse and a shift toward home equity loans in the securitized portfolio, resulting in narrower spreads. Investment income fell 15 percent from the prior quarter primarily due to higher gains resulting from the sale of investments classified in the available-for-sale portfolios in the third quarter of 1993 compared to the fourth quarter and increased 10 percent over the prior year fourth quarter due to lower realized gains in 1992. The higher levels of fee income in the fourth quarter compared to the prior and year-ago quarters primarily related to interchange and other fee income resulting from growth in the owned credit card portfolios and seasonality. Other income increased in the fourth quarter over the previous quarter and the prior year fourth quarter due to increased income on the Company's 25 percent equity investment in a commercial joint venture and prepayment fees received upon the payoff of commercial assets. Total costs and expenses declined 9 percent compared to the third quarter of 1993 but were up 5 percent compared to the year-ago period. Costs and expenses in the third quarter of 1993 were up due to previously mentioned gains on available-for-sale investments which resulted in higher levels of deferred insurance policy acquisition cost amortization. The effective tax rate in the 1993 fourth quarter was essentially flat compared to the previous quarter and up from 29.6 percent in the prior year. The higher tax rate in 1993 primarily was due to the impact of the enactment of new Federal tax legislation and a change in the treatment of purchase accounting adjustments resulting from the adoption of FAS No. 109. SCHEDULE VIII HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE X HOUSEHOLD FINANCE CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 * Represents less than 1 percent of total revenues as reported in the related statements of income. EXHIBIT INDEX

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ITEM 1. BUSINESS. Keystone International, Inc. ("Keystone" or the "Company") designs, manufactures and markets, on a worldwide basis, valves and other specialized industrial products that control the flow of liquids, gases and fibrous and slurry materials for use in various industries, including chemical, power, food and beverage, marine and government, petroleum production and refining, water, commercial construction, oil and gas pipeline, mining and metals, and pulp and paper. Keystone, incorporated in Texas in 1947, is one of the leading manufacturers of flow control products in the world. The Company's operations are conducted in a single industry segment. For information concerning geographic segments, see Note 12 to the Consolidated Financial Statements in Item 8 of this Report. Substantially all of the products sold outside the United States are manufactured and assembled at facilities in Canada, The Netherlands, Japan, the United Kingdom, France, Italy, Germany, Korea, Singapore, the People's Republic of China, Mexico, Brazil, Australia, New Zealand, and India. Most of Keystone's employees engaged in operations outside the United States, including plant managers and other executive personnel, are citizens of the nations in which they work. The various aspects of Keystone's operations outside the United States take into account local conditions and customs, but basic business methods are similar in all areas. Sales and operations outside the United States are subject to the inherent risk of fluctuations in currency rates. As with other United States companies engaged in business outside the United States, Keystone is subject to political and economic uncertainties, the risk of expropriation and embargo, foreign exchange restrictions and political disruptions. Keystone purchases virtually all castings and certain finished or semi-finished components used in its products. Machining of components and assembling are done primarily by the Company, although a limited amount of machining and assembling is done under contract by outside parties. Keystone does not believe that compliance with federal, state or local environmental laws adversely affects its business, earnings or competitive position. Management believes that the Company's present level of product liability coverage is adequate, and will make adjustments in such coverage in the future as it believes appropriate after considering the cost and availability of such insurance and any legal developments in the product liability area. While Keystone has a number of patents and patent applications relating to or covering certain features of its products, its patents are not of a scope to exclude competition in any significant way or preclude competitors from successfully marketing substitute products. Competition is on the basis of quality, service, delivery and price. There was no single customer which accounted for more than 10% of sales during 1993. Although the Company does not necessarily know the intended use or ultimate customer for all of its products, particularly those sold through distributors, its business is not dependent on a single customer or a few customers. Sales in diverse geographic areas and to a large number of customers and industries lessen exposure to adverse conditions in a single industry or area. These factors, however, do not afford protection against a general economic downturn. Keystone extends 30-day credit to most customers except in certain foreign markets where local trade practices differ. Credit losses have not been material. Keystone carries some inventory of all its products, and it generally satisfies its working capital requirements out of internally generated funds. Reference is made to Note 5 of the Consolidated Financial Statements in Item 8 of this Report for information about lines of credit that are available to finance working capital. In the fourth quarter of 1991, the Company recognized a pretax charge to income of $22,372,000 for restructuring and merger expenses. For information concerning these charges, see Note 3 to the Consolidated Financial Statements in Item 8 of this Report. At December 31, 1993, the Company's backlog of unshipped orders was $100,268,000 compared with $107,853,000 at December 31, 1992. Orders in backlog at year-end are usually shipped during the following year. In the past, the effect of changes or cancellations of orders has been minimal. At December 31, 1993, Keystone had approximately 4,200 employees worldwide. ITEM 2. ITEM 2. PROPERTIES. Keystone's domestic manufacturing operations are located in Houston and Harlingen, Texas; Blue Bell, Pennsylvania; Andrews and Fort Wayne, Indiana; Black Mountain, North Carolina; Penns Grove, New Jersey and Pelham, Alabama. These facilities, including the corporate offices located in Houston, contain approximately 309,000 square feet of office space and 810,000 square feet of manufacturing space on 165 acres of land owned by the Company. Keystone's other manufacturing and assembly facilities are in most cases owned by the Company and are located in 16 other countries. The Company also leases warehouse and office space in which it maintains its sales offices. Aggregate rentals for leased premises totalled $3,015,000 during 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is a party to routine litigation incidental to its business, none of which in the opinion of management will have a material adverse impact on the consolidated financial position or future results of operations of the Company. 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. The common stock of Keystone is traded on the New York Stock Exchange under the symbol KII. The following table shows the high and low sales prices as reported by the New York Stock Exchange Composite Tape and cash dividends declared per share. The approximate number of security holders of the Company's common stock was 3,081 as of February 22, 1994. This number does not include the number of security holders for whom shares are held in a "nominee" or "street" name. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - --------------- (1) After considering the estimated tax benefits of $5,235, the effect of restructuring and merger expenses was to reduce income from continuing operations by $17,137, or $.50 per share. See Note 3 to the Consolidated Financial Statements in Item 8 of this Report. (2) The 8.75% Notes totalling $43,000 were due November 1, 1993 and as of December 31, 1992 were classified as current portion of long-term debt. These 8.75% notes were refinanced on November 1, 1993 with $45,000 6.34% Senior Notes due November 1, 2000. See Note 5 to the Consolidated Financial Statements in Item 8 of this Report. (3) In 1991, the cumulative effect of the change in accounting principle represents a charge relating to the adoption of the accounting standard for postretirements benefits other than pensions. See Note 9 to the Consolidated Financial Statements in Item 8 of this Report. The 1993 cumulative effect of change in accounting principle represents a credit relating to the adoption of the new accounting standard for income taxes. See Note 6 to the Consolidated Financial Statements in Item 8 of this Report. Reference is made to the Notes to Consolidated Financial Statements in Item 8 of this Report for a summary of accounting policies and additional information. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. SUMMARY The following table sets forth for the periods indicated (i) percentages which certain items reflected in the accompanying Consolidated Statements of Income bear to net sales of the Company and (ii) the percentage increase or decrease of amounts of such items as compared to the indicated prior period: - --------------- * Percentage not meaningful. RESULTS OF OPERATIONS (DOLLAR AMOUNTS IN THOUSANDS) Net Sales Net sales decreased 2% in 1993 compared with a 2% increase in 1992. Shown below is an analysis of net sales. The translation effect of weakening foreign currencies had a significant impact in 1993 on the results of international operations. - --------------- * Percentage not meaningful. The Company's sales and results of operations outside the United States are subject to the inherent risk of fluctuations in currency rates. During 1993, a basket of European currencies weakened in relation to the U.S. dollar by approximately 12%, which impacted the U.S. dollar results of the Company's European operations. Further weakening may occur in 1994. Keystone's European operations represent about 29% of the Company's consolidated sales. Costs and Expenses Cost of sales as a percentage of sales were 57.4%, 56.7% and 57.4% in 1993, 1992 and 1991, respectively. The decrease in gross profit as a percentage of sales in 1993 compared to 1992 was due to lower margins earned in Europe where the Company is experiencing increased price competition. In 1992, the improvement in gross profit as a percentage of sales compared to 1991 was primarily due to improvements in gross margins at the two Italian companies acquired in 1989 and a decrease in lower margin project-oriented business, reflective of more selective sales order activity. Selling, general and administrative expenses increased by 1% and 2% in 1993 and 1992, respectively. The increases are primarily attributable to costs related to increased sales volume primarily in the Asia-Pacific region, partially offset by the translation effect of weakening foreign currencies. The Company's ongoing program to maintain tight controls over selling, general and administrative expenses has resulted in maintaining the amount as a percentage of sales in the 28% range. As a percentage of net sales, selling, general and administrative expenses were 28.9%, 28.1% and 27.9% in 1993, 1992 and 1991, respectively. Restructuring and merger expenses in 1991 of $22,372 represent $19,993 accrued for operational restructuring primarily in the United States and Europe as well as $2,379 of expenses associated with the merger and rationalization of operations of Kunkle Industries, Inc. The Company's restructuring actions focus on strengthening its capabilities as a low-cost provider of quality flow control products and systems worldwide. During 1993, the majority of the remaining restructuring and merger provision was utilized. Major restructuring and merger activities during 1993 related to the completion of the Houston, Texas-based product rationalization and relocation in which a facility was acquired in Guadalajara, Mexico and refurbished to accommodate the Company's manufacturing requirements. As part of this relocation, several small product lines were moved from Houston to this lower-cost facility. Other activities during the year included the consolidation of certain facilities primarily in European locations. The Company believes the remaining restructuring reserves, which are expected to be utilized during 1994, are sufficient to cover the restructuring projects which are still in process. Other expense includes amortization of intangible assets and debt costs as well as exchange gains and losses on transactions denominated in foreign currencies. In 1992, other expense also included a reserve of $2,000 for management's estimate of potential environmental exposure at one of the Company's inoperative facilities. Management still believes this reserve is adequate and potential exposure will not have a material impact on the Company's consolidated financial position or future results of operations. The Company's effective income tax rate was 37%, 39% and 47% in 1993, 1992 and 1991, respectively. The Company records taxes on all unremitted foreign earnings at a rate not less than the U.S. statutory rate. The primary components of the difference between the domestic statutory tax rate and the actual effective tax rate is caused by net operating losses of certain foreign entities not currently realizable for tax purposes and foreign taxes in excess of the U.S. statutory rate. The effective tax rate in 1993 includes the remeasurement of deferred tax assets at the current U.S. statutory rate in accordance with the new accounting standard for income taxes. See Note 6 to the Consolidated Financial Statements in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The response to this item is submitted as a separate section of this Report on page 9. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Part III (Items 10 through 13) is omitted since the Registrant expects to file with the Securities and Exchange Commission within 120 days after the close of the fiscal year ended December 31, 1993, a definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 which involves the election of directors. If for any reason such a statement is not filed within such a period, this Report will be appropriately amended. 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 on page 9. (a)(3) Exhibits: (b) Reports on Form 8-K. The Company filed no reports on Form 8-K for the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 9th day of March, 1994. KEYSTONE INTERNATIONAL, INC. By: RAYMOND A. LEBLANC (Raymond A. LeBlanc) 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 9th day of March, 1994. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES FORM 10-K ITEMS 8 AND 14(A)(1) AND (2) INDEX OF FINANCIAL STATEMENTS AND SCHEDULES The following financial statements of the Registrant and its subsidiaries required to be included in Items 8 and 14(a)(1) are listed below: The following financial statement schedules of the Registrant and its subsidiaries are included in Item 14(a)(2): Consolidated Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: --------------------------- Schedules other than those listed above are omitted because the conditions requiring their filing do not exist or because the required information is given in the financial statements, including the notes thereto. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (AMOUNTS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' INVESTMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these financial statements. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation -- The consolidated financial statements include the accounts of Keystone International, Inc. and its subsidiaries ("Keystone" or the "Company"). All significant intercompany accounts and transactions have been eliminated. Foreign Currency Translation -- Assets and liabilities of most foreign subsidiaries are translated at current exchange rates, and related revenues and expenses are translated at average exchange rates for the year. Since the functional currencies of these subsidiaries are not the U.S. dollar, the resulting translation adjustments are recorded as a separate component of shareholders' investment. Translation gains and losses relating to the Company's Brazilian subsidiary, which operates in a highly inflationary economy, are charged against income. Cash Equivalents -- The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Depreciation and Amortization -- Keystone provides depreciation for financial reporting purposes primarily on a straight-line method over the estimated useful lives of the assets. Goodwill is included in other assets and is being amortized over periods ranging from ten to forty years. Other intangible assets, which primarily include engineering drawings, patents and tradenames, are being amortized over periods ranging from three to twenty years. (2) ACQUISITIONS During November 1991, the Company acquired Kunkle Industries, Inc. and an associated company ("Kunkle") in a transaction accounted for as a pooling-of-interests. As the effect of this acquisition was not significant to the results of operations of the Company, prior year financial statements were not restated. Also, the Company has made other small acquisitions during 1993, 1992 and 1991. The total effect of these acquisitions was not material to the consolidated results of Keystone. (3) RESTRUCTURING AND MERGER EXPENSES Restructuring and merger expenses in 1991 of $22,372 represent $19,993 accrued for operational restructuring primarily in the United States and Europe as well as $2,379 of expenses associated with the merger and rationalization of operations of Kunkle. The Company's restructuring actions focus on strengthening its capabilities as a low-cost provider of quality flow control products and systems worldwide. During 1993, the majority of the remaining restructuring and merger provision was utilized. Major restructuring and merger activities during 1993 related to the completion of the Houston, Texas-based product rationalization and relocation in which a facility was acquired in Guadalajara, Mexico and refurbished to accommodate the Company's manufacturing requirements. As part of this relocation, several small product lines were moved from Houston to this lower-cost facility. Other activities during the year included the consolidation of certain facilities primarily in European locations. The Company believes the remaining restructuring reserves, which are expected to be utilized during 1994, are sufficient to cover the restructuring projects which are still in process. (4) INVENTORIES Inventories are stated at cost which is not in excess of market. Keystone uses the last-in, first-out (LIFO) method of determining inventory cost for most of its domestic inventories. Inventories valued at LIFO cost comprised approximately 40% of consolidated inventories at December 31, 1993. The remainder of Keystone's inventories are costed using the first-in, first-out (FIFO) method. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Inventories, which include material, labor and manufacturing overhead costs, consisted of the following at December 31, 1993 and 1992: (5) LONG-TERM DEBT AND SHORT-TERM BANK BORROWINGS In November 1993, the Company refinanced its 8.75% notes totalling $43,000 with $45,000 6.34% Senior Notes due November 1, 2000. Other long-term notes payable at December 31, 1993 consists primarily of debt related to the construction of new manufacturing facilities in Japan and debt assumed in two 1989 Italian acquisitions which bear interest at weighted average interest rates of approximately 7% and 12%, respectively. Annual maturities of all long-term debt for the next five years are as follows: 1994 -- $2,216; 1995 -- $6,718; 1996 -- $2,495; 1997 -- $1,905; 1998 -- $1,477; 1999 and thereafter -- $49,705. Short-term bank borrowings of $6,944 at December 31, 1993 primarily represent borrowings under various committed and uncommitted lines of credit aggregating $61,000. Interest rates on these borrowings vary according to the country in which the funds are borrowed, but generally approximate the market rate of interest. The Company made cash interest payments of $5,654, $6,849, and $7,853 during 1993, 1992 and 1991, respectively. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109 -- "Accounting for Income Taxes." This statement provides, among other things, for the recognition and presentation of deferred tax assets and liabilities for the future consequences of temporary differences between the financial statement basis and the tax basis of assets and liabilities using the tax rates in effect during the period when taxes are actually paid or recovered. Accordingly, income tax provisions will increase or decrease in the same period in which a change in tax rates is enacted. The adoption of this accounting method resulted in a credit to income of $1,879 which is reflected in the Consolidated Statements of Income as a cumulative effect of change in accounting principle. The cumulative effect results primarily from calculating temporary differences using currently enacted tax rates as required. Prior year financial statements were not restated for SFAS No. 109. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The provisions (benefits) for income taxes are summarized as follows: The tax effects of the significant temporary differences which comprise the net deferred tax asset as of December 31, 1993 are as follows: A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. Keystone has recorded no deferred tax assets for which a valuation reserve is required. The major components in 1993 of the deferred tax provision include amounts related to temporary differences between financial and tax reporting methods for inventories of $1,387, reserves and accruals of $(1,859) and restructuring and merger expenses of $3,210. In 1992, the primary components of the deferred tax provision include amounts related to temporary differences between financial and tax reporting methods for inventories of $1,401, depreciation and amortization expense of $1,202 and restructuring and merger expenses of $2,256. In 1991, the primary components of the deferred tax benefit include amounts related to temporary differences between financial and tax reporting methods for inventories of $(1,378), reserves and accruals of $(2,992), unremitted foreign earnings of $(922), and restructuring and merger expenses of $(5,235). KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A reconciliation between the actual provision for income taxes and income taxes computed by applying the federal statutory rate follows: The Company made cash tax payments, net of refunds, of approximately $20,651, $26,854 and $25,974 during 1993, 1992 and 1991, respectively. Income from continuing operations before income taxes of foreign subsidiaries was $36,215 in 1993, $43,982 in 1992, and $33,989, including $8,235 in restructuring expenses, in 1991. The Internal Revenue Service (IRS) has completed its examination of the Company's federal income tax returns for the years 1986 through 1988 and the Company has received an assessment of additional tax. Most issues have been resolved for these years, and the Company is vigorously pursuing administrative remedies for the remaining issues. In addition, the IRS is currently examining the federal income tax returns filed by the Company for the years 1989 and 1990. Management believes that any adjustment that may result from these examinations will not have a material adverse impact on the Company's consolidated financial position or future results of operations. (7) SHAREHOLDERS' INVESTMENT Incentive Stock Plans -- Keystone has a number of restricted stock grant and stock option plans which are incentive stock plans administered by a committee of outside directors for the benefit of the Company's key employees. As of December 31, 1993, 1,434 shares were available for award under these plans. Shares issued under the stock grant plans are owned by the employees at the time of grant, subject to certain restrictions, principally continued employment with Keystone for a period to be set by the committee, typically five years. The deferred compensation expense related to the stock grants is being amortized to expense on a straight-line basis over the period of time the stock is restricted, and the unamortized portion is classified as a reduction of shareholders' investment in the accompanying Consolidated Balance Sheets. As of December 31, 1993, there were 309 shares as to which restrictions had not lapsed under the stock grant plans. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Stock options are issued at exercise prices which are not less than the fair market value at the date of grant. Information about Keystone's stock option plans for the three years ended December 31, 1993 is set forth below: Shareholder Rights Plan -- In June 1990, the Company adopted a Shareholder Rights Plan and declared a dividend of one Depositary Preferred Share purchase right ("Right") for each share of Common Stock outstanding at the close of business on July 2, 1990. Each Right entitles the shareholder to buy from the Company 1/1000 of a share of a new series of preferred stock at an exercise price of $80 per Right. The Board of Directors has authorized 900 preferred shares, designated as Preferred Shares -- Junior Participating Series A, for issuance upon exercise of such Rights. The Rights will not be exercisable unless a party acquires, or announces a tender offer for, beneficial ownership of 20% or more of the Company's Common Stock. The Rights may be redeemed by the Company at a price of $.001 per Right at any time prior to their expiration on March 31, 2000 or any earlier distribution of Rights certificates in accordance with the terms of the plan. If a party acquires a 20% or more position in the Company, each Right, except those held by the acquiring party, will entitle its holder to purchase, at the exercise price, Depositary Preferred Shares having a value of two times the $80 exercise price, with each Depositary Preferred Share valued at the market price of a share of Common Stock. In the event the Company is acquired in a merger or other business combination transaction, each Right will entitle its holder to purchase, at the exercise price, that number of the acquiring company's common shares having a value of two times the exercise price of the Right. (8) EARNINGS PER SHARE Earnings per share is computed by dividing net income by the weighted average number of common and common equivalent shares outstanding. The weighted average number of common shares and common equivalent shares used in computing earnings per share was 35,085, 34,902 and 34,676 in 1993, 1992 and 1991, respectively. There is no significant difference between earnings per share on a primary and a fully diluted basis. (9) EMPLOYEE BENEFIT PLANS Defined Contribution and Benefit Plans -- Keystone has qualified and nonqualified profit sharing and stock bonus plans for employees of its domestic operations. Contributions to these plans, which may be in the form of cash or shares of the Company's stock, are based on a discretionary percentage (as approved by the Board of Directors) of pretax income before profit sharing and stock bonus contributions. Certain foreign subsidiaries and one domestic subsidiary also maintain retirement benefit plans for their employees. KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Keystone's expenses related to these profit sharing, stock bonus and retirement benefit plans were $5,183 in 1993, $5,322 in 1992 and $5,010 in 1991. Bonus Plan -- Keystone has incentive bonus plans for certain key employees. The amounts of such bonuses, which are included in selling, general and administrative expenses, were $5,851, $5,689, and $6,669 for 1993, 1992 and 1991, respectively. Postretirement Benefit Plans -- Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" on the immediate recognition basis. The standard requires that the cost of these benefits, primarily health care benefits, be recognized in the financial statements during the employee's service period. The Company controls its obligation for retiree health care by maintaining an unfunded, defined contribution plan for those domestic retirees with at least 25 years of service. Postretirement benefit expenses charged to operating income were $991, $899, and $832 for 1993, 1992, and 1991, respectively. Other long-term liabilities included $9,678 and $8,885 at December 31, 1993 and 1992, respectively, related to the long-term obligation for postretirement benefits. Accrued liabilities included $175 at both December 31, 1993 and 1992 related to the current obligation for postretirement benefits. (10) COMMITMENTS AND CONTINGENCIES Litigation -- Keystone and its subsidiaries are engaged in various claims and litigation arising from their operations. In the opinion of management, uninsured losses, if any, resulting from these matters will not have a material adverse impact on the consolidated financial position or future results of operations of the Company. Rental Expense -- Rental expense was $6,322, $6,348, and $6,114 for 1993, 1992 and 1991, respectively. The Company has entered into various leases, including an insignificant amount of capital leases, which provide for future minimum lease payments as follows: 1994 -- $5,429; 1995 -- $3,129; 1996 -- $1,351; 1997 -- $749; 1998 -- $329; 1999 and thereafter $2,755. Letters of Credit -- At December 31, 1993 and 1992, the Company had outstanding letters of credit of $4,949 and $5,288, respectively. (11) QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a tabulation of the unaudited quarterly results of operations for each of the two years ended December 31, 1993: KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (12) INDUSTRY AND GEOGRAPHIC AREA INFORMATION Industry Segments -- Keystone operates in one dominant industry segment which involves the design, manufacture and marketing of flow control products. Geographic Segments -- Keystone's export sales, other than those intercompany sales reported below as sales between geographic areas, are not significant. Sales between geographic areas consist of sales of finished products, raw materials and unfinished products which are sold at adjusted market prices. Keystone does not derive more than 10% of its revenue from any single customer. Corporate assets consist primarily of cash, certificates of deposit and other assets. Keystone's geographic area data for each of the three years ended December 31, 1993 are as follows: (Table continued on following page) KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (13) OTHER ASSETS The following presents details of other assets, including certain prior year reclassifications which have been made to conform with current year presentation, at December 31, 1993 and 1992: (14) ACCRUED LIABILITIES The following presents details of accrued liabilities at December 31, 1993 and 1992: KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (15) SUPPLEMENTARY INCOME STATEMENT INFORMATION The following presents selected income statement information for the years ended: SCHEDULE V KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - --------------- (1) Includes the change in asset cost due to application of Statement No. 52 of the Financial Accounting Standards Board regarding foreign currency translation. Also, 1991 includes assets acquired in pooling transactions of $18,090. (2) Includes assets acquired in purchase transactions of $2,076, $1,294 and $799 in 1993, 1992 and 1991, respectively. The notes to consolidated financial statements are an integral part of this schedule. SCHEDULE VI KEYSTONE INTERNATIONAL, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - --------------- (1) The annual straight-line depreciation rates generally in use are as follows: (2) Represents primarily the change in accumulated depreciation due to application of Statement No. 52 of the Financial Accounting Standards Board regarding foreign currency translation. Also, 1991 includes $11,751 in accumulated depreciation of assets acquired in pooling transactions. The notes to consolidated financial statements are an integral part of this schedule. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors, Keystone International, Inc.: We have audited the accompanying consolidated balance sheets of Keystone International, Inc. (a Texas corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These consolidated 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 consolidated 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 Keystone International, 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 explained in Note 6 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. As explained in Note 9 to the consolidated financial statements, effective January 1, 1991, the Company changed its method of accounting for postretirement benefit obligations. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in the index of financial statements and schedules 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. February 4, 1994 Houston, Texas

44570_1993.txt

44570_1993

1993

44570

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

720556_1993.txt

720556_1993

1993

720556

Item 1. Business GENERAL California Energy Company, Inc. (the "Company"), together with its subsidiaries, is primarily engaged in the exploration for and development of geothermal resources and the development, ownership and operation of environmentally responsible independent power production facilities worldwide utilizing geothermal resources and other energy sources such as hydroelectric, natural gas, oil and coal. The Company was an early participant in the domestic independent power market and is now one of the largest geothermal power producers in the United States. The Company is also actively pursuing opportunities in the international independent power market. The Company is a Delaware corporation which was formed in 1971. The Company's Common Stock is traded on the New York, Pacific and London Stock Exchanges under the symbol "CE". Approximately 37% of the Company's Common Stock is owned by a Peter Kiewit Sons', Inc. subsidiary, Kiewit Energy Company (references herein to "Kiewit" means Peter Kiewit Sons', Inc. and its affiliates including Kiewit Energy Company, Kiewit Diversified Group Inc. and Kiewit Construction Group Inc. or other subsidiaries thereof, as applicable). Kiewit is a large construction, mining and telecommunications company headquartered in Omaha, Nebraska. Kiewit is a joint venture participant in certain of the Company's international private power projects. Through its subsidiaries, the Company currently has substantial ownership interests in, and operates, four geothermal facilities that are qualified facilities under the Public Utility Regulatory Policies Act of 1978 ("PURPA"), which requires electric utilities to purchase electricity from qualified independent power producers. Three of the Company's geothermal power production facilities are located at the Naval Air Weapons Station at China Lake, California (together, the "Coso Project") and are each owned by separate partnerships (collectively the "Coso Joint Ventures" and individually the "Navy I Joint Venture", the "BLM Joint Venture" and the "Navy II Joint Venture"). The Company owns an interest of approximately 50% in each of the Coso Joint Ventures and, through a subsidiary, acts as the managing general partner of each. The Coso Project continues to constitute the Company's primary source of electrical generation capacity constituting an aggregate generating capacity of approximately 240 net megawatts ("NMW"). The Coso Project power production facilities have a gross capacity of approximately 88 megawatts ("MW") each (referred to individually as the "Navy I Project", the "BLM Project" and the "Navy II Project"). The Coso Joint Ventures sell all electricity generated by the Coso Projects pursuant to three long-term "Interim Standard Offer No. 4" contracts (the "SO4 Agreements") between each of the Coso Joint Ventures and Southern California Edison Company ("SCE"). These SO4 Agreements provide for energy payments, capacity payments and capacity bonus payments. The fixed price periods for energy payments of the SO4 Agreements extend until August 1997, March 1999 and January 2000 for each of the Navy I Joint Venture, the BLM Joint Venture and the Navy II Joint Venture, respectively. Energy payments under the SO4 Agreements have been fixed at rates ranging from 10.1 cents per kilowatt hour ("kWh") in 1993 to 14.6 cents per Kwh in August 1998. After the fixed price period expires for each of the Coso Projects, the energy will be purchased at SCE's then prevailing avoided cost (as determined by the California Public Utilities Commission) which at present is substantially lower than the current energy payments under the SO4 Agreement. In addition to the energy payments, SCE makes fixed annual capacity payments to the Coso Joint Ventures, and under certain circumstances is required to make capacity bonus payments. The price for capacity and capacity bonus payments is fixed for the life of the SO4 Agreements. See "The Coso Project -- SO4 Power Sales Agreements." The Company also owns and operates a 10 MW geothermal power plant located at Desert Peak, Nevada which is a qualified facility that sells power to Sierra Pacific Power Company, and operates and owns a 70% interest in a geothermal steam field at Roosevelt Hot Springs, Utah, which supplies 25 MW of geothermal steam to Utah Power & Light Company under a 30-year steam sales agreement. Pursuant to a memorandum of understanding, the Company has commenced early stage site work on a proposed 30 MW geothermal project at Newberry, Oregon (the "Newberry Project"), which is expected to be completed in early 1997 and to be wholly owned and operated by the Company. In September 1993, the Company acquired The Ben Holt Co., a 30 person engineering firm located in Pasadena, California which specializes in the design of geothermal power plants and has international experience. The Ben Holt Co. will provide support to the Company's domestic and international projects as well as continue its services to third parties. Domestically, the Company plans to focus on developing and operating geothermal power projects, an area in which the Company believes it has a competitive advantage due to its geotechnical and project management expertise and extensive geothermal leaseholdings. The Company intends to continue to pursue geothermal opportunities in the Pacific Northwest where it has extensive geothermal leaseholdings. In March 1993, the Company acquired 26,000 acres of geothermal leases and three successful production wells in the Glass Mountain area of Northern California. In addition, the Company has diversified into other environmentally responsible sources of power generation. The Company is currently constructing a 50 NMW natural gas fired cogeneration project in Yuma, Arizona (the "Yuma Project"), which is expected to be wholly owned by the Company and to sell electricity to San Diego Gas & Electric Company ("SDG&E") under a 30-year power sales contract. The Company anticipates that this project will be completed by mid- year 1994. See "Other Domestic Projects and Development Opportunities - Yuma." The Company expects future diversification through the selective acquisition of partially developed or existing power generating projects and intends to maintain a significant equity interest in, and to operate, the projects which it develops or acquires. International Activities The Company presently believes that the international independent power market holds the majority of new opportunities for financially attractive private power development in the next several years. The Company is actively pursuing selected opportunities in nations where power demand is high and the Company's geothermal resource development and operating experience, project development expertise and strategic relationships are expected to provide it with a competitive advantage. The Company believes that the opportunities to successfully develop, construct, finance, own and operate international power projects are increasing as several countries have initiated the privatization of the power generation capacity and have solicited bids from foreign developers to purchase existing generating facilities or to develop new capacity. Some of these countries, such as the Philippines and Indonesia, also have extensive geothermal resources. The Company has recently entered into international joint venture agreements with Kiewit and Distral S.A. ("Distral"), firms with significant power plant construction experience, in an effort to augment and accelerate the Company's capabilities in foreign energy markets. Joint venture activities with Distral are expected to be conducted in South America, Central America and the Caribbean and joint venture activities with Kiewit are expected to be conducted in Asia, in particular the Philippines and Indonesia, and in other regions not covered by the Distral joint venture agreement. See "International Geothermal and Other Development Opportunities - International Joint Venture Agreements." The Company has obtained "take-or-pay" power sales contracts for two geothermal power projects in the Philippines aggregating approximately 300 MW in capacity. The Upper Mahiao project (the "Upper Mahiao Project"), a 120 MW geothermal facility with an estimated total project cost of approximately $226 million, is expected to be constructed on the island of Leyte and will be over 95% owned and operated by the Company. A syndicate of international banks is expected to provide approximately $170 million project finance construction loan for the project. The Company's equity commitment to such project would be approximately $56 million. The Export-Import Bank of the United States ("ExIm Bank") is expected to provide the term loan that would be used to refinance the construction loan for this project, as well as political risk insurance to the syndicate of commercial banks for the construction loan. The Company intends to arrange for similar insurance on its equity investment through the Overseas Private Investment Corporation ("OPIC") or from other governmental agencies or commercial sources. The Company expects that both the construction and the term loan agreements for the Upper Mahiao Project will be executed in April 1994 and that the notice to proceed will be issued promptly thereafter under the construction contract, which was executed in January 1994. Commercial operation of this project is presently scheduled for mid-year 1996. The Mahanagdong project (the "Mahanagdong Project"), a 180 MW geothermal project with an anticipated total project cost of approximately $310 million, is expected to be operated by the Company and owned 45% by the Company, 45% by Kiewit and up to 10% by another industrial company. The Company's equity investment for the Mahanagdong Project would be approximately $40 million, and the Company intends to obtain political risk insurance on its investment similar to that for the Upper Mahiao Project. The Company is in the process of arranging construction financing for this project from a syndicate of international banks on terms similar to those of the Upper Mahiao Project construction loan. The construction financing is expected to close in mid-year 1994, with commercial operation presently scheduled for mid-year 1997. See "International Geothermal and Other Development Opportunities - The Philippines." The Company has been awarded the geothermal development rights to three geothermal fields in Indonesia at Dieng, Patuha and Lampung/South Sumatra, the initial phases of which could aggregate an additional generating capacity of 500 NMW. The Company is currently negotiating power sales contracts for these projects in Indonesia. See "International Geothermal and Other Development Opportunities - Indonesia." Geothermal Energy Geothermal energy can be economically extracted when water contained within porous and permeable rock formations comes sufficiently close to molten rock to heat the water to temperatures of 400 degrees Fahrenheit or more. The heated water then ascends towards the surface of the earth, where it can be extracted by drilling geothermal production wells. The energy necessary to operate a geothermal power plant is typically obtained from several such wells, which are drilled using established technology similar to that employed in the oil and gas industry. The geothermal production wells are normally located within approximately one to two miles of a power plant, as geothermal fluids cannot typically be transported economically over longer distances. From the well heads, the heated fluid flows through pipelines to a series of separators, where it is separated into water "brine" and steam. The steam is passed through a turbine which drives a generator to generate electricity. Once the steam has passed through the turbine it is then cooled and condensed back into water, which along with any brine and noncondensable gases is returned to the geothermal reservoir via injection wells. The geothermal reservoir is a renewable source of energy if natural ground water sources and reinjection of extracted geothermal fluids are adequate to replenish the geothermal reservoir after the withdrawal of geothermal fluids. Geothermal plants in the United States are eligible to be "Qualified Facilities" under PURPA. See "Regulatory and Environmental Matters" The Independent Power Production Market and Competition In the United States, the independent power industry expanded rapidly in the 1980's, facilitated by the enactment of PURPA. PURPA was enacted to encourage the production of electricity by non-utility companies. According to the Utility Data Institute and the North American Electricity Reliability Council, independent power producers were responsible for about 50,000 MW, or 43%, of the U.S. electric generation capacity which has come on line since 1980. As the size of United States independent power market has increased, available domestic power capacity and competition in the industry have also significantly increased. The Company competes with other independent power producers including affiliates of utilities, in obtaining long-term contracts to sell electric power and steam to utilities. In addition, utilities may elect to expand or create generating capacity through their own direct investments in new plants. Over the past decade, obtaining a power sales contract from a U.S. utility has generally become increasingly difficult, expensive and competitive. Many states now require power sales contracts to be awarded by competitive bidding, which both increases the cost of obtaining such contracts and decreases the chances of obtaining such contracts as bids significantly outnumber awards in most competitive solicitations. Many of the Company's competitors have more extensive and more diversified developmental or operating experience (including international experience) and greater financial resources than the Company. The federal Energy Policy Act of 1992 is expected to further increase domestic competition. Due to the rapidly growing demand for new power generation capacity in many foreign countries and resulting privatization of power development, significant new markets for independent power generation now exist outside the United States. The Company intends to take advantage of opportunities in these new markets and to develop, construct and acquire generation projects outside the United States. See "International Geothermal and Other Development Opportunities." Business Development Strategies The Company is focusing on market opportunities domestically in which it believes it has relative competitive advantages, such as geothermal (because of the Company's geotechnical and project management expertise and extensive geothermal leaseholdings). In addition, the Company expects to consider diversification into other environmentally responsible sources of energy, primarily through the selected acquisition of partially developed or existing power generating projects. The Company is also actively pursuing selected opportunities abroad in developing nations where power demand is high and the Company's geothermal operating experience, project development expertise and strategic relationships with Kiewit and Distral are expected to provide it with a competitive advantage. The Company believes that the opportunities to successfully develop, construct and finance international projects are increasing as several countries, including the Philippines and Indonesia, have initiated the privatization of their power generation capacity and have solicited bids from foreign developers for the purchase of existing generating capacity or the development of new capacity. In evaluating and negotiating international projects, the Company intends to employ a strategy whereby a substantial portion of the political and financial risks are, through contract provisions or insurance coverage, borne by parties other than the Company; however, there can be no assurance that such insurance will be available on commercially reasonable terms, or that such third parties will perform such contract provisions. THE COSO PROJECT In 1979, the Company entered into a 30-year contract (the "Navy Contract") with the United States Department of the Navy ("the Navy") to explore for, develop and generate electricity from geothermal resources located on approximately 5,000 acres of the Naval Air Weapons Station at China Lake, California. In 1985, the Company entered into a 30-year lease (the "BLM Lease") with the United States Bureau of Land Management ("BLM") for approximately 19,000 acres of land adjacent to the land covered by the Navy Contract. The Company formed the Coso Joint Ventures with one primary joint venture partner, Caithness Corporation ("Caithness"), to develop and construct the three facilities which comprise the Coso Project. The Coso Joint Ventures entered into contracts to supply electricity to SCE. The contracts were entered into pursuant to the provisions of PURPA, which, subject to certain conditions, requires electric utilities to purchase electricity from qualifying independent power producers. The three joint ventures which own the Coso Projects are (i) Coso Finance Partners, which owns the Navy I Project, (ii) Coso Energy Developers, which owns the BLM Project, and (iii) Coso Power Developers, which owns the Navy II Project. The Company holds ownership interests of approximately 46% in the Navy I Joint Venture; of approximately 48% in the BLM Joint Venture, after payout to the Company and its joint venture partner; and of 50% in the Navy II Joint Venture. The remaining portions are owned by partnerships formed by Caithness and certain investors (the "Caithness Partnerships"). In addition, the Company indirectly holds rights to certain cash flows from the Caithness Partnerships in the BLM Project, and, to a lesser extent, the Navy I Project and Navy II Project. See "The Coso Project -- Interest in Caithness Partnerships". Each of the Coso Joint Ventures is managed by a management committee which consists of two representatives from the Company and two representatives from the Caithness Partnerships. The Company also acts as the operator of each of the fields and plants, for which it receives fees from the Coso Joint Ventures. The Coso Geothermal Resource The area in which the Coso Projects are located has been designated as a "Known Geothermal Resource Area" ("KGRA") by the United States Department of the Interior, Bureau of Land Management ("BLM") pursuant to the Geothermal Steam Act of 1970. Areas are designated as KGRAs when the BLM determines that a commercially viable geothermal resource is likely to exist. There are over 100 other KGRAs in the United States. The Coso geothermal resource is located in Inyo County, California, approximately 150 miles northeast of Los Angeles. The Coso geothermal resource is a liquid-dominated hot water resource contained within the heterogeneous fractured granitic rocks of the Coso mountains. It is believed that the heat source for the Coso geothermal resource is a molten rock or "magma" body located beneath the field at a depth of six to seven miles. Water in the system is believed to be supplied from groundwater flow from the Sierra Nevada mountains located approximately 10 miles west of the site. Production is obtained by drilling wells into the fracture systems, which tap into these reservoirs of hot water. As is common in this type of geothermal resource, the heterogeneous, fractured structure makes it somewhat difficult to predict the performance of new wells even when the new wells are located in relatively close proximity to existing wells. Geothermal exploration, development and operations are subject to uncertainties similar to those typically associated with oil and gas exploration and development, including dry holes and uncontrolled well flows. The success of geothermal projects ultimately depends on the heat content of the extractable fluids, the geology of the reservoir, the reservoir's actual life, and operational factors relating to the extraction of the fluids, including operating expenses, electricity price levels and capital expenditure requirements. Because of the geological complexities of geothermal reservoirs, the geographic area and sustainable output of a geothermal reservoir can only be estimated and cannot be definitively established. There is, accordingly, a risk of an unexpected decline in the capacity of geothermal wells, and a risk of a geothermal reservoir not being sufficient for sustained generation of the electrical power capacity desired. Average production of a typical new geothermal production well is expected by the Coso Joint Ventures to decline 35% to 45% in the first year, 15% to 25% in the second year, 5% to 15% in the third year and 5% or less each year thereafter, due to mechanical deterioration of the well bore, well bore scaling, a decline in well pressure due to the withdrawal of geothermal fluids, and other chemical and physical factors. The Coso Joint Ventures have adopted a program of geothermal well replacement which is intended to compensate for production decreases. Production available at the wellhead for the Navy I Project, the BLM Project and the Navy II Project presently is in excess of the steam necessary for power production at full capacity for each plant. Under the loans financing the power plants, each Joint Venture is required to meet a steam covenant as of May 1st of each year which requires geothermal reserves of 125% of the resource required to operate each plant at full capacity. Management of the Company believes, based on geological and engineering surveys and analysis of wells drilled, that the Coso Projects' geothermal resource is sufficient to supply steam to the Coso Projects of adequate temperature and in sufficient quantities for the respective terms of the SO4 Agreements. Because of the uncertainties related to developing, exploring and operating geothermal resources and the limited history of extracting the geothermal resource at the sites of the Navy I Project, the BLM Project and the Navy II Project, there is no assurance that the geothermal reservoir will continue to supply steam to the Coso Project at current levels for the remaining terms of the SO4 Agreements. The Company believes that the facilities producing electricity at the Coso Project emit significantly less emissions than electricity production facilities using combustible materials as an energy source. The geothermal fluids contain certain noncondensable gases, such as hydrogen sulfide ("H2S"), carbon dioxide ("C02"), hydrogen, nitrogen, ammonia, methane, and argon, as well as traces of arsenic (a metal which remains dissolved in the brine after separation). Certain of the Coso Joint Ventures hold permits to operate the turbine-generator units which require that the release of certain noncondensable gases be below specified levels. The Coso Joint Ventures have, from time to time, exceeded such levels, particularly with respect to the BLM Project. As a result, new H2S emissions control systems were installed at the BLM Project in 1992. H2S emissions control systems are also now under contract to be installed at the Navy I Project and the Navy II Project in 1994. Operating permits and California state laws require that arsenic levels may not exceed specified levels so as not to endanger worker health and safety. Arsenic comes into contact with the interior of the pipes and turbine systems and may be released into sumps during well tests. Failure to construct and operate the Coso Projects within the applicable regulatory limits may result in the applicable regulatory agencies levying fines on the Coso Joint Ventures or curtailing operation of the Coso Projects until compliance with the regulatory limits is achieved. The Coso area is subject to frequent low-level seismic disturbances, and more serious seismic disturbances are possible. The Coso Project's wells and turbine generator units have been designed and built to withstand relatively significant seismic disturbances, but there can be no assurance that they will withstand any particular disturbance. See "Insurance". The Coso Facilities The physical facilities used for geothermal energy production are substantially the same at the Navy I Project, the BLM Project and the Navy II Project. The geothermal fluids produced at the wellhead consist of a mixture of hot water and steam. The mixture flows from the wellhead through a gathering system of insulated steel pipelines to high pressure separation vessels called separators. There, steam is separated from the water and is sent to a demister in the power plant, where any remaining water droplets are removed. This produces a stream of dry steam, which passes through the high pressure inlet of a turbine generator, producing electricity. The hot water previously separated from the steam at the high pressure separators is piped to low pressure separators, where low pressure steam is separated from the water and sent to the low pressure inlet of a turbine generator. The hot water remaining after low pressure steam separation is injected back into the Coso geothermal resource. Steam exhausted from the steam turbine is passed to a surface condenser consisting of an array of tubes through which cold water circulates. Moisture in the steam leaving the turbine generators condenses on the tubes and, after being cooled further in a cooling tower, is used to provide cold circulating water make up for the condenser. At the Navy I Project and the Navy II Project, the primary atmospheric emission control system consists of the surface condenser, noncondensable gas removal equipment, a gas compressor unit and the injection wells. The noncondensable gas, which consists primarily of CO2 with a small percentage of H2S, is compressed, mixed with the hot water exiting the low pressure separator and reinjected into the geothermal reservoir. The BLM Project has the same injection facilities. The Coso Joint Ventures believe that certain residual, noncondensable gases, primarily CO2 and a small percentage of H2S which were originally being returned to the geothermal reservoir through the injection wells at the respective Coso Projects were recycling into the production wells supplying the Coso Projects, which, together with related equipment problems, increased H2S emissions and reduced the ability to use the energy content of the extracted geothermal fluids which in turn reduced the overall electrical generating capacity for the Coso Project. Therefore, in addition to the injection wells, a Dow SulFerox H2S abatement system was installed at the BLM Project and new LO-CAT II H2S abatement systems are under contract to be installed at the Navy I Project and Navy II Project in 1994, as described below. All of the Coso Projects are designed to operate 24 hours a day every day of the year. Currently, each year three of the nine turbine generators are shut down for approximately two weeks for regular inspection, maintenance and repair. The Company attempts to schedule these shut-downs during off-peak periods. Weekend outages are scheduled twice a year for all nine units. The Navy I Project. The geothermal resource for the Navy I Project currently is produced from approximately 32 wells located within a radius of approximately 3,000 feet of the Navy I Project area. The Navy I Project consists of three individual turbine generators, each with approximately 32 MW of electrical generating capacity. The Navy I Project has an aggregate gross electrical generating capacity of approximately 96 MW, and operated at an average operating capacity factor of 98.5% in 1991, 99.8% in 1992 and 111.2% in 1993, based on a capacity of 80 NMW. The Navy I Joint Venture recently executed agreements with ARI Technologies, Inc. for the Engineering, Procurement and Construction of a LO-CAT II H2S abatement system and the right to use that technology. The LO-CAT II H2S abatement system is expected to be completed in 1994. The BLM Project. The BLM Project's geothermal resource currently is produced from approximately 20 wells located within a radius of approximately 4,000 feet from either the BLM East or BLM West site. The BLM Project consists of three turbine generators. Two of these turbine generators are located at the BLM East site in a dual flash system, each with a nameplate capacity of 29 MW; and one is located at the BLM West site in a single flash system, with a nameplate capacity of 29 MW. The BLM Project has an aggregate gross electrical generating capacity of approximately 96 MW, and operated at an average operating capacity factor of 71.4% in 1991, 87.2% in 1992, and 98.1% in 1993, based on a capacity of 80 NMW. The BLM Joint Venture recently completed the construction of two Dow SulFerox H2S abatement systems for the BLM Project which have improved the BLM Project's operating efficiency. These H2S abatement systems were designed by Dow Chemical USA and constructed by Gilbert Industrial Corp. The Navy II Project. The geothermal resource for the Navy II Project currently is produced from approximately 25 wells located within a radius of approximately 5,000 feet of the Navy II Project area. The Navy II Project consists of three individual turbine generators, each with approximately 32 MW of electrical generating capacity. The Navy II Project has an aggregate gross electrical capacity of approximately 96 MW, and operated at an average operating capacity factor of 99.9% in 1991, 98.1% in 1992, and 102.6% in 1993, based on a capacity of 80 NMW. The Navy II Joint Venture recently executed agreements with ARI Technologies, Inc. for the Engineering, Procurement and Construction of a LO-CAT II H2S abatement system and the right to use that technology. The LO-CAT II H2S abatement system is expected to be completed in 1994. Power Transmission Lines. The electricity generated by the Navy I Project is transmitted over a 28.8 mile 115 kilovolt ("kV") transmission line to the SCE substation at Inyokern, California. This transmission line is owned and operated by the Navy I Joint Venture. The electricity produced by the BLM Project and the Navy II Project is transmitted on a 230 Kv power line connected to the SCE substation at Kramer Junction, California (the "Transmission Line"). Coso Transmission Line Partners, a California general partnership ("CTLP"), holds title to the Transmission Line and related facilities, which are used by both the BLM Joint Venture and the Navy II Joint Venture. The BLM Joint Venture and the Navy II Joint Venture are the general partners of CTLP. CTLP charges the BLM Joint Venture and the Navy II Joint Venture for its costs, allocated in accordance with the proportion of the transmission capability of the Transmission Line dedicated for each Project's use. Pursuant to a Transmission Line Operation and Maintenance Agreement dated as of July 28, 1989 between CTLP and the Company, the Transmission Line is operated by the Company on behalf of CTLP for an annual fee. Management of the Coso Joint Ventures The managing partner of the Navy I Joint Venture is China Lake Operating Company ("CLOC"), the managing partner of the BLM Joint Venture is Coso Hotsprings Intermountain Power, Inc. ("CHIP"), and the managing partner of the Navy II Joint Venture is Coso Technology Corporation ("CTC"). CLOC, CHIP and CTC are wholly- owned subsidiaries of the Company. Each managing partner is responsible for the conduct of the business of its Joint Venture, and each has subcontracted with the Company to operate and maintain its respective plant and geothermal field pursuant to operation and maintenance agreements as described below. As such, the managing partners have control over the day-to-day businesses of the Coso Joint Ventures, including budgeting and development of the Coso Projects, subject to the oversight of the Management Committee. No managing partner may be removed without the consent of the Company. The business operations of each Coso Joint Venture are overseen by a management committee (each a "Management Committee"). In each case the Management Committee consists of two delegates appointed by the managing partner and two delegates appointed by the Caithness Partnerships. Pursuant to the partnership agreement of each of the Coso Joint Ventures, each Management Committee holds meetings on a quarterly basis and on such other dates as shall be called by any of the partners. Action of the Management Committee may be taken by majority vote of a quorum of at least three delegates present at a meeting, or by written consent or confirmed telephonic vote of at least three delegates. The Management Committee of each of the Coso Joint Ventures must consent to certain investment and business decisions of the managing partners, including, without limitation, certain decisions regarding contracts, engagement of outside consultants, termination of the Coso Joint Ventures and approval of budgets. For the purposes of the Coso Project Loans, if the annual budget proposed by the managing partner is not approved by the Management Committee in a timely fashion, the managing partner is required to retain an independent engineering firm to review the proposed budget. If this proposed budget is approved by the independent engineering firm as reasonably designed to operate and maintain a facility of this type and to maximize revenues and net income, the budget as proposed by the managing partner is deemed to be approved. Otherwise, any controversies or claims arising out of the partnership agreements of the Coso Joint Ventures are to be settled by binding arbitration. Plant Operation and Maintenance Agreements. By a separate Plant Operations and Maintenance Agreement ("Plant O&M Agreement") for each Coso Joint Venture, dated July 15, 1988, in the case of the Navy I Project, August 3, 1988, in the case of the BLM Project, and December 30, 1988, in the case of the Navy II Project, the Company has agreed to perform on behalf of CLOC, CHIP and CTC the operation and maintenance services for the Coso Projects. In each case, the Company's performance of these services will be in accordance with an annual operating budget for each Coso Project. Pursuant to each Plant O&M Agreement, the Company's general duties include hiring and training of personnel, testing and operation of the three turbine generators for each Coso Project, providing inventories of tools and spare parts, upkeep of the Transmission Line, furnishing reports required by SCE, the BLM, the Navy or other governmental authorities, and protecting and enforcing all warranty rights and claims related to each Coso Project. Each Coso Joint Venture is a third-party beneficiary of its respective Plant O&M Agreement. CLOC, CHIP and CTC compensate the Company for its services rendered under each Plant O&M Agreement, including reimbursement for all of the Company's direct costs incurred in operating each Coso Project, and the operator fees approved by the Coso Joint Ventures' respective Management Committee. CLOC, CHIP and CTC have the right to suspend all services performed by the Company under the respective Plant O&M Agreements under certain circumstances, including the inability of the Coso Projects or the Transmission Line to operate for any reason, SCE's refusal or inability to accept power generated by a Coso Project, or Navy or BLM activities or restrictions which prohibit economic operation of the Navy I Project, the BLM Project or the Navy II Project. In the event of such suspension, CLOC, CHIP and CTC are relieved of their respective obligations to compensate the Company after 30 days, after compensating the Company for costs associated with winding down or resumption of operations. Each Plant O&M Agreement between CLOC, CHIP or CTC and the Company may be terminated by the Company upon six months' notice. Otherwise each Plant O&M Agreement may be terminated in the event of an uncured default by either party and shall be terminated upon the termination by SCE of the applicable SO4 Agreement upon the occurrence of an uncured default thereunder. Under the current financing arrangements for the Coso Project, the Plant O&M Agreements have a term equal to the longest maturity of the notes issued by Coso Funding Corporation and may not be terminated by a Coso Joint Venture without the consent of the trustee under the indenture for such notes, and any material amendments or modifications must be approved by the trustee and an independent engineering firm. Field Operation and Maintenance Agreements. The arrangements for the operation and maintenance of the Navy I, the BLM and the Navy II geothermal resources are substantially the same as those for the Navy I, the BLM, and the Navy II plants and facilities, as set forth above. The obligations of the Company, pursuant to the three Field Operations and Maintenance Agreements, dated July 15, 1988 for the Navy I Project, August 8, 1988 for the BLM Project, and December 30, 1988 for the Navy II Project (each a "Field O&M Agreement"), include performing all testing, permitting and record keeping services required by the Navy I Joint Venture, the BLM Joint Venture and the Navy II Joint Venture, the BLM, the Navy or other government authorities, proper operation and maintenance of the steam gathering, delivery and injection systems, maintenance of a qualified staff, and contracting with drilling companies for repair and replacement of wells. The compensation, suspension, emergency procedure, third-party beneficiary and termination provisions of each Field O&M Agreement are substantially the same as the corresponding provisions in the Plant O&M Agreements, as set forth above. Coso Royalty and Other Revenue Sharing Agreements The receipt of revenues from the Navy I Project, the BLM Project and the Navy II Project are subject to the following royalty and other revenue sharing arrangements: The Navy Contract. In December 1979, the Company entered into the 30-year Navy Contract with the Government of the United States, acting through the Navy, which granted to the Company exclusive rights to explore, develop and use the geothermal resource located within the Naval Air Weapons Station near China Lake, California, in the Coso KGRA (the "Navy Contract"). The term of the Navy Contract may be extended for an additional 10 years at the option of the Navy. The Navy Contract has been modified on several occasions to provide for, among other things, assignment of all of the Company's rights with respect to the Navy I Project and the Navy II Project to the Navy I Joint Venture and the Navy II Joint Venture, respectively. In accordance with the terms of the financing arrangements for the Coso Project, the Navy I and Navy II Joint Venture's rights and interests pursuant to the Navy Contract have been assigned as security for the notes issued by Coso Funding Corporation in connection with the refinancing of existing bank debt of the Coso Project. Navy I Project. Under the terms of the Navy Contract, as a royalty for Unit 1 of the Navy I Project, the Navy I Joint Venture is obligated to pay for electricity supplied by SCE to the Navy. This obligation amounted to $9,620,900 in 1993 for 112 million kWh of electricity. The Navy is obligated to reimburse the Navy I Joint Venture for the electricity used, at a formula price specified in the Navy Contract. For 1993, the reimbursement to the Navy I Joint Venture equaled approximately 71% of the SCE price paid by the Coso Joint Venture. The percentage reimbursement from the Navy is escalated semi-annually, not to exceed 95% of the SCE price, in accordance with a weighted index based on the Consumer Price Index and price indices for the oil industry, the electric power plant industry and the construction industry. In addition, the Navy I Joint Venture is obligated to pay the Navy the sum of $25.0 million in respect of Unit 1 of the Navy I Project on December 31, 2009, which is the expiration date of the initial term of the Navy Contract. This payment will be made from a sinking fund, to which the Navy I Joint Venture has been making payments since 1987. Payments to the sinking fund are to be made at an annual rate of $600,000. As of December 31, 1993, approximately $2.7 million was on deposit in this sinking fund, representing both sinking fund payments and accrued interest. For Units 2 and 3 at the Navy I Project, the Navy I Joint Venture's royalty expenses are a fixed percentage of its electricity sales. The royalty expense per Kwh remained constant at 10.0% through 1993 and will escalate over the life of the Navy Contract in accordance with the following schedule: 1994-1998. . . . . . . . . . . . . . . . . . . . . . 10.0% 1999-2003. . . . . . . . . . . . . . . . . . . . . . 15.0% 2004-2009. . . . . . . . . . . . . . . . . . . . . . 20.0% Navy II Project. The Navy II Joint Venture's royalty expenses are a fixed percentage of its electricity sales. The royalty expense per Kwh remained constant at 4.0% through 1993 and will escalate over the life of the Navy Contract in accordance with the following schedule: 1994 . . . . . . . . . . . . . . . . . . . . . . . . .4.0% 1995-1999. . . . . . . . . . . . . . . . . . . . . . 10.0% 2000-2004. . . . . . . . . . . . . . . . . . . . . . 18.0% 2005-2010. . . . . . . . . . . . . . . . . . . . . . 20.0% The Navy II Joint Venture is also obligated to pay any shortfalls in the obligation of the Navy I Joint Venture to make annual sinking fund payments of $600,000 in respect of the Navy I Joint Venture's obligation in respect of Unit I of the Navy I Project to pay the Navy the sum of $25.0 million on December 31, 2009. Termination. The Navy has the right to terminate the Navy Contract at any time by giving the Navy I Joint Venture or the Navy II Joint Venture, or both, as applicable, six months prior written notice for "reasons of national security, national defense preparedness, national emergency, or for any reasons the Contracting Officer shall determine that such termination is in the best interest of the U.S. Government." In the event of such termination, the United States Government is required to pay the Navy I Joint Venture, or the Navy II Joint Venture, or both, as applicable, for its unamortized exploratory investment and for its investment in installed power plant facilities, up to a maximum based on the nameplate capacity of the turbine generators. With respect to each of the Navy I and Navy II Joint Ventures, for the first aggregate 25 MW, the maximum is $2.7 million per MW, and for the next 25 MW (i.e. up to 50 MW), the maximum payment is $2.5 million per MW. For 50-75 MW the maximum payment is $1.4 million per MW for the Navy I Joint Venture and $2.3 million per MW for the Navy II Joint Venture. For a total nameplate capacity of 75 MW for either the Navy I Project or the Navy II Project, the total maximum payment for termination compensation would be $165.0 million for the Navy I Joint Venture, and $187.5 million for the Navy II Joint Venture. The total aggregate termination compensation for both the Navy I and Navy II Joint Venture could therefore not exceed $352.5 million. There is no provision in the contract to compensate either the Navy I or the Navy II Joint Venture for the loss of anticipated profits resulting from such termination. The BLM Lease. On April 29, 1985 the Company and the BLM entered into an "Offer to Lease and Lease for Geothermal Resources," #CA11402 effective as of May 1, 1985 (the "BLM Lease"), pursuant to which the Company acquired a leasehold interest in approximately 2,500 acres of land, including rights to explore, develop and use the geothermal resource thereon. All of the Company's rights pursuant to the BLM Lease have been assigned to the BLM Joint Venture. The BLM Lease was recorded on May 9, 1988 as Instrument No. 88-2092 of the Official Records of Inyo County. The primary term of the BLM Lease is 10 years, however, the term extends automatically "for so long thereafter as geothermal steam is produced to be utilized in commercial quantities but shall in no event continue for more than forty years after the end of the primary term." Such an automatic extension due to the continuation of production is termed being "held by production." The BLM Joint Venture also enjoys a preferential right of renewal of the BLM Lease for a second forty-year term if the BLM Lease is held by production at the termination of the forty-year automatic extension. If the initial 10-year term expired at the present time, the BLM Lease would be deemed to be "held by production," entitling the BLM Joint Venture to an automatic extension. Royalties to the BLM are 10% of the amount of value of steam produced, 5.0% of any by-products and 5.0% of commercially demineralized water. These rates are fixed for the life of the BLM Lease. Since increased steam production is required to increase revenues, the royalties based on the value of the steam typically increase with the revenues. Under the method which has been agreed to for valuing the steam utilized by the BLM Project, the 10% royalty translates to an approximate royalty rate of 5.1% on revenues from electricity sales. The BLM Project does not currently produce demineralized water, but the sulphur and carbon dioxide by-products of the Dow SulFerox H2S abatement system are subject to the BLM royalty schedule. The BLM has the right to establish minimum production levels after notice and an opportunity to be heard, and the right to reduce the above royalties if necessary to encourage the greater recovery of leased resources, or as otherwise justified. In addition to the royalties mentioned above, the BLM Joint Venture is also obligated to pay a royalty to Coso Land Company ("CLC"), an affiliate of the BLM Joint Venture (the "CLC Royalty"). The CLC Royalty is equal to 5.0% of the value of the steam utilized by the BLM Project, but is subordinated to all other royalties, all debt service of the BLM Joint Venture and all operating costs of the BLM Project. The royalty may not be transferred without consent and is unsecured. Pursuant to the BLM Lease, the BLM Joint Venture must comply with certain "Navy Constraints on Naval Weapon Center Lands." These constraints include, among other things, certain security measures and restrictions of access, the Navy's right to suspend operations if an imminent threat to the environment is present, permitting requirements, information and data exchange, and the Navy's right of inspection. In addition, BLM leases can be terminated by operation of law, as follows: (i) at the anniversary date, for failure to pay the full amount of the annual rental by such date, and (ii) at the end of the primary term, if there is no production in commercial quantities, there is no producing well, or actual drilling operations are not being diligently prosecuted. Other Revenue Sharing Arrangements. The Company has outstanding Senior Notes (the "Senior Notes"). The Senior Notes bear interest at the rate of 12% per annum, plus 10% of the Company's share of the net cash flow from the Coso Project through December 31, 1994. SO4 Power Sales Agreements The Navy I Joint Venture, the BLM Joint Venture and the Navy II Joint Venture have acquired SO4 Agreements which were originally executed by SCE and the China Lake Joint Venture ("CLJV"), and by SCE and Coso Geothermal Company ("CGC"), each of which are California general partnerships between the Company, Caithness and others. Under the terms of the SO4 Agreements, the Navy I Joint Venture, the BLM Joint Venture and the Navy II Joint Venture have agreed to sell and SCE has agreed to purchase the net electrical output of the Navy I, the BLM and the Navy II Projects. The SO4 Agreements require that each Coso Project maintain its status as a qualifying facility under PURPA throughout its respective contract term. Pursuant to the SO4 Agreements, SCE must purchase all of the net electrical output of the Navy I Project until August 2011, of the BLM Project until March 2019 and of the Navy II Project until January 2010. In each case, SCE must pay the Navy I Joint Venture, the BLM Joint Venture and the Navy II Joint Venture capacity payments, capacity bonus payments and energy payments in accordance with each Coso Project's output. Capacity Payments. A Coso Project qualifies for an annual capacity payment by meeting specified performance requirements on a monthly basis during an approximately four-month long peak period, which currently runs during the months of June through September of each year. The basic performance requirement is that the Coso Project deliver an average kWh output during specified on-peak hours of each month in the peak period at a rate equal to at least an 80% Contract Capacity Factor. The "Contract Capacity Factor" equals (1) a plant's actual electricity output, measured in kWhs, during the hours of measurement, divided by (2) the product obtained by multiplying the plant's "Contract Capacity," as stated in the SO4 Agreement applicable to such plant, by the number of hours in the measurement period. If a Project maintains the required 80% Contract Capacity Factor during the applicable periods, the annual capacity payment will be equal to the product of the capacity payment per kWh stated in its SO4 Agreement and the Contract Capacity. The Navy I Project has a Contract Capacity of 75 MW, and a capacity payment per kW year of $161.20, for an annual maximum capacity payment of $12,090,000. The BLM Project and the Navy II Project each have a Contract Capacity of 67.5 MW, and capacity payments per kW year of $175.00 and $176.00, respectively, yielding annual maximum capacity payments of $11,812,500 and $11,880,000, respectively. Although capacity prices per kWh remain constant throughout the life of each SO4 Agreement, capacity payments are disbursed by SCE on a monthly basis in accordance with a tariff schedule filed with the CPUC. Payments are made unevenly throughout the year, and are weighted toward the on-peak periods; currently, approximately 84% of the capacity payments received by the Coso Joint Ventures from SCE are paid in respect of peak months, and 16% in respect of non-peak months. As of the end of the 1992 peak season, each of the Coso Projects earned, for the first time, the maximum capacity and bonus payments available under its respective SO4 Agreement for the peak months. In 1993 each of the Coso Projects also earned the maximum capacity and bonus payments available under its respective SO4 Agreement for the peak and non- peak months. Capacity Bonus Payments. Each Coso Joint Venture is entitled to receive capacity bonus payments during both on-peak and non-peak months by operating at a Contract Capacity Factor of between 85% and 100% during on-peak hours of each month. A plant qualifies for capacity bonus payments in respect of peak months provided that the plant operates at least at an 85% Contract Capacity Factor during the on-peak hours of the month, and qualifies in respect of non- peak months if performance requirements for on-peak months have been satisfied and the plant also operates at a Contract Capacity Factor of at least 85% during mid-peak hours of the non-peak month. Capacity bonus payments for each month increase with the level of kWhs delivered between the 85% and 100% Contract Capacity Factor levels during the month. The annual capacity bonus payment for each month is equal to a percentage based on the plant's on-peak Contract Capacity Factor (which percentage may not exceed 18% of one-twelfth of the annual capacity payment). Energy Payments. In addition to capacity and bonus payments, SCE must make monthly energy payments to each Coso Joint Venture in accordance with kWh of energy delivered by each Coso Project. The energy price component for electricity delivered to SCE is subject to different pricing mechanisms during the first 10 years of each SO4 Agreement than are applicable during the remaining term of each agreement. During the first 10 years following the commencement of firm power delivery, the energy price per kWh varies between so- called on-peak and non-peak periods, but the time weighted average of these prices equals a fixed price per kWh specified in the SO4 Agreements. The stated fixed price in the SO4 Agreements escalates at an average annual rate of approximately 7.7% per year for the remainder of the initial 10-year period under the SO4 Agreement for the Navy I Project, 6.4% per year for the BLM Project and the Navy II Project. This period ends in August 1997 for the Navy I Joint Venture, March 1999 for the BLM Joint Venture and January 2000 for the Navy II Joint Venture. The fixed average energy prices per kWh which will remain in effect through the year 1998 and which management of the Coso Joint Ventures believes will be the minimum amounts payable in 1999 and 2000 are as follows: Annual % Year Price/kWh Increase 1993 10.1 cents 1994 10.9 cents 7.9% 1995 11.8 cents 8.3% 1996 12.6 cents 6.8% 1997 13.6 cents 7.9% 1998 14.6 cents 7.4% 1999 14.6 cents 0.0% 2000 14.6 cents 0.0% After the initial 10-year period under each SO4 Agreement expires, the energy price paid for electricity delivered under the agreement will be based upon SCE's short-run avoided cost (as determined and published from time to time by the CPUC) which at present is substantially lower than the current energy payments under the SO4 Agreement. The short-run avoided cost is the product of its Incremental Energy Rate ("IER") (system efficiency) and its avoided fuel rate, plus various additions that have been adopted by the CPUC. The IER and the additions are determined yearly in the purchasing utility's Energy Cost Adjustment Clause proceeding before the CPUC. The purchasing utility's avoided fuel and the corresponding fuel rate are determined monthly by the CPUC. For the majority of months, the utility's avoided fuel has historically been gas, although in some winter months the avoided fuel has been oil. When the avoided fuel is gas, the electric utility's fuel rate is based on the utility's forecast of its average cost of gas. When the avoided fuel is oil, the utility's fuel rate is based on the utility's actual average cost of the most recent period's oil purchase. Consequently, after the initial 10-year period, energy payments under the SO4 Agreements will fluctuate based on average fuel costs in the California energy market. The Company cannot predict the likely level of avoided cost energy prices at the expiration of the fixed price period. Although from time to time, various third parties attempt to forecast SCE's future avoided costs, the Company believes that all forecasts of avoided costs are inherently speculative in nature because SCE's actual avoided costs will be dependent upon, among other factors, SCE's future fuel costs, system operation characteristics and regulatory action. Non-Recourse Coso Project Financing In December 1992, the Coso Joint Ventures refinanced the existing bank debt on the Coso Projects with the proceeds of the sale of approximately $560 million in non-recourse senior secured notes (the "Notes") in a private placement pursuant to Rule 144A under the Securities Act of 1933. The Notes were issued by Coso Funding Corp. ("Coso Funding"), a corporation owned by the Coso Joint Ventures and formed exclusively for the purpose of issuing the Notes. Coso Funding has lent the Coso Joint Ventures substantially all of the net proceeds of the sale of the Notes in loans known as the "Project Loans". The Notes were issued in the following amounts, fixed interest rates and maturities: Amount Rate Maturity $ 12,904,000 4.94% December 31, 1992 $ 17,506,000 5.35% June 30, 1993 $ 17,506,000 5.72% December 31, 1993 $ 28,823,000 6.50% June 30, 1994 $ 28,823,000 6.87% December 31, 1994 $ 33,552,000 7.22% June 30, 1995 $ 33,552,000 7.41% December 31, 1995 $167,992,000 7.99% December 31, 1997 $144,504,000 8.53% December 31, 1999 $ 75,083,000 8.87% December 31, 2001 Mandatory semi-annual principal repayments are required with respect to Notes due 1997, 1999 and 2001 beginning on June 30, 1996, 1998 and 2000, respectively. At the time of their issuance, the Notes were rated "BBB-" by Standard & Poor's Corporation, "Baa3" by Moodys Investor's Service Inc., and "BBB" by Duff & Phelps Credit Rating Co., all investment grade ratings. The obligations of each Coso Joint Venture under the Project Loans are non-recourse obligations. Coso Funding may look solely to each Coso Joint Venture's pledged assets for satisfaction of such Coso Joint Venture's Project Loan. In addition, the Project Loans are cross-collateralized by certain support loans ("Support Loans") only to the extent of the other Coso Joint Ventures' available cash flow and, under certain circumstances, the debt service reserve funds, and not as to other assets. The Company is not liable for the repayment of the Notes or the Project Loans. Reference is made to the indenture relating to the Notes (the "Notes Indenture") for a detailed description of the refinancing terms, including the definition of certain terms used herein. Security. The Notes are secured by an assignment of Coso Funding's interest in the Project Loans of the Coso Joint Ventures and a security interest in all collateral thereunder, as well as by each Coso Joint Venture's agreement to make payments under certain circumstances in respect of the other Coso Joint Ventures' Project Loans, and each Coso Joint Venture's commitment to advance Support Loans to the other Coso Joint Ventures, as described below. Security for payment of each Coso Joint Venture's Project Loan includes: (1) an assignment of all such Coso Joint Venture's revenues which will be applied against the payment of obligations of each Coso Joint Venture, including its Project Loan, in accordance with priorities of payment described below; (2) a mortgage on the geothermal property interests of each Coso Joint Venture and the respective Coso Project; (3) a collateral assignment of certain material contracts; (4) a pledge of the partnership interests in the Coso Joint Ventures; (5) a pledge of the stock of all Corporate general partner entities for each Coso Joint Venture; (6) a debt service reserve fund; (7) a contingency fund; (8) a pledge of such Coso Joint Venture's capital stock of Coso Funding; (9) a pledge of such Coso Joint Venture's partnership interest in CTLP, if any; and (10) any other funds of such Coso Joint Venture on deposit under the Notes Indenture. The assets described in clauses (1) through (10) and any other assets securing a Coso Joint Venture's Project Loan at any time are collectively referred to herein as the "Collateral." Each Coso Joint Venture's assets secures only its own Project Loan, and is not cross- collateralized with the assets pledged under the other Coso Joint Ventures' Project Loans. However, each Coso Joint Venture is obligated, to the extent of available cash flow, and under certain conditions, its debt service reserve fund balance, to make Support Loans to the other Coso Joint Ventures. Priority of Payments. Each Coso Joint Venture's revenues are applied in the following order of priority: (a) royalties due to the Navy or the BLM; (b) operating and maintenance expenses; (c) capital expenditures; (d) repayment of working capital lines of credit of up to $10.0 million; (e) principal and interest payments on such Coso Joint Venture's Project Loan; (f) Support Loans to the other Coso Joint Ventures or payments under Project Loan pledge agreements to maintain an operating capital balance of $1.0 million and in respect of principal and interest due under the other Coso Joint Ventures' Project Loans (to the extent described below under "--Support Loans and Project Loan Pledge Agreements"); (g) replenishment of any shortfall in such Coso Joint Venture's own debt service reserve fund; (h) Support Loans to replenish shortfalls in the other Coso Joint Ventures' debt service reserve funds; (i) payments in connection with permitted interest rate swap arrangements; (j) repayment of any outstanding Support Loans; (k) subordinated royalty payments due to affiliates; (l) other subordinated obligations, including existing subordinated debt due to affiliates; and (m) distributions to partners. Conditions to Cash Distributions From the Coso Joint Ventures. The terms of the financing restrict the ability of the Coso Joint Ventures to distribute cash to their partners. In order to distribute cash, (i) no event of default may exist under the Project Loans or the Notes, and no notice of such an impending event of default may have been received from the trustee under the Notes Indenture, (ii) certain financial ratios must be met, and (iii) certain thresholds must be met regarding the availability of an adequate geothermal resource for each of the Coso Projects and for the Coso Project as a whole, as described in the Notes Indenture. In addition, the consent of the Management Committee of each of the Coso Joint Ventures is required for cash distributions. See "The Coso Project -- Management of the Coso Joint Ventures". Required Geothermal Percentage. The terms of the financing require that an independent geothermal engineer prepare a report annually on the geothermal resource available at the Coso Project as of May 1 of each year. The resource is measured by comparing the geothermal resource available at the wellhead, or otherwise available pursuant to contract, with the resource that would be required to fuel the Coso Projects at their specified capacity levels of 80 NMW for the Navy I and Navy II Projects and 70 NMW for the BLM Project. If the geothermal resource for the Coso Project falls below a set threshold, initially 125% of the resource required to operate at full capacity, as measured on May 1 of each year, then the relevant Coso Joint Venture(s) are required to develop additional steam reserves under a plan of corrective action approved by the independent geothermal engineer. Depending upon the results of such efforts, the relevant Coso Joint Venture(s) may reduce the geothermal resource threshold for permitting cash distributions by increasing cash reserves available for debt service. Cash distributions otherwise permitted will be suspended during any period when the geothermal resources threshold is not met. On May 1, 1993, the Coso Project met the required steam reserve covenants. Debt Service Reserve and Contingency Funds. The debt service reserve funds for the Coso Joint Ventures are currently fully funded. With respect to the Navy I Joint Venture, the debt service reserve requirement requires that the Navy I debt service reserve fund be equal to at least the next semi-annual principal and interest payment on the Navy I Joint Venture's Project Loan. With respect to the BLM Joint Venture and the Navy II Joint Venture, the debt service reserve requirements will require that the debt service reserve funds of the BLM Joint Venture and the Navy II Joint Venture together be equal to at least the aggregate of the next semi-annual principal and interest payments on the Project Loans of such Coso Joint Ventures. In connection with the financing, contingency funds were funded from the Project Loan to the Navy I Joint Venture to the extent of approximately $14.0 million, from the Project Loan to the BLM Joint Venture to the extent of approximately $20.3 million, and from the Project Loan to the Navy II Joint Venture to the extent of approximately $34.1 million. The amount of the contingency fund for each Coso Joint Venture represented the approximate maximum amount, if any, which could theoretically be payable by such Coso Joint Venture to third parties to satisfy and discharge all liens of record and other contract claims encumbering the respective Coso Projects at the time of the sale of the Notes, including liens and contract claims which were the subject of litigation between the Coso Joint Ventures, on the one hand, and Mission Power Engineering Company ("MPE"), on the other hand, and to establish a reserve for any other contingencies. The contingency funds were established in order to obtain ratings to facilitate the offer and sale of the Notes. The litigation with MPE was settled in June 1993. As a result of the various payments and releases involved in such settlement, the Coso Joint Ventures agreed to make a net payment of $20,000,000 to MPE from the contingency fund and MPE released its mechanics' liens on the Coso Projects. After paying the settlement amount to MPE, the remaining balance of the contingency fund (approximately $49 million) was used to fully fund the Coso Projects' debt service reserve funds to the maximum of $68 million, and the remaining $24 million was retained in the contingency fund for future capital expenditures and debt service according to the Project Loans. Support Loans and Project Loan Pledge Agreements. The Support Loans and the Project Loan pledge agreements have the effect of cross-collateralizing the Project Loans, but only to a limited extent. There is no cross-collateralization of the Coso Joint Ventures' assets. Subject to certain limitations and conditions, each Coso Joint Venture has agreed to advance Support Loans to each other Coso Joint Venture, in the event that the borrowing Joint Venture's revenues are insufficient to meet scheduled semi-annual principal and interest payments. The Navy I Joint Venture's obligation to advance Support Loans is subordinate to the BLM and Navy II Joint Ventures' obligations to advance Support Loans. In addition, the debt service reserve fund of the Navy I Joint Venture will be utilized to fund a Support Loan only to the extent that the amount in the Navy I Joint Venture debt service reserve fund exceeds the amount required to defease in full the Navy I Joint Venture's share of the then outstanding Notes. If a Coso Joint Venture elects to terminate its Support Loan obligations as permitted under certain circumstances, it will remain obligated under a Project Loan pledge agreement to fund principal and interest on the Project Loans of the other Coso Joint Ventures to the extent of its available cash flow and, to a limited extent, its debt service reserve fund. Interest in Caithness Partnerships In connection with the refinancing of the Coso Projects, the Company contributed approximately $9.8 million to CEGC-Mojave Partnership ("CEGC-Mojave"), a recently formed partnership which used the proceeds to acquire a limited partnership interest in Caithness CEA Geothermal L.P. ("CCG"), a partnership which is, in turn, a limited partner in Caithness Coso Holdings, L.P., the Caithness Partnership which is a partner in the BLM Project. In addition, certain cash flows of four Caithness affiliates have been pledged to CEGC-Mojave which relate in part to cash received as a result of distributions from the Navy I, BLM and Navy II Projects. Under the terms of the CEGC-Mojave partnership agreement, with certain exceptions, up to 25% of the cash flows related to the Caithness affiliates will be distributed to such affiliates, and the remainder, including all of the cash flows related to the interest in CCG, will be distributed to the Company until the Company receives a return of its initial investment plus a 17% annual rate of return, at which time all distributions revert to the Caithness affiliates. Coso Joint Venture Notes due to the Company In connection with the refinancing of the Coso Project, the Coso Joint Ventures prepaid a portion of certain notes to the Company in respect of prior advances made by the Company to the Coso Project, and amended certain outstanding notes owing to the Company. As a result the BLM Joint Venture and Navy II Joint Venture have notes due to the Company in the aggregate amount of principal and accrued interest of $21,557,996 due March 19, 2002 which bear interest at 12 1/2% annually. The notes are subordinated to the senior Project Loans on the Coso projects and interest is not paid currently, but accrues on a pay in kind basis until final maturity. OTHER DOMESTIC PROJECTS AND DEVELOPMENT OPPORTUNITIES Desert Peak The Company is the owner and operator of a 10 MW geothermal plant at Desert Peak, Nevada that is currently selling electricity to Sierra Pacific Power Company under a power sales contract that expires December 31, 1995 and that may be extended on a year-to- year basis as agreed by the parties. The price for electricity under this contract is 6.3 cents per kWh, comprising an energy payment of 1.8 cents per kWh (which is adjustable pursuant to an inflation-based index) and a capacity payment of 4.5 cents per kWh. The Company is currently negotiating the terms of an extension to this contract. Roosevelt Hot Springs The Company operates and owns an approximately 70% interest in a 25 MW geothermal steam field which supplies geothermal steam to a power plant owned by Utah Power & Light Company ("UP&L") located on the Roosevelt Hot Springs property under a 30-year steam sales contract. The Company obtained approximately $20.3 million of the cash portion of the purchase price for the properties under a pre- sale agreement with UP&L whereby UP&L paid in advance the entire purchase price for the Company's proportionate share of the steam produced by the steam field. The Company must make certain penalty payments to UP&L if the steam produced does not meet quantity and quality requirements. Yuma During 1992 the Company acquired a development stage 50 MW natural gas fired cogeneration project in Yuma, Arizona. The Yuma Project is designed to be a qualified facility under PURPA and to provide 50 NMW of electricity to SDG&E over an existing 30 year power purchase contract. The electricity is to be sold at SDG&E's avoided cost. The power will be wheeled to SDG&E over transmission lines constructed and owned by Arizona Public Service Company ("APS"). An Agreement for Interconnection and a Firm Transmission Service Agreement have been executed between APS and the Yuma Project entity and have been accepted for filing by the Federal Energy Regulatory Commission ("FERC"). The Power Sales Agreement with SDG&E requires the Yuma Project to commence reliable operations by December 31, 1994. The Company currently anticipates that construction will be completed and reliable operations will commence by mid-1994. The project entity has executed steam sales contracts with an adjacent industrial entity to act as its thermal host in order to maintain its status as a qualified facility, which is a requirement of its SDG&E contract. Since the industrial entity has the right under its contract to terminate the agreement upon one year's notice if a change in its technology eliminates its need for steam, and in any case to terminate the agreement at any time upon three years notice, there can be no assurance that the Yuma Project will maintain its status as a qualified facility. However, if the industrial entity terminates the agreement, the Company anticipates that it will be able to locate an alternative thermal host in order to maintain its status as a qualified facility or build a greenhouse at the site for which the Company believes it would obtain qualified facility status. A natural gas supply and transportation agreement has been executed with Southwest Gas Corporation. The Yuma Project is being constructed pursuant to a fixed price turnkey contract with Raytheon Engineers & Constructors for approximately $43 million, of which the Company has to date funded approximately $39 million from internal sources. The Company currently intends to fund the balance from internal sources as construction expenditures are incurred. Newberry Under a Bonneville Power Administration ("BPA") geothermal pilot program, the Company is developing a 30 NMW geothermal project at Newberry, Oregon (the "Newberry Project"). Pursuant to a Memorandum of Understanding executed in January 1993, the Company has agreed to sell 20 NMW of Power to BPA and 10 NMW to Eugene Water and Electric Board ("EWEB") from the Newberry Project. In addition, BPA has an option to purchase up to an additional 100 MW of production from the project under certain circumstances. In a public-private development effort, the Company is responsible for development, permitting, financing, construction and operation of the project (which will be 100% owned by the Company), while EWEB will cooperate in the development efforts by providing assistance with government and community affairs and sharing in the development costs (up to 30%). The Newberry Project is currently expected to commence commercial operation in 1997. The memorandum of understanding provides that under certain circumstances the contracts may be utilized at an alternative location. A draft environmental impact study with respect to the Newberry Project was completed in January 1994 and is expected to be finalized in mid-year 1994, at which time the Company expects to commence drilling of the geothermal wells and to execute the power sales contracts, subject to obtaining all governmental permits and approvals. Glass Mountain In March 1993, the Company completed the acquisition of an approximate 65% interest in 26,000 acres of geothermal leaseholds at Glass Mountain in Northern California, which include three successful production wells with an existing capacity of between 15 to 30 MW. The Company believes that this acreage represents one of the finest undeveloped geothermal reservoirs in the country. The Company has attempted to negotiate the terms of a power sales contract to exploit this geothermal resource; however, no agreement exists to date. INTERNATIONAL GEOTHERMAL AND OTHER DEVELOPMENT OPPORTUNITIES The Company presently believes that the international independent power market holds the majority of new opportunities for financially attractive private power development in the next several years, because the demand for new generating capacity is growing more rapidly in foreign markets, especially emerging nations, than in the United States. The World Bank estimates that developing countries will need approximately 380,000 MW of new generating capacity over the next decade. The need for such rapid expansion has forced many countries to select private power development as their only practical alternative and to restructure their legislative and regulatory schemes to facilitate such development. The Company believes that this significant need for power has created strong local support for private power projects in many foreign countries and increased the availability of long- term multilateral lending agency and foreign source financing and political risk insurance for certain international private power projects, particularly those utilizing indigenous fuel sources and renewable or otherwise environmentally responsible generating facilities. The Company intends to focus its international efforts on the development, construction, ownership and operation of such projects. In developing its international strategy, the Company intends to pursue development opportunities in countries which it believes have an acceptable risk profile and where the Company's geothermal resource development and operating experience, project development expertise or strategic relationship with Kiewit or local partners are expected to provide it with a competitive advantage. The Company is currently pursuing a number of electric power project opportunities in countries such as the Philippines and Indonesia, which have initiated private power programs and have extensive geothermal resources. The Company's development efforts include both so-called "green field" development, in which the Company attempts to negotiate unsolicited power sales contracts for new generation capacity or engages in competitive bids in response to government agency or utility requests for proposals for new capacity, as well as the acquisition of or participation in the joint development of projects which are under development or already operating. To better position itself to pursue international project development opportunities in the Asian market, the Company recently established an office in Singapore to oversee its activities in that region, including the Philippines and Indonesia. In pursuing international projects, the Company intends to maintain a significant equity interest in, and to operate, the projects that it develops or acquires. In order to compete more effectively internationally, the Company's strategy is to diversify its project portfolio, reduce its future equity commitments and leverage its capabilities in international projects by developing most international projects on a joint venture basis. To that end, the Company has recently entered into international joint venture agreements with Kiewit and Distral (firms with extensive power plant construction experience) in a effort to augment and accelerate the Company's capabilities in foreign energy markets. Joint venture activities with Distral are expected to be conducted in South America, Central America and the Caribbean and joint venture activities with Kiewit are expected to be conducted in Asia (in particular the Philippines and Indonesia) and in other regions not covered by the Distral joint venture agreement. See "- International Joint Venture Agreements." International Joint Venture Agreements As part of the Company's international development strategy, the Company recently signed separate joint venture agreements with Kiewit and Distral. These joint ventures provide the Company with strategic alliances with firms possessing unique private power and construction expertise. The Company believes these strategic joint venture relationships will augment and accelerate its development capabilities in foreign energy markets and provide it with a relative competitive advantage. In addition, the Company believes that participation in these joint ventures will help the Company diversify its project risk profile, leverage its development capabilities and reduce future requirements to raise additional equity for projects. The Company also believes that it is important in foreign transactions to establish strong relationships with local partners (such as Distral in Central and South America and P.T. Himpurna and P.T. ESA (each as defined below) in Indonesia) who are knowledgeable of local cultural, political and commercial practices and who provide a visible local presence and local project representation. Kiewit Joint Venture. On December 14, 1993, the Company signed a joint venture agreement with Kiewit affiliates (Kiewit Diversified Group Inc. and Kiewit Construction Group Inc.). Kiewit is one of the largest construction companies in North America and has been in the construction business since 1884. Kiewit is a diversified industrial company with approximately $2.0 billion in revenues in 1993 from operations in construction, mining and telecommunications. Kiewit has built a number of power plants in the United States and large infrastructure projects and industrial facilities worldwide, and owns approximately 37% beneficial interest in the Company. The Kiewit joint venture agreement, which has an initial term of three years, provides each party a right of first refusal to pursue jointly all "build, own and operate" or "build, own, operate and transfer" power projects identified by the other party or its affiliates outside of the United States, except in locations covered by the Distral joint venture agreement described below. The Kiewit joint venture agreement provides that, if both parties agree to participate in a project, they will share all development costs equally, each of the Company and Kiewit will provide 50% of the equity required for financing a project developed by the joint venture and the Company will operate and manage any such project. The agreement contemplates a joint development structure under which, on a project by project basis, the Company will be the development manager, managing partner and/or project operator, an equal equity participant with Kiewit and a preferred participant in the construction consortium, and Kiewit will be an equal equity participant and the preferred turnkey construction contractor, with the construction consortium providing customary security to project lenders (including the Company) for liquidated damages and completion guarantees. The joint venture agreement may be terminated by either party on 15 days written notice, provided that such termination cannot affect the pre-existing contractual obligations of either party. Distral Joint Venture. On December 14, 1993, the Company entered into a joint venture agreement with Distral of the Lancaster Distral Group. Distral is a South American turnkey construction contractor and manufacturer of boilers, generators and heavy equipment, and has constructed, engineered or supplied equipment to numerous coal, gas and hydroelectric power plants located in Central and South America. The Company believes that, in addition to its extensive experience in energy-related business, Distral brings substantial knowledge of the customs and commercial practices in Central and South America, as well as knowledge of the general power markets and specific power project opportunities in such regions. The joint venture agreement, which has an initial term of three years, provides that the joint venture will have the right of first refusal to jointly pursue all power projects identified by the joint venture, the Company, Distral or their affiliates (other than Kiewit) in the Caribbean, South America and that part of Central America south of Mexico. The agreement provides that the Company and Distral will share all development costs equally, if both parties agree to participate in a project. The Company is required to provide at least 50% of the equity required to finance any project developed by the joint venture; provided, however, that the Company may assign up to 50% of its equity interest in any such project to Kiewit and its affiliates. The agreement contemplates a joint development structure under which the Company and Distral will jointly operate and maintain each joint venture project, with the Company responsible for overall supervision and management. The Distral agreement may be terminated at any time by the Company or Distral, provided that such termination cannot affect the pre- existing contractual obligations of either party. The Philippines The Company believes that increasing industrialization, a rising standard of living and an expanding power distribution network has significantly increased demand for electrical power in the Philippines. Currently, according to the 1993 Power Development Program of the National Power Corporation of the Philippines ("NAPOCOR"), demand for electricity exceeds supply. NAPOCOR has also reported that its ability to sustain current levels of electric production from existing facilities has been limited due to frequent breakdowns in many of its older electric generating plants and an extended drought, which has limited hydroelectric generation. As a result, the Philippines has experienced severe power outages, with Manila suffering significant daily brownouts during much of 1993. Although the occurrence of brownouts has been recently reduced, NAPOCOR has said that it still anticipates significant energy shortages in the future. In 1993, the Philippine Congress, pursuant to Republic Act 7648, granted President Ramos emergency powers to remedy the Philippines' energy crisis, including authority to (i) exempt power projects from public bidding requirements, (ii) increase power rates and (iii) reorganize NAPOCOR. Until 1987, NAPOCOR had a monopoly on power generation and transmission in the Philippines. In 1987, then President Aquino issued Executive Order No. 215, which grants private companies the right to develop certain power generation projects, such as those using indigenous energy sources on a "build-operate-transfer" or "build-transfer" basis. In 1990, the Philippine Congress enacted Republic Act No. 6957, which authorizes private development of priority infra-structure projects on a "build-operate-transfer" and a "build-transfer" basis. In addition, under that Act, such power projects are eligible for certain tax benefits, including exemption from Philippine national income taxes for at least six years and exemption from, or reimbursement for, customs duties and value added taxes on capital equipment to be incorporated into such projects. In a effort to remedy the shortfall of electricity, the Republic of the Philippines, NAPOCOR and the Philippine National Oil Company-Energy Development Company ("PNOC-EDC") are jointly soliciting bids for private power projects. The potential Philippine indigenous resources include geothermal, hydro and coal, of which geothermal power has been identified as a preferred alternative. The Philippine Government has elected to promote geothermal power development due to the domestic availability and the minimal environmental effects of geothermal power in comparison to other forms of power production. PNOC-EDC, which is responsible for developing the Philippines' domestic energy sources, has been successful in the exploration and development of geothermal resources. The Company has been awarded and signed power contracts with PNOC-EDC for two geothermal projects, Upper Mahiao and Mahanagdong, aggregating 300 MW. The following is a summary description of certain information concerning these and other projects as it is currently known to the Company. Since these projects are still in development, however, there can be no assurance that this information will not change over time. In addition, there can be no assurance that development efforts on any particular project, or the Company's efforts generally, will be successful. Upper Mahiao. The Company is negotiating the final terms of the construction and term project financing for a 120 MW geothermal project to be located in the Greater Tongonan area of the island of Leyte, Republic of the Philippines (the "Upper Mahiao Project"). The Upper Mahiao Project will be built, owned and operated by CE Cebu Geothermal Power Company, Inc. ("CE Cebu"), a Philippine corporation that will be more than 95% indirectly owned by the Company. It will sell 100% of its capacity on a "take-or-pay" basis (described below) to PNOC-EDC, which will in turn sell the power to NAPOCOR for distribution to the island of Cebu, located about 40 miles west of Leyte. The Company estimates that Upper Mahiao will have a total project cost of approximately $226 million, including interest during construction, project contingency costs and a debt service reserve fund. A consortium of international banks is expected to provide an approximately $170 million project-financed construction loan, supported by political risk insurance from the Export-Import Bank of the United States ("ExIm Bank"). The Company expects that the term loan for the project will also be provided by the ExIm Bank, and that both the construction and the term loan agreements will be executed in April 1994. Shortly thereafter, the Company expects to issue a notice to proceed to the Contractor under the Mahiao EPC Contract (as defined below), with commercial operations scheduled for mid-year 1996. The Company expects that its equity commitment to the Upper Mahiao Project will be about $56 million. The Company intends to arrange for political risk insurance on this equity investment through OPIC or from governmental agencies or commercial sources. The Upper Mahiao Project will be constructed by Ormat, Inc. ("Ormat") and its affiliates pursuant to supply and construction contracts (collectively the "Mahiao EPC Contract"), which, taken together, provide for the construction of the plant on a fixed- price, date-certain, turnkey basis. Ormat is an international manufacturer and construction contractor that builds binary geothermal turbines; it has provided its equipment to several geothermal power projects throughout the United States and internationally. The Mahiao EPC Contract provides liquidated damage protection of 30% of the Mahiao EPC Contract price. Ormat's performance under the Mahiao EPC Contract will be backed by a completion guaranty of Ormat, by letters of credit, and by a guaranty of Ormat Industries, Ltd., an Israeli corporation and the parent of Ormat, in each case for the benefit of, and satisfactory to, the project lenders. Under the terms of the Energy Conversion Agreement, executed on September 6, 1993 (the "Upper Mahiao ECA"), CE Cebu will build, own and operate the Project during the two-year construction period and the ten year cooperation period, after which ownership will be transferred to PNOC-EDC at no cost. The effectiveness of the Upper Mahiao ECA is subject to the satisfaction or waiver of certain conditions prior to April 8, 1994 (subject to extension by agreement of the parties) including finalization of the principal project documents (including a power purchase agreement between PNOC-EDC and NAPOCOR), posting by Ormat of a construction performance bond in favor of PNOC-EDC in the amount of approximately $11.8 million, obtaining permits and approvals from various Philippine governmental authorities and arranging financing commitments. In the event the parties are unable to satisfy such conditions before the agreed upon effectivity date, either party may terminate the Upper Mahiao ECA and such party shall reimburse the other party for its costs and expenses incurred in connection with such agreement. The Upper Mahiao Project will be located on land to be provided by PNOC-EDC at no cost; it will take geothermal steam and fluid, also provided by PNOC-EDC at no cost, and convert its thermal energy into electrical energy to be sold to PNOC-EDC on a "take-or-pay" basis. Specifically, PNOC-EDC will be obligated to pay for the electric capacity that is nominated each year by CE Cebu, irrespective of whether PNOC-EDC is willing or able to accept delivery of such capacity. PNOC-EDC will pay to CE Cebu a fee (the "Capacity Fee") based on the plant capacity nominated to PNOC-EDC in any year (which, at the plant's design capacity is approximately 95% of total contract revenues) and a fee ( the "Energy Fee") based on the electricity actually delivered to PNOC-EDC (approximately 5% of total contract revenues). The Capacity Fee consists of three separate components: a fee to recover the capital costs of the project, a fee to recover fixed operating costs and a fee to cover return on investment. The Energy Fee is designed to cover all variable operating and maintenance costs of the power plant. Payments under the Upper Mahiao ECA will be denominated in U.S. dollars, or computed in dollars and paid in Philippine pesos at the then-current exchange rate, except for the Energy Fee, which will be used to pay peso-denominated expenses. The ECA provides a mechanism to convert Philippine pesos to dollars. Significant portions of the Capacity Fee and Energy Fee will be indexed to U.S. and Philippine inflation rates, respectively. PNOC-EDC's "take-or- pay" performance requirement, and its other obligations under the Upper Mahiao ECA, are guaranteed by the Republic of the Philippines through a performance undertaking. The payment of Capacity Fees is not excused if PNOC-EDC fails to deliver or remove the steam or fluids or fails to provide the transmission facilities, even if its failure was caused by a force majeure event. In addition, PNOC-EDC must continue to make Capacity Fee Payments if there is a force majeure event (e.g. war, nationalization, etc.) that affects the operation of the Upper Mahiao Project and that is within the reasonable control of PNOC- EDC or the government of the Republic of the Philippines or any agency or authority thereof. If CE Cebu fails to meet certain construction milestones or the power plant fails to achieve 70% of its design capacity by the date that is 120 days after the scheduled completion date (as that date may be extended for force majeure and other reasons under the Upper Mahiao ECA), the Upper Mahiao Project may, under certain circumstances, be deemed "abandoned," in which case the Upper Mahiao Project must be transferred to PNOC-EDC at no cost, subject to any liens existing thereon. PNOC-EDC is obligated to purchase CE Cebu's interest in the facility under certain circumstances, including (i) extended outages resulting from the failure of PNOC-EDC to provide the required geothermal fluid, (ii) changes in tax, environmental or other laws which would materially adversely affect CE Cebu's interest in the project, (iii) transmission failure, (iv) failure of PNOC-EDC to make timely payments of amounts due under the Upper Mahiao ECA, (v) privatization of PNOC-EDC or NAPOCOR, and (vi) certain other events. Prior to completion of the Upper Mahiao Project, the buy-out price will be equal to all costs incurred through the date of the buy-out, including all Upper Mahiao Project debt, plus an additional rate of return on equity of ten percent per annum. In a post-completion buy-out, the price will be the net present value at a ten percent discount rate of the total remaining amount of Capacity Fees over the remaining term of the Upper Mahiao ECA. Mahanagdong. The Mahanagdong Project is expected to be a 180 MW geothermal project, which will also be located on the island of Leyte. The Mahanagdong Project will be built, owned and operated by CE Luzon Geothermal Power Company, Inc. ("CE Luzon"), a Philippine corporation that is currently expected to be indirectly owned as follows: 45% by the Company, 45% by Kiewit and up to 10% by another industrial company. It will sell 100% of its capacity on a take-or-pay basis (as described above for the Upper Mahiao Project) to PNOC-EDC, which will in turn sell the power to NAPOCOR for distribution to the island of Luzon. The Company estimates that Mahanagdong will have a total project cost of approximately $310 million, including interest during construction, project contingency costs and a debt service reserve fund. The proposed capital structure is 75% debt, with a construction and term loan of approximately $225 million and 25% equity, or approximately $85 million in equity contributions. The Company believes that political risk insurance from ExIm Bank for financing of the procurement of U.S. goods and services is available and, if appropriate, will request similar coverage from the Export-Import Bank of Japan for Japanese goods and services. The Company is in the process of arranging construction financing for the Mahanagdong Project from a consortium of international banks. Construction of the Mahanagdong Project is expected to commence in mid-year 1994, with commercial operation presently scheduled for mid-year 1997. The Company's equity investment for the Mahanagdong Project is expected to be about $40 million, and the Company expects to arrange for political risk insurance on this equity investment through OPIC or from governmental agencies or commercial sources. The Mahanagdong Project will be constructed by a consortium of Kiewit Construction Group, Inc. ("KCG") and The Ben Holt Co. ("BHCO") (the "EPC Consortium"), pursuant to fixed-price, date- certain, turnkey supply and construction contracts (collectively the "Mahanagdong EPC Contract"). The obligations of the EPC Consortium under the Mahanagdong EPC Contract will be supported by letters of credit, bonds, guarantees or other acceptable security in an aggregate amount equal to approximately 30% of the Mahanagdong EPC Contract's price, plus a joint and several guaranty of each of the EPC Consortium members. KCG, a wholly-owned subsidiary of Kiewit, will be the lead member of the EPC Consortium, with an 80% interest. KCG performs construction services for a wide range of public and private customers in the U.S. and internationally. Construction projects undertaken by KCG during 1992 included: transportation projects, including highways, bridges, airports and railroads; power facilities; buildings and sewer and waste disposal systems; with the balance consisting of water supply systems, utility facilities, dams and reservoirs. KCG accounted for 80% of Kiewit's revenues, contributing $1.7 billion in revenues in 1993. KCG has an extensive background in power plant construction. BHCO will provide design and engineering services for the EPC Consortium, holding a 20% interest. BHCO, wholly-owned by the Company, is a California based engineering firm with over 25 years of geothermal experience, specializing in feasibility studies, process design, detailed engineering, procurement, construction and operation of geothermal power plants, gathering systems and related facilities. The Company will provide a guaranty of BHCO's obligations under the Mahanagdong EPC Contract. The terms of the Energy Conversion Agreement (the "Mahanagdong ECA"), executed on September 18, 1993, are substantially similar to those in the Upper Mahiao ECA. The Mahanagdong ECA provides for a three-year construction period, and its effectivity deadline date is in July 1994. All of PNOC-EDC's obligations under the Mahanagdong ECA will be guaranteed by the Republic of the Philippines through a performance undertaking. The Capacity Fees are expected to be approximately 97% of total revenues at the expected capacity levels and the Energy Fees are expected to be approximately 3% of such total revenues. Casecnan. The Company has been granted exclusive rights to negotiate an energy sales contract with NAPOCOR and a water sales contract with the National Philippine Irrigation Administration in connection with a proposed 60 MW hydro-electric generating facility to be located in the Casecnan area on the island of Luzon. These contracts will be structured as take-or-pay capacity and energy agreements, with capacity payments representing the bulk of the revenues. Negotiations have only recently commenced on this potential project, and there can be no assurance at this time that any agreement will be reached by the parties. Indonesia The Republic of Indonesia is experiencing demand for electrical power that exceeds current supply, and has a number of promising geothermal reservoirs. Recent Indonesian legislation has facilitated foreign ownership and operation of private electrical power generation and transmission facilities. The Company's subsidiaries are currently negotiating several potential project agreements for geothermal power facilities in Indonesia. The following is a summary description of certain information concerning these projects as it is currently known to the Company. Since those projects are still in development, however, there can be no assurance that this information will not change materially over time. In addition, there can be no assurance that development efforts on any particular project, or the Company's efforts generally, will be successful. Dieng. Through memoranda of understanding executed by Perusahaan Pertambangan Minyak Dan Gas Bumi Negara ("Pertamina"), the Indonesian national oil company, and assigned to the Company, the Company has been awarded the exclusive right to develop geothermal resources in the Dieng region of central Java, Indonesia (the "Dieng Project"). A subsidiary of the Company has entered into a Joint Development Agreement with P.T. Himpurna Enersindo Abadi ("P.T. HEA"), its Indonesian partner, which is a subsidiary of Himpurna, an association of Indonesian military veterans, whereby the Company and P.T. HEA have agreed to work together on an exclusive basis to develop the Dieng Project (the "Dieng JV"). The Dieng JV is expected to be structured such that subsidiaries of the Company will have a 45% interest, subsidiaries of Kiewit will have the option to take a 45% interest and P.T. HEA will have a 10% interest in the Dieng Project. The Dieng JV expects to conduct geothermal exploration and development in the Dieng field, to build, own and operate power generating facilities and to sell the power generated to Perusahaan Umum Listrik Negara ("PLN"), the Indonesian national electric utility. The Dieng JV and Pertamina are currently negotiating a proposed Joint Operation Contract (the "Dieng JOC") pursuant to which Pertamina would contribute the geothermal field and the wells and other facilities presently located thereon and the Dieng JV initially would build, own and operate four power production units comprising an aggregate of 220 MW. The Dieng JV will accept the field operation responsibility for developing and supplying the geothermal steam and fluids required to operate the plants. The current proposed Dieng JOC would expire (subject to extension by mutual agreement) on the date which is the later of (i) 42 years following completion of well testing and (ii) 30 years following the date of commencement of commercial operation of the final unit completed. Upon the expiration of the proposed Dieng JOC, all facilities would be transferred to Pertamina at no cost. Under the proposed Dieng JOC, the Dieng JV would be required to pay Pertamina a production allowance equal to three percent of the Dieng JV's net operating income from the Dieng Project, plus a further percentage based upon the negotiated value of existing Pertamina geothermal production facilities that the Company expects will be contributed by Pertamina. The Dieng JV and Pertamina are currently negotiating a proposed "take-or-pay" Energy Sales Contract (the "Dieng ESC") with PLN whereby PLN would agree to purchase and pay for all electricity delivered or capacity made available from the Dieng Project for a term equal to that of the Dieng JOC. Under the current draft, the price paid for electricity would equal a base energy price per kWh multiplied by the number of kWh the plants deliver or are "capable of delivering," whichever is greater. Electricity revenue payments would also be adjusted for inflation and fluctuations in exchange rates. Assuming execution of the Dieng JOC and the Dieng ESC, the Company presently intends to begin well testing by the second quarter of 1994 and to commence construction of an initial 55 MW unit in the fourth quarter of 1994, and then to proceed on a modular basis with construction of three additional units to follow shortly thereafter, resulting in an aggregate first phase at this site of 220 MW. The Company estimates that the total project cost of these units will be approximately $450 million. The Company anticipates that the Dieng Project will be designed and constructed by a consortium consisting of KCG and BHCO, and that the Company (through a subsidiary) will be responsible for operating and managing the Dieng Project. The Dieng field has been explored domestically for over 20 years and BHCO has been active in the area for more than five years. The Company has a significant amount of data, which it believes to be reliable as to the production capacity of the field. However, a number of significant steps, both financial and operational, must be completed before the Dieng Project can proceed. These steps, none of which can be assured, include obtaining required regulatory permits and approvals, entering into the Dieng JOC, undertaking and completing the well testing contemplated by the Dieng JOC, entering into the Dieng ESC, the construction agreement and other project contracts, and arranging financing. Patuha. The Company has also negotiated a memorandum of understanding and expects to execute a definitive agreement with Pertamina for the exclusive geothermal development rights with respect to the Patuha geothermal field in Java, Indonesia (the "Patuha Project"). The Company has entered into an agreement to establish a joint venture for Patuha with P.T. Enerindo Supra Abadi, an Indonesian company ("P.T. ESA") (the "Patuha JV"). P.T. ESA is an affiliate of the Bukaka Group, which has extensive experience in general construction, fabrication and electrical transmission construction in Indonesia. In exchange for project development services, P.T. ESA is expected to receive a 10% equity interest in the Patuha Project with an option to acquire an additional 20% interest for cash upon the satisfaction of certain conditions. Subject to the exercise of that option, subsidiaries of the Company will have a 45% interest and subsidiaries of Kiewit will have the option to take a 45% interest in the Patuha Project. The Patuha JV is currently negotiating both a Joint Operation Contract ("JOC") and an Energy Sales Contract ("ESC"), each of which currently contains terms substantially similar to those described above for the Dieng Project. The Patuha JV presently intends to proceed on a modular basis like the Dieng Project, with an initial 55 MW unit to be built followed by three additional units, in total aggregating 220 MW. The Company estimates that the total cost of these four units will be approximately $450 million. Assuming execution of both a JOC and an ESC, field development is expected to commence in the first quarter of 1995 with construction of the first unit expected to begin by mid-year 1996. The Patuha Project remains subject to a number of significant uncertainties, as described above in connection with the Dieng Project, and there can be no assurance that the Patuha Project will proceed or reach commercial operation. Lampung/South Sumatra. The Company and P.T. ESA have also formed a joint venture (the "Lampung JV") to pursue development of geothermal resources in the Lampung/South Sumatra regions (the "Lampung Project"). The Lampung JV is presently exploring several geothermal fields in this region and is negotiating a memorandum of understanding for a JOC and ESC for these prospects containing terms substantially similar to those described above for the Dieng Project. The Company presently intends to develop the Lampung Project and other possible Indonesia projects using a structure similar to that contemplated for the Dieng Project, with the same construction consortium, similar equipment and similar financing arrangements. The Lampung Project remains subject to a number of significant uncertainties, as described above for the Dieng Project, and there can be no assurance that the Company will pursue the Lampung Project or that it will proceed or reach commercial operation. REGULATORY AND ENVIRONMENTAL MATTERS Environmental Regulation The Company's projects are subject to environmental laws and regulations at the federal, state and local levels in connection with the development, ownership and operation of the projects. These environmental laws and regulations generally require that a wide variety of permits and other approvals be obtained for the construction and operation of an energy-producing facility and that the facility then operate in compliance with such permits and approvals. Failure to operate the facility in compliance with applicable laws, permits and approvals can result in the levy of fines or curtailment of operations by regulatory agencies. Management of the Coso Joint Ventures believe that the Coso Joint Ventures are in compliance in all material respects with all applicable environmental regulatory requirements and that maintaining compliance with current governmental requirements will not require a material increase in capital expenditures or materially affect its financial condition or results of operations. Likewise, management of the Company believes that the Company's other projects are in compliance with all applicable environmental regulatory requirements. It is possible, however, that future developments, such as more stringent requirements of environmental laws and enforcement policies thereunder, could affect the costs of and the manner in which the Coso Joint Ventures or the Company's other projects conduct their businesses. Federal Energy Regulations The principal federal regulatory legislation relating to the Company's geothermal energy activities is PURPA. PURPA and associated state legislation have conferred certain benefits on the independent power production industry. In particular, PURPA exempts certain electricity producers ("Qualifying Facilities") from federal and state regulation as a public utility. PURPA also requires utilities, such as SCE, to purchase electricity from qualifying facilities at the particular utility's avoided cost. Each of the Coso Projects meets the requirements promulgated under PURPA to be Qualifying Facilities. Qualifying Facility status under PURPA provides two primary benefits. First, regulations under PURPA exempt qualifying facilities from the Public Utility Holding Company Act of 1935 ("PUHCA"), most provisions of the Federal Power Act (the "FPA") and state laws concerning rates of electric utilities, and financial and organizational regulations of electric utilities. Second, FERC's regulations promulgated under PURPA require that (1) electric utilities purchase electricity generated by Qualifying Facilities, the construction of which commenced on or after November 9, 1978, at a price based on the purchasing utility's full avoided cost; (2) the electric utility sell back-up, interruptable, maintenance and supplemental power to the Qualifying Facility on a non- discriminatory basis; and (3) the electric utility interconnect with the Qualifying Facility in its service territory. The Projects remain subject, among other things, to FERC approvals and permits for power development, and to federal, state and local laws and regulations regarding environmental compliance, leasing, siting, licensing, construction, and operational and other matters relating to the exploration, development and operation of its geothermal properties. In 1992, Congress enacted comprehensive new energy policy legislation in its passage of the Energy Policy Act. This new law is designed to, among other things, foster competition in energy production and provide independent power producers with competitive access to the transmission grid. To achieve these goals, the Energy Policy Act amended PUHCA to create a new class of generating facility called Exempt Wholesale Generators ("EWGs"). EWGs are generally exempt from public utility regulation under PUHCA. The Energy Policy Act also provides new authority to FERC to mandate that owners of transmission lines provide wheeling access at just and reasonable rates. Previously limited, wheeling rights enhance the ability of independent power producers to negotiate transmission access and encourages development of facilities whose most feasible siting lies outside the purchasing utility's service area or which, like many geothermal sites, are remotely located. Permits and Approvals The Company has obtained certain permits, approvals and certificates necessary for the current exploration, development and operation of its Projects. Similar permits, approvals and certificates will be required for any future expansion of the Coso Project and for any development of the Company's other geothermal properties or for other power project development by the Company. Such compliance is costly and time consuming, and may in certain instances be dependent upon factors beyond the Company's control. The Company believes that its operating power facilities are currently in material compliance with all applicable federal, state and local laws and regulations. No assurance can be given, however, that in the future all necessary permits, approvals, variances and certificates will be obtained and all applicable statutes and regulations will be complied with, nor can assurance be given that additional and more stringent laws, taxes or regulations will not be established in the future which may restrict the Company's current operations or delay the development of new geothermal properties, or which may otherwise have an adverse impact on the Company. INSURANCE The Coso Projects are insured for $600.0 million per occurrence for general property damage and $600.0 million per occurrence for business interruption, subject to a $25,000 deductible for property damage ($500,000 for turbine generator and machinery) and a 15-day deductible for business interruption. Catastrophic insurance (earthquake and flood) for the Coso Project is capped at $200.0 million per occurrence for property damage and $200.0 million per occurrence for business interruption. Liability insurance coverage is $51.0 million (occurrence based) with a $10,000 deductible. Operators' extra expense (control of well) insurance for the Coso Project is $10.0 million per occurrence with a $25,000 deductible which is non-auditable. The policies are issued by international and domestic syndicates with each company rated A- or better by A.M. Best Co., Inc. There can be no assurance, however, that earthquake, property damage, business interruption or other insurance will be adequate to cover all potential losses sustained by the Company or that such insurance will continue to be available on commercially reasonable terms. EMPLOYEES As of December 31, 1993, the Company employed approximately 249 people, of which approximately 160 people were employed at the Navy I, Navy II and BLM Projects, collectively. The Coso Joint Ventures do not hire or retain any employees. All employees necessary to the operation of the Coso Project are provided by the Company under certain plant and field operations and maintenance agreements. Item 2. Item 2. Properties As described under "Business", the Company's most significant physical properties are its four operating power facilities and its related real property interests. The Company also maintains an inventory of more than 400,000 acres of geothermal property leases and owns a 70% interest in a geothermal steam field. An affiliate of the Company owns the approximately 42 acre site in Yuma, Arizona where the 50 MW gas fired cogeneration facility is being constructed. The Company owns a one-story office building in Omaha, Nebraska, which houses its principal executive offices. The Company also leases office space in Ridgecrest, California, which houses the operating offices for the Coso Project and in Singapore and Manila, which house offices for the Company's international activities in the region. Item 3. Item 3. Legal Proceedings The Company is not a party to any material legal proceedings. 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's Matters The Company's Common Stock is listed on the New York Stock Exchange, the Pacific Stock Exchange and the London Stock Exchange using the symbol CE. Prior to listing on the New York Stock Exchange on August 12, 1993, the Company's Common Stock was listed on the American Stock Exchange. The following table sets forth, for the calendar periods indicated, the high and low closing sales prices of the Company's Common Stock as reported by the American Stock Exchange for the periods through August 11, 1993 and the New York Stock Exchange thereafter. All prices have been adjusted to reflect the Company's stock dividends during those calendar periods. Period High Low First Quarter $16.25 $11.63 Second Quarter 13.25 11.50 Third Quarter 13.00 11.38 Fourth Quarter 17.38 11.88 Period High Low First Quarter 21.50 16.50 Second Quarter 20.00 17.25 Third Quarter 18.38 16.00 Fourth Quarter 20.13 18.13 As of March 21, 1994, there were 1,408 stockholders of record of the Company's Common Stock. The present policy of the Board is to retain earnings to provide sufficient funds for the operation and expansion of the Company's business. Accordingly, the Company has not paid, and does not have any present plan to pay, cash dividends on its Common Stock. In January of 1990 and January of 1991, the Company paid a 4% stock dividend to the holders of its Common Stock. The Company did not pay such a dividend in 1992 or 1993, and has no plans to pay any such dividend in the future. Prior to March 24, 1994, the agreements relating to the Senior Notes issued by the Company prohibit the payment of dividends unless the Company has a net worth of at least $50 million, after giving effect to the payment of such dividends, and dividends do not exceed 50% of the Company's net income accumulated after December 31, 1987. Pursuant to a Defeasance Agreement dated March 23, 1994 such restrictions were released by the holder of the Senior Notes. The Certificate of Designation with respect to the Company's Series C Redeemable Convertible Exchangeable Preferred Stock (the "Series C Preferred Stock") prohibits cash dividend payments with respect to the Common Stock unless all accumulated dividends on the Series C Preferred Stock have been paid. The Indenture for the Senior Discount Notes issued by the Company on March 24, 1994 prohibit the payment of dividends unless certain financial covenants are satisfied. Reference is made to the indenture relating to the Senior Discount Notes for a detailed description of these restrictions. In June of 1993, the Company issued $100,000,000 of 5% convertible subordinated debentures ("Debentures") due July 31, 2000. The Debentures are convertible into shares of the Company's Common Stock at any time prior to redemption or maturity at a conversion price of $22.50 per share, subject to adjustment in certain circumstances. Interest on the Debentures is payable semi- annually in arrears on July 31 and January 31 of each year, commencing on July 31, 1993. The debentures are redeemable for cash at any time on or after July 31, 1996 at the option of the Company. The redemption prices (expressed in percentages of the principal amount) based on twelve month periods beginning July 31, 1996 are 102%, 101%, 100% and 100% for 1996, 1997, 1998 and 1999, respectively. The Debentures are unsecured general obligations of the Company and subordinated to all existing and future senior indebtedness of the Company. In December of 1993, the Company registered 4,444,444 shares of the Company's Common Stock in the event a holder elected to exercise the conversion rights under the Debentures. Item 6. Item 6. Selected Financial Data There is hereby incorporated by reference the information which appears under the caption "Selected Financial Data" in the Annual Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation There is hereby incorporated by reference the information which appears under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operation" in the Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data There is hereby incorporated by reference the information which appears in the Consolidated Financial Statements and notes thereto in the Annual Report. Since the preparation of the Consolidated Financial Statements, the Company closed on the Senior Discount Notes described in the Consolidated Financial Statements at footnote 16, "Subsequent Event." On March 24, 1994 the Company received the proceeds of about $390 million from the closing on its Senior Discount Note offering. The Senior Discount Notes bear interest at the rate of 10.25% per annum, with cash interest payment commencing in 1997 and accrete to an aggregate principal amount of $529 million at maturity. The notes are unsecured obligations of the Company. The Company intends to use the proceeds from the offering to: (i) fund equity commitments in, and the construction costs of, geothermal power project presently planned in the Philippines and Indonesia, (ii) to fund equity investments in, and loan to, other potential international and domestic private power projects and related facilities, (iii) for corporate or project acquisitions permitted under the indenture, and (iv) for general corporate purposes. 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 There is hereby incorporated by reference the information which appears under the caption "Information Regarding Nominees for Election as Directors and Directors Continuing in Office" in the Proxy Statement. Set forth below are the current executive officers of the Company and their positions with the Company: Executive Officer Position Richard R. Jaros Chairman of the Board of Directors David L. Sokol President and Chief Executive Officer Gregory E. Abel Assistant Vice President and Controller Edward F. Bazemore Vice President, Human Resources David W. Cox Vice President, Legislative and Regulatory Affairs Philip H. Essner Vice President, Land Management and Insurance Vincent R. Fesmire Vice President, Development and Implementation Thomas R. Mason Senior Vice President, Engineering, Construction and Operations Steven A. McArthur Senior Vice President, General Counsel and Secretary Donald M. O'Shei, Sr. Vice President, Marketing; President, CE International, Ltd. John G. Sylvia Vice President, Chief Financial Officer and Treasurer Set forth below is certain information with respect to each executive officer of the Company other than Messrs. Jaros and Sokol (for whom information is incorporated by reference from the Proxy Statement): GREGORY E. ABEL, 31, Assistant Vice President and Controller. Mr. Abel joined the Company in 1992. Mr. Abel is a Chartered Accountant and from 1984 to 1992 he was employed by Price Waterhouse. As a Manager in the San Francisco office of Price Waterhouse, he was responsible for clients in the energy industry. EDWARD F. BAZEMORE, 57, Vice President, Human Resources. Mr. Bazemore joined the Company in July 1991. From 1989 to 1991, he was Vice President, Human Resources, at Ogden Projects, Inc. in New Jersey. Prior to that, Mr. Bazemore was Director of Human Resources for Ricoh Corporation, also in New Jersey. Previously, he was Director of Industrial Relations for Scripto, Inc. in Atlanta, Georgia. DAVID W. COX, 38, Vice President, Legislative and Regulatory Affairs. Mr. Cox joined the Company in 1990. From 1987 to 1990, Mr. Cox was Vice President with Bank of America N.T. & S.A. in the Consumer Technology and Finance Group. From 1984 to 1987, Mr. Cox held a variety of management positions at First Interstate Bank. PHILIP H. ESSNER, 51, Vice President, Land Management and Insurance. Mr. Essner administers the Company's geothermal lease acquisition and land position programs, and obtains permits from regulatory agencies. Mr. Essner also manages the Company's insurance programs. He has been a Vice President of the Company since 1983. VINCENT R. FESMIRE, 53, Vice President, Development and Implementation. Mr. Fesmire joined the Company in October 1993. Prior to joining the Company, Mr. Fesmire was employed for 19 years with Stone & Webster, an engineering firm, serving in various management level capacities with an expertise in geothermal design engineering. THOMAS R. MASON, 50, Senior Vice President, Engineering, Construction and Operations. Mr. Mason joined the Company in March 1991. From October 1989 to March 1991, Mr. Mason was Vice President and General Manager of Kiewit Energy Company. Mr. Mason acted as a consultant in the energy field from June 1988 to October 1989. Prior to that, Mr. Mason was Director of Marketing for Energy Factors, Inc., a non-utility developer of power facilities. STEVEN A. McARTHUR, 36, Senior Vice President, General Counsel and Secretary. Mr. McArthur joined the Company in February 1991. From 1988 to 1991 he was an attorney in the Corporate Finance Group at Shearman & Sterling in San Francisco. From 1984 to 1988 he was an attorney in the Corporate Finance Group at Winthrop, Stimson, Putnam & Roberts in New York. DONALD M. O'SHEI, SR., 60, Vice President; President, CE International, Ltd. General O'Shei was in charge of engineering and operations for the Company from October 1988 until October 1991. He rejoined the Company as a Vice President in August, 1992. Previously he was President and Chief Executive Officer of AWD Technologies, Inc., a hazardous waste remediation firm, and President and General Manager of its predecessor company, Atkinson- Woodward Clyde. He was a brigadier general in the U.S. Army prior to joining the Guy F. Atkinson Co. in 1982 as Director of Corporate Planning and Development. JOHN G. SYLVIA, 35, Vice President, Chief Financial Officer and Treasurer. Mr. Sylvia joined the Company in 1988. From 1985 to 1988, Mr. Sylvia was a Vice President in the San Francisco office of the Royal Bank of Canada, with responsibility for corporate and capital markets banking. From 1986 to 1990, Mr. Sylvia served as an Adjunct Professor of Applied Economics at the University of San Francisco. From 1982 to 1985, Mr. Sylvia was a Vice President with Bank of America. Item 11. Item 11. Executive Compensation There is hereby incorporated by reference the information which appears under the caption "Executive Officer and Director Compensation" in the Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management There is hereby incorporated by reference the information which appears under the caption "Security Ownership of Significant Stockholders and Management" in the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions There is hereby incorporated by reference the information which appears under the caption "Certain Transactions and Relationships" in the Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements and Schedules (i) Financial Statements Filed herewith are the consolidated balance sheet of California Energy Company, Inc. and subsidiaries as of December 31, 1993, and December 31, 1992, and the consolidated statements of operations, cash flows and stockholder's equity for the years ended December 31, 1993, 1992 and 1991, and the related reports of independent auditors. (ii) Financial Statement Schedules Schedule No. Name of Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties III Financial Statements of the Company (Parent Company only) V Consolidated Property, Plant and Equipment VI Consolidated Accumulated Depreciation and Amortization of Property, Plant and Equipment IX Short-Term Borrowings X Consolidated Supplementary Income Statement Information The other financial statement schedules are either not required for the Company or are included at the notes to the financial statements. (b) Reports on Form 8-K The Company filed a Report on Form 8-K on October 1, 1993 reporting the signing of Energy Conversion Agreement with the Philippine National Oil Company - Energy Development Corporation for two separate Philippines geothermal power projects totaling 300 MW under Item 5. thereof, "Other Events". The Company filed a Report on Form 8-K on November 2, 1993 reporting the Company agreed to acquire 100% of the stock of Westmoreland Energy, Inc. from Westmoreland Coal Company. The Company filed a Report on Form 8-K on December 1, 1993 reporting that it terminated the proposed acquisition of Westmoreland Energy, Inc. stock. (c) Exhibits The exhibits listed on the accompanying Exhibit Index (except in the case of Exhibit 13.0, in which case only the portion of the Annual Report which constitutes the Company's Consolidated Financial Statements and notes thereto) are filed as part of this Annual 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 the Company's currently effective Registration Statements on Form S-8: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant, 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 of 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, in the City of Omaha, State of Nebraska, on this 30th day of March, 1994. CALIFORNIA ENERGY COMPANY, INC. By David L. Sokol President and Chief Executive Officer By: /s/ Steven A. McArthur Steven A. McArthur Attorney-in-Fact Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Date /s/ David L. Sokol* March 30, 1994 David L. Sokol President and Chief Executive Officer, Director /s/ John G. Sylvia March 30, 1994 John G. Sylvia Vice President, Chief Financial Officer, Chief Accounting Officer and Treasurer *By: /s/ Steven A. McArthur March 30, 1994 Steven A. McArthur Attorney-in-Fact /s/ Edgar D. Aronson * March 30, 1994 Edgar D. Aronson Director /s/ Judith E. Ayres * March 30, 1994 Judith E. Ayres Director /s/ Harvey F. Brush* March 30, 1994 Harvey F. Brush Director /s/ James Q. Crowe* March 30, 1994 James Q. Crowe Director /s/ Richard K. Davidson* March 30, 1994 Richard K. Davidson Director /s/ Richard R. Jaros* March 30, 1994 Richard R. Jaros Chairman of the Board of Directors /s/ Ben Holt* March 30, 1994 Ben Holt Director /s/ Everett B. Laybourne* March 30, 1994 Everett B. Laybourne Director /s/ Daniel J. Murphy* March 30, 1994 Daniel J. Murphy Director /s/ Herbert L. Oakes, Jr.* March 30, 1994 Herbert L. Oakes, Jr. Director /s/ Walter Scott, Jr.* March 30, 1994 Walter Scott, Jr. Director /s/ Barton W. Shackelford* March 30, 1994 Barton W. Shackelford Director /s/ David E. Wit* March 30, 1994 David E. Wit Director *By: /s/ Steven A. McArthur March 30, 1994 Steven A. McArthur Attorney-in-Fact California Energy Company, Inc. Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties as of December 31, 1993, 1992, 1991 (dollars in thousands) Balance at Beginning of Period Additions Collected Current Noncurrent Year ended December 31, 1993 $--- $--- $--- $--- $--- Year ended December 31, 1992 --- --- --- --- --- Year ended December 31, 1991 100 --- 100 --- --- Robert D. Tibbs* *Relocation Loan, repaid January 2, 1991 California Energy Company, Inc. Schedule III Parent Company Only Balance Sheets as of December 31, 1993 and 1992 (dollars and shares in thousands, except per share amounts) ASSETS 1993 1992 Cash and investments $126,824 $ 53,321 Restricted cash 13,535 634 Development projects in progress 44,272 21,428 Investment in and advances to subsidiaries and joint ventures 215,660 168,949 Equipment, net of accumulated depreciation 2,587 1,575 Notes receivable - joint ventures 21,558 19,098 Deferred charges and other assets 16,458 17,214 Total assets $440,894 $282,219 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Accounts payable $ 86 $ 937 Other accrued liabilities 10,550 5,061 Income taxes payable 4,000 --- Senior notes 35,730 35,730 Convertible subordinated debenture 100,000 --- Deferred income taxes 18,310 15,212 Total liabilities 168,676 56,940 Deferred income relating to joint ventures 1,915 2,165 Redeemable preferred stock 58,800 54,350 Stockholders' equity: Preferred stock - authorized 2,000 shares no par value --- --- Common stock - authorized 60,000 shares par value $0.0675 per share; issued and outstanding 35,446 and 35,258 shares 2,404 2,380 Additional paid-in capital 100,965 97,977 Retained earnings 111,031 68,407 Treasury stock, 157 common shares at cost (2,897) --- Total stockholders' equity 211,503 168,764 Total liabilities and stockholders' equity $440,894 $282,219 The accompanying notes are an integral part of these financial statements. California Energy Company, Inc. Schedule III Parent Company Only (continued) Statement of Operations for the three years ended December 31, 1993 (dollars in thousands) Revenues: 1993 1992 1991 Equity in earnings of subsidiary companies and joint ventures before extraordinary items $61,412 $53,685 $38,364 Interest and other income 8,756 4,557 4,923 Total revenues 70,168 58,242 43,287 Expenses: General and administration 6,564 6,796 5,585 Interest, net of capitalized interest 2,346 714 2,836 Total expenses 8,910 7,510 8,421 Income before provision for income taxes 61,258 50,732 34,866 Provision for income taxes 18,184 11,922 8,284 Income before change in accounting principle and extraordinary item 43,074 38,810 26,582 Cumulative effect of change in account principle 4,100 --- --- Equity in extraordinary item of joint ventures (Less applicable income taxes of $1,533) --- (4,991) --- Net income 47,174 33,819 26,582 Preferred dividends 4,630 4,275 --- Net income available to common stockholders $42,544 $29,544 $26,582 The accompanying notes are an integral part of these financial statement. California Energy Company, Inc. Schedule III Parent Company Only (continued) Condensed Statement of Cash Flows for the three years ended December 31, 1993 (dollars in thousands) 1993 1992 1991 Cash flows from operating activities $45,671 $22,597 $ 631 Cash flows from investing activities: Increase in development projects in progress (22,844) (4,218) (3,458) Decrease (increase) in advances to and investments in subsidiaries and joint ventures (36,812) 12,155 (41,162) Other (9,945) (15,711) 251 Cash flows from investing activities (69,601) (7,774) (44,369) Cash flows from financing activities: Proceeds from sale of common, treasury and preferred stocks, and exercise of warrants and stock options 2,912 8,065 111,458 Payment in senior notes --- --- (6,000) Purchase of treasury stock (2,897) (4,887) --- Net change in short-term bank loan --- --- (15,000) Proceeds from issue of convertible subordinated debentures 100,000 --- --- Purchase of warrants --- (11,716) --- Deferred charges relating to debt financing (2,582) --- --- Cash flows from financing activities 97,433 (8,538) 90,458 Net increase in cash and investments 73,503 6,285 46,720 Cash and investments at beginning of period 53,321 47,036 316 Cash and investment at end of period $126,824 $53,321 $47,036 Interest paid (net of amount capitalized) $ (897) $ 464 $ 3,342 Income taxes paid $ 6,819 $ 4,129 $ 1,682 The accompanying notes are an integral part of these financial statement. California Energy Company, Inc. Schedule III Parent Company Only (continued) Supplemental Notes to Financial Statement (dollars in thousands) Related Party Transactions The Company bills the Coso Project partnerships and joint ventures for management, professional and operational services. Billings for the years ended December 31, 1993, 1992 and 1991 were $18,285, $19,629 and $18,316, respectively. Dividends received from subsidiaries for the years ended December 31, 1993, 1992 and 1991 were $49,053, $33,524 and 18,935, respectively. Reclassification Certain amounts in the fiscal 1992 and 1991 financial statements have been reclassified to conform to the fiscal 1993 presentation. Such reclassifications do not impact previously reported net income or retained earnings. California Energy Company, Inc. Schedule V Consolidated Property, Plant and Equipment as of December 31, 1993, 1992, and 1991 (dollars in thousands) California Energy Company, Inc. SCHEDULE VI Consolidated Accumulated Depreciation and Amortization of Property, Plant and Equipment as of December 31, 1993, 1992, and 1991 (dollars in thousands) California Energy Company, Inc. SCHEDULE IX Short-Term Borrowings as of December 31, 1993, 1992, and 1991 (dollars in thousands) The short-term borrowing payable to a bank was under a $15,000 multi-year Credit Agreement. The average amount outstanding during the period was computed based on month-end balances. The weighted average interest rate during the period was the effective rate incurred. California Energy Company, Inc. Schedule X Consolidated Supplementary Income Statement Information for the three years ended December 31, 1993 (dollars in thousands) Exhibit Index 3.1 The Company's Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 of the Company's Form 10-K for the year ended December 31, 1992, File No. 1- 9874 (the "1992 Form 10-K")) 3.2 Certificate of Amendment of the Company's Restated Certificate of Incorporation, dated June 23, 1993 (incorporated by reference to the Company's Form 8-A, dated July 28, 1993, File No. 1-9874 (the "Form 8-A")) 3.3 The Company's Certificate of Designation with respect to the Company's Series C Redeemable Convertible Exchangeable Preferred Stock, dated November 20, 1991 (incorporated by reference to Exhibit 3.1 of the Company's 1992 Form 10-K) 3.4 The Company's By-Laws as amended through September 24, 1993. 4.1 Specimen copy of form of Common Stock Certificate. 4.2 Shareholders Rights Agreement between the Company and Manufacturers Hanover Trust Company of California dated December 1, 1988 (incorporated by reference to Exhibit 1 to Company's Form 8-K dated December 5, 1988, File No. 1-9874). 4.3 Amendment Number 1 to Shareholder Rights Agreement, dated February 15, 1991 (incorporated by reference to Exhibit 4.2 to the Company's 1992 Form 10-K). 4.4 Note Purchase Agreement between the Company and Principal Mutual Life Insurance Company dated March 15, 1988 (incorporated by reference to Exhibit 1 to Company's Form 8-K dated April 11, 1988). 4.5 Defeasance Agreement between Principal Mutual Life Insurance Company and the Company dated March 3, 1994. 4.6 Consent and Agreement between Principal Mutual Life Insurance Company and the Company dated March 24, 1994. 4.7 Escrow Deposit Agreement between Bank of America National Trust and Savings Association and the Company dated March 3, 1994. 10.1 Joint Venture Agreement for China Lake Joint Venture between the Company and Caithness Geothermal 1980 Ltd., restated as of January 1, 1984 (incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1, 33-7770). 10.2 Amended Joint Venture Agreement for Coso Land Company between the Company and Caithness Geothermal 1980 Ltd., dated as of June 1, 1983 (incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1, 33-7770). 10.3 Amended General Partnership Agreement for Coso Finance Partners between China Lake Operating Company and ESCA I L.P. dated July 13, 1988 (incorporated by reference to Exhibit 10.3 to the Company's 1992 Form 10-K). 10.4 First Supplemental Amendment to the Amended and Restated General Partnership Agreement for Coso Finance Partners between China Lake Operating Company and ESCA L.P. (Undated) (incorporated by reference to Exhibit 10.4 to the Company's 1992 Form 10-K). 10.5 Second Supplemental Amendment to the Amended and Restated General Partnership Agreement for Coso Finance Partners between China Lake Operating Company and ESCA L.P. dated as of July 13, 1988 (incorporated by reference to Exhibit 10.5 to the Company's 1992 Form 10-K). 10.6 Third Supplemental Amendment to the Amended and Restated General Partnership Agreement for Coso Finance Partners between China Lake Operating Company and ESCA L.P. dated as of December 16, 1992 (incorporated by reference to Exhibit 10.6 to the Company's 1992 Form 10-K). 10.7 General Partnership Agreement for Coso Finance Partners II between China Lake Geothermal Management Company and ESCA II L.P. dated July 7, 1987 (incorporated by reference to Exhibit 10.7 to the Company's 1992 Form 10-K). 10.8 Restated General Partnership Agreement for Coso Energy Developers between Coso Hotsprings Intermountain Power Inc. and Caithness Coso Holdings L.P. dated as of March 31, 1988 (incorporated by reference to Exhibit 10.8 to the Company's 1992 Form 10-K). 10.9 First Amendment to the Restated General Partnership Agreement for Coso Energy Developers between Coso Hotsprings Intermountain Power, Inc. and Caithness Coso Holdings L.P. dated as of March 31, 1988 (incorporated by reference to Exhibit 10.9 to the Company's 1992 Form 10-K). 10.10 Second Amendment to the Restated General Partnership Agreement for Coso Energy Developers between Coso Hotsprings Intermountain Power, Inc. and Caithness Coso Holdings L.P. dated as of December 16, 1992 (incorporated by reference to Exhibit 10.10 to the Company's 1992 Form 10-K). 10.11 Amended and Restated General Partnership Agreement for Coso Power Developers between Coso Technology Corporation and Caithness Navy II Group L.P. dated July 31, 1989 (incorporated by reference to Exhibit 10.11 to the Company's 1992 Form 10-K). 10.12 First Amendment to the Amended and Restated General Partnership for Coso Power Developers between Coso Technology Corporation and Caithness Navy II Group L.P. dated as of March 19, 1991 (incorporated by reference to Exhibit 10.12 to the Company's 1992 Form 10-K). 10.13 Second Amendment to the Amended and Restated General Partnership Agreement for Coso Power Developers between Coso Technology Corporation and Caithness Navy II Group L.P. dated as of December 16, 1992 (incorporated by reference to Exhibit 10.13 to the Company's 1992 Form 10-K). 10.14 Form of Amended and Restated Field Operation and Maintenance Agreement between Coso Joint Ventures and the Company dated as of December 16, 1992 (incorporated by reference to Exhibit 10.14 to the Company's 1992 Form 10-K). 10.15 Form of Amended and Restated Project Operation and Maintenance Agreement between Coso Joint Venture and the Company dated as of December 16, 1992 (incorporated by reference to Exhibit 10.15 to the Company's 1992 Form 10-K). 10.16 Trust Indenture between Coso Funding Corp. and Bank of America National Trust and Savings Association dated as of December 16, 1992 (incorporated by reference to Exhibit 10.16 to the Company's 1992 Form 10-K). 10.17 Form of Amended and Restated Credit Agreement between Coso Funding Corp. and Coso Joint Ventures dated as of December 16, 1992 (incorporated by reference to Exhibit 10.17 to the Company's 1992 Form 10-K). 10.18 Form of Support Loan Agreement among Coso Joint Ventures dated December 16, 1992 (incorporated by reference to Exhibit 10.18 to the Company's 1992 Form 10-K). 10.19 Form of Project Loan Pledge Agreement between Coso Joint Ventures and Bank of America National Trust and Savings dated as of December 16, 1992 (incorporated by reference to Exhibit 10.19 to the Company's 1992 Form 10-K). 10.20 Power Purchase Contracts between Southern California Edison Company and: (a) China Lake Joint Venture, executed June 4, 1984 with a term of 24 years; (b) China Lake Joint Venture, executed February 1, 1985 with a term of 23 years; and (c) Coso Geothermal Company, executed February 1, 1985 with a term of 30 years (incorporated by reference to Exhibit 10.7 to the Company's Registration Statement on Form S-1, 33-7770). 10.21 Contract No. N62474-79-C-5382 between the United States of America and China Lake Joint Venture, restated October 19, 1983 as "Modification P00004," including modifications through "Modification P00026," dated December 16, 1992 (incorporated by reference to Exhibit 10.21 to the Company's 1992 Form 10-K). 10.22 Lease between the BLM and Coso Land Company, effective November 1, 1985 (with Designation of Geothermal Operator) (incorporated by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1, 33- 7770). 10.23 Stock Purchase Agreement between the Company and Kiewit Energy Company dated as of February 18, 1991, as amended as of June 19, 1991 (incorporated by reference to Exhibit 1 to the Company's Form 8-K dated February 26, 1991). 10.24 Amendment No. 2 to Stock Purchase Agreement between Kiewit Energy Company and the Company dated as of January 8, 1992 (incorporated by reference to Exhibit 10.24 to the Company's 1992 Form 10-K). 10.25 Amendment No. 3 to Stock Purchase Agreement between Kiewit Energy Company and the Company dated as of April 2, 1993. 10.26 Shareholders Agreement between the Company and Kiewit Energy Company dated as of February 18, 1991, as amended as of June 19, 1991 and as of November 20, 1991 (incorporated by reference to Exhibit 1 to the Company's Form 8-K dated February 26, 1991, Exhibit 1 to the Company's Form 8-K dated July 18, 1992, and Exhibit 3 to the Company's Form 8-K dated November 21, 1991). 10.27 Amendment No. 3 to Shareholder's Agreement between the Company and Kiewit Energy Company dated as of April 2, 1993 (incorporated by reference to Exhibit 14 to the Company's Form 8-A). 10.28 Amendment No. 4 to Shareholder's Agreement between the Company and Kiewit Energy Company dated as of July 20, 1993. 10.29 Registration Rights Agreement between the Company and Kiewit Energy Company dated as of February 18 1991, as amended as of June 19, 1991 (incorporated by reference to Exhibit 1 to the Company's Form 8-K dated February 26, 1991, and Exhibit 1 to the Company's Form 8-K dated July 18, 1992). 10.30 Registration Rights Agreement between the Company and Kiewit Energy Company dated June 19, 1991, as amended November 20, 1991 (incorporated by reference to Exhibit 1 of the Company's Form 8-K dated June 19, 1991 and Exhibit 4 to the Company's Form 8-K dated November 21, 1991). 10.31 Stock Option Agreement between the Company and Kiewit Energy Company dated as of February 18, 1991, as amended as of June 19, 1991 (incorporated by reference to Exhibit 1 to the Company's Form 8-K dated February 26, 1991, and Exhibit 1 to the Company's Form 8-K dated July 18, 1992). 10.32 Stock Option Agreement between the Company and Kiewit Energy Company dated as of June 19, 1991 (incorporated by reference to Exhibit 1 to the Company's Form 8-K dated July 18, 1991). 10.33 Securities Purchase Agreement between the Company and Kiewit Energy Company dated as of November 20, 1991 (incorporated by reference to Exhibit 2 to the Company's Form 8-K dated November 21, 1991). 10.34 Sublease between the Company and Kiewit Energy Company dated March 15, 1991 (incorporated by reference to Exhibit 10.32 to the Company's 1992 Form 10-K). 10.35 Amended and Restated 1986 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.33 to the Company's 1992 Form 10-K). 10.36 Form of severance letter between the Company and certain executive officers of the Company (incorporated by reference to Exhibit 10.35 to the Company's 1992 Form 10- K). 10.37 Indenture between the Company and The Chemical Trust Company of California dated as of June 24, 1993 (incorporated by reference to the Company's Form 8-K dated June 24, 1993, File No. 1-9874). 10.38 Registration Rights Agreement among the Company, Lehman Brothers, Inc. and Alex Brown & Sons Incorporated dated June 24, 1993 (incorporated by reference to the Company's Form 8-K dated June 24, 1993, File No. 1-9874). 10.39 Indenture dated March 24, 1994 between the Company and IBJ Schroder Bank and Trust Company (incorporated by reference to Exhibit 3 to the Company's Form 8-K dated March 28, 1994). 10.40 Employment Agreement between the Company and David L. Sokol dated as of April 2, 1993. 10.41 Termination Agreement between the Company and Richard R. Jaros dated as of December 9, 1993. 10.42 Standard Offer Number 2, Standard Offer for Power Purchase with a Firm Capacity Qualifying Facility effective June 15, 1990 ("SO2") between San Diego Gas & Electric Company and Bonneville Pacific Corporation. 10.43 Amendment Number One to the SO2 dated September 25, 1990. 10.44 Joint Venture Agreement among the Company, Kiewit Diversified Group Inc. and Kiewit Construction Group Inc. dated December 14, 1993. 10.45 Joint Venture Agreement between the Company and Distral dated December 14, 1993. 11.0 Calculation of Earnings Per Share in accordance with Interpretive Release No. 34-9083. 13.0 The Company's 1993 Annual Report (only the portions thereof specifically incorporated herein by reference are deemed filed herewith). 21.0 Subsidiaries of Registrant. 23.0 Consents of Independent Accountants. 24.0 Power of Attorney. 27.0 Financial Data Schedule.

813828_1993.txt

813828_1993

1993

813828

ITEM 1. BUSINESS. BACKGROUND Viacom International Inc. (the "Company") is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. Viacom Networks operates three advertiser-supported basic cable television program services, MTV: MUSIC TELEVISION(R), including MTV EUROPE(TM) and MTV LATINO(TM), VH-1(R)/VIDEO HITS ONE(R), and NICKELODEON(R)/NICK AT NITE(R), and three premium subscription television program services, SHOWTIME(R), THE MOVIE CHANNEL(TM) and FLIX(TM). The Company, directly and through Viacom Networks, participates as a joint venturer in four additional advertiser- supported basic cable program services: LIFETIME(R), COMEDY CENTRAL(TM), NICKELODEON (TM) (U.K.), and ALL NEWS CHANNEL(TM). On March 29, 1994, the Company agreed to sell its one-third partnership interest in LIFETIME to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. Viacom Entertainment distributes television series, feature films, made-for-television movies, mini-series and specials for television exhibition in domestic and international markets, produces television series and movies for prime time broadcast network television, acquires and distributes television series for initial exhibition on a "first run" basis, and develops, produces, distributes and markets interactive software for the stand-alone and other multimedia marketplaces. Viacom Cable Television owns and operates cable television systems in California, and the Pacific Northwest and Midwest regions of the United States. Viacom Broadcasting owns and operates five network-affiliated television stations and fourteen radio stations. Viacom International Inc. was originally organized in Delaware in August 1970 as a wholly owned subsidiary of CBS Inc., and was reincorporated in Ohio in 1975 (the "Predecessor Company"). On June 9, 1987, the Predecessor Company became an indirect wholly owned subsidiary of Viacom Inc. in a leveraged buyout pursuant to a merger (the "Merger") of a subsidiary of Viacom Inc. into the Predecessor Company, which was the surviving corporation. On April 26, 1990, pursuant to a plan of liquidation, the Predecessor Company merged into a direct wholly owned subsidiary of Viacom Inc., and the surviving Delaware corporation simultaneously changed its name to "Viacom International Inc." All references herein to the term "Company" refer, unless the context otherwise requires, to Viacom International Inc., its consolidated subsidiaries and the Predecessor Company. The Company's principal offices are located at 1515 Broadway, New York, New York 10036 (telephone (212) 258-6000). Viacom Inc. was organized in Delaware in 1986 for the purpose of acquiring the Company. As of December 31, 1993, National Amusements, Inc. ("NAI"), a closely held corporation that owns and operates approximately 850 movie screens in the United States and the United I - 1 Kingdom, owned 45,547,214 shares or 85.2% of the Class A Common Stock ("Class A Common Stock"), and 46,565,414 shares or 69.1% of the Class B Common Stock ("Class B Common Stock") outstanding on such date. NAI is not subject to the informational filing requirements of the Securities Exchange Act of 1934, as amended. Sumner M. Redstone, the controlling shareholder of NAI, is the Chairman of the Board of Viacom Inc. and the Company. As of December 31, 1993, the principal asset of Viacom Inc. (together with its subsidiaries, unless the context otherwise requires, "Viacom Inc.") was the common stock of the Company. Viacom Inc.'s principal executive offices are located at 200 Elm Street, Dedham, Massachusetts 02026. As of December 31, 1993, the Company and its affiliated companies employed approximately 5,000 persons. On March 11, 1994, pursuant to a tender offer (the "Paramount Offer") commenced in the fourth quarter of 1993, Viacom Inc. acquired 61,657,432 shares of Paramount Communications Inc. ("Paramount") common stock constituting a majority of the shares outstanding. The Paramount Offer was made pursuant to an Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. As a result of the Paramount Merger Agreement, a new wholly owned subsidiary of Viacom Inc. will merge with and into Paramount (the "Paramount Merger"), and Paramount will become a wholly owned subsidiary of Viacom Inc. after the effective time of the Paramount Merger, which is expected to occur in the second quarter of 1994. Except where expressly noted, information is given as of December 31, 1993, and does not include information on or with respect to Paramount or its businesses. Information with respect to Paramount in response to Item 1 is incorporated by reference herein from (i) Item 1 of Paramount's Transition Report on Form 10-K for the six-month period ended April 30, 1993, as such report was amended in its entirety by Form 10-K/A No. 1 dated September 28, 1993, as further amended by Form 10-K/A No. 2 dated September 30, 1993 and as further amended by Form 10-K/A No. 3 dated March 21, 1994 and (ii) Paramount's Quarterly Reports on Form 10-Q for the quarters ended July 31, 1993, October 31, 1993 and January 31, 1994 (the documents in clauses (i) and (ii) being hereinafter collectively referred to as the "Paramount Reports"). Information in the Paramount Reports is given as of the date of each such report and is not updated herein. A copy of each of the Paramount Reports is included as an exhibit hereto. Descriptions of all documents incorporated by reference herein or included as exhibits hereto are qualified in their entirety by reference to the full text of such documents so incorporated or included. The businesses of Paramount are entertainment and publishing. Entertainment includes the production, financing and distribution of motion pictures, television programming and prerecorded videocassettes, and the operation of motion picture theaters, independent television stations, regional theme parks and Madison Square Garden. Publishing includes the publication and distribution of hard cover and paperback books for the general public, textbooks for elementary schools, high schools and colleges, and the provision of information services for business and professions. On January 7, 1994, Viacom Inc. and Blockbuster Entertainment I - 2 Corporation ("Blockbuster") entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger"). Blockbuster is an international entertainment company with businesses operating in the home video, music retailing and filmed entertainment industries. Blockbuster also has investments in other entertainment related businesses. The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. holds sufficient shares of Paramount common stock to approve, on behalf of Paramount, the Paramount Merger and intends to vote its shares of Paramount in favor of the merger, and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The contribution to revenues and earnings from operations of each industry segment and the identifiable assets attributable to each industry segment for each of the last three years ending December 31, are set forth in Note 12 ("Business Segments") to the Consolidated Financial Statements of Viacom Inc. and the Company included elsewhere herein. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS Financial information relating to foreign and domestic operations for each of the last three years ending December 31, is set forth in Notes 11 and 12 ("Foreign Operations" and "Business Segments") to the Consolidated Financial Statements of Viacom Inc. and the Company included elsewhere herein. BUSINESS VIACOM NETWORKS Viacom Networks operates three advertiser-supported basic cable television program services, MTV: MUSIC TELEVISION(R) ("MTV"), including MTV EUROPE(TM) and MTV LATINO(TM), VH-1(R)/VIDEO HITS ONE(R) ("VH-1") and NICKELODEON(R)/NICK AT NITE(R), and three premium subscription television program services, SHOWTIME(R), THE MOVIE CHANNEL(TM) and FLIX(TM). The Company, directly and through Viacom Networks, participates as a joint venturer in four additional advertiser-supported basic cable program services: LIFETIME(R) with The Hearst Corporation and Capital Cities/ABC Video Enterprises, Inc., COMEDY CENTRAL(TM) with Home Box Office ("HBO"), a division of Time Warner Entertainment Company, L.P., NICKELODEON(TM)(U.K.) with a subsidiary of British Sky Broadcasting Limited, and ALL NEWS I - 3 CHANNEL(TM) with Conus Communications. On March 29, 1994, the Company agreed to sell its one-third partnership interest in Lifetime to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. MTV Networks launched two new services in 1993, NICKELODEON (U.K.) in September and MTV LATINO in October. Viacom Networks also distributes special events and feature films on a pay-per-view basis through SET(TM) PAY PER VIEW and packages satellite-delivered program services for distribution to home satellite dish owners through SHOWTIME SATELLITE NETWORKS(TM). Viacom Networks, through its operation of the Showtime Entertainment Group, also arranges for the development and production of original programs and motion pictures, including feature films under the Viacom Pictures label. These original programs and motion pictures premiere domestically on SHOWTIME and certain of such programming is exploited in various media worldwide. Basic cable program services derive revenues primarily from two sources: the sale of advertising time to national advertisers and per-subscriber license fees paid by cable operators and other distributors. Basic cable services are generally offered to customers of cable television operators and other distributors as part of a package or packages of services for a periodic subscription fee. Premium subscription television program services derive revenues primarily from subscriber fees paid by cable television operators and other distributors. Subscribers typically pay fees for each premium service to cable television operators and other distributors. MTV NETWORKS. MTV Networks ("MTVN") operates MTV: MUSIC TELEVISION, MTV EUROPE, MTV LATINO, NICKELODEON (including the NICKELODEON and NICK AT NITE program segments, and the U.K. NICKELODEON network) and VH-1 which are transmitted via satellite for distribution by cable television operators and other distributors. The MTV, VH-1, NICKELODEON and NICK AT NITE trademarks are strongly identified with the product lines they represent and are significant assets of their respective businesses. MTV: MUSIC TELEVISION is a 24-hours-a-day, seven-days-a-week program service offering a format which consists primarily of rock music videos, augmented by music and general lifestyle information, promotions, news, interviews, comedy, concert tour information, specials, documentaries and other youth-oriented programming. MTV targets young adult viewers from the ages of 12 to 34. In addition to rock music videos, MTV offers regularly scheduled youth-oriented programming such as the animated BEAVIS & BUTT-HEAD(TM), specials such as the Annual MTV Video Music Awards and the MTV Movie Awards, public affairs campaigns, and series such as UNPLUGGED(TM). MTV successfully merchandised BEAVIS & BUTT-HEAD in 1993, featuring a BEAVIS & BUTT- HEAD album, "THE BEAVIS & BUTT-HEAD EXPERIENCE", released in December 1993 by Geffen Records, and "MTV'S BEAVIS & BUTT-HEAD: THIS BOOK SUCKS", which was the first book of the MTV Books imprint published by Callaway Editions/Pocket Books, a division of Simon & Schuster, in November 1993. Following the conclusion of MTV's 1992 CHOOSE OR LOSE political awareness campaign and continuing its emphasis on public affairs, MTV launched the FREE YOUR MIND campaign in 1993, focusing on issues of diversity and discrimination, which included on-air promotional spots, news reports and specials and contests. I - 4 UNPLUGGED features live acoustical performances by major recording artists such as Eric Clapton, Rod Stewart and 10,000 Maniacs. MTV licenses the distribution of UNPLUGGED home video versions of these performances, and MTV and the applicable record labels release the soundtracks to MTV's UNPLUGGED series. MTV Productions made its first venture into theatrical film-making by agreeing with Geffen Pictures in 1993 to jointly develop JOE'S APARTMENT into a feature-length film for distribution by Warner Bros. JOE'S APARTMENT is the award-winning short film about a young man's efforts to cope with a big dirty city and a tiny apartment full of talking cockroaches. At December 31, 1993, MTV was licensed to approximately 52.2 million domestic cable subscribers (based on subscriber counts provided by each cable system). According to the December 1993 sample reports issued by the A. C. Nielsen Company (the "Nielsen Report"), MTV reached approximately 59 million subscriber households. MTV EUROPE is a 24-hours-a-day, seven-days-a-week video music network distributed via cable systems and direct-to-home satellite transmission throughout Europe, reaching over 58.3 million subscribers as of December 31, 1993 (based on subscriber counts provided by each distributor of the service). During 1993, MTV EUROPE expanded its reach by entering into distribution arrangements in certain countries in Eastern Europe, the former Soviet Union and the Middle East. MTV EUROPE is designed to communicate with Europe's youth in their language by providing approximately 85% European-sourced youth programming, including music videos, fashion, movie shows, MTV NEWS, trends and social issues. In October 1993, MTVN launched MTV LATINO, a 24-hours-a-day, seven-days-a-week music-based program service customized for Spanish- speaking viewers, ages 12 to 34, in Latin America and the United States. MTV LATINO reaches subscribers to cable, multichannel, multidistribution systems ("MMDS"), satellite master antenna television ("SMATV") and direct-to-home viewers in approximately 20 territories in Latin America. MTV LATINO was distributed to approximately 2.4 million subscribers as of December 31, 1993 (based on subscriber counts provided by authorized distributors). MTVN has licensing arrangements covering the distribution of regionally-specific program services called MTV: MUSIC TELEVISION in Asia, Japan and Brazil. MTVN provides creative input and programming, production, marketing and research expertise and support in connection with licenses to each such licensee of the right to package and exhibit a customized MTV program service containing MTV trademarks and logos and a mix of MTV-owned and controlled programming and interstitial material with locally produced programming and interstitial material. Such arrangements include agreements with a subsidiary of HutchVision Limited for a 24-hours-a-day MTV Asia service, which is distributed to 42 million subscriber households via the AsiaSat 1 satellite on the Hong Kong-based Satellite Television Asian Region (STAR) system to 30 countries in Asia and parts of the Middle East; the Abril Group for MTV Brazil, which airs 16-hours-a-day in Brazil, reaching 9.5 million households; and Music Channel Co. Ltd., a joint venture of Pioneer Electronic Corp., TDK Corp. and Tokyu Agency, Inc. for MTV Japan, which launched in December 1992 and is distributed to approximately 810,000 subscriber households in Japan via the Superbird B satellite. I - 5 MTVN licenses, in international markets, the format rights and/or broadcast television exhibition rights to MTVN-owned or controlled programming. MTVN also licenses the exhibition of "MTV Internacional", a Spanish-language MTV-produced one-hour program, to Spanish-language television stations in the U.S. and abroad. MTVN anticipates further worldwide licensing of MTVN networks, programs, merchandise and format rights. NICKELODEON, the first network for kids, is a 24-hours-a-day, seven-days-a-week entertainment program service which combines acquired and originally produced programs in a pro-social, non-violent format, comprising two distinct program segments: NICKELODEON, targeted to audiences ranging from the ages of 2 to 15, and NICK AT NITE, targeted to family audiences including NICKELODEON'S 2 to 15 year old audience and ranging up to age 54. Cable television operators and other distributors typically carry both of the NICKELODEON programming segments. In 1993, NICKELODEON expanded its successful original animated programming block, NICKTOONS(R), with the introduction of ROCKO'S MODERN LIFE(TM). NICKELODEON continues to develop original animation projects such as REAL MONSTERS(TM), in addition to THE REN & STIMPY SHOW(TM), DOUG(TM) and RUGRATS(R). NICKELODEON also exhibits on Saturday nights SNICK(TM), its first prime-time block of original NICKELODEON programming. MTVN, in cooperation with MCA Inc. ("MCA"), operates NICKELODEON STUDIOS FLORIDA at Universal Studios in Orlando, Florida, which combines state-of-the-art television production facilities with interactive features that demonstrate the operation of NICKELODEON's studios from a kid's perspective. NICKELODEON and Sony Music entered into an agreement in April 1993 for Sony to manufacture and distribute NICKELODEON home video and audio products in the U.S. and Canada through its Sony Wonder Children's label. In June 1993, NICKELODEON launched NICKELODEON MAGAZINE, a bi-monthly humor-based children's publication. At December 31, 1993 circulation was approximately 225,000 (based on subscription and newsstand sales); distribution is handled, under agreement with NICKELODEON, by the New York Times' The Family Circle, Inc. (U.S.), and Worldwide Media Service, Inc. (U.K.). At December 31, 1993, NICKELODEON was licensed to approximately 53.4 million cable subscribers (based on subscriber counts provided by each cable system). At December 31, 1993, NICK AT NITE was licensed to approximately 53.1 million cable subscribers (based on subscriber counts provided by each cable system). According to the Nielsen Report, NICKELODEON and NICK AT NITE each reached approximately 60.9 million subscriber households. In December 1992, Nickelodeon Huggings U.K. Limited, a subsidiary of the Company, entered into a joint venture with a subsidiary of British Sky Broadcasting Limited for the launch and operation of NICKELODEON program service in the United Kingdom and Ireland. NICKELODEON in the U.K. is a 12-hours-a-day, seven-days-a-week, satellite-delivered children's programming service which launched in September 1993, and it carries a mix of programming, including original productions from NICKELODEON in the U.S. and programming originally produced by the joint venture for the U.K. market. Pursuant to the joint venture agreement and related parent agreements, the Company guarantees the obligation of its subsidiary and has both the right of first negotiation/last refusal with respect to any sale I - 6 of, and the right to approve any purchaser of, the British Sky Broadcasting subsidiary's interest in NICKELODEON U.K. The Company's subsidiary is obligated to fund loans in an amount equal to 50% of NICKELODEON U.K.'s working capital deficit. The Company funded loans of approximately B.P.3,500,000 in 1993 and expects to fund loans of approximately B.P.7,000,000 in 1994. VH-1/VIDEO HITS ONE is a 24-hours-a-day, seven-days-a-week music program service. VH-1 targets an audience of baby boomers, 25 to 49 years old, rather than the 12 to 34 year-olds targeted by MTV. The format consists primarily of music video clips from the adult contemporary, soft rock, classic oldies, contemporary jazz and country genres, augmented by original animation, music and general lifestyle information and programming, comedy, fashion, nostalgia, interviews and promotions. VH-1 offers programs such as original and acquired comedy programming including STAND-UP SPOTLIGHT and Gallagher specials; FT: FASHION TELEVISION; and the ONE-TO-ONE series which profiles pop artists. At December 31, 1993, VH-1 was licensed to approximately 45.5 million cable subscribers (based on subscriber counts provided by each cable system). According to the Nielsen Report, VH-1 reached approximately 49.5 million subscriber households. Substantially all such subscribers also receive MTV. MTVN has agreements with some U.S. record companies which, in exchange for cash and advertising time, license the availability of such companies' music videos for exhibition on MTV and on MTVN's other basic cable networks; a number of other record companies provide MTVN with music videos in exchange for promotional consideration only. The agreements generally provide that the videos are available for debut by MTVN and, in some cases, that videos are subject to exclusive periods on MTV. These record companies provide a substantial portion of the music videos exhibited on MTV and VH-1. MTVN is currently in negotiations for the renewal and extension of certain of its record company agreements. Although MTVN believes that these agreements will be renewed, there can be no assurance that the terms of such renewals will be as favorable as existing arrangements. MTVN derives revenues principally from two sources: the sale of time on its own networks to advertisers and the license of the services to cable television and other system operators. The sale of MTVN advertising time is affected by viewer demographics, viewer ratings and market conditions for advertising time. Adverse changes in market conditions for advertising may affect MTVN's revenues. MTVN derives revenues from license fees paid by cable operators and other distribution systems which deliver programming by satellite and microwave transmissions. In 1993, MTVN derived approximately 58% of its revenues from music programming and approximately 42% of its revenues from children's and other programming. MTVN also derives revenues from the sale of advertising time within internally produced or co-produced programming distributed to television stations and from the sale of advertising time within such programs produced by third parties. MTVN, through its operation of One World Entertainment, sells barter advertising time in series licensed for distribution to television stations by the Company and third parties, in exchange for a commission. COMEDY CENTRAL. The Company and HBO, through a 50-50 joint venture, operate COMEDY CENTRAL, a 24-hours-a-day, seven-days-a-week program service targeted to audiences ranging from the ages of 18 to I - 7 34. The format consists primarily of comedy programming, including movies, series, situation comedies, stand-up and sketch comedy, commentary, promotions, specials, and other original and acquired comedy programming. Pursuant to the joint venture agreement, the Company is obligated to make capital contributions in an amount equal to 50% of the partnership's working capital deficit (and Viacom Inc. has guaranteed such obligation). The Company's capital contributions for 1993 totaled $13.6 million. For 1994, the Company estimates its contribution obligation to be approximately $9 million. COMEDY CENTRAL reached approximately 30.3 million subscriber households according to the Nielsen Report. LIFETIME. The Company owns a one-third partnership interest in LIFETIME, an advertiser-supported basic cable television network that provides programming directed primarily toward women in the 18 to 54 age group. On March 29, 1994, the Company agreed to sell its one- third partnership interest in LIFETIME to its partners The Hearst Corporation and Capital Cities/ABC Inc. for approximately $317.6 million; this transaction is expected to close in the second quarter of 1994. SHOWTIME NETWORKS INC. Showtime Networks Inc. ("SNI") operates three 24-hours-a-day, commercial-free, premium subscription services offered to cable television operators and other distributors: SHOWTIME, offering theatrically released feature films, dramatic series, comedy specials, boxing events, family programs and original movies; THE MOVIE CHANNEL, offering feature films and related programming including film festivals; and FLIX, an added value premium subscription service featuring movies primarily from the 1960s, 70s and 80s which was launched on August 1, 1992. SHOWTIME, THE MOVIE CHANNEL and FLIX are offered to cable television operators and other distributors (including the Company) under affiliation agreements which for SHOWTIME and THE MOVIE CHANNEL are generally for a term of three to five years and in each case are distributed to the systems they serve by means of domestic communications satellites. As of December 31, 1993, SHOWTIME, THE MOVIE CHANNEL and FLIX, in the aggregate, had approximately 11,900,000 cable and other subscribers in approximately 8,700 cable systems and other distribution systems in 50 states and certain U.S. territories. SNI also provides special events, such as sports events, and feature films to licensees on a pay-per-view basis through its operation of SET PAY PER VIEW, a division of the Company. Showtime Satellite Networks Inc. ("SSN"), a subsidiary of SNI, packages for distribution to home satellite dish owners (on a direct retail basis) SHOWTIME, THE MOVIE CHANNEL, FLIX, Viacom Networks' basic cable program services, ALL NEWS CHANNEL (a 24-hour satellite- delivered news service which is a joint venture between Viacom Satellite News Inc., a subsidiary of the Company, and Conus Communications Company Limited Partnership, a limited partnership whose managing general partner is Hubbard Broadcasting, Inc.) and certain third-party program services. SHOWTIME, THE MOVIE CHANNEL and FLIX are also offered to third-party licensees for subdistribution to home satellite dish owners. In order to exhibit theatrical motion pictures on premium subscription television, SNI enters into commitments to acquire rights, with an emphasis on acquiring exclusive rights for SHOWTIME and THE MOVIE CHANNEL, from major or independent motion picture I - 8 producers and other distributors (including the Company). SNI's exhibition rights always cover the United States and may on a contract-by-contract basis cover additional territories. Theatrical motion pictures are generally exhibited first on SHOWTIME and THE MOVIE CHANNEL after an initial period for theatrical, home video and pay-per-view exhibition and before the period has commenced for standard broadcast television and basic cable television exhibition. FLIX primarily offers motion pictures from the 1960s, 70s and 80s, most of which have been previously made available for standard broadcast and other exhibitions. The cost of acquiring premium television rights to programming, including exclusive rights, is the principal expense of SNI. At December 31, 1993, in addition to such commitments reflected in Viacom Inc.'s and the Company's financial statements, SNI had commitments to acquire such rights at a cost of approximately $1.8 billion. Most of the $1.8 billion is payable within the next seven years as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. In November 1993, SNI entered into a seven-year agreement with Metro-Goldwyn-Mayer Inc. ("MGM") under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to MGM and United Artists feature films. The agreement includes all qualifying films theatrically released from September 1, 1994 through August 31, 2001, up to a maximum of 150 pictures. This agreement follows a previous agreement between SNI and Pathe Entertainment, Inc., a predecessor-in-interest to MGM. The recent agreement also calls for SNI and MGM to co-finance the production of certain exclusive original movies to be produced for SNI's program services. Also in 1993, SNI and Sony Pictures Entertainment Inc. entered into a five-year agreement under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to TriStar Pictures feature films. A continuation of SNI's previous three-year arrangement with TriStar, this new agreement includes all qualifying TriStar films theatrically released from 1994 through 1998, up to a maximum of 75 pictures. Feature films theatrically released by TriStar include SLEEPLESS IN SEATTLE, CLIFFHANGER and PHILADELPHIA. In February 1994, SNI reached an agreement in principle with Castle Rock Entertainment ("Castle Rock") to acquire the exclusive premium television rights in the licensed territory to additional Castle Rock feature films. This agreement follows SNI's previous output arrangement with Castle Rock, which included such previously theatrically released feature films as A FEW GOOD MEN, CITY SLICKERS, WHEN HARRY MET SALLY, MISERY, MALICE and IN THE LINE OF FIRE. The new agreement includes all qualifying Castle Rock motion pictures theatrically released from 1994 through 1999, up to a maximum of 55 pictures. In March 1994, SNI entered into an agreement with Orion Pictures Corporation ("Orion") under which SNI agreed to acquire the exclusive premium television rights in the licensed territory to up to 30, in the aggregate, motion pictures, including qualifying motion pictures theatrically released from 1994 through 1996 and qualifying original motion pictures. This agreement follows a previous output agreement between SNI and Orion. I - 9 In 1989, SNI agreed with Walt Disney Pictures ("Disney") to acquire exclusive premium television rights in the licensed territory to qualifying feature films (up to a maximum of 125 films) produced and distributed by Disney's major distribution labels (other than the Disney label) and theatrically released during the five-year period commencing January 1, 1991. These films include SISTER ACT 2, TOMBSTONE, THE JOY LUCK CLUB and WHAT'S LOVE GOT TO DO WITH IT. In addition, SNI has agreements with (among other suppliers) New Line Distribution, Inc., Imagine Films Entertainment, Inc., Cannon Pictures, Inc., and Polygram Filmed Entertainment Distribution, Inc. SNI also arranges for the development and production of original programs and motion pictures that premiere on SHOWTIME through its operation of the Showtime Entertainment Group, which was formed in 1992. The Showtime Entertainment Group reflects SNI's increased commitment to the development and production of original programming and includes the operation of Viacom Pictures, a division of the Company. Viacom Pictures arranges for the development and production of motion pictures that are exhibited theatrically in foreign markets and premiere domestically on SHOWTIME. These films are then made available for distribution to various media worldwide, with the exception of the U.S. theatrical market. These feature films are generally budgeted at an average cost of approximately $5 million. During 1993, Viacom Pictures completed principal photography on two films: PAST TENSE, starring Scott Glenn, Anthony LaPaglia and Lara Flynn Boyle, and ROSWELL, starring Kyle MacLachlan, Martin Sheen and Dwight Yoakam. The Showtime Entertainment Group also has entered into commitments to produce, distribute and/or exhibit other original programming, including series, films, documentary programs, comedy specials and boxing events. In 1993, for example, SNI televised comedy specials featuring Tim Allen, Brett Butler and Shelley Long, boxing matches featuring such fighters as Julio Cesar Chavez, and the critically acclaimed dramatic anthology series entitled FALLEN ANGELS, episodes of which were directed by Michael Mann, Steve Soderbergh, Jonathan Kaplan and Tom Cruise and starred Gary Oldman, Laura Dern, Meg Tilly, Gabrielle Anwar, James Woods, Joe Mantegna, Gary Busey and Alan Rickman. In addition to exhibiting these original programs and motion pictures on its premium subscription services, SNI distributes certain of such programming for exploitation in various media worldwide. ADDITIONAL INFORMATION ABOUT VIACOM NETWORKS. The domestic program services of MTVN and SNI are currently transmitted over transponders principally on GE Americom's C-3 and C-4 and the Hughes Galaxy I and V domestic satellites. In 1994, Viacom Networks program services on Galaxy I will move to AT&T's Telstar 302. NICKELODEON (U.K.) program service is transmitted over the Astra 1-C satellite. MTV LATINO is transmitted over PanAmSat-1. MTV EUROPE is transmitted over the Astra 1-A, Astra 1-B and Eutelsat II-F1 satellites. The Company has entered into pre-launch agreements for international satellite coverage on Apstar-1 and Apstar-2, covering a broad Asian area, on PanAmSat-2 (Pacific Rim area), PanAmSat-3 (Latin America) and PanAmSat-4 (India/Middle East and South Africa) and Eutelsat II-F6 (greater Europe), all for service beginning in 1994 and 1995. I - 10 The Company entered into agreements, as of August 27, 1992, with United States Satellite Broadcasting Inc. ("USSB"), a subsidiary of Hubbard Broadcasting, Inc., for the direct broadcast satellite distribution using high-powered Ku-band technology ("DBS") of each of the Company's wholly owned basic cable and premium networks. These networks are expected to be offered by USSB to DBS customers beginning in 1994, and will be delivered directly to dishes located at DBS customers' homes from the first high-powered Ku-band satellite serving the U.S., which was launched in December 1993. DBS delivery utilizes consumer dishes significantly smaller than the C-band consumer dishes currently in use by home satellite dish owners in the U.S. VIACOM ENTERTAINMENT Viacom Entertainment is comprised of (i) Viacom Enterprises, which distributes television series, feature films, made-for- television movies, mini-series and specials for television exhibition in various markets throughout the world and also distributes television series for initial United States television exhibition on a non-network ("first run") basis and for international television exhibition; (ii) Viacom Productions, which produces television series and other television properties independently and in association with others primarily for initial exhibition on U.S. prime time network television; (iii) Viacom New Media, which was established in 1992 to develop, produce, distribute and market interactive software for the stand alone and other multimedia marketplaces; (iv) Viacom World Wide, which explores and develops business opportunities in international markets primarily in cable and premium television; and (v) Viacom MGS Services, which duplicates and distributes television and radio commercials. Viacom Enterprises and Viacom Productions are expected to be consolidated with Paramount's television operations during 1994. VIACOM ENTERPRISES. Viacom Enterprises distributes or syndicates television series, feature films, made-for-television movies, mini- series and specials, and first run series for television exhibition in domestic and/or international broadcast, cable and other markets. Feature film and television properties are acquired from third parties or result from the Company's own production activities, including television properties produced by Viacom Productions and certain television properties produced by or for MTV Networks. Third-party agreements for the acquisition of distribution rights are generally long-term and exclusive in nature; such agreements frequently guarantee a minimum recoupable advance payment to such third parties and generally provide for periodic payment to such third parties based on the amount of revenues derived from distribution activities after deduction of Viacom Enterprises' percentage distribution fee, recoupment of distribution expenses and recoupment of any advance payments. At December 31, 1993, Viacom Enterprises held domestic and/or international television distribution rights to approximately 5,000 half-hour series episodes, 2,000 one-hour series episodes, 1,500 feature films and television movies, and 30 mini-series. At December 31, 1993, Viacom Enterprises distributed television product to, among other outlets, approximately 750 domestic broadcast television stations, including stations in every principal city in the U.S., and to outlets in approximately 120 other countries I - 11 around the world. Viacom Enterprises generally licenses product to exhibitors for periods of one to six years, with license fee payments due over a somewhat shorter period. Episodes of a network television series from the first four seasons on a broadcast network generally become available for exhibition in domestic syndication to broadcast television stations commencing upon the start of the fifth broadcast season on the network; episodes from each subsequent broadcast season generally become available for such domestic syndication at the conclusion of each such subsequent broadcast season. Episodes of network television series are available for exhibition by foreign stations prior to or concurrent with their initial network runs. Generally, a network television series must air for at least three full broadcast seasons before it has value for such domestic syndication. Television programs can be made available to stations and other outlets, such as cable television services, on a first run basis without having been exhibited on any of the networks. The Company has greater control over the availability for exhibition in such domestic syndication of programming developed by and for Viacom's cable networks than of programming developed for network television. The Company has adopted a strategy of internal development of first run programs utilizing in- house creative resources from within Viacom Enterprises and from elsewhere within the Company, such as MTV Networks. Feature films which have been released theatrically generally become available for exhibition in such domestic syndication after their theatrical, home video, pay-per-view, and premium television exhibition periods have expired (which is generally three to four years after domestic theatrical release) and for network or ad hoc network exhibition between the first and second premium television windows. Such feature films generally become available for free television exhibition by foreign stations after the foreign theatrical, home video, pay-per- view (if any) and premium television (if any) exhibition periods have expired (which is generally two to three years after theatrical release in the applicable foreign market). The Company controls the exclusive worldwide broadcast, basic cable, premium, and home video television distribution rights to ROSEANNE, now in its sixth network broadcast season on ABC, and THE COSBY SHOW, which completed its eight-year network run at the end of the 1991/92 network broadcast season. The start of the sixth network season of ROSEANNE automatically triggered the first of three 26-week extensions of individual station licenses for ROSEANNE's initial licensing in domestic syndication, which was made on a cash plus barter basis. The second licensing period in domestic syndication for THE COSBY SHOW commenced in September 1993 (upon expiration of the term for the initial licensing in domestic syndication of THE COSBY SHOW) on an all-cash basis. The Company also controls certain worldwide exclusive distribution rights to classic network series such as I LOVE LUCY, THE ANDY GRIFFITH SHOW, THE BEVERLY HILLBILLIES, HAWAII FIVE-O and THE TWILIGHT ZONE. The Company is also offering VIACOM SEASONAL SPECIALS FEATURING NICKTOONS which brings six one hour seasonally themed specials, drawn from MTV Networks' critically acclaimed NICKTOONS animation block, to broadcast television. In addition, the Company controls the exclusive worldwide distribution rights in all media to various network television movies and series produced by Viacom Productions such as the PERRY MASON I - 12 television movies starring Raymond Burr, the DIAGNOSIS MURDER television movies and series starring Dick Van Dyke and the MATLOCK series starring Andy Griffith. Most episodes of MATLOCK and most of the PERRY MASON television movies are currently available for exhibition in domestic syndication. (See "BUSINESS -- Viacom Entertainment -- Viacom Productions") The Company had accumulated a backlog of unbilled license agreements of approximately $399 million at December 31, 1993. As the entire license fee amount is billed during the term of various licensing contracts, the Company will recognize as revenues that portion of such amount representing its distribution fees. Down payments and other accelerated payments of license fees are included in the backlog and are recognized as revenues in accordance with the billing terms of the license agreements. (See Note 1 to the Consolidated Financial Statements of Viacom Inc. and the Company for an explanation as to how license fees are billed.) Approximately 58% of the Company's backlog is attributable to license fees for ROSEANNE and THE COSBY SHOW. As THE COSBY SHOW becomes a smaller portion of the total backlog, the percentage of the total license fee recognized as revenue by the Company will be reduced. Since the late 1970s, the Company has produced and/or acquired television series for distribution on a first run basis. There is a financial exposure to the Company when it acquires or produces such series to the extent that advertising revenues derived by the Company and/or license fees paid by television stations to the Company are not sufficient to cover production costs. The Company typically offers to license new episodes of a first run series on a broadcast season basis. Generally, a first run series may be canceled by the Company for any reason at any time; in such event, television station licenses for such first run series are subject to termination by the Company, and the Company may have certain financial obligations to the producer notwithstanding cancellation. The Company is currently offering the third season (since its national launch) of THE MONTEL WILLIAMS SHOW, a first run one-hour strip (five times per week) talk show which premiered in Spring 1991 and was nationally launched in September 1992, on a cash plus barter basis, and NICK NEWS, a first run half hour weekly (one time per week) news and information show targeted for audiences 12 years old and under, which was nationally launched in September 1993 on an all-barter basis. The Company licenses certain ancillary rights to third parties, including home video, video disc and merchandising rights. These rights can be acquired concurrently with a program acquisition, derived from programs or characters created in-house, or directly licensed from the holders of such rights. These activities have not been a source of significant revenues to date. For the year ended December 31, 1993, approximately 37% of Viacom Enterprises' revenues were attributable to foreign operations and export business. A substantial portion of such revenues is derived in countries that have import quotas and other restrictions which limit the number of foreign programs and films exhibited in such countries. (See "BUSINESS -- Regulation -- Viacom Entertainment -- European Community Directive") VIACOM PRODUCTIONS. Viacom Productions Inc. ("Viacom Productions") produces programs independently and in association with others primarily for U.S. network prime time television. I - 13 These programs, which include television movies, series and mini- series, are also a source of product for the Company's distribution activities. There is a financial exposure to the Company with respect to such programs to the extent that revenues from distribution or syndication in foreign or domestic broadcast, cable and/or other markets are not sufficient to cover production deficits (i.e., the ---- difference between production costs and network license fees). For the 1993/94 broadcast season, Viacom Productions is producing the eighth network broadcast season of Andy Griffith's MATLOCK series (ABC); three additional PERRY MASON mystery television movies (NBC); the first network broadcast season of Dick Van Dyke's DIAGNOSIS MURDER series (CBS); two television movies starring Louis Gossett, Jr. (NBC); and several two-hour television movies, including THE ANISSA AYALA STORY (NBC); DESPERATE JOURNEY, starring Mel Harris (ABC); and SIN AND REDEMPTION, starring Richard Grieco (CBS). Viacom Productions also produces movies for cable television networks, including THEY, starring Vanessa Redgrave (SHOWTIME) and A FRIENDLY SUIT, starring Melissa Gilbert and Marlee Matlin (LIFETIME). VIACOM NEW MEDIA. Viacom New Media, the Company's interactive publishing division, was formed in 1992 to develop, produce, distribute and market interactive software for the stand-alone and other multimedia marketplaces. ICOM Simulations, Inc., an interactive software development company, was acquired by the Company in May 1993 and has been integrated into Viacom New Media; among other things, ICOM Simulations, Inc. is known for its SHERLOCK HOLMES CONSULTING DETECTIVE series of CD-ROM products. Viacom New Media released an interactive horror movie on CD-ROM entitled DRACULA UNLEASHED in the fourth quarter of 1993. In 1994, Viacom New Media expects to release original video games and CD-ROM products based on certain MTV Networks programs, including ROCKO'S MODERN LIFE (currently scheduled for second quarter 1994 release) and BEAVIS & BUTT-HEAD. Viacom New Media also expects to participate in the development of interactive programming for the Viacom/AT&T Castro Valley cable system project. (See "BUSINESS -- Viacom Cable Television") VIACOM WORLD WIDE LTD. Viacom World Wide Ltd. ("Viacom World Wide") explores and develops international business opportunities in all media, focusing primarily on countries with recently deregulated television industries. Viacom World Wide works closely with the Company's other operating units in identifying international business opportunities. Viacom World Wide also provides consulting services to companies overseas. Over the past year, Viacom World Wide has provided strategic and business planning services to corporations in the Middle East and engineering services in Japan. None of these services has been a source of significant revenues to date nor required significant capital contributions by the Company. VIACOM MGS SERVICES. Viacom MGS Services Inc. ("MGS") distributes, duplicates and stores taped and filmed television commercials, radio commercials, and other programs for advertisers and agencies, production houses and industrial and educational customers. VIACOM CABLE TELEVISION CABLE OPERATIONS. At December 31, 1993, Viacom Cable Television ("Viacom Cable") was approximately the 13th largest multiple cable television system operator in the United States with approximately 1,094,000 subscribers. In January 1993, the Company completed the I - 14 sale of its suburban Milwaukee cable system, serving approximately 47,000 customers, to Warner Communications Inc., a unit of Time Warner Entertainment Co., L.P. as part of the settlement of the Company's antitrust lawsuit against Time Warner Inc. Viacom Cable's systems are operated pursuant to non-exclusive franchises granted by local governing authorities. Viacom Cable offers two tiers of primary (i.e., non-premium) service: "Limited Service", which consists generally of local and distant broadcast stations and all public, educational and governmental channels ("PEG") required by local franchise authorities; and, the "Satellite Value Package", which provides additional channels of satellite-delivered cable networks. Monthly service fees for these two levels of primary service constitute the major source of the systems' revenue. The monthly service fees for Limited Service and the Satellite Value Package are regulated under the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation"). At December 31, 1993, the fixed monthly fees charged to customers for primary services varied by geographic area and ranged from $9.00 to $14.84 per month for Limited Service and from $21.25 to $25.78 for the combination of Limited Service plus the Satellite Value Package, in each case for all of an individual customer's television connections. The Company offers customers the Company's own basic programming services, as well as third-party services such as CNN and ESPN. An installation charge is levied in many cases but does not constitute an important source of revenue. Customers are free to discontinue service at will. None of Viacom Cable's systems is exempt from rate regulation under the 1992 Cable Act. Viacom Cable offers premium cable television programming, including the Company's premium subscription television services, to its customers for an additional monthly fee of up to $12.25 per premium service. As of December 31, 1993, the Company's cable television systems had approximately 718,000 subscriptions to premium cable television program services. Viacom Cable customers who elect to subscribe to Limited Service alone are also able to purchase premium and pay-per-view services offered by the Company without first having to "buy through" the Satellite Value Package. The 1992 Cable Act requires cable operators to implement this practice where no technological limitations exist. (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation") Viacom Cable also derives revenue from sales of available advertising spots on advertiser-supported programming and sharing of revenues from sales of products on home shopping services offered by Viacom Cable to its customers. Cable operators require substantial capital expenditures to construct systems and significant annual expenditures to maintain, rebuild and expand systems. The equipment of each cable system consists principally of receiving apparatus, trunk lines, feeder cable and drop lines connecting the distribution network to the premises of the customers, electronic amplification and distribution equipment, converters located in customers' homes and other components. System construction and operation and quality of equipment used must conform with federal, state and local electrical and safety codes and certain I - 15 regulations of the FCC. Viacom Cable, like many other cable operators, is analyzing potential business applications for its broadband network, including interactive video, video on demand, data services and telephony. These applications, either individually or in combination, may require technological changes such as fiber optics and digital compression. If these applications justify capital spending in excess of current projections, Viacom Cable will revise its capital needs accordingly. Although management believes the equipment used in the cable operations is in good operating condition, except for ordinary wear and tear, Viacom Cable invests significant amounts each year to upgrade, rebuild and expand its cable systems. During the last five years, Viacom Cable's capital expenditures were as follows: 1989: $40 million; 1990: $46 million; 1991: $45 million; 1992: $55 million; and 1993: $79 million. The Company expects that Viacom Cable's capital expenditures in 1994 will be approximately $100 million. Viacom Cable has constructed a fiber optic cable system in Castro Valley, California to provide more channels with significantly better picture quality, and to accommodate testing of new services including an interactive on-screen programming guide known as StarSight (in which a consolidated affiliate of the Company currently has a 21.4% equity interest which it has the right to increase to 35%), other interactive programs with Viacom New Media, video-on-demand premium services, multiplexed premium services, and advanced interactive video and data services. Viacom has entered into an agreement with AT&T to test and further develop such services. As part of Viacom's strategic relationship with NYNEX Corporation ("NYNEX"), Viacom has granted NYNEX a right of first refusal with respect to providing telephony service upgrade expertise to Viacom Cable. I - 16 I - 17 VIACOM BROADCASTING Viacom Broadcasting is engaged in the operation of five television and 14 radio stations. The Company's television and radio stations operate pursuant to the Communications Act of 1934, as amended (the "Communications Act"), and licenses granted by the FCC, which are renewable every five years in the case of television stations and every seven years in the case of radio stations. VIACOM TELEVISION. The Company owns and operates the following five television properties: NETWORK STATION AND AFFILIATION METROPOLITAN AND EXPIRATION YEAR AREA SERVED TYPE DATE OF AGREEMENT ACQUIRED - -------------------------------------------------------------------- KMOV-TV St. Louis, MO VHF CBS/December 31, 1994 1986 WVIT-TV Hartford-New Haven- New Britain-Waterbury, CT UHF NBC/July 2, 1995 1978 WNYT-TV Albany-Troy-Schenectady, NY VHF NBC/September 28, 1980 KSLA-TV Shreveport, LA VHF CBS/June 30, 1995 1983 WHEC-TV Rochester, NY VHF NBC/August 13, 1994 1983 As reflected in the table above, each of the Company's television stations is affiliated with a national television network. Such affiliations can be an advantage, because network programming is often competitively stronger and results in lower programming costs than would otherwise be necessary to obtain programming from other sources. The Company expects that the affiliation agreements which expire in 1994 will be renewed. I - 18 In addition to fees paid by networks to their affiliates, the principal source of revenue for the Company's television stations is the sale of broadcast time that has not been sold by the networks to national, local and regional advertisers. Such sales may involve all or part of a program or spot announcements within or between programs. Broadcast time is sold to national advertisers through national sales representatives who are compensated on a commission basis at normal industry rates. Advertising is sold to local and regional advertisers through a station's own sales force. Local and national spot advertising is generally sold pursuant to contracts which are for short periods and are generally cancelable upon prior notice but which are frequently renewed for additional terms. VIACOM RADIO. The Company owns and operates the 14 radio stations listed below. On June 16, 1993, the Company acquired the assets of KQLZ-FM (now KXEZ-FM), serving Los Angeles, California and on November 1, 1993, the Company acquired the assets of WCXR-FM and WCPT-AM serving Washington, D.C., in exchange for the assets of KIKK-AM/FM serving Houston, Texas and cash. The Company now operates multiple FM and/or multiple AM stations in Seattle, Washington (2 FMs, 1 AM), Los Angeles, California (2 FMs) and Washington, D.C. (2 FMs, 2 AMs) as permitted by the FCC's recently liberalized ownership rules which permit common ownership of two or more AM or two or more FM stations in the same market. Pursuant to the FCC's order on March 4, 1994 consenting to the transfer of control of Paramount's broadcast licenses to Viacom Inc., which licenses include a television station serving Washington, D.C., the Company has undertaken to dispose of one AM and one FM radio station serving Washington, D.C. no later than September 11, 1995. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Ownership Limitations") I - 19 STATION AND METROPOLITAN POWER RADIO YEAR AREA SERVED FREQUENCY WATTS STATION FORMAT ACQUIRED - ----------------------------------------------------------------------- WLTW-FM New York, NY 106.7 MHz 50,000 Adult 1980 Contemporary WLIT-FM Chicago, IL 93.9 MHz 50,000 Adult 1982 Contemporary WLTI-FM Detroit, MI 93.1 MHz 50,000 Adult 1988 Contemporary WMZQ-AM-FM Washington, (AM) 1390 KHz 5,000 Country 1984 D.C. (FM) 98.7 MHz 50,000 1980 WCXR-FM 105.4 MHz 50,000 Classic Rock 1993 WCPT-AM 730 KHz 5,000 D* CNN Headline 1993 Washington, 20 N* News D.C. KBSG-AM-FM Tacoma/Seattle, (FM) 97.3 MHz 100,000 Oldies 1987 WA (AM) 1210 KHz 10,000 D* 1989 1,000 N* KNDD-FM Seattle, WA 107.7 MHz 100,000 New Rock (AOR) 1992 I - 20 STATION AND METROPOLITAN POWER RADIO YEAR AREA SERVED FREQUENCY WATTS STATION FORMAT ACQUIRED - ----------------------------------------------------------------------- KYSR-FM Los Angeles, 98.7 MHz 75,000 Adult 1990 CA Contemporary KXEZ-FM Los Angeles, 100.3 MHz 50,000 Adult 1993 CA Contemporary KSRY-FM San Francisco, 98.9 MHz 50,000 Adult 1990 CA Contemporary KSRI-FM Santa Cruz/San 99.1 MHz 50,000 Adult 1990 Jose, CA Contemporary _________________________ * D/N = Day/Night As indicated in the table above, the radio stations generally have specialized program formats targeted to specific audiences. In addition, the stations' programming includes entertainment, news, religion, sports, education and other topics of general interest. The stations also provide time for public affairs, educational and cultural programs and for discussion of local and national issues. Radio station revenues are derived almost entirely from the sale of advertising time. Only a small amount of such revenues is derived from sponsored programs or non-broadcast sources. As is customary in the industry, national representatives are engaged to obtain advertising from and to sell broadcast time to national advertisers, and are compensated on a commission basis. The stations' own sales forces sell advertising time to local and regional advertisers. Local, regional and national advertising is generally sold pursuant to contracts which are for short periods and generally are cancelable upon prior notice, but frequently are renewed for additional terms. REGULATION The Company's entertainment, cable television and broadcasting businesses are subject to extensive regulation by federal, state and local governmental authorities and its programming businesses are affected thereby. The rules, regulations, policies and procedures affecting these businesses are constantly subject to change. The descriptions which follow are summaries and should be read in conjunction with the texts of the statutes, rules and regulations I - 21 described herein. The descriptions do not purport to describe all present and proposed federal, state and local statutes, rules and regulations affecting the Company's businesses. VIACOM ENTERTAINMENT The Company's first run, network and other production operations and its distribution of off-network, first run and other programs in domestic and foreign syndication are not directly regulated by legislation. However, existing and proposed rules and regulations of the FCC applicable to broadcast networks, individual broadcast stations and cable could affect Viacom Entertainment. FINANCIAL INTEREST AND SYNDICATION RULES. The financial interest and syndication rules ("finsyn rules") were adopted by the FCC in 1970. These rules significantly limited the role of broadcast television networks in broadcast television program syndication. The financial interest rule prohibited a network from acquiring a financial or proprietary right or interest in the exhibition (other than its own broadcast network exhibition), distribution or other commercial use in connection with the broadcasting of any television program of which it is not the sole producer. The syndication rule prohibited a network from syndicating programming domestically to television stations for non-network exhibition and precluded a network from reserving any rights to participate in income derived from domestic broadcast syndication, or from foreign broadcast syndication where the network was not the sole producer. For the purposes of these rules, a broadcast network was defined as any entity which offers an interconnected program service on a regular basis for 15 or more hours per week to at least 25 affiliated television stations in 10 or more states. In 1991 the FCC adopted modified finsyn rules. In 1992, these rules were vacated by the U.S. Court of Appeals for the Seventh Circuit (the "Seventh Circuit Appeals Court"), acting on appeals filed by ABC, CBS, NBC and others. In 1993 the FCC adopted a decision (the "Decision") further modifying the finsyn rules effective as of June 5, 1993, although ABC, CBS, and NBC could not commence operating under the modified finsyn rules until November 10, 1993 when the antitrust consent decrees to which they are subject were modified to eliminate certain restrictions by an order (the "Order") of the U.S. District Court for the Central District of California (the "District Court"). The modified rules will expire in November 1995, absent an affirmative FCC action retaining or further modifying them. The FCC is to initiate a final review of the modified rules six months prior to their November 1995 expiration date and proponents of their continuance have the burden of proving that the public interest requires their continued retention. The Decision has been appealed by the networks and others, and all appeals have been consolidated before the Seventh Circuit Appeals Court. The Company is unable to predict what action the court will take when it reviews the Decision or what effect, if any, the Decision will have on the Company's distribution and production activities. I - 22 The Decision eliminates certain restrictions on network acquisition of financial interests and syndication rights in network programming. With respect to first run programs, networks may not acquire any financial interests or syndication rights except in programs produced solely by the network and in programs distributed only outside the U.S. The networks are also prohibited by the modified rules from directly engaging in syndication in the U.S. of both network prime time entertainment programs and first run programs, but they may syndicate non- prime time network programs and network non-entertainment programs in the U.S. and any programs in foreign markets. Networks must also release prime time entertainment programs in which they hold syndication rights into the syndication market no later than four years after the program's network debut or within six months after the end of the network run, whichever is earlier. In addition, networks are also subject to certain certification and reporting requirements. A network is defined in the modified rules as any entity that provides more than 15 hours of prime time programming per week to affiliates reaching 75% of television households nationwide. Emerging networks not currently meeting the network definition are exempt from the modified rules except for certain reporting requirements which become applicable when they commence providing 16 hours per week of prime time programs to their affiliates. The networks must use an independent syndicator to distribute off- network prime time entertainment programs in which they hold syndication rights, and there must be no contractual or other understandings between the network and the syndicator regarding the subsequent sale or scheduling of the syndicated program that would have the direct or indirect effect of affiliate station favoritism. The FCC will consider complaints if a party can make a showing undermining the credibility of the independence of the syndicator, and it is unclear whether such complaints may be directed only to the network involved or whether independent syndicators may also be subject to such complaints. PRIME TIME ACCESS RULE. The Prime Time Access Rule ("PTAR") prohibits network affiliates in the top 50 markets (designated by the FCC based on survey data) from exhibiting network or off-network programming during more than three out of the four prime time hours, with certain limited exceptions. The Decision provided that first run programming produced by a network will be considered network programming for this purpose. A number of interested parties have raised the issue of whether PTAR should be modified or repealed. Certain programmers are seeking modification of PTAR to permit the exhibition of off-network programming. The licensee of WCPX-TV, Orlando, Florida, has sought elimination of PTAR on First Amendment grounds and certain West Coast network affiliates have obtained PTAR waivers from the FCC that facilitated the commencement of network prime time one hour earlier. If PTAR itself is so modified or is eliminated, the Company is unable to predict the effect, if any, on its first run and other I - 23 distribution activities. The Company is also unable to predict whether earlier commencement of network prime time programming would affect the availability of prime time for the presentation of syndicated programs on network-affiliated stations. EUROPEAN COMMUNITY DIRECTIVE. In October 1989, the European Commission directed each European Community member country to adopt broadcast quota regulations based on its guidelines by October 3, 1991. All member countries other than Spain and the Flemish region of Belgium have enacted legislation aimed at adopting such regulations. Such broadcast quota regulations may limit the amount of U.S. produced programming to be purchased by foreign customers which could have an adverse impact on the Company's foreign syndication operations. Similar rules are contained in a Council of Europe Convention which went into force on May 1, 1993. This has currently been ratified by Cyprus, Italy, Poland, San Marino, Switzerland, the Vatican and the United Kingdom. VIACOM CABLE Federal Regulation 1992 CABLE ACT. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") substantially amending the regulatory framework under which cable television systems have operated since the Communications Act of 1934, as amended (the "Communications Act"), was amended by the Cable Communications Policy Act of 1984 (the "1984 Act"). The FCC through its rules and regulations began implementing the requirements of the 1992 Cable Act in 1993 and is currently engaged in several proceedings in order to adopt additional rules and regulations or to reconsider and/or amend certain of the rules and regulations previously adopted. The extent and materiality of the effects of the 1992 Cable Act on Viacom Cable and Viacom Networks depend to a large degree on the final form of the FCC's implementing regulations and the outcome of judicial challenges to various provisions of the 1992 Cable Act as more fully discussed below. The following is a summary of certain significant issues: Rate Regulation. Rate regulations adopted in April 1993 by the FCC --------------- (the "April 1993 Regulations") govern rates charged to subscribers for regulated tiers of cable service and became effective on September 1, 1993. On February 22, 1994, the FCC adopted additional rules (the "February 22nd Regulations") which have not yet been published in their final form. The "benchmark" formula adopted as part of the April 1993 Regulations establishes an "initial permitted rate" which may be charged by cable operators for specified tiers of cable service. The regulations also establish the prices which may be charged for equipment used to receive these services. Because the text of the February 22nd Regulations has not been released, it is not possible to know the extent or nature of the revisions to the April 1993 Regulations. However, from public statements made during the FCC's February 22 meeting and news releases issued thereafter, it appears that the February 22nd Regulations will contain a new formula for determining permitted rates. The new formula may require up to a I - 24 17% reduction of rates from those charged on September 30, 1992, rather than the 10% reduction required by the April 1993 Regulations. The February 22nd Regulations also adopted interim standards governing "cost-of-service" proceedings pursuant to which a cable operator would be permitted to charge rates in excess of rates which it would otherwise be permitted to charge under such regulations, provided that the operator substantiates that its costs in providing services justify such rates. Based on its implementation of the April 1993 Regulations, the Company estimates that it will recognize a reduction to revenues ranging from $27 million to $32 million on an annualized basis, substantially all of which will be reflected as a reduction in earnings from operations of its cable television division. The Company's estimated reduction does not reflect further reductions to revenue which would result from the lowering of the initial permitted rates pursuant to the February 22nd Regulations. These new and reduced initial permitted rates will apply prospectively from a date to be announced by the FCC when it publishes precise regulations which implement the February 22nd Regulations. Until the February 22nd Regulations are released, it is not possible to predict the effects of the interim standards governing cost-of- service proceedings; however, based on the FCC's public statements, the Company believes it is unlikely that it will be able to utilize such proceedings so as to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations. The Company's ability to mitigate the effects of these new rate regulations by employing techniques such as the pricing and repricing of new or currently offered unregulated program services and ancillary services may also be restricted by the new regulations adopted as part of the February 22nd Regulations. No such mitigating factors are reflected in the estimated reductions to revenues. The stated reduction to revenues may be mitigated by the higher customer growth due to lower primary service rates. The Company also cannot predict the effect, if any, of cable system rate regulation on license fee rates payable by cable systems to program services such as those owned by the Company. Vertical Integration. Certain pricing and other restrictions are -------------------- imposed on vertically integrated cable programmers (such as the Company) with respect to their dealings with multichannel distributors of programming, such as cable systems, SMATV systems, MMDS operators and TVRO and DBS distributors (as defined in "BUSINESS--Competition-- Viacom Cable Television"). The FCC's implementing regulations governing access by multichannel distributors to the programming of vertically integrated cable programmers limit the extent to which a vertically integrated cable programmer can differentiate in pricing or other terms and conditions of carriage between and among multichannel distributors. Because the application of these new regulations is subject to numerous uncertainties, the Company is currently unable to determine their impact, if any, on the Company. The FCC's implementing regulations also limit the number of channels on a cable system which may be used to carry the programming of such system's affiliated (vertically integrated) cable programmers. These regulations provide generally that no more than 40% of such a system's channels can be used to carry the programming of the system's I - 25 affiliated cable programmers. These channel occupancy limits apply only up to 75 channels of a given system. The FCC also considered whether limits should be placed on a multichannel distributor's right to participate in the production or creation of programming, and concluded that no such limits are appropriate at this time. The FCC's implementing regulations governing access by multichannel distributors to the programming of vertically integrated cable programmers and regarding channel occupancy limits are subject to pending petitions for reconsideration at the FCC. Must Carry/Retransmission Consent. Commercial television stations --------------------------------- which are "local" to communities served by a cable system can elect to require either (a) carriage (and with certain restrictions, channel position) on the cable system ("Must Carry"), or (b) payment (monetary or in-kind) in consideration for their consent to the retransmission of their signal by the cable system ("Retransmission Consent"). In addition, a cable system may not carry any commercial non-satellite- delivered television station which is "distant" to communities served by such system or any radio station without obtaining the consent of such station for such retransmission; however, such television and radio stations do not have Must Carry rights. Such stations may require payment in consideration for Retransmission Consent. Viacom Cable has negotiated retransmission rights for a number of commercial stations which it carries. Some of these agreements are on an interim basis and may be canceled by the stations. Viacom Cable carries other stations pursuant to their exercise of their Must Carry rights. Local non-commercial television stations have Must Carry rights, but may not elect Retransmission Consent. The Must Carry rules were challenged by cable program services and cable system operators. In April 1993, a District of Columbia three judge court upheld the rules against a facial First Amendment attack. The U.S. Supreme Court accepted review; oral argument was heard in January 1994 and a decision is expected by July 1994. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Must Carry/Retransmission Consent") Limits on Number of Subscribers. The FCC's implementing ------------------------------- regulations generally impose a 30% horizontal ownership limit on the number of homes passed by cable that any one cable operator can serve nationwide through systems in which it has an attributable interest (the Company serves approximately 2% of "homes passed" nationwide). In view of a recent federal district court decision holding that this imposition of horizontal ownership limits is unconstitutional, the FCC has stayed the effectiveness of this 30% limit until final judicial resolution of the constitutional issue. Buy Through to Premium Services. Pursuant to the 1992 Cable ------------------------------- Act, a cable system may not require subscribers to purchase any tier of service other than the basic service tier in order to obtain services offered by the cable operator on a per channel (e.g., premium services) or pay-per-view basis. A cable system ---- which is not now fully addressable and which cannot utilize other means to facilitate access to all of its programming will have up to 10 years to fully comply with this provision through the implementation of fully addressable technology. The Company's cable systems have already begun to implement compliance. I - 26 Among other things, the 1992 Cable Act and the FCC's implementing regulations also: (i) with certain exceptions, require a three-year holding period before the resale of cable systems; (ii) provide that franchising authorities cannot unreasonably refuse to grant competing franchises (all of the Company's current franchises are non-exclusive); (iii) require that the FCC study the cost and benefits of issuing regulations with respect to compatibility between cable system equipment and consumer electronics such as VCRs and issue such regulations as may be appropriate; and (iv) facilitate the manner in which third parties can lease channel capacity from cable systems and provide that the maximum rates which a cable system can charge for leased channel capacity may be set by the FCC. Pursuant to the 1992 Cable Act, the FCC adopted minimum customer service standards and also determined the circumstances under which local franchising authorities may impose higher standards. Lawsuits have been filed challenging the constitutionality of various provisions of the 1992 Cable Act including the provisions relating to rate regulation, Must Carry, Retransmission Consent, the pricing and other restrictions imposed on vertically integrated cable programmers with respect to their dealings with multichannel programming distributors, and the mandated availability of cable channels for leased access and PEG programming. COMPETITION WITH TELEPHONE COMPANIES. In a recent decision by the U.S. District Court for the Eastern District of Virginia, the Court declared the restrictions contained in the Communications Act on the provision of video programming by a telephone company in its local service area to be unconstitutional and has enjoined enforcement of those restrictions. The Court has held that this decision does not apply to geographic areas outside of its jurisdiction. An appeal of the Court's holding of the unconstitutionality of such restrictions has been filed. Several similar suits have recently been filed in different jurisdictions by regional Bell Operating Companies (including NYNEX) ("BOCs") challenging the very same restrictions. In an interpretation of the current restrictions contained in the Communications Act, the FCC in 1992 established its "Video Dial Tone" policy. The Video Dial Tone policy is being challenged in court by cable interests as violating the Communications Act. It is also being challenged by telephone interests as not being liberal enough. The policy permits in-service-area delivery of video programming by a telephone company (a "telco", as further defined below) and exempts telcos from the Communications Act's franchising requirements so long as their facilities are capable of two-way video and are used for transmission of video programming on a common carrier basis, i.e. use of the facilities must be available to all programmers - ---- and program packagers on a non-discriminatory, first-come first- served basis. Telcos are also permitted to provide to facilities users additional "enhanced" services such as video gateways, video processing services, customer premises equipment and billing and collection. These can be provided on a non-common carrier basis. There are currently pending in Congress four principal bills (in the Senate, S. 1086, the Telecommunications Infrastructure Act of 1993, and S. 1822, the Communications Act of 1994 (which is expected to supersede S. 1086) and in the House, H.R. 3626, the Antitrust Reform Act 1993, and H.R. 3636, the National Communications Competition and Information Infrastructure Act of 1993) which would, among other things, permit a I - 27 BOC or a Regional Holding Company ("RHC"; a BOC or RHC, a "telco") to offer cable service under certain stated conditions including providing safeguards and transition rules designed to protect against anti- competitive activity by the telcos and cross-subsidization of a telco's cable business by the telco's charges to its telephone customers. These bills also generally eliminate state and local entry barriers which currently either prohibit or restrict an entity's (including a cable operator's) capacity to offer telecommunications services (including telephone exchange service) in competition with telcos and to interconnect on a non-discriminatory basis with telcos and utilize certain telco facilities in order to provide service in competition with a telco. The Clinton Administration has indicated its intention to propose reform of federal telecommunications legislation, although such proposal has not been finalized. At present, state and/or local laws do not prohibit cable television companies from engaging in certain kinds of telephony business in most states. Viacom Cable is a general partner in three partnerships providing commercial competitive access services which link business customers to long distance carriers via private networks owned by the cable television company partners and leased to the partnerships. If the pending legislation does not become law, and the various appeals courts uphold the unconstitutionality of the Communications Act's restrictions on telco video programming, the telcos have stated their intent to immediately enter the video programming business. COMPULSORY COPYRIGHT. Cable television systems are subject to the Copyright Act of 1976 which provides a compulsory license for carriage of distant broadcast signals at prescribed rates. No license fee is charged by the copyright holder for retransmission of broadcast signals which are "local" to the communities served by the cable system. The FCC has recommended to Congress that it eliminate the compulsory license for retransmission of both distant and local signals, requiring instead that approval be received from the copyright holders for retransmission. If the compulsory license is repealed, Viacom Cable could incur additional costs for its carriage of programming of certain broadcast stations and if some broadcast stations are not carried, customer satisfaction with cable service may be adversely affected until satisfactory replacement programming is obtained. Pending legislation in the 103rd Congress includes a bill (H.R.759) to affirm the application of the compulsory license to MMDS and other alternative video transmission technologies; a bill (H.R.1103) to eliminate the sunset provision of the Satellite Home Viewer Act and continue the application of the compulsory license to satellite carriers that transmit to home dish owners; and a bill (H.R.12) to provide for payment by television broadcasters to program producers where a broadcaster exercises its Retransmission Consent rights enacted in the 1992 Cable Act and thereby obtains payment from a cable operator for retransmission of the broadcaster's signal. State and Local Regulation. State and local regulation of cable is exercised primarily through the franchising process under which a company enters into a franchise agreement with the appropriate franchising authority and agrees to abide by applicable ordinances. The 1992 Cable Act permits the FCC to I - 28 broaden the regulatory powers of the franchising authorities, particularly in the areas of rate regulation and customer service standards. (See "BUSINESS --- Regulation -- Viacom Cable -- Federal Regulation") Under the 1984 Act, franchising authorities may control only cable- related equipment and facilities requirements and may not require the carriage of specific program services. However, if the Must Carry provisions of the 1992 Cable Act are upheld by the Supreme Court, federal law (as implemented by FCC regulations) will mandate the carriage of both commercial and non-commercial television broadcast stations "local" to the area in which a cable system is located. (See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation") The 1984 Act, as amended, guarantees cable operators due process rights in franchise renewal proceedings and provides that franchises will be renewed unless the cable operator fails to meet one or more enumerated statutory criteria. The Company's current franchises expire on various dates through 2017. During the five-year period 1994 through 1998, franchises having an aggregate of approximately 230,081 customers (as of October 31, 1993) will expire unless renewed. The Company expects its franchises to be renewed. VIACOM NETWORKS 1992 CABLE ACT. See "BUSINESS -- Regulation -- Viacom Cable -- Federal Regulation -- 1992 Cable Act". MODIFICATION OF FINAL JUDGMENT. The Modification of Final Judgment (the "MFJ") is the consent decree pursuant to which AT&T was reorganized and was required to divest its local telephone service monopolies. As a result, seven RHCs were formed (including NYNEX) comprised of operating companies within their regions (the BOCs). In addition, that portion of the continental United States served by the BOCs was divided into geographical areas termed Local Access and Transport Areas ("LATAs"). The MFJ restricts the RHCs, the BOCs and their affiliates from engaging in inter-LATA telecommunications services and from manufacturing telecommunications products. As a result of NYNEX's investment in Viacom Inc., the Company could arguably be considered an affiliate of an RHC for MFJ purposes. As a result, the Company transferred certain of Viacom Networks' and other operations and properties to an affiliated entity which will be consolidated into the Company for financial reporting purposes. Neither the transfer nor the operations of the affiliate as an entity separate from the Company will have a material effect on the financial condition or the results of operations of the Company. However, should the MFJ restrictions be modified or waived, the Company intends to retransfer the assets and operations and any future appreciation in the value of such assets after such retransfer will be for the benefit of the holders of Viacom Common Stock. VIACOM BROADCASTING Television and radio broadcasting are subject to the jurisdiction of the FCC pursuant to the Communications Act. I - 29 THE COMMUNICATIONS ACT. The Communications Act authorizes the FCC: to issue, renew, revoke or modify broadcast licenses; to regulate the radio frequency, operating power and location of stations; to approve the transmitting equipment used by stations; to adopt rules and regulations necessary to carry out the provisions of the Communications Act; and to impose certain penalties for violations of the Communications Act and the FCC's regulations governing the day-to-day operations of television and radio stations. BROADCAST LICENSES. Broadcast station licenses (both television and radio) are ordinarily granted for the maximum allowable period of five years in the case of television and seven years in the case of radio, and are renewable for additional five-year or seven-year periods upon application and approval. Such licenses may be revoked by the FCC for serious violations of its regulations. Petitions to deny renewal of a license or competing applications may be filed for the frequency used by a renewal applicant. If a petition to deny is filed, the FCC will determine whether renewal is in the public interest based upon presentations made by the licensee and the petitioner. If a competing application is filed, a comparative hearing is held to determine which applicant should be granted the license. In the absence of egregious and willful violations of FCC rules, license holders, as a practical matter, can generally expect renewal by the FCC. The licenses for the Company's television stations expire as follows: WVIT-TV on April 1, 1994; each of WNYT-TV and WHEC-TV on June 1, 1994; KSLA-TV on June 1, 1997; and KMOV-TV on February 1, 1998. The Company's licenses for its radio stations expire as follows: WMZQ- AM-FM, WCPT-AM and WCXR-FM on October 1, 1995; WLTI-FM on October 1, 1996; WLIT-FM on December 1, 1996; KSRI-FM and KSRY-FM on August 1, 1997; KYSR-FM and KXEZ-FM on December 1, 1997; each of KBSG-AM-FM and KNDD-FM on February 1, 1998; and WLTW-FM on June 1, 1998. The Company has applied for renewal of and expects that the licenses which expire in 1994 will be renewed. The Communications Act prohibits the assignment of a license or the transfer of control of a license without prior approval of the FCC. The Communications Act also provides that no license may be held by a corporation if (1) any officer or director is an alien, or (2) more than 20% of the voting stock is owned of record or voted by aliens or is subject to control by aliens. In addition, no corporation may hold the voting stock of another corporation owning broadcast licenses if any of the officers or directors of such parent corporation are aliens or more than 25% of the voting stock of such parent corporation is owned of record or voted by aliens or is subject to control by aliens, unless specific FCC authorization is obtained. MUST CARRY/RETRANSMISSION CONSENT. The 1992 Cable Act contains provisions which grant certain Must Carry rights to commercial broadcast television stations that are "local" to communities served by a cable system, including the right to elect either to require a cable operator to carry the station pursuant to the Must Carry provisions of the Act or to require that the cable operator secure the station's Retransmission Consent on a negotiated basis before the station can be carried (i.e., retransmitted) on the cable system. Each of the ---- Company's television stations elected in 1993 to negotiate with their I - 30 local cable systems for the systems' right to retransmit the station's signal. All such negotiations were successfully completed assuring continued carriage of each station on all of their local cable systems at least through December 1996. The Must Carry Rules were challenged by cable program services and cable system operators. In April 1993, a District of Columbia three judge court upheld the rules against a facial First Amendment attack. The U.S. Supreme Court accepted review; oral argument was heard in January 1994 and a decision is expected by July 1994. If the Must Carry Rules are determined to be unconstitutional, the Company's television stations do not expect to be materially affected since they expect to continue to obtain carriage pursuant to Retransmission Consent negotiations. If a station is not carried by a cable system in its area, that station could experience a decline in revenues. The Company's television stations have traditionally been carried prior to the institution of Retransmission Consent and in the absence of Must Carry. (See "BUSINESS -- Regulation - -- Viacom Cable Television -- Must Carry/Retransmission Consent and Compulsory Copyright") RESTRICTIONS ON BROADCAST ADVERTISING. In past Congressional sessions, committees of Congress examined proposals for legislation that would eliminate or severely restrict advertising of beer and wine either through direct restrictions on content or through elimination or reduction of the deductibility of expenses for such advertising under federal tax laws. Such proposals generated substantial opposition, but it is possible that similar proposals will be reintroduced in Congress. The elimination of all beer and wine advertising would have an adverse effect on the revenues of the Company's television and radio stations. Congress may again take up Campaign Finance Reform legislation similar to that which was passed by the 102nd Congress but vetoed by President Bush. Such legislation could reduce revenues of the Company's television and radio stations derived from political advertising by candidates for certain public offices. On April 9, 1991, the FCC adopted regulations to implement the Children's Television Act of 1990 (the "Children's Television Act") which limit the amount of advertising in children's programming, including a prohibition on children's programming which contains characters that are based on products advertised on such programs. The FCC will take into account the efforts made by broadcasters to meet the educational and informational needs of children as part of assessing the broadcaster's record of performance in the public interest before granting renewal of broadcast licenses. The impact, if any, of these regulations on the Company's television stations is not material. The FCC has instituted an inquiry into the manner in which TV stations have been complying with the Children's Television Act. Additionally, the FCC is considering whether to impose limits on the amount of advertising time which a television station can sell during any broadcast hour or part thereof. OWNERSHIP LIMITATIONS. The FCC has placed limits on the number of radio and television stations in which one entity can own an "attributable interest". The Company currently owns radio stations below those ownership limits and, with the transfer of control of licenses held by Paramount, owns the maximum permitted number of I - 31 television stations. The FCC has adopted a number of rules designed to prevent monopoly or undue concentration of control of the media of mass communications. In 1992 the FCC amended its regulations to permit a single entity to have an "attributable" ownership or management interest in up to 18 AM and 18 FM stations nationwide (20 AM and 20 FM beginning in 1994), including multiple AM and/or FM stations licensed to serve the same market. Minority-controlled broadcasters can own an additional three AM and three FM stations. The limit on the number of such multiple stations in a particular market which a single entity may own or control depends upon the total number of AM and/or FM stations in that market, provided that, at the time of purchase, the combined audience share of such multiple stations does not exceed 25%. With respect to television, the FCC's rules limit the maximum number of stations nationwide in which one entity can have an "attributable" ownership or management interest, to that number which serves up to 25% of U.S. television households, provided, however, that (except in limited circumstances) the total number of stations will not exceed 12. Unlike certain of the new radio rules, there is now no allowance for ownership of multiple television stations licensed to serve the same market, although the FCC is examining the issue. The FCC also permits radio stations to broker the programming and sales inventories of their stations to other radio stations within the same area, subject to various restrictions, so long as ultimate operational control and ownership is retained and exercised by the licensee. Such brokerage agreements function, as a practical matter, to effect a consolidation of competitive radio broadcast stations within a market in much the same manner as multiple ownership of radio facilities by one entity. Similar brokerage agreements among television stations are being implemented in a smaller number of markets than in radio and are not now subject to any explicit FCC regulations. The FCC's ownership limitations also prohibit a single entity from owning multiple "same service" (e.g., TV, AM or FM) stations licensed ---- to serve different markets if the broadcast signals of such stations overlap, to a specified measurable degree. The maximum number of commonly owned stations serving neighboring markets whose signals can overlap is the same as that maximum number of commonly owned stations which an entity can own or control in a single market. Additional ownership prohibitions preclude common ownership in the same market of (i) television stations and cable systems; (ii) television or radio stations and newspapers of general circulation; and (iii) radio and television stations. Radio-television cross-ownership prohibitions are subject to waiver by the FCC on a case-by-case basis. The Company operates two AM and two FM stations as well as a television station serving Washington, D.C. Ownership of the television station (WDCA) was obtained when Viacom Inc. acquired majority ownership of Paramount on March 11, 1994. Pursuant to the FCC's order consenting to the transfer of control of the broadcast licenses of Paramount to the Company, the Company has undertaken to dispose of one AM and one FM radio station serving Washington, D.C. no later than September 11, 1995. The FCC's previous prohibition on a national television network's (ABC, CBS, and NBC) owning or operating cable systems has been repealed but with certain limits as to the number of homes which network-owned cable systems can pass on a national and local basis. TERRITORIAL EXCLUSIVITY. The FCC is considering changes to its I - 32 non-network program territorial exclusivity rules which provide that a broadcaster, with certain limited exceptions, cannot obtain exclusivity to syndicated programming as against other broadcast stations beyond a 35-mile radius from its city of license. The proposed rule would permit expansion of the 35-mile exclusivity area thereby increasing the protection given the programming contracted for by a broadcaster. The Company cannot predict the effect, if any, that any change of this rule may have on its broadcast operations. HDTV. The FCC is considering technical standards to be adopted for the transmission of high definition television ("HDTV"), an advanced television system which enhances picture and sound quality, as well as the methods and timetable for implementation of an HDTV transmission standard by broadcasters. A standard has been recommended to the FCC by an advisory committee. The standard which is ultimately adopted for HDTV transmissions and the manner in which that transmission standard will be implemented and the development of technologies such as "digital compression" will have an economic and competitive impact on broadcasting and cable operations. The Company cannot predict the effect of implementation of these technologies on its operations. The FCC has stated its intention not to disadvantage broadcasters and it is expected that any HDTV standard which is ultimately adopted will be fashioned so as to accommodate the needs of broadcasters vis-a-vis competitive video delivery technologies. The FCC has already determined that TV stations will be given up to six years to implement HDTV once a standard has been selected and that stations which do not convert to the HDTV standard will lose their licenses to broadcast at the end of a proposed 15-year period from adoption of the standard. The cost of converting to HDTV will not have a material effect on the Company. COMPETITION VIACOM NETWORKS MTVN COMPETITION. MTVN services are in competition for available channel space on existing cable systems and for fees from cable operators and alternative media distributors, with other cable program services, and nationally distributed and local independent television stations. MTVN also competes for advertising revenue with other cable and broadcast television programmers, and radio and print media. For basic cable television programmers, such as MTVN, advertising revenues derived by each programming service depend on the number of households subscribing to the service through local cable operators and other distributors. A number of record companies have announced plans to launch music-based program services in the U.S. and internationally. For example, Tele-Communications, Inc. and Bertelsmann AG announced plans for a music video/home shopping channel and Sony Corp.'s Sony Music and Time Warner Inc.'s Time Warner Music Group are discussing the formation of a worldwide music video program service with such other major record companies as EMI Music, a unit of Thorn EMI PLC, and PolyGram. As of December 31, 1993, there were 32 principal cable program I - 33 services and superstations under contract with A.C. Nielsen Company, including MTV, VH-1, NICKELODEON (including NICKELODEON and NICK AT NITE program segments), each with over 10,000,000 subscribers. The Nielsen Report ranked NICKELODEON/NICK AT NITE seventh, MTV eleventh, and VH-1 sixteenth, in terms of subscriber households. MTV EUROPE is engaged in a number of related litigations in Europe contesting the legality of certain joint licensing activities by the major worldwide record companies. In 1992, MTV EUROPE initiated a proceeding before the European Commission, seeking the dissolution, under Articles 85 and 86 of the Treaty of Rome, of the record companies' joint licensing organizations -- Video Performance Limited (VPL) and International Federation of Phonogram and Videogram Producers (IFPI) -- through which the record companies exclusively license rights to exhibit music video clips on television in Europe and elsewhere. The EC issued a preliminary letter in 1993 stating its non-binding opinion that the arrangements constituted an unlawful restriction of trade under Article 85, and reserved its right to address abuse of monopoly power under Article 86. MTVN has been informed that the EC has issued a Statement of Objections, which commences formal legal proceedings against VPL and IFPI, and their major record company members. MTV EUROPE has been licensed to continue to exhibit music video clips during the EC proceeding under an EC-assisted interim agreement with VPL and IFPI, which expires in July 1994. In December 1993, MTV EUROPE commenced a separate proceeding before the European Commission, challenging the operation of VIVA, a German language music service owned by four of the five major record companies, as another example of illegal cartel activity. In a separate U.K. high court action, MTV EUROPE is seeking reimbursement of license fees paid to VPL and IFPI, on the grounds that these fees were unlawfully extracted by the record companies' cartel organizations. SNI COMPETITION. The principal means of competition in the provision of premium subscription television program services are: (1) the acquisition and packaging of an adequate number of quality recently released motion pictures; and (2) the offering of prices, marketing and advertising support and other incentives to cable operators and other distributors so as to favorably position and package SNI's premium subscription television program services to subscribers. HBO is the dominant company in the premium subscription television category, offering two premium subscription television program services, the HBO service and Cinemax. SNI is second to HBO with a significantly smaller share of the premium subscription television category. In addition, in February 1994, Encore Media Corp. (an affiliate of Liberty Media Corporation and Tele-Communications, Inc.) launched Starz!, a premium subscription television program service that will exhibit recently released motion pictures. The Company believes that Starz! will directly compete with SNI's premium program services. On November 9, 1993, the Company filed an amended complaint in its antitrust suit against Tele-Communications, Inc., Liberty Media Corporation, Satellite Services, Inc., Encore Media Corp., Netlink USA, Comcast Corporation and QVC Network, Inc., which action is pending in I - 34 the Southern District of New York. (See "Item 3 - Legal Proceedings") VIACOM ENTERTAINMENT Distribution and production of programming for television is a highly competitive business. The Company competes directly with other distributors and producers including major motion picture studios and other companies which produce and/or distribute programs and films. The main competitive factors in the television program distribution business are the availability and quality of product, promotion and marketing, and access to licensees of product. Major studios and distributors with a history of successful programming are better positioned to acquire and/or produce and distribute quality product. These studios and distributors also have greater available resources for promotion and marketing. Brand name identification is an advantage to a distributor in promoting and marketing programs for domestic and first run exhibition. The decline in the demand by licensees for recent off-network series and series produced for first run exhibition (due to renewal of existing series by stations during the past year) and feature films (due primarily to the recent expansion of the Fox network to supply programming to its affiliated stations seven nights a week) has been partly offset by a resurgence in demand by stations for first run hours and an increasing number of programming outlets, particularly cable networks. Distributors are advantageously positioned to obtain clearances from stations they also own. This advantage increases with an increase in the number of stations so owned, the size of the markets served by those stations and the viewership of those stations. Since the successful launch of a program for first run exhibition generally requires securing licenses in New York, Los Angeles and Chicago, distributors owning stations serving these markets are at the greatest advantage among distributors owning stations. Distribution of programming for television in international markets is also a highly competitive business. The Company competes in such markets with both U.S. and non-U.S. producers and distributors. Deregulation by certain foreign countries has given rise to new broadcast stations and cable services which, along with technological advances such as DBS, are continuing to increase the number of potential international customers. However, as a result of a political directive adopted by the European Community in 1989, which became effective in October 1991, most European Community countries have adopted broadcast quota regulations based on the guidelines of the directive. Such broadcast quota regulations may adversely affect the amount of U.S. produced programming to be purchased by foreign customers. (See "BUSINESS -- Regulation -- Viacom Entertainment -- European Community Directive") Program production for network television, which is a source of product for the Company's distribution operations, and program production for first run exhibition on cable and other media are highly competitive businesses. The Company competes with the major studios and other production companies. A company with a program airing on a network, which program the network deems commercially successful, is at an advantage in getting that network and, to a lesser extent, other I - 35 networks, to license additional programs. (See "BUSINESS -- Viacom Entertainment -- Viacom Productions") Subsequent to December 31, 1993, Viacom Inc. acquired Paramount, which is a significantly larger distributor and producer of television programming. It is anticipated that this acquisition and the combination of the Company's television distribution and production businesses with those of Paramount will significantly enhance the Company's competitive position in these businesses. VIACOM NEW MEDIA The emerging market for interactive multimedia software is highly competitive and rapidly evolving. Major competitors include hardware manufacturers who also manufacture and publish cartridge video games, software publishers, and interactive software publishing divisions that have been established by diversified entertainment companies similar to the Company. VIACOM CABLE TELEVISION The Company's cable systems operate pursuant to non-exclusive franchises granted by local governing authorities (either municipal or county) and primarily compete with over-the-air broadcast television. Cable systems also compete with other distribution systems which deliver programming by microwave transmission ("MDS" and "MMDS") and satellite transmission to master antennas ("SMATV") or directly to subscribers via either "TVRO" or "DBS" technology. A new type of distribution system called Multichannel Local Distribution Service ("MLDS"), which is similar to but more advanced than MMDS due to greater channel capacity, could also become competitive with cable. In 1991, the FCC concluded a proceeding aimed at eliminating a number of technological and regulatory limitations applicable to, and thereby supporting the potential growth of, MMDS and SMATV as competitive video delivery technologies. Certain DBS distribution systems are expected to commence their services in the near future, including United States Satellite Broadcasting, Inc., with which the Company has distribution agreements for each of the Company's wholly owned basic cable and premium networks, and Hughes DirecTV The development of these other distribution systems could in the future result in substantial competition for the Company's cable systems, depending upon the marketing plans and programming provided. However, a developing technology called "digital compression" may allow cable systems to significantly increase the number of channels of programming they deliver and thereby help cable systems meet competition from these other distribution systems. The acquisition of new franchises has slowed as an increasingly limited number of franchises and systems are left to be developed. The resulting reduced rate of construction may affect the cable industry's ability to sustain its historical subscriber growth rate. However, cable operators have increasingly sought to expand their subscriber bases through the acquisition of contiguous systems, which provide increased operating efficiencies. The Company's plan to expand in the cable business includes supplying additional services to its customers, I - 36 increasing primary and premium subscriber penetrations, developing existing franchise areas and, to a lesser degree, reviewing possible acquisitions of existing systems, principally contiguous systems, directly or through participation with others in partnerships or joint ventures. Since the Company's cable television systems are franchised on a non-exclusive basis, other cable operators have been franchised and may continue to apply for franchises in certain areas served by the Company's cable systems. In addition, the 1992 Cable Act prohibits a franchiser from granting exclusive franchises and from unreasonably refusing to reward additional competitive franchises. In 1986, the U.S. Supreme Court held that cable system operations implicate First Amendment rights and that local franchising authorities may violate those rights by establishing franchise requirements, unless there is a legitimate government purpose. Since this decision, various federal district and appellate courts have issued contradictory opinions with respect to the enforceability of specific franchise requirements. Depending on the resolution of these cases, competitive entry by other operators into Viacom Cable's franchise areas and Viacom Cable's entry into other franchise areas could be more easily achieved. The entry of telephone companies into the cable television business may adversely affect Viacom Cable. The FCC's Video Dial Tone regulations (See "BUSINESS -- Regulation -- Viacom Cable Television -- Competition with Telephone Companies") are an indication of the FCC's willingness to narrow the cross-ownership prohibitions contained in the Communications Act to the extent that it can do so consistent with its interpretation of the Act. VIACOM BROADCASTING The principal methods of competition in the television and radio broadcasting field are the development of audience interest through programming and promotions. Television and radio stations also compete for advertising revenues with other stations in their respective coverage areas and with all other advertising media. They also compete with various other forms of leisure time activities, such as cable television systems and audio players and video recorders. These competing services, which may provide improved signal reception and offer an increased home entertainment selection, have been in a period of rapid development and expansion. Technological advances and regulatory policies will have an impact, upon the future competitive broadcasting environment. In particular, recent FCC liberalization of its radio station ownership limits will allow for increased group ownership of stations. However, the Company is unable to predict what impact these rule changes will have on its businesses in their markets. (See "BUSINESS -- Regulation -- Viacom Broadcasting -- Ownership Limitations") DBS satellite distribution of programs is expected to commence in 1994. Additionally, the FCC has issued rules which may significantly increase the number of multipoint distribution service stations (i.e., ---- video services distributed on microwave frequencies which can only be received by special microwave antennas). The FCC has also authorized I - 37 video uses of certain frequencies which have not traditionally been used or permitted for commercial video services and has issued rules which will increase the number of FM and AM stations. The FCC is also considering authorizing digital audio broadcasts ("DAB"), which could ultimately permit increased radio competition by satellite delivery of audio stations directly to the home (or to cars) and result in an increased spectrum being used for digital delivery of radio signals, and it has authorized and is in the process of licensing low power television stations ("LPTV stations") that may serve various communities with coverage areas smaller than those served by full conventional television stations. Because of their coverage limitations, LPTV stations may be allocated to communities which cannot accommodate a full power television station because of technical requirements. ITEM 2. ITEM 2. PROPERTIES. The Company maintains its worldwide headquarters at 1515 Broadway, New York, New York, where it rents approximately 720,000 square feet for executive offices, including MTVN. The Company also rents approximately 24,000 square feet at the same location for WLTW-FM and Viacom Broadcasting headquarters. The lease runs to 2010, with four renewal options for five years each. The lease also grants the Company options for additional space at the then fair market value, including sufficient space for SNI and Paramount headquarters staff, and a right of first negotiation for other available space in the building. The Company also leases approximately 106,000 square feet at 1775 Broadway, New York, New York. The lease expires in 1998. In 1992, the Company sublet approximately 53,000 square feet of such space to COMEDY CENTRAL. The Company also operates a data processing facility in Rutherford, New Jersey and owns a 30,000 square foot building at 140 West 43rd Street, New York, New York, which supports office and conferencing requirements. Viacom MGS Services leases approximately 25,000 square feet at 619 West 54th Street, New York, New York. During 1993, the Company leased premises in California, Ohio, Oregon, Tennessee and Washington, the locations of Viacom Cable's operations. Viacom Cable's operations require a large investment in physical assets consisting primarily of receiving apparatus, trunk lines, feeder cable and drop lines connecting the distribution network to the premises of the customers, electronic amplification and distribution equipment, converters located in customers' homes and other components. Significant expenditures are also required for replacement of and additions to such system assets as a result of technological advances, ordinary wear and tear and regulatory standards. Approximately 47% of the Company's cable television systems' fixed assets have been installed within the past five years and, except for ordinary wear and tear, the Company believes that this equipment is in good condition. I - 38 In addition to its leased space at 1515 Broadway, Viacom Broadcasting owns office and studio space in Hartford, Connecticut, occupied by television station WVIT-TV; in Menands, New York, occupied by television station WNYT-TV; in Shreveport, Louisiana, occupied by television station KSLA-TV; and in Rochester, New York, occupied by television station WHEC-TV. Television station KMOV-TV, St. Louis, Missouri, leases office and studio space for a term expiring December 31, 2002. WLIT-FM, Chicago, Illinois, leases office and studio space for a term expiring in April 2002. WLTI-FM, Detroit, Michigan, leases office and studio space for a term expiring in August 2002. WMZQ-FM, Washington, D.C., leases office and studio space for a term expiring in December 1998. WMZQ-AM, Arlington, Virginia, leases office and studio space for a term expiring in August 2014. WCPT-AM and WCXR-FM lease office and studio space in Alexandria, Virginia for a term expiring in November 2001. KBSG-AM/FM, Tacoma/Seattle, Washington, lease office and studio space for a term expiring in August 1999. KYSR-FM, and KXEZ-FM, Los Angeles, California, lease office and studio space for a term expiring in October 1999. KSRY-FM, San Francisco, California, leases office and studio space for a term expiring in March 1997. KSRI-FM, Santa Cruz, California, leases office and studio space for a term expiring in July 1995. KNDD-FM, Seattle, Washington, leases office and studio space for a term expiring in February 2001. Viacom Broadcasting owns the broadcasting antenna equipment of its radio and television stations and the main transmission and antenna sites used by its five television stations and radio stations WMZQ-FM, WCPT-AM, KYSR-FM and KNDD-FM. The other radio stations, WLTW-FM, WLIT- FM, WLTI-FM, WCXR-FM, WMZQ-AM, KBSG-AM, KBSG-FM, KSRY-FM, KSRI-FM and KXEZ-FM lease their transmission and antenna sites. The leases expire in August 2005, September 2002, December 1995, February 2000, August 2014, February 2000, December 1997, February 2000, May 1999, and November 2000, respectively. MTVN, by agreement with MCA, leases approximately 75,000 square feet of studio and office space for NICKELODEON STUDIOS FLORIDA, which agreement expires (with extensions at MCA's option) in 2003. MTVN leases approximately 58,600 square feet of other office facilities and studios (i.e., excluding 1515 Broadway, 1775 Broadway, NICKELODEON ---- STUDIOS, Orlando and Universal City, Los Angeles). MTVN also owns the Network Operations Center in Smithtown, New York at which it assembles and uplinks its programming signals. The center consists of a 15,000 square foot building housing television and satellite transmission equipment. In March 1993, a subsidiary of the Company entered into an agreement to purchase approximately 50,000 square feet of office and studio space in London, England. The Company leases the space to MTV EUROPE. SNI's executive offices are located at 1633 Broadway, New York, New York, where it rents approximately 106,000 square feet. SNI leases approximately 58,000 square feet of other office facilities (i.e., ---- excluding 1633 Broadway, 1775 Broadway and Universal City, Los I - 39 Angeles). For a description of the transponders employed by MTVN and SNI, see "BUSINESS -- Viacom Networks -- Additional Information about MTVN and SNI." Other than Brazil, where the office facility is owned, most of the domestic and international television program and feature film sales offices are held under leases aggregating approximately 9,000 square feet. Also, the Company maintains approximately 83,000 square feet of consolidated offices in Universal City, Los Angeles for Viacom Entertainment, MTVN and SNI. The Company also maintains a tape storage and operations service center of approximately 22,500 square feet for Viacom Networks and Viacom Enterprises in New York, New York. The Company believes that all of its facilities are adequate for the activities conducted at such facilities. However, the Company anticipates that it will lease or purchase additional office space both in the New York area as well as in other areas where the Company and its subsidiaries are presently located. Information with respect to Paramount in response to Item 2 is incorporated by reference herein from the Paramount Reports. Information in the Paramount Reports is given as of the date of each such report and is not updated herein. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Stockholder Litigation. Seven putative class action complaints were filed by alleged Blockbuster stockholders in the Delaware Court of Chancery against Blockbuster, the members of its Board of Directors, Viacom Inc. and Sumner M. Redstone. By Order dated January 31, 1994, the seven actions were consolidated under the caption In re Blockbuster Entertainment Corp. Shareholders' Litigation, Consolidated Civil Action No. 13319. On February 18, 1994, plaintiffs filed the Consolidated and Amended Class Action Complaint (the "Complaint"). The Complaint generally alleges that Blockbuster's directors have violated their fiduciary duties of loyalty and fair dealing by allegedly failing to ensure the maximization of stockholder value in the sale of control of Blockbuster, including the alleged failure to authorize and direct that a process designed to secure the best value available for Blockbuster stockholders be undertaken, and by implementing measures such as the Subscription Agreement which allegedly were designed solely to thwart or impede other competing transactions. Among other things, the plaintiffs seek to (i) preliminarily and permanently enjoin the purchase by Blockbuster of shares of Viacom Class B Common Stock pursuant to the Subscription Agreement (see next paragraph); (ii) preliminarily and permanently enjoin the Blockbuster Merger or any anti-takeover devices designed to facilitate the Blockbuster Merger; (iii) require the Blockbuster directors to maximize stockholder value by exploring third party interest; and/or (iv) recover damages from the I - 40 Blockbuster directors for their alleged breaches of fiduciary duty. The defendants believe that plaintiffs' allegations are without merit and intend to defend themselves vigorously. On February 28, 1994, plaintiffs filed motions in the Delaware Chancery Court seeking expedited discovery, a temporary restraining order enjoining consummation of the Subscription Agreement and the scheduling of a preliminary injunction hearing. On March 1, 1994, Vice Chancellor Carolyn Berger issued an order denying plaintiffs' motions. Following issuance of the above-described order, plaintiffs filed a Motion for Clarification or, in the alternative, for Certification on Interlocutory Appeal, requesting that the Chancery Court clarify whether its order also refers to a hearing for a preliminary injunction. Plaintiffs requested that, if the order is limited to a hearing for a temporary restraining order, the Chancery Court schedule a hearing on plaintiffs' motion for a preliminary injunction. On March 2, 1994, plaintiffs informed the Chancery Court that they had decided not to seek an interlocutory appeal and indicated their understanding that the order precluded preliminary injunctive relief as to the Subscription Agreement. On March 7, 1994, the plaintiffs filed a motion for a preliminary injunction, seeking an order preliminarily enjoining the defendants from (i) taking any steps to effectuate or enforce the Blockbuster Merger Agreement, the Subscription Agreement and the Stockholders Stock Option Agreement; (ii) making any payment to Viacom of its fees and expenses pursuant to Section 8.05(b) of the Blockbuster Merger Agreement; and (iii) entering into any competing transaction with a party other than Viacom, which transaction includes a stock component unless adequate price protection for the stockholders of Blockbuster is provided. Plaintiffs have also moved for an injunction requiring the Blockbuster defendants to investigate all bona fide offers to acquire Blockbuster and to provide such bona fide offerors access to information concerning Blockbuster in order to facilitate such offers. No schedule has been set for a hearing on the motion. On March 10, 1994, Defendant Sumner Redstone filed a motion to dismiss the Complaint as to him, on the grounds of lack of personal jurisdiction, insufficiency of process, and insufficiency of service of process. Also, on March 10, 1994, defendant Viacom filed a motion to dismiss the Complaint as to itself, for failure to state a claim against Viacom upon which relief can be granted. No schedule has been set for a hearing on these motions. Antitrust Matters On September 23, 1993, the Company filed an action in the United States District Court for the Southern District of New York styled Viacom International Inc. v. Tele-Communications, Inc., et al., Case No. 93 Civ. 6658, against Tele-Communications, Inc. ("TCI"), Liberty Media Corporation, Satellite Services, Inc. ("SSI"), Encore Media Corp., Netlink USA, and QVC Network, Inc. The complaint alleges violations of Sections 1 and 2 of the Sherman Act, Section 7 of the Clayton Act, Section 12 of the Cable Act, and New York's Donnelly Act, and tortious interference, against all defendants, and a breach of contract claim against defendants TCI and SSI only. In addition to I - 41 other relief, the Company seeks injunctive relief against defendants' anticompetitive conduct and damages in an amount to be determined at trial, including trebled damages and attorneys' fees under the Sherman and Clayton Acts and damages resulting from QVC Network, Inc.'s proposed acquisition of Paramount Communications Inc. The 19 claims for relief in the complaint are based on allegations that defendants exert monopoly power in the U.S. cable industry through their control over approximately one in four of all cable households in the United States. Among other things, the complaint alleges that defendants conspired and attempted to force SNI to enter into a merger with a TCI-controlled pay television service; defendants have attempted to eliminate The Movie Channel from at least 28 of TCI's systems and have plans to eliminate The Movie Channel from another 27 such systems; defendants have conspired with General Instrument Corporation ("GI") to entrench GI's monopoly power in the markets for digital compression and encryption systems and to use such monopoly power to weaken and eliminate the defendants' competitors; and TCI's construction of a central authorization center to illegally control the distribution of programming services through refusals to deal and denial of direct access. On November 9, 1993, the Company amended its complaint in Viacom International Inc. v. Tele-Communications, Inc., et al., Case No. 93 Civ. 6658, to add Comcast Corporation as an additional defendant and to incorporate into the allegations additional anticompetitive activities by the defendants. Each of the defendants has answered and has generally denied the material allegations of the Company's amended complaint. Following the filing of its amended complaint, the Company has agreed to voluntarily dismiss certain of its breach of contract claims against TCI and SSI. Viacom Cable, through a subsidiary of the Company, was one of the original partners ("Original Partners") of Primestar Partners L.P. ("Primestar"). Primestar was launched in 1990 to deliver programming directly to dishes located at subscribers' homes from a mid-powered Ku- band satellite. The Company has withdrawn from Primestar by, among other things, exercising in November 1991 the Company's contractual right not to continue funding its share of Primestar's capital requirements. The Department of Justice ("DOJ") has conducted an inquiry into the structure and business of Primestar to ensure that the Original Partners did not engage in any concerted action prohibited by law. In addition, several state Attorneys General ("AGs") have reviewed the structure and business plan of Primestar as well as certain business practices of the Original Partners which reflect business practices in the cable industry, generally. The AGs' inquiry resulted in a final judgment entered into with the consent of the Original Partners in September of 1993. The DOJ has concluded its inquiry by submitting a similar consent judgment for judicial approval. Both judgments address (i) access by multichannel distributors competitive with cable to programming controlled by any of the Original Partners and (ii) the extent of programming which may be licensed exclusively by the cable operations of the Original Partners. The provisions of the AGs' decree expire in 1997 and 1999. If approved, as expected, the provisions of the DOJ decree will expire in 1999. The terms of the judgments do not materially affect the Company. Information with respect to Paramount in response to Item 3 is I - 42 incorporated by reference herein from the Paramount Reports. Information in the Paramount Reports is given as of the date of each such report and is not updated herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable EXECUTIVE OFFICERS OF VIACOM INC. AND THE COMPANY Set forth below is certain information concerning the current executive officers of Viacom Inc. and the Company, which information is hereby included in Part I of this report. POSITIONS WITH VIACOM INC. NAME AGE AND THE COMPANY - ------------------------------------------------------------------------ Sumner M. Redstone 70 Chairman of the Board of Viacom Inc. and the Company Frank J. Biondi, Jr 49 President, Chief Executive Officer and Director of Viacom Inc. and the Company Raymond A. Boyce 58 Senior Vice President, Corporate Relations of Viacom Inc. and the Company Neil S. Braun 41 Senior Vice President of Viacom Inc. and the Company Vaughn A. Clarke 40 Vice President, Treasurer of Viacom Inc. and the Company Philippe P. Dauman 40 Executive Vice President, General Counsel, Chief Administrative Officer and Secretary and Director of Viacom Inc. and the Company Earl H. Doppelt 40 Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company Thomas E. Dooley 37 Executive Vice President, Finance, Corporate Development and Communications of Viacom Inc. and the Company Michael D. Fricklas 34 Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company I - 43 John W. Goddard 52 Senior Vice President of Viacom Inc. and the Company; President, Chief Executive Officer of Viacom Cable Edward D. Horowitz 46 Senior Vice President, Technology of Viacom Inc. and the Company; Chairman, Chief Executive Officer of New Media and Interactive Television Kevin C. Lavan 41 Vice President, Controller and Chief Accounting Officer of Viacom Inc. and the Company Henry J. Leingang 44 Senior Vice President, Chief Information Officer of Viacom Inc. and the Company William A. Roskin 51 Senior Vice President, Human Resources and Administration of Viacom Inc. and the Company George S. Smith, Jr. 45 Senior Vice President, Chief Financial Officer of Viacom Inc. and the Company Mark M. Weinstein 51 Senior Vice President, Government Affairs of Viacom Inc. and the Company None of the executive officers of Viacom Inc. or the Company is related to any other executive officer or director by blood, marriage or adoption except that Brent D. Redstone, a Director of Viacom Inc. and the Company, is the son of Sumner M. Redstone. Mr. Redstone has been Chairman of the Board and a Director of the Company since the Merger. Mr. Redstone is also Chairman of the Board and a Director of Viacom Inc. Mr. Redstone has served as President, Chief Executive Officer of NAI since July 1967, and continues to serve in such capacity; he has also served as the Chairman of the Board of NAI since 1986. Mr. Redstone became a director of Paramount in March 1994. He served as the first Chairman of the Board of the National Association of Theater Owners, and is currently a member of the Executive Committee of that organization. During the Carter Administration, Mr. Redstone was appointed a member of the Presidential Advisory Committee on the Arts for the John F. Kennedy Center for the Performing Arts and, in 1984, he was appointed a Director of the Kennedy Presidential Library Foundation. Since 1982, Mr. Redstone has been a member of the faculty of Boston University Law School, where he has lectured in entertainment law. In 1944, Mr. Redstone graduated I - 44 from Harvard University and, in 1947, received an L.L.B. from Harvard University School of Law. Upon graduation, he served as Law Secretary with the United States Court of Appeals, and then as a Special Assistant to the United States Attorney General. Mr. Biondi has been President, Chief Executive Officer and a Director of Viacom Inc. and the Company since July 1987. He became a director of Paramount in March 1994. From November 1986 to July 1987, Mr. Biondi was Chairman, Chief Executive Officer of Coca-Cola Television and, from 1985, Executive Vice President of the Entertainment Business Sector of The Coca-Cola Company. Mr. Biondi joined HBO in 1978 and held various positions there until his appointment as President, Chief Executive Officer in 1983. In 1984, he was elected to the additional position of Chairman and continued to serve in such capacities until October 1984. Mr. Boyce has been an executive officer of Viacom Inc. and the Company since January 1988 when he was elected Senior Vice President, Corporate Relations of the Company. In April 1988, he was elected Senior Vice President, Corporate Relations of Viacom Inc. Mr. Boyce served as Vice President, Public Relations of the Entertainment Business Sector of The Coca-Cola Company from 1982 to 1987. In 1979, Mr. Boyce joined Columbia Pictures Industries, Inc. and served first as Director, Corporate Communications and later as Vice President, Corporate Communications until The Coca-Cola Company's acquisition of Columbia Pictures Industries, Inc. in 1982. Mr. Braun has been an executive officer of Viacom Inc. and the Company since November 1987 when he was elected Senior Vice President of each. He served as Chairman, Chief Executive Officer of Viacom Entertainment from July 1992 to March 1994. Prior to that, Mr. Braun served as Senior Vice President, Corporate Development and Administration of Viacom Inc. and the Company from November 1987 to July 1992 and from October 1989 to July 1992, he also served as Chairman of Viacom Pictures. Mr. Braun served as President, Chief Operating Officer of Imagine Films Entertainment from May 1986 until he joined the Company. From 1982 until 1986, Mr. Braun held various positions at HBO including Senior Vice President, Film Programming of HBO and Executive Vice President of HBO Video, Inc. Mr. Clarke was elected Vice President, Treasurer of Viacom and the Company in April 1993. Prior to that, he spent 12 years at Gannett Co., Inc., where he held various management positions, most recently as Assistant Treasurer. Mr. Dauman has been a Director of Viacom Inc. and the Company since the Merger. In March 1994, he was elected Executive Vice President, General Counsel, Chief Administrative Officer and Secretary of Viacom Inc. and the Company. From February 1993 to March 1994, he served as Senior Vice President, General Counsel and Secretary of Viacom Inc. and the Company. Prior to that, Mr. Dauman was a partner in the law firm of Shearman & Sterling in New York, which he joined in 1978. Mr. Dauman became a Director of National Amusements, Inc. in 1992 and Paramount in March 1994. Mr. Dooley has been an executive officer of the Company since I - 45 January 1987. In March 1994, he was elected Executive Vice President, Finance, Corporate Development and Communications of Viacom Inc. and the Company. From July 1992 to March 1994, Mr. Dooley served as Senior Vice President, Corporate Development of Viacom Inc. and the Company. From August 1993 to March 1994, he also served as President, Interactive Television. Prior to that, he served as Vice President, Treasurer of the Company and Viacom Inc. since 1987. In December 1990, he was named Vice President, Finance of Viacom Inc. and the Company. Mr. Dooley joined the Company in 1980 in the corporate finance area and has held various positions in the corporate and divisional finance areas, the most recent of which was Director of Business Analysis from 1985 to 1986. Mr. Doppelt was elected Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company in March 1994. Prior to that, he served as Senior Vice President of Paramount since 1992 and as Deputy General Counsel of Paramount since 1985. He joined Paramount in 1983 as Associate Litigation Counsel, and in 1985 was appointed Assistant Vice President and Deputy General Counsel. In 1986, he became a Vice President of Paramount. From 1977 to 1983, Mr. Doppelt was an attorney in private practice at the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. Mr. Fricklas was elected Senior Vice President, Deputy General Counsel of Viacom Inc. and the Company in March 1994. From June 1993 to March 1994, he served as Vice President, Deputy General Counsel of Viacom Inc. and the Company. He served as Vice President, General Counsel and Secretary of Minorco (U.S.A.) Inc. from 1990 to 1993. Prior to that, Mr. Fricklas was an attorney in private practice at the law firm of Shearman & Sterling. Mr. Goddard has been an executive officer of the Company since August 1980. In November 1987, Mr. Goddard was elected Senior Vice President of Viacom Inc. and in September 1983, Mr. Goddard was elected Senior Vice President of the Company and President, Chief Executive Officer of Viacom Cable and continues to serve in those capacities. In August 1980, Mr. Goddard was appointed President of Viacom Cable and, in September 1980, he was elected Vice President of the Company. From September 1978 through July 1980, Mr. Goddard was Executive Vice President, Viacom Communications. From June 1971 until September 1978, Mr. Goddard was President and General Manager of Tele-Vue Systems, a subsidiary of the Company. Mr. Horowitz has been an executive officer of Viacom Inc. and the Company since April 1989. In March 1994, he was elected Senior Vice President, Technology of Viacom Inc. and the Company and Chairman, Chief Executive Officer of New Media and Interactive Television. Prior to that, he served as Senior Vice President of Viacom Inc. and the Company from April 1989 and as Chairman, Chief Executive Officer of Viacom Broadcasting from July 1992 to March 1994. From 1974 to April 1989, Mr. Horowitz held various positions with HBO, most recently as Senior Vice President, Technology and Operations. Mr. Horowitz held several other management positions with HBO, including Senior Vice President, Network Operations and New Business Development and Vice President, Affiliate Sales. I - 46 Mr. Lavan has been an executive officer of the Company since December 1987. In May 1989, he was elected Vice President of Viacom Inc. and the Company. In December 1990, he assumed the added responsibilities of oversight of Company tax matters. From 1991 to 1992, he also served as Senior Vice President and Chief Financial Officer of Viacom Pictures. Mr. Lavan joined Viacom in 1984 as Assistant Controller and, in December 1987, was elected Controller, Chief Accounting Officer of Viacom Inc. and the Company and he continues to serve in such capacities. Mr. Leingang was elected Senior Vice President, Chief Information Officer in May 1993. Prior to that, he served as Vice President, Chief Information Officer upon joining Viacom in 1990. Mr. Leingang was Vice President, Information Services of the Train Group (formerly Triangle Industries) from 1984 to 1990. From 1982 to 1984, he served as Corporate Director, MIS, and Manager, MIS Planning and Control for Interpace Corporation. Prior to that he held positions with Touche Ross & Company, McGraw-Hill Book Company and General Electric Credit Corp. Mr. Roskin has been an executive officer of Viacom Inc. and the Company since April 1988 when he became Vice President, Human Resources and Administration of each. In July 1992, Mr. Roskin was elected Senior Vice President, Human Resources and Administration of Viacom Inc. and the Company. From May 1986 to April 1988, he was Senior Vice President, Human Resources at Coleco Industries, Inc. From 1976 to 1986, he held various executive positions at Warner Communications, Inc., serving most recently as Vice President, Industrial and Labor Relations. Mr. Smith has been an executive officer of the Company since May 1985. In November 1987, he was elected Senior Vice President, Chief Financial Officer of Viacom Inc. and the Company and he continues to serve in such capacities. In May 1985, Mr. Smith was elected Vice President, Controller of the Company and, in October 1987, he was elected Vice President, Chief Financial Officer of the Company. From 1983 until May 1985, he served as Vice President, Finance and Administration of the Viacom Broadcasting Division and from 1981 until 1983, he served as Controller of Viacom Radio. Mr. Smith joined the Company in 1977 in the Corporate Treasurer's office and until 1981 served in various financial planning capacities. Mr. Weinstein has been an executive officer of the Company since January 1986. In February 1993, he was elected Senior Vice President, Government Affairs of Viacom Inc. and the Company. Prior to that, Mr. Weinstein served as Senior Vice President, General Counsel and Secretary of the Company and of Viacom Inc. since the fall of 1987. In January 1986, Mr. Weinstein was appointed Vice President, General Counsel of the Company. From 1976 through 1985, he was Deputy General Counsel of Warner Communications Inc. and in 1980 became Vice President. Previously, Mr. Weinstein was an attorney in private practice at the law firm of Paul, Weiss, Rifkind, Wharton & Garrison. I - 47 PART II Item 5. Item 5. Market for Viacom Inc.'s Common Equity and Related Security Holder Matters. Viacom Inc. voting Class A Common Stock and Viacom Inc. non-voting Class B Common Stock are listed and traded on the American Stock Exchange ("ASE") under the symbols "VIA" and "VIAB," respectively. The following table sets forth, for the calendar period indicated, the per share range of high and low sales prices for Viacom Inc.'s Class A Common Stock and Class B Common Stock, as reported on the ASE Composite Tape by the National Quotation Bureau Incorporated. As of March 30, 1994 there were approximately 6,912 holders of Viacom Inc. Class A Common Stock, and 6,861 holders of Viacom Inc. Class B Common Stock. Viacom Class A Viacom Class B Common Stock Common Stock --------------- ---------------- High Low High Low ---- --- ---- --- 1st quarter $37 1/4 $32 1/8 $36 1/2 $31 1/4 2nd quarter 38 1/2 32 3/8 36 7/8 30 1/2 3rd quarter 34 7/8 30 7/8 32 7/8 29 4th quarter 44 28 1/8 41 7/8 27 1st quarter $46 1/2 $37 1/2 $44 1/8 $35 1/4 2nd quarter 52 5/8 37 1/8 49 1/2 36 3rd quarter 67 1/2 50 1/2 61 1/4 45 3/4 4th quarter 66 1/2 47 60 1/2 40 3/8 The parent, Viacom Inc., has substantially no source of funds other than dividends paid by the Company on its stock. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes), unless its total leverage ratio is less than a specified amount. II-1 Item 6. Item 6. Selected Financial Data. VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES (Thousands of dollars, except per share amounts) See Notes to Consolidated Financial Statements for information on transactions and accounting classifications which have affected the comparability of the periods presented above. Viacom Inc. has not declared cash dividends for any of the periods presented above. II-2 Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. General ------- Management's discussion and analysis of the combined results of operations and financial condition of Viacom Inc. and the Company should be read in conjunction with the Consolidated Financial Statements and related Notes. Information presented below does not include information with respect to Paramount, which became a subsidiary of Viacom Inc. on March 11, 1994. Information with respect to Paramount's results of operations and financial condition and Paramount's audited and unaudited financial statements, in each case including the notes thereto, are incorporated by reference herein from the Paramount Reports (as defined in Item 1). Information in the Paramount Reports is given as of the date of each such report and is not updated herein. A copy of each of the Paramount Reports is included as an exhibit hereto. Descriptions of all documents incorporated by reference herein or included as exhibits hereto are qualified in their entirety by reference to the full text of such documents so incorporated or included. Viacom Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, "Viacom Inc.") is a holding company whose principal asset is the common stock of Viacom International Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, the "Company"). The Company is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. Viacom Inc. is an approximately 76.3% owned subsidiary of National Amusements, Inc. ("NAI"), a closely held corporation that owns and operates approximately 850 movie screens in the United States and the United Kingdom. In early March 1994, Viacom Inc. acquired a majority interest in Paramount Communications Inc. ("Paramount") pursuant to the terms of its tender offer. Paramount will become a wholly owned subsidiary of Viacom Inc. upon the closing of the merger pursuant to the Paramount merger agreement. Viacom Inc. has also entered into a merger agreement with Blockbuster Entertainment Corporation ("Blockbuster") pursuant to which Blockbuster will merge into Viacom Inc. (See "Paramount Merger, Blockbuster Merger and Related Transactions" for additional information regarding the mergers). The primary differences between Viacom Inc.'s and the Company's financial statements are as follows: a) the capitalization of the two companies -- the Company's shareholders' equity reflects the contribution to capital of Viacom Inc.'s exchangeable preferred stock, which was exchanged for 15.5% Junior Subordinated Exchange Debentures due 2006 (the "Exchange Debentures") on March 31, 1989 which in turn were fully redeemed during 1991; b) during 1993, Viacom Inc. issued $1.8 billion of 5% cumulative convertible preferred stock and declared related preferred stock dividends of $12.8 million, c) certain general and administrative expenses recorded by Viacom Inc. of $5.0 million (1993), $9.0 million (1992) and $12.9 million (1991), which include transactions associated with the long-term deferred incentive compensation plans; and d) Viacom Inc. recorded net interest income of $3.1 million (1993) and net interest expense of $45.2 million (1991). II-3 Business Segment Information ---------------------------- The following tables set forth revenues, earnings from operations, depreciation and amortization by business segment and a reconciliation of total earnings from operations to net earnings (loss) attributable to common stock for the periods indicated: Year Ended December 31, Percentage Change ----------------------------- ----------------- From From 1993 1992 1991 1992 1991 ---- ---- ---- To To 1993 1992 ---- ---- (Thousands of Dollars) Revenues: Networks $1,221,200 $1,058,831 $ 922,157 15% 15% Entertainment 209,110 248,335 273,488 (16) (9) Cable Television 415,953 411,087 378,026 1 9 Broadcasting 181,778 168,847 159,182 8 6 Intercompany elimination (23,092) (22,417) (21,291) (3) (5) ---------- --------- ---------- Total revenues $2,004,949 $1,864,683 $1,711,562 8 9 ========== ========== ========== Earnings from operations: Networks $ 272,087 $ 205,576 $ 172,296 32 19 Entertainment 32,480 59,662 73,214 (46) (19) Cable Television 110,176 122,037 103,954 (10) 17 Broadcasting 42,293 31,956 27,734 32 15 Corporate (72,041) (71,304) (64,964) (1) (10) ---------- --------- ---------- Total earnings from operations $ 384,995 $ 347,927 $ 312,234 11 11 ========== ========== ========== Depreciation and amortization: Networks $ 44,747 $ 41,754 $ 30,123 Entertainment 9,549 6,792 7,160 Cable Television 71,520 68,505 66,604 Broadcasting 23,475 24,509 27,062 Corporate 3,766 3,242 1,915 ---------- --------- ---------- Total depreciation and amortization $ 153,057 $ 144,802 $ 132,864 ========== ========== ========== II-4 Reconciliation to net earnings (loss) attributable to common stock: Total earnings from operations $ 384,995 $ 347,927 $ 312,234 Interest expense, net (144,953) (194,104) (297,451) Other items, net 61,774 1,756 (6,536) ---------- --------- ---------- Earnings before income taxes 301,816 155,579 8,247 Provision for income taxes 129,815 84,848 42,060 Equity in loss of affiliated companies, net of tax (2,520) (4,646) (12,743) ---------- --------- ---------- Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle 169,481 66,085 (46,556) Extraordinary losses, net of tax (8,867) (17,120) (3,101) Cumulative effect of change in accounting principle 10,338 -- -- ---------- --------- ---------- Net earnings (loss) 170,952 48,965 (49,657) Cumulative convertible preferred stock dividend requirement of Viacom Inc. 12,750 -- -- ---------- --------- ---------- Net earnings (loss) attributable to common stock $ 158,202 $ 48,965 $ (49,657) ========== ========== ========== II-5 Results of Operations --------------------- 1993 vs. 1992 ------------- Revenues increased 8% to $2.0 billion in 1993 from $1.9 billion in 1992. Earnings from operations increased 11% to $385.0 million in 1993 from $347.9 million in 1992. Explanations of variances in revenues and earnings from operations for each operating segment follow. Net earnings attributable to common stock of $158.2 million, or $1.31 per share, for the year ended December 31, 1993, reflect net interest expense of $145.0 million, a pre-tax gain aggregating $72.4 million from the sale of the Wisconsin cable television system and sales of a portion of an investment held at cost, and a provision for income taxes of $129.8 million. Net earnings of $49.0 million, or $.41 per share, for the year ended December 31, 1992, reflect net interest expense of $194.1 million and a provision for income taxes of $84.8 million. The comparability of results of operations for 1993 and 1992 has been affected by (1) the sale of the Wisconsin cable television system, effective January 1, 1993 and (2) the change in estimate of copyright royalty revenues during 1992 in the Entertainment segment. (See "Cable Television" and "Entertainment" for additional information concerning the changes noted above.) Networks (Basic cable and premium television networks) The constituents of Networks are MTV Networks ("MTVN") and Showtime Networks Inc. ("SNI"). Networks revenues increased 15% to $1.221 billion in 1993 from $1.059 billion in 1992. Networks earnings from operations increased 32% to $272.1 million in 1993 from $205.6 million in 1992. MTVN revenues increased 27% to $677.9 million in 1993 from $533.4 million in 1992: 70% of the increase was attributable to increased advertising sales; 21% was due to increased affiliate fees; and 9% was due to other sources. The increases in advertising sales and affiliate fees were principally due to rate increases. The increase in other sources was principally due to revenues from new business ventures including licensing and merchandising. Earnings from operations of MTVN increased 39% to $239.7 million in 1993 from $172.9 million in 1992, reflecting the increased revenues, partially offset by increased programming and marketing expenses at each of the networks and other costs of operating the networks, including start up losses of MTV Latino and Nickelodeon Magazine aggregating $6.5 million. The increased programming and marketing expenses at each of the networks (including animated programming on Nickelodeon and MTV) was to a large extent responsible for the Company's ability to increase advertising rates. II-6 SNI revenues increased 3% to $543.3 million in 1993 from $525.7 million in 1992, including Viacom Pictures in each period presented, due to (i) an increase of $13.6 million in revenues of Showtime Satellite Networks ("SSN"), primarily due to a 40% increase in SSN's subscriber base, principally attributable to the use of upgraded scrambling technology, partially offset by a decrease of 8% in average rates, (ii) an increase of $4.4 million in revenues of Showtime and The Movie Channel (excluding revenues generated by SSN), reflecting a 3% increase in the combined subscriber base with a decrease in average rates of 2% and (iii) a $.4 million decrease in other revenue sources. SNI's premium movie services, Showtime, The Movie Channel and FLIX, served approximately 11.9 million subscribers as of December 31, 1993 and 10.7 million subscribers as of December 31, 1992. SNI's overall earnings from operations decreased 1% to $32.3 million in 1993 from $32.7 million in 1992, reflecting increased programming and marketing expenses, partially offset by the increased revenues. Entertainment (Television programming, syndication, production and new media) The Entertainment segment distributes television series, feature films, made-for-television movies and mini-series for television exhibition around the world, produces television series and made-for- television movies, and also distributes television and radio commercials. The Entertainment segment also includes Viacom New Media, which develops, produces, distributes and markets interactive software. Entertainment revenues decreased 16% to $209.1 million in 1993 from $248.3 million in 1992. The revenue variance was principally due to lower syndication revenues, lower copyright revenues resulting from a change in estimate which increased revenue by approximately $10 million in 1992, and decreased network production revenues. Lower sales to the broadcast, cable and other markets reflect lower syndication revenues for The Cosby Show and softness in the syndication marketplace due to a decrease in the number of independent broadcast television stations because of new network affiliations. Revenues from the domestic broadcast syndication of The Cosby Show were approximately 12% and 18% of Entertainment revenues during 1993 and 1992, respectively. The decrease was due to the ending of the first domestic syndication cycle of The Cosby Show during the third quarter of 1993. The second domestic broadcast syndication cycle of The Cosby Show, which began in the third quarter of 1993, will generate significantly lower revenues. Network license fees were lower because fewer shows were produced for network television; however the decrease does not have a significant impact on Entertainment earnings from operations. Earnings from operations decreased 46% to $32.5 million in 1993 from $59.7 million in 1992, reflecting the decreased revenues and $6.1 million of start-up losses associated with Viacom New Media, which anticipates releasing approximately nine interactive video games based II-7 on MTV Networks' programming by the end of 1994. The Company had accumulated a backlog of unbilled syndication license agreements of approximately $399.0 million at December 31, 1993. As the license fees are billed over the term of the various licensing contracts, the Company will recognize as revenues that portion of such license fees representing its distribution fees. Approximately 58% of the Company's backlog was attributable to license fees for Roseanne and The Cosby Show. As The Cosby Show becomes a smaller portion of the total backlog, the percentage of the total license fee recognized as revenue by the Company will be reduced. Cable Television (Cable television systems) Cable Television revenues increased 1% to $416.0 million in 1993 from $411.1 million in 1992. Earnings from operations decreased 10% to $110.2 million in 1993 from $122.0 million in 1992. On a comparable basis with the 1992 results (excluding the Wisconsin cable system, which was sold effective January 1, 1993), Cable Television revenues increased 6% to $416.0 million in 1993 from $393.6 million in 1992: 52% of this increase resulted from increases in rates for basic services; 32% from increased basic customers; 8% from increased pay-per-view revenues; and 8% from increases in other revenue sources. Total revenue per basic customer per month increased 3% to $32.03 in 1993 from $31.04 in 1992. Earnings from operations decreased 6% to $110.2 million in 1993 from $117.6 million in 1992, reflecting increased operating expenses (which included non-recurring costs associated with the implementation of Federal Communication Commission ("FCC") rate regulations discussed below), partially offset by increased revenues. The 1992 Cable Act amended the Communications Act of 1934, as amended (the "Communications Act"). Rate regulations adopted in April 1993 by the FCC govern rates charged to subscribers for regulated tiers of cable service and became effective on September 1, 1993. On February 22, 1994, the FCC adopted additional rules (the "February 22nd Regulations") which have not yet been published in their final form. The "benchmark" formula adopted as part of the regulations in April 1993 establishes an "initial permitted rate" which may be charged by cable operators for tiers of cable service. The regulations also establish the prices which may be charged for equipment used to receive these services. Because the text of the February 22nd Regulations has not been released, it is not possible to know the extent or nature of revisions to the April 1993 regulations. However, from public statements made during the FCC meeting and news releases issued thereafter, it appears that the February 22nd Regulations will contain a new formula for determining permitted rates. The new formula will require up to a 17% reduction of rates from those charged on September 30, 1992, rather than the 10% reduction required by the April 1993 regulations. The February 22nd Regulations also adopted interim standards governing "cost-of-service" proceedings pursuant to which a II-8 cable operator would be permitted to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations, provided that the operator substantiates that its costs in providing services justify such rates. Based on its implementation of the April 1993 rate regulations, the Company estimates that it will recognize a reduction to revenues ranging from $27 million to $32 million on an annualized basis substantially all of which will be reflected as a reduction in earnings from operations of its cable division. The Company's estimated reduction does not reflect further reductions to revenue which would result from the lowering of the initial permitted rates pursuant to the February 22nd Regulations. These new and reduced initial permitted rates will apply prospectively from a date to be announced by the FCC when it publishes precise regulations which implement the February 22nd Regulations. Until the February 22nd Regulations are released, it is not possible to predict the effects of the interim standards governing cost-of-service proceedings; however, based on the public statements, Viacom believes it is unlikely that it will be able to utilize such proceedings so as to charge rates in excess of rates which it would otherwise be permitted to charge under the regulations. The Company's ability to mitigate the effects of these new rate regulations by employing techniques such as the pricing and repricing of new or currently offered unregulated program services and ancillary services may be restricted by the new regulations adopted as part of the February 22nd Regulations. No such mitigating factors are reflected in the estimated reductions to revenues. The stated reduction to revenues may be mitigated by higher customer growth due to lower basic rates. The "must carry" provisions of the 1992 Cable Act are not material to the Company's results of operations. As of December 31, 1993, the Company operated systems in California, Oregon, Washington, Ohio and Tennessee, serving approximately 1,094,000 basic customers subscribing to approximately 718,000 premium units. Basic customers and premium units decreased 2% and 9%, respectively, since December 31, 1992; and, excluding the Wisconsin cable system customers in 1992, basic customers and premium units increased 2% and decreased 5%, respectively. As part of the settlement of the Time Warner antitrust lawsuit, the Company entered into an agreement to sell all the stock of Viacom Cablevision of Wisconsin, Inc. to Warner Communications Inc. ("Warner"), effective January 1, 1993. As consideration for the stock, Warner paid the sum of $46 million, $20 million of which was received during 1992, plus repayment of debt in the amount of $49 million, resulting in a pre-tax gain of approximately $55 million reflected in "Other items, net." As of December 31, 1992, the Wisconsin cable system served approximately 47,000 basic customers subscribing to approximately 34,000 premium units. II-9 Broadcasting (Television and radio stations) As of December 31, 1993, the Broadcasting segment operated five network-affiliated television stations and 14 radio stations. Broadcasting revenues increased 8% to $181.8 million in 1993 from $168.8 million in 1992. Earnings from operations increased 32% to $42.3 million in 1993 from $32.0 million in 1992. Television revenues increased 4% to $90.3 million in 1993 from $87.1 million in 1992, reflecting an increase in national and local advertising revenues. Earnings from operations increased 20% to $20.3 million in 1993 from $16.9 million in 1992, primarily reflecting the increased revenues. Television Stations: STATION LOCATION AFFILIATION MARKET RANK (a) ------- -------- ----------- ------ -------- KMOV-TV St. Louis, MO CBS 18 2 WVIT-TV Hartford/New NBC 25 3 Haven, CT WNYT-TV Albany/Schenectad NBC 52 2 y, NY WHEC-TV Rochester, NY NBC 71 2 KSLA-TV Shreveport, LA CBS 74 1 (a) Source: Nielsen, November 1993. Radio revenues increased 12% to $91.4 million in 1993 from $81.8 million in 1992, reflecting increased national and local advertising revenues. Earnings from operations increased 45% to $26.6 million in 1993 from $18.3 million in 1992, primarily reflecting the increased revenues, partially offset by increased selling costs. Radio Stations: STATION LOCATION FORMAT MARKET RANK (a) ------- -------- ------ ------ ----- WLTW-FM New York, NY Adult 1 1 Contemp KYSR-FM Los Angeles, CA Adult 2 2 Contemp KXEZ-FM (b) Los Angeles, CA Adult 2 2 Contemp WLIT-FM Chicago, IL Adult 3 7 Contemp KSRY-FM San Francisco, Adult 4 24 CA Contemp (Tie) II-10 KSRI-FM Santa Cruz/San Adult 4 24 Jose, CA Contemp (Tie) WLTI-FM Detroit, MI Adult 6 8 Contemp WMZQ-AM/FM Washington, DC Country 8 4 (Tie) WCXR-FM (c) Washington, DC Classic Rock 8 9 (Tie) WCPT-AM (c) Washington, DC Headline 8 NA(d) News KBSG-AM/FM Seattle/Tacoma, Oldies 13 2 WA KNDD-FM (e) Seattle, WA Modern Rock 13 5 (AOR) (a) Source: Arbitron, Fall 1993, based on target demographics. (b) Acquired in June 1993. (c) Acquired in November 1993. (d) Rank not applicable. (e) Acquired in December 1992. See "Acquisition and Ventures" for disclosure of acquisitions and exchanges of radio stations that occurred in 1993 and 1992. Other Income and Expense Information Corporate expenses increased 1% to $72.0 million in 1993 from $71.3 million in 1992, reflecting increased overall expenses offset by decreased compensation expense associated with the Long-Term Incentive Plans (the "Plans"), which consist of the Long-Term Incentive Plan ("LTIP") and the Long-Term Management Incentive Plan ("LTMIP"). The Plans provide for grants of phantom shares and stock options. The value of phantom shares issued under the Plans is determined by reference to the fair market value of Viacom Class A Common Stock and Viacom Class B Common Stock (collectively, "Common Stock"). The Plans also provide for subsequent cash payments with respect to such phantom shares based on appreciated value, subject to certain limits, and vesting requirements. As a result of the fluctuation in the market value of its Common Stock, Viacom Inc. recorded compensation expense associated with the Plans of $3.9 million in 1993 and $8.2 million in 1992. During December 1992, a significant portion of the liability associated with the LTIP was satisfied by the cash payment of $68.6 million and the issuance of 177,897 shares of Viacom Class B Common Stock valued at $6.9 million. The Plans' phantom shares currently have a maximum potential liability of $19.5 million, all of which was accrued as of December 31, 1993. II-11 Net interest expense decreased 25% to $145.0 million in 1993 from $194.1 million in 1992, reflecting improvements made to the capital structure (as described below) and reduced interest rates, including rates associated with the Credit Agreement (as defined in "Capital Structure"). The Company and Viacom Inc. had approximately $2.4 billion principal amount of debt outstanding as of December 31, 1993 and December 31, 1992 at weighted average interest rates of 5.3% and 6.5%, respectively. On July 15, 1993, the Company redeemed all $298 million principal amount outstanding of 11.80% Senior Subordinated Notes. During 1992, the following changes to the capital structure were made: a) on March 4, 1992, the Company issued $150 million principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due 1999; b) on March 10, 1992, the Company redeemed all $193 million of the outstanding 11.5% Senior Subordinated Extendible Reset Notes ("11.5% Reset Notes") due 1998; c) on May 28, 1992, the Company issued $100 million principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due 2001; and d) on June 18, 1992, the Company redeemed all $356.5 million of the outstanding 14.75% Senior Subordinated Discount Debentures ("Discount Debentures") due 2002 (see "Capital Structure"). (See "Liquidity and Capital Resources" for additional information concerning changes in Viacom Inc.'s and the Company's capital structure.) For 1993, "Other items, net" reflects the pre-tax gain of approximately $55 million on the sale of the stock of the Wisconsin cable system (see "Cable Television"), a pre-tax gain of $17.4 million in the aggregate from sales of a portion of an investment held at cost, and an increase of $9.1 million to previously established non-operating litigation reserves and other items. The settlement of the Time Warner antitrust lawsuit resulted in various business arrangements, which have a positive effect on Viacom Inc. currently and are expected to continue to have a favorable effect on a prospective basis. "Other items, net" reflects a gain of $35 million recorded in the third quarter of 1992; this gain represents payments received in the third quarter of 1992 relating to certain aspects of the settlement of the lawsuit, net of Viacom Inc.'s 1992 legal expenses related to this lawsuit. "Other items, net" also reflects a reserve for litigation of $33 million during the second quarter of 1992 related to a summary judgment against Viacom Inc. in a dispute with CBS Inc. arising under the 1970 agreement associated with the spin-off of Viacom International Inc. by CBS Inc. On July 30, 1993, the Company settled all disputes arising under that litigation. "Equity in loss of affiliated companies, net of tax," consists primarily of the Company's share of Lifetime's net earnings, Comedy Central's net losses and Nickelodeon (UK)'s net losses in II-12 1993. "Equity in loss of affiliated companies, net of tax" decreased 46% to $2.5 million in 1993 from $4.6 million in 1992, primarily reflecting improved operating results at Lifetime and Comedy Central, partially offset by net losses on equity investments made in 1993. (See "Acquisitions and Ventures.") The provision for income taxes represents federal, state and foreign income taxes on earnings before income taxes. The annual effective tax rate of 43% for 1993 and 54.5% for 1992 (which continues to be adversely affected by amortization of acquisition costs which are not deductible for tax purposes) is decreased as a result of reductions of certain prior year tax reserves of $22.0 million and $20.0 million in 1993 and 1992, respectively. The reductions relate to management's current opinion on several tax issues based upon the progress of federal, state and local audits. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" on a prospective basis and recognized a cumulative benefit from a change in accounting principle of $10.3 million. In August 1993, the Omnibus Budget Reconciliation Act of 1993 (the "Reconciliation Act") was signed into law. It is not expected that the Reconciliation Act will have a significant effect on the Company's financial position or results of operations. In 1993, the Company recognized an after-tax extraordinary loss from the early extinguishment of the 11.80% Notes of $8.9 million (net of a tax benefit of $6.1 million). In 1993, Viacom Inc. declared dividends on its Preferred Stock (as defined in "Capital Structure") of $12.8 million. In 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting For Postemployment Benefits" ("SFAS 112"), which the Company will adopt in 1994. SFAS 112 requires that postemployment benefits be accounted for under the accrual method versus the currently used pay-as-you-go method. SFAS 112 is not expected to have a significant effect on the Company's financial position or results of operations. 1992 vs. 1991 ------------- Revenues increased 9% to $1.9 billion in 1992 from $1.7 billion in 1991. Operating expenses increased 8% to $854.0 million in 1992 from $790.8 million in 1991. Earnings from operations increased 11% to $347.9 million in 1992 from $312.2 million in 1991. Explanations of variances in revenues and earnings from II-13 operations for each operating segment follow. Net earnings of $49.0 million, or $.41 per share, for the year ended December 31, 1992, reflect net interest expense of $194.1 million and a provision for income taxes of $84.8 million. The net loss of $49.7 million, or $.44 per share, for the year ended December 31, 1991, reflects net interest expense of $297.5 million and a provision for income taxes of $42.1 million. Networks (Basic cable and premium television networks) Networks revenues increased 15% to $1.058 billion in 1992 from $922.2 million in 1991. Earnings from operations increased 19% to $205.6 million in 1992 from $172.3 million in 1991. MTVN revenues increased 30% to $533.4 million in 1992 from $411.4 million in 1991: 77% of the increase was attributable to increased advertising sales; 19% was due to increased affiliate fees; and 4% was due to other sources. The increases in advertising sales and affiliate fees were principally due to rate increases. The increase in other sources was principally due to revenues from new business ventures including licensing and merchandising. Earnings from operations of MTVN increased 23% to $172.9 million in 1992 from $141.0 million in 1991, reflecting the increased revenues, partially offset by increased programming expenses and other costs of operating the networks. The Company increased programming expenses, particularly for new animated programming on Nickelodeon. This new programming was to a large extent responsible for the Company's ability to increase advertising rates. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. Subsequent to August 30, 1991, the results of operations of MTV EUROPE have been included in MTVN's results of operations. Prior to such date, the investment in MTV EUROPE was accounted for under the equity method; therefore, operating results were included in "Equity in loss of affiliated companies, net of tax." The financial results of MTV EUROPE were not material to the financial results of the Company or the Networks segment; however, as the pan-European marketplace develops for both advertising revenues and affiliate fees, the financial results of MTV EUROPE may become material. In the aggregate, MTV (excluding MTV EUROPE), VH-1 and Nickelodeon/Nick at Nite revenues increased 21%, subscribers increased 3% and earnings from operations increased 18% during 1992 versus 1991. SNI revenues increased 3% to $515.3 million in 1992 from $501.3 million in 1991: 30% of the revenue increase was due to rate increases for SSN; 23% was due to a higher average subscriber II-14 base during the year for SSN principally attributable to the use of upgraded scrambling technology in 1992; 23% was due to a higher average cable subscriber base during the year for Showtime and The Movie Channel; and 24% of this increase was due to other revenue sources. SNI's premium movie services served approximately 10.7 million subscribers as of December 31, 1992 and 10.2 million subscribers as of December 31, 1991. SNI's overall earnings from operations increased 7% to $35.2 million in 1992 from $33.0 million in 1991, reflecting the increase in revenues, partially offset by an increase in programming expenses. Entertainment (Television programming, syndication, production and new media) Entertainment revenues decreased 9% to $248.3 million in 1992 from $273.5 million in 1991. The revenue variance was principally due to lower sales to broadcast, cable and other markets, lower network license fees and lower copyright royalty revenues. Lower sales to the broadcast, cable and other markets reflect softness in the syndication marketplace due to a generally weak economy and due to a decrease in the number of independent broadcast television stations because of new network affiliations. Network license fees were lower because there were fewer shows produced for network television. Copyright royalties were lower due to changes made by cable operators in the tiering of their services, which generated lower copyright royalty liabilities and therefore less income for program producers and syndicators. During the first quarter of 1992, certain legal developments indicated that the percentage of income recognized under certain copyright royalty arrangements should be increased. This change in estimate resulted in an increase in revenues of approximately $10 million. During the first quarter of 1991, the Company began to recognize copyright royalty revenue on an accrual basis rather than a cash basis, as a sufficient pattern had been established to make these revenues estimable; this change resulted in an increase in revenues of approximately $13.0 million. Earnings from operations decreased 19% to $59.7 million in 1992 from $73.2 million in 1991, reflecting the decreased revenues and changes in estimate noted above, and expenses associated with staff changes and the implementation of new systems of approximately $4.0 million. Cable Television (Cable television systems) Cable television revenues increased 9% to $411.1 million in 1992 from $378.0 million in 1991: 68% of this increase resulted from increases in rates for basic services; 26% from increased basic customers; 10% from increased premium customers; partially offset by a negative 4% from decreases in other revenue sources. Total II-15 revenue per basic customer per month increased 5% to $31.06 in 1992 from $29.41 in 1991. Earnings from operations increased 17% to $122.0 million in 1992 from $104.0 million in 1991, reflecting the increased revenues, partially offset by increased operating expenses. As of December 31, 1992, the Company operated systems in California, Oregon, Washington, Wisconsin, Ohio and Tennessee, serving approximately 1,116,000 basic customers subscribing to approximately 786,000 premium units. Basic customers and premium units increased 3% and 1%, respectively, since December 31, 1991. Broadcasting (Television and radio stations) Broadcasting revenues increased 6% to $168.8 million in 1992 from $159.2 million in 1991. Earnings from operations increased 15% to $32.0 million in 1992 from $27.7 million in 1991. Television revenues increased 9% to $87.1 million in 1992 from $80.1 million in 1991, reflecting an increase in national and local advertising revenues at each of the stations, primarily due to higher rates driven by the Olympics and the political campaign. Earnings from operations increased 38% to $16.9 million in 1992 from $12.2 million in 1991, reflecting the increased revenues, partially offset by increased programming and selling expenses. Radio revenues increased 3% to $81.8 million in 1992 from $79.0 million in 1991, reflecting an increase in local advertising revenues, partially offset by a decrease in national advertising revenues. Earnings from operations decreased 7% to $18.3 million in 1992 from $19.6 million in 1991, driven by increased operating, selling and promotion costs, partially offset by the increased revenues. Other Income and Expense Information Corporate expenses increased 10% to $71.3 million in 1992 from $65.0 million in 1991, primarily due to severance costs, partially offset by decreased legal costs and decreased compensation expense associated with the Long-Term Incentive Plans. As a result of the fluctuation in the market value of its Common Stock, Viacom Inc. recorded compensation expense associated with the Plans of $8.2 million and $12.3 million in 1992 and 1991, respectively. Net interest expense decreased 35% to $194.1 million in 1992 from $297.5 million in 1991, reflecting improvements made to the capital structure and reduced interest rates, including rates associated with the Credit Agreement (as defined in "Capital Structure"). The II-16 Company and Viacom Inc. had approximately $2.4 billion and $2.3 billion principal amount of debt outstanding as of December 31, 1992 and December 31, 1991 at weighted average interest rates of 6.5% and 9.2%, respectively. During 1991, Viacom Inc. realized net proceeds of approximately $317.7 million from the issuance of non- voting Class B Common Stock ("Viacom Class B Common Stock"); redeemed all $402 million of its outstanding Exchange Debentures; the Company repurchased $43 million principal amount of the Discount Debentures; and the Company issued $200 million principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due 2001. (See "Liquidity and Capital Resources" for additional information concerning changes in Viacom Inc.'s and the Company's capital structure.) Viacom Inc. and the Company file a separate consolidated federal income tax return and have done so since the period commencing June 11, l991, the date on which NAI's percentage ownership of Viacom was reduced to less than 80% (see "Capital Structure"). Prior to such date, Viacom Inc. and the Company filed a consolidated federal income tax return with NAI, and participated in a tax-sharing agreement with NAI with respect to federal income taxes. The tax-sharing agreement obligated Viacom Inc. and the Company to make payment to NAI to the extent that they would have paid federal income taxes on a separate company basis, and entitled them to receive a payment from NAI to the extent their losses and credits reduced NAI's federal income taxes. "Equity in loss of affiliated companies, net of tax," decreased 64% to a loss of $4.6 million in 1992 from a loss of $12.7 million in 1991, driven by improvements at Lifetime and Comedy Central. In 1992, the Company recognized after-tax extraordinary losses from the early extinguishment of the Discount Debentures of $13.7 million (net of a tax benefit of $8.9 million) and the 11.50% Reset Notes of $3.4 million (net of a tax benefit of $2.4 million). Liquidity and Capital Resources ------------------------------- Paramount Merger, Blockbuster Merger and Related Transactions ------------------------------------------------------------- On March 11, 1994, Viacom Inc. acquired, pursuant to a tender offer (the "Paramount Offer"), 61,657,432 shares of Paramount common stock, constituting a majority of the shares outstanding, at a price of $107 per share in cash. The Paramount Offer was financed by (i) the sale of Preferred Stock (see "Capital Structure"), proceeds of which are reflected as cash and cash equivalents on the balance sheet as of December 31, 1993, (ii) the sale of Viacom Class B Common Stock to Blockbuster and (iii) borrowings under a credit agreement (as described below). The II-17 Paramount Offer was made pursuant to the Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. Paramount will become a wholly owned subsidiary of Viacom Inc. (the "Paramount Merger") at the effective time of a merger between Paramount and a subsidiary of Viacom Inc. (the "Paramount Effective Time") which is expected to occur in the second quarter of 1994. Pursuant to the Paramount Merger Agreement, each share of Paramount common stock outstanding at the time of such merger (other than shares held in the treasury of Paramount or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights) will be converted into the right to receive (i) 0.93065 of a share of Viacom Class B Common Stock, (ii) $17.50 principal amount of 8% exchangeable subordinated debentures of Viacom Inc., (iii) 0.93065 of a contingent value right ("CVR"), (iv) 0.5 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the third anniversary of the Paramount Merger at a price of $60 per share, and (v) 0.3 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the fifth anniversary of the Paramount Merger at a price of $70 per share. If the debentures are issued prior to the completion of the proposed merger of Viacom Inc. and Blockbuster, the debentures will be exchangeable, at the option of Viacom Inc., into 5% exchangeable preferred stock of Viacom Inc. on or after January 1, 1995 if the proposed merger with Blockbuster has not previously been consummated. Each CVR will represent the right to receive the amount, if any, by which the Target Price exceeds the greater of the Current Market Value or the Minimum Price (see defined terms in following paragraph). The CVRs will mature on the first anniversary of the Paramount Effective Time (the "Maturity Date"); provided, however, that Viacom Inc. may, at its option, (i) extend the Maturity Date to the second anniversary of the Paramount Effective Time (the "First Extended Maturity Date") or (ii) extend the First Extended Maturity Date to the third anniversary or the Paramount Effective Time (the "Second Extended Maturity Date"). Viacom Inc., at its option, may pay any amount due under the terms of the CVRs in cash or in the equivalent value of registered securities of Viacom Inc., including without limitation, common stock, preferred stock, notes, or other securities. The "Minimum Price" means (a) at the Maturity Date, $36, (b) at the First Extended Maturity Date, $37 and (c) at the Second Extended Maturity Date, $38. Target Price means (a) at the Maturity Date, $48, (b) at the First Extended Maturity Date, $51, and (c) at the Second Extended Maturity Date, $55. The "Current Market Value" means the average market price of Viacom Class B Common Stock for a specified period. II-18 On January 7, 1994, Viacom Inc. and Blockbuster entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger") subject to shareholder approval. At the effective time of the Blockbuster Merger, each share of Blockbuster common stock outstanding at the time of the Blockbuster Merger (other than shares held in the treasury of Blockbuster or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights, if available) will be converted into the right to receive (i) 0.08 of a share of Viacom Class A Common Stock, (ii) 0.60615 of a share of Viacom Class B Common Stock, and (iii) up to an additional 0.13829 of a share of Viacom Class B Common Stock, with the exact fraction of a share being dependent on the market prices of Viacom Class B Common Stock during the year following the effective time of the Blockbuster Merger, and with the right to receive such additional fraction of a share to be evidenced by one variable common right ("VCR"). The VCRs mature on the first anniversary of the Blockbuster Merger ("VCR Conversion Date"). The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. intends to vote its shares of Paramount in favor of the merger and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. On March 10, 1994, Blockbuster purchased approximately 22.7 million shares of Viacom Class B Common Stock for an aggregate purchase price of $1.25 billion, or $55 per share. If (with certain exceptions) the Blockbuster Merger Agreement is terminated and in the event that Viacom Class B Common Stock trades (for a specified period) at a level below $55 per share during the one year period after such termination, Viacom Inc. may be obligated to make certain payments of up to a maximum of $275 million, at its option, in cash or securities, or to sell certain assets to Blockbuster. The Viacom Class B Common Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On February 15, 1994, Blockbuster entered into a credit agreement with certain financial institutions named therein, pursuant to which such financial institutions have advanced to Blockbuster, on an unsecured basis, an aggregate of $1.0 billion to finance a portion of the purchase of the shares under the Subscription Agreement (the "Blockbuster Facility"). The II-19 Blockbuster Facility contains certain events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness incurred by Blockbuster under the Blockbuster Facility. On March 11, 1994, Viacom Inc. borrowed $3.7 billion under a credit agreement dated as of November 19, 1993, as amended on January 4, 1994 and February 15, 1994, among Viacom Inc., the banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agent (the "Merger Credit Agreement"). The Merger Credit Agreement provides that, in order to pay for the Paramount Offer and related expenses, up to $3.7 billion may be borrowed, repaid and reborrowed until November 18, 1994, at which time all amounts outstanding will become due and payable. The Merger Credit Agreement provides that Viacom Inc. may elect to borrow at either the Base Rate or the Eurodollar Rate (each as defined below), subject to certain limitations. The "Base Rate" will be the higher of (i) the Citibank N.A., Base Rate and (ii) the Federal Funds Rate plus 0.50%. The "Eurodollar Rate" will be the London Interbank Offered Rate plus (i) 0.9375%, until Viacom Inc.'s senior unsecured long-term debt is rated by Standard & Poor's Corporation or Moody's Investors Service, Inc., and (ii) thereafter, a variable rate ranging from 0.25% to 0.9375% dependent on the senior unsecured long-term debt rating assigned to Viacom Inc. The Merger Credit Agreement provides that Viacom Inc. will pay each bank a facility fee on such bank's commitment until November 18, 1994. The Merger Credit Agreement contains certain covenants which, among other things, require Viacom Inc. to meet certain financial ratios. As of December 31, 1993, Viacom Inc. had promissory notes outstanding in the aggregate amount of $26 million, in order to finance expenses associated with the Mergers and expects to obtain additional financing as required to finance such expenses. Viacom Inc. anticipates that, following the Mergers, Viacom Inc., Paramount and Blockbuster, on a pro forma combined basis (the "Combined Company") will have outstanding total indebtedness of approximately $10 billion ($8 billion if the Blockbuster Merger is not consummated) and 5% Preferred Stock (as defined in "Capital Structure") with a liquidation preference of $1.2 billion ($1.8 billion if the Blockbuster Merger is not consummated). Of such $10 billion, $3.7 billion was borrowed under the Merger Credit Agreement and must be repaid by November 18, 1994. In addition, the $1.0 billion II-20 borrowed under the Blockbuster Facility must be repaid by February 14, 1995 and both the Blockbuster Facility and a previous Blockbuster credit agreement contain certain covenants and events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness under such Blockbuster facilities prior to the Blockbuster Merger. Accordingly, assuming consummation of the Blockbuster Merger, the foregoing facilities, together with other current maturities, may require Viacom Inc. to refinance up to $5.7 billion ($4.0 billion if the Blockbuster Merger is not consummated) within the next 12 months. Viacom Inc. also anticipates that, following the Mergers, the Combined Company will fund its anticipated operating, investing and financing activities, including the anticipated cash requirements of its joint ventures, commitments, capital expenditures, preferred stock dividend requirements and principal and interest payments on outstanding indebtedness, through a variety of sources, which may include, but may not be limited to, funds generated internally by Viacom Inc. and its subsidiaries (including following the Mergers funds generated by Blockbuster and Paramount), bank refinancing, and the public or private sale of debt or equity securities. The Blockbuster Merger is subject to shareholder approval. In the event the Blockbuster Merger is not consummated, Viacom Inc. believes that it will still be capable of meeting all of its obligations. Viacom Inc. and the Company - Liquidity and Capital Resources ------------------------------------------------------------- (prior to the Paramount Offer and the Mergers) ---------------------------------------------- The Company's scheduled maturities of long-term debt through December 31, 1998, assuming full utilization of the $1.9 billion commitment under the Credit Agreement and $300 million under the Loan Facility Agreement, are $300 million (1994), $380 million (1995), $380 million (1996) $380 million (1997) and $380 million (1998). On January 4, 1993, Viacom Inc. borrowed $42.2 million from The Bank of New York ("BONY") pursuant to an unsecured credit agreement ("Term Loan Agreement") to satisfy its obligation under the LTIP. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. (See "Capital Structure " for defined terms and additional information). The Company's joint ventures are expected to require estimated cash contributions of approximately $20 million to $40 million in 1994. Capital expenditures are primarily related to additional construction and equipment upgrades for the Company's existing cable franchises, certain transponder payments and information system costs. Planned capital expenditures, II-21 including information systems costs, are approximately $150 million to $170 million in 1994. The Company was in compliance with all covenants and had satisfied all financial ratios and tests as of December 31, 1993 under its Credit Agreement and the Company expects to remain in compliance and satisfy all such financial ratios and tests during 1994. Debt as a percentage of total capitalization of Viacom Inc. was 47% at December 31, 1993 and 76% at December 31, 1992. The decrease in debt as a percentage of total capitalization resulted principally from the issuance of Preferred Stock (as defined in "Capital Structure") during 1993. The commitments of the Company for program license fees which are not reflected in the balance sheet as of December 31, 1993, which are estimated to aggregate approximately $1.9 billion, principally reflect commitments under SNI's exclusive arrangements with several motion picture companies. This estimate is based upon a number of factors. A majority of such fees are payable within the next seven years, as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. During July 1991, the Company received reassessments from 10 California counties of its Cable Division's real and personal property, related to the June 1987 acquisition by NAI, which could result in substantially higher California property tax liabilities. The Company is appealing the reassessments and believes that the reassessments as issued are unreasonable and unsupportable under California law. The Company believes that the final resolution of this matter will not have a material effect on its consolidated financial position or results of operations. Net cash flow from operating activities increased 45% to $147.6 million in 1993 from $102.0 million in 1992, resulting from increased net earnings before extraordinary items and cumulative effect of change in accounting principle, partially offset by increased payments for accrued expenses. Net cash expenditures for investing activities of $128.4 million in 1993 principally reflects capital expenditures, the acquisitions of KXEZ-FM and ICOM Simulations, Inc. and the additional investment in StarSight Telecast Inc. ("StarSight") and advances to Comedy Central, partially offset by proceeds from the sale of the Wisconsin cable system, proceeds related to the radio station swap and proceeds from the sale of an investment held at cost. Net cash expenditures for investing activities of $116.8 million in 1992 principally reflect capital expenditures, advances to II-22 Comedy Central and a deposit received on the sale of Viacom Cablevision of Wisconsin Inc. Financing activities reflect borrowings and repayment of debt under the Credit Agreement during each period presented; the redemption of the 11.80 % Notes and the issuance of the Preferred Stock during 1993, and the redemption of the 11.50% Reset Notes and Discount Debentures, and the issuance of the 9.125% Notes and the 8.75% Reset Notes during 1992. Acquisitions and Ventures ------------------------- On November 1, 1993, the Company exchanged KIKK-AM/FM, Houston, Texas, for Westinghouse Broadcasting Company, Inc.'s WCXR-FM and WCPT-AM, Washington, D.C., and cash. On June 16, 1993, the Company purchased KXEZ-FM (formerly KQLZ- FM), Los Angeles, California from Westwood One Stations Group- LA, Inc. for $40 million in cash and certain other consideration. The Company sold KXEZ-FM to Viacom Inc. in exchange for a $40 million promissory note. On May 5, 1993, the Company completed the purchase of privately held ICOM Simulations, Inc. On March 31, 1993, the Company increased its percentage of ownership in StarSight. On August 5, 1993, StarSight completed an initial public offering of 3,105,000 shares of common stock. On September 16, 1993, the Company exercised a warrant to purchase 833,333 shares of StarSight common stock at a cost of $5.625 per share. In November 1993, the Company transferred its ownership percentage in StarSight to a consolidated affiliate of the Company. As a result of these transactions, the affiliate of the Company's percentage ownership of StarSight is approximately 21%. The investment in StarSight is accounted for under the equity method. In December 1992, the Company entered into a 50-50 joint venture called Nickelodeon (UK) with a subsidiary of British Sky Broadcasting Limited. Nickelodeon (UK) began airing on September 1, 1993. The Company's investment is accounted under the equity method and therefore the results of operations is included in "Equity in loss of affiliated companies, net of tax." The Company exchanged KHOW-AM and FM, Denver, Colorado for Noble Broadcast Group, Inc.'s KNDD-FM, Seattle, Washington effective December 28, 1992. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. The approximate value of the purchase was $65.0 million, which included intangibles of II-23 approximately $61.6 million. As consideration for the sale, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock (see "Capital Structure"). Capital Structure ----------------- The following table and related notes set forth the capitalization of Viacom Inc. and subsidiaries as of December 31, 1993 and December 31, 1992: December 31, December 31, 1993 1992 ----------- ----------- (Thousands of Dollars) Current portion of long-term debt $ 55,004 $ -- =========== ============ Long-term debt: Notes payable to banks (a) $ 1,928,271 1,648,984 11.8% Senior Subordinated Notes due -- 298,000 1998 (b) 9.125% Senior Subordinated Notes due 150,000 150,000 1999 (c) 8.75% Senior Subordinated Reset Notes 100,000 100,000 due 2001 (d) 10.25% Senior Subordinated Notes due 200,000 200,000 2001 (e) 5.75% Convertible Subordinated 15 30 Debentures due 2001 ----------- ------------ Total long-term debt $ 2,378,286 $ 2,397,014 =========== ============ Shareholders' equity (f): Preferred Stock $ 1,800,000 $ -- Common Stock and additional paid-in 922,072 918,671 capital Accumulated deficit (3,958) (162,160) ----------- ------------ Total shareholders' equity $ 2,718,114 $ 756,511 =========== ============ II-24 (a) -- At December 31, 1993, there were aggregate borrowing facilities of $1.9 billion and $300 million under (i) an unsecured credit agreement guaranteed by Viacom Inc. (amended and restated as of January 17, 1992 (as amended, the "Credit Agreement") among the Company, the named banks ("Banks"), Citibank, N.A. ("Citibank") as agent and The Bank of New York ("BONY") as co-agent and (ii) an unsecured credit agreement, dated June 2, 1993, among the Company and the named banks and BONY and Citibank as agents (the "Loan Facility Agreement"). The Loan Facility Agreement has a 364-day term and is identical to the Credit Agreement in all other material terms and conditions. Borrowings of $1.765 billion were outstanding under the Credit Agreement as of December 31, 1993, including $274 million aggregate principal amount assumed by five subsidiaries of the Company ("Subsidiary Obligors"). Borrowings of $150 million were outstanding under the Loan Facility Agreement as of December 31, 1993, $135 million of which were classified as long-term. Subsequent to December 31, 1993, Viacom Inc. borrowed approximately $3.7 billion pursuant to the Merger Credit Agreement in connection with the Paramount Merger (see "Paramount Merger, Blockbuster Merger and Related Transactions"). The following is a summary description of the Credit Agreement. The description does not purport to be complete and should be read in conjunction with the Credit Agreement. The Credit Agreement provides for three facilities: Facility A - $700 million under a term loan having a final maturity of June 30, 1999; Facility B - $926 million under a revolver, which converts on January 1, 1995 into a term loan having a final maturity of June 30, 1999; and Facility B-1 - $274 million under a term loan having a final maturity of June 30, 1999. The interest rate on all loans made under the three facilities is based upon Citibank, N.A.'s base rate, the domestic certificate of deposit rate or the London Interbank Offered Rate and is affected by the Company's leverage ratio. At December 31, 1993, the London Interbank Offered Rates (upon which the Company's borrowing rate was based) for borrowing periods of one month and two months were 3.25% and 3.3125%, respectively. The Company is permitted to issue commercial paper with a maturity at the time of issuance not to exceed nine months, provided that following each issuance of II-25 commercial paper, (i) the aggregate face amount of commercial paper outstanding shall not exceed $500 million less the aggregate amount of competitive bid rate borrowings (described below), outstanding at such time and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company is also permitted to make short- term competitive bid rate borrowings from the Banks until December 1, 1994, provided that following the making of each proposed competitive bid rate borrowing, (i) the aggregate amount of the competitive bid rate loans outstanding shall not exceed $500 million less the aggregate face amount of commercial paper outstanding and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company and Subsidiary Obligors are required to repay the principal outstanding under the Credit Agreement in quarterly payments equal to percentages of the original aggregate principal amount with respect to the Facility A loans and Facility B-1 loans, and of the outstanding principal amount with respect to the Facility B loans, under the Credit Agreement, in the amount of 5% for the period commencing January 2, 1995 through and including January 2, 1999; and 7.5% on April 1, 1999 and on June 30, 1999. The Company may prepay at any time a portion or all of the principal outstanding under the Credit Agreement. Any such optional prepayments shall be applied to the remaining installments of Facility A and Facility B loans in the order that the Company designates. The Company is required to make mandatory prepayments upon receipt of net cash sale proceeds in connection with permitted sales of assets not in the ordinary course of business. All such prepayments shall be applied until December 31, 1994 to reduce the Facility B loans outstanding; provided, however, that any amounts so repaid may be reborrowed prior to December 31, 1994. All such prepayments after December 31, 1994 shall be applied pro rata against the remaining installments of first, the Facility A loans and second, the Facility B loans. In the event of a sale of the stock or substantially all of the assets of any Subsidiary Obligor, the Facility B-1 loan of such Subsidiary Obligor shall be repaid in full; provided, however, that upon such prepayment prior to December 31, 1994, the Facility B commitment of each Facility B Bank shall be increased by an amount equal to the principal amount of such Facility B Bank's Facility B-1 loan prepaid as a result of such prepayment and such amounts may be borrowed by the Company prior to December 31, 1994. The Company is required to prepay principal outstanding under the Credit Agreement with the proceeds of certain issuances of unsecured senior debt in an amount equal to the proceeds so received, together with accrued interest to the date of such prepayment on the principal amount prepaid, with such prepayments applied against remaining installments of first, the II-26 Facility A loans and second, the Facility B loans. The Credit Agreement contains certain covenants which, among other things, require the Company to maintain certain financial ratios and impose on the Company and its subsidiaries certain limitations on (i) the incurrence of indebtedness or the guarantee or assumption of indebtedness of another; (ii) the creation or incurrence of mortgages, pledges or security interests on the property or assets of the Company or any of its subsidiaries in order to secure debt or the sale of assets of the Company or its subsidiaries; (iii) the merger or consolidation of the Company with any person or other entity; (iv) the incurrence of capitalized leases and purchase money indebtedness; (v) the payment of cash dividends or the redemption or repurchase of any capital stock of the Company; and (vi) investments and acquisitions. The Credit Agreement also contains certain customary events of default. The Credit Agreement also provides that it is an event of default if National Amusements, Inc. ("NAI") fails to own at least 51% of the outstanding voting stock of Viacom Inc. or Viacom Inc. fails to own at least 67% of the outstanding voting stock of the Company. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes, including the satisfaction of Viacom Inc.'s obligations under the LTIP), unless its total leverage ratio is less than a specified amount. The Company is required to pay a commitment fee based on the aggregate average daily unborrowed portion of the Facility B commitment, with any amounts outstanding under competitive bid rate loans and commercial paper being deemed unborrowed for the purpose of calculating the commitment fee. The Company also is required to pay certain agency fees to the agent. The Credit Agreement does not require compensating balances. On January 4, 1993, Viacom Inc. borrowed $42.2 million from BONY pursuant to the Term Loan Agreement. The interest rate in the Term Loan Agreement is based upon BONY's prime rate or the London Interbank Offered Rate. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. Viacom Inc. may prepay at any time a portion or all of the principal amount outstanding under the Term Loan Agreement. Any such optional prepayments shall be applied to reduce the principal installment due January 1995 and shall include all accrued interest II-27 on the amount of principal prepaid. Viacom Inc. shall be obligated to prepay the loan in the amount of any dividends received from the Company. The Term Loan Agreement contains certain covenants which impose certain limitations on (i) the incurrence of indebtedness and (ii) payment of cash dividends or the redemption or repurchase of any capital stock of Viacom. The Term Loan Agreement also contains certain customary events of default. The Term Loan Agreement has been amended to allow Viacom Inc. to complete the Paramount Offer and Paramount Merger. The indebtedness under the Credit Agreement, Loan Facility Agreement and Term Loan Agreement bear interest at floating rates, causing the Company to be sensitive to changes in prevailing interest rates. The Company enters into interest rate protection agreements with off-balance sheet risk in order to reduce its exposure to changes in interest rates on its variable rate long- term debt. These interest rate protection agreements include interest rate swaps and interest rate caps. At December 31, 1993, the Company and Viacom Inc. had interest rate protection agreements outstanding with commercial banks, with respect to $1.1 billion of indebtedness under the Credit Agreement and $42.2 million under the Term Loan Agreement. These agreements effectively change the Company's interest exposure under the Credit Agreement to a ceiling of 5.64% on the interest rate caps, and under the Term Loan Agreement to a fixed weighted average rate of 6.65% on interest rate swaps. The interest rate protection agreements are in effect for a fixed period of time. The Company is exposed to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company does not anticipate nonperformance by the counterparties. The Company had commercial paper outstanding of $60.9 million as of December 31, 1993. The Company also has aggregate money market facilities of $40 million, all of which was available at December 31, 1993. (b) -- On July 15, 1993, the Company redeemed all of the $298 million principal amount outstanding of the 11.80% Senior Subordinated Notes ("11.80% Notes") at a redemption price equal to 103.37% of the principal amount plus accrued interest to July 15, 1993. The Company recognized an after-tax extraordinary loss from the early extinguishment of debt of $8.9 million, net of a tax benefit of approximately $6.1 million on the transaction. The Company borrowed the funds necessary for the redemption under its bank credit facilities. (c) -- On March 4, 1992, the Company issued $150 million aggregate principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due August 15, 1999. Interest is payable II-28 semiannually on February 15 and August 15, commencing August 15, 1992. The 9.125% Notes may not be redeemed prior to February 15, 1997. They are redeemable at the option of the Company, in whole or in part, during the 12 month period beginning February 15, 1997 at a redemption price of 102.607% of the principal amount, during the 12 month period beginning February 15, 1998 at 101.304% of the principal amount, and on or after February 15, 1999 at 100% of the principal amount. Any such redemption will include accrued interest to the redemption date. The 9.125% Notes are not subject to any sinking fund requirements. (d) -- On May 28, 1992, the Company issued $100 million aggregate principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due on May 15, 2001. Interest is payable semiannually on May 15 and November 15, commencing November 15, 1992. On May 15, 1995 and May 15, 1998, unless a notice of redemption of the 8.75% Reset Notes on such date has been given by the Company, the interest rate on the 8.75% Reset Notes will, if necessary, be adjusted from the rate then in effect to a rate to be determined on the basis of market rates in effect on May 5, 1995 and on May 5, 1998, respectively, as the rate the 8.75% Reset Notes should bear in order to have a market value of 101% of principal amount immediately after the resetting of the rate. In no event will the interest rate be lower than 8.75% or higher than the average three year treasury rate (as defined in the indenture) multiplied by two. The interest rate reset on May 15, 1995 will remain in effect on the 8.75% Reset Notes through and including May 15, 1998 and the interest rate reset on May 15, 1998 will remain in effect on the 8.75% Reset Notes thereafter. The 8.75% Reset Notes are redeemable at the option of the Company, in whole but not in part, on May 15, 1995 or May 15, 1998, at a redemption price of 101% of principal amount plus accrued interest to, but not including, the date of redemption. The 8.75% Reset Notes are not subject to any sinking fund requirements. (e) -- On September 15, 1991, the Company issued $200 million aggregate principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due September 15, 2001. Interest is payable semiannually on March 15 and September 15, commencing March 15, 1992. The 10.25% Notes are not redeemable by the Company prior to maturity and are not subject to any sinking fund requirements. (f) -- On December 31, 1993, there were 53,449,325 outstanding shares of Viacom Class A Common Stock (100,000,000 shares authorized) and 67,347,131 outstanding shares of Viacom Class B Common Stock (150,000,000 shares authorized). On October 22, 1993, Blockbuster purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series A Preferred Stock") for $600 million. On November 19, 1993, NYNEX Corporation ("NYNEX") purchased 24 million shares of cumulative convertible preferred stock, par value $.01 II-29 per share, of Viacom Inc. ("Series B Preferred Stock," collectively with the Series A Preferred Stock, "Preferred Stock") for $1.2 billion. Series A Preferred Stock and Series B Preferred Stock have liquidation preferences of $25 per share and $50 per share, respectively. The Preferred Stock has an annual dividend rate of 5%, is convertible into shares of Viacom Class B Common Stock at a conversion price of $70 and does not have voting rights other than those required by law. The Preferred Stock is redeemable by Viacom Inc. at declining premiums after five years. The Preferred Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. Both NYNEX and Blockbuster may, under certain limited circumstances, require Viacom Inc. to repurchase their respective preferred shares, but such right does not inure to the benefit of subsequent holders of such preferred shares. NAI holds approximately 76.3% and the public holds approximately 23.7% of outstanding Viacom Inc. Common Stock as of December 31, 1993. NAI's percentage of ownership consists of 85.2% of the outstanding Viacom Class A Common Stock and 69.1% of the outstanding Viacom Class B Common Stock, as of December 31, 1993. Pursuant to a purchase program initiated in August 1987, NAI announced its intention to buy, from time to time, up to an additional 3,000,000 shares of Viacom Class A Common Stock and 2,423,700 shares of Viacom Class B Common Stock. As of December 31, 1993, NAI had acquired an aggregate of 3,374,300 shares of Common Stock, consisting of 1,466,200 shares of Viacom Class A Common Stock and 1,908,100 shares of Viacom Class B Common Stock, pursuant to this buying program. On August 20, 1993, NAI ceased making purchases of Common Stock. _____________________ The Company and Viacom Inc. filed a shelf registration statement with the Securities and Exchange Commission ("SEC") registering $800 million of debt securities (or, if such debt securities are issued at an original issue discount, such greater principal amount as shall result in an aggregate offering price equal to $800 million) guaranteed by Viacom Inc. The registration statement was declared effective by the SEC on March 11, 1993. Some or all of the debt securities may be issued by the Company in one or more offerings. During April 1993, the Company and Viacom Inc. terminated the prior shelf registration statement, under which an aggregate of $300 million principal amount of additional debt securities remained available. NAI, Sumner M. Redstone and the Company each have purchased on the open market and may in the future continue to purchase on the open market or in privately negotiated transactions certain debt securities of the Company. During 1993, there were no purchases of debt securities made by NAI, Sumner M. Redstone or the II-30 Company. During 1992, Sumner M. Redstone purchased directly or beneficially $350,000, $605,000, $15,000 and $200,000 of 11.50% Senior Subordinated Extendible Reset Notes, 9.125% Senior Subordinated Notes, 10.25% Senior Subordinated Notes and 8.75% Senior Subordinated Reset Notes, respectively. During 1991, NAI and Sumner M. Redstone purchased $3,110,000 and $869,000 of 11.80% Senior Subordinated Notes, respectively. During 1991, NAI purchased $311,000 of the 11.50% Senior Subordinated Extendible Reset Notes. During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. II-31 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS - --------------------------------- To the Boards of Directors and Shareholders of Viacom Inc. and Viacom International Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of cash flows and of shareholders' equity present fairly, in all material respects, the financial position of Viacom Inc. and its subsidiaries and of Viacom International Inc., a wholly- owned subsidiary of Viacom Inc., and its subsidiaries, at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the management of Viacom Inc. and Viacom International Inc.; 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 7 to the financial statements, Viacom Inc. and Viacom International Inc. adopted Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes" in 1993. PRICE WATERHOUSE 1177 Avenue of the Americas New York, New York 10036 February 4, 1994, except as to Note 2, which is as of March 11, 1994 II-32 MANAGEMENT'S STATEMENT OF RESPONSIBILITY FOR FINANCIAL REPORTING - ---------------------------------------------------------------- Management has prepared and is responsible for the consolidated financial statements and related notes of Viacom Inc. They have been prepared in accordance with generally accepted accounting principles and necessarily include amounts based on judgments and estimates by management. All financial information in this annual report is consistent with the consolidated financial statements. The Company maintains internal accounting control systems and related policies and procedures designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and properly recorded, and that accounting records may be relied upon for the preparation of consolidated financial statements and other financial information. The design, monitoring, and revision of internal accounting control systems involve, among other things, management's judgment with respect to the relative cost and expected benefits of specific control measures. The Company also maintains an internal auditing function which evaluates and reports on the adequacy and effectiveness of internal accounting controls, policies and procedures. Viacom Inc.'s consolidated financial statements have been audited by Price Waterhouse, independent public accountants, who have expressed their opinion with respect to the presentation of these statements. The Audit Committee of the Board of Directors, which is comprised solely of directors who are not employees of the Company, meets periodically with the independent accountants, with our internal auditors, as well as with management, to review accounting, auditing, internal accounting controls and financial reporting matters. The Audit Committee is also responsible for recommending to the Board of Directors the independent accounting firm to be retained for the coming year, subject to stockholder approval. The independent accountants and the internal auditors have full and free access to the Audit Committee with and without management's presence. VIACOM INC. By: /s/Frank J. Biondi, Jr. ----------------------------------------- Frank J. Biondi, Jr. President, Chief Executive Officer By: /s/George S. Smith, Jr. ------------------------------------------ George S. Smith, Jr. Senior Vice President, Chief Financial Officer By: /s/Kevin C. Lavan ------------------------------------------ Kevin C. Lavan Vice President, Controller and Chief Accounting Officer II-33 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- (Thousands of dollars, except per share amounts) Year Ended December 31, ------------------------------ 1993 1992 1991 ---- ---- ---- Revenues $2,004,949 $1,864,683 $1,711,562 Expenses: Operating 877,609 853,977 790,816 Selling, general and administrative 589,288 517,977 475,648 Depreciation and amortization 153,057 144,802 132,864 --------- ---------- ---------- Total expenses 1,619,954 1,516,756 1,399,328 --------- ---------- --------- Earnings from operations 384,995 347,927 312,234 Other income (expense): Interest expense, net (144,953) (194,104) (297,451) Other items, net (See Note 14) 61,774 1,756 (6,536) --------- ---------- --------- Earnings before income taxes 301,816 155,579 8,247 Provision for income taxes 129,815 84,848 42,060 Equity in loss of affiliated companies, net of tax (2,520) (4,646) (12,743) --------- ---------- --------- Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle 169,481 66,085 (46,556) Extraordinary losses, net of tax (See Note 4) (8,867) (17,120) (3,101) Cumulative effect of change in accounting principle 10,338 -- -- --------- ---------- --------- Net earnings (loss) 170,952 48,965 (49,657) Cumulative convertible preferred stock dividend requirement of Viacom Inc. 12,750 -- -- --------- ---------- --------- Net earnings (loss) attributable to common stock $ 158,202 $ 48,965 $ (49,657) ========= ========= ========== Weighted average number of common shares 120,607 120,235 113,789 Net earnings (loss) per common share: Earnings (loss) before extraordinary losses and cumulative effect of change in accounting principle $ 1.30 $ .55 $ (.41) Extraordinary losses (.07) (.14) (.03) Cumulative effect of change in accounting principle .08 -- -- --------- ---------- --------- Net earnings (loss) $ 1.31 $ .41 $ (.44) ========= ========= ========= See notes to consolidated financial statements. II-34 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS --------------------------- (Thousands of dollars) December 31, ------------------------- 1993 1992 ---- ---- Assets Current Assets: Cash and cash equivalents $1,882,381 $ 48,428 Receivables, less allowances of $33,889 and $25,779 351,765 319,804 Distribution fees advanced and committed, current 18,620 19,631 Program rights and deferred program costs, current 264,212 215,109 Prepaid distribution costs 73,722 89,723 Other current assets 95,693 65,793 ---------- ---------- Total current assets 2,686,393 758,488 Property and Equipment: Land 16,486 17,869 Buildings 41,627 37,486 Cable television systems 414,918 388,170 Broadcasting facilities 52,100 50,665 Equipment and other 349,332 258,565 Construction in progress 26,982 10,858 ----------- ---------- 901,445 763,613 Less accumulated depreciation 347,243 306,548 ---------- ---------- Net property and equipment 554,202 457,065 ---------- ---------- Distribution fees advanced and committed, non-current 263,281 228,784 Program rights and deferred program costs, non-current 526,247 462,122 Intangibles, at amortized cost 2,180,571 2,195,936 Other assets 206,174 214,699 ---------- ---------- $6,416,868 $4,317,094 ========== ========== See notes to consolidated financial statements. II-35 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS --------------------------- (Thousands of dollars, except per share amounts) December 31, ----------------------- 1993 1992 ---- ---- Liabilities and Shareholders' Equity Current Liabilities: Accounts payable $ 96,579 $ 71,199 Accrued interest 20,684 38,229 Deferred income, current 50,930 68,295 Other accrued expenses 264,921 290,937 Income taxes 140,453 96,529 Owners' share of distribution revenue 139,081 158,351 Program rights, current 197,966 187,956 Current portion of long-term debt 55,004 -- ---------- ---------- Total current liabilities 965,618 911,496 ---------- ---------- Long-term debt 2,378,286 2,397,014 Program rights, non-current 86,752 92,886 Other liabilities 268,098 159,187 Commitments and contingencies (See Note 10) Shareholders' Equity of Viacom Inc. (See Notes 1 and 6): Preferred Stock, par value $.01 per share; 100,000,000 shares authorized; 48,000,000 shares issued and outstanding; stated at liquidation value 1,800,000 -- A Common Stock, par value $.01 per share; 100,000,000 shares authorized; 53,449,325 (1993) and 53,380,390 (1992) shares issued and outstanding 535 534 B Common Stock, par value $.01 per share; 150,000,000 shares authorized; 67,347,131 (1993) and 67,069,688 (1992) shares issued and outstanding 673 671 Additional paid-in capital 920,864 917,466 Accumulated deficit (3,958) (162,160) ---------- ---------- Total shareholders' equity 2,718,114 756,511 ---------- ---------- $6,416,868 $4,317,094 ========== ========== See notes to consolidated financial statements. II-36 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- Year Ended December 31, -------------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Net cash flow from operating activities: Net earnings (loss) $170,952 $ 48,965 $ (49,657) Adjustments to reconcile net earnings (loss) to net cash flow from operating activities: Depreciation and amortization 153,057 144,802 132,864 Interest accretion and interest in kind on debentures -- -- 59,196 Reserve for litigation (See Note 14) -- 33,000 -- Equity in loss of affiliated companies, net of tax 2,520 4,646 12,743 Gain on the sale of the cable system, net of tax (45,873) -- -- Gain on the sale of investment held at cost, net of tax (10,882) -- -- Extraordinary losses, net of tax 8,867 17,120 3,101 Deferred compensation . 3,924 8,202 12,328 Provision (benefit) for deferred income taxes 24,364 15,068 (8,756) (Decrease) increase in accounts payable and accrued expenses (17,189) 53,400 6,831 Increase in receivables (31,881) (49,756) (61,929) Increase in programming related assets and liabilities, net (137,549) (138,568) (66,391) Increase in income taxes payable 58,501 7,389 37,732 (Decrease) increase in deferred income (8,999) 22,933 (2,384) (Increase) decrease in unbilled receivables (6,516) 17,749 (27,630) Payment of LTIP liability (3,606) (68,599) -- Other, net (12,080) (14,362) 21,819 ---------- --------- --------- Net cash flow from operating activities 147,610 101,989 69,867 ---------- --------- --------- Investing activities: Capital expenditures (135,011) (110,222) (72,157) Investments in and advances to affiliated companies. (21,618) (23,708) (44,372) Advances from affiliated companies 13,441 9,447 5,546 Proceeds from sale of cable system and radio station 93,739 20,000 -- Proceeds from sale of investment held at cost 18,140 -- -- Proceeds from sale of transponders 51,000 -- -- Acquisitions (82,197) -- -- Deposits on transponders (49,934) (9,723) -- Payment of deferred merger costs (15,382) -- -- Other, net (616) (2,636) (4,120) ---------- --------- --------- Net cash flow from investing activities (128,438) (116,842) (115,103) ---------- --------- --------- Financing activities: Borrowings from banks under credit facilities 334,291 8,343,967 6,695,048 Repayments to banks under credit facilities -- (7,968,466) (6,764,593) Issuance of notes -- 250,000 200,000 Redemption of notes and debentures (298,015) (549,454) (407,580) Issuance of Preferred Stock 1,800,000 -- -- Issuance of B Common Stock -- -- 317,987 Payment of deferred financing costs (18,106) (22,659) (5,869) Payment of premium on redemption of notes (10,054) (19,753) (4,078) Other, net 6,665 924 (18) ---------- --------- --------- Net cash flow from financing activities 1,814,781 34,559 30,897 ---------- --------- --------- Net increase (decrease) in cash and cash equivalents 1,833,953 19,706 (14,339) Cash and cash equivalents at beginning of year 48,428 28,722 43,061 ---------- --------- --------- Cash and cash equivalents at end of year $1,882,381 $ 48,428 $ 28,722 ========== ========= ========= See notes to consolidated financial statements. II-37 -- VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS ----------------------- OF SHAREHOLDERS' EQUITY ----------------------- (Thousands of dollars) See notes to consolidated financial statements. II-38 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1) SUMMARY OF ACCOUNTING POLICIES Basis of Presentation -Viacom Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, "Viacom Inc.") is a holding company whose principal asset is the common stock of Viacom International Inc. (together with its consolidated subsidiaries, unless the context otherwise requires, the "Company"). The Company is a diversified entertainment and communications company with operations in four principal segments: Networks, Entertainment, Cable Television and Broadcasting. The primary differences between Viacom Inc.'s and the Company's financial statements include the following factors: a) the capitalization of the two companies -- the Company's shareholders' equity reflects the contribution to capital of Viacom Inc.'s exchangeable preferred stock, which was exchanged for 15.5% Junior Subordinated Exchange Debentures due 2006 (the "Exchange Debentures") on March 31, 1989 which in turn were fully redeemed during 1991; b) during 1993, Viacom Inc. issued $1.8 billion of 5% cumulative convertible preferred stock (see Note 6) and declared related preferred stock dividends of $12.8 million, c) certain general and administrative expenses recorded by Viacom Inc. of $5.0 million (1993), $9.0 million (1992) and $12.9 million (1991), which include transactions associated with the long-term deferred incentive compensation plans; and d) Viacom Inc. recorded net interest income of $3.1 million (1993) and net interest expense of $45.2 million (1991). Certain amounts reported on the balance sheet and statements of cash flows for prior years have been reclassified to conform with the current presentation. Principles of Consolidation - The consolidated financial statements include the accounts of Viacom Inc., the Company and all investments of more than 50% in subsidiaries and other entities. All significant intercompany transactions have been eliminated. Investments in affiliated companies of more than 20% but less than or equal to 50% are accounted for under the equity method. Investments of 20% or less are accounted for under the cost method. In 1993, the fiscal year end for certain foreign operations was changed from October 31 to December 31. Cash Equivalents - Cash equivalents are defined as short-term (3 months or less) highly liquid investments. Program Rights - The Company acquires rights to exhibit programming on its broadcast stations or cable networks, and produces its own programs. The costs incurred in acquiring and producing programs are capitalized and amortized over the license period or over the estimated exhibition life of the program. Costs related to the production of programs are either charged to earnings or capitalized to the extent they are estimated to be recoverable from future revenue. Program rights and the related liabilities are recorded at the gross amount of the liabilities when the license period has begun, the cost of the program is determinable and the program is accepted and available for airing. Program Distribution - Fees for distributing television shows and feature films are recognized upon billing over contractual periods generally ranging from one to five years, except that such fees for internally produced programs are recognized when such programs are delivered and fees for barter advertising revenue are recognized when the programs are available and a noncancellable contract has been executed. Receivables reflect gross billings, which include the owners' share. Amounts due to owners are recorded as liabilities in "Owners' share of distribution revenue" or are deducted from "Distribution fees advanced and committed, current." Minimum guarantees to owners are recorded as liabilities and are liquidated by payments in accordance with contract terms. A corresponding asset is recorded as "Distribution fees advanced and committed" and is reduced by the owners' share of billings until fully recovered or amortized as operating expenses against the Company's share of total estimated billings based on the ratio of total estimated costs to total estimated billings. Prepaid distribution costs incurred on behalf of the owners are recovered from the owners' share of billings or amortized as operating expenses against the Company's share of total estimated billings based on the ratio of total estimated costs to total estimated billings. II-39 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) All amortization estimates are reviewed periodically by management and are adjusted prospectively. Minimum guarantees or other costs estimated not to be recoverable from total estimated billings are expensed in the period any shortfall is determined. Depreciation and Amortization - Depreciation is computed principally by the straight-line method over estimated useful lives ranging principally from 3 to 15 years. Capitalized lease amortization of $5.5 million (1993) and $3.0 million (1992) is included in depreciation expense. Depreciation expense was $92.8 million (1993), $81.5 million (1992) and $70.1 million (1991). Intangibles resulting from business acquisitions are generally amortized over 40 years. Accumulated amortization relating to intangibles at December 31 was $412.5 million (1993) and $361.1 million (1992) . Equity in Loss of Affiliated Companies - Equity in loss of affiliated companies is primarily comprised of the Company's one-third interest in Lifetime, the 50% interest in Comedy Central, the 50% interest in Nickelodeon (UK) during 1993 and the 49.99% interest in MTV EUROPE prior to August 30, 1991. (See Note 3.) Provision for Doubtful Accounts - The provision for doubtful accounts charged to expense was $16.7 million (1993), $9.4 million (1992) and $15.9 million (1991). Net Earnings (Loss) per Common Share - Earnings (loss) per share is calculated based on the weighted average number of shares outstanding during the year. The effect of the assumed exercise of stock options and conversion of convertible debentures is not material for each of the years presented. For 1993, the assumed conversion of the Preferred Stock (as defined in Note 2) would have an antidilutive effect on fully-diluted earnings per common share. Therefore, the effects of such assumption are not reflected in net earnings (loss) per common share. Interest Rate Protection Agreements - The amount to be paid or received is accrued as interest rates change and is recognized over the life of the agreements as an adjustment to interest expense. 2) SUBSEQUENT EVENTS On March 11, 1994, Viacom Inc. acquired, pursuant to a tender offer (the "Paramount Offer"), 61,657,432 shares of Paramount common stock, constituting a majority of the shares outstanding, at a price of $107 per share in cash. The Paramount Offer was financed by (i) the sale of Preferred Stock (see "Note 6"), proceeds of which are reflected as cash and cash equivalents on the balance sheet as of December 31, 1993, (ii) the sale of Viacom Class B Common Stock to Blockbuster and (iii) borrowings under a credit agreement (as described below). The Paramount Offer was made pursuant to the Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 (the "Paramount Merger Agreement") between Viacom Inc. and Paramount. Paramount will become a wholly owned subsidiary of Viacom Inc. (the "Paramount Merger") at the effective time of a merger between Paramount and a subsidiary of Viacom Inc. (the "Paramount Effective Time") which is expected to occur in the second quarter of 1994. Pursuant to the Paramount Merger Agreement, each share of Paramount common stock outstanding at the time of such merger (other than shares held in the treasury of Paramount or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights) will be converted into the right to receive (i) 0.93065 of a share of Viacom Class B Common Stock, (ii) $17.50 principal amount of 8% exchangeable subordinated debentures of Viacom Inc., (iii) 0.93065 of a contingent value right ("CVR"), (iv) 0.5 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the third anniversary of the Paramount Merger at a price of $60 per share, and (v) 0.3 of a warrant to purchase one share of Viacom Class B Common Stock at any time prior to the fifth anniversary of the Paramount Merger at a price of $70 per share. If the debentures are issued prior to the completion of the purposed merger of Viacom Inc. and Blockbuster, the debentures will be exchangeable, at the option of Viacom Inc., into 5% exchangeable preferred stock of Viacom Inc. on or after January 1, 1995 if the proposed merger with Blockbuster has not previously been consummated. II-40 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Each CVR will represent the right to receive the amount, if any, by which the Target Price exceeds the greater of the Current Market Value and the Minimum Price (see defined terms in following paragraph). The CVRs will mature on the first anniversary of the Paramount Effective Time (the "Maturity Date"); provided, however, that Viacom Inc. may, at its option, (i) extend the Maturity Date to the second anniversary of the Paramount Effective Time (the "First Extended Maturity Date") or (ii) extend the First Extended Maturity Date to the third anniversary or the Paramount Effective Time (the "Second Extended Maturity Date"). Viacom Inc., at its option, may pay any amount due under the terms of the CVRs in cash or in the equivalent value of registered securities of Viacom Inc., including without limitation, common stock, preferred stock, notes, or other securities. The "Minimum Price" means (a) at the Maturity Date, $36, (b) at the First Extended Maturity Date, $37 and (c) at the Second Extended Maturity Date, $38. Target Price means (a) at the Maturity Date, $48, (b) at the First Extended Maturity Date, $51, and (c) at the Second Extended Maturity Date, $55. The "Current Market Value" means the average market price of Viacom Class B Common Stock for a specified period. On January 7, 1994, Viacom Inc. and Blockbuster entered into an agreement and plan of merger (the "Blockbuster Merger Agreement") pursuant to which Blockbuster will be merged with and into Viacom Inc. (the "Blockbuster Merger") subject to approval. At the effective time of the Blockbuster Merger, each share of Blockbuster common stock outstanding at the time of the Blockbuster Merger (other than shares held in the treasury of Blockbuster or owned by Viacom Inc. and other than shares held by any stockholders who shall have demanded and perfected appraisal rights, if available) will be converted into the right to receive (i) 0.08 of a share of Viacom Class A Common Stock, (ii) 0.60615 of a share of Viacom Class B Common Stock, and (iii) up to an additional 0.13829 of a share of Viacom Class B Common Stock, with the exact fraction of a share being dependent on the market prices of Viacom Class B Common Stock during the year following the effective time of the Blockbuster Merger, and with the right to receive such additional fraction of a share to be evidenced by one variable common right ("VCR"). The VCRs mature on the first anniversary of the Blockbuster Merger ("VCR Conversion Date"). The mergers pursuant to the Paramount Merger Agreement and Blockbuster Merger Agreement (collectively, the "Mergers") have been unanimously approved by the Boards of Directors of each of the respective companies. The obligations of Viacom Inc., Blockbuster and Paramount to consummate the mergers are subject to various conditions, including obtaining requisite stockholder approvals. Viacom Inc. intends to vote its shares of Paramount in favor of the merger and NAI has agreed to vote its shares of Viacom Inc. in favor of the Mergers; therefore, stockholder approval of the Paramount Merger is assured, and approval by Viacom Inc. of the Blockbuster Merger is also assured. The Mergers will be accounted for under the purchase method of accounting. The unaudited condensed pro forma data for the year ended or at December 31, 1993 presented below assumes the Mergers occurred on January 1, 1993 for statement of operations data or at December 31, 1993 for balance sheet data. Intangible assets are expected to be amortized over 40 years on a straight-line basis. The unaudited pro forma information is not necessarily indicative of the combined results of operations or financial position of Viacom Inc., Paramount and Blockbuster (the "Combined Company") following the Mergers that would have occurred if the completion of the Mergers had occurred on the dates previously indicated nor are they necessarily indicative of future operating results of the Combined Company. II-41 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Year Ended or at December 31, 1993 ---------------- (Millions of dollars) (Unaudited) Results of operations data: Revenues $9,624.1 Earnings from operations $ 887.9 Net earnings before extraordinary items, cumulative effect of changes in accounting principles and preferred stock dividends $ 135.6 Net earnings attributable to common stock before extraordinary items and cumulative effect of changes in accounting principles $ 75.6 Primary earnings per common share before extraordinary items and cumulative effect of changes in accounting principles $ .18 Balance sheet data: Total assets $24,377.3 Long-term debt, including current maturities $ 9,998.8 Shareholders' equity: Preferred $ 1,200.0 Common $ 8,844.8 On March 10, 1994, Blockbuster purchased approximately 22.7 million shares of Viacom Class B Common Stock for an aggregate purchase price of $1.25 billion, or $55 per share. If (with certain exceptions) the Blockbuster Merger Agreement is terminated and in the event that Viacom Class B Common Stock trades (for a specified period) at a level below $55 per share during the one year period after such termination, Viacom Inc. may be obligated to make certain payments of up to a maximum of $275 million, at its option, in cash or securities, or to sell certain assets to Blockbuster. The Viacom Class B Common Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On February 15, 1994, Blockbuster entered into a credit agreement with certain financial institutions named therein, pursuant to which such financial institutions have advanced to Blockbuster, on an unsecured basis, an aggregate of $1.0 billion to finance a portion of the purchase of the shares under the Subscription Agreement (the "Blockbuster Facility"). The Blockbuster Facility contains certain events of default, including a change of control default, which will require either a waiver in connection with the Blockbuster Merger or the refinancing of the indebtedness incurred by Blockbuster under the Blockbuster Facility. On March 11, 1994, Viacom Inc. borrowed $3.7 billion under a credit agreement dated as of November 19, 1993, as amended on January 4, 1994 and February 15, 1994, among Viacom Inc., the banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agents (the "Merger Credit Agreement"). The Merger Credit Agreement provides that, in order to pay for the Paramount Offer and related expenses, up to $3.7 billion may be borrowed, repaid and reborrowed until November 18, 1994, at which time all amounts outstanding will become due and payable. The Merger Credit Agreement provides that Viacom Inc. may elect to borrow at either the Base Rate or the Eurodollar Rate (each as defined below), subject to certain limitations. The "Base Rate" will be the higher of (i) the Citibank N.A., Base Rate and (ii) the Federal Funds Rate plus 0.50%. The "Eurodollar Rate" will be the London Interbank Offered Rate plus (i) 0.9375%, until Viacom Inc.'s senior unsecured long-term debt is rated by Standard & Poor's Corporation or Moody's Investors Service, Inc., and (ii) thereafter, a variable II-42 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) rate ranging from 0.25% to 0.9375% dependent on the senior unsecured long-term debt rating assigned to Viacom Inc. The Merger Credit Agreement provides that Viacom Inc. will pay each bank a facility fee on such bank's commitment until November 18, 1994. The Merger Credit Agreement contains certain covenants which, among other things require Viacom Inc. to meet certain financial ratios. As of December 31, 1993, Viacom Inc. has promissory notes outstanding in the aggregate amount of $26 million, in order to finance expenses associated with the Mergers and expects to obtain additional financing as required to finance such expenses. 3) ACQUISITIONS AND VENTURES On November 1, 1993, the Company exchanged KIKK-AM/FM, Houston, Texas, for Westinghouse Broadcasting Company, Inc.'s WCXR-FM and WCPT-AM, Washington, D.C., and cash. On June 16, 1993, the Company purchased KXEZ-FM (formerly KQLZ-FM), Los Angeles, California from Westwood One Stations Group-LA, Inc. for $40 million in cash and certain other consideration. The Company sold KXEZ-FM to Viacom Inc. in exchange for a $40 million promissory note. On May 5, 1993, the Company completed the purchase of privately held ICOM Simulations, Inc. On March 31, 1993, the Company increased its percentage of ownership in StarSight Telecast Inc. ("StarSight"). On August 5, 1993, StarSight completed an initial public offering of 3,105,000 shares of common stock. On September 16, 1993, the Company exercised a warrant to purchase 833,333 shares of StarSight common stock at a cost of $5.625 per share. In November 1993, the Company transferred its ownership percentage in StarSight to a consolidated affiliate of the Company. As a result of these transactions, the affiliate's of the Company's percentage ownership of StarSight is approximately 21%. The investment in StarSight is accounted for under the equity method. In December 1992, the Company entered into a 50-50 joint venture called Nickelodeon (UK) with a subsidiary of British Sky Broadcasting Limited. Nickelodeon (UK) began airing on September 1, 1993. The Company's investment is accounted for under the equity method. The Company exchanged KHOW-AM and FM, Denver, Colorado for Noble Broadcast Group, Inc.'s KNDD-FM, Seattle, Washington effective December 28, 1992. On August 30, 1991, Viacom Inc. increased its interest in MTV EUROPE to 100% through the purchase of the 50.01% interest held by an affiliate of Mirror Group Newspapers. The approximate value of the purchase was $65.0 million, which included intangibles of approximately $61.6 million. As consideration for the sale, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock (See Note 6). II-43 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4) BANK FINANCING AND DEBT Total debt, which includes short-term and long-term debt, consists of the following: December 31, December 31, 1993 1992 ------------ ------------ (Thousands of dollars) Notes payable to banks (a) $1,983,275 $1,648,984 11.80% Senior Subordinated Notes due 1998 -- 298,000 9.125% Senior Subordinated Notes due 1999 (b) 150,000 150,000 8.75% Senior Subordinated Reset Notesdue 2001 (c) 100,000 100,000 10.25% Senior Subordinated Notes due 2001 (d) 200,000 200,000 5.75% Convertible Subordinated Debentures due 2001 15 30 ---------- ---------- 2,433,290 2,397,014 Less current portion 55,004 -- ---------- ---------- $2,378,286 $2,397,014 ========== ========== (a) -- At December 31, 1993, there were aggregate borrowing facilities of $1.9 billion and $300 million under (i) an unsecured credit agreement guaranteed by Viacom Inc. (amended and restated as of January 17, 1992, (as amended, the "Credit Agreement") among the Company the named banks ("Banks"), Citibank, N.A. ("Citibank") as agent and The Bank of New York ("BONY") as co-agent and (ii) an unsecured credit agreement, dated June 2, 1993, among the Company and the named banks and BONY and Citibank as agents (the "Loan Facility Agreement"). The Loan Facility Agreement has a 364-day term and is identical to the Credit Agreement in all other material terms and conditions. Borrowings of $1.765 billion were outstanding under the Credit Agreement as of December 31, 1993, including $274 million aggregate principal amount assumed by five subsidiaries of the Company ("Subsidiary Obligors"). Borrowings of $150 million were outstanding under the Loan Facility Agreement as of December 31, 1993, $135 million of which were classified as long-term. The following is a summary description of the amended and restated Credit Agreement. The description does not purport to be complete and should be read in conjunction with the Credit Agreement. The Credit Agreement provides for three facilities: Facility A - $700 million under a term loan having a final maturity of June 30, 1999; Facility B - $926 million under a revolver, which converts on January 1, 1995 into a term loan having a final maturity of June 30, 1999; and Facility B-1 - $274 million under a term loan having a final maturity of June 30, 1999. The interest rate on all loans made under the three facilities is based upon Citibank, N.A.'s base rate, the domestic certificate of deposit rate or the London Interbank Offered Rate and is affected by the Company's leverage ratio. At December 31, 1993, the London Interbank Offered Rates (upon which the Company's borrowing rate was based) for borrowing periods of one month and two months were 3.25% and 3.3125%, respectively. The Company is permitted to issue commercial paper with a maturity at the time of issuance not to exceed nine months, provided that following each issuance of commercial paper, (i) the aggregate face amount of commercial paper outstanding shall not exceed $500 million less the aggregate amount of competitive bid rate borrowings (described II-44 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) below), outstanding at such time and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company is also permitted to make short-term competitive bid rate borrowings from the Banks until December 1, 1994, provided that following the making of each proposed competitive bid rate borrowing, (i) the aggregate amount of the competitive bid rate loans outstanding shall not exceed $500 million less the aggregate face amount of commercial paper outstanding and (ii) the aggregate amount of all Facility B loans and competitive bid rate loans outstanding, together with the aggregate face amount of commercial paper outstanding, shall not exceed $926 million. The Company and Subsidiary Obligors are required to repay the principal outstanding under the Credit Agreement in quarterly payments equal to percentages of the original aggregate principal amount with respect to the Facility A loans and Facility B-1 loans, and of the outstanding principal amount with respect to the Facility B loans, under the Credit Agreement, in the amount of 5% for the period commencing January 2, 1995 through and including January 2, 1999; and 7.5% on April 1, 1999 and on June 30, 1999. The Company may prepay at any time a portion or all of the principal outstanding under the Credit Agreement. Any such optional prepayments shall be applied to the remaining installments of Facility A and Facility B loans in the order that the Company designates. The Company is required to make mandatory prepayments upon receipt of net cash sale proceeds in connection with permitted sales of assets not in the ordinary course of business. All such prepayments shall be applied until December 31, 1994 to reduce the Facility B loans outstanding; provided, however, that any amounts so repaid may be reborrowed prior to December 31, 1994. All such prepayments after December 31, 1994 shall be applied pro rata against the remaining installments of first, the Facility A loans and second, the Facility B loans. In the event of a sale of the stock or substantially all of the assets of any Subsidiary Obligor, the Facility B-1 loan of such Subsidiary Obligor shall be repaid in full; provided, however, that upon such prepayment prior to December 31, 1994, the Facility B commitment of each Facility B Bank shall be increased by an amount equal to the principal amount of such Facility B Bank's Facility B-1 loan prepaid as a result of such prepayment and such amounts may be borrowed by the Company prior to December 31, 1994. The Company is required to prepay principal outstanding under the Credit Agreement with the proceeds of certain issuances of unsecured senior debt in an amount equal to the proceeds so received, together with accrued interest to the date of such prepayment on the principal amount prepaid, with such prepayments applied against remaining installments of first, the Facility A loans and second, the Facility B loans. The Credit Agreement contains certain covenants which, among other things, require the Company to maintain certain financial ratios and impose on the Company and its subsidiaries certain limitations on (i) the incurrence of indebtedness or the guarantee or assumption of indebtedness of another; (ii) the creation or incurrence of mortgages, pledges or security interests on the property or assets of the Company or any of its subsidiaries in order to secure debt or the sale of assets of the Company or its subsidiaries; (iii) the merger or consolidation of the Company with any person or other entity; (iv) the incurrence of capitalized leases and purchase money indebtedness; (v) the payment of cash dividends or the redemption or repurchase of any capital stock of the Company; and (vi) investments and acquisitions. The Credit Agreement also contains certain customary events of default. The Credit Agreement also provides that it is an event of default if National Amusements, Inc. ("NAI") fails to own at least 51% of the outstanding voting stock of Viacom Inc. or Viacom Inc. fails to own at least 67% of the outstanding voting stock of the Company. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes, including the satisfaction of Viacom Inc.'s obligations under the LTIP), unless its total leverage ratio is less than a specified amount. The Company is required to pay a commitment fee based on the aggregate average daily unborrowed portion of the Facility B commitment, with any amounts outstanding under competitive bid rate loans and commercial paper being deemed unborrowed for the purpose of calculating the commitment fee. The Company also is required to pay certain agency fees to the agent. The Credit Agreement does not require compensating balances. II-45 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) On January 4, 1993, Viacom Inc. borrowed $42.2 million from BONY pursuant to the Term Loan Agreement. The interest rate in the Term Loan Agreement is based upon BONY's prime rate or the London Interbank Offered Rate. Viacom Inc. repaid $13.9 million of debt under the Term Loan Agreement on January 15, 1994, the first scheduled maturity date. The remaining $28.3 million under the Term Loan Agreement matures on January 15, 1995. Viacom Inc. may prepay at any time a portion or all of the principal amount outstanding under the Term Loan Agreement. Any such optional prepayments shall be applied to reduce the principal installment due January 1995 and shall include all accrued interest on the amount of principal prepaid. Viacom Inc. shall be obligated to prepay the loan in the amount of any dividends received from the Company. The Term Loan Agreement contains certain covenants which impose certain limitations on (i) the incurrence of indebtedness and (ii) payment of cash dividends or the redemption or repurchase of any capital stock of Viacom. The Term Loan Agreement also contains certain customary events of default. The Term Loan Agreement has been amended to allow Viacom Inc. to complete the Paramount Offer and the Paramount Merger. The indebtedness under the Credit Agreement, Loan Facility Agreement and Term Loan Agreement bear interest at floating rates, causing the Company to be sensitive to changes in prevailing interest rates. The Company enters into interest rate protection agreements with off-balance sheet risk in order to reduce its exposure to changes in interest rates on its variable rate long-term debt. These interest rate protection agreements include interest rate swaps and interest rate caps. At December 31, 1993, the Company and Viacom Inc. had interest rate protection agreements outstanding with commercial banks, with respect to $1.1 billion of indebtedness under the Credit Agreement and $42.2 million under the Term Loan Agreement. These agreements effectively change the Company's interest exposure under the Credit Agreement to a ceiling of 5.64% on the interest rate caps, and under the Term Loan Agreement to a fixed weighted average rate of 6.65% on interest rate swaps. The interest rate protection agreements are in effect for a fixed period of time. The Company is exposed to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company does not anticipate nonperformance by the counterparties. The Company had commercial paper outstanding of $60.9 million as of December 31, 1993. The Company also has aggregate money market facilities of $40 million, all of which was available at December 31, 1993. (b) -- On March 4, 1992, the Company issued $150 million aggregate principal amount of 9.125% Senior Subordinated Notes ("9.125% Notes") due August 15, 1999. Interest is payable semiannually on February 15 and August 15, commencing August 15, 1992. The 9.125% Notes may not be redeemed prior to February 15, 1997. They are redeemable at the option of the Company, in whole or in part, during the 12 month period beginning February 15, 1997 at a redemption price of 102.607% of the principal amount, during the 12 month period beginning February 15, 1998 at 101.304% of the principal amount, and on or after February 15, 1999 at 100% of the principal amount. Any such redemption will include accrued interest to the redemption date. The 9.125% Notes are not subject to any sinking fund requirements. (c) -- On May 28, 1992, the Company issued $100 million aggregate principal amount of 8.75% Senior Subordinated Reset Notes ("8.75% Reset Notes") due on May 15, 2001. Interest is payable semiannually on May 15 and November 15, commencing November 15, 1992. On May 15, 1995 and May 15, 1998, unless a notice of redemption of the 8.75% Reset Notes on such date has been given by the Company, the interest rate on the 8.75% Reset Notes will, if necessary, be adjusted from the rate then in effect to a rate to be determined on the basis of market rates in effect on May 5, 1995 and on May 5, 1998, respectively, as the rate the 8.75% Reset Notes should bear in order to have a market value of 101% of principal amount immediately after the resetting of the rate. In no event will the interest rate be lower than 8.75% or higher than the average three year treasury rate (as defined in the indenture) multiplied by two. The interest rate reset on May 15, 1995 will remain in effect on the 8.75% Reset Notes through and including May 15, 1998 and the interest rate reset on May 15, 1998 will remain in effect on the 8.75% Reset Notes thereafter. The 8.75% Reset Notes are redeemable at the option of the Company, in whole but not in part, on May 15, 1995 or May 15, 1998, at a redemption price of 101% of II-46 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) principal amount plus accrued interest to, but not including, the date of redemption. The 8.75% Reset Notes are not subject to any sinking fund requirements. (d) -- On September 15, 1991, the Company issued $200 million aggregate principal amount of 10.25% Senior Subordinated Notes ("10.25% Notes") due September 15, 2001. Interest is payable semiannually on March 15 and September 15, commencing March 15, 1992. The 10.25% Notes are not redeemable by the Company prior to maturity and are not subject to any sinking fund requirements. _____________________ II-47 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The extraordinary losses and related tax benefits associated with the extinguishment of certain debt of Viacom Inc. and the Company are summarized as follows: 11.50% 11.80% Reset Discount Exchange Notes Notes Debentures Debentures Total ------ ------ ---------- ---------- ----- (Thousands of dollars) Year ended December 31, 1993: - ---------------------------- Extraordinary loss (a) $14,953 $ -- $ -- $ -- $14,953 Tax benefit 6,086 -- -- -- 6,086 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ 8,867 $ -- $ -- $ -- $ 8,867 ======= ====== ======= ====== ======= Year ended December 31, 1992: - ---------------------------- Extraordinary loss (b) $ -- $5,800 $22,600 $ -- $28,400 Tax benefit -- 2,361 8,919 -- 11,280 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ -- $3,439 $13,681 $ -- $17,120 ======= ====== ======= ====== ======= Year ended December 31, 1991: - ---------------------------- Extraordinary loss (c) $ -- $ -- $ 3,761 $ 947 $ 4,708 Tax benefit -- -- 1,284 323 1,607 ------- ------ ------- ------ ------- Extraordinary loss, net of tax $ -- $ -- $ 2,477 $ 624 $ 3,101 ======= ====== ======= ====== ======= (a) On July 15, 1993, the Company redeemed all of the $298 million principal amount outstanding of the 11.80% Senior Subordinated Notes ("11.80% Notes") at a redemption price equal to 103.37% of the principal amount plus accrued interest to July 15,1993. (b) On June 18, 1992, the Company redeemed all of the $356.5 million principal amount outstanding of the 14.75% Senior Subordinated Discount Debentures ("Discount Debentures") at a redemption price equal to 105% of the principal amount plus accrued interest to June 18, 1992. On March 10, 1992, the Company redeemed all of the $193 million principal amount outstanding of its 11.50% Senior Subordinated Extendible Reset Notes ("11.50% Reset Notes") at a redemption price equal to 101% of the principal amount plus accrued interest to the redemption date. (c) During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. On August 30, 1991 and October 31, 1991, Viacom Inc. redeemed $250 million and $152 million, respectively, constituting the entire principal amount of the Exchange Debentures. The Company borrowed the funds necessary for each of these redemptions under its bank credit facilities existing in the respective periods. _____________________ NAI, Sumner M. Redstone and the Company each have purchased on the open market and may in the future continue to purchase on the open market or in privately negotiated transactions certain debt securities of the Company. During 1993, there were no purchases of debt securities made by NAI, Sumner M. Redstone or the Company. During 1992, Sumner M. Redstone purchased directly and beneficially $350,000, $605,000, $15,000 and $200,000 of 11.50% Senior II-48 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Subordinated Extendible Reset Notes, 9.125% Senior Subordinated Notes, 10.25% Senior Subordinated Notes and 8.75% Senior Subordinated Reset Notes, respectively. During 1991, NAI and Sumner M. Redstone purchased $3,110,000 and $869,000 of 11.80% Senior Subordinated Notes, respectively. During 1991, NAI purchased $311,000 of the 11.50% Senior Subordinated Extendible Reset Notes. During December 1991, the Company purchased $43 million of Discount Debentures at an average price of 107.375% of their principal amount plus accrued interest. Interest costs incurred, interest income and capitalized interest are summarized below: Year Ended December 31, -------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Interest Incurred $154,509 $195,725 $298,591 Interest Income $ 9,184 $ 1,119 $ 626 Capitalized Interest $ 372 $ 502 $ 513 Scheduled maturities of long-term debt of the Company through December 31, 1998, assuming full utilization of the $1.9 billion commitment under the Credit Agreement and $300 million commitment under the Loan Facility, are $300 million (1994), $380 million (1995), $380 million (1996), $380 million (1997) and $380 million (1998). Scheduled maturities of debt of Viacom Inc. under the Term Loan Agreement are $13.9 million (repaid on January 15, 1994) and $28.3 million (1995). (See Note 2 regarding Paramount Merger financing and scheduled maturity of debt.) 5) FAIR VALUE OF FINANCIAL INSTRUMENTS The Company's carrying value of the financial instruments approximates fair value, except for differences with respect to the senior subordinated debt and certain differences related to other financial instruments which are not significant. The carrying value of the senior subordinated debt is $450 million and the fair value, which is estimated based on quoted market prices, is $486 million. 6) SHAREHOLDERS' EQUITY On October 22, 1993, Blockbuster purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series A Preferred Stock") for $600 million. On November 19, 1993, NYNEX Corporation ("NYNEX") purchased 24 million shares of cumulative convertible preferred stock, par value $.01 per share, of Viacom Inc. ("Series B Preferred Stock," collectively with the Series A Preferred Stock, "Preferred Stock") for $1.2 billion. Series A Preferred Stock and Series B Preferred Stock have liquidation preferences of $25 per share and $50 per share, respectively. The Preferred Stock has an annual dividend rate of 5%, is convertible into shares of Viacom Class B Common Stock at a conversion price of $70 and does not have voting rights other than those required by law. The Preferred Stock is redeemable by Viacom Inc. at declining premiums after five years. The Preferred Stock purchased by Blockbuster will be canceled upon consummation of the Blockbuster Merger. On August 30, 1991, Viacom Inc. issued 2,210,884 shares of Viacom Class B Common Stock to an affiliate of Mirror Group Newspapers in exchange for the remaining 50.01% interest in MTV EUROPE (See Note 3). On September 17, 1991, all such shares of B Common Stock were sold by Mirror Group Newspapers in an underwritten public offering. II-49 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) On June 11, 1991, Viacom Inc. completed the sale of 10,781,600 shares of Viacom Class B Common Stock in a registered public offering and the private placement of an additional 500,000 shares of Viacom Class B Common Stock with NAI. Viacom Inc. realized proceeds, net of underwriting discounts and other related expenses, of approximately $317.7 million from the sale and private placement. NAI holds approximately 76.3% and the public holds approximately 23.7% of outstanding Viacom Inc. Common Stock as of December 31, 1993. NAI's percentage of ownership consists of 85.2% of the outstanding Viacom Class A Common Stock and 69.1% of the outstanding Viacom Class B Common Stock, as of December 31, 1993. Pursuant to a purchase program initiated in August 1987, NAI announced its intention to buy, from time to time, up to an additional 3,000,000 shares of Viacom Class A Common Stock and 2,423,700 shares of Viacom Class B Common Stock. As of December 31, 1993, NAI had acquired an aggregate of 3,374,300 shares of Common Stock, consisting of 1,466,200 shares of Viacom Class A Common Stock and 1,908,100 shares of Viacom Class B Common Stock, pursuant to this buying program. On August 20, 1993, NAI ceased making purchases of Common Stock. Under the restrictions contained in the Credit Agreement, the Company is prohibited from (i) paying any dividends on its stock to Viacom Inc. for the purpose of enabling Viacom Inc. to pay any dividend on its common stock, or (ii) making any other dividend payments to Viacom Inc. (other than for certain limited specified purposes), unless its total leverage ratio is less than a specified amount. Long-Term Incentive Plans - The purpose of the Long-Term Incentive Plans (the "Plans"), which consist of the Long-Term Incentive Plan ("LTIP") and the Long- Term Management Incentive Plan ("LTMIP"), is to benefit and advance the interests of Viacom Inc. by rewarding certain key employees for their contributions to the financial success of the Company and thereby motivating them to continue to make such contributions in the future. The Plans provide for grants of equity-based interests pursuant to awards of phantom shares, stock options, stock appreciation rights, restricted shares or other equity- based interests ("Awards"), and for subsequent payments of cash with respect to phantom shares or stock appreciation rights based, subject to certain limits, on their appreciation in value over stated periods of time. During December 1992, a significant portion of the liability associated with the LTIP was satisfied through the cash payment of $68.6 million and the issuance of 177,897 shares of Viacom Class B Common Stock valued at $6.9 million. The LTMIP provides that an aggregate of 7,000,000 Awards may be granted over five years. As of December 31, 1993, there were 1,994,020 Awards available for future grant, and 4,616,155 Awards outstanding consisting of phantom shares for 643,098 shares of common stock at an average grant price of $29 and vesting over three years from the date of grant, and stock options for 3,973,057 shares of common stock with exercise prices ranging from $20.75 to $55.25 and vesting over four years from the date of grant. The stock options expire 10 years after the date of grant. II-50 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) A summary of stock option activity follows: Number of Option Shares Price range ------- ----------- Balance at December 31, 1991 3,148,357 $20.75 to $29.375 Granted 643,740 31.875 Exercised (45,291) 20.75 to 29.00 Canceled (189,215) 20.75 to 29.375 --------- Balance at December 31, 1992 3,557,591 20.75 to 31.875 Granted 856,990 43.25 to 55.25 Exercised (346,378) 20.75 to 31.875 Canceled (95,146) 20.75 to 55.25 --------- Balance at December 31, 1993 3,973,057 $20.75 to $55.25 ========= Available for future grant: December 31, 1993 1,994,020 December 31, 1992 2,752,854 Exercisable: December 31, 1993 1,448,570 December 31, 1992 775,040 Viacom Inc. has reserved 224,410 shares of Viacom Class A Common Stock and 29,462,933 shares of Viacom Class B Common Stock, principally for exercise of stock options and the conversion of the Preferred Stock. 7) INCOME TAXES The provision for income taxes shown below for the years ended December 31, 1993, 1992 and 1991 represents federal, state and foreign income taxes on earnings before income taxes. The tax benefits relating to losses accounted for under the equity method of accounting, which are shown net of tax on the Company's statement of operations, are $.6 million (1993), $2.2 million (1992) and $6.4 million (1991). See Note 4 for tax benefits relating to the Extraordinary Losses. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") on a prospective basis and recognized an increase to earnings of $10.3 million in 1993 as the cumulative effect of a change in accounting principle. SFAS 109 mandates the liability method for computing deferred income taxes. II-51 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Earnings before income taxes are attributable to the following jurisdictions: Year Ended December 31, ------------------------------ 1993 1991 1992 ---- ---- ---- (Thousands of dollars) United States $267,804 $138,215 $ (2,716) Foreign 34,012 17,364 10,963 -------- -------- -------- Total $301,816 $155,579 $ 8,247 ======== ======== ======== Components of the provision for income taxes on earnings before income taxes are as follows: Year Ended December 31, ---------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Current: Federal $89,484 $47,347 $29,039 State and local 10,357 17,851 16,618 Foreign 5,610 4,582 5,159 -------- ------- ------- 105,451 69,780 50,816 Deferred 24,364 15,068 (8,756) -------- ------- ------- $129,815 $84,848 $42,060 ======== ======= ======= II-52 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) A reconciliation of the U.S. Federal statutory tax rate to the Company's effective tax rate on earnings before income taxes is as follows: Year Ended December 31, ----------------------- 1993 1992 1991 ---- ---- ---- Statutory U.S. tax rate 35.0% 34.0% 34.0% State and local taxes, net of federal tax benefit 5.7 4.7 10.8 Foreign taxes, net of federal tax benefit .5 1.9 41.3 Amortization of intangibles 7.1 18.2 405.3 Divestiture gain - nontaxable portion (3.2) -- -- Property and equipment basis difference -- 7.2 150.0 Other purchase accounting adjustments -- -- (46.8) Alternative minimum tax -- (88.7) Income tax reserve adjustment (5.0) (12.9) -- Effect of changes in statutory rate .5 -- -- Other, net 2.4 1.4 4.2 ----- ----- ------- Effective tax rate 43.0% 54.5% 510.1% ===== ===== ====== The annual effective tax rate of 43% for 1993 and 54.5% for 1992 includes a reduction of certain prior year tax reserves in the amount of $22 million and $20 million, respectively. The reduction is based on management's view concerning the outcome of several tax issues based upon the progress of federal, state and local audits. As of December 31, 1993, after having given effect to SFAS 109, the Company had total non-current deferred net tax liabilities of $85.2 million and current deferred net tax assets of $16.3 million. The deferred net tax assets are deemed to be fully realizable and therefore no valuation allowance has been established. At December 31, 1993, the Company had no net operating loss or investment tax credit carryovers. II-53 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following is a summary of the deferred tax accounts in accordance with SFAS 109 for the year ended December 31, 1993. (Thousands of dollars) Current deferred tax assets and (liabilities): Differences between book and tax recognition of revenue $ 17,826 Differences between book and tax expense for program costs (4,127) Other differences between tax and financial statement values 2,591 -------- Gross current deferred net tax assets 16,290 -------- Noncurrent deferred tax assets and (liabilities): Tax depreciation in excess of book depreciation (69,118) Reserves in excess of tax expense 39,336 Tax amortization in excess of book amortization (32,985) Differences between book and tax expense for program costs (18,442) Differences between book and tax recognition of revenue (3,505) Other differences between tax and financial statement values (497) ---------- Gross noncurrent deferred net tax liabilities (85,211) ---------- Total net deferred tax liabilities $ (68,921) ========== The following table identifies the deferred tax items which were part of the Company's tax provision under previously applicable accounting principles for the years ended December 31, 1992 and 1991: Year Ended December 31, ----------------------- 1992 1991 ---- ---- (Thousands of dollars) Deferred compensation $22,682 $(3,044) Depreciation 7,594 4,320 Syndication advance payments 4,118 (771) Alternative minimum tax - (7,821) Litigation accrual (13,324) - Sale of cable system (6,850) - Other, net 848 (1,440) ------- ------ $15,068 $(8,756) ======= ======== II-54 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) There are no significant temporary differences relating to foreign undistributed earnings or investments in foreign subsidiaries for 1993, 1992 or 1991. Thus, no related deferred taxes have been recorded by the Company for these years. Viacom Inc. and its subsidiaries file a consolidated federal income tax return and have done so since the period commencing June 11, 1991, the date on which NAI's percentage of ownership of Viacom Inc. was reduced to less than 80%. Prior to such date, Viacom Inc. and the Company filed a consolidated federal income tax return with NAI, and also participated in a tax-sharing agreement with NAI with respect to federal income taxes. The tax-sharing agreement obligated Viacom Inc. and the Company to make payment to NAI to the extent they would have paid federal income taxes on a separate company basis, and entitled them to receive a payment from NAI to the extent losses and credits reduced NAI's federal income taxes. 8) PENSION PLANS, OTHER POSTRETIREMENT BENEFITS AND POSTEMPLOYMENT BENEFITS The Company and certain of its subsidiaries have non-contributory pension plans covering substantially all employees. The benefits for these plans are based primarily on an employee's years of service and pay near retirement. All employees are vested in the plans after five years of service. The Company's policy for all pension plans is to fund amounts in accordance with the Employee Retirement Income and Security Act of 1974. Plan assets consist principally of common stocks, marketable bonds and United States government securities. Net periodic pension cost for the periods indicated included the following components: Year Ended December 31, ---------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Service cost - benefits earned during the period $5,442 $4,581 $3,919 Interest cost on projected benefit obligation 4,106 3,300 2,761 Return on plan assets: Actual (1,777) (1,421) (4,434) Deferred (gain) loss (1,134) (752) 2,952 Unrecognized prior service cost 480 454 450 -------- ------- ------- Net pension cost $7,117 $6,162 $5,648 ====== ====== ====== II-55 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The funded status of the pension plans for the periods indicated is as follows: Year Ended December 31, ----------------------- 1993 1992 ---- ---- (Thousands of dollars) Actuarial present value of benefit obligations: Accumulated benefit obligation: Vested $34,440 $ 24,095 Non-vested 3,177 1,740 --------- -------- Total $37,617 $ 25,835 ======= ======== Projected benefit obligation $58,845 $ 43,626 Plan assets at fair value 32,649 28,282 --------- -------- Plan assets less than the projected benefit obligation (26,196) (15,344) Unrecognized loss during the year 8,104 476 Unrecognized prior service cost 3,743 4,384 Adjustment to recognize minimum liability (576) (768) --------- -------- Pension liability at year end $(14,925) $(11,252) ========= ======== For purposes of valuing the 1993 and 1992 projected benefit obligation, the discount rate was 7.5% (1993) and 8.25% (1992) and the rate of increase in future compensation was 6% for each of the years. For determining the pension expense for each of the years, the long-term rate of return on plan assets was 9%. In 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting For Postemployment Benefits" ("SFAS 112") which the Company will be required to adopt in 1994. SFAS 112 requires that postemployment benefits be accounted for under the accrual method versus the currently used pay-as-you-go method. The Company is evaluating the impact of SFAS 112 and it is not expected that SFAS 112 will have a significant effect on the Company's consolidated financial position or results of operations. 9) RELATED PARTY TRANSACTIONS The Company, through the normal course of business, is involved in transactions with affiliated companies. The Company sold programming to affiliates amounting to $5.5 million (1993), $3.3 million (1992) and $.9 million (1991) and paid subscriber fees of $6.1 million (1993), $5.4 million (1992) and $2.0 million (1991). In addition, rent and other expenses of $5.8 million, $4.7 million and $4.0 million were charged to affiliated companies during 1993, 1992 and 1991, respectively. Related party accounts receivable and accounts payable were immaterial for each period. The Company received approximately $.9 million (1993) and $1.3 million (1992) under its tax-sharing agreement with NAI and paid approximately $.9 million (1991). II-56 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 10) COMMITMENTS AND CONTINGENCIES The Company has long-term noncancellable lease commitments for office space and equipment, transponders, studio facilities and vehicles. At December 31, 1993, minimum rental payments under noncancellable leases are as follows: Operating Capital Leases Leases ------ ------ (Thousands of dollars) 1994 $ 59,746 $ 9,632 1995 58,946 10,660 1996 56,795 11,689 1997 53,125 12,717 1998 55,373 13,746 1999 and thereafter 390,181 38,764 -------- ------- Total minimum lease payments $674,166 97,208 ======== Less amounts representing interest 34,121 ------- Present value of net minimum payments $63,087 ======= Future minimum capital lease payments and operating lease payments have not been reduced by future minimum sublease rentals of $26.0 million and $.5 million, respectively. Rent expense amounted to $74.2 million (1993), $67.9 million (1992) and $64.6 million (1991). Capital leases represent the financing of transponders of $67.0 million (1993) and $26.2 million (1992), net of accumulated amortization of $7.8 million (1993) and $3.0 million (1992). The commitments of the Company for program license fees which are not reflected in the balance sheet as of December 31, 1993, which are estimated to aggregate approximately $1.9 billion, principally reflect commitments under SNI's exclusive arrangements with several motion picture companies. This estimate is based upon a number of factors. A majority of such fees are payable within the next seven years, as part of normal programming expenditures of SNI. These commitments are contingent upon delivery of motion pictures which are not yet available for premium television exhibition and, in many cases, have not yet been produced. During July 1991, the Company received reassessments from 10 California counties of its Cable Division's real and personal property, related to the June 1987 acquisition by NAI, which could result in substantially higher California property tax liabilities. The Company is appealing the reassessments and believes that the reassessments as issued are unreasonable and unsupportable under California law. The Company believes that the final resolution of this matter will not have a material effect on its consolidated financial position or results of operations. There are various lawsuits and claims pending against the Company. Management believes that any ultimate liability resulting from those actions or claims will not have a material adverse effect on the Company's financial position or results of operations (See Note 14). II-57 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 11) FOREIGN OPERATIONS The consolidated financial statements include the following amounts applicable to foreign subsidiaries: Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Revenues $ 122,200 $68,193 $31,786 Earnings before income taxes $ 34,012 $17,364 $10,963 Net earnings $ 33,747 $16,384 $ 9,294 Current assets $ 54,190 $47,769 $38,452 Total assets $ 115,744 $73,817 $40,422 Total liabilities $ 68,728 $57,441 $30,897 Total export revenues were $25.2 million (1993), $34.9 million (1992) and $26.7 million (1991). Foreign currency transaction gains and losses were immaterial in each period presented. II-58 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 12) BUSINESS SEGMENTS Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of dollars) Revenues: Networks $1,221,200 $1,058,831 $ 922,157 Entertainment 209,110 248,335 273,488 Cable Television 415,953 411,087 378,026 Broadcasting 181,778 168,847 159,182 Intercompany elimination (23,092) (22,417) (21,291) ---------- ---------- ---------- Total revenues $2,004,949 $1,864,683 $1,711,562 ========== ========== ========== Earnings from operations: Networks $ 272,087 $ 205,576 $ 172,296 Entertainment 32,480 59,662 73,214 Cable Television 110,176 122,037 103,954 Broadcasting 42,293 31,956 27,734 Corporate (72,041) (71,304) (64,964) ---------- ---------- ---------- Total earnings from operations $ 384,995 $ 347,927 $ 312,234 ========== ========== ========== Depreciation and amortization: Networks $ 44,747 $ 41,754 $ 30,123 Entertainment 9,549 6,792 7,160 Cable Television 71,520 68,505 66,604 Broadcasting 23,475 24,509 27,062 Corporate 3,766 3,242 1,915 ---------- ---------- ---------- Total depreciation and amortization $ 153,057 $ 144,802 $ 132,864 ========== ========== ========== Identifiable assets at year end: Networks $1,794,418 $1,604,504 $1,453,643 Entertainment 845,620 829,607 855,357 Cable Television 963,047 972,066 979,668 Broadcasting 744,208 722,023 742,650 Corporate 2,069,575 188,894 157,060 ---------- ---------- ---------- Total identifiable assets at year end $6,416,868 $4,317,094 $4,188,378 ========== ========== ========== Capital expenditures: Networks $ 35,786 $ 26,076 $ 6,170 Entertainment 4,933 7,102 916 Cable Television 79,482 54,596 44,967 Broadcasting 4,886 5,102 3,101 Corporate 9,924 17,346 2,275 ---------- ---------- ---------- Total capital expenditures $ 135,011 $ 110,222 $ 57,429 ========== ========== ========== II-59 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 13) QUARTERLY FINANCIAL DATA (unaudited): Summarized quarterly financial data for 1993 and 1992 appears below: First Second Third Fourth Quarter Quarter Quarter Quarter Total Year ------- ------- ------- ------- ---------- (Thousands of dollars, except per share amounts) - ---- Revenues $470,650 $495,799 $508,122 $530,378 $2,004,949 Earnings from operations $ 90,182 $106,562 $110,153 $ 78,098 $ 384,995 Earnings before extraordinary losses and cumulative effect of changes in accounting principle (1) $ 70,626 $ 41,628 $ 30,901 $ 26,326 $ 169,481 Net earnings $ 80,964 $ 41,628 $ 22,034 $ 26,326 $ 170,952 Net earnings attributable to common stock (2) $ 80,964 $ 41,628 $ 22,034 $ 13,576 $ 158,202 Net earnings per common share: Earnings before extraordinary losses and cumulative effect of changes in accounting principle $ .59 $ .35 $ .25 $ .11 $ 1.30 Net earnings $ .67 $ .35 $ .18 $ .11 $ 1.31 Average number of common shares 120,479 120,517 120,645 120,782 120,607 - ---- Revenues $430,568 $451,053 $471,498 $511,564 $1,864,683 Earnings from operations (3) $ 83,399 $ 96,873 $100,010 $ 67,645 $ 347,927 Earnings (loss) before extraordinary losses (4) $ 10,527 $ (1,145) $ 45,049 $ 11,654 $ 66,085 Net earnings (loss) $ 7,088 $(14,826) $ 45,049 $ 11,654 $ 48,965 Net earnings (loss) per common share: Earnings (loss) before extraordinary losses $ .09 $ (.01) $ .37 $ .10 $ .55 Net earnings (loss) $ .06 $ (.12) $ .37 $ .10 $ .41 Average number of common shares 120,228 120,229 120,230 120,250 120,235 (1) The first quarter of 1993 reflects a pre-tax gain of $55 million related to the sale of the stock of Viacom Cablevision of Wisconsin Inc. (See Note 14). (2) The fourth quarter of 1993 reflects Preferred Stock dividends of $12.8 million (See Note 6). (3) The third quarter of 1992 reflects a reversal of compensation expense associated with the Long-Term Incentive Plans. The fourth quarter of 1992 reflects a significant expense associated with the Long-Term Incentive Plans. The fluctuations in compensation expense associated with the Long- Term Incentive Plans for the third and fourth quarter of 1992 resulted primarily from the fluctuations in market value of Viacom Inc.'s Common Stock (See Note 6). (4) The second quarter of 1992 reflects the reserve for litigation of $33 million related to a summary judgment against the Company in a dispute with CBS Inc. The third quarter of 1992 reflects a gain of $35 million related to certain aspects of the settlement of the Time Warner antitrust lawsuit (See Note 14). II-60 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 14) OTHER ITEMS, NET As part of the settlement of the Time Warner antitrust lawsuit, the Company sold all the stock of Viacom Cablevision of Wisconsin, Inc. to Warner Communications Inc. ("Warner"). This transaction was effective on January 1, 1993. As consideration for the stock, Warner paid the sum of $46 million plus repayment of debt under the Credit Agreement in the amount of $49 million, resulting in a pre-tax gain of approximately $55 million reflected in "Other items, net." Also reflected in this line item is the net gain on the sale of a portion of an investment held at cost and adjustments to previously established non-operating litigation reserves, and other items. "Other items, net" reflects a gain of $35 million recorded in the third quarter of 1992; this gain represents payments received in the third quarter relating to certain aspects of the settlement of the Time Warner antitrust lawsuit, net of the Company's 1992 legal expenses related to this lawsuit. "Other items, net" also reflects a reserve for litigation of $33 million during the second quarter of 1992 related to a summary judgment against Viacom in a dispute with CBS Inc. arising under the 1970 agreement associated with the spin-off of Viacom International Inc. by CBS Inc. On July 30, 1993, the Company settled all disputes arising under the above litigation. In September 1991, the Company recorded a reserve for its investment in a start-up joint venture. On August 16, 1991, the Company sold 129,837 shares of Turner Broadcasting System, Inc. Class B Common Stock for approximately $1.9 million. These transactions resulted in a pre-tax loss of approximately $6.5 million, which is reflected in "Other items, net." II-61 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 15) SUPPLEMENTAL CASH FLOW INFORMATION Year Ended December 31, ------------------------ 1993 1992 1991 ---- ----- ---- (Thousands of dollars) Cash payments for interest net of $167,383 $194,879 $233,904 amounts capitalized Cash payments for income taxes 32,675 50,738 24,539 Cash received for income taxes 1,074 1,470 3,301 Supplemental schedule of non-cash financing and investing activities: B Common stock issued as satisfaction for LTIP liability -- 6,894 -- Equipment acquired under capitalized leases 44,381 26,192 -- B Common Stock issued to acquire the remaining 50.01% interest in MTV EUROPE -- -- 65,000 II-62 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. II-63 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES The following consolidated financial statements and schedules of the registrant and its subsidiaries are submitted herewith as part of this report: Reference (Page/s) -------- 1. Report of Independent Accountants.................. II-32 2. Management's Statement of Responsibility for Financial Reporting................................ II-33 3. Consolidated Statements of Operations for the years ended December 31, 1993, 1992, and 1991........... II-34 4. Consolidated Balance Sheets as of December 31, 1993 and 1992........................................... II-35-II-36 5. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991........... II-37 6. Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991... II-38 7. Notes to Consolidated Financial Statements......... II-39-II-62 Report of Independent Accountants on Financial Statement Schedules................................... Financial Statement Schedules: II. Amounts receivable from related parties. VIII. Valuation and qualifying accounts.......... IX. Short-term borrowings...................... X. Supplementary statement of operations information................................ 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 consolidated financial statements and notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Boards of Directors and Shareholders of Viacom Inc. and Viacom International Inc. Our audits of the consolidated financial statements referred to in our report dated February 4, 1994, except as to Note 2, which is as of March 11, 1994, appearing on page II-32 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 1177 Avenue of the Americas New York, New York 10036 February 4, 1994 VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Thousands of Dollars) VIACOM INC. AND VIACOM INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION (Thousands of Dollars) Col. A Col. B ------ ----------------------------- Charged to Costs and Expenses ----------------------------- Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- ITEM Maintenance and repairs $21,104 $25,649 $20,145 Advertising costs $79,827 $51,124 $68,858 Amortization $60,278 $63,256 $62,795 Taxes, other than payroll and $30,362 $21,000 $19,805 income taxes NOTE: ---- Items not presented above are less than 1% of revenues or are presented elsewhere in the consolidated financial statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Information Concerning Directors and Nominees" is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information contained in the Viacom Inc. Definitive Proxy Statement under the captions "Directors' Compensation" and "Executive Compensation" is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information contained in the Viacom Inc. Definitive Proxy Statement under the caption "Related Transactions" is incorporated herein by reference. III - 1 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) and (d) Financial Statements and Schedules (see Index on Page) (b) Reports on Form 8-K Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of October 5, 1993 relating to the agreement dated as of October 4, 1993 between Viacom Inc. and NYNEX Corporation ("NYNEX") pursuant to which NYNEX subscribed for and agreed to purchase from Viacom Inc. 24 million shares of newly issued Series B Cumulative Convertible Preferred Stock of Viacom Inc. for an aggregate purchase price of $1.2 billion. Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of October 27, 1993 relating to the completion of the issuance and sale to Blockbuster Entertainment Corporation ("Blockbuster") by Viacom Inc. of 24 million shares of new issued Series A Cumulative Convertible Preferred Stock and the election of H. Wayne Huizenga, Chairman and Chief Executive Officer of Blockbuster, as a director of Viacom Inc. and Viacom International Inc. Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of November 19, 1993 relating to the completion of the issuance and sale to NYNEX Corporation ("NYNEX") of 24 million shares of newly issued Series B Cumulative Convertible Preferred Stock for an aggregate purchase price of $1.2 billion and the election of William C. Ferguson, Chairman and Chief Executive Officer of NYNEX, as a director of Viacom Inc. and Viacom International Inc. (c) Exhibits (see index on Page E-1) IV-1 SIGNATURES Pursuant to the requirements of Section 13 or 15(D) of the Securities Exchange Act of 1934, Viacom Inc. has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. VIACOM INC. By /s/Frank J. Biondi, Jr. --------------------------------- Frank J. Biondi, Jr., President, Chief Executive Officer By /s/George S. Smith, Jr. --------------------------------- George S. Smith, Jr., Senior Vice President, Chief Financial Officer By /s/Kevin C. Lavan --------------------------------- Kevin C. Lavan, Vice President, Controller, Chief Accounting Officer Date: March 31, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of Viacom Inc. and in the capacities and on the dates indicated: By * March 31, 1994 -------------------------------- George S. Abrams, Director By /s/Frank J. Biondi, Jr. March 31, 1994 -------------------------------- Frank J. Biondi, Jr., Director By /s/Philippe P. Dauman March 31, 1994 -------------------------------- Philippe P. Dauman, Director By * March 31, 1994 -------------------------------- William C. Ferguson, Director By * March 31, 1994 -------------------------------- H. Wayne Huizenga, Director By * March 31, 1994 -------------------------------- Ken Miller, Director By * March 31, 1994 -------------------------------- Brent D. Redstone, Director By * March 31, 1994 -------------------------------- Sumner M. Redstone, Director By * March 31, 1994 -------------------------------- Frederic V. Salerno, Director By * March 31, 1994 -------------------------------- William Schwartz, Director * By /s/Philippe P. Dauman March 31, 1994 -------------------------------- Philippe P. Dauman Attorney-in-Fact for the Directors VIACOM INC. AND SUBSIDIARIES INDEX TO EXHIBITS ITEM 14(C) EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (2) Plan of Acquisition (a) Certificate of Ownership and Merger of Viacom International Inc. into Arsenal Holdings II, Inc. as filed with the Office of Secretary of State of Delaware and effective on April 26, 1990 (incorporated by reference to Exhibit 2(1) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (b) Certificate and Agreement of Merger of Viacom International Inc. into Arsenal Holdings II, Inc. filed with the Office of the Secretary of State of Ohio and effective April 26, 1990 (incorporated by reference to Exhibit 2(2) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (c) Agreement and Plan of Merger dated as of January 7, 1994 between Viacom Inc. and Blockbuster Entertainment Corporation (incorporated by reference to Exhibit 99(c)(9) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 20) dated January 7, 1994). (d) Voting Agreement dated as of January 7, 1994 between National Amusements, Inc. and Blockbuster Entertainment Corporation (filed herewith). (e) Amended and Restated Stockholders Stock Option Agreement dated as of January 7, 1994 among Viacom Inc. and each person listed on the signature pages thereto (filed herewith). (f) Amended and Restated Proxy Agreement dated as of January 7, 1994 among Viacom Inc. and each person listed on the signature pages thereto (filed herewith). (g) Voting Agreement dated as of January 21, 1994 between National Amusements, Inc. and Paramount Communications Inc. (incorporated by reference to Exhibit 99(a)(66) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 29) dated January 24, 1994). (h) Amended and Restated Agreement and Plan of Merger dated as of February 4, 1994 between Viacom Inc. and Paramount Communications Inc. (incorporated by reference to Exhibit 99(a)(92) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 38) dated February 7, 1994). E-1 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (3) Articles of Incorporation and By-laws (a) Restated Certificate of Incorporation of Viacom Inc. (incorporated by reference to Exhibit 3(a) to the Annual Reports on Form 10- K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554). (b) Certificate of the Designations, Powers, Preferences and Relative, Participating or other Rights, and the Qualifications, Limitations or Restrictions thereof, of Series A Cumulative Convertible Preferred Stock ($0.01 par value) of Viacom Inc. (incorporated by reference to Exhibit 4.1 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended September 30, 1993) (File Nos. 1-9553/1-9554). (c) Certificate of the Designations, Powers, Preferences and Relative, Participating or other Rights, and the Qualifications, Limitations or Restrictions thereof, of Series B Cumulative Convertible Preferred Stock ($0.01 par value) of Viacom Inc. (filed herewith). (d) By-laws of Viacom Inc. (incorporated by reference to Exhibit 3.3 to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33-13812). (e) Certificate of Incorporation of Viacom International Inc. (formerly Arsenal Holdings II, Inc.) (incorporated by reference to Exhibit 3(e) to the Annual Reports on Form 10- K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990, as amended on Form 8, dated June 3, 1991) (File Nos. 1-9553/1-9554). (f) By-laws of Viacom International Inc. (formerly Arsenal Holdings II, Inc.) (incorporated by reference to Exhibit 3(f) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990, as amended on Form 8, dated June 3, 1991) (File Nos. 1-9553/1-9554). E-2 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (4) Instruments defining the rights of security holders, including indentures: (a) Specimen certificate representing the Viacom Inc. Voting Common Stock (currently Class A Common Stock) (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33- 13812). (b) Specimen certificate representing Viacom Inc. Class B Non-Voting Common Stock (incorporated by reference to Exhibit 4(a) to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1990) (File Nos. 1-9553/1-9554). (c) Specimen certificate representing Viacom Inc. Series A Cumulative Convertible Preferred Stock of Viacom Inc. (filed herewith). (d) Specimen certificate representing Viacom Inc. Series B Cumulative Convertible Preferred Stock of Viacom Inc. (filed herewith). (e) Indenture, dated as of September 15, 1991, among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s Guarantied Senior Subordinated Debt Securities (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1-9553/1-9554) as supplemented by the First Supplemental Indenture dated as of September 15, 1991 among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s 10.25% Senior Subordinated Notes due September 15, 2001 (incorporated by reference to Exhibit 4.2 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1-9553/1-9554) as further supplemented by the Second Supplemental Indenture dated as of March 4, 1992 among Viacom International Inc., as Issuer, Viacom Inc., as Guarantor, and The Bank of New York, as Trustee, relating to Viacom International Inc.'s 9.125% Senior Subordinated Notes due August 15, 1999 and relating to Viacom International Inc.'s 8.75% Senior Subordinated Reset Notes due May 15, 2001 (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of March 4, 1992) (File Nos. 1-9553/1-9554). (f) Specimen of Note evidencing the 10.25% Senior Subordinated Notes due September 15, 2001 (incorporated by reference to Exhibit 4.3 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of September 20, 1991) (File Nos. 1- 9553/1-9554). (g) Specimen of Note evidencing the 9.125% Senior Subordinated Notes due August 15, 1999 (incorporated by reference to Exhibit 4.2 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of March 4, 1992) (File Nos. 1-9553/1- 9554). E-3 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (h) Specimen of Note evidencing the 8.75% Senior Subordinated Reset Notes due May 15, 2001 (incorporated by reference to Exhibit 4.1 to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of May 28, 1992) (File Nos. 1-9553/1- 9554). (i) Indenture, dated as of July 15, 1988, between Viacom International Inc. and Bankers Trust Company, Trustee, relating to Viacom International Inc.'s 11.80% Senior Subordinated Notes due 1998 (incorporated by reference to Exhibit 4.1 to the Registration Statement on Form S-2 filed by Viacom International Inc.) (File No. 33-21280) and the First Supplement to Indenture dated April 27, 1990 between Viacom International Inc. and Bankers Trust Company, as Trustee (incorporated by reference to Exhibit 4(2) to the Current Report on Form 8-K of Viacom International Inc. with a report date of April 26, 1990) (File No. 1-9554). (j) Form of Note evidencing the 11.80% Senior Subordinated Notes due 1998 (incorporated by reference to Exhibit A to the Indenture filed as Exhibit 4.1 to the Registration Statement on Form S-2 filed by Viacom International Inc.) (File No. 33-21280). (k) Indenture, dated as of June 15, 1986, between Viacom International Inc. and Morgan Guaranty Trust Company of New York, Trustee, relating to Viacom International Inc.'s 5 3/4% Convertible Subordinated Debentures Due 2001 (incorporated by reference to Exhibit 4.5(b) to the Annual Report on Form 10-K of Viacom International Inc. for the fiscal year ended December 31, 1986) (File No. 1-6514), and the First Supplement to Indenture, dated June 9, 1987, among Viacom International Inc., Viacom Inc. and Morgan Guaranty Trust Company of New York, Trustee (incorporated by reference to Exhibit 4.5(b) to the Registration Statement on Form S-4 filed by Viacom Inc.) (File No. 33-13812). (l) Credit Agreement, dated as of September 26, 1989 (the "Credit Agreement"), among Viacom International Inc., the banks listed therein (the "Banks"), and Citibank, N.A. as Agent and The Bank of New York as Co-Agent, as amended and restated as of January 17, 1992 among Viacom Inc., as Guarantor, Viacom International Inc., the Subsidiary Obligors, the Banks, Citibank, N.A. as Agent, and The Bank of New York as Co-Agent (incorporated by reference to Exhibits 10(1) and 10(2) to the Current Reports on Form 8-K of Viacom Inc. and Viacom International Inc. with a report date of January 22, 1992) as amended by Letter Agreements dated as of May 13, 1993 and April 7, 1993 (incorporated by reference to Exhibits 4.1 and 4.2 to the Current Reports on Form 10- Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993) (File Nos. 1-9553/1-9554) (m) Loan Facility Agreement dated as of June 2, 1993 among the Company and the banks named therein and The Bank of New York as Administrative Managing Agent, and The Bank of New York and Citibank as Managing Agents (incorporated by reference to Exhibit 10.1 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1- 9553/1-9554). E-4 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (n) Credit Agreement dated as of November 19, 1993, as amended as of January 4, 1994 and as further amended as of February 15, 1994, among Viacom Inc., the Banks named therein, and The Bank of New York, Citibank, N.A. and Morgan Guaranty Trust Company of New York, as Managing Agents (incorporated by reference to Exhibit 99(a)(11) to Viacom Inc. Schedule 14D- 1 Tender Offer Statement (Amendment No. 46) dated March 3, 1994). (10) Material Contracts (a) Viacom Inc. 1989 Long-Term Management Incentive Plan (as amended and restated through April 23, 1990) (incorporated by reference to Exhibit A to Viacom Inc.'s Definitive Proxy Statement dated April 27, 1990).* (b) Viacom Inc. Long-Term Incentive Plan (incorporated by reference to Exhibit A to Viacom Inc.'s Definitive Proxy Statement dated April 29, 1988), and amendment thereto (incorporated by reference to Exhibit 10(d) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 21, 1991) (File Nos. 1- 9553/1-9554), and as further amended by amendment dated December 17, 1992 (incorporated by reference to Exhibit 10(d) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (c) Viacom Inc. Long-Term Incentive Plan (Divisional) (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554).* (d) Viacom International Inc. Deferred Compensation Plan for Non-Employee Directors (as amended and restated through December 17, 1992) (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (e) Viacom Inc. and Viacom International Inc. Retirement Income Plan for Non-Employee Directors (incorporated by reference to Exhibit 10(f) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1989) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-5 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ------------------------------------------------------------------- (f) Viacom Inc. Stock Option Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554).* (g) Excess Benefits Investment Plan for Certain Key Employees of Viacom International Inc. (effective April 1, 1984 and amended as of January 1, 1990) (incorporated by reference to Exhibit 10(h) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (h) Excess Pension Plan for Certain Key Employees of Viacom International Inc. (incorporated by reference to Exhibit 10(i) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (i) Employment Agreement, dated as of August 1, 1987, between Viacom International Inc. and Frank J. Biondi, Jr. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (File No. 1-9553/1-9554). Guarantee Agreement, dated as of August 1, 1987, from Viacom Inc. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (Files Nos. 1-9553/1-9554). Agreement under the Viacom Inc. Long-Term Incentive Plan, dated March 7, 1989, between Viacom Inc. and Frank J. Biondi, Jr. (incorporated by reference to Exhibit 10(e) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1988) (File Nos. 1- 9553/1-9554).* (j) Agreement, dated as of January 1, 1990, between Viacom International Inc. and Neil S. Braun (incorporated by reference to Exhibit 10(l) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(k) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (k) Amended and Restated Employment Agreement, dated as of October 1, 1987, between Viacom International Inc. and John W. Goddard (incorporated by reference to Exhibit 10(l) to the Annual Reprints on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1991) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-6 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (l) Agreement, dated as of August 1, 1990, between Viacom International Inc. and George S. Smith, Jr. (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554).* (m) Agreement, dated as of August 1, 1990, between Viacom International Inc. and Mark M. Weinstein (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1990) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of February 1, 1993 (incorporated by reference to Exhibit 10(n) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (n) Agreement, dated as of August 1, 1992, between Viacom International Inc. and Thomas E. Dooley (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(o) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1- 9554).* (o) Agreement, dated as of January 1, 1992, between Viacom International Inc. and Edward Horowitz (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554) as amended by an Agreement dated as of October 1, 1992 (incorporated by reference to Exhibit 10(p) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* (p) Agreement dated as of February 1, 1993 between Viacom International Inc. and Philippe P. Dauman (incorporated by reference to Exhibit 10(q) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554).* * Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 14(c). E-7 EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE NO. - ----------------------------------------------------------------- (q) Partnership Agreement between Viacom HA! Holding Company and The Comedy Channel Corp. dated as of December 17, 1990 (incorporated by reference to Exhibit 10.2 to the Registration Statement on Form S-3 filed by Viacom International Inc.) (File No. 33-40170). (r) Lease Agreement between First Security Bank of Utah, N.A., as owner trustee and Viacom International Inc. dated as of August 12, 1992 (incorporated by reference to Exhibit 10(t) to the Annual Reports on Form 10-K of Viacom Inc. and Viacom International Inc. for the fiscal year ended December 31, 1992, as amended by Form 10-K/A Amendment No. 1 dated November 29, 1993 and as further amended by Form 10-K/A Amendment No. 2 dated December 9, 1993) (File Nos. 1-9553/1-9554). (s) Lease Agreement dated as of June 22, 1993 between Mellon Financial Services Corporation and Viacom International Inc. (incorporated by reference to Exhibit 10.2 to the Quarterly Reports on Form 10-Q of Viacom Inc. and Viacom International Inc. for the quarter ended June 30, 1993)(File Nos. 1-9553/1-9554). (t) Stock Purchase Agreement dated as of October 4, 1993 between Viacom Inc. and NYNEX Corporation, as amended as of November 19, 1993 (filed herewith). (u) Amended and Restated Stock Purchase Agreement dated October 21, 1993 between Viacom Inc. and Blockbuster Entertainment Corporation (filed herewith). (v) Subscription Agreement, dated January 7, 1994 between Viacom Inc. and Blockbuster Entertainment Corporation (incorporated by reference to Exhibit 99(c)(8) to Viacom Inc. Schedule 14D-1 Tender Offer Statement (Amendment No. 20) dated January 7, 1994). (12) Statements re Computation of Ratios (a) Computation of Ratio of Earnings to Fixed Changes of Viacom International Inc. (filed herewith). (b) Computation of Ratio of Earnings to Fixed of Viacom Inc. (filed herewith). (21) Subsidiaries of Viacom Inc. and Viacom International Inc. (filed herewith). (23) Consents of Experts and Counsel (a) Consent of Price Waterhouse (filed herewith). (b) Consent of Ernst & Young (filed herewith). (24) Powers of Attorney (filed herewith). (99) Additional Exhibits (a) Item 1, Item 2 and Item 3 of Paramount's Transition Report on Form 10-K for the six- month period ended April 30, 1993, as such report was amended in its entirety by Form 10-K/A No. 1 dated September 28, 1993, as further amended by Form 10-K/A No. 2 dated September 30, 1993 and as further amended by Form 10-K/A No. 3 dated March 21, 1994 (filed herewith). (b) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended July 31, 1993 (filed herewith). (c) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended October 31, 1993 (filed herewith). (d) Quarterly Report on Form 10-Q of Paramount Communications Inc. for the quarter ended January 31, 1994 (filed herewith). E-8

56047_1993.txt

56047_1993

1993

56047

ITEM 1. BUSINESS THE COMPANY Kirby Corporation (the "Company") was incorporated January 31, 1969 in Nevada as a subsidiary of Kirby Petroleum Co. Pursuant to the plan of liquidation of Kirby Industries, Inc. ("Industries"), Kirby Petroleum Co., which was then a wholly owned subsidiary of Industries, transferred to the Company in 1975 substantially all of its nonproducing oil and gas acreage, royalty interests and interests in oil and gas limited partnerships. The Company became publicly owned on September 30, 1976, when its common stock was distributed pro rata to the stockholders of Industries in connection with the liquidation of Industries. In September, 1984, the Company changed its name from "Kirby Exploration Company" to "Kirby Exploration Company, Inc." and in April, 1990, the name was changed from "Kirby Exploration Company, Inc." to "Kirby Corporation." Unless the context otherwise requires, all references herein to the Company include the Company and its subsidiaries. The Company's principal executive office is located at 1775 St. James Place, Suite 300, Houston, Texas 77056, and its telephone number is (713) 629-9370. The Company's mailing address is P.O. Box 1745, Houston, Texas 77251-1745. BUSINESS AND PROPERTY The Company and its subsidiaries conduct operations in three business segments: marine transportation, diesel repair and insurance. The Company's marine transportation segment is conducted through three divisions, organized around the markets they serve: the Inland Chemical Division, engaged in the inland transportation of industrial chemicals and agricultural chemicals by tank barge; the Inland Refined Products Division, engaged in the inland transportation of refined petroleum products by tank barge; and the Offshore Division, engaged in the offshore transportation of petroleum products by tank barge and tank ship and dry bulk, container, palletized cargo by barge and break-bulk and container ship. The Company's marine transportation divisions are strictly providers of transportation services and do not presently assume ownership of any of the products they transport. The Company's diesel repair segment is engaged in the overhaul and repair of diesel engines and related parts sales in two distinct markets: the marine market, serving vessels powered by large diesel engines utilized in the various inland and offshore marine industries; and the locomotive market, serving the shortline and industrial railroad markets. The Company's insurance segment is engaged primarily in the writing of property and casualty insurance in the Commonwealth of Puerto Rico through a 70% owned subsidiary. The Company and its subsidiaries have approximately 2,050 employees with approximately 150 in the Commonwealth of Puerto Rico and the balance in the United States. The following table sets forth by industry segment the combined gross revenues, operating profits (before general corporate expenses, interest expense and income taxes) and identifiable assets (including goodwill) attributable to the continuing principal activities of the Company for the periods indicated (in thousands): MARINE TRANSPORTATION The Company is engaged in marine transportation as a provider of service for both the inland and offshore markets. As of March 14, 1994, the equipment owned or operated by the Company's three marine transportation divisions was composed of 400 inland tank barges, 10 inland dry cargo barges, 123 inland towing vessels, six offshore tank ships, two offshore tank barges, six offshore dry cargo barges, four offshore break-bulk and container ships and nine offshore tugboats with the following specifications and capacities: - --------------- (*) Includes four barges and five tugboats owned by Dixie Fuels Limited and one barge and tugboat owned by Dixie Fuels II, Limited, partnerships in which a subsidiary of the Company owns a 35% and 50% interest, respectively. The following table sets forth the approximate marine transportation revenue and percentage of such revenue derived from the three divisions for the periods indicated (dollars in thousands): INLAND TANK BARGE INDUSTRY The Company's Inland Chemical Division and Inland Refined Products Division operate in the United States inland tank barge industry, which provides marine transportation of liquid bulk cargos for customers along the United States inland waterway system. Among the most significant segments of this industry are the transportation of industrial and agricultural chemicals, refined petroleum products and crude oil. The Company operates in each of these segments. The use of marine transportation by the petroleum and petrochemical industry is a major reason for the location of domestic refineries and petrochemical facilities on navigable inland waterways and along the Gulf Coast. Much of the United States farm belt is likewise situated within access to the inland waterway system, relying on marine transportation of farm products including agricultural chemicals. Although no official industry statistics are maintained, the Company believes that the total number of tank barges that operate in the inland waters of the United States has declined from an estimate of approximately 4,200 in 1981 to approximately 2,900 in 1993. The Company believes this decrease is primarily attributable to the following reasons: increasing age of the domestic tank barge fleet resulting in scraping; rates inadequate to justify new construction; reduction in financial incentives to construct new equipment; and an increase in regulations that mandate expensive equipment modification which some owners are unwilling or unable to undertake given current rate levels and the age of the fleet. Although well maintained tank barges can be efficiently operated for more than 30 years, the cost of hull work for required annual Coast Guard certifications, as well as general safety and environmental concerns, force operators to periodically reassess their ability to recover maintenance costs. Previously, tax and financing incentives to operators and investors to construct tank barges, including short life depreciation, investment tax credits and government guaranteed financing, led to the growth in the supply of domestic tank barges to a peak of approximately 4,200 in 1981. These tax incentives have since been eliminated and government financing programs have since been curtailed. The supply of tank barges resulting from the earlier programs is slowly aligning with demand for tank barge services, primarily through attrition, as discussed above. While the United States tank barge fleet has decreased in size, domestic production of petrochemicals, a major component of the industry's revenues, has increased between 1982 and 1993 by approximately 48%. Growth in the economy and the continued substitution of plastics and synthetics in a wide variety of products have been major factors behind the increase of capacity in the petrochemical industry. Texas and Louisiana, which are within the Company's areas of operations, currently account for more than 78% of the total United States production of petrochemicals. COMPETITION IN THE INLAND TANK BARGE INDUSTRY The Company operates in the highly competitive marine transportation market for commodities transported on the major inland rivers and tributaries and the Gulf Intracoastal Waterway. The industry has become increasingly concentrated within recent years as smaller and/or economically weaker companies have gone out of business or have been acquired by stronger or larger companies. Competition has historically been based primarily on price; however, shipping customers, through increased emphasis on safety, the environment, quality and a greater reliance on a "single source" supply of services, are more frequently requiring that their supplier of inland tank barge services have the capability to handle a variety of tank barge requirements, and offer flexibility, safety, environmental responsibility and quality of service consistent with the customer's own operations. The Company's direct competitors are primarily noncaptive marine transportation companies. "Captive" companies are those companies that are owned by major oil and/or petrochemical companies which, although competing in the inland barge market to varying extents, primarily transport cargos for their own account. Although industry statistics are not categorized by individual firms, the Company believes it is the largest inland tank barge carrier based on its number of barges and barrels of available capacity. While the Company competes primarily with other barge companies, it also competes with companies owning crude oil and refined products pipelines, and, to a lesser extent, rail tank cars and tank trucks in some areas and markets. The Company believes that inland marine transportation of bulk liquid products enjoys a substantial cost advantage over rail and truck transportation. The Company also believes that crude oil and refined products pipelines, although sometimes a less expensive form of transportation than barges, are not as adaptable to diverse products and are generally limited to fixed point-to-point distribution of commodities in high volumes over extended periods of time. INLAND CHEMICAL DIVISION The Company's Inland Chemical Division provides transportation services for three distinct markets: industrial chemicals, agricultural chemicals and barge fleeting services. Collectively, the Division operates a fleet of 285 inland tank barges, 84 towboats and two bowboats. Industrial Chemicals. Dixie Carriers, Inc. ("Dixie"), a subsidiary of the Company, and its subsidiaries, Dixie Marine, Inc. ("Dixie Marine") and TPT Transportation Company ("TPT Transportation"), and Chotin Carriers, Inc. ("Chotin"), a subsidiary of the Company, provide service to the industrial chemical industry through intraplant movements of petrochemical feedstock and the transportation of industrial processed chemicals and lube oils to industry users. Operating a fleet of 216 inland tank barges, 56 towboats and two bowboats, the fleet operates primarily along the Gulf Intracoastal Waterway, the Mississippi River and its tributaries and the Houston Ship Channel. The business is conducted under contracts with customers with whom the Company has long-term relationships, as well as under short-term and spot contracts. Currently, approximately 76% of the industrial chemical revenues are derived from term contracts and 24% from the spot market. All of the inland tank barges used in the transportation of industrial chemicals are of double hull construction for increased environmental protection and, where applicable, are capable of controlling vapor emissions to meet occupational health and safety regulations and air quality concerns. Chotin was acquired on June 1, 1992 by means of a merger of Scott Chotin, Inc. ("Scott Chotin") with and into Chotin. TPT Transportation acquired the assets of TPT, a marine transportation division of Ashland Oil, Inc. on March 3, 1993. See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosure on the Chotin merger and the TPT Transportation asset purchase. Dixie's and Dixie Marine's headquarters are located in Houston, Texas and Chotin's and TPT Transportation's headquarters are in Baton Rouge, Louisiana. Agricultural Chemicals. Brent Transportation Corporation ("Brent Transportation"), a subsidiary of Dixie, operates 69 inland tank barges, including 11 cryogenic anhydrous ammonia barges, and 17 towboats primarily in transportation of agricultural chemicals, including anhydrous ammonia, to points along the Mississippi River and its tributaries and the Gulf Intracoastal Waterway. Brent Transportation's assets were acquired effective April 1, 1989, in connection with the purchase of certain assets of Brent Towing Company, Inc., and related affiliates ("Brent"), which had been engaged in the transportation of agricultural chemicals and other liquid cargos since 1961. Brent Transportation conducts its business with customers with whom it has long-term relationships and, to a lesser extent, under short-term contracts. Brent Transportation's headquarters are in Greenville, Mississippi. The Company believes that Brent Transportation has the largest inland barge fleet that primarily transports agricultural chemicals. Barge Fleeting Services. Western Towing Company ("Western"), a subsidiary of Dixie, owns 11 towboats and operates what the Company believes to be the largest commercial barge fleeting service (provision of temporary barge storage facilities) in the Port of Houston, at Bolivar Peninsula and in the Port of Freeport, Texas. Western's towboats are engaged primarily in shifting (distribution and gathering of barges) in the Houston-Galveston area. INLAND REFINED PRODUCTS DIVISION The Company's Inland Refined Products Division provides transportation services for the refined products and harbor services markets. Collectively, the Division operates a fleet of 115 inland tank barges, 26 towboats, seven harbor tugboats and four bowboats. Refined Products. Sabine Transportation Company ("Sabine Transportation"), a subsidiary of the Company, and OMR Transportation Company ("OMR Transportation"), a subsidiary of Dixie, provide service from Gulf Coast refineries through movements of primarily gasoline, diesel fuel and jet fuel to waterfront terminals on the Gulf Intracoastal Waterway and the Mississippi River and its tributaries. Many of Sabine Transportation's barges are split-product barges which maximize shipping alternatives for customers by allowing for the efficient transportation of smaller individual volumes of petroleum products and providing a means to carry up to four grades of products in the same barge. In addition, by consolidating the product requirements of several customers in split-product equipment, the Refined Products Division is able to offer quantity discounted rates to customers who are carrying small quantities of product. Currently, approximately 36% of the Inland Refined Products Division's revenues are derived from long-term contracts and 64% from the spot market. The Inland Refined Products Division was formed with the acquisition by Sabine Transportation of certain assets of Sabine Towing & Transportation, Inc. ("Sabine") on March 13, 1992 and the acquisition by OMR Transportation of certain of the assets of Ole Man River Towing, Inc. and related entities ("Ole Man River") on April 2, 1992. The Inland Refined Products Division was expanded on December 21, 1993 with the acquisition by OMR Transportation of 53 inland tank barges from Midland Enterprises Inc. and its wholly owned subsidiary, Chotin Transportation, Inc. ("Chotin Transportation"). See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosures on the Sabine Transportation, OMR Transportation and Chotin Transportation asset purchases. Sabine Transportation's headquarters are in Port Arthur, Texas and OMR Transportation's headquarters are located in Vicksburg, Mississippi. Harbor Services. Sabine Transportation provides towing, docking and shifting services for vessels calling at the ports of Beaumont, Port Arthur and Orange, Texas and the port of Lake Charles, Louisiana. Operating seven harbor tugboats, the Company believes that this fleet holds a combined market share of approximately 55% in the ports which it serves. In addition, Sabine Transportation provides offshore ship assistance and drill-rig movements off the Texas and Louisiana coasts. OFFSHORE TRANSPORTATION INDUSTRY The Company's Offshore Division is engaged in U.S. flag offshore tank ship and tank barge operations, offshore dry bulk cargo barge operations and offshore container and break-bulk cargo barge and ship operations. The Division provides transportation of petroleum products, dry bulk, containers and palletized cargos, including United States Government preference agricultural commodities, worldwide with particular emphasis in the Gulf of Mexico, along the Atlantic Seaboard, Caribbean Basin ports and South American, West African and Northern European ports. COMPETITION IN THE OFFSHORE TRANSPORTATION INDUSTRY The offshore marine transportation market, like the inland transportation market, is highly competitive. The Company operates predominantly in United States domestic trade which is subject to the Jones Act, a federal law that limits participation between domestic ports within the United States and its territories to U.S. flag vessels. For a discussion of the Jones Act, see "Governmental Regulations" below. The Company's direct competitors are primarily captive and noncaptive operators of U.S. flag ocean-going barges, container and break-bulk ships and tank ships. Competition is based upon price, service and equipment availability. There are a limited number of vessels meeting the requirements of the Jones Act which are currently eligible to engage in domestic United States marine transportation. OFFSHORE DIVISION Offshore Tank Ship and Tank Barge Operations. Sabine Transportation operates a fleet of six owned U.S. flag single skin tank ships, that transport petroleum products primarily domestically in the Gulf of Mexico, along the East Coast and internationally to ports in the Caribbean Basin. Currently, four of Sabine Transportation's tank ships are chartered to various oil companies for the transportation of their products and two operate in the spot market, transporting petroleum products as cargo offers. Classified as "handy size," the tank ships have deadweight capacities ranging between 28,000 and 35,000 tons with a total capacity of 1,538,000 barrels. As discussed under "Environmental Regulations" below, the Oil Pollution Act of 1990 ("OPA") has placed a number of stringent requirements on tank ship owners and operators, including the phasing out of all single hull vessels beginning in 1995, depending on vessel size and age. In accordance with the OPA, Sabine Transportation's tank ships are scheduled to be retired from service as follows: one -- January 1, 1995; one -- January 1, 1996; one -- October 1, 1996; one -- October 30, 2000; one -- November 4, 2004; and one -- January 1, 2005. In order to stay in service beyond the retirement date, these tank ships would have to be either retrofitted with a double hull cargo section or used exclusively in foreign trade. In addition to the tank ships, the Company, through Dixie, owns and operates two ocean-going tank barge and tugboat units, one of which is single skin and one double skin. The single skin 157,000 barrel barge and tug unit and the double skin 165,000 barrel barge and tug unit provide service in the transportation of refined petroleum products between domestic ports along the Gulf of Mexico and along the Atlantic Seaboard. The single skin tank barge is scheduled to be removed from service in accordance with the OPA on January 1, 2005. The double skin tank barge meets all of the OPA construction requirements. Offshore Dry Bulk Cargo Operations. The Company's offshore dry bulk cargo operations are conducted through Dixie's wholly owned equipment and through two general partnerships, Dixie Fuels Limited ("Dixie Fuels") and Dixie Fuels II, Limited ("Dixie Fuels II"), in which a subsidiary of Dixie owns a 35% and 50% interest, respectively. Dixie and Dixie Fuels transport dry bulk cargos, such as coal, limestone, cement, fertilizer, flour, raw sugar and grain, as well as containers between domestic ports along the Gulf of Mexico, the East Coast and West Coast, and to ports in the Caribbean Basin with occasional movements to West Africa and other international ports as cargo offers. Management believes that Dixie, including the operations of Dixie Fuels and Dixie Fuels II, is the second largest domestic offshore dry bulk barge carrier in terms of deadweight capacity. Dixie owns one ocean-going dry bulk barge and tugboat unit that is engaged in transportation of dry bulk commodities primarily between domestic ports along the Gulf of Mexico and along the Atlantic Seaboard. Dixie, as general partner, also manages the operations of Dixie Fuels, which operates a fleet of four ocean-going dry bulk barges, four ocean-going tugboats and one shifting tugboat. The remaining 65% of Dixie Fuels is owned by Electric Fuels Corporation ("EFC"), an affiliate of Florida Power Corporation ("Florida Power"). Dixie Fuels operates primarily under long-term contracts of affreightment, including a contract that expires in the year 2002 with EFC to transport coal across the Gulf of Mexico to Florida Power's facility at Crystal River, Florida. Dixie Fuels also has a 12-year contract, which commenced in 1989, with Holnam, Inc. ("Holnam") to transport Holnam's limestone requirements from a facility adjacent to the Florida Power facility at Crystal River to Holnam's plant in Theodore, Alabama. The Holnam contract provides cargo for a portion of the return voyage for the vessels that carry coal to Florida Power's Crystal River facility. Dixie Fuels is also engaged in the transportation of coal, fertilizer and other bulk cargos on a short-term basis between domestic ports and of grain from domestic ports to points primarily in the Caribbean Basin. Dixie also manages the operations of Dixie Fuels II, which operates an ocean-going dry bulk barge and tug unit. The remaining 50% of Dixie Fuels II is owned by EFC. Dixie Fuels II is engaged in the transportation of dry bulk cargo and containers between domestic ports, ports in the Caribbean Basin and international ports as cargo offers. Since May, 1993, Dixie Fuels II's barge and tug unit has been engaged in the international transportation of preference agricultural aid cargos for the United States Government. Offshore Break-bulk and Container Cargo Operations. In May, 1993, the Company completed the acquisition of AFRAM Lines (USA) Co., Ltd. ("AFRAM Lines") by means of a merger of AFRAM Lines with and into AFRAM Carriers, Inc. ("AFRAM"). AFRAM is engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for departments and agencies of the United States Government. AFRAM's fleet of three U.S. flag break-bulk and container ships specialize in the transportation of United States Government military and preference aid cargos. See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosures on the AFRAM merger. In addition, for a discussion of preference aid cargos, see "Governmental Regulations" below. AFRAM's headquarters are located in Houston, Texas. In early March, 1994, the Company, through its subsidiary, Americas Marine Express, Inc. ("Americas Marine"), began all-water marine transportation services between Memphis, Tennessee and Mexico, Guatemala, Honduras and El Salvador. The new transportation service utilizes a chartered river/ocean vessel that offers direct sailing between the locations. The new service provides exporters and importers in the north, central and mid-south states with a direct shipping alternative between Memphis and Mexico and Central America on a fourteen day round trip basis. The direct all-water liner service accepts 20 foot and 40 foot containers, including refrigerated and tank containers, as well as other cargo on a space available basis. The Company is of the opinion that the liner service offers container shippers to the interior of the United States a lower transportation cost alternative, predictable delivery time, a consistent product flow to their customers and other benefits inherent in a direct all-water liner service. CONTRACTS AND CUSTOMERS The majority of the marine transportation contracts are for terms of one to five years. Currently, the three marine transportation divisions of the Company operate under long-term contracts with Agricultural Minerals Corporation, Chevron Chemical Company, EFC, Holnam, Monsanto Chemical Company, Odfjell Tank Ships (USA) Inc. and Shell Oil Company, among many others. While these companies have generally been customers of the Company's marine transportation divisions for several years and management anticipates a continuing relationship, there is no assurance that any individual contract will be renewed. No single customer of the Company's marine transportation segment accounted for more than 10% of the Company's revenue in 1993, 1992 or 1991. EMPLOYEES The Company's three marine transportation divisions have approximately 1,725 employees, of which approximately 1,425 are vessel crew members. Approximately 39% of the 1,425 vessel crew members are subject to various collective bargaining agreements with various labor organizations. No one collective bargaining agreement covers more than 10% of the 1,425 vessel crew members. PROPERTIES The principal office of Dixie is located in Houston, Texas, in facilities under a lease that expires in 1996. The marine transportation operating divisions are located on the Gulf Intracoastal Canal at Belle Chasse, Louisiana, a suburb of New Orleans; in Houston, Texas, near the Houston Ship Channel; in Greenville, Mississippi and in Vicksburg, Mississippi. The Greenville location is leased and the Belle Chasse, Houston and Vicksburg locations are owned. Western's facilities are located on a 10.24-acre tract of land owned by Dixie lying between the San Jacinto River and Old River Lake near Houston, Texas. The principal office of Chotin and TPT Transportation is located in Baton Rouge, Louisiana in owned facilities. The principal office and operating units of Sabine Transportation are located in Port Arthur, Texas on 30 acres of owned waterfront property along the Sabine-Neches Waterway. The principal office of AFRAM is located in Houston, Texas in leased facilities. The principal office of Americas Marine is located in Memphis, Tennessee in leased facilities. GOVERNMENTAL REGULATIONS General. The Company's transportation operations are subject to regulation by the United States Coast Guard, federal laws, state laws and certain international conventions. The transportation of cargos in bulk are exempt from economic regulations under the Interstate Commerce Act. Therefore, with the exception of AFRAM and Americas Marine, the rates charged by the Company for the transportation of such bulk cargos are negotiated between the Company and its customers and are not set by tariff. AFRAM and Americas Marine generally operate under published tariffs. AFRAM also bids for United States Government cargo. The majority of the Company's tank barges, all offshore barges and all ships are inspected by the United States Coast Guard and carry certificates of inspection. The Company's inland and offshore towing vessels are not subject to United States Coast Guard inspection requirements; however, the Company's offshore tugboats and offshore dry bulk and tank barges are built to American Bureau of Shipping ("ABS") classification standards. These offshore vessels are inspected periodically by the ABS to maintain the vessels in class. The crew employed by the Company aboard vessels, including captains, pilots, engineers, able-bodied seamen and tankermen, are licensed by the United States Coast Guard. The Company is required by various governmental agencies to obtain licenses, certificates and permits for its vessels depending upon such factors as the cargo transported, the waters in which the vessel operates, the age of the vessels and other factors. The Company is of the opinion that the Company's vessels have obtained and can maintain all required licenses, certificates and permits required by such governmental agencies. The Company believes that safety concerns highlighted by the highly publicized barge collision with the railroad bridge near Mobile, Alabama in September, 1993 will result in additional regulations being imposed on the barge industry in the form of personnel licensing and navigation equipment requirements. Generally, the Company endorses the anticipated additional regulations and believes it is currently operating to standards at least the equal of such anticipated additional regulations. Jones Act. The Jones Act is a federal law that restricts domestic marine transportation in the United States to vessels built and registered in the United States. Furthermore, the Jones Act requires that the vessels be manned by United States citizens and owned by United States citizens. For corporations, 75% of the corporations' beneficial stockholders must be United States citizens. The Company presently meets all of the requirements of the Jones Act for its owned vessels. Compliance with the United States ownership requirements of the Jones Act is very important to the operations of the Company and the loss of the Jones Act status could have a significant negative effect to the Company. The Company monitors the citizenship requirements under the Jones Act of its employees and beneficial stockholders and will take any remedial action necessary to insure compliance with the Jones Act requirements. The requirements that the Company's vessels be United States built, manned by United States citizens and the crewing requirements of the Coast Guard significantly increase the capital and labor costs of U.S. flag vessels when compared with foreign flag vessels. The Company's business would be adversely affected if the Jones Act were to be modified so as to permit foreign competition. During the past several years, the Jones Act and cargo preference laws, see "Preference Cargo" below, have come under attack by interests seeking to facilitate foreign flag competition for cargos reserved for U.S. flag vessels under the Jones Act and cargo preference laws. These efforts have been consistently defeated by large margins in the United States Congress. The Company believes that continued efforts will be made to gain access to such trade and if such access is successful, it could have an adverse effect on the Company. Construction and Operating Differential Subsidies. The Merchant Marine Act of 1970 permits deferral of taxes on earnings deposited into capital construction funds. Such funds and interest earned from such funds can be used for the construction of or acquisition of U.S. flag vessels. In addition, to encourage U.S. flag vessels to engage in foreign trade, the Merchant Marine Act provides for direct subsidies to equalize the disparity between costs of U.S. flag operations and construction and the costs of foreign operations and construction. The Company does not receive either of these subsidies on any of its vessels. Preference Cargo. The Merchant Marine Act of 1936, as amended, requires that preference be given to U.S. flag vessels in the transportation of certain United States Government impelled cargos (cargos shipped either by the United States Government or by a foreign nation, with the aid or guarantee of the United States Government). Currently, 75% of the Government directed foreign aid and agricultural assistance programs, which includes grains and other food concessions, are required to be transported in U.S. flag vessels. Such programs currently benefit the Company's offshore break-bulk ships and dry bulk barge and tug units, some of which work primarily in this trade. The transportation of such cargo accounted for approximately 10% of the Company's transportation revenues in 1993, 1% in 1992 and 2% in 1991. The transportation of United States military cargo is also classified as a preference cargo, which requires the use of U.S. flag vessels, if available. The Company's AFRAM break-bulk ships have from time to time been chartered by the Military Sealift Command ("MSC"). Charters to MSC accounted for 2% of the Company's 1993 transportation revenues. The chartering by the MSC depends upon the requirements of the United States military for marine transportation of cargos, and, therefore, depends in part on world conditions and United States foreign policy. Currently, none of the Company's vessels are chartered to the MSC. The preference cargo law is often opposed by agricultural interests which perceive they would benefit from the ability to transport preference cargos aboard foreign flag vessels. Like the Jones Act, the Company is of the opinion that continued efforts will be made to significantly reduce, or remove completely, the requirement that 75% of such cargos be transported in U.S. flag vessels. Any reduction in this percentage could have an adverse effect on the Company's operations and, therefore, the Company will continue to participate in efforts to preserve the present preference cargo requirements. User Fees. Federal legislation requires that inland marine transportation companies pay a waterway user fee in the form of a tax based on propulsion fuel used by vessels engaged in trade along the inland waterways that are maintained by the United States Corps of Engineers. Such user fees are designed to help defray the cost associated with replacing major components of the inland waterway system such as locks, dams and to build new waterway projects. A significant portion of the inland waterways on which the Company's vessels operate are maintained by the Corps of Engineers. The Company presently pays a waterway tax of 23.4 cents per gallon, reflecting a 4.3 cents per gallon increase imposed during October, 1993 and a 2 cents per gallon increase imposed in January, 1994. In mid-February, 1993, President Clinton announced his economic plan which included a proposal to raise the user tax by an additional $1.00 per gallon, such user tax to be phased in until taking full effect in 1997. The Company and marine transportation and shipping groups vigorously protested the user tax proposal, stating that such a rate increase could significantly reduce the ability of the Company's customers to be internationally competitive and would place the inland river transportation system at a competitive disadvantage to other modes of transportation. These efforts were successful in defeating the $1.00 per gallon proposal as, in October, 1993, President Clinton signed into law the 1993 budget which included a 4.3 cents per gallon increase in the waterway user tax, increasing the total tax to 21.4 cents per gallon. In January, 1994, an additional 2 cents per gallon was phased in, the result of prior legislation. Currently, an additional 2 cents per gallon is scheduled to be phased in effective January 1, 1995, with the user tax rate reaching an ultimate rate of 25.4 cents per gallon. There can be no assurance that additional user fees, above the presently planned amounts, may not be imposed in the future. ENVIRONMENTAL REGULATIONS The Company's operations are affected by various regulations and legislation enacted for protection of the environment by the United States Government, as well as many coastal and inland waterway states. Water Pollution Regulations. The Federal Water Pollution Act of 1972, as amended by the Clean Water Act of 1977, the OPA, and the Comprehensive Environmental Response, Compensation and Liability Act of 1981 impose strict prohibitions against the discharge of oil and its derivatives or hazardous substances into the navigable waters of the United States. These acts impose civil and criminal penalties for any prohibited discharges and impose substantial liability for cleanup of these discharges and any associated damages. Certain states also have water pollution laws that prohibit discharges into waters that traverse the state or adjoin the state and impose civil and criminal penalties and liabilities similar in nature to those imposed under federal laws. The OPA and various state laws of similar intent, substantially increased over historic levels statutory strict exposure of owners and operators of vessels for oil spills, both in terms of limit of liability and scope of damages. The Company considers its most significant pollution liability exposure to be the carriage of persistent oils (crude oil, asphalt, # 5 oil, # 6 oil, lube oil and other black oil). The Company restricts the carriage of persistent oil in inland equipment to double skin barges only. Currently, the only persistent oil carried in the Company's offshore fleet is in a Sabine Transportation single skin tank ship which ceases operation at year-end 1994. One of the most important requirements under OPA is the requirement that all newly constructed tank ships or tank barges engaged in the transportation of oil and petroleum products in the United States must be double hulled and all existing single hull tank ships or tank barges be retrofitted with double hulls or phased out of domestic service between January 1, 1995 and 2015, in order to comply with the new standards. See "Offshore Division -- Offshore Tank Ships and Tank Barge Operations" for a discussion of the effects of OPA on the Company's offshore equipment. As a result of several recent highly publicized oil spills, federal or state legislators could impose additional licensing, certification or equipment requirements on marine vessel operations. Generally, the Company believes that it is in a good position to accommodate any reasonably foreseeable regulatory changes and that it will not incur significant additional costs. The Company manages its exposure to losses from potential discharges of pollutants through the use of well maintained and equipped vessels, the safety and environmental programs of the Company and the Company's insurance program. In addition, the Company uses double skin barges in the transportation of more hazardous substances. There can be no assurance, however, that any new regulations or requirements or any discharge of pollutants by the Company will not have an adverse effect on the Company. Financial Responsibility Requirement. Commencing with the Federal Water Pollution Control Act of 1972, as amended, vessels over three hundred gross tons operating in United States waters have been required to maintain evidence of financial ability to satisfy statutory liabilities for water pollution. This evidence is in the form of a Certificate of Financial Responsibility ("CFR") issued by the United States Coast Guard. The majority of the Company's tank barges and all the tank ships are subject to this CFR requirement and the Company has fully complied since inception of the requirement. The OPA amended the CFR requirements principally by expanding the scope of liability subject to the requirements and by significantly increasing the financial ability requirements. The United States Coast Guard promulgated a Notice of Proposed Rulemaking on September 26, 1991 that would implement the new financial responsibility requirements of OPA. The proposed rule, if implemented in present form, would eliminate the ability of the Company to utilize its insurance, which greatly exceeds the financial responsibility requirements, as a means of satisfying the financial ability requirement under OPA. Under the proposed rule the Company would be required to demonstrate net worth and working capital equal to the maximum statutory limit of liability under OPA and the Comprehensive Environmental Response, Compensation and Liability Act of 1981. The Company believes it will be able to satisfy the more stringent CFR requirements currently proposed. The Company is also of the opinion that such proposed regulations are unnecessarily stringent and that a majority of domestic and foreign vessel operators subject to the proposed regulation will be unable to comply. Clean Air Regulations. The Federal Clean Air Act of 1979 requires states to draft State Implementation Plans ("SIPs") designed to reduce atmospheric pollution to levels mandated by this act. Several SIPs provide for the regulation of barge loading and degassing emissions. The implementation of these regulations will require a reduction of hydrocarbon emissions released in the atmosphere during the loading of most petroleum products and the degassing and cleaning of barges for maintenance or change of cargo. These new regulations will require operators who operate in these states to install vapor control equipment on their barges. The Company expects that future toxic emission regulations will be developed and will apply this same technology to many chemicals that are handled by barge. Most of the Company's barges engaged in the transportation of petrochemicals, chemicals and refined products are already equipped with vapor control systems. Although a risk exists that new regulations could require significant capital expenditures by the Company and otherwise increase the Company's costs, the Company believes that, based upon the regulations that have been proposed thus far, no material capital expenditures beyond those currently contemplated by the Company or increase in costs are likely to be required. Contingency Plan Requirement. Commencing August 8, 1993, OPA and several state statutes of similar intent require the majority of the vessels operated by the Company to maintain approved oil spill contingency plans as a condition of operation. The Company has submitted plans that it believes comply with requirements, but approval has not yet been granted. Occupational Health Regulations. The Company's vessel operations are primarily regulated by the United States Coast Guard for occupational health standards. The Company's shore personnel are subject to the United States Occupational Safety and Health Administration regulations. The Coast Guard has promulgated regulations that address the exposure to benzene vapors, which require the Company, as well as other operators, to perform extensive monitoring, medical testing and record keeping of seamen engaged in the handling of benzene transported aboard vessels. It is expected that these regulations may serve as a prototype for similar health regulations relating to the carriage of other hazardous liquid cargos. The Company believes that it is in compliance with the provisions of the regulations that have been adopted and does not believe that the adoption of any further regulations will impose additional material requirements on the Company. There can be no assurance, however, that claims will not be made against the Company for work related illness or injury or that the further adoption of health regulations will not adversely affect the Company. Insurance. The Company's marine transportation operations are subject to the hazards associated with operating heavy equipment carrying large volumes of cargo in a marine environment. These hazards include the risk of loss of or damage to the Company's vessels, damage to third parties from impact, fire or explosion as a result of collision, loss or contamination of cargo, personal injury of employees, pollution and other environmental damages. The Company maintains insurance coverage against these hazards. Risk of loss of or damage to the Company's vessels is insured through hull insurance policies currently insuring approximately $500 million in hull values. Vessel operating liabilities, such as collision, cargo, environmental and personal injury, are insured primarily through the Company's participation in protection and indemnity mutual insurance associations under which the protection against such hazards is in excess of $1 billion for each incident, except in the case of oil pollution, which is limited to $500 million for each incident, but is limited to $700 million for each incident in the case of the Company's tank ships and ocean-going tank barges. However, because it is mutual insurance, the Company is exposed to funding requirements and coverage shortfalls in the event claims by the Company or other members exceed available funds and reinsurance. Environmental Protection. The Company has a number of programs that were implemented to further its commitment to environmental responsibility in its operations. One such program is environmental audits of barge cleaning vendors, principally directed at management of cargo residues and barge cleaning wastes. Another program is the participation by the Company in the Chemical Manufacturer's Association Responsi- ble Care program and the American Petroleum Institute STEP program, both of which are oriented to continuously reducing the chemical and petroleum industries' impact on the environment, including the distribution services area. Safety. The Company manages its exposure to the hazards incident to its business through safety, training and preventive maintenance efforts. The Company places considerable emphasis on safety through a program oriented towards extensive monitoring of safety performance for the purpose of identifying trends and initiating corrective action, and for the purpose of rewarding personnel achieving superior safety performance. The Company believes that its safety performance consistently places it among the industry leaders, which is evidenced by what it believes are lower insurance costs (as a percentage of revenue) and a lower injury level than many of its competitors. Quality. The Company is totally committed to the concept of quality in its business philosophy. Through Quality Project Teams and Quality Steering Committees, the Company's quality commitment is carried throughout the marine transportation organization. Such committees are dedicated to directing attention to the continuous improvement of the business processes, focusing efforts on achieving customer satisfaction the first time, every time and carefully monitoring statistical measures of the Company's progress in meeting its quality objectives. The Company's commitment to quality has been expanded in recent years to include the installation and maintenance of Quality Assurance Systems in compliance with the International Quality Standard, ISO 9002 ("ISO"). During 1993, Dixie's offshore operations and Dixie's inland operations were awarded ISO certifications by ABS Quality Evaluations, a leading registrar of quality systems. Dixie's offshore operation was the first U.S. flag offshore vessel operator to achieve this distinction, while Dixie's inland operation was the second inland marine transportation company to be recognized in the United States. At present, the balance of the Company's marine transportation operations are working toward certification during 1994 and 1995. Achieving ISO certification demonstrates the Company's total commitment to quality throughout the organization. The benefits of implementing these Quality Assurance Systems are significant for the Company's marine transportation operations since such Quality Assurance Systems provide additional internal controls that improve operating efficiency. Through documentation, problems are easier to identify and correct, training is streamlined and favorable operational practices are easier to identify and install company-wide. In addition, the Company's commitment to safety and environmental protection is further enhanced. DIESEL REPAIR The Company is presently engaged in the overhaul and repair of diesel engines and related parts sales through two operating subsidiaries: Marine Systems, Inc. ("Marine Systems") and Rail Systems, Inc. ("Rail Systems"). As a provider of diesel repair services for customers in the marine and rail industries, the Company's diesel repair segment is divided into the marine and locomotive markets. MARINE DIESEL REPAIR Through Marine Systems, the Company is engaged in the overhaul and repair of marine diesel engines, reduction gear repair, line boring, block welding services and related parts sales for customers in the marine industry. The marine diesel repair industry services tugs and towboats powered by large diesel engines utilized in the inland and offshore barge industries. It also services marine equipment in the offshore petroleum exploration and well service industry, the offshore commercial fishing industry and vessels owned by the United States Government. Marine Systems operates through four divisions providing in-house and in-field repair capabilities. These four divisions are: Gulf Coast (based in Houma, Louisiana); East Coast (based in Chesapeake, Virginia); Midwest (based in East Alton, Illinois); and West Coast (based in National City, California, with service facilities in Seattle, Washington and the Pacific Basin). All four of Marine Systems' divisions are nonexclusive authorized service centers for the Electromotive Division of General Motors Corporation ("EMD") selling parts and service. Marine Systems is positioned through the location of its divisions to serve all of the marine industry of the United States. Marine Systems' Gulf Coast and Midwest divisions concentrate on larger diesel engines, including those manufactured by EMD, that are more commonly used in the inland and offshore barge and oil service industries. The East Coast division overhauls and repairs the larger EMD engines used by the military and commercial customers from Connecticut to Miami. The West Coast division concentrates on large EMD engines used by the offshore commercial fishing industry, the military, commercial business in the Pacific Northwest and customers in Alaska. Marine Systems' emphasis is on service to its customers and can send its crews from any of its locations to service customers' equipment anywhere in the world. During 1993, Marine Systems enhanced its long-term opportunities with the addition of two distributorship agreements. Under a long-term agreement with Paxman Diesels, Ltd. of Colchester, England, a manufacturer of diesel engines, Marine Systems will sell engine parts and other authorized repair services. Paxman engines are used primarily by the United States Coast Guard in its patrol boats. In addition, during 1993, Marine Systems signed a long-term agreement with Falk Corporation, a marine reduction gear manufacturer, whereby Marine Systems will sell parts and offer authorized repair services. The following table sets forth the revenues of Marine Systems for the periods indicated (dollars in thousands): MARINE CUSTOMERS Major customers of Marine Systems include inland and offshore dry bulk and tank barge operators, oil service companies, petrochemical companies, offshore fishing companies, other marine transportation entities and the United States Coast Guard, Navy and Army. Marine Systems also provides services to the Company's fleet, which accounted for approximately 6% of Marine Systems' total 1993 revenues; however, such revenues are eliminated in consolidation, and not included in the table above. No single customer of Marine Systems accounted for more than 10% of the Company's revenues in 1993, 1992 or 1991. Since Marine Systems' business can be cyclical and is linked to the relative health of the diesel power tug and towboat industry, the offshore supply boat industry, the military and the offshore commercial fishing industry, there is no assurance that its present gross revenues can be maintained in the future. The results of the diesel repair service industry are largely tied to the industries it serves, and, therefore, have been somewhat influenced by the cycles of such industries. MARINE COMPETITIVE CONDITIONS Marine Systems' primary competitors are 10 to 15 independent diesel repair companies. While price is a major determinant in the competitive process, reputation, consistent quality and expeditious service, experienced personnel, access to parts inventories and market presence are significant factors. A substantial portion of Marine Systems' business is obtained by competitive bids. Many of the parts sold by Marine Systems are generally available from other distributors, however, Marine Systems is one of a limited number of distributors of EMD parts. Although the Company believes it is unlikely, termination of Marine Systems' relationship with the supplier could adversely affect its business. LOCOMOTIVE DIESEL REPAIR Through Rail Systems, the Company is engaged in the overhaul and repair of locomotive diesel engines and sale of replacement parts for locomotives serving the shortline and industrial railroads within the continental United States. In October, 1993, EMD, the world's largest manufacturer of diesel-electric locomotives, awarded an exclusive United States rail distributorship to Rail Systems to provide replacement parts, service and support to these important and expanding markets. The operations of Rail Systems commenced in January, 1994. Rail Systems has an office and service facility in Nashville, Tennessee. The service facility is primarily a parts warehouse. Service to the actual locomotives are completed at sites convenient for the customer by Rail Systems' service crews. LOCOMOTIVE CUSTOMERS Shortline railroads have been a growing component of the United States railroad industry since deregulation of the railroads in the 1970's. Generally shortline railroads have been created through the divestiture of branch routes from the major railroad systems. These short routes provide switching and short haul of freight, with an emphasized need for responsive and reliable service. Currently, about 500 shortline railroads in the United States operate approximately 2,400 EMD engines. Approximately 280 United States industrial users operate approximately 1,300 EMD engines. Generally, the EMD engines operated by the shortline and industrial users are older and, therefore, require more maintenance. LOCOMOTIVE COMPETITIVE CONDITIONS As an exclusive United States distributor for EMD parts, Rail Systems will provide all EMD parts sales to these markets, as well as provide rebuilt and service work. Currently, other than Rail Systems, there are three primary companies providing service for the shortline and industrial locomotives. In addition, the industrial companies in some cases, provide their own service. EMPLOYEES Marine Systems and Rail Systems have approximately 120 employees. PROPERTIES The principal office of Marine Systems is located in Houma, Louisiana. Parts and service facilities are located in Houma, Louisiana; in Chesapeake, Virginia; in East Alton, Illinois; in National City, California; and in Seattle, Washington. The Chesapeake, East Alton, National City and Seattle locations are on leased property and the Houma location is situated on approximately four acres of owned land. The principal office and service facility of Rail Systems is located in leased facilities in Nashville, Tennessee. INSURANCE The Company is engaged in the writing of property and casualty insurance primarily through Universal Insurance Company ("Universal"), a corporation located in the Commonwealth of Puerto Rico. Since its formation in 1972, Universal has evolved primarily from an automobile physical damage insurer to a full service property and casualty insurer, with emphasis on the property insurance lines. Universal is ranked third among Puerto Rican insurance companies in terms of policyholders' surplus and admitted assets, and has achieved an A+ (Superior) rating from A. M. Best Company, a leading insurance rating agency, for ten consecutive years. On September 25, 1992, Universal merged with Eastern America Insurance Company ("Eastern America"), a property and casualty insurance company in Puerto Rico, with Universal being the surviving entity. As of December 31, 1993, the Company owned approximately 70% of Universal's voting common stock with the remaining approximately 30% owned by Eastern America Financial Group, Inc. ("Eastern America Group"), the former parent of Eastern America. The Company owns 100% of the non-voting common and preferred stocks of Universal. In accordance with a shareholder agreement among Universal, the Company and Eastern America Group, through options and redemption rights, Universal has the right to purchase the Company's interest in Universal over a period of up to 12 years, the result of which would be Eastern America Group becoming the owner of 100% of Universal's stock. To date, Universal has redeemed from the Company 44,933 shares of Class B common stock for a total redemption price of $8,000,000. Of the total redemptions to date, $7,000,000, or 39,128 shares, were redeemed in July, 1993 and $1,000,000, or 5,805 shares, were redeemed in December, 1992. INSURANCE OPERATION Universal writes a broad range of property and casualty insurance. Universal, however, is primarily a property insurer, generating approximately 66% of its 1993 premiums written from property lines. Universal's principal property insurance line is automobile physical damage, specifically the vehicle single-interest risk line, which insures lending institutions against the risk of loss of the unpaid balance of their automobile loans with respect to financed vehicles. Vehicle single-interest premiums accounted for 25% of Universal's consolidated premiums written in 1993. Universal's insurance business is generated primarily through independent agents and brokers in Puerto Rico. While no one agent, other than the Eastern America Insurance Agency, an affiliate of Eastern America Group, accounted for more than 5% of premiums written in 1993, Universal could be adversely affected if it were to lose several of its higher producing agents. Universal maintains an extensive program of reinsurance of the risks that it insures, primarily under arrangements with reinsurers in London and the United States. Property lines are reinsured under quota share agreements up to $5,000,000. Casualty claims above $500,000 are reinsured up to $4,000,000. Ocean marine and surety lines are reinsured under various pro rata and excess treaties up to $500,000 and $4,000,000, respectively. Catastrophe automobile physical damage, fire and allied lines and marine coverage affords recovery of losses over $500,000, $1,500,000 and $250,000 up to $15,000,000, $64,000,000 and $3,000,000, respectively. Because Universal's business is written in Puerto Rico, Universal's insurance risk is not as diversified as the risk of a carrier that covers a broader geographical area. A natural catastrophe could cause property damage to a large number of Universal's policyholders, which would result in significantly increased losses to Universal. However, the Company believes that Universal's reinsurance program will limit its net exposure in any such catastrophe. Property damage from Hurricane Hugo in September, 1989 attributable to Universal was approximately $34,000,000; however, the net impact was $1,450,000 after deducting the reinsurance recoverables. At December 31, 1993, Universal had investments of $122,412,000, consisting primarily of short-term and available-for-sale securities. At such date, approximately 97% of that portfolio was invested in United States Government instruments due to their safety and to the favorable Puerto Rican tax treatment of such securities. Universal's insurance business is governed by the Insurance Code of the Commonwealth of Puerto Rico and in accordance with the regulations issued by the Commissioner of Insurance of the Commonwealth of Puerto Rico. REINSURANCE OPERATION Prior to 1991, the Company participated in the international reinsurance market through Mariner Reinsurance Company Limited ("Mariner"), a wholly owned subsidiary of the Company, and through Universal. From 1972 through 1990, Mariner was engaged in the pro rata and excess of loss reinsurance business dealing principally with brokers in London. This reinsurance consisted of certain property and casualty reinsurance lines whereby Mariner participated in the reinsurance of certain Lloyd's underwriters, British insurance companies, and other foreign insurance companies. In addition, Mariner reinsured certain treaties of Universal. Effective January 1, 1987, Mariner ceased writing any new or renewal reinsurance and Mariner's business portfolio was assumed by Universal; however, in 1989, two reinsurance contracts were transferred back to Mariner. Effective January 1, 1991, Universal ceased accepting new participation in the international reinsurance market and the entire reinsurance business portfolio was assumed by Mariner. During the 1992 year, Mariner, based on certain delayed and certain timely loss advices, increased its loss reserves. See "Note 5" to the financial statements included under Item 8 elsewhere herein for further disclosures on the increase in the Mariner reserves. With the 1990 year being the final year for participation in the reinsurance market, neither Mariner nor Universal was involved in any subsequent catastrophes such as Hurricane Andrew. Neither Universal nor Mariner does business with any of the Company's other subsidiaries, nor is there any connection, other than common ownership. The Company is currently pursuing strategies to withdraw from the runoff of Mariner's reinsurance business at the earliest possible date. Such strategies include the possible commutation of Mariner's open book of reinsurance business in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. CAPTIVE INSURANCE OPERATION Effective January 1, 1994, the Company established a captive insurance company, Oceanic Insurance Limited ("Oceanic"). The captive will insure only risks of the Company and its domestic subsidiaries. EMPLOYEES Universal has approximately 150 employees, all in the Commonwealth of Puerto Rico. Mariner's and Oceanic's activities are handled by the Company's employees and by agents in Bermuda. PROPERTIES Universal's office is located in San Juan, Puerto Rico. The office is leased with an expiration date of January 31, 1998. ITEM 2. ITEM 2. PROPERTIES The information appearing in Item 1 is incorporated herein by reference. The Company and Dixie currently occupy leased office space at 1775 St. James Place, Suite 300, Houston, Texas under a lease that expires in 1996. The Company believes that its facilities are adequate for its needs and additional facilities would be readily available. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See "Note 13" to the financial statements included under Item 8 elsewhere herein for a discussion of legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year December 31, 1993, no matter was submitted to a vote of security holders through solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are as follows: No family relationship exists between the executive officers or between the executive officers and the directors. Officers are elected to hold office until the annual meeting of directors, which immediately follows the annual meeting of stockholders, or until their respective successors are elected and have qualified. George A. Peterkin, Jr. holds a degree in business administration, was elected a Director of the Company in 1973 and was employed as its President on October 1, 1976. He had served as a Director of Kirby Industries, Inc. since 1969 and as President of Industries since January, 1973. Prior to that, he was President of Dixie from 1953 through 1972. J. H. Pyne holds a degree in liberal arts from the University of North Carolina and has served as President of Dixie since July, 1984, was elected a Director of the Company in July, 1988, and was elected Executive Vice President of the Company in 1992. He also served in various operating and administrative capacities with Dixie from 1978 to 1984, including Executive Vice President from January to June, 1984. Prior to joining Dixie, he was employed by Northrop Services, Inc. and served as an officer in the United States Navy. Brian K. Harrington is a Certified Public Accountant and holds an M.B.A. degree from the University of Oregon. He has served as Treasurer and Principal Financial Officer of the Company and Dixie since May, 1989, Vice President since September, 1989 and Senior Vice President since 1993. Prior to joining the Company, he was engaged as a financial consultant with emphasis in the petrochemical distributing industry, providing services to Dixie and other companies. Prior to 1979, he was Vice President of Planning, Marketing and Development for Paktank Corporation. G. Stephen Holcomb holds a degree in business administration from Stephen F. Austin State University and has served the Company as Vice President, Controller, Assistant Treasurer and Assistant Secretary since January, 1989. He also served as Controller from January, 1987 to January, 1989, and as Assistant Controller and Assistant Secretary from 1976 through 1986. Prior to that, he was Assistant Controller of Kirby Industries, Inc. from 1973 to 1976. Prior to joining the Company, he was employed by Cooper Industries, Inc. Ronald C. Dansby holds a degree in business administration from the University of Houston and has served the Company as Vice President -- Inland Chemical Division since 1993. He also serves as President of Dixie Marine, joining the Company in connection with the acquisition of Alamo Inland Marine Co. ("Alamo") in 1989. He had served as President of Alamo since 1974. Prior to that, he was employed by Alamo Barge Lines and Monsanto Chemical Company from 1962 to 1973. Steven M. Bradshaw holds a M.B.A. degree from Harvard Business School and has served the Company as Vice President -- Inland Refined Products Division since 1993. He also serves as Executive Vice President -- Marketing of Dixie since 1990 and served in various operating and administrative capacities with Dixie from 1981 to 1990, including Vice President -- Sales from 1985 to 1990. Prior to joining Dixie, he was employed by the Ohio River Company and served as an officer in the United States Navy. Patrick L. Johnsen holds a degree in nautical science from California Maritime Academy and has served as Vice President -- Offshore since 1993. Prior to joining the Company in August, 1993, he served in senior seagoing and shoreside capacities with Mobil Shipping and Transportation, including Chartering and United States Fleet Manager. Prior to joining Mobil in 1978, he was employed at sea by various shipping companies, including Sabine. Dorman L. Strahan attended Nicholls State University and has served the Company as Vice President -- Diesel Repair since 1993. He also serves as President of Marine Systems since 1986 and President of Rail Systems since 1993. After joining the Company in 1982 in connection with the acquisition of Marine Systems, he served as Vice President of Marine Systems until 1985. Mark R. Buese holds a degree in business administration from Loyola University and has served the Company as Vice President -- Administration since 1993. He also serves as Vice President of Dixie since 1985 and served in various sales, operating and administrative capacities with Dixie from 1978 through 1985, including President of Western. Jack M. Sims holds a degree in business administration from the University of Miami and has served the Company as Vice President -- Human Resources since 1993. Prior to joining the Company in March, 1993, he served as Vice President - -- Human Resources for Virginia Indonesia Company from 1982 through 1992, Manager -- Employee Relations for Houston Oil and Minerals Corporation from 1977 through 1981 and in various professional and managerial positions with Shell Oil Company from 1967 through 1977. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the American Stock Exchange under the symbol KEX. The following table sets forth the high and low sales prices for the common stock for the periods indicated as reported by The Wall Street Journal. As of March 14, 1994, the Company had 28,275,133 outstanding shares held by approximately 2,300 stockholders of record. On September 5, 1989, the Company paid a cash dividend of $.10 per share of common stock to stockholders of record as of August 14, 1989. A similar dividend was paid in 1988. The Company does not have an established dividend policy. Decisions regarding the payment of future dividends will be made by the Board of Directors based on the facts and circumstances that exist at that time. Prior to 1988, the Company had not paid any cash dividends on its common stock since it became a publicly held company in 1976. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The comparative selected financial data of the Company and consolidated subsidiaries is presented for the five years ended December 31, 1993. The information should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations of the Company and the Financial Statements and Schedules included under Item 8 elsewhere herein (in thousands, except per share amounts): (Footnotes on following page) - --------------- (1) Comparability with prior periods is affected by the acquisitions of Alamo and Brent in the second quarter of 1989, the acquisition of Sabine in the first quarter of 1992, the acquisition of Ole Man River and merger with Scott Chotin in the second quarter of 1992, the merger with Eastern America in the third quarter of 1992, the acquisition of TPT in the first quarter of 1993, the merger with AFRAM Lines in the second quarter of 1993 and the acquisition of Chotin Transportation in the fourth quarter of 1993. (2) The extraordinary item for the years ended December 31, 1989 and 1990 represents the reduction in equivalent income taxes from utilization of financial net operating loss carryforwards. (3) Cumulative effect on prior years from the adoption of Statement of Financial Accounting Standards ("Accounting Standards") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," net of equivalent income taxes and Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF THE COMPANY RESULTS OF OPERATIONS The Company reported net earnings for the 1993 year of $22,829,000, or $.86 per share, compared with net earnings before the cumulative effect of changes in accounting principles for the 1992 year of $13,598,000, or $.60 per share, and net earnings of $13,298,000, or $.61 per share, for 1991. Net earnings for 1992 were $681,000, or $.03 per share. The Company adopted, effective January 1, 1992, Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and Accounting Standards No. 109, "Accounting for Income Taxes." Collectively, the recognition of the cumulative effect of the adoption of the Accounting Standards for all prior years reduced the Company's 1992 net earnings by $12,917,000, or $.57 per share. The adoption of both Accounting Standards also reduced the Company's 1992 operating earnings after taxes by $1,271,000, or $.06 per share. Accounting Standards No. 106 established a new accounting principle for the cost of retiree health care benefits. The cumulative effect on prior years for the change in accounting principle resulted in an expense after applicable income taxes of $2,258,000, or $.10 per share. In addition to the impact of the cumulative effect on prior years, the effect of adoption of Accounting Standards No. 106 reduced the Company's 1992 operating earnings after applicable income taxes by $355,000, or $.02 per share. Accounting Standards No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. The cumulative effect on prior years for the change in accounting principle resulted in an expense of $10,659,000, or $.47 per share. The effect of the adoption of Accounting Standards No. 109 reduced the Company's 1992 operating earnings after taxes by $916,000, or $.04 per share. In 1993, the corporate federal income tax rate was increased from 34% to 35%. In accordance with Accounting Standards No. 109, the effect of the increase in the corporate federal income tax rate resulted in additional federal taxes of $1,131,000, or $.04 per share, for 1993. The adoption of the Accounting Standards had no effect on the Company's cash flow. The Company conducts operations in three business segments: marine transportation, diesel repair and property and casualty insurance. A discussion of each segment follows: MARINE TRANSPORTATION The Company's marine transportation revenues for the 1993 year totaled $283,747,000, reflecting a 49% increase when compared with $190,214,000 reported in 1992 and a 143% increase when compared with $117,003,000 reported in 1991. The 49% increase for the 1993 year reflects the operations of three marine transportation companies acquired during the 1992 year, one in March, one in April and one in June, and the operations of three marine transportation companies acquired during the 1993 year, TPT Transportation on March 3, AFRAM on May 14 and Chotin Transportation on December 21, all of which were accounted for under the purchase method of accounting. Collectively, the operations of TPT Transportation, AFRAM and Chotin Transportation generated revenues during 1993 of approximately $61,400,000 since their dates of acquisition. In addition, the revenues for each year reflect the new and existing equipment additions to both the inland and offshore fleets made during the years. The transportation segment's inland operations were curtailed to some degree during the 1993 third quarter by flooding in the upper Mississippi River and the closing of the Algiers Lock at New Orleans. Collectively, the pretax effect of the two events reduced the 1993 results by an estimated $2.4 million. Flooding in the upper Mississippi River closed the upper River to marine transportation movements from June 24 through August 22 and continued to disrupt deliveries even after that date. Movements north of Cairo, Illinois were curtailed substantially; several of the inland river towing units were stranded by the flood; and the segment's lower Mississippi River marine operations were rescheduled. The closing of the Algiers Lock for repair from July 1 through September 10 required the inland towing vessels to use alternate routes, which resulted in time delays. The Algiers Lock is situated along the main artery of the Intracoastal Waterway near New Orleans. As a provider of service for both the inland and offshore United States markets, the marine transportation segment is divided into three divisions organized around the markets they serve: the Inland Chemical Division, serving the inland industrial and agricultural chemical markets; the Inland Refined Products Division, serving the inland refined products market; and the Offshore Division, which serves the offshore petroleum products, container, dry bulk and palletized cargo markets. Movements of inland industrial chemicals for the petrochemical processing industry, handled by the segment's Inland Chemical Division, were intermittently weak during the 1993 year. In the latter part of the 1993 first quarter, the Inland Chemical Division's equipment utilization and rates reflected signs of improvement from the recessionary pressures which negatively influenced the market during all of 1992 as well as the second half of 1991. While the improvement continued through the 1993 second quarter, equipment utilization was somewhat lower during the 1993 third quarter and remained static during the balance of 1993. Budgetary constraints by petrochemical manufacturers have held back needed rate increases. Movements of liquid fertilizer and anhydrous ammonia have remained at high levels for the 1993, 1992 and 1991 years due to continued heavy usage of fertilizer products and consistent export sales. For the 1993 year, the movements of liquid fertilizer were conducted well past the normal fertilizer season, as fertilizer terminals which could not be reached during the flooding in the upper Mississippi River were supplied and the demand for fertilizer was enhanced due to flooding of the River farmlands. The Inland Refined Products Division, which moves inland refined products (gasoline, diesel fuel and jet fuel) reflected improvements during the 1993 year primarily due to a strong demand for gasoline and the resupplying of terminals in the upper Mississippi River flood areas. Such growth in demand benefitted equipment utilization and enabled modest rate increases. The Inland Refined Products Division, formed in 1992 with the acquisitions by Sabine Transportation and OMR Transportation, reflected weakness of demand during the 1992 year, as the peak driving season fell below expectations. Revenues from the Offshore Division improved significantly during the 1993 year, primarily from the merger with AFRAM Lines on May 14, 1993. Throughout 1993, the Division's dry bulk, container and palletized cargo vessels have remained in heavy demand, being taken out of service only for scheduled maintenance. The merger with AFRAM Lines has improved the Division's ability to transport cargos for United States Government aid programs and military use. The Offshore Division's liquid market, however, has shown price and demand weakness due to excess capacity in the offshore liquid market, particularly affecting spot prices. During 1993, certain equipment was idle due to lack of business. For the 1992 year, revenues from the Offshore Division were significantly enhanced with the addition of Sabine Transportation's six tank ships, all of which were fully booked, except for periods of scheduled maintenance. Each year includes gains from the disposition of primarily single skin barges and other surplus or obsolete transportation assets. Such gains totaled $525,000 for 1993, $494,000 for 1992 and $1,414,000 for 1991. Costs and expenses, excluding interest expense, for the marine transportation segment for the 1993 year increased to $242,553,000, an increase of 49% over the comparable 1992 expense of $162,973,000 and 140% over 1991 costs and expenses of $100,884,000. Most of the increases for both comparable periods reflect the costs and expenses, including depreciation, associated with the acquisitions and mergers consummated during the 1993 and 1992 years. In addition, the increases reflect higher equipment costs, employee health and welfare costs, general and administrative costs and inflationary increases in costs and expenses. The marine transportation pretax earnings for 1993 were $35,668,000, an increase of 63% over 1992 pretax earnings of $21,836,000 and 164% over 1991 pretax earnings of $13,507,000. DIESEL REPAIR The Company's diesel repair segment reported diesel repair revenues of $31,952,000 for 1993 reflecting an 11% decrease compared with $35,753,000 for 1992 and a 7% decrease compared with $34,288,000 for 1991. With diesel repair facilities in five locations nationwide that cater to specific markets, each location has been influenced by different economic or environmental conditions during the three comparable periods. The East Coast facility, catering to the military, has been slowed in 1993 and 1992 by United States military reductions and government budget restraints. The Midwest facility, which caters to the inland barge industry, has been hampered to some degree in 1993 and 1992 by the recession, however, the 1993 year was significantly affected by the flooding in the upper Mississippi River during the 1993 third quarter. Revenues from the segment's Midwest facility were reduced by an estimated $900,000, as customers affected by the flooding either curtailed or postponed scheduled repairs and overhauls and significantly curtailed parts purchases. The Gulf Coast facility, tied to the inland and offshore barge and oil service industries was hampered during 1992 by the recession, however, during 1993, business has remained relatively constant. The West Coast facilities, whose primary emphasis is the offshore tuna fishing industry, were negatively affected during 1993 and 1992 by deferred maintenance of equipment by their commercial fishing customers due to low tuna prices caused by the worldwide surplus of tuna. Diesel repair revenues increased by $6,000,000 in 1992 and $2,000,000 in 1991 due to the West Coast facility acquisition in July, 1991. Costs and expenses, excluding interest expense, for the diesel repair segment for 1993 totaled $30,121,000, compared with $33,328,000 for 1992 and $31,904,000 for 1991. The decrease of 10% for 1993 when compared with 1992 reflects the overall decline in revenues and its effect on the segment's profit margins. The increase for 1992 and 1991 reflects the growth of the segment's direct parts sales and overhaul and repair revenues. In addition, for the 1992 year, the increase in costs and expenses partially reflects the opening of the Seattle facility and the acquisition of the West Coast facility in 1991, which also increased the 1991 costs and expenses. The diesel repair segment's pretax earnings for 1993 were $1,577,000, a decrease of 30% compared with 1992 pretax earnings of $2,263,000 and 29% under 1991 pretax earnings of $2,213,000. PROPERTY AND CASUALTY INSURANCE The Company's property and casualty insurance segment, which is conducted primarily through Universal, reported premiums written of $80,993,000 for 1993, compared with $52,830,000 for 1992 and $36,481,000 for 1991. The 53% increase in premiums written during 1993 compared with 1992 reflected business generated from Eastern America's portfolio brought in with the merger of Eastern America with and into Universal in September, 1992, a new government policy, two vehicle single-interest portfolio transfers and the addition of vehicle single-interest business from two financial institutions, which was the result of an improvement in automobile sales during 1993. The 45% increase in premiums written during 1992 compared with 1991 reflected the increased emphasis in participation in the commercial multi-peril and double-interest lines of business, as premium volumes in the automobile single-interest line remained low due to depressed new automobile sales in Puerto Rico. Premiums written for the 1992 year also included $3 million of single-interest premiums associated with a portfolio transfer which occurred during the 1992 first quarter. In addition, the 1992 year reflected the merger of Eastern America with and into Universal. Premiums written in 1991 reflected the reduction in the automobile single-interest line, offset to some degree by increased participation in the commercial multiple-peril and automobile double-interest lines of business. Net premiums earned for 1993 totaled $48,243,000 compared with $29,552,000 for 1992 and $23,561,000 for 1991. The 63% increase in net premiums earned during 1993 compared with 1992 reflected the business generated from the Eastern America portfolio as well as a significant increase in the single-interest line of business during 1993. Net premiums earned for all three years were negatively affected by the high reinsurance costs for the commercial multiple-peril line associated with the ceding of a portion of the gross premium under the segment's reinsurance program. Due to the number of worldwide catastrophic events within the past few years, the cost of the segment's reinsurance program continued to substantially increase. Investment income is generated primarily from the segment's investment in United States Treasury securities, due to their investment safety and favorable Puerto Rico tax treatment. Investment income totaled $7,741,000 for 1993 compared with $6,454,000 for 1992 and $5,994,000 for 1991. The segment, prior to the decline in interest rates, procured a constant yield from the purchase of United States Treasury securities with fixed rates. Even though interest rates on investment securities have remained low since 1991, the insurance segment's investment portfolio has reflected excellent market performance during 1992 and 1993. In addition, the 1993 investment income reflected the full year effect of the merger with Eastern America. The investment portfolio of Eastern America at the date of the merger totaled approximately $21 million. In addition, the insurance segment recognized investment gains of $1,164,000 in 1993, $1,478,000 in 1992 and $853,000 in 1991. Losses, claims and settlement expenses for 1993 totaled $37,496,000 compared with $26,289,000 for 1992 and $18,103,000 for 1991. The 43% increase for 1993 compared with 1992 reflected the merger with Eastern America as well as the significant increase in business volume, particularly from the single-interest line. In addition, the 1992 year reflected an abnormal year for losses from the commercial multiple-peril line, which experienced high losses from specific events. The 1992 year also included a reserve of $2,500,000 recorded in Mariner, the Company's Bermuda reinsurance subsidiary, which participated in the writing of property and casualty lines of reinsurance from 1970 through 1990. During 1992, Mariner received certain delayed large loss advices, which resulted in the increase in its loss reserves. The 1990 year was the last year for participation in the reinsurance market. For the 1991 year, the insurance segment's loss experience was favorable, the result of a decrease in losses from the commercial multiple-peril and automobile single-interest lines. Management continues to review the runoff of the reinsurance business previously written by Mariner with the intent of seeking an expedient withdrawal from this business and closure of Mariner's activities, including consideration of commutation of Mariner's book of business. A commutation would entail the transfer of liability from known and incurred but not reported losses to a second party in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. Policy acquisition costs for 1993 totaled $11,085,000 compared with $8,649,000 for 1992 and $7,181,000 for 1991. Generally, policy acquisition costs for each year increased due to the higher commission rates associated with the property insurance lines. The results for the 1993 and 1992 year also reflected the merger with Eastern America. As of December 31, 1993 and 1992, the Company owned 70% and 75%, respectively, of the voting common stock of Universal, with the balance owned by Eastern America Group. The Company owned 100% of the non-voting common and preferred stocks. Minority interest expense for the 1993 year totaled $1,623,000. The Company's portion of the property and casualty insurance segment's pretax earnings totaled $4,539,000 for 1993, compared with $1,108,000 for 1992 and $4,891,000 for 1991. FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY In October, 1990, the Board of Directors approved the authorization to purchase 2,000,000 shares of common stock. Currently, approximately 1,700,000 shares remain under the repurchase authorization. The Company is authorized to purchase the common stock on the American Stock Exchange and in private negotiated transactions. When repurchasing common shares, the Company is subject to price, trading volume and other market considerations. Shares repurchased may be used for reissuance upon the exercise of stock options and other purposes. The purchase of additional shares depends on numerous conditions, including the price of the common stock, capital investment opportunities and other factors. From 1988 through January, 1991, the Company purchased approximately 2,300,000 shares of common stock at an average price of $5.71 per share. The Company and Dixie have separate revolving credit agreements with an established line of credit of $50,000,000 each. Proceeds under the credit agreements, which provide for interest rates, based at the Company's option, on the prime rate, Eurodollar rate or CD rates, can be used for general corporate purposes, the purchase of new or existing equipment or for business acquisitions. As of March 14, 1994, the Company and Dixie had $33,600,000 and $33,900,000, respectively, available for takedown under the credit agreements. The Company and Dixie entered into the separate credit agreements in April, 1993 providing for aggregate borrowings of up to $30,000,000 and $50,000,000, respectively. In August, 1993, the Company's line of credit was increased to $50,000,000. In March, 1992, Dixie entered into a $20,000,000 acquisition credit facility with Texas Commerce Bank National Association which provided the transportation segment with in-place financing for possible future acquisitions. On June 1, 1992, the acquisition credit facility was activated with the merger of Scott Chotin into a subsidiary of the Company and in August, 1992, the acquisition credit facility was retired. In August, 1992, Dixie sold $50,000,000 of 8.22% notes, due June 30, 2002, in a private placement. Proceeds from these notes were used to retire the $20,000,000 acquisition credit facility with Texas Commerce Bank National Association and the retirement of two $5,000,000, 10% subordinated promissory notes originally issued as part of the purchase in 1989 of the assets of Brent, with the balance of the proceeds used to reduce the amount outstanding under Dixie's $50,000,000 revolving credit agreement. In May, 1993, the Company called for redemption on June 4, 1993, the entire $50,000,000 aggregate principal amount of its 7 1/4% Convertible Subordinated Debentures due 2014 ("Debentures") issued in October, 1989 at a redemption price of 105.075% of the principal amount of the Debentures, plus accrued interest on the principal of the Debentures from April 1, 1993 to the date fixed for redemption. Prior to, or on May 27, 1993, the fifth business day prior to the date set for redemption under the Debentures, the holders of the entire $50,000,000 of Debentures elected to convert such Debentures into common stock of the Company at a conversion price of $11.125 per share. The conversion of the Debentures increased the issued and outstanding common stock of the Company by 4,494,382 shares. Business Acquisitions and Developments Following the Company's stated strategy of acquiring businesses to complement its existing operations, the Company has been actively engaged in the acquisition of, or merger with, companies during the 1991, 1992 and 1993 years. In May, 1991, Brent Transportation purchased for $2,550,000 in cash all of the operating assets of International Barges, Inc. The assets consist of three cryogenic inland tank barges currently operating under a term contract transporting industrial anhydrous ammonia. The acquisition incorporates the handling of industrial anhydrous ammonia with Brent Transportation's established market position in the transporting of anhydrous ammonia for use in agriculture. In July, 1991, Marine Systems purchased the operating assets of Steve Ewing's Diesel Service, Inc., a National City, California based company engaged in the repair and overhaul of marine diesel engines and related parts sales. The acquired assets, consisting of inventory and fixed assets, are operated under the name of Ewing Marine Systems, Inc. The acquisition expanded the diesel repair segment's markets to the West Coast and the Pacific Basin and enables the segment to offer nationwide service to its customers. On March 13, 1992, the Company completed the purchase of Sabine for $36,950,000 in cash. Sabine, located in Port Arthur, Texas, was engaged in coastal and inland marine transportation of petroleum products and in harbor tug services. The purchased properties included six U.S. flag tank ships, 33 owned and five leased inland tank barges, 11 owned and four leased towboats, three owned bowboats, eight owned tugboats, land and buildings. The Company has continued to use the assets of Sabine in the same business that Sabine conducted prior to the purchase. The purchase was financed through $9,950,000 of existing cash balances, borrowings of $9,000,000 under the transportation segment's bank revolving credit agreement, as well as an $18,000,000 bank term loan with a negative pledge of the assets acquired from Sabine. Based on audited information, assets acquired from Sabine had total revenues for the years ended December 31, 1990 and 1991 of $62,886,000 and $62,986,000, respectively. Operations of the assets acquired from Sabine are included as part of the Company's operations effective March 13, 1992, in accordance with the purchase method of accounting. On April 2, 1992, OMR Transportation completed the purchase of Ole Man River for $25,575,000 in cash. Ole Man River, located in Vicksburg, Mississippi, was engaged in inland marine tank barge transportation of petroleum products along the Mississippi River System and the Gulf Intracoastal Waterway. The purchased properties included 24 owned and two leased tank barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Ole Man River in the same business that Ole Man River conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Based on audited information, Ole Man River had total revenues for the years ended December 31, 1990 and 1991 of $14,676,000 and $15,550,000, respectively. Operations of the assets acquired from Ole Man River are included as part of the Company's operations effective April 2, 1992, in accordance with the purchase method of accounting. On June 1, 1992, the Company completed the acquisition of Scott Chotin by means of a merger with and into a wholly owned subsidiary of the Company for an aggregate consideration of approximately $34,900,000. Pursuant to the Agreement and Plan of Merger, the Company issued 870,892 shares of common stock, valued at $12.625 per share, to certain Scott Chotin shareholders and paid the shareholders of Scott Chotin approximately $9,700,000 in cash in exchange for the working capital and all of the outstanding common stock of Scott Chotin, discharged existing debt of Scott Chotin of approximately $7,400,000 and paid to certain executives and shareholders of Scott Chotin $5,000,000 for agreements not to compete. In addition, the Company recorded a liability reserve for the issuance, over a three-year period after the closing, of up to 170,000 additional shares of the Company's stock contingent upon the resolution of certain potential liabilities resulting from operations of Scott Chotin prior to the merger. In June, 1993, the Company issued 22,500 shares under the contingent stock agreement. Scott Chotin, located in Mandeville, Louisiana, was engaged in inland marine tank barge transportation of industrial chemicals and asphalt along the Mississippi River System and the Gulf Intracoastal Waterway. Scott Chotin's inland fleet consisted of 29 owned tank barges, six of which operate in the asphalt trade, 10 owned dry cargo barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Scott Chotin in the same business that Scott Chotin conducted prior to the merger. The cash portion of the merger was financed through existing cash balances, borrowings under a subsidiary of the Company's $20,000,000 acquisition line of credit, as well as a $16,000,000 bank term loan with a negative pledge of the assets. Based on audited information, Scott Chotin recorded total revenues for the years ended May 31, 1991 and 1992 of $20,894,000 and $18,817,000, respectively. Scott Chotin's operations are included as part of the Company's operations effective June 1, 1992, in accordance with the purchase method of accounting. On September 25, 1992, the Company completed the acquisition of Eastern America, a property and casualty insurance company in Puerto Rico, by means of a merger of Eastern America with and into the Company's insurance subsidiary, Universal, with Universal being the surviving entity. Presently, the Company owns approximately 70% of the voting common stock of Universal, with the remaining approximately 30% owned by Eastern America Group, the former parent of Eastern America. Through options and redemption rights included in the merger transaction, Eastern America Group could become the owner of up to 100% of Universal's stock over a period of up to 12 years. Based on audited information, Eastern America reported total revenues of $11,951,000 and $13,544,000 for the years ended December 31, 1990 and 1991, respectively. To date, Universal has redeemed a total 44,933 shares of its common stock from the Company at a price of $8,000,000. In July, 1993, Universal redeemed 39,128 shares for $7,000,000 and in December, 1992, Universal redeemed 5,805 shares for $1,000,000. Eastern America's operations are included as part of the Company's operations effective September 25, 1992, in accordance with the purchase method of accounting. On March 3, 1993, TPT Transportation completed the purchase of TPT, a marine transportation division of Ashland Oil, Inc., for approximately $24,400,000 in cash, subject to post-closing adjustments. TPT was engaged in the inland marine transportation of industrial chemicals and lube oil primarily from the Gulf Intracoastal Waterway to customers primarily on the upper Ohio River. TPT's inland fleet consisted of 61 owned and six leased double skin tank barges, four owned and one leased single skin tank barges and five owned towboats. Of the 72 barges, 32 are equipped with vapor control systems while 30 barges are dedicated to the transportation of lube oil, where vapor control equipment is not required. The Company has continued to use the assets of TPT in the same business that TPT conducted prior to the purchase. The asset purchase was financed under the transportation segment's bank revolving credit agreement. Based on unaudited information, TPT had total revenues for the fiscal year ended September 30, 1992, of $17 million. The asset purchase was accounted for in accordance with the purchase method of accounting effective March 3, 1993. On May 14, 1993, the Company completed the acquisition of AFRAM Lines by means of a merger with and into a wholly owned subsidiary of the Company, for an aggregate consideration of $16,725,000. In addition, the merger provides for an earnout provision not to exceed $3,000,000 in any one year and not to exceed a maximum of $10,000,000 over a four year period. The earnout provision will be recorded as incurred as an adjustment to the purchase price. As of December 31, 1993, a $2,250,000 earnout provision, which accrues from April 1 to March 31 of the following year, had been recorded. Under the terms of the merger, the Company issued 1,000,000 shares of its common stock in exchange for all of AFRAM Lines outstanding stock and paid certain executives and shareholders of AFRAM Lines agreements not to compete totaling $2,000,000. AFRAM Lines located in Houston, Texas, was engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for Departments and Agencies of the United States Government. The Company has continued to use the assets of AFRAM Lines in the same business that AFRAM Lines conducted prior to the merger. AFRAM Lines fleet consisted of three U.S. flag container and break-bulk ships which specialize in the transportation of United States Government military and aid cargos. Based on audited information, AFRAM Lines recorded transportation revenues for the years ended June 30, 1992 and 1991 of $38,758,000 and $29,817,000, respectively. Unaudited historical transportation revenues for the year ended December 31, 1992 were $46,268,000. The merger, effective as of April 1, 1993, was accounted for in accordance with the purchase method of accounting. The financial results for the 1993 year include the net earnings from the operations from May 14, 1993, as the net earnings from April 1, 1993 to May 14, 1993, were recorded as a reduction of the purchase price. In May, 1993, Marine Systems enhanced its long-term opportunities with the addition of two distributorship agreements. Under a long-term agreement with Paxman Diesels, Ltd. of Colchester, England, a manufacturer of diesel engines, Marine Systems will sell engine parts and offer authorized repair services. In addition, in May, 1993, Marine Systems signed a long-term agreement with Falk Corporation, a marine reduction gear manufacturer, whereby Marine Systems will sell parts and offer authorized repair services. As an expansion of the diesel repair segment, the Company is engaged through Rail Systems in the overhaul and repair of locomotive diesel engines and sale of replacement parts for locomotives, serving shortline and industrial railroads within the continental United States. In October, 1993, EMD, the world's largest manufacturer of diesel-electric locomotives, awarded an exclusive shortline and industrial rail distributorship to Rail Systems to provide replacement parts, service and support to these important and expanding markets. The operations of Rail Systems commenced in January, 1994. On December 21, 1993, OMR Transportation completed the cash purchase of certain assets of Chotin Transportation. Chotin Transportation, located in Cincinnati, Ohio, was engaged in the inland marine transportation of refined products by tank barge primarily from the lower Mississippi River to the Ohio River under a long-term contract with a major oil company. The purchased properties included 50 single skin and three double skin inland tank barges and a transportation contract, which expires in the year 2000. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Chotin Transportation are included as part of the Company's operations effective December 21, 1993, in accordance with the purchase method of accounting. In March, 1994, the Company through its subsidiary, Americas Marine, began all-water marine transportation services between Memphis, Tennessee and Mexico, Guatemala, Honduras and El Salvador. The new transportation service utilizes a chartered foreign flag river/ocean vessel which offers direct sailing between the locations. The new service provides exporters and importers in the north, central and mid-south states with a direct shipping alternative between the locations on a fourteen day round trip basis. The direct all-water liner service accepts 20 foot and 40 foot containers, including refrigerated and tank containers, as well as other cargo on a space available basis. Capital Expenditures The Company continued to enhance its existing operations through the acquisitions of existing equipment during the 1991, 1992 and 1993 years and construction of new equipment during the 1991 and 1992 years. During 1991, six new 29,000 barrel capacity double skin inland tank barges, which were constructed under a contract entered into in May, 1990, were placed in service. Three of the barges were placed into service in July, one in August and two in September. The six barges cost approximately $8,000,000, including enhancements after delivery. In March, 1991, an option was exercised to purchase six additional 29,000 barrel capacity double skin inland tank barges at a total purchase price including enhancements after delivery, of approximately $8,000,000. The first barge was placed in service in November, 1991, followed by one barge each month through March, 1992. The remaining barge was placed in service in May, 1992. Through a 50% partnership with EFC, one dry cargo barge and tug unit for use in the offshore market was purchased for approximately $5,500,000, with capitalized restorations and modifications to the barge and tug unit of approximately $7,500,000. The equipment was placed in service in May, 1991. In July, 1992, a 165,000 barrel double skin ocean-going tank barge and tug unit was purchased for approximately $9,200,000. The unit is currently working in the offshore refined products trade. In July, 1992, four existing inland towboats were purchased for a total purchase price of $1,650,000. The towboats are being used in the industrial chemical market. In July, 1992, the diesel repair segment expanded its market to the Pacific Northwest with the opening of a service facility in Seattle, Washington, serving both the inland and offshore marine industries. Emphasis is focused on the repair of diesel engines in the marine transportation industry and various governmental agencies. In August, 1992, a 17,000 barrel capacity pressure barge which was constructed under a contract entered into in September, 1991, was placed into service in the industrial chemical market. Cost of the barge was approximately $2,700,000. In October, 1993, three inland towboats were purchased for approximately $895,000. The towboats are being used in the refined products market. In addition to the new and existing transportation equipment mentioned above, during 1991, 1992 and 1993, the Company's transportation subsidiaries continued to add to their fleet through separate purchases of existing equipment. In 1991, two existing towboats and seven existing double skin inland tank barges were purchased for use in the industrial and agricultural chemical market. In 1992, four inland tank barges were purchased and renovated for use in the agricultural market and an inland towboat was purchased for use in the refined products market. In 1993, three existing double skin inland tank barges were purchased and renovated for use in the agricultural market and one inland towboat was purchased for use in the fleeting and shifting operation. Liquidity Within the past three years, the Company has generated significant cash flow from its operating segments to fund its capital expenditures, asset acquisitions, debt service and other operating requirements. During 1993, 1992 and 1991, the Company generated net cash provided by operating activities of $61,614,000, $38,372,000 and $26,498,000, respectively. During each year, inflation has had a relatively minor effect on the financial results of the Company. The marine transportation segment has long-term contracts which generally contain cost escalation clauses whereby certain costs, including fuel can be passed through to its customers, while the segment's short-term, or spot business, is based principally on current prices. In addition, the marine transportation assets acquired and accounted for using the purchase method of accounting were adjusted to a fair market value and, therefore, the cumulative long-term effect on inflation was reduced. The repair portion of the diesel repair segment is based on prevailing current market rates. For the property and casualty insurance segment, 97% of its investments were classified as available-for-sale or short-term investments, which consists primarily of United States Governmental instruments. Universal is subject to dividend restrictions under the stockholders' agreement between the Company, Universal and Eastern America Group. In addition, Universal is subject to industry guidelines and regulations with respect to the payment of dividends. The Company has no present plan to pay dividends on common stock in the near future. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this item is submitted as a separate section of this report (see Item 14, page 60). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On October 20, 1992, the Company engaged the accounting firm of KPMG Peat Marwick to serve as the principal independent public accountant. The services of the accounting firm of Deloitte & Touche, who previously served as the Company's independent public accountant, were terminated effective October 20, 1992, except for the Company's subsidiary, Universal, which continues to be audited by Deloitte & Touche. The engagement of KPMG Peat Marwick to serve as the principal independent public accountant and the termination of Deloitte & Touche were approved by unanimous consent of the Company's Board of Directors upon the recommendation by the Company's Audit Committee. With respect to the audit for the year ended December 31, 1991 and the unaudited period to October 20, 1992, there have been no disagreements with Deloitte & Touche on any matters of accounting principles or practices, financial statement disclosure, or accounting scope or procedure. The report of Deloitte & Touche on the financial statements for the year ended December 31, 1991 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. PART III ITEMS 10 THROUGH 13. The information for these items has been omitted inasmuch as the registrant will file a definitive proxy statement with the Commission pursuant to the Regulation 14A within 120 days of the close of the fiscal year ended December 31, 1993, except for the information regarding executive officers which is provided in a separate item caption, "Executive Officers of the Registrant," and is included as an unnumbered item following Item 4 in Part I of this Form 10-K. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Kirby Corporation We have audited the accompanying consolidated statements of earnings, stockholders' equity and cash flows of Kirby Corporation and its subsidiaries for the year ended December 31, 1991. Our audit also included the financial statement schedules listed in Part IV, Item 14, for the year ended December 31, 1991. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on such financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations, changes in stockholders' equity and cash flows of Kirby Corporation and its subsidiaries for the year ended December 31, 1991 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the consolidated financial statements for the year ended December 31, 1991, taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Houston, Texas March 2, 1992, except for Note 2 as to which the date is March 18, 1992 INDEPENDENT AUDITORS' REPORT To the Board of Directors of Kirby Corporation: We have audited the accompanying consolidated balance sheets of Kirby Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we have also audited the related financial statement schedules. 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 based on our audits. The financial statements and financial statement schedules of Kirby Corporation and consolidated subsidiaries as of and for the year ended December 31, 1991 were audited by other auditors whose report thereon dated March 2, 1992, except for Note 2 to which the date is March 18, 1992, expressed an unqualified opinion on those statements. We did not audit the consolidated financial statements of Universal Insurance Company and its subsidiaries, a 70 percent owned subsidiary, which statements reflect total assets constituting 33 percent and 32 percent and total revenues constituting 14 percent and 16 percent in 1993 and 1992, respectively, of the related consolidated totals. Those statements and the amounts included in the related 1993 and 1992 financial statement schedules were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Universal Insurance Company and its subsidiaries, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kirby Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also, in our opinion, based on our audits and the report of the other auditors, the related financial statement schedules, when considered in relation to the 1993 and 1992 basic consolidated financial statements taken as a whole, present fairly, in all material respects the information set forth therein. As discussed in note 3 to the consolidated financial statements, the Company changed its method of accounting for investments in equity securities in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." As discussed in note 5 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" in 1993. As discussed in note 7 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." 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 1992. KPMG PEAT MARWICK Houston, Texas February 21, 1994 KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS DECEMBER 31, 1992 AND 1993 ASSETS See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS DECEMBER 31, 1992 AND 1993 LIABILITIES AND STOCKHOLDERS' EQUITY See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS Principles of Consolidation. The consolidated financial statements include the accounts of Kirby Corporation and its subsidiaries ("the Company"). The assets and liabilities for the insurance operations have not been classified as current or noncurrent, in accordance with insurance practice. The Company's equity in certain partnerships is reflected in the accounts at its pro rata share of the assets, liabilities, revenues and expenses of the partnerships. The purchase price of certain subsidiaries exceeded the equity in net assets of the respective companies at dates of acquisition. The excess is being amortized over 10 to 25 year periods. All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to reflect current presentation of financial information. Operations. The Company is engaged in three industry segments as follows: Marine Transportation -- Marine transportation by United States flag vessels on the inland waterway system and in United States coastwise and foreign trade. The principal products transported include petrochemical feedstocks, processed chemicals, agricultural chemicals, refined petroleum products, coal, limestone, grain and sugar. Container and palletized cargo are also transported for United States Government aid programs and military. Diesel Repair -- Repair of diesel engines, reduction gear repair and sale of related parts and accessories, primarily for customers in the marine industry and beginning in 1994, for customers in the shortline and industrial railroad industry. Insurance -- Writing of property and casualty insurance in Puerto Rico. The insurance subsidiary operates under the provisions of the Insurance Code of the Commonwealth of Puerto Rico and is subject to regulations issued by the Commissioner of Insurance of the Commonwealth of Puerto Rico. General Accounting Policies: Accounting Principles. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles. Cash Equivalents. Cash equivalents consist of short-term, highly liquid investments with maturities of three months or less at date of purchase. Depreciation. Property and equipment is depreciated on the straight-line method over the estimated useful lives of the assets as follows: marine transportation equipment, 6-22 years; buildings, 10-25 years; other equipment, 2-10 years; leasehold improvements, term of lease. Concentrations of Credit Risk. Financial instruments which potentially subject the Company to concentrations of credit risk are primarily trade accounts receivables. The Company's marine transportation customers include the major oil refineries. The diesel repair customers are offshore well service companies, inland and offshore marine transportation companies and the United States Government. The insurance segment customers include agents and customers who reside in Puerto Rico. In addition, credit risk exists through the placement of certificates of deposits with local financial institutions by the insurance segment. Marine Transportation, Diesel Repair and Other Accounting Policies: Property, Maintenance and Repairs. Property is recorded at cost. Improvements and betterments are capitalized as incurred. When property items are retired, sold, or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts with any gain or loss on the disposition included in operating income. Maintenance and repairs are charged to operating expenses as incurred on an annual basis. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS -- (CONTINUED) Taxes on Income. The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. 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 of a change in tax rates is recognized in income in the period that includes the enactment date. In 1991, the provision for deferred income taxes represents the tax effect of differences in the timing of income and expense recognition for tax and financial reporting purposes. The Company files a consolidated federal income tax return with its domestic subsidiaries and Mariner Reinsurance Company Limited ("Mariner"). Insurance Accounting Policies: Investments. Fixed maturity investments held as of December 31, 1993 are primarily classified as available-for-sale securities and are reported at fair market value, with unrealized gains and losses reported in the accompanying balance sheet as unrealized net gains in value of investments. For 1992, the investment in fixed maturities consisted of an investment and a trading account. Investment account securities were recorded at cost, adjusted for the amortization of premiums and accretion of discounts and trading account securities were recorded at market value. The difference between the market value and the amortized cost of trading securities was presented in the accompanying balance sheets as unrealized net gains in value of investments. Short-term investments consisting of certificates of deposit, United States Treasury bills and United States Treasury notes maturing within one year from acquisition date, are recorded at amortized cost. Equity securities are recorded at market value. Reinsurance. By reinsuring certain levels of risk in various areas with reinsurers, the exposure of losses which may arise from catastrophes or other events which may cause unfavorable underwriting results are reduced. Amounts recoverable from reinsurance are estimated in a manner consistent with the claim liability associated with the reinsured policy. Deferred Policy Acquisition Costs. Deferred policy acquisition costs representing commissions paid to agents are deferred and amortized following the daily pro rata method over the terms of the policies in 1993 (monthly pro rata method in prior years), except for automobile physical damage single-interest policies, which are amortized following the sum-of-the years method. Deferred policy acquisition costs are written off when it is determined that future policy revenues are not adequate to cover related future losses and loss adjustments expenses. Earnings on investments are taken into account in determining whether this condition exists. No deficiencies have been determined in the periods presented. Accrued Losses, Claims and Settlement Expenses. Accrued losses, claims and settlement expenses include estimates based on individual claims outstanding and an estimated amount for losses incurred but not reported (IBNR) based on past experience. Unearned Premiums. Unearned premiums are deferred and amortized following the daily pro rata method over the terms of the policies in 1993 (monthly pro rata method in prior years), except for automobile physical damage single-interest policies, which are amortized to income following the sum-of-the-years method. Guarantee Fund Assessment. The Company's Puerto Rican property and casualty insurance subsidiary is a member of the Puerto Rico Insurance Guaranty Association and is required to participate in losses payable KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS -- (CONTINUED) to policyholders under risks underwritten by insolvent associated members. Losses are estimated based on its share and accrued on a current basis. Changes In Accounting Principles: The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which changes the accounting and disclosure requirements for reinsurance contracts entered into by ceding insurance companies. Effective December 31, 1993, the Company adopted SFAS No. 113, the effects of which are more fully described in Note 5, Insurance Disclosure. The FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which establishes standards of financial accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Effective December 31, 1993, the Company adopted SFAS No. 115, the effects of which are more fully described in Note 3, Investments. The FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which establishes a new accounting principle for the cost of retiree health care and other postretirement benefits. Effective January 1, 1992, the Company adopted SFAS No. 106, the effects of which are more fully described in Note 10, Retirement Plans. The FASB issued SFAS No. 109, "Accounting for Income Taxes," which requires a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Effective January 1, 1992, the Company adopted SFAS No. 109, the effects of which are more fully described in Note 7, Taxes on Income. (2) ACQUISITIONS 1992 YEAR: On March 13, 1992, a subsidiary of the Company completed the purchase of certain assets of Sabine Towing & Transportation Co., Inc. ("Sabine"), a wholly owned subsidiary of Sequa Corporation, for $36,950,000 in cash. Sabine, located in Port Arthur, Texas was engaged in coastal and inland marine transportation of petroleum products and harbor tug services. The purchased properties included six United States flag tank ships, 33 owned and five leased inland tank barges, 11 owned and four leased inland towboats, three owned bowboats, eight owned harbor tugboats, land and buildings. The Company has continued to use the assets of Sabine in the same business that Sabine conducted prior to the purchase. The purchase was financed through $9,950,000 of existing cash balances, borrowings of $9,000,000 under the transportation segment's bank revolving credit agreement, as well as an $18,000,000 bank term loan with a negative pledge of the assets acquired from Sabine. Operations of the assets acquired from Sabine are included as part of the Company's operations effective March 13, 1992, in accordance with the purchase method of accounting. On April 2, 1992, a subsidiary of the Company completed the purchase of substantially all of the operating assets of Ole Man River Towing, Inc. and related entities ("Ole Man River") for $25,575,000 in cash. Ole Man River, located in Vicksburg, Mississippi, was engaged in inland marine tank barge transportation of petroleum products along the Mississippi River System and the Gulf Intracoastal Waterway. The purchased properties included 24 owned and two leased inland tank barges, eight owned inland towboats, land and buildings. The Company has continued to use the assets of Ole Man River in the same business that Ole Man River conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Ole Man KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) River are included as part of the Company's operations effective April 2, 1992, in accordance with the purchase method of accounting. On June 1, 1992, the Company completed the acquisition of Scott Chotin, Inc. ("Scott Chotin") by means of a merger of Scott Chotin with and into a subsidiary of the Company for an aggregate consideration of approximately $34,900,000. Pursuant to the Agreement and Plan of Merger, the Company issued 870,892 shares of common stock, valued at $12.625 per share to certain Scott Chotin shareholders and paid the shareholders of Scott Chotin approximately $9,700,000 in cash in exchange for the working capital and all of the outstanding common stock of Scott Chotin, discharged existing debt of Scott Chotin of approximately $7,400,000 and paid to certain executives and shareholders of Scott Chotin $5,000,000 for agreements not to compete. In addition, the Company recorded a liability reserve for the issuance, over a three-year period after the closing, of up to 170,000 additional shares of the Company's common stock contingent upon the resolution of certain potential liabilities resulting from operations of Scott Chotin prior to the merger. In June, 1993, the Company issued 22,500 shares of common stock under the contingent stock agreement. Scott Chotin, located in Mandeville, Louisiana was engaged in inland marine tank barge transportation of industrial chemicals and asphalt along the Mississippi River System and the Gulf Intracoastal Waterway. Scott Chotin's inland fleet consisted of 29 owned tank barges, six of which operate in the asphalt trade, 10 owned dry cargo barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Scott Chotin in the same business that Scott Chotin conducted prior to the purchase. The cash portion of the merger was financed through existing cash balances, borrowings under the transportation segment's $20,000,000 acquisition line of credit, as well as a $16,000,000 bank term loan with a negative pledge of the assets of Scott Chotin. Scott Chotin's operations are included as part of the Company's operations effective June 1, 1992, in accordance with the purchase method of accounting. On September 25, 1992, the Company completed the acquisition of Eastern America Insurance Company ("Eastern America"), a property and casualty insurance company in Puerto Rico, by means of a merger of Eastern America with and into the Company's insurance subsidiary, Universal Insurance Company ("Universal"), with Universal being the surviving entity. Presently, the Company owns approximately 70% of the voting common stock of Universal, with the remaining approximately 30% owned by Eastern America Financial Group, Inc. ("Eastern America Group"), the former parent of Eastern America. Through options and redemption rights included in the merger transaction, Eastern America Group could become the owner of up to 100% of Universal's stock over a period of up to 12 years. To date, Universal has redeemed a total 44,933 shares of their common stock from the Company at a price of $8,000,000. In July, 1993, Universal redeemed 39,128 shares for $7,000,000 and in December, 1992, Universal redeemed 5,805 shares for $1,000,000. Eastern America's operations are included as part of the Company's operations effective September 25, 1992, in accordance with the purchase method of accounting. 1993 YEAR: On March 3, 1993, a subsidiary of the Company completed the purchase of certain assets of TPT ("TPT"), a marine transportation division of Ashland Oil, Inc., for $24,400,000 in cash. TPT, located in Freedom, Pennsylvania, was engaged in the inland marine transportation of industrial chemicals and lube oils by tank barges predominantly from the Gulf Intracoastal Waterway to customers primarily on the upper Ohio River. The purchased properties included 61 owned and six leased double skin inland tank barges, four owned and one leased single skin inland tank barges and five owned inland towboats. The Company has continued to use the assets of TPT in the same business that TPT conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Based on unaudited information, the acquired assets of TPT had total revenues for the year ended September 30, 1992 of KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) $17,000,000. Operations of the assets acquired from TPT are included as part of the Company's operations effective March 3, 1993, in accordance with the purchase method of accounting. On May 14, 1993, the Company completed the acquisition of AFRAM Lines (USA) Co., Ltd. ("AFRAM Lines") by means of a merger of AFRAM Lines with a subsidiary of the Company for an aggregate consideration of $16,725,000. Additionally, the merger provides for an earnout provision not to exceed $3,000,000 in any one year and not to exceed a maximum of $10,000,000 over a four-year period. The earnout provision will be recorded as incurred as an adjustment to the purchase price. As of December 31, 1993, a $2,250,000 earnout provision, which accrues from April 1 to March 31 of the following year, had been recorded. Pursuant to the Agreement and Plan of Merger, the Company issued 1,000,000 shares of common stock, valued at $14.725 per share, in exchange for all of AFRAM Lines' outstanding stock and paid to certain executives and shareholders of AFRAM Lines $2,000,000 for agreements not to compete. AFRAM Lines, located in Houston, Texas, was engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for Departments and Agencies of the United States Government. The Company has continued to use the assets of AFRAM Lines in the same business that AFRAM Lines conducted prior to the merger. AFRAM Lines' fleet consisted of three United States flag container and break-bulk ships which specialize in the transportation of United States Government aid and military cargos. The cash portion of the merger was financed through borrowings under the Company's bank revolving credit agreement. Pursuant to the Agreement and Plan of Merger, the effective date of the merger was April 1, 1993, and the merger was accounted for in accordance with the purchase method of accounting. The financial results for the 1993 year include the net earnings from the operations of AFRAM Lines from May 14, 1993, as the net earnings from April 1, 1993 to May 14, 1993, were recorded as a reduction of the purchase price. On December 21, 1993, a subsidiary of the Company completed the purchase of certain assets of Midland Enterprises Inc. and its wholly owned subsidiary, Chotin Transportation Company ("Chotin Transportation") for $14,950,000 in cash. Chotin Transportation, located in Cincinnati, Ohio, was engaged in the inland marine transportation of refined products by tank barge primarily from the lower Mississippi River to the Ohio River under a long-term contract with a major oil company. The Company has continued to use the assets of Chotin Transportation in the same business that Chotin Transportation conducted prior to the purchase. The purchased properties included 50 single skin and three double skin inland tank barges and the transportation contract, which expires in the year 2000. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Chotin Transportation are included as part of the Company's operations effective December 21, 1993, in accordance with the purchase method of accounting. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) The following unaudited pro forma financial information for the year ended December 31, 1991 is based on adjusted historical financial statements of the Company, Sabine, Ole Man River, Scott Chotin and Eastern America. The unaudited pro forma financial information for the year ended December 31, 1992 is based on adjusted historical financial statements of the Company, Sabine, Ole Man River, Scott Chotin, Eastern America and AFRAM Lines. The unaudited pro forma financial information for the year ended December 31, 1993 is based on adjusted historical financial statements of the Company and AFRAM Lines. The financial information assumes the acquisitions and mergers were completed as of the beginning of the periods indicated. The pro forma financial information is not necessarily indicative of the results of operations that would have been achieved had the asset purchases and mergers been consummated as of the periods indicated. In addition, the pro forma information is not necessarily indicative of the results of operations that may be obtained in the future. (3) INVESTMENTS With the adoption of SFAS No. 115 effective December 31, 1993 that established new criteria for the accounting and reporting of investments in debt and equity securities that have readily determinable fair value, management revaluated its investment strategy in accordance with the new provisions. Under the provisions of SFAS No. 115, investments are to be classified under one of three categories. Management determined that substantially all debt and equity securities held at December 31, 1993 qualify as available-for-sale securities. The adoption of SFAS No. 115 increased the carrying value of investment account securities by approximately $4,100,000 and stockholders' equity by $3,075,000, net of applicable deferred income taxes. SFAS No. 115 precludes restatement of prior year financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (3) INVESTMENTS -- (CONTINUED) A summary of the insurance subsidiaries' investments as of December 31, 1992 is as follows (in thousands): A summary of the insurance subsidiaries' investments as of December 31, 1993 is as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (3) INVESTMENTS -- (CONTINUED) A summary of the available-for-sale securities by maturities as of December 31, 1993 is as follows (in thousands): Short-term and all other investments primarily consist of United States Treasury obligations, certificates of deposits, commercial paper and banker's acceptances. The Company does not invest in high-yield securities judged to be below investment grade. Investment income for the years ended December 31, 1991, 1992 and 1993 is summarized as follows (in thousands): Realized net gains on investments for the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): Changes in unrealized net gains (losses) in value of investments for the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (4) PROPERTY AND EQUIPMENT The following is a summary of property and equipment and the related allowance for depreciation at December 31, 1992 and 1993 (in thousands): (5) INSURANCE DISCLOSURE The financial results of the Company's insurance subsidiaries, Universal, a property and casualty insurance subsidiary located in Puerto Rico, and Mariner, a wholly owned subsidiary located in Bermuda, are consolidated with the Company's other operations. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (5) INSURANCE DISCLOSURE -- (CONTINUED) As of December 31, 1992 and 1993, the Company owned 75% and 70% of Universal's voting common stock and 100% of Universal's non-voting common and preferred stocks, respectively (see Note 2). Condensed combined statements of earnings of the insurance subsidiaries which are reflected in the consolidated financial statements are as follows (in thousands): Policy acquisition costs deferred and amortized against earnings during the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): In 1993, the insurance subsidiaries adopted SFAS No. 113, which specifies the accounting by insurance enterprises for the reinsurance of insurance contracts and eliminates the practice by insurance enterprises of reporting assets and liabilities relating to reinsured contracts net of the effects of reinsurance. The adoption of SFAS No. 113 increased the assets and liabilities by approximately $15,510,000 as of December 31, 1993. The transfer of risk provisions of SFAS No. 113 did not affect the accounting for reinsurance contracts presently in place. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (5) INSURANCE DISCLOSURE -- (CONTINUED) The insurance subsidiary participated in the international reinsurance market by assuming participations in risks originally undertaken by other underwriters. Effective January 1, 1991, the insurance subsidiary ceased accepting participations in the international reinsurance market. During 1992, the Company's Bermudian reinsurance subsidiary received certain delayed and certain timely large loss advises, the receipt of which caused the Company to increase the reinsurance subsidiary's loss reserves by $2,500,000 to cover both known and unknown losses. The Company is currently pursuing strategies to withdraw from the runoff of Mariner's reinsurance business at the earliest possible date. Such strategies include the possible commutation of Mariner's open book of reinsurance business in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. Net earnings and stockholders' equity of only the Company's Puerto Rican property and casualty insurance subsidiary as determined in accordance with Puerto Rican statutory accounting practices and generally accepted accounting principles for the years ended December 31, 1991, 1992 and 1993 are as follows (in thousands): The net assets of the insurance subsidiary available for transfer to the parent company are limited to the amount that its stockholders' equity, as determined in accordance with statutory accounting practices, exceeds minimum statutory capital requirements. (6) LONG-TERM DEBT Long-term debt at December 31, 1992 and 1993 consisted of the following (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (6) LONG-TERM DEBT -- (CONTINUED) The aggregate payments due on the long-term debt in each of the next five years are as follows (in thousands): On May 4, 1993, the Company called for redemption on June 4, 1993, the entire $50,000,000 aggregate principal amount of its 7 1/4% Convertible Subordinated Debentures due 2014 ("Debentures") issued in October, 1989 at redemption price of 105.075% of the principal amount of the Debentures, plus accrued interest on the principal of the Debentures from April 1, 1993 to the date fixed for redemption. Prior to, or on May 27, 1993, the fifth business day prior to the date set for redemption, under the terms of the October, 1989 offering, the holders of the entire $50,000,000 of Debentures elected to convert such Debentures into common stock of the Company at a conversion price of $11.125 per share. The conversion of the Debentures increased the issued and outstanding Common Stock of the Company by 4,494,382 shares. The carrying amount and unamortized premium on the Debentures were accounted for as a decrease in stockholders' equity. On April 23, 1993, the Company and the Company's principal marine transportation subsidiary, entered into two separate revolving credit agreements (the "Credit Agreements") with Texas Commerce Bank National Association ("TCB"), as agent bank, providing for aggregate borrowings of up to $30,000,000 and $50,000,000, respectively, maturing on June 30, 1996. On August 12, 1993, the Company amended its Credit Agreement with TCB and increased the Company's provision for aggregate borrowings from $30,000,000 to $50,000,000. The Credit Agreements are unsecured; however, the Company's Credit Agreement contains a negative pledge with respect to the capital stock of certain subsidiaries of the Company and the marine transportation subsidiary's Credit Agreement contains a negative pledge with respect to certain scheduled assets. In addition, the Credit Agreements provide for the grant to TCB of a first priority lien on the capital stock or assets, as applicable, subject to the negative pledge, generally in the event of the occurrence and continuation of a default. Interest on the Credit Agreements, subject to an applicable margin ratio and type of loan, is floating prime rate or, at the Company and the marine transportation subsidiary's option, rates based on an Eurodollar interbank rate or certificate of deposit rate. Proceeds under the Credit Agreements may be used for general corporate purposes, the purchase of existing or new equipment or for possible business acquisitions. The Credit Agreements contain covenants that require the maintenance of certain financial ratios and certain other covenants that are substantially similar to the covenants contained in the marine transportation subsidiary's prior $60,000,000 revolving credit agreement, which was terminated in connection with the new Credit Agreements. These covenants cover, among other things, the disposal of capital stock of subsidiaries and assets outside the ordinary course of business. The Credit Agreements also contain usual and customary events of default. The Company and the marine transportation subsidiary were in compliance with the matters as of December 31, 1993. At December 31, 1993, the Company and the marine transportation subsidiary had $32,000,000 and $23,900,000 respectively, available for takedown under the Credit Agreements. On March 6, 1992, the Company entered into a $18,000,000 credit agreement with TCB which matures on March 6, 1997. The purchase of Sabine, on March 13, 1992, was financed with the $18,000,000 credit agreement, existing cash balances, and borrowings under the marine transportation subsidiary's credit agreement. The $18,000,000 credit agreement has a negative pledge of the assets acquired from Sabine. Principal payments of $667,000 are due quarterly up through December 31, 1996. Interest on the credit agreement, subject to an applicable margin ratio and type of loan, is floating prime rate, or at the Company's KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (6) LONG-TERM DEBT -- (CONTINUED) option, rates based on a Eurodollar interbank rate or certificate of deposit rates. The remaining principal balance of $5,333,000 is fully due and payable on March 6, 1997, together with any unpaid interest accrued thereon. At December 31, 1993, $13,333,000 was outstanding under the loan agreement and the weighted average interest rate was 4.32%. On May 28, 1992, the Company entered into a $16,000,000 credit agreement with TCB which matures on June 1, 1997. The purchase of Scott Chotin, on June 1, 1992, was financed with the $16,000,000 credit agreement, existing cash balances, and borrowings under a $20,000,000 acquisition credit facility with TCB. The credit agreement has a negative pledge of the assets acquired from Scott Chotin. Principal payments of $571,000 are due quarterly up through March 31, 1997. Interest on the credit agreement, subject to an applicable margin ratio and type of loan, is floating prime rate, or at the Company's option, rates based on an Eurodollar interbank rate or certificate of deposit rates. The remaining principal balance of $5,143,000 is fully due and payable on June 1, 1997, together with any unpaid interest accrued thereon. At December 31, 1993, $12,571,000 was outstanding under the loan agreement and the weighted average interest rate was 4.57%. On August 13, 1992, the Company's transportation segment sold $50,000,000 of 8.22% senior notes due June 30, 2002, in a private placement. Proceeds from these notes were used to retire the $20,000,000 acquisition credit facility with TCB and the retirement of two $5,000,000, 10% subordinated promissory notes originally issued as part of the purchase of the assets of a marine transportation company on May 23, 1989, with the balance of the proceeds used to reduce the amount outstanding under the marine transportation subsidiary's credit agreement with TCB. Principal payments of $5,000,000, plus interest, are due annually through June 30, 2002. At December 31, 1993, $45,000,000 was outstanding under the senior notes. The Company is of the opinion that the terms of the outstanding debt represents the fair value of such debt as of December 31, 1993. (7) TAXES ON INCOME Earnings before taxes on income and details of the provision (benefit) for taxes on income for United States and Puerto Rico operations for the years ended December 31, 1991, 1992 and 1993 are as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) For the years ended December 31, 1992 and 1993, taxes on income were accounted for under the asset and liability method required by SFAS No. 109. The cumulative effect on prior years of the adoption of SFAS No. 109 decreased net earnings by $10,659,000, or $.47 per share, and is reported separately in the statement of earnings for the year ended December 31, 1992. In addition to the impact of the cumulative effect on prior years, the effect of the adoption of SFAS No. 109 decreased the net earnings for the 1992 year by $916,000, or $.04 per share. Prior year financial statements were not restated. Under SFAS No. 109, a change in tax rates is required to be recognized in income in the period that includes the enactment date. The 1993 Revenue Reconciliation Act included an increase in the corporate federal income tax rate from 34% to 35%, thereby requiring an increase in the Company's tax expense for the 1993 year of $1,131,000. Of the total tax adjustment, $779,000 applied to a one-time, non-cash, federal deferred tax charge for prior years and $352,000 reflects the 1% tax rate increase on earnings for the 1993 year. The Company's effective income tax rate for United States federal income taxes varied from the statutory tax rate for the years ended December 31, 1991, 1992 and 1993 due to the following: The Company's effective income tax rate for Puerto Rico income taxes varied from the statutory tax rate for the years ended December 31, 1991, 1992 and 1993 due to the following: The significant components of deferred United States taxes on income attributable to earnings from operations for the years ended December 31, 1992 and 1993 are as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) For the year ended December 31, 1991, the deferred income tax provision results from the timing differences in the recognition of income and expense for tax and financial reporting purposes. The sources and tax effect of the timing differences related to the United States operations for the year ended December 31, 1991 is as follows (in thousands): Deferred Puerto Rico income taxes arise from the recognition of certain income and expense items in different periods for income tax and for financial reporting purposes. Such items consist principally of deferred acquisition costs, salvage and subrogation recoveries, provision for doubtful accounts and accrual for guarantee fund assessments. The tax effects of temporary differences that give rise to significant portions of the current deferred tax assets and non-current deferred tax liabilities at December 31, 1992 and 1993 are as follows (in thousands): As of December 31, 1993, there was no valuation allowance. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) Subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets as of December 31, 1992 were allocated as follows (in thousands): At December 31, 1993, the Company has alternative minimum tax credit carryforwards of approximately $7,397,000 which are available to reduce future federal regular income taxes, if any, over an indefinite period. (8) LEASES The Company and its subsidiaries currently lease various facilities and equipment under a number of cancelable and noncancelable operating leases. Total rental expense for the years ended December 31, 1991, 1992 and 1993 follows (in thousands): Rental commitments under noncancelable leases are as follows (in thousands): (9) STOCK OPTION PLANS The Company has three stock option plans, which were adopted in 1976, 1982 and 1989 for selected officers and other key employees. The 1976 Employee Plan, as amended, provided for the issuance until 1986 of incentive and non-qualified stock options to purchase up to 1,000,000 shares of common stock. The 1982 Employee Plan provided for the issuance until 1992 of incentive and non-qualified stock options to purchase up to 600,000 shares of common stock. The 1989 Employee Plan provides for the issuance of incentive and nonincentive stock options to purchase up to 600,000 shares of common stock. All three of the stock option plans authorize the granting of limited stock appreciation rights. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (9) STOCK OPTION PLANS -- (CONTINUED) Changes in options outstanding under the employee plans described above for the 1991, 1992 and 1993 years are summarized as follows: At December 31, 1993, 94,714 shares were available for future grants under the employee plans and 478,014 shares under the employee plans were issued with limited stock appreciation rights. The 1989 Director Stock Option Plan provides for the issuance of options to purchase up to 150,000 shares of common stock to the Company's directors, who are not employees of the Company. Stock options totaling 60,000 shares were granted to non-employee directors during the year ended December 31, 1989, at an option price of $7.5625 per share, and remain outstanding as of December 31, 1991, 1992 and 1993. During the year ended December 31, 1993, an additional 10,000 shares were granted at an option price of $18.625 per share and remain outstanding as of December 31, 1993. In July, 1993, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, the granting of 25,000 shares of non-qualified stock options to Robert G. Stone, Jr. at an option price of $18.625. Such price represents the fair market value of the Company's common stock on the date of grant. The grant serves as an incentive to retain the optionee as Chairman of the Board of the Company or as a member of the Board of Directors of the Company. In January, 1994, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, the 1994 Employee Stock Option Plan, providing for the issuance of options to key employees of the Company to purchase up to 1,000,000 shares of common stock. No options have been granted under the 1994 Employee Plan. In January, 1994, the Board of Directors of the Company adopted, subject to stockholders approval at the 1994 Annual Meeting of Stockholders, the 1994 Nonemployee Director Stock Option Plan, providing for the issuance of options to Directors of the Company, including Advisory Directors, to purchase up to 100,000 shares of common stock. The 1994 Nonemployee Director Stock Option Plan is intended as an incentive to KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (9) STOCK OPTION PLANS -- (CONTINUED) attract and retain qualified, independent Directors. To date, 12,000 shares have been granted under the 1994 Director Plan, subject to shareholder approval at the 1994 Annual Meeting of Stockholders. Also, in January, 1994, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, an amendment to the 1989 Director Stock Option Plan. Such amendment would reduce the number of stock options automatically granted to future directors from 10,000 shares of the Company's common stock to 5,000 shares of the Company's common stock. (10) RETIREMENT PLANS The transportation subsidiaries sponsor defined benefit plans for certain ocean-going personnel. The plan benefits are based on an employee's years of service. The plans' assets primarily consist of fixed income securities and corporate stocks. Funding of the plans is based on actuarial computations that are designed to satisfy minimum funding requirements of applicable regulations and to achieve adequate funding of projected benefit obligations. Net periodic pension cost of the defined benefit plans as determined by using the projected unit credit actuarial method was $174,000, $908,000 and $1,080,000 in 1991, 1992 and 1993, respectively. The components of net periodic pension cost are as follows (in thousands): The funding status of the plans as of December 31, 1992 and 1993 was as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (10) RETIREMENT PLANS -- (CONTINUED) The Company, transportation subsidiaries and the diesel repair subsidiary sponsor defined contribution plans for all shore-based employees and certain ocean-going personnel. Maximum contributions to these plans equal the lesser of 15% of the aggregate compensation paid to all participating employees, or up to 20% of each subsidiary's earnings before federal income tax after certain adjustments for each fiscal year. The aggregate contributions to the plans were approximately $1,948,000, $2,124,000 and $1,484,000 in 1991, 1992 and 1993, respectively. The insurance subsidiary sponsors a qualified, non-contributory profit-sharing plan which provides retirement benefits to eligible employees. Voluntary contributions to the plan equal no less than 1% of the annual participant's compensation, as defined, plus a portion of the administration expenses of the plan during the first 10 years. The insurance subsidiary's contributions to the plan were approximately $227,000, $231,000 and $269,000 in 1991, 1992 and 1993, respectively. In addition to the Company's defined benefit pension plans, the Company sponsors an unfunded defined benefit health care plan that provides limited postretirement medical benefits to employees, who meet minimum age and service requirements, and eligible dependents. The plan is contributory, with retiree contributions adjusted annually. As discussed in Note 1, the Company adopted SFAS No. 106 effective January 1, 1992. The cumulative effect on prior years of the adoption of SFAS No. 106 decreased net earnings by $2,258,000, net of applicable income taxes of $1,163,000, or $.10 per share, and is reported separately in the statement of earnings for the year ended December 31, 1992. In addition to the impact of the cumulative effect on prior years, the effect of the adoption of SFAS No. 106 decreased the net earnings for the 1992 year by $355,000, net of applicable income taxes of $183,000 or $.02 per share. Prior year financial statements were not restated. The following table presents the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheet at December 31, 1993 (in thousands): The Company's unfunded defined benefit health care plan, which provides limited postretirement medical benefits, limits cost increases in the Company's contribution to 4% per year. For measurement purposes, a 4% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (10) RETIREMENT PLANS -- (CONTINUED) rate) was assumed for future periods. Accordingly, health care cost trend rate assumption would have no effect on the amounts reported. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% at December 31, 1993. SFAS No. 112, "Employers' Accounting for Postemployment Benefits," issued in November, 1992, which is required to be applied in the first quarter of 1994, is not expected to have a material effect on the Company's financial statements. (11) EARNINGS PER SHARE OF COMMON STOCK Primary earnings per share of common stock for the year ended December 31, 1991, 1992 and 1993 were based on the weighted average number of common stock and common stock equivalent shares outstanding of 21,952,000, 22,607,000 and 26,527,000 respectively. Fully diluted earnings per share of common stock for the year ended December 31, 1991 assume the conversion of the 7 1/4% debentures (see Note 6) and the exercise of stock options using the treasury stock method. Net earnings for the computation were increased by the interest expense, net of federal income taxes, on the debentures. The weighted average number of shares used in the computation of fully diluted earnings per common share for 1991 was 26,454,000. (12) QUARTERLY RESULTS (UNAUDITED) The unaudited quarterly results for the year ended December 31, 1992 are as follows (in thousands, except per share amounts): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (12) QUARTERLY RESULTS (UNAUDITED) -- (CONTINUED) The unaudited quarterly results for the year ended December 31, 1992 have been restated for the effect of the adoption of SFAS No. 106, more fully described in Note 10 and the adoption of SFAS No. 109, more fully described in Note 7. The adoption of SFAS No. 106 and SFAS No. 109,, effective January 1, 1992, reduced the net earnings (loss) before the cumulative effect of the accounting changes for the four quarters of 1992 as follows (in thousands, except per share amounts): The unaudited quarterly results for the year ended December 31, 1993 are as follows (in thousands, except per share amounts): (13) CONTINGENCIES AND COMMITMENTS The Company's Puerto Rican insurance subsidiary has appealed to the Supreme Court of Puerto Rico, a July 5, 1989 Superior Court judgment of approximately $1,100,000, plus interest of approximately $1,935,000 as of December 31, 1993, resulting from a civil suit claiming damages. The Supreme Court of Puerto Rico decided during 1992 to review the case. Management is of the opinion, based on consultation with its legal counsel, that the judgment will be reversed or at least substantially reduced, however, reserves have been established for the entire amount of the judgment plus accrued interest. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (13) CONTINGENCIES AND COMMITMENTS -- (CONTINUED) There are various other suits and claims against the Company, none of which in the opinion of management will have a material effect on the Company. Management has recorded necessary reserves and believes that it has adequate insurance coverage or has meritorious defenses for the foregoing claims and contingencies. (14) INDUSTRY SEGMENT DATA The Company conducts operations in three industry segments as follows: Marine Transportation -- Marine transportation by United States flag vessels on the inland waterway system and in United States coastwise and foreign trade. The principal products transported include petrochemical feedstocks, processed chemicals, agricultural chemicals, refined petroleum products, coal, limestone, grain and sugar. Container and palletized cargo are also transported for United States Government aid programs and military. Diesel Repair -- Repair of diesel engines, reduction gear repair and sale of related parts and accessories, primarily for customers in the marine industry and beginning in 1994, for customers in the shortline and industrial railroad industry. Insurance -- Writing of property and casualty insurance in Puerto Rico. The following table sets forth by industry segment the combined gross revenues, operating profits (before general corporate expenses, interest expense and income taxes), identifiable assets (including goodwill), depreciation and amortization and capital expenditures attributable to the continuing principle activities of the Company for the years ended December 31, 1991, 1992 and 1993 (in thousands): (Table continued on following page) KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (14) INDUSTRY SEGMENT DATA -- (CONTINUED) Identifiable assets are those assets that are used in the operation of each segment. General corporate assets are principally cash, short-term investments, accounts receivable, furniture and equipment. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: Included in Part III of this report: Report of KPMG Peat Marwick, Independent Public Accountants, on the financial statements of Kirby Corporation and Consolidated Subsidiaries for the years ended December 31, 1992 and 1993. Report of Deloitte and Touche, Independent Public Accountants, on the financial statements of Kirby Corporation and Consolidated Subsidiaries for the year ended December 31, 1991. Balance Sheets, December 31, 1992 and 1993. Statements of Earnings, for the years ended December 31, 1991, 1992 and Statements of Stockholders' Equity, for the years ended December 31, 1991, 1992 and 1993 Statements of Cash Flows, for the years ended December 31, 1991, 1992 and 1993 Notes to Financial Statements, for the years ended December 31, 1991, 1992 and 1993 (a) 2. Financial Statement Schedules: Included in Part IV of this report: All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. (a) 3. Exhibits - --------------- * Filed herewith + Management contract, compensatory plan or arrangement SCHEDULE V KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES PLANT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE VI KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPLETION, DEPRECIATION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE X KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE V KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 - --------------- (1) Reconciliation of net investment income to investment income amount reflected in the statements of earnings is as follows: (2) Included as part of selling, general and administrative expenses, taxes, other than on income, and depreciation and amortization in the statements of earnings. SCHEDULE VI KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 - --------------- * Reconciliation of total premiums to net premiums earned, the amount reflected in the statements of earnings is as follows. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KIRBY CORPORATION (Registrant) By: BRIAN K. HARRINGTON Brian K. Harrington Senior Vice President Dated: March 14, 1994 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.

49588_1993.txt

49588_1993

1993

49588

ITEM 1. BUSINESS. I.C.H. Corporation ("ICH," the "Company," or "Registrant") is an insurance holding company that engages primarily in the business of life insurance, accident and health insurance and the sale of annuities through its subsidiary insurance companies (the "ICH Companies"). A chart illustrating ICH's holding company system and identifying each ICH Company as of March 18, 1994 is included under "ICH Holding Company System" at the end of this ITEM 1. ICH's business strategy has undergone significant change during the past five years. After pursuing a strategy of growth through leveraged acquisitions, ICH has, since 1989, sold a number of subsidiaries in transactions designed to reduce leverage. Primarily as a result of sales of subsidiaries, ICH's total consolidated assets declined from $9.3 billion at December 31, 1988 to $3.7 billion at year end 1993. In December 1989, ICH sold Great Southern Life Insurance Company, based in Dallas, Texas, to Financial Holding Corporation. In March 1990, ICH sold certain other subsidiaries, including Philadelphia Life Insurance Company, based in Dallas, Texas, and Massachusetts General Life Insurance Company, situated in Denver, Colorado, to Life Partners Group, Inc. In November 1992, ICH sold Bankers Life and Casualty Company ("Bankers") and Bankers' subsidiary, Certified Life Insurance Company ("Certified"), to Bankers Life Holding Corporation ("BLHC"), an affiliate of Conseco, Inc. ("Conseco"). These sales generated liquidity for the retirement of existing debt, and the transactions with Life Partners Group, Inc. and BLHC were structured so that ICH retained an interest in the subsidiaries sold, enabling it to benefit from their future performance and appreciation. With the November 1992 sale of control of Bankers and Certified, ICH also achieved the dual goals of balancing the mix of its life and health insurance business and positioning ICH to restructure its insurance operations. Since year end 1992, ICH has pursued a strategy of rebalancing and simplifying its capital structure. The debt reduction ICH had accomplished through December 1992 affected primarily the Company's senior secured loans, which carried the lowest interest rates. During 1993, the Company targeted the more expensive elements of its capital structure. On September 30, 1993, ICH sold its remaining interest in Bankers, represented by 13,316,168 shares of BLHC (approximately 24.4% of those outstanding) to Conseco and one of Conseco's subsidiaries for $287.6 million, resulting in a gain of $197.7 million. The sale of the BLHC stock enhanced the Company's common equity, generated substantial liquidity for use in the Company's capital restructuring and other corporate purposes, and enabled the Company to retire its $5.50 Redeemable Preferred Stock, Series 1987-A, stated value $50 million, held by Conseco's subsidiary. During the fourth quarter of 1993, ICH completed a voluntary exchange offer, pursuant to which it issued $91.2 million 11 1/4% Senior Subordinated Notes due 2003 to existing security holders, in exchange for outstanding notes and debentures; it called for redemption all of its 16 1/2% Senior Subordinated Debentures due 1994 that remained outstanding following the exchange offer; and it redeemed its $8.00 Redeemable Preferred Stock, Series 1987-C, stated value $50 million, that carried a 16% annual dividend rate. At year end 1993, ICH had reduced the amount of its long term debt to $418.0 million, from $1,412.8 million at December 31, 1988, and had a debt to equity ratio of .8 to 1. In February 1994, ICH retired its Class B Common Stock, a class of common equity that carried special voting rights in the election of directors. The Class B Common Stock was issued to Consolidated National Corporation ("CNC") in 1985, and enabled CNC to elect 75% of the Company's directors. Effective February 11, 1994, the Company repurchased, for $500,000, all of its Class B Common Stock from CNC, concurrently with CNC's sale of shares of ICH's Common Stock to Torchmark Corporation ("Torchmark") and Stephens Inc. ("Stephens"). The Company and CNC terminated the Management and Consulting Agreement, pursuant to which CNC, through its affiliates, Robert T. Shaw and C. Fred Rice, has provided management services to ICH since 1985, and ICH entered into ten year Independent Contractor and Services Agreements with each of Messrs. Shaw and Rice. As a result of these transactions, the Company now has only one class of common equity, Common Stock, and, as of February 11, 1994, no stockholder beneficially owned 10% or more of the outstanding Common Stock. Torchmark, a diversified insurance and financial services company headquartered in Birmingham, Alabama, and Stephens, an investment banking firm headquartered in Little Rock, Arkansas, are the largest stockholders of the Company, beneficially owning, respectively, 9.78% and 9.74% of the Common Stock of the Company as of February 11, 1994. A representative of each of Torchmark and Stephens has been added to the Company's Board of Directors, filling existing vacancies. During 1994, ICH intends to continue to investigate opportunities to improve its capital structure, to reduce the cost of its capital funds, and to strengthen and expand its insurance operations. By May 30, 1994, ICH intends to accomplish the termination of the reinsurance treaties that were entered into in connection with ICH's sale of Marquette National Life Insurance Company ("Marquette") to CNC in 1990, and reacquire Marquette as part of the assets transferred when the reinsured liabilities are recaptured, pursuant to the agreement, dated June 15, 1993, among ICH, CNC and Consolidated Fidelity Life Insurance Company ("CFLIC"), as amended. Upon the successful completion of the recaptures, ICH will retire its senior secured debt, with a $30 million outstanding principal balance, and its Series 1984-A Preferred Stock and Series 1987-B Preferred Stock that are held by CFLIC, the subsidiary of CNC that currently acts as reinsurer under the treaties, in exchange for the preferred stock of CFLIC that ICH acquired when the June 15, 1993 agreement was executed. See the discussion under the heading "Transactions With Consolidated Fidelity Life Insurance Company" appearing in ITEM 7 of this Report. After March 31, 1994, if the recaptures are not complete, CNC will have the right, subject to regulatory approval, to transfer to ICH all of the common stock of CFLIC in exchange for the assets of CFLIC that were to be retained by CNC upon completion of the recaptures. Upon completion of the transactions contemplated by the June 15, 1993 agreement, CNC and its principals, Messrs. Shaw and Rice, will beneficially own less than 3% of the Company's Common Stock, based on shares currently outstanding. At December 31, 1993, ICH had short-term investments and readily marketable fixed maturity investments totaling approximately $131.3 million, substantially all of which represents proceeds remaining from the September 1993 sale of BLHC common stock. ICH intends to ultimately deploy these remaining proceeds in its continuing capital restructuring program and for the strengthening and growth of its insurance business and general corporate purposes. The actual uses of the funds will be subject to a number of factors, including developments in the marketplace, regulatory and competitive conditions in the industry, the availability of capital resources and the interest rate environment. NOTE: The financial information presented in this Report includes the assets and results of operations of divested companies prior to their sale and, in the case of Bankers and Certified, includes the results of their operations from November 1992 through September 1993, based on the equity method of accounting. For this reason, the financial data presented for years before, during and after the years in which sales of subsidiaries occurred may not be comparable. See Note 2 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K. INSURANCE OPERATIONS The primary ICH Companies actively marketing insurance products are: SOUTHWESTERN LIFE INSURANCE COMPANY ("Southwestern"): Headquartered in Dallas, Texas, Southwestern concentrates on the sale of individual life insurance and annuities through general agents and brokers. On the basis of reporting as required by insurance regulatory authorities ("SAP"), Southwestern had total assets of $1,297.7 million at December 31, 1993, and markets products in 39 states, the District of Columbia and Guam. UNION BANKERS INSURANCE COMPANY ("Union Bankers"): Headquartered in Dallas, Texas, Union Bankers markets individual health and life insurance products and annuities in 45 states and the District of Columbia through general agents and brokers. It had total assets of $209.2 million at December 31, 1993, based on SAP. CONSTITUTION LIFE INSURANCE COMPANY ("Constitution"): Headquartered in Louisville, Kentucky, Constitution currently concentrates on the sale of annuity products through brokers. Licensed in 48 states and the District of Columbia, Constitution had total assets, including separate accounts, of $555.7 million at December 31, 1993, based on SAP. PHILADELPHIA AMERICAN LIFE INSURANCE COMPANY ("Philadelphia American"): Headquartered in Houston, Texas, Philadelphia American markets group life, health and disability insurance and provides fee-based third party administrative services to group plans. Philadelphia American had total assets based on SAP of $78.8 million at December 31, 1993, and conducts business in 47 states, the District of Columbia and the Virgin Islands. BANKERS LIFE AND CASUALTY COMPANY OF NEW YORK ("Bankers New York"): Headquartered in Woodbury, New York, this ICH Company concentrates on the sale of life insurance and annuities in eight states through general agents, special marketing groups and relationships with financial institutions. Bankers New York had total assets of $193.5 million at December 31, 1993, based on SAP. INTEGRITY NATIONAL LIFE INSURANCE COMPANY ("Integrity"): Headquartered in Louisville, Kentucky, Integrity markets home service life insurance and health insurance through general agents. It had total assets based on SAP of $39.5 million at December 31, 1993, and is licensed in 19 states and the District of Columbia. BANKERS MULTIPLE LINE INSURANCE COMPANY ("Bankers Multiple"): With operations based in both Louisville, Kentucky, and Dallas, Texas, Bankers Multiple offers errors and omissions insurance and group and individual health insurance through brokers and by direct mail. It is licensed in all 50 states and the District of Columbia, and had total assets based on SAP of $59.2 million at December 31, 1993. The following table summarizes the consolidated premium income and other considerations and the consolidated premium equivalents of ICH during the past three years. Pro forma information is also presented as if the sale of Bankers and Certified had occurred at the beginning of the period presented. Premium income represents gross receipts on the ICH Companies' traditional life and health insurance for individuals and groups, and other considerations consist of policy charges for the cost of insurance, policy administrative charges, surrender charges, and amortization of policy initiation fees relating to universal and interest sensitive life insurance and accumulation products such as guaranteed investment contracts and certain annuities. In contrast, premium equivalents represent gross receipts on universal and interest sensitive life insurance and on accumulation products, less other considerations. Additional information regarding ICH's industry segments is reflected in ITEM 7 and Note 17 of the Notes to Financial Statements and Schedules V and VI of the Financial Statement Schedules included in ITEM 8 of this Report on Form 10-K. Since 1990, market, economic and regulatory conditions have challenged ICH's strategy of significantly increasing the size of its accumulation business and expanding its life insurance business through internal growth. Investor and consumer confidence in the insurance industry was weakened during 1991 by the much publicized conservatorship proceedings involving Executive Life Insurance Company and Mutual Benefit Life Insurance Company. The commencement of these proceedings in April and July, 1991, respectively, was followed by a series of downgrades in the ratings of a number of insurers by nationally recognized statistical rating organizations. While ratings do not constitute recommendations to buy or sell, and are subject to change or withdrawal at any time, they are considered an important measurement in some markets. Combined with declining interest rates and weak economies in certain regions of the country, these developments inhibited internal growth in the accumulation and life insurance product lines, particularly affecting those insurers that did not have the highest ratings. They prompted state insurance agencies to more aggressively exercise regulatory jurisdiction over insurers and resulted in a national trend to impose stricter capital and surplus requirements and more conservative investment guidelines industrywide. The ICH Companies were susceptible to these market, economic and regulatory conditions. The amount of corporate debt remaining from ICH's prior acquisitions, the perceived interdependence of the ICH Companies created by a stacked holding company structure and losses incurred in connection with past investment strategies contributed to a series of ratings downgrades that began in 1991 and continued in 1993, with downgrades by Duff & Phelps Credit Rating Company ("Duff & Phelps") in January 1993, by A.M. Best Company ("A.M. Best") in February 1993 and by Moody's Investors Service ("Moody's") in June 1993. These factors also contributed to increased regulatory oversight of the ICH insurance holding company organization. As a result of these downgrades, ICH has a subordinated debt rating of B3 by Moody's and B- by Standard & Poor's Corporation, and a preferred stock rating of Caa by Moody's and CCC+ by Standard and Poor's Corporation (all of which are below investment grade). ICH's lead life insurance subsidiary, Southwestern, has a B++ rating by A.M. Best (very good) and a claims paying rating of A by Duff & Phelps (investment grade), BBB- by Standard & Poor's Insurance Rating Services (adequate financial security, but capacity to meet policyholder obligations is susceptible to adverse economic and underwriting conditions) and Ba2 by Moody's (questionable financial security). Integrity has been assigned a rating of B+ and the remaining ICH Companies have been assigned a rating of B++ by A.M. Best. Since the November 1992 sale of Bankers and Certified, ICH has concentrated on restructuring its corporate organization, rebalancing and simplifying its capital structure and reducing and refinancing its corporate debt to alleviate the concerns cited by the rating organizations and to restore to the ICH Companies the excellent claims paying ratings they have historically held. The ICH Companies have consolidated operationally, to reduce costs and increase efficiencies. They have redesigned the manner in which they develop and market products, targeting markets and products less sensitive to credit ratings, and they have restructured their insurance holding company organization, from a vertical to a substantially horizontal configuration. INDIVIDUAL LIFE INSURANCE The ICH Companies underwrite life insurance under a wide variety of conventional and special whole life and interest sensitive policies ("permanent insurance"), as well as ordinary term policies. The following table summarizes the life insurance operations during the past five years. Certain information is separately presented in the table below for the existing ICH Companies and for subsidiaries sold by ICH during the indicated periods. For purposes of the following table, the term "remaining subsidiaries" refers to insurance subsidiaries of ICH that were owned at the end of the specified period. The life insurance products issued by the ICH Companies consist of whole life insurance, which provides policyholders with permanent life insurance and fixed, guaranteed rates of return on the cash value element of policy premiums, and universal and interest-sensitive life insurance policies. The profitability of traditional whole life products and universal and interest-sensitive life policies is dependent on investment income earned, the ultimate underwriting experience and the realization of anticipated unit administrative costs. Although the ICH Companies experienced an increased demand for traditional products during 1993, most new individual life insurance sales by the ICH Companies, measured by premium volume, continue to be made under universal and interest-sensitive life policies that provide whole life insurance with adjustable rates of return based on current interest rates. The principal difference between universal and interest-sensitive life insurance policies centers on policy provisions affecting the amount and timing of premium payments. Universal life policies permit policyholders to vary the frequency and size of their premium payments, although policy benefits also may vary. Premium payments under the interest-sensitive whole life policies are not variable by the policyholders. The ICH Companies' universal and interest-sensitive life products are marketed to individuals directly and through qualified retirement plans, deferred compensation plans, and employer-sponsored payroll deduction plans. The principal traditional life insurance products sold by the ICH Companies consist of a series of specially designed whole life policies that are marketed primarily to insureds 50 years of age and older and a graded death benefit whole life policy. Total sales of individual life insurance by the ICH Companies declined approximately 6% in 1993, compared to declines of 33% in each of 1992 and 1991 (excluding Bankers and Certified). During 1993, the ICH Companies implemented a number of changes in the manner in which their individual life insurance products are developed and marketed to reverse the decline in sales. Southwestern and Union Bankers have created a combined distribution system for most of the ICH Companies' life and health insurance products that are marketed through general agents and brokers, promoting the cross marketing of products and coordinating broker compensation arrangements across product lines to increase the incentives for new life sales. New simplified issue life insurance products have been introduced targeting the senior citizen market and other markets less sensitive to credit ratings, and marketing trends are more closely integrated into the product development process. With these changes, the ICH Companies are focusing on a broader market where there is an increased demand for individual life insurance policies in smaller face amounts. In the future, ICH intends to increase the amount of its life insurance business through both internal growth and the acquisition of blocks of business or companies. Factors important in any acquisition transaction will include the synergistic opportunities offered, improved economies of scale, and the projected rate of return on the investment compared with the cost of the Company's capital funds. INDIVIDUAL HEALTH INSURANCE Substantially all of ICH's consolidated premium income and other considerations for individual health insurance are received from Medicare supplement plans, comprehensive and major medical (collectively, "comprehensive") health plans and long-term care plans. The following table sets forth, by policy type, the amounts and percentages of ICH's consolidated premium income and other considerations for individual health insurance during the indicated periods. The table also provides pro forma information as if the sale of Bankers and Certified had taken place at the beginning of 1992. As shown in the table, ICH sold a substantial portion of its health insurance business in the November 1992 sale of Bankers. The ICH Companies currently underwrite Medicare supplement plans, comprehensive health plans and long-term care plans, with an emphasis on the sale of Medicare supplement insurance. Medicare supplement plans provide coverage for the deductible and coinsured portions of Medicare and for major losses exceeding Medicare maximums, and automatically adjust coverages in accordance with changes in Medicare benefits. The comprehensive health plans provide coverage for hospital, medical, and surgical costs within various prescribed policy deductible and coinsurance limits and are marketed primarily to self-employed individuals, other workers who are not fully covered by group health insurance, and early retirees. In addition, cost containment products, which provide specific health insurance benefits up to certain limits, and dreaded disease policies have been designed for those who cannot afford comprehensive coverage or who seek supplemental coverage for specific risks. During 1993, the ICH Companies changed the commission structure and eliminated waiting periods for entry level customers for its Medicare supplement products to further penetrate the senior citizens market. In the "under age" market, the ICH Companies' product development efforts have concentrated on specified risk and cost containment products. The ICH Companies entered the long-term care business in late 1985 and market their products to all persons ages 50 through 84. These products are developed to meet the needs of all persons regardless of their stature or income status. To meet regulatory requirements adopted in various states, the ICH Companies developed new long term care plans during 1993, which resulted in an interruption of marketing efforts in some states. Introduced in late 1993, the ICH Companies' new long term care products now offer a full range of benefits for varying periods, including lifetime benefits. The comprehensive health plans currently offered by the ICH Companies in many states have certain built-in protections against rising policy claims due to escalating health care costs. Under each of these plans, premiums are increased automatically in accordance with government indices of cost escalation and based on actuarial tables that are keyed to the insured's age at each plan anniversary. In contrast, premiums on many traditional health plans issued by the ICH Companies may not be increased without notice to or approval by insurance regulatory authorities. In addition, as a part of their product development process, the ICH Companies constantly monitor actual claims experience and health medical loss ratios and, subject to regulatory constraints, adjustments are made to the terms of new products as they are developed and the availability of products. Product adjustments include changes to the underwriting criteria used, agent commissions paid, the premiums charged and levels of deductibles. Due to escalating health care costs and marginal profitability, management began deemphasizing sales of comprehensive health plans in late 1990 and has decreased the number of states in which these plans are marketed. Federal and state legislation and regulations impose minimum loss ratios with respect to Medicare supplement plans, restrict first year commissions payable to agents and require standardized benefits under and disclosure obligations for Medicare supplement plans. Changes to the Medicare law made by the Omnibus Budget Reconciliation Act of 1990 have had the effect of increasing the regulation of Medicare supplement plans in all states, requiring minimum loss ratios of at least 65%, standardizing benefits to promote comparability of plans, guaranteeing renewability and prohibiting those offering Medicare supplement plans from underwriting for health conditions or claims experience of those who first become eligible for Medicare. The health insurance industry faces increasing government regulation as a result of legislative efforts to increase access to health care coverage and adopt measures to contain, and control, escalating health care costs. Health insurance premium increases, selective underwriting procedures, the portability of insurance and exclusions for pre-existing conditions have been the target of many individual and group health insurance reform efforts, at both the state and national levels. See the discussion under "Regulation" appearing in this Item below. These reform efforts have created uncertainty in the health insurance industry, particularly among insurers offering comprehensive health insurance products. With their increased emphasis on supplemental and specified risk health insurance products, the ICH Companies believe they are pursuing a business strategy in their individual health insurance segment that coincides with the essential elements of many of the health care reform efforts currently under consideration. However, ICH currently cannot predict which, if any, of the health care reform proposals under consideration by Congress and the various states will be implemented, whether any additional health insurance measures will be adopted in the foreseeable future or the impact such reform measures ultimately would have on the ICH Companies' existing portfolio of products or their established distribution systems. ACCUMULATION PRODUCTS The ICH Companies' accumulation products include traditional annuities, which are sold primarily through independent agents and brokers. During 1993, the ICH Companies significantly increased their marketing efforts for annuity products, adopting the strategic goal of using annuities to represent their accumulations business segment. In the current interest rate environment, annuities have become attractive as replacements for certificates of deposit. The ICH Companies have promoted the sale of annuities through marketing relationships with established distribution systems targeting the senior citizen market. During 1993, annuities accounted for 94% of the ICH Companies' accumulation product premium equivalents, a trend management expects to continue. Substantially all of ICH's annuity considerations are attributable to sales of flexible premium deferred annuities and single premium deferred annuities. Generally, such flexible premium deferred annuities permit annual payments in such amounts as the holder deems appropriate, and the single premium deferred annuities underwritten by the ICH Companies require a one-time lump sum payment. While deciding to emphasize the sale of annuities, the ICH Companies, during 1993, decided to no longer pursue growth in their accumulations business through the sale of guaranteed investment contracts. Constitution, the ICH Company that had been positioned in 1990 to underwrite guaranteed investment contracts, was significantly downsized during 1993 as a part of the restructuring of the ICH insurance holding company reorganization, and no longer actively markets guaranteed investment contract products. A significant amount of Constitution's in force guaranteed investment contract business was terminated in 1992 and 1993, primarily as the result of scheduled maturities and the early termination of contracts. GROUP BUSINESS Group insurance is highly competitive. Most policies are written on a periodic basis, and competitive bids are often sought prior to renewal. Philadelphia American is the only ICH Company making any significant new sales to groups, although Bankers Multiple continues to underwrite health insurance under an established Association group plan. Many of the factors affecting the profitability of the individual comprehensive health insurance products are equally applicable to group health insurance plans. Philadelphia American also provides fee-based administrative services, processing comprehensive health insurance claims under diverse group plans. Philadelphia American does not assume any underwriting risk under its administrative-only arrangements, which are entered into with large and medium-sized employers. Instead, Philadelphia American merely processes and pays claims for an administrative fee, while the employer acts as a self-insurer and provides the policyholder benefits. Philadelphia American also provides groups with managed care plans, under which it develops a network of providers with negotiated cost controls and administers group claims and makes available stop loss coverage for group benefits. The total claims administered by Philadelphia American under these fee-based administrative arrangements increased from $288.9 million during 1992 to $310.7 million during 1993. Many states have considered and enacted small group insurance reform legislation. While the definitions used and requirements imposed vary significantly from state to state, typical components of legislation targeting small group insurance reform include community rating, limitations on underwriting, restrictions on exclusions for pre-existing conditions and restrictions on rate increases. If enacted by Congress, national health care reform legislation could significantly change the manner in which group business is conducted. Philadelphia American incurred significant losses in its group business during 1993, resulting in pre-tax operating losses of $12.9 million with respect to the ICH Companies' group and other business for the year. See the discussion under the subheading "Group and Other Insurance" under "Analysis of Operating Results by Industry Segment" in ITEM 7 of this Report, which discussion is incorporated herein by reference, for an analysis of the factors contributing to the losses. Due to the unprofitable performance of its group insurance plans during 1993 and the uncertainties created by the currently proposed national health care reform efforts, Philadelphia American intends to further de-emphasize the sale of fully insured traditional indemnity group plans in favor of fee-based administrative services and managed health care programs. MARKETING The ICH Companies are collectively licensed to sell their insurance products in all 50 of the United States and in certain protectorates of the United States. The following table identifies those states which accounted for 5% or more of the subsidiaries' 1993 combined direct premiums from life, health, and annuity sales to residents in such states. As of year end 1993, individual life and health insurance products offered by the ICH Companies are sold primarily through more than 11,000 independent agents. Substantially all independent agents selling insurance products for the ICH Companies also represent other insurers. Group insurance is sold principally through independent agencies that are assisted by group sales staffs employed by an ICH subsidiary, and alternate funded plans are marketed directly by employees of an ICH Company. The ICH Companies develop their marketing programs essentially on three levels. First, the ICH Companies design competitive insurance products for targeted markets that provide an appropriate return over the life of the product. Factors considered in designing insurance products include insurance regulatory requirements, underwriting limitations, federal income tax laws, and competitive features like premium rates, rates of return, and other policy benefits. Secondly, the subsidiaries develop facilities and support staffs designed to provide superior services to agents and policyholders. Thirdly, the ICH Companies adopt competitive agent compensation arrangements that are intended to provide incentives for the agents to increase their production of new insurance and to promote continued renewals of in-force insurance written through them. Historically, these incentives have involved awards, overrides, and compensation scales that escalate with production and provide additional commission payments for renewal business. During 1993, the ICH Companies centralized the marketing strategy for most of the ICH Company individual life and health insurance products that are distributed through general agents and brokers. Southwestern and Union Bankers now offer their products through shared distribution systems, with agent and broker compensation packages coordinated across product lines. Southwestern has terminated its exclusive marketing arrangements for individual life insurance products, and has eliminated broker compensation based solely on insurance in force, with no emphasis on new production. UNDERWRITING The ICH Companies employ professional underwriting staffs and have adopted and follow detailed underwriting procedures designed to assess and quantify insurance risks before issuing life and health insurance policies to individuals and groups. Except with respect to Medicare supplement insurance, which is heavily regulated, the underwriting practice of each ICH Company is to require medical examinations (including blood tests, where permitted) of applicants for certain health insurance and for life insurance in excess of prescribed policy amounts. These requirements vary according to the applicant's age and by policy type, and streamlined procedures have been developed based on the amount and type of coverage sought. The ICH Companies also rely on medical records and each potential policyholder's written application for insurance. In issuing health insurance, the ICH Companies use information from the application and, in some cases, inspection reports, physician statements, or medical examinations to determine whether a policy should be issued as applied for, issued with reduced coverage under a health rider, or rejected. Acquired Immunity Deficiency Syndrome ("AIDS") claims identified to date, as a percentage of total claims, have not been significant for ICH's subsidiaries. Evaluating the impact of future AIDS claims under the life and health insurance policies issued by ICH is extremely difficult, in part due to the insufficient and conflicting data regarding the number of persons now infected by the AIDS virus and uncertainty as to the speed at which the disease may spread through the general population. The ICH Companies have implemented, where legally permitted, underwriting procedures designed to assist in the detection of the AIDS virus in applicants. INVESTMENTS The ICH Companies derive a substantial portion of their income from investments. State insurance laws impose certain restrictions on the nature and extent of investments by insurance companies and, in some states, may require divestiture of assets contravening these restrictions. At December 31, 1993, based on statutory insurance accounting practices, intercompany investments in equity securities of ICH's subsidiaries constituted approximately 19.53% of the combined adjusted capital and surplus of ICH's insurance subsidiaries. These intercompany investments have been eliminated, in accordance with generally accepted accounting principles, in the financial statements appearing in this Form 10-K. The following table summarizes, for the indicated periods, certain results of the investments of ICH and its consolidated subsidiaries. See ITEM 7 for a description of factors affecting the comparability of the indicated periods. The investments of the ICH Companies are managed under the supervision of management and of each company's board of directors. See the discussion under the heading "Investment Portfolio" in ITEM 7, and Note 5 of the Notes to Financial Statements appearing elsewhere in this Form 10-K, which are incorporated herein by reference, for information about the composition and performance of ICH's investment portfolio. Diversification of risk, asset-liability management and reduction of the Company's exposure to losses arising from prepayments of collateralized mortgage obligations are key elements of the Company's investment policies. Beginning in 1992, the ICH Companies have relied increasingly on independent investment advisors in the management of their investments. Conseco Capital Management, Inc., the investment advisory subsidiary of Conseco, provides investment management services to the ICH Companies; it managed approximately $430 million of their investments during 1993. Westridge Capital Corporation managed the investment of approximately $42 million of the assets and hedged the risk for one of Constitution's accumulation products during 1993. New England Asset Management, Inc. provides advice in the management of substantially all of the remaining investment portfolios of the ICH Companies and advised the ICH Companies in connection with the sale of a substantial portion of their residual and interest-only collateralized mortgage obligations to, and the reinvestment of a portion of the proceeds from the sale in trust certificates sold by, Fund America Investors Corporation II in July 1993. REINSURANCE In keeping with industry practices, the ICH Companies reinsure with unaffiliated insurance companies and, to a lesser extent, other ICH Companies portions of the life and health insurance and annuities underwritten by them. Under most of the subsidiaries' reinsurance arrangements, new insurance and annuity sales are reinsured automatically rather than on bases that would require the reinsurer's prior approval. Generally, the ICH Companies enter into indemnity reinsurance arrangements to assist in diversifying their risks and to limit their maximum loss on large or unusually hazardous risks, including risks that exceed the ICH Companies' respective policy-retention limits currently ranging up to $500,000 per insured. Indemnity reinsurance does not discharge the ceding insurer's liability to meet policy claims on the reinsured business. The ceding insurer remains responsible for policy claims on the reinsured business to the extent the reinsurer fails to pay such claims. CFLIC, a subsidiary of CNC, reinsures certain annuity business written by Bankers and Southwestern, under reinsurance agreements that were entered into in connection with ICH's 1990 sale of Marquette to CNC. On June 15, 1993, ICH, CNC and CFLIC entered into an agreement that gives ICH the right, and under which ICH has the obligation, to negotiate the termination of these reinsurance agreements. See the discussion under the heading "Transactions With Consolidated Fidelity Life Insurance Company" appearing in ITEM 7 of this Form 10-K, which discussion is incorporated herein by reference. ICH, CNC and CFLIC have agreed with Torchmark and Stephens that the reinsurance agreements will be terminated by May 30, 1994, and CNC will have the right to transfer its ownership interest in CFLIC to ICH, in exchange for designated assets of CFLIC, if the recaptures are not completed by March 31, 1994. The termination of the reinsurance agreements is dependent on the completion of successful negotiations and the receipt of all required regulatory approvals. In a few instances, ICH's subsidiaries have reinsured blocks of insurance policies to provide funds for enhancing surplus, financing acquisitions and other purposes. Under these financing arrangements, statutorily determined profits on the reinsured business are accelerated through the reinsurer's payment of ceding commissions representing the present value of profits on the business over the reinsurance period. During 1993, the ICH Companies reduced by $13.1 million the financial reinsurance ICH Companies had obtained during 1991. In addition, a surplus relief treaty between an ICH Company and a third party reinsurer was terminated as a part of the restructuring of the ICH holding company organization that was completed September 29, 1993. Historically, reinsurance has not had a significant effect on ICH's consolidated results of operations, with net ceded premium income and other considerations representing 5% or less of total premium income and other considerations in each of the past three years. ADMINISTRATIVE OPERATIONS The administration operations of most of the ICH Companies are consolidated through Facilities Management Installation, Inc. ("FMI"), the service corporation subsidiary of ICH. Functioning as the employer of substantially all of the employees performing services in ICH's insurance operations, FMI provides management and administrative services to the ICH Companies directly and through arrangements with third parties. Claims administration, risk underwriting, regulatory compliance and development and marketing of insurance products are performed on the basis of function or business segment. A significant portion of the data processing services required in the administrative operations of the ICH Companies is provided by a third party vendor. Because of the operational interrelationships among the ICH Companies, the sales of subsidiaries in prior years have required changes in the administrative operations of various ICH Companies, including changes in executive responsibilities and personnel requirements. The complete separation of the operations of the ICH Companies and the subsidiaries previously sold occurred in 1993, with the expiration of the servicing arrangements that were entered into when the former subsidiaries were sold in 1989 and 1990. Following a full-scale review, the administrative operations of the ICH Companies have been reorganized to remove inefficiencies, redundancies and excess capacities, and the operations of several ICH Companies have been consolidated across product lines in a primary location under a common management team. COMPETITION The insurance industry is highly competitive, with approximately 2,000 life and health insurance companies in the United States. Certain large insurers and insurance holding company systems have substantially greater capital and surplus, larger and more diversified portfolios of life and health insurance policies, and larger agency sales operations than those of the ICH Companies. Financial and claims paying ratings assigned to insurers by the nationally recognized independent rating agencies, always a key ingredient, have in some markets become preemptive, especially in the area of accumulation products. The ICH Companies also are encountering increased competition from banks, securities brokerage firms, and other financial intermediaries marketing insurance products and other investments such as savings accounts and securities. The ICH Companies compete primarily on the basis of experience, size, accessibility, cost structure and pricing, claims responsiveness, product design and diversity, service and distribution. ICH believes that its insurance subsidiaries are generally competitive based on premium rates and service, have longstanding relationships with their agents, and offer a diverse portfolio of products. REGULATION STATE INSURANCE REGULATION. The discussion under the heading "Regulatory Environment" appearing under ITEM 7 of this Report on Form 10-K is incorporated herein by reference. In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the health care system, either nationally or at the state level. In addition, some states have already enacted health care and insurance reforms and others continue to consider additional reforms. Among the proposals under consideration in Congress and some state legislatures are insurance market reforms to increase the availability of group health insurance to small business and control the cost of insurance, requirements that all businesses offer health insurance coverage to their employees and the creation of a single government health insurance plan that would cover all citizens. Reform legislation proposed by the Clinton administration would ultimately guarantee universal access to health care coverage and create purchasing alliances for government established health care plans. Alternative legislative proposals that have been developed to reform the health care system have goals ranging from universal access to health care coverage through managed competition to health care cost containment through, among other things, health insurance reform. ICH currently cannot predict what impact health care reform proposals will have on the health insurance industry, whether any additional health insurance measures will be adopted in the foreseeable future or, if adopted, whether such reform proposals or measures will have a material effect on its operations. Certain subsidiaries of ICH have entered into agreements with state insurance departments which impose restrictions or reporting requirements in connection with their operation of business or their payment of dividends. In management's view, none of these regulatory agreements have adversely affected the insurance business of the ICH Companies. In conjunction with the receipt of the approval of the Texas Department of Insurance required for the restructuring of the ICH insurance holding company organization in September 1993, ICH and its Texas-based subsidiaries, Southwestern and Union Bankers, entered into an agreement with the Texas Department of Insurance, which superseded the regulatory agreement they had entered into on March 31, 1993. Among other things, the agreement with the Texas Department of Insurance requires ICH, Southwestern and Union Bankers to provide the Texas Department with designated information on an on-going basis; requires Southwestern to provide 30 days prior notice of any stockholder dividend, to limit the amount it invests in private placement securities, and to not invest in interest-only collateralized mortgage obligations; and requires 30 days prior notice of any financial reinsurance transaction or acquisition of business through assumption reinsurance by either Southwestern or Union Bankers. The agreement with the Texas Department also addresses the reinsurance agreements under which CFLIC reinsures business written by Southwestern, and provides that any recapture of the reinsured business by Southwestern can occur only after receipt of the written concurrence of the Texas Department. In March 1993, ICH had agreed with the Texas Department to develop a plan addressing the enhancement and diversification of the asset portfolio supporting the reserve liabilities reinsured by CFLIC, and in June 1993 ICH entered into an agreement with CFLIC and CNC giving ICH the authority, and responsibility, for negotiating the termination of CFLIC's reinsurance agreements. In connection with the restructuring of the ICH holding company organization in September 1993, Constitution and the Kentucky Department of Insurance terminated a stipulation that required Constitution to maintain adjusted surplus of at least $100 million or discontinue the sale of insurance. Primarily as a result of actions taken in connection with the restructuring, as reported in its annual statutory financial statements, Constitution had approximately $55.6 million in adjusted surplus (statutory capital and surplus plus the asset valuation reserve) as of December 31, 1993. ICH's subsidiary, Modern American Life Insurance Company ("Modern American"), signed an agreement with the Missouri Department of Insurance in December 1992 that, among other things, currently restricts Modern American's ability to invest in securities of affiliates and requires Modern American to obtain the consent of the Missouri Department before paying any stockholder dividends. During 1992, Modern American also agreed with the Florida Department of Insurance that it would suspend writing insurance and not enter into any reinsurance agreements in Florida. FEDERAL INCOME TAXATION. ICH's life insurance subsidiaries are taxed under the life insurance company provisions of the Internal Revenue Code of 1986, as amended (the "Code"). Under the Code, a life insurance company's taxable income incorporates income from all sources, including life and health premiums, investment income, and certain decreases in reserves. The Code currently establishes the maximum corporate tax rate of 35% and imposes a corporate alternative minimum tax at a 20% rate. SEE Note 13 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K. Beginning in 1992, ICH and its subsidiaries file life-nonlife consolidated federal income tax returns. Amendments to the Code adopted in 1990 require the capitalization and amortization over a ten year period of certain policy acquisition costs incurred in connection with the sale of certain insurance products. Prior tax laws permitted these costs to be deducted as they were incurred. This new rule applies to the life, health and annuity business issued by the ICH Companies. By deferring deductions, this new rule has the effect of increasing the current tax incurred, and decreasing deferred taxes payable by a corresponding amount. The lost after-tax earnings caused by accelerating the current tax liability is the primary effect of this provision on the statutory net income of ICH's insurance subsidiaries. Certain proposals to make additional changes in the federal income tax laws and regulations affecting insurance companies or insurance products continue to be considered at various levels in the United States Congress and the Internal Revenue Service. ICH currently cannot predict whether any additional tax reform measures will be adopted in the foreseeable future or, if adopted, whether such measures will have a material effect on its operations. RESERVES. In accordance with applicable insurance laws, ICH's insurance subsidiaries have established and carry as liabilities actuarial reserves to meet their respective policy obligations. Life insurance reserves, when added to interest thereon at certain assumed rates and premiums to be received on outstanding policies, are calculated to be sufficient to meet policy obligations. The actuarial factors used in determining such reserves are based on statutorily prescribed mortality and interest rates. Reserves maintained for health insurance include the unearned premiums under each policy, reserves for claims that have been reported but are not yet due, and reserves for claims that have been incurred but have not been reported. Furthermore, for all health policies under which renewability is guaranteed, additional reserves are maintained in recognition of the actuarially calculated probability that the frequency and amount of claims will increase as the attained age of the insured increases. The ICH Companies maintain reserves on reinsured business once it is assumed by them and take credit for reserves on reinsured business after it is ceded to other insurers by them. Reserves for the assumed reinsurance are computed on bases essentially comparable to direct insurance reserves. The reserves carried in the financial statements included elsewhere in this Form 10-K are calculated based on generally accepted accounting principles and may differ from those specified by the laws of the various states and carried in the statutory financial statements of the insurance subsidiaries. These differences arise from the use of different mortality and morbidity tables and interest assumptions, the introduction of lapse assumptions into the reserve calculation, and the use of the level premium reserve method on all insurance business. In addition, beginning in 1993, to the extent the ICH Companies remain primarily liable for benefits on policies which have been ceded to other insurers, the reserve credits taken for regulatory reporting purposes are eliminated under generally accepted accounting principles. See Note 1 of the Notes to Financial Statements included in ITEM 8 of this Report on Form 10-K for certain additional information regarding reserve assumptions under generally accepted accounting principles. EMPLOYEES At March 1, 1994, ICH and its subsidiaries employed a total of approximately 1,320 persons, excluding agents, who are not employees but are independent contractors. ICH HOLDING COMPANY SYSTEM ICH was organized in 1966 as a Missouri corporation and was reincorporated in Delaware during 1977. The following chart summarizes as of March 18, 1994 the relationships among ICH and its significant subsidiaries. Each percentage used in the chart represents the parent's percentage ownership interest in the outstanding voting securities of the respective subsidiary company. The years in which ICH formed, or acquired more than 50% of, the indicated subsidiaries are set forth parenthetically. [GRAPHIC] The above chart reflects the restructuring of the ICH insurance holding company system, from a vertical to a substantially horizontal structure, that was effected September 29, 1993. The restructuring was designed to increase the financial independence of the ICH Companies and reduce the effect of multi-jurisdictional regulation that results when insurance subsidiaries are held indirectly, through other insurance subsidiaries. - --------- *The following companies are direct or indirect subsidiaries of ICH, but do not have any significant operations: American MedCAP Inc.; BML Agency, Inc.; BML Agency, Inc. of Ohio; Dallas Insurance Services Company; I.C.H. Financial Services, Inc.; Independence National, Inc.; Investment Dissolution Corporation; Philadelphia American Property Company; Quail Creek Communications, Inc.; Quail Creek Recreation, Inc.; Quail Creek Water Company, Inc.; REO Holding Corporation; Southeast Title & Insurance Company; and Western Pioneer Corporation. Prior to the restructuring, Southwestern and Philadelphia American were held by ICH indirectly through Modern American, and Union Bankers, Bankers Multiple, Bankers New York, and Constitution were held by ICH indirectly through Southwestern. By virtue of the restructuring, which involved a series of transactions including the retirement of debt and equity securities, the payment of dividends, the termination of a reinsurance agreement between Modern American and Constitution, and the execution of a new reinsurance agreement between Modern American and Southwestern, Modern American eliminated its investment in securities of affiliates, Southwestern reduced its investment in insurance subsidiaries to Constitution and Bankers New York, and ICH made its ownership of its insurance subsidiaries more direct. The restructuring was completed following the receipt of approvals by the Missouri, Texas, Illinois, Kentucky and Pennsylvania Insurance Departments. See ITEM 2 of this Form 10-K for a description of an appeal of the approvals granted by the Missouri Department of Insurance. ITEM 1A. ITEM 1A. EXECUTIVE OFFICERS OF REGISTRANT. Set forth below is certain information regarding the current executive officers of I.C.H. Corporation as of March 1, 1994. ROBERT L. BEISENHERZ, age 48. Chairman of the Board and Chief Executive Officer since October 1992, a director since March 1992 and President since February 1992. Mr. Beisenherz served as Executive Vice President of ICH from June, 1990, when he joined ICH, until February 1992. Throughout 1991 and until his election as President in February 1992, Mr. Beisenherz also served as an executive officer of subsidiaries of Consolidated National Corporation. For the previous 17 years, he was a consulting actuary with Lewis & Ellis, Inc., consulting actuaries, Dallas, Texas. JOSEPH P. CROWLEY, age 49. Senior Vice President -- Group Marketing and Claims since March 1993. Mr. Crowley has served as President of ICH's subsidiary, Philadelphia American Life Insurance Company, since 1984 and President and Chief Operating Officer since 1987. He is responsible for the group and managed care operations of Philadelphia American and, during 1993, he was also responsible for overseeing individual health claims. ROBERT C. GREVING, age 42. Senior Vice President and Chief Actuary since September 1992. Mr. Greving joined the ICH organization in 1990 and serves as Executive Vice President, Chief Actuary and a director of ICH's subsidiary, Southwestern Life Insurance Company, and as an officer of various other ICH subsidiaries. Mr. Greving was a Senior Vice President and Actuary of American Founders Life Insurance Company from January 1988 until July 1990. American Founders Life Insurance Company was placed under protective receivership by the Texas Insurance Department from April 14, 1989 until its release on September 19, 1989. The commencement of the supervisory proceedings was prompted by the Chapter 11 bankruptcy of its ultimate parent, American Continental Corporation. JOHN T. HULL, age 50. Executive Vice President since March 1993 and Treasurer since 1983. Mr. Hull served from 1983 to 1993 as Senior Vice President and from 1979 to 1982 as the chief accountant for ICH and certain of its affiliates. He has served since 1983 as Treasurer of several ICH subsidiaries. W. SHERMAN LAY, age 54. Executive Vice President -- Operating Companies since September 1993. Mr. Lay served as Senior Vice President from 1986 until 1993 and has served as an officer of various affiliates of ICH since 1971. Mr. Lay serves as an officer and a director of various ICH insurance subsidiaries, including the position of Chief Executive Officer of Philadelphia American, President of Constitution Life Insurance Company and, since October 1993, President of Southwestern. EDWARD R. MEKEEL, JR., age 47. Executive Vice President and Chief Financial Officer since September 1992. Mr. Mekeel also serves as a director and chief financial officer of various ICH subsidiaries. Before joining ICH in 1992, Mr. Mekeel was employed as the Senior Vice President and Chief Financial Officer and a director of First Capital Life Insurance Company from July 1989 until October 1991, and from August 1983 until June 1989, he was employed as the Senior Vice President and Controller of Mutual Benefit Life Insurance Company and served as an officer and director of various of its affiliates. In May 1991, the California Commissioner of Insurance commenced involuntary conservatorship proceedings against First Capital Life Insurance Company while Mr. Mekeel was still an executive officer and director. When the Commissioner was appointed Conservator, Mr. Mekeel was appointed one of the conservation managers, a function he performed until his employment relationship ended in October 1991. C. FRED RICE, age 55. Senior Executive Vice President--Marketing and Real Estate since 1985. A director since 1975 and a member of the Executive Committee, Investment Committee, Compensation Committee, and Stock Option Committee, Mr. Rice is an employee of CNC. Mr. Rice has served as Vice President, Secretary, and a director of CNC since 1984. He also has served since 1970 as an officer and director of various affiliates of ICH. Mr. Rice currently serves as a director of Financial Benefit Group, Inc. H. DON RUTHERFORD, age 57. Senior Vice President--Individual Marketing since March 1993. Mr. Rutherford joined Union Bankers Insurance Company in 1967, and serves as Senior Executive Vice President and Senior Marketing Officer of that subsidiary. Mr. Rutherford serves as Marketing Director for the individual life and health products of ICH's insurance organization. SHERYL G. SNYDER, age 47. Executive Vice President since March 1992 and General Counsel since December 1990. Mr. Snyder had been a partner of the law firm of Wyatt, Tarrant & Combs, Louisville, Kentucky since 1978 and associated with the firm since 1973. He has served as president of the Louisville and Kentucky State Bar Associations. Officers are elected by the Board of Directors of ICH and hold office until their respective successors are duly elected and qualified. All of the executive officers of ICH are employed by its wholly-owned subsidiary, Facilities Management Installation, Inc., except Mr. Rice. Set forth below is certain information regarding other former directors and/or executive officers of ICH. PHILLIP E. ALLEN, age 63. Vice Chairman of the Board and Secretary from April 1990 until his retirement in May 1993. Mr. Allen served as Secretary of ICH from 1986 and as an officer and director of various affiliates of ICH from 1983 until his retirement. He served as General Counsel of ICH and certain of its affiliates from 1978, and as Executive Vice President--Corporate Operations of ICH from 1983, until his election as Vice Chairman of the Board of ICH in April, 1990. Mr. Allen continues to provide services to the Company pursuant to the Retirement/Retainer Agreement he and the Company entered into at the time of his retirement. THOMAS J. BROPHY, age 58. Executive Vice President from 1986 until September 1993. Mr. Brophy served as President of Southwestern from June 1990, and as its Chief Operating Officer from 1987, until September 1993. From 1987 until 1990, he was Senior Executive Vice President of Southwestern. Mr. Brophy was employed by Great Southern Life Insurance Company from 1974 until the closing of ICH's sale of Great Southern in December 1989 and served as Senior Executive Vice President and Chief Operating Officer of Great Southern from 1983 until such closing. FMI had an administrative services agreement with Mutual Security Life Insurance Company ("MSL") when, on October 5, 1990, the Indiana Insurance Department placed MSL in rehabilitation. Under the agreement, FMI provided administrative services for a closed block of business written by MSL, and to facilitate the performance of these services, Mr. Brophy was appointed, in April 1990, a Vice President of MSL, to serve without compensation or other benefit. While the Indiana Office of Rehabilitation requested FMI to continue providing the administrative services after the rehabilitation proceedings were commenced, Mr. Brophy immediately resigned as an officer of MSL, effective October 9, 1990. ROBERT T. SHAW, age 59, served as Chairman of the Board from 1975 and Chief Executive Officer from 1975 to 1989 and from February 1992 until his resignation in October 1992. He also served from 1966 until 1992 as an officer and director of various affiliates of ICH. Mr. Shaw is an employee of CNC and has served as President, Treasurer, and a director of CNC since 1984. Throughout 1993, Mr. Shaw provided services to ICH by virtue of CNC's management and consulting agreement with ICH, and he currently provides services pursuant to a ten year Independent Contractor and Services Agreement he and the Company entered into February 11, 1994. ITEM 2. ITEM 2. PROPERTIES. The following table sets forth certain information regarding the principal physical properties of I.C.H. Corporation and its subsidiaries as of March 1, 1994. A 2,600-acre residential and recreational real estate development in Perry Park, Kentucky is owned by ICH. ICH's subsidiaries own certain real estate located in Chicago, Illinois, which was acquired from Bankers Life and Casualty Company at the time of its sale in November 1992, and an office building with 129,000 square footage, at 2551 Elm Street, Dallas, Texas, where Union Bankers Insurance Company was formerly headquartered; they also hold, for investment purposes, certain real estate, none of which is included in the table below. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Modern American Life Insurance Company is a Defendant in a class action lawsuit filed by William D. Castle and others on or about May 14, 1993 in the Circuit Court of Jackson County, Missouri, styled WILLIAM D. CASTLE, ET AL. V. MODERN AMERICAN LIFE INSURANCE COMPANY, CV93-10275 (the "CASTLE case"). The suit purports to be brought on behalf of a class of persons who own what Plaintiffs denominate as charter contracts, issued by life insurance companies merged into or acquired by Modern American Life Insurance Company and its predecessors. The petition alleges breach of contract, and seeks declaratory judgment, costs, expenses and such other relief as the Court deems appropriate. As an alternative, the petition seeks rescission. On or about October 12, 1993, the Plaintiffs in the CASTLE case also filed a lawsuit in the Circuit Court of Cole County, Missouri, naming Modern American and the Director of the Missouri Department of Insurance (the "Missouri Director") as Defendants. The second lawsuit, styled ROBERT J. MEYER, ET AL. V. JAY ANGOFF, DIRECTOR OF THE MISSOURI DEPARTMENT OF INSURANCE AND MODERN AMERICAN LIFE INSURANCE COMPANY, CV193-1331CC (the "MEYER case"), is an appeal from the regulatory proceedings before the Missouri Department of Insurance, by which Modern American received regulatory approvals required for it to participate in the restructuring of the ICH insurance holding company organization. The restructuring was completed on or about September 29, 1993. The Plaintiffs in the MEYER case are seeking reversal or remand of the Director's order of approval. The Cole Circuit Court has determined that it will review the Department's decision on the record pursuant to Missouri's administrative procedure act. Modern American believes it has meritorious defenses to both the CASTLE and MEYER cases and intends to defend both cases vigorously. A subsidiary of ICH, together with six other solvent parties, has been notified by the Texas Natural Resource Conservation Commission (formerly known as the Texas Water Commission) that it is a potentially responsible party under Texas environmental legislation with respect to certain property owned by that subsidiary and leased to a third party in Texas. That property is part of a tract of approximately 17 acres that allegedly has been contaminated with creosote. The potentially responsible parties have engaged an environmental consulting firm to investigate the extent of the contamination and develop a clean-up plan, after which the costs of the clean-up can be estimated. The Phase I Remedial Investigation was completed during the first half of 1993, and the Phase I Remedial Investigation Technical Memorandum (Phase I Report) was finalized by the end of 1993. Phase II of the Remedial Investigation and the risk assessment are to be performed during 1994. ICH's subsidiary has agreed to pay 6% of the cost of the investigation, and a former ICH subsidiary, which ICH has agreed to indemnify, has also agreed to pay 6% of the cost of the investigation. There is no agreement among the potentially responsible parties with regard to any responsibility for or the allocation of costs of any remedial action which may ultimately be determined necessary. A potentially responsible party brought an action, TOWNE SQUARE ASSOCIATES AND MILLENNIUM III REAL ESTATE CORPORATION V. GSV PROPERTIES, ET AL., Cause No. 91-15951, filed November 1991 in the 250th Judicial District, Travis County, Texas, naming the other potentially responsible parties defendants, including ICH's subsidiary and former subsidiary. ICH's subsidiary and former subsidiary asserted a counter-claim against the plaintiff as well as the other defendants, contesting their status as potentially responsible parties and seeking contribution and/or indemnity. The claims between the plaintiff and ICH's subsidiary and former subsidiary have now been resolved and the Texas Natural Resource Conservation Commission is contesting the Court's jurisdiction over the remaining claims. ICH and Robert L. Beisenherz, Chairman and Chief Executive Officer of the Company (collectively "the Company"), as well as Robert T. Shaw, former Chairman of the Company, and certain former affiliates of the Company, were added by an Amended Complaint, filed December 3, 1993, as Defendants in a lawsuit pending in Marion Circuit Court in Indianapolis, Indiana. MUTUAL SECURITY LIFE INSURANCE COMPANY, BY ITS LIQUIDATOR, JOHN F. MORTELL V. JAMES M. FAIL, EMILY S. FAIL, JACK A. GOCHENAUR, ALVIN R. TOWNSEND, SR., JANICE T. TOWNSEND, CHARLES D. CASPER, HARRY T. CARNEAL, CLIFFORD G. SMITH, KATHERYN F. SMITH, THOMAS K. PENNINGTON, MICHAEL BOEDEKER, MELVIN R. SCHOCK, LIFESHARES GROUP, INC., LSC-MARKETING, INC., LIFESHARES SERVICES COMPANY, MICHAEL S. LANG, LANG ASSOCIATES, INC., BETA FINANCIAL CORPORATION, THE OKLAHOMA BANK, ROBERT T. SHAW, CONSOLIDATED NATIONAL CORPORATION, I.C.H. CORPORATION, BANKERS LIFE AND CASUALTY COMPANY, MARQUETTE NATIONAL LIFE INSURANCE COMPANY, ROBERT L. BEISENHERZ, MARILYN BEISENHERZ, THEODORE L. KESSNER, AND CROSBY, GUENZEL, DAVIS, KESSNER & KUESTER (the "MUTUAL SECURITY case"). On January 3, 1994, the suit was removed to the United States District Court, the Southern District of Indiana at Indianapolis, Case No. IP94-0001 C. A motion to remand the MUTUAL SECURITY case back to State Court, filed by the Plaintiff Liquidator, is currently pending. The Plaintiff, the Commissioner of Insurance, who had been appointed Liquidator of Mutual Security Life Insurance Company ("MSL") pursuant to a Final Order of Liquidation, entered on December 6, 1991, alleges in the amended complaint that the Defendant Fail and others acquired control of MSL through a series of transactions, and misused assets of MSL to acquire control of Bluebonnet Savings Bank, FSB, thereby contributing to the insolvency of MSL. The allegations against the Company arise primarily from a loan that was made to James Fail in 1989 by Bankers Life and Casualty Company, at that time a subsidiary of the Company. The Plaintiff alleges that the Company and others are liable for the acts of James Fail under doctrines of joint venture and conspiracy, including alleged violations of the Racketeer Influenced & Corrupt Organizations Act ("RICO"), 18 U.S.C. Section 1961, ET SEQ. The complaint seeks unspecified compensatory damages, treble damages, costs, attorney fees and all other appropriate relief. Pleadings responsive to the Amended Complaint have not yet been filed, and discovery has not yet commenced. The Company believes it has meritorious defenses to the MUTUAL SECURITY case and intends to defend the suit vigorously. Except as described above, ICH and its subsidiaries are not parties, and their property is not subject, to any material pending legal proceedings other than ordinary routine litigation incidental to their respective businesses. SEE Note 12 of the Notes to Financial Statements included elsewhere in this Form 10-K. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock of I.C.H. Corporation is listed for trading on the American and Chicago Stock Exchanges under the symbol "ICH". The following table sets forth for the periods indicated the high and low sale prices per share of the Common Stock as reported by the American Stock Exchange. At March 18, 1994, 47,834,739 shares of Common Stock of ICH were outstanding and were owned of record by approximately 52,000 stockholders. No cash dividends have been declared by ICH on its Common Stock since 1985. ICH anticipates that it will continue for the foreseeable future to follow a policy of retaining substantially all its earnings, and that as a result no cash dividends on the Common Stock will be declared. Certain indentures currently restrict ICH from declaring or paying dividends on its capital stock in excess of specified amounts, and ICH's senior secured loan agreement prohibits the payment of cash dividends on Common Stock. See the discussion under the heading "Liquidity and Capital Resources--Parent Company" in ITEM 7 and Note 3 of the Notes to Financial Statements included in ITEM 8 in this Form 10-K. On February 11, 1994, ICH repurchased from Consolidated National Corporation 100,000 shares of the Class B Common Stock of ICH, representing all of the shares of that class authorized, issued and outstanding. As a result of that repurchase, ICH is no longer authorized to issue Class B Common Stock. No cash dividends had been declared on the shares of ICH's Class B Common Stock since 1985. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table sets forth for the indicated periods selected historical financial information for ICH and its consolidated subsidiaries. Such information should be read in conjunction with the consolidated financial statements of ICH, and the related notes and schedules, included elsewhere herein. Factors affecting the comparability of certain indicated periods are discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following is an analysis of the results of operations and financial condition of ICH and its consolidated subsidiaries. The consolidated financial statements and related notes and schedules included elsewhere in this Form 10-K should be read in conjunction with this analysis. RECENT EVENTS AND OTHER FACTORS During 1993, ICH successfully completed the sale for cash of its interest in Bankers Life Holding Corporation ("BLHC"), completed an exchange offer for a substantial portion of its debt scheduled to mature over the next several years, significantly reduced its and its subsidiaries' exposure to the risks associated with highly volatile mortgage-backed securities, and realized significant gains from the sale of investments in CCP Insurance, Inc. ("CCP Insurance"). These transactions resulted in a significant improvement in ICH's financial position, and the sale of the interest in BLHC provided ICH with substantial liquidity with which to meet its financial obligations. In addition, ICH completed the restructuring of its insurance holding company system, reduced its subsidiaries' dependence on financial reinsurance by in excess of 40%, and began the process of terminating significant reinsurance arrangements with an affiliated company. ICH utilized a portion of the proceeds from its sale of BLHC and cash remaining from its sale of Bankers Life and Casualty Company ("Bankers") in 1992 to further reduce some of the more expensive components of its capital structure. In management's opinion, ICH made significant progress in improving its relationship with regulatory authorities, and continued progress in consolidating the operations of its Texas-based insurance subsidiaries and in further reducing operating expenses. The successes in 1993 were offset, in part, by lower than anticipated earnings from continuing operations and additional losses and writedowns in the Company's investment portfolio. Subsequent to year-end, in February 1994, ICH purchased and retired its Class B Common Stock which had given its previous holders the ability to elect 75% of the members of ICH's Board of Directors. Following is an analysis of these various events and factors, including management's assessment of their impact on the financial position and liquidity of ICH, as well as management's future expectations. SALE OF INVESTMENT IN BANKERS LIFE HOLDING CORPORATION At year-end 1992, ICH's subsidiaries held direct and indirect common equity interests in BLHC totaling approximately 39.9%. Such interests had been acquired in conjunction with the sale of ICH's subsidiary, Bankers, in November 1992. During the first quarter of 1993, ICH acquired such interests from its subsidiaries. Effective March 31, 1993, BLHC completed an initial public offering of 19.55 million shares of its common stock, or an aggregate 35.8% interest in BLHC, at $22 per share. Proceeds of the offering, after underwriting expenses, approximated $405 million. Effective the same day, Conseco Capital Partners, L.P. ("CCP") announced a plan of dissolution and BLHC common shares held by CCP were subsequently distributed to the respective partners. ICH received 2,917,318 shares of BLHC common stock as a result of such distribution, increasing its direct ownership in BLHC common stock to 13,316,168 shares, or approximately 24.4% of BLHC's outstanding common shares following the offering. ICH reflected a pre-tax gain on the BLHC offering totaling approximately $99.4 million, primarily representing ICH's equity in the net proceeds of such offering. BLHC utilized a portion of the offering proceeds to redeem certain of its outstanding securities, including $50 million stated value of BLHC preferred stock and $34.7 million principal amount of BLHC junior subordinated notes held by ICH's subsidiaries. Because a portion of the purchase price paid for such investments had been allocated to ICH's common equity investments in BLHC, such redemptions resulted in additional pre-tax gains totaling approximately $8.3 million. On September 30, 1993, ICH sold its investment in BLHC to Conseco, Inc. ("Conseco") and one of Conseco's subsidiaries for $287.6 million cash. ICH utilized $50 million of the proceeds to redeem $50 million stated value of its Series 1987-A Preferred Stock held by a Conseco subsidiary. The sale of the BLHC shares resulted in a pre-tax gain totaling approximately $197.6 million. For financial reporting purposes, the gains resulting from BLHC's offering and the sale of ICH's remaining interest in BLHC totaling approximately $297.0 million have been reflected as a single line item in the 1993 statement of earnings. ICH continued to reflect its equity in the operating results of BLHC through the date of sale. Effective March 31, 1993, Bankers and an ICH subsidiary terminated a reinsurance agreement under which Bankers had previously ceded substantially all of its directly underwritten participating life insurance business to ICH's subsidiary. Assets, primarily fixed maturities and cash, with a fair value of approximately $163.6 million were transferred to Bankers and Bankers assumed policy liabilities on the reinsured business totaling approximately $186.2 million. ICH realized a gain on the termination of the reinsurance agreement totaling approximately $22.6 million which has been reflected in other income in the 1993 statement of earnings. CHANGES IN CAPITAL STRUCTURE During 1993, ICH completed an exchange offer for a portion of its outstanding debt and significantly reduced some of the more expensive components of its debt and equity structure. Subsequent to year-end, a significant transaction occurred affecting control of the Company. As discussed above, $50 million stated value of ICH's Series 1987-A Preferred Stock was redeemed in conjunction with the sale of the interest in BLHC. In addition, on December 2, 1993, ICH redeemed for $50 million cash all of its Series 1987-C Preferred Stock at its stated value. These redemptions reduced ICH's annual preferred dividend requirements by $13.5 million. Utilizing a portion of the proceeds from the sale of BLHC and cash remaining from the sale of Bankers in 1992, ICH retired all of the remaining $124.9 million principal amount of its 16 1/2% Senior Subordinated Debentures due 1994 ("Debentures") during 1993. Approximately $37.5 million of the Debentures were redeemed through a scheduled sinking fund payment in January 1993, an additional $37.5 million were called in March 1993 at a price of 101.84% of the amount redeemed, approximately $4.1 million were exchanged for new debt of the Company in November 1993, and the remaining Debentures were redeemed at par effective for financial reporting purposes as of December 30, 1993. Interest savings on the retired Debentures, excluding the exchanged debt, will approximate $20.2 million annually. In November 1993, ICH completed an exchange offer whereby $4.1 million of the Debentures and $87.1 million of its 11 1/4% Senior Subordinated Notes due 1996 ("Old Notes") were exchanged for $91.2 million of 11 1/4% Senior Subordinated Notes due 2003 ("New Notes"). See Note 3 of the Notes to Financial Statements for additional information regarding terms of the New Notes. Prior to the exchange offer, ICH and its subsidiaries held $46.8 million of the Old Notes which can, at ICH's option and upon repurchase of the $34.1 million of such Old Notes held by its subsidiaries, be utilized to partially satisfy its first $100 million sinking fund obligation relative to the Old Notes on December 1, 1994. The results of the exchange offer provided ICH additional flexibility in meeting such sinking fund obligation, since the amount of the Old Notes exchanged for New Notes can, also at ICH's option, be taken into consideration in determining what portion, if any, of the Old Notes it wishes to redeem through operation of the sinking fund. Assuming ICH utilizes its available Old Notes and defers sinking fund payments by an amount equivalent to the Old Notes which were exchanged, ICH would not have any sinking fund obligation in 1994 and its obligation in 1995 would total $66.1 million. Alternatively, and assuming its ability to generate the required liquidity, ICH may, at its option, determine to retire up to $100 million of the Old Notes at their par value through operation of the sinking fund in each of 1994 and 1995. ICH also has the option of calling any portion of the Old Notes at a 3% premium through November 30, 1994, and at a 2% premium during the following twelve month period. Thereafter, the Old Notes may be called at their par value. On February 11, 1994, ICH purchased all of the 100,000 shares of its Class B Common Stock from Consolidated National Corporation ("CNC") for total cash consideration of $500,000. The Class B Common Stock had entitled CNC to elect 75% of ICH's Board of Directors and, by virtue of such voting power, CNC was considered to be ICH's controlling shareholder. The Class B Common Stock was immediately cancelled and retired following ICH's purchase. Concurrently, Stephens Inc. ("Stephens") and Torchmark Corporation ("Torchmark") purchased 4,457,000 shares and 4,667,000 shares, respectively, of ICH Common Stock from CNC. Stephens is an investment banking firm with its principal offices located in Little Rock, Arkansas, and Torchmark is a diversified insurance and financial services company headquartered in Birmingham, Alabama. One officer each from Stephens and Torchmark was elected to fill vacancies on the ICH Board of Directors. In addition, a management and services agreement between ICH and CNC was cancelled, and new ten-year services agreements were entered into with the two principal shareholders of CNC. As a result of these transactions and the transactions with Consolidated Fidelity Life Insurance Company as described below, CNC's ownership in ICH will be reduced to approximately one million shares, or 2%, of ICH's outstanding Common Stock. Management believes these transactions are significant for various reasons. Most importantly, management believes that ICH's access to both debt and equity capital markets has previously been limited because of the control position held by CNC through the Class B stock, and that the retirement of the Class B stock and considerable reduction in CNC's holdings of ICH Common Stock could ultimately enhance ICH's ability to refinance its currently outstanding debt. TRANSACTIONS WITH CONSOLIDATED FIDELITY LIFE INSURANCE COMPANY Effective June 15, 1993, ICH entered into an agreement (the "Agreement") which initiated the process of terminating certain reinsurance arrangements involving Consolidated Fidelity Life Insurance Company ("CFLIC"), a subsidiary of CNC. The reinsurance arrangements involve certain annuity business with reserves totaling approximately $330.0 million as of December 31, 1993, which was transferred by a subsidiary of ICH, Southwestern Life Insurance Company ("Southwestern"), to an unaffiliated reinsurer in 1990. The unaffiliated reinsurer, in turn, transferred the business to another CNC subsidiary, Marquette National Life Insurance Company ("Marquette"). In 1991, Marquette transferred the annuity business to CFLIC. The reinsurance arrangements have been under review by the Texas Department of Insurance ("Texas Department") and, in March 1993, ICH and Southwestern agreed with the Texas Department that they would, among other things, develop a plan to enhance and diversify the assets supporting the liabilities reinsured by CFLIC, including possibly recapturing the reinsured annuity business. The recapture is subject to negotiations with the unaffiliated reinsurer and approval by the Texas Department. CNC and CFLIC agreed to structure the proposed recapture in a manner that will permit ICH to redeem or retire certain of its outstanding securities, provided that CFLIC would be allowed to retain certain assets following the recapture. CFLIC holds ICH's senior secured debt, with a current balance of $30 million, which it acquired in 1992 from ICH's bank lenders. In addition, CFLIC holds approximately $22.2 million stated value of ICH's Series 1984-A Preferred Stock, $7 million stated value of Series 1987-B Preferred Stock, and 620,423 shares of ICH's Common Stock. CFLIC also intends to terminate another reinsurance arrangement under which business written by Bankers is reinsured by CFLIC. Under terms of the Agreement, ICH is responsible for the negotiation on CFLIC's behalf of both the Southwestern and Bankers recaptures and the management of the affairs of CFLIC and Marquette, including management of their investments, until the recaptures are effected. Upon completion of the recaptures, CFLIC will have no remaining insurance business. To facilitate the recaptures of the reinsured business, ICH acquired $63 million of CFLIC preferred stock in exchange for its ownership interest in certain investments with an estimated fair value as of June 15, 1993, of $63 million, including its ownership in a limited partnership (HMC/Life Partners, L.P.) and 83% of ICH's ownership interest in I.C.H. Funding Corporation ("ICH Funding"). ICH Funding is a special purpose entity that was formed in 1992 to hold ICH's residual interest in a pool of mortgage-backed securities acquired from Bankers. The CFLIC preferred stock is non-redeemable and non-voting with cumulative 6% annual dividends that are payable "in-kind" until the recaptures are completed. ICH and CFLIC anticipate that the assets received by CFLIC from ICH in consideration for the preferred stock, along with other assets held by CFLIC, including its ownership in Marquette, will be transferred to Southwestern upon recapture of the annuity business. Following the recaptures, CFLIC is obligated to repurchase its preferred stock by transferring its ownership interest in the ICH debt and preferred securities and additional assets to ICH. Upon their receipt, ICH intends to retire the ICH securities. For financial reporting purposes, no gain or loss was recognized on the transfer of assets to CFLIC. The Agreement identifies the specific assets and liabilities plus, subject to certain conditions, an amount of cash that will be retained by CFLIC following the recaptures. All remaining assets held by CFLIC, including the ICH securities, will revert to ICH in redemption of CFLIC's preferred stock. As a consequence, ICH will benefit or suffer the consequences to the extent of any appreciation or depreciation in the value of the assets transferred to CFLIC. At December 31, 1993, ICH has reflected its investment in the CFLIC preferred stock at its approximate fair value of $54 million, or $9 million less than the value assigned to such preferred stock at June 15, 1993. The reduction in fair value between the two dates was primarily attributable to a decline in the fair value of the 83% interest in ICH Funding transferred to CFLIC. Management believes the transactions with CFLIC will be beneficial for several reasons. In addition to eliminating $30 million in scheduled debt principal requirements, the redemption or retirement of the ICH securities will reduce ICH's interest and preferred dividend requirements by approximately $5.4 million annually. Further, the recapture of the Southwestern annuity business will substantially eliminate the possibility for conflicts of interest between CNC and its subsidiaries and ICH. Management's present goal is to complete the transactions with CFLIC as soon as possible. RESTRUCTURING OF ICH HOLDING COMPANY SYSTEM In September 1993, ICH completed the restructuring of its insurance holding company system, from a vertical to a substantially horizontal structure. The restructuring was designed to increase the financial independence of ICH's subsidiary insurance companies and reduce the effect of multi-jurisdictional regulation that results when such subsidiaries are held indirectly, through other insurance subsidiaries. In the process of such restructuring, a surplus debenture due to ICH from a subsidiary with an outstanding principal balance of $105.8 million was retired and added to ICH's investment in its subsidiaries. As a consequence, there are no remaining surplus debentures due to ICH from its subsidiaries. The restructuring is expected to facilitate more accurate analysis and understanding of the Company by ratings agencies, securities analysts, and regulators, and will permit the direct payment of dividends from subsidiaries to ICH in future periods. Following such restructuring, ICH's subsidiaries affected by the restructuring have maintained risk-based capital levels substantially in excess of those required by applicable regulatory authorities. RATINGS ICH's subordinated debt and preferred stock are rated by various nationally recognized statistical rating organizations, such as Moody's Investors Service, Inc. ("Moody's") and Standard and Poor's Corporation ("S&P"). These agencies, along with Duff & Phelps Credit Rating Company ("Duff & Phelps"), have also rated the claims paying ability of certain of ICH's insurance subsidiaries. In addition, A.M. Best, an agency specializing in the rating of insurance companies, has assigned ratings to each of ICH's insurance subsidiaries. Over the last two years, substantially all of the ratings issued by these agencies have reflected ratings downgrades. Virtually all ratings downgrades experienced by ICH and its subsidiaries were attributed to high or continuing leverage at the parent company level. Moody's has rated ICH's subordinated debt at "B3" and its preferred stock at "Caa," both of which are below investment grade. S&P has rated ICH's debt at "B-" and its preferred stock at "CCC+," both of which are also below investment grade. Southwestern has been assigned claims paying ratings of "Ba2" by Moody's (questionable financial security), "BBB-" by S&P (adequate financial security, but capacity to meet policyholder obligations susceptible to adverse economic and underwriting conditions) and "A" by Duff & Phelps (high claims paying ability). A.M. Best has assigned "B++" ratings (very good) to all of ICH's significant insurance subsidiaries. The ratings assigned to ICH by ratings agencies have a significant effect on ICH's ability to borrow funds, as well as the interest rates that ICH must pay in order to borrow funds. The claims paying ratings assigned to ICH's subsidiaries could have a significant effect on a given subsidiary's ability to market its products, as well as its ability to retain its presently existing insurance in force. Except for an increase in the level of withdrawals of guaranteed investment contracts ("GICs") as discussed in "Liquidity and Capital Resources -Insurance Operations," management does not believe that ICH's insurance subsidiaries have experienced more than normal policy surrenders and withdrawals as a result of the ratings downgrades received in 1992 and 1993. In addition and notwithstanding such ratings downgrades, total new business produced by ICH's insurance subsidiaries, excluding GIC business, increased in 1993 as compared to 1992. Substantially all of ICH's and its subsidiaries' present ratings were issued prior to ICH's sale of its investment in BLHC, the restructuring of its insurance holding company system, the completion of its debt exchange offer, the retirement of its remaining Debentures, and the redemptions of $100 million in preferred stocks and the Class B Common Stock. Management believes, as a result of these previously discussed events, that the financial condition of ICH and its insurance subsidiaries has significantly improved and that, as a result, the possibility exists for upgrades in such financial and claims paying ratings. ICH has arranged for meetings with all applicable rating agencies in March 1994, but there can be no assurance that ICH's or its subsidiaries' ratings will be upgraded following such meetings. REGULATORY ENVIRONMENT ICH's insurance subsidiaries are subject to comprehensive regulation in the various states in which they are authorized to do business. The laws of these states establish supervisory agencies with broad administrative powers, among other things, to grant and revoke licenses for transacting business, to regulate trade practices, reserve requirements, the form and content of policies, and the type and amount of investments, and to review premium rates for fairness and adequacy. These supervisory agencies periodically examine the business and accounts of ICH's insurance subsidiaries and require them to file detailed annual financial statements and reports prepared in accordance with statutory accounting practices. In addition, as an insurance holding company, ICH is also subject to regulatory oversight in the states in which its insurance subsidiaries are domiciled. Primarily as a result of the failures of several large insurance holding companies during the past few years, increased scrutiny has been placed upon the insurance regulatory framework, and a number of state legislatures have enacted legislation that has altered, and in many cases increased, state authority to regulate insurance companies and their holding company systems. Further, some Congressional leaders have proposed legislation which could result in the federal government's assuming some role in the regulation of the insurance industry. In light of these developments, the National Association of Insurance Commissioners (the "NAIC") and state insurance regulators have also become involved in the process of re-examining existing laws and regulations and their application to insurance companies. In particular, this re-examination has focused on insurance company investment and solvency issues and, in some instances, has resulted in new interpretations of existing law, the development of new laws and the implementation of non-statutory guidelines. The NAIC has formed committees and appointed advisory groups to study and formulate regulatory proposals on such diverse issues as the use of surplus debentures, the accounting for reinsurance transactions, uniform investment laws and the adoption of risk-based capital requirements. In addition, in connection with its accreditation of states to conduct periodic examinations, the NAIC has encouraged and persuaded states to adopt model NAIC laws on specific topics, such as holding company regulations, the structure of reinsurance transactions, and the definition of extraordinary dividends. During 1992 and continuing in 1993, in part as a result of these activities, ICH's insurance subsidiaries became subject to substantially more oversight by insurance regulators, and such increased oversight will likely continue in 1994 and future periods. During 1992, a special working group (the "Group") of the NAIC, which included the representatives of seven states, conducted an extensive review of the operations and financial condition of ICH and CNC and their respective insurance subsidiaries. Retaining the services of an independent accounting firm, other than ICH's public accountants, the Group placed particular emphasis on reviewing transactions between related parties and major transactions with certain other unaffiliated companies, differences between GAAP and statutory reporting practices, cash flow projections, off-balance sheet risks and non-traditional investments, and the insurance subsidiaries' risk-based capital requirements. In December 1992, based on their review of the findings, the Group advised ICH they had material concerns about asset quality and the cash flow position of ICH. The asset quality concerns were discussed in detail in ICH's 1992 Annual Report on Form 10-K and, as indicated in such discussion, substantially all of the Group's concerns had already been addressed by ICH. Management believes that the Group's concerns regarding ICH's cash flow position were effectively overcome in 1993 by the sale of ICH's investment in BLHC and the successful completion of ICH's debt exchange offer. As a result of these events and the resolution of remaining asset quality concerns, the Group's utilization of other independent accountants to review the affairs of ICH and its subsidiaries has been effectively eliminated and management believes that regulators from the states in which ICH's insurance subsidiaries are domiciled were significantly more cooperative in granting the required approvals for ICH to accomplish the restructuring of its insurance holding company system. The Group has nevertheless indicated that it will likely continue to monitor, to the extent it deems appropriate, the activities and the operations of ICH and CNC and their respective insurance subsidiaries. However, based on the progress made to date in resolving concerns expressed by the Group, management does not anticipate that ICH will encounter any regulatory difficulty in proceeding with its corporate objective to grow its insurance operations through strategic acquisitions or other means. Life insurance companies are generally required under statutory accounting rules to maintain an asset valuation reserve ("AVR") which consists of two components: a "default component" to provide for future credit-related losses on fixed income investments and an "equity component" to provide for losses on all types of equity investments, including real estate. Life insurance companies are also required to maintain an interest maintenance reserve ("IMR"), which is credited with the portion of realized capital gains and losses from the sale of fixed maturity investments attributable to changes in interest rates. The IMR is required to be amortized against statutory earnings on a basis reflecting the remaining period to maturity of the fixed income securities sold and there are no limitations as to the amounts which can be accumulated in the IMR. At December 31, 1993, the AVR of ICH's insurance subsidiaries totaled $45.0 million. The IMR of such subsidiaries was insignificant. Increases in the AVR and the IMR do not reduce either statutory or GAAP operating income, but result in a reduction in the statutory surplus of ICH's insurance subsidiaries. Historically, insurance companies have been required to satisfy the minimum capital requirements of the states in which such companies were domiciled. Such minimum capital requirements tended to be relatively small, fixed dollar amounts that bore little, if any, reflection of the size of the company or the nature and diversification of the risks taken by the company. Over the past several years, the NAIC and various states have undertaken projects to develop risk-based capital ("RBC") requirements for insurance companies and model laws that would provide the framework for triggering a range of regulatory options in the event an insurance company failed to maintain adequate RBC levels. Effective with statutory annual statements filed for the year ending December 31, 1993 and thereafter, each life insurance company is required to calculate, utilizing NAIC formulas, their level of targeted adjusted capital. Such NAIC formulas focus on 1) asset impairment risks, 2) insurance risks, 3) interest rate risks, and 4) general business risks. A risk-based capital ratio ("RBC ratio") is then determined based on the company's level of adjusted capital and surplus, including AVR and other adjustments, to its targeted adjusted capital. In states which have adopted the NAIC regulations, the new RBC requirements provide for four different levels of regulatory attention depending on an insurance company's RBC ratio. The "Company Action Level" is triggered if a company's RBC ratio is less than 200% but greater than or equal to 150%, or if a negative trend has occurred (as defined by the regulations) and the company's RBC ratio is less than 250%. At the Company Action Level, the company must submit a comprehensive plan to the regulatory authority which discusses proposed corrective actions to improve its capital position. The "Regulatory Action Level" is triggered if a company's RBC ratio is less than 150% but greater than or equal to 100%. At the Regulatory Action Level, the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. The "Authorized Control Level" is triggered if a company's RBC ratio is less than 100% but greater than or equal to 70%, and the regulatory authority may take any action it deems necessary, including placing the company under regulatory control. The "Mandatory Control Level" is triggered if a company's RBC ratio is less than 70%, and the regulatory authority is mandated to place the company under its control. Management believes that the levels of capital in ICH's insurance subsidiaries is sufficient to meet RBC requirements. Based on the NAIC's formulas, the RBC ratios for all but one of ICH's life insurance subsidiaries, based on financial statements as filed with regulatory authorities, exceeded 325% at December 31, 1993. One subsidiary's RBC ratio approximated 250% and management is in the process of evaluating alternatives to achieve at least a 300% RBC ratio for such subsidiary by year-end 1994. From time to time, assessments are levied on ICH's insurance subsidiaries by life and health guaranty associations in states in which they are licensed to do business. Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. ICH's insurance subsidiaries, other than Bankers and Certified, paid assessments of $3.2 million, $2.2 million and $1.2 million in the years 1993, 1992 and 1991, respectively. Bankers and Certified paid assessments of $.6 million and $1.7 million for the ten months ended October 31, 1992 and the year 1991, respectively. Although the economy and other factors have recently caused the number and size of insurance company failures to increase, based on information currently available, ICH believes that any future assessments are not reasonably likely to have a material adverse effect on its insurance subsidiaries. INVESTMENT PORTFOLIO ICH pursues an investment strategy principally designed to balance the duration of investment assets against the liabilities of its insurance subsidiaries for future policy and contract benefits and, under certain circumstances, to manage its exposure to changes in market interest rates. Over the past several years, ICH has taken steps to restructure its investment portfolio in order to improve the overall quality of the portfolio. While these actions have resulted in substantially reduced exposure to credit risks, average yields have decreased from 9.1% in 1991 to 8.3% in 1992 and 6.9% in 1993. As a result of the investment portfolio restructuring, substantial investments were made in mortgage-backed securities and collateralized mortgage obligations in 1991 which were highly sensitive to subsequent changes in market interest rates and which contributed to the decline in investment yields. Further, the overall decline in market interest rates over the past several years has had a significant impact on ICH's ability to maintain the level of earnings on its invested assets. In accordance with applicable insurance laws, ICH's insurance subsidiaries maintain substantial portfolios of investment assets that are held, in large part, to fund their future contractual obligations to policyholders. In structuring these portfolios, ICH has emphasized, and expects to continue to emphasize, investments in fixed maturities. In addition, ICH has maintained significant levels of short-term investments to meet its liquidity needs. Since 1991, fixed maturities and short-term investments have represented more than 75% of ICH's consolidated investments, while no other category of investment represented more than 10%. Additional information regarding the categories and amounts of ICH's investment assets is reflected in Note 5 of the Notes to Financial Statements. During 1993, the NAIC initiated the process of drafting a model investment act. In general, the currently drafted investment act is substantially more restrictive than the present investment laws of the states in which ICH's insurance subsidiaries are domiciled. Management cannot predict with any certainty whether or when such a model investment act will be adopted and whether such act will "grandfather" certain existing investments. However, if adopted, it is likely that such model investment act will significantly limit the types of investments that can be made by ICH's insurance subsidiaries in future periods, as well as the amounts that can be invested in various investment categories, and could result in an overall reduction in investment yields. Prior to 1992, ICH had carried all of its fixed maturities at amortized cost (less permanent declines), because management had stated its intent and believed ICH had the ability to hold all such investments to their ultimate maturities. If a determination was made to dispose of particular fixed maturity investments, the carrying values of such investments were adjusted to the lower of cost or market value. In 1992, management evaluated ICH's investment strategy, specifically in light of the sale of Bankers and ICH's need for liquidity. Based in part on ICH's decision to retain three independent investment advisors during 1992 to manage in excess of $1 billion of its investments, management determined that ICH's fixed maturities would be classified into three categories effective December 31, 1992. Fixed maturity investments which were determined to be readily marketable were classified as "actively managed" and adjusted to their fair value through an adjustment to unrealized investment gains and losses in stockholders' equity. Those investments which ICH intended to sell, primarily certain mortgage-backed securities, were classified as "held for sale" and were adjusted to their fair value (if lower than cost) through a charge to earnings. Certain private placement securities which were not readily marketable and which ICH had both the ability and the positive intent to hold to maturity were classified as "held to maturity" and carried at amortized cost. In April 1993, the Financial Accounting Standards Board adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 expands the use of fair value accounting for certain investments in debt and equity securities and requires that financial institutions classify their fixed maturity investments into three categories. Fixed maturity investments that an entity has the positive intent and ability to hold to maturity are to be classified as "held to maturity" and will continue to be reported at amortized cost. Fixed maturity and equity investments available for sale, which may or may not be traded before maturity, are to be marked to their current value, with any unrealized gains and losses reported as a separate component of stockholders' equity. Finally, fixed maturity and equity investments held only for trading must be marked to their current value, with any unrealized gains or losses reflected in earnings. SFAS No. 115 is required to be adopted for 1994 financial statements, but earlier adoption is encouraged. In 1993, ICH adopted the provisions of SFAS No. 115 and has categorized its fixed maturity and equity investments into two categories, available for sale and held to maturity. At year-end 1993, ICH and its subsidiaries did not hold any securities which would meet the criteria of being classified in a trading category. In its 1992 balance sheet, ICH has reclassified its "actively managed" and "held for sale" fixed maturities as available for sale. ICH's fixed maturity portfolio generally includes government and corporate debt securities and mortgage-backed securities. Historically, this portfolio has been structured in part to balance desirable yields with credit concerns. ICH has concentrated its fixed maturity investments within categories that are rated investment-grade, while in certain instances holding selected noninvestment-grade securities that provide higher yields. ICH classifies its high-yield securities as noninvestment-grade if they are unrated or are rated less than BBB-by S&P or Baa by Moody's. Based on such classifications, ICH's noninvestment-grade fixed maturities represented 4.0% of ICH's consolidated investment portfolio at year-end 1993 as compared to 3.8% at year-end 1992 and 4.7% at year end 1991. Following is a summary of fixed maturity investments segregated by investment quality based on S&P ratings and the two categories of such investments as reflected in ICH's consolidated balance sheet at December 31, 1993 (in millions): Investments in noninvestment-grade debt securities generally have greater risks than investment-grade securities. Risk of loss upon default by the borrower is greater with noninvestment-grade securities because these securities are generally unsecured and often are subordinated to other creditors of the issuers, and because the issuers have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recessions or increasing interest rates, than are investment-grade issuers. ICH's subsidiaries hold substantial investments in mortgage-backed securities and collateralized mortgage obligations (collectively, "CMOs"). These investments generally offer relatively high yields and, because of the quality of the underlying collateral, are usually given the highest ratings by S&P and Moody's. Beginning in late 1990 and continuing through 1991 management utilized a strategy of investing in CMOs to enhance the credit quality of ICH's investment portfolio without incurring a reduction in investment yields. At year-end 1993, CMO's totaling $798.1 million represented 46.5% of ICH's fixed maturity investments and 30.2% of total invested assets. Of this amount, $709.2 million represented conventional CMO obligations with principal guarantees that are reflected as available for sale and carried at their fair value and $88.9 million primarily represented so-called derivative CMOs, such as residual interests in a pool or pools of mortgage loans, of which $72.7 million are reflected as available for sale at their fair value and $16.2 million are reflected as held to maturity and carried at amortized cost. As reflected in its year-end 1992 financial statements, ICH held mortgage-backed residual interests and interest-only certificates ("IOs") with a carrying value and fair value of $422.7 million. Such year-end values were reflected net of reserves for anticipated losses in 1993 totaling $34.9 million, which had been provided based on the prepayment experience incurred and expected on the mortgage loans underlying such residual interests and IOs through the first three months of 1993. At June 30, 1993, the carrying value and fair value of such investments had declined to $358.3 million as a result of principal repayments. Based on an analysis of subsequent prepayment experience, management believed that the reserves provided at year-end 1992 had been adequate and, as a consequence, ICH did not incur any significant additional losses on its residual interests and IOs during the first six months of 1993. Effective July 30, 1993, ICH and its subsidiaries, along with CFLIC, entered into a transaction designed to substantially reduce their exposure to the prepayment risks associated with their investments in residual interest and IO mortgage-backed securities, including liquidating a substantial portion of such investments. ICH's subsidiaries and CFLIC sold directly-owned residual interests and IOs with a carrying value of approximately $137.7 million and $26.5 million, respectively, to an unaffiliated third party, Fund America Investors Corporation II ("Fund America"). In addition, ICH and CFLIC sold to Fund America 75% of their rights with respect to residual interests in certain mortgage-backed securities which were acquired in conjunction with the sale of Bankers and are held in a special-purpose trust (the "Trust") to collateralize certain mortgage note obligations (see Note 3 of the Notes to Financial Statements included elsewhere in this Report). CFLIC had acquired its interest in the Trust as previously discussed under "Transactions With Consolidated Fidelity Life Insurance Company." Because ICH was deemed to be the Trust's sponsor and, with CFLIC, retained a majority ownership in the residual interest, the accounts of the Trust were included in ICH's consolidated balance sheet at year-end 1992 and at June 30, 1993. Following is a summary of the various accounts of the Trust as reflected in ICH's balance sheet at June 30, 1993, and ICH's net residual interest in the Trust (in millions): The net carrying value of the 75% interests in the Trust sold by ICH and CFLIC to Fund America approximated $7.0 million and $33.7 million, respectively, at the date of sale. Fund America sponsored the formation of a new trust (the "New Trust") into which it deposited the purchased securities. Interests in the New Trust aggregating $217 million, or 68.4% of its total outstanding securities, were sold to other unaffiliated parties. A portion of the sales proceeds were utilized to acquire additional securities which were deposited into the New Trust, including certain securities maturing in 2030 designed to assure the ultimate return of principal on the interests in the New Trust retained by ICH, its subsidiaries and CFLIC. The remaining proceeds, after underwriting expenses, were utilized to pay a portion of the purchase price for the securities purchased from ICH and its subsidiaries and CFLIC. The remainder of the purchase price was paid by issuing participation certificates representing residual interests in the pool of $101.0 million principal amount of securities placed in the New Trust. The participation certificates received in the transaction were valued for financial reporting purposes at their fair value, assuming an 11% annual return to maturity. Before the recognition of gains totaling approximately $14.3 million resulting from the disposal of certain securities utilized to hedge prepayment risks on the mortgage-backed securities, the transactions resulted in losses for ICH and CFLIC totaling approximately $23.1 million. ICH reflected its portion of the losses resulting from these transactions as realized investment losses in its 1993 results. Following is a summary of the effects of the above-described transactions: Because ICH and CFLIC no longer hold a direct or indirect majority interest in the Trust and have not guaranteed any portion of the collateralized mortgage note obligations, the accounts of the Trust have not been consolidated with those of the Company for periods subsequent to the sale to Fund America on July 30, 1993. Management had originally intended to reflect ICH's investments in the Fund America certificates, its remaining interest in the Trust, and its investments in certain other residual interests at their amortized cost in the held to maturity category of fixed maturities to eliminate the accounting volatility associated with these types of investments. In late 1993, the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board addressed "Impairment Recognition for a Purchased Investment in a Collateralized Mortgage Obligation Investment or in a Mortgage-Backed Interest-Only Certificate", in their EITF Issue No. 98-13. The focus of the EITF issue involved the criteria to be used to determine when writedowns should be taken on these types of investments as a result of the issuance of SFAS No. 115. ICH had previously determined when writedowns would be taken, based on an earlier EITF consensus, utilizing the undiscounted expected future cash flows on these types of investments. The writedown required under this approach was the amount necessary to reduce the carrying value of an individual security to a zero expected future yield and was reflected as a realized investment loss. The EITF reached a tentative consensus that the criteria for determining when future writedowns were required should be based on the discounted expected future cash flows, utilizing a "risk-free" rate of return. If the discounted cash flows are less than the carrying value of the investment, a permanent impairment in the value of the investment is to be recognized. Under the provisions of SFAS No. 115, if impairment is indicated, an individual security should be written down to its fair value as a new cost basis and the writedown should be accounted for as a realized loss. ICH has implemented the provisions of EITF Issue No. 93-18 and, in conjunction with its adoption of SFAS No. 115 effective as of December 31, 1993, has reflected writedowns relative to certain residual interest mortgage-backed securities totaling $4.9 million, net of tax effects. Such writedowns have been reflected as the cumulative effect of a change in accounting method in the 1993 statement of earnings. The EITF is also expected to address at a meeting scheduled for March 24, 1994, whether, due to their nature, these types of investments can ever be classified as held to maturity under the provisions of SFAS No. 115. Authoritative sources have indicated that the EITF will likely require that these types of investments be classified as available for sale and be reflected at their fair value. Accordingly, at December 31, 1993, ICH has classified its investments in the Fund America certificates and its remaining investment in the Trust as available for sale and has reduced the carrying value of such investments from $95.5 million to their estimated fair value of $67.1 million. Such reduction, totaling $28.4 million, has been reflected as an unrealized investment loss through a charge to stockholder's equity. The fair value of these investments was estimated by an investment banking firm assuming an 11% annual return to maturity. At December 31, 1993, mortgage loans principally involving commercial real estate totaled $138.5 million, representing approximately 5.2% of ICH's investment portfolio. ICH has a stated policy of not directly initiating or making new mortgage loans, except under limited circumstances, including primarily loans to finance sales of company-owned real estate. New mortgage loans have totaled approximately $3.1 million, $17.0 million and $12.2 million during 1993, 1992 and 1991, respectively. Substantially all other mortgage loans owned by ICH and its subsidiaries were as a result of acquisitions of life insurance companies in 1986 and prior years. Delinquencies on mortgage loans in excess of 60 days represented approximately .2% of total mortgage loans outstanding, as compared to 4% at year-end 1992. Management believes that its mortgage loan portfolio is well seasoned and that the collateral underlying these mortgage loans is sufficient to recover the carrying value of such investments and, as a result, no significant losses should be incurred. Real estate investments totaling $67.5 million and home office real estate totaling $13.3 million represented 2.5% and .5% of ICH's investment portfolio, respectively, at December 31, 1993. ICH has a stated policy of not directly making real estate investments, except for foreclosures on its existing mortgage loans. Mortgage loan foreclosures totaled $3.2 million, $5.7 million and $20.9 million for the three years 1993, 1992 and 1991, respectively. During 1993, ICH completed its obligation to purchase certain real estate from former subsidiaries for approximately $19 million. In addition, in conjunction with the sale of Bankers in 1992, ICH purchased all of the real estate held by Bankers, primarily its home office real estate, for $9 million. Bankers has entered into a long-term lease for a portion of the property sold to ICH and ICH is attempting to sell the remaining properties. The Bankers real estate has been independently appraised at a value in excess of ICH's carrying value. At December 31, 1993, ICH and its subsidiaries held limited partnership interests in various partnerships with a carrying value totaling $43.6 million, as compared to $39.8 million at year-end 1992 and $36.9 million at year-end 1991. These investments were made primarily to participate in the potential appreciation resulting from certain leveraged buyouts and corporate reorganizations. In addition, included in such investments at year-end 1993 was a $25.0 million investment, representing a 49% limited partnership interest, in a partnership formed to acquire through auction certain mortgage loans and real estate formerly held by failed savings and loan associations for resale. ICH believes that on a selective basis these investments offer attractive risk-adjusted returns; however, such investments are not readily marketable and, in the event of a need for liquidity, ICH may be unable to quickly convert such investments into cash. See Note 6 of the Notes to Financial Statements for additional information regarding ICH's investments in limited partnerships. Included in the limited partnership investments at year-end 1991 was ICH's 21.4% interest in Conseco Capital Partners, L.P. ("Predecessor CCP") with a carrying value of $17.0 million. In 1992, Predecessor CCP formed a new insurance holding company, CCP Insurance, and completed an initial public offering of shares of CCP Insurance common stock. ICH's subsidiaries received 1,764,439 shares of CCP Insurance in exchange for their investment in Predecessor CCP and ICH's subsidiaries acquired an additional 525,000 shares of CCP Insurance through its offering. In September 1993, CCP Insurance completed an underwritten primary and secondary offering of shares of its common stock. ICH's subsidiaries sold all of their 1,764,439 shares of CCP insurance common stock in the offering and realized investment gains totaling $27.8 million. In addition, during 1993, ICH's subsidiaries sold 455,375 of the 525,000 shares of CCP Insurance acquired in its initial public offering and realized additional investment gains totaling $5.3 million. Included in the limited partnership investments at year-end 1992 and 1991 was ICH's investment in the HMC/Life Partners, L.P. with a carrying value of approximately $5.0 million. During March 1993, Life Partners Group, Inc. ("LPG"), the holding company formed to acquire certain subsidiaries from ICH in 1990, completed an initial public offering of 15.2 million shares of its common stock, or a 58.5% interest in LPG, at $17 per share. ICH had acquired a 31% interest in the HMC/Life Partners, L.P. at the time of the sale of such subsidiaries and the partnership, in turn, directly owned 5.1 million shares of the LPG common stock. Based on an assumed liquidation of the partnership and distribution of shares under provisions of the partnership agreement, the holder of ICH's partnership interest would be entitled to receive shares of LPG common stock with a fair value at December 31, 1993, of approximately $21.3 million, or $16.3 million more than the adjusted cost of ICH's investment in the partnership. As discussed earlier under "Transactions With Consolidated Fidelity Life Insurance Company," the investment in the HMC/Life Partners, L.P. was transferred to CFLIC in exchange for preferred stock as the first step in a series of transactions to terminate certain reinsurance arrangements involving CFLIC and Southwestern. During 1993, two other companies controlled by partnerships in which ICH's subsidiaries had ownership interests completed initial public offerings of shares of their common stock. Assuming a liquidation of the partnerships and a distribution of the shares of common stock held by the partnerships, ICH's subsidiaries would be entitled to receive shares of common stock with a fair value totaling $5.3 million in excess of their adjusted cost basis in such partnerships. At December 31, 1993, the carrying values of such partnership interests were adjusted to reflect the increase in value, with a corresponding increase in unrealized investment gains reflected in stockholders' equity. In addition, during 1993, ICH reflected a $5.0 million writeoff of a partnership interest through realized investment losses following the commencement of bankruptcy proceedings by the company controlled by such partnership. At December 31, 1993, ICH had pre-tax unrealized investment gains totaling $33.9 million, consisting of $21.4 million of unrealized gains related to available for sale fixed maturities, $7.2 million of unrealized gains attributable to equity securities, and $5.3 million of unrealized gains attributable to investments in limited partnerships. Such unrealized investment gains are reflected in stockholders' equity, net of a $10.4 million adjustment in deferred policy acquisition costs and other policy liabilities, a $5.2 million adjustment for the minority interest in certain unrealized investment losses and $8.2 million in deferred income tax effects. At December 31, 1992, pre-tax unrealized investment gains totaled $28.5 million, of which $24.1 million was attributable to ICH's equity investment in CCP Insurance, and were reflected in stockholders' equity, net of $9.7 million in deferred income tax effects. The unrealized gains related to available for sale fixed maturities are primarily as a result of declines in market interest rates between the two dates. Except as may be required to meet its liquidity requirements, ICH has no current plans over the near-term to liquidate a significant portion of such available for sale fixed maturities to realize such gains. The following table reflects investment writedowns which were included in realized investment gains or losses during each of the three years in the period ending December 31, 1993: The writedowns in fixed maturity investment in 1993 and 1991 were related to noninvestment-grade securities. As a result of reductions in market interest rates and a corresponding increase in mortgage loan refinancings, ICH incurred substantial writedowns related to its residual interests and interest-only CMOs in 1992. As previously discussed, ICH substantially reduced its exposure to such investments and, except for $7.6 million of writedowns taken in conjunction with the adoption of SFAS No. 115 reflected as a cumulative effect of a change in accounting method, there were no similar writeoffs during 1993. Investment real estate writedowns have increased over the three year period as a result of the general deterioration in real estate markets. Because of the factors discussed above, ICH's losses on its mortgage loan portfolio have been nominal during the three year period. The $18.4 million writedown in 1991 related to a reinsurance treaty with Executive Life Insurance Company. Such treaty was terminated in 1992 without further writedowns required. LIQUIDITY AND CAPITAL RESOURCES ICH reduced its reported indebtedness by $75.5 million in 1991, $162.8 million in 1992 and $125.3 million in 1993. Such reductions totaling $363.6 million were effected primarily through ICH's prepayment of $168.4 million of senior secured debt and subordinated debt with proceeds from the sale of Bankers in 1992 and BLHC in 1993, through a $45 million prepayment of senior secured indebtedness in 1992, and through the payment of $146 million of scheduled subordinated debt sinking fund and principal installments. The following table sets forth, for the periods indicated, certain ratio data regarding the operations of ICH and its consolidated subsidiaries. Pro forma ratio data is presented as if the sale of Bankers and ICH's investment in BLHC had occurred as of the beginning of each period presented and is based on the same assumptions utilized in preparing the pro forma results of operations reflected in Note 2 of the Notes to Financial Statements, including elimination of the after-tax gains on the sales of Bankers in 1992 and the Company's investment in BLHC in 1993. Realized investment losses (resulting primarily from writedowns) reduced operating earnings by $119.1 million and $26.4 million for 1992 and 1991, respectively. See "Insurance Operations" following for additional information regarding items of an infrequent and non-recurring nature which have affected ICH's operating results. INSURANCE OPERATIONS The primary sources of liquidity for ICH's insurance subsidiaries include operating cash flows and short-term investments. The net cash provided by operating activities and by policyholder contract deposits of ICH and its subsidiaries, after the payment of policyholder contract withdrawals and benefits, operating expenses, and interest requirements approximated $87.7 million in 1992 and $220.7 million in 1991. In 1993, such operating cash flows resulted in net cash requirements totaling approximately $205.5 million. Exclusive of withdrawals by holders of GICs as discussed below, cash provided by operating activities during 1993 totaled approximately $124.5 million. ICH believes that its short-term investments are readily marketable and can be sold quickly for cash. Cash and short-term investments totaled $366.9 million, or 14% of consolidated investments, at year-end 1993, compared to $421.8 million or 14% at year-end 1992 and $386.5 million or 9% at year-end 1991. The principal requirement for liquidity of ICH's insurance subsidiaries is their contractual obligations to policyholders, including policy loans and payments of benefits and claims. As a result of continued cash flows of its insurance subsidiaries, ICH believes that reserves maintained by such subsidiaries have been adequate to pay policy benefits and claims. Further, policy loans by ICH's subsidiaries have represented 7% or less of ICH's consolidated investment assets during the past three years. As previously discussed, the claims-paying ratings assigned to certain of ICH's subsidiaries by various nationally recognized statistical ratings organizations were lowered during 1992 and 1993. Except for withdrawals made by certain GIC holders, management believes ICH's subsidiaries have not experienced more than normal policy surrenders and withdrawals as a result of these ratings downgrades. For the year ended December 31, 1993, policyholder contract withdrawals, principally GICs, exceeded policyholder contract deposits by approximately $207.4 million. Withdrawals by GIC holders totaled $329.0 million. Approximately $184.3 million of such withdrawals represented scheduled maturities of GICs which were not reinvested with an ICH subsidiary. In addition, as a result of the previously discussed restructuring of ICH's holding company system, the surplus of such subsidiary was significantly reduced and, as a consequence, some policyholders became entitled to an early withdrawal of their GICs. The subsidiary also voluntarily offered certain other GIC holders the right of early withdrawal. Unscheduled and early GIC withdrawals totaled $144.7 million. Because of its available liquidity and readily marketable securities, the subsidiary has not encountered, and management does not anticipate that the subsidiary will encounter, any difficulty in meeting its obligations relative to such withdrawals. The substantial withdrawal of GICs during 1993 is expected to have a positive effect on ICH's future results of operations because the rates of interest being credited to such GICs exceeded the rates ICH's subsidiary was earning on the related invested assets. Certain of ICH's insurance subsidiaries have ceded blocks of insurance to unaffiliated reinsurers to provide funds for financing acquisitions and other purposes. These reinsurance transactions, or so-called "surplus relief reinsurance," represent financing arrangements and, in accordance with generally accepted accounting practices, are not reflected in the accompanying financial statements except for the risk fees paid to or received from reinsurers. Net statutory surplus provided by such treaties before tax effects totaled $51.5 million at December 31, 1993, or approximately 41% less than the $87.5 million of surplus relief at December 31, 1992. These arrangements are expected to terminate over the next several years through the recapture of the ceded blocks of business and such recaptures will result in a charge to the statutory earnings of the recapturing companies. During 1993, a treaty that had provided approximately $22.2 million of surplus relief for an ICH subsidiary as of year-end 1992 was recaptured in conjunction with ICH's restructuring of its insurance holding company system. PARENT COMPANY The primary sources of liquidity for ICH have historically included dividends and loans from its insurance subsidiaries and payments of principal and interest on surplus debentures issued by certain insurance subsidiaries. As previously discussed, in 1993, the sale of ICH's investment in BLHC provided a substantial amount of liquidity for the parent company. The unpaid principal balance of surplus debentures issued to ICH by its insurance subsidiaries totaled $247.6 million at December 31, 1992 and $607.2 million at December 31, 1991. Of the 1992 amount, surplus debentures in the aggregate unpaid principal amount of $141.8 million was payable by Southwestern and $105.8 million was payable by Modern American. In 1993, Southwestern repaid the remaining balance on its surplus debenture utilizing proceeds from its 1992 sale of Bankers. In the restructuring of ICH's insurance holding company system in 1993, the surplus debenture from Modern American was retired and added to ICH's investment in its subsidiaries. At December 31, 1993, there were no remaining surplus debentures due ICH by its subsidiaries. State insurance laws generally restrict the ability of insurance companies to make loans to affiliates or to pay cash dividends in excess of the greater of such companies' net gains from operations during the preceding year or 10% of their policyholder surplus determined in accordance with accounting practices prescribed by such states. These regulatory restrictions historically have not affected the ability of ICH to meet its liquidity requirements. However, certain states in which ICH's subsidiaries are domiciled, including New York and Kentucky, have adopted laws that have restricted the payment of cash dividends to the lesser of such companies' net gains from operations or 10% of their policyholder surplus. Other states may consider similar legislation in future periods or may consider legislation that would base the level of cash dividends which may be paid to the maintenance of specified risk-based capital levels. The adoption of such laws could significantly reduce the level of cash dividends that could be paid without regulatory approval. ICH received cash dividends from Modern American totaling $149 million in 1991, but received no cash dividends from its insurance subsidiaries in either 1993 or 1992. In 1992, Modern American agreed with the Missouri Department of Insurance that it would not pay any dividends without obtaining the prior approval from the Missouri Department and, in 1993, Southwestern agreed with the Texas Department that it would not pay any dividend without giving it thirty days prior notice. The restructuring of ICH's insurance holding company system in 1993 substantially reduced the size of Modern American and it no longer holds title to the common stock of any of ICH's insurance subsidiaries. Therefore, the restrictions on Modern American's ability to pay dividends are not expected to have a significant affect on future dividends to ICH from ICH's subsidiaries. In addition, as a result of the restructuring, all of ICH's insurance subsidiaries, other than Constitution Life Insurance Company and Bankers Life and Casualty Company of New York, are aligned horizontally beneath ICH and, as a consequence, are expected to be able to make direct payments of dividends to ICH in future periods. Prior to 1992, ICH had issued demand and collateralized notes to certain of its subsidiaries in order to meet short-term liquidity requirements. At December 31, 1991, ICH's obligations to its subsidiaries under such notes, including accrued interest thereon, totaled $47.6 million. Although management believed such loans met the investment criteria of the various states, during 1993 and 1992 ICH repaid all of such obligations to its subsidiaries. ICH does not intend to utilize such borrowings in future periods. ICH's principal needs for liquidity are debt service and, to a lesser extent, preferred dividend requirements. ICH's consolidated indebtedness totaled approximately $418.0 million at December 31, 1993, compared to $543.3 million at December 31, 1992, and $706.1 million at December 31, 1991. Substantially all indebtedness of ICH was incurred in the connection with acquisitions of subsidiaries in periods prior to 1987, including collateralized senior debt and unsecured subordinated debt, a portion of which was exchanged for new debt in 1993. See Note 3 of the Notes to Financial Statements for additional information regarding ICH's consolidated indebtedness, including annual maturities. Primarily as a result of the sale for cash of ICH's interest in BLHC in 1993, ICH believes that it has adequate resources to meet its existing commitments, including preferred stock dividends, for all of 1994. The following table reflects ICH's cash sources and requirements on a projected basis for 1994 and on an actual basis for 1993. Cash available at the end of 1993 includes approximately $60.3 million of readily marketable fixed maturity investments which were acquired for the purpose of obtaining higher yields than could be achieved through holdings in short-term investments. The 1994 projected cash requirements assume no sinking fund payments relative to ICH's Old Notes. See "Changes in Capital Structure" for a discussion of ICH's options relative to sinking fund requirements in 1994. In addition, the 1994 projections assume that the CFLIC transactions with ICH will be effected during the 1994 second quarter, including the redemption of CFLIC's preferred stock by the return to ICH of its $30 million senior secured loan and ICH's Series 1986-A and Series 1987-B preferred stocks. See "Transactions With Consolidated Fidelity Life Insurance Company." As a result of the acquisition and retirement of ICH's Class B Common Stock in early 1994, management now believes that ICH has improved its ability to refinance its presently outstanding debt at substantially reduced interest rates. Such a refinancing is, of course, dependent on numerous factors, such as an improvement in the ratings assigned by nationally recognized statistical rating organizations, market interest rates, a successful underwriting, and other factors. ICH intends to monitor these factors closely over the next several months to determine whether such a refinancing is possible. There can be no assurance that ICH will, in fact, attempt to restructure its presently outstanding debt; however, in the event that it does, the 1994 projected cash sources and requirements as reflected above could materially change. ICH's actual cash sources in 1993 were approximately $295.6 million more than were previously projected for 1993, substantially all of which were attributable to ICH's sale of its investment in BLHC for $287.6 million. Actual cash requirements in 1993 exceeded projected requirements by approximately $174.3 million. Significant items that were not included in the 1993 projections and that accounted for a substantial portion of the increase in cash requirements include ICH's redemption of $100 million of its outstanding preferred stock, an additional $45.9 million redemption of its Debentures, and intercompany income tax allocation payments to ICH's insurance subsidiaries totaling $15.0 million. The increase in tax allocation payments was a result of the BLHC transaction which resulted in a taxable gain and reimbursement to ICH's subsidiaries for utilization by ICH of their tax loss carryforwards. Primarily as a result of the increase in cash sources, which was not completely offset by an increase in cash requirements, available cash and marketable securities at the end of 1993 was approximately $121.3 million more than originally projected. RESULTS OF OPERATIONS ICH's results in 1993 and 1992 have been affected by numerous items of an infrequent and non-recurring nature. In 1993, ICH realized significant gains on the sale of its investment in BLHC, other invested assets, and the termination of a reinsurance arrangement with Bankers, and realized a benefit from the change in corporate income tax rates. In addition, significant writedowns of certain capitalized costs and operating facilities were taken in connection with the continuation of an operational consolidation and provisions were made for the costs associated with agreements entered into with ICH's former controlling shareholders and certain other contingencies. In 1992, ICH realized a gain on the sale of Bankers, which was offset by charges for significant losses on the portfolio of CMO residual interests and IOs, a litigation settlement, costs incurred to modify a data processing services arrangement, and costs incurred or accrued relative to an operational consolidation. The following table reflects the results of ICH's basic operations from 1991 through 1993 and the effects that the above described charges and credits had on ICH's operating results for each of the three years. The decline in pre-tax operating earnings from $59.6 million in 1991 to $47.7 million in 1992 was attributable, in part, to including Bankers' results for only the first ten months of 1992 compared to the full year in 1991. ICH was unable to effectively redeploy the proceeds from the sale of Bankers during the last two months of 1992 to replace the reduction in operating earnings resulting from such sale. In addition, a reduction in yields on invested assets between 1991 and 1992 contributed to a narrowing of the spreads between earnings on invested assets and interest credited to policyholders' accounts or required to meet policyholder obligations and further contributed to the reduction in operating earnings. The decline in the pre-tax operating earnings of $47.7 million to a pre-tax operating loss of $6.6 million in 1993 reflects, in part, the exclusion of Bankers' results for all of 1993. ICH did reflect its equity in the operating results of BLHC for the first nine months of 1993 totaling $29.1 million. However, ICH was still unable in 1993 to redeploy proceeds from the sale to fully replace the earnings of Bankers. Following the sale of its interest in BLHC in September 1993, ICH has methodically proceeded to utilize its available liquidity to further reduce the costs of its capital structure, but during the interim period has had to maintain larger than desirable amounts invested in lower-yielding short-term investments. In addition, interest spreads relative to ICH's insurance operations further narrowed in 1993 resulting in reduced operating earnings, and ICH incurred sizeable losses in its group health operations. ANALYSIS OF OPERATING RESULTS BY INDUSTRY SEGMENT ICH's major industry segments consist of individual life insurance, individual health insurance, group and other insurance, accumulation products, and corporate (including surplus investment). The following table sets forth the consolidated revenues, expenses, pre-tax operating earnings and product sales attributed or allocated to each industry segment. "Pre-tax operating earnings (loss)" reflected in the table represent ICH's consolidated operating earnings or loss before realized investment gains or losses, corporate interest expense, amortization of excess cost, provision for income taxes, the cumulative effect of accounting changes, and extraordinary gains and losses. See Note 17 of the Notes to Financial Statements and Schedule V of the Financial Statement Schedules for additional information regarding ICH's segment results. INDIVIDUAL LIFE. Revenues of the individual life insurance segment accounted for approximately 37.8% of consolidated revenues excluding corporate revenues and realized investment gains and losses in 1993, as compared to 20% in 1992 and 21% in 1991. Such increase in 1993 is directly attributable to the sale of Bankers in 1992. Bankers revenues had been derived predominantly from sales of individual health insurance products and, as a result of the sale, the relative proportion of ICH's revenues attributable to the individual life insurance segment increased significantly. Most individual life insurance sales over the last three years were of universal and interest-sensitive life insurance products, although several new traditional whole life products were introduced into the marketplace during 1993. Exclusive of sales by Bankers, individual life sales have declined from $21.0 million in 1991 to $14.0 million in 1992 to $13.1 million in 1993. Management believes these declines are attributable to the downgrade in the claims-paying rating of ICH's most significant life insurance subsidiary, Southwestern, and to slow market acceptance of several new products introduced during 1991. However, as a result of changes in marketing strategies to target sales in the senior citizen marketplace and the new products introduced in 1993, sales of individual life insurance products increased significantly in the latter half of 1993, exceeding sales during the comparable period in 1992. Pre-tax operating earnings of the individual life insurance segment decreased from $80.0 million in 1991 to $42.5 million in 1992, but increased to $45.1 million in 1993. Included in pre-tax operating earnings in 1993 was a non-recurring gain on the termination of a reinsurance arrangement between an ICH subsidiary and Bankers totaling $22.6 million. Excluding such gain, pre-tax operating earnings in 1993 totaled $22.5 million. Bankers derived substantial profits from its individual life insurance business and the sale of Bankers accounts for a significant portion of the decline in pre-tax operating earnings of this segment. Declining market interest rates and the reduced yields earned by ICH on its investment portfolio have also contributed to the decline in the operating profits of this segment. Over one-half of ICH's life insurance reserves represent reserves on traditional life insurance products having fixed contractual interest rates. Consequently, declining investment yields have resulted in significantly reduced profit margins on the traditional block of business. Remaining life insurance reserves consist primarily of reserves on interest-sensitive products and credited rates on such policies have been and are continuing to be reduced to correspond with the decline in yields on investments. Management expects to continue to emphasize growth in its individual life insurance segment and, barring a further decline in investment yields, believes the changes made in its marketing strategies and the introduction of new products in 1993 will result in increased sales of individual life insurance products and an improvement in the operating results of this segment in 1994. INDIVIDUAL HEALTH. Sales and revenues in the individual health segment declined significantly in 1993 as a result of the sale of Bankers. Individual health premiums earned by Bankers represented approximately 74.8% of total individual health premiums in 1992 and 75.7% in 1991. The individual health premiums earned in 1993 and the remaining premiums earned in each of 1992 and 1991 were primarily attributable to Union Bankers Insurance Company ("Union Bankers") and Bankers Multiple Line Insurance Company ("Bankers Multiple"), former Bankers subsidiaries which were retained by ICH when Bankers was sold. Union Bankers has emphasized the sale of Medicare supplement products through brokerage agencies. Bankers Multiple specializes in the sale of comprehensive health products through a large general agency. Another ICH subsidiary, Integrity National Life Insurance Company, sells individual health insurance products, primarily Medicare supplement business, in the home service market. Exclusive of Bankers in 1992, new sales of individual health products increased from $60.3 million in 1992 to $63.6 million in 1993 and premiums earned increased from $216.2 million in 1992 to $220.3 million in 1993. The ratio of policy benefits to premiums earned (exclusive of Bankers) declined from 68.4% in 1992 to 62.3% in 1993, resulting in an approximately $15.0 million improvement in the gross operating margins of ICH's insurance subsidiaries. Management expects to continue to emphasize growth in the individual health segment, primarily in the senior citizens market through the sales of Medicare supplement and long-term care, or nursing home, products. GROUP AND OTHER INSURANCE. New sales of group life and health insurance increased from $47.3 million in 1991 to $61.9 million in 1992, but declined to $41.2 million in 1993. All sales of new group business in 1993 were made by Philadelphia American Life Insurance Company ("Philadelphia American"), as were substantially all new sales in 1992. Several large group health cases were added at the end of 1992, increasing the volume of new 1992 sales; however, primarily as a result of competitive factors, Philadelphia American purposely did not attempt to achieve the same level of new sales during 1993. In addition to revenues from sales of group insurance products, Philadelphia American derives substantial revenues from administrative services only ("ASO") contracts whereby it process claims for non-affiliated groups without assuming underwriting risks. Bankers Multiple also underwrites a profitable real estate agents errors and omissions product, the results of which are included in the group and other insurance segment. While sales of new group business declined during 1993 as compared to 1992, earned premiums of this segment (excluding Bankers) increased from $103.8 million in 1992 to $136.5 million in 1993 as a result of sales in 1992. The related ratio of policy benefits to earned premiums of the group segment increased dramatically from 62.9% in 1992 to 74.8% in 1993 and contributed to a pre-tax operating loss of $12.9 million in 1993, as compared to pre-tax operating earnings of $5.1 million in 1992. During the last half of 1993, Philadelphia American encountered an unexpected increase in claim costs driven by an upswing in the utilization and cost of physician services and several large individual claims covered under group plans. Additionally, in the course of evaluating Philadelphia American's results for the fourth quarter of 1993, management determined that errors had been made in the second and third quarters of 1993 in accounting for certain reinsurance activities and had resulted in an approximate $7.4 million overstatement of Philadelphia American's pre-tax operating earnings for such periods. These errors contributed to an inadequate assessment of the need for premium rate increases on certain of Philadelphia American's group health cases, which, in turn, contributed to the adverse claims experience on these cases which continued into the 1993 fourth quarter. Management has taken several actions which are expected to rapidly reduce losses and return this segment to profitability in 1994. These actions include 1) terminating several large, but unprofitable group cases at or near the end of 1993, 2) identifying several additional group cases which will not be renewed during the first six months of 1994, and 3) implementing substantial rate increases to restore profitability to its remaining group business. In addition, internal controls at Philadelphia American have been strengthened and personnel changes have been made to prevent a future reoccurrence of accounting errors in reported results. Because of uncertainties regarding the potential impact of currently proposed national health care reforms, management does not believe that it would be prudent to presently invest additional capital resources to grow the group segment of its business. However, Philadelphia American intends to actively pursue new ASO business to more fully utilize its present claims processing capabilities without incurring additional underwriting risks. ACCUMULATION PRODUCTS. Sales of accumulation products, primarily GICs, declined significantly in 1993 as compared to prior periods. In 1993, new GIC sales totaled $5.3 million, as compared to $292.1 million in 1992. Such decline in GIC sales was offset, in part, by an increase in new annuity sales. ICH's subsidiaries produced $84.6 of annuity sales, principally single premium deferred annuities, in the accumulation segment in 1993, as compared to $27.2 million in 1992 (excluding Bankers). The substantial decline in GIC sales was directly attributable to a downgrade in the claims-paying ratings assigned to an ICH subsidiary as previously discussed. As a result of these ratings downgrades, ICH's subsidiaries redirected their marketing efforts in 1993 to sales of annuities in the less ratings-sensitive individual marketplace. The accumulation products segment reflected a pre-tax operating loss of $6.7 million in 1993, as compared to a slight profit in 1992. The loss was primarily attributable to the decline in yields earned on invested assets during 1993. Substantially all of the $329.0 million in GIC liabilities which were withdrawn in 1993 bore interest at guaranteed fixed rates which, in many cases, exceeded rates being earned on the related invested assets. At year-end 1993, approximately 75% of the remaining $377.7 million in GIC liabilities bear interest at floating rates and a substantial portion of the remaining fixed rated liabilities are expected to be withdrawn in 1994. As a consequence, and barring a further decline in investment yields, management anticipates that the accumulation segment will realize a return to profitability in 1994. Because of its present claims-paying ratings, ICH's insurance subsidiaries have effectively withdrawn from the GIC marketplace. Management expects to continue to emphasize sales of new annuities. CORPORATE. Revenues allocated to the corporate segment include investment income on the capital and surplus of ICH's insurance subsidiaries. In addition, such revenues also include gains on the sale of ICH's investment in BLHC in 1993 and its investment in Bankers in 1992. Historically, ICH has allocated all corporate overhead expenses to the various operating segments. In 1993, $45.6 million in expenses were allocated to the corporate segment, including $23.9 million in writeoffs of capitalized data processing costs and certain home office real estate, a $9.0 million provision for services agreements entered into with ICH's former controlling shareholders, an $9.3 million provision for anticipated costs of litigation and other contingencies, and $4.4 million of expenses associated with the restructuring of ICH's collateralized mortgage note obligation. In 1992, $41.5 million of expenses were allocated to this segment, including an $18.0 million litigation settlement, $12.6 million of costs associated with modifying its data processing servicing arrangements with Perot Systems, and $10.9 million in costs related to a planned operational consolidation of three of ICH's Texas-based insurance subsidiaries. INTEREST EXPENSE AND PREFERRED DIVIDEND REQUIREMENTS ICH's consolidated interest expense totaled $66.2 million in 1993, $79.0 million in 1992 and $98.6 million in 1991. The reductions in interest expense were primarily as a result of the principal reductions in ICH's long-term indebtedness made during the periods as previously discussed under "Liquidity and Capital Resources." The reductions in interest expense in 1993 and 1992 were offset, in part, by the interest expense incurred relative to collateralized mortgage note obligations totaling $6.0 million in 1993 and $2.3 million in 1992. The collateralized mortgage note obligations were initially incurred in conjunction with the sale of Bankers in 1992. As a result of the transactions entered into in July 1993 to reduce ICH's exposure to prepayment risks on certain mortgage-backed securities (see "Investment Portfolio"), the accounts of a special-purpose trust, which included the collateralized mortgage note obligations and the related interest expense, are no longer included in ICH's consolidated balance sheet or statement of earnings after July 30, 1993. Preferred dividend requirements totaled $28.8 million in 1993 and $30.8 million in each of 1992 and 1991. As the result of the redemption of $100 million stated value of ICH's preferred stocks in 1993, preferred dividend requirements are expected to be reduced to approximately $17.3 million in 1994. Assuming the completion of the transactions with CFLIC by March 31, 1994, as previously discussed under "Transactions With Consolidated Fidelity Life Insurance Company," ICH's preferred dividend requirements in 1994 would be reduced by an additional $2.5 million. INCOME TAX PROVISIONS AND DEFERRED INCOME TAX ASSETS In 1993, income tax expense represented approximately 31% of consolidated operating earnings before income taxes, or 4% less than the expected corporate income tax rate. During 1993, the corporate income tax rate was increased from 34% to 35%, retroactive to January 1, 1993. The effect of such rate increase on ICH's deferred income tax asset as of the beginning of 1993, a benefit totaling $3.5 million, has been included in the 1993 income tax provision. Other significant items affecting the 1993 effective income tax rate included a reduction in the valuation allowance for ICH's deferred income tax asset based on the utilization of available loss carryforwards to offset income taxes otherwise payable as a result of the BLHC sale and other investment gains and the utilization of capital loss carryforwards which had previously not been reflected for financial reporting purposes. In 1992, ICH reported an income tax credit totaling $69.2 million on a consolidated operating loss before income taxes of $18.4 million. This unusual relationship was primarily attributable to the significant tax basis gain on the sale of Bankers and a reduction in the Company's valuation allowance for its deferred tax asset as a result of utilizing available capital loss carryforwards to reduce taxes otherwise payable as a result of such gain. In 1991, income tax expense represented 24% of consolidated operating earnings before income taxes. The effective rate was approximately 10% lower than the expected rate, substantially all of which was attributable to a reduction in the deferred tax asset valuation allowance based on tax planning strategies for the utilization of a portion of ICH's capital loss carryforwards. See Note 13 of the Notes to Financial Statements for an analysis of the various components affecting ICH's income tax provisions. At December 31, 1993 and 1992, ICH reported deferred income tax assets totaling $53.0 million and $121.0 million, respectively. The substantial reduction in the deferred income tax asset between the periods is primarily as a result of the tax effects associated with the gains realized in 1993 from the sales of ICH's interest in BLHC and other capital gains. The tax assets were comprised of the tax benefit (cost) associated with the following types of temporary differences based on the respective 35% and 34% tax rates in effect at the end of 1993 and 1992: Operating and capital loss carryforwards have significantly different characteristics as to expiration dates and their usability. For federal income tax purposes, operating losses may be carried forward for a maximum of fifteen years from the year they are incurred; capital losses may be carried forward for a maximum of five years. In addition, ordinary loss carryforwards may be utilized to offset ordinary income or capital gains, whereas capital loss carryforwards can only be utilized to offset capital gains. As a consequence, taxpayers have substantially more flexibility in being able to utilize operating loss carryforwards than capital loss carryforwards. For federal income tax purposes, at December 31, 1993, ICH's subsidiaries had $39.0 million of ordinary loss carryforwards expiring in 2005 and $14.9 million of capital loss carryforwards expiring in 1998. Management has periodically assessed the ability of ICH's insurance subsidiaries to produce taxable income in future periods sufficient to fully utilize their operating book/tax temporary differences and tax loss carryforwards. These assessments have included actuarial projections under alternative scenarios of future profits on the existing insurance in force of ICH's insurance subsidiaries, including provisions for adverse deviation, adjusted to reflect ICH's anticipated debt service costs. While management believes that there will be sufficient future taxable income to realize substantially all of the benefit of ICH's remaining temporary differences, valuation allowances totaling $16.3 million and $24.2 million were provided against ICH's deferred tax assets at December 31, 1993 and 1992, respectively, to reflect the uncertainties of realizing all of the benefits of available tax loss carryforwards. Alternative minimum tax ("AMT") credit carryforwards result from the acceleration of income taxes under certain circumstances and can be carried forward for an indefinite period. The $13.9 million and $11.7 million component of ICH's deferred income tax assets at December 31, 1993 and 1992, respectively, represents taxes incurred under AMT provisions which are expected to be recovered through reduced income tax payments over the next several years. CUMULATIVE EFFECT OF ACCOUNTING CHANGES Effective January 1, 1993, ICH adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and incurred a charge for the cumulative effect of the adoption of the accounting change as of that date totaling $1.8 million, after tax effects. In addition, effective December 31, 1993, ICH adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and incurred a charge for the cumulative effect of the adoption of the accounting change as of that date totaling $4.9 million, after tax effects. Effective January 1, 1991, ICH adopted SFAS No. 109, "Accounting for Income Taxes," and the benefit of the cumulative effect of the adoption of the accounting change as of that date totaled $8.8 million. EXTRAORDINARY LOSSES For the years 1993 and 1992, ICH incurred extraordinary losses, net of tax effects, totaling $1.9 million and $4.3 million, respectively. The extraordinary losses in both periods were related to early extinguishment of debt. See Note 15 of the Notes to Financial Statements for an analysis of the components of such losses. IMPACT OF INFLATION Medical cost inflation has had a significant impact on the individual health and group health lines of business. Benefit costs have continued to increase in recent years in excess of the Consumer Price Index and will likely continue. This impact, however, has been substantially offset by increases in premium rates. Management does not believe that inflation has otherwise had a significant impact on its results of operations over the past three years. KNOWN TRENDS AND UNCERTAINTIES WHICH MAY AFFECT FUTURE RESULTS PROPOSED HEALTH CARE REFORM President Clinton has targeted health care reform as a top domestic priority of his administration, and has proposed to Congress legislation, the American Health Security Act, that would significantly change the manner in which the entire health care industry operates. The reform legislation proposed by the Clinton administration would ultimately guarantee universal access to health care coverage and create purchasing alliances for government established health care plans. Alternative legislative proposals that have been developed to reform the health care system have goals ranging from universal access to health care coverage through managed competition to health care cost containment through, among other things, health insurance reform. ICH currently cannot predict what impact health care reform proposals will have on the health insurance industry, whether any health insurance measures will be adopted in the foreseeable future or, if adopted, whether such reform proposals or measures will have a material effect on its operations. FEDERAL INCOME TAX AUDIT ISSUES See Note 12 of the Notes to Financial Statement for a discussion of potential income tax audit issues. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. AND FINANCIAL STATEMENT SCHEDULES OF I.C.H. CORPORATION AND SUBSIDIARIES (ITEMS 8, 14(A), AND 14(C)) FINANCIAL STATEMENTS FINANCIAL STATEMENT SCHEDULES 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 or the information is presented in the consolidated financial statements or related notes. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders I.C.H. Corporation We have audited the consolidated financial statements and financial statement schedules of I.C.H. Corporation and Subsidiaries as listed in the index on page 47 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of I.C.H. 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. As more fully described in Notes 14 and 5 to these consolidated financial statements, effective January 1, 1993 and December 31, 1993, the Company adopted Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities," respectively. COOPERS & LYBRAND Dallas, Texas March 14, 1994 I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) BASIS OF PRESENTATION The consolidated financial statements include the accounts of I.C.H. Corporation (Company) and its wholly-owned and majority-owned subsidiaries from date of acquisition or through date of divestiture. All significant intercompany accounts and transactions have been eliminated in consolidation. Previously reported amounts for 1992 and 1991 have in some instances been reclassified to conform to the 1993 presentation. See Note 2 for 1993 and 1992 organization changes. The Company's insurance subsidiaries maintain their accounts in conformity with accounting practices prescribed or permitted by state insurance regulatory authorities. In the accompanying financial statements such accounts have been adjusted to conform with generally accepted accounting principles (GAAP). (B) INVESTMENTS Fixed maturity investments include bonds and preferred stocks with mandatory redemption features. The Company classifies all fixed maturity investments into two categories as follows: - Available for sale securities, representing securities that are readily marketable and that may be sold prior to maturity due to changes that might occur in market interest rate risks, changes in the security's prepayment risk, the Company's management of its income tax position, its general liquidity needs, increases in loan demand, the need to increase regulatory capital, changes in foreign currency risk, or similar factors. Available for sale securities are carried at fair value. - Held to maturity securities, representing securities such as private placements which are not readily marketable and which the Company has the ability and positive intent to hold to maturity. Held to maturity securities are carried at amortized cost. The Company may dispose of such securities under certain unforeseen circumstances, such as issuer credit deterioration or regulatory requirements. Fixed maturity investments and related futures contracts which are denominated in or linked to foreign currencies are revalued to reflect changes in the exchange rate as of the balance sheet date. Anticipated prepayments on mortgage-backed securities are taken into consideration in determining estimated future yields on such securities. Equity securities include investments in common stocks and non-redeemable preferred stocks and are carried at fair value. Policy loans and collateral loans are stated at their current unpaid principal balance, net of unamortized discount and related liabilities for which the Company has the right to offset. Short-term investments include commercial paper, invested cash and other investments purchased with maturities generally less than three months and are carried at amortized cost. The Company considers all short-term investments to be cash equivalents. Mortgage loans are stated at the aggregate unpaid principal balances, less unamortized discount. Fees received and costs incurred with origination of mortgage loans are deferred and amortized as yield adjustments over the remaining lives of the mortgages. Real estate, substantially all of which was acquired through foreclosure, is recorded at the lower of fair value minus estimated costs to sell or cost. If the fair value of the foreclosed real estate minus estimated costs to sell is less than cost, a valuation allowance is provided for the deficiency. Increases or decreases in the valuation allowance are charged or credited to income. Investments in limited partnerships and 20% to 50% interests in the common stocks of other entities, whose affairs are not controlled by the Company (equity investees), are reflected on the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) equity method, or at cost, adjusted for the Company's share, after allowance for possible dilution, of the undistributed earnings and losses (both realized and unrealized) since acquisition. At December 31, 1992 the carrying value of the Company's residual ownership interest in a divested subsidiary had been adjusted for (i) the excess of the sales proceeds received over (ii) the Company's basis in the 39.9% interest in the divested subsidiary retained by the Company. A portion of such excess of sales proceeds over the Company's basis was being amortized into earnings on a straight-line basis over ten years. The Company regularly evaluates investments based on current economic conditions, past credit loss experience and other circumstances. A decline in net realizable value that is other than temporary is recognized as a realized investment loss and a reduction in the cost basis of the investment. The Company discounts expected cash flow in the computation of net realizable value of its investments, other than certain mortgage-backed securities. In those circumstances where the expected cash flows of residual interest and interest-only mortgage-backed securities, discounted at a risk-free rate of return, result in an amount less than the carrying value, a realized loss is reflected in an amount sufficient to adjust the carrying value of a given security to its fair value. Net realized investment gains and losses, including gains and losses on foreign currency transactions and held for sale securities, are included in the determination of net earnings. Unrealized investment gains and losses on available for sale securities and marketable equity securities are charged or credited directly to stockholders' equity. The specific identification method is used to account for the disposition of investments. (C) DUE FROM REINSURERS At December 31, 1993, amounts recoverable from reinsurers, including amounts equal to the assets supporting insurance liabilities ceded to reinsurers and amounts due for the reimbursement of related benefit payments, are reflected as receivables due from reinsurers. Amounts due from reinsurers are evaluated as to their collectibility and, if appropriate, reserves for doubtful collectibility are established through a charge to earnings. (D) EXCESS COST OF INVESTMENT IN SUBSIDIARIES OVER NET ASSETS ACQUIRED The excess cost of investments in subsidiaries over net assets acquired is being amortized on the straight-line basis over a 40-year period. The Company periodically assesses the recoverability of its excess cost through an actuarial projection of undiscounted future earnings of the Company's insurance subsidiaries (excluding excess cost amortization) over the remaining life of such excess cost. Such projections are prepared under various interest rate scenarios, with anticipated levels of new business production for only a five-year period. (E) DEFERRED POLICY ACQUISITION COSTS AND PRESENT VALUE OF FUTURE PROFITS OF ACQUIRED BUSINESS Costs which vary with and are related to the acquisition of new business have been deferred to the extent that such costs are deemed recoverable through future revenues. These costs include commissions, certain costs of policy issuance and underwriting and certain variable agency expenses. For traditional life and health products deferred costs are amortized with interest over the premium paying period in proportion to the ratio of anticipated annual premium revenue to the anticipated total premium revenue. Deferred policy acquisition costs related to universal life, interest-sensitive and investment products are amortized in relation to the present value, using the assumed crediting rate, of expected gross profits on the products, and retrospective adjustments of these amounts are made whenever the Company revises its estimates of current or future gross profits to be realized from a group of policies. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The present value of future profits on business in force of acquired subsidiaries represents the portion of the cost to acquire such subsidiaries that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the dates of acquisitions. Such value is the actuarially determined present value of the future cash flows from the acquired policies, based on projections of future premium collection, mortality, morbidity, surrenders, operating expenses, investment yields, and other factors. The account is amortized with interest over the estimated remaining life of the acquired policies. Recoverability of deferred policy acquisition costs and the present value of future profits of acquired business is evaluated annually by comparing the current estimate of discounted expected future cash flows to the unamortized asset balance by line of insurance business. If such current estimate indicates that the existing insurance liabilities, together with the present value of future cash flows from the business, will not be sufficient to recover the unamortized asset balance, the difference is charged to expense. Amortization is adjusted in future years to reflect the revised estimate of future profits. Anticipated returns, including realized and unrealized gains and losses, from the investment of policyholder balances are considered in determining the amortization of deferred policy acquisition costs. When fixed maturities are stated at their fair value, an adjustment is made to deferred policy acquisition costs and unearned revenue reserves equal to the changes in amortization that would have been recorded if those fixed maturities had been sold at their fair value and the proceeds reinvested at current yields. Furthermore, if future yields expected to be earned on fixed maturities decline, it may be necessary to increase certain insurance liabilities. Adjustments to such liabilities are required when their balances, in addition to future net cash flows including investment income, are insufficient to cover future benefits and expenses. (F) SEPARATE ACCOUNTS Separate accounts represent segregated assets whose values directly determine the amounts of the liabilities for variable products and separate account pension deposits. The insurance company does not have an investment risk with these assets and liabilities. The risk lies solely with the holder of the contract. (G) FUTURE POLICY BENEFITS The liability for future policy benefits of long duration contracts has been computed by the net level premium method based on estimated future investment yield, mortality, morbidity and withdrawal experience. Reserve interest assumptions are graded and range from 6% to 10%. Mortality, morbidity and withdrawal assumptions reflect the experience of the life insurance subsidiaries modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. The assumptions vary by plan, year of issue and duration. The future policy benefit reserves include a provision for policyholder dividends based upon dividend scales assumed at the date of purchase of acquired companies or as presently contemplated. (H) POLICY AND CONTRACT CLAIMS Policy and contract claims include provisions for reported claims in process of settlement, valued in accordance with the terms of the related policies and contracts, as well as provisions for claims incurred and unreported based on prior experience of the Company. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (I) UNIVERSAL LIFE AND INVESTMENT CONTRACT LIABILITIES Benefit reserves for universal life, interest-sensitive and investment products are determined following the retrospective deposit method and consist principally of policy account values before any surrender charges, plus certain deferred policy fees which are amortized using the same assumptions and factors used to amortize deferred policy acquisition costs. (J) INCOME TAXES Deferred income taxes are recorded to reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Excess cost of investment in subsidiaries over net assets acquired is reduced for the tax benefits obtained from the utilization of an acquired company's tax deductions. (K) RECOGNITION OF PREMIUM REVENUE AND RELATED EXPENSES Premium revenue for traditional life insurance products is reported as earned when due. Accident and health premiums are earned over the period for which premiums are paid. Benefits and expenses are associated with earned premiums so as to result in recognition of profits over the premium paying period. This association is accomplished by means of a provision for future policy benefit reserves and the amortization of deferred policy acquisition costs. (L) PARTICIPATING POLICIES Participating life insurance policies represent approximately 1% and 4% of the total individual life insurance in force at December 31, 1993 and 1992, respectively. The amount of dividends to be paid is determined annually by the boards of directors of the life insurance subsidiaries. A portion of the earnings of the Company is allocated to the participating policyholders and included in other policyholder funds. (M) FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: CASH AND SHORT-TERM INVESTMENTS: The carrying amounts reported in the balance sheet for these instruments approximate their fair values. INVESTMENT SECURITIES: Fair values for fixed maturity securities (including mandatorily redeemable preferred stocks) are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or are estimated based on expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. The fair values for equity securities are based on quoted market prices and are recognized in the balance sheet. MORTGAGE AND COLLATERAL LOANS: The fair values for mortgage and collateral loans are estimated using discounted cash flow analyses, based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations. POLICY LOANS: The Company does not believe an estimate of the fair value of policy loans can be made without incurring excessive cost. Policy loans have no stated maturities and are usually repaid by reductions to benefits and surrenders. Because of the numerous assumptions which would have to be made to estimate fair value, the Company further believes that such information would not be meaningful. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INVESTMENTS IN LIMITED PARTNERSHIPS: Fair values for the Company's investments in limited partnerships are based on the estimated fair values of the partnership assets and liabilities, assuming a liquidation of the partnership and distribution of proceeds to the partners. OFF-BALANCE-SHEET INSTRUMENTS: Fair values for the Company's off-balance-sheet interest rate swaps are based on formulas using current assumptions. INVESTMENT CONTRACTS: Fair values for the Company's liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. NOTES PAYABLE: The fair value of the Company's long-term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. (N) EARNINGS PER SHARE CALCULATIONS Primary earnings per share are computed by dividing earnings, less preferred dividend requirements, by the weighted average number of common shares outstanding. In computing fully diluted earnings per share, the weighted average number of common shares outstanding is adjusted to reflect common stock equivalents resulting from stock options and the assumed conversion of the Company's Series 1984-A and 1986-A Preferred Stock into common shares, and preferred dividend requirements are adjusted to eliminate dividends on the shares assumed to have been converted. The computation of fully diluted earnings per share excludes the assumed conversion of such preferred shares for each period in which the assumed conversion would be antidilutive. 2. ACQUISITIONS AND DISPOSITIONS On November 9, 1992, the Company completed the sale of its wholly-owned subsidiary, Bankers Life and Casualty Company (Bankers), and Bankers' subsidiary, Certified Life Insurance Company (Certified), to an affiliate of Conseco, Inc. (Conseco) for $600 million cash, subject to final adjustment. Prior to the closing, Bankers transferred its ownership in all of its other subsidiaries to the Company, and the Company and its subsidiaries purchased certain other assets from Bankers, including primarily a residual interest in certain mortgage-backed securities, Bankers' home office real estate, and certain equity investments. The Company provided financing for the acquisition totaling $101.4 million and, in return, retained an approximate 29.7% interest in Bankers. The financing consisted of a $16.7 million common equity investment in Bankers Life Holding Corporation (BLHC), the Conseco entity formed for the purpose of making the acquisition, and the purchase of $34.7 million of BLHC 11% Junior Subordinated Debentures due 2003 and $50.0 million of a BLHC preferred stock yielding an 11% annual return. In addition, Conseco Capital Partners, L.P. (CCP) acquired a 52.6% interest in BLHC, and the Company, through one of its subsidiaries, made an additional $9.6 million investment to acquire a 19.3% ownership interest in CCP. As a result of the 29.7% interest in BLHC and the indirect investment through CCP, the Company retained a residual interest in Bankers totaling approximately 39.9%. The results of operations of Bankers and Certified were included in the Company's consolidated results of operations through October 31, 1992, the effective date of the sale for financial reporting purposes. Subsequent to that date, the Company reflected its proportionate share of the operating results of CCP and BLHC based on the equity method. Because of the significant ownership interest in Bankers retained by the Company, the sale of Bankers was accounted for as a step transaction in accordance with GAAP. Accordingly, the Company reflected its residual interest in Bankers on its historical accounting basis and reflected a gain on the approximate 60.1% interest in Bankers deemed to have been sold totaling $110,734,000 in the Company's consolidated statement of earnings for the year ended December 31, 1992. In conjunction with the sale of Bankers, the Company I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 2. ACQUISITIONS AND DISPOSITIONS (CONTINUED) indemnified the purchasers against certain contingencies relating to taxes and other matters associated with Bankers and Certified in periods prior to the closing date. The Company believes its liability, if any, will not be material. Effective March 31, 1993, BLHC completed an initial public offering (Offering) of 19.55 million shares of its common stock, or an approximate 35.8% interest in BLHC at $22 per share. Proceeds of the Offering, after underwriting expenses, approximated $405 million. Effective the same day, CCP announced a plan of dissolution and BLHC shares held by CCP were subsequently distributed to the respective partners in accordance with that plan. The Company received 2,917,318 shares of BLHC common stock as a result of such distribution, increasing its direct ownership in BLHC common stock to 13,316,168 shares, or approximately 24.4% of BLHC's outstanding common shares following the Offering. The Company reflected a gain on the BLHC Offering totaling $99,376,000, primarily representing the Company's 24.4% equity in the net proceeds of such Offering. BLHC utilized a portion of the Offering proceeds to redeem certain of its outstanding securities, including the $50 million stated value of BLHC preferred stock and the $34.7 million principal amount of BLHC Junior Subordinated Notes held by the Company. Because a portion of the purchase price paid for such investments had been allocated to the Company's common equity investments in BLHC, such redemptions resulted in additional gains totaling $8,252,000, which have been included as a component of realized investment gains. On September 30, 1993, the Company sold its remaining investment in BLHC to Conseco and one of Conseco's subsidiaries for $287,639,000 cash. The Company utilized $50 million of the proceeds to redeem $50 million stated value of the Series 1987-A Preferred Stock of the Company from a Conseco subsidiary. The sale of the BLHC shares resulted in a gain totaling $197,665,000. The gains resulting from BLHC's Offering and the sale of the Company's remaining interest in BLHC totaling $297,041,000 have been reflected as a single line item in the consolidated statement of earnings for the year ended December 31, 1993. The Company continued to reflect its equity in the earnings of BLHC through the date of sale. In addition to the sales of Bankers and the Company's interest in BLHC and the subsequent application of the proceeds from such sales, other transactions occurred during 1993 or are expected to occur in 1994 that have had or are expected to have a significant effect on the Company's results of operations, including 1) the sale in 1993 of a 75% interest in a special purpose trust holding certain mortgage-backed securities and the deconsolidation of the accounts of such trust (see Note 3), 2) the sale in 1993 of the Company's investment in the common stock of CCP Insurance, Inc. (CCP Insurance) (see Note 6) and the reinvestment of the proceeds from such sale, and 3) the assumed completion in 1994 of the recapture of certain annuity business ceded to an affiliate under a reinsurance agreement and the related retirement of certain of the Company's debt and preferred stock upon completion of the recapture (see Note 4). Following is unaudited pro forma results of the Company with reported results adjusted to reflect the effects on operations of the above described transactions. The approximate after-tax gains realized on the sale of Bankers totaling $73.1 million in 1992 and the Company's interest in BLHC totaling $193.1 million in 1993 are included in the Company's historical results, but have been eliminated from the pro forma results. The $600 million of proceeds from the sale of Bankers in 1992 was utilized 1) to retire $75 million of the Company's 16 1/2% Senior Subordinated Debentures due 1994 (Debentures), 2) to retire $85 million of the Company's senior secured debt, 3) to purchase $84.7 million of BLHC debt and preferred stock, 4) to purchase $26.3 million of BLHC and CCP equity investments, and 5) to purchase assets from Bankers for $280.5 million. The remaining $48.5 million of proceeds from the sale of Bankers, along with the remaining proceeds from the sales of the Company's investments in BLHC and CCP Insurance, is assumed to have been invested at a new money rate of 6 1/4%. The Company utilized $100 million of the proceeds from the sale I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 2. ACQUISITIONS AND DISPOSITIONS (CONTINUED) of BLHC to redeem the Company's Series 1986-A and 1986-C preferred stocks and approximately $45.9 million of its Debentures, and the remaining proceeds totaled approximately $141.7 million. The pro forma results further assume that all of the transactions occurred as of the first day of each period persented. Such pro forma results may not represent what the Company's results would have been had the assumed transactions occurred at the beginning of such periods and do not purport to project the Company's results for any future period. 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION The carrying amount of notes payable at December 31, 1993 and 1992, and the fair value of notes payable at December 31, 1993, are summarized as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION (CONTINUED) The following summary sets forth the maturities and sinking fund requirements of notes payable during each of the five years following December 31, 1993 (in thousands): At December 31, 1993, the Company held $46,793,000 principal amount of the Old Notes which, at the Company's option, can be used to partially satisfy its first $100 million sinking fund obligation relative to such notes due December 1, 1994. In addition, at its option, the Company can defer the remainder of its sinking fund obligation in 1994 and a portion of its sinking fund obligation in 1995 based on the $87,106,000 of Old Notes which were exchanged for an equal amount of New Notes. Accordingly, in the above schedule of maturities and sinking fund requirements, it has been assumed that there is no sinking fund requirement relative to the Old Notes in 1994 and the sinking fund requirement in 1995 will total $66,101,000. At its option, the Company may alternatively determine to use sinking fund provisions in 1994 and 1995 to retire up to $100 million principal amount of the Old Notes at their par value in each year. At December 31, 1993 and 1992, the Company had notes receivable totaling $26,500,000 and $26,000,000, respectively, which were collateralized by the Company's note payable in the amount of I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 3. NOTES PAYABLE AND COLLATERALIZED MORTGAGE NOTE OBLIGATION (CONTINUED) $20,340,000 and $19,780,000, respectively. The Company has the right to set off its obligation against the notes receivable. In the accompanying balance sheets, the Company's notes receivables have been reflected net of amounts due under the notes payable. Immediately prior to its sale, Bankers held certain mortgage-backed securities and other related securities used as hedges with a carrying value of $252,049,000. In conjunction with the sale of Bankers, these securities were placed in a special purpose trust (the Trust), organized by a new special purpose subsidiary, I.C.H. Funding Corporation (ICH Funding). Bankers was issued a $159,162,000 bond collateralized by the securities placed in the Trust. The Company retained a residual interest in the Trust totaling $91,797,000. All of the receipts on the securities placed in the Trust were to be applied first to repay the principal and interest on the bond retained by Bankers of 8.5%. The bond to Bankers with a carrying value of $157,231,000 at December 31, 1992, was reflected in the accompanying balance sheet as a collateralized mortgage note obligation. The Company was granted an option to purchase Bankers' interest in the bond at its remaining carrying value within ninety days following the sale of Bankers. On February 5, 1993, the Trust completed the sale to unaffiliated parties of interests in the trust totaling $171,000,000 and utilized $142,092,000 of the proceeds to retire the remaining obligation due Bankers. On July 30, 1993, the Company and its affiliate, CFLIC, sold 75% of their rights with respect to the Trust to an unaffiliated party and the accounts of the Trust, including the collateralized mortgage note obligations, were eliminated from the consolidated financial statements of the Company for periods subsequent to that date. 4. RELATED PARTY TRANSACTIONS Effective June 15, 1993, the Company entered into an agreement (the Agreement) with CNC and CFLIC, pursuant to which the Company acquired $63 million of a newly-issued preferred stock from CFLIC in exchange for the Company's ownership interest in certain investments with a carrying value and an estimated fair value as of that date of $63 million, including the Company's ownership in a limited partnership (the HMC/Life Partners, L.P.) and 83% of the Company's ownership in ICH Funding. The transactions with CFLIC were entered into as the first step in a series of transactions which are intended to terminate certain reinsurance arrangements involving CFLIC. The reinsurance arrangements involve certain annuity business with reserves totaling $330.0 million as of December 31, 1993, which was transferred by the Company's subsidiary, Southwestern Life Insurance Company (Southwestern), to an unaffiliated insurer in 1990. The unaffiliated insurer, in turn, transferred the business to another CNC subsidiary, Marquette National Life Insurance Company (Marquette), and, in 1991, Marquette transferred the annuity business to CFLIC. Under terms of the Agreement, upon termination of the reinsurance agreements involving CFLIC and Southwestern, along with the termination of other reinsurance arrangements involving CFLIC and Bankers, the CFLIC preferred stock is to be redeemed by the return of certain assets presently held by CFLIC to the Company, including the Company's senior secured debt totaling $30 million, the Company's 1984-A Preferred Stock with a stated value of $22,242,000, the Company's 1986-B Preferred Stock with a stated value of $7 million, and certain other assets to be determined. The CFLIC preferred stock is non-redeemable and non-voting, with 6% annual dividends that are payable "in-kind" until the reinsurance arrangements are terminated. The Company and CFLIC anticipate that the assets received by CFLIC from the Company as consideration for the preferred stock, along with other assets held by CFLIC, including its ownership in Marquette, will be transferred to Southwestern upon recapture of the annuity business. The termination of the reinsurance arrangements are subject to negotiations with the unaffiliated reinsurer and approval by regulatory authorities. After March 31, 1994, if the recaptures are not complete, CNC will have the right, subject to regulatory approval, to transfer to the Company all of the common stock of CFLIC in exchange for the assets of CFLIC that were to be retained by CNC upon completion of the recaptures. For financial reporting purposes, no gain or loss was recognized on the transfer of the assets to CFLIC. At December 31, 1993, the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 4. RELATED PARTY TRANSACTIONS (CONTINUED) Company has reflected its investment in the CFLIC preferred stock at its approximate fair value of $54 million, or less than the $63 million fair value initially assigned to such stock based primarily on the change in the fair value of the assets transferred to CFLIC subsequent to June 15, 1993. In addition, the Company has continued to include the accounts of ICH Funding in its consolidated financial statements, with CFLIC's ownership interest reflected as a minority interest in such investment. Experience refunds received from CFLIC under the Southwestern reinsurance arrangement totaled $4,851,000, $2,068,000 and $10,788,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Bankers business reinsured by CFLIC was not profitable in 1992 and 1991 due primarily to a loss incurred relative to certain reinsurance recoverables and, as a consequence, Bankers was not entitled to an experience refund in either 1992 or 1991. Bankers was a party to a service agreement with Marquette and CFLIC whereby it provided investment management, administrative, data processing, and general supervisory and management services related to business reinsured with CFLIC, in exchange for annual fees equal to .45% of reserves on the reinsured policies. Fees earned from providing such services totaled $1,593,000 for the ten months ended October 31, 1992 and $2,043,000 for the year ended December 31, 1991. Such fees were taken into consideration in the determination of profitability of the reinsured business. In addition, a subsidiary entered into a service agreement effective January 1992, whereby the subsidiary provided administrative services for Marquette. Fees earned from providing such services totaled $449,000 and $2,016,000 for the years ended December 31, 1993 and 1992, respectively. On February 11, 1994, the Company purchased all of the 100,000 shares of its Class B Common Stock held by CNC for total cash consideration of $500,000. The Class B Common Stock had entitled CNC to elect 75% of the Company's Board of Directors (see Note 10). Concurrently with the purchase of such stock, the Company entered into Independent Contractor and Services Agreements (Services Agreements) with Robert T. Shaw and C. Fred Rice, the controlling shareholders of CNC. The Services Agreements provide for a lump sum payment to Messrs. Shaw and Rice totaling $2 million as of the closing date and additional payments totaling $8,575,000 over a ten-year period. In addition, the Company agreed to provide customary employee benefits to Messrs. Shaw and Rice and their dependents. In the event of the deaths of Messrs. Shaw or Rice, any amounts not previously paid under the Services Agreements will become immediately payable to their estates. In consideration for the Services Agreements, Messrs. Shaw and Rice agreed that they would attempt to identify business opportunities in the insurance industry which may be suitable for the Company and to consult with the Company regarding such other matters as the Company may reasonably request. In addition, Mr. Rice will continue to serve as an executive officer of the Company and, if re-elected, will continue to serve on the Company's Board of Directors. The Services Agreements replaced a management and consulting contract with CNC that provided for annual payments to CNC totaling $2 million. In addition, Mr. Shaw was granted an option, exercisable within a six month period, to acquire certain aircraft equipment currently owned by the Company at its depreciated book value. At December 31, 1993, the Company has provided a liability for the present value of amounts payable under the Services Agreements totaling $9,050,000. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 4. RELATED PARTY TRANSACTIONS (CONTINUED) At December 31, 1993 and 1992, the Company held a $2 million promissory note from CNC bearing interest at 10% and payable in December 1995. The note and accrued interest were repaid on February 11, 1994. Through June 1993, FMI had leased office space under a ten-year lease in a building owned by Messrs. Shaw and Rice. Effective March 30, 1990, FMI had sublet substantially all of the office space to a former subsidiary which was sold as of that date. 5. INVESTMENTS Investment income by type of investment was as follows: Following is an analysis of realized gains (losses) on investments: Prior to 1992, all of the Company's fixed maturities were carried at amortized cost because management had stated its intent and believed ICH had the ability to hold all such investments to I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) their ultimate maturities. During 1992, the Company retained the services of three independent investment advisors to manage in excess of $1 billion of the Company's fixed maturities and, as a result, at December 31, 1992, the Company had classified its fixed maturities into three categories, including actively managed, held for sale and held to maturity. In 1993, the Company adopted the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and has classified its fixed maturities into two categories, including available for sale and held to maturity. SFAS No. 115 also establishes criteria for the recognition of a permanent impairment in the carrying value of debt and equity securities. The Company reflected a charge for the cumulative effect of writedowns of certain mortgage-backed securities required under the provisions of SFAS No. 115 totaling $7,573,000. The cumulative charge has been reflected net of $2,651,000 in related income tax effects. The actively managed and held for sale securities in 1992 have been reclassified in the following tables as available for sale. The amortized cost of investments in fixed maturities, the cost of equity securities and the estimated values of such investments at December 31, 1993 and 1992 by categories of securities are as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) The mortgage-backed securities held in trust at December 31, 1992, collateralized the Company's mortgage note obligation to Bankers (see Note 3). The Company held a residual interest in the securities held in trust with a carrying value at December 31, 1992, totaling $79,715,000. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) The amortized cost and estimated fair value of fixed maturities 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. Excluding scheduled maturities and sales related to reinsurance transactions, proceeds from sales of investments in debt securities during 1993, 1992 and 1991 and the related gross gains and gross losses realized on such sales were as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) Following are changes in unrealized appreciation (depreciation) on investments (in thousands): The carrying value of nonaffiliated invested assets for which no investment income was recorded during the twelve months ended December 31, 1993, was as follows (in thousands): In addition, the Company owns preferred stock in CFLIC with a carrying value of $54 million at December 31, 1993 (see Note 4). There were no dividends declared on the CFLIC preferred stock during 1993. Other than the Company's investment in securities of Fund America Investors Corporation II with a carrying value and fair value of $58,577,000, the Company had no investments exceeding 10% of stockholders' equity. At December 31, 1993, the Company held unrated or noninvestment-grade corporate debt securities with a carrying value of $107,012,000 and an aggregate fair value of $106,197,000. These holdings amounted to 6.2% of the Company's fixed maturity investments and 4.0% of total cash and invested assets. The holdings of noninvestment-grade securities are widely diversified and include securities of 42 issuers. At December 31, 1993, the Company held residual interest mortgage-backed securities with a carrying value of $78,246,000 and a fair value of $75,590,000. The effective annual yield on such investments based on their carrying value approximated 12.6% at December 31, 1993. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 5. INVESTMENTS (CONTINUED) At December 31, 1993, the Company held mortgage loans principally involving commercial real estate with a carrying value and estimated fair value of $138,504,000 and $142,998,000, respectively. Approximately 62% of such mortgages involved property located in Texas, consisting of first mortgage liens on completed income-producing properties. Mortgages on individual properties do not exceed $8 million. The Company's life insurance subsidiaries are required to maintain certain amounts of assets on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $301,971,000 at December 31, 1993, including securities of the Company with an estimated fair value of $19,491,000, which have been eliminated in consolidation in the accompanying balance sheet. 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS At December 31, 1992, the Company owned a 39.9% indirect equity interest in Bankers, consisting of a 29.7% equity interest in BLHC and 10.2% equity interest through its limited partnership investment in CCP. In addition, the Company owned $34.7 million principal amount of BLHC 11% Junior Subordinated Debentures due 2003 and $50.0 million of a BLHC 11% preferred stock. The 1992 sale of Bankers was accounted for as a "step transaction" in accordance with GAAP. Accordingly, gain recognition was limited to the 60.1% interest deemed to have been sold. The excess of the sales price over the Company's basis in Bankers on the 39.9% portion of the investment deemed to have been retained by the Company (excess of sales price over basis in retained interest) was reflected as a reduction in the carrying value of the Company's investments in BLHC and CCP. Effective March 31, 1993, the Company's ownership interest in BLHC was reduced to 24.4% as a result of BLHC's offering and on September 30, 1993, the Company sold its investment in BLHC (see Note 2). I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) At December 31, 1992, CCP had no assets or liabilities, other than its investment in BLHC. Financial information of BLHC and the Company's carrying value and equity in earnings of BLHC as of and for the two months ended December 31, 1992, and the Company's equity in the earnings of BLHC for the nine months ended September 30, 1993, is as follows (in thousands): Following is an analysis of the Company's equity investments in BLHC and CCP (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) Following is an analysis of the Company's investment in limited partnerships (excluding the Company's investment in CCP at December 31, 1992, which was reflected as an investment in equity investees): The fair value of the Company's investments in limited partnerships approximated their carrying value of $43,640,000 at December 31, 1993. Included in the limited partnership investments at December 31, 1991, was the Company's 21.4% interest in CCP (Predecessor CCP). On July 21, 1992, Predecessor CCP formed a new insurance holding company, CCP Insurance, Inc. and completed an initial public offering (IPO) of common stock in CCP Insurance. Predecessor CCP was liquidated and the Company received 1,764,439 shares of CCP Insurance common stock in exchange for its 21.4% interest in Predecessor CCP. At the date of exchange, the Company's carrying value in Predecessor CCP totaled $19,509,000, which became the Company's basis in the shares of CCP Insurance common stock. The Company subsequently reflected its investment in CCP Insurance, along with 525,000 shares of CCP Insurance purchased in the IPO, as marketable equity securities. Effective September 29, 1993, CCP Insurance completed an underwritten primary and secondary offering of shares of its common stock. The Company sold all of the 1,764,439 shares of the common stock of CCP Insurance in conjunction with the offering for $47,272,000 and realized investment gains totaling $27,758,000. In addition, during 1993, the Company sold 455,375 shares of CCP Insurance common stock in open market transactions and realized gains totaling $5,310,000. At December 31, 1993, the Company continues to hold 69,625 shares of CCP Insurance common stock with a fair value of approximately $1.9 million. Financial information of Predecessor CCP and the Company's equity in the earnings of Predecessor CCP is as follows (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 6. INVESTMENTS IN EQUITY INVESTEES AND LIMITED PARTNERSHIPS (CONTINUED) Following is a summary of the equity in earnings of equity investees and limited partnerships: 7. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Certain of the Company's subsidiaries have entered into interest rate swap arrangements to convert the interest rate characteristics of certain investments to match those of related insurance liabilities. The agreements expire from 1994 to 1997 and exchange fixed-rate payments ranging from 5.45% to 8.44% for three month LIBOR-based interest payments on notional amounts of $43.9 million. The interest rate differential to be received or paid is recognized over the lives of the agreements as an adjustment to interest expense. The subsidiaries are exposed to credit risk in the event of default by counterparties to the extent of any amounts that have been recorded in the balance sheet and market risk as a result of potential future increases in LIBOR. The fair value of interest rate swap arrangements at December 31, 1993, approximated $2.5 million. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 8. INSURANCE LIABILITIES Insurance liabilities consist of the following: The estimated fair value of guaranteed investment contracts approximated their carrying value at December 31, 1993 because it is expected that substantially all of such contracts will be terminated during 1994. The estimated fair value of the liabilities for other investment contracts is approximately equal to their carrying value at December 31, 1993, because interest rates credited to account balances approximate current rates paid on similar investments and are generally not guaranteed beyond one year. Fair values for the Company's insurance liabilities other than those for investment-type insurance contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts. 9. STOCKHOLDERS' EQUITY AND RESTRICTIONS At December 31, 1993, substantially all of consolidated stockholders' equity represented net assets of the Company's insurance subsidiaries that cannot be transferred to the Company in the form of dividends, loans or advances. Generally, the net assets of the Company's insurance subsidiaries available for transfer to the Company are limited to the greater of the subsidiaries' net gain from operations during the preceding year or 10% of the subsidiaries' net surplus as of the end of the preceding year as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities. Payment of dividends in excess of such amounts would generally require approval by the regulatory authorities. At December 31, 1993, approximately $34.0 million was available under existing laws for the payment of dividends by insurance subsidiaries to the I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 9. STOCKHOLDERS' EQUITY AND RESTRICTIONS (CONTINUED) Company during 1994 without prior approval; however, Modern American has agreed with its domiciliary state that it will not pay any stockholder dividends without obtaining prior regulatory approval. In addition, Southwestern has agreed with its domiciliary state that it will give 30 days prior notice before the payment of any stockholder dividends. On the basis of reporting as prescribed or permitted by insurance regulatory authorities, the consolidated insurance subsidiaries have audited combined stockholders' equity, after elimination of amounts attributable to investments in consolidated insurance subsidiaries, of approximately $259,856,000 and $227,003,000 as of December 31, 1993 and 1992, respectively, and audited combined net income (loss) as follows: Gains and losses relative to individual investments are generally reflected for statutory reporting purposes as unrealized investment gains or losses until such time as the specific investments are sold or otherwise disposed of. In addition, statutory investment gains and losses are reported net of related income tax effects. Statutory realized investment losses in 1992 include losses on the disposition of First Executive Corporation common stock totaling $118 million which were reflected prior to 1992 for financial reporting purposes. During 1992, certain employees who had previously purchased shares of the Company's Common Stock under a Restricted Stock Purchase Agreement pledged the shares of Common Stock to collateralize notes receivable which had been issued to a former affiliate in 1982, but which were subsequently acquired by the Company in 1985. The notes and accrued interest totaling $1,471,000 and $1,906,000 at December 31, 1993 and 1992, respectively, bear interest at 9%, mature in 1996 and were collateralized by 375,564 shares and 530,976 shares of the Company's Common Stock at each of the respective dates. In addition, the Company has other notes receivable with a carrying value of $258,000 at December 31, 1993 and 1992, which are collateralized by 51,534 shares of the Company's Common Stock. In the accompanying balance sheets, such notes and accrued interest have been reflected as reductions in stockholders' equity. 10. CAPITAL STOCK At December 31, 1993, the Company had three classes of capital stock, including Series Preferred Stock (no par value), Common Stock ($1.00 par value) and Class B Common Stock ($1.00 par value). At December 31, 1993, there were three series of Preferred Stock outstanding, the Series 1984-A Preferred Stock, the $1.75 Convertible Exchangeable Preferred Stock, Series 1986-A (Series 1986-A Preferred Stock), and the Series 1987-B Preferred Stock. The holder of each outstanding share of the Series 1984-A Preferred Stock is entitled to cumulative annual dividends of $4.93 and liquidating distributions of up to the $41.07 stated value. Such dividends and liquidating distributions are payable in preference to the Common Stock and Class B Common Stock. The Series 1984-A Preferred Stock may be converted, at the option of the holder, at any time into shares of Common Stock at the rate of one share of Common Stock for each .3160 shares of Series 1984-A Preferred Stock. The Series 1984-A Preferred Stock has the right to vote as a class with the Common Stock on all matters submitted to a vote of the holders of the Common Stock. The Company, at its option, may redeem all of the shares of the Series 1984-A Preferred Stock at their stated value. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) The holder of each outstanding share of Series 1986-A Preferred Stock is entitled to cumulative annual dividends of $1.75 and liquidating distributions of up to $25 per share. Such dividends and liquidating distributions are payable in preference to the Common Stock, Class B Common Stock and all other series of the Company's Preferred Stock currently outstanding. The Series 1986-A Preferred Stock may be converted, at the option of the holder, at any time into shares of Common Stock at the rate of .7692 shares of Common Stock for each share of Series 1986-A Preferred Stock. The Company may redeem, at its option, any or all shares of the Series 1986-A Preferred Stock at redemption prices declining annually to $25 per share after December 1, 1996 plus accrued and unpaid dividends. The Series 1986-A Preferred Stock is exchangeable, in whole but not in part, at the Company's option on any dividend payment date commencing December 1, 1988 for the Company's 7% Convertible Subordinated Debentures due 2011 at the rate of $25 principal amount of Debentures for each share of Series 1986-A Preferred Stock. The Series 1986-A Preferred Stock is nonvoting, except as required by law and except that, if six quarterly dividends are unpaid and past due, the holders of the Series 1986-A Preferred Stock may elect two directors to the Company's Board of Directors. The Series 1987-B Preferred Stock has a stated value of $50 per share, provides for cash liquidating distributions of up to such stated value and provides for cumulative annual dividends of $4.50 per share. Dividends and liquidating distributions on the 1987-B Preferred Stock are payable in preference to those payable on the Common Stock and Class B Common Stock, but are subordinated in right of payment to dividends and liquidating distributions payable on the Series 1986-A Preferred Stock. The 1987-B Preferred Stock ranks on parity with the Series 1984-A Preferred Stock. The 1987-B Preferred Stock is neither convertible nor entitled to any voting rights, except as required by law. The Company may redeem shares of the 1987-B Preferred Stock at any time at the $50 stated value. Through February 10, 1994, the Common Stock and Class B Common Stock were entitled to vote as separate classes on stockholder actions that directly or indirectly could effect a change in the aggregate number or par value of shares of Class B Common Stock or in the powers, preferences or rights of the holders of Class B Common Stock. The Company's Board of Directors was classified by its Certificate of Incorporation to require, so long as the Class B Common Stock was outstanding, that at least 50% of the Company's directors were to be independent, and that 75% of the directors were to be elected by the Class B Common Stock and the remaining 25% were to be elected by the Common Stock and voting Preferred Stock. The Class B Common Stock had the same rights to dividends and liquidating distributions as the Common Stock. On February 11, 1994, the Company purchased all of the outstanding shares of Class B Common Stock and immediately cancelled and retired such shares (see Note 4). On August 7, 1991, the Company's shareholders approved an amendment to the 1990 Stock Option Incentive Plan which increased the shares available for grant from 2.4 million shares to 2.9 million shares. In connection with the sale of the Company's remaining investment in BLHC on September 30, 1993 (see Note 2), the Company redeemed all of the outstanding shares of its Series 1987-A Preferred Stock at their $50 per share stated value. On December 2, 1993, the Company redeemed for cash all of the outstanding shares of its Series 1987-C Preferred Stock at their $50 per share stated value. Annual dividend requirements on the redeemed shares totaled $5.50 per share and $8.00 per share, respectively. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) Capital stock activity for the three years ended December 31, 1993, was as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 10. CAPITAL STOCK (CONTINUED) Shares reserved for issuance at December 31, 1993: 11. REINSURANCE The life insurance subsidiaries have set their retention limit for acceptance of risk on life insurance policies at various levels currently up to $500,000. There are reinsurance agreements with various companies whereby insurance in excess of the respective subsidiaries' retention limits is reinsured. To the extent that reinsuring companies become unable to meet their obligations under these agreements, the subsidiaries remain contingently liable. Insurance in force ceded in 1993 and 1992 under risk sharing arrangements totaled approximately $5.7 billion and $5.4 billion, respectively. Through 1992, the liability for future policy benefits was stated after deductions for amounts applicable to such risk sharing reinsurance ceded. As of December 31, 1992, such amount totaled $251,911,000. In 1993, the Company adopted the provisions of SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which changes the accounting and reporting for reinsurance contracts. SFAS No. 113 requires that when a reinsurance contract does not relieve the reinsurer from the legal liability to its policyholders, ceding insurers must report amounts recoverable from reinsurers as assets rather than as a reduction of the related policyholder liabilities. In addition, financial reporting disclosures were amended to require information relative to the volume of premiums ceded to and the benefits paid by reinsurers under related reinsurance arrangements. At December 31, 1993, the Company has reflected in its balance sheet an asset for amounts due from reinsurers totaling $388,083,000 and has correspondingly increased its insurance liabilities by the same amount. Following is information relative to premiums ceded to unaffiliated reinsurers and the related benefits incurred by such reinsurers for the year ended December 31, 1993 (in thousands): Amounts due from reinsurers at December 31, 1993, includes $334,633,000 due from Employers Reassurance Company (ERC) relative to certain annuity business which ERC has retroceded to CFLIC. The Company has begun the process of terminating the reinsurance arrangements with ERC and CFLIC (see Note 4). Certain of the Company's insurance subsidiaries have ceded blocks of insurance under reinsurance treaties to provide funds for financing acquisitions and other purposes. In addition, certain subsidiaries have assumed reinsurance from unaffiliated reinsurers under similar arrangements. These reinsurance transactions, generally known as "surplus relief reinsurance," represent financing arrangements and, in accordance with GAAP, are not reflected in the accompanying financial statements except for the risk fees paid to or received from reinsurers. Net statutory surplus provided by I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 11. REINSURANCE (CONTINUED) such treaties totaled $51.5 million and $87.5 million at December 31, 1993 and 1992, respectively. Risk fees paid to or received from reinsurers generally range from 2% to 4% of the net amount of surplus provided. 12. COMMITMENTS, LITIGATION AND CONTINGENT LIABILITIES At December 31, 1993, the Company and its subsidiaries had long-term leases covering certain of their facilities and equipment. The net minimum rental commitments under noncancellable operating leases with lease terms in excess of one year are $6.3 million, $5.9 million, $.7 million, $.3 million and $.3 million for the years 1994, 1995, 1996, 1997, and 1998, respectively, and $.1 million for subsequent years. In addition, as a result of a judgement involving a mortgage loan foreclosure, a subsidiary is obligated under a real property lease for payments totaling $120,000 annually through November 2082. At December 31, 1993, the Company had an outstanding commitment to make limited partnership investments of up to $25 million in Conseco Capital Partners II, L.P. The partnership was formed to make corporate acquisitions of specialized annuity, life and health insurance companies and related businesses. The Company and its subsidiaries have been under examination by the Internal Revenue Service (IRS) for the tax years 1983 through 1992. The IRS has completed its examination for the years 1983 through 1985 and had previously issued Preliminary Notices of Deficiencies totaling approximately $17.5 million, before interest. The Company protested such assessed deficiencies and subsequently has tentatively reached an agreement with the IRS under which the Company and certain of its subsidiaries will incur approximately $4.6 million of additional taxes and interest. The IRS has not completed its examination for the years 1986 through 1992 and therefore has not issued Notices of Deficiencies for those years. Management believes that the ultimate liability for additional taxes and interest for these later years will not exceed amounts recorded in the Company's financial statements. In the course of their examination of the income tax returns of the Company and its subsidiaries for the years 1986 through 1989, the examining agent involved has submitted a Request for Technical Advice to the IRS Chief Counsel's Office regarding the deductibility of interest expense on the surplus debentures issued by the Company's insurance subsidiaries. The issue involves approximately $444 million of interest deductions claimed by the Company's subsidiaries during the periods under examination and, if disallowed as deductions, would result in additional income tax expense, before interest, of approximately $163 million. For years subsequent to the periods under examination, the Company's subsidiaries have claimed additional interest deductions totaling $190 million which, if likewise disallowed, would result in additional income tax expense, before interest, totaling approximately $65 million. Management believes the surplus debentures in question were legally enforceable debt instruments, as opposed to equity contributions, and that the related interest was properly deductible. In addition, the appropriate domiciliary states of the Company's insurance subsidiaries recognized such surplus debentures as valid debt instruments. Further, all existing case law has held in the favor of taxpayers with regard to the issue of whether surplus debentures represent debt, as opposed to equity and, as a consequence, management believes that the Company and its subsidiaries do not have significant exposure to additional taxes as a result of this Request for Technical Advice. From time to time, assessments are levied on the Company's insurance subsidiaries by life and health guaranty associations in states in which they are licensed to do business. Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. In some states, these assessments can be partially recovered through a reduction in future premium taxes. The Company's insurance subsidiaries paid assessments of $3.2 million, $2.8 million and $2.9 million in I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 12. COMMITMENTS, LITIGATION AND CONTINGENT LIABILITIES (CONTINUED) the years 1993, 1992 and 1991, respectively. Based on information currently available, management believes that any future assessments are not reasonably likely to have a material adverse effect on the Company's insurance subsidiaries. Modern American is a defendant in a class action lawsuit filed on or about May 14, 1993 in the Circuit Court of Jackson County, Missouri, styled WILLIAM D. CASTLE, ET AL. V. MODERN AMERICAN LIFE INSURANCE COMPANY (the CASTLE case). The suit purports to be brought on behalf of a class of persons who own what plaintiffs denominate as charter contracts, issued by life insurance companies merged into or acquired by Modern American and its predecessors. The petition alleges breach of contract, and seeks declaratory judgment, costs, expenses and such other relief as the Court deems appropriate. As an alternative, the petition seeks rescission. On or about October 12, 1993, the plaintiffs in the CASTLE case also filed a lawsuit in the Circuit Court of Cole County, Missouri, naming Modern American and the Director of the Missouri Department of Insurance (the Missouri Director) as defendants. The second lawsuit, styled ROBERT J. MEYER, ET AL. V. JAY ANGOFF, DIRECTOR OF THE MISSOURI DEPARTMENT OF INSURANCE AND MODERN AMERICAN LIFE INSURANCE COMPANY (the MEYER case), is an appeal from the regulatory proceedings before the Missouri Department of Insurance, by which Modern American received regulatory approvals required for it to participate in a restructuring of the Company's insurance holding company organization. The restructuring was completed on or about September 29, 1993. The plaintiffs in the MEYER case are seeking reversal or remand of the Director's order of approval, declaratory judgment and such other relief to which they claim they are entitled. The Cole Circuit Court has determined that it will review the Missouri Department's decision on the record pursuant to Missouri's administrative procedure act. Modern American believes it has meritorious defenses to both the CASTLE and MEYER cases and intends to defend both cases vigorously. Various other lawsuits and claims are pending against the Company and its subsidiaries. Based in part upon the opinion of counsel as to the ultimate disposition of the above discussed and other matters, management believes that the liability, if any, will not be material. See Note 2 for a discussion regarding indemnifications made by the Company with respect to the sale of Bankers. 13. FEDERAL INCOME TAXES Effective January 1, 1991, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The cumulative effect to January 1, 1991 of this statement on the Company's consolidated balance sheet was the recognition of a deferred tax asset totaling $43,880,000 and a reduction in excess cost resulting from the recognition of utilization of tax deductions of acquired companies totaling $35,097,000. The adjustment of these accounts resulted in a net cumulative effect totaling $8,783,000 which has been reflected as a separate line item in the consolidated statement of earnings. Through 1991, the Company filed a consolidated federal income tax return with its wholly-owned non-life insurance subsidiaries. The Company's life insurance subsidiaries also filed federal income tax returns as a consolidated group. Beginning in 1992, the Company and its non-life insurance subsidiaries joined with the Company's life insurance subsidiaries in filing a single consolidated tax return. ICH Funding will file a separate income tax return for periods subsequent to ICH's transfer of an 83% ownership interest to CFLIC in June 1993 (see Note 4). I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 13. FEDERAL INCOME TAXES (CONTINUED) The Company's deferred federal income tax asset at December 31, 1993 and 1992, is comprised of the tax benefit (cost) associated with the following items based on 35% and 34% tax rates in effect at the end of each of the respective periods: As a result of the sale of Bankers, BLHC and other investment transactions in 1993 and 1992, the Company realized significant benefits from the utilization of capital temporary differences and, accordingly, reduced its deferred tax valuation allowances. The provision for income taxes is included in the statements of earnings as follows: The components of the provision for income taxes on operating earnings (loss) are as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 13. FEDERAL INCOME TAXES (CONTINUED) A reconciliation of the income tax provisions based on the prevailing corporate tax rate of 35% in 1993 and 34% in 1992 and 1991 to the provision reflected in the consolidated financial statements is as follows: The benefit from the reduction in the deferred tax asset in 1993 as reflected in the above reconciliation exceeds the actual change in the valuation allowance as a result of the change in corporate tax rates during 1993. At December 31, 1993, the Company and its subsidiaries had the following income tax carryforwards available (in millions): The IRS is examining federal income tax returns of the Company and certain insurance subsidiaries through 1989. See Note 12 for a discussion of certain proposed deficiencies. 14. BENEFIT AND OPTION PLANS The Company has not established retirement benefit plans for its employees. However, Bankers had a noncontributory unfunded deferred compensation plan for qualifying members of its career agency force. Net pension costs included in other operating expenses included the following components (in thousands): The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 8% and 5%, respectively. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 14. BENEFIT AND OPTION PLANS During 1993, the Company entered into agreements with certain employees providing for severance benefits supplemental to those available to all employees under the Company's welfare benefit plans. The agreements generally provide for a benefit of two times the annual salary of each covered employee upon the voluntary or involuntary termination of their employment for any reason other than gross misconduct, plus an additional benefit of up to one year's salary if, in the aggregate, shares of the Company's Common Stock acquired by such employees under the Company's incentive stock option plans or the stock purchase plan of a predecessor company are disposed of at less than a minimum specified price. For the year ended December 31, 1993, the Company reflected a charge for the total anticipated cost of providing benefits under the agreements totaling $2,820,000. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires that an enterprise accrue, during the years that an employee renders the necessary service, the expected cost of providing postretirement life and health care benefits to an employee and the employee's beneficiaries and covered dependents. The Company's transition obligation as of January 1, 1993, approximated $22,873,000. The Company had previously provided a liability totaling $20,127,000 at December 31, 1992, for postretirement benefits for retired employees of certain acquired companies through its purchase accounting relative to such companies. The Company reflected a charge for the cumulative effect to January 1, 1993, of providing postretirement benefits for its remaining employees totaling $2,746,000. The cumulative charge has been reflected net of $934,000 in related income tax effects. The Company's obligation for accrued postretirement benefits is unfunded. Following is an analysis of the change in the liability for accrued postretirement benefits for the year ended December 31, 1993 (in thousands): The liability for accrued postretirement benefits includes the following at December 31, 1993 (in thousands): For measurement purposes, a 10% annual rate of increase in the health care cost trend rate was assumed for 1993; the rate was assumed to decrease gradually to 5 1/2% for 2015 and remain 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 January 1, 1993 by $2,099,000 and the aggregate of the service and interest components of net periodic postretirement benefit cost for 1993 by $382,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7 1/2%. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 14. BENEFIT AND OPTION PLANS (CONTINUED) Southwestern and certain former subsidiaries provided certain health care and life insurance benefits for retired employees. Employees meeting certain age and length of service requirements become eligible for these benefits. The cost of providing these benefits and similar benefits for active employees is recognized as expenses as claims are incurred. These costs approximated $2,430,000 and $2,960,000 for 1992 and 1991, respectively. Under provisions of the 1990 Stock Option Incentive Plan the Company is authorized to grant options to certain key employees for the purchase of up to 2.9 million shares of the Company's Common Stock at a price not less than fair market value at date of grant. The options are exercisable for up to ten years from date of grant and become exercisable at various times ranging from six months to three years. The Company had previously granted options for the purchase of up to 156,780 shares of the Company's Common Stock exercisable through June 1993. Stock options granted are summarized as follows: 15. EXTRAORDINARY LOSSES For the years 1993 and 1992, the Company incurred extraordinary losses, all related to early extinguishment of debt, as follows: I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 15. EXTRAORDINARY LOSSES (CONTINUED) Exclusive of scheduled sinking fund obligations, in 1993, the Company redeemed $83,379,000 of its 16 1/2% Debentures utilizing proceeds from the sales of Bankers and BLHC. In 1992, the Company prepaid $130 million of its senior secured loan utilizing proceeds from the sale of Bankers totaling $85 million and internally-generated funds totaling $45 million. 16. QUARTERLY FINANCIAL DATA (UNAUDITED) For the quarter ended March 31, 1993, the Company reported a non-operating gain totaling $79,459,000, net of tax effects, representing the Company's equity in the proceeds of BLHC's initial public offering. As a result of the Company's subsequent sale of its remaining interest in BLHC, such non-operating gain was reclassified as a component of revenues and operating earnings. Revenues and results of operations for the 1993 first quarter have accordingly been adjusted to reflect such reclassification. The results of operations for the quarters ended June 30, 1993 and September 30, 1993, have been restated to correct for accounting errors determined in the course of preparation of the Company's year-end financial statements. The errors involved the incorrect accounting for certain group I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 16. QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED) health reinsurance activities and the correction of income tax provisions for a special purpose subsidiary which can no longer be included in the Company's consolidated income tax return. Following is a summary of the effect of these corrections on the reported results (in thousands, except per share amounts): Fully diluted earnings per share are independently calculated for each interim period. In those periods where the results of such calculations would be antidilutive, primary earnings per share are reflected in lieu of fully diluted earnings per share. Therefore, the sum of the quarterly earnings per share on a fully diluted basis will not necessarily equal fully diluted earnings per share for the entire year. Reporting results of insurance operations on a quarterly basis necessitates numerous estimates throughout the year, principally in the calculation of reserves and in the determination of the effective rate for federal income taxes. It is the Company's practice to review its estimates at the end of each quarter and, if necessary, make appropriate refinements, with the resulting effect being reported in current operations. Only at year-end is the Company able to retrospectively assess the precision of its previous quarterly estimates. The Company's fourth quarter results contain the effect of the difference between previous estimates and final year-end results and, therefore, the results of an interim period may not be indicative of the results for the entire year. 17. INDUSTRY SEGMENT DATA The Company and its subsidiaries are principally engaged in the sale and underwriting of individual life and health insurance, group insurance and accumulation products. Total revenues by segment reflect sales to unaffiliated customers. Operating earnings (loss) equal total revenues less operating expenses. Premium income and other considerations includes premium income, mortality and administration charges, surrender charges and amortization of deferred policy initiation fees. Net investment income and other income are allocated to the segments based on rates ranging from 6% to 10% related to reserves generated by each of the four insurance segments. Corporate revenues and operating earnings include gains (losses) on the sales of subsidiaries, equity in earnings (losses) of unconsolidated affiliates and limited partnerships, and the remaining net investment income considered to be income applicable to the investment of capital and surplus funds. Operating expenses are allocated to each segment based on a ratio of operating expenses to premiums and premium equivalents. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 17. INDUSTRY SEGMENT DATA (CONTINUED) 18. SUPPLEMENTAL DATA TO CONSOLIDATED STATEMENTS OF CASH FLOWS Cash payments (receipts) for interest expense and income taxes were as follows: The following reflects assets and liabilities disposed relative to the sales of subsidiaries and net cash flow relative to such sales during the year ended December 31, 1992 (in thousands): I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 19. OTHER OPERATING INFORMATION Other operating costs and expenses for the three years ended December 31, 1993, are as follows: In October 1992, the Company entered into a settlement agreement and agreed to pay a $12.6 million settlement fee to Perot Systems, Inc. to modify an existing data processing services arrangement. Under the settlement agreement, Perot Systems agreed to eliminate minimum fee requirements totaling $15.6 million annually through July 1992, to lower its unit transaction charges, and to procure the release of the Company relative to its guarantee of certain equipment lease obligations. Bankers paid $6.3 million of the settlement fee and Conseco agreed to a reduction in Bankers' required capital and surplus as of the date of sale by a corresponding amount. For the years ended December 31, 1993 and 1992, the Company reflected consolidation and reorganization expenses totaling $23,870,000 and $10,885,000, respectively. The expenses were associated with the operational consolidation of three of the Company's Texas-based insurance subsidiaries. The 1993 expenses include a $10,757,000 writedown of certain home office real estate, a $9,760,000 writeoff of certain capitalized data processing costs and $3,353,000 in writeoffs of other property and equipment. The 1992 expense included an accrual for the expenses anticipated to be incurred relative to such consolidation and an $8,000,000 writedown of certain home office real estate. In addition, during 1993, the Company assessed its exposure to the costs associated with pending litigation and certain other contingencies and provided reserves totaling $9,320,000 for the costs anticipated to be incurred relative to such matters. The litigation settlement expense in 1992 related to a class action suit which had been filed by certain policyholders and which was settled in that year. I.C.H. CORPORATION AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS--(CONTINUED) 19. OTHER OPERATING INFORMATION (CONTINUED) Changes in the present value of future profits of acquired business for the three years ended December 31, 1993, are as follows: Based on current conditions and assumptions as to future events on all policies in force, approximately 10% and 9% of the present value of future profits of acquired business as of December 31, 1993, are expected to be amortized in each of the next two years, respectively, and 8% in each of the succeeding three years. The interest accrual rate for the present value of future profits of acquired business ranged from 8% to 10% during each of the three years in the period ended December 31, 1993. SCHEDULE II I.C.H. CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE III I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) The accompanying notes are an integral part of the financial statements. SCHEDULE III (CONTINUED) I.C.H. CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of I.C.H. Corporation and Subsidiaries. Notes payable at December 31, 1993 and 1992, are summarized as follows: The following summary sets forth the scheduled maturities and sinking fund requirements of notes payable during each of the five years following December 31, 1993 (in thousands): Dividends from subsidiaries and equity investees consist of the following: Prior to the sale of Bankers, the parent company acquired certain assets from Bankers at their fair value. The tax attributes related to such assets were likewise transferred to ICH and the income tax consequences which had been reflected for financial purposes have been reflected as a deemed dividend to the parent company. SCHEDULE V I.C.H. CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) SCHEDULE VI I.C.H. CORPORATION AND SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) These agreements will terminate during the next few years. SCHEDULE VIII I.C.H. CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. The information appearing under ITEM 1A in Part I of this Form 10-K and the information appearing under the heading "Election of Directors" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders are incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information appearing under the heading "Executive Compensation" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information appearing under the heading "Security Ownership" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information appearing under the subheading "Certain Transactions" under "Executive Compensation" in the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Registrant's 1994 Annual Meeting of Stockholders is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. 1. EXHIBITS. The exhibits listed on the Index to Exhibits appearing on pages 99-105 of this Form 10-K and the footnotes thereto are incorporated herein by reference. The exhibit descriptions incorporated by reference identify by asterisk (*) each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to ITEM 14(C). 2. FINANCIAL STATEMENTS. The list of audited consolidated financial statements of ICH and the related auditor's report appearing under the heading "Financial Statements" in the Index to Financial Statements and Financial Statement Schedules of I.C.H. Corporation and Subsidiaries in ITEM 8 on page of this Form 10-K is incorporated herein by reference. 3. FINANCIAL STATEMENT SCHEDULES. The list of schedules appearing under the heading "Financial Statement Schedules" in the Index to Financial Statements and Financial Statement Schedules of I.C.H. Corporation and Subsidiaries in ITEM 8 on page 47 of this Form 10-K is incorporated herein by reference. 4. FORM 8-K. On October 1, 1993, the Registrant filed a Report on Form 8-K, dated September 30, 1993, to report, under ITEM 5 of that form, the closing of the Registrant's sale of 13,316,168 shares of common stock of Bankers Life Holding Corporation; the sale of shares of common stock of CCP Insurance, Inc. by subsidiaries of the Registrant in conjunction with an underwritten public offering; and the completion of the restructuring of the Registrant's insurance holding company organization, from a vertical to a substantially horizontal configuration and matters relating to the receipt of regulatory approvals in connection therewith. The Registrant filed a Report on Form 8-K, dated January 15, 1994, to report, under ITEM 5 of that form, the execution of Stock Purchase Agreements pursuant to which the Registrant agreed to repurchase its Class B Common Stock from Consolidated National Corporation ("CNC") and CNC agreed to sell shares of the Registrant's Common Stock to Torchmark Corporation and Stephens Inc.; and a Report on Form 8-K, dated February 11, 1994, to report, under ITEM 1 of that form, the closing of said Stock Purchase Agreements and the sales of Common Stock and Class B Common Stock and other transactions contemplated thereby. 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. I.C.H. CORPORATION BY: /s/ ROBERT L. BEISENHERZ -------------------------------------- Robert L. Beisenherz CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND PRESIDENT Date: 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. INDEX TO EXHIBITS The following documents are incorporated by reference or filed as Exhibits to the Annual Report on Form 10-K of I.C.H. Corporation for the year ended December 31, 1993:

66960_1993.txt

66960_1993

1993

66960

ITEM 1. DESCRIPTION OF BUSINESS GENERAL DEVELOPMENT OF BUSINESS. UtiliCorp United Inc. (the company) is an electric and natural gas utility company with total assets of more than $2.8 billion. The company was formed in 1985 from Missouri Public Service Company. Today it operates utilities in eight states through seven divisions, and in one Canadian province through a subsidiary. At December 31, 1993, the company had approximately 1,158,000 utility customers and 4,700 employees. The operating divisions of UtiliCorp are Missouri Public Service, WestPlains Energy, Peoples Natural Gas, Michigan Gas Utilities, West Virginia Power, Northern Minnesota Utilities and Kansas Public Service. West Kootenay Power operates as a Canadian subsidiary. In addition to these utility operations, the company is active in non-regulated areas of the utility industry through two subsidiaries, Aquila Energy Corporation (Aquila) and UtilCo Group. The company also markets natural gas in the United Kingdom through several joint ventures and owns joint venture interests in electric distribution operations in New Zealand. Aquila was originally purchased as part of Peoples Natural Gas. It was made a wholly-owned subsidiary of UtiliCorp in 1986 to take advantage of the many marketing and transportation opportunities created by deregulation of the natural gas industry. See page I-4 for further discussion. Formed in 1986, UtilCo Group held ownership interests in 15 independent power projects in six states at December 31, 1993. These projects have an aggregate capacity of 732 MW. UtilCo Group's ownership interests range from 15% to 50%, and its share of project assets at the end of 1993 totaled $363.1 million. United Gas, the company's natural gas marketing venture in the United Kingdom (U.K.), became a contributor to earnings in 1993 due to continued efforts to further develop markets in areas of the U.K. where it supplies gas. The company and six regional electric distribution utilities in the U.K. have entered into joint venture agreements to supply gas to large volume customers in the electric utilities' service areas via facilities owned by British Gas. In July 1993, the company finalized a joint venture arrangement with the Waikato Electricity Authority in New Zealand. Under the arrangement, UtiliCorp agreed to purchase a 33% interest in Waikato-based WEL Energy Group Ltd. (WEL), for approximately $21 million to be paid over time. The company paid $2.7 million at closing and will make additional investments in the future based on the capital requirements of WEL. The business of the company is seasonal only to the extent that weather patterns may have an effect on revenues. The electric revenues of the company's Missouri Public Service and WestPlains Energy divisions peak during the summer months while the electric revenues of its West Virginia Power division and the West Kootenay Power subsidiary peak during the winter months. The company's gas and energy related businesses revenues peak during the winter months. The company's strategy is to balance its services by business segment, region, climate, and regulatory jurisdiction, and to be in the forefront of utility deregulation. In pursuit of these goals, the company actively seeks expansion opportunities in both the regulated and non-regulated segments of the industry. I-1 Additional information related to key events in 1993 and the general development of the company can be found under "Key Events of 1993" on page 17 and in Note 2 on page 37 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. Segment information for the three years ended December 31, 1993 appears in Note 12 on page 47 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. NARRATIVE DESCRIPTION OF BUSINESS. ELECTRIC OPERATIONS Through three of its divisions, Missouri Public Service ("MPS"), WestPlains Energy ("WPE") and West Virginia Power ("WVP"), and one subsidiary, West Kootenay Power, Ltd. ("WKP"), the company serves approximately 418,000 electric customers in four states and British Columbia. Over each of the last three years, the largest customer class has been residential sales which have accounted for approximately 36%, 35% and 39% of Megawatt hour ("MWH") sales during 1993, 1992 and 1991, respectively, and 43%, 42% and 46% of total electric revenues during the same period. A summary of the company's electric revenues, MWH sales, and customers, by class is set forth under "Electric Operations" on page 54 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. The electric segment has generated an average of 62% of its energy requirements over the past three years while purchasing the remainder through firm contracts and spot market purchases. The following table shows the overall fuel and purchased power mix for the past three years: A divisional summary of generation capability, firm purchased power contracts and cost of energy is set forth in Exhibit 99(a) to this Annual Report on Form 10-K and is incorporated by reference herein. As part of the acquisition of WPE in 1991, the company entered into a long- term operating lease of an 8% interest in the Jeffrey Energy Center ("Jeffrey"), a 2,070-megawatt coal-fired generating station. (See the related discussion under "Commitments and Contingencies" on page 45 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein.) The company through its MPS division also has an 8% ownership interest in Jeffrey. In late 1992 and early 1993, the company renegotiated its major coal supply and rail contracts, all at favorable prices. These contracts supply a substantial portion of the company's coal requirements. The company also purchases coal in the spot market when market conditions dictate. A summary of the electric operations is set forth on pages 18 and 19 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. I-2 Competition The company believes that competition possible as a result of open transmission legislation now being considered by Congress may benefit the electric industry. The company is confident that its electric utilities will be able to compete effectively with outside producers in providing electric service to existing and new customers. GAS OPERATIONS The company serves approximately 740,000 customers in eight states through its Peoples Natural Gas ("PNG"), Michigan Gas Utilities ("MGU"), Northern Minnesota Utilities ("NMU"), Kansas Public Service ("KPS"), WVP and MPS divisions. Residential sales have accounted for approximately 55%, 54% and 52% of gas revenues during 1993, 1992 and 1991, respectively, and approximately 51%, 50% and 47% of thousand cubic feet ("MCF") tariff gas volumes sold during 1993, 1992 and 1991, respectively. Gas volumes delivered for third parties have averaged approximately 47% of total MCF deliveries over the past three years due primarily to the deregulation within the natural gas industry. A summary of the company's gas revenues, MCF sales and customers, by class, for the past three years is set forth under "Gas Operations" on page 54 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. In 1993, the company's gas divisions purchased approximately 71% of their gas supply requirements through spot market purchases. A divisional summary of information on contract and spot market purchases and gas costs is set forth in Exhibit 99(b) to this Annual Report on Form 10-K, and is incorporated by reference herein. Recent Acquisition On February 1, 1993, the company purchased the Nebraska gas distribution system of Arkla, Inc.'s ("Arkla") Minnegasco division ("Nebraska System") for approximately $99 million, including $21 million in working capital. The Nebraska System serves about 124,000 gas customers in 63 eastern Nebraska communities, including the city of Lincoln. The Nebraska System is being operated as part of PNG. Pending Acquisitions On May 7, 1993, the company signed an acquisition agreement with Arkla to purchase its Kansas gas distribution and transmission systems ("Kansas Systems") for approximately $25 million. The Kansas Systems serve about 22,000 customers in Wichita and several surrounding communities. The company expects to complete the acquisition of the Kansas Systems in the first half of 1994. The transaction is subject to the receipt of regulatory approval. Upon completion, the Kansas Systems will be operated as part of PNG. On February 15, 1994, the company announced the signing of a definitive agreement for the purchase of a Missouri intrastate natural gas pipeline system owned by Edisto Resources Corporation. The $75 million purchase price includes the gas distribution system at Fort Leonard Wood, Missouri along with a pipeline that crosses the Mississippi river north of St. Louis. The transaction requires regulatory approval and is expected to close later in 1994. A summary of the gas operations is set forth on pages 20 and 21 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. I-3 Competition The company's gas divisions are subject to competition in the industrial sector from fuel oil, propane, coal and waste wood. The company has been able to maintain its customer base through flexible tariff rates, attractive storage pricing and transportation services. The company believes it can continue to retain industrial customers through such mechanisms in the future. Residential customer competition comes primarily from electric utility incentives and low-cost financing offers. The company has been able to maintain its customer base through similar programs of its own. ENERGY RELATED BUSINESSES Aquila formed three business units in 1989 to focus on various segments of its operations: Aquila Energy Marketing Corporation, Aquila Energy Resources Corporation and Aquila Gas Pipeline Corporation (formerly Aquila Gas Systems Corporation). In October 1993, Aquila Gas Pipeline Corporation (AGP) completed an initial public offering of 5.4 million shares of common stock, representing about 18% of the outstanding stock of AGP. Aquila Energy Marketing Corporation (AEM) has a marketing, supply and transportation network consisting of relationships with more than 1,700 gas producers and 800 local distribution companies and end-users throughout the United States, Mexico and Canada. Through more than 350 transportation agreements, it has over 13,000 gas receiving and delivery points available on a network of 33 pipelines. Aquila Energy Resources Corporation (AER) acquires proved gas and oil reserves and operates onshore and offshore production facilities. Supplementary information on gas and oil-producing activities appears in Note 13 on pages 48 and 49 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. In 1991, the company, through Aquila, purchased the remaining 51% partnership interest in Aquila-Clajon Limited Holdings, L.P. and Aquila-Clajon General Holdings, L.P. (collectively, the "Clajon Partnerships"). The Clajon Partnerships were renamed Aquila Southwest which is now a primary component of the operations of AGP. AGP owns and operates a 2,300-mile intrastate gas transmission and gathering network, four processing plants that extract and sell natural gas liquids and a subsidiary that markets natural gas. AER's net gas and oil production, average gross sales price per MCF of gas and per barrel of oil, and average production costs of gas and oil stated on an MCF equivalent basis are reflected below: I-4 AEM has entered into numerous long-term gas supply contracts at fixed prices. At December 31, 1993, AEM had minimum fixed price sales obligations of 29.0, 15.2, 15.2, 15.2 and 15.2 BCF for deliveries in the year 1994 to 1998, respectively, at prices that range from $1.73 to $3.41 per MCF. During 1993, Aquila continued its review of its long-term strategy which began in mid-1992. Upon completion of this planning process, the company recorded an after tax restructuring charge of $45 million. For additional information regarding the operations of Aquila, the initial public offering of AGP, the revised long-term strategy and the restructuring charge, please refer to pages 23, 24 and 25 of the 1993 Annual Report to Shareholders and Notes 3 and 4 to the Consolidated Financial Statements included therein. Such information is incorporated by reference herein. In June 1992, the company and Aquila filed a lawsuit in a Houston, Texas federal court against two former officers of AER, as well as the wife of one of them, seeking to recover actual and punitive damages for improper payments related to the acquisition of gas and oil reserves. The company is also pursuing action to recover part of the loss through insurance coverage. (See related discussion under Item 3 Legal Proceedings beginning on Page I-10.) Competition Aquila has various competitors for the markets it serves, including other marketing companies, gas pipelines, distribution companies, major oil and gas companies and alternative fuels. Aquila's ability to compete successfully and grow in this environment is contingent upon performance, price and the stability of the gas markets. The competition Aquila encounters in acquiring assets typically comes from pipeline and production companies. The primary focus of all groups is to find strategically located reserves to support their individual markets. REGULATION The following table summarizes the regulatory jurisdictions under which each of the Company's regulated businesses operates. There is no state regulatory body in Nebraska which has jurisdiction over utility operations. However, in Nebraska, municipalities which are served by PNG regulate rates and services therein. I-5 Certain of AGP's pipeline volumes and rates are regulated by the Texas Railroad Commission. Information related to recent rate related matters is set forth under "Revenues" on pages 18, 19 and 20 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. ENVIRONMENTAL The company is regulated by certain local, state and federal agencies in the United States and by provincial and federal agencies in Canada. The company is subject to various environmental regulations including air quality standards and emission limitations, clean water criteria pertaining to certain facilities and the handling and disposal of hazardous substances. Compliance with existing regulations, and those which may be promulgated in the future, can result in considerable capital expenditures and operation and maintenance expense. A further discussion of environmental matters is set forth in Note 10 under "Environmental" on pages 45 and 46 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. ITEM 2. ITEM 2. PROPERTIES The company owns, through its divisions and Canadian subsidiary, electric production, transmission and distribution systems and gas transmission and distribution systems throughout its service territory. The company owns, through Aquila, proved natural gas and oil reserves and gas gathering, processing and transportation pipeline systems. Substantially all of the company's domestic utility plant is mortgaged under the terms of a First Mortgage Indenture dated January 1, 1946, as supplemented (the "Indenture"), and a General Mortgage Indenture and Deed of Trust dated September 15, 1988, as supplemented. Substantially all of MGU's utility plant is mortgaged under terms pursuant to an Indenture of Mortgage and Deed of Trust dated July 1, 1951, as supplemented (the "MGU Indenture"). Substantially all of the Company's WKP subsidiary's utility plant is mortgaged under terms pursuant to a separate indenture. I-6 UTILITY FACILITIES The company's electric production facilities, as of December 31, 1993, are as follows: At December 31, 1993, the company owned substations aggregating 8,674,164 KVA, 5,934 miles of transmission line ranging from 34,500 volt to 345,000 volt, 17,648 miles of overhead distribution line and 2,291 miles of underground distribution line. At December 31, 1993, the company's gas operations had 21 operating natural gas compressor stations with 11,692 aggregate total horsepower, 2,839 miles of gas gathering and transmission pipelines and 18,625 miles of distribution mains and services located throughout its divisional service territories. I-7 AQUILA ENERGY CORPORATION PROPERTIES Supplementary information on gas and oil producing activities of Aquila and non-regulated operations of a utility division is set forth under "Reserve Quantity Information (Unaudited)" on pages 48 and 49 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. The number of productive gas and oil wells in which Aquila has an interest at December 31, 1993 is reflected below: The following table sets forth the gross and net, developed and undeveloped acreage in which Aquila has an interest as of December 31, 1993: Aquila drilled 1 gross (.3 net) exploratory well during 1993. It drilled no exploratory wells during either 1992 or 1991. The number of development wells completed and wells acquired during 1993, 1992 and 1991 follows: At December 31, 1993, Aquila had 7 gross (3.67 net) wells in the process of being drilled. I-8 AGP has ten natural gas pipeline systems having an aggregate length of approximately 2,371 miles and 51 compressor stations having approximately 80,414 horsepower. These pipelines do not form an interconnected system. Set forth below is information with respect to AGP's pipeline systems as of December 31, 1993: AGP owns and operates four natural gas processing and treating plants. One is located in southwest Oklahoma and had a rated capacity and average utilization of 115,000 MCF and 73,000 MCF, respectively, in 1993. AGP operates three plants in southeast Texas having rated capacities of 230,000 MCF, 25,000 MCF and 3,000 MCF. Average utilization was 212,000 MCF, 26,000 MCF and 1,000 MCF, respectively, for these plants in 1993. The availability of natural gas reserves to AGP depends on their development in the area served by its pipelines and on AGP's ability to purchase gas currently sold to or transported through other pipelines. The development of additional gas reserves will be affected by many factors including the prices of natural gas and crude oil, exploration and development costs and the presence of natural gas reserves in the areas served by AGP's systems. Additional information regarding Aquila's property and other non-regulated property is set forth in Note 3 on page 38 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. I-9 OTHER PROPERTIES Information regarding the company's UtilCo Group subsidiary's generating projects is set forth in Exhibit 99(c) to this Annual Report on Form 10-K and incorporated by reference herein. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On June 17, 1992, a class action suit was filed in the United States District Court for the Western District of Missouri by a stockholder against the Company and certain unnamed employees of the Company and/or its subsidiary, Aquila Energy Corporation. The case caption is WILLIAM ALPERN V. UTILICORP UNITED INC., ET AL. In this case, plaintiff alleges that the Company violated various securities laws, including Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 of the Securities and Exchange Commission, both by making misrepresentations and omitting to state material facts in connection with public disclosures. The plaintiff also alleges a claim under Section 11 of the Securities Act of 1933, as amended. Among other relief, plaintiff seeks unspecified compensatory damages. Discovery in the case is now underway. On June 17, 1992, UtiliCorp commenced a civil suit against Vincent Marquez and Richard Stegall, former employees of Aquila Energy Resources Corporation, and Mr. Stegall's former wife, Corre Stegall. Aquila Energy Resources Corporation is a wholly-owned subsidiary of Aquila Energy Corporation which, in turn, is a wholly-owned subsidiary of UtiliCorp. This case was filed in the United States District Court for the Southern District of Texas in Houston, alleging that the defendants breached their fiduciary duty, committed fraud, embezzled plaintiffs' money and converted plaintiffs' funds for defendants' own use or use of others. Mrs. Stegall filed an answer denying knowledge of any of the matters alleged. Marquez and Stegall filed a joint answer and counterclaim, admitting that funds were received by them or other third parties as alleged in the complaint but denying any wrongdoing on their part and contending that all such payments were done under the direction and approval of plaintiffs. In their counterclaim, Marquez and Stegall have alleged five separate claims: (1) fraud; (2) misrepresentation; (3) fraudulent inducement; (4) tortious interference; and (5) libel and slander. All of these claims are premised on the basic factual contentions that UtiliCorp and Aquila authorized and approved the use of the brokers and the middlemen on the transactions in question, authorized and approved the payments to the brokers and middlemen on the transactions in question, and further authorized and approved payments to Stegall on the transactions in question as extra bonus compensation. Marquez and Stegall allege that their damages are undetermined, but suggest they have been damaged in the approximate amount of $7,500,000. Marquez and Stegall have also filed a third-party complaint against the former president of Aquila, claiming that he personally authorized and approved all of their conduct which is the subject matter of plaintiffs' complaint. On April 30, 1993, UtiliCorp and Aquila amended their complaint, seeking damages of approximately $15 million, and adding 32 additional defendants, consisting of individuals and corporations who either participated with defendants Marquez and Stegall in the misappropriation or who received a portion of the misappropriated funds. UtiliCorp and Aquila also sought injunctive relief against all defendants with respect to their bank accounts containing these funds. The court granted a temporary restraining order, but on May 7, dissolved the injunction, except as to the Marquez Ranch, where the court appointed a Receiver. The court has denied several motions for summary judgment filed by various defendants who were added by the amended complaint. The court has granted one motion for summary judgment, by defendants PK Investments and its principals, Charlene Poulos and John Keys, but the court has refused to make such judgment final. Ten of the defendants have all filed counterclaims, sounding in abuse of process, bad faith, slander, libel and tortious interference, all relating to their joinder in the lawsuit and the action taken to obtain the temporary restraining order. I-10 Four defendants have filed additional counterclaims for breach of contract and fraud relating to the transactions which are the subject of the UtiliCorp and Aquila claims and are similar to the counterclaims originally asserted by defendants Marquez and Stegall. The case will be tried in late September or early October 1994. On August 13, 1992, a class action suit was filed in the United States District Court of the Southern District of Texas, Houston Division, against the Company, Aquila Energy Corporation, Aquila Energy Resources Corporation, Richard C. Green, Jr., Marc L. Petersen, Richard D. Stegall and Vincent F. Marquez. The case is captioned MARTIN AND SELMA KAPLAN V. UTILICORP UNITED INC., ET AL. In this case plaintiffs allege that the defendants violated various securities laws, including Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 of the Securities and Exchange Commission, and allege common law fraud and deceit, alleging misrepresentations and omissions of material facts in connection with public disclosures. Plaintiffs sought unspecified compensatory damages. On November 10, 1992, the District Court dismissed all counts in the KAPLAN case as to all defendants. The dismissal was affirmed by the United States Court of Appeals to the Fifth Circuit, and no further appeals were taken. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No such matters were submitted during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE COMPANY Richard C. Green, Jr. Chairman of the Board of Directors, President and Chief Executive Officer. Age 39. Chairman of the Board of Directors since February 1989 and President and Chief Executive Officer since May 1985. John R. Baker Vice Chairman. Age 67. Present position three years. Prior position was Senior Vice President, Corporate Development for six years. Robert K. Green Managing Executive Vice President. Age 32. Present position since May 1993. Previously Executive Vice President for four months. Prior executive positions at the company's Missouri Public Service division, beginning in 1988, included two years as President. Mr. Green was an attorney during 1987 - 1988 at the Kansas City law firm of Blackwell Sanders Matheny Weary & Lombardi. Joseph J. Colosimo Managing Senior Vice President. Age 43. Present position since May 1993. Previously Vice President, Human Resources since 1991. Prior positions include Corporate Director, Human Resources & Ethics, Loral Aerospace, 1990 - 1991; Director, Personnel & Organization, Ford Aerospace, 1988 - 1990; and Manager, Human Resources, Western Development Laboratories, Ford Aerospace, 1984 - 1988. Robert L. Howell Managing Senior Vice President. Age 53. Present position since May 1993. Previously Vice President, Corporate Development since 1988. Mr. Howell came to the Company from National Computer Systems where he had been Director - New Business Development since 1985. I-11 Judith A. Samayoa Vice President. Age 41. Present position since September 1993. Previously Vice President, Accounting since 1987. Dale J. Wolf Vice President, Treasurer and Corporate Secretary. Age 54. Present position five years. Prior position was Vice President, Finance and Treasurer for four years. James S. Brook Vice President. Age 43. Present position effective November 1993. Prior position was Senior Vice President of the Company's Missouri Public Service division for four years. Mr. Brook also held several positions at West Kootenay Power, including Treasurer and Chief Financial Officer from 1980 - 1982 and Vice President-Finance from 1982 - 1990. Leo E. Morton Vice President. Age 48. Present position effective February 1, 1994. Mr. Morton came to the Company from AT&T where he was employed for 21 years in a variety of engineering and management positions. B. C. Burgess Vice President. Age 48. Present position effective February 1, 1994. Mr. Burgess came to the Company from Bell Atlantic where he was Vice President - Information Services from May 1993. Prior position was with Sprint in various management positions from 1985 - 1993. Alan R. Caron Vice President. Age 42. Present position effective February 1, 1994. Prior position was Senior Vice President at the Company's Missouri Public Service division since November, 1990. Mr. Caron held various management positions with E. F. Johnson Company, Enscan, Inc. and Minnegasco, Inc. (all subsidiaries of Diversified Energies, Inc.) from 1985 - 1990. Michael D. Bruhn Vice President. Age 39. Present position effective February 1, 1994. Prior position was Director - Corporate Development for the Company since 1991. Prior to joining the Company, Mr. Bruhn held the position of Senior Vice President - Corporate Finance at B.C. Christopher Securities Co. for four years and Vice President - Corporate Finance at George K. Baum & Co. for over three years. All officers are elected annually by the Board of Directors for a term of one year. Robert K. Green is the brother of Richard C. Green, Jr., and Avis G. Tucker, Director, is the aunt of Richard C. Green, Jr. and Robert K. Green. I-12 PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The company's common stock is listed on the New York, Pacific and Toronto stock exchanges under the symbol UCU. At December 31, 1993, the company had 33,902 common shareholders of record. Information relating to market prices of Common Stock and cash dividends on Common Stock is set forth in Note 14 on page 50 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. Cash dividends on the Common Stock of the company and its predecessor have been paid each year since 1939. Cash dividends on and acquisition of the company's capital stock are restricted by provisions of the company's first mortgage indentures and by the Preference Stock provisions of the Certificate of Incorporation. Under the most restrictive of these provisions, contained in the MGU Indenture, the company may not declare or pay any dividend (other than a dividend payable in shares of its capital stock), whether in cash, stock or otherwise, or make any other distribution, on or with respect to any class of its capital stock, or purchase or otherwise acquire any shares of, any class of its capital stock if, after giving effect thereto, the sum of (i) the aggregate amount of all dividends declared and all other distributions made (other than dividends declared or distributions made in shares of its capital stock) on shares of its capital stock, of any class, subsequent to December 31, 1984, plus (ii) the excess, if any, of the amount applied to or set apart for the purchase or other acquisition of any shares of its capital stock, of any class, subsequent to December 31, 1984, over such amounts as shall have been received by the company as the net cash proceeds of sales of shares of its capital stock, of any class, subsequent to December 31, 1984, would exceed the sum of the net income of the company since January 1, 1985, plus $50 million. In addition, the company may not declare such dividends unless it maintains a tangible net worth of at least $250 million and the aggregate principal amount of its outstanding indebtedness does not exceed 70% of its capitalization. None of the company's retained earnings was restricted as to payment of cash dividends on its capital stock as of December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information regarding the five-year selected financial data is set forth on pages 52 and 53 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. Information regarding the restructuring charge and gain on sale of subsidiary stock can be found in Note 4 on page 39 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. Information concerning utility and energy related acquisitions and non-regulated property and investments appears in Note 2 and Note 3, respectively, on pages 37 and 38 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. Information related to the company's capitalization is set forth under "Consolidated Statement of Capitalization" on page 34 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. 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 can be found under "Operations and Finance" on pages 17 through 30 of the company's 1993 Annual Report to Shareholders. Such information is incorporated by reference herein. II-1 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, together with the report thereon of Arthur Andersen & Co. dated January 31, 1994, are set forth on pages 32 through 51 of the company's 1993 Annual Report to Shareholders. Financial statements for the year ended December 31, 1991, were audited by Price Waterhouse and their report is set forth on page IV-4 of this Annual Report on Form 10-K. Such information is incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On May 5, 1992, the company dismissed Price Waterhouse as its independent accountants. The report of Price Waterhouse on the financial statements for the year ended December 31, 1991 contained no adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principle. The company's Audit Committee and Board of Directors approved the decision to change independent accountants. In connection with its audit for the year ended December 31, 1991 and through May 5, 1992, there had been no disagreements with Price Waterhouse on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of Price Waterhouse would have caused them to make reference thereto in their report on the financial statements for such year. During the year ended December 31, 1991 and through May 5, 1992, there were no reportable events (as defined in Regulation S-K Item 304(a)(v)). The company requested that Price Waterhouse furnish it with a letter addressed to the SEC stating whether or not it agrees with the above statements. A copy of such letter, dated May 5, 1992, was filed as Exhibit 16 to the company's current report on Form 8-K, dated May 5, 1992. The company engaged Arthur Andersen & Co. as its new independent accountants as of May 5, 1992 and since that date, there have been no disagreements with Arthur Andersen & Co. on accounting and financial disclosures. II-2 PART III ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY, EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding these items appears in the company's definitive proxy statement for its annual meeting of shareholders to be held May 4, 1994, and is hereby incorporated by reference in this Form 10-K Annual Report, pursuant to General Instruction G(3) of Form 10-K. For information with respect to the executive officers of the company, see "Executive Officers of the Company" following Item 4 in Part I. III-1 PART IV 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. (3) List of Exhibits: Incorporated herein by reference to the Index to Exhibits. The following exhibits relate to a management contract or compensatory plan or arrangement: 10(a)(2) UtiliCorp United Inc. Deferred Income Plan. 10(a)(3) UtiliCorp United Inc. 1986 Stock Incentive Plan. 10(a)(4) UtiliCorp United Inc. Annual Incentive Plan. 10(a)(5) UtiliCorp United Inc. 1990 Non-Employee Director Stock Plan. 10(a)(6) Supplemental Executive Retirement Agreement dated November 10, 1988, between the company and Edward H. Muncaster. IV-1 10(a)(7) Supplemental Executive Retirement Agreement dated October 13, 1988, between the company and Dale J. Wolf. 10(a)(8) Severance Compensation Agreement dated as of May 3, 1989, between the company and each Executive of the Company. 10(a)(9) Executive Severance Payment Agreement 10(a)(10) Temporary Contract Employee Agreement (b) Reports on Form 8-K. A current report on Form 8-K dated February 4, 1993, with respect to Items 5 and 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated February 25, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated March 22, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated September 1, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. IV-2 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of UtiliCorp United Inc. We have audited in accordance with generally accepted auditing standards, the consolidated financial statements for 1993 and 1992 described on page 51 of UtiliCorp United Inc.'s Annual Report to the Board of Directors and Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The Financial Statement Schedules listed in Item 14(a)2 are presented for the purposes of complying with the Securities and Exchange Commission's rules and are not part 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. Kansas City, Missouri January 31, 1994 ------------------------ CONSENT OF INDEPENDENT ACCOUNTANTS As 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. 33-49803, No. 33-47289, and No. 33-39466) and on Form S-8 (No. 33-45525, No. 33-50260, No. 33-45074 and No. 33-52094) of UtiliCorp United Inc. of our report dated January 31, 1994 appearing on page 51 of the 1993 Annual Report to the Board of Directors and Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears above. It should be noted that we have not audited any financial statements of UtiliCorp United Inc. subsequent to December 31, 1993 or performed any audit procedures subsequent to the date of our report. ARTHUR ANDERSEN & CO. Kansas City, Missouri March 14, 1994 IV-3 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of UtiliCorp United Inc. In our opinion, the consolidated balance sheet and consolidated statement of capitalization and the related consolidated statement of income, of common shareholders' equity and of cash flows for the year ended December 31, 1991 (appearing on pages 32 through 35 of the 1993 Annual Report to Shareholders of UtiliCorp United Inc. which has been incorporated by reference in this Annual Report on Form 10-K), present fairly, in all material respects, the financial position, results of operations and cash flows of UtiliCorp United Inc. and its subsidiaries for the year then ended 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. We have not audited the consolidated financial statements of UtiliCorp United Inc. for any period subsequent to December 31, 1991. In 1992, the company gave retroactive effect to a change in the method of accounting for gas and oil properties. PRICE WATERHOUSE Kansas City, Missouri February 7, 1992, except with respect to the retroactive effect of a change in the method of accounting for gas and oil properties, as to which date is November 6, 1992. IV-4 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of UtiliCorp United Inc. Our audits of the consolidated financial statements referred to in our report, appearing on page IV-4 of this Annual Report on Form 10-K also included an audit of the Financial Statement Schedules for the year ended December 31, 1991 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. In 1992, the company gave retroactive effect to a change in the method of accounting for gas and oil properties. PRICE WATERHOUSE Kansas City, Missouri February 7, 1992, except with respect to the retroactive effect of a change in the method of accounting for gas and oil properties, as to which date is November 6, 1992. 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. 33-49803, No. 33-47289 and No. 33-39466) and on Form S-8 (No. 33-45525, No. 33-50260, No. 33-45074 and No. 33-52094) of UtiliCorp United Inc. of our report appearing on page IV-4 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 Kansas City, Missouri March 14, 1994 IV-5 INDEX TO EXHIBITS *3(a)(1) Certificate of Incorporation of the Company. (Exhibit 3(a)(1) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *3(a)(2) Certificate of Amendment to Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to Registration Statement No. 33-16990 filed September 3, 1987.) *3(a)(3) Certificate of Designation of the $1.775 Series Cumulative Convertible Preference Stock, as amended. (Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989.) *3(a)(4) Certificate of Designation of the Preference Stock (Cumulative), $2.05 Series. (Exhibit 3(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *3(a)(5) By-laws of the Company as amended. (Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) *4(a)(1) Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(a)(2) Certificate of Amendment to Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to Registration Statement No. 33-16990 filed September 3, 1987.) *4(a)(3) Certificate of Designation of the $1.775 Series Cumulative Convertible Preference Stock, as amended. (Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989.) *4(a)(4) Certificate of Designation of the Preference Stock (Cumulative), $2.05 Series. (Exhibit 4(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(a)(5) By-laws of the Company as amended. (Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) *4(b)(1) Indenture, dated January 1, 1946. (Exhibit 5(a)(1) to Registration Statement No. 2-54964, filed November 7, 1975.) *4(b)(2) Fourteenth Supplemental Indenture, dated as of March 15, 1967. (Exhibit 5(a)(15) to Registration Statement No. 2-60474, filed December 14, 1977.) *4(c)(1) Indenture, dated as of November 1, 1990, between the Company and The First National Bank of Chicago, Trustee. (Exhibit 4(a) to the Company's Current Report on Form 8-K, dated November 30, 1990.) *4(c)(2) First Supplemental Indenture, dated as of November 27, 1990. (Exhibit 4(b) to the Company's Current Report on Form 8-K, dated November 30, 1990.) *4(c)(3) Second Supplemental Indenture, dated as of November 15, 1991. (Exhibit 4(a) to UtiliCorp United Inc.'s Current Report on Form 8-K dated December 19, 1991.) *4(c)(4) Third Supplemental Indenture, dated as of January 15, 1992. (Exhibit 4(c)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(c)(5) Fourth Supplemental Indenture, dated as of February 24, 1993. (Exhibit 4(c)(5) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. IV-6 4(c)(6) Fifth Supplemental Indenture, dated as of April 1, 1993. *4(d) Twentieth Supplemental Indenture, dated as of May 26, 1989, Supplement to Indenture of Mortgage and Deed of Trust, dated July 1, 1951. (Exhibit 4(d) to Registration Statement No. 33-45382, filed January 30, 1992.) Long-Term debt instruments of the Company in amounts not exceeding 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis will be furnished to the Commission upon request. *10(a)(1) Agreement for the Construction and Ownership of Jeffrey Energy Center, dated as of January 13, 1975, among Missouri Public Service Company, The Kansas Power and Light Company, Kansas Gas and Electric Company and Central Telephone & Utilities Corporation. (Exhibit 5(e)(1) to Registration Statement No. 2-54964, filed November 7, 1975.) *10(a)(2) UtiliCorp United Inc. Deferred Income Plan. (Exhibit 10(a)(2) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(3) UtiliCorp United Inc. 1986 Stock Incentive Plan. (Exhibit 10(a)(3) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(4) UtiliCorp United Inc. Annual Incentive Plan. (Exhibit 10(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(5) UtiliCorp United Inc. 1990 Non-Employee Director Stock Plan. (Exhibit 10(a)(5) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(6) Supplemental Executive Retirement Agreement dated November 10, 1988, between the Company and Edward H. Muncaster. (Exhibit 10(a)(16) to the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) *10(a)(7) Supplemental Executive Retirement Agreement dated October 13, 1988, between the Company and Dale J. Wolf. (Exhibit 10(a)(10) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) *10(a)(8) Severance Compensation Agreement dated as of May 3, 1989, between the Company and each Executive of the Company. (Exhibit 10(a)(13) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) *10(a)(9) Executive Severance Payment Agreement (Exhibit 10 to the Company's Quarterly Report on Form 10-Q filed for the quarter ended September 30, 1993.) 10(a)(10) Temporary Contract Employee Agreement *10(a)(11) Lease Agreement dated as of August 15, 1991, between Wilmington Trust Company, as Lessor, and the Company, as Lessee. (Exhibit 10(a)(13) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) 10(a)(12) Credit Agreement dated as of December 13, 1993 among the Company as Borrower, the Banks Named Therein as Banks, and Citibank, N.A., as Agent [Three-Year Facility] 10(a)(13) Credit Agreement dated as of December 13, 1993 among the Company as Borrower, the Banks Named Therein as Banks, and Citibank, N.A., as Agent [360-Day Facility] 11 Statement regarding Computation of Per Share Earnings. IV-7 13 1993 Annual Report to Shareholders. 21 Subsidiaries of the Company. 23(a) Consent of Arthur Andersen & Co. appearing on Page IV-3 of this Form 10-K. 23(b) Consent of Price Waterhouse appearing on Page IV-5 of this Form 10-K. 99(a) 1993 Utility Data - Electric Operations 99(b) 1993 Utility Data - Gas Operations 99(c) UtilCo Group Generating Projects __________ *Exhibits marked with an asterisk are incorporated by reference as indicated pursuant to Rule 12(b)-23. IV-8 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UTILICORP UNITED INC. By: /s/ Richard C. Green, Jr. ------------------------------ Richard C. Green, Jr. President and Chief Executive Officer Date March 14, 1994 -------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, which include the Principal Executive Officer, the Principal Financial Officer, the Principal Accounting Officer and a majority of the Board of Directors, on behalf of the Company and in the capacities and on the dates indicated. March 14, 1994 Chairman of the Board of Directors, President and Chief Executive Officer (Principal Executive Officer) /s/ Richard C. Green, Jr. ------------------------- Richard C. Green, Jr. March 14, 1994 Vice President - Finance (Principal Financial Officer) /s/ Dale J. Wolf ------------------------- Dale J. Wolf March 14, 1994 Vice President (Principal Accounting Officer) /s/ James S. Brook ------------------------- James S. Brook March 14, 1994 Managing Executive Vice President and Director /s/ Robert K. Green ------------------------- Robert K. Green March 14, 1994 Director /s/ John R. Baker ------------------------- John R. Baker March 14, 1994 Director /s/ Avis G. Tucker ------------------------- Avis G. Tucker March 14, 1994 Director /s/ Robert F. Jackson ------------------------- Robert F. Jackson March 14, 1994 Director /s/ Don R. Armacost ------------------------- Don R. Armacost IV-9 March 14, 1994 Director /s/ L. Patton Kline ------------------------- L. Patton Kline March 14, 1994 Director /s/ Herman Cain ------------------------- Herman Cain IV-10 UTILICORP UNITED INC. SCHEDULE V -- UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1993 (in millions) S-1 UTILICORP UNITED INC. SCHEDULE V - UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1992 (in millions) S-2 UTILICORP UNITED INC. SCHEDULE V -- UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1991 (in millions) S-3 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1993 (in millions) S-4 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1992 (in millions) S-5 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1991 (in millions) S-6 UTILICORP UNITED INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in millions) S-7 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1993 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under two $200 million revolving credit facilities with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The two $200 million revolving credit facilities (the "Facilities") replaced a $400 million credit Facility in December 1993. The Facilities provide back-up liquidity for the company's commercial paper programs and allow the company additional short-term borrowing capacity on a committed basis. The company pays a fee of .225% on the average daily unused portion of the Facilities. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up liquidity facility. S-8 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1992 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under a $400 million revolving credit facility with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The $400 million credit facility (the "Credit") was initiated in March, 1991 and replaced back-up lines of credit totaling $160 million. The Credit provides back-up liquidity for the Company's commercial paper programs and allows the Company additional short-term borrowing capacity on a committed basis. The Company pays a fee of 1/4 of 1 percent on the average daily unused portion of the Credit. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up liquidity facility. S-9 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1991 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under a $400 million revolving credit facility with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The $400 million credit facility (the "Credit") was initiated in March, 1991 and replaced back-up lines of credit totaling $160 million. The Credit provides back-up liquidty for the Company's commercial paper programs and allows the Company additional short-term borrowing capacity on a committed basis. The Company pays a fee of 1/4 of 1 percent on the average daily unused portion of the Credit. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up credit facility. S-10 UTILICORP UNITED INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in millions) S-11 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. (3) List of Exhibits: Incorporated herein by reference to the Index to Exhibits. The following exhibits relate to a management contract or compensatory plan or arrangement: 10(a)(2) UtiliCorp United Inc. Deferred Income Plan. 10(a)(3) UtiliCorp United Inc. 1986 Stock Incentive Plan. 10(a)(4) UtiliCorp United Inc. Annual Incentive Plan. 10(a)(5) UtiliCorp United Inc. 1990 Non-Employee Director Stock Plan. 10(a)(6) Supplemental Executive Retirement Agreement dated November 10, 1988, between the company and Edward H. Muncaster. IV-1 10(a)(7) Supplemental Executive Retirement Agreement dated October 13, 1988, between the company and Dale J. Wolf. 10(a)(8) Severance Compensation Agreement dated as of May 3, 1989, between the company and each Executive of the Company. 10(a)(9) Executive Severance Payment Agreement 10(a)(10) Temporary Contract Employee Agreement (b) Reports on Form 8-K. A current report on Form 8-K dated February 4, 1993, with respect to Items 5 and 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated February 25, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated March 22, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. A current report on Form 8-K dated September 1, 1993, with respect to Item 7 was filed with the Securities and Exchange Commission by the company. IV-2 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of UtiliCorp United Inc. We have audited in accordance with generally accepted auditing standards, the consolidated financial statements for 1993 and 1992 described on page 51 of UtiliCorp United Inc.'s Annual Report to the Board of Directors and Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 31, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The Financial Statement Schedules listed in Item 14(a)2 are presented for the purposes of complying with the Securities and Exchange Commission's rules and are not part 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. Kansas City, Missouri January 31, 1994 ------------------------ CONSENT OF INDEPENDENT ACCOUNTANTS As 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. 33-49803, No. 33-47289, and No. 33-39466) and on Form S-8 (No. 33-45525, No. 33-50260, No. 33-45074 and No. 33-52094) of UtiliCorp United Inc. of our report dated January 31, 1994 appearing on page 51 of the 1993 Annual Report to the Board of Directors and Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears above. It should be noted that we have not audited any financial statements of UtiliCorp United Inc. subsequent to December 31, 1993 or performed any audit procedures subsequent to the date of our report. ARTHUR ANDERSEN & CO. Kansas City, Missouri March 14, 1994 IV-3 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of UtiliCorp United Inc. In our opinion, the consolidated balance sheet and consolidated statement of capitalization and the related consolidated statement of income, of common shareholders' equity and of cash flows for the year ended December 31, 1991 (appearing on pages 32 through 35 of the 1993 Annual Report to Shareholders of UtiliCorp United Inc. which has been incorporated by reference in this Annual Report on Form 10-K), present fairly, in all material respects, the financial position, results of operations and cash flows of UtiliCorp United Inc. and its subsidiaries for the year then ended 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. We have not audited the consolidated financial statements of UtiliCorp United Inc. for any period subsequent to December 31, 1991. In 1992, the company gave retroactive effect to a change in the method of accounting for gas and oil properties. PRICE WATERHOUSE Kansas City, Missouri February 7, 1992, except with respect to the retroactive effect of a change in the method of accounting for gas and oil properties, as to which date is November 6, 1992. IV-4 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of UtiliCorp United Inc. Our audits of the consolidated financial statements referred to in our report, appearing on page IV-4 of this Annual Report on Form 10-K also included an audit of the Financial Statement Schedules for the year ended December 31, 1991 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. In 1992, the company gave retroactive effect to a change in the method of accounting for gas and oil properties. PRICE WATERHOUSE Kansas City, Missouri February 7, 1992, except with respect to the retroactive effect of a change in the method of accounting for gas and oil properties, as to which date is November 6, 1992. 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. 33-49803, No. 33-47289 and No. 33-39466) and on Form S-8 (No. 33-45525, No. 33-50260, No. 33-45074 and No. 33-52094) of UtiliCorp United Inc. of our report appearing on page IV-4 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 Kansas City, Missouri March 14, 1994 IV-5 INDEX TO EXHIBITS *3(a)(1) Certificate of Incorporation of the Company. (Exhibit 3(a)(1) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *3(a)(2) Certificate of Amendment to Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to Registration Statement No. 33-16990 filed September 3, 1987.) *3(a)(3) Certificate of Designation of the $1.775 Series Cumulative Convertible Preference Stock, as amended. (Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989.) *3(a)(4) Certificate of Designation of the Preference Stock (Cumulative), $2.05 Series. (Exhibit 3(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *3(a)(5) By-laws of the Company as amended. (Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) *4(a)(1) Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(a)(2) Certificate of Amendment to Certificate of Incorporation of the Company. (Exhibit 4(a)(1) to Registration Statement No. 33-16990 filed September 3, 1987.) *4(a)(3) Certificate of Designation of the $1.775 Series Cumulative Convertible Preference Stock, as amended. (Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989.) *4(a)(4) Certificate of Designation of the Preference Stock (Cumulative), $2.05 Series. (Exhibit 4(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(a)(5) By-laws of the Company as amended. (Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993.) *4(b)(1) Indenture, dated January 1, 1946. (Exhibit 5(a)(1) to Registration Statement No. 2-54964, filed November 7, 1975.) *4(b)(2) Fourteenth Supplemental Indenture, dated as of March 15, 1967. (Exhibit 5(a)(15) to Registration Statement No. 2-60474, filed December 14, 1977.) *4(c)(1) Indenture, dated as of November 1, 1990, between the Company and The First National Bank of Chicago, Trustee. (Exhibit 4(a) to the Company's Current Report on Form 8-K, dated November 30, 1990.) *4(c)(2) First Supplemental Indenture, dated as of November 27, 1990. (Exhibit 4(b) to the Company's Current Report on Form 8-K, dated November 30, 1990.) *4(c)(3) Second Supplemental Indenture, dated as of November 15, 1991. (Exhibit 4(a) to UtiliCorp United Inc.'s Current Report on Form 8-K dated December 19, 1991.) *4(c)(4) Third Supplemental Indenture, dated as of January 15, 1992. (Exhibit 4(c)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *4(c)(5) Fourth Supplemental Indenture, dated as of February 24, 1993. (Exhibit 4(c)(5) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. IV-6 4(c)(6) Fifth Supplemental Indenture, dated as of April 1, 1993. *4(d) Twentieth Supplemental Indenture, dated as of May 26, 1989, Supplement to Indenture of Mortgage and Deed of Trust, dated July 1, 1951. (Exhibit 4(d) to Registration Statement No. 33-45382, filed January 30, 1992.) Long-Term debt instruments of the Company in amounts not exceeding 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis will be furnished to the Commission upon request. *10(a)(1) Agreement for the Construction and Ownership of Jeffrey Energy Center, dated as of January 13, 1975, among Missouri Public Service Company, The Kansas Power and Light Company, Kansas Gas and Electric Company and Central Telephone & Utilities Corporation. (Exhibit 5(e)(1) to Registration Statement No. 2-54964, filed November 7, 1975.) *10(a)(2) UtiliCorp United Inc. Deferred Income Plan. (Exhibit 10(a)(2) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(3) UtiliCorp United Inc. 1986 Stock Incentive Plan. (Exhibit 10(a)(3) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(4) UtiliCorp United Inc. Annual Incentive Plan. (Exhibit 10(a)(4) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(5) UtiliCorp United Inc. 1990 Non-Employee Director Stock Plan. (Exhibit 10(a)(5) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) *10(a)(6) Supplemental Executive Retirement Agreement dated November 10, 1988, between the Company and Edward H. Muncaster. (Exhibit 10(a)(16) to the Company's Annual Report on Form 10-K for the year ended December 31, 1988.) *10(a)(7) Supplemental Executive Retirement Agreement dated October 13, 1988, between the Company and Dale J. Wolf. (Exhibit 10(a)(10) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989.) *10(a)(8) Severance Compensation Agreement dated as of May 3, 1989, between the Company and each Executive of the Company. (Exhibit 10(a)(13) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) *10(a)(9) Executive Severance Payment Agreement (Exhibit 10 to the Company's Quarterly Report on Form 10-Q filed for the quarter ended September 30, 1993.) 10(a)(10) Temporary Contract Employee Agreement *10(a)(11) Lease Agreement dated as of August 15, 1991, between Wilmington Trust Company, as Lessor, and the Company, as Lessee. (Exhibit 10(a)(13) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) 10(a)(12) Credit Agreement dated as of December 13, 1993 among the Company as Borrower, the Banks Named Therein as Banks, and Citibank, N.A., as Agent [Three-Year Facility] 10(a)(13) Credit Agreement dated as of December 13, 1993 among the Company as Borrower, the Banks Named Therein as Banks, and Citibank, N.A., as Agent [360-Day Facility] 11 Statement regarding Computation of Per Share Earnings. IV-7 13 1993 Annual Report to Shareholders. 21 Subsidiaries of the Company. 23(a) Consent of Arthur Andersen & Co. appearing on Page IV-3 of this Form 10-K. 23(b) Consent of Price Waterhouse appearing on Page IV-5 of this Form 10-K. 99(a) 1993 Utility Data - Electric Operations 99(b) 1993 Utility Data - Gas Operations 99(c) UtilCo Group Generating Projects __________ *Exhibits marked with an asterisk are incorporated by reference as indicated pursuant to Rule 12(b)-23. IV-8 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UTILICORP UNITED INC. By: /s/ Richard C. Green, Jr. ------------------------------ Richard C. Green, Jr. President and Chief Executive Officer Date March 14, 1994 -------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, which include the Principal Executive Officer, the Principal Financial Officer, the Principal Accounting Officer and a majority of the Board of Directors, on behalf of the Company and in the capacities and on the dates indicated. March 14, 1994 Chairman of the Board of Directors, President and Chief Executive Officer (Principal Executive Officer) /s/ Richard C. Green, Jr. ------------------------- Richard C. Green, Jr. March 14, 1994 Vice President - Finance (Principal Financial Officer) /s/ Dale J. Wolf ------------------------- Dale J. Wolf March 14, 1994 Vice President (Principal Accounting Officer) /s/ James S. Brook ------------------------- James S. Brook March 14, 1994 Managing Executive Vice President and Director /s/ Robert K. Green ------------------------- Robert K. Green March 14, 1994 Director /s/ John R. Baker ------------------------- John R. Baker March 14, 1994 Director /s/ Avis G. Tucker ------------------------- Avis G. Tucker March 14, 1994 Director /s/ Robert F. Jackson ------------------------- Robert F. Jackson March 14, 1994 Director /s/ Don R. Armacost ------------------------- Don R. Armacost IV-9 March 14, 1994 Director /s/ L. Patton Kline ------------------------- L. Patton Kline March 14, 1994 Director /s/ Herman Cain ------------------------- Herman Cain IV-10 UTILICORP UNITED INC. SCHEDULE V -- UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1993 (in millions) S-1 UTILICORP UNITED INC. SCHEDULE V - UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1992 (in millions) S-2 UTILICORP UNITED INC. SCHEDULE V -- UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1991 (in millions) S-3 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1993 (in millions) S-4 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1992 (in millions) S-5 UTILICORP UNITED INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF UTILITY PLANT AND PROPERTY IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1991 (in millions) S-6 UTILICORP UNITED INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in millions) S-7 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1993 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under two $200 million revolving credit facilities with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The two $200 million revolving credit facilities (the "Facilities") replaced a $400 million credit Facility in December 1993. The Facilities provide back-up liquidity for the company's commercial paper programs and allow the company additional short-term borrowing capacity on a committed basis. The company pays a fee of .225% on the average daily unused portion of the Facilities. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up liquidity facility. S-8 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1992 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under a $400 million revolving credit facility with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The $400 million credit facility (the "Credit") was initiated in March, 1991 and replaced back-up lines of credit totaling $160 million. The Credit provides back-up liquidity for the Company's commercial paper programs and allows the Company additional short-term borrowing capacity on a committed basis. The Company pays a fee of 1/4 of 1 percent on the average daily unused portion of the Credit. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up liquidity facility. S-9 UTILICORP UNITED INC. SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31, 1991 (dollars in millions) The Company borrows funds for corporate purposes through the sale of commercial paper, under a $400 million revolving credit facility with a group of banks and through uncommitted money market lines of credit with banks. The commercial paper is generally sold for periods of 60 days or less, and short-term bank borrowings generally are arranged for periods of 30 to 90 days. The $400 million credit facility (the "Credit") was initiated in March, 1991 and replaced back-up lines of credit totaling $160 million. The Credit provides back-up liquidty for the Company's commercial paper programs and allows the Company additional short-term borrowing capacity on a committed basis. The Company pays a fee of 1/4 of 1 percent on the average daily unused portion of the Credit. (a) Based upon daily balances outstanding. (b) Includes domestic and European commercial paper. (c) Does not include cost of back-up credit facility. S-10 UTILICORP UNITED INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (in millions) S-11

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ITEM 2. PROPERTIES Gas. PG&W's gas system consists of approximately 2,159 miles of distribution lines, nine city gate and 67 major regulating stations and miscellaneous related and additional property. PG&W believes that its gas utility properties are adequately maintained and in good operating condition in all material respects. Continued expenditures will, however, be required with regard to PG&W's on-going valve maintenance program. See "Business-Gas Business-Valve Maintenance." Most of PG&W's gas utility properties are subject to mortgage liens securing certain funded debt. These properties are subject to a first mortgage lien pursuant to the Indenture of Mortgage and Deed of Trust dated as of March 15, 1946, as supplemented by twenty-eight supplemental indentures (collectively, the "Indenture") from PG&W to Morgan Guaranty Trust Company of New York, as Trustee, and a second mortgage lien pursuant to a Subordinate Open End Mortgage, Security Agreement, Assignment of Leases, Rents and Profits, Financing Statement and Fixture Filing, dated as of September 10, 1991 (the "Intercreditor Mortgage"), from PG&W to Swiss Bank Corporation, New York Branch ("SBC"), as Collateral Agent, which secures PG&W's obligations under the Letter of Credit Agreement dated as of December 1, 1987, as amended, between PG&W and SBC. Water. PG&W's water system consists principally of 43 active and standby reservoirs and stream intakes, ten water treatment plants, various distribution system storage tanks, approximately 1,675 miles of aqueducts and pipelines, and miscellaneous related and additional property. In addition, PG&W owns approximately 53,000 acres of land situated in northeastern Pennsylvania, approximately 70% of which is used in connection with its water utility operations. From time to time, PG&W engages in the sale of non-watershed land and other physical property. Proposed legislation in Pennsylvania, if enacted, would require water utilities to obtain the PPUC's prior approval for the transfer of any watershed land (as defined) and would require the PPUC to credit to ratepayers 50% of the net proceeds (as defined) of any sale, lease or other transfer of such land permitted by the PPUC. PG&W currently anticipates that it will realize average gross profits of approximately $600,000 per year through 1996 from sales of non-watershed land and other physical property. Sales on non-watershed lands and other physical property would not be subject to the proposed legislation; however, there can be no assurance that the proceeds ultimately received will inure exclusively to the benefits of PEI's shareholders. In PG&W's opinion, its water utility properties are adequately maintained and in good operating condition in all material respects. Continued capital expenditures will nonetheless be required for PG&W's on-going program of water main replacement and rehabilitation and other improvements to ensure the integrity of PG&W's distribution system. See "Business-Water Business-Main Replacement and Rehabilitation Program and Other Distribution System Improvements." Most of PG&W's water utility properties are subject to mortgage liens securing certain funded debt. These water utility properties are subject to a first mortgage lien pursuant to the Indenture. Additionally, certain of these properties are subject to a second mortgage lien (the "PENNVEST Mortgage") pursuant to a loan agreement, dated October 16, 1987, between PG&W and the Pennsylvania Water Facilities Loan Board and pursuant to loan agreements, dated March 3, 1989, December 3, 1992, and April 5, 1993, between PG&W and the Pennsylvania Infrastructure Investment Authority, which were primarily used to finance the construction of certain water facilities. These properties are also subject to a second or third mortgage lien (depending on whether they are subject to the PENNVEST Mortgage) pursuant to the Intercreditor Mortgage. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Construction Litigation On April 22, 1992, a complaint was filed in the Court of Common Pleas of Lackawanna County, Pennsylvania, by the Quandel Group Inc. ("Quandel") against PG&W in connection with the construction of PG&W's Brownell Water Treatment Plant. In its complaint, Quandel, the general contractor for the project, made various allegations and sought approximately $1.3 million in damages, plus interest. PG&W answered the complaint and also filed a counterclaim against Quandel seeking approximately $1.6 million in damages and expenses for failure of Quandel to complete construction of the Brownell Water Treatment Plant in a timely and proper manner. Also, PG&W joined Gannett-Fleming Water Resources Engineers, Inc. (Gannett-Fleming), the designer of the project, as an additional defendant in this action. On January 25, 1994, Quandel and PG&W reached an agreement settling Quandel's claim against PG&W and PG&W's counterclaim against Quandel on terms that had no material impact on PG&W's results of operations or financial position. Additionally, as part of this settlement, Quandel agreed to indemnify PG&W for any liability arising out of Quandel's claim against Gannett-Fleming in this action, which is still pending, or otherwise relating to the construction of the Brownell Water Treatment Plant. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, there were no matters submitted to a vote of security holders of the registrant through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's common stock is owned entirely by PEI and is not traded. The dividends per share of common stock paid by PG&W during the years ended December 31, 1992 and 1993, were as follows: [CAPTION] 1992 1993 [S] [C] [C] First quarter $ .705 $ .7100 Second quarter .670 .7100 Third quarter .705 .7100 Fourth quarter .460 .6925 Total $ 2.540 $2.8225 Information relating to restriction on the payment of dividends by PG&W is set forth in Note 7 to the Financial Statements in Item 8 of this Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table expresses certain items in PG&W's Statements of Income contained in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of PG&W and the report of independent public accountants thereon are presented on pages 42 through 71 of this Form 10-K. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Pennsylvania Gas and Water Company: We have audited the accompanying balance sheets and statements of capitalization of Pennsylvania Gas and Water Company (the "Company") (a Pennsylvania corporation and a wholly-owned subsidiary of Pennsylvania Enterprises, Inc.) as of December 31, 1993 and 1992, and the related statements of income, common shareholder's 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 Pennsylvania Gas and Water Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 1 and 9, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions pursuant to standards promulgated by the Financial Accounting Standards Board. 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 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, N.Y. March 4, 1994 PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF INCOME PENNSYLVANIA GAS AND WATER COMPANY BALANCE SHEETS PENNSYLVANIA GAS AND WATER COMPANY BALANCE SHEETS PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the financial statements. PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF CAPITALIZATION PENNSYLVANIA GAS AND WATER COMPANY STATEMENTS OF COMMON SHAREHOLDER'S INVESTMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 PENNSYLVANIA GAS AND WATER COMPANY NOTES TO FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Pennsylvania Gas and Water Company ("PG&W"), a wholly-owned subsidiary of Pennsylvania Enterprises, Inc. ("PEI"), is a regulated public utility subject to the jurisdiction of the Pennsylvania Public Utility Commission ("PPUC") for rate and accounting purposes. PG&W has five wholly-owned subsidiaries: Penn Gas Development Co. and four small water companies, which have not been consolidated since they are insignificant. The equity method is used to account for PG&W's investment in these subsidiaries. Utility Plant and Depreciation. Utility plant is stated at cost, which represents the original cost of construction, including payroll, administrative and general costs, an allowance for funds used during construction, and the plant acquisition adjustments. The plant acquisition adjustments represent the difference between the cost to PG&W of plant acquired as a system and the cost of such plant when first devoted to public service, and are primarily attributable to land, water rights and goodwill. Except for approximately $340,000 recorded in 1993 with respect to water plant, the plant acquisition adjustments relate to acquisitions made prior to October 31, 1970, and thus are not required to be amortized for financial reporting purposes since PG&W believes there has been no diminution in their value. Also, such plant acquisition adjustments are not being amortized, consistent with PPUC Orders. The plant acquisition adjustments of approximately $340,000 recorded in 1993 will be amortized over a ten-year period commencing on January 1, 1994, in accordance with the PPUC's December 15, 1993, Order regarding the increase in water rates for customers in the Spring Brook Water Rate Area served by the Ceasetown and Watres Water Treatment Plants. The allowance for funds used during construction ("AFUDC") is defined as the net cost during the period of construction of borrowed funds used and a reasonable rate upon other funds when so used. Such allowance is charged to utility plant and reported as either other income, net (with respect to the cost of equity funds) or as a reduction of interest expense (with respect to the cost of borrowed funds) in the accompanying statements of income. AFUDC varies according to changes in the level of construction work in progress and in the sources and costs of capital. The weighted average rate for such allowance was approximately 9% in 1991, 7% in 1992 and 8% in 1993. PG&W provides for depreciation on a straight-line basis for gas plant and all common plant. As of December 31, 1993, depreciation was provided on a straight-line basis for approximately 61% of the water plant and on a 4% compound interest method for the remainder of the water plant. Exclusive of transportation and work equipment, the annual provision for depreciation, as related to the average depreciable original cost of utility plant, resulted in the following percentages: [CAPTION] 1991 1992 1993 [S] [C] [C] [C] Gas 2.33% 2.51% 2.49% Water 1.42 1.57 1.71 Common 7.22 6.76 8.06 The increase in the annual rate of depreciation relative to water plant in both 1992 and 1993 reflects a change from the 4% compound interest method to the straight-line method of depreciation with respect to certain of that plant, as ordered by the PPUC. Such change in method of depreciation is generally being made as PG&W is allowed to initially increase its rates for customers receiving filtered water service. Under the terms of the settlement discussed in Note 2 relative to the water rate increase approved by the PPUC on December 15, 1993, for customers in the Spring Brook Water Rate Area served by the Ceasetown and Watres Water Treatment Plants, PG&W will begin depreciating all water facilities located in the areas served by those plants on a straight-line basis effective January 1, 1994. This change is expected to increase the annual provision for depreciation by approximately $1.5 million and to increase the overall annual rate of depreciation with respect to water plant to approximately 2.21%. When depreciable property is retired, the original cost of such property is removed from the utility plant accounts and is charged, together with the cost of removal less salvage, to accumulated depreciation. No gain or loss is recognized in connection with retirements of depreciable property, other than in the case of significant involuntary conversions or extraordinary retirements. Revenues and Cost of Gas. PG&W bills its customers based on estimated or actual meter readings on a cycle basis. Gas customers and certain water customers, primarily large users, are billed monthly on a cycle that extends throughout the month. Other water customers are billed bi-monthly or quarterly on cycles that extend over the respective periods. The estimated unbilled amounts from the most recent meter reading dates through the end of the period being reported on are recorded as accrued revenues. PG&W generally passes on to its customers increases or decreases in gas costs from those reflected in its tariff charges. In accordance with this procedure, PG&W defers any current under or over-recoveries of gas costs and collects or refunds such amounts in subsequent periods. In accordance with an Order adopted by the PPUC on May 31, 1990, PG&W is recovering 90% of its total take-or-pay liabilities through the billing of a surcharge to customers generally over a four-year period beginning June 1, 1990. This surcharge is reflected as operating revenue and is offset by a corresponding charge to the cost of gas. The take-or-pay liabilities billed to PG&W, which will be recovered in future periods by means of such surcharge, are included in deferred cost of gas and supplier refunds, net. The cost of gas also includes that portion (i.e., 10%) of PG&W's take-or-pay liabilities which it has agreed to absorb in accordance with the PPUC's Order of May 31, 1990. Deferred Charges. PG&W generally accounts for and reports its costs in accordance with the economic effect of rate actions by the PPUC. To this extent, certain costs are recorded as deferred charges pending their recovery in rates. Such deferred charges include, among other amounts, deferred treatment plant costs and carrying charges as discussed in Note 2, certain pre-operating costs relative to PG&W's water treatment plants, costs associated with the Early Retirement Plan as discussed in Note 9, and certain preliminary survey and investigation costs. These amounts either relate to previously-issued orders of the PPUC or are of a nature which, in the opinion of PG&W, will be recoverable in future rates, based on past actions of the PPUC or other relevant factors. PG&W records, as deferred charges, the direct financing costs incurred in connection with the issuance of long-term debt and redeemable preferred stock and equitably amortizes such amounts over the life of such securities. Cash and Cash Equivalents. For the purposes of the statements of cash flows, PG&W considers all highly liquid debt instruments purchased, which generally have a maturity of three months or less, to be cash equivalents. Such instruments are carried at cost, which approximates market value. Income Taxes. The provision for income taxes consists of the following components: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Included in operating expenses: Currently payable - Federal $ 2,328 $ 4,664 $ 5,644 State 570 1,888 1,917 Total currently payable 2,898 6,552 7,561 Deferred, net - Federal 2,454 2,512 2,535 State 263 (503) (851) Total deferred, net 2,717 2,009 1,684 Amortization of investment tax credits (256) (256) (256) Total included in operating expenses 5,359 8,305 8,989 Included in other income, net: Currently payable - Federal 104 (29) (44) State (24) (26) (28) Total currently payable 80 (55) (72) Deferred, net - Federal (31) 39 (6) State 7 - - Total deferred, net (24) 39 (6) Total included in other income, net 56 (16) (78) Total provision for income taxes $ 5,415 $ 8,289 $ 8,911 Deferred income taxes result from timing differences in the recognition of revenues and expenses for tax and accounting purposes and, with respect to elements of operating income, are recorded consistent with the treatment allowed by the PPUC for ratemaking purposes. The source of these timing differences and the tax effect of each is as follows: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Excess of tax depreciation over depreciation for accounting purposes $ 2,441 $ 2,502 $ 3,214 Deferred treatment plant costs, net 982 585 1,458 Take-or-pay costs, net (222) (446) (1,126) Other, net (508) (593) (1,868) Total deferred taxes, net $ 2,693 $ 2,048 $ 1,678 Included in: Operating expenses $ 2,717 $ 2,009 $ 1,684 Other income, net (24) 39 (6) Total deferred taxes, net $ 2,693 $ 2,048 $ 1,678 The total provision for income taxes shown in the accompanying statements of income differs from the amount which would be computed by applying the statutory federal income tax rate to income before income taxes. The following table summarizes the major reasons for this difference: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Income before income taxes $16,545 $21,245 $25,212 Tax expense at statutory federal income tax rate $ 5,625 $ 7,223 $ 8,824 Increases (reductions) in taxes resulting from - State income taxes, net of federal income tax benefit 795 1,161 935 Allowance for equity funds used during construction and equity component of deferred treatment plant carrying charges - - (545) Amortization of investment tax credits (256) (256) (256) Other, net (749) 161 (47) Total provision for income taxes $ 5,415 $ 8,289 $ 8,911 Effective January 1, 1993, PG&W adopted the provisions of Financial Accounting Standards Board ("FASB") Statement 109, "Accounting for Income Taxes," which superseded previously issued income tax accounting standards. The adoption of FASB Statement 109 did not have a significant effect on PG&W's results of operations. In accordance with the provisions of FASB Statement 109, PG&W recorded as of January 1, 1993, an additional deferred tax liability and an asset, representing the probable future rate recovery of the previously unrecorded deferred taxes, primarily relating to certain temporary differences in the basis of utility plant which had not previously been recorded because of the regulatory rate practices of the PPUC. As of December 31, 1993, a total of $87.0 million in deferred income taxes, relating primarily to temporary differences involving utility plant and consisting of deferred tax liabilities of $95.6 million and deferred tax assets of $8.6 million, were so reflected in these financial statements in accordance with the requirements of FASB Statement 109. (2) RATE MATTERS Gas Utility Operations Annual Gas Cost Adjustment. Pursuant to the provisions of the Pennsylvania Public Utility Code, which require that the tariffs of gas distribution companies, such as PG&W, be adjusted on an annual basis to reflect changes in their purchased gas costs, the PPUC ordered PG&W to make the following changes during 1991, 1992 and 1993 to the gas costs contained in its gas tariff rates: [CAPTION] Change in Calculated Effective Rate per MCF Increase (Decrease) Date From To in Annual Revenue [S] [C] [C] [C] December 1, 1991 $3.20 $2.46 $(20,800,000) December 1, 1992 2.46 2.79 9,500,000 December 1, 1993 2.79 3.74 28,800,000 The annual changes in gas rates on account of purchased gas costs have no effect on PG&W's earnings since the change in revenue is offset by a corresponding change in the cost of gas. Recovery of Take-or-Pay Costs. On April 27, 1990, PG&W filed an application with the PPUC seeking approval to recover 90% ($13.9 million based on then current estimates) of its total take-or-pay liabilities, and $250,000 of related carrying costs, through billings to customers generally over a four-year period beginning June 1, 1990. The PPUC approved this application, effective June 1, 1990. In connection with this approval, PG&W agreed to absorb a portion of its take-or-pay liabilities. The amount to be so absorbed by PG&W is currently estimated to be $1.8 million, substantially all of which had been charged to expense as of December 31, 1993. As of December 31, 1993, PG&W had billed $14.8 million of take-or-pay costs to its customers and had deferred $1.1 million of such costs, including related carrying charges, for future billing to customers. Under terms of the PPUC's Order in respect of take-or-pay obligations, the surcharge by which PG&W bills its customers for take-or-pay costs is to be adjusted annually as of June 1 to reflect changes in PG&W's total estimated liability for take-or-pay costs (which is currently projected to be as much as $18.1 million) and the portion of such costs remaining to be recovered from its customers. In accordance therewith, the PPUC approved an adjustment in PG&W's take-or-pay surcharge effective June 1, 1993, based on the estimated $3.5 million of take-or-pay costs that remained to be collected from its customers as of such date. Water Rate Filings Scranton Area Water Rate Increases. March, 1991, Increase. On June 8, 1990, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $25.5 million in additional annual revenue. This rate increase request involved the approximately 54,700 customers at such date who would be furnished water from the one previously existing and the four new water treatment plants in the Scranton Water Rate Area. In December, 1990, PG&W and certain parties filing objections to the rate increase request reached a settlement that provided for an approximate 110% rate increase designed to produce $15.0 million of additional annual revenue to be phased-in over a two- year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92 entitled "Regulated Enterprises-Accounting for Phase-in Plans." The settlement provided that $10.2 million of the increased revenue (an approximate 75% increase in rates) was to be realized through an immediate rate increase and that the remaining $4.8 million of the increased revenue (an additional 35% increase in rates) was to be realized through another rate increase one year later (at the beginning of year two of the phase-in period). The settlement also specified that the $4.8 million in revenue that would be deferred during the first year of the phase-in period was to be collected from customers in the form of a surcharge in years two through ten of the phase-in period. By Order adopted March 22, 1991, the PPUC approved the settlement and permitted PG&W a water rate increase estimated to produce additional annual revenue of $15.0 million, effective March 23, 1991. In accordance with the accounting requirements for a qualified phase-in plan as prescribed by FASB Statement 92, PG&W recorded a $1.2 million nonrecurring charge to earnings as of December 31, 1990, representing the estimated net present value of carrying charges on the $4.8 million of revenue to be deferred in the first year of the phase-in period. This charge was required because the terms of the settlement did not provide for the billing of any carrying charges on such deferred revenue. Additionally, in accordance with the provisions of FASB Statement 92, PG&W commenced recording the entire $15.0 million increase in annual revenue allowed by the PPUC as additional revenue beginning March 23, 1991. However, pursuant to the terms of the settlement, PG&W deferred the billing of $4.7 million of the increased revenue recorded during the first year of the phase-in period (i.e., the period March 23, 1991, through March 22, 1992). The amount so deferred was $100,000 less than the $4.8 million originally estimated because of slightly lower than anticipated consumption. Effective March 23, 1992, PG&W began to bill the $4.7 million that had been so deferred by means of the surcharge that will be in effect in years two through ten of the phase-in period, and as of December 31, 1993, $871,000 had been so billed to its Scranton Water Rate Area customers. June, 1993, Increase. On September 25, 1992, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $9.9 million in additional annual revenue, to be effective November 24, 1992. This rate increase request involved the approximately 56,000 customers in PG&W's Scranton Water Rate Area at such date. On November 13, 1992, the PPUC suspended this rate increase for seven months (until June 24, 1993) in order to investigate the reasonableness of the proposed rates. By Order entered June 23, 1993, the PPUC rejected the proposed rate increase in its entirety "due to inadequate service" (i.e., water quality). However, by the same Order, the PPUC granted PG&W the alternative of a rate increase designed to produce an additional $5.0 million in annual revenue, provided that PG&W dedicate the entire increase to augment the improvements to its water distribution system until "...the demonstration by [PG&W] to [the PPUC] that it is providing adequate service." PG&W accepted this alternative and placed such $5.0 million rate increase into effect as of June 23, 1993. On August 19, 1993, the PPUC approved a settlement agreement resolving certain disputed issues relating to its June 23, 1993, Order. This settlement agreement provided, among other things, for (i) modification by the PPUC of its June 23, 1993, Order to reduce the amount of the revenue increase that it ordered be dedicated to distribution system improvements by the related income taxes and other expenses and the $319,000 additional expense for retiree health care and life insurance benefits that the PPUC allowed PG&W in its revenues (which resulted in the requirement for an additional annual expenditure for distribution system improvements by PG&W of $2.5 million), (ii) the agreement by PG&W to spend a total of $4.9 million annually (an additional $2.5 million over its actual average annual expenditure of $2.4 million during the three-year period ended June 30, 1993) for distribution system improvements in the Scranton Water Rate Area until the PPUC is satisfied that PG&W is providing adequate service, (iii) the modification by the PPUC of its June 23, 1993, Order to restore the Hollister Reservoir to PG&W's rate base, and (iv) the withdrawal by PG&W and the Office of Consumer Advocate (the "OCA") of their appeals to the Commonwealth Court of Pennsylvania regarding the PPUC's June 23, 1993, Order. Spring Brook Water Rate Increases. Nesbitt Service Area. On April 30, 1991, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $2.6 million in additional annual revenue. This rate increase request involved the approximately 14,300 customers in the Spring Brook Water Rate Area at such date who were served exclusively by the Nesbitt Water Treatment Plant. PG&W and certain parties filing objections to the rate increase request reached a settlement that provided for a $1.9 million increase in annual revenue which the PPUC approved effective January 30, 1992. However, on February 27, 1992, the PPUC granted a petition of the OCA, a complainant in the rate proceeding and a signatory to the settlement, for reconsideration and clarification of the PPUC Order which approved the settlement. As a result, the $1.9 million rate increase remains subject to further PPUC and possible appellate review. Although it cannot be certain, PG&W believes that the $1.9 million increase will not be rescinded in whole or in part or affected in any other way as a result of the OCA's petition and as of March 23, 1994, no further action had been taken by the PPUC with respect to the OCA's petition. Crystal Lake Service Area. On June 30, 1992, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $4.4 million in additional annual revenue, to be effective August 29, 1992. This rate increase request involved the approximately 5,000 customers in the Spring Brook Water Rate Area served exclusively by the Crystal Lake Water Treatment Plant, which became fully operational in August, 1992. On December 15, 1992, PG&W and certain parties filing objections to the rate increase request reached a settlement providing for an approximate 130% rate increase designed to produce $2.0 million of additional annual revenue to be phased-in over a two-year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92. The settlement further provided that $1.1 million of the increased revenue (an approximate 72% increase in rates) was to be realized through an immediate rate increase and that the remaining $900,000 in increased revenue (an additional 58% increase in rates) was to be realized through another rate increase one year later (i.e., at the beginning of year two of the phase-in period). The settlement also specified that the $900,000 in revenue that would be deferred during the first year of the phase-in period, as well as an approximate $243,000 in carrying charges, was to be collected from customers in the form of a surcharge in years three through five of the phase-in period. By Order adopted February 25, 1993, the PPUC approved the settlement effective March 9, 1993. In accordance with the provisions of FASB Statement 92, PG&W commenced recording the entire $2.0 million increase in annual revenue allowed by the PPUC as additional revenue beginning March 9, 1993, along with the related carrying charges on revenue deferred in accordance with the phase-in plan. Ceasetown and Watres Service Areas. On April 29, 1993, PG&W filed an application with the PPUC seeking a water rate increase, designed to produce $19.5 million in additional annual revenue, to be effective June 28, 1993. This rate increase request involved approximately 59,300 customers in PG&W's Spring Brook Water Rate Area, principally those customers (i) served by the Ceasetown Water Treatment Plant which was placed in service on March 31, 1993, (ii) served by the Watres Water Treatment Plant which was placed in service on September 30, 1993, (iii) served jointly by the Ceasetown and Watres Water Treatment Plants, and (iv) who are served exclusively by the Nesbitt Water Treatment Plant. On June 3, 1993, the PPUC suspended this rate increase for seven months (until January 28, 1994) by operation of law in order to institute an investigation into the reasonableness of the proposed rates. On September 23, 1993, PG&W and certain parties filing objections to the rate increase request reached a settlement providing for an overall 119% rate increase involving approximately 44,900 customers, principally those served either exclusively or jointly by the Ceasetown and Watres Water Treatment Plants, designed to produce $11.9 million of additional annual revenue to be phased-in over a two-year period under the terms of a qualified phase-in plan, pursuant to FASB Statement 92, "Regulated Enterprises-Accounting for Phase-In Plans." Under the terms of the settlement, except for approximately 200 customers who were previously served jointly by the Hillside and Nesbitt Water Treatment Plants, none of the approximately 14,600 customers now served exclusively by the Nesbitt Water Treatment Plant would receive an increase. The settlement further provided that $6.4 million of the increased revenue (an approximate 65% increase in rates) was to be realized through an immediate rate increase and that the remaining $5.5 million of the increased revenue (an additional 54% increase in rates) was to be realized through a further rate increase one year later (i.e., at the beginning of year two of the phase-in period). The settlement also specified that the $5.5 million in revenue to be deferred during the first year of the phase-in period, as well as an approximate $1.3 million in related carrying charges, is to be collected from customers in the form of a surcharge in years three through five of the phase-in period. By Order adopted December 15, 1993, the PPUC approved the settlement effective December 16, 1993. In accordance with the provisions of FASB 92, PG&W commenced recording the entire $11.9 million increase in annual revenue allowed by the PPUC as additional revenue beginning December 16, 1993, along with the related carrying charges on revenue deferred in accordance with the phase-in plan. Deferred Treatment Plant Costs and Carrying Charges. Pursuant to an Order of the PPUC entered September 5, 1990, PG&W deferred all operating expenses, including depreciation and property taxes, and the carrying charges (equivalent to the AFUDC) relative to the four new Scranton Area water treatment plants and related facilities from the dates of commercial operation of the plants until March 23, 1991, the effective date of the Scranton Area water rate increase approved by the PPUC on March 22, 1991. By its Order entered June 23, 1993, relative to the Scranton Water Rate Area, the PPUC granted PG&W's request to recover the $5.1 million of costs deferred relative to the Scranton Area water treatment plants and related facilities over a ten-year period beginning June 23, 1993. Similarly, as permitted by an Order of the PPUC entered September 24, 1992, PG&W has deferred all operating expenses, including depreciation and property taxes, and the carrying charges relative to the Crystal Lake Water Treatment Plant and related facilities from August 3, 1992 (the date of commercial operation of that plant), until March 9, 1993, the effective date of the water rate increase approved by the PPUC on February 25, 1993, for customers in PG&W's Spring Brook Water Rate Area served exclusively by the Crystal Lake Water Treatment Plant. Additionally, in accordance with an Order of the PPUC entered July 28, 1993, PG&W deferred all expenses and the carrying charges relative to the Ceasetown and Watres Water Treatment Plants and related facilities, until December 16, 1993, the effective date of the water rate increase for customers served by the Ceasetown and Watres Water Treatment Plants approved by the PPUC on December 15, 1993. As of December 31, 1993, a total of $4.6 million of costs, consisting of $424,000 of operating expenses and $745,000 of carrying charges relative to the Crystal Lake Water Treatment Plant and related facilities, and $1.7 million of operating expenses and $1.7 million of carrying charges relative to the Ceasetown and Watres Water Treatment Plants and related facilities, had been so deferred pursuant to the respective PPUC Orders permitting the deferral of such costs. As contemplated by the PPUC's Orders of September 24, 1992, and July 28, 1993, PG&W will seek recovery of the costs relative to the Crystal Lake, Ceasetown and Watres Water Treatment Plants that have been deferred pursuant to such Orders in its next rate increase request relative to the Spring Brook Water Rate Area. Although it cannot be certain, PG&W believes that the recovery of such costs will be allowed by the PPUC in future rate increases, particularly in view of the PPUC's action allowing the recovery of the costs deferred with respect to the Scranton Area water treatment plants and related facilities. (3) OTHER INCOME, NET Other income, net was comprised of the following elements: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Equity component of deferred treatment plant carrying charges $ - $ - $ 821 Allowance for equity funds used during construction - - 734 Gain on sale of non-watershed land and other property, net of related income taxes 182 102 20 Interest income on repurchase agreements, net of related income taxes 254 2 16 Interest on note to affiliate 437 133 - Net interest expense on proceeds remaining in construction fund - (23) (785) Premium on retirement/defeasance of debt - (127) (81) Other 261 (57) (165) Total $ 1,134 $ 30 $ 560 (4) COMMON STOCK Since January 1, 1991, PG&W has issued the following amounts of common stock to PEI, its parent company, in addition to shares issued in connection with PEI's Dividend Reinvestment and Stock Purchase Plan: [CAPTION] Purchase Price Date Purchased Number of Shares Per Share* Aggregate [S] [C] [C] [C] March 23, 1992 171,779 $ 40.75 $ 7.0 million June 19, 1992 137,143 $ 40.25 $ 5.5 October 27, 1993 834,000 $ 38.25 $31.9 Total 1,142,922 $44.4 million * Approximately equal to the book value of PG&W's common stock at the date of issuance. The proceeds from the shares issued on June 19, 1992, and October 27, 1993, were used to repay bank borrowings which had been incurred primarily to finance construction expenditures. The shares issued on March 23, 1992, represented capitalization of the $7.0 million contribution made by PEI to PG&W on January 30, 1992, which had been temporarily treated as an intercompany advance pending approval by the PPUC of the issuance of shares of common stock relative to such contribution. Upon its receipt, the $7.0 million contribution was also utilized to repay bank borrowings incurred primarily to finance construction expenditures. These issuances of common stock by PG&W and the related reductions in its bank borrowings acted to improve PG&W's debt/equity ratio, as well as its interest and fixed charge coverages. (5) PREFERRED STOCK Preferred Stock of PG&W Subject to Mandatory Redemption On September 16, 1988, PG&W issued 250,000 shares of its 9.50% 1988 series cumulative preferred stock, $100 par value. On December 23, 1993, PG&W redeemed 100,000 shares of the 9.50% 1988 series cumulative preferred stock at a price of $103.5625 per share (plus accrued dividends to the redemption date), which included a voluntary redemption premium of $3.5625 per share ($356,250 in the aggregate). The remaining 150,000 shares of the 9.50% 1988 series cumulative preferred stock, which are currently outstanding, are subject to mandatory redemption on December 15, 1997, at a price of $100 per share, plus unpaid dividends accrued on such shares. On December 16, 1988, PG&W issued 150,000 shares of its 8.90% cumulative preferred stock, $100 par value. The 8.90% cumulative preferred stock is subject to mandatory redemption of 18,750 shares on each of December 15, 1997, March 15, 1998, June 15, 1998, and September 15, 1998, and 75,000 shares on December 15, 1998, in each instance, at a price of $100 per share, plus unpaid dividends accrued on such shares. The holders of the 5.75% cumulative preferred stock have a noncumulative right each year to tender to PG&W and to require it to purchase at a per share price not exceeding $100, up to (a) that number of shares of the 5.75% cumulative preferred stock which can be acquired for an aggregate purchase price of $80,000 less (b) the number of such shares which PG&W may already have purchased during the year at a per share price of not more than $100. Eight hundred such shares were acquired and cancelled by PG&W in each of the three years in the period ended December 31, 1993, for an aggregate purchase price in each year of $80,000. As of December 31, 1993, the aggregate annual maturities and sinking fund requirements of PG&W's cumulative preferred stock subject to mandatory redemption for each of the next five years ending December 31, were as follows: [CAPTION] Year Amount [S] [C] 1994 $ 80,000 1995 $ 80,000 1996 $ 80,000 1997 $16,955,000 (a) 1998 $13,205,000 (b) (a) Includes the entire $15.0 million principal amount of the 9.50% 1988 series cumulative preferred stock currently outstanding and $1,875,000 of the 8.90% cumulative preferred stock, both of which are subject to redemption on December 15, 1997. (b) Includes the entire $13,125,000 principal amount of the 8.90% cumulative preferred stock that is subject to redemption during 1998. At PG&W's option, the following series of cumulative preferred stock subject to mandatory redemption may currently be redeemed at the prices indicated: [CAPTION] Current Redemption Price Series Per Share Aggregate [S] [C] [C] 5.75% $ 102.00 $ 1,958,400 8.90% $ 103.96 $15,594,000 9.50% 1988 Series $ 103.56 $15,534,375 Preferred Stock of PG&W Not Subject to Mandatory Redemption On August 18, 1992, PG&W issued 250,000 shares of its 9% cumulative preferred stock, par value $100 per share, for aggregate net proceeds of approximately $23.6 million. The 9% cumulative preferred stock is not redeemable by PG&W prior to September 15, 1997. Thereafter, it is redeemable at the option of PG&W, in whole or in part, upon not less than 30 days' notice, at $100 per share plus accrued dividends to the date of redemption and at a premium of $8 per share if redeemed from September 15, 1997, to September 14, 1998, and a premium of $4 per share if redeemed from September 15, 1998, to September 14, 1999. At PG&W's option, the 4.10% cumulative preferred stock may currently be redeemed at a redemption price of $105.50 per share or for an aggregate redemption price of $10,550,000. Dividend Information The dividends on the preferred stock of PG&W in each of the three years in the period ended December 31, 1993, were as follows: [CAPTION] Series 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] 4.10% $ 405 $ 409 $ 410 5.75% 121 117 113 8.90% 1,335 1,335 1,335 9.00% - 829 2,250 9.50% 1988 series 2,375 2,375 2,354 Total $4,236 $5,065 $6,462 Dividends on all series of PG&W's preferred stock are cumulative, and if dividends in an amount equivalent to four full quarterly dividends on all shares of preferred stock then outstanding are in default and until all such dividends have been paid, the holders of the preferred stock, voting separately as one class, shall be entitled to elect a majority of the Board of Directors of PG&W. Additionally, PG&W may not declare dividends on its common stock if any dividends on shares of preferred stock then outstanding are in default. (6) LONG-TERM DEBT Long-term debt consisted of the following components at December 31, 1992 and 1993: 8%, 1987 Series B Note. On December 23, 1987, the Luzerne County Industrial Development Authority (the "Authority") issued $30.0 million of its 8% Exempt Facilities Revenue Bonds, 1987 Series B (Pennsylvania Gas and Water Company Project) (the "1987 Series B Bonds") and in connection therewith, PG&W issued a promissory note in the principal amount of $30.0 million (its 8%, 1987 Series B Note) to PNC Bank (formerly Northeastern Bank of Pennsylvania), as trustee (the "IDA Trustee") for the 1987 Series B Bonds, as security for the 1987 Series B Bonds. The 1987 Series B Bonds mature on December 1, 2017; bear interest at an initial annual rate of 8% through November 30, 1994; are secured by a letter of credit issued by Swiss Bank Corporation, New York Branch expiring on December 20, 1994, for which the annual fee is $279,000; and on December 1, 1994, will be redeemed or, at the option of PG&W, purchased by PG&W for remarketing as of that date. Under the terms of the 1987 Series B Note, PG&W agreed to pay the debt service requirements on the 1987 Series B Bonds. 7.20% Series First Mortgage Bonds. On September 15, 1992, the Authority issued $50.0 million of its Exempt Facilities Revenue Refunding Bonds, 1992 Series A (Pennsylvania Gas and Water Company Project) (the "1992 Series A Bonds") and, in connection therewith, PG&W issued $50.0 million of its 7.20% First Mortgage Bonds to the IDA Trustee for the 1992 Series A Bonds, as security for the 1992 Series A Bonds. The proceeds from the issuance of the 1992 Series A Bonds, along with additional funds provided by PG&W, were deposited with the IDA Trustee for the Authority's $50.0 million of 8-1/2% Exempt Facilities Revenue Bonds, 1987 Series A (Pennsylvania Gas and Water Company Project) (the "1987 Series A Bonds") on September 15, 1992, for use in redeeming the 1987 Series A Bonds on October 1, 1992. The deposit of such funds acted to discharge all of PG&W's obligations with respect to its 8-1/2%, 1987 Series A Note in the principal amount of $50.0 million which had been issued to the IDA Trustee in connection with the 1987 Series A Bonds and which was subject to repayment on October 1, 1992. Under the terms of the 7.20% First Mortgage Bonds, PG&W will make payments to the IDA Trustee in amounts sufficient and at the times necessary to pay the debt service requirements on the 1992 Series A Bonds. 8.375% Series First Mortgage Bonds. On December 14, 1992, PG&W issued $30.0 million of its 8.375% Series First Mortgage Bonds due 2002. The proceeds from the issuance of these bonds were used to repay approximately $28.7 million of bank borrowings, thereby providing PG&W with additional borrowing capacity for future capital expenditures and other working capital needs. 7.125% Series First Mortgage Bonds. On December 22, 1992, the Authority issued $30.0 million of its Exempt Facilities Revenue Bonds, 1992 Series B (Pennsylvania Gas and Water Company Project) (the "1992 Series B Bonds") and, in connection therewith, PG&W issued $30.0 million of its 7.125% Series First Mortgage Bonds to the IDA Trustee for the 1992 Series B Bonds, as security for the 1992 Series B Bonds. The proceeds from the issuance of the 1992 Series B Bonds were deposited in a construction fund held by the IDA Trustee for the 1992 Series B Bonds, pending their utilization to finance the construction of various additions and improvements to PG&W's water facilities for which construction commenced subsequent to September 23, 1992. As of December 31, 1993, $12.9 million was so held by the IDA Trustee and was available to finance the future construction of qualified water facilities for PG&W. Under the terms of the 7.125% Series First Mortgage Bonds, PG&W will make payments to the IDA Trustee in amounts sufficient and at the times necessary to pay the debt service requirements on the 1992 Series B Bonds. 10% and 9-1/4% Series First Mortgage Bonds. On May 1, 1993, PG&W redeemed the $5,700,000 of its 10% Series First Mortgage Bonds due 1995 and the $3,750,000 of its 9-1/4% Series First Mortgage Bonds due 1996 then outstanding, utilizing funds from bank borrowings. The 10% Series First Mortgage Bonds were redeemed at a price of 100.42% of principal (plus accrued interest to the redemption date), which included a voluntary redemption premium aggregating $23,940. The 9-1/4% Series First Mortgage Bonds were redeemed at a price of 100.98% of principal (plus accrued interest to the redemption date), which included a voluntary redemption premium aggregating $36,750. 6.05% Series First Mortgage Bonds. On December 21, 1993, the Authority issued $19.0 million of its Exempt Facilities Revenue Refunding Bonds, 1993 Series A (Pennsylvania Gas and Water Company Project) (the "1993 Series A Bonds") and, in connection therewith, PG&W issued $19.0 million of its 6.05% Series First Mortgage Bonds to the IDA Trustee for the 1993 Series A Bonds, as security for the 1993 Series A Bonds. PG&W will make payments to the IDA Trustee pursuant to the 6.05% Series First Mortgage Bonds in amounts sufficient and at the times necessary to pay the debt service requirements on the 1993 Series A Bonds. The proceeds from the issuance of the 1993 Series A Bonds, along with additional funds provided by PG&W, were deposited with the IDA Trustee for the Authority's $19.0 million of 7% Exempt Facilities Revenue Bonds, 1989 Series A (Pennsylvania Gas and Water Company Project) (the "1989 Series A Bonds") on December 21, 1993, for use in redeeming the 1989 Series A Bonds on January 1, 1994. The deposit of such funds acted to discharge all of PG&W's obligations with respect to its 7%, 1989 Series A Note in the principal amount of $19.0 million which had been issued to the IDA Trustee in connection with the 1989 Series A Bonds and which was subject to repayment on January 1, 1994. As of December 31, 1993, the aggregate annual maturities and sinking fund requirements of long-term debt for each of the next five years ending December 31, were: [CAPTION] Year Amount [S] [C] 1994 $38,584,000 (a) 1995 $47,730,000 (b) 1996 $50,758,000 (c) 1997 $ 3,694,000 1998 $ 611,000 (a) Includes the 8%, 1987 Series B Note in the principal amount of $30.0 million due 2017, but subject to repayment or refinancing on December 1, 1994. Such amount also includes the aggregate principal amount of approximately $7.0 million relative to six water facility loans of PG&W having a weighted annual interest rate of 9.33% which were voluntarily repaid by PG&W on January 31, 1994, with bank borrowings. (b) Includes $47.0 million of bank borrowings outstanding as of December 31, 1993. (c) Includes the 9.57% Series First Mortgage Bonds in the principal amount of $50.0 million due 1996. Most of PG&W's properties are subject to mortgage liens securing certain funded debt. Additionally, PG&W's gross revenues and receipts, accounts receivable and certain of its other rights and interests are subject to liens securing various water facility loans from agencies established by the Commonwealth of Pennsylvania for the purpose of providing financial assistance to public water supply and sewage systems in the state. These liens are limited to the amount of the related loans outstanding, which aggregated $19.3 million as of December 31, 1993, and $12.1 million as of March 23, 1994, subsequent to the prepayment of certain of such loans. (7) DIVIDEND RESTRICTIONS Several of PG&W's debt instruments contain restrictions on the payment by PG&W of dividends to PEI. Under the most restrictive of these provisions, which is contained in the letter of credit agreement relating to the 1987 Series B Bonds issued by the Luzerne County Industrial Development Authority with respect to which PG&W has issued its 1987 Series B Note in the principal amount of $30.0 million, PG&W may not pay dividends to PEI of more than $12.5 million in 1994 and thereafter. In addition, provisions of such agreement and also PG&W's revolving bank credit agreement (the "Credit Agreement" as defined in Note 8 to these financial statements) prohibit PG&W from paying any dividends to PEI in the event of any default under those agreements. These restrictions are not expected to prohibit PG&W from paying a sufficient amount of dividends to PEI to permit PEI to pay its current $2.20 per share annual dividend on its common stock. In addition, the preferred stock provisions of PG&W's Restated Articles of Incorporation and the indenture of mortgage under which PG&W has issued first mortgage bonds provide for certain dividend restrictions. (8) BANK NOTES PAYABLE On April 25, 1991, PG&W entered into an agreement with the various banks with which it had previously arranged lines of credit. The purpose of the agreement was to consolidate PG&W's existing bank lines of credit to provide for uniform terms relative to its bank borrowings and to extend the due dates of such borrowings. As such, the agreement superseded PG&W's individual bank lines of credit. The aggregate amount available to PG&W in 1992 under this agreement was $45.0 million. On March 1, 1993, PG&W elected to reduce the amount so available to $35.0 million in order to reduce the commitment fee that would otherwise be payable and since no more than $35.0 million would be required by PG&W under the agreement prior to its expiration on April 30, 1993. The interest rate on borrowings under the agreement was prime. The agreement also required the payment of a commitment fee of 1/2 of 1% per annum on the average daily amount of the unused portion of the available funds. The commitment fees paid with respect to this agreement totaled $60,000 in 1991, $152,000 in 1992 and $43,000 in 1993. On April 19, 1993, PG&W entered into a revolving bank credit agreement (the "Credit Agreement") with a group of six banks under the terms of which $60.0 million is available for borrowing by PG&W. The Credit Agreement terminates on April 30, 1995, at which time any borrowings outstanding thereunder are due and payable. The interest rate on borrowings under the Credit Agreement is generally less than prime. The Credit Agreement also requires the payment of a commitment fee of 3/8 of 1% per annum on the average daily amount of the unused portion of the available funds. As of March 23, 1994, $41.0 million of borrowings were outstanding under the Credit Agreement. PG&W also has three short-term bank lines of credit with an aggregate borrowing capacity of $7.0 million which provide for borrowings at interest rates generally less than prime and mature on April 30, 1994. As of March 23, 1994, PG&W had no borrowings outstanding under the short-term bank lines of credit. The commitment fees paid with respect to these agreements totaled $70,000 in 1993. Because of limitations imposed by the terms of PG&W's preferred stock, PG&W is prohibited, without the consent of the holders of a majority of the outstanding shares of its preferred stock, from issuing more than $12.0 million of unsecured debt due on demand or within one year from issuance. PG&W had $5.7 million of unsecured debt due on demand or within one year from issuance outstanding as of December 31, 1993, which included a $3.7 million demand loan from PEI. Information relating to PG&W's bank lines of credit and borrowings under those lines of credit is set forth below: (9) POSTRETIREMENT BENEFITS Substantially all employees of PG&W are covered by PEI's trusteed, noncontributory, defined benefit pension plan. Pension benefits are based on years of service and average final salary. PG&W's funding policy is to contribute an amount necessary to provide for benefits based on service to date, as well as for benefits expected to be earned in the future by current participants. To the extent that the present value of these obligations is fully covered by assets in the trust, a contribution may not be made for a particular year. Net pension costs, including amounts capitalized, were $243,000, $333,000 and $443,000 in 1991, 1992 and 1993, respectively. The following items were the components of the net pension cost for the years 1991, 1992 and 1993: [CAPTION] 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Present value of benefits earned during the year $ 637 $ 789 $ 854 Interest cost on projected benefit obligations 2,120 2,262 2,402 Return on plan assets (3,824) (2,646) (3,127) Net amortization and deferral 1,310 (72) 314 Net pension cost $ 243 $ 333 $ 443 The discount rate used to determine the actuarial present value of the projected benefit obligations, the expected long-term rate of return on plan assets and the projected increase in future compensation levels assumed in determining the net pension cost for each of the years 1991, 1992 and 1993, were as follows: [CAPTION] [S] [C] Discount rate 8% Expected long-term rate of return on plan assets 9% Projected increase in future compensation levels 5-1/2% The funded status of the plan as of December 31, 1992 and 1993, was as follows: [CAPTION] 1992 1993 (Thousands of Dollars) [S] [C] [C] Actuarial present value of the projected benefit obligations: Accumulated benefit obligations Vested $ 21,813 $ 24,265 Nonvested 139 125 Total 21,952 24,390 Provision for future salary increases 7,746 9,769 Projected benefit obligations 29,698 34,159 Market value of plan assets, primarily invested in equities and bonds 30,963 32,471 Plan assets in excess of (less than) projected benefit obligations 1,265 (1,688) Unrecognized net transition asset as of January 1, 1986, being amortized over 20 years (2,988) (2,758) Unrecognized prior service costs 2,412 2,279 Unrecognized net (gain) loss (704) 1,710 Accrued pension cost at year-end $ (15) $ (457) In March, 1991, as part of a cost reduction program, PG&W offered an Early Retirement Plan ("ERP") to its employees who would be 60 years of age or older and have a minimum of five years of service as of April 30, 1991. Of the 79 eligible employees, 73 elected to accept this offer and retired in 1991. In accordance with FASB Statement 88 "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," PG&W recorded, as of April 30, 1991, an additional pension liability of $2.0 million, reflecting the increased costs associated with the ERP. This liability, which was included in "Other deferred credits" as of December 31, 1992 and 1993, partially offsets an asset included in "Other deferred charges," representing the probable future rate recovery of such liability. As a result, the provisions of FASB Statement 88 did not have a significant effect on PG&W's results of operations for 1991. During 1992, PG&W began amortizing the portion of the deferred charges relative to its gas operations over a 20-year period and will begin amortizing the portion relating to its water operations as such amounts are approved in rates. In addition, the deferred liability is being amortized as an offset against pension expense over a 20 year amortization period approximating the effect of including the additional pension costs related to the ERP in the present value of benefits earned during the year. In addition to pension benefits, PG&W provides certain health care and life insurance benefits for retired employees. Substantially all of PG&W's employees may become eligible for those benefits if they reach retirement age while working for PG&W. Prior to January 1, 1993, the cost of retiree health care and life insurance, which totaled $800,000 in 1991 and $870,000 in 1992, was expensed as the premiums were paid under insurance contracts. Effective January 1, 1993, PG&W adopted the provisions of FASB Statement 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The provisions of FASB Statement 106 require that PG&W record the cost of retiree health care and life insurance benefits as a liability over the employees' active service periods instead of on a benefits-paid basis as was PG&W's prior practice. The following items were the components of the net cost of postretirement benefits other than pensions for the year 1993: [CAPTION] (Thousands of Dollars) [S] [C] Present value of benefits earned during the year $ 226 Interest cost on accumulated benefit obligation 967 Return on plan assets (a) -0- Amortization of transition obligation over 20 years 617 Net cost of postretirement benefits other than pensions 1,810 Less disbursements for benefits (983) Increase in liability for postretirement benefits other than pensions $ 827 Reconciliations of the accumulated benefit obligation to the accrued liability for postretirement benefits other than pensions as of January 1, 1993, and December 31, 1993, follow: [CAPTION] January 1, December 31, 1993 1993 (Thousands of Dollars) [S] [C] [C] Accumulated benefit obligation: Retirees $ 9,878 $ 10,149 Fully eligible active employees 1,649 1,735 Other active employees 815 1,222 12,342 13,106 Plan assets at fair value (a) -0- -0- Accumulated benefit obligation in excess of plan assets 12,342 13,106 Unrecognized transition obligation (12,342) (11,725) Unrecognized net loss -0- (554) Accrued liability for postretirement benefits other than pensions $ -0- $ 827 For purposes of calculating the costs to be accrued by PG&W under FASB Statement 106, an 8% discount rate and a 5.5% projected annual increase in future compensation levels were assumed. It was also assumed that the per capita cost of covered health care benefits would increase at an annual rate of 12% in 1993 and that this rate would decrease gradually to 5.5% for the year 2003 and remain at that level thereafter. The health care cost trend rate assumption had a significant effect on the amounts accrued. To illustrate, increasing the assumed health care cost trend rate by 1 percentage point in each year would increase the transition obligation as of January 1, 1993, by approximately $723,000 and the aggregate of the service and interest cost components of the net cost of postretirement benefits other than pensions for the year 1993 by approximately $60,000. (a) As of December 31, 1993, PG&W had segregated funds totaling $182,000, pending the establishment of a qualified trust fund for a portion of its liability for postretirement benefits other than pensions, as discussed in the paragraph immediately above. The additional costs accrued pursuant to FASB Statement 106 are allocated between PG&W's gas utility and water utility operations. By Order entered June 23, 1993, relative to the rate increase request that PG&W had filed on September 25, 1992, with respect to the Scranton Water Rate Area, the PPUC allowed PG&W to recover in revenues the additional costs ($319,000 for the year 1993, based on then current estimates) that were required to be accrued pursuant to FASB Statement 106 and which were allocable to the Scranton Water Rate Area. Similarly, by Order entered December 15, 1993, relative to the rate increase request that PG&W had filed on April 29, 1993, relative to the Spring Brook Water Rate Area, the PPUC allowed PG&W to recover in revenues the additional costs ($322,000 for the year 1993 based on then current estimates) that were required to be accrued pursuant to FASB Statement 106 and which were allocable to the Spring Brook Water Rate Area. Since PG&W did not seek an increase in its base gas rates during 1993, the $407,000 ($232,000 net of related income taxes) of additional cost incurred with regard to its gas utility operations as a result of the adoption of the provisions of FASB Statement 106 was expensed. (10) CONSTRUCTION EXPENDITURES PG&W estimates the cost of its 1994 construction program will be $46.8 million. Construction of water facilities, estimated to cost $29.8 million, will be financed with the $12.9 million of proceeds from the issuance of the 1993 Series A Bonds held by the IDA Trustee as of December 31, 1993, for the benefit of PG&W, internally generated funds and borrowings under PG&W's revolving bank credit facilities, pending the periodic issuance of stock and long-term debt. Construction of gas facilities, estimated to cost $17.0 million, will be financed with internally generated funds and borrowings under PG&W's revolving bank credit facilities, pending the periodic issuance of stock and long-term debt. (11) COMMITMENTS AND CONTINGENCIES Valve Maintenance On November 16, 1993, the PPUC staff issued an Emergency Order, subsequently ratified by the PPUC (the "Emergency Order"), requiring PG&W by January 31, 1994, to survey its gas distribution system to verify the location and spacing of its gas shut off valves, to add or repair valves where needed and to establish programs for the inspection and maintenance of all such valves and the verification of all gas service line information. The Emergency Order was issued following the occurrence of two gas incidents (one concerning an explosion and the other a fire) in PG&W's service area in June and October, 1993, respectively, involving nearby gas shut off valves that had been paved over by third parties and could not be readily located due to alleged inaccurate service line records. The Emergency Order also cited four additional incidents occurring since January 31, 1991, in which shut off valves had been paved over or records were inaccurate. In connection with these incidents, the PPUC has alleged that PG&W has violated certain federal and state regulations related to gas pipeline valves. The PPUC has the authority to assess fines for such violations. The PPUC ordered PG&W to develop a plan, including a timetable, by December 30, 1993, for compliance with the terms of the Emergency Order. PG&W met the December 30, 1993, deadline for submission of this plan. However, PG&W included in such plan, a timetable, which, in effect, requested an extension of the January 31, 1994, deadline contained in the Emergency Order, which PG&W viewed as unrealistic. On February 2, 1994, the PPUC staff notified PG&W that it considers the plan submitted by PG&W "only a general plan of action to address the problem with valving in [PG&W's] system" and that the plan "is lacking in detail and more information is needed." As a result, the PPUC staff indicated that it intends to initiate an informal investigation of the matter, including PG&W's responsibility for the incidents referred to in the Emergency Order. Although it is not presently possible to determine what action the PPUC will ultimately take with respect to possible violations of law and the matters raised by the Emergency Order, PG&W does not believe that compliance with, or any liability that might result from such violations or the Emergency Order will have a material adverse effect on its financial position or results of operations. Environmental Matters PG&W, like many gas distribution companies, once utilized manufactured gas plants in connection with providing gas service to its customers. None of these plants has been in operation since 1960, and several of the plant sites are no longer owned by PG&W. Pursuant to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), PG&W filed notices with the United States Environmental Protection Agency (the "EPA") with respect to the former plant sites. None of the sites is or was formerly on the proposed or final National Priorities List. The EPA has conducted site inspections and made preliminary assessments of each site and has concluded that no further remedial action is planned. While this conclusion does not constitute a legal prohibition against further regulatory action under CERCLA or other applicable federal or state law, PG&W does not believe that additional costs, if any, related to these manufactured gas plant sites would be material to its financial position or results of operations since environmental remediation costs generally are recoverable through rates over a period of time. On February 4, 1994, PG&W was requested by the Pennsylvania Department of Environmental Resources to perform an evaluation to determine if a pipeline owned by PG&W was the source of certain soil contamination discovered by the Pennsylvania Department of Transportation in late 1993 in an area adjacent to that pipeline at a road crossing in Jackson Township, Northumberland County, Pennsylvania. This pipeline was purchased by Scranton-Spring Brook Water Service Company ("Scranton-Spring Brook"), a predecessor of PG&W, in 1956, but was never operated by Scranton-Spring Brook or PG&W in the area in question. At this time, pending further environmental analysis and evaluation, neither the source nor the extent of the contamination is known. However, if the source of the contamination is determined to be PG&W's pipeline, PG&W would be required to perform such remediation work as is necessary and to dispose of the contaminated soil. While it cannot be certain, PG&W does not presently believe that any liability it might have with respect to such contamination would have a material adverse effect on either its financial position or results of operations. Further, if PG&W were determined to be the responsible party with respect to the subject contamination, it would seek to recover any liability it were to so incur from the former owner and operator of the pipeline and/or its successors. Additionally, to the extent it could not recover its costs from such parties, PG&W could seek authority of the PPUC to recover those costs in the rates charged to its natural gas customers. (12) INDUSTRY SEGMENTS Financial information with respect to PG&W's industry segments for the years ended December 31, 1991, 1992 and 1993 is included in Item 1 of this Form 10-K. Such industry segment information is incorporated herein as part of these Financial Statements. (13) QUARTERLY FINANCIAL DATA (UNAUDITED) [CAPTION] QUARTER ENDED March 31, June 30, September 30, December 31, 1992 1992 1992 1992 (Thousands of Dollars, Except Per Share Amounts) [S] [C] [C] [C] [C] Operating revenues $ 70,673 $ 34,000 $ 25,440 $ 61,765 Operating income 12,620 6,270 4,160 10,863 Earnings (loss) applicable to common stock 5,763 (44) (2,704) 4,876 Earnings (loss) per share of common stock (a) 1.55 (.01) (.67) 1.21 [CAPTION] QUARTER ENDED March 31, June 30, September 30, December 31, 1993 1993 1993 1993 (Thousands of Dollars, Except Per Share Amounts) [S] [C] [C] [C] [C] Operating revenues $ 78,318 $ 37,251 $ 27,959 $ 63,160 Operating income 13,315 5,672 4,762 12,407 Earnings (loss) applicable to common stock 6,827 (1,037) (1,506) 5,555 Earnings (loss) per share of common stock (a) 1.70 (.26) (.37) 1.20 (a) The total of the earnings per share for the quarters does not equal the earnings per share for the year, as shown elsewhere in Item 8 of this Form 10-K, as a result of PG&W's issuance of additional shares of common stock at various dates during the year. Because of the seasonal nature of PG&W's gas heating business, there are substantial variations in operations reported on a quarterly basis. (14) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: o Restricted funds held by trustee. The fair value of the restricted funds held by trustee has been based on the current market values of the financial instruments in which such funds have been invested. o Long-term debt. The fair value of PG&W's long-term debt has been estimated based on the current quoted market price for the portion of such debt which is publicly traded and, with respect to the portion of such debt which is not publicly traded, on the estimated borrowing rates at December 31, 1993, for long-term debt of comparable credit quality with similar terms and maturities. o Preferred stock subject to mandatory redemption. The fair value of PG&W's preferred stock subject to mandatory redemption has been estimated based on the market value as of December 31, 1993, for preferred stock of comparable credit quality with similar terms and maturities. The carrying amounts and estimated fair values of PG&W's financial instruments at December 31, 1992 and 1993, were as follows: [CAPTION] 1992 1993 Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value (Thousands of Dollars) [S] [C] [C] [C] [C] Restricted funds held by trustee $ 28,020 $ 28,016 $ 12,853 $ 12,857 Long-term debt (including current portion) 284,882 291,704 306,843 327,436 Preferred stock subject to mandatory redemption (including current portion) 42,000 43,929 31,920 33,087 PG&W believes that the regulatory treatment of any excess or deficiency of fair value relative to the carrying amounts of these items, if such items were settled at amounts approximating those above, would dictate that these amounts be used to increase or reduce its rates over a prescribed amortization period. Accordingly, any settlement would not result in a material impact on PG&W's financial position or the results of operations of either PEI or PG&W. ITEM 9. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 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, notes to financial statements and report of independent public accountants for PG&W are presented in Item 8 of this Form 10-K. Page Report of Independent Public Accountants . . . . . . . . . . . . 42 Statements of Income for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . . 43 Balance Sheets as of December 31, 1992 and 1993. . . . . . . . . 44 Statements of Cash Flows for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . . 46 Statements of Capitalization as of December 31, 1992 and 1993. . 47 Statements of Common Shareholder's Investment for each of the three years in the period ended December 31, 1993. . . . . 48 Notes to Financial Statements. . . . . . . . . . . . . . . . . . 49 2. Financial Statement Schedules The following financial statement schedules for PG&W are filed as a part of this Form 10-K. Schedules not included have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Schedule Number Page V Property, Plant and Equipment for the three-year period ended December 31, 1993. . . . . . . . . . . . . . . . . 75 VI Accumulated Depreciation of Property, Plant and Equipment for the three-year period ended December 31, 1993. . . . 76 VIII Valuation and Qualifying Accounts for the three-year period ended December 31, 1993 . . . . . . . . . . . . . 77 X Supplementary Income Statement Information for the three-year period ended December 31, 1993. . . . . . . . 78 3. Exhibits See "Index to Exhibits" located on page 80 for a listing of all exhibits filed herein or incorporated by reference to a previously filed registration statement or report with the Securities and Exchange Commission. Schedule V Schedule VI Schedule VIII PENNSYLVANIA GAS AND WATER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE-YEAR PERIOD ENDED DECEMBER 31, 1993 [CAPTION] Year ended December 31, 1991 1992 1993 (Thousands of Dollars) [S] [C] [C] [C] Taxes other than income taxes were as follows: State gross receipts tax $ 5,993 $ 6,715 $ 7,212 State capital stock tax 1,773 1,936 1,961 Payroll taxes 2,224 2,276 2,444 Real estate and personal property taxes 2,777 2,951 3,717 Other taxes 710 772 888 $13,477 $14,650 $16,222 Charged to: Other taxes $12,814 $14,730 $16,019 Other accounts 663 (80) 203 $13,477 $14,650 $16,222 NOTE: The amounts of maintenance and repairs, depreciation and income taxes, which are charged to accounts other than those set forth in the statements of income, are not significant. PG&W did not incur any significant costs for royalties, rents, advertising or research and development during the three- year 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. [CAPTION] PENNSYLVANIA GAS AND WATER COMPANY (Registrant) [S] [C] [C] Date: March 23, 1994 By: /s/ Dean T. Casaday Dean T. Casaday President and Chief Executive Officer (Principal Executive Officer) Date: March 23, 1994 By: /s/ John F. Kell, Jr. John F. Kell, Jr. Vice President, Finance (Principal Financial Officer and Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. [CAPTION] Signature Capacity Date [S] [C] [C] /s/ Kenneth L. Pollock Chairman of the Board of March 23, 1994 Kenneth L. Pollock Directors /s/ William D. Davis Vice Chairman of the Board March 23, 1994 William D. Davis of Directors /s/ Dean T. Casaday Director, President and March 23, 1994 Dean T. Casaday Chief Executive Officer /s/ Robert J. Keating Director March 23, 1994 Robert J. Keating /s/ John D. McCarthy Director March 23, 1994 John D. McCarthy /s/ Kenneth M. Pollock Director March 23, 1994 /s/ Kenneth M. Pollock /s/ James A. Ross Director March 23, 1994 James A. Ross /s/ Ronald W. Simms Director March 23, 1994 Ronald W. Simms INDEX TO EXHIBITS Exhibit Number (3) Articles of Incorporation and By Laws: 3-1 Restated Articles of Incorporation of PG&W, as amended -- filed as Exhibit 3-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 3-2 By-Laws of PG&W, as amended and restated on October 17, 1991 -- filed as Exhibit 3-2 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. (4) Instruments Defining the Rights of Security Holders, Including Debentures: 4-1 Indenture of Mortgage and Deed of Trust, dated as of March 15, 1946, between Scranton-Spring Brook Water Service Company (now PG&W) and Guaranty Trust Company, as Trustee (now Morgan Guaranty Trust Company of New York) -- filed as Exhibit 2(c) to PG&W's Bond Form S- 7, Registration No. 2-55419. 4-2 Fourth Supplemental Indenture, dated as of March 15, 1952 -- filed as Exhibit 2(d) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-3 Ninth Supplemental Indenture, dated as of March 15, 1957 -- filed as Exhibit 2(e) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-4 Tenth Supplemental Indenture, dated as of September 1, 1958 -- filed as Exhibit 2(f) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-5 Twelfth Supplemental Indenture, dated as of July 15, 1960 -- filed as Exhibit 2(g) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-6 Fourteenth Supplemental Indenture, dated as of December 15, 1961 -- filed as Exhibit 2(h) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-7 Fifteenth Supplemental Indenture, dated as of December 15, 1963 -- filed as Exhibit 2(i) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-8 Sixteenth Supplemental Indenture, dated as of June 15, 1966 -- filed as Exhibit 2(j) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-9 Seventeenth Supplemental Indenture, dated as of October 15, 1967 -- filed as Exhibit 2(k) to PG&W's Bond Form S-7, Registration No. 2- 55419. 4-10 Eighteenth Supplemental Indenture, dated as of May 1, 1970 -- filed as Exhibit 2(1) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-11 Nineteenth Supplemental Indenture, dated as of June 1, 1972 -- filed as Exhibit 2(m) to PG&W's Bond Form S-7, Registration No. 2-55419. Exhibit Number 4-12 Twentieth Supplemental Indenture, dated as of March 1, 1976 -- filed as Exhibit 2(n) to PG&W's Bond Form S-7, Registration No. 2-55419. 4-13 Twenty-first Supplemental Indenture, dated as of December 1, 1976 -- filed as Exhibit 4-16 to PG&W's Annual Report on Form 10-K for 1982, File No. 1-3490. 4-14 Twenty-second Supplemental Indenture, dated as of August 15, 1989 -- filed as Exhibit 4-22 to PG&W's Annual Report on Form 10-K for 1989, File No. 0-7812. 4-15 Twenty-third Supplemental Indenture, dated as of August 15, 1989 -- filed as Exhibit 4-23 to PG&W's Annual Report on Form 10-K for 1989, File No. 0-7812. 4-16 Twenty-fourth Supplemental Indenture, dated as of September 1, 1991, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-3 to PEI's Common Stock Form S-2, Registration No. 33-43382. 4-17 Twenty-fifth Supplemental Indenture, dated as of September 1, 1992, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 4-18 Twenty-sixth Supplemental Indenture, dated as of December 1, 1992, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed as Exhibit 4-20 to PG&W's Bond Form S-2, Registration No. 33-54278. 4-19 Twenty-seventh Supplemental Indenture, dated as of December 1, 1992, from PG&W to Morgan Guaranty Trust Company -- filed as Exhibit 4-19 to PG&W's Annual Report on Form 10-K for 1992, File No. 0-7812. 4-20 Twenty-eighth Supplemental Indenture, dated as of December 1, 1993, from PG&W to Morgan Guaranty Trust Company of New York, as Trustee -- filed herewith. NOTE: The First, Second, Third, Fifth, Sixth, Seventh, Eighth, Eleventh and Thirteenth Supplemental Indentures merely convey additional properties to the Trustee. 4-21 Statement Affecting Class or Series of Shares with respect to 9.50% 1988 Series Cumulative Preferred Stock of PG&W -- filed as Exhibit 4-18 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, File No. 1-3490. 4-22 Statement Affecting Class or Series of Shares with respect to 8.90% Cumulative Preferred Stock of PG&W -- filed as Exhibit 4-20 to PG&W's Annual Report on Form 10-K for 1988, File No. 1-3490. Exhibit Number (10) Material Contracts: 10-1 Service Agreement for storage service under Rate Schedule LGA, dated August 6, 1974, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-3 to PG&W's Annual Report on Form 10-K for 1984, File No. 1-3490. 10-2 Service Agreement for transportation service under Rate Schedule FT, dated February 1, 1992, by and between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-4 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-3 Service Agreement for storage service under Rate Schedule SS-2, dated April 1, 1990, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-8 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-4 Service Agreement for sales service under Rate Schedule FS, dated August 1, 1991, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-6 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-5 Service Agreement for transportation service under Rate Schedule FT, dated August 1, 1991, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-10 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-6 Service Agreement for transportation service under Rate Schedule IT, dated January 31, 1992, between PG&W and Transcontinental Gas Pipe Line Corporation -- filed as Exhibit 10-8 to PG&W's Annual Report on Form 10-K for 1991, File No. 1-3490. 10-7 Service Agreement for storage service under Rate Schedule LSS, dated October 1, 1993, by and between PG&W and Transcontinental Gas Pipe Line Corporation -- filed herewith. 10-8 Service Agreement for storage service under Rate Schedule GSS, dated October 1, 1993, by and between PG&W and Transcontinental Gas Pipeline Corporation Company -- filed herewith. 10-9 Service Agreement for transportation service under Rate Schedule FTS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-10 Service Agreement for transportation service under Rate Schedule SST, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-11 Service Agreement for storage service under Rate Schedule FSS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-12 Service Agreement for transportation service under Rate Schedule FTS-1, dated November 1, 1993, by and between PG&W and Columbia Gulf Transmission Company -- filed herewith. Exhibit Number 10-13 Service Agreement for transportation service under Rate Schedule ITS-1, dated November 1, 1993, by and between PG&W and Columbia Gulf Transmission Company -- filed herewith. 10-14 Service Agreement for transportation service under Rate Schedule ITS, dated November 1, 1993, by and between PG&W and Columbia Gas Transmission Corporation -- filed herewith. 10-15 Service Agreement (Contract No. 946) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-16 Service Agreement (Service Package No. 171) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-17 Service Agreement (Service Package No. 187) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline Company -- filed as Exhibit 10-3 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-18 Service Agreement (Service Package No. 190) for transportation service under Rate Schedule FT-A, dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline -- filed as Exhibit 10-4 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-19 Service Agreement (Contract No. 2289) for storage service under Rate Schedule FS dated September 1, 1993, by and between PG&W and Tennessee Gas Pipeline -- filed as Exhibit 10-5 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-3490. 10-20 Joint Venture Agreement, dated May 1, 1975, between Robert Mosbacher and Transco Exploration Company, et. al., and Exhibit "B," Ratification thereof by PG&W, dated July 11, 1975 -- filed as Exhibit 5(1) to PG&W's Bond Form S-7, Registration No. 2-55419. 10-21 Project Facilities Agreement, dated December 1, 1987, between Luzerne County Industrial Development Authority and PG&W -- filed as Exhibit 10-19 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-22 Remarketing Agreement, dated December 1, 1987, among PG&W, Butcher & Singer Inc. and Dean Witter Reynolds Inc. -- filed as Exhibit 10-21 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. Exhibit Number 10-23 8% Bond Purchase Agreement, dated December 15, 1987, among Luzerne County Industrial Development Authority, PG&W, Butcher & Singer Inc. and Dean Witter Reynolds Inc. -- filed as Exhibit 10-22 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-24 Bond Purchase Agreement, dated September 1, 1989, relating to PG&W's First Mortgage Bonds 9.23% Series due 1999 and First Mortgage Bonds 9.34% Series due 2019 among Allstate Life Insurance Company, Allstate Life Insurance Company of New York and PG&W -- filed as Exhibit 10-33 to PG&W's Annual Report on Form 10-K for 1989, File No. 1-3490. 10-25 Form of Bond Purchase Agreement, dated as of September 1, 1991, re: $50.0 million of 9.57% First Mortgage Bonds, due September 1, 1996, entered into between PG&W and each of the following parties: Pacific Mutual Life Insurance Company, Principal Mutual Life Insurance Company, Great West Life & Annuity Insurance Company, The Life Insurance Company of Virginia, Lutheran Brotherhood, Transamerica Life Insurance and Annuity Company and The Franklin Life Insurance Company -- filed as Exhibit 10-7 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-26 Amended and Restated Project Facilities Agreement dated as of September 1, 1992, between PG&W and the Luzerne County Industrial Development Authority -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 10-27 7.20% Bond Purchase Agreement, dated September 2, 1992, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-3490. 10-28 Project Facilities Agreement, dated December 1, 1992, between Luzerne County Industrial Development Authority and PG&W -- filed as Exhibit 10-29 to PG&W's Annual Report on Form 10-K for 1992, File No. 1-3490. 10-29 7.125% Bond Purchase Agreement, dated December 10, 1992, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed as Exhibit 10-30 to PG&W's Annual Report on Form 10-K for 1992, File No. 1-3490. 10-30 Second Amended and Restated Project Facilities Agreement dated as of December 1, 1993, between PG&W and the Luzerne County Industrial Development Authority -- filed herewith. Exhibit Number 10-31 6.05% Bond Purchase Agreement, dated December 2, 1993, among the Luzerne County Industrial Development Authority, PG&W and Butcher & Singer, a division of Wheat First Securities, Inc., as representative on behalf of itself and Legg Mason Wood Walker Incorporated -- filed herewith. 10-32 Letter of Credit Agreement, dated December 1, 1987, between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-20 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. 10-33 Amendment No. 1, dated as of September 10, 1991, to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-6 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-34 Amendment No. 2, dated as of December 13, 1991 to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-15 to PEI's Common Stock Form S- 2, Registration No. 33-43382. 10-35 Amendment No. 3, dated as of May 11, 1992, to December 1987 Reimbursement Agreement between PG&W and Swiss Bank Corporation, New York Branch -- filed as Exhibit 10-2 to PG&W's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-3490. 10-36 Subordinate Open End Mortgage, Security Agreement, Assignment of Leases, Rents and Profits, Financing Statement and Fixture Filing, dated as of September 10, 1991, made by PG&W, as Mortgagor, to Swiss Bank Corporation, as Collateral Agent and Mortgagee -- filed as Exhibit 10-1 to PEI's Common Stock Form S-2, Registration No. 33- 43382. 10-37 Collateral Agency and Intercreditor Agreement, dated as of September 10, 1991, among Manufacturers Hanover Trust Company (now Chemical Bank), as Bank Agency, Swiss Bank Corporation, New York Branch, First Eastern Bank, N.A., Hanover Bank, Meridian Bank, Northeastern Bank of Pennsylvania (now PNC Bank, Northeast PA), Philadelphia National Bank (now CoreStates Bank, N.A.), United Penn Bank (now Mellon Bank, N.A.), National Australia Bank, Limited, New York Branch, Swiss Bank Corporation, New York Branch, as Collateral Agent and PG&W -- filed as Exhibit 10-2 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-38 Credit Agreement, dated as of April 19, 1993, by and among PG&W, the Banks parties thereto and PNC Bank, Northeast PA, as agent, and CoreStates Bank, N.A. and NBD Bank, N.A. as Co-Agents -- filed as Exhibit 10-1 to PG&W's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. 10-39 9.50% Cumulative Preferred Stock Purchase Agreement, dated December 11, 1987, between PG&W and the purchasers named therein -- filed as Exhibit 10-23 to PG&W's Annual Report on Form 10-K for 1987, File No. 1-3490. Exhibit Number 10-40 Recapitalization Agreement, dated September 16, 1988, between PG&W and the original purchasers of PG&W's 9.50% Cumulative Preferred Stock, pursuant to which shares of the 9.50% Cumulative Preferred Stock were exchanged for shares of PG&W's 9.50% 1988 Series Cumulative Preferred Stock -- filed as Exhibit 10-24 to PG&W's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, File No. 1-3490. 10-41 Form of Change in Control Agreement between PEI and certain of its Officers -- filed as Exhibit 10-34 to PG&W's Annual Report on Form 10-K for 1989, File No. 1-3490. 10-42 Agreement, dated as of March 15, 1991, by and between PEI, PG&W and Robert L. Jones -- filed as Exhibit 10-38 to PG&W's Annual Report on Form 10-K for 1990, File No. 1-3490. 10-43 Employment Agreement, dated August 30, 1991, between PEI and Dean T. Casaday -- filed as Exhibit 10-16 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-44 Supplemental Retirement Agreement, dated as of December 23, 1991, between PEI and Dean T. Casaday -- filed as Exhibit 10-17 to PEI's Common Stock Form S-2, Registration No. 33-43382. 10-45 Pennsylvania Enterprises, Inc. 1992 Stock Option Plan, effective June 3, 1992 -- filed as Exhibit A to PEI's 1993 definitive Proxy Statement, File No. 0-7812. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

37032_1993.txt

37032_1993

1993

37032

ITEM 1. BUSINESS -------- First Virginia Banks, Inc. (the "Corporation") is a registered bank holding company which was incorporated under the laws of the Commonwealth of Virginia in October, 1949. Since its formation in 1949, the Corporation has acquired control of 55 operating commercial banks, with three acquisitions in the State of Maryland and three in the State of Tennessee, and has organized seven new banks located in the State of Virginia. Forty-one of the banks have been merged or consolidated with other banks controlled by the Corporation and located in the same geographic area, so that, as of December 31, 1993, the Corporation owned all of the outstanding stock of 21 commercial banks (the "Member Banks") with combined assets of $6.916 billion. On that date, the Member Banks operated 268 offices throughout the State of Virginia, 37 offices in Maryland and 20 offices in Tennessee. In addition to the 21 banks, the Corporation owns, directly or through subsidiaries, several bank related member companies with offices in Virginia and six other states, making the Corporation the fourth largest Bank Holding Company with headquarters in the state and the sixth largest banking organization in Virginia, based on total assets of $7.037 billion as of December 31, 1993. Competitive Factors - ------------------- Other banking organizations have been active in opening new banking offices through acquisition and control of existing banks, mergers, branching and formation of new banks and in acquiring or forming bank-related subsidiaries in areas where the Corporation's Member Banks compete. Accordingly, each Member Bank faces strong competition. Savings and loan associations and credit unions actively compete for deposits. Such institutions, as well as consumer finance companies, mortgage companies, loan production offices of out-of-state banks, factors, insurance companies and pension trusts are important competitors for various types of loans. The bank-related member companies also operate in highly competitive fields. At midyear 1993, the banking offices and deposits controlled by the Corporation's Member Banks represented approximately 12.7% and 9.4% of the banking offices and domestic bank deposits, respectively, in Virginia. Regulation - ---------- The Corporation and its subsidiaries are subject to the supervision and examination of the Federal Reserve Board, the Federal Deposit Insurance Corporation and the state regulators of Virginia, Maryland and Tennessee which have jurisdiction over financial institutions and have obtained regulatory approval for their various activities to the extent required. Employees - --------- As of December 31, 1993, the Corporation and its subsidiaries employed 5,255 individuals. Lines of Business - ----------------- All of the Corporation's income is derived from banking or bank-related activities. While each of the member companies is engaged in bank-related activities, several of them conduct lines of business not expressly permitted for banks under applicable regulations. During the last three years, the results of their operations have not been material in relation to the consolidated operating results of the Corporation. Statistical Disclosure by Bank Holding Companies - ------------------------------------------------ The following statistical information appears in this Form 10-K on the page indicated: Page ---- Average balance sheets and interest rates on earning assets and interest-bearing liabilities 12/17 Average book value of investment securities 12/17 Average demand, savings and time deposits 12/17 Effect of rate-volume changes on net interest income 18/19 Type of loans 26 Page ---- Maturity ranges of time certificates of deposit of $100,000 or more 28 Risk elements - loan portfolio 31 Summary of loan loss experience 33 Maturity ranges and average yields - investment securities 35 Loan maturities and sensitivity to changes in interest rates 36 Return on equity and assets, dividend payout ratio and equity to assets ratio 9/10 Executive Officers of the Registrant - ------------------------------------ There are no arrangements or understandings between the named executive officers and any other person pursuant to which they were selected as an officer. There are no family relationships among the executive officers. Messrs. Campbell, Cash, Geithner, Hicks, Lanzillotta, O'Donnell and Zalokar and Ms. Tomlin have held their present positions with the Corporation for more than five years. ROBERT H. ZALOKAR Chairman of the Board and Chief Executive Officer since 1985 and President from 1978 through 1984; 38 years of service; BS, University of Kansas. Has held numerous executive officer positions with the First Virginia organization including President of First Virginia Bank, Falls Church, from 1973 to 1978, CEO from 1979 to 1985, and Chairman since 1979. Mr. Zalokar is 66. PAUL H. GEITHNER, JR. President and Chief Administrative Officer since 1985; 25 years of service; BA, Amherst College; MBA, Wharton Graduate Division, University of Pennsylvania. Elected Vice President 1969, responsible for member banks from 1973 to 1975; Senior Vice President 1974; Assistant to the Chairman and President 1978. Mr. Geithner is 63. SHIRLEY C. BEAVERS, JR. Executive Vice President since April 1992; President and Chief Executive Officer of First Virginia Services, Inc. since May 1986; 24 years of service; BS and MBA, American University. Has held various officer positions with First Virginia organizations including that of Executive Vice President and Chief Operating Officer, First Virginia Bank, Falls Church. Mr. Beavers is 48. BARRY J. FITZPATRICK Executive Vice President since April 1992; 24 years of service; BBA, University of Notre Dame; MBA, American University, and graduate of the Stonier Graduate School of Banking. Has held several officer positions with First Virginia organizations including Senior Vice President and Regional Executive Officer, Eastern Region, from March 1982 to April 1992 and President and CEO of member banks in the Roanoke Valley from 1972 to 1982. Mr. Fitzpatrick is 54. RAYMOND E. BRANN, JR. Senior Vice President and Regional Executive Officer, Eastern Region, since April 1992; 29 years of service, BS, University of Virginia; MBA, Old Dominion University. Has held various officer positions with First Virginia organizations including that of Senior Vice President and Regional Executive Officer, Tennessee-Western Virginia Region from December 1986 to April 1992, and President and CEO of several member banks, including First Virginia Bank- Colonial and Tri-City Bank and Trust Company. Mr. Brann is 53. HUGH L.CAMPBELL Senior Vice President since 1978; 30 years of service; AB, Washington & Lee University; MBA, Colgate Darden Graduate School of Business Administration, University of Virginia; Advanced Management Program, Harvard University, 1979. Responsible for commercial lending, loan administration and financial planning. Mr. Campbell is 56. CHARLES R. CASH Senior Vice President and Regional Executive Officer, Shenandoah Valley Region, since 1982; Chairman, President and CEO of First Virginia Bank- Shenandoah Valley since 1970; 30 years of service; graduate certificate, American Institute of Banking. Has held several executive officer positions with banks in the Shenandoah Valley area which have, through merger, become First Virginia Bank-Shenandoah Valley. Mr. Cash is 64. DOUGLAS M. CHURCH, JR. Senior Vice President since October 1990; 20 years of service; BS, University of Virginia, and graduate of The Stonier Graduate School of Banking. Has held various officer positions with First Virginia organizations including Executive Vice President of First Virginia Services, Inc. and Executive Vice President, Retail Services, of First Virginia Bank from May 1988 until October 1990. Mr. Church is 43. HENRY HOWARD HICKS, JR. Senior Vice President and Regional Executive Officer, Southwest Region, since 1982; 40 years of service; graduate certificate, American Institute of Banking. Has held various executive officer positions with First Virginia organizations including President and CEO of First Virginia Bank-Southwest from 1971 to 1982. Mr. Hicks is 58. A. PAUL LANZILLOTTA Senior Vice President, Trust Services, since 1979; Executive Vice President, First Virginia Bank, Falls Church, since 1978; 31 years of service; BS, Boston College; JD and LLM, Georgetown University. Joined First Virginia Bank as Trust Officer; appointed Vice President and Trust Officer of the Corporation in 1967 and Senior Vice President and Trust Officer in 1976. Mr. Lanzillotta is 62. JUSTIN C. O'DONNELL Senior Vice President and Regional Executive Officer, Northern Region, since 1988; President and CEO, First Virginia Bank, Falls Church, since 1985; 11 years of service; BS, Duquesne University, and graduate of The Stonier Graduate School of Banking. Joined First Virginia Bank as Senior Vice President and Manager of the Commercial Division in 1982. Mr. O'Donnell is 58. CHARLES L. ROBBINS, III Senior Vice President and Regional Executive Officer, Tennessee-Western Virginia Region, since April 1992; President and CEO, Tri-City Bank and Trust Company, Tennessee, since 1992; 20 years of service; BS, George Mason University, and graduate of The Stonier Graduate School of Banking. Has held various officer positions with First Virginia Bank, Falls Church, including Senior Vice President and Branch Administrator from August 1987 until April 1992. Mr. Robbins is 41. RICHARD F. BOWMAN Vice President and Treasurer since February 1992; 18 years of service; AB, College of William & Mary; Certified Public Accountant and Chartered Bank Auditor. Employed as Staff Auditor; appointed Assistant General Auditor in 1978 and served as Vice President and Controller from November 1979 thru January 1992. Mr. Bowman is 42. THOMAS P. JENNINGS Vice President, General Counsel and Secretary since January 1993; 15 years of service; BA, Wake Forest University; JD, University of Virginia. Employed as Assistant Counsel; appointed Associate Counsel in 1979, General Counsel in 1980, and Vice President and General Counsel in March 1986. Mr. Jennings is 46. MELODYE MAYES TOMLIN Vice President and General Auditor since 1986; 15 years of service; BS, Radford University, and graduate of The Stonier Graduate School of Banking; Certified Public Accountant. Employed as Staff Auditor; appointed Regional Audit Manager in 1980 and Assistant General Auditor in 1983. Mrs. Tomlin is 37. Ages are as of February 25, 1994. ITEM 2. ITEM 2. PROPERTIES ---------- The banking subsidiaries operated a total of 325 banking offices on December 31, 1993. Of these offices, 195 were owned by the banks, two are owned by the Corporation and leased to the banks, one was owned by an affiliated company and leased to a bank, and 127 were leased from others. The Corporation owns other properties, including the two Corporate headquarters buildings which house personnel of the Corporation and its subsidiaries. On December 31, 1993, the book value of all real estate and the unamortized cost of improvements to leased premises totaled $113,312,000. There are no mortgages secured by properties. As of December 31, 1993, a total annual base rental of approximately $11,210,000 was being paid on leased premises, of which approximately $5,465,000 was being paid to affiliated companies. As of December 31, 1993, total lease commitments having a remaining term in excess of one year to persons other than affiliates were approximately $29,593,000. The majority of the properties are modern and well furnished and provide adequate parking. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- There are no legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation or any of its subsidiaries is a party or of which any of their property is subject. Management believes that the liability, if any, resulting from current litigation will not be material to the financial statements of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- There was no submission of matters to a vote of security holders during the fourth quarter of 1993. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED ----------------------------------------------------- STOCKHOLDER MATTERS ------------------- The common stock of the Corporation is listed for trading on the New York Stock Exchange (Trading Symbol: FVB) and the Philadelphia Stock Exchange. The dividends paid per share and the high and low sales price (adjusted for the three-for-two stock split in July 1992) for common shares traded on the New York Stock Exchange were: Sales Price ------------------------------ Dividends 1993 1992 Per Share -------------- -------------- ------------ High Low High Low 1993 1992 ------ ------ ------ ------ ----- ----- 1st Quarter...... $40.00 $36.37 $26.83 $23.33 $.260 $.233 2nd Quarter...... 39.00 32.50 30.75 25.58 .260 .233 3rd Quarter ..... 41.00 34.00 33.63 29.87 .280 .247 4th Quarter...... 40.50 31.75 37.87 30.25 .280 .250 The Corporation's preferred stock is not actively traded. The 5% cumulative convertible preferred stock, Series A, pays a dividend of 12 1/2 cents per share in each quarter. The 7% cumulative convertible preferred stock, Series B and C, pays a dividend of 17 1/2 cents per share each quarter. The 8% cumulative convertible preferred stock, Series D, pays a dividend of 20 cents per share each quarter. As of December 31, 1993, there were 17,868 holders of record of the Corporation's voting securities, of which 16,965 were holders of common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA 6. SELECTED FINANCIAL DATA ----------------------- A five-year summary of selected financial data follows: 1993 1992 1991 1990 1989 ---------- ---------- ---------- ---------- ---------- (Dollar amounts in thousands, except per-share data) Balance Sheet Data Cash.................. $ 326,136 $ 381,384 $ 361,027 $ 291,275 $ 314,125 Overnight investments. 235,000 235,000 205,000 160,000 215,000 Investment securities: Taxable ............. 1,940,671 1,911,301 1,554,940 1,015,684 830,479 Tax-exempt........... 235,363 253,926 257,889 271,097 238,603 Loans, net............ 4,036,391 3,793,033 3,470,561 3,390,486 3,294,770 Other assets.......... 263,322 265,903 269,843 255,605 230,987 ---------- ---------- ---------- ---------- ---------- Total Assets......... $7,036,883 $6,840,547 $6,119,260 $5,384,147 $5,123,964 ========== ========== ========== ========== ========== Deposits ............. $6,136,389 $6,013,746 $5,349,971 $4,715,882 $4,426,663 Short-term borrowings. 151,859 150,681 144,816 85,667 132,197 Mortgage and other indebtedness ........ 1,008 5,227 11,467 11,836 37,480 Other liabilities .... 56,126 63,494 72,888 73,075 73,025 Stockholders' Equity.. 691,501 607,399 540,118 497,687 454,599 ---------- ---------- ---------- ---------- ---------- Total Liabilities and Stockholders' Equity $7,036,883 $6,840,547 $6,119,260 $5,384,147 $5,123,964 ========== ========== ========== ========== ========== Operating Results Interest income ...... $ 504,782 $ 525,270 $ 515,837 $ 501,412 $ 471,560 Interest expense ..... 164,959 204,826 260,286 264,856 243,105 ---------- ---------- ---------- ---------- ---------- Net interest income..... 339,823 320,444 255,551 236,556 228,455 Provision for loan loss. 6,450 17,355 14,024 13,404 11,039 Noninterest income...... 82,540 77,087 72,283 68,376 63,060 Noninterest expenses.... 245,767 238,891 218,243 202,037 188,129 ---------- ---------- ---------- ---------- ---------- Income before income tax 170,146 141,285 95,567 89,491 92,347 Provision for income tax 54,122 43,812 25,959 24,380 24,973 ---------- ---------- ---------- ---------- ---------- Net income ............$ 116,024 $ 97,473 $ 69,608 $ 65,111 $ 67,374 ========== ========== ========== ========== ========== Dividends declared: Preferred ............$ 54 $ 61 $ 71 $ 76 $ 78 Common................ 36,519 31,830 28,995 27,247 25,242 Per Share of Common Stock Net income ............ 3.57 3.02 2.17 2.03 2.13 Dividends declared..... 1.13 .99 .91 .85 .80 Stockholders' equity... 21.29 18.85 16.80 15.51 14.37 Market price at year-end 32.75 36.63 23.67 15.17 20.00 1993 1992 1991 1990 1989 ---------- ---------- ---------- ---------- ---------- Ratios - ------ Earnings: Return on average assets 1.68% 1.50% 1.22% 1.25% 1.39% Return on average equity 17.81 17.03 13.44 13.59 15.55 Net interest margin..... 5.46 5.46 5.03 5.15 5.36 Risk-based capital: Tier 1 or core capital.. 16.84 15.52 14.74 14.05 - Tier 2 or total capital. 18.09 16.77 16.00 15.28 - Capital strength: Ratio of average equity to average assets...... 9.45 8.80 9.08 9.22 8.94 Dividends declared as a percentage of net income (per share, not restated for poolings of interests).......... 31.65 32.78 41.94 41.87 37.56 Data for prior years have been restated for material acquisitions accounted for as poolings of interests. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND --------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- Net income for First Virginia Banks, Inc. increased to a record level in 1993. The record earnings continued from the excellent levels achieved in the previous two years, and allowed First Virginia to outperform almost all of the other 100 largest banks in the country. Many banks had difficulty in maintaining deposit levels with interest rates declining to the lowest level in many years, and, as a result, nonbanking organizations competed aggressively for the consumer dollar. First Virginia, however, was able to increase its average deposits by 6%, with particularly strong growth in consumer transaction accounts. Similarly, despite a lackluster economy, First Virginia capitalized on its strong position in the consumer automobile financing market and increased its average loans by 8%. The value of First Virginia's extensive retail-oriented branch network was a key factor in increasing market share during 1993, with minimal increases in expense. Net income in 1993 increased 19% to $116,024,000, as compared to the $97,473,000 earned in the previous year. Net income per share increased $.55 to $3.57, as compared to the $3.02 earned in 1992. This remarkable performance allowed the Corporation to achieve a return on assets of 1.68%, which exceeded First Virginia's peer group figures by 25% and was one of the highest of all banks in the country. While many banking institutions had excellent results in 1993, First Virginia has performed at consistently high levels. Over the past ten years, First Virginia has averaged a return on assets of 1.35% where 1.00% generally has been considered the benchmark of a high performance bank. The Corporation achieved a return on stockholders' equity of 17.81%, as compared to 17.03% in the previous year. This level also exceeded the Corporation's industry peer group average of 16.00% in 1993, which is particularly noteworthy as the Corporation has an equity level that is 17% greater than banks of comparable size. First Virginia has consistently achieved a higher return on stockholders' equity than its peer group. For the past ten years, First Virginia's return on equity has averaged 15.87%, as compared to the 13.73% average for its peer group of banks in the $5-$10 billion asset size range. During 1993, the Corporation increased its dividend rate twice and has increased its dividend 25 times over the past twelve years. By year-end, the annual dividend rate was $1.24 per share, up 19% over the $1.04 rate at the end of 1992. Average assets increased 6% during 1993 and at year-end exceeded $7 billion for the first time. This increase was slower than the 14% average growth in 1992 and the 10% average growth in 1991, as the concern by depositors over the safety and soundness of their financial institution dissipated due to the considerable improvement in the asset quality, capital and income of banks in 1993. In addition, during 1992, the Corporation had acquired $270 million in deposits from the former CorEast Federal Savings Bank, and acquisition activity in 1993 was not as great. The Corporation added seven branches during 1993. Three branches with approximately $44 million in assets were added when the Corporation acquired United Southern Bank of Morristown in Tennessee, and one branch with approximately $22 million in deposits was acquired from Home Federal Savings Bank in Greeneville, Tennessee. Loans grew 8% on average during 1993 to $3.958 billion which was more than the 6% growth in 1992. Indirect automobile loan production activity increased 25% during 1993; however, commercial lending was weak and real estate loans did not increase at as great a rate as in 1992. The decline in interest expense was the primary contributor to the increase in income for both 1993 and 1992. Most of the decline in rates occurred throughout 1992, and interest levels were fairly stable in 1993. However, interest costs declined 19%, because the rates in early 1992 were higher than those in 1993. A decline in the Corporation's provision for loan losses due to improved credit quality was also a major factor in increasing net income and contributed $.22 per share. An increase in the federal corporate income tax rate reduced income by $.05 per share in 1993. Year Ended December 31 1993 1992 1991 vs. vs. vs. 1992 1991 1990 ----- ----- ----- Earnings per share - prior period............. $3.02 $2.17 $2.03 ----- ----- ----- Net change during the year: Taxable interest income..................... (.37) .24 .30 Tax-exempt interest income.................. (.04) (.05) - Interest expense ........................... .80 1.13 .09 Provision for loan losses................... .22 (.07) (.01) Gain on sale of mortgage servicing rights... .02 (.04) - Other noninterest income.................... .08 .14 .07 FDIC insurance premium expense.............. (.02) (.05) (.10) Other noninterest expense................... (.12) (.37) (.23) Income taxes................................ (.01) (.07) .02 Increased common shares outstanding......... (.01) (.01) - ----- ----- ----- Net increase during the period............ .55 .85 .14 ----- ----- ----- Earnings per share - current period........... $3.57 $3.02 $2.17 ===== ===== ===== AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-earning assets: Investment securities: U.S. Government & its agencies $1,863,228 $117,634 6.31% State and municipal obligations(1) 240,503 19,222 7.99 Other(1) 36,906 2,571 6.97 ---------- -------- Total investment securities 2,140,637 139,427 6.51 ---------- -------- Loans, net of unearned income:(2) Installment 2,669,463 254,157 9.52 Real estate 691,048 63,413 9.18 Other(1) 597,811 47,549 7.95 ---------- -------- Total loans 3,958,322 365,119 9.22 ---------- -------- Federal funds sold and securities purchased under agreements to resell 270,392 8,359 3.09 ---------- -------- Total earning assets and interest income 6,369,351 512,905 8.05 ---------- -------- Noninterest-earning assets: Cash and due from banks 305,900 Premises and equipment, net 137,124 Other assets 129,245 Less allowance for loan losses (50,882) ---------- Total Assets $6,890,738 ========== (1) Income from tax-exempt securities and loans is included in interest income on a taxable-equivalent basis. Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 35% in 1993, 34% in 1992 and 1991, increased by 5.0% in recognition of the partial disallowance of interest costs incurred to carry the tax-exempt investments. (2) Nonaccruing loans are included in their respective categories. AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-bearing liabilities: Transaction accounts $1,218,697 $ 31,840 2.61% Money-market accounts 746,703 20,090 2.69 Savings deposits 1,276,937 37,432 2.93 Certificates of deposit: Large denomination 167,697 6,353 3.79 Other 1,627,982 65,460 4.02 ---------- -------- Total interest-bearing deposits 5,038,016 161,175 3.20 Short-term borrowings 150,951 3,563 2.36 Notes and mortgages 1,374 221 16.06 ---------- -------- Total interest-bearing liabilities and interest expense 5,190,341 164,959 3.18 ---------- -------- Noninterest-bearing liabilities: Demand deposits 990,007 Other 58,929 Stockholders' equity 651,461 ---------- Total liabilities and stockholders' equity $6,890,738 ========== Net interest income and net interest margin $347,946 5.46% ======== AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-earning assets: Investment securities: U.S. Government & its agencies $1,815,126 $125,528 6.92% State and municipal obligations(1) 252,240 21,615 8.57 Other(1) 43,047 3,297 7.66 ---------- -------- Total investment securities 2,110,413 150,440 7.13 ---------- -------- Loans, net of unearned income:(2) Installment 2,431,099 261,774 10.77 Real estate 610,223 61,814 10.13 Other(1) 618,784 50,447 8.15 ---------- -------- Total loans 3,660,106 374,035 10.22 ---------- -------- Federal funds sold and securities purchased under agreements to resell 260,606 9,516 3.65 ---------- -------- Total earning assets and interest income 6,031,125 533,991 8.85 ---------- -------- Noninterest-earning assets: Cash and due from banks 246,218 Premises and equipment, net 140,016 Other assets 133,129 Less allowance for loan losses (47,060) ---------- Total Assets $6,503,428 ========== (1) Income from tax-exempt securities and loans is included in interest income on a taxable-equivalent basis. Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 35% in 1993, 34% in 1992 and 1991, increased by 5.0% in recognition of the partial disallowance of interest costs incurred to carry the tax-exempt investments. (2) Nonaccruing loans are included in their respective categories. AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-bearing liabilities: Transaction accounts $1,059,112 $ 34,540 3.26% Money-market accounts 788,729 26,067 3.30 Savings deposits 954,503 35,883 3.76 Certificates of deposit: Large denomination 187,662 8,767 4.67 Other 1,856,277 94,207 5.08 ---------- -------- Total interest-bearing deposits 4,846,283 199,464 4.12 Short-term borrowings 145,227 4,149 2.86 Notes and mortgages 10,833 1,213 11.20 ---------- -------- Total interest-bearing liabilities and interest expense 5,002,343 204,826 4.09 ---------- -------- Noninterest-bearing liabilities: Demand deposits 864,000 Other 64,812 Stockholders' equity 572,273 ---------- Total liabilities and stockholders' equity $6,503,428 ========== Net interest income and net interest margin $329,165 5.46% ======== AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-earning assets: Investment securities: U.S. Government & its agencies $1,236,261 $ 97,334 7.87% State and municipal obligations(1) 265,679 23,136 8.71 Other(1) 52,846 4,462 8.44 ---------- -------- Total investment securities 1,554,786 124,932 8.04 ---------- -------- Loans, net of unearned income:(2) Installment 2,314,535 269,373 11.64 Real estate 502,038 54,832 10.92 Other(1) 629,980 60,694 9.63 ---------- -------- Total loans 3,446,553 384,899 11.17 ---------- -------- Federal funds sold and securities purchased under agreements to resell 256,574 14,880 5.80 ---------- -------- Total earning assets and interest income 5,257,913 524,711 9.98 ---------- -------- Noninterest-earning assets: Cash and due from banks 232,017 Premises and equipment, net 141,302 Other assets 114,018 Less allowance for loan losses (43,865) ---------- Total Assets $5,701,385 ========== (1) Income from tax-exempt securities and loans is included in interest income on a taxable-equivalent basis. Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 35% in 1993, 34% in 1992, increased by 5.0% in recognition of the partial disallowance of interest costs incurred to carry the tax-exempt investments. (2) Nonaccruing loans are included in their respective categories. AVERAGE BALANCE SHEETS AND INTEREST RATES ON EARNING ASSETS AND INTEREST-BEARING LIABILITIES ------------------------------ Interest Average Income/ Balance Expense Rate ---------- --------- ------- (Dollars in thousands) Interest-bearing liabilities: Transaction accounts $ 845,836 $ 40,382 4.77% Money-market accounts 632,143 32,573 5.15 Savings deposits 588,709 28,243 4.80 Certificates of deposit: Large denomination 250,484 16,381 6.54 Other 1,908,463 135,009 7.07 ---------- -------- Total interest-bearing deposits 4,225,635 252,588 5.98 Short-term borrowings 125,422 6,479 5.17 Notes and mortgages 11,466 1,219 10.63 ---------- -------- Total interest-bearing liabilities and interest expense 4,362,523 260,286 5.97 ---------- -------- Noninterest-bearing liabilities: Demand deposits 755,998 Other 65,010 Stockholders' equity 517,854 ---------- Total liabilities and stockholders' equity $5,701,385 ========== Net interest income and net interest margin $264,425 5.03% ======== EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME 1993 Compared to 1992 Increase (Decrease) Due to Change in ------------------------------ Total Average Average Increase Volume Rate (Decrease) -------- -------- -------- Interest income (In thousands) - --------------- Investment securities: U.S. Government and its agencies $ 3,327 $(11,221) $ (7,894) State and municipal obligations* (1,006) (1,387) (2,393) Other* (470) (256) (726) -------- -------- -------- Total investment securities 1,851 (12,864) (11,013) -------- -------- -------- Loans: Installment 25,666 (33,283) (7,617) Real estate 8,187 (6,588) 1,599 Other* (1,709) (1,189) (2,898) -------- -------- -------- Total loans 32,144 (41,060) (8,916) -------- -------- -------- Federal funds sold and securities purchased under agreements to resell 357 (1,514) (1,157) -------- -------- -------- Total interest income 34,352 (55,438) (21,086) -------- -------- -------- Interest expense - ---------------- Transaction accounts 5,204 (7,904) (2,700) Money-market accounts (1,389) (4,588) (5,977) Savings deposits 12,122 (10,573) 1,549 Certificates of deposit: Large denomination (933) (1,481) (2,414) Other (11,586) (17,161) (28,747) -------- -------- -------- Total interest-bearing deposits 3,418 (41,707) (38,289) Short-term borrowings 164 (750) (586) Notes and mortgages (1,059) 67 (992) -------- -------- -------- Total interest expense 2,523 (42,390) (39,867) -------- -------- -------- Net interest income $ 31,829 $(13,048) $ 18,781 ======== ======== ======== *Fully taxable-equivalent basis The increase or decrease due to a change in average volume has been determined by multiplying the change in average volume by the average rate during the preceding period, and the increase or decrease due to a change in average rate has been determined by multiplying the current average volume by the change in average rate. EFFECT OF RATE-VOLUME CHANGES ON NET INTEREST INCOME 1992 Compared to 1991 Increase (Decrease) Due to Change in ------------------------------ Total Average Average Increase Volume Rate (Decrease) -------- -------- -------- Interest income (In thousands) - --------------- Investment securities: U.S. Government and its agencies $ 45,576 $(17,382) $ 28,194 State and municipal obligations* (1,170) (351) (1,521) Other* (827) (338) (1,165) -------- -------- -------- Total investment securities 43,579 (18,071) 25,508 -------- -------- -------- Loans: Installment 13,566 (21,165) (7,599) Real estate 11,816 (4,834) 6,982 Other* (1,079) (9,168) (10,247) -------- -------- -------- Total loans 24,303 (35,167) (10,864) -------- -------- -------- Federal funds sold and securities purchased under agreements to resell 234 (5,598) (5,364) -------- -------- -------- Total interest income 68,116 (58,836) 9,280 -------- -------- -------- Interest expense - ---------------- Transaction accounts 10,182 (16,024) (5,842) Money-market accounts 8,069 (14,575) (6,506) Savings deposits 17,549 (9,909) 7,640 Certificates of deposit: Large denomination (4,108) (3,506) (7,614) Other (3,692) (37,110) (40,802) -------- -------- -------- Total interest-bearing deposits 28,000 (81,124) (53,124) Short-term borrowings 1,023 (3,353) (2,330) Notes and mortgages (67) 61 (6) -------- -------- -------- Total interest expense 28,956 (84,416) (55,460) -------- -------- -------- Net interest income $ 39,160 $ 25,580 $ 64,740 ======== ======== ======== *Fully taxable-equivalent basis The increase or decrease due to a change in average volume has been determined by multiplying the change in average volume by the average rate during the preceding period, and the increase or decrease due to a change in average rate has been determined by multiplying the current average volume by the change in average rate. STATEMENT OF INCOME STATEMENT OF INCOME - ------------------- NET INTEREST INCOME The table on the previous pages details the changes in earning assets, interest-bearing liabilities and demand deposits for the last three years, along with the related levels of fully taxable-equivalent interest income and expense. The variance in interest income and expense caused by differences in average balances and rates is shown in the table on the previous pages. Interest rates during 1993 declined slightly but were fairly stable for most of the year and bounced around in a narrow band. Lower inflation rates and a sluggish economy in 1993 resulted in little action by the Federal Reserve, following vigorous actions in 1991 and 1992 in lowering the general level of interest rates. Long-term rates fell by a greater degree than short-term rates in 1993; however, because the Corporation maintains a short-term maturity distribution of its loans and investments, this decline did not have a great effect on First Virginia. Net interest income increased 6% in 1993, mirroring the 6% increase in average earning assets while the net interest margin remained unchanged at a relatively high level of 5.46%, as compared to 1992. Although interest rates were fairly stable during 1993, the decline in rates during 1992 resulted in a faster rate of decline in interest income than in interest expense. The Corporation is slightly liability sensitive in the short term and consequently, as rates declined in 1992, the Corporation was able to decrease the cost of funds on deposits at a faster pace than its decline on loans and investments. In 1993, however, maturing loans and investments were being repriced at a faster rate than deposits, and the net interest margin fell steadily throughout the year after peaking in the fourth quarter of 1992. It is anticipated that this trend will continue in the first half of 1994, before stabilizing later in the year. The decline in net interest income in 1993 due to rates was offset by an increase in income due to volume and also by the mix of earning assets. Almost all of the increase in deposits during 1993 was invested in loans which produce a higher yield than investment securities. Loans comprised 62.1% of earning assets in 1993, up from the 60.7% recorded in 1992 but significantly lower than the 70% level achieved in the late 1980s and early 1990s. Deposits grew 6% on average during 1993, with the majority of that growth concentrated in relatively low-cost demand deposits and NOW accounts, both of which grew 15% on average. In addition, consumer savings were up 34% on average, as consumers showed a preference to stay liquid due to the low level of interest rates so that they could take advantage of any increases in rates as the economy improved. The Corporation continued its policy of maintaining a slightly higher rate on these types of core consumer deposits than did its major competitors. The Corporation's primary source of deposits is from its retail base of consumer accounts. Despite paying slightly higher rates for these types of accounts, the Corporation still was able to lower its cost of funds 91 basis points to 3.18% during 1993. PROVISION FOR LOAN LOSSES The provision for loan losses declined 63%, or $10.9 million during 1993 to $6.5 million after increasing 24% in 1992. The decline in the provision during 1993 was due primarily to a lower level of net charge-offs which dropped to a record low of .13% of loans, as compared to .35% of loans in 1992. The allowance for loan losses, as a percentage of year-end loans, declined three basis points to 1.25% of loans due to the improvement in the Corporation's charge-off experience and the improvement in asset quality. If loan quality and net charge-off experience remain favorable, the Corporation intends to reduce its allowance for loan losses further in 1994 which will lower the provision for loan loss expense. The decline in net charge-offs during 1993 was reflected in all categories of loans, particularly in indirect automobile loans. The Corporation has increased the quality of automobile loans that it has purchased from dealers over the past several years and as a result, the charge-off rate has declined from .50% in 1991 to .29% in 1992 and to a low of .06% in 1993. As the economy improved during 1993 and consumers reduced their debt levels and refinanced their mortgage loans at substantially lower interest rates, they improved their liquidity and debt payment ability which resulted in lower loan charge-offs. This trend was also reflected in record low levels of charge-offs in direct installment loans and by a reduction of 31 basis points in the charge-off rate of credit cards, to 2.80%. The Corporation substantially avoided the problems with commercial real estate and development loans which plagued its competitors in the early 1990s. During 1993, only $22,000 in net real estate loan losses were charged off, and the Corporation had a net recovery in commercial loans for the year. In the previous year, the Corporation had net charge-offs of $3.1 million in commercial loans, primarily for residential real estate development loans. The Corporation makes approximately 81% of its loans to consumers for small amounts with regular, monthly repayment schedules, which therefore makes its risk exposure to loan charge-offs less than that of many other banks. OTHER INCOME Noninterest income increased 7% in both 1993 and 1992, reflecting the Corporation's efforts to increase the percentage of income received from noninterest income sources. During 1993, the Corporation introduced a mutual fund product and continued its promotion of brokerage services, insurance products and other noninterest products. While noninterest income, as a percentage of total income, is smaller than the percentage at most other banking organizations, it meets the Corporation's objective of growing at a faster pace than noninterest expense, which increased 3% in 1993. Historically, the Corporation has not had the commercial or specialized services enjoyed by comparably sized banks which provide a major source of noninterest income generating customers. Efficiency Ratio Chart (The lower, the better) National First Southern Peer Virginia Regionals Group -------- --------- -------- 1993 57.0% 61.4% 60.6% 1992 58.4% 61.8% 60.0% 1991 65.1% 64.7% 63.6% 1990 64.7% 64.0% 63.8% 1989 62.8% 64.3% 64.0% Southern Regionals: Banking companies with assets over $2 billion (30 in 1993) National Peer Group: Banking companies with assets of between $5 and $10 billion (19 in 1993) Source: Keefe, Bruyette & Woods Service charges on deposit accounts increased 4% during 1993 after increasing 2% in the previous year, and they comprise the largest segment of noninterest income. Despite the 15% growth in transaction accounts in 1993 and the 20% growth in 1992, competitive pressures did not permit the Corporation to increase prices during 1993, and, as a result, service charge income did not grow as rapidly as outstanding balances. Service charges from commercial deposit accounts increased at an 8% pace, as the Corporation increased the processing fees on major corporate accounts. Income from other customer services increased 9% in 1993, following two years of double-digit growth. Interchange income from automated teller machines continued to increase rapidly due to the Corporation's extensive branch network and the location of its teller machines. Income from this area increased 13% in 1993, following a 19% increase in 1992. Commissions from the sale of customer checks increased 7% in 1993, after increasing 28% in the prior year due to higher volumes and a change in the Corporation's contract with its primary check provider. Income from insurance premiums and commissions declined slightly in 1993, resulting from lower sales of annuity products which became less attractive due to the decline in interest rates, and from lower sales of homeowners insurance following record mortgage origination activity in the previous year. Sales had increased 8% in 1992, as the Corporation had acquired two insurance agencies in the middle of 1991. Fee income from credit card activities declined 2% in 1993, after declining 4% in 1992, which reflects the increased competition in the credit card area from nonbank issuers and large, nationwide issuers. The Corporation issues its credit cards primarily in its geographic market areas at very competitive rates. Income from trust services increased 12% in 1993, following a 9% increase in 1992 and 11% growth in 1991. Assets under management exceeded one billion dollars for the first time in 1993, as the Corporation increased its emphasis on growth from this area. The Corporation had a $711,000 gain from the sale of securities in 1993, as compared to a small loss in 1992. The gain in 1993 was due primarily to a gain on the sale of an equity security acquired a number of years ago. The Corporation's policy is to retain its investment securities to maturity. Dispositions prior to maturity normally are the result of the sale of an acquired bank's securities which do not conform to First Virginia's investment policies, or the sale of securities for which the underlying credit has deteriorated. Other noninterest income includes $1.2 million in 1993 and $1.9 million in 1991 from the sale of mortgage servicing rights. The Corporation normally sells a package of servicing rights each year but elected not to make a sale in 1992 in order to build the servicing portfolio for future fee income. Excluding the sale of mortgage servicing rights in 1993, other income increased 5% due to a 16% increase in mortgage servicing fees. In 1992, other income increased 29% due to increases in mortgage-related fees, as higher loan origination volume generated increased fees. OTHER EXPENSES Noninterest expenses increased 3% in 1993, following a 9% increase in 1992. The 1992 increase was largely attributable to a 24% increase in Federal Deposit Insurance Corporation (FDIC) insurance assessments, as rates increased significantly due to the failures of savings banks and the depletion of the insurance fund. In 1993, the FDIC adopted a new fee schedule reflecting the risk and capital levels of each institution. Due to the Corporation's high level of capital and conservative asset structure, its member banks qualified for the lowest assessment level possible. As a result, the insurance rate for First Virginia did not increase in 1993, and expense in this area increased 8%, consistent with deposit growth. Salaries and employee benefits increased 4% in 1993, following an 11% increase in 1992. Salaries and wages increased 4% in 1993, consistent both with inflation and with the minimal growth in employment levels resulting from new branches and service growth only. Profit-sharing expense increased 19% in 1993 and 38% in 1992, due to the increase in the overall profitability of the Corporation. Incentive plans linked to the price of the Corporation's stock declined $4.2 million in 1993, due to the decline in the Corporation's stock price during the year. Health-care costs continued to grow at a faster pace than inflation and employment levels, and it increased 14% in both 1993 and 1992. In 1993, the Corporation adopted the Financial Accounting Standards Board Statement (SFAS) No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." The adoption of this statement requires that postretirement benefits, such as retirees' medical expenses paid by the employer, be accounted for during the years of the retirees' active employment. As a result of adopting this statement, the Corporation increased its annual expense for retiree medical benefits by $1.9 million. See note 13 to the consolidated financial statements for additional information. Occupancy expense increased 4% in both 1993 and 1992, due to an increase in the number of branches. In addition, in 1993, a major tenant in the Corporation's headquarters building left upon termination of its lease, and replacement tenants have not yet occupied all of the vacated space. Equipment expense increased 4% in 1993, as compared to a 7% increase in 1992, because the Corporation increased its branch automation project slightly in 1993. In December, the existing mainframe computer was replaced, almost doubling the capacity of the old computer while reducing the operating cost substantially. Other operating expenses declined 2% in 1993, after increasing 11% in 1992. Due to the improvement in loan quality, collection expenses declined 25% in 1993. Foreclosed property expenses were not material and totaled $.9 million each year. Charge-offs due to teller differences and miscellaneous customer claims declined 28%. Both years had higher advertising expenses and an increase in amortization of mortgage servicing rights due to the decline in interest rates and the subsequent refinancing and prepayment of many mortgages. PROVISION FOR INCOME TAXES Income tax expense increased 24% in 1993, to $54.1 million, due primarily to a 20% increase in pretax income. During 1993, the federal corporate income tax rate increased 1%, to 35%, and this change resulted in an increase of the Corporation's effective income tax rate to 31.8%, up from the 31.0% rate in 1992. Income tax expense increased 69% in 1992, due primarily to the increase in income in that year but also due to a 3.8% increase in the effective tax rate from 1991 to 1992. The primary reason for the increase in the effective tax rate in 1992, and to a lesser extent in 1993, was a decline in the benefit received from tax-exempt municipal securities. Since 1982, various changes in tax laws have reduced the availability and attractiveness of tax- exempt securities for banks, and the Corporation has not been able to replace maturing tax-exempt securities with new, comparable, tax-exempt securities. In the fourth quarter of 1992, the Corporation adopted SFAS No. 109 "Accounting for Income Taxes." This statement changed the manner in which deferred income taxes are recorded, from an income-statement approach to a balance-sheet approach. In 1992, the Corporation charged an additional $886,000 to expense upon adopting this statement. Due to the change in the federal corporate tax rate in 1993, the Corporation credited expense of $432,000 to adjust for certain deferred-tax benefits, as required by SFAS No. 109. Balance Sheet - ------------- The Corporation's objective is to invest 70%-80% of its deposits in loans, which is the primary source of income. At the end of 1993, the ratio of loans to deposits was 65.8%, as compared to 63.1% at the end of 1992. The Corporation last met its loan objective in 1990 when the loan-to-deposit ratio stood at 72.8%. Despite the relatively low level of loans to deposits, the Corporation has been able to maintain its net interest margin at a high level without extending the life of its investment portfolio or compromising the quality of earning assets. Strong loan growth in 1993 enabled the Corporation to increase the percentage of its average earning assets invested in loans, as average loans increased 8%. The Corporation experienced relatively strong loan growth in 1992, but the increase in deposits outpaced the growth of loans. In 1992, the Corporation purchased $278 million in deposits from failed thrifts. And from 1990 to 1992, the Corporation's reputation for safety and soundness and the well-publicized problems of its competitors resulted in annual, double-digit increases in deposits that could not be invested immediately in loans. This deposit influx slowed in 1993, as the savings and loan crisis abated and as the capital and asset quality levels of the Corporation's competitors improved. The table below shows the average balances of the various categories of earning assets as a percentage of total earning assets for the years indicated. 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ Loans .................. 62.14% 60.69% 65.55% 71.26% 73.90% Taxable securities...... 29.83 30.81 24.52 19.74 17.10 Tax-exempt securities... 3.78 4.18 5.05 5.18 5.18 Overnight investments... 4.25 4.32 4.88 3.82 3.82 ------ ------ ------ ------ ------ 100.00% 100.00% 100.00% 100.00% 100.00% ====== ====== ====== ====== ====== LOANS The economy strengthened in 1993 and consumer confidence increased throughout the year as concerns over employment prospects decreased somewhat. The decline in interest rates over the last several years has induced many consumers to refinance their homes at substantially lower rates, thus improving their liquidity and disposable income. Automobile sales nationally were very strong, and First Virginia's traditional strength in the indirect automobile financing market resulted in a 25% increase in the production of these loans. At the end of 1993, automobile loans outstanding were up 15% from the end of 1992, and prospects for further increases in 1994 are promising. The age of the average automobile on the road is still very high, and with the increased monthly income freed up from mortgage refinancings, consumers are in a good position to purchase new cars. During 1993, the Corporation opened its first automobile loan production office outside of its natural market areas. This office has been very successful, and the Corporation is currently exploring additional locations. The Corporation has combined local attention and service to its automobile dealers with central oversight and administration of the program. Each loan application is examined individually by a seasoned loan administrator rather than using a depersonalized credit-scoring system. This procedure permits the Corporation to limit its delinquencies and losses while simultaneously examining each application for compensating credit attributes. Home equity loans are the second largest source of loans for the Corporation and comprise 28% of all loans. At year-end, home equity loans were up 5% over 1992, after advancing 6% in the previous year. Activity was down slightly, as compared to 1992, due to the high level of activity in first mortgage loans as consumers refinanced and consolidated existing home equity loans. Consumers utilized the cash received from these transactions rather than borrowing additional funds. At the end of the year, however, strong advertising promotions and a slowdown in first mortgage refinance activity brought about much stronger activity in this area, and the "pipeline" of loans in process was at a record level. The Corporation typically requires a maximum loan-to-equity ratio of 70%-75% and does not take a second mortgage behind a jumbo first mortgage, in order to reduce its risk in foreclosure. Residential real estate loans declined 7% during 1993, after increasing 30% in 1992. Activity was very strong in this area all year, and the Corporation's mortgage banking subsidiary had its second most successful year in loan originations. Due to the low level of interest rates, however, the Corporation did not deem it appropriate to invest in long-term, fixed-rate loans in 1993 and sold most of the loans it originated to unaffiliated investors. The Corporation primarily retains 15-year, fixed-rate mortgage loans for its own portfolio or longer-term loans with rates that adjust every three to five years. Due to the intense competition with "teaser" financing rates and their higher probability for early refinancing, the Corporation does not normally invest in one-year, adjustable-rate mortgages. Revolving credit loans, including credit cards, declined for the fourth consecutive year and were down 1% at year-end, after falling 2% in 1992. The Corporation limits its solicitation efforts primarily to its natural market areas and despite attractive interest rates and fee schedules, as compared to its competitors, it has experienced slight attrition. Commercial loans increased 3% at the end of 1993, as compared to a 7% drop at the end of 1992. The majority of the advance was due to an increase in floor plan loans to automobile dealers to finance their inventory. Approximately 33% of commercial loans are floor plan loans to automobile dealers which are secured by individual automobiles, subject to periodic inventory audits. Other commercial loan activity has been weak with little demand following the end of the recession and expansion plans being curtailed at many businesses. The Corporation has experienced increased competition for attractive commercial loans, with some of its competitors offering extended terms and low, fixed rates at levels the Corporation is not willing to accept. Real estate development and construction loans declined 17% to $90.8 million at the end of 1993, comprised only 2% of the total loan portfolio, and were primarily for residential properties with strong sales. Commercial mortgage loans increased 6% in 1993, after advancing 10% in 1992, and consisted primarily of owner-occupied facilities. The majority of the growth in this area came from loans to well-established country clubs and churches. LOANS December 31 1993 1992 1991 1990 1989 ---------- ---------- ---------- ---------- ---------- (In thousands) Consumer: Automobile...........$1,571,418 $1,362,138 $1,243,927 $1,271,395 $1,249,131 Home equity, fixed and variable rate 1,242,982 1,178,378 1,109,067 1,033,336 911,219 Revolving credit loans, including credit cards 161,995 163,711 166,961 173,780 174,809 Other......... 167,942 184,879 193,175 200,767 203,247 Real estate: Construction and land development 90,823 109,378 109,809 133,475 107,731 Commercial mortgage. 301,315 284,579 257,944 207,195 182,483 Residential mortgage.. 493,968 529,315 405,924 382,474 384,012 Other, including Industrial Development Authority loans 63,082 69,898 70,204 75,959 76,002 Commercial 321,428 311,932 336,264 365,021 435,050 ---------- ---------- ---------- ---------- ---------- 4,087,318 3,842,373 3,919,378 3,434,403 4,723,684 Deduct unearned income, principally on consumer loans (327,635) (351,835) (377,897) (408,999) (388,009) ---------- ---------- ---------- ---------- ---------- Loans, net of unearned income $4,087,318 $3,842,373 $3,515,378 $3,434,403 $3,335,675 ========== ========== ========== ========== ========== Loans and other assets which were not performing in accordance with their original terms are discussed on several of the following pages under the caption NONPERFORMING ASSETS. INVESTMENT SECURITIES The investment portfolio increased on average by 1% in 1993, after increasing at 30% plus rates in the preceding two years. The rapid deposit growth in 1991 and 1992, which exceeded loan growth, resulted in large increases in the investment portfolio. With the slowdown in deposit growth in 1993 and the increase in lending, the residual amount of excess funds invested in the securities portfolio declined. The Corporation places primary importance on safety and liquidity in the investment portfolio. Accordingly, the majority of the portfolio is invested in U.S. Government securities with a maximum life of five years and an average life of approximately two years. At the end of 1993, U.S. Government securities comprised 88% of the securities portfolio, as compared to 86% at the end of 1992. The Corporation generally does not invest in mortgage-backed securities or collateralized mortgage obligations due to the unpredictability of cash flows and maturities, and to the Corporation's emphasis on liquidity. The percentage of securities invested in U.S. Government securities has been increasing gradually since 1982 when changes in federal income tax laws reduced the tax benefits derived by banks on investments in municipal securities. The limited availability of bank-qualified municipal securities and the reduction in yield due to the loss of tax benefits have generally made municipal securities less attractive to the Corporation. First Virginia has limited its investments in municipal securities primarily to publicly issued securities of municipalities with a rating of A1 or better, or to unrated, general-obligation securities of municipalities in its market areas with which it is familiar. In May 1993, the Financial Accounting Standards Board issued Statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities." The statement requires investments to be classified into one of three categories. Securities for which an enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and are accounted for at amortized cost. Securities which are bought and held primarily for the purpose of sale in the near term are classified as trading securities and are accounted for at market value, with unrealized gains and losses included in earnings. All other securities are classified as available-for-sale securities, are accounted for at market value with unrealized gains and losses excluded from earnings, but are reported as a separate component of shareholders' equity. The impact of this statement may cause some banks to report widely fluctuating earnings and capital. The Corporation will adopt this statement in the first quarter of 1994. Because the Corporation's stated policy is to hold most securities until their stated maturity and it has the ability to do so, it is expected that almost all securities will be classified as held to maturity, and therefore, the statement will not have a material effect. Less than $.5 million in equity securities will be classified as available for sale and subject to market valuation. OVERNIGHT INVESTMENTS Overnight investments, consisting primarily of federal funds sold and securities repurchase agreements, generally are governed by the size of normally anticipated deposit swings and loan demand. In addition, the amount of customer repurchase agreements are covered by investments in overnight securities. In 1993, average overnight investments increased 4% to $270.4 million, after increasing 2% in 1992. DEPOSITS Deposit growth slowed substantially in 1993, after increasing rapidly in the preceding two years. Average outstanding deposits increased 6%, following a 15% increase in 1992. Many banks experienced deposit stagnation or declines in 1993, as the low level of interest rates induced many depositors to seek higher-yielding instruments in areas outside the banking system. Competition from the stock market and mutual funds, insurance products, and bonds placed pressure on banks to maintain their deposits. In addition, in the Corporation's market area, the concern for safety and soundness arising from the thrift crisis and the problems of other banks evaporated due to the demise of most thrifts and the improvement in asset quality and capital of its banking competitors. The Corporation's large and extensive branch system placed the Corporation in good position to continue garnering low-cost consumer core deposits. In addition, the Corporation's largest market -- the Washington-Baltimore area - - - continues to be very attractive and generated the majority of the growth in 1993. First Virginia continued to increase market share to 9.4% of the Virginia market in the middle of 1993. The Corporation was able to capitalize on the changes in ownership of the former First American, Dominion and Maryland National banks in attracting depositors. Demand deposits increased 15% in 1993, following a 14% increase in 1992, while NOW accounts increased 15%, following 25% growth in 1992. Demand deposits comprise 16.4% of average deposits, while NOW accounts comprise 20.2%. Total transaction accounts constitute 36.6% of total deposits. The decline in interest rates which occurred in 1992 has influenced consumers to remain liquid while they wait for interest rates to increase again. Traditional consumer savings accounts, which can be withdrawn at any time without penalty, increased 34% in 1993 following a 62% increase in 1992 and now comprise 21.2% of deposits. At some point, consumers may transfer these funds to higher-cost certificates of deposit when interest rates go up; however, the Corporation is benefiting from the lower cost of these funds at this time. Money-market accounts declined 5% in 1993 after growing 25% in 1992, as some of these customers transferred balances to higher-yielding accounts in 1993. Other certificates of deposit, which are primarily consumer deposits, declined 12.3% on average after declining 2.7% in 1992. The low level of interest rates induced consumers to lengthen their maturities in this category, with the most popular new and reinvestment categories being two or five-year certificates. Large-denomination certificates declined 11% in 1993, as compared to a 25% decline in 1992. The Corporation does not actively bid on these types of deposits or rely on them for its funding sources, and they constitute less than 3% of total deposits. They are primarily composed of high-savings-level consumers and bear rates identical to other certificates of deposit. The Corporation does not purchase any brokered deposits or solicit deposits outside of its primary market areas. Maturity ranges for certificates of deposit with balances of $100,000 or more on December 31, 1993 were (in thousands): One month or less.............................................. $ 21,980 After one month through three months........................... 38,332 After three through six months ................................ 38,023 After six through twelve months ............................... 37,635 Over twelve months............................................. 29,390 -------- $165,360 ======== Average Deposits Pie Chart (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Noninterest Bearing $ 990.0 $ 864.0 $ 756.0 Transaction 1,218.7 1,059.1 845.8 Savings 1,276.9 954.5 588.7 Money Market 746.7 788.7 632.1 Other Consumer CDs 1,628.0 1,856.3 1,908.5 Large-Denomination CDs 167.7 187.7 250.5 -------- -------- -------- $6,028.0 $5,710.3 $4,981.6 ======== ======== ======== OTHER INTEREST-BEARING LIABILITIES Short-term borrowings consist primarily of commercial paper issued by the parent company and securities sold by the member banks with an agreement to repurchase them on the following business day. These short-term obligations are issued principally as a convenience to customers in connection with cash management activities utilized by these customers. Average short-term borrowings from these sources increased 4% in 1993 after advancing 16% during 1992. During 1993, the Corporation paid off its remaining long-term indebtedness composed of a mortgage loan on its headquarters building in Falls Church. The only remaining long-term debt are capitalized lease obligations on branch office facilities which are not subject to prepayment. A shelf registration for the issuance of $50 million of senior notes was filed with the Securities and Exchange Commission in 1989. Moody's has indicated that the notes, when and if issued, will have a rating of A-1. The Corporation's commercial paper is rated P-1 by Moody's and A-1 by Standard & Poor's, and the lead bank's certificates of deposit are rated A+/A-1 by Standard & Poor's. In 1993, Moody's initiated a rating on the lead bank's long and short-term deposits and obligations of Aa3 and Prime-1, respectively, the highest rating of any bank's deposits in the Corporation's market area. STOCKHOLDERS' EQUITY First Virginia maintains its capital at some of the highest levels relative to other banks in the country. The ratio of stockholders' equity to assets was 9.83% at the end of 1993, as compared to an average of 8.38% for similar banks in its peer group with assets between $5 - $10 billion, according to Keefe, Bruyette & Woods. The Corporation's Tier 1 leverage ratio was 9.68% at the end of 1993, as compared to 8.91% at the end of 1992. This level exceeds the regulatory minimum of 3.0% by over three times and gives the Corporation considerable available capital for growth and safety. Each of the Corporation's individual banks maintains a capital ratio well in excess of regulatory minimums, and all qualify as "well capitalized" banks, allowing them the lowest FDIC premium rate and the freedom to operate without restrictions from regulatory bodies. Over the past five years, stockholders' equity has increased at an annual, compounded growth rate of 10.9% and totaled $692 million at the end of 1993. The dividend rate on the common stock was increased twice in 1993, and at the end of 1993, the annual rate had increased 19.2% over the rate at the end of 1992. Dividends have grown at an 8.5% compound growth rate over the past five years. In 1992, a three-for-two stock split was declared and was accounted for in the form of a dividend. As a result, $10.7 million was transferred from surplus to common stock; however, the total capital of the Corporation was not affected. First Virginia and its subsidiary banks are required to comply with capital adequacy standards established by the Federal Reserve and the FDIC. The Corporation exceeded the additional, regulatory risk-based capital requirements by wide margins due in part to the high level of capital and in part to the conservative nature of the Corporation's assets. The Tier 1 risk- based capital ratio totaled 16.84% at the end of 1993, and the Tier 2 or total risk-based capital ratio equaled 18.09%. The regulatory minimums are 4.0% and 8.0%, respectively. Asset Quality - ------------- The Corporation has a number of policies to ensure that lending and investment activities expose the Corporation to a minimum of risk while producing a profit consistent with the exposure to risk. These policies are reviewed constantly by the Corporation's senior management, and each member bank's internal loan monitoring system provides a detailed, monthly report of production, delinquencies, and nonperforming and potential problem loans. This careful monitoring has resulted in a consistent record of low delinquencies and charge-offs as well as few nonperforming loans in relation to the entire loan portfolio. The Corporation has no foreign or highly leveraged transaction loans, and loans are made only within the trade areas of the member banks. Loans are generally not participated with or purchased from banks not affiliated with the First Virginia system. In addition, participations between banks within the First Virginia system must be participated first with the Corporation's lead bank where another comprehensive loan review process is performed. Approximately 82% of the Corporation's loans is made to consumers and normally is secured by personal or real property. First Virginia has no significant concentration of credit to any single industry or borrower, and its loans are spread throughout its market areas. The Corporation's legal lending limit to any one borrower is approximately $97 million; however, it generally limits its loans to any one borrower and related interests to $15 million. Occasionally, the Corporation may exceed its internal limit. One of the Corporation's specialty loan areas is the automobile finance area, and loans are made to consumers both directly in the branches of the member banks and indirectly through automobile dealerships. Roughly 34% of the total loan portfolio is comprised of consumer automobile loans, but because the loan amounts are relatively small and are spread across many individual borrowers, the risk of any major charge-offs is minimized. The Corporation also makes loans directly to automobile dealers in order to finance their inventories. Over the past several years, real estate development and construction loans have been a problem for many banks in the Corporation's market areas, particularly in the Washington, D.C., market. The Corporation has a small exposure in these types of loans, and at the end of 1993, total construction and development loans amounted to only $90.8 million, or approximately 2% of the total loan portfolio. While the Corporation has not been unaffected by the problems affecting the real estate industry, its conservative lending policies and orientation, primarily toward owner-occupied or residential properties, has minimized the extent of exposure in this area. NONPERFORMING ASSETS Nonperforming assets declined 15% in 1993 and totaled $27.6 million at year-end. Nonperforming assets were .68% as a percentage of total loans and nonperforming assets, down from the .85% at the end of 1992. After peaking in 1990 at 1.07%, nonperforming assets have steadily declined to their historical levels and are significantly below the levels of similarly sized institutions both in the Corporation's market areas and nationwide. Foreclosed properties declined 36% in 1993, following a 31% decline in 1992. At the end of 1993, the Corporation had $7.1 million in foreclosed real estate, with slightly less than one half of that total comprised of one property in the Norfolk area and the rest composed of small, individual properties spread throughout the Corporation's market areas. The Corporation had no in-substance foreclosures at the end of 1993 and no foreclosed commercial real estate in the Washington, D.C., area market. The table on the following page shows the total of nonperforming assets at the end of the past five years. Experience has shown that actual losses on nonperforming assets are only a small percentage of such assets. The Corporation expects to recover virtually all of its nonperforming assets, many with full interest. During 1993, the Corporation collected approximately $1.5 million in previously unaccrued interest on loans in a nonaccrual status that were collected in full. Nonperforming Assets December 31 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- (In thousands) Nonaccruing loans ..... $18,387 $20,453 $17,425 $24,812 $12,576 Restructured loans..... 2,175 1,139 1,337 1,745 2,539 Properties acquired by foreclosure........ 7,086 11,099 16,160 10,278 1,507 ------- ------- ------- ------- ------- Total................ $27,648 $32,691 $34,922 $36,835 $16,622 ======= ======= ======= ======= ======= Percentage of total loans and foreclosed real estate .68% .85% .99% 1.07% .50% Loans 90 days past due.. $ 2,752 $ 4,595 $ 8,935 $ 6,293 $ 6,958 ======= ======= ======= ======= ======= Loans past due 90 days or more totaled $2.8 million at the end of 1993, a decline of 40% as compared to 1992 which in turn had a 49% decline as compared to 1991. This decrease represented a record low of .07% of outstanding loans. Loans past due 30 days or more declined 21% to $17.0 million and also represented a record low of .42% of the total loan portfolio. These ratios are considerably below industry averages and reflect the high, overall quality of the Corporation's loan portfolio. A loan generally is classified as nonaccrual when full collectibility of principal or interest is in doubt; when repossession, foreclosure or bankruptcy proceedings are initiated; or when other legal actions are taken. In the case of installment loans, a loan is placed in nonaccrual if payments are delinquent 120 days. The same is true for credit card loans if they are 180 days past due, and for other loans after payments are delinquent for 90 days. If collateral on a loan is sufficient to insure full collection of principal and interest, an exception to the general policy might be made. Loans may also be placed in a nonaccruing status at any time prior to that indicated above if the Corporation anticipates that interest or principal will not be collected. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level which management believes is adequate to absorb potential losses in the loan portfolio. Management's methodology in determining the adequacy of the allowance considers specific credit reviews, past loan-loss experience, current economic conditions and trends, and the growth and composition of the loan portfolio. Every commercial loan is reviewed and rated at least annually according to the Corporation's credit standards, and trends in the total portfolio are examined for potential deterioration in overall quality. At the end of 1993, the allowance represented 1.25% of total loans - down three basis points from the level at the end of 1992 and within the long- range band the Corporation believes to be adequate. The allowance covered net charge-offs approximately 10 times, up considerably from the end of 1992 when it covered net charge-offs 3.85 times. Only a small percentage of the allowance has been allocated to specific credits, with the majority being available for currently unidentified losses. Management believes that the allowance is adequate to absorb any potential, unidentified losses. Net charge-off experience improved significantly during 1993, and nonperforming loans and delinquencies all improved to historical lows. The Corporation constantly monitors the level of the allowance, considering its long-term experience and short-term individual requirements. If asset quality and loan charge-offs remain at the current historically low levels, the Corporation intends to lower its long-term band during 1994 to the 1.15% - 1.20% range. The allowance is charged when management determines that the prospect of recovering the principal of a loan has diminished significantly. Subsequent recoveries, if any, are credited to the allowance. Net charge-offs declined 60% in 1993 to $5.1 million, after maintaining itself in a band between $10 and $13 million from 1989 to 1992. All categories of loans showed significant declines in net charge-offs, as asset quality improved. Net loan charge-offs on credit card loans still remained at the relatively high level of 2.80%, reflecting a trend since 1989 of higher bankruptcies and fraud in this area. The Corporation's loss experience with credit card loans is still significantly below the national averages. Despite the Corporation's exposure to automobile lending, its actual loss experience has been very favorable, and its net charge-offs declined 77% in 1993 to .06% of the portfolio. Part of this favorable experience reflects the effort beginning in early 1991 to increase the credit standards for indirect automobile loans and the Corporation's policy of purchasing primarily "A" paper on new cars. Commercial loans had a net recovery during 1993, as the Corporation experienced no significant problems during the year. An analysis of the activity in the allowance for loan losses for each of the last five years is presented in the table on the following page. Allowance for Loan Losses December 31 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- (In thousands) Balance at beginning of year $49,340 $44,817 $43,917 $40,905 $40,165 Balances of acquired banks 259 - - 291 - Provision charged to operating expense........ 6,450 17,355 14,024 13,404 11,039 ------- ------- ------- ------- ------- Total ................ 56,049 62,172 57,941 54,600 51,204 ------- ------- ------- ------- ------- Charge-offs: Consumer: Credit card............. 4,516 4,852 4,756 3,189 2,474 Indirect automobile..... 2,827 5,139 7,062 5,826 6,187 Other................... 1,464 2,758 3,291 2,555 2,662 Real estate.............. 39 473 201 224 454 Commercial............... 365 3,298 1,176 2,235 1,597 ------- ------- ------- ------- ------- Total ................ 9,211 16,520 16,486 14,029 13,374 ------- ------- ------- ------- ------- Recoveries: Consumer: Credit card............. 758 632 516 438 410 Indirect automobile..... 2,102 2,024 1,807 1,698 1,417 Other................... 765 813 681 812 815 Real estate.............. 17 18 53 34 22 Commercial............... 447 201 305 364 411 ------- ------- ------- ------- ------- Total ................ 4,089 3,688 3,362 3,346 3,075 ------- ------- ------- ------- ------- Net charge-offs deducted.. 5,122 12,832 13,124 10,683 10,299 ------- ------- ------- ------- ------- Balance at end of year ... $50,927 $49,340 $44,817 $43,917 $40,905 ======= ======= ======= ======= ======= Net Loan Losses (Recoveries) to Average Loans by Category: Credit card.............. 2.80% 3.11% 2.96% 1.87% 1.48% Indirect automobile...... .06 .29 .50 .40 .47 Other consumer........... .05 .16 .23 .16 .18 Real estate.............. - .07 .03 .04 .10 Commercial............... (.01) .50 .14 .28 .17 ------- ------- ------- ------- ------- Total Loans............... .13% .35% .38% .31% .31% ======= ======= ======= ======= ======= Percentage of allowance for loan losses to year-end loans. 1.25% 1.28% 1.27% 1.28% 1.23% Nonperforming Asset Ratios Ribbon Chart (the lower, the better) National First Southern Peer Virginia Regionals Group -------- --------- -------- 1993 0.68% 1.24% 0.98% 1992 0.85% 2.62% 1.58% 1991 0.99% 2.49% 2.22% 1990 1.07% 2.56% 2.28% 1989 0.50% 1.31% 1.30% Southern Regionals: Banking companies with assets over $2 billion (30 in 1993) National Peer Group: Banking companies with assets of between $5 and $10 billion (19 in 1993) Source: Keefe, Bruyette & Woods Reserve Coverage Ratios Ribbon Chart (the higher, the better) National First Southern Peer Virginia Regionals Group -------- --------- -------- 1993 248 252 265 1992 229 161 204 1991 239 139 134 1990 165 104 117 1989 271 142 146 Southern Regionals: Banking companies with assets over $2 billion (30 in 1993) National Peer Group: Banking companies with assets of between $5 and $10 billion (19 in 1993) Source: Keefe, Bruyette & Woods Net Charge-Offs Ratios Ribbon Chart (the lower, the better) National First Southern Peer Virginia Regionals Group -------- --------- -------- 1993 0.13 0.33 0.29 1992 0.35 0.78 0.66 1991 0.38 0.96 0.89 1990 0.31 0.87 0.75 1989 0.31 0.49 0.47 Southern Regionals: Banking companies with assets over $2 billion (30 in 1993) National Peer Group: Banking companies with assets of between $5 and $10 billion (19 in 1993) Source: Keefe, Bruyette & Woods LIQUIDITY AND SENSITIVITY TO INTEREST RATES - ------------------------------------------- The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities. Liquidity management involves the ability to meet the cash flow requirements of the Corporation's loan and deposit customers. Interest-rate-sensitivity management seeks to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. The Corporation does not hedge its position with swaps, options or futures but instead maintains a highly liquid and short-term position in all of its earning assets and interest-bearing liabilities. In order to meet its liquidity needs, the Corporation schedules the maturity of its investment securities so that approximately an equal amount will mature each month. The weighted-average life of the securities portfolio at the end of 1993 was just over 24 months - basically unchanged from the end of 1992 and 1991. Because the Corporation views its securities portfolio primarily as a source of liquidity and safety, it does not necessarily react to changes in the yield curve in an attempt to enhance its yield. Accordingly, the average life of the portfolio does not change much as the Corporation maintains a constant approach to its portfolio and invests primarily in U.S. Government securities with a life no greater than five years. Municipal securities are also generally limited to lives of no more than five years but due to availability and other factors are occasionally purchased in serial issues with longer lives. The maturity ranges of the securities and the average taxable-equivalent yields as of December 31, 1993, are as follows: U.S. Government State and and its Agencies Municipal Other --------------- ------------- ------------ Amount Yield Amount Yield Amount Yield ---------- ---- -------- ---- ------- ---- (Dollars in thousands) One year or less.............. $ 553,240 6.3% $ 79,720 7.9% $10,484 7.6% After one year through five years 1,351,086 5.7 146,797 7.5 18,256 5.6 After five through ten years.. 391 8.3 3,491 9.1 99 6.8 After ten years............... - - 5,355 9.2 50 10.0 No stated maturity............ - - - - 7,065 6.7 ---------- -------- ------- Total ........................ $1,904,717 5.9% $235,363 7.7% $35,954 6.5% ========== ======== ======= Weighted-average maturity..... 25 months 25 months A cash reserve consisting primarily of overnight investments is also maintained by the parent company to meet any contingencies and to provide additional capital, if needed, to the member banks. The majority of the Corporation's loans are fixed-rate installment loans to consumers, and mortgage loans whose maturities are longer than the deposits by which they are funded. A degree of interest-rate risk is incurred if the interest rate on deposits should rise before the loans mature. However, the substantial liquidity provided by the monthly repayments on these loans can be reinvested at higher rates which largely reduces the interest-rate risk. Home equity lines of credit have adjustable rates that are tied to the Prime Rate. Many of the loans not in the installment or mortgage categories have maturities of less than one year or have floating rates which may be adjusted periodically to reflect current market rates. These loans are summarized in the following table. Between 1 year 1 and 5 After or less years 5 years Total -------- -------- ------- -------- (In thousands) Maturity ranges: Commercial........................ $295,953 $ 92,220 $44,036 $432,209 Construction and land development. 81,424 7,303 2,096 90,823 -------- -------- ------- -------- Total ............................. $377,377 $ 99,523 $46,132 $523,032 ======== ======== ======= ======== Floating-rate loans: Commercial........................ $ 16,285 $ 7,075 $ 23,360 Construction and land development. 6,343 515 6,858 -------- ------- -------- Total ............................. $ 22,628 $ 7,590 $ 30,218 ======== ======= ======== First Virginia's Asset/Liability Committee is responsible for reviewing the Corporation's liquidity requirements and for maximizing net interest income, consistent with capital requirements, liquidity, interest rates and economic outlooks, competitive factors and customer needs. Liquidity requirements are reviewed in detail for each of the Corporation's individual banks; however, overall asset/liability management is performed on a consolidated basis in order to achieve a consistent and coordinated approach. One of the tools the Corporation uses to determine its interest-rate risk is gap analysis. Gap analysis attempts to examine the volume of interest- rate-sensitive assets minus interest-rate-sensitive liabilities. The difference between the two is the interest sensitivity gap which indicates how future changes in interest rates may affect net interest income. Regardless of whether interest rates are expected to increase or fall, the objective is to maintain a gap position that will minimize any changes in net interest income. A negative gap exists when the Corporation has more interest-sensitive liabilities maturing within a certain time period than interest-sensitive assets. Under this scenario, if interest rates were to increase, it would tend to reduce net interest income. At December 31, 1993, the Corporation had a slightly negative interest-rate gap in the short term (under three months) but was slightly asset sensitive in the longer term. The table on the next page shows the Corporation's interest-sensitivity position at December 31, 1993. INTEREST-SENSITIVITY ANALYSIS 1 to 30-Day 1 to 90-Day 1 to 180-Day Sensitivity Sensitivity Sensitivity ----------- ----------- ----------- (Dollars in thousands) Earning assets: Loans, net of unearned income.... $ 792,200 $1,044,228 $1,391,412 Investment securities............ 52,499 116,805 303,745 Federal funds purchased and securities purchased under agreements to resell........... 235,000 235,000 235,000 ----------- ----------- ----------- Total earning assets......... 1,079,699 1,396,033 1,930,157 ----------- ----------- ----------- Funding sources: Non-interest bearing demand deposits................ - - - NOW accounts..................... - - - Money-market accounts............ 724,462 724,462 724,462 Savings deposits................. - - - Certificates of deposit.......... 235,634 493,640 859,741 Large-denomination certificates of deposit..................... 21,980 60,312 98,335 Short-term borrowings............ 151,859 151,859 151,859 Long-term borrowings............. - - - ----------- ----------- ----------- Total funding sources........ 1,133,935 1,430,273 1,834,397 ----------- ----------- ----------- Interest-sensitivity gap........... $ (54,236) $ (34,240) $ 95,760 =========== =========== =========== Interest-sensitivity gap as a percentage of earning assets..... (.83)% (.53)% 1.47% Ratio of interest-sensitive assets to interest-sensitive liabilities .95x .98x 1.05x INTEREST-SENSITIVITY ANALYSIS (Continued) Beyond One 1 to 365-Day Year or Sensitivity Nonsensitive Total ----------- ----------- ----------- (Dollars in thousands) Earning assets: Loans, net of unearned income.... $2,087,491 $1,999,827 $4,087,318 Investment securities............ 560,678 1,615,356 2,176,034 Federal funds purchased and securities purchased under agreements to resell........... 235,000 - 235,000 ----------- ----------- ----------- Total earning assets......... 2,883,169 3,615,183 6,498,352 ----------- ----------- ----------- Funding sources: Noninterest-bearing demand deposits................ 1,039,933 1,039,933 NOW accounts..................... 1,294,867 1,294,867 Money-market accounts............ 724,462 - 724,462 Savings deposits................. 1,325,943 1,325,943 Certificates of deposit.......... 1,226,052 359,772 1,585,824 Large-denomination certificates of deposit..................... 135,970 29,390 165,360 Short-term borrowings............ 151,859 - 151,859 Long-term borrowings............. 1,008 1,008 ----------- ----------- ----------- Total funding sources........ 2,238,343 4,050,913 6,289,256 ----------- ----------- ----------- Interest-sensitivity gap........... $ 644,826 $ (435,730) $ 209,096 =========== =========== =========== Interest-sensitivity gap as a percentage of earning assets..... 9.92% (6.71)% 3.22% Ratio of interest-sensitive assets to interest-sensitive liabilities 1.29x .89x 1.03x First Virginia does not manage its interest-rate risk simply with static maturity and repricing reports. It also uses a dynamic modeling process which projects the impact of different interest rate, loan and deposit growth scenarios over a twelve-month period. A large part of First Virginia's loans and deposits comes from its retail base and does not automatically reprice on a contractual basis in reaction to changes in interest-rate levels. Accordingly, First Virginia has not experienced earnings volatility as may be indicated by its interest-sensitive gap position. The Corporation has consistently maintained a net interest margin in excess of 5.00%, whether rates are high or low, and has been able to maintain adequate liquidity to provide for changes in interest rates and in loan and deposit demands. Quarterly Results - ----------------- The results of operations for the first three quarters of 1993 have been analyzed in quarterly reports to shareholders. The results of operations for each of the quarters during the two years ended December 31, 1993, are summarized in the table on the next two pages (in thousands, except per-share data or as otherwise indicated). The figures for the first two quarters of 1993 have been restated to include the results of the acquisition of United Southern Bank of Morristown during the third quarter. Prior-year results have not been restated, because they would not have a material effect upon the Corporation's financial statements. Net income for the fourth quarter of 1993 increased 9% over the same quarter in 1992. The primary reason for the increase was a 66% decline in the provision for loan losses due to a lower rate of actual net charge-offs on loans. In addition, the fourth quarter of 1993 included a gain of $679,000 on the sale of some equity securities that the Corporation acquired a number of years ago. The net interest margin declined 37 basis points to 5.28% in the fourth quarter of 1993, as compared to the same quarter in 1992, because the Corporation's investments and loans continued to reprice at a faster rate than deposits. In the fourth quarter of 1992, the net interest margin peaked, after increasing throughout the year, due to declining interest rates which affected deposits to a greater degree than earning assets. During the fourth quarter of 1993, the Corporation sold a package of mortgage servicing rights and recorded a gain of $1.2 million. Over the past several years, the Corporation has sold a package of servicing rights each year but did not do so in 1992 due to its desire to increase future service fee income through the retention of mortgages it originated. The fourth quarter of 1993 also included an additional write-down of $1.0 million on previously purchased mortgage servicing rights due to an increase in the prepayment rate of the underlying mortgages. The comparable quarter of 1992 reflected an additional expense of $.8 million for the write-down of mortgage servicing rights. Nonperforming assets declined 15%, as compared to the fourth quarter of 1992, and were down 5%, as compared to the third quarter. At the end of the fourth quarter, nonperforming assets amounted to .68% of loans as compared to .85% at the end of 1992. Noninterest income increased 10%, as compared to the 1992 fourth quarter, due to the gain on the sale of servicing rights and the gain on the sale of securities. Noninterest expenses declined slightly, as compared to the fourth quarter of 1992, due to a decrease in employment expense primarily related to a decline in stock-related compensation resulting from the decline in the Corporation's stock price. QUARTERLY RESULTS -------------------------------------- Quarter Ended -------------------------------------- Dec. 31 Sept. 30 June 30 Mar. 31 Condensed Statements of Income -------- -------- -------- -------- (Dollar amounts in thousands, except per-share data) Interest and fees on loans $ 89,372 $ 91,778 $ 91,424 $ 90,545 Income from securities 32,589 32,752 33,460 34,503 Other interest income 2,059 2,212 2,260 1,828 -------- -------- -------- -------- Total interest income 124,020 126,742 127,144 126,876 -------- -------- -------- -------- Interest on deposits 38,990 40,729 40,826 40,630 Interest on borrowed funds 1,062 981 850 891 -------- -------- -------- -------- Total interest expense 40,052 41,710 41,676 41,521 -------- -------- -------- -------- Net interest income 83,968 85,032 85,468 85,355 Provision for loan losses 1,416 820 2,026 2,188 Other income 22,088 20,802 20,084 19,566 Other expense 62,392 62,452 60,820 60,103 Provision for income taxes 13,259 14,039 13,414 13,410 -------- -------- -------- -------- Net income $ 28,989 $ 28,523 $ 29,292 $ 29,220 ======== ======== ======== ======== Net income per share $ .89 $ .88 $ .90 $ .90 Average Quarterly Balances Average balances (in millions): Securities $ 2,182 $ 2,128 $ 2,111 $ 2,140 Loans 4,047 3,992 3,936 3,857 Total earning assets 6,495 6,403 6,344 6,233 Total assets 7,021 6,919 6,869 6,750 Demand deposits 1,037 1,005 988 929 Interest-bearing deposits 5,073 5,044 5,043 4,991 Total deposits 6,110 6,049 6,031 5,920 Interest-bearing liabilities 5,245 5,199 5,181 5,135 Total stockholders' equity 681 662 642 621 Key Ratios Rates earned on assets 7.72% 8.02% 8.16% 8.33% Rates paid on liabilities 3.03 3.18 3.23 3.28 Net interest margin 5.28 5.43 5.53 5.63 Return on average assets 1.65 1.65 1.71 1.73 Return on average equity 17.03 17.23 18.25 18.81 QUARTERLY RESULTS -------------------------------------- Quarter Ended -------------------------------------- Dec. 31 Sept. 30 June 30 Mar. 31 Condensed Statements of Income -------- -------- -------- -------- (Dollar amounts in thousands, except per-share data) Interest and fees on loans $ 92,287 $ 92,570 $ 93,977 $ 92,927 Income from securities 36,373 36,844 37,088 33,688 Other interest income 1,891 1,991 2,501 3,133 -------- -------- -------- -------- Total interest income 130,551 131,405 133,566 129,748 -------- -------- -------- -------- Interest on deposits 43,724 48,451 52,446 54,843 Interest on borrowed funds 1,279 1,264 1,373 1,446 -------- -------- -------- -------- Total interest expense 45,003 49,715 53,819 56,289 -------- -------- -------- -------- Net interest income 85,548 81,690 79,747 73,459 Provision for loan losses 4,192 3,505 5,704 3,954 Other income 20,096 19,301 19,328 18,362 Other expense 62,644 60,102 58,972 57,173 Provision for income taxes 12,266 11,778 10,595 9,173 -------- -------- -------- -------- Net income $ 26,542 $ 25,606 $ 23,804 $ 21,521 ======== ======== ======== ======== Net income per share $ .82 $ .79 $ .74 $ .67 Quarterly Average Balances Average balances (in millions): Securities $ 2,188 $ 2,184 $ 2,176 $ 1,891 Loans 3,786 3,704 3,635 3,514 Total earning assets 6,213 6,126 6,072 5,710 Total assets 6,693 6,586 6,544 6,182 Demand deposits 909 880 875 791 Interest-bearing deposits 4,958 4,905 4,889 4,631 Total deposits 5,867 5,785 5,764 5,422 Interest-bearing liabilities 5,123 5,064 5,042 4,778 Total stockholders' equity 599 580 563 547 Key Ratios Rates earned on assets 8.53% 8.70% 8.96% 9.26% Rates paid on liabilities 3.49 3.91 4.29 4.74 Net interest margin 5.65 5.48 5.40 5.30 Return on average assets 1.59 1.56 1.46 1.39 Return on average equity 17.74 17.74 16.91 15.73 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- CONSOLIDATED BALANCE SHEETS December 31 1993 1992 ---------- ---------- (In thousands) ASSETS Cash and noninterest-bearing deposits in banks $ 326,136 $ 381,384 Federal funds sold and securities purchased under agreements to resell................. 235,000 235,000 ---------- ---------- Total cash and cash equivalents....... 561,136 616,384 ---------- ---------- Investment securities: U.S. Government & its agencies............. 1,904,717 1,871,284 State and municipal obligations............ 235,363 253,926 Other...................................... 35,954 40,017 ---------- ---------- Total investment securities (market value $2,228,818-1993 and $2,225,780-1992)................... 2,176,034 2,165,227 ---------- ---------- Loans......................................... 4,414,953 4,194,208 Deduct: Unearned income................... (327,635) (351,835) ---------- ---------- Loans, net of unearned income.......... 4,087,318 3,842,373 Allowance for loan losses......... (50,927) (49,340) ---------- ---------- Net loans............................. 4,036,391 3,793,033 ---------- ---------- Premises and equipment........................ 137,007 136,654 Other assets.................................. 126,315 129,249 ---------- ---------- Total Assets............................... $7,036,883 $6,840,547 ========== ========== CONSOLIDATED BALANCE SHEETS (Continued) December 31 1993 1992 ---------- ---------- (In thousands) LIABILITIES Deposits: Noninterest-bearing........................ $1,039,933 $1,012,268 Interest-bearing: Transaction accounts.................. 1,294,867 1,204,929 Money-market accounts................. 724,462 766,156 Savings deposits...................... 1,325,943 1,195,665 Certificates of deposit: Large denomination................. 165,360 157,810 Other.............................. 1,585,824 1,676,918 ---------- ---------- Total deposits..................... 6,136,389 6,013,746 Interest, taxes and other liabilities......... 56,126 63,494 Short-term borrowings......................... 151,859 150,681 Mortgage indebtedness......................... 1,008 5,227 ---------- ---------- Total Liabilities.......................... 6,345,382 6,233,148 ---------- ---------- STOCKHOLDERS' EQUITY Preferred stock, $10 par value................ 805 825 Common stock, $1 par value.................... 32,444 32,185 Capital Surplus............................... 68,406 64,930 Retained Earnings............................. 589,846 509,459 ---------- ---------- Total Stockholders' Equity................. 691,501 607,399 ---------- ---------- Total Liabilities and Stockholders' Equity. $7,036,883 $6,840,547 ========== ========== See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31 1993 1992 1991 -------- -------- -------- (In thousands, except per share data) Interest income: Interest and fees on loans.......... $363,119 $371,761 $382,456 Interest and dividends on investment securities: U.S. Government & its agencies... 117,634 125,528 97,334 State and municipal obligations..................... 13,165 15,209 16,759 Other............................ 2,505 3,256 4,408 Income from federal funds sold and securities purchased under agreements to resell......... 8,359 9,516 14,880 -------- -------- -------- Total interest income............ 504,782 525,270 515,837 -------- -------- -------- Interest expense: Deposits: Transaction accounts............. 31,840 34,540 40,382 Money market accounts............ 20,090 26,067 32,573 Savings deposits................. 37,432 35,883 28,243 Certificates of deposit: Large denomination............ 6,353 8,767 16,381 Other......................... 65,460 94,207 135,009 Short-term borrowings............... 3,563 4,149 6,479 Long-term indebtedness.............. 221 1,213 1,219 -------- -------- -------- Total interest expense........... 164,959 204,826 260,286 -------- -------- -------- Net interest income...................... 339,823 320,444 255,551 Provision for loan losses................ 6,450 17,355 14,024 -------- -------- -------- Net interest income after provision for loan losses......................... 333,373 303,089 241,527 -------- -------- -------- CONSOLIDATED STATEMENTS OF INCOME (Continued) Year Ended December 31 1993 1992 1991 -------- -------- -------- (In thousands, except per share data) Net interest income after provision for loan losses......................... 333,373 303,089 241,527 -------- -------- -------- Other income: Service charges on deposit accounts.. 34,448 33,080 32,475 Insurance premiums and commissions... 6,555 6,591 6,107 Credit card service charges and fees. 11,070 11,278 11,696 Trust services....................... 5,001 4,467 4,113 Income from other customer services.. 16,533 15,173 12,742 Securities gains (losses) before income tax provisions (credits) of $246-1993, $(100)-1992, and $(12)-1991..................... 711 (159) 8 Other................................ 8,222 6,657 5,142 -------- -------- -------- Total other income............... 82,540 77,087 72,283 -------- -------- -------- Other expenses: Salaries and employee benefits...... 134,296 129,137 116,490 Occupancy........................... 18,207 17,499 16,841 Equipment........................... 19,634 18,864 17,554 Telephone........................... 5,508 5,511 5,305 Printing and supplies............... 5,485 5,219 5,337 Credit card processing fees......... 6,431 6,467 7,100 FDIC assessment..................... 13,412 12,453 10,046 Other............................... 42,794 43,741 39,570 -------- -------- -------- Total other expenses............. 245,767 238,891 218,243 -------- -------- -------- Income before income taxes............... 170,146 141,285 95,567 Provision for income taxes............... 54,122 43,812 25,959 -------- -------- -------- NET INCOME............................... $116,024 $ 97,473 $ 69,608 ======== ======== ======== Net income per share of common stock..... $ 3.57 $ 3.02 $ 2.17 Average primary shares of common stock outstanding......... 32,512 32,252 32,092 See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY 1993 1992 1991 -------- -------- -------- Preferred stock (Dollars in thousands) - --------------- Balance at beginning of year.............. $ 825 $ 1,027 $ 1,114 Redemption of 2,021 shares-1993, 20,241 shares-1992 and 8,635 shares-1991 upon conversion to common stock.............. (20) (202) (87) -------- -------- -------- Balance at end of year.................... $ 805 $ 825 $ 1,027 ======== ======== ======== Common stock - ------------ Balance at beginning of year.............. $ 32,185 $ 32,093 $ 32,009 Issuance of 196,679 shares for an acquired bank........................ 197 - - Issuance of 3,026 shares-1993, 29,770 shares-1992 and 12,746 shares-1991 upon conversion of preferred stock...... 3 30 13 Issuance of 48,500 shares-1993, 25,467 shares-1992 and 52,875 shares-1991 for stock options....................... 48 26 53 Issuance of 11,084 shares-1993, 36,239 shares-1992 and 18,624 shares-1991 for stock appreciation rights........... 11 36 18 -------- -------- -------- Balance at end of year.................... $ 32,444 $ 32,185 $ 32,093 ======== ======== ======== Capital surplus - --------------- Balance at beginning of year.............. $ 64,930 $ 63,121 $ 61,229 Increase arising from: Acquisition of a bank................... 2,117 - - Conversion of preferred stock........... 17 172 74 Issuance of common stock for the dividend reinvestment plan............ - 222 719 Exercise of stock options............... 937 321 696 Exercise of stock appreciation rights... 405 1,094 403 -------- -------- -------- Balance at end of year.................... $ 68,406 $ 64,930 $ 63,121 ======== ======== ======== Retained earnings - ----------------- Balance at beginning of year.............. $509,459 $443,877 $403,335 Increase attributable to an acquired bank. 1,139 Net income................................ 116,024 97,473 69,608 Dividends declared: Preferred stock......................... (54) (61) (71) Common stock $1.13 per share-1993, $.99 per share-1992 and $.91 per share-1991 (36,519) (31,830) (28,995) Dividends paid by a bank prior to its acquisition......................... (203) - - -------- -------- -------- Balance at end of year.................... $589,846 $509,459 $443,877 ======== ======== ======== See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31 1993 1992 1991 -------- -------- -------- (In thousands) Operating activities - -------------------- Net income.................................... $116,024 $ 97,473 $ 69,608 Adjustments to reconcile net income to net cash provided by operating activities: Provision for depreciation and amortization 12,487 12,280 11,567 Gain on sale of fixed assets............... (208) (54) (105) Provision for loan losses.................. 6,450 17,355 14,024 Amortization of securities premiums........ 20,936 20,099 10,178 Accretion of securities discounts.......... (775) (1,232) (1,957) Net increase in mortgage loans held for sale (9,068) (34,263) (13,476) Loss (gain) on sale of securities.......... (711) 159 (8) Amortization of intangible assets.......... 3,963 3,666 2,262 Deferred income tax credits................ (1,943) (1,445) (3,394) Decrease (increase) in prepaid expenses.... (2,708) (5,566) 3,999 Decrease (increase) in interest receivable. 6,489 (2,733) (8,579) Decrease in interest payable............... (1,940) (14,531) (1,302) Increase in other accrued expenses......... 2,720 9,423 437 -------- -------- -------- Net cash provided by operating activities 151,716 100,631 83,254 -------- -------- -------- Investing activities - -------------------- Maturity of investment securities............. 626,353 475,329 448,358 Sale of investment securities................. 5,122 2,941 716 Purchase of investment securities............. (662,409) (849,695) (983,334) Net increase in loans......................... (240,530) (305,355) (80,413) Purchase of premises and equipment............ (12,996) (8,393) (11,275) Sales of premises and equipment............... 362 786 594 Goodwill acquired............................. - - (1,170) Mortgage servicing rights acquired............ (747) (748) (1,066) Other intangible assets acquired.............. (625) (2,987) (1,322) Other......................................... (7,409) 3,759 (5,759) -------- -------- -------- Net cash used for investing activities... (292,879) (684,363) (634,671) -------- -------- -------- CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Year Ended December 31 1993 1992 1991 -------- -------- -------- (In thousands) Financing activities - -------------------- Net increase in deposits...................... 122,643 663,775 634,089 Net increase in short-term borrowings......... 1,178 5,865 59,149 Principal payments on long-term borrowings.... (4,219) (6,240) (712) Proceeds from long-term borrowings............ - - 344 Cash dividends paid: Common $1.08 per share-1993, $.96 per share-1992 and $.89 per share-1991......... (34,830) (30,945) (28,517) Preferred................................... (54) (65) (73) Cash dividends paid by a bank prior to its acquisition............................. (204) - - Proceeds from issuance of common stock........ 1,401 1,699 1,889 -------- -------- -------- Net cash provided by financing activities 85,915 634,089 666,169 -------- -------- -------- Net increase (decrease) in cash and cash equivalents..................... (55,248) 50,357 114,752 Cash and cash equivalents at beginning of year...................... 616,384 566,027 451,275 -------- -------- -------- Cash and cash equivalents at end of year. $561,136 $616,384 $566,027 ======== ======== ======== See notes to consolidated financial statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------ 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Corporation and all of its subsidiaries. The Corporation's subsidiaries are predominantly engaged in banking. Foreign banking activities and operations other than banking are not significant. All material intercompany transactions and accounts have been eliminated. Certain amounts for years prior to 1993 have been reclassified for comparative purposes. All prior years have been restated to reflect a three-for-two common stock split in 1992. INVESTMENT SECURITIES All securities are held for investment purposes. Debt securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Equity securities are carried at the lower of aggregate cost or market value. Changes in market values of equity securities regarded as temporary are charged (credited) directly to stockholders' equity. Reductions in market values of equity securities regarded as other than temporary are charged to income, and the carrying value of the securities is permanently reduced by such amounts. The adjusted carrying value of the specific security sold is used to compute gains or losses on the sale of investment securities. LOANS Interest on installment loans is recorded as income in amounts that will provide an approximate level yield over the terms of the loans. Accrual of interest on other loans is based generally on the daily amount of principal outstanding. Interest is not accrued on loans if the collection of such interest is doubtful. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is maintained at a level that is considered adequate to provide for potential losses in the loan portfolio. Management's evaluation of the adequacy of the allowance is based on a review of individual loans, past loss experience, current and anticipated economic conditions, the value of underlying collateral and other factors. PREMISES AND EQUIPMENT Premises and equipment are carried at cost, less accumulated depreciation and amortization computed principally on the straight-line method over lives not exceeding 50 and 20 years for buildings and equipment, respectively. Gains and losses on disposition are reflected in current operations. Maintenance and repairs are charged to operating expenses, and major alterations and renovations are capitalized. Capital leases are carried at the lower of the present value of their net minimum lease payments or the fair value of the leased properties at the inception of the lease, less accumulated amortization computed on the straight-line method over the noncancelable terms of the leases which do not exceed 20 years. INCOME TAXES In 1992, the Corporation changed its method of accounting for income taxes from the deferred method to the liability method required by Financial Accounting Standards Board Statement No. 109 (SFAS No. 109), "Accounting for Income Taxes" (see Note 14 "Income Taxes"). Under the liability method, deferred-tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities (i.e., temporary differences) and are measured at the enacted rates that will be in effect when these differences reverse. As permitted under SFAS No. 109, prior years' financial statements have not been restated. OTHER REAL ESTATE OWNED Other real estate owned primarily represents properties acquired by the Corporation's affiliates through customer loan defaults. The real estate is stated at an amount equal to the lesser of the loan balance prior to foreclosure, plus the costs incurred for improvements to the property, or fair value, less the estimated selling costs of the property. At the time of foreclosure, any excess of cost over the estimated fair value is charged to the allowance for loan losses. After foreclosure, the estimated fair value is reviewed periodically by management. Any further declines in fair value are charged against current earnings or any applicable foreclosed property valuation allowance. 2. ACQUISITIONS On August 27, 1993, the Corporation acquired United Southern Bank of Morristown, Tennessee, in exchange for 196,679 shares of common stock. As of December 31, 1992, United Southern Bank had total assets of $43.2 million and stockholders' equity of $3.4 million. Because the restatement would not have had a material effect upon the Corporation's financial statements, the accounts of United Southern Bank have not been retroactively reflected in periods prior to 1993. On June 19, 1991, Harwood-Andrews, Inc., was acquired for cash and was merged into First Virginia Insurance Services, Inc. On August 1, 1991 assets of Ferraro & Pinholster, Inc. were acquired by First Virginia Insurance Services, Inc. Both acquisitions were accounted for using the purchase method of accounting and were not material to the consolidated assets. As of December 31, 1993, unamortized goodwill of $10,136,000 arose from purchase acquisitions and is being amortized on a straight-line basis. Acquisitions purchased prior to 1976 are being amortized over 40 years, and those acquired after 1975 are being amortized over periods of 10 to 20 years. Unamortized core deposit intangibles were $3,141,000 on December 31, 1993, and are being amortized over periods of 5 to 10 years. 3. RESTRICTIONS ON CASH BALANCES The Corporation's banking affiliates are required by the Federal Reserve Board or by state banking laws to maintain certain minimum cash balances consisting of vault cash and deposits in the Federal Reserve Bank or in other commercial banks. Such restricted balances totaled $162,948,000 and $149,970,000 as of December 31, 1993 and 1992, respectively. 4. INVESTMENT SECURITIES The carrying amounts of investment securities and the related approximate market values were (in thousands): Carrying Unrealized Unrealized Fair Amount Gains Losses Value ---------- ------- ------ ---------- December 31,1993: U.S. Government and its agencies...$1,904,717 $46,992 $1,788 $1,949,921 State and municipal obligations.... 235,363 6,712 313 241,762 Other ............................. 35,954 1,201 20 37,135 ---------- ------- ------ ---------- Total............................$2,176,034 $54,905 $2,121 $2,228,818 ========== ======= ====== ========== December 31,1992: U.S. Government and its agencies...$1,871,284 $53,122 $1,797 $1,922,609 State and municipal obligations.... 253,926 7,486 151 261,261 Other ............................. 40,017 1,961 68 41,910 ---------- ------- ------ ---------- Total............................$2,165,227 $62,569 $2,016 $2,225,780 ========== ======= ====== ========== Proceeds from the sale of investment securities during 1993 were $5,122,000, resulting in gains of $712,000 and losses of $1,000. Proceeds from the maturity of investment securities were $626,353,000, resulting in no gains or losses. Securities having a carrying value of $444,986,000 and $364,349,000 at December 31, 1993 and 1992, respectively, were pledged to secure public deposits and for other purposes required by law. 5. LOANS Loans consisted of (in thousands): December 31 1993 1992 ---------- ---------- Consumer: Automobile installment ............................$1,571,418 $1,362,138 Home equity, fixed and variable rate............... 1,242,982 1,178,378 Revolving credit loans, including credit cards..... 161,995 163,711 Other.............................................. 167,942 184,879 Real estate: Construction and land development.................. 90,823 109,378 Commercial mortgage................................ 301,315 284,579 Residential mortgage............................... 493,968 529,315 Other, including Industrial Development Authority.. 63,082 69,898 Commercial........................................... 321,428 311,932 ---------- ---------- 4,414,953 4,194,208 Less unearned income, principally on consumer loans . 327,635 351,835 ---------- ---------- Loans, net of unearned income ..................... 4,087,318 3,842,373 Less allowance for loan losses....................... 50,927 49,340 ---------- ---------- Net loans .........................................$4,036,391 $3,793,033 ========== ========== Loans on which interest is not being accrued or whose terms have been modified to provide for a reduced rate of interest because of financial difficulties of borrowers and interest income earned with respect to such loans were (in thousands): December 31 1993 1992 ------- ------- Nonaccruing loans.....................................$18,387 $20,453 Restructured loans ................................... 2,175 1,139 ------- ------- $20,562 $21,592 ======= ======= Income recorded.......................................$ 107 $ 85 Income anticipated under original loan agreements ....$ 1,639 $ 1,507 There were no formal commitments of a material amount to lend additional funds under these agreements, but additional advances may be made in the future if it is in the interest of the Corporation to do so. Loans modified for reasons other than a reduction in the interest rate were not material in amount. The Corporation's loans are widely dispersed among individuals and industries. On December 31, 1993, there was no concentration of loans in any single industry that exceeded 5% of total loans. The Corporation, in the normal course of business, has made commitments to extend loans and has written standby letters of credit which are not recognized in the financial statements. On December 31, 1993 and 1992, standby letters of credit totaled $19,984,000 and $20,495,000, respectively, and the unfunded amounts of loan commitments were (in thousands): 1993 1992 ---------- ---------- Fixed rate revolving credit lines ...................$ 497,728 $ 478,754 Adjustable rate loans: Home equity lines ................................. 333,530 315,648 Commercial loans................................... 276,570 295,070 Construction and land development loans............ 49,783 42,446 Other ............................................. 132,543 79,956 ---------- ---------- Total ...........................................$1,290,154 $1,211,874 ========== ========== A majority of the commercial, construction and land development commitments, and letters of credit will expire within one year, and all loan commitments can be terminated by the Corporation if the borrower violates any condition of the commitment agreement. The credit risk associated with loan commitments and letters of credit is essentially the same as that involved with loans that are funded and outstanding. The Corporation uses the same credit standards on a case-by-case basis in evaluating loan commitments and letters of credit as it does when funding loans, including the determination of the type and amount of collateral, if required. 6. ALLOWANCE FOR LOAN LOSSES Activity in the allowance for loan losses was (in thousands): Year ended December 31 1993 1992 1991 ------- ------- ------- Balance January 1...............................$49,340 $44,817 $43,917 Increase attributable to an acquired bank ...... 259 - - Provision charged to operating expense ......... 6,450 17,355 14,024 ------- ------- ------- 56,049 62,172 57,941 ------- ------- ------- Deduct: Loans charged off............................. 9,211 16,520 16,486 Less recoveries............................... 4,089 3,688 3,362 ------- ------- ------- Net charge-offs............................... 5,122 12,832 13,124 ------- ------- ------- Balance December 31.............................$50,927 $49,340 $44,817 ======= ======= ======= 7. PREMISES AND EQUIPMENT Premises and equipment consisted of (in thousands): December 31 1993 1992 -------- -------- Land .................................................$ 28,035 $ 24,666 Premises and improvements............................. 134,939 131,010 Furniture and equipment............................... 88,207 83,175 -------- -------- 251,181 238,851 Accumulated depreciation and amortization............. 114,174 102,197 -------- -------- Carrying value .....................................$137,007 $136,654 ======== ======== 8. INDEBTEDNESS Short-term borrowings consisted of (in thousands): December 31 1993 1992 -------- -------- Securities sold under agreements to repurchase .......$134,637 $129,345 Commercial paper (parent company only) ............... 17,222 21,336 -------- -------- $151,859 $150,681 ======== ======== Securities sold under agreements to repurchase generally mature within three days from the transaction date. Commercial paper maturities range from 1 to 270 days. Bank lines of credit available to the Corporation amounted to $25,000,000 at December 31, 1993 and 1992. Such lines were not being used on either of those dates. Mortgage indebtedness, including capital lease obligations, of the Corporation and its subsidiaries was (in thousands): December 31 1993 1992 ------ ------ 9 3/4%, payable through February 2012 (parent company only)...................$ - $4,095 Capital leases ........................................ 1,008 1,132 ------ ------ $1,008 $5,227 ====== ====== The capital leases are on properties which had a carrying value of $609,000 on December 31, 1993. The principal maturities of debt, other than short-term borrowings, in each of the five years after December 31, 1993, will be $123,000, $133,000, $140,000, $29,000, and $16,000, respectively. Interest paid on deposits and indebtedness during the years 1993, 1992 and 1991 totaled $166,892,000, $219,356,000 and $261,580,000, respectively. 9. PREFERRED STOCK There are 3,000,000 shares of preferred stock, par value of $ 10.00 per share, authorized. The following four series of cumulative convertible pre- ferred stock were outstanding as of December 31: Number of Shares Series Dividends 1993 1992 ------ ------ A 5% 24,673 25,831 B 7% 10,110 10,670 C 7% 13,964 13,968 D 8% 31,712 32,011 ------ ------ 80,459 82,480 ====== ====== The Series A and Series B shares are convertible into one and one-half shares of common stock, and the Series C shares are convertible into one and two-tenths shares of common stock. They may be redeemed at the option of the Corporation for $10.00 per share. The Series D shares are convertible into one and one-half shares of common stock. They are redeemable at the option of the Corporation for $10.16 until March 15, 1994, and for $.08 less per year each succeeding year to a minimum of par value. 10. COMMON STOCK There are 60,000,000 shares of common stock, par value $1.00 per share, authorized, and 32,444,000 shares and 32,185,000 shares were outstanding on December 31, 1993 and 1992, respectively. On December 31, 1993, options to purchase 345,263 shares of common stock and 11,625 stock appreciation rights were outstanding under employee stock option and stock appreciation rights plans. An additional 281,500 shares are authorized for further granting of options and rights. Options for 207,512 shares were exercisable on December 31, 1993, at a weighted-average price of $18.96. Additional options becoming exercisable in subsequent years total 60,001 in 1994 at an average price of $28.15, 20,250 in 1995 at an average price of $32.43, 19,250 in 1996 at an average price of $32.45, 19,250 in 1997 at an average price of $32.45, and 19,000 in 1998 at an average price of $32.45. Transactions involving employee stock options were as follows: Year ended December 31 1993 1992 1991 ------- ------- ------- Balance at beginning of year (41,250 for $12.25, 62,250 for $19.75, 71,241 for $14.833 and 120,000 for $19.167 and 63,000 for $15.25 in 1991)....................304,613 389,004 357,741 Options granted: For $23.083 per share ........................ - - 113,250 For $32.75 per share ......................... 60,000 - - For $32.125 per share ........................ 50,000 - - Options exercised: For $12.25 per share ......................... (3,000) (14,250) (16,500) For $19.75 per share .........................(10,850) (21,000) (3,750) For $14.833 per share ........................ (9,750) (9,966) (34,875) For $19.167 per share ........................(15,750) (16,675) (25,362) For $15.25 per share ......................... - (22,500) - For $23.083 per share ........................(30,000) - - Options canceled or forfeited: For $14.833 per share ........................ - - (1,500) ------- ------- ------- Balance at end of year ........................345,263 304,613 389,004 ======= ======= ======= A stock appreciation right entitles the holder to the difference between the value of a share of common stock on the exercise date and the value on the date the right was granted. Payment will be made with common stock based on its value on the exercise date. In 1984, 78,000 rights were granted for $12.25, and in 1989, 48,750 were granted for $19.167. In 1991, 18,624 shares were issued for 81,612 rights. In 1992, 36,239 shares were issued for 78,350 rights, and in 1993, 11,084 shares were issued for 22,800 rights. On December 31, 1993, 11,625 rights were exercisable for an average price of $18.05 per share. Holders of 172,113 options outstanding on December 31, 1993, with an average price of $21.15, may elect on the exercise date to receive the benefits of a stock appreciation right rather than an option. Compensation expense is recognized in connection with stock appreciation rights based on the current market value of the common stock. No compensation expense is recognized in connection with stock options, unless an election can be made by the holder to treat the option as a stock appreciation right. A stock option is accounted for at the difference between the market price of the option on the measurement date or date granted and the amount the employee is required to pay. All options are granted at full market price on the date of the grant and, therefore, no compensation expense is recognized. In certain cases, a holder may exercise an option as a stock appreciation right. Stock appreciation rights are measured in the same way as an option, except that in subsequent periods if a change in the market value of the shares occurs, then adjustments between the current market price and previously accrued amounts are recorded as compensation expense. At December 31, 1993, 1,142,863 shares of common stock were reserved: 116,498 for the conversion of preferred stock and 638,388 for stock options and stock appreciation rights and 387,977 for a bank acquisition. The Corporation has adopted a shareholder rights plan, which under certain circumstances will give the holders of the Corporation's common stock the right to purchase shares of its preferred stock or other securities. The rights will become exercisable if a person or entity should acquire 20% or more of the Corporation's voting stock, unless it is acquired pursuant to an offer for all outstanding shares of common stock at a price and on terms determined by the Board of Directors to be adequate and in the best interests of the Corporation and its stockholders. If the rights become exercisable, the holder of each share of common stock, except the person or entity acquiring 20% or more of the voting stock, will have the right to purchase for $90 the number of one one-hundredths of a share of preferred stock or equivalent security equal to $180, divided by the then market value of one share of common stock. In the event of a merger involving an exchange of common stock, the holder of each right, except the acquiring person or entity, will also have the right to purchase for $90 the number of shares of common stock of the acquiring company having a then market value of $180. The Corporation may redeem the rights for $.01 per right, at its option, at any time prior to the date they become exercisable. The rights expire on August 8, 1998. 11. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, (SFAS No. 107) "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases where quoted market prices are not available, fair values are based on estimates using discounted cash flow analysis or other valuation techniques. Those techniques involve subjective judgment and are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. As a result, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, cannot be realized in immediate settlement of the instrument. The following methods and assumptions were used by the Corporation in estimating the fair value of its financial instruments: Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets' fair values. Investment Securities: Fair values for investment securities are based on quoted market prices. Loans: For variable-rate loans that reprice frequently, with no significant change in credit risk, fair values are based on carrying values. The fair values for certain mortgage loans (e.g., one-to-four family residential) and credit cards are based on quoted market prices of similar loans sold in con- junction with securitization transactions and are adjusted for differences in loan characteristics. The fair values for other loans are estimated with discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Deposits: For deposits with no defined maturity, SFAS No. 107 defines the fair value as the amount payable on demand and prohibits adjusting fair value for any value derived from retaining those deposits for an expected future period of time. That component, commonly referred to as a deposit base intangible, is neither considered in the fair value amounts nor is it recorded as an intangible asset in the balance sheet. Fair values for fixed- rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated, expected monthly maturities. Short-Term Borrowings: The carrying amount of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings approximate their fair values. Long-Term Debt: The Corporation's long-term debt consists entirely of capitalized lease obligations which are exempt from the disclosure requirements of SFAS No. 107. Off-Balance Sheet Instruments: The estimated fair value of off-balance sheet items was not material at December 31, 1993. The estimated fair values of the Corporation's financial instruments as of December 31, 1993 are as follows: Carrying Fair Amount Value ---------- ---------- Financial assets: Cash and cash equivalents..........................$ 561,136 $ 561,136 Investment securities.............................. 2,176,034 2,228,813 Loans, net......................................... 4,087,318 4,171,083 Financial liabilities: Deposits........................................... 6,136,389 6,144,630 Short-term borrowings.............................. 151,859 151,859 SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. The disclosures also do not include certain intangible assets such as deposit base intangibles, mortgage servicing rights and goodwill. Accordingly, the aggregate fair value amount presented should not be interpreted as representing the underlying value of the Corporation. 12. RETIREMENT BENEFITS The Corporation and its subsidiaries have a noncontributory, defined- benefit pension plan covering substantially all of their qualified employees. The benefits are based on years of service and the employee's compensation during the last five years of employment. The Corporation's funding policy is to make annual contributions in amounts necessary to satisfy the Internal Revenue Service's funding standards to the extent they are deductible against taxable income. Contributions are intended to provide not only for benefits attributed to service to date, but also for those expected to be earned in the future. Contributions to the plan totaled $3,385,000, $2,587,000 and $732,000 in 1993, 1992 and 1991, respectively. Contributions include normal costs of the plan and amortization for periods of up to 40 years of unfunded past service cost. Pension expense included the following components (in thousands): Year ended December 31 1993 1992 1991 ------ ------ ------ Service cost - benefits earned during the period..$2,541 $2,239 $2,059 Interest cost on projected benefit obligation..... 4,615 4,185 3,951 Actual return on plan assets......................(3,267) (2,609) (9,014) Net amortization and deferral ....................(2,336) (2,510) 4,652 ------ ------ ------ Net periodic pension cost.......................$1,553 $1,305 $1,648 ====== ====== ====== The following table sets forth the plan's funded status and amounts recognized in the consolidated balance sheets (in thousands): December 31 1993 1992 1991 ------- ------- ------- Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $46,693, $38,372 and $32,877......... $51,485 $42,535 $36,653 ======= ======= ======= Plan assets at fair value ........................ $67,126 $62,489 $59,136 Projected benefit obligation for service rendered to date............................. 66,242 58,553 54,195 ------- ------- ------- Plan assets in excess of projected benefit obligation 884 3,936 4,941 Unrecognized net (gain) loss from past experience different from that assumed and effects of change in assumptions............................. 7,988 3,343 (2,077) Unamortized prior service cost....................... (2,611) (2,864) 255 Unrecognized net obligation at January 1, 1990 being recognized over 15 years ................... 86 100 114 ------- ------- ------- Prepaid pension cost included in other assets........$ 6,347 $ 4,515 $ 3,233 ======= ======= ======= The assets of the plan consist of U.S. Treasury securities-33%, other debt obligations- 33%, stocks- 28%, and cash and equivalents- 6%. The weighted- average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.25% and 4.75%, respectively. The expected long-term rate of return on plan assets was 9%. The Corporation and its subsidiaries have a thrift plan to which employees with one year of service may elect to contribute up to 6% of their salary. The Corporation contributes to the plan to the extent of 50% of the employees' contributions, and an additional 25% contribution is made if a specified profit objective is met. A 75% employer match was made in each of the years 1993, 1992 and 1991 when the Corporation's contributions to the plan totaled $3,055,000, $2,784,000 and $2,681,000, respectively. The plan is administered under the provisions of Section 401(k) of the Internal Revenue Code. Certain retired individuals who were participating in any of the Corporation's medical plans at retirement may elect to receive medical benefits similar to those provided for active employees if they make their elections within 30 days of retirement. Terminated employees may elect to receive such benefits for a limited period. 13. OTHER POSTRETIREMENT BENEFIT PLANS In addition to the Corporation's defined benefit pension plan, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits to full-time employees who have worked at least 10 years and have attained age 55 while in service with the Corporation. The benefits are based on years of service and are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles and coinsurance. Employees hired after December 31, 1993, may participate in the plan but must pay 100% of the cost. The accounting for the plan anticipates future cost-sharing changes to the written plan that are consistent with the Corporation's expressed intent to increase the retiree contribution rate annually for the expected increase in medical costs for that year. The Corporation has set a maximum amount that it will contribute per year of approximately three times the 1993 contribution level. The plan is not funded. In 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 106 (SFAS No. 106), "Employers' Accounting for Postretirement Benefits Other than Pensions." The effect of adopting the new rules increased 1993 net periodic postretirement benefit cost by $1,977,000 and decreased 1993 net income by $1,285,000. Postretirement benefit cost for 1992, which was recorded on a cash basis, has not been restated. The following table presents the plan's funded status, reconciled with amounts recognized in the Corporation's statement of financial position (in thousands). December 31 ------- Accumulated postretirement benefit obligation: Retirees ................................................ $ 6,083 Fully eligible, active plan participants ................ 2,587 Other active plan participants .......................... 8,206 ------- 16,876 Plan assets at fair value .................................. - ------- Accumulated postretirement benefit obligation in excess of plan assets ................................ 16,876 Unrecognized net gain or (loss) ............................ 3,299 Unrecognized transition obligation ......................... 11,600 ------- Accrued postretirement benefit cost ........................ $ 1,977 ======= Net periodic postretirement benefit cost includes the following components: 1993 1992 ------ ------ Service cost ........................................ $ 691 $ 270 Interest cost ....................................... 977 - Amortization of transition obligation over 20 years . 610 - ------ ------ Net periodic postretirement benefit cost............. $2,278 $ 270 ====== ====== The weighted-average, annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) is 11.3% for 1994 and is assumed to decrease gradually to 5.0% for 2003 and to 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 $967,000, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $81,000. The Corporation has limited its exposure to increases in health care, cost-trend rates by setting a cap on the maximum amount it will ever pay on any one retiree and by passing through 100% of the cost of retiree health care to new employees hired after December 31, 1993. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% at December 31, 1993. 14. INCOME TAXES In 1992, the Corporation adopted Financial Accounting Standards Board Statement No. 109 (SFAS No. 109), "Accounting for Income Taxes," which increased the 1992 provision for income taxes by $886,000. Significant components of the Corporation's deferred-tax liabilities and assets are as follows (in thousands): December 31 1993 1992 ------- ------- Deferred-tax liabilities: Life insurance reserves................................$ 2,812 $ 2,487 Depreciation........................................... 6,635 6,726 Other.................................................. 4,252 4,017 ------- ------- Total deferred-tax liabilities ........................ 13,699 13,230 ------- ------- Deferred-tax assets: Installment loan interest and fees..................... 2,628 2,537 Deferred compensation.................................. 4,504 4,040 Allowance for loan losses.............................. 17,769 16,691 Other.................................................. 5,262 4,483 ------- ------- Total deferred tax assets.............................. 30,163 27,751 ------- ------- Net deferred-tax assets .................................$16,464 $14,521 ======= ======= The provision for income taxes includes amounts currently payable and amounts deferred to or from other years as a result of differences in timing of income or expenses for reporting and tax purposes. The income tax provision includes the following amounts (in thousands): Liability Deferred Method Method ---------------- ------- 1993 1992 1991 ------- ------- ------- Current: Federal income taxes ..............................$54,590 $44,120 $28,515 State income taxes................................. 1,475 1,137 838 ------- ------- ------- Total current...................................... 56,065 45,257 29,353 ------- ------- ------- Deferred (benefit): Federal income taxes .............................. (1,858) (1,272) (3,349) State income taxes................................. (85) (173) (45) ------- ------- ------- Total deferred .................................... (1,943) (1,445) (3,394) ------- ------- ------- $54,122 $43,812 $25,959 ======= ======= ======= Income taxes paid during the year..................$60,207 $46,010 $28,744 ======= ======= ======= The components of the provision for deferred income taxes for the year ended December 31, 1991 are as follows (in thousands): ------- Deferred (benefit): Provision for loan loss..............................................$ (317) Depreciation ........................................................ (333) Installment loan interest and fees .................................. (978) Other, net........................................................... (1,766) ------- Provision for deferred income taxes....................................$(3,394) ======= The exclusion of certain categories of income and expense from taxable net income results in an effective tax rate which is lower than the statutory federal rate. The differences in the rates are as follows (dollars in thousands): Liability Method Deferred Method ------------------------------- --------------- 1993 1992 1991 --------------- --------------- --------------- Amount Percent Amount Percent Amount Percent ------- ------- ------- ------- ------- ------- Statutory rate................$59,551 35.0% $48,037 34.0% $32,493 34.0% Nontaxable interest on municipal obligations....... (5,847) (3.4) (6,210) (4.4) (6,704) (7.0) Adoption of SFAS No. 109...... 886 .6 Other items .................. 418 .2 1,099 .8 170 .2 ------- ------- ------- ------- ------- ------- Effective rate................$54,122 31.8% $43,812 31.0% $25,959 27.2% ======= ======= ======= ======= ======= ======= 15. EARNINGS PER SHARE Earnings per share of common stock, after giving effect to dividends on preferred stock of $54,000 in 1993, $61,000 in 1992 and $71,000 in 1991, are based on 32,512,000, 32,252,000 and 32,092,000 average shares outstanding, respectively. The dilutive effect upon earnings per share of the conversion of the outstanding, convertible preferred stock and other items was not material for any of the three years. 16. LEASES The Corporation's subsidiaries have entered into lease agreements with unaffiliated persons for premises, principally banking offices. Many of the leases have one or more renewal options, generally for five or ten years, and some contain a provision for increased rent during the renewal period. Leases containing a provision for contingent payments are immaterial in number or amount. Portions of a few premises are subleased, and the amount of rent received is not material. There are no significant restrictions imposed on the Corporation or its subsidiaries by the lease agreements. The subsidiaries also lease a portion of their computer systems and other equipment. Leases on 10 banking offices have been recorded as capital leases. The effect of capitalizing such leases on net income has not been material. Minimum rental payments over the noncancelable term of operating and capital leases having a remaining term in excess of one year are (in thousands): 1994..............................................$ 4,890 1995.............................................. 4,509 1996.............................................. 3,935 1997.............................................. 3,173 1998.............................................. 2,449 Thereafter........................................ 10,637 ------- Total minimum lease payments......................$29,593 ======= During 1993, 1992 and 1991, occupancy and equipment expense included the rent paid on operating leases of $13,668,000, $13,242,000 and $12,387,000, respectively, and was reduced by rental income of $2,024,000, $2,571,000 and $2,555,000, respectively, applicable to leases to unaffiliated persons, generally for a five-to-ten-year duration. 17. COMMITMENTS AND CONTINGENCIES The Corporation, in the normal course of its business, is the subject of legal proceedings instituted by customers and others. In the opinion of the Corporation's management, there were no legal matters pending as of December 31, 1993, which would have a material effect on its financial statements. 18. RESTRICTIONS ON LOANS AND DIVIDENDS FROM SUBSIDIARIES The Corporation's banking affiliates and its life insurance subsidiary are subject to federal and/or state statutes which prohibit or restrict certain of their activities, including the transfer of funds to the Corporation. There are restrictions on loans from banks to their parent company, and banks and life insurance companies are limited as to the amount of cash dividends which they can pay. As of December 31, 1993, the Corporation's equity in the net assets of its subsidiaries, after elimination of intercompany deposits and loans, totaled $606,939,000. Of that amount, $511,005,000 was restricted as to the payment of dividends. Consolidated retained earnings in the amount of $250,005,000 were free of limitations on the payment of dividends to the Corporation's stockholders as of December 31, 1993. 19. RELATED-PARTY TRANSACTIONS Directors and officers of the Corporation and their affiliates were customers of, and had other transactions with, the Corporation in the ordinary course of business. The Corporation has made residential mortgage loans at favorable rates to officers of the Corporation and its subsidiaries who have been relocated for the convenience of the Corporation. Other loan transactions with directors and officers were made on substantially the same terms as those prevailing for comparable loans to other persons and did not involve more than normal risk of collectibility or present other unfavorable features. As of December 31, 1993, and 1992, loans to directors and executive officers of the Corporation and its largest subsidiary bank, where the aggregate of such loans exceeded $60,000, totaled $35,056,000 and $39,342,000, respectively. During 1993, $1,850,000 of new loans were made and repayments totaled $6,136,000. These totals include loans to certain business interests and family members of the directors and executive officers, and no losses are anticipated in connection with any of the loans. 20. FIRST VIRGINIA BANKS, INC. (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION (IN THOUSANDS) BALANCE SHEETS December 31 1993 1992 -------- -------- Assets Cash and noninterest-bearing deposits principally in affiliated banks.......................$ 1,474 $ 1,158 Securities purchased under agreements to resell......... 28,390 30,080 Investment in affiliates based on the Corporation's equity in their net assets: Member banks......................................... 541,769 491,781 Bank-related companies............................... 10,381 9,748 Investment securities, (market value $28,107-1993 and $7,215-1992)................................... 27,101 5,732 Loans (including $52,758-1993 and $47,896-1992 to affiliated companies) .......................... 53,429 49,391 Premises and equipment.................................. 40,128 40,524 Goodwill................................................ 7,884 8,540 Other assets ........................................... 30,360 26,478 -------- -------- Total Assets .........................................$740,916 $663,432 ======== ======== Liabilities Interest, taxes and other liabilities ..................$ 32,193 $ 30,602 Commercial paper ....................................... 17,222 21,336 Mortgage indebtedness .................................. - 4,095 -------- -------- Total Liabilities .................................... 49,415 56,033 -------- -------- Stockholders' Equity Preferred stock......................................... 805 825 Common stock............................................ 32,444 32,185 Capital surplus......................................... 68,406 64,930 Retained earnings....................................... 589,846 509,459 -------- -------- Total Stockholders' Equity............................ 691,501 607,399 -------- -------- Total Liabilities and Stockholders' Equity............$740,916 $663,432 ======== ======== STATEMENTS OF INCOME Year Ended December 31 1993 1992 1991 -------- ------- ------- Income Dividends from affiliates: Member banks .....................................$ 68,674 $63,171 $37,784 Bank-related companies ........................... 25 335 170 Service fees from affiliates........................ 10,529 10,884 9,810 Rental income: Affiliates ...................................... 5,185 5,891 5,921 Other ........................................... 1,782 2,252 2,307 Interest and dividends on investment securities .... 1,901 1,433 2,744 Other income: Affiliates ....................................... 2,390 2,096 1,774 Other ............................................ 751 494 49 -------- ------- ------- Total income.................................... 91,237 86,556 60,559 -------- ------- ------- Expenses Salaries and employee benefits...................... 12,685 16,680 12,673 Interest ........................................... 517 1,594 1,999 Other expenses: Paid to affiliates................................ 806 1,517 1,493 Other ............................................ 9,673 9,834 10,119 -------- ------- ------- Total expenses.................................. 23,681 29,625 26,284 -------- ------- ------- Income before income taxes and equity in undistributed income of affiliates ............ 67,556 56,931 34,275 Income tax benefits................................. 1,054 2,368 1,701 -------- ------- ------- Income before equity in undistributed income of affiliates............. 68,610 59,299 35,976 Equity in undistributed income of affiliates ....... 47,414 38,174 33,632 -------- ------- ------- Net income..........................................$116,024 $97,473 $69,608 ======== ======= ======= STATEMENTS OF CASH FLOWS Year Ended December 31 1993 1992 1991 ------- ------- ------- Net cash provided by operating activities............$69,025 $68,301 $40,638 ------- ------- ------- Investing activities: Proceeds from maturity of investment securities.... 27,343 5,920 7,969 Proceeds from the sale of investment securities.... 824 Purchase of investment securities .................(48,931) (5,198) (11,908) Net (increase) decrease in loans................... (4,862) (37,152) 308 Purchases of premises and equipment ............... (1,891) (1,096) (1,388) Sales of premises and equipment ................... 3 (28) 23 Investment in affiliates........................... (3,453) (6,000) (271) Other.............................................. 2,260 (4,654) (2,441) ------- ------- ------- Net cash used for investing activities..........(28,707) (48,208) (7,708) Financing activities: Net increase (decrease) in short-term borrowings .. (4,114) 2,054 2,914 Principal payments on long-term borrowings......... (4,095) (5,890) (422) Cash dividends - common............................(34,830) (30,945) (28,517) Cash dividends - preferred ........................ (54) (65) (73) Proceeds from issuance of common stock............. 1,401 1,698 1,890 ------- ------- ------- Net cash used for financing activities .........(41,692) (33,148) (24,208) ------- ------- ------- Net increase (decrease) in cash and cash equivalents..................... (1,374) (13,055) 8,722 Cash and cash equivalents at beginning of year . 31,238 44,293 35,571 ------- ------- ------- Cash and cash equivalents at end of year........$29,864 $31,238 $44,293 ======= ======= ======= Net cash provided by operating activities has been reduced (increased) by the following cash payments (receipts): Interest on indebtedness...........................$ 518 $ 1,598 $ 1,998 Income taxes....................................... (954) (1,727) (420) MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING - --------------------------------------------------- The management of First Virginia Banks, Inc. has prepared and is responsible for the accompanying financial statements, together with the financial data and other information presented in this annual report. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles appropriate under the circumstances. The financial statements include amounts that are based on management's best estimates and judgments. Management maintains and depends upon an internal accounting control system designed to provide reasonable assurance that transactions are executed in accordance with management's authorization, that financial records are reliable as the basis for the preparation of all financial statements, and that the Corporation's assets are safeguarded. The design and implementation of all systems of internal control are based on judgments required to evaluate the costs of control in relation to the expected benefits and to determine the appropriate balance between these costs and benefits. The Corporation maintains a professional internal audit staff to monitor compliance with the system of internal accounting control. Operational and special audits are conducted, and internal audit reports are submitted to appropriate management. The Audit Committee of the Board of Directors, comprised solely of outside directors, meets periodically with the independent public accountants, management and internal auditors to review accounting, auditing and financial reporting matters. The independent public accountants and internal auditors have free access to the Committee, without management present, to discuss the results of their audit work and their evaluations of the adequacy of internal controls and the quality of financial reporting. The financial statements in this annual report have been audited by the Corporation's independent auditors, Ernst & Young, for the purpose of determining that the financial statements are presented fairly. Their independent professional opinion on the Corporation's financial statements is presented on the following page. /S/ Robert H. Zalokar _______________________ Robert H. Zalokar Chairman and Chief Executive Officer /S/ Richard F. Bowman _______________________ Richard F. Bowman Vice President, Treasurer and Chief Financial Officer REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS - --------------------------------------------- To the Stockholders and Board of Directors First Virginia Banks, Inc. We have audited the accompanying consolidated balance sheets of First Virginia Banks, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the 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, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Virginia Banks, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Washington, D.C. January 13, 1994 /S/ Ernst & Young ___________________ 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 Board of Directors is divided into three classes (A, B and C). The term of office for Class A directors will expire at the Annual Meeting to be held on April 22, 1994. Five persons, all of whom are presently on the Board, have been nominated to serve as Class A directors. If elected, the five nominees will serve for a term of three years. It is the intention of the persons named in the proxy, unless stockholders specify otherwise by their proxies, to vote for the election of the five nominees named below as Class A Directors. Although the Board of Directors does not expect that any of the persons named will be unable to serve as a director, should any of them be unable to accept nomination or election, it is intended that shares represented by the proxy will be voted by the proxy holders for such other person or persons as may be designated by the present Board of Directors. Certain information concerning the nominees for election and the Class B and Class C directors who will continue in office after the meeting is set forth below and on the following pages, as furnished by them. Nominees For Class A Directors E. Cabell Brand, 70, is President of Recovery and Development Systems, Inc., a company in Salem, Virginia that engages in business and environmental consulting and international development projects. He is a director of First Virginia Bank-Southwest, Roanoke, Virginia and has been a director of First Virginia since 1976. He serves on the Management Compensation and Benefits Committee and the Director Nominating Committee and beneficially owns 5,538 shares of Common Stock. (1) Elsie C. Gruver, 67, is a community and civic leader in Arlington, Virginia and has been a director of First Virginia since 1973. She is Chairman of the Public Policy Committee and a member of the Audit Committee and beneficially owns 7,837 shares of Common Stock. (2) W. Lee Phillips, Jr., 58, is a professional engineer and land surveyor based in Falls Church, Virginia and has been a director of First Virginia since 1985. He is a director of First Virginia Bank, Falls Church, Virginia. He serves on the Audit Committee as well as the Management Compensation and Benefits Committee and beneficially owns 8,209 shares of Common Stock. (3) Josiah P. Rowe, III, 66, is Co-Publisher and General Manager of The Free Lance Star Publishing Co. of Fredericksburg, Virginia and has been a director of First Virginia since 1991. He is a director of First Virginia Bank, Falls Church, Virginia. He serves on the Public Policy Committee and the Director Nominating Committee and beneficially owns 1,500 shares of Common Stock and 100 shares of Preferred Stock. Albert F. Zettlemoyer, 59, is President of the Government Systems Group of UNISYS Corporation in McLean, Virginia and is Executive Vice President of UNISYS and has been a director of First Virginia since 1978. He serves on the Audit Committee and chairs the Management Compensation and Benefits Committee. He beneficially owns 3,000 shares of Common Stock. (4) Class B Directors Edward L. Breeden, III, 59, is a partner in the law firm of Breeden, MacMillan & Green in Norfolk, Virginia, and has been a director of First Virginia since 1982. He is a director of First Virginia Bank of Tidewater, Norfolk, Virginia and of First Virginia Life Insurance Company. He serves on both the Executive Committee and the Public Policy Committee and chairs the Audit Committee. He beneficially owns 65,747 shares of Common Stock. (5) Gilbert R. Giordano, 65, is a partner in the law firm of Giordano, Bush, Villareale & Vaughan, P.A. in Upper Marlboro, Maryland and has been a director of First Virginia since 1989. He is Chairman of the Board of First Virginia Bank-Maryland, Upper Marlboro, Maryland. He serves on the Audit Committee and the Director Nominating Committee and beneficially owns 203,755 shares of Common Stock. (6) Eric C. Kendrick, 47, is President of Mereck Associates, Inc., a real estate management and development firm in Arlington, Virginia and has been a director of First Virginia since 1986. He serves on the Management Compensation and Benefits Committee and the Public Policy Committee. He beneficially owns 63,127 shares of Common Stock. (7) Richard T. Selden, 71, is the Carter Glass Professor of Economics at the University of Virginia in Charlottesville, Virginia and has been a director of First Virginia since 1978. He is a director of First Virginia Bank, Falls Church, Virginia. Dr. Selden serves on the Audit Committee and beneficially owns 3,200 shares of Common Stock. (8) Robert H. Zalokar, 66, is Chairman of the Board and Chief Executive Officer of First Virginia and Chairman of the Board, First Virginia Bank, Falls Church, Virginia. He has been a director of First Virginia since 1959. Mr. Zalokar is also Chairman of First Virginia Life Insurance Company, First Virginia Mortgage Company and First Virginia Services, Inc. as well as Chairman or director of other nonbank affiliates. He serves on the Executive Committee and is an ex officio member of the Public Policy Committee and the Director Nominating Committee. He owns 124,055 shares of Common Stock. (9) Class C Directors Paul H. Geithner, Jr., 63, is President and Chief Administrative Officer of First Virginia and has been a director of First Virginia since 1984. He is also a director of First Virginia Bank in Falls Church, First Virginia Life Insurance Company, First Virginia Insurance Services, Inc., First Virginia Mortgage Company and other affiliated companies. He is a member of the Public Policy Committee and the Executive Committee and beneficially owns 45,849 shares of Common Stock. (10) L. H. Ginn, III, 60, is President of Lighting Affiliates, Inc., a distributor of electrical fixtures located in Richmond, Virginia and has been a director of First Virginia since 1978. Mr. Ginn is a retired U. S. Army Reserve Major General. He is Chairman of the Board of First Virginia Bank-Colonial, Richmond, Virginia. He is a member of the Executive Committee and the Director Nominating Committee and beneficially owns 10,856 shares of Common Stock. (11) T. Keister Greer, 72, is counsel for Greer & Melesco, attorneys in Rocky Mount, Virginia and has been a director of First Virginia since 1976. He is Chairman of the Board of First Virginia Bank-Franklin County, Rocky Mount, Virginia. Mr. Greer is a member of the Public Policy Committee and the Director Nominating Committee and beneficially owns 17,400 shares of Common Stock. (12) Edward M. Holland, 54, is an attorney in Arlington, Virginia and a member of the Virginia General Assembly (Senate) and has been a director of First Virginia since 1974. He is also a director of First Virginia Bank, Falls Church, Virginia. He serves on the Executive Committee and the Management Compensation and Benefits Committee and beneficially owns 60,979 shares of Common Stock. (13) Thomas K. Malone, Jr., 74, is retired Chairman and Chief Executive Officer of First Virginia and has been a director of First Virginia since 1957. He is a director of First Virginia Bank in Falls Church, First Virginia Life Insurance Company and First Virginia Mortgage Company. He is also Chairman Emeritus of Marymount University in Arlington, Virginia. Mr. Malone is Chairman of both the Executive Committee and the Director Nominating Committee. He also serves on the Public Policy Committee and beneficially owns 44,632 shares of Common Stock. (14) (1)Includes 264 shares of Common Stock held indirectly through his spouse. (2)Includes 1,782 shares of Common Stock held in a Keogh Plan, 900 shares held in an Individual Retirement Account, 1,900 shares held in her spouse's Keogh Plan, and 900 shares held in her spouse's Individual Retirement Account. (3)Includes 3,000 shares held by a trust in which Mr. Phillips is a trustee. (4)All of the shares are held jointly with his spouse. (5)Includes 7,500 shares held by a corporation of which Mr. Breeden is President, 16,325 shares held by two foundations of which Mr. Breeden is Chairman, 16,275 shares held by two trusts in which Mr. Breeden is trustee, and 21,900 shares held by an estate in which Mr. Breeden is the executor. (6)Includes 4,669 shares held by his spouse, 5,355 shares held by his spouse as trustee for his son, 108 shares held by his spouse and daughter, 484 shares held by his spouse and son, 6,000 shares held by the Giordano Family Foundation and 387 shares held by his daughter. (7)Includes 16,998 shares held by two trusts in which Mr. Kendrick is trustee, 1,729 shares held by a corporation in which Mr. Kendrick is a director and 750 shares held by his spouse. (8)Includes 652 shares held in a trust in which Dr. Selden is trustee. (9)Includes options to purchase 5,213 shares of Common Stock which are currently exercisable. (10)Includes 2,359 shares held indirectly through his spouse and includes options to purchase 14,750 shares of Common Stock which are currently exercisable. It does not include options to purchase 13,750 shares which are not currently exercisable and 9,750 stock appreciation rights ("SARs"). (11)Includes 229 shares held indirectly through his spouse and 837 shares held by a trust in which Mr. Ginn is trustee. (12)Includes 5,400 shares of Common Stock held by a trust in which Mr. Greer has a beneficial interest. (13)Includes 34,479 shares held by a corporation in which Mr. Holland is an officer, director, and owner. (14)Includes 10,125 shares of Common Stock held jointly with his spouse (shared voting and investment power). As of February 25, 1994, executive officers and directors as a group beneficially owned 922,049 shares of Common Stock representing approximately 2.8% of those shares outstanding, of which 170,238 shares represent shares covered by currently exercisable options (or options exercisable within 60 days) and 200 shares of Preferred Stock representing approximately .25% of those shares outstanding. No officer or director owned as much as 1.0% of First Virginia Common Stock. Messrs. Breeden, Greer and Giordano are members of or are associated with law firms which have been in the last two years, and are proposed in the future to be, retained by First Virginia and its subsidiaries. During the past two years, Dr. Selden has been and is proposed in the future to be, retained by First Virginia as a consultant. Messrs. Brand, Breeden, Geithner, Ginn, Giordano, Greer, Holland, Malone, Phillips, Rowe, Selden and Zalokar have been directors of various subsidiaries of First Virginia during the past five years. Ages of the directors are stated as of February 25, 1994. BENEFICIAL OWNERSHIP OF NAMED EXECUTIVE OFFICERS The following table sets forth certain information regarding the named executives' beneficial ownership of First Virginia Common Stock as of February 25, 1994. Shares of Common Stock of First Virginia Beneficially Owned Name of Officer Number * Percent of Class Robert H. Zalokar 124,055 .3824 Paul H. Geithner, Jr. 45,849 .1413 Barry J. Fitzpatrick 40,722 .1255 Shirley C. Beavers, Jr. 31,134 .0960 Justin C. O'Donnell 25,042 .0772 * The amounts shown represent the total shares owned outright by such individuals together with shares which are issuable upon the exercise of all stock options which are currently exercisable. Specifically, the following individuals have the right to acquire the shares indicated after their names, upon the exercise of stock options: Mr. Zalokar, 5,213; Mr. Geithner, 14,750; Mr. Fitzpatrick, 25,500; Mr. Beavers, 22,500; and Mr. O'Donnell, 15,750. COMMITTEES AND MEETINGS OF THE BOARD OF DIRECTORS First Virginia's Board of Directors has a standing Audit Committee, Director Nominating Committee, Management Compensation and Benefits Committee, Public Policy Committee, and Executive Committee. The Audit Committee, comprised of Directors Breeden, Giordano, Gruver, Phillips, Selden, and Zettlemoyer, held five meetings during 1993. Functions of the Committee include (1) reviewing with the independent public accountants and management such matters as: the financial statements and the scope of First Virginia's audit, compliance with laws and regulations, and the adequacy of First Virginia's system of internal procedures and controls and resolution of material weaknesses; (2) reviewing with First Virginia's internal auditors the activities and performance of the internal auditors; (3) reviewing with management the selection and termination of the independent public accountants and any significant disagreements between the independent public accountants and management; and (4) reviewing the nonaudit services of the independent public accountant. Under Section 36 of the Federal Deposit Insurance Act, the Audit Committee also performs similar functions for the two largest First Virginia member banks. The Director Nominating Committee, comprised of Directors Malone, Brand, Ginn, Giordano, Greer, Rowe, and Zalokar, held one meeting in 1993. The functions of the Committee include annually recommending to the Board the names of persons to be considered for nomination and election by First Virginia's stockholders and, as necessary, recommending to the Board the names of persons to be elected to the Board between annual meetings. The Committee also considers candidates recommended by stockholders upon receipt of a letter and resume for the proposed candidate. Such information should be sent to First Virginia's Secretary. The Management Compensation and Benefits Committee, comprised of Directors Zettlemoyer, Brand, Holland, Kendrick, and Phillips, held one meeting in 1993. The Committee has the authority to establish the level of compensation (including bonuses) and benefits of management of First Virginia. In addition, the Committee has authority to award long-term incentive compensation, e.g., stock options and stock appreciation rights, to First Virginia's management based on such factors as individual and corporate performance. The Public Policy Committee, comprised of Directors Gruver, Breeden, Geithner, Kendrick, Malone, Rowe, and Zalokar, met four times during 1993. This Committee recommends to the full Board the amount of funds to be allocated each year for charitable contributions, approves contributions upon request, and supervises First Virginia's matching gifts program. The Committee also monitors the programs developed for compliance with the Community Reinvestment Act and Title VII of the Civil Rights Act of 1964. The Executive Committee, comprised of Directors Malone, Breeden, Geithner, Ginn, Holland, and Zalokar, held 12 meetings in 1993. The Committee exercises all of the powers of the Board of Directors when the Board is not in session, except for those powers reserved for the Board under state law and by First Virginia's Articles of Incorporation and Bylaws and those powers delegated to other committees. During 1993, there were 12 meetings of the Board of Directors. All directors attended more than 75% of the aggregate total number of meetings of the Board and committees of the Board on which they served. SECTION 16 TRANSACTIONS Section 16(a) of the Securities Exchange Act of 1934 requires First Virginia's executive officers and directors to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. Executive officers and directors are required by SEC regulation to furnish First Virginia with copies of all Section 16(a) forms they file. Based on a review of the forms that were filed and written representations from the executive officers and directors, First Virginia believes that during the year 1993 all filing requirements applicable to its officers and directors were met. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following Summary Compensation Table shows the annual compensation for First Virginia's Chief Executive Officer and for the four most highly compensated executive officers other than First Virginia's Chief Executive Officer for the last three fiscal years. SUMMARY COMPENSATION TABLE Long-Term Annual Compensation Compensation (a) (b) (c) (d) (e) (f) (g) Other All Annual Options/ Other Name And Compen- SARs Compen- Principal Salary Bonus sation Awarded sation Position Year ($) (1) ($) (2) ($) (3) (#) (4) ($) (5) - -------- ---- ------- ------- ------- ------- ------- Robert H. Zalokar 1993 500,000 306,388 8,509 0 108,901 Chairman and Chief Executive 1992 490,000 270,714 10,608 0 93,979 Officer of First Virginia 1991 478,923 210,660 30,000 Paul H. Geithner, Jr. 1993 315,000 131,679 5,583 10,000 60,347 President of First Virginia 1992 300,000 113,050 3,987 0 52,513 1991 293,885 86,526 11,250 Barry J. Fitzpatrick 1993 189,000 90,406 69,099 10,000 25,203 Executive Vice President 1992 169,310 72,830 29,236 0 18,723 of First Virginia 1991 152,576 28,366 11,250 Shirley C. Beavers, Jr. 1993 189,000 90,406 6,045 10,000 31,385 Executive Vice President of 1992 175,769 72,830 5,160 0 26,112 First Virginia and President, 1991 171,250 33,698 11,250 First Virginia Services, Inc. Justin C. O'Donnell 1993 202,600 45,386 5,437 2,000 33,604 Senior Vice President of 1992 192,950 43,394 4,089 0 30,549 First Virginia and President 1991 190,481 34,197 4,500 and Chief Executive Officer of First Virginia Bank (1)The Salary Column (Column (c)) includes the base salary earned by the executive officer, which includes amounts that are deferred under the First Virginia Banks, Inc. Employees Thrift Plan and the First Virginia Pre-Tax Health Benefit Plan. (2)The Bonus Column (Column (d)) includes the amount earned as a bonus for that year even if paid in the following year. It also includes amounts earned for that year under the First Virginia Banks, Inc. Profit Sharing Plan. (3)The Other Annual Compensation Column (Column (e)) includes the amount of taxes paid by First Virginia for certain benefits. In the case of Barry J. Fitzpatrick, it includes perquisites which amounted to $46,503 for 1993. Of this amount, $23,432 was for a country club initiation fee and dues and $15,247 was for moving expenses. None of the other named executive officers had perquisites and other personal benefits that exceeded the lesser of $50,000 or 10% of the total of annual salary and bonus reported for the named executive officer in the Summary Compensation Table. (4)Column (f) includes the number of stock options and SARs that were granted, after adjusting for the three-for-two stock split in July, 1992. Some of the options granted in 1991 had tandem SARs attached to them. (5)The All Other Compensation Column (Column (g)) includes the amount paid by the employer under the First Virginia Banks, Inc. Employees Thrift Plan which, for each of the named officers, was $6,745. It also includes the amounts paid by the employer under the First Virginia Supplemental Benefits Plan. This plan provides supplemental retirement benefits for those key officers who are restricted from receiving further benefits under the Thrift Plan as a result of the $8,994 limitation on pretax contributions imposed by the Internal Revenue Code for 1993. For 1993, these amounts were: for Mr. Zalokar, $40,548; Mr. Geithner, $17,703; Mr. Fitzpatrick, $8,637; Mr. Beavers, $8,648; and Mr. O'Donnell, $5,910. It also includes the premium amounts paid by the employer under the First Virginia Split Dollar Life Insurance Plan. For 1993, these amounts were: for Mr. Zalokar, $41,750; Mr. Geithner, $28,247; Mr. Fitzpatrick, $8,642; Mr. Beavers, $14,800; and Mr. O'Donnell, $15,296. It also includes the "above-market" earnings on deferred compensation earned during 1993. These amounts were: for Mr. Zalokar, $19,858; Mr. Geithner, $7,652; Mr. Fitzpatrick, $1,179; Mr. Beavers, $1,192; and Mr. O'Donnell, $5,653. Pursuant to SEC transition rules regarding executive compensation disclosure, Columns (e) and (g) do not include information for fiscal year 1991. First Virginia has supplemental compensation agreements with Messrs. Zalokar and Geithner which provide that in the event of their resignation or retirement, they are entitled to annual compensation equal to 60% of their average annual compensation earned by them during the five consecutive years of their highest compensation less any benefits they receive under the First Virginia Pension Trust Plan. "Compensation" under the Agreements includes not only their "Salary" and "Bonus" shown in the Summary Compensation Table but any other compensation that would be included on their IRS Form W-2. Mr. Geithner's Agreement also provide for a 50% survivor benefit to his surviving spouse should she survive him. Under their supplemental compensation agreements, Messrs. Zalokar and Geithner are to provide consulting services to First Virginia following retirement and must not engage in any activities which compete with First Virginia. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS The following table shows for each of the named executive officers (1) the number of options that were granted during 1993, (2) out of the total number of options granted to all employees, the percent granted to the named executive officer, (3) the exercise price, (4) the expiration date and (5) the potential realizable value of the options, assuming that the market price of the underlying securities appreciates in value from the date of grant to the end of the option term, at a 5% and 10% annualized rate. Stock Option Grants In 1993 Potential Percent Realizable of Total Value at Options Assumed Annual Options Granted to Exercise Rates of Stock Granted Employees or Base Expir- Price Appreciation (# Shs.) in Fiscal Price ation for Option Term (1) Year (2) ($/Sh.) Date 5%($) 10%($) Robert H. Zalokar ---- ---- ---- ---- ---- ---- Paul H. Geithner,Jr. 10,000 9.09% 32.75 12/14/03 205,960 621,950 Barry J. Fitzpatrick 10,000 9.09% 32.75 12/14/03 205,960 621,950 Shirley C. Beavers, Jr. 10,000 9.09% 32.75 12/14/03 205,960 621,950 Justin C. O'Donnell 2,000 1.82% 32.125 12/15/03 40,406 102,398 (1)Except in the case of Mr. Geithner (all of whose options are exercisable in one year), options granted to the named executive officers in 1993 are exercisable over a five year period provided certain performance goals are achieved by First Virginia. (2)Options to purchase 110,000 shares of First Virginia Common Stock were granted to employees during 1993. No freestanding SARs were granted in 1993 to employees and none of the options that were granted had any tandem SARs. The following table shows for each of the named executive officers the number of shares of First Virginia Common Stock acquired upon the exercise of stock options and stock appreciation rights during 1993, the value realized upon their exercise, the number of unexercised stock options and SARs at the end of 1993 and the value of unexercised in-the-money stock options and SAR rights at the end of 1993. Stock options or freestanding SARs are considered "in-the- money" if the fair market value of the underlying securities exceeds the exercise price of the option or SAR. Some of the stock options which were granted to First Virginia's executive officers include a provision that would accelerate the vesting of the options upon a change-in-control of First Virginia. Aggregated Options/SAR Exercises in 1993 and Yearend Options/SAR Values Value Number of Unexercised Unexercised In-the-Money Options/SARs Options/ Shares at Yearend SARs at Acquired (#) Yearend ($) Name on Value Exercisable/ Exercisable/ Exercise Realized Unexercisable Unexercisable (#) ($) -------- -------- ------------- ------------- Robert H. 30,000 297,501 5,213/0 70,810/0 Zalokar Paul H. 4,939 137,000 26,500/13,750 328,250/36,250 Geithner, Jr. Barry J. 1,500 20,750 25,500/13,750 343,750/36,250 Fitzpatrick Shirley C. 5,154 133,438 22,500/13,750 305,625/36,250 Beavers, Jr. Justin C. O'Donnell 2,944 110,750 15,750/3,500 231,562/15,750 PENSION PLAN The table on the following page shows the estimated annual benefit payable upon retirement under the First Virginia Pension Trust Plan based on specified remuneration and years of credited service classifications, assuming a participant retired on December 31, 1993 at age 65. The table ends at an average annual pay of $250,000, although because of IRS regulations, compensation in excess of $235,840 was not taken into account in determining benefits under the Plan in 1993. In 1994, compensation in excess of $150,000 will not be taken into account in determining benefits under the Plan. Credited service in excess of thirty years is also not taken into account in determining benefits under the Plan. Annual Benefits Under First Virginia's Pension Trust Plan Average Annual 10 Years 15 Years 20 Years 25 Years 30 Years Pay of of of of of for Past Service Service Service Service Service 60 Months - --------- ------- ------- ------- ------- ------- $150,000 22,860 34,290 45,720 57,150 68,580 175,000 26,860 40,290 53,720 67,150 80,580 200,000 30,860 46,290 61,720 77,150 92,580 225,000 34,860 52,290 69,720 87,150 104,580 250,000 38,860 58,290 77,720 97,150 115,641 Under the First Virginia Pension Trust Plan, a participant retiring at age 65 with 30 years of credited service under the Plan will receive a maximum annual pension benefit equal to 1.1% of his average annual pay multiplied by 30 years of credited service plus 0.5% of his average annual pay in excess of his covered compensation multiplied by 30 years of credited service. The calculation of "average annual pay" is based on annual compensation for the highest five consecutive years out of the participant's final 10 years of service. "Covered compensation" is calculated by multiplying the annual average of Social Security taxable wage bases in effect for the 35 years ending with the last day of the year in which the participant attains Social Security retirement age. This table and the Summary Compensation Table may be used to estimate pension benefits for each of the individuals listed in the Summary Compensation Table. Remuneration on earnings determining pension benefits under the Plan includes salaries and bonuses (which are listed in the Summary Compensation Table) but it also includes any other taxable compensation including compensation resulting from the exercise of nonqualified options and SARs. Credited service as of December 31, 1993 for each of the named executives was as follows: Mr. Zalokar, 31 years; Mr. Geithner, 25.3 years; Mr. Fitzpatrick, 24.4 years; Mr. Beavers, 24.3 years and Mr. O'Donnell, 11.3 years. DIRECTORS' COMPENSATION, CONSULTING ARRANGEMENTS AND PLANS WHICH INCLUDE CHANGE IN CONTROL ARRANGEMENTS For 1994, directors of First Virginia who are not salaried officers will be paid an annual retainer of $13,000 per year, a fee of $850 for each meeting of the Board of Directors attended, and a fee of $700 for each meeting of a Committee of the Board of Directors attended. Committee chairmen will receive $850 for each committee meeting they chair, except that the Chairman of the Executive Committee shall receive $1,750 for each meeting. Directors are reimbursed for out-of-town expenses incurred in connection with Board and Committee meetings. Directors can participate in First Virginia's deferred compensation plans which allow them to defer their retainers and fees. During 1993, Mr. Edwin T. Holland, the founder and former Chairman and Chief Executive Officer of First Virginia, and Mr. Thomas K. Malone, Jr., former Chairman and Chief Executive Officer of First Virginia, were paid $139,608 and $84,337 respectively under their supplemental compensation agreements, in addition to the amounts they received from the First Virginia Pension Trust Plan. Both Messrs. Holland and Malone provide consulting services under their supplemental compensation agreements. During 1993, Virginia H. Brown, formerly Virginia H. Beeton, received $71,000 pursuant to her former husband's Supplemental Retirement Agreement with First Virginia in addition to what she received from the First Virginia Pension Trust Plan. Her former husband, Ralph A. Beeton, was Chairman and Chief Executive Officer of First Virginia. First Virginia also has two key employee salary reduction deferred compensation plans, one of which began in 1983 and the other in 1986, and two directors' deferred compensation plans, one of which also began in 1983 and the other in 1986, ("Deferred Compensation Plans") for key employees of First Virginia and its subsidiaries and directors of First Virginia. Under the Deferred Compensation Plans, participants elect to defer some or all of their compensation from First Virginia, and First Virginia agrees to pay at retirement (or to participant's beneficiary or estate on participant's death) a sum substantially in excess of what each participant has deferred. To fund the benefits under the Deferred Compensation Plans, First Virginia has purchased life insurance contracts on the lives of the participants with First Virginia as the beneficiary. For the period ending December 31, 1993, none of the executive officers of First Virginia deferred any compensation under the Deferred Compensation Plans. The 1983 deferred compensation plans include a provision regarding "change in control," which is defined to include, among other things, an acquisition by one person or group of 25% of the voting power of First Virginia's outstanding securities. Generally, the 1983 Key Employee Salary Reduction Deferred Com- pensation Plan requires that an employee continue his/her position with First Virginia and/or its subsidiaries until retirement in order to receive his/her benefits. If there is a "change in control" of First Virginia, and a director is terminated under the directors' plan, or in the case of the employee plan, an employee is terminated "without cause" or the employee terminates his/her employment for "good reason," as those terms are defined under the employee plan, then the director or employee, as the case may be, becomes entitled to his/her benefits under the 1983 Deferred Compensation Plans at retirement, notwithstanding the fact that his/her affiliation with First Virginia has terminated. In 1988, First Virginia established a Split Dollar Life Insurance Plan ("Split Dollar Plan") under which individual life insurance is available to 17 executive employees (two of whom have retired) including those named in the Cash Compensation Table. Under the Split Dollar Plan, an executive can purchase ordinary life insurance policies with coverage of at least two times the executive's base annual salary, up to a limit of $1,000,000. A portion of the premiums will be loaned to the executives by First Virginia up to the later of ten years or the executive's retirement date. At the end of this period, if assumptions about mortality, dividends and other factors are realized, First Virginia will recover all of its loans for premiums from the cash value of the policy. The policy will then be transferred to the executive, who will pay all further premiums, if any, under the policy. Executives who participate in the Split Dollar Plan forego any insurance coverage over $50,000 under the First Virginia Group Life Insurance Plan. During 1989, the Split Dollar Plan was amended so that in the event of a "change in control," which term is defined in the same manner as the 1983 deferred compensation plans, only the executive would have the right to terminate the policy. First Virginia's Board of Directors approved in 1992 the establishment of a trust with Chemical Bank as the trustee to partially secure the benefits of some of First Virginia's nonqualified compensation plans, including the Deferred Compensation Plans and the First Virginia Supplemental Benefits Plan, in case of a change in control. Under the trust agreement establishing the trust, if a "change in control" takes place, the trustee would pay the benefits under the covered compensation plans out of the trust assets that have been contributed to the trust by First Virginia if First Virginia refused to pay the benefits. The trust is considered a "grantor trust" subject to the claims of First Virginia's general creditors. For accounting purposes, the trust assets are considered corporate assets and, therefore, there will be no balance sheet impact to First Virginia from the establishment of the trust. The trust agreement does not include a provision which would accelerate the vesting or payment of any of the benefits under the covered compensation plans in case of a change in control. During 1993, First Virginia contributed approximately $1,464,000 to the Trust. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The current members of First Virginia's Management Compensation and Benefits Committee are E. Cabell Brand, Edward M. Holland, Eric C. Kendrick, W. Lee Phillips, Jr. and Albert F. Zettlemoyer. Edward M. Holland is the son of Edwin T. Holland, the founder and former Chairman and Chief Executive Officer of First Virginia. As noted above, Edwin T. Holland receives a fee from First Virginia pursuant to a Supplemental Compensation Agreement. Also, as noted above, Edward M. Holland's sister, Virginia H. Brown, receives a benefit pursuant to her former husband's Supplemental Retirement Agreement with First Virginia. Albert F. Zettlemoyer's daughter is an officer of First Virginia Bank. None of the members of the Management Compensation and Benefits Committee served as members of the compensation committees of another entity. No executive officer of First Virginia served as a director of another entity that had an executive officer serving on First Virginia's compensation committee. No executive officer of First Virginia served as a member of the compensation committee of another entity which had an executive officer who served as a director of First Virginia. MANAGEMENT COMPENSATION AND BENEFITS COMMITTEE REPORT CONCERNING FIRST VIRGINIA'S EXECUTIVE COMPENSATION POLICY The Management Compensation and Benefits Committee (the "Committee") of the Board of Directors establishes the policy for the compensation of the executive officers of First Virginia. It is also responsible for administering some of First Virginia's executive compensation programs. The Committee is composed entirely of outside directors who are not eligible, with the exception of the Directors' Deferred Compensation Plans, to participate in the plans over which it has authority. The overall goal of First Virginia's compensation policy is to motivate, reward and retain its key executive officers. The Committee believes this should be accomplished through an appropriate combination of competitive base salaries and both short-term and long-term incentives. The primary components of First Virginia's executive compensation program are base salaries, bonuses, (e.g. short-term compensation), and equity compensation (e.g. long-term compensation). Executive officers also participate in other broad based employee compensation and benefit programs. Base Salary The Committee's policy for determining base salaries is that two primary factors should be considered: (1)the degree of responsibility the executive officer has, and (2)the compensation levels of corresponding positions at other banking companies of comparable size that compete with and serve the same markets as First Virginia. This "Local Peer Group" of companies consists of Central Fidelity Banks, Inc., Crestar Financial Corporation and Signet Banking Corporation based in Virginia, First Maryland Bancorp and Mercantile Bankshares Corporation based in Maryland, and First Tennessee National Corporation and First American Corporation of Tennessee. Base salaries are targeted to be competitive with those in the "Local Peer Group." For 1993 Mr. Zalokar's base salary was $500,000 which was approximately the mid-point of the salaries for CEOs paid to his counterparts in the "Local Peer Group." Short Term Incentives/Bonuses The Committee grants bonuses to the executive officers and CEO based on the extent to which the Corporation achieves or exceeds annual performance objectives. The Committee may award bonuses to the CEO and to the executive officers if First Virginia achieves a return on total average assets (ROA) of at least 1% (the same basis for determining payments of profit sharing to all employees). ROA is generally considered the most important single factor in measuring the performance of a banking company and achievement of a 1% ROA is generally considered the mark of a good performing banking company. Bonus awards are based on the following: (a)Up to 50% of the executive's salary may be awarded if First Virginia achieves a return on average assets ("ROA") equivalent to 80% or more of its target amount for the year. For the chief executive officer, First Virginia would also have to achieve 80% of targeted amounts for return on total stockholders' equity ("ROE"), asset quality (as determined by the ratios of nonperforming assets to total loans ["NPA ratio"] and net loan charge-offs ["CO ratio"]) and capital strength (based on the average equity to asset ratio ["Equity/asset ratio"] and the Tier I risk based capital ratio); and (b)Up to 30% depending upon the degree to which First Virginia's earnings, asset quality and capital ratios exceed the average for the other major banking companies based in the Southeast, (the "Southeastern Regional Peer Group,") as compiled by Keefe, Bruyette and Woods, the New York securities firm which specializes exclusively in the banking and thrift industry; and (c)Up to 20% may be awarded at the discretion of the Committee based on an individual executive's performance. Listed below are the annualized ratios for First Virginia and the Southeastern Regional Peer Group based on results for the first nine months of 1993, the latest data available to the Committee at the time the incentive awards were considered. First Virginia KBW Southeastern Profit Plan Actual Regional Peer Group Earnings ROA 1.44% 1.70% 1.22% ROE 15.89 18.09 15.68 Asset Quality NPA Ratio 1.00 .72 1.72 CO Ratio .38 .13 .28 Capital Strength Equity/Asset Ratio 8.5 9.57 7.94 Tier I Risk Based Capital Ratio 12.5 16.18 11.18 Based on these results the Committee awarded Mr. Zalokar a bonus of $280,000. Long Term Compensation/Stock Options The Committee believes that the granting of stock options is the most appropriate form of long-term compensation for executives and that such awards of equity encourage the executive to achieve a significant ownership stake in First Virginia's success. Equity compensation awards are only made if First Virginia exceeds the weighted average of the returns reported by the major competitors in its banking markets (Central Fidelity, Signet, Crestar, Mercantile Bancshares, First Tennessee and First American of Tennessee). The performance ratios are weighted as follows: ROA 35%, ROE 25%, five year cumulative total return to shareholder ("Five Year Return") 15%, Nonperforming Asset Ratio 15% and Charge- off Ratio 10%. The following table shows the performance ratios of First Virginia and average for its major market area competitors of comparable size for the first nine months of 1993, the latest data available to the Committee at the time incentive awards were considered. Market Area First Virginia Major Competitors ROA 1.70% 1.33% ROE 18.09 16.56 Five Year Return 296.80 230.19 NPA Ratio .72 2.20 CO Ratio .13 .81 As of September 30, 1993 (the latest date information is available for the peer group), the weighted average of these performance factors for First Virginia was 199.5% of the peer group. Except in the case of executive officers who are close to retirement, awards vest and are exercisable over a five-year period in equal annual installments beginning one year from the date of grant. However, each installment can only be exercised if the performance goals for that year are met; otherwise, that portion of the option lapses. For 1993, the Committee awarded stock options to various executive officers because First Virginia did meet the performance criteria mentioned above. Mr. Zalokar did not receive any of the stock option awards. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND --------------------------------------------------- MANAGEMENT ---------- No person is known by management of the Corporation to own beneficially, directly or indirectly, more than five percent of any class of the Corporation's voting securities. The number of shares of the Corporation's voting securities beneficially owned by each of the Corporation's directors and by all of its directors and officers as a group is shown in Part III, item 10, on pages 69 through 72 of this report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- During the past year, certain of the directors and officers of First Virginia and their associates had loans outstanding from First Virginia's banking subsidiaries. Each of these loans was made in the ordinary course of the lending bank's business. In some cases, where officers of First Virginia or its subsidiaries had to be relocated, residential mortgage loans were made by First Virginia at favorable interest rates. All other loans have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and did not involve more than the normal risk of collectibility, or present other unfavorable features. As of December 31, 1993, the aggregate amount of loans outstanding to all directors and executive officers of First Virginia and associates and members of their immediate families was approximately $10,908,000. First Virginia Bank and First Virginia Card Services, Inc. extend VISA and MasterCard privileges to directors, officers and employees of First Virginia and its subsidiaries. Except as noted below, interest is charged on VISA and MasterCard credit balances of employees and officers at a rate of 1% per month on sales transactions. Directors and executive officers of First Virginia and its subsidiaries are subject to generally prevailing rates. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K --------------------------------------------------------------- FINANCIAL STATEMENTS: The following consolidated financial statements and report of independent auditors of the Corporation and its subsidiaries are in Part I, item 8 on the following pages: Page Consolidated Balance Sheets - December 31, 1993 and 1992 42/43 Consolidated Statements of Income - Three Years Ended December 31, 1993 44/45 Consolidated Statements of Stockholders' Equity - Three Years Ended December 31, 1993 46 Consolidated Statements of Cash Flows - Three Years Ended December 31, 1993 47/48 Notes to Consolidated Financial Statements 49/66 Report of Independent Auditors 68 EXHIBITS: The following exhibits are filed as a part of this report: (3) Restated Articles of Incorporation and Bylaws. (4) Instruments defining the rights of holders of the Corporation's long-term debt are not filed herein because the total amount of securities authorized thereunder does not exceed 10% of consolidated total assets. The Corporation hereby agrees to furnish a copy of such instruments to the Commission upon its request. (10) Management contracts for Messrs. Ralph A. Beeton, Paul H. Geithner, Jr., Edwin T. Holland, Thomas K. Malone, Jr., and Robert H. Zalokar are incorporated by reference to Exhibit 10 of the 1992 Annual Report on Form 10-K. Also incorporated from that exhibit are: (1) Key employee salary reduction deferred compensation plans and Directors' deferred compensation plans for 1983 and 1986 and (2) A compensatory plan known as the Split-Dollar Life Insurance Plan. (3) There are also four plans relating to options and rights. The 1982 Stock Appreciation Rights Plan is incorporated by reference to Registration Statement Number 33-6759 on Form S-8 dated Juns 25, 1986. The 1982 Incentive Stock Option Plan is incorporated by reference to Post- effective Amendment Number 2 to Registration Statement Number 2-77151 on Form S-8 dated October 30, 1987. The 1986 Incentive Stock Option Plan, Nongualified Stock Option Plan and Stock Appreciation Rights Plan is incorporated by reference to Registration Statement Number 33-17358 on Form S-8 dated September 28, 1987. The 1991 Incentive Stock Option Plan, Nonqualified Stock Option Plan and Stock Appreciation Rights Plan is incorporated by reference to Registration Statement Number 33-54802 on Form S-8 dated November 20, 1992. (11) Statement RE: Computation of Per Share Earnings. (13) First Virginia Banks, Inc. 1993 Annual Report to its Stockholders. (Not included in the electronic filing) (22) Subsidiaries of the Registrant. (24) Consent of Independent Auditors. FINANCIAL STATEMENT SCHEDULES: 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. REPORTS ON FORM 8-K: No reports on form 8-K were required to be 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 as of March 23, 1993 on its behalf by the undersigned, thereunto duly authorized. FIRST VIRGINIA BANKS, INC. /s/ Robert H. Zalokar ___________________________________ Robert H. Zalokar, Chairman and Chief Executive Officer /s/ Richard F. Bowman ___________________________________ Richard F. Bowman, Vice President and Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons as of March 23, 1994 on behalf of the registrant and in the capacities indicated. SIGNATURE TITLE --------- ----- /s/ Robert H. Zalokar ____________________________ Chairman, Chief Robert H. Zalokar Executive Officer and Director /s/ Richard F. Bowman ____________________________ Principal Financial Richard F. Bowman and Accounting Officer /s/ E. Cabell Brand ____________________________ Director E. Cabell Brand /s/ Edward L. Breeden ____________________________ Director Edward L. Breeden, III ____________________________ Director Paul H. Geithner, Jr. /s/ L. H. Ginn ____________________________ Director L. H. Ginn, III SIGNATURE TITLE --------- ----- /s/ Gilbert R. Giordano ____________________________ Director Gilbert R. Giordano /s/ T. Keister Greer ____________________________ Director T. Keister Greer /s/ Elsie C. Gruver ____________________________ Director Elsie C. Gruver /s/ Edward M. Holland ____________________________ Director Edward M. Holland /s/ Eric C. Kendrick ____________________________ Director Eric C. Kendrick /s/ Thomas K. Malone, Jr. ____________________________ Director Thomas K. Malone, Jr. /s/ W. Lee Phillips, Jr. ____________________________ Director W. Lee Phillips, Jr. /s/ Josiah P. Rowe ____________________________ Director Josiah P. Rowe, III /s/ Richard T. Selden ____________________________ Director Richard T. Selden /s/ Albert F. Zettlemoyer ____________________________ Director Albert F. Zettlemoyer ANNUAL REPORT ON FORM 10-K For the Year Ended December 31, 1993 ITEM 14 EXHIBITS The Exhibits filed with this annual report are included herein. FIRST VIRGINIA BANKS, INC. 6400 Arlington Boulevard Falls Church, Virginia 22042-2336 Exhibit 3 FIRST VIRGINIA BANKS, INC. ARTICLES OF INCORPORATION ARTICLE I. The name of the Corporation is First Virginia Banks, Inc. ARTICLE II. The purpose of the Corporation is to acquire, own, manage and dispose of the capital stock and other securities of banks and other corporations and to render to such banks and corporations, and to others, such advice and services as may be permitted by law. In addition, the Corporation shall have the power to transact any business not prohibited by law or required to be stated in these Articles of Incorporation. ARTICLE III. The Corporation shall have the authority to issue 60,000,000 shares of Common Stock, $1.00 par value, and 3,000,000 shares of Preferred Stock, $10.00 par value. A. Voting of Shares. Except as otherwise made mandatory by law, there shall be no class voting, and each outstanding share regardless of class (whether Common or Preferred), shall entitle the holder thereof to one vote on each matter submitted to a vote at any meeting of stockholders. B. Preemptive Rights. No holders of any class of stock of this Corporation shall have any preemptive or other preferential right to purchase or subscribe to (i) any shares of any class of stock of the Corporation, whether now or hereafter authorized, (ii) any warrants, rights or options to purchase any such stock, or (iii) any obligations convertible into any such stock or into warrants, rights or options to purchase any such stock. C. Preferred Shares Issuable in Series. Authority is expressly vested in the Board of Directors to divide the Preferred Stock into series and, within the following limitations, to fix and determine the relative rights and preferences of the shares of any series so established, and to provide for the issuance thereof. Each series shall be so designated as to distinguish the shares thereof from the shares of all other series and classes. All shares of the Preferred Stock shall be identical except as to the following relative rights and preferences, as to which there may be variations between different series: 1. The rate of dividend, the time of payment, and the dates from which they shall be cumulative, and the extent of participation rights, if any; 2. The price at and the terms and conditions on which shares may be redeemed; 3. The amount payable upon shares in event of involuntary liquidation; 4. The amount payable upon shares in event of voluntary liquidation; 5. Sinking fund provisions for the redemption or purchase of shares; and 6. The terms and conditions on which shares may be converted, if the shares of any series are issued with the privilege of conversion. Prior to the issuance of any shares of a series of Preferred Stock, the Board of Directors shall establish such series by adopting a resolution setting forth the designation and number of shares of the series and the relative rights and preferences thereof, to the extent permitted by the provisions hereof, and the Corporation shall file in the office of the State Corporation Commission of Virginia articles of serial designation as required by law, and the Commission shall have issued a certificate of serial designation. D. Common Characteristics of All Series of Preferred Stock. Each and every series of Preferred Stock, now existing or hereafter issued, shall have the following common characteristics: 1. It shall rank on a parity and be of equal dignity as to dividends and assets with all other series according to the respective dividend rates and amounts distributable upon any voluntary or involuntary liquidation of the Corporation fixed for each such series and without preference or priority of any series over any other series. 2. It shall have no other dividend rights than those set forth in the provisions pertaining to dividends for such series contained herein or in any articles of serial designation. 3. If at any time less than all of a series then outstanding shall be called for redemption, the shares to be redeemed shall be selected by lot in such manner as may be determined by the Board of Directors. 4. All shares of a series redeemed or repurchased by the Corporation shall be canceled in the manner provided by law and shall become authorized and unissued shares undesignated as to series. 5. On or at any time before the date fixed for redemption of any Preferred Stock which has been issued, the Corporation shall deposit in trust, for the account of the holders of the shares to be redeemed, funds necessary for such redemption with a bank or trust company in good standing doing business in the State of Virginia, and having capital, surplus and undivided profits aggregating at least $5,000,000, designated or to be designated in such notice of redemption. Upon the making of such deposit, then all shares with respect to the redemption shall, whether or not the certificates therefor shall have been surrendered for cancellation, be deemed no longer to be outstanding for any purpose, and all rights with respect to such shares shall thereupon cease and terminate, except the right of the holders of the certificates for such shares to receive, out of the funds so deposited in trust, from and after the date of such deposit, the amount payable upon the redemption thereof, and except for such right, if any, to convert such shares in the manner prescribed for the series of which it is a part. At the expiration of three years after the redemption date, any such moneys then remaining on deposit with such bank or trust company shall be paid over to the Corporation, free of trust, and thereafter the holders of the certificates for such shares shall have no claims against such bank or trust company, but only claims as unsecured creditors against the Corporation, or against the Commonwealth of Virginia in the event of escheat by law, for amounts equal to their pro rata shares of the money so paid over. ARTICLE IV. The Corporation may, with the approval of a majority of the entire Board of Directors, establish, adopt, alter, amend or repeal pension plans, pension trust, profit-sharing plans, stock-option plans, stock- purchase plans and other incentive, bonus or deferred compensation plans, for the officers or employees of the Corporation or its subsidiaries, including employees who are directors of the Corporation or any subsidiary. ARTICLE V. A. The number of directors of the Corporation, not less than 3 and not more than 30, shall be fixed by the Bylaws and in the absence of a Bylaw fixing the number, shall be sixteen. Upon the adoption of this Paragraph A, of Article V, the directors shall be divided into three classes (A, B and C), as nearly equal in number as possible. The initial term of office for members of Class A shall expire at the annual meeting of stockholders in 1985; the initial term of office for members of Class B shall expire at the annual meeting of stockholders in 1986; and the initial term of office for members of Class C shall expire at the annual meeting of stockholders in 1987. At each annual meeting of stockholders following such initial classification and election, directors elected to succeed those directors whose terms expire shall be elected for a term of office to expire at the third succeeding annual meeting of stockholders after their election, and shall continue to hold office until their respective successors are elected and qualified. In the event of any increase in the number of directors fixed in the Bylaws, the additional directors shall be so classified that all classes of directors have as nearly equal numbers of directors as may be possible. In the event of any decrease in the number of directors of the Corporation, all classes of directors shall be decreased equally as nearly as may be possible. B. Subject to the rights of the holders of any series of Preferred Stock then outstanding, newly created directorships resulting from an increase by not more than two in the authorized number of directors or any vacancies in the Board of Directors resulting from death, resignation, retirement, disqualification, removal from office or other cause shall be filled by the affirmative vote of a majority of the directors then in office, whether or not a quorum. Each director so chosen shall hold office until the expiration of the term of the director, if any, whom he has been chosen to succeed, or if none, until the expiration of the term of the class assigned to the additional directorship to which he has been elected, or until his earlier death, resignation or removal. No decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director. Subject to the rights of the holders of any series of Preferred Stock then outstanding, any director or the entire Board of Directors may be removed from office at any time, but only the affirmative vote of the holders of at least four-fifths (80%) of the stock entitled to vote generally in the election of directors at a meeting called for that purpose. C. The affirmative vote of the holders of not less than four-fifths (80%) of the stock entitled to vote generally in the election of directors shall be required to amend, or repeal this Article V or adopt any provision inconsistent with this Article V, or to adopt a Bylaw to fix the number of directors. ARTICLE VI. INDEMNIFICATION AND ELIMINATION OF LIABILITY OF DIRECTORS, ADVISORY DIRECTORS AND OFFICERS A. The Corporation shall indemnify a person who is or was made a party to any proceeding, or is threatened to be made a party to any proceeding, including a proceeding by or in the right of the Corporation, because the person is or was a director, advisory director, or officer of the Corporation or because, while a director, advisory director, or officer of the Corporation, the person is or was serving any other legal entity in any capacity at the request of the Corporation against all liabilities, fines, penalties, and claims imposed upon or asserted against the person(including amounts paid in settlement) and reasonable expenses incurred in the proceeding (including counsel fees), except such liabilities and expenses as are incurred because of the person's willful misconduct or knowing violation of the criminal law. The right to indemnify under this paragraph shall inure to the benefit of heirs, executors and administrators of such a person. The Corporation may, upon majority vote of a quorum of disinterested directors, contract in advance to indemnify and advance the expenses of any director, advisory director, or officer. B. Unless a determination has been made that indemnification is not permissible, the Corporation shall make advances and reimbursements for expenses incurred by a director, advisory director, or officer in a proceeding upon receipt of an undertaking from the director, advisory director, or officer to repay the same if it is ultimately determined that the director, advisory director, or officer is not entitled to indemnification. Such undertaking shall be an unlimited unsecured general obligation of the director, advisory director, or officer and shall be accepted without reference to his ability to make repayment. C. The Corporation may, to a lesser extent or to the same extent that the Corporation is required to provide indemnification and make advances and reimbursements for expenses to its present or former directors, advisory directors, and officers, provide indemnification and make advances and reimbursements for expenses to its present or former employees and agents, the directors, advisory directors, officers, employees and agents of its affiliates, subsidiaries and predecessor entities, and any person serving in any other legal entity in any capacity at the request of the Corporation, and may contract in advance to do so. The determination that indemnification under this paragraph is permissible, the authorization of such indemnification and the evaluation as to the reasonableness of expenses in a specific case shall be made as authorized from time to time by general or specific action of the Board of Directors, which action may be taken before or after a claim for indemnification is made, or as otherwise provided by law. D. In any proceeding brought by a shareholder in the right of the Corporation or brought by or on behalf of shareholders of the Corporation, no damages may be assessed against a director, advisory director or officer of the Corporation arising out of a single transaction, occurrence or course of conduct, provided that this elimination of liability shall not be applicable if the director, advisory director or officer engaged in willful misconduct or knowing violation of the criminal law or of any federal or state securities law. E. The provisions of this Article shall be applicable from and after its adoption, even though some or all of the underlying conduct or events relating to the proceeding with respect to which indemnity is claimed may have occurred before such adoption. No amendment, modification or repeal of this Article shall diminish the rights provided hereunder to any person arising from conduct or events occurring before the adoption of such amendment, modification or repeal. F. The Corporation may purchase and maintain insurance to indemnify it against the whole or any portion of the liability assumed by it in accordance with this Article and may also procure insurance on behalf of any person who is or was a director, advisory director, officer, employee or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another Corporation, partnership, joint venture, trust, employee benefit plan or other enterprise, against any liability or expenses incurred by such person in any such capacity or arising from the person's status as such, whether or not the Corporation would have the power to indemnify the person against such liability under the provisions of this Article. ARTICLE VII. SERIAL DESIGNATIONS The first series of Preferred Stock, consisting of 522,500 shares, is designated as "Series A Preferred Stock." Said series, in addition to the common characteristics described in section D of ARTICLE III, is issued subject to the following terms and conditions: DIVIDENDS: The holders of the Series A Preferred Stock shall be entitled to receive, when and as declared by the Board of Directors, yearly dividends at the rate of 5% per annum, payable quarterly on such dates as the Board of Directors shall determine, together with proper adjustment for any dividend period which is less than a full quarter. Such dividends shall be paid before any dividends are paid upon, or set apart for, the Common Stock of the Corporation and shall be cumulative from the date of issuance so that if for any quarterly dividend period dividends at the rate of 5% per annum shall not have been paid upon or set apart for the Series A Preferred Stock, the deficiency, with interest thereon at the rate of six percent (6%) per annum on such dividends as are in arrears, shall be fully paid or set apart for payment before any dividends shall be paid upon, or set apart for, the Common Stock. REDEMPTION: The Corporation shall have no right to redeem the Series A Preferred Stock until five years after the date on which it is issued. Thereafter, all or any part thereof may be redeemed at any time at the option of the Board of Directors upon not less than forty-five nor more than ninety days written notice of the date fixed for redemption given to the holders thereof in the manner in which notices of stockholders' meetings are required to be given by law. The redemption price at any time during the sixth year after such stock is issued shall be $10.50 per share. Thereafter during the seventh and each subsequent full year after such stock is issued the redemption price shall be reduced by 5 cents per share per year until the beginning of the sixteenth full year after it is issued, after which time it may be redeemed for $10 per share. In addition the redemption price shall include all unpaid accrued dividends, with interest thereon at the rate of six percent (6%) per annum on such dividends as are in arrears, to the date fixed for redemption. LIQUIDATION: 1. In the event of the voluntary dissolution of the Corporation and the distribution of its assets to its stockholders, if there is no other series of Preferred Stock issued or outstanding, then the holders of the Series A Preferred Stock shall be entitled to receive the then redemption price for their shares plus all unpaid accrued dividends, with interest thereon at the rate of six percent (6%) per annum on such dividends as are in arrears, to the date of payment before any amount shall be paid to the holders of the Common Stock. 2. In the event of the voluntary dissolution of the Corporation and the distribution of its assets to its stockholders, if there are other series of Preferred Stock issued and outstanding, then the holders of the Preferred Stock of all series shall be preferred as to both dividends and assets over the holders of the Common Stock. In such event the holders of the Series A Preferred Stock shall be entitled to receive the then redemption price for their shares plus all unpaid accrued dividends, with interest thereon at the rate of six percent (6%) per annum on such dividends as are in arrears, to the date of payment before any amount shall be paid to the holders of the Common Stock. If, for any reason, there are insufficient assets to pay these amounts to the holders of the Series A Preferred Stock and to pay the holders of other series of preferred stock the amounts to which they are also entitled, then the holders of the Series A Preferred Stock and of such other preferred stock, as stated aforesaid, shall be paid ratably in proportion to the amounts to which they are respectively entitled. 3. The provisions hereinabove set forth with regard to a voluntary dissolution of the Corporation shall also be applicable to an involuntary dissolution except that the holders of Preferred Stock shall only be entitled to receive, in addition to dividends and interest, if any, the par value of their shares in lieu of the then redemption price. CONVERSION: 1. At the election of the holder, shares of Series A Preferred Stock may be converted into shares of the Common Stock ($1 par value) of the Corporation at any time at the following listed Basic Conversion Rates, or at such Adjusted Conversion Rates as may hereafter be determined by application of the formulae set forth in paragraph 8, subject to the following listed terms and conditions: a. Until and including March 31, 1977 (herein called the first conversion period) the Basic Conversion Rate shall be 1.40 shares of Common Stock for one share of Series A Preferred Stock; b. Thereafter, until and including March 31, 1982 (herein called the second conversion period) the Basic Conversion Rate shall be 1.20 shares of Common Stock for one share of Series A Preferred Stock; c. Thereafter for as long as any Series A Preferred Stock shall remain outstanding (herein called the third conversion period) the Basic Conversion Rate shall be one share of Common Stock for one share of Series A Preferred Stock. 2. Any holder of shares of Series A Preferred Stock desiring to convert the same shall, during regular business hours, deliver the certificate(s) therefor, properly endorsed, to any transfer agent therefor or to any transfer agent for the Common Stock of the Corporation, or to the Corporation, if there be no such transfer agent, together with a notice in writing of his election to convert the same, and shall receive, in exchange therefor a certificate or certificates for shares of Common Stock in accordance with the conversion rate prevailing with respect to shares of Series A Preferred Stock upon the day of delivery of such notice accompanied by such certificate(s) for the shares of Series A Preferred Stock to be converted. All shares of Series A Preferred Stock surrendered for conversion during any day shall be deemed to have been surrendered together as of the close of business on such day in order that a single conversion rate as to all of such shares shall be determined after giving effect to any transactions affecting the conversion rate during or prior to such day. 3. The right of conversion shall expire as to any shares of Series A Preferred Stock which shall be called for redemption unless, on or before the day and hour for the expiration of the right of conversion specified in the notice of redemption, the certificate(s) representing such shares together with the notice hereinabove provided for shall have been delivered as provided in the foregoing paragraph 2. In case of voluntary or involuntary dissolution of the Corporation all conversion rights applicable to shares of Series A Preferred Stock shall terminate at 2 P.M. Eastern Standard Time, on the sixtieth day next following the date on which such dissolution shall have been authorized by the stockholders of the Corporation, or otherwise ordered, and in case of such dissolution, the Corporation shall notify the holders of the Series A Preferred Stock in the same manner that it is required to give notice of a redemption of such stock that the conversion rights of the shares of Series A Preferred Stock will terminate, which notice shall specify the date of such termination and the conversion rate then in effect applicable to the shares of Series A Preferred Stock. 4. As to any shares of Series A Preferred Stock converted or any shares of Common Stock issuable on conversion no dividends shall be deemed to have accrued at the time of conversion and the holders thereof shall only receive such dividends as they are entitled to receive as holders of record on the dates dividends are declared. 5. The Corporation shall not be required to issue any fraction of a share upon conversion of any share or shares of Series A Preferred Stock. If more than one share of Series A Preferred Stock shall be surrendered for conversion at one time by the same holder, the number of full shares of Common Stock issuable upon conversion thereof shall be computed on the basis of the total number of shares of Series A Preferred Stock so surrendered. If any fractional interest in a share of Common Stock would be deliverable upon conversion, the Corporation shall make an adjustment therefor in cash unless its Board of Directors shall have determined to adjust fractional interests by issuance of scrip certificates or in some other manner. Adjustment in cash shall be made on the basis of the Current Market Value of one share of Common Stock as that term is defined in paragraph 8C below. 6. If the holder of any shares of Series A Preferred Stock so surrendered for conversion shall request that the stock certificate(s) representing the Common Stock issuable upon such conversion be issued in the name of a person or names of persons other than the holder of record thereof, such holder shall pay all stock transfer taxes that may be payable in respect thereof. The Corporation shall pay all original issue taxes imposed, if any, in respect of the issuance of Common Stock upon conversion of shares of Series A Preferred Stock in order that such shares may be issued in the name or names of the respective holder or holders of record of the shares of Series A Preferred Stock so surrendered for conversion. 7. No adjustment shall be made in the Basic Conversion Rates, hereinabove specified, or in any Adjusted Conversion rate which may be in effect at any time if the Corporation shall (i) issue or sell any shares of its Common Stock or securities convertible into Common Stock to the public for cash or to the public or others in consideration for the acquisition by the Corporation or any of its subsidiaries of all or a portion of the stock or assets of any corporation, partnership, or proprietorship, for the business purposes of the Corporation, or (ii) issue or sell any rights to purchase shares of its Common Stock to the then holders of its Common Stock if, at the same time, similar rights are offered to the then holders of the Series A Preferred Stock in such a manner that each of them receives the same rights to purchase shares of Common Stock that he would have received if he had converted his shares of Series A Preferred Stock into Common Stock immediately prior to the time such rights were issued, or (iii) issue or sell any shares of its Common Stock to the holders of the warrants outstanding on March 24, 1967, which warrants provided for the sale and purchase of 350,000 shares of Common Stock, or (iv) issue any shares of its Common Stock to the holders of the options outstanding on March 24, 1967, which options provided for the sale and purchase of 46,500 shares of Common Stock, or (v) issue any shares of its Common Stock pursuant to its Incentive Bonus Plan initially approved by the stockholders on April 28, 1966, or (vi) issue any shares of its Common Stock upon the exercise of rights, warrants or options, the execution of stock purchase contracts, or the conversion of convertible securities if, at the time such rights, warrants or options were issued, such stock purchase contracts entered into, or such convertible securities were issued the conversion rates then in effect were adjusted, in the manner hereinafter described in paragraph 8 or if, at that time, no adjustments in conversion rates were required by the provisions of paragraph 8. 8. Except as is provided in paragraph 7 above the conversion rates in effect from time to time shall be subject to adjustments, made to the nearest one-hundredth share of Common Stock, as follows: A. If the Corporation shall pay any dividend or make any other distribution in shares of Common Stock or in securities convertible into Common Stock the conversion rate for each conversion period in effect immediately prior to such action shall be proportionately increased so that the holders of the Series A Preferred Stock shall be able to convert their shares of Series A Preferred Stock into a number of shares of Common Stock equal to the same percentage of the shares of Common Stock outstanding immediately after the payment of such dividend or the making of such distribution into which they could have converted their shares of Series A Preferred Stock immediately prior to the payment of such dividend or the making of such distribution. For purpose of determining the number of shares of Common Stock outstanding both before and after the payment of such dividend or the making of such distribution all rights (which term as hereinafter used in the description of the Series A Preferred Stock shall be deemed to mean rights, warrants or options) and contracts (which term as hereinafter used in the description of the Series A Preferred Stock shall be deemed to mean contracts or agreements of any kind) then outstanding for the purchase of shares of Common Stock and all of the then outstanding securities issued by the Corporation which are convertible into shares of Common Stock shall be deemed to have been exercised or converted in the manner which they could have been exercised or converted immediately prior to the paying of such dividend or the making of such distribution or, if any of them could not have been exercised or converted on that date in accordance with their terms, then such rights, contracts and convertible securities shall be deemed to have been exercised or converted in the manner which they could be exercised or converted on the date upon which they first become exercisable or convertible. B. If the Corporation shall split the outstanding shares of its Common Stock into a greater number of shares or combine its outstanding shares of Common Stock into a smaller number of shares the conversion rates for each conversion period in effect immediately prior to such action shall be proportionately increased, in the case of a split, or decreased, in case of a combination, so that the holders of the Series A Preferred Stock shall be able to convert their shares of Series A Preferred Stock into a number of shares of Common Stock equal to the same percentage of the shares of Common Stock outstanding immediately after the completion of such action into which they could have converted their shares of Series A Preferred Stock immediately prior to the taking of such action. For the purpose of determining the number of the shares of Common Stock outstanding both before and after the taking of such action all rights, contracts, and convertible securities then outstanding for the purchase of shares of Common Stock shall be deemed to have been exercised or converted in the manner which they could have been exercised or converted immediately prior to such split or combination or, if any of them could not have been exercised or converted on that date in accordance with their terms, then such rights, contracts and convertible securities shall be deemed to have been exercised or converted in the manner which they could be exercised or converted on the date upon which they first become exercisable or convertible. C. If the Corporation shall issue any rights or enter into any contracts for the purchase of shares of its Common Stock, whether or not said rights or contracts can be exercised or executed immediately, at a price (including the consideration received for such rights or contracts) which is less than ninety-five percent of the Current Market Value (as defined below in this paragraph) of the Common Stock of the Corporation on the date such rights are issued or such contracts are entered into, the conversion rates for each conversion period in effect immediately prior to such date shall be increased to an amount determined by multiplying such conversion rates by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to the date such rights are issued or such contracts entered into plus the number of additional shares of Common Stock offered for sale pursuant to such rights or contracts and the denominator of which shall be the number of shares of Common Stock of the Corporation outstanding immediately prior to such date plus the number of shares of Common Stock of the Corporation which the aggregate subscription or purchase price (including the consideration received for such rights or contracts) of the total number of shares offered pursuant to said rights or contracts would purchase at the Current Market Value of the Common Stock of the Corporation at such date. For the purpose of determining the number of shares of Common Stock of the Corporation outstanding immediately prior to the issue of such rights or the making of such contracts all outstanding rights and contracts for the purchase of shares of Common Stock and all securities issued by the Corporation which are convertible into shares of Common Stock shall be deemed to have been exercised or converted in the manner which they could have been exercised or converted immediately prior to the issuing of such rights or the making of such contracts or, if any then outstanding rights or contracts or any then outstanding convertible securities could not have been exercised or converted on that date in accordance with their terms, then such outstanding rights, contracts and convertible securities shall be deemed to have been exercised or converted in the manner which they could be exercised or converted on the date upon which they first become exercisable or convertible. As used in this paragraph the term Current Market Value at the date of issue of such rights or making of such contracts shall mean the last reported sales price per share of the Common Stock of the Corporation on the American Stock Exchange or the New York Stock Exchange on such date, if the shares are listed on either of said exchanges, or the mean of the low bid and high asked price in the over-the-counter market on such day if such shares are not listed on either of said exchanges. D. If the Corporation shall issue any rights or enter into any contracts for the purchase of any security convertible into shares of its Common Stock, whether or not said rights or contracts can be exercised or executed immediately, and, on the date such rights are issued or such contracts are made the price per share of each share of Common Stock of the Corporation into which such security is initially convertible (including the consideration received for such rights or contracts) is less than ninety- five per cent of the Current Market Value of the Common Stock of the Corporation, as defined in paragraph C above, then the conversion rates for each conversion period in effect immediately prior to the issue of such rights or the making of such contracts shall be increased in the manner hereinabove described in paragraph C in the same manner as if such rights or contracts were rights or contracts to purchase the number of shares of Common Stock represented by such convertible securities on the date they are issued, if they are convertible on the date on which they are issued and, if not, the number of shares of Common Stock represented by such convertible securities on the date when they first become convertible. E. If any rights or contracts to purchase any shares of Common Stock or convertible securities of the Corporation shall be issued in connection with the issue or sale of other securities of the Corporation, such rights or contracts shall be deemed to have been issued or sold without consideration. F. If the Corporation shall consolidate or merge with another corporation, or reclassify its Common Stock (other than by way of subdivision or contraction of outstanding shares of Common Stock) each share of Series A Preferred Stock shall thereafter be convertible into the number of shares of stock or other securities or property of the Corporation or of the corporation resulting from such consolidation, merger, or reclassification, to which the Common Stock of the Corporation, deliverable upon conversion of shares of Series A Preferred Stock, would have been entitled, upon such consolidation, merger or reclassification had the holder of such share of Series A Preferred Stock exercised his right of conversion in the manner in which it could have been exercised on the date of such consolidation, merger or reclassification or, if it could not have been converted on that date, then in the manner in which it could have first been exercised thereafter, and such shares of Common Stock been issued and outstanding, and had such holder been the holder of record of such Common Stock at the time thereof, and lawful provision therefor shall be made as part of any such consolidation, merger or reclassification. G. If (i) The Corporation shall declare any dividend payable otherwise than in cash upon its Common Stock to the holders of its Common Stock, or (ii) The Corporation shall offer only to the holders of its Common Stock any additional shares of stock of any class of the Corporation or any right to subscribe thereto, or (iii) Any capital reorganization, or reclassification of the capital stock of the Corporation, or consolidation or merger of the Corporation with another corporation, or sale of all or substantially all of the assets of the Corporation shall be proposed, then, in any one or more of said events, the Corporation shall notify the holders of the Series A Preferred Stock in the same manner that it is required to give notice of the redemption of said stock prior to the date on which (a) the books of the Corporation shall close, or a record be taken for such stock dividend or subscription rights, or (b) such reclassification, reorganization, consolidation, merger or sale, shall take place, as the case may be. Such notice shall also state the conversion rate at the time in effect applicable to the shares of Series A Preferred Stock. H. The Corporation shall at all times reserve and keep available out of its authorized and unissued Common Stock, solely for the purpose of effecting the conversion of shares of Series A Preferred Stock, such number of shares of Common Stock as, from time to time, shall be sufficient to effect the conversion of all shares of Series A Preferred Stock from time to time outstanding. The Corporation, from time to time, shall in accordance with the laws of the Commonwealth of Virginia, increase the authorized amount of its Common Stock if at any time the number of shares of Common Stock remaining unissued shall not be sufficient to permit the conversion of all shares of Series A Preferred Stock then outstanding. I. The exercise of the conversion privilege shall be subject to such regulations not inconsistent with the provisions of this paragraph 8 as may at any time or from time to time be adopted by resolution of the Board of Directors, and any resolution so adopted may, at any time or from time to time, be amended or repealed. MISCELLANEOUS: 1. There shall be no sinking fund provided for the redemption of shares of Series A Preferred Stock. 2. The Corporation may not redeem any shares of its Common Stock so long as any dividends on its Series A Preferred Stock are in arrears. ARTICLE VIII. The second series of Preferred Stock, consisting of 84,000 shares, is designated as "Second Series A Preferred Stock." Said series, in addition to the common characteristics described in Section D of ARTICLE III, is issued subject to the following terms and conditions (whenever the words "Identical to ARTICLE VII" appear next to a subject heading or paragraph(s) thereof, they shall be taken to mean (i) that the entire contents of the particular heading or paragraph(s) thereof, as the case may be, are identical to the corresponding provisions pertaining to "Series A Preferred Stock" set forth in ARTICLE VII hereof, except that each reference therein to "Series A Preferred Stock" is changed to "Second Series A Preferred Stock," and (ii) that such corresponding provisions of ARTICLE VII, with each reference therein to "Series A Preferred Stock" changed to "Second Series A Preferred Stock," are incorporated herein verbatim by reference): DIVIDENDS: All provisions are Identical to ARTICLE VII. REDEMPTION: All provisions are Identical to ARTICLE VII. LIQUIDATION: All provisions are Identical to ARTICLE VII. CONVERSION: Paragraphs 1, 2, 3, 4, 5 and 6 pertaining to CONVERSION are Identical to ARTICLE VII. 7. No adjustment shall be made in the Basic Conversion Rates, hereinabove specified, or in any Adjusted Conversion Rate which may be in effect at any time if the Corporation shall (i) issue or sell any shares of its Common Stock or securities convertible into Common Stock to the public for cash or to the public or others in consideration for the acquisition by the Corporation or any of its subsidiaries of all or a portion of the stock or assets of any corporation, partnership, or proprietorship, for the business purposes of the Corporation, or (ii) issue or sell any rights to purchase shares of its Common Stock to the then holders of its Common Stock if, at the same time, similar rights are offered to the then holders of the Second Series A Preferred Stock in such a manner that each of them receives the same rights to purchase shares of Common Stock that he would have received if he had converted his shares of Second Series A Preferred Stock into Common Stock immediately prior to the time such rights were issued, or (iii) issue or sell any shares of its Common Stock to the holders of the warrants outstanding on February 16, 1968, which warrants provided for the sale and purchase of 350,000 shares of Common Stock, or (iv) issue any shares of its Common Stock to the holders of the options outstanding on February 16, 1968, which options provided for the sale and purchase of 42,500 shares of Common Stock, or (v) issue any shares of its Common Stock pursuant to its Incentive Bonus Plan initially approved by the stockholders on April 28, 1966, or (vi) issue any shares of its Common Stock upon the exercise of rights, warrants or options, the execution of stock purchase contracts, or the conversion of convertible securities if, at the time such rights, warrants or options were issued, such stock purchase contracts entered into, or such convertible securities were issued the conversion rates then in effect were adjusted, in the manner hereinafter described in paragraph 8 or if, at that time, no adjustments in conversion rates were required by the provisions of paragraph 8. Paragraph 8 and subparagraphs A through I thereunder, inclusive, pertaining to CONVERSION are Identical to ARTICLE VII. MISCELLANEOUS: All provisions are Identical to ARTICLE VII. ARTICLE IX. The third series of Preferred Stock, consisting of 80,000 shares, is designated as "Third Series A Preferred Stock." Said series, in addition to the common characteristics described in section D of ARTICLE III, is issued subject to the following terms and conditions (whenever the words "Identical to ARTICLE VII" appear next to a subject heading or paragraph(s) thereof, they shall be taken to mean (i) that the entire contents of the particular heading or paragraph(s) thereof, as the case may be, are identical to the corresponding provisions pertaining to "Series A Preferred Stock" set forth in ARTICLE VII hereof, except that each reference therein to "Series A Preferred Stock" is changed to "Third Series A Preferred Stock," and (ii) that such corresponding provisions of ARTICLE VII, with each reference therein to "Series A Preferred Stock" changed to "Third Series A Preferred Stock," are incorporated herein verbatim by reference): DIVIDENDS: All provisions are Identical to ARTICLE VII. REDEMPTION: All provisions are Identical to ARTICLE VII. LIQUIDATION: All provisions are Identical to ARTICLE VII. CONVERSION: Paragraphs 1, 2, 3, 4, 5 and 6 pertaining to CONVERSION are identical to ARTICLE VII. 7. No adjustment shall be made in the Basic Conversion Rates, hereinabove specified, or in any Adjusted Conversion Rate which may be in effect at any time if the Corporation shall (i) issue or sell any shares of its Common Stock or securities convertible into Common Stock to the public for cash or to the public or others in consideration for the acquisition by the Corporation or any of its subsidiaries of all or a portion of the stock or assets of any corporation, partnership, or proprietorship, for the business purposes of the Corporation, or (ii) issue or sell any rights to purchase shares of its Common Stock to the then holders of its Common Stock if, at the same time, similar rights are offered to the then holders of the Third Series A Preferred Stock in such a manner that each of them receives the same rights to purchase shares of Common Stock that he would have received if he had converted his shares of Third Series A Preferred Stock into Common Stock immediately prior to the time such rights were issued, or (iii) issue or sell any shares of its Common Stock to the holders of the warrants outstanding on October 2, 1968, which warrants provided for the sale and purchase of 350,000 shares of Common Stock, or (iv) issue any shares of its Common Stock to the holders of the options outstanding on October 2, 1968, which options provided for the sale and purchase of 38,875 shares of Common Stock, or (v) issue any shares of its Common Stock pursuant to its Incentive Bonus Plan initially approved by; the stockholders on April 28, 1966, or (vi) issue any shares of its Common Stock upon the exercise of rights, warrants or options, the execution of stock purchase contracts, or the conversion of convertible securities if, at the time such rights, warrants or options were issued, such stock purchase contracts entered into, or such convertible securities were issued the conversion rates then in effect were adjusted, in the manner hereinafter described in paragraph 8 or if, at that time, no adjustments in conversion rates were required by the provisions of paragraph 8. Paragraph 8 and subparagraphs A through I thereunder, inclusive, pertaining to CONVERSION are identical to ARTICLE VII. MISCELLANEOUS: All provisions are Identical to ARTICLE VII. ARTICLE X. A. Higher Vote for Certain Business Combinations. In addition to any affirmative vote of holders of a class or series of capital stock of the Corporation required by law or these Articles, and except as otherwise expressly provided in Section B of this Article X, a Business Combination (as hereinafter defined) with or upon a proposal by a Related Person (as hereinafter defined) shall require the affirmative vote of the holders of at least eighty percent (80%) of the voting power of the voting stock of the Corporation, voting together as a single class. B. When Higher Vote Is Not Required. The provisions of Section A of this Article X shall not be applicable to a particular Business Combination and such Business Combination shall require only such affirmative vote as is required by law and other provisions of the Articles or the Bylaws of the Corporation, if all of the conditions specified in any one of the following Paragraphs (1), (2) or (3) are met: 1. Approval by Directors. The Business Combination has been approved by a vote of a majority of directors, which includes a majority of all the Continuing Directors (as hereinafter defined); or 2. Combination with Subsidiary. The Business Combination is solely between the Corporation and a subsidiary of the Corporation; or 3. Price Conditions and Procedures. All of the following conditions have been met: a. Such holders shall receive the aggregate amount of (i) cash and (ii) fair market value (as of the date of the consummation of the Business Combination) of consideration other than cash, per share of Common or Preferred in such Business Combination by holders thereof at least equal to the highest per share price (including any brokerage commissions, transfer taxes and soliciting dealers' fees) paid by the Related Person for any shares of such class or series of stock acquired by it; provided, that if the highest preferential amount per share of a series of Preferred Stock to which the holders thereof would be entitled in the event of any voluntary or involuntary liquidation, dissolution or winding-up of the affairs of the Corporation (regardless of whether the Business Combination to be consummated constitutes such an event) is greater than such aggregate amount, holders of such series of Preferred Stock shall receive an amount for each such share at least equal to the highest preferential amount applicable to such series of Preferred Stock. b. The consideration to be received by holders of a particular class or series of outstanding Common or Preferred Stock shall be in cash or in the same form as the Related Person has previously paid for shares of such class or series of stock. If the Related Person has paid for shares of any class or series of stock with varying forms of consideration, the form of consideration given for such class or series of stock in the Business Combination shall be either cash or the form used to acquire the largest number of shares of such class or series of stock previously acquired by it. c. No Extraordinary Event (as hereinafter defined) occurs after the Related Person has become a Related Person and prior to the consummation of the Business Combination. d. A proxy or information statement describing the proposed Business Combination and complying with the requirements of the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (or any subsequent provisions replacing such Act, rules or regulations) is mailed to public stockholders of the Corporation at least 30 days prior to the consummation of such Business Combination (whether or not such proxy or information statement is required pursuant to such Act or subsequent provisions). C. Certain Definitions. For purposes of this Article X: 1. A "person" shall mean any individual, firm, corporation or other entity, or a group of "persons" acting or agreeing to act in the manner set forth in Rule 13d-5 under the Securities Exchange Act of 1934, as in effect on January 1, 1984. 2. The term "Business Combination" shall mean any of the following transactions, when entered into by the Corporation, or a subsidiary of the Corporation, with, or upon a proposal by, a Related Person: a. the merger or consolidation of the Corporation, or any subsidiary of the Corporation; or b. the sale, lease, exchange, mortgage, pledge, transfer or other disposition (in one or a series of transactions) of any assets of the Corporation or any subsidiary of the Corporation having an aggregate fair market value of $5,000,000 or more; or c. the issuance or transfer by the Corporation or any subsidiary of the Corporation (in one or a series of transactions) of securities of the Corporation or that subsidiary having an aggregate fair market value of $5,000,000 or more; or d. the adoption of a plan or proposal for the liquidation or dissolution of the Corporation; or e. the reclassification of securities (including a reverse stock split), recapitalization, consolidation or any other transaction (whether or not involving a Related Person) which has the direct or indirect effect of increasing the voting power, whether or not then exercisable, of a Related Person in any class or series of capital stock of the Corporation or any subsidiary of the Corporation; or f. any agreement, contract or other arrangement providing directly or indirectly for any of the foregoing. 3. The term "Related Person" shall mean any person (other than the Corporation, a subsidiary of the Corporation or any profit sharing, employee stock ownership or other employee benefit plan of the Corporation or a subsidiary of the Corporation or any trustee of or fiduciary with respect to any such plan acting in such capacity) that is the direct or indirect beneficial owner (as defined in Rule 13d-3 and Rule 13d- 5 under the Securities Exchange Act of 1934, as in effect on January 1, 1984) of five percent (5%) or more than five percent (5%) of the outstanding capital stock of the Corporation entitled to vote for the election of directors, and any Affiliate or Associate of any such person. 4. The term "Continuing Director" shall mean any member of the Board of Directors who is not affiliated with a Related Person and who was a member of the Board of Directors immediately prior to the time that the Related Person became a Related Person, and any person who is not affiliated with the Related Person and is recommended to be a Continuing Director by a majority of Continuing Directors who are then members of the Board of Directors. 5. "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 under the Securities Exchange Act of 1934, as in effect on January 1, 1984. 6. The term "Extraordinary Event" shall mean, as to any Business Combination and Related Person, any of the following events that is not approved by a majority of all Continuing Directors: a. any failure to declare and pay at the regular date therefor any full quarterly dividend (whether or not cumulative) on outstanding Preferred Stock; or b. any reduction in the annual rate of dividends paid on the Common Stock (except as necessary to reflect any subdivision of the Common Stock); or c. any failure to increase the annual rate of dividends paid on the Common Stock as necessary to reflect any reclassification (including any reverse stock split), recapitalization, reorganization or any similar transaction that has the effect of reducing the number of outstanding shares of the Common Stock; or d. the receipt by the Related Person, after such Related Person has become a Related Person, of a direct or indirect benefit (except proportionately as a shareholder) from any loans, advances, guarantees, pledges or other financial assistance or any tax credits or other tax advantages provided by the Corporation or any subsidiary of the Corporation, whether in anticipation of or in connection with the Business Combination or otherwise. 7. A majority of the Continuing Directors shall have the power to make all determinations with respect to this Article X, including, without limitation, determining the transactions that are Business Combinations, the persons who are Related Persons, the time at which a Related Person became a Related Person, and the fair market value of any assets, securities or other property, and any such determinations of such Continuing Directors shall be conclusive and binding. D. No Effect on Fiduciary Obligations of Related Persons. Nothing contained in this Article X shall be construed to relieve any Related Person from any fiduciary obligation imposed by law. E. Amendment or Repeal. The affirmative vote of the holders of not less than eighty percent (80%) of the total voting power of the voting stock of the Corporation, voting together as a single class, shall be required in order to amend or repeal this Article X or adopt any provision inconsistent with this Article X. ARTICLE XI. A. The power to adopt, alter, amend or repeal Bylaws shall be vested in the Board of Directors, which may take such action by the vote of a majority of the directors present and voting at a meeting where a quorum is present, provided that if, as of the date such action shall occur, there is a Related Person as defined in this Article XI of the Articles of Incorporation, such majority shall include a majority of the Continuing Directors as defined in this Article XI of the Articles of Incorporation; the stockholders, by the affirmative vote of the holders of not less than four-fifths (80%) of the voting power of all of the then outstanding shares of capital stock of the Corporation entitled to vote generally in the election of directors, may adopt new Bylaws, or alter, amend or repeal Bylaws adopted by either the stockholders or the Board of Directors. In addition, the stockholders may prescribe by the affirmative vote of the holders of not less than four-fifths (80%) of the voting power of all of the then outstanding shares of capital stock of the Corporation entitled to vote generally in the election of directors that any Bylaw made by them shall not be altered, amended or repealed by the Board of Directors. B. This Article shall not be amended, modified or repealed except by the affirmative vote of the holders of not less than four-fifths (80%) of the voting power of all of the then outstanding shares of capital stock of the Corporation then entitled to vote generally in the election of directors. C. Certain Definitions. For purposes of this Article XI: 1. A "person" shall mean any individual, firm, corporation or other entity, or a group of "persons" acting or agreeing to get together in the manner set forth in Rule 13d-5 under the Securities Exchange Act of 1934, as in effect on January 1, 1984. 2. The term "Related Person" shall mean any person (other than the Corporation, a subsidiary of the Corporation or any profit sharing, employee stock ownership or other employee benefit plan of the Corporation or a subsidiary of the Corporation or any trustee of or fiduciary with respect to any such plan acting in such capacity) that is the direct or indirect beneficial owner (as defined in Rule 13d-3 and Rule 13d-5 under the Securities Exchange Act of 1934, as in effect on January 1, 1984) of five percent (5%) or more than five percent (5%) of the outstanding capital stock of the Corporation entitled to vote for the election of directors, and any Affiliate or Associate of any such person. 3. The term "Continuing Director" shall mean any member of the Board of Directors who is not affiliated with a Related Person and who was a member of the Board of Directors immediately prior to the time that the Related Person became a Related Person, and any successor to a Continuing Director who is not affiliated with the Related Persons and is recommended to succeed a Continuing Director by a majority of Continuing Directors who are then members of the Board of Directors. 4. "Affiliate" and "Associate" shall have the respective meanings ascribed to such terms in Rule 12b-2 under the Securities Exchange Act of 1934, as in effect on January 1, 1984. ARTICLE XII. A. A seventh series of Preferred Stock, par value $10.00 per share, is created as follows: Section 1. Designation and Amount. The shares of such series shall be designated as "Series E Participating Preferred Stock," and the number of shares constituting such series shall be 300,000. Such number of shares may be increased or decreased by resolution of the Board of Directors; provided, that no decrease shall reduce the number of shares of Series E Participating Preferred Stock to a number less than that of the shares then outstanding plus the number of shares issuable upon exercise of outstanding rights, options or warrants or upon conversion of outstanding securities issued by the Corporation. Section 2. Dividends and Distributions. (A) The holders of shares of Series E Participating Preferred Stock in preference to the holders of shares of Common Stock, par value $1.00 per share (the "Common Stock"), of the Corporation and any other junior stock, shall be entitled to receive, when, as and if declared by the Board of Directors out of funds legally available for the purpose, quarterly dividends payable in cash on the first day of January, April, July and October in each year (each such date being referred to herein as a "Quarterly Dividend Payment Date"), commencing on the first Quarterly Dividend Payment Date after the first issuance of a share or fraction of a share of Series E Participating Preferred Stock in an amount per share (rounded to the nearest cent) equal to the greater of (a) $1.00, or (b) subject to the provision for adjustment hereinafter set forth, 100 times the aggregate per share amount of all cash dividends, and 100 times the aggregate per share amount (payable in kind) of all non-cash dividends or other distributions other than a dividend payable in shares of Common Stock or a subdivision of the outstanding shares of Common Stock (by reclassification or otherwise), declared on the Common Stock, since the immediately preceding Quarterly Dividend Payment Date, or, with respect to the first Quarterly Dividend Payment Date, since the first issuance of any share or fraction of a share of Series E Participating Preferred Stock. In the event the Corporation shall at any time after August 8, 1988 (the "Rights Declaration Date") (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock, or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the amount to which holders of shares of Series E Participating Preferred Stock were entitled immediately prior to such event under clause (b) of the preceding sentence shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. (B) The Corporation shall declare a dividend or distribution on the Series E Participating Preferred Stock as provided in paragraph (A) above immediately after it declares a dividend or distribution on the Common Stock (other than a dividend payable in shares of Common Stock); provided that, in the event no dividend or distribution shall have been declared on the Common Stock during the period between any Quarterly Dividend Payment Date and the next subsequent Quarterly Dividend Payment Date, a dividend of $1.00 per share on the Series E Participating Preferred Stock shall nevertheless be payable on such subsequent Quarterly Dividend Payment Date. (C) Dividends shall begin to accrue and be cumulative on outstanding shares of Series E Participating Preferred Stock from the Quarterly Dividend Payment Date next preceding the date of issue of such shares of Series E Participating Preferred Stock unless the date of issue of such shares is prior to the record date for the first Quarterly Dividend Payment Date, in which case dividends on such shares shall begin to accrue from the date of issue of such shares, or unless the date of issue is a Quarterly Dividend Payment Date or is a date after the record date for the determination of holders of shares of Series E Participating Preferred Stock entitled to receive a quarterly dividend and before such Quarterly Dividend Payment Date in either of which events such dividends shall begin to accrue and be cumulative from such Quarterly Dividend Payment Date. Accrued but unpaid dividends shall not bear interest. Dividends paid on the shares of Series E Participating Preferred Stock in an amount less than the total amount of such dividends at the time accrued and payable on such shares shall be allocated pro rata on a share-by- share basis among all such shares at the time outstanding. The Board of Directors may fix a record date for the determination of holders of shares of Series E Participating Preferred Stock entitled to receive payment of a dividend or distribution declared thereon, which record date shall be no more than 30 days prior to the date fixed for the payment thereof. Section 3. Certain Restrictions. (A) Whenever quarterly dividends or other dividends or distributions payable on the Series E Participating Preferred Stock as provided in Section 2 are in arrears, thereafter and until all accrued and unpaid dividends and distributions, whether or not declared, on shares of Series E Participating Preferred Stock outstanding shall have been paid in full, the Corporation shall not (i) declare or pay dividends on, make any other distributions on, or redeem or purchase or otherwise acquire for consideration any shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series E Participating Preferred Stock; (ii) declare or pay dividends on or make any other distributions on any shares of stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series E Participating Preferred Stock except dividends paid ratably on the Series E Participating Preferred Stock and all such parity stock on which dividends are payable or in arrears in proportion to the total amounts to which the holders of all such shares are then entitled; (iii) redeem or purchase or otherwise acquire for consideration shares of any stock ranking on a parity (either as to dividends or upon liquidation, dissolution or winding up) with the Series E Participating Preferred Stock provided that the Corporation may at any time redeem, purchase or otherwise acquire shares of any such parity stock in exchange for shares of any stock of the Corporation ranking junior (either as to dividends or upon dissolution, liquidation or winding up) to the Series E Participating Preferred Stock; or (iv) purchase or otherwise acquire for consideration any shares of Series E Participating Preferred Stock or any shares of stock ranking on a parity with the Series E Participating Preferred Stock except in accordance with a purchase offer made in writing or by publication (as determined by the Board of Directors) to all holders of such shares upon such terms as the Board of Directors, after consideration of the respective annual dividend rates and other relative rights and preferences of the respective series and classes, shall determine in good faith will result in fair and equitable treatment among the respective series or classes. (B) The Corporation shall not permit any subsidiary of the Corporation to purchase or otherwise acquire for consideration any shares of stock of the Corporation unless the Corporation could, under paragraph (A) of this Section 3, purchase or otherwise acquire such shares at such time and in such manner. Section 4. Liquidation, Dissolution or Winding Up. (A) Upon any liquidation (voluntary or otherwise), dissolution or winding up of the Corporation, no distribution shall be made to the holders of shares of stock ranking junior (either as to dividends or upon liquidation, dissolution or winding up) to the Series E Participating Preferred Stock unless, prior thereto, the holders of shares of Series E Participating Preferred Stock shall have received per 1/100 share thereof, the greater of the issuance price thereof or the payment made per share of Common Stock, plus an amount equal to accrued and unpaid dividends and distributions thereon, whether or not declared, to the date of such payment (the "Series E Liquidation Preference"). Following the payment of the full amount of the Series E Liquidation Preference, no additional distributions shall be made to the holders of shares of Series E Participating Preferred Stock unless, prior thereto, the holders of shares of Common Stock shall have received an amount per share (the "Common Adjustment") equal to the quotient obtained by dividing (i) the Series E Liquidation Preference by (ii) 100 (as appropriately adjusted as set forth in subparagraph C below to reflect such events as stock splits, stock dividends and recapitalizations with respect to the Common Stock) (such number in clause (ii), the "Adjustment Number"). Following the payment of the full amount of the Series E Liquidation Preference and the Common Adjustment in respect to all outstanding shares of Series E Participating Preferred Stock and Common Stock, respectively, holders of Series E Participating Preferred Stock and holders of shares of Common Stock shall receive their ratable and proportionate share of the remaining assets to be distributed in the ratio of the Adjustment Number to 1 with respect to such Preferred Stock and Common Stock, on a per share basis, respectively. (B) In the event there are not sufficient assets available to permit payment in full of the Series E Liquidation Preference and the liquidation preferences of all other series of Preferred Stock, if any, which rank on a parity with the Series E Participating Preferred Stock then such remaining assets shall be distributed ratably to the holders of such parity shares in proportion to their respective liquidation preferences. In the event there are not sufficient assets available to permit payment in full of the Common Adjustment, then such remaining assets shall be distributed ratably to the holders of Common Stock. (C) In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock, or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the Adjustment Number in effect immediately prior to such event shall be adjusted by multiplying such Adjustment Number by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that were outstanding immediately prior to such event. Section 5. Consolidation, Merger, etc. In case the Corporation shall enter into any consolidation, merger, combination or other transaction in which the shares of Common Stock are exchanged for or changed into other stock or securities, cash and/or any other property, then in any such case the shares of Series E Participating Preferred Stock shall at the same time be similarly exchanged or changed in an amount per share (subject to the provision for adjustment hereinafter set forth) equal to 100 times the aggregate amount of stock, securities, cash and/or any other property (payable in kind), as the case may be, into which or for which each share of Common Stock is changed or exchanged. In the event the Corporation shall at any time after the Rights Declaration Date (i) declare any dividend on Common Stock payable in shares of Common Stock, (ii) subdivide the outstanding Common Stock, or (iii) combine the outstanding Common Stock into a smaller number of shares, then in each such case the amount set forth in the preceding sentence with respect to the exchange or change of shares of Series E Participating Preferred Stock shall be adjusted by multiplying such amount by a fraction the numerator of which is the number of shares of Common Stock outstanding immediately after such event and the denominator of which is the number of shares of Common Stock that are outstanding immediately prior to such event. Section 6. Redemption. The shares of Series E Participating Preferred Stock shall not be redeemable. Section 7. Ranking. The Series E Participating Preferred Stock shall rank on a parity with all other series of the Corporation's Preferred Stock as to the payment of dividends and the distribution of assets. Section 8. Amendment. The Articles of Incorporation of the Corporation shall not be further amended in any manner which would materially alter or change the powers, preferences or special rights of the Series E Participating Preferred Stock so as to affect them adversely without the affirmative vote of the holders of a majority or more of the outstanding shares of Series E Participating Preferred Stock voting separately as a class. Section 9. Fractional Shares. Series E Participating Preferred Stock may be issued in fractions of a share which shall entitle the holder in proportion to such holders' fractional shares, to exercise voting rights, receive dividends, participate in distributions and to have the benefit of all other rights of holders of Series E Participating Preferred Stock. ARTICLE XIII. Except as otherwise provided under Article V, Article X and Article XI, these Articles of Incorporation may be amended by the affirmative vote of a majority of all votes entitled to be cast by each voting group of the Corporation entitled to vote on the amendment at a meeting at which a quorum of each voting group exists. Exhibit 3 BYLAWS OF FIRST VIRGINIA BANKS, INC. ARTICLE I MEETING OF STOCKHOLDERS Section 1. Annual Meetings. The annual meeting of the stockholders for the election of directors and for the transaction of such other business as may properly come before the meeting shall be held on such date each year that shall be established by the board of directors; however, if no such date is established, then the annual meeting shall be on the fourth Wednesday in April each year, if not a legal holiday, and if so, then on the next succeeding business day. Section 2. Special Meetings. Except as provided in Article II, Section 4 of these bylaws, special meetings of the stockholders shall be called by the president or secretary only at the written request of a majority of the directors, provided that, if as of the date of the request for such special meeting there is a Related Person as defined in Article X of the Articles of Incorporation, such majority shall include a majority of the Continuing Directors, as defined in Article X of the Articles of Incorporation or by the holders of four-fifths (80%) of the voting power of all of the then outstanding shares of capital stock of the corporation entitled to vote generally in the election of directors. The request shall state the purpose or purposes for which the meeting is to be called. The notice of every special meeting of stockholders shall state the purpose for which it is called. Section 3. Hour and Place of Meeting. All meetings of the stockholders may be held at such hour and place within or without the State of Virginia as may be provided in the notice of meeting. Section 4. Notice of Meetings. Written notice of the annual and of any special meeting of the stockholders shall be given not less than ten days nor more than sixty days before the meeting (except as a different time is specified by law), by or at the direction of the board of directors or the person calling the meeting, to each holder of record of shares of the corporation entitled to vote at the meeting, in person or by mail sent to the address recorded on the stock transfer books of the corporation on the date mailed, unless otherwise required by law. If any stockholder shall fail or decline to furnish mailing address, then such notice need not be sent to him unless required by law. All such notices should state the day, hour, place and purpose(s) of the meeting, and the matters to be considered. Section 5. Voting List. A complete list of the stockholders entitled to vote at any meeting or any adjournment thereof, with the address of and number of shares held by each on the record date, shall, for a period of ten days prior to such meeting, be kept on file at the registered office or principal place of business of the corporation or at the office of the transfer agent or registrar and shall be subject to inspection by any stockholder at any time during usual business hours except as such right of inspection may be subject to limitations prescribed by law. Such list shall also be produced and kept open at the time and place of the meeting and shall be open to inspection by any stockholder during the whole time of the meeting. Whenever the production or exhibition of any voting list, or of the stock transfer books of the corporation, shall be required by law, the production of a copy thereof certified correct by the transfer agent shall be deemed to be substantial compliance with such requirement. Section 6. Quorum. A majority of the shares entitled to vote, represented in person or by proxy, shall constitute a quorum at a meeting of stockholders. Once a quorum has been duly convened, the quorum shall not be deemed broken by the departure of any stockholder or holder of a proxy. In the absence of a quorum, the stockholders present in person or by proxy, by majority vote and without notice other than by announcement at the meeting, may adjourn the meeting from time to time until a quorum shall be present. At any such adjourned meeting at which a quorum shall be present, any business may be transacted which could have been transacted at the meeting as originally called. Section 7. Organization. At all meetings of the stockholders, the chairman of the board, or in his absence the vice chairmen, in the order of their appointment, or in their absence the president, or in the absence of all of them a person chosen by a majority of the stockholders represented in person or by proxy and entitled to vote at the meeting shall preside as chairman of the meeting. The secretary of the corporation, or in his absence or if he be appointed chairman of the meeting, an assistant secretary shall act as secretary at all meetings of the stockholders; but if neither the secretary nor any assistant secretary be present and able to act as such, the chairman may appoint any person to act as secretary of the meeting. Section 8. Conduct of Meetings. Parliamentary rules as formulated by Cushman, Robert's or Sturgis' Manual shall govern the conduct of all meetings of the stockholders upon verbal announcement thereof by the chairman, except that where such rules conflict with the provisions of these bylaws, the statutes of Virginia, or the Articles of Incorporation, the provisions of the said bylaws, statutes or Articles shall prevail. The chairman of all meetings of the stockholders may announce from time to time such rules and guidelines for the conduct of business as he may determine in his discretion. Section 9. Voting. Except as otherwise provided by law or by Articles of Serial Designation with respect to any class or classes of preferred stock outstanding, each stockholder shall be entitled to one vote for each share of stock held by him and registered in his name on the books of the corporation on the date fixed by the resolution of the board of directors as the record date for the determination of the stockholders entitled to notice of and to vote at such meeting as more fully set forth elsewhere in these bylaws. Such vote may be given in person or by proxy appointed by an instrument in writing executed by a stockholder or his duly authorized attorney, and delivered to the secretary of the meeting. No proxy shall be valid after eleven months from its date, unless otherwise provided therein. If a quorum is present, the affirmative vote of a majority of the shares represented at the meeting and entitled to vote on the subject matter shall be the act of the stock- holders, except when a larger vote or a vote by class is required by the Articles of Incorporation, any other provision of these bylaws or the laws of the state of Virginia and except that in elections of directors those receiving the greatest number of votes shall be deemed elected even though not receiving a majority. Section 10. Counting of Votes. The chairman shall appoint three tellers to count the vote respecting the election of directors and any other questions put to vote, whether such vote is by written ballot or by a show of hands or by viva voce', and at least two out of three tellers shall certify in writing the results of any such voting. Written ballots shall not be required unless first decided upon by the chairman on matters to be brought before the stockholders and a teller may but need not be, a stockholder of the corporation. ARTICLE II BOARD OF DIRECTORS Section 1. General Powers. The business and affairs of the corporation shall be managed by the board of directors subject to any requirement of stockholder action. Section 2. Number. The number of directors shall be fifteen (15). Section 3. Terms of Directors. A person up for election shall be elected to serve a term of three years and shall not be eligible to stand for election or re-election if on the date of the stockholders' meeting at which he is to be elected or re-elected, he has then reached the age of 72 years, except that if any such person shall have been duly appointed as chairman of the corporation or of a member bank at any time prior to the date that he reaches the age of 72 years, he shall be eligible to continue to stand for election as a director thereafter; provided, however, that he shall not in any case be eligible to stand for such election beyond the date that he reaches the age of 75. Further, except as provided above, when a director shall reach the age of 72 during such term, he shall resign from the board of directors effective on the day preceding the next succeeding annual meeting of the stockholders at which such director's term expires. If any such director shall become ill and unable to perform his duties as a director, he shall resign from the board of directors effective on the day of the next succeeding meeting of the board of directors or the date set forth in the notice of resignation, whichever is earlier. Section 4. Vacancies. Any vacancy on the board of directors for any cause, except a vacancy created by an increase by more than two in the number of directors, may be filled for the unexpired portion of the term by a majority vote of all of the remaining directors, though less than a quorum, given at a regular meeting or at a special meeting called for that purpose. In case the entire board shall die or resign, any stockholder may call a spe- cial meeting of the stockholders upon notice as hereinbefore provided for meetings of the stockholders, at which special meeting the directors for the unexpired portion of the term may be elected. Section 5. Fees. Directors, as such, shall not receive any stated salary for their services, but, by resolution of the board of directors, a fixed sum and expenses of attendance, if any, may be allowed for attendance at each regular or special meeting of the board or any meeting of any committee. Nothing herein contained shall be construed to preclude any director from serving the corporation in any other capacity and receiving compensation therefor. Section 6. Senior Advisory Board. There shall be a senior advisory board which shall consist of such directors of the corporation as shall resign from the board of directors hereafter at or after reaching the age of 72 or as shall resign because of poor health and who request to transfer to it. The members of such board shall serve at the pleasure of the corporation's board of directors and shall be subject to reappointment from year to year by said board of directors, but not more than three years from the date first elected to such senior advisory board. Members of the senior advisory board shall receive notice of and be entitled to attend all meetings of the corporation's regular board of directors and shall receive the same fees and expenses as are paid to members of the board of directors, but will not be entitled to vote at such meetings. Section 7. Stock Ownership of Directors. Every director shall be the owner in his sole name and have in his personal possession or control stock of the corporation having a par value of not less than One Thousand Dollars ($1,000). Such stock must be unpledged and unencumbered at the time such director becomes a director and during the whole of his term as such. Any director violating the provisions of this section shall immediately vacate his office. ARTICLE III DIRECTORS' MEETINGS Section 1. Regular Meetings. Regular meetings of the board of directors shall be held without other notice than this bylaw immediately after, and at the same place as, the annual meeting of stockholders. Additional regular meetings shall be held at least monthly. The board of directors may provide by resolution the time and place, either within or without this state, for the holding of additional regular meetings without other notice than such resolution. Section 2. Special Meetings. Special meetings of the board of directors shall be held whenever called by the chairman of the board, by the president, or by any two of the directors. Notice of each such meeting shall be mailed to each director, addressed to his residence or usual place of business, at least three days before the day on which the meeting is to be held, or shall be sent to such place by telegraph or mailgram, or be delivered personally or by telephone, not later than the day before the day on which the meeting is to be held. Neither the business to be transacted at, nor the purpose of, any special meeting need be specified in the notice or waiver of notice of such meeting. Section 3. Organization. At all meetings of the board of directors, the chairman, or in his absence the vice chairmen in the order of their appointment, or in their absence, the president (or in his absence the executive vice president if a member of the board), or, in the absence of all of them, any director selected by the board of directors shall act as chair- man; and the secretary of the corporation, or, in his absence or if he be elected chairman of the meeting, an assistant secretary, shall act as secretary; but if neither the secretary nor any assistant secretary be present and able to act as such, the chairman may appoint any person present to act as secretary of the meeting. Section 4. Quorum and Manner of Acting. Unless otherwise provided by law or the Articles of Incorporation, a majority of the number of directors fixed by the bylaws at the time of any regular or special meeting shall constitute a quorum for the transaction of business at such meeting, and 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 those present may adjourn the meeting from time to time until a quorum be had. Notice of any such adjourned meeting need not be given. Section 5. Order of Business. At all meetings of the board of directors business may be transacted in such order as from time to time the board may determine. Section 6. Action Without a Meeting. Any action which is required to be taken at a meeting of the directors or of a director's committee may be taken without a meeting if a consent in writing, setting forth the action so to be taken, shall be signed either before or after such action by all of the directors or by all of the members of the committee, as the case may be, and such consent is filed in the minute book of the proceedings of the board or committee. Such consent shall have the same force and effect as a unanimous vote. Section 7. Telephone Meetings. Members of the board of directors or any committee designated thereby may participate in a meeting of such board or committee by means of conference telephone or similar communications equipment whereby all persons participating in the meeting can hear each other, and a written record can be made of the action taken at the meeting. ARTICLE IV COMMITTEES OF THE BOARD Section 1. Executive Committee. The board of directors, by a resolution adopted by a majority of the number of directors, may designate three or more directors, to include the chairman, the vice chairmen, if one or more be appointed, and the president, to constitute an executive committee. Members of the executive committee shall serve until removed, until their successors are designated or until the executive committee is dissolved by the board of directors. All vacancies which may occur in the executive committee shall be filled by the board of directors. The executive committee, when the board of directors is not in session, may exercise all of the powers of the board of directors except to approve an amendment to the Articles of Incorporation, these bylaws, a plan of merger or consolidation, a plan of exchange under which the corporation would be acquired, the sale, lease or exchange, or the mortgage or pledge for a consideration other than money, of all, or substantially all, the property and assets of the corporation otherwise than in the usual and regular course of its business, the voluntary dissolution of the corporation, or revocation of voluntary dissolution proceedings, and may authorize the seal of the corporation to be affixed as required. The executive committee may make its own rules for the holding and conduct of its meetings (except that at least two members of the committee shall be necessary to constitute a quorum), the notice thereof required and the keeping of its records, and shall report all of its actions to the board of directors. Section 2. Management Compensation and Benefits Committee. The board of directors shall, by resolution, appoint a Management Compensation and Benefits Committee that shall be comprised entirely of "outside directors" as that term is defined under proposed Item 402(j)(2) of Regulation S-K of the Securities and Exchange Commission; that is, "directors who do not have employment or consulting arrangements with the corporation or its affiliates and who are not employed by an entity that has an employee of the corporation serving as a member of a committee which establishes that entity's compensation policy." (If, in the final SEC rules, Item 402(j)(2) of the SEC's Regulation S-K includes a different definition of "outside directors" than that described above, then these Bylaws will follow the definition as stated in the final rules, as amended from time to time.) Such committee shall fix its own rules and procedures and shall meet at least once each year. The committee shall have the authority to establish the level of compensation (including bonuses) and benefits of management of the corporation. Such committee shall also have all of the authority vested under any stock option or other equity-based compensation plan of the corporation including but not limited to the authority to grant stock options, stock appreciation rights, restricted or phantom stock, etc. to the corporation's management. Section 3. Public Policy Committee. The board of directors shall, by resolution, appoint not less than three nor more than six of its members to constitute a public policy committee. The board shall likewise designate the chairman of the committee. In addition, the chairman of the board shall be an ex-officio member of the public policy committee and shall be entitled to vote on all matters coming before the committee. The committee shall recommend to the board of directors the total amount of funds to be allocated each calendar year for charitable contributions to be made by the corporation. The committee shall have authority to approve contributions by the corporation within the dollar limits set by the approved annual budget and may delegate some or all of its authority for final approval to the chief executive officer provided that all contributions approved by the chief executive officer are subsequently reported to the committee for review. The committee shall exercise general supervision over the corporation's matching gifts program and shall have authority to add and/or delete those colleges and universities eligible for inclusion in the program. The committee shall monitor on an ongoing basis the programs developed for compliance with the Community Reinvestment Act as well as Title VII of the Civil Rights Act of 1964 (Equal Employment Opportunity) and as a result may make recommendations to the chief executive officer in respect thereto. The committee shall perform such other duties and functions as shall be assigned to said committee from time to time by the board of directors. The chairman of the committee shall report regularly to the board of directors on the results of its meetings. The committee shall meet quarterly except that it may additionally meet on call of its chairman as may be necessary. Section 4. Audit Committee. The Board of Directors shall appoint an Audit Committee that shall be comprised entirely of directors who meet the standard of independence set forth by the New York Stock Exchange for audit committees of listed companies. Such committee shall be comprised of a minimum of three members and shall fix its own rules and procedures. The committee shall meet at least quarterly. The committee shall review the following: (1) with the independent public accountant and management, the financial statements and the scope of the corporation's audit; (2) with the independent public accountant and management, the adequacy of the corporation's system of internal procedures and controls, including the resolution of material weaknesses; (3) with the corporation's internal auditors, the activities and performance of the internal auditors; (4) with management and the independent accountant, compliance with laws and regulations; (5) with management, the selection and termination of the independent public accountant and any significant disagreements between the independent public accountant and management; and (6) the nonaudit services of the corporation's independent public accountant. The committee, when so delegated by a member bank, shall perform such audit committee functions for such bank as are requested by the bank to fulfill its requirements under Section 36 of the Federal Deposit Insurance Act and under the regulations and guidelines adopted by the FDIC to implement Section 36. The committee shall also review any other matters concerning auditing and accounting as it deems necessary and appropriate. The committee, at its discretion, may retain counsel without prior permission of the Board or management. Section 5. Other Committees. Other committees with limited authority may be designated by a resolution adopted by a majority of the directors present at a meeting at which a quorum is present. ARTICLE V OFFICERS Section 1. Number. The officers of the corporation may be a chairman of the board, a president, one or more vice chairmen (who also may serve as a consultant and advisor to the board but not as a full-time employee of the corporation or any of its affiliates), one or more executive vice presidents, one or more vice presidents (any one or more of whom may be designated as senior vice presidents), a secretary, and a treasurer. At the discretion of the board of directors, there may be one or more assistant vice presidents, assistant secretaries, and assistant treasurers; a general counsel and one or more assistant general counsel and assistant counsel; a general auditor, one or more assistant general auditors and audit managers, an electronic data processing auditor, and a trust auditor; a communications officer; one or more marketing officers, and such other officer titles designated by the board from time to time. The chairman of the board, the vice chairmen, and the president shall be chosen from members of the board of directors. The same person may hold any two of such offices, except the office of secretary may not be held by any person holding the office of president. Section 2. Election, Term of Office and Qualifications. Officers of the corporation shall be chosen annually by the board of directors at its regular meeting immediately following the annual meeting of stockholders, and each officer shall hold office until the next annual meeting of stockholders and until his successor shall have been chosen and qualified or until he shall resign or shall have been removed in the manner hereinafter provided. Section 3. Other Officers, Agents and Employees. The board of directors may from time to time appoint such other officers as it may deem necessary, to hold office for such time as may be designated by it or during its pleasure, and may also appoint, from time to time, such agents and employees of the corporation as may be deemed proper, or may authorize any officer to appoint and remove such agents and employees, and may from time to time prescribe the powers and duties of such officers, agents and employees of the corporation in the management of its property and affairs, and may authorize any officer to prescribe the powers and duties of agents and employees. Section 4. Vacancies. If any vacancy shall occur among the officers of the corporation, such vacancy shall be filled by the board of directors. Section 5. Removal of Officers. Any officer or agent of the corporation may be removed with or without cause at any time by the board of directors or such officer as may be provided in the bylaws. Any person or agent appointed or employed by the corporation otherwise than by the board of directors may be removed with or without cause at any time by any officer having authority to appoint whenever such officer in his absolute discretion shall consider that the best interests of the corporation will be served thereby. Section 6. Chairman of the Board. The chairman of the board shall be the chief executive officer of the corporation and subject to the control of the board of directors, shall have general direction of the business affairs and property of the corporation and shall do and perform such other duties as may be prescribed in these bylaws or which may be assigned to him from time to time by the board of directors. The chairman of the board shall preside at all meetings of the board of directors and at all meetings of the stock- holders. He shall prescribe the duties and have general supervision over all other officers, employees and agents of the corporation enumerated in these bylaws or established by resolution of the board of directors or otherwise, and shall have the power to appoint, employ, suspend or remove with or without the advice of the board of directors any such officer, employee or agent unless otherwise specifically provided in these bylaws, and shall fix the salaries of all such officers, employees and agents of the corporation and its subsidiaries within the limits established from time to time by the board of directors. He shall have power to sign all stock certificates, deeds, contracts and other instruments authorized by the board of directors or its executive committee unless other direction is given therefor, and he shall be a member of all standing committees of the board except the account- ing and auditing committee and the management compensation and benefits committee. Honorary Chairman of the Board. The board of directors may appoint a former full-time officer who has held the office of chairman of the board of the corporation to the position of honorary chairman of the board and provide such person with a reasonable amount of office space as long as desired by him. If appointed, such person shall act as chairman of the senior advisory board as such body exists from time to time. Section 7. Vice Chairmen of the Board. The board of directors may appoint one or more vice chairmen of the board and, if any such officers are appointed, may assign such specific duties to any one of them as it deems necessary and advisable. Such officers may, but need not, be full-time salaried employees of the corporation. Any such full-time vice chairmen shall report to the corporation's chief executive officer and shall perform such duties as such officers may prescribe and assign from time to time. Section 8. Succession of Duties. The bylaw duties of the chairman of the board may be exercised and carried out by any vice chairmen when such have been appointed by the board of directors in the absence or disability of the chairman of the board in order of their appointment; if no vice chairmen are so appointed, then the president shall carry out such duties in the absence of the chairman of the board; and in the absence of the president, the executive vice president or any vice president in the order of their election shall carry out all such duties in the absence or disability of the chairman of the board. Section 9. President. The president shall be the chief administrative officer of the corporation and as such shall perform such duties as the chairman of the board or the board of directors may prescribe from time to time by resolution or as may be prescribed by these bylaws. He shall exercise all the powers and discharge all the duties of the chairman of the board during the latter's absence or inability to act. He shall have concurrent power with the chairman of the board to sign all deeds, contracts and instruments authorized by the board of directors or its executive committee unless the board otherwise directs, and he may be a member of the standing committees of the board except the accounting and auditing committee when appointed by the board. He shall report to the chairman of the board in carrying out his assignments and in conducting the affairs of his office. Section 10. Executive Vice President. The board of directors may elect one or more executive vice presidents and any such person so elected to such office shall perform such duties as the board of directors or the chairman of the board may assign and prescribe from time to time. Section 11. Vice Presidents. Each vice president shall have such powers and perform such duties as the board of directors or the chairman may from time to time prescribe, and shall perform such other duties as may be prescribed in these bylaws. Each vice president shall have power to sign all deeds, contracts and instruments authorized by the board of directors or its executive committee unless they otherwise direct. In case of the absence or inability to act of the president, and the executive vice presidents in the order of their appointments, then such vice president as the board of directors may designate for the purpose (but in the absence of such designation then the vice presidents in order of appointment) shall have the powers and discharge the duties of the president. Section 12. Secretary. The secretary shall keep the minutes of all meetings of the stockholders, the board of directors and meetings of committees of the board as they are held, in a book or books kept for that purpose. He shall keep in safe custody the seal of the corporation and he may affix such seal to any instrument duly executed on behalf of the corporation. The secretary shall have charge of the certificate books and such other books and papers as the board of directors may direct. He shall attend to the giving and serving of all notices of the corporation, and shall also have such other powers and perform such other duties as pertain to his office, or as from time to time may be assigned to him by the board of directors or the corporation's chief executive officer. Section 13. Treasurer. The treasurer shall be the principal financial and accounting officer of the corporation. He shall have charge of the funds, securities, receipts and disbursements of the corporation, and shall deposit all moneys and other valuable effects in the name and to the credit of the corporation in such banks or other depositaries as the board of directors may from time to time designate. He shall render to the chairman of the board, or to the board of directors, or to the president, whenever any of them shall require him so to do, an account of the financial condition of the corporation and its affiliates and all of his transactions as treasurer. He shall keep correct books of account of all its business and transactions. If required by the board of directors, he shall give a bond in such sum and on such conditions and with such surety as the board of directors may designate, for the faithful performance of the duties of his office and the restoration to the corporation, at the expiration of his term of office, or, in case of his death, resignation or removal from office, of all books, papers, vouchers, money or other property of whatever kind in his possession belonging to the corporation. He shall also have such other powers and perform such other duties as pertain to his office or as from time to time may be assigned to him by the board of directors or the president. Section 14. General Counsel. The general counsel, if one be appointed, shall have charge of all litigation of the corporation, and shall keep himself advised of the character and progress of all legal proceedings and claims by and against the corporation or in which it is interested by reason of its ownership and control of other corporations. He shall give to the board of directors reports from time to time on all legal matters affecting the corporation and, when requested, his opinion upon any question affecting the interests of the corporation. He may, with the consent of the chief executive officer, employ on behalf of the corporation special counsel for the handling of any legal matter pertaining to the business of the corporation which he deems necessary and advisable. The general counsel may, but need not be, a full-time salaried officer of the corporation. He shall from time to time consult with the corporation's legal advisory committee on legal matters affecting the corporation and its affiliates. Section 15. General Auditor. The general auditor, if one be appointed, shall perform such internal auditing and accounting functions with regard to the member banks and companies as the board of directors or any appropriate committee thereof may from time to time determine, and shall have such additional powers and duties as may be prescribed by these bylaws and as the board of directors or any appropriate committee thereof may from time to time determine, and shall have additional responsibilities and duties in con- nection therewith as may be prescribed by these bylaws, applicable laws and regulations or the board of directors or any appropriate committee thereof. Except as stated, the general auditor and other auditing staff shall be subject to day-to-day administrative direction of the chief executive officer of the corporation and any such officer or employee may be dismissed by the chief executive officer for reasons as may be applied in dismissing any other personnel of the corporation, provided that a report of any such dismissal of internal auditing personnel with the reasons therefor shall be made to the board of directors or its executive committee at the next succeeding meeting thereof. All other officers and personnel appointed or assigned to assist in the internal audit function of the corporation, its member banks and companies, may be assigned such day-to-day duties and responsibilities as may be necessary by the general auditor to carry out the responsibilities of the internal audit function. The office of general auditor may not be held by any person holding other offices in the corporation or its affiliates except with the specific approval of the board of directors. Section 16. Assistant Secretary. In the absence or disability of the secretary, the assistant secretary (or if more than one, then the assistant secretary designated by the board of directors or the president for such purpose) shall perform all the duties of the secretary and, when so acting, shall have all the powers of, and be subject to all the restrictions upon, the secretary. Each assistant secretary shall also perform such other duties as from time to time may be assigned to him by the board of directors, the chief executive officer or the secretary. Section 17. Assistant Treasurer. In the absence or disability of the treasurer, the assistant treasurer (or if more than one, then the assistant treasurer designated by the board of directors or the chief executive officer for such purpose) shall perform all the duties of the treasurer and, when so acting, shall have all the powers of, and be subject to all restrictions upon, the treasurer. Each assistant treasurer shall also perform such other duties as from time to time may be assigned to him by the board of directors, the chief executive officer or the treasurer. ARTICLE VI CAPITAL STOCK Section 1. Certificates. Certificates representing shares of the capital stock of the corporation shall be in such form as is permitted by law and prescribed by the board of directors or the chief executive officer and shall be signed by the persons authorized to sign the same by the bylaws or specific resolution of the board of directors. Certificates may, but need not be, sealed with the seal of the corporation or a facsimile thereof. The signature of the officers upon such certificates may be facsimiles if the certificate is countersigned by a transfer agent or registered by registrar other than the corporation itself or an employee of the corporation. In case any officer who has signed or whose facsimile signature has been placed upon a stock certificate shall have ceased to be such officer before such certificate is issued, it may be issued by the corporation with the same effect as if he were such officer at the date of its issue. Section 2. Issue and Registration of Certificates: Transfer Agents and Registrars. Transfer agents and/or registrars for the stock of the corporation may be appointed by the board of directors and may be required to countersign stock certificates. Certificates of stock shall be issued in consecutive order and the certificate books shall be kept at an office of the corporation or at the office of the transfer agent. Certificates shall be numbered and registered in the order in which they are issued. New certificates and, in the case of cancellation, old certificates, shall, before they are delivered, be passed to a registrar if one is appointed by the board of directors, and such registrar shall register the issue or transfer of such certificates. Upon the return of the certificates by the registrar, the new certificates shall be delivered to the person entitled thereto. Section 3. Transfer of Stock. The stock of the corporation shall be transferable or assignable on the books of the corporation by the holders in person or by attorney on surrender of the certificates for such shares duly endorsed and, if sought to be transferred by attorney, accompanied by a written power of attorney to have the same transferred on the books of the corporation. Section 4. Lost, Destroyed and Mutilated Certificates. Holders of the stock of the corporation shall immediately notify the corporation of any loss, destruction or mutilation of the certificate therefor, and the board of directors may in its discretion, or any officer of the corporation appointed by the board of directors for that purpose may in his discretion, cause one or more new certificates for the same number of shares in the aggregate to be issued to such stockholder upon the surrender of the mutilated certificate or upon satisfactory proof of such loss or destruction and the deposit of a bond in such form and amount and with such surety as the board of directors may require. Section 5. Record Date. For the purposes of determining stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or entitled to receive payment of any dividend, or in order to make a determination of stockholders for any other proper purpose, the board of directors may fix in advance a date as the record date for any such determination of stockholders, such date in any case to be not more than fifty days prior to the date on which the particular action requiring such determination of stockholders is to be taken. If no record date is fixed for the determination of stockholders entitled to notice of or to vote at a meeting of stockholders, or stockholders entitled to receive payment of a dividend, the date on which notice of the meeting is mailed or the date on which the resolution of the board of directors declaring such dividend is adopted, as the case may be, shall be the record date for such determination of stockholders. When a determination of stockholders entitled to vote at any meeting of stockholders has been made as provided in this section, such determination shall apply to any adjournment thereof. ARTICLE VII CONTRACTS, LOANS, BANK ACCOUNTS, CHECKS, SECURITIES, ETC.: AUTHORITY OF OFFICERS Section 1. Contracts. The board of directors may authorize any officer or officers, agent or agents to enter any contract or to execute and deliver any instrument on behalf of the Corporation, and such order may be general or confined to specific instances. Section 2. Loans. The board of directors may authorize any officer or officers, agent or agents to effect loans and advances at any time for the corporation from any bank, trust company, insurance company, or other institution, or from any person, firm, association, or corporation, and in connection with such loans and advances to make, execute and deliver promissory notes or other evidences of indebtedness of the corporation, and, as security for the payment of any and all loans, advances, indebtedness and liabilities of the corporation, to pledge, hypothecate or transfer any and all stocks, securities and other personal property at any time held by the corporation, and to that end to transfer, endorse, assign and deliver the same in the name of the corporation. Such authority may be general or confined to specific instances, except that any pledge, hypothecation or transfer of the capital stock or assets of any subsidiary corporation shall be authorized only by a specific resolution of the board of directors. Section 3. Bank Accounts. All funds of the corporation, not otherwise employed, shall be deposited from time to time to the credit of the corporation in such banks or trust companies or other depositaries as the board of directors may select. Section 4. Checks, Securities, Etc. All checks, drafts or orders for the payment of money, notes or other evidences of indebtedness issued in the name of the corporation, all stock powers, endorsements, assignments, or other instruments for the transfer of securities held by the corporation shall be executed and delivered by, and all such securities shall be voted and proxies for the voting thereof shall be executed and delivered by such officer or officers, agent or agents to whom the board of directors shall delegate the power, and under such conditions and restrictions as they may impose. ARTICLE VIII MISCELLANEOUS Section 1. Fiscal Year. The fiscal year of the corporation shall begin on the first day of January and end on the thirty-first day of December in each year. Section 2. Dividends. The board of directors may from time to time declare, and the corporation may pay, dividends on its outstanding shares in the manner and upon the terms and conditions provided by law and its Articles of Incorporation. Section 3. Corporate Seal. The board of directors shall provide a corporate seal which shall be circular in form and shall have inscribed thereon the name of the corporation, the state of Virginia, and year of incorporation and the words, "Corporate Seal". ARTICLE IX EMERGENCIES Section 1. Emergency Bylaws. During any emergency resulting from an attack on the United States or any nuclear or atomic disaster, which is declared to be such by an appropriate agency of the state or federal government, these bylaws shall be modified (but only to the extent required by such emergency) as follows: a. A meeting of the board of directors may be called by any officer or director by giving at least one hour's notice to such of the directors as it may be feasible to reach at the time and by such means as may be feasible at the time, including publication or radio. b. The directors in attendance at the meeting, if not less than three, shall constitute a quorum. To the extent required to constitute a quorum at any meeting of the board of directors, the officers of the corporation who are present shall be deemed, in order of rank and within the same rank in order of seniority, directors for such meeting. For purposes of this bylaw, officers shall rank as follows: chairman of the board, vice chairmen, president, executive vice president, senior vice president, vice president, secretary, treasurer, assistant vice president, assistant secretary, and assistant treasurer. Officers holding similar titles shall rank in the order of their appointment. Section 2. Termination of Emergency. Except as provided in this article, the regular bylaws of the corporation shall remain in full force and effect during any emergency, and upon its termination, these emergency bylaws shall cease to be operative. ARTICLE X AMENDMENTS The board of directors shall have the power to alter, amend or repeal any bylaws of the corporation and to adopt new bylaws; but any bylaws made by the board of directors may be repealed or changed, and new bylaws made, by the stockholders, who may prescribe that any bylaw made by them shall not be altered, amended or repealed by the board of directors. EXHIBIT 11 FIRST VIRGINIA BANKS, INC. STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS Year Ended December 31 1993 1992 1991 -------- ------- ------- (In thousands, except per share data) PRIMARY: Average common shares outstanding 32,408 32,144 32,036 Dilutive effect of stock options 104 108 56 -------- ------- ------- Total average common shares 32,512 32,252 32,092 ======== ======= ======= Net income $116,024 $97,473 $69,608 Provision for preferred dividends (53) (61) (71) -------- ------- ------- Net income applicable to common stock $115,971 $97,412 $69,537 ======== ======= ======= Net income per share of common stock $3.57 $3.02 $2.17 ======== ======= ======= FULLY DILUTED: Average common shares outstanding 32,408 32,144 32,036 Dilutive effect of stock options 107 113 64 Conversion of preferred stock 117 133 154 -------- ------- ------- Total average common shares 32,632 32,390 32,254 ======== ======= ======= Net income $116,024 $97,473 $69,608 ======== ======= ======= Net income per share of common stock $3.56 $3.01 $2.16 ======== ======= ======= Years prior to 1992 have been restated to reflect the three-for-two common stock split in July of 1992. EXHIBIT 22 SUBSIDIARIES OF THE REGISTRANT December 31, 1993 State of Incorporation ------------- First Virginia Banks, Inc. Virginia Banking Subsidiaries: Northern Region: First Virginia Bank Virginia First General Mortgage Company Virginia First Virginia Mortgage Company Virginia First Virginia Commercial Corporation Virginia First Virginia Card Services, Inc. Virginia First Virginia Credit Services, Inc. Virginia First Virginia Bank-Central Maryland Maryland C.B. Properties, Inc. Maryland C.B. Properties II, Inc. Maryland First Virginia Bank-Maryland Maryland Eastern Region: First Virginia Bank of Tidewater Virginia First Virginia Bank-Colonial Virginia First Virginia Bank-Commonwealth Virginia First Virginia Bank-Central Virginia First Virginia Bank-South Hill Virginia Southwest Region: First Virginia Bank-Southwest Virginia First Virginia Bank-Franklin County Virginia First Virginia Bank-Southside Virginia First Virginia Bank-Highlands Virginia First Virginia Bank-Piedmont Virginia First Virginia Bank-Clinch Valley Virginia Shenandoah Valley Region: First Virginia Bank-Shenandoah Valley Virginia First Virginia Bank of Augusta Virginia First Virginia Bank-Planters Virginia Tennessee-Western Virginia Region: First Virginia Bank-Mountain Empire Virginia Tri-City Bank and Trust Company Tennessee Bank of Madisonville Tennessee United Southern Bank Tennessee Nonbanking Subsidiaries First Virginia Insurance Services, Inc. Virginia First Virginia Services, Inc. Virginia First Virginia Life Insurance Company Virginia Springdale Advertising Agency, Inc. Virginia Northern Operations Center, Inc. Virginia Southwest Operations Center, Inc. Virginia Eastern Operations Center, Inc. Virginia First Virginia Software, Inc. Virginia United Land Corporation Maryland Springdale Temporary Services, Inc. Virginia All of the organizations listed above are 100% owned by First Virginia Banks, Inc. or one of its subsidiary banks. EXHIBIT 24 Consent of Independent Auditors Board of Directors First Virginia Banks, Inc. We consent to the incorporation by reference into Registration Statement Number 33-52507 on Form S-4 dated March 4, 1994, Post-effective Amendment No. 1 to Registration Statement Number 33-38024 on Form S-8 dated January 10, 1994, Registration Statement Number 33-51587 on Form S-3 dated December 20, 1993, Registration Statement Number 33-54802 on Form S-8 dated November 20, 1992, Registration Statement Number 33-31890 on form S-3 dated November 1, 1989, Post-effective Amendment Number 3 to Registration Statement Number 2-67507 on Form S-3 dated January 7, 1988, Post-effective Amendment Number 2 to Registration Statement Number 2-77151 on Form S-8 dated October 30, 1987, Registration Statement Number 33-17358 on Form S-8 dated September 28, 1987, Registration Statement Number 33-15360 on Form S-3 dated June 26, 1987, of our report dated January 13, 1994, with respect to the consolidated financial statements of First Virginia Banks, Inc. included in this Annual Report on Form 10-K for the year ended December 31, 1993. Washington, D.C. March 23, 1994

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ITEM 1. BUSINESS GENERAL Westwood One, Inc. (the "Company" or "Westwood One") is a leading producer and distributor of nationally sponsored radio programs and believes it is the nation's second largest radio network. The Company's principal source of revenue is selling radio time to advertisers. The Company generates revenue principally by its radio networks entering into radio station affiliation agreements to obtain audience and commercial spots and then selling the audience and spots to national advertisers. The Company is strategically positioned to provide a broad range of programming and services which both deliver audience to advertisers and news, talk, sports, and entertainment programs to radio stations. The Company produces and distributes regularly scheduled news, talk, sports, and entertainment programs through its various operating radio networks: Mutual Broadcasting System, NBC Radio Networks (National Radio Network, The Source and Talknet) and Westwood One Radio. The Company's programs encompass exclusive live concerts, music and interview shows, national music countdowns, lifestyle short features, live talk shows, and sports events (principally covering the NFL, Notre Dame football and other college football and basketball games). The Company also produces and distributes special event programs, including exclusive satellite simulcasts with HBO and other cable networks. Mutual Broadcasting System, National Radio Network and Talknet are primarily adult-oriented networks, in the News, Sports, Talk and Country formats. Westwood One Radio and The Source are primarily youth-oriented networks, in the Contemporary Hit Radio ("CHR"), Album Oriented Rock ("AOR"), Country and Black formats. The Company's programs are broadcast in every radio market in the United States measured by Arbitron, the leading rating service, and are carried by Armed Forces Radio, VOA Europe and other foreign broadcast services. Westwood One, through its networks and programming, enables national advertisers to purchase advertising time and to have their commercial messages broadcast on radio stations throughout the United States, reaching demographically defined listening audiences. The Company delivers both of the major demographic groups targeted by national advertisers: the 25 to 54-year old adult market and the 12 to 34-year-old youth market. The Company currently sells advertising time to over 300 national advertisers, including each of the 25 largest network radio advertisers. Radio stations are able to obtain quality programming from Westwood One to meet their objective of attracting larger listening audiences and increasing local advertising revenue. Westwood One, through the development of internal programming as well as through acquisitions, has developed an extensive tape library of previously aired programs, interviews, live concert performances, news and special events. The Company uses its library as a major source of new programming. The tape library enhances Westwood One's future programming and revenue generating capabilities. INDUSTRY BACKGROUND RADIO BROADCASTING On January 1, 1993, there were approximately 9,750 commercial radio stations in the United States. The radio broadcast industry, however, remains highly fragmented with no broadcaster owning more than 36 radio stations. This fragmentation is due primarily to FCC limitations on multiple station ownership. A radio station selects a style of programming ("format") to attract a target listening audience and thereby attract commercial advertising directed at that audience. There are many formats from which a station may select, including news, talk, sports and various types of music and entertainment programming. The number of formats has become further segmented over recent years. For example, what once was the Rock & Roll format has now been divided into several narrower formats, including Album Oriented Rock, Adult Contemporary Music ("AC") and Contemporary Hit Radio, each with a more demographically specific audience. The increase in the number of program formats has intensified competition among stations for local advertising revenue. A radio station has two principal ways of effectively competing for these revenues. First, it can differentiate itself in its local market by selecting and successfully executing a format targeted at a particular audience thus enabling advertisers to place their commercial messages on stations aimed at audiences with certain demographic characteristics. Second, a station can broadcast special programming, sporting events or national news product, such as supplied by Westwood One, not available to its competitors within its format. National programming broadcast on an exclusive geographic basis can help differentiate a station within its market, and thereby enable a station to increase its audience and local advertising revenue. RADIO ADVERTISING Radio advertising time can be purchased on a local, regional or national basis. Local purchases allow an advertiser to select specific radio stations in chosen geographic markets for the broadcast of commercial messages. However, this process can be expensive and time-consuming, and may not permit the advertiser to select the specific program in which its advertisements will be broadcast. Local and regional purchases are typically best suited for an advertiser whose business or ad campaign is in a specific geographic area. Advertising purchased from a radio network is one method by which an advertiser targets its commercial messages to a specific demographic audience. A national advertising purchase can enable an advertiser to achieve its objective with one purchase, at a lower cost per listener, and to select a particular program environment in which its advertisements will be broadcast. In recent years the increase in the number of program formats has led to more demographically specific listening audiences, making radio an attractive, alternative medium for national advertisers. In addition, nationally broadcast news, concerts and special event programming have made radio an effective medium of reach (size of listening audiences) as well as frequency (number of exposures to the target audience). To verify audience delivery and demographic composition, specific measurement information is available to national advertisers. In the top 175 markets, the number of listeners per station is measured and published by independent rating services such as The Arbitron Ratings Co. and Statistical Research, Inc.'s RADAR. These rating services provide demographic information such as the age and sex composition of the listening audiences. Consequently, national advertisers can verify that their advertisements are being heard by their target listening audience. BUSINESS STRATEGY Westwood One's principal business is providing targeted radio audiences and commercial spots to national advertisers through its recognized programming and other network products. The Company, through its various radio networks, produces and distributes quality programming to radio stations seeking to increase their listening audience and improve local and national advertising revenue. The Company sells advertising time within its programs to national advertisers desiring to reach large listening audiences nationwide with specific demographic characteristics. In fiscal 1993 the Company developed and implemented a strategy to focus on its core radio network business and to reduce debt by divesting of all other businesses. During the year other businesses such as radio stations (WYNY-FM and KQLZ-FM) and Radio & Records were disposed. Consequently, the financial results for these businesses are reported as discontinued operations in the Company's financial statements. Additionally, in fiscal 1993 the Company completed the sale of an unconsolidated subsidiary, WNEW-AM, (reported in 1992) and sold a parcel of real estate that had been held for sale for two years. The net proceeds from all these transactions enabled the Company to reduce its debt to $60,149,000 at November 30, 1993 from $178,579,000 at November 30, 1992. Lastly, in the fourth quarter of 1993 the Company repaid its Revolving Facility and term loan with a bank by entering into a new senior debt agreement with a maximum borrowing capacity of $20,000,000. In refocusing on its core network and radio syndication business, the Company has concentrated on across-the-board cost reductions in order to improve profitability. In late fiscal 1993 the Company took a major step to enhance its future and ability to compete by entering into a definitive agreement to acquire Unistar Radio Networks, Inc. ("Unistar") for $101,300,000 along with the following additional matters in connection with the acquisition: (a) the sale by the Company to Infinity Network, Inc. ("INI"), a wholly-owned subsidiary of Infinity Broadcasting Corporation ("Infinity"), of 5,000,000 shares of the Company's Common Stock and a warrant to purchase up to an additional 3,000,000 shares of Common Stock at an exercise price of $3.00 per share, for a total purchase price of $15,000,000; (b) a Management Agreement between the Company and Infinity pursuant to which (a) the Chief Executive Officer of Infinity, currently Mel Karmazin, will become Chief Executive Officer of the Company, (b) the Chief Financial Officer of Infinity, currently Farid Suleman, will become Chief Financial Officer of the Company and (c) Infinity will manage the business and operation for an annual base fee of $2,000,000 (adjusted for inflation), an annual cash bonus payable in the event of meeting certain financial targets and additional warrants to acquire up to 1,500,000 shares of common stock exercisable at certain market prices per share. (c) a Voting Agreement providing for the reconstitution of the Board of Directors into a nine-member Board and the voting of Norman Pattiz's shares of the Company's Common Stock and Class B Stock and the shares of the Common Stock held by the Infinity subsidiary. Unistar is a producer and distributor of radio programs and 24-hour continuous play formats to radio stations nationwide. Unistar serves approximately 2,000 affiliated radio stations, and similar to Westwood One, produces and distributes regularly scheduled news, business, sports and entertainment programs through its various operating radio networks: Unistar Power Radio Network, CNN+Radio Network, Unistar Super Radio Network, CNBC Business Radio Network and Unistar Programming Network. Generally, Unistar pays the cost of producing or acquiring the broadcasting rights for its programming and pays compensation to its affiliated stations for broadcasting the programs and commercial announcements included therein. Like the Company, Unistar derives substantially all of its revenue from the sale of commercial time to national advertisers. The Company anticipates financing the acquisition ($101,300,000), repaying its current senior debt agreement ($13,648,000 at November 30, 1993) and improving its working capital with a new senior loan from a syndicate of banks in the amount of $125,000,000 and the sale of $15,000,000 of Common Stock to INI. RADIO PROGRAMMING The depth of Westwood One's programming has grown through internal expansion and through acquisition. The Company produces and distributes regularly scheduled and special syndicated programs, including exclusive live concerts, music and interview shows, national music countdowns, lifestyle short features, news broadcasts, talk programs, sporting events, and sports features. The Company controls most aspects of production of its programs, therefore being able to tailor its programs to respond to current and changing listening preferences. The Company produces both regularly scheduled short-form programs (typically 5 minutes or less) and long-form programs (typically 60 minutes or longer). Typically, the short-form programs are produced at the Company's in-house facilities located in Culver City, California, New York, New York and Arlington, Virginia. The long-form programs include shows produced entirely at the Company's in-house production facilities and recordings of live concert performances and sports events made on location. Westwood One also produces and distributes special event syndicated programs. In fiscal 1993 the Company produced and distributed numerous special event programs, including the multi-venue Country music extravaganza, Country Takes Manhattan, worldwide broadcasts of Paul McCartney Live In The New World, Zooropa 93: U2 Live From Dublin, Aerosmith Live From Brussels, the HBO simulcast of Madonna: Live Down Under "The Girlie Show", and exclusive live concert broadcasts of Tom Petty and The Heartbreakers, and Rod Stewart. Westwood One believes these broadcasts have contributed to its reputation and are an integral part of its business strategy to increase its share of the national radio network advertising market. Westwood One obtains most of the programming for its concert series by recording live concert performances of prominent recording artists. The agreements with these artists often provide the exclusive right to broadcast the concerts worldwide over the radio (whether live or pre-recorded) for a specific period of time. The Company may also obtain interviews with the recording artist and retain a copy of the recording of the concert and the interview for use in its radio programs and as additions to its extensive tape library. The agreements provide the artist with master recordings of their concerts and nationwide exposure on affiliated radio stations. In certain cases the artists may receive compensation. Westwood One's other programs are produced at its in-house production facilities. The Company determines the content and style of a program based on the target audience it wishes to reach. The Company assigns a producer, writer, narrator or host, interviewer and other personnel to record and produce the programs. Because Westwood One controls the production process, it can refine the programs' content to respond to the needs of its affiliated stations and national advertisers. In addition, the Company can alter program content in response to current and anticipated audience demand. The Company believes that its tape library is a valuable asset and significantly enhances its future programming and revenue generating capabilities. The library contains previously broadcast programs, live concert performances, interviews, daily news programs, sports and entertainment features, Capitol Hill hearings and other special events. New programs can be created and developed at a low cost by excerpting material from the library. For example, in 1993 Westwood One delved into its vast archives to bring back the sounds of the 70's and 80's for its new series The Retro Show. The Company also utilized its extensive music and interview resources for one time only specials and ongoing series such as Off The Record with Mary Turner, Classic Tracks and On The Edge. AFFILIATED RADIO STATIONS Westwood One's radio network business strategy addresses the programming needs and financial limitations of radio stations. The Company offers radio stations a wide selection of regularly scheduled and special event syndicated programming. These programs are completely produced by the Company and, therefore, the stations have no production costs. Typically, each program is offered for broadcast by the Company exclusively to one station in its geographic market, which assists the station in competing for audience share in its local marketplace. In addition, except for news programming, Westwood One's programs contain available commercial air time that the stations may sell to local advertisers. Westwood One typically distributes promotional announcements to the stations and places advertisements in trade and consumer publications to further promote the upcoming broadcast of its programs. Westwood One's networks enter into affiliation agreements with radio stations. In the case of news and current events programming, the agreements commit the station to broadcast only the advertisements associated with these programs and allows the station flexibility to have the news headlined by their newscasters. The other affiliation agreements require a station to broadcast the Company's programs and to use a portion of the program's commercial slots to air national advertisements and any related promotional spots. Radio stations in the top 200 national markets may also receive compensation for airing national advertising associated with the Company's news and current events programming. Affiliation agreements specify the number of times and the approximate time of day each program and advertisement may be broadcast. Westwood One requires that each station complete and promptly return to the Company an affidavit (proof-of-performance) that verifies the time of each broadcast. Affiliation agreements for Westwood One's entertainment programming are non-cancelable for 26 weeks and are automatically renewed for subsequent 26-week periods, if not canceled 30 days prior to the end of the existing contract term. Affiliation agreements for Westwood One's news and current events programming generally run for a period of at least one year, are automatically renewable for subsequent periods and are cancelable by either the Company or the station upon 90 days' notice. The Company has 34 people responsible for station relations and marketing its programs to radio stations. Station relationships are managed geographically to allow the marketing staff to concentrate on specific geographical regions. This enables the Company's staff to develop and maintain close, professional relationships with radio station personnel and to provide them with quick programming assistance. NATIONAL ADVERTISERS Westwood One provides national advertisers with a cost-effective way to communicate their commercial messages to large listening audiences nationwide that have specific demographic characteristics. An advertiser can obtain both frequency (number of exposures to the target audience) and reach (size of listening audience) by purchasing advertising time in the Company's programs. By purchasing time in programs directed to different formats, advertisers can be assured of obtaining high market penetration and visibility as their commercial messages will be broadcast on several stations in the same market at the same time. Westwood One generally guarantees an advertiser delivery of an audience of a specified size and demographic composition, which can be verified through independent surveys. Furthermore, advertisers receive affidavits that indicate the number of times and the time of day the advertisers' commercial messages were broadcast. The Company supports its national sponsors with promotional announcements and advertisements in trade and consumer publications. This support promotes the upcoming broadcasts of Company programs and is designed to increase the advertisers' target listening audience. The Company sells its commercial time to advertisers either as "bulk" or "flighted" purchases. Bulk purchases are long-term contracts (26 to 52 weeks) that are sold "up-front" (early advertiser commitments for national broadcast time) at discounts below prevailing market prices. Flighted purchases are contracts for a specific, short-term period of time (one to six weeks) that are sold at or above prevailing market prices. The Company's strategy for growth in advertising revenue is to increase the amount of advertising time sold on the usually more profitable flighted basis, to increase revenue of the non-RADAR rated programs, and to increase audience size for news, talk and current events programming. COMPETITION The Company operates in a very competitive environment. In marketing its programs to national advertisers, the Company directly competes with other radio networks, some of which may have greater financial resources than the Company, as well as with smaller independent radio syndication producers and distributors. In addition, Westwood One competes for advertising revenue with network television, cable television, print and other forms of communications media. The Company believes that the high quality of its programming and the strength of its station relations and advertising sales forces enable it to compete effectively with other forms of communication media. Westwood One markets its programs to radio stations, including affiliates of other radio networks, that it believes will have the largest and most desirable listening audience for each of its programs. The Company often has different programs airing on a number of stations in the same geographic market at the same time. The Company believes that in comparison with any other independent radio syndication producer and distributor or radio network it has a larger and more diversified selection of programming from which national advertisers and radio stations may choose. In addition, the Company both produces and distributes programs, thereby enabling it to respond more effectively to the demands of advertisers and radio stations. The increase in the number of program formats has led to increased competition among local radio stations for audience. As stations attempt to differentiate themselves in an increasingly competitive environment, their demand for quality programming available from outside programming sources has increased. This demand has been intensified by high operating and production costs at local radio stations and increased competition for local advertising revenue. GOVERNMENT REGULATION Radio broadcasting and station ownership are regulated by the FCC. Westwood One, as a producer and distributor of radio programs, is not subject to regulations by the FCC. EMPLOYEES On January 15, 1994, Westwood One, had 269 full-time employees, including a domestic advertising sales force of 48 people. In addition, the Company maintains continuing relationships with approximately 50 independent writers, program hosts, technical personnel and producers. Certain employees at the Mutual Broadcasting System and NBC Radio Networks are covered by collective bargaining agreements. The Company believes relations with its employees and independent contractors are good. ITEM 2. ITEM 2. PROPERTIES The Company owns a 7,600 square-foot building in Culver City, California in which its production facilities are located; a 14,000 square-foot building and an adjacent 10,000 square-foot building in Culver City, California which contains administrative, sales and marketing offices, and storage space; and a 7,700 square-foot unoccupied building in Culver City which contained production facilities and offices for KQLZ -FM until shortly after the station was sold. In addition, the Company leases offices in New York, Chicago, Detroit, Dallas, and Arlington, Virginia. The Company believes that its facilities are more than adequate for its current level of operations and contemplates reducing its available square footage in the Culver City area. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company submitted to the Securities and Exchange Commission ("Commission") an offer of settlement arising out of a formal investigation by the Commission which has been pending since 1989. The settlement offer, which was accepted by the Commission on January 7, 1994 and an order entered on January 19, 1994, involved the Company's consent, without admitting or denying any of the findings of the Commission, to an administrative cease and desist order based upon findings that in 1987 and 1988 the Company violated antifraud and accounting provisions of the federal securities laws and the rules thereunder in its revenue recognition and accounting practices during that period. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's shareholders during the fourth quarter of the fiscal year ended November 30, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS On January 15, 1994 there were approximately 475 holders of record of the Company's Common Stock, several of which represent "street accounts" of securities brokers. Based upon the number of proxies requested by brokers in conjunction with its special shareholders' meeting on January 28, 1994, the Company estimates that the total number of beneficial holders of the Company's Common Stock exceeds 5,000. The Company's Common Stock has been traded in the over-the-counter market under the NASDAQ symbol WONE since the Company's initial public offering on April 24, 1984. The following table sets forth the range of high and low last sales prices on the NASDAQ/National Market System, as reported by NASDAQ, for the Common Stock for the fiscal quarters indicated. No cash dividend was paid on the Company's stock during fiscal 1993 or 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS EXCEPT PER SHARE DATA) The table below summarizes selected consolidated financial data of the Company for each of the last five fiscal years: OPERATING RESULTS FOR FISCAL YEAR ENDED: BALANCE SHEET DATA AT PERIOD ENDED: - --------------- No cash dividend was paid on the Company's common stock during the five years ended November 30, 1993. Operating results for all prior periods have been reclassified to conform to the fiscal 1993 presentation for discontinued operations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (IN THOUSANDS EXCEPT FOR SHARE AND PER SHARE AMOUNTS) In June 1993, the Company completed the sales of its two owned-and-operated radio stations, WYNY-FM and KQLZ-FM (collectively, the "Stations"), and in November 1993 Westinghouse Electric Corporation ("WEC") acquired Radio & Records and the remaining net assets of Westwood One Stations Group, Inc. ("The Group") (a subsidiary initially set up by the Company as the owner of the Stations and Radio & Records in order to collateralize loans from WEC) in complete satisfaction of The Group's remaining obligations for the principal amount of loans and accrued interest thereon owed to WEC. Accordingly, the results of the Stations and Radio & Records are classified as discontinued operations for all periods presented. The following table sets forth the consolidated statements of operations in dollars and as a percent of revenue for the three years ended November 30, 1993, 1992, and 1991, accompanied by dollar and percent comparisons covering 1993 vs 1992 and 1992 vs 1991: - --------------- NM -- not meaningful Westwood One derives substantially all of its revenue from the sale of advertising time to advertisers. Revenue decreased 2% to $99,579 in fiscal 1993 from $101,290 in fiscal 1992 and decreased 7% in fiscal 1992 from $108,586 in fiscal 1991. The decrease in revenue in fiscal 1993 was attributed to the non-recurrence of the Company's exclusive radio coverage of the 1992 Summer Olympics, partially offset by revenue growth associated with an overall increase in the market. The decrease in revenue in fiscal 1992 was primarily attributable to a 13% erosion of the national network radio revenue marketplace (according to the Radio Network Association). The decline in revenue in 1992 would have been slightly greater had the Company not had the exclusive radio coverage for the 1992 Summer Olympics. The Company's market share, based on advertising revenue reported to the Radio Network Association, was 24% in fiscal 1993 as compared to approximately 25% in fiscal 1992 and 24% in 1991. Operating costs and expenses (excluding depreciation and amortization) primarily include affiliate compensation (to radio stations in exchange for commercial spots, which the Company sells to advertisers), current period production costs of syndicated radio programs (excluding the amortization of production costs) and network administration, which typically do not vary directly with revenue, and selling expenses (including agency commissions related to advertising revenue) which often vary closely with revenue. Operating costs and expenses excluding depreciation and amortization decreased 12% to $80,918 in fiscal 1993 from $92,249 in fiscal 1992 and increased 7% in fiscal 1992 from $86,287 in fiscal 1991. The 1993 decrease is primarily due to cost reduction programs associated with affiliate compensation, programming, news and related staff expenses, the non-recurrence of the 1992 Summer Olympics, and lower agency commissions. The fiscal 1992 increase is primarily attributable to costs associated with broadcasting the 1992 Summer Olympics, a provision for contract losses and higher affiliate compensation expense, partially offset by lower syndicated music programming expense, reduced agency commissions, lower write-offs of doubtful accounts and lower transmission expense. Depreciation and amortization dropped 17% to $16,384 in 1993 from $19,661 in 1992 and dropped 11% in 1992 from $22,055 in 1991. The reductions are primarily due to lower amortization of production costs and lower write-offs resulting from fewer terminated station affiliation agreements. Corporate general and administrative expenses decreased 26% to $4,468 in fiscal 1993 from $6,017 in fiscal 1992 and decreased 3% in fiscal 1992 from $6,175 in fiscal 1991. The decrease in 1993 was attributable to across-the-board expense cuts and the non-recurrence of one-time charges from 1992. In 1992, reduced legal and consulting fees were almost offset by a one-time charge for a vested benefit related to a new executive officer's employment contract, an executive search fee and expenses associated with restructuring loan agreements. Severance and termination expenses of $2,063 in 1992 were principally due to management changes implemented to achieve future efficiencies. Operating loss decreased 88% to $2,191 in 1993 from $18,700 in 1992 after a 215% increase in 1992 from a loss of $5,931 in 1991. The 1993 significant improvement was primarily due to extensive cost reduction programs and the non-recurrence of prior year severance and termination expenses, partially offset by the non-recurrence of profit from the 1992 Summer Olympics. The increase in the 1992 operating loss occurred principally due to the profit impact of lower revenue resulting from the overall decline in the marketplace (somewhat offset by profit from the 1992 Olympics), increased operating costs and expenses excluding depreciation and amortization and significant severance and termination expenses, partially offset by lower depreciation and amortization. Interest expense was $6,551, $5,562 and $5,610 in fiscal 1993, 1992 and 1991, respectively. The 18% increase in fiscal 1993 was primarily due to restructuring expenses accompanied by an increased interest rate associated with amending the terms of the Company's bank revolving credit facility and term loan. In fiscal 1993, other income of $60 was principally comprised of investment income. In fiscal 1992 and 1991, other expense of $301 and $1,081, respectively, was due principally to provisions in 1992 and 1991 of $250 and $1,428, respectively, to write-down a parcel of real estate that was held for sale to its net realizable value, partially offset by investment income. Equity in net loss of an unconsolidated subsidiary represents the Company's share of the operating performance of WNEW-AM, which was sold in August 1992. Loss on the sale of an unconsolidated subsidiary of $6,536 in 1992 represents the provision for the sale of WNEW-AM, which closed on December 15, 1992. Loss before taxes, discontinued operations, and extraordinary gain decreased 73% to $8,682 in 1993 from $31,888 in 1992 and increased 120% in 1992 from $14,523 in 1991. The 1993 dramatic improvement was attributable to the decreased operating loss and the elimination of both the equity in net loss and loss on sale of an unconsolidated subsidiary resulting from its sale in the third quarter of fiscal 1992. The increased loss in 1992 was principally due to the increased operating loss, the loss on the sale of an unconsolidated subsidiary, and the provision for the write-down to net realizable value of a parcel of real estate. Starting in fiscal 1993 the Company no longer has deferred tax liabilities available to offset its loss from continuing operations resulting in a reduced benefit for income taxes of $10,491 in 1993. The benefit for income taxes increased 132% to $10,491 in 1992 from $4,519 in 1991, principally as a result of the change in pre-tax loss. The Company's effective tax rates in fiscal 1992 and 1991 were 33% and 31%, respectively. Loss from continuing operations decreased $12,715 to $8,682 in 1993 from $21,397 in 1992 and increased $11,393 in 1992 from $10,004 in 1991 due to changes in the pre-tax loss, partially offset by the benefit for income taxes. Loss on discontinued operations, net of income tax benefit, was $3,140 in 1993, $2,721 in 1992 and $6,778 in 1991. The 1993 loss represents the operating performance of discontinued operations through March 1, 1993. The decrease in the loss in 1992 was due to improved operating performance of WYNY-FM and Radio & Records, lower interest expense and the non-occurrence of costs associated with a 1991 format change at KQLZ-FM. The $12,087 provision for loss on disposal of discontinued operations includes estimated future costs and operating results of the discontinued assets from March 1, 1993 until the date of disposition. The Company had an extraordinary gain on the debt exchange offer in fiscal 1991, net of taxes, amounting to $25,618. In 1992, the Financial Accounting Standards Board issued FAS No. 109 "Accounting for Income Taxes". The Company will adopt the standard on December 1, 1993, and currently estimates that its deferred tax liability will be increased by approximately $2,000. The resulting expense will be recorded in the statement of operations and reported as a cumulative effect of a change in an accounting principle. LIQUIDITY AND CAPITAL RESOURCES At November 30, 1993, the Company's cash and cash equivalents were $3,868, a decrease of $2,587 from November 30, 1992. The decrease in cash of $2,587 combined with the cash provided before financing activities of $92,544 and the proceeds from the issuance of common stock of $1,507 were used to reduce outstanding borrowings by $96,638. Additionally, WEC acquired the outstanding stock of Radio & Records and the net assets of Westwood One Stations Group in complete satisfaction of the Group's remaining debt and a conversion to common stock of $2,068 face value of Senior Debentures occurred. Consequently, total debt was reduced to $60,149 at November 30, 1993, a decrease of $118,430 from $178,579 at November 30, 1992. For fiscal 1993, net cash from operating activities was $2,045, a decrease of $7,207 from fiscal 1992. The decrease was primarily attributable to higher prior year network collections associated with fourth quarter 1991 revenue and a large reduction in accounts payable and accrued liabilities primarily related to reduced interest, partially offset by improved broadcast cash flow (based on the consolidated statement of operations, calculated by subtracting from revenue, operating costs and expenses excluding depreciation and amortization) and receipt of a multi-year license fee (deferred revenue). Net cash provided by investing activities was $90,499, an increase of $101,841 over the prior year, principally due to net proceeds from the sales of two radio stations, an unconsolidated subsidiary and a parcel of real estate. Consequently, cash provided before financing activities increased by $94,634 from 1992. The Company used the assets of The Group as collateral for a revolving credit facility and for the 16% Senior Subordinated Debentures with WEC, both non-recourse to the Company, which amounted to $104,960 at November 30, 1992. In June 1993 the Company completed the sale of both radio stations and used the net proceeds to retire the 16% Debentures ($43,733) and reduce the outstanding balance of the revolving credit facility. Effective November 1, 1993, WEC acquired Radio & Records and the remaining net assets of The Group in complete satisfaction of The Group's remaining obligations for the principal amount of loans and accrued interest thereon owed to WEC. On November 22, 1993 the Company repaid its Revolving Facility and term loan by entering into a new senior debt agreement involving a revolving facility and two term loans with a maximum borrowing capacity of $20,000. At November 30, 1993, the Company had outstanding borrowings under the revolving facility of $6,648 and available borrowings of $6,352. From December 1, 1993 through January 15, 1994, holders of the Company's Senior Debentures converted $12,542 face amount of the Senior Debentures into 3,584,000 shares of the Company's common stock, reducing the outstanding amount of the Senior Debentures to $18,516. In order to finance the acquisition of Unistar (which will be accounted for as a purchase) the Company anticipates obtaining a new senior loan with a syndicate of banks in the amount of $125,000. Additionally, the Company will sell 5 million shares of Common Stock and a warrant to purchase up to an additional 3 million shares of Common Stock at an exercise price of $3.00 per share (subject to certain vesting conditions) to INI for $15,000. The proceeds will be used to acquire Unistar and repay its indebtedness ($101,300), repay the Company's current senior debt agreement, and improve working capital. Immediately following the acquisition, and as a condition to obtaining a new senior loan, the Company will also redeem its Senior Debentures. Management believes that the Company's cash, anticipated cash flow from operations and available borrowings will be sufficient to finance current and forecasted operations and debt obligations over the next 12 months. Furthermore, management believes the acquisition of Unistar will strengthen the Company's liquidity. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and the related notes and schedules of the Company are indexed on page of this Report, and attached hereto as pages through and by this reference incorporated 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 This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information is incorporated by reference to the Company's definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the Company's fiscal year. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THIS REPORT ON FORM 10-K 1. Financial statements and schedules to be filed thereunder are indexed on page hereof. 2. Exhibits - --------------- (1) Filed as an exhibit to Registrant's registration statement on Form S-1 (File Number 2-98695) and incorporated herein by reference. (2) Filed as an exhibit to Registrant's registration statement on Form S-1 (Registration Number 33-9006) and incorporated herein by reference. (3) Filed as an exhibit to Registrant's Form 8 dated March 1, 1988 (File Number 0-13020), and incorporated herein by reference. (4) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1987 (File Number 0-13020) and incorporated herein by reference. (5) Filed as part of Registrant's September 25, 1986 proxy statement (File Number 0-13020) and incorporated herein by reference. (6) Filed as an exhibit to Registrant's current report on Form 8-K dated September 4, 1987 (File Number 0-13020) and incorporated herein by reference. (7) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1988 (File Number 0-13020) and incorporated herein by reference. (8) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1989 (File Number 0-13020) and incorporated herein by reference. (9) Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1990 (File Number 0-13020) and incorporated herein by reference. (10) Filed as an exhibit to Registrant's application for qualification of indentures on Form T-3 which became effective and qualified on January 11, 1991 (File Number 22-20701) and incorporated herein by reference. (11) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1990 (File Number 0-13020) and incorporated herein by reference. (12) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1991 (File Number 0-13020) and incorporated herein by reference. (13) Filed as part of Registrant's March 27, 1992 proxy statement (File Number 0-13020) and incorporated herein by reference. (14) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1992 (File Number 0-13020) and incorporated herein by reference. (15) Filed as an exhibit to Registrant's June 18, 1993 Registration Statement on Form S-8. (16) Filed as part of Registrant's January 7, 1994 proxy statement (File Number 0-13020) and incorporated herein by reference. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the fourth quarter of fiscal 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. WESTWOOD ONE, INC. February 1, 1994 By NORMAN J. PATTIZ ---------------------------------- Norman J. Pattiz Chairman of the Board of Directors 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. WESTWOOD ONE, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules have been omitted because they are not applicable, the required information is immaterial, or the required information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF WESTWOOD ONE, INC. In our opinion, the consolidated financial statements listed in the index to consolidated financial statements and financial statement schedules on page present fairly, in all material respects, the financial position of Westwood One, Inc. and its subsidiaries at November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the three fiscal years in the period ended November 30, 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. PRICE WATERHOUSE Century City, California February 1, 1994 WESTWOOD ONE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes to consolidated financial statements. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The consolidated financial statements include the accounts of all wholly-owned subsidiaries. Investments in 20 to 50 percent-owned companies are accounted for under the equity method. Revenue Recognition Revenue is recognized when commercial advertisements are broadcast. Cash Equivalents The Company considers all highly liquid instruments purchased with a maturity of less than three months to be cash equivalents. Depreciation Depreciation is computed using the straight line method over the estimated useful lives of the assets. Production Costs The Company defers a portion of its costs for recorded library material and produced radio entertainment programs with a life of longer than a year. Recorded library material includes previously broadcast programs, live concert performances, interviews, news and special events. Production costs are amortized using the straight line method over the period of expected benefit, not to exceed five years. Approximately 79% of current and deferred production costs at November 30, 1993 will be amortized by November 30, 1995. The current portion of deferred production costs represents the portion to be amortized over the next twelve months. Capitalized Station Affiliation Agreements Expenditures associated with major new affiliate agreements are capitalized and amortized starting once the affiliate's audience is included in rating service publications for use in generating advertising revenue. Capitalized station affiliation agreements exclude station affiliation agreements acquired as part of a purchase of an existing network. These expenditures, which are included in other assets, are amortized over 10 years or the period of known benefit, whichever is less. Measurement of Intangible Asset Impairment The Company periodically evaluates the carrying value of Intangible Assets. The Company considers the ability to generate positive broadcast cash flow (based on the consolidated statement of operations, calculated by subtracting from revenue, operating costs and expenses excluding depreciation and amortization) as the key factor in determining whether the assets have been impaired. To date, the Company has not experienced an impairment in any of its intangible assets. Income Taxes Deferred income taxes are provided for timing differences, resulting principally from deferred production costs. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) Earnings (Loss) per Share Net income (loss) per share is based on the weighted average number of common shares outstanding during the year. Average shares outstanding, used to compute per share figures, were as follows: Reclassification Financial statements for all prior periods have been reclassified to conform to the fiscal 1993 presentation. The principal adjustments were to include the amortization of intangible assets acquired through acquisition in arriving at an operating loss and to segregate discontinued operations. NOTE 2 -- DISCONTINUED OPERATIONS At the end of the Company's first fiscal quarter of 1993, the Company classified the results of operations from Radio & Records and its Los Angeles (KQLZ-FM) and New York (WYNY-FM) radio stations as discontinued operations. These three businesses collateralized the Company's 16% Debentures and Revolving Credit Facility with Westinghouse Electric Corporation ("WEC"). In June 1993 the Company completed the sales of its Los Angeles and New York radio stations, and used the net proceeds from the sales to retire the Company's 16% Debentures and reduce the outstanding balance of its Revolving Credit Facility. On November 1, 1993, WEC acquired the outstanding stock of Radio & Records and the net assets of Westwood One Stations Group for the outstanding balance of the Revolving Credit Facility, accrued interest and any other potential claims. Accordingly, the historical net loss of the Company's owned-and operated radio stations and Radio & Records have been reported separately from continuing operations, and the prior periods have been restated (including an allocation of interest of $7,043, $12,273, and $13,058 for fiscal 1993, 1992 and 1991, respectively). The Company made a provision for the loss on the disposition of these assets including estimated future costs and operating results from March 1, 1993 until the date of disposition, of $12,087, which includes a fourth quarter provision of $3,587 as a result of the net proceeds from the disposal of Radio & Records and the WEC agreement. Revenue from discontinued operations for fiscal 1993, 1992 and 1991 were $22,282, $36,443, and $35,764, respectively. The consolidated statements of cash flows include both continuing and discontinued operations of the Company. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 3 -- PROPERTY AND EQUIPMENT: Property and equipment is summarized as follows at: NOTE 4 -- INTANGIBLE ASSETS: Intangible assets are summarized as follows at: Station affiliation agreements are comprised of values assigned to agreements acquired as part of the purchase of radio networks and are amortized using an accelerated method over 40 years. The value of station affiliation agreements, whose period of known benefit will expire in the next twelve months, is $549 and $800 at November 30, 1993 and 1992, respectively. Goodwill represents the excess of the cost of purchased businesses over the fair value of their net assets at the date of acquisition. Intangible assets, except for acquired station affiliation agreements, are amortized on a straight-line method over 40 years. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 5 -- FINANCING ARRANGEMENTS AND LONG-TERM DEBT: Financing Arrangements In addition to long-term debt, the Company has a secured Revolving Facility in the maximum amount of $13,000 (based on a percentage of Eligible Accounts Receivable). The Revolving Facility bears interest, payable monthly, at the rate of prime plus 2.25%. At November 30, 1993, the Company owed $6,648 under this Revolving Facility and had available borrowings of $6,352. The Loan and Security Agreement for the Revolving Facility and the term notes (see below) contain provisions which require the Company to maintain minimum levels of Working Capital and Adjusted Tangible Net Worth along with a minimum current ratio. (See Note 12 -- Subsequent Events) Long-Term Debt Long-term debt consists of the following at: The Company has two Term Notes which mature on December 1, 1995 ("Note A") and December 1, 1996 ("Note B") (collectively the "Notes"). The Notes bear interest at the rate of prime plus 2.25%. Interest is payable monthly. Principal is payable monthly on each note commencing on January 1, 1994 in the amounts of $83 and $58 for Note A and Note B, respectively. (See Note 12 -- Subsequent Events). During fiscal 1993, the Company paid or exchanged the following debt instruments which were outstanding at the beginning of the year: Prime plus 1 1/2% term loan from bank, Prime plus 1 1/4% Revolving Credit Facility and 16% Senior Subordinated Debentures (See Note 2 -- Discontinued Operations). The 9% Convertible Senior Subordinated Debentures ("Senior Debentures") are unsecured and subordinated in right of payment to senior indebtedness of the Company. Interest on the Senior Debentures is payable semiannually on April 15 and October 15. The Senior Debentures are WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) convertible at any time prior to maturity, unless previously redeemed, into shares of Common Stock of the Company at the conversion price of $3.50 per share, subject to adjustment upon the occurrence of certain events. The Senior Debentures are redeemable at the option of the Company at a declining premium to par until 1996 and at par thereafter. In fiscal 1993, $2,068 of Senior Debentures were converted to Common Stock (See Note 12 -- Subsequent Events). The 6 3/4% Convertible Subordinated Debentures ("Debentures") are unsecured and subordinated in right of payment to senior indebtedness and Senior Debentures. Interest on the Debentures is payable semiannually on April 15 and October 15. The Debentures are convertible at any time prior to maturity, unless previously redeemed, into shares of Common Stock of the Company at the conversion price of $24.58 per share, subject to adjustment upon the occurrence of certain events. On January 11, 1991, the Company accepted, and, thereafter, retired $83,037 principal amount of the Debentures (84% of the then outstanding bonds) tendered pursuant to its offer to exchange its Senior Debentures for any and all of its Debentures. As a result of this transaction, the Company recorded an extraordinary gain, net of taxes, of $25,618. The aggregate maturities of long-term debt for the next five fiscal years and thereafter, pursuant to the Company's debt agreements as in effect at November 30, 1993, are as follows: NOTE 6 -- SHAREHOLDERS' EQUITY: The authorized capital stock of the Company consists of Common stock, Class B stock and Preferred stock. Common stock is entitled to one vote per share while Class B stock is entitled to 50 votes per share. In December 1992, the Company's Board of Directors authorized the issuance of 41,500 shares of common stock to an officer of the Company for services performed in fiscal 1992. In October 1990 the Company issued 267,740 shares of common stock to a company owned by the Chairman of the Board in full satisfaction of an amount owed that company for transportation services. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) As part of a settlement relating to class action lawsuits filed against the Company, it issued warrants to purchase 3,000,000 shares of the Company's common stock at $17.25 per share. The warrants expire on September 4, 1997. Warrants not exercised may be redeemable under certain circumstances at $1.00 per warrant. As part of a seven year employment agreement which commenced December 1, 1986, 112,500 shares of Class B stock were placed in escrow for the Chairman of the Board. As of November 30, 1993, all the shares were vested. NOTE 7 -- STOCK OPTIONS: The Company has stock option plans established in 1984 and 1989 which provide for the granting of options to directors, officers and key employees to purchase stock at its market value on the date the options are granted. No additional options can be granted under the 1984 Plans. There are 2,800,000 shares authorized under the 1989 Plan, as amended. Options granted generally become exercisable after one year in 25% increments per year and expire within ten years from the date of grant. The 1989 Plan will remain in existence for 10 years or until otherwise terminated by the Board of Directors. Information concerning options outstanding under the Plans is as follows: On December 1, 1986, the Chairman of the Board was granted options not covered by the Plans to acquire 525,000 shares of common stock, which vested ratably over a seven-year term or immediately upon a change in control of the Company. The options became exercisable at the fair market value of the common stock, as defined, on the date of vesting. At November 30, 1993, all the options granted are exercisable at exercise prices ranging from $1.67 to $16.31 per share. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 8 -- INCOME TAXES: Starting in fiscal 1993 the Company no longer has deferred tax liabilities available to offset its losses. The components of the (benefit) for income taxes related to continuing operations is summarized as follows: The deferred tax benefits recorded for the two years ended November 30, 1992, are attributable to the reversal of deferred taxes for timing differences, provided for in earlier years. Certain of these deferred taxes were reinstated in fiscal 1991 as a result of a tax expense of $19,828 on the extraordinary gain. A reconciliation between the Company's effective income tax rate and the U.S. statutory rate is as follows: The Company has approximately $90,000 of available U.S. net operating loss carryforwards for tax purposes. Utilization of the carryforwards is dependent upon future taxable income and they begin to expire in 2003. As a result of the Company's prior and pending debt and equity transactions, some of the Federal net operating losses may be subject to certain limitations. In 1992, the Financial Accounting Standards Board issued FAS No. 109 "Accounting for Income Taxes". The Company will adopt the standard on December 1, 1993, and currently estimates that its deferred tax liability will be increased by approximately $2,000. The resulting expense will be recorded in the statement of operations and reported as a cumulative effect of a change in an accounting principle. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 9 -- COMMITMENTS AND CONTINGENCIES: The Company has various non-cancelable, long-term operating leases for office space and equipment. In addition, the Company is committed under various contractual agreements to pay for talent, broadcast rights, research and certain digital audio transmission services. The approximate aggregate future minimum obligations under such operating leases and contractual agreements for the five years after November 30, 1993, are set forth below: NOTE 10 -- SUPPLEMENTAL CASH FLOW INFORMATION: Supplemental Information on cash flows, including amounts from discontinued operations, and non-cash transactions is summarized as follows: WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) NOTE 11 -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): The following is a tabulation of the unaudited quarterly results of operations for each of the quarters for the fiscal years ended November 30, 1993 and 1992: NOTE 12 -- SUBSEQUENT EVENTS(UNAUDITED): The Company submitted to the Commission an offer of settlement arising out of a formal investigation by the Commission which has been pending since 1989. The settlement offer, which was accepted by the Commission on January 7, 1994 and an order entered on January 19, 1994, involved the Company's consent, without admitting or denying any of the findings of the Commission, to an administrative cease and desist order based upon findings that in 1987 and 1988 the Company violated antifraud and accounting provisions of the federal securities laws and the rules thereunder in its revenue recognition and accounting practices during that period. WESTWOOD ONE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) From December 1, 1993 through January 15, 1994, holders of the Company's Senior Debentures converted $12,542 face amount of the Senior Debentures into 3,584,000 shares of the Company's Common Stock. On January 28, 1994 the shareholders of the Company approved and authorized the acquisition by the Company of all the issued and outstanding capital stock of Unistar Radio Networks, Inc. ("Unistar") and the assumption of $84,711 of Unistar's indebtedness for an aggregate purchase price of $101,300. The acquisition will be accounted for as a purchase and, accordingly, Unistar's results of operations will be included in the consolidated statement of operations from the date the acquisition is consummated. In order to finance the acquisition of Unistar, the Company anticipates obtaining a new senior loan with a syndicate of bank's in the amount of $125,000. Additionally, the Company will sell 5 million shares of Common Stock and a warrant to purchase up to an additional 3 million shares of Common Stock at an exercise price of $3.00 per share (subject to certain vesting conditions) to a wholly-owned subsidiary of Infinity Broadcasting Corporation for $15,000. The net proceeds will be used to acquire Unistar and repay its indebtedness ($101,300), repay the Company's current senior debt agreement, and improve working capital. Immediately following the acquisition, and as a condition to obtaining a new senior loan, the Company will also redeem its Senior Debentures. WESTWOOD ONE, INC. SCHEDULE IX CONSOLIDATED SHORT-TERM BORROWINGS (IN THOUSANDS) Notes: Short-term borrowings during the years covered by this schedule consist of loans made under various established credit lines. The average amount outstanding during each period was computed by dividing the average outstanding principal balance by 365 days. The weighted average interest rate during each period was computed by dividing the actual interest expense on such borrowings by the average amount outstanding during that period.

872551_1993.txt

872551_1993

1993

872551

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

47217_1993.txt

47217_1993

1993

47217

ITEM 1. BUSINESS. PRODUCTS AND SERVICES Hewlett-Packard Company was incorporated in 1947 under the laws of the State of California as the successor to a partnership founded in 1939 by William R. Hewlett and David Packard. Hewlett-Packard Company, together with its consolidated subsidiaries (the "Company"), is engaged worldwide in the design, manufacture and service of electronic equipment and systems for measurement, computation and communications. The Company offers a wide variety of systems and standalone products, including electronic test equipment, computer systems and peripheral products, medical electronic equipment, calculators and other personal information products, solid state components and instrumentation for chemical analysis. These products are used in industry, business, engineering, science, education and medicine. A summary of the Company's net revenue as contributed by its major classes of products and services is found on page 44 of the Company's 1993 Annual Report to Shareholders, which page (excluding order data) is incorporated herein by reference. The Company's computers, computer systems, personal information products, personal peripheral products and other peripherals are used in a variety of applications, including scientific and engineering computation and analysis, instrument control and business information management. The Company's core computing products and technologies include its PA-RISC architecture for systems and workstations and software infrastructure for open systems. The Company's general-purpose computers and computer systems include scalable families of systems and servers for use in small workgroups, larger departments and entire data centers. Key products include the HP 9000 series, which runs HP-UX, HP's implementation of the UNIX(R)(/1/) operating system, and comprises both workstations with powerful computational and graphics capabilities and multiuser computers for both technical and commercial applications; and the HP Vectra series of IBM-compatible personal computers for use in business, engineering, manufacturing and chemical analysis. The Company offers software programming services, network services, distributed system services and data management services. Customers of the Company's computers, computer systems and software infrastructure products include original equipment manufacturers, dealers and value-added resellers, as well as end users for a variety of applications. In the field of computing during fiscal 1993, the Company expanded its Corporate Business Systems product line, a family of multiuser systems and servers that spans products in both the HP 9000 and the HP 3000 series. Other introductions included models 715, 725 and 735 of the Series 700 family of workstations, which incorporates the Company's PA-RISC architecture; the HP ENVIZEX family of X stations; HP Vectra personal computers based on the Intel486(/2/) DX and DX2 microprocessors; and a series of HP Vectra PC servers. Software introductions included a portfolio of new applications that expand the capabilities of HP OpenView, the Company's network- and systems-management platform; Release 2.0 of Dashboard for Windows, an upgrade of the Company's push-button utility panel for Windows; and Earth Data System, developed jointly by the Company and Ellery Systems Inc., which facilitates global environmental research. The Company's peripheral products include a variety of system and desktop printers, such as the HP LaserJet family; the HP DeskJet family, which is based on the Company's thermal inkjet technology; a family of graphic plotters and page scanners; video display terminals; disk (magnetic and optical) and tape drives and related autochangers. In fiscal 1993 the Company introduced the HP LaserJet 4Si and 4Si/MX printers, which are 600-dots-per-inch laser printers that can work concurrently with PCs, Macintosh computers, UNIX system-based workstations and multiple networks; the HP 4L and 4ML printers, the Company's - -------- (/1/)UNIX is a registered trademark of UNIX System Laboratories Inc. in the U.S.A. and other countries. (/2/)Intel486 is a U.S. trademark of Intel Corp. lowest-priced HP LaserJet printers for individual users; the HP DeskJet 1200C and 1200C/PS color printers, which offer laser-printer speed and functionality; and the HP DeskJet 310 and 310M portable printers. Other fiscal 1993 introductions included the HP Kittyhawk Personal Storage Module II, a 1.3-inch disk drive that stores 42.8 megabytes of text, and the HP FAX-900 and 950, both plain-paper fax machines based on the Company's thermal inkjet technology. The Company also produces measurement systems for use in electronics, medicine and analytical chemistry. Test and measurement instruments include voltmeters and multimeters that measure voltage, current and resistance; counters that measure the frequency of an electrical signal; oscilloscopes and logic analyzers that measure electrical changes in relation to time; signal generators that provide the electrical stimulus for the testing of systems and components; specialized communications test equipment; and atomic frequency standards, which are used in accurate time-interval and timekeeping applications. Instruments for medical applications include continuous monitoring systems for critical-care patients, medical data-management systems, fetal monitors, electrocardiographs, cardiac catheterization laboratory systems, blood gas measuring instruments, diagnostic ultrasonic imaging systems and cardiac defibrillators. Instruments for analytical applications include gas and liquid chromatographs, mass spectrometers, laboratory data systems and spectrophotometers. Key product introductions for measurement systems in fiscal 1993 included a network-monitoring system that gives telecom providers enhanced analytical and problem-solving capabilities; and the HP 3D Capillary Electrophoresis system, which offers bioscientists leading-edge separation capabilities. The Company continues to demonstrate its ability to combine measurement and computation. The Company's Unified Laboratory strategy is designed to improve a user's productivity by allowing computers in the analytical laboratory to serve as adjuncts to analytical instrumentation while broadening the user's ability to communicate with other parts of the organization. The Office of the Chemist is a subset of the Unified Laboratory in which an office-based workstation or PC, with business software such as spreadsheets, is combined with analytical equipment and data to allow a chemist to work more efficiently. The Company's Clinical Information System combines patient data from monitoring instruments with other information to assist nurses in providing health care. The Company also manufactures electronic component products consisting principally of microwave semiconductor, fiber-optic and optoelectronic devices (including light-emitting diodes). The products primarily are sold to other manufacturers for incorporation into their electronic products but also are used in many of the Company's products. In fiscal 1993 the Company introduced fiber-optic transceivers that reduce the costs of high-speed, multimedia networks; and a greenish-yellow, high-brightness light-emitting diode designed for use in highway signs, traffic signals and illuminated displays. During 1993 the Company's acquisition of BT&D Technologies, Ltd., a joint venture between British Telecommunications plc and DuPont, helped round out the Company's offering of components for the communications market. BT&D's products include fiber optic couplers, transmitters and receivers that go directly into the communications network for very high-speed, long-wavelength, laser-driven voice and data applications. The Company provides service for its equipment, systems and peripherals, including support and maintenance services, parts and supplies for design and manufacturing systems, office and information systems, general-purpose instruments, computers and computer systems, peripherals and network products. During fiscal 1993, the Company derived 24 percent of its net revenue from such services. The Company strives, in all its businesses, to promote industry standards that recognize customer preferences for open systems in which different vendors' products can work together. The Company often bases its product innovations on such standards and seeks to make its technology innovations into industry standards through licensing to other companies and standards-setting groups. For example, during fiscal 1993 the Company worked to make its serial infrared technology and its standard instrument control library into industry standards. MARKETING Customers. The Company has approximately 600 sales and support offices and distributorships in 110 countries. Sales are made to industrial and commercial customers, educational and scientific institutions, healthcare providers (including individual doctors, hospitals, clinics and research laboratories) and, in the case of its calculators and other personal information products, computer peripherals and PCs, to individuals for personal use. Sales Organization. More than half of the Company's orders are derived through value-added resale channels, including dealers and original equipment manufacturers. The remaining product revenue results from the efforts of its own sales organization selling to end users. In fiscal 1993 a higher proportion of the Company's net revenue than in fiscal 1992 was generated from products such as personal peripherals, which are primarily sold through dealers and other value-added resellers. Sales operations are supported by approximately 35,000 individuals, including field service engineers, sales representatives, service personnel and administrative support staff. International. The Company's total orders originating outside of the United States as a percentage of total Company orders were approximately 54 percent in fiscal 1993, 55 percent in fiscal 1992 and 56 percent in fiscal 1991. The majority of these international orders were from customers other than foreign governments. Approximately two-thirds of the Company's international orders in each of the last three fiscal years were derived from Europe, with most of the balance coming from Japan, other countries in Asia Pacific, Latin America and Canada. Most of the Company's sales in international markets are made by foreign sales subsidiaries. In countries with low sales volume, sales are made through various representative and distributorship arrangements. Certain sales in international markets, however, are made directly by the parent Company from the United States. The Company believes that its overall net profit margins on international sales are comparable to those obtained on sales made in the United States. The Company's international business is subject to risks customarily encountered in foreign operations, including fluctuations in monetary exchange rates, import and export controls and the economic, political and regulatory policies of foreign governments. The Company believes that its international diversification provides stability to its worldwide operations and reduces the impact on the Company of adverse economic changes in any single country. A summary of the Company's net revenue, earnings from operations and identifiable assets by geographic area is found on page 42 of the Company's Annual Report to Shareholders, which page is incorporated herein by reference. COMPETITION The Company encounters aggressive competition in all areas of its business activity. Its competitors are numerous, ranging from some of the world's largest corporations to many relatively small and highly specialized firms. The Company competes primarily on the basis of technology, performance, price, quality, reliability, distribution and customer service and support. The Company's reputation, the ease of use of its products and the ready availability of customer training are also important competitive factors. The computer market is characterized by vigorous competition among major corporations with long-established positions and a large number of new and rapidly growing firms. While the absence of reliable statistics makes it difficult to state the Company's relative position, the Company believes that it is the second-largest U.S.-based manufacturer of general-purpose computers, personal peripherals such as desktop printers, and calculators and other personal information products, all for industrial, scientific and business applications. The markets for test and measurement instruments are influenced by specialized manufacturers which often have great strength in narrow market segments. In general, however, the Company believes that it is one of the principal suppliers in these markets. BACKLOG The Company believes that backlog is not a meaningful indicator of future business prospects due to the volume of products delivered from shelf inventories, the shortening of product delivery schedules, and the portion of revenue that relates to its service business. Therefore, the Company believes that backlog information is not material to an understanding of its business. PATENTS The Company's general policy has been to seek patent protection for those inventions and improvements likely to be incorporated into its products or to give the Company a competitive advantage. While the Company believes that its patents and applications have value, in general no single patent is in itself essential. The Company believes that its technological position depends primarily on the technical competence and creative ability of its research and development personnel. MATERIALS The Company's manufacturing operations employ a wide variety of semiconductors, electro-mechanical components and assemblies, and raw materials such as plastic resins and sheet metal. The Company believes that the materials and supplies necessary for its manufacturing operations are presently available in the quantities required. The Company purchases materials, supplies and product sub-assemblies from a substantial number of vendors. For many of its products, the Company has existing alternate sources of supply, or such sources are readily available. A portion of the Company's manufacturing operations is dependent on the ability of significant suppliers to deliver integral sub- assemblies and components in time to meet critical manufacturing schedules. The failure of suppliers to deliver these subassemblies and components in a timely manner may adversely affect the Company's operating results until alternate sourcing could be developed. The Company believes that alternate suppliers or design solutions could be arranged within a reasonable time so that material long-term adverse impacts would be unlikely. RESEARCH AND DEVELOPMENT The process of developing new high technology products is complex and uncertain and requires innovative designs that anticipate customer needs and technological trends. After the products are developed, the Company must quickly manufacture products in sufficient volumes at acceptable costs to meet demand. Expenditures for research and development amounted to $1.8 billion in fiscal 1993, $1.6 billion in fiscal 1992 and $1.5 billion in fiscal 1991. In fiscal 1993, research and development expenditures were 8.7 percent of net revenue. This work is Company-sponsored, except for minor research and development done in the Company's laboratories pursuant to government-sponsored projects. ENVIRONMENT The operations of the Company involve the use of substances regulated under various federal, state and international laws governing the environment. It is the Company's policy to apply strict standards for environmental protection to sites inside and outside the U.S., even if not subject to regulations imposed by local governments. Liability for environmental remediation is accrued when it is considered probable and costs can be estimated. Environmental expenditures are presently not material to HP's operations or financial position. EMPLOYEES The Company had approximately 96,200 employees worldwide at October 31, 1993. ITEM 2. ITEM 2. PROPERTIES. The principal executive offices of the Company are located at 3000 Hanover Street, Palo Alto, California 94304. As of October 31, 1993, the Company owned or leased a total of approximately 40.9 million square feet of space worldwide. The Company believes that its existing properties are in good condition and suitable for the conduct of its business. The Company's plants are equipped with machinery, most of which is owned by the Company and is in part developed by it to meet the special requirements for manufacturing precision electronic instruments and systems. At the end of fiscal year 1993 the Company was productively utilizing the vast majority of the space in its facilities, while actively disposing of space determined to be excess. The Company anticipates that most of the capital necessary for expansion will continue to be obtained from internally generated funds. Investment in new property, plant and equipment amounted to $1.4 billion in fiscal 1993, $1.0 billion in fiscal 1992 and $862 million in fiscal 1991. The locations of the Company's major sales, marketing, product development and manufacturing facilities are listed on page 48 of the Company's 1993 Annual Report to Shareholders, which page is incorporated herein by reference. As of October 31, 1993, the Company's marketing operations occupied approximately 11 million square feet, of which 3.9 million square feet are located within the United States. The Company owns 56% of the space used for marketing activities and leases the remaining 44%. The Company's manufacturing plants, research and development facilities and warehouse and administrative facilities occupied 29.9 million square feet, of which 22.8 million square feet are located within the United States. The Company owns 79% of its manufacturing, research and development, warehouse and administrative space and leases the remaining 21%. None of the property owned by the Company is held subject to any major encumbrances. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are presently pending no legal proceedings, other than routine litigation incidental to the Company's business, to which the Company is a party or to which any of its property is subject. The Company is a party to, or otherwise involved in, proceedings brought by federal or state environmental agencies under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), known as "Superfund," or state laws similar to CERCLA. The Company is also conducting environmental investigation or remediation at several of its current or former operating sites pursuant to administrative orders or consent agreements with state environmental agencies. Liability for environmental remediation is accrued when it is considered probable and costs can be estimated. Environmental expenditures are presently not material to HP's operations or financial position. 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. Information regarding the market prices of the Company's common stock and the markets for that stock may be found on pages 45 and the inside back cover, respectively, of the Company's 1993 Annual Report to Shareholders. The number of shareholders and information concerning the Company's current dividend rate are set forth in the section entitled "Common Stock, Dividend Policy" found on the inside back cover of that report. Additional information concerning dividends may be found on pages 23, 30, 31 and 45 of the Company's 1993 Annual Report to Shareholders. Such pages (excluding order data) are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Selected financial data for the Company is set forth on page 23 of the Company's 1993 Annual Report to Shareholders, which page (excluding order data) is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A discussion of the Company's financial condition, changes in financial condition and results of operations appears in the "Financial Review" found on pages 25-27 and 29 of the Company's 1993 Annual Report to Shareholders. Such pages are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of the Company, together with the report thereon of Price Waterhouse, independent accountants, and the unaudited "Quarterly Summary" are set forth on pages 24, 28, 30-43 and 45 of the Company's 1993 Annual Report to Shareholders, which pages (excluding order data) are incorporated herein by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. With the exception of the information incorporated by reference in Parts I, II and IV of this Form 10-K, the Company's 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding directors of the Company is set forth under "Election of Directors" on pages 4-11 of the Company's Notice of Annual Meeting of Shareholders and Proxy Statement, dated January 20, 1994 (the "Notice and Proxy Statement"), which pages are incorporated herein by reference. The names of the executive officers of the Company, their ages, titles and biographies as of December 27, 1993, are set forth below. All officers are elected for a one-year term. EXECUTIVE OFFICERS: JAMES L. ARTHUR; AGE 59; SENIOR VICE PRESIDENT AND GENERAL MANAGER, WORLDWIDE CUSTOMER SUPPORT OPERATIONS. Mr. Arthur assumed his current position as General Manager of the Company's Worldwide Customer Support Operations in 1989. He served as Director of the U.S. Field Operations from 1984 to 1989. He became a Vice President of the Company in 1982 and a Senior Vice President in 1987. EDWARD W. BARNHOLT; AGE 50; SENIOR VICE PRESIDENT AND GENERAL MANAGER, TEST AND MEASUREMENT ORGANIZATION. Mr. Barnholt was elected a Senior Vice President in 1993. He became Vice President and General Manager, Test and Measurement Organization, with responsibility for the Company's Electronic Instrument and Microwave and Communications Groups, along with the Communications Test Business Unit, in 1990. Prior to 1990, he had been General Manager of the Electronic Instrument Group since 1984. Mr. Barnholt was elected a Vice President of the Company in 1988. RICHARD E. BELLUZZO; AGE 40; VICE PRESIDENT AND GENERAL MANAGER, COMPUTER PRODUCTS ORGANIZATION. Mr. Belluzzo was named General Manager of the Computer Products Organization in 1993. Earlier in 1993 he became General Manager of the newly formed Hardcopy Products Group. He was elected a Vice President in 1992. He was named operations manager for the Boise Printer Operation when it was formed in 1987 and became General Manager of that operation when it became a division in 1988. ALAN D. BICKELL; AGE 57; SENIOR VICE PRESIDENT AND MANAGING DIRECTOR, GEOGRAPHIC OPERATIONS. Mr. Bickell was elected a Vice President in 1984. He was Managing Director of Intercontinental Operations from 1974 until 1992, when he was elected to his current position. JOEL S. BIRNBAUM; AGE 56; SENIOR VICE PRESIDENT, RESEARCH AND DEVELOPMENT. Mr. Birnbaum was elected a Senior Vice President in 1993. He became Vice President, Research and Development and Director, HP Laboratories in September 1991. Additionally, he served as General Manager, Information Architecture Group from 1988 until 1991 and General Manager, Information Technology Group from 1986 to 1988. He was elected a Vice President in 1984. He is a director of Corporation for National Research Infrastructure. S.T. JACK BRIGHAM III; AGE 54; VICE PRESIDENT, CORPORATE AFFAIRS AND GENERAL COUNSEL. Mr. Brigham was elected a Vice President in 1982 and became Vice President, Corporate Affairs in 1992. He has served as General Counsel since 1976. DOUGLAS K. CARNAHAN; AGE 52; VICE PRESIDENT AND GENERAL MANAGER, MEASUREMENT SYSTEMS ORGANIZATION. Mr. Carnahan was elected a Vice President in 1992. He was General Manager of the Publishing Products Business Unit from 1988 to 1991, when he was promoted to General Manager of the Printing Systems Group. In June 1993 he was named General Manager of Component Products, and in October 1993 he assumed his current post as General Manager of the Measurement Systems Organization. RAYMOND W. COOKINGHAM; AGE 50; VICE PRESIDENT AND CONTROLLER. Mr. Cookingham was elected a Vice President in 1993. In 1984, he was named controller for the Company's product groups and was promoted to Controller of the Company in 1986. F. E. (PETE) PETERSON; AGE 52; VICE PRESIDENT, PERSONNEL. Mr. Peterson was elected to his current position in 1992. In 1985, he was named Corporate Personnel Operations Manager with responsibility for integrating personnel policies and programs with the worldwide business strategies of the Company. In 1990, he assumed additional responsibility as Director of Corporate Personnel. LEWIS E. PLATT; AGE 52; CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER, AND CHAIRMAN OF THE EXECUTIVE COMMITTEE. Mr. Platt has served as a director of the Company, President and Chief Executive Officer since November 1, 1992. The Board elected Mr. Platt to succeed David Packard as Chairman on September 17, 1993. He was an Executive Vice President from 1987 to 1992. Mr. Platt held a number of management positions in the Company prior to becoming its President, including managing the Computer Systems Organization from 1990 to 1992 and the Computer Products Sector from 1988 to 1990. He is a director of Molex Inc. He also serves on the Cornell University Council and the Wharton School Board of Overseers. WILLEM P. ROELANDTS; AGE 48; SENIOR VICE PRESIDENT AND GENERAL MANAGER, COMPUTER SYSTEMS ORGANIZATION. Mr. Roelandts was elected a Senior Vice President in 1993. He served as General Manager of the Computer Systems Group from 1988 until he became General Manager of the Networked Systems Group in the Computer Systems Organization in 1990. He was elected a Vice President and General Manager, Computer Systems Organization in 1992. ROBERT P. WAYMAN; AGE 48; EXECUTIVE VICE PRESIDENT, FINANCE AND ADMINISTRATION AND CHIEF FINANCIAL OFFICER. Mr. Wayman was elected a director of the Company effective December 1, 1993. He has been an Executive Vice President since 1992, at which time he assumed responsibility for administration. He has held a number of financial management positions in the Company and was elected a Vice President and Chief Financial Officer in 1984. He serves as a member of the Board of the Private Sector Council and of the Kellogg Advisory Board, Northwestern University. Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth on page 11 of the Notice and Proxy Statement, which page is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information regarding the Company's compensation of its executive officers is set forth on pages 12-17 and 23 of the Notice and Proxy Statement, which pages are incorporated herein by reference. Information regarding the Company's compensation of its directors is set forth on pages 2-4 of the Notice and Proxy Statement, which pages are 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 set forth on pages 8-11 of the Notice and Proxy Statement, which pages are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information regarding transactions with the Company's executive officers and directors is set forth on pages 23-24 of the Notice and Proxy Statement, which pages are 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: - -------- *Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. 2. Financial Statement Schedules: Report of Independent Accountants on Financial Statement Schedules. The financial statement schedules should be read in conjunction with the financial statements in the 1993 Annual Report to Shareholders. Schedules not included in these financial statement schedules have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits: - -------- *Indicates management contract or compensatory plan or arrangement. Exhibit numbers may not correspond in all cases to those numbers in Item 601 of Regulation S-K because of special requirements applicable to EDGAR filers. (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. HEWLETT-PACKARD COMPANY D. CRAIG NORDLUND Date: January 28, 1994 By: _________________________________ D. CRAIG NORDLUND ASSOCIATE GENERAL COUNSEL AND SECRETARY POWER OF ATTORNEY Know All Persons By These Presents, that each person whose signature appears below constitutes and appoints D. Craig Nordlund and Ann O. Baskins, or either of them, his attorneys-in-fact, for him in any and all capacities, to sign any amendments to this report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that either of said attorneys- in-fact, or substitute or substitutes, may 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. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and the Board of Directors of Hewlett-Packard Company Our audits of the consolidated financial statements referred to in our report dated November 22, 1993 appearing on page 43 of the 1993 Annual Report to Shareholders of Hewlett-Packard Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules 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 statments. PRICE WATERHOUSE San Francisco, California November 22, 1993 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES ---------------- SCHEDULE II AMOUNTS RECEIVABLE FROM DIRECTORS, OFFICERS AND EMPLOYEES (THOUSANDS) - -------- (a) The year-end balance represents loans granted to two officers of the Company. The loan amounts are $150,000 and $111,000. Both loans carry an interest rate of 4.03% and mature in 1994. (b) The year-end balance represents a U.S. housing loan granted to one employee, who is not an officer or director of the Company. The loan carries an interest rate of 3.69% and matures in 1998. (c) The year-end balance represents a loan granted to one officer of the Company. The loan carried an interest rate of 4.6% and matured in 1993. (d) The year-end balance represents a U.S. housing loan granted to one employee, who was not an officer or director of the Company. The loan carried an interest rate of 0% and matured in 1993. (e) During the year ended October 31, 1991, all U.S. housing loans to officers were repaid. (f) The year-end balance represents a U.S. housing loan granted to one employee, who was not an officer or director of the Company. The loan carried an interest rate of 0% and matured in 1992. S-1 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES ---------------- SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (MILLIONS) - -------- (a) Included in "Additions at Cost" for the year ended October 31, 1993 are $3 million of land, $31 million of buildings and leasehold improvements and $50 million of machinery and equipment acquired in connection with the acquisition of several companies, none of which were significant to the financial position of the Company. Included in "Additions at Cost" for the year ended October 31, 1992 are $2 million of land, $10 million of buildings and leasehold improvements and $39 million of machinery and equipment acquired in connection with the acquisition of Avantek, Inc., Colorado Memory Systems, Inc. and Texas Instruments Incorporated's family of commercial UNIX-system based multiuser computers and related systems. S-2 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES ---------------- SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (MILLIONS) S-3 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES ---------------- SCHEDULE IX SHORT-TERM BORROWINGS (MILLIONS, EXCEPT INTEREST RATES) - -------- (a) "Notes payable and short-term borrowings" in the Company's consolidated balance sheet includes the balances shown above and also the current portion of long-term debt, amounting to $20 million at October 31, 1993, $36 million at October 31, 1992 and $24 million at October 31, 1991. (b) The computation of the weighted average interest rate during the year is based on month-end balances and interest rates. ---------------- SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (MILLIONS) S-4 EXHIBIT INDEX - -------- *Indicates management contract or compensatory plan or arrangement. Exhibit numbers may not correspond in all cases to those numbers in Item 601 of Regulation S-K because of special requirements applicable to EDGAR filers. (b) Reports on Form 8-K None.

89966_1993.txt

89966_1993

1993

89966

ITEM 1. BUSINESS. -------- General The Company owns and operates two hotels, casinos and bowling centers, the Showboat Hotel, Casino and Bowling Center in Las Vegas, Nevada ("Las Vegas Showboat") and the Showboat Casino Hotel in Atlantic City, New Jersey ("Atlantic City Showboat") and a riverboat casino in New Orleans, Louisiana through its respective Nevada and New Jersey subsidiaries. The Company's wholly-owned Nevada subsidiaries include Showboat Operating Company and Showboat Development Company. Showboat Development Company's wholly owned subsidiaries include Showboat Mohawk, Inc., Showboat Indiana, Inc., Lake Pontchartrain Showboat, Inc. and Showboat Louisiana, Inc. The Company commenced operations on September 9, 1954, as a partnership and was incorporated under the laws of the state of Nevada in 1960. The Company became a registered public company on December 19, 1968. It was listed in the American Stock Exchange in February 1973 and was listed on the New York Stock Exchange on May 30, 1984. The Company operated only the Las Vegas Showboat until March 30, 1987 when the Atlantic City Showboat commenced operations. The Company's New Jersey subsidiaries include its wholly- owned subsidiary Ocean Showboat, Inc. ("OSI"), and OSI's wholly-owned subsidiaries Atlantic City Showboat, Inc. ("ACSI") and Ocean Showboat Finance Corporation ("OSFC"). Unless the context otherwise requires, the "Company" or "SBO," as applicable, refers to Showboat, Inc. and its subsidiaries. The Company's executive offices are located at 2800 Fremont Street, Las Vegas, Nevada 89104, and its telephone number is (702) 385-9141. Through its subsidiary, Showboat Louisiana, Inc., the Company acquired a 30% equity interest in Showboat Star Partnership, a Louisiana general partnership which owns a riverboat casino on Lake Pontchartrain in New Orleans, Louisiana named the "Star Casino," for a capital contribution of $18.6 million in 1993. The Star Casino commenced operations on November 8, 1993. Effective March 1, 1994, the Company purchased an additional 20% equity interest in the Showboat Star Partnership from a partner in exchange for $9.0 million. A management agreement entered into between Lake Pontchartrain Showboat, Inc., a subsidiary of the Company ("LPSI"), and Star Casino, Inc., a general partner of Showboat Star Partnership, provides that LPSI shall receive a management fee of 5% of gaming revenues, net of gaming taxes and regulatory boarding fees, in exchange for managing the Star Casino's operations. Star Casino, Inc. assigned the management agreement to the Showboat Star Partnership. The Company's marketing and operating strategy is to develop a high volume of traffic through its casinos, emphasizing slot machine play which accounted for 84.2%, 73.2% and 68.6% of the casino revenues of the Las Vegas Showboat, the Atlantic City Showboat, and the Star Casino, respectively, in 1993. Customers are attracted to the Las Vegas Showboat by competitive slot machines, bingo, moderately priced food and accommodations, a friendly "locals" atmosphere and a 106-lane bowling center. The Atlantic City Showboat targets the drive-in customer by providing competitive games and excellent service in an attractive convenient facility. The Star Casino, like the Las Vegas Showboat, targets "locals" with its excellent service, attractive and convenient facility and accessible location. Fiscal Year 1993 Developments Star Casino In July 1993, the Company and Star Casino, Inc., a Louisiana corporation owned by Louie Roussel, III, formed the Showboat Star Partnership, a Louisiana general partnership, to own the Star Casino, a riverboat casino located on the south shore of Lake Pontchartrain in New Orleans, Louisiana. Until March 1, 1994, Showboat Louisiana, Inc. owned 30% of the partnership and Star Casino, Inc. was the managing partner. Effective March 1, 1994, Showboat Louisiana, Inc. purchased from Star Casino, Inc. an additional 20% equity interest in the partnership for $9.0 million and the partners formed a ten member managing committee on which Showboat Louisiana, Inc. appoints five members. The Star Casino offers an aggregate of 21,900 square feet of casino space on three levels containing 762 slot machines and 41 table games. The riverboat facility also includes an approximately 34,000 square foot terminal building containing a bar, restaurant and administrative offices. The casino operations of the Star Casino are managed by the Company through LPSI, which receives a management fee of five percent of gaming revenue, net of gaming taxes and regulatory boarding fees, pursuant to a management agreement. The Star Casino commenced gaming operations on November 8, 1993, after receiving the approval of the Louisiana Riverboat Gaming Commission, the Riverboat Gaming Division of the Louisiana State Police and the U.S. Coast Guard. Development and Management Services Division The Company formed a Development and Management Services Division ("Development Division") in 1993 to investigate and secure new properties in the United States and around the world. The Development Division evaluates all expansion opportunities based upon certain criteria, including but not limited to, demographics, location and competition. Showboat's Development Division also provides management services to support a new facility upon its opening. The Development Division will provide a new project with human resources, marketing, design and construction, management information systems, regulatory compliance, operations and financial services. Expansion Opportunities The Company is evaluating expansion opportunities in emerging gaming markets in the United States and elsewhere in the world. Announced expansion opportunities include: East Chicago, Indiana On February 2, 1994, the Showboat Marina Partnership, consisting of Showboat Indiana Investment Limited Partnership, a wholly-owned limited partnership ("SII"), and Waterfront Entertainment and Development, Inc., an Indiana corporation ("Waterfront"), filed Part I of its gaming application with the Indiana Riverboat Gaming Commission to operate a riverboat casino on Lake Michigan in East Chicago, Indiana. Showboat Marina Partnership intends to file Part II of its gaming application on April 12, 1994. Showboat Marina Partnership is the only applicant for the East Chicago gaming berth. Showboat Marina Partnership is owned 55% by SII and 45% by Waterfront. The Company will invest $17.5 million in the Showboat Marina Partnership and will help the partnership to obtain in excess of $50.0 million in debt financing. East Chicago residents passed a referendum on November 2, 1993 authorizing gaming in East Chicago. St. Regis Mohawk Reservation, New York The Company, through Showboat Mohawk Investment Limited Partnership, a wholly-owned limited partnership ("SMI"), is negotiating with the St. Regis Mohawk Tribe ("Tribe") and Native American Gaming Consultants, a corporation formed under tribal law ("NAGC"), such documents as are necessary to develop, construct, manage and operate Class III gaming on the Tribe's Reservation in Hogansburg, New York. The proposed agreements contemplate that SMI will initially operate Class III games in an approximately 19,000 square foot casino that will be expanded to approximately 40,000 square feet. An initial loan in the approximate amount of $35 million will be made to the Tribe by SMI for the purchase of an existing building, the "TVI Site," and for certain improvements to the building. SMI will receive a management fee of 20% of earnings before interest, taxes and depreciation throughout the management term, which will be five years. On October 15, 1993, New York Governor Mario Cuomo signed a Compact with the Tribe, permitting Class III gaming. Class III games include blackjack, craps, roulette, best hand poker, big six, keno, and other authorized games. Any agreements between SMI and the Tribe will be subject to approval by the National Indian Gaming Commission. Sydney, Australia Sydney Harbour Casino Holdings Limited, a corporation consisting of Showboat Australia Pty Limited, a wholly-owned Australian subsidiary of the Company, and Leighton Properties Pty Limited, Australia's largest publicly traded construction group, was selected by the New South Wales Casino Control Authority as one of two companies on the short list for the first casino license in Sydney, Australia. Only one license to operate a casino with table games and slot machines in Sydney, Australia will be awarded by the Casino Control Authority. Private clubs offering slot machines are currently in operation. The Casino Control Authority is expected to make its final selection on or after May 6, 1994. Atlantic City Showboat Expansion During 1993, the Company continued the construction of a three-part $76.2 million expansion project, after credits of $8.8 million from the Casino Reinvestment Development Authority ("CRDA"), at the Atlantic City Showboat. For a discussion of CRDA credits see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." The first stage of the expansion was completed in May 1993 and added Atlantic City's first horse race simulcasting facility. Approximately 4,500 square feet of casino space was added in June 1993. With the additional casino space, the Company added approximately 340 slot machines and 28 table games to its Atlantic City Casino in 1993. In the second stage of the expansion, the Company anticipates adding an additional 15,000 square feet of casino space by the Summer of 1994. With the additional casino space, the Company anticipates the addition of approximately 550 slot machines and 10 table games, bringing the then total number of slot machines and table games at the Atlantic City Showboat to approximately 3,000 and 108, respectively. The final stage of the expansion is the addition of a new 284-room hotel tower, now under construction, which is scheduled to open in the Spring of 1995. On July 9, 1993, ACSI purchased approximately four acres of real property abutting the Atlantic City Showboat from the Atlantic City Housing Authority and Urban Redevelopment Agency. ACSI is constructing the new hotel tower on this site. (See "Item 2. ITEM 2. PROPERTIES. ---------- Las Vegas The Las Vegas Showboat is located on the eastern edge of the City of Las Vegas approximately two and one-half miles from both downtown Las Vegas and the area commonly known as the "Strip" where many of Las Vegas' major resort hotel casinos are located. The Las Vegas Showboat is primarily a two-story structure with an eighteen-story high-rise hotel and a 620-car parking garage. The hotel registration area, bowling center, restaurants, bars and entertainment lounge surround the casino area and are on the first floor of the Las Vegas Showboat. The 408-seat buffet, 1,300-seat bingo room, meeting and banquet facilities, employee dining room, and the Company's executive offices are located on the second floor. The Las Vegas Showboat's high-rise tower contains 352 of the Showboat's 482 guest rooms. The entire facility covers approximately 26 acres, which includes approximately 19.25 acres of improved parking area. The Company also owns and operates the 33-room Showboat Motel located immediately across the street from the Showboat on approximately one acre of land. The facilities are constantly monitored to make sure that the needs of the Company's business and customers are met. The Company holds fee title to all of the above-described properties. The real property, buildings and improvements comprising the Las Vegas Showboat secure the Company's First Mortgage Bonds. All of the above-mentioned land and buildings are leased to Showboat Operating Company, a wholly-owned subsidiary. Atlantic City The Atlantic City Showboat is located on an approximately ten and one-half acre rectangular site which ACSI leases from Resorts International, Inc. ("Resorts") pursuant to a 99-year lease dated October 26, 1983 (as amended, "Lease"). Under the New Jersey Act, both Resorts and ACSI, because of their lessor- lessee relationship, are jointly and severally liable for the acts of the other with respect to any violations of the New Jersey Act by the other. In order to limit the potential liability which could result from this provision, ACSI, OSI and Resorts have agreed to indemnify each other from all liabilities and losses which may arise as a result of the joint and several liability imposed by the New Jersey Act. However, the New Jersey Commission could determine that the party seeking indemnification is not entitled to or is barred from such indemnification. Pursuant to the New Jersey Act, the New Jersey Commission approved, subject to certain changes, an Assumption Agreement ("Assumption Agreement") executed by Trump Taj Mahal Associates Limited Partnership and Trump Taj Mahal Realty Corp. (collectively, "Trump Taj"), ACSI and Resorts in connection with Trump Taj's acquisition of the land on which the Taj Mahal Casino Hotel is constructed and pursuant to which Trump Taj assumed some of Resorts' obligations in the Lease. The New Jersey Commission ruled that the Assumption Agreement is a lease under the New Jersey Act for casino regulatory purposes. As a result, for casino regulatory purposes, a lessor-lessee relationship is deemed to exist among ACSI, Resorts, and Trump Taj making them jointly and severally liable for the acts of the other with respect to any violations of the New Jersey Act by the others. In order to limit their potential liability, ACSI, Resorts and Trump Taj have entered into an agreement to indemnify each other from all liabilities and losses which may arise as a result of the joint and several liability imposed upon them by the New Jersey Act. However, the New Jersey Commission could determine that the party seeking indemnification is not entitled to or is barred from such indemnification. In the event Resorts is unable under the laws of New Jersey to act as lessor of the site to the Atlantic City Showboat ("Premises"), ACSI has an option to purchase the Premises for the greater of $66.0 million or the fair market value of the "leased fee estate" (determined by appraisal in the case of disagreement), subject to a maximum purchase price of 11 times the annual rent in the option year. However, if the appraisal is not completed within the time period specified by the New Jersey Commission, the purchase price is equal to the lesser of $66.0 million or 11 times the annual rent in the option year. If ACSI is unable to continue operating the Atlantic City Showboat under the New Jersey gaming laws, Resorts has a similar option to purchase ACSI's interest in the Premises together with the Atlantic City Showboat building and all furniture, fixtures and equipment thereon for their fair market value as of the option date (determined by appraisal in the case of disagreement). Also, should Resorts elect to sell its interest in the Lease or the Premises to an unaffiliated third party, ACSI has a first right of purchase unless such sale is made to a person who acquires all of the assets and liabilities of Resorts (subject to the Lease). Similarly, Resorts has a first right of purchase of ACSI's leasehold interest in the Premises or the Atlantic City Showboat if ACSI elects to sell the same to any person other than an affiliate of ACSI or a mortgagee of ACSI's leasehold interest and improvements on the leased land. Any such transfer by ACSI, other than to a permitted transferee, requires Resorts' consent which cannot be unreasonably withheld. The Lease and all amendments thereto are subject to review and approval by the New Jersey Commission, and Resorts and ACSI have agreed that they will accept any reasonable modification to the Lease that may be required by the New Jersey Commission. If either party determines that the requested Lease modifications are unduly burdensome, the Lease may be terminated, subject to arbitration in the case of disagreement. The Lease, as amended to date, has been approved by the New Jersey Commission. In addition, Resorts, pursuant to a ruling by the New Jersey Commission, in its capacity as lessor of the site of the Atlantic City Showboat, must obtain a casino service industry license. Resorts presently holds a casino service industry license, which must be renewed every three years. The First Mortgage Bonds are also secured by a first leasehold mortgage on ACSI's interest in the Lease, the Atlantic City Showboat building and future improvements on the leased land as well as certain personal property therein. Such mortgage is subject and subordinate to Resorts' rights under the Lease and its fee interest in the Premises. Subject to certain limited excep-tions, the Lease may not be amended without the consent of the trustee under the Indenture governing the First Mortgage Bonds unless certain opinions are delivered to the effect that the amendment does not materially impair the security of the mortgage. An event of default under the Lease constitutes an event of default under the mortgage and the Indenture. In addition to its rental payment obligations under the Lease, ACSI is obligated to contribute up to one-third of the costs of certain infrastructure improvements to be constructed on a 56-acre tract ("Urban Renewal Tract"). The Atlantic City Showboat is located on a portion of the Urban Renewal Tract owned by Resorts. ACSI is obligated to contribute only toward improvements of which it is the beneficiary or which are expected to benefit ACSI and all future occupants of the Urban Renewal Tract. ACSI has contributed to infrastructure improvements involving the construction of certain sewer and water lines and the realigning of a portion of Delaware Avenue ("Realigned Delaware Avenue") to permit direct ingress and egress from the Realigned Delaware Avenue to the Atlantic City Showboat, which improvements have been completed. Realigned Delaware Avenue has not yet been dedicated to the City of Atlantic City. Pending dedication of the Realigned Delaware Avenue to the City, the Atlantic City Housing Authority granted to ACSI a permanent easement and right of way ("Easement") for the Realigned Delaware Avenue for the benefit of ACSI and ACSI's employees, agents, guests, suppliers, visitors, invitees and all others seeking access to the Atlantic City Showboat. Until acceptance of a deed of dedication of the Realigned Delaware Avenue by the City of Atlantic City, ACSI shall maintain at its expense and pay, if billed separately, the real property taxes associated with the Easement, or reimburse Resorts for its allocable share of such real property taxes for the Easement. In addition, the CRDA approved a plan effective November 1992 to widen Delaware Avenue to four traffic lanes and two parking lanes. Delaware Avenue leads directly from White Horse Pike (U.S. Route 30) to the Atlantic City Showboat. ACSI proposed and the CRDA approved that $8.0 million of ACSI's deposits with the CRDA will be used for the widening of Delaware Avenue. In connection with its approval, the CRDA required ACSI to donate $2.0 million of its deposits with the CRDA to certain CRDA programs. The Company anticipates that the widening of Delaware Avenue will be completed by the Spring of 1994. ACSI's Board of Directors routinely authorizes capital expenditures at the Atlantic City Showboat. In addition to the three-part expansion of the Atlantic City Showboat which began in 1993, the Board has authorized expending $17.6 million for recurring annual capital improvements in 1994. None of these recurring annual capital expenditures in 1994 commit the Company to additional capital expenditures in subsequent years. During 1993, the Company continued the construction of a three-part $76.2 million expansion project, after credits of $8.8 million from CRDA, at the Atlantic City Showboat. For a discussion of CRDA credits see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." The first stage of the expansion was completed in May 1993 and added Atlantic City's first horse race simulcasting facility. Approximately 4,500 square feet of casino space was added in June 1993. With the additional casino space, the Company added approximately 340 slot machines and 28 table games to its Atlantic City Casino in 1993. In the second stage of the expansion, the Company anticipates adding an additional 15,000 square feet of casino space by the Summer of 1994. With the additional casino space, the Company anticipates the addition of approximately 550 slot machines and 10 table games, bringing the then total number of slot machines and table games at the Atlantic City Showboat to approximately 3,000 and 108, respectively. The final stage of the expansion is the addition of a new 284-room hotel tower, now under construction, which is scheduled to open in the Spring of 1995. On July 9, 1993, ACSI purchased approximately four acres of real property (the "Land") abutting the Atlantic City Showboat from the Atlantic City Housing Authority and Urban Redevelopment Agency ("ACHA"). ACSI is constructing the new hotel tower on this site. ACSI purchased the Land subject to certain conditions which, in most instances, expire upon ACSI completing the construction of the planned improvements. In the event that ACSI fails to comply with the following conditions prior to completion of the improvements, the Land shall revert and become revested in ACHA free and clear of all liens after the expiration of all cure periods including the liens created pursuant to the Indenture for the First Mortgage Bonds: (a) ACSI paying all real estate taxes or ACSI failing to keep the Land free of all liens except for permitted liens; (b) ACSI failing to commence construction of the improvements prior to October 1, 1993 (construction did commence before the required date) and to complete construction of the improvements by July 1, 1995; (c) without first obtaining the written consent of ACHA no stockholder holding 10% or more of the stock of ACSI may transfer its stock and ACSI may not (i) increase its capitalization, (ii) merge with another entity, (iii) amend its corporate documents, or (iv) issue additional stock; and (d) fail to comply with all terms and provisions of the Contract of Sale for Sale of Land for Private Redevelopment between ACHA and ACSI ("Contract of Sale"). On January 4, 1994, ACHA declared ACSI to be in default for noncompliance with certain provisions contained in the Contract of Sale pertaining to affirmative action of ACSI's general contractor's and subcontractors' workforce. Since the declaration of default, ACSI has been diligently working to cure the defaults. Although no assurance can be given in this regard, ACSI management believes that as a result of its efforts ACHA will ultimately rescind its notice of default. The Company believes that it presently is utilizing the Atlantic City facilities at an acceptable level. See Item 1. "BUSINESS" p. 3. The Atlantic City facilities are constantly monitored to make sure that the needs of the Company's business and customers are met. Other Facilities ACSI leases a 63,200 square-foot warehouse and office in Egg Harbor Township, New Jersey, approximately 15 miles from the Atlantic City Showboat. The lease term is through July 31, 2001. ACSI holds an option to purchase the warehouse for $1.9 million. This option may be exercised by ACSI on or after January 1, 1996, and shall remain in effect until March 31, 2001. ACSI leases a parking area for its employees from the Trump Taj Mahal Associates for 400 parking spaces. This lease expires, unless earlier terminated, on December 31, 1997. ACSI provides, through an independent contractor, a shuttle service for its employees between the two parking areas and the Atlantic City Showboat. Continued availability of such employee parking and shuttle service facility is required as a condition to the renewal of ASCI's casino license. During 1993, ACSI purchased an additional parcel of land nearby for approximately $1.0 million to serve as an overflow for parking. The Company leases office space for the Development Division in Ventnor, New Jersey pursuant to a lease agreement executed on December 20, 1993 between Showboat Operating Company and Ventroy Associates. The term of the lease is five years commencing on January 1, 1994, with monthly rental payments of $11,386. Lake Pontchartrain, Louisiana The Star Casino is located on the south side of Lake Pontchartrain in New Orleans, Louisiana, approximately seven miles from New Orleans' "French Quarter." The terminal building and parking area are located on approximately 19.6 acres. The terminal building is a two-story structure containing approximately 34,000 square feet. The terminal building houses a restaurant and cocktail lounge on the first floor and administrative offices on the second floor. On-site parking for 1,150 cars is located immediately adjacent to the terminal building. Showboat Star Partnership leases land, wharf and water bottom from the Orleans Levee District for use in its riverboat gaming operations. The term of the land lease agreement is for ten years, with four options to renew for a period of ten years each. Additionally, Showboat Star Partnership leases a building from the Orleans Levee District, which is adjacent to its terminal building, pursuant to a lease agreement dated February 1, 1994. The Showboat Star Partnership is currently determining the best use for the additional building. The term of the lease agreement for the additional building is one year, with nine options to renew for a period of one year each. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. ----------------- The Company is from time to time involved in legal proceedings arising in the ordinary course of business. The Company is not a party to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. --------------------------------------------------- Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. ----------------------------------------- --------------------------- The Company's common stock is listed on the New York Stock Exchange. The range of high and low sales prices for the Company's common stock for each quarter in the last two years is as follows: On March 15, 1994, the closing price of the Company's common stock on the New York Stock Exchange was $19 5/8. The Company has paid quarterly dividends since 1970. The declaration and payment of dividends is at the discretion of the Board of Directors. The Board of Directors considers, among other factors, the Company's earnings, financial condition and capital spending requirements in determining an appropriate dividends. The Company is restricted in the payment of cash, dividends, loans or other similar transactions by the terms of an Indenture executed by it in connection with the issuance of First Mortgage Bonds. See Note 4 to the Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ----------------------- ____________________ (a) In 1989, the Company sold the common stock and substantially all of the assets of Showboat Sports, Inc., a wholly-owned subsidiary, for $10.0 million. The Company recognized a gain on the sale of $4.9 million. (b) In the years ended December 31, 1991 and 1990, the Company recognized an extraordinary gain of $.2 million and $4.0 million, respectively, net of tax, as a result of the purchase of $12.1 million and $18.5 million, respectively, of its Mortgage-Backed Bonds. See Note 10 to the Consolidated Financial Statements. (c) In the year ended December 31, 1992, the Company recognized an extraordinary loss of $3.4 million net of tax, as a result of the planned redemption of all of its outstanding Debentures. See Note 10 to the Consolidated Financial Statements. (d) The Company adopted FAS 109 in 1993 and reported the cumulative effect of the change in method of accounting for income taxes as of January 1, 1993 in the 1993 Consolidated Statement of Income. (e) In the year ended December 31, 1993, the Company recognized an extraordinary loss of $6.7 million, net of tax, as a result of the redemption of all of its outstanding Mortgage-Backed Bonds. See Note 10 to the Consolidated Financial Statements. (f) In 1993, the Company acquired a 30% equity interest in Showboat Star Partnership which was engaged in the development of a riverboat casino on Lake Pontchartrain in New Orleans, Louisiana. Operation of the riverboat casino commenced on November 8, 1993. The Company's share of the partnership's loss from the commencement of operations through December 31, 1993, including the write-off of preopening costs, of $1.3 million is included in income from operations for the quarter ended December 31, 1993. (g) In the year ended December 31, 1992, the Company sold 3.45 million shares of its common stock in a public offering. Net proceeds of the offering were $50.4 million. Proceeds of the offering were used in January 1993 to redeem all of the Company's Debentures and to prepay the outstanding balance of its construction and term loan. See Notes 4 and 7 to the Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------- ------------- RESULTS OF OPERATIONS. --------------------- General The consolidated financial statements of the Company include the accounts of SBO and its wholly-owned subsidiaries, Showboat Development Company ("SDC"), Showboat Operating Company ("SOC") and OSI. They also include SDC's wholly- owned subsidiaries LPSI and Showboat Louisiana, Inc. ("SLI") and OSI's wholly- owned subsidiaries which are ACSI and OSFC. SBO and its subsidiaries operate Las Vegas Showboat, Atlantic City Showboat and Star Casino. LPSI was formed in 1993 to manage the Star Casino on Lake Pontchartrain in New Orleans, Louisiana pursuant to a management agreement. SLI was also formed in 1993 to hold a 30% equity interest in Showboat Star Partnership ("SSP") which owns Star Casino, the riverboat casino managed by LPSI. In 1993, the Company invested $18.6 million in SSP for its 30% equity interest. Effective March 1, 1994, the Company acquired an additional 20% equity interest in SSP from a partner for $9.0 million bringing the Company's equity interest to 50%. Operation of Star Casino commenced on November 8, 1993. The investment by SLI in SSP has been accounted for under the equity method of accounting. The Company's equity in the loss of SSP is included in the Consolidated Statement of Income as equity in loss of an unconsolidated affiliate. Revenues from management fees paid by SSP to LPSI are included in other revenues in the Consolidated Statement of Income. Material Changes in Results of Operations Year Ended December 31, 1993 (1993) Compared to Year Ended December 31, 1992 (1992) Revenues Net revenues for the Company increased to $375.7 million in 1993 from $355.2 million in 1992, an increase of $20.5 million or 5.8%. Casino revenues increased $16.3 million or 5.2% to $329.5 million in 1993 from $313.2 million in 1992. Nongaming revenues, which consist principally of food, beverage, room and bowling revenues, were $78.3 million in 1993 compared to $71.2 million in 1992, an increase of $7.1 million or 10.0%. The Atlantic City Showboat generated $294.2 million of net revenues in 1993 compared to $277.3 million in 1992, an increase of $16.9 million or 6.1%. Casino revenues were $268.8 million in 1993 compared to $254.7 million in 1992, an increase of $14.1 million or 5.5%. The increase in casino revenues was due to an increase in slot machine revenues of $14.7 million or 8.0% to $196.8 million in 1993 from $182.1 million in 1992. This compares to 4.8% growth in slot machine revenues in the Atlantic City market in 1993 compared to 1992. The improved slot revenue growth experienced by the Atlantic City Showboat is attributed to an increase in slot units throughout the year to 2,411 slot units at the end of 1993, up from 2,073 slot units at the end of 1992, an increase of 340 slot units or a weighted average rate of 9.9%. The increase in slot machine revenues was partially offset by the $4.0 million or 5.5% decrease in table games revenues which resulted primarily from the 3.2% decline in table games revenues in the Atlantic City market during 1993 compared to 1992. Casino revenues were positively impacted by the addition of simulcasting and Poker as part of the opening of Jake's Betting Parlor in the second quarter of 1993. These games contributed $2.2 million and $1.1 million, respectively, during the year ended December 31, 1993. Nongaming revenues increased $5.6 million or 12.0% in 1993 to $52.7 million from $47.1 million in 1992. This increase was attributed to promotional programs offering casino customers rooms, food and beverage at a reduced price as well as increases in complimentary services. At the Las Vegas Showboat, net revenues increased to $81.1 million in 1993 from $77.9 million in 1992, an increase of $3.2 million or 4.1%. Casino revenues increased $2.2 million or 3.8% in 1993 to $60.7 million from $58.5 million in 1992. Slot machine revenues showed the greatest improvement in casino revenues with an increase of $1.6 million or 3.4%. Slot machine revenues accounted for 84.2% of casino revenues in 1993 and 84.5% of casino revenues in 1992. Increases in gaming revenues were primarily the result of higher patron volume due to promotions and increased advertising. Nongaming revenues increased $1.0 million or 4.3% in 1993 to $25.1 million from $24.1 million in 1992. These increases were principally in rooms and food and beverage resulting from targeted marketing programs for rooms and promotional programs offering food at a reduced price. LPSI generated $.4 million in management fee revenues in 1993. LPSI receives management fees of 5.0% of Star Casino's casino revenues after gaming taxes of 18.5% and boarding fees totaling $5.00 per passenger boarding the vessel. Star Casino opened November 8, 1993 and generated net revenues of $12.0 million in 1993 consisting primarily of casino revenues of $10.9 million. Income from Operations The Company's income from operations decreased to $45.4 million in 1993 from $46.5 million in 1992, a decrease of $1.1 million or 2.3%. The Company incurred approximately $3.8 million in expenses relating to the pursuit of expansion opportunities in jurisdictions outside of Nevada and New Jersey in 1993 compared to $.9 million in 1992. Income from operations at the Atlantic City Showboat, before management fees, was $44.0 million in 1993 compared to $39.6 million in 1992, an increase of $4.4 million or 11.1%. The increase in income from operations was primarily due to increased revenues which were offset by a $12.5 million or 5.3% increase in operating expenses, before management fees, to $250.3 million in 1993 compared to $237.7 million in 1992. The increase in operating expenses was primarily due to the increased capacity and volume of business. General and administrative expenses increased due to increases in utilities and maintenance costs resulting from the expanded facility. General and administrative expenses were also impacted by an $.8 million or 13.2% increase in real estate taxes and an $.8 million parking assessment absorbed by Atlantic City Showboat. In addition, depreciation expense increased $1.3 million or 7.4% in 1993 as a result of the expansion at the Atlantic City Showboat. Income from operations at the Las Vegas Showboat declined $1.3 million or 16.6% in 1993 to $6.5 million from $7.8 million in 1992. The decrease was primarily due to a $4.5 million or 6.4% increase in operating expenses to $74.6 million in 1993 from $70.1 million in 1992. Increased operating expenses resulted primarily from increases in payroll and payroll related expenses, increased advertising and repairs and maintenance expenses. LPSI incurred a loss from operations of $.4 million which was primarily the result of administrative expenses incurred before the November 8, 1993 opening of Star Casino. The loss from operations of SLI of $.9 million represents SLI's 30% share of the net loss of SLI's unconsolidated affiliate, SSP. SSP had a net loss of $2.8 million resulting primarily from preopening costs of Star Casino of $4.2 million in 1993, of which Showboat's share was $1.3 million. Before the write- off of preopening costs, SSP's income was $1.4 million of which Showboat's share was $.4 million. Other (Income) Expense Other (income) expense consisted of $24.7 million interest expense, net of $1.1 million of capitalized interest, and $3.2 million of interest income in 1993 compared to interest expense of $25.3 million and interest income of $1.4 million in 1992. Two offsetting factors impacted 1993 interest expense. In January 1993, the Company repurchased all of its Debentures and prepaid its construction and term loan that had an outstanding balance of $17.2 million. In June 1993, the Company repurchased all of its Mortgage-Backed Bonds. This resulted in a $14.4 million decrease in interest expense. This decrease was offset by the issuance in May 1993 of $275.0 million of First Mortgage Bonds resulting in a $15.8 million increase in interest expense. In connection with its expansion project at the Atlantic City Showboat, the Company capitalized $1.1 million of interest costs. Income Taxes In 1993, the Company incurred, before the income tax benefit on an extraordinary loss, income taxes of $10.5 million, or an effective rate of 43.8%, compared to $6.8 million, or an effective rate of 29.9% in 1992. Differences between the Company's effective tax rate and statutory federal tax rates are due to permanent differences between financial and tax reporting. In 1993, these differences consisted principally of $.9 million in state income taxes resulting from the utilization, for financial reporting purposes, of New Jersey net operating loss carryforwards, a $.6 million restricted interest assessment, net of tax, resulting from an Internal Revenue Service audit of prior years and $.4 million resulting from the increase in federal tax rates. In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes." The Company adopted the provisions of FAS 109 effective January 1, 1993 without restating prior years' financial statements. The adoption of FAS 109 resulted in a reduction of net deferred tax liability of $.6 million and this amount has been reported separately as a cumulative effect of the change in the method of accounting for income taxes in the 1993 Consolidated Statement of Income. Net Income In 1993, the Company realized income before an extraordinary loss on the extinguishment of debt and the cumulative effect of the change in the method of accounting for income taxes of $23.9 million or $.89 per share. On June 18, 1993, the Company redeemed all of its Mortgage-Backed Bonds at 105.7% of the principal amount plus accrued and unpaid interest up to and including the redemption date. The Company recognized an extraordinary loss, before an income tax benefit, of $11.2 million as a result of the write-off of unamortized debt issue costs of $2.7 million and payment of a 5.7% redemption premium of $8.5 million. The after tax loss was $6.7 million or $.44 per share. The Company also recognized a cumulative effect adjustment for the change in the method of accounting for income taxes of $.6 million or $.04 per share. Net income for 1993 was $7.3 million or $.49 per share. In 1992, the Company realized income before an extraordinary loss on the extinguishment of debt of $15.9 million or $1.37 per share. As a result of the repurchase of the Company's outstanding Debentures, the Company recognized an extraordinary loss, net of tax, of $3.4 million or $.29 per share. This loss resulted from the write-off of original issue discount and issuance costs associated with the Debentures. Net income for 1992 was $12.4 million or $1.08 per share. Year Ended December 31, 1992 (1992) Compared to Year Ended December 31, 1991 (1991) Revenues Net revenues for the Company increased to $355.2 million in 1992 from $331.6 million in 1991, an increase of $23.6 million or 7.1%. Casino revenues increased $24.8 million or 8.6% to $313.2 million in 1992 from $288.4 million in 1991. Nongaming revenues were $71.2 million in 1992 compared to $71.7 million in 1991, a decrease of $.5 million or .7%. The Atlantic City Showboat generated $277.3 million of net revenues in 1992 compared to $260.8 million in 1991, an increase of $16.5 million or 6.3%. Casino revenues were $254.7 million in 1992 compared to $237.2 million in 1991, an increase of $17.5 million or 7.4%. The increase in casino revenues was due primarily to an increase in slot machine revenues of $20.4 million or 12.6% to $182.1 million in 1992 from $161.7 million in 1991. This compares to a 14.2% growth in slot machine revenues in the Atlantic City market in 1992 compared to 1991. Slot machine revenues were also favorably impacted by a one-time reversal of a $1.2 million slot progressive jackpot accrual. Slot machine revenues at the Atlantic City Showboat accounted for 71.5% of casino revenues in 1992 and 68.2% of casino revenues in 1991. The increase in slot machine revenues was partially offset by the $2.9 million or 3.8% decrease in table games revenues to $72.6 million in 1992 from $75.5 million in 1991. The decrease in table games revenues resulted primarily from the Company decreasing the number of table games units by 24 tables in the third quarter of 1991 and by the 3.4% decline in table games revenues in the Atlantic City market during 1992 compared to 1991. Nongaming revenues declined $1.0 million or 2.2% in 1992 to $47.1 million from $48.1 million in 1991. This decrease was primarily attributed to a $3.1 million or 9.4% decline in food and beverage revenues associated with a reduction in promotional offers. The reduction in food and beverage revenues were partially offset by a $1.3 million or 12.8% increase in room revenues due to more effective room utilization and a $.9 million or 77.2% increase in entertainment revenues. At the Las Vegas Showboat, net revenues increased to $77.9 million in 1992 from $70.8 million in 1991, an increase of $7.1 million or 10.1%. Casino revenues increased $7.3 million or 14.3% in 1992 to $58.5 million from $51.2 million in 1991. The most significant improvement in casino revenues occurred in slot machine revenues which increased $5.7 million or 13.1% in 1992. Casino revenues were also favorably impacted by a $1.1 million or 49.9% reduction in bingo losses in 1992. Slot machine revenues continued to dominate casino revenues at 84.5% of casino revenues in 1992 and 85.3% of casino revenues in 1991. Increases in casino revenues were due to an overall increase in the volume of business, principally as a result of the continuation of certain targeted marketing activities. Nongaming revenues increased $.5 million or 2.0% in 1992 to $24.1 million from $23.6 million in 1991. Increases in food and beverage revenues of $.9 million or 6.5% and hotel revenues of $.3 million or 6.3% were offset by a reduction of $.7 million in other revenues as a result of the recognition in 1991 of a one-time benefit of $.8 million from the reversal of an accrual. Income from Operations The Company's income from operations increased to $46.5 million in 1992 from $35.5 million in 1991, an increase of $11.0 million or 31.0%. Income from operations at the Atlantic City Showboat was $39.6 million in 1992 compared to $31.2 million in 1991, an increase of $8.4 million or 26.9%. This increase was primarily due to improved casino revenues caused by the 14.2% slot machine revenue growth experienced in the Atlantic City market in 1992. Operating expenses increased $8.1 million or 3.5% to $237.7 million in 1992 compared to $229.6 million in 1991. The increase in operating expenses was comprised of a $5.6 million or 28.9% increase in promotional coin incentives offered in conjunction with slot marketing programs and a 6.8% increase in general and administrative costs consisting primarily of a $3.0 million increase in payroll and benefits. Increases in operating expenses were offset by a $3.3 million or 16.0% decrease in depreciation and amortization expense to $17.5 million in 1992 from $20.8 million in 1991. Improvements in income from operations, excluding that realized from the reduction in depreciation and amortization expense, occurred principally in the quarter ended March 31, 1992. At the Las Vegas Showboat, income from operations, increased to $7.8 million in 1992 from $4.3 million in 1991, an increase of $3.5 million or 81.4%. The improvement in operating results reflected the continued implementation of cost effective marketing programs which resulted in increased revenues of $7.2 million offset by a $3.7 million or 5.6% increase in operating expenses in 1992 to $70.1 million from $66.4 million in 1991. In general, increases in operating expenses were consistent with increases in volume of business. Income from operations in 1992 was adversely impacted by $.9 million of expenses incurred by the Company in conjunction with the investigation of new gaming opportunities outside of Nevada and New Jersey. Other (Income) Expense In 1992, other (income) expense consisted of $25.3 million of interest expense and $1.4 million of interest income compared to $27.5 million and $2.1 million, respectively, in 1991. Reductions in interest expense of $1.4 million were realized as a result of the fourth quarter 1991 repurchase of $12.1 million of the Mortgage-Backed Bonds. Other reductions in interest expense were primarily a result of reduced principal balances due to scheduled principal amortization. Income Taxes In 1992, the Company incurred income tax expense, before income tax benefit on an extraordinary loss, of $6.8 million, or an effective tax rate of 29.9%, compared to $4.1 million, or an effective tax rate of 40.5%, in 1991. Differences between the Company's effective tax rate and statutory federal tax rates are due to permanent differences between financial and tax reporting which consisted principally of the estimated tax reporting impact of the financial reporting provision for loss on Casino Reinvestment Development Authority obligations and disallowance of certain employee meals. Net Income In 1992, the Company realized income before an extraordinary loss on the extinguishment of debt of $15.9 million or $1.37 per share. The Company recognized an extraordinary loss, net of tax, of $3.4 million or $.29 per share as a result of the write-off of original issue discount and issuance costs associated with the redemption of the Debentures. Net income for 1992 was $12.4 million or $1.08 per share. In 1991, the Company realized income before an extraordinary gain on the extinguishment of debt of $6.0 million or $.53 per share. In 1991, the Company purchased $12.1 million face value of its Mortgage-Backed Bonds and realized an extraordinary gain, net of tax, of $.2 million or $.02 per share. Net income for 1991 was $6.2 million or $.55 per share. Liquidity and Capital Resources As of December 31, 1993, the Company held cash and cash equivalents of $122.8 million compared to $99.6 million at December 31, 1992. In January 1993, the Company utilized $34.4 million of its cash and cash investments to redeem all of its Debentures at par plus accrued interest and $17.3 million to prepay the outstanding balance of the Company's construction and term loan. In May 1993, the Company issued $275.0 million of First Mortgage Bonds. In June 1993, the Company utilized $162.3 million of the proceeds from the sale of the First Mortgage Bonds to redeem all of its outstanding Mortgage-Backed Bonds at 105.7% plus accrued interest. The remaining proceeds have been reserved by the Company to benefit existing facilities and to expand into new facilities or gaming jurisdictions. In 1993, the Company expended approximately $3.8 million in its investigation of expansion opportunities in new jurisdictions. During 1993, the Company expended approximately $59.7 million on capital improvements at its Las Vegas and Atlantic City facilities. The Company is engaged in an $85.0 million expansion project, before credits of $8.8 million from the CRDA, at its Atlantic City facility. During 1993 the Company expended approximately $31.8 million on the expansion project and $27.9 million on recurring capital improvements. The balance of the expansion project is expected to be completed in 1994 and 1995. ACSI's current CRDA funding credit of approximately $8.8 million is approximately 20% of the maximum allowable expansion costs as determined by the CRDA. This percentage represents ACSI's current share of the allowable Atlantic City casino industry total for expansion-related credits. The amount of ACSI's CRDA funding credit could increase to a maximum of 35% or $14.9 million, depending upon whether or not other casino applicants in Atlantic City discontinue their expansion projects for which credit has been applied. Likewise, ACSI's allowed funding credit could decrease in the event that other casino applicants in Atlantic City increase their allowable expansion costs. On May 18, 1993, the Company issued $275.0 million of First Mortgage Bonds. The First Mortgage Bonds are unconditionally guarantied by SOC, OSI and ACSI. Interest on the First Mortgage Bonds is payable semi-annually on May 1 and November 1 of each year. The First Mortgage Bonds are not redeemable prior to May 1, 2000. Thereafter, the First Mortgage Bonds will be redeemable at any time at the option of the Company, in whole or in part, at redemption prices specified in the Indenture. The First Mortgage Bonds are senior secured obligations of the Company and rank senior in right of payment to all existing and future subordinated indebtedness of the Company and pari passu with the Company's senior indebtedness. The First Mortgage Bonds are secured by a deed of trust representing a first lien on the Las Vegas hotel casino (other than certain assets), by a pledge of all outstanding shares of capital stock of OSI and an intercompany note by ACSI in favor of SBO and a pledge of certain intellectual property rights of the Company. OSI's obligation under its guaranty is secured by a pledge of all outstanding shares of capital stock of ACSI. ACSI's obligations under its guaranty are secured by a leasehold mortgage representing a first lien on the Atlantic City hotel casino (other than certain assets). SOC's guaranty is secured by a pledge of certain of its assets related to the Las Vegas hotel casino. The Indenture places significant restrictions on SBO and its subsidiaries, including restrictions on making loans and advances by SBO to subsidiaries which are Non-Recourse Subsidiaries or subsidiaries in which SBO owns less than 50% of the equity. All capitalized terms not otherwise defined in this paragraph have the meanings assigned to the Indenture. The Indenture also places significant restrictions on the incurrence of additional Indebtedness by SBO and its subsidiaries, the creation of additional Liens on the Collateral securing the First Mortgage Bonds, transactions with Affiliates and the investment of SBO and its subsidiaries in certain Investments. In addition, the terms of the Indenture prohibit SBO and its subsidiaries from making a Restricted Payment unless, at the time of such Restricted Payment: (i) no Default or Event of Default has occurred or would occur as a consequence of such restricted payment; (ii) SBO, at the time of such Restricted Payment and after giving proforma effect thereto as if such Restricted Payment had been made at the beginning of the applicable four-quarter period, would have been permitted to incur at least $1.00 of additional Indebtedness; and, (iii) such Restricted Payment, together with the aggregate of all other Restricted Payments by SBO and its subsidiaries is less than the sum of (x) 50% of the Consolidated Net Income of SBO for the period (taken as one accounting period) from April 1, 1993 to the end of SBO's most recently ended fiscal quarter for which internal financial statements are available, plus (y) 100% of the aggregate net cash proceeds received by SBO from the issuance or sale of Equity Interests of SBO since the Issue Date, plus (z) Excess Non-Recourse Subsidiary Cash Proceeds received after the Issue Date. The term Restricted Payment does not include, among other things, the payment of any dividend if, at the time of declaration of such dividend, the dividend would have complied with the provisions of the Indenture; the redemption, repurchase, retirement, or other acquisition of any Equity Interest of SBO out of proceeds of, the substantially concurrent sale of other Equity Interests of SBO; Investments by SBO in an amount not to exceed $75 million in the aggregate in any Non-Recourse Subsidiary engaged in a Gaming Related Business; Investments by SBO in any Non-Recourse Subsidiary engaged in a Gaming Related Business in an amount not to exceed in the aggregate 100% of all cash received by SBO from any Non-Recourse Subsidiary up to $75 million in the aggregate and thereafter, 50% of all cash received by SBO from any Non-Recourse Subsidiary other than cash required to be repaid or returned to such Non-Recourse Subsidiary provided that the aggregate amount of Investments pursuant thereto does not exceed $125 million in the aggregate; and the purchase, redemption, defeasance of any Pari ---- Passu Indebtedness with a substantially concurrent purchase, redemption, - ----- defeasance, or retirement of the First Mortgage Bonds (on a pro rata basis). ACSI has available a $15.0 million line of credit guarantied by OSI. The line, which expires August 31, 1994, has interest payable at the bank's prime rate of 6.0% plus .5%. Borrowings on this line of credit may not be used for the payment of management fees or to fund ventures in other jurisdictions. At December 31, 1993, ACSI had all the funds available for use. The Company entered into the Showboat Star Partnership agreement to own and operate a riverboat casino on the south shore of Lake Pontchartrain in New Orleans, Louisiana. The Company initially invested $18.6 million for a 30% equity interest in the partnership and subsequently on March 1, 1994, purchased an additional 20% equity interest from a partner for $9.0 million. The Company also has a management agreement for the partnership's gaming operations which provides for a management fee of 5% of gaming revenues, net of gaming taxes of 18.5% and boarding fees totaling up to $5.00 per passenger boarding the vessel. The riverboat casino commenced operations on November 8, 1993. The Company believes it has sufficient capital resources to cover the cash requirements of the Company. The ability of the Company to satisfy its cash requirements, however, will be dependent upon the future performance of its casino hotels which will continue to be influenced by prevailing economic conditions and financial, business and other factors, certain of which are beyond the control of the Company. The Company is evaluating potential expansion opportunities in new gaming jurisdictions. Additionally, the Company has announced that it is (i) a member of a partnership which is the only applicant for gaming berth for East Chicago, Indiana; (ii) completing negotiations for a tribal casino on the St. Regis Mohawk reservation; and (iii) one of two final applicants for the sole casino in Sydney, Australia. Each of the three identified expansion opportunities will require significant capital investment. The Company anticipates that (i) it will contribute $17.5 million to the East Chicago partnership and obtain financing in excess of $50 million for the construction of a gaming vessel and related land site improvements, (ii) it will initially loan up to $35 million for renovating and outfitting an existing building on the St. Regis Mohawk reservation for the conduct of a gaming business and for working capital purposes; and (iii) it will contribute $150 million (Australian) to the holding company of the Sydney casino licensee if the consortium to which it is a member is awarded the casino license. No assurance can be given that any of the announced opportunities will be realized. If the Company achieves any of the foregoing expansion opportunities, or others, the Company shall make a significant capital investment, and additional financing will be required. The Company anticipates that additional funds shall be obtained through loans or a public offering of equity or debt securities. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ------------------------------------------- Independent Auditors' Report; Consolidated Balance Sheets December 31, 1992 and 1993; Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991; Consolidated Statements of Shareholders' 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; and Notes to Consolidated Financial Statements Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties. Schedule V Property and equipment Schedule VI Accumulated Depreciation and Amortization of Property and Equipment Schedule VIII Valuation and Qualifying Accounts Schedule X Supplementary income statement information All other information is omitted because it is inapplicable. Independent Auditors' Report The Shareholders and Board of Directors Showboat, Inc.: We have audited the consolidated financial statements of Showboat, Inc. 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 Showboat, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations 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 Notes 1 and 8 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 No. 109, "Accounting for Income Taxes". KPMG PEAT MARWICK Las Vegas, Nevada February 18, 1994, except for Note 1 paragraph 3 and Note 12 paragraph 2, which are as of March 1, 1994 SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 1993 1992 ASSETS --------- --------- (In thousands) Current assets: Cash and cash equivalents $122,787 $99,601 Receivables, net 5,913 5,092 Inventories 2,359 2,411 Prepaid expenses 4,044 3,969 Current deferred income taxes 4,865 3,483 --------- --------- Total current assets 139,968 114,556 --------- --------- Property and equipment: Land 9,425 3,609 Land improvements 541 841 Buildings 261,009 246,090 Furniture and equipment 145,178 122,573 Construction in progress 27,194 7,253 --------- --------- 443,347 380,366 Less accumulated depreciation and amortization 145,527 129,183 --------- --------- 297,820 251,183 --------- --------- Other assets, at cost: Deposits and other assets 7,892 16,074 Investment in Showboat Star Partnership 17,750 - Debt issuance costs, net of accumulated amortization of $323,000 at December 31, 1993 and $3,131,000 at December 31, 1992 7,270 3,087 --------- --------- 32,912 19,161 --------- --------- $470,700 $384,900 ========= ========= -60- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (continued) 1993 1992 LIABILITIES AND SHAREHOLDERS' EQUITY --------- --------- (In thousands) Current liabilities: Current maturities of long-term debt $3,574 $54,055 Accounts payable 14,173 10,096 Income taxes payable 1,752 1,453 Dividends payable 375 284 Accrued liabilities 23,664 25,167 --------- --------- Total current liabilities 43,538 91,055 --------- --------- Long-term debt 277,043 155,061 --------- --------- Deferred income taxes 14,961 12,766 --------- --------- Commitments and contingencies (Note 12) Shareholders' equity: Common stock, $1 par value; 20,000,000 shares authorized; issued 15,794,578 shares at December 31, 1993 and 1992 15,795 15,795 Additional paid-in capital 71,162 69,374 Retained earnings 54,628 48,778 --------- --------- 141,585 133,947 Less: Cost of shares in treasury, 814,483 shares and 991,043 shares at December 31, 1993 and 1992, respectively (6,370) (7,761) Unearned compensation for restricted stock (57) (168) --------- --------- Total shareholders' equity 135,158 126,018 --------- --------- $470,700 $384,900 ========= ========= See accompanying notes to consolidated financial statements. SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 1993, 1992 and 1991 (In thousands except per share data) 1993 1992 1991 --------- --------- --------- Revenues: Casino $329,522 $313,247 $288,442 Food and beverage 48,669 44,511 46,802 Rooms 19,355 17,280 15,612 Sports and special events 4,251 4,443 4,506 Other 5,982 4,932 4,791 --------- --------- --------- 407,779 384,413 360,153 Less complimentaries 32,052 29,177 28,593 --------- --------- --------- Net revenues 375,727 355,236 331,560 --------- --------- --------- Costs and expenses: Casino 129,898 125,773 115,468 Food and beverage 55,608 51,173 51,388 Rooms 13,083 12,169 11,282 Sports and special events 3,198 3,141 3,140 General and administrative 92,739 84,058 78,022 Selling, advertising and promotion 11,629 10,402 11,067 Depreciation and amortization 23,303 22,012 25,692 --------- --------- --------- 329,458 308,728 296,059 --------- --------- --------- Income from operations from consolidated subsidiaries 46,269 46,508 35,501 Equity in loss of unconsolidated affiliate (850) - - --------- --------- --------- Income from operations 45,419 46,508 35,501 --------- --------- --------- -62- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 1993, 1992 and 1991 (In thousands except per share data) (continued) 1993 1992 1991 --------- --------- --------- Income from operations 45,419 46,508 35,501 --------- --------- --------- Other (income) expense: Interest income (3,215) (1,441) (2,098) Interest expense, net of amounts capitalized 24,696 25,335 27,497 --------- --------- --------- 21,481 23,894 25,399 --------- --------- --------- Income before income tax expense, extraordinary items and cumulative effect adjustment 23,938 22,614 10,102 Income tax expense 10,474 6,757 4,088 --------- --------- --------- Income before extraordinary items and cumulative effect adjustment 13,464 15,857 6,014 Extraordinary items, net of income tax (6,679) (3,408) 180 Cumulative effect of change in method of accounting for income taxes 556 - - --------- --------- --------- Net income $7,341 $12,449 $6,194 ========= ========= ========= Income per common and equivalent share: Income before extraordinary items and cumulative effect adjustment $0.89 $1.37 $0.53 Extraordinary items, net of income tax (0.44) (0.29) 0.02 Cumulative effect of change in method of accounting for income taxes 0.04 - - --------- --------- --------- Net income $0.49 $1.08 $0.55 ========= ========= ========= See accompanying notes to consolidated financial statements SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 Less Additional Less Unearned Common paid-in Retained Treasury compen- stock capital earnings stock sation Total --------- --------- --------- --------- --------- --------- (In thousands) Balance, December 31, 1990 $12,345 $22,416 $32,405 ($7,765) ($553) $58,848 Net income - - 6,194 - - 6,194 Cash divi- dends ($.10 per share) - - (1,135) - - (1,135) Share trans- actions un- der stock plans - 27 - (19) 15 23 Amortization of un- earned compen- sation - - - - 203 203 --------- --------- --------- --------- --------- --------- Balance, December 31, 1991 $12,345 $22,443 $37,464 ($7,784) ($335) $64,133 --------- --------- --------- --------- --------- --------- -64- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (continued) Less Additional Less Unearned Common paid-in Retained Treasury compen- stock capital earnings stock sation Total --------- --------- --------- --------- --------- --------- (In thousands) Balance, December 31, 1991 $12,345 $22,443 $37,464 ($7,784) ($335) $64,133 Net income - - 12,449 - - 12,449 Cash divi- dends ($.10 per share) - - (1,135) - - (1,135) Issuance of 3,450,000 shares of common stock 3,450 46,916 - - - 50,366 Share trans- actions un- der stock plans - 15 - 23 11 49 Amortization of un- earned compen- sation - - - - 156 156 --------- --------- --------- --------- --------- --------- Balance, December 31, 1992 $15,795 $69,374 $48,778 ($7,761) ($168) $126,018 --------- --------- --------- --------- --------- --------- -65- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (continued) Less Additional Less Unearned Common paid-in Retained Treasury compen- stock capital earnings stock sation Total --------- --------- --------- --------- --------- --------- (In thousands) Balance, December 31, 1992 $15,795 $69,374 $48,778 ($7,761) ($168) $126,018 Net income - - 7,341 - - 7,341 Cash divi- dends ($.10 per share) - - (1,491) - - (1,491) Share trans- actions un- der stock plans - 1,788 - 1,391 - 3,179 Amortization of un- earned compen- sation - - - - 111 111 --------- --------- --------- --------- --------- --------- Balance, December 31, 1993 $15,795 $71,162 $54,628 ($6,370) ($57) $135,158 ========= ========= ========= ========= ========= ========= See accompanying notes to consolidated financial statements. SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 1993 1992 1991 --------- --------- --------- (In thousands) Cash flows from operating activities: Net income $7,341 $12,449 $6,194 Adjustments to reconcile net income to net cash provided by operating activities: Allowance for doubtful accounts 1,849 1,644 2,924 Depreciation and amortization 23,303 22,012 25,692 Amortization of original issue discount and debt issuance costs 744 1,011 811 Provision for deferred income taxes 813 238 1,230 Amortization of unearned compensation 111 156 203 Provision for loss on Casino Reinvestment Development Authority obligation 1,122 1,068 1,057 Equity in loss of unconsolidated affiliate 850 - - Extraordinary (gain) loss on extinguishment of debt 11,166 5,164 (273) Loss on disposition of property and equipment 517 264 350 Increase in receivables, net (2,670) (1,537) (899) (Increase) decrease in inventories and prepaid expenses (23) (265) 599 (Increase) decrease in deposits and other assets (554) 284 (448) Increase (decrease) in accounts payable 85 395 (826) Increase in income taxes payable 968 429 2 Increase (decrease) in accrued liabilities (1,503) 400 1,007 --------- --------- --------- Net cash provided by operating activities 44,119 43,712 37,623 --------- --------- --------- -67- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 (continued) 1993 1992 1991 --------- --------- --------- (In thousands) Cash flows from investing activities: Acquisition of property and equipment ($59,686) ($21,050) ($13,381) Proceeds from sale of property and equipment 78 105 311 Investment in Showboat Star Partnership (18,600) - - (Increase) decrease in deposits and other assets 4,046 910 (1,097) Deposit for Casino Reinvestment Development Authority obligation (3,289) (3,161) (2,892) --------- --------- --------- Net cash used in investing activities (77,451) (23,196) (17,059) --------- --------- --------- Cash flows from financing activities: Principal payments of long-term debt (3,914) (8,879) (7,635) Proceeds from issuance of long-term debt 275,000 - 1,098 Early extinguishment of debt (208,085) - (11,696) Debt issuance costs (7,593) - (74) Payment of dividends (1,400) (1,141) (1,140) Issuance of common stock 2,510 50,366 - Other - 49 23 --------- --------- --------- Net cash provided by (used in) financing activities 56,518 40,395 (19,424) --------- --------- --------- Net increase in cash and cash equivalents 23,186 60,911 1,140 Cash and cash equivalents at beginning of year 99,601 38,690 37,550 --------- --------- --------- Cash and cash equivalents at end of year $122,787 $99,601 $38,690 ========= ========= ========= -68- (continued) SHOWBOAT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992 and 1991 (continued) 1993 1992 1991 --------- --------- --------- (In thousands) Supplemental disclosures of cash flow information: Cash paid during the year for: Interest, net of amount capitalized $25,741 $24,562 $26,937 Income taxes 3,650 4,400 2,948 Supplemental schedule of non-cash investing and financing activities: Capital lease obligations incurred in connection with acquisition of equipment - 152 131 Increase (decrease) in property and equipment acquisitions included in construction contracts and reten- tions payable and long-term debt 3,914 1,890 (309) Share transactions under long-term incentive plan - 27 35 Transfer deposits for Casino Reinvestment Development Authority obligation to construction in progress 6,667 - - See accompanying notes to consolidated financial statements. SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations and Principles of Consolidation Showboat, Inc. and subsidiaries, collectively the Company, conduct casino gaming operations in Las Vegas, Nevada, Atlantic City, New Jersey and New Orleans, Louisiana. In addition, the Company operates support services including hotel, restaurant, bar, bowling and convention facilities. The consolidated financial statements include the accounts of Showboat, Inc. (SBO) and its wholly-owned subsidiaries which are Showboat Development Company (SDC), Showboat Operating Company (SOC) and Ocean Showboat, Inc. (OSI). They also include SDC's wholly-owned subsidiaries, Lake Pontchartrain Showboat, Inc. (LPSI) and Showboat Louisiana, Inc. (SLI), and OSI's wholly-owned subsidiaries Atlantic City Showboat, Inc. (ACSI) and Ocean Showboat Finance Corporation (OSFC). All material intercompany balances and transactions have been eliminated in consolidation. LPSI was formed in 1993 to manage a riverboat casino in New Orleans, Louisiana pursuant to a management contract. SLI was also formed in 1993 to hold a 30% equity interest in Showboat Star Partnership (SSP) which owns the riverboat casino managed by LPSI. In 1993, the Company invested $18,600,000 in SSP for its 30% equity interest in the riverboat casino. Effective March 1, 1994, the Company purchased an additional 20% equity interest from its partner for $9,000,000 (Note 12). Operation of the riverboat casino commenced on November 8, 1993. The investment by SLI in SSP has been accounted for under the equity method of accounting. The Company's equity in the income or loss of SSP is included in the Consolidated Statement of Income as equity in loss of unconsolidated affiliate. LPSI receives a management fee from SSP of 5.0% of casino revenues net of gaming taxes of 18.5% and boarding fees. Management fees are included in other revenues in the Consolidated Statement of Income. Casino Revenue and Complimentaries In accordance with common industry practice, casino revenues are the net of gaming wins less losses. Complimentaries primarily consist of rooms, food and beverage furnished gratuitously to customers. The sales values of such services are included in the respective revenue classifications and are then deducted as complimentaries. Complimentary rates are periodically reviewed and adjusted by management. -70- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Cash Equivalents For purposes of the statements of cash flows, the Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Fair Value of Certain Financial Instruments The carrying amount of cash equivalents, accounts receivable and all current liabilities approximates fair value because of the short maturity of these instruments. See Notes 4 and 11 for additional fair value disclosures. Property and Equipment Property and equipment are stated at cost. Depreciation, including amortization of capitalized leases, is computed using the straight-line method. The cost of maintenance and repairs is charged to expense as incurred; significant renewals and betterments are capitalized. Estimated useful lives for property and equipment are 5 to 15 years for land improvements, 10 to 40 years for buildings and 2 to 10 years for furniture and equipment. Interest Costs Interest is capitalized in connection with the construction of major facilities. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the asset's estimated useful life. For the year ended December 31, 1993, $1,085,000 of interest cost was capitalized. No interest was capitalized in the years ended December 31, 1992 and 1991. -71- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Income Taxes In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). Under the asset and liability method of FAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. Effective January 1, 1993, the Company adopted FAS 109 and has reported the cumulative effect of that change in accounting method in the 1993 Consolidated Statement of Income. The Company previously used the asset and liability method under Statement of Financial Accounting Standards No. 96 (FAS 96). Under the asset and liability method of FAS 96, deferred tax assets and liabilities were recognized for all the events that had been recognized in the financial statements. Under FAS 96, the future tax consequences of recovering assets or settling liabilities at their financial statement carrying amounts were considered in calculating deferred income taxes. Generally, FAS 96 prohibited consideration of any other future events in calculating deferred income taxes. The Company and its subsidiaries file a consolidated federal income tax return. For tax reporting purposes, the Company has elected to continue its fiscal year ending June 30. Postemployment and Postretirement Benefits The Company does not currently provide any significant postemployment or postretirement benefits. -72- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Amortization of Original Issue Discount and Debt Issuance Costs Original issue discount is amortized over the life of the related indebtedness using the effective interest method. Costs associated with the issuance of debt have been deferred and are being amortized over the life of the related indebtedness using a weighted average method based on retirement schedules specified in the debt indentures. Income Per Common and Equivalent Share Income per common and equivalent share is based on the weighted average number of shares outstanding. Such averages were 15,099,147, 11,584,275 and 11,410,208 during the years ended December 31, 1993, 1992 and 1991, respectively. Fully-diluted and primary income per common and equivalent share are the same. Preopening and Development Costs The Company is currently investigating expansion opportunities in new gaming jurisdictions. Costs associated with these investigations are expensed as incurred until such time as a particular opportunity is determined to be viable, generally when the Company is selected as the operator of a new gaming facility or a gaming license has been granted. Costs incurred during the construction and preopening phase are capitalized. Types of costs capitalized include professional fees, salaries and wages, temporary office expenses, marketing expenses and training costs. When the new operation opens for business, preopening costs will be amortized over a period not to exceed 12 months using the straight-line method. Costs associated with the preopening of the riverboat casino on Lake Pontchartrain in New Orleans, Louisiana were written-off upon commencement of operations on November 8, 1993 and totaled $4,246,000. The Company's share of those costs of $1,274,000 are included in equity in loss of unconsolidated affiliate in the December 31, 1993 Consolidated Statement of Income. Reclassifications Certain prior year balances have been reclassified to conform to the current year's presentation. -73- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 2. RECEIVABLES Receivables consist of the following: December 31, ------------------- 1993 1992 --------- --------- (In thousands) Casino $6,816 $6,964 Hotel 1,020 715 Employees 88 86 Other 935 406 --------- --------- 8,859 8,171 Less allowance for doubtful accounts 2,946 3,079 --------- --------- Receivables, net $5,913 $5,092 ========= ========= 3. ACCRUED LIABILITIES Accrued liabilities consist of the following: December 31, ------------------- 1993 1992 --------- --------- (In thousands) Interest $4,240 $6,029 Salaries and wages 8,289 7,540 Taxes, other than taxes on income 1,988 1,641 Medical and liability claims 2,983 3,036 Advertising and promotion 2,397 3,068 Outstanding chips and tokens 1,204 1,308 Other 2,563 2,545 --------- --------- Total accrued liabilities $23,664 $25,167 ========= ========= -74- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4. LONG-TERM DEBT Long-term debt consists of the following: December 31, ------------------- 1993 1992 --------- --------- (In thousands) 9 1/4% First Mortgage Bonds due 2008 (a) $275,000 $ - 11 3/8% Mortgage-Backed Bonds Due 2002 (b) - 149,444 13% Subordinated Sinking Fund Debentures Due October 1, 2004 (c) - 32,949 Construction and term loan, repaid in 1993 - 17,192 Capitalized lease obligations (Note 5) 5,617 9,531 --------- --------- 280,617 209,116 Less current maturities 3,574 54,055 --------- --------- $277,043 $155,061 ========= ========= (a) On May 18, 1993, the Company issued $275,000,000 of 9 1/4% First Mortgage Bonds due 2008 (First Mortgage Bonds). The proceeds from the sale of the First Mortgage Bonds were $268,469,000, net of underwriting discounts and commissions. Proceeds from the sale of the First Mortgage Bonds were used to redeem all of the outstanding 11 3/8% Mortgage-Backed Bonds Due 2002 at 105.7% of the principal amount plus accrued interest. The remaining proceeds were reserved by the Company to benefit existing facilities and to expand into new facilities or gaming jurisdictions. The First Mortgage Bonds are unconditionally guarantied by OSI, ACSI and SOC. Interest on the First Mortgage Bonds is payable semi-annually on May 1 and November 1 of each year commencing November 1, 1993. The First Mortgage Bonds are not redeemable prior to May 1, 2000. Thereafter, the First Mortgage Bonds will be redeemable, in whole or in part, at redemption prices specified in the Indenture for the First Mortgage Bonds (Indenture). The First Mortgage Bonds are senior secured obligations of the Company and rank senior in right of payment to all existing and future subordinated indebtedness of the Company and pari passu with the Company's senior indebtedness. The First Mortgage Bonds are -75- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4. LONG-TERM DEBT (continued) secured by a deed of trust representing a first lien on the Las Vegas hotel casino (other than certain assets), by a pledge of all outstanding shares of capital stock of OSI, an intercompany note by ACSI in favor of SBO and a pledge of certain intellectual property rights of the Company. OSI's obligation under its guaranty is secured by a pledge of all outstanding shares of capital stock of ACSI. ACSI's obligation under its guaranty is secured by a leasehold mortgage representing a first lien on the Atlantic City hotel casino (other than certain assets). SOC's guaranty is secured by a pledge of certain assets related to the Las Vegas hotel casino. The Indenture places significant restrictions on SBO and its subsidiaries, including restrictions on making loans and advances by SBO to subsidiaries which are Non-Recourse Subsidiaries or subsidiaries in which SBO owns less than 50% of the equity. All capitalized terms not otherwise defined in this paragraph have the meanings assigned to the Indenture. The Indenture also places significant restrictions on the incurrence of additional Indebtedness by SBO and its subsidiaries, the creation of additional Liens on the Collateral securing the First Mortgage Bonds, transactions with Affiliates and the investment of SBO and its subsidiaries in certain Investments. In addition, the terms of the Indenture prohibit SBO and its subsidiaries from making a Restricted Payment unless, at the time of such Restricted Payment: (i) no Default or Event of Default has occurred or would occur as a consequence of such restricted payment; (ii) SBO, at the time of such Restricted Payment and after giving pro forma effect thereto as if such Restricted Payment had been made at the beginning of the applicable four-quarter period, would have been permitted to incur at least $1.00 of additional Indebtedness; and, (iii) such Restricted Payment, together with the aggregate of all other Restricted Payments by SBO and its subsidiaries is less than the sum of (x) 50% of the Consolidated Net Income of SBO for the period (taken as one accounting period) from April, 1993 to the end of SBO's most recently ended fiscal quarter for which internal financial statements are available, plus (y) 100% of the aggregate net cash proceeds received by SBO from the issuance or sale of Equity Interests of SBO since the Issue Date, plus (z) Excess Non-Recourse Subsidiary Cash Proceeds received after the Issue Date. The term Restricted Payment does not include, among other things, the payment of any dividend if, at the time of declaration of such dividend, the dividend would have complied with the -76- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4. LONG-TERM DEBT (continued) provisions of the Indenture; the redemption, repurchase, retirement, or other acquisition of any Equity Interest of SBO out of proceeds of, the substantially concurrent sale of other Equity Interests of SBO; Investments by SBO in an amount not to exceed $75,000,000 in the aggregate in any Non-Recourse Subsidiary engaged in a Gaming Related Business; Investments by SBO in any Non-Recourse Subsidiary engaged in a Gaming Related Business in an amount not to exceed in the aggregate 100% of all cash received by SBO from any Non-Recourse Subsidiary up to $75,000,000 in the aggregate and thereafter, 50% of all cash received by SBO from any Non-Recourse Subsidiary other than cash required to be repaid or returned to such Non-Recourse Subsidiary provided that the aggregate amount of Investments pursuant thereto does not exceed $125,000,000 in the aggregate; and the purchase, redemption, defeasance of any pari passu Indebtedness with a substantially concurrent purchase, redemption, defeasance, or retirement of the First Mortgage Bonds (on a pro rata basis). (b) In March 1987, the Company issued $180,000,000 of 11 3/8% Mortgage-Backed Bonds Due 2002 (Mortgage-Backed Bonds). Interest was payable semi-annually on March 15 and September 15 of each year. During the years ended December 31, 1991 and 1990, the Company repurchased $12,096,000 and $18,460,000 face value, respectively, of the Mortgage-Backed Bonds (Note 10). In accordance with the provisions of the Indenture for the First Mortgage Bonds, the Mortgage-Backed Bonds were redeemed on June 18, 1993 at 105.7% of par plus accrued interest. (c) During fiscal year 1985, the Company issued $57,500,000 of 13% (effective rate of 15.75%) Subordinated Sinking Fund Debentures Due October 1, 2004 (Debentures), with interest payable semi-annually. The Debentures were redeemable at any time at the option of the Company, in whole or in part, at par plus accrued interest or the Debentures may have been reacquired through purchases in the open market. The Debentures had a mandatory sinking fund requirement beginning October 1, 1991, designed to -77- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4. LONG-TERM DEBT (continued) retire 80% of the issue prior to maturity. On October 1, 1992 and 1991, the Company applied $2,875,000 of previously repurchased Debentures toward the sinking fund requirement. On October 29, 1992, the Company made a redemption of $2,875,000 of Debentures. On January 29, 1993, the Company redeemed in full the Debentures at par plus accrued interest (Note 10). At December 31, 1993, the Company's Atlantic City subsidiary, ACSI, had available an unsecured line of credit for general working capital purposes totaling $15,000,000. Interest is payable monthly at the bank's prime rate plus .5%. The Bank's prime rate was 6.0% at December 31, 1993. The line of credit is guarantied by OSI and expires in August 1994. Borrowings on this line of credit may not be used for the payment of management fees or to fund ventures in other jurisdictions. At December 31, 1993, ACSI had all the funds under this line of credit available for use. Maturities of the Company's long-term debt are as follows: Year ending (In thousands) December 31, 1994 $3,574 1995 20 1996 1,950 1997 25 1998 29 Thereafter 275,019 --------- $280,617 ========= The fair value of the Company's First Mortgage Bonds was $283,250,000 at December 31, 1993 based on the quoted market price of the First Mortgage Bonds. The carrying amount of capital leases approximates fair value at December 31, 1993. -78- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 5. LEASES The Company leases certain furniture and equipment and a warehouse under long-term lease agreements. The leases covering furniture and equipment expire in 1994 and the warehouse lease expires in 2001. The Company has the option to purchase the warehouse from January 1, 1996 through March 31, 2001 at an option price of approximately $1,928,000. Property leased under capital leases by major classes are as follows: December 31, ------------------- 1993 1992 --------- --------- (In thousands) Building - warehouse $2,050 $2,050 Furniture and equipment 22,621 23,417 --------- --------- 24,671 25,467 Less accumulated amortization 19,456 21,308 --------- --------- $5,215 $4,159 ========= ========= ACSI is leasing 10 1/2 acres of Boardwalk property in Atlantic City, New Jersey for a term of 99 years commencing October 1983. Annual rent payments, which are payable monthly, commenced upon opening of the Atlantic City Showboat. The rent is adjusted annually based upon increases or decreases in the Consumer Price Index. In April 1993, the annual rent increased $243,000 to $8,118,000. ACSI is responsible for taxes, assessments, insurance and utilities. -79- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 5. LEASES (continued) The following is a schedule of future minimum lease payments for capital leases and operating leases (with initial or remaining terms in excess of one year) as of December 31, 1993: Capital Operating Leases Leases --------- --------- Year ending (In thousands) December 31, 1994 $4,014 $9,537 1995 286 9,773 1996 1,961 9,629 1997 33 9,783 1998 33 9,916 Thereafter 20 797,971 --------- --------- Total minimum lease payments 6,347 $846,609 ========= Less amount representing interest (10.4% to 12.9%) 730 --------- Present value of net minimum capital lease payments $5,617 ========= Rent expense for all operating leases was $9,287,000, $8,659,000 and $8,046,000 for the years ended December 31, 1993, 1992 and 1991, respectively. -80- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 6. STOCK PLANS On May 17, 1990, the shareholders of SBO approved a long-term incentive plan in which officers and key employees of the Company participate. Up to 600,000 shares of SBO common stock may be awarded to plan participants as either restricted shares or stock options. Restricted shares and options shall vest over a five-year period. The options are exercisable, subject to vesting, over ten years at option prices determined by SBO's Compensation Committee provided that the option price is not less than 100% of the fair market value of the Company's common stock determined on the date of grant of the options. As of December 31, 1993, 127,900 restricted shares have been issued from treasury. On May 17, 1990, the shareholders of SBO approved the Directors' Stock Option Plan whereby options to purchase up to 120,000 shares of SBO common stock may be granted at an option price no less than 100% of the fair market value of the shares on the date of grant. Under the terms of the Directors' Plan, each option shall be exercisable in full one year after the date of grant. Unless special circumstances exist, each option shall expire on the tenth anniversary of the date of grant or two years after the director's retirement. In April 1992, the Board of Directors of the Company adopted the 1992 Employee Stock Option Plan (Plan) for all full-time and part-time employees. The Company reserved an aggregate of 1,000,000 shares of SBO common stock for issuance under the Plan. The exercise price of an option awarded under the Plan cannot be less than the fair market value of the Company's common stock on the date of grant. The number of options granted to an employee is based on the employee's years of service with the Company. Options, all of which expire ten years from the date of grant, are subject to vesting and continued affiliation with the Company. -81- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 6. STOCK PLANS (continued) A summary of certain stock option information is as follows: Year ended December 31, ----------------------------- 1993 1992 1991 --------- --------- --------- Options outstanding at January 1 901,080 393,570 386,850 Granted 96,550 521,550 21,000 Exercised (176,560) (6,840) (2,280) Forfeited (8,750) (7,200) (12,000) --------- --------- --------- Options outstanding at December 31 812,320 901,080 393,570 ========= ========= ========= Option price range at December 31 $6.50 to $6.50 to $6.50 to $18.00 $14.50 $8.00 Options exercisable at December 31 529,495 120,430 82,245 Unearned compensation in connection with restricted stock issued for future services was recorded on the date of grant at the fair market value of SBO's common stock and is being amortized ratably from the date of grant over the five-year vesting period as it is earned. Compensation expense of $111,000, $156,000 and $203,000 was recognized during the years ended December 31, 1993, 1992 and 1991, respectively. Unearned compensation has been shown as a reduction of shareholders' equity in the accompanying Consolidated Balance Sheets. -82- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 7. SHAREHOLDERS' EQUITY On December 24, 1992, the Company issued 3,450,000 shares of its $1.00 par value common stock in a public offering. The price to the public was $15.50 per share. Net proceeds of the offering, after deducting all associated costs, was $50,366,000 or $14.60 per newly issued share. Proceeds of the offering were used in January 1993 to redeem all of SBO's 13% Subordinated Sinking Fund Debentures Due 2004 and to fully prepay the balance outstanding on the construction and term loan. 8. INCOME TAXES As discussed in Note 1, the Company adopted FAS 109 effective January 1, 1993. The cumulative effect of the change in method of accounting for income taxes of $556,000 is determined as of January 1, 1993 and is reported separately in the Consolidated Statement of Income for the year ended December 31, 1993. Prior year financial statements have not been restated to apply the provisions of FAS 109. Total income tax expense for the year ended December 31, 1993 was allocated as follows: (In thousands) Continuing operations $10,474 Extraordinary item (4,487) Shareholders' equity, related to compensation expense deferred and reported as a reduction of shareholders' equity for financial reporting purposes (661) --------- $5,326 ========= -83- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. INCOME TAXES (continued) Income tax expense attributable to income from continuing operations consists of: Year ended December 31, ----------------------------- 1993 1992 1991 --------- --------- --------- (In thousands) U.S. federal Current $7,910 $6,519 $2,858 Deferred 965 238 1,230 --------- --------- --------- 8,875 6,757 4,088 --------- --------- --------- State and local Current 1,195 - - Deferred 404 - - --------- --------- --------- 1,599 - - --------- --------- --------- Total Current 9,105 6,519 2,858 Deferred 1,369 238 1,230 --------- --------- --------- $10,474 $6,757 $4,088 ========= ========= ========= In 1992 and 1991, income tax expense of $6,757,000 and $4,088,000, respectively, represents income tax expense from continuing operations before extraordinary items. In 1992, as a result of an extraordinary loss of $5,164,000 (Note 10), the Company recognized an income tax benefit of $1,756,000 resulting in total income tax expense of $5,001,000. In 1991, as a result of an extraordinary gain of $273,000 (Note 10), the Company recognized additional income tax expense of $93,000 resulting in total income tax expense of $4,181,000. -84- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. INCOME TAXES (continued) Income tax expense attributable to income from continuing operations differed from the amounts computed by applying the U.S. federal income tax rate of 35% for the year ended December 31, 1993 and 34% for the years ended December 31, 1992 and 1991 to pretax income from continuing operations as a result of the following: Year ended December 31, ----------------------------- 1993 1992 1991 --------- --------- --------- (In thousands) Computed "expected" tax expense $8,378 $7,689 $3,435 Increase (reduction) in income taxes resulting from: Change in the beginning of the year balance of the valuation allowance for deferred tax assets allocated to income tax expense 224 - - Adjustment to deferred tax assets and liabilities for enacted changes in tax rates 383 - - State and local income taxes, net of federal tax benefit 930 - - Impact of settlement of Internal Revenue Service examination - (102) - Restricted interest assessment, net of tax 619 - - Impact of graduated tax rates (90) - - Other, net 30 (830) 653 --------- --------- --------- Income tax expense $10,474 $6,757 $4,088 ========= ========= ========= -85- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. INCOME TAXES (continued) The significant components of deferred income tax expense attributable to income from continuing operations for the year ended December 31, 1993 are as follows: (In thousands) Deferred tax expense (exclusive of other components listed below) $762 Adjustment to deferred tax assets and liabilities for enacted changes in tax rates 383 Change in beginning of the year balance of the valuation allowance for deferred tax assets 224 --------- $1,369 ========= For the years ended December 31, 1992 and 1991, deferred income tax expense of $238,000 and $1,230,000, respectively, results from temporary differences in the recognition of income and expenses for income tax and financial reporting purposes. The sources and tax effects of these temporary differences are as follows: Year ended December 31, ------------------- 1992 1991 --------- --------- (In thousands) Depreciation and amortization $1,250 $556 Utilization of credit carryforwards, net 1,145 (676) Provision for loss on Casino Reinvestment Development Authority obligation (1,496) 31 Allowance for doubtful accounts 309 342 Preopening costs 369 1,511 Accrued vacations (359) (149) Impact of settlement of Internal Revenue Service examination (625) - Other, net (355) (385) --------- --------- $238 $1,230 ========= ========= -86- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. INCOME TAXES (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, 1993 are as follows: (In thousands) Deferred tax assets: Casino Reinvestment Development Authority obligation ($1,566) Accrued vacations (1,621) Allowance for doubtful accounts (1,210) Alternative minimum tax credit carryforwards (2,423) Other (3,606) --------- Total gross deferred tax assets (10,426) Less valuation allowance 601 --------- Net deferred tax assets (9,825) --------- Deferred tax liabilities: Depreciation and amortization 17,350 Capitalized interest 2,571 --------- Total gross deferred tax liabilities 19,921 --------- Net deferred tax liability $10,096 ========= -87- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 8. INCOME TAXES (continued) Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of the net deferred tax liability at December 31, 1992 relate to the following: (In thousands) Depreciation and amortization $13,931 Utilization of credit carryforwards (2,032) Capitalized interest 2,572 Allowance for doubtful accounts (1,047) Accrued vacations (1,328) Provision for loss on Casino Reinvestment Development Authority obligation (1,496) Other (1,317) --------- Net deferred tax liability $9,283 ========= The valuation allowance for deferred tax assets as of January 1, 1993 was $377,000. The net change in the total valuation allowance for the year ended December 31, 1993 was an increase of $224,000. At December 31, 1993, the Company had available $2,423,000 of alternative minimum tax credit carryforwards which are available to reduce future federal regular income taxes, if any, over an indefinite period. For State of New Jersey income tax purposes, the Company has available $1,144,000 of net operating loss carryforwards which expire through 1997. -88- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 9. EMPLOYEE BENEFIT PLANS The Company maintains a profit sharing and retirement plan for eligible employees who are not covered by a collective bargaining agreement or by another retirement plan to which the Company is required to contribute. Contributions to the plan are made at the discretion of the Board of Directors of SBO. The benefits are limited to the allocated interest in the fund assets and each participant's account vests over a seven-year period. Contributions accrued by the Company were $195,000, $175,000 and $150,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company maintains a retirement and savings plan for eligible employees of ACSI and OSI. Under the terms of the plan, eligible employees may defer up to 3% of their compensation, as defined, of which 100% of the deferral is matched by ACSI. Eligible employees may contribute an additional 12% of their compensation which will not be matched by the Company. Contributions by the Company vest over a five-year period. The Company contributed $1,330,000, $1,110,000 and $776,000 to this plan for the years ended December 31, 1993, 1992 and 1991, respectively. Effective January 1, 1994, SOC and LPSI adopted the provisions of the retirement and savings plan previously available to the eligible employees of ACSI and OSI. The Company has requested a determination letter from the Internal Revenue Service to allow the Company to merge the present profit sharing plan and the retirement and savings plan. The Company's union employees are covered by union-sponsored, collectively-bargained, multi-employer pension plans. The Company contributed and charged to expense $1,197,000, $1,182,000 and $1,184,000 during the years ended December 31, 1993, 1992 and 1991, respectively. These contributions are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of hours worked. -89- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 10. EXTRAORDINARY ITEMS On June 18, 1993, the Company redeemed all of its remaining Mortgage-Backed Bonds at 105.7% plus accrued and unpaid interest up to and including the redemption date. The Company recognized an extraordinary loss before any income tax benefit of $11,166,000 as a result of the write-off of the unamortized debt issuance costs of $2,666,000 and the payment of a 5.7% redemption premium of $8,500,000. The after tax loss was $6,679,000 or $.44 per share. On December 30, 1992, the Company notified debentureholders of its intent to redeem all of the outstanding Debentures at par plus accrued interest on January 29, 1993. Accordingly, at December 31, 1992, the Company reclassified the outstanding principal balance of $32,949,000 to current maturities of long-term debt and recognized an extraordinary loss of $5,164,000 before an income tax benefit of $1,756,000 as a result of the write-off of the unamortized discount and debt issuance costs. The after tax loss was $3,408,000 or $.29 per share. In 1991, OSI purchased $12,096,000 face value of the Company's Mortgage-Backed Bonds for $11,696,000. Accordingly, after a charge of $127,000 for unamortized bond issuance costs, the Company realized an extraordinary gain of $273,000 before income taxes of $93,000 resulting in an after tax gain of $180,000 or $.02 per share. -90- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 11. NEW JERSEY INVESTMENT OBLIGATION The New Jersey Casino Control Act (Act) provides, among other things, for an assessment on a gaming licensee based upon its gross casino revenues after completion of its first full year of operation. This assessment may be satisfied by investing in qualified direct investments, purchasing bonds issued by the Casino Reinvestment Development Authority (CRDA), or paying an "alternative tax". In order for direct investments to be eligible, they must be approved by the CRDA. Deposits with the CRDA bear interest at two-thirds of market rates resulting in a current value lower than cost. At December 31, 1993 and 1992, deposits and other assets include $5,010,000 and $9,431,000, respectively, representing the Company's deposit with the CRDA of $7,488,000 as of December 31, 1993 and $14,121,000 as of December 31, 1992, net of a valuation allowance of $2,478,000 and $4,690,000, respectively. The carrying value of these deposits, net of the valuation allowance, approximates fair value. The CRDA, as an agency of the City of Atlantic City, is responsible for the redevelopment of the area surrounding the Boardwalk. The Company has requested and the CRDA has approved that $8,000,000 of the Company's deposits with the CRDA will be used in connection with the expansion of a City street leading to the Atlantic City Showboat. In connection with its approval, the CRDA required the Company to donate $2,000,000 of its deposits with the CRDA to certain public programs. Construction of the City street commenced in the fourth quarter of 1993 and is expected to be completed in 1994. The Company has reclassified these CRDA deposits, net of the valuation allowance, totaling $6,667,000 to construction in progress. When construction is complete, these costs will be amortized over seven years. The CRDA has set aside these deposits in a restricted account and the Company no longer receives the benefit of investment income on these funds. -91- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 11. NEW JERSEY INVESTMENT OBLIGATION (continued) The Company has applied for and received approval for approximately $8,800,000 in funding credits from the CRDA in connection with the construction of Atlantic City Showboat's additional hotel rooms. Pending the execution of a Credit Agreement with the CRDA, which states the terms and conditions by which the Company may receive funding credit, the Company may begin applying for and receiving funds from the CRDA as expenditures are made for the construction of the hotel rooms to the extent ACSI has available funds on deposit with the CRDA. The Company has approximately $2,500,000 in available deposits with the CRDA which they may apply for upon execution of the Credit Agreement, with the balance being applied to portions of future CRDA deposits. 12. COMMITMENTS AND CONTINGENCIES During 1993, the Company entered into construction contracts which commit the commit the Company to approximately $39,000,000 in expenditures in 1994 and approximately $7,000,000 in 1995. In December 1993, the Company agreed to purchase an additional 20% equity interest in Showboat Star Partnership from a partner for $9,000,000, increasing the Company's interest in the partnership to 50% subject to the approval of the Louisiana Riverboat Gaming Commission. The Louisiana Riverboat Gaming Commission approved the transaction in February 1994 and effective March 1, 1994, the Company acquired the additional 20% equity interest in Showboat Star Partnership. -92- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 12. COMMITMENTS AND CONTINGENCIES (continued) In February 1994, Showboat and Waterfront Entertainment and Development, Inc. formed the Showboat Marina Partnership (SMP). SMP has filed a gaming application with the Indiana Gaming Commission to operate a riverboat on Lake Michigan in East Chicago, Indiana. Under the terms of the partnership agreement, Showboat will own 55% of SMP and is required to make an initial capital contribution of $1,000,000 and an additional contribution of $16,500,000 at such later dates as specified in the initial development budget. On January 4, 1994 the Atlantic City Housing Authority and Urban Redevelopment Agency (ACHA) declared ACSI to be in default for noncompliance with certain provisions contained in the contract between the two parties for ACSI's purchase of the land in Atlantic City for a new hotel tower currently under construction. Since the declaration of default, ACSI has been diligently working to cure the defaults. Management believes that as result of such efforts ACHA will ultimately rescind its notice of default. The Company is involved in various claims and legal actions arising in the ordinary course of business. Additionally, the Company is presently undergoing an audit by the Internal Revenue Service for the tax years ending June 30, 1989 and 1990. The State of New Jersey is currently auditing the Company's state income tax returns for the tax years ended June 30, 1986 through 1992. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's financial position or results of operations. -93- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 13. SELECTED QUARTERLY DATA (Unaudited) Summarized unaudited financial data for interim periods for the years ended December 31, 1993 and 1992 are as follows: Quarter ended (a) Year --------------------------------------- ended 3/31/93 6/30/93 9/30/93 12/31/93 12/31/93 --------- --------- --------- --------- --------- (In thousands except per share data) Net revenues $85,496 $92,706 $108,005 $89,520 $375,727 Income from operations (b) 7,685 11,983 18,250 7,501 45,419 Income before extraordinary loss and cumula- tive effect adjustment(c)(d) 1,921 3,751 7,356 436 13,464 Net income (loss) 2,477 (2,928) 7,356 436 7,341 Income before extraordinary loss and cumulative effect adjustment per share(c)(d) 0.13 0.24 0.48 0.03 0.89 Net income (loss) per share 0.16 (0.20) 0.48 0.03 0.49 Quarter ended (a) Year --------------------------------------- ended 3/31/92 6/30/92 9/30/92 12/31/92 12/31/92 --------- --------- --------- --------- --------- (In thousands except per share data) Net revenues $85,523 $89,250 $99,105 $81,358 $355,236 Income from operations 10,074 12,224 18,981 5,229 46,508 Income before extraordinary loss(e) 2,628 3,973 8,426 830 15,857 Net income (loss) 2,628 3,973 8,426 (2,578) 12,449 Income before extraordinary loss per share (e) 0.23 0.34 0.73 0.07 1.37 Net income (loss) per share 0.23 0.34 0.73 (0.22) 1.08 -94- (continued) SHOWBOAT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 13. SELECTED QUARTERLY DATA (Unaudited) (continued) (a) Quarterly results may not be comparable due to the seasonal nature of the Atlantic City operation. (b) In 1993, the Company acquired a 30% equity interest in Showboat Star Partnership which was engaged in the development of a riverboat casino on Lake Pontchartrain in New Orleans, Louisiana. Operation of the riverboat casino commenced on November 8, 1993. The Company's share of the partnership's loss from the commencement of operations through December 31, 1993, including the write-off of preopening costs of $1,274,000, is included in income from operations for the quarter ended December 31, 1993. (c) The Company adopted FAS 109 in 1993 and reported the cumulative effect of the change in method of accounting for income taxes as of January 1, 1993 in the 1993 Consolidated Statement of Income. (d) In the quarter ended June 30, 1993, the Company recognized an extraordinary loss of $6,679,000, net of tax, as a result of the redemption of all of its outstanding Mortgage-Backed Bonds (Note 10). (e) In the quarter ended December 31, 1992, the Company recognized an extraordinary loss of $3,408,000, net of tax, as a result of the planned redemption of all of its outstanding Debentures (Note 10). Schedule VI SHOWBOAT, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT (In thousands) Years Ended December 31, 1993, 1992 and 1991 Balance Additions at charged to Balance beginning costs and Retire- at end Classification of year expenses ments of year - ------------------------------- --------- --------- --------- --------- For the year ended December 31, 1993: Land improvements $741 $24 ($304) $461 Buildings 42,658 7,019 (293) 49,384 Furniture and equipment 85,784 16,260 (6,362) 95,682 --------- --------- --------- --------- $129,183 $23,303 ($6,959) $145,527 ========= ========= ========= ========= For the year ended December 31, 1992: Land improvements $713 $28 $ - $741 Buildings 36,374 6,288 (4) 42,658 Furniture and equipment 73,010 15,696 (2,922) 85,784 --------- --------- --------- --------- $110,097 $22,012 ($2,926) $129,183 ========= ========= ========= ========= For the year ended December 31, 1991: Land improvements $685 $28 $ - $713 Buildings 30,234 6,143 (3) 36,374 Furniture and equipment 61,632 19,521 (8,143) 73,010 --------- --------- --------- --------- $92,551 $25,692 ($8,146) $110,097 ========= ========= ========= ========= Schedule VIII SHOWBOAT, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands) Years Ended December 31, 1993, 1992 and 1991 Balance Charged at to costs Charged Balance beginning and to other Deductions at end Description of year expenses accounts (a) of year - --------------------- --------- --------- --------- --------- --------- Year ended December 31, 1993: Allowance for doubtful accounts $3,079 $1,849 $ - $1,982 $2,946 Year ended December 31, 1992: Allowance for doubtful accounts 3,988 1,644 - 2,553 3,079 Year ended December 31, 1991: Allowance for doubtful accounts 5,021 2,924 - 3,957 3,988 (a) Accounts written-off. Schedule X SHOWBOAT, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 Charged to costs and expenses Year ended December 31, ----------------------------- 1993 1992 1991 --------- --------- --------- (In thousands) Maintenance and repairs $9,455 $9,128 $8,571 ========= ========= ========= Taxes other than payroll and income taxes: Gaming taxes and licenses $26,580 $26,523 $24,378 Property taxes 7,374 6,529 6,088 Other 588 735 712 --------- --------- --------- $34,542 $33,787 $31,178 ========= ========= ========= Advertising costs $14,085 $11,864 $13,923 ========= ========= ========= Amortization of intangible assets is not set forth inasmuch as such items do not exceed one percent of total sales as shown in the related Consolidated Statements of Income. The Company pays no royalties. 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 information is furnished with respect to each member of the Board of Directors of the Company, each of whom, unless otherwise indicated, has served as a director continuously since the year shown opposite his or her name. Similar information is presented for the executive officers who are not directors. There are no family relationships between or among any of the Company's directors, nominees to the Board of Directors or executive officers, except: (a) J.K. Houssels and Jeanne S. Stewart formerly were married and are the parents of J. Kell Houssels, III; and (b) Carolyn M. Sparks is the daughter of Fred L. Morledge who was a director from 1960 until July 1990, and Mr. Morledge currently holds the title of Director Emeritus of the Company. IDENTIFICATION OF DIRECTORS - --------------------------- - --------------- /1/ Positions held with the Company and any other business experience since 1989 and other directorships in companies with a class of securities registered under Section 12 of the Securities Exchange Act of 1934 ("Exchange Act") or subject to the requirements of Section 15(d) of the Exchange Act and companies registered under the Investment Company Act of 1940. /2/ Mr. Gaughan also owns the Nevada Hotel and Casino, the Gold Spike Inn and Casino, and a controlling interest in the Las Vegas Club Hotel & Casino, each of which is located in Las Vegas, Nevada. NON-DIRECTOR EXECUTIVE OFFICERS - ------------------------------- G. Clifford Taylor, Jr., 48, has been Executive Vice President and Chief Operating Officer of the Company's Nevada subsidiaries since December 1, 1988. He has served as Assistant Secretary of the Company since May 1990. He has also served as Treasurer of the Company and Showboat Operating Company since February 1981, and Showboat Development Company since June 1983. He has been Treasurer of Ocean Showboat, Inc. since December 1983, Atlantic City Showboat, Inc. since June 1984 and Ocean Showboat Finance Corporation since December 1986. He serves at the pleasure of the respective boards of directors. R. Craig Bird, 47, has been Vice President-Financial Administration of the Company since February 1988 and the Executive Vice President and Chief Operating Officer of Showboat Development Company since October 1993. Mr. Bird was Vice President-Financial Administration of Atlantic City Showboat, Inc. from March 1990 to October 1993. He serves at the pleasure of the respective boards of directors. Leann K. Schneider, 40, has been Vice President-Finance and Chief Financial Officer of the Company; Vice President-Finance and Chief Financial Officer of Showboat Operating Company since May 1990; Chief Financial Officer and Treasurer of Showboat Development Company since May 1993; and Treasurer of Showboat Mohawk, Inc., Showboat Louisiana, Inc. and Showboat Grande, Inc. since July 1993 and Treasurer of Showboat Indiana, Inc. since September 1993. From December 1989 until May 1990, she served as Vice President-Financial Relations and Chief Financial Officer of the Company. From December 1988 until December 1989, she served as Vice President-Financial Relations and Acting Chief Financial Officer of the Company. She serves at the pleasure of the respective boards of directors. Mark J. Miller, 37, has served as Executive Vice President and Chief Operating Officer of Atlantic City Showboat, Inc. since October 1993. Vice President-Finance of Ocean Showboat, Inc. since April 1988; and Vice President- Finance and Chief Financial Officer of Ocean Showboat Finance Corporation since April 1991. He served as Vice President-Finance and Chief Financial Officer of Atlantic City Showboat, Inc. from December 1988 to October 1993. He serves at the pleasure of the respective boards of directors. 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 ten percent of the Common Stock, to file with the Securities and Exchange Commission and the New York Stock Exchange initial reports of ownership and reports of changes in ownership of Common Stock. Directors, executive officers and greater than ten percent shareholders are required by Securities and Exchange Commission regulation to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely upon review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the fiscal year ended December 31, 1993, all Section 16(a) filing requirements were complied with except that one report of ownership for one transaction, covering an aggregate of 500 shares, was filed late by J.K. Houssels, and one report of ownership for one transaction, covering an aggregate of three shares, was filed late by George A. Zettler. Mr. Houssels' late filing disclosed a disposition by gift of 500 shares which was inadvertently not timely reported on Mr. Houssels' Forms 4, and Mr. Zettler's late filing disclosed a purchase of Common Stock due to a dividend reinvestment which also was inadvertently not timely reported on Mr. Zettler's Forms 4. The following tables set forth compensation received by J.K. Houssels, the Company's Chief Executive Officer, and the four other highest paid executive officers of the Company during the last fiscal year for each year of the three- year period ended December 31, 1993 for services rendered in all capacities to the Company and its subsidiaries: SUMMARY COMPENSATION TABLE *Pursuant to the transitional provisions applicable to the revised rules on executive officer and director compensation disclosure adopted by the Securities and Exchange Commission, for the amounts of "Other Annual Compensation" and "All Other Compensation" for fiscal years ended before December 15, 1992, no disclosure is required. /1/Amounts represented in this column were received by the named individuals under either the Ocean Showboat, Inc. Stock Exchange Plan ("Stock Exchange Plan") or the Company's 1989 Executive Long-Term Incentive Plan ("1989 Plan") or both. Under the Stock Exchange Plan, the Company exchanged restricted shares of Common Stock for shares of Ocean Showboat, Inc. common stock. The restricted shares of Common Stock vested over a seven-year period, with the last of the restricted shares of Common Stock vesting in March 1992. The 1989 Plan is a Company-maintained incentive plan which provides for awards of restricted stock and stock options to key executives of the Company's operating subsidiaries. /2/This amount represents excess coverage life insurance costs. /3/This amount represents the Company's contribution to the named individual's 401(K) Plan account. /4/This amount includes $25,200 in costs for excess coverage life insurance and a $16,176 automobile allowance. /5/This amount represents the vesting of 4,800 shares under the 1989 Plan. /6/Of this amount, $73,806.63 (5,417 shares) vested under the Stock Exchange Plan and $21,800.00 (1,600 shares) vested under the 1989 Plan. /7/This amount represents the vesting of 5,417 shares under the Stock Exchange Plan. /8/Of this amount, $23,612.13 (1,733 shares) vested under the Stock Exchange Plan and $21,800.00 (1,600 shares) vested under the 1989 Plan. /9/Of this amount, $13,005.00 (1,734 shares) vested under the Stock Exchange Plan and $12,000.00 (1,600 shares) vested under the 1989 Plan. /10/This amount represents the vesting of 1,500 shares under the 1989 Plan. /11/This amount represents the vesting of 500 shares under the 1989 Plan. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES Compensation Committee Interlocks and Insider Participation. - ----------------------------------------------------------- The Company's executive compensation is determined by the Compensation Committee ("Compensation Committee") of the Board of Directors. Until November 1993, the Compensation Committee consisted of Messrs. Zettler and Nasky. In January 1994, the Compensation Committee was reconstituted to consist of Messrs. Zettler and Richardson. At all times during 1993, H. Gregory Nasky was a director of the Company and the Secretary of the Company and its subsidiaries. Mr. Nasky was appointed Chief Executive Officer and Managing Director of Showboat Australia Pty Limited in November 1993. Additionally, Mr. Nasky was a member of the law firm of Vargas & Bartlett, previous general counsel to the Company. On March 1, 1994, Vargas & Bartlett was reorganized from which the law firm of Kummer Kaempfer Bonner & Renshaw was formed and proceeded as general counsel to the Company. Mr. Nasky is of counsel to Kummer Kaempfer Bonner & Renshaw. During 1993, the law firm of Vargas & Bartlett was paid $57,696.61 by the Company's Nevada gaming subsidiary, $53,872.48 by the Company's New Jersey subsidiaries, $350,247.97 by Showboat Development, $196,182.12 by the Company for its public bond offering, and $122,288.25 by the Company for other parent company matters. Compensation of Directors - ------------------------- Remuneration of Non-Employee Directors. For 1993, each non-employee -------------------------------------- director received a retainer of $1,500 per quarter plus attendance fees of $1,000 per meeting attended. Such fees are paid by the Company and OSI, as applicable. In addition, non-employee members of the Compensation Committee and the Audit Committee are paid $850 for each committee meeting attended. Only non-employee directors receive the retainer or attendance fees. Reasonable out- of-pocket expenses incurred in attending scheduled meetings are reimbursed as to all directors. 1989 DIRECTORS' STOCK OPTION PLAN. The Company maintains a director --------------------------------- stock option plan entitled the 1989 Directors' Stock Option Plan ("Option Plan"). The Option Plan is designed to encourage non-employee directors to take a long-term view of the affairs of the Company; to attract and retain new superior non-employee directors; and to aid in compensating non-employee directors for their services to the Company. The Company's non-employee directors are William C. Richardson, John D. Gaughan, Jeanne S. Stewart, George A. Zettler and Carolyn M. Sparks. Stock options granted under the Option Plan are intended to be designated non-qualified options or options not qualified as incentive stock options under Section 422 of the Internal Revenue Code of 1986, as amended. Subject to adjustment by reason of stock dividend or split or other similar capital adjustments, an aggregate of 120,000 shares of Common Stock are reserved for issuance under the Option Plan. The administration of the Option Plan is carried out by a committee ("Committee") consisting of not less than two non-employee directors of the Company selected by and serving at the pleasure of the Company's Board of Directors. The Committee, unless permitted by holders of the majority of outstanding Common Stock, shall not have any discretion to determine or vary any matters which are fixed under the terms of the Option Plan. Fixed matters include, but are not limited to, which non-employee directors shall receive awards, the number of shares of the Common Stock subject to each option award, the exercise price of any option, and the means of acceptable payment for the exercise of the option. The Committee shall have the authority to otherwise interpret the Option Plan and make all determinations necessary or advisable for its administration. All decisions of the Committee are subject to approval of the Company's Board of Directors. Current members of the Committee are Mr. Zettler and Mr. Richardson. Under the terms of the Option Plan, each option shall be exercisable in full one year after the date of grant. Unless special circumstances exist, each option shall expire on the later of the tenth anniversary of the date of its grant or two years after the non-employee director retires. Each non-employee director initially receives a one-time option to purchase 5,000 shares of Common Stock following his or her election to the Board of Directors. Thereafter, each non-employee director receives a grant to purchase 1,000 shares of Common Stock each year, for five years following his or her election to the Board of Directors. The option exercise price is the greater of $7.625 or the fair market value, as defined under the Option Plan, of the Common Stock on the date such options are granted. The per share exercise price of options granted during 1993 pursuant to the Option Plan was $18.00. As of March 1, 1994, options representing 66,000 shares have been granted to the current five non-employee directors and three former non-employee directors and a director who has since become an employee. Of the outstanding options, options representing 60,000 shares are currently exercisable. The balance may not be exercised until April 27, 1994. As of December 31, 1993, none of the options granted pursuant to the Option Plan have been exercised. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ----------------------------------------------- -------------- The following table sets forth the number of shares of Common Stock and the number of shares of Common Stock subject to options held by the Company's directors and those executive officers named in the Summary Compensation Table (See "Item 11. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ---------------------------------------------- The Company made an unsecured loan to Frank A. Modica, Chief Operating Officer, Executive Vice President and Director of the Company, in the amount of $64,659.50 on September 30, 1993. Effective January 1, 1994, the loan was reduced to $56,801.75. The loan is payable on demand, or if no demand is made, on December 31, 1994, unless extended. The loan bears no interest, but interest is imputed to Mr. Modica at a rate of 3.91% per annum, compounded monthly. The Company made an unsecured loan to R. Craig Bird, Vice President- Financial Administration of the Company, and his spouse in the amount of $20,400.69 on August 5, 1993. The loan is payable on demand, or if no demand is made on August 4, 1994, unless extended. The loan bears no interest, but interest is imputed to Mr. and Mrs. Bird at a rate of 3.85% per annum, compounded monthly. The Company's subsidiary, Atlantic City Showboat, Inc., leases space at the Atlantic City Showboat to Mr. Bird for the operation of a gift shop and certain vending machines. During 1993, Mr. Bird paid rent and vending commissions to Atlantic City Showboat, Inc. in the amount of $112,888.29 and $39,793.89, respectively. The Company entered into a five-year lease agreement with Exber, Inc. commencing on February 15, 1994, for land nearby the Las Vegas Showboat. Exber, Inc., a Nevada corporation controlled by John D. Gaughan, a Director of the Company, has rights to the land pursuant to a sublease agreement dated November 5, 1966. The Company pays monthly rent of $13,095.80 and has an option to purchase the land and all of Exber, Inc.'s rights thereto for the purchase price of $1.4 million. Carolyn M. Sparks, a Director of the Company, is a co-owner of International Insurance Services, Ltd. The Company engaged International Insurance Services, Ltd. as its insurance adjuster for the Company's Nevada subsidiaries. During 1993, the Company paid International Insurance Services, Ltd. $115,858 for services rendered to the Company. Mr. Nasky was a member of the law firm of Vargas & Bartlett, previous general counsel to the Company. For information regarding fees paid to Vargas & Bartlett, see "Item 11. Executive Compensation -- Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. ------------------------------------------- ------------------- (a)(l) The following consolidated financial statements of the Company and its subsidiaries have been filed as a part of this report (See "Item 8: Financial Statements and Supplementary Data"): Independent Auditors' Report; 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 Shareholders' 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; and Notes to Consolidated Financial Statements (2) The following additional information for the Years Ended December 31, 1993, 1992 and 1991 is submitted herewith/ SEE ITEM 8., FINANCIAL STATEMENT AND SUPPLEMENTARY DATA: Schedule II Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Schedule V Property and equipment Schedule VI Accumulated Depreciation and Amortization of Property and Equipment Schedule VIII Valuation and Qualifying Accounts Schedule X Supplementary income statement information All other schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. (3) Exhibits/1/ Exhibit Number Description/2/ - ------- ----------- 3.01 Restated Articles of Incorporation of the Company dated June 28, 1988 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1988, Part IV, Item 14(a)(3), Exhibit 3.01. 3.02 Restated Bylaws of the Company dated February 25, 1993, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 3.02. 4.01 Specimen common stock certificate for the common stock of the Company, is incorporated herein by reference from the Company's Form 10-Q for the Quarter Ended March 31, 1985, Part II, Item 6(a), Exhibit 4.01. 4.02 Form of Indenture for the 9 1/4% First Mortgage Bonds due 2008 among the Company, OSI, ACSI, SBOC, and Trustee dated May 18, 1993; Guaranty in favor of the Trustee issued by OSI, ACSI and SBOC; and Form of Bond Certificate for the 9 1/4% First Mortgage Bonds due 2008 are incorporated herein by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.01. 10.01 Ground Lease between OSI and Resorts International, Inc. ("Resorts") dated October 26, 1983 is incorporated by reference herein from the Company's Form 8-K, as amended by the Form 8, filed with the Securities and Exchange Commission on November 28, 1983. Assignment and Assumption of Leases between OSI and ACSI dated December 3, 1985; First Amendment to Agreement between Resorts and ACSI dated January 15, 1985; Second Amendment to Lease - ---------------- /1/Copies of exhibits to this Form 10-K will be furnished to any requesting security holder who furnishes the Company a list identifying the exhibits to be copied by the Company at a charge of $.25 per page. /2/All exhibits which are incorporated by reference are incorporated from the Company's respective periodic reports, Securities and Exchange Commission File Number 1-7123. Agreement between Resorts and ACSI dated July 5, 1985 are incorporated herein by reference from the Form 10-K for the Year Ended June 30, 1985, Part IV, Item 14(a)(3), Exhibit 10.02. Restated Third Amendment to Lease Agreement dated August 28, 1986 between Resorts and ACSI is incorporated herein by reference from the Form 10-K for the Year Ended June 30, 1986, Part IV, Item 14(a)(3), Exhibit 10.08; Fourth Amendment to Lease Agreement by and between Resorts and ACSI dated December 16, 1986; Fifth Amendment to Lease Agreement between Resorts and ACSI dated March 2, 1987; Sixth Amendment to Lease Agreement between Resorts and ACSI dated March 13, 1987; Indemnity Agreement among Resorts, ACSI, and OSI dated January 15, 1985; Amended Indemnity Agreement among Resorts, ACSI, and OSI dated December 3, 1985 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.02; and Seventh Amendment to Lease Agreement between Resorts and ACSI dated October 18, 1988 is incorporated herein by reference from the Company's Form 8-K dated November 16, 1988, Item 7(c), Exhibit 28.01; and Eighth Amendment to Lease Agreement by and between ACSI and Resorts International, Inc. dated May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.06. 10.02 Equipment Lease Agreement by and between Tri-Continental Leasing Corporation and ACSI dated as of April 29, 1986; and Guarantee of SBO dated April 29, 1986 are incorporated herein by reference from the Company's Form 8-K dated April 21, 1986, Item 7(c), Exhibit 10.02; Progress Payment Agreement among Tri-Continental Leasing Corporation, ACSI, Tele-Measurements, Inc. dated April 29, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and Tele-Measurements, Inc. dated April 29, 1986; and Amendment to Lease Agreement dated April 10, 1986 between Tri-Continental Leasing Corporation and ACSI dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.05. 10.03 Agreement dated June 26, 1986 between Tri-Continental Leasing Corporation and ACSI; Corporate Guaranty dated June 9, 1986 of SBO are incorporated herein by reference from the Company's Form 8-K, dated June 17, 1986, Item 7(c), Exhibit 10.01; Commitment letter to ACSI from Tri-Continental Leasing Corporation dated May 19, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and DCA Incorporated dated August 1, 1986; Progress Payment Agreement among Tri- Exhibit Number Description - ------- ----------- Continental Leasing Corporation, ACSI and DCA Incorporated dated August 1, 1986; and Amendment to Lease Agreement dated May 22, 1986 between Tri-Continental Leasing Corporation and ACSI among Bell- Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.06. 10.04 Corporate Guaranty of SBO dated June 9, 1986; Equipment Lease between Tri-Continental Leasing Corporation and ACSI dated June 26, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and Bally Manufacturing Corporation dated August 1, 1986; Progress Payment Agreement among Tri-Continental Leasing Corporation, ACSI, and Bally Manufacturing Corporation dated September 1, 1986; Amendment to Lease Agreement dated May 22, 1986 between Tri- Continental Leasing Corporation and ACSI among Bell-Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.07. 10.05 Equipment Lease and Addendum between Bell-Atlantic Tri-Con Leasing Corporation and ACSI dated May 29, 1987; and Corporate Guaranty of SBO dated May 7, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.08. 10.06 Corporate Guaranty of SBO dated May 28, 1987; and Equipment Lease between Bell-Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated August 19, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.09. 10.07 Tax Allocation Agreement among SBO and each of its subsidiaries dated effective May 10, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.11. First Amendment to Tax Allocation Agreement among SBO and each of its subsidiaries dated effective May 10, 1993. Exhibit Number Description - ------- ----------- 10.08 Promissory Note in the principal amount of $56,801.75 between the Company and Frank A. Modica dated December 31, 1993. 10.09 Form of Indemnification Agreement between SBO and each director and officer of the Company is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1987, Part IV, Item 14(a)(3), Exhibit 10.13. 10.10 Statement regarding the Company's Incentive Bonus Plans is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.12. 10.11 Parent Services Agreement by and between Company and ACSI dated November 21, 1985 is incorporated herein by reference from the Company's Form 8-K, dated November 25, 1985, Item 7(c), Exhibit 10.01. Amendment No. 1 to Parent Services Agreement by and between the Company and ACSI dated February 1, 1987 is incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.17. Amendment No. 2 to Parent Services Agreement by and between the Company and ACSI dated December 31, 1990 is incorporated herein by reference from the Company's Form 8-K, dated December 31, 1990, Item 7(c), Exhibit 28.01; and Amendment No. 3 to Parent Services Agreement by and between the Company and ACSI dated May 8, 1991 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.14. Agreement No. 4 to Parent Services Agreement by and between the Company and ACSI dated August 17, 1993. 10.12 Closing Escrow Agreement among Housing Authority and Urban Redevelopment Agency of the City of Atlantic City, Resorts, ACSI, Trump Taj Mahal Associates Limited Partnership, and Clapp & Eisenberg, P.C. dated as of September 21, 1988; Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Realty Corp. dated as of September 21, 1988; First Amendment of Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Associates Limited Partnership, and Trump Taj Mahal Realty Corp. dated as of September 21, 1988; Exhibit Number Description - ------- ----------- Settlement Agreement among ACSI, Trump Taj Mahal Associates Limited Partnership, Trump Taj Mahal Realty Corp., Resorts and the Housing Authority and Urban Renewal Redevelopment Agency of the City of Atlantic City dated October 18, 1988; Tri-Party Agreement among Resorts International, Inc., ACSI and Trump Taj Mahal Associates Limited Partnership dated October 18, 1988; Declaration of Easement and Right of Way Agreement between the Housing Authority and Redevelopment Agency of the City of Atlantic City, as grantor, and ACSI, as grantee, dated October 18, 1988; and Certificate of Trump Taj Mahal Associates Limited Partnership and Resorts, dated November 16, 1988 are incorporated herein by reference from the Company's Form 8-K dated November 16, 1988, Item 7(c), Exhibit 28.01; Revised Second Amendment to Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Associates Limited Partnership and Trump Taj Mahal Realty Corp. dated as of May 24, 1989, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1989, Part IV, Item 14(a)(3), Exhibit 10.17. 10.13 Lease between the Company and Showboat Operating Company, dated January 1, 1989 is incorporated herein by reference from the Company's Form 8-K, dated January 1, 1989, Item 7(c), Exhibit 28.01. 10.14 Management Services Agreement between SBO and Showboat Operating Company, dated January 1, 1989, is incorporated herein by reference from the Company's Form 8-K, dated January 1, 1989, Item 7(c), Exhibit 28.03. 10.15 Promissory Note in the principal amount of $20,400.69 among SBO, R. Craig Bird and Debra E. Bird, dated August 5, 1993. 10.16 Securities Purchase Contract between the Casino Reinvestment Development Authority and ACSI dated March 29, 1988 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1988, Part IV, Items 14(a)(3), Exhibit 10.23. 10.17 Lease of Retail Store #7 among ACSI, R. Craig Bird and Debra E. Bird dated April 10, 1987; Guaranty of Lease among ACSI, R. Craig Bird and Debra E. Bird are incorporated herein by reference from the Company's Form Exhibit Number Description - ------- ----------- 10-K for the Year Ended December 31, 1988, Part IV, Item 14(a)(3), Exhibit 10.24. 10.18 ACSI Executive Health Examinations Plan effective date January 1, 1989 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1989, Part IV, Item 14(a)(3), Exhibit 10.24. 10.19 ACSI Executive Medical Reimbursement Plan, effective date August 15, 1991, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.23. 10.20 SBO, Showboat Operating Company, and ACSI 1989 Long Term Incentive Plan As Amended and Restated February 25, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.23. 10.21 Letter agreement dated September 23, 1992 between Trump Taj Mahal Associates and Atlantic City Showboat, Inc. and letter agreement dated October 26, 1992 to Trump Taj Mahal Associates from Atlantic City Showboat, Inc. is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.24. 10.22 Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI, dated as of October 6, 1989; and First Amendment to Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI dated as of December 18, 1990 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1990, Part IV, Item 14(a)(3), Exhibit 10.30; and Second Amendment to Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI dated as of October 28, 1991 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.26. 10.23 Equipment Lease Agreement between Valley Leasing Company, Inc. ("Valley"), as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-1, dated August 15, 1990, Amendments to Equipment Lease Agreement between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-1, dated August 22, 1990, Exhibit Number Description - ------- ----------- Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-1, dated August 15, 1990, Certificate of Guarantor and Authorization of Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-1, dated December 24, 1990, and Continuing Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-1; Equipment Lease Agreement between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-2, dated September 14, 1990, Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, for Lease No. 7700140-2, dated September 14, 1990, Certificate of Guarantor and Authorization of Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-2, dated December 24, 1990, and Continuing Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO as guarantor, Lease No. 7700140-2; Equipment Lease Agreement between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-3, dated December 24, 1990, and Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, dated December 24, 1990 are incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1990, Part IV, Item 14(a)(3), Exhibit 10.31. 10.24 SBO 1989 Directors' Stock Option Plan As Amended and Restated February 25, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.27. 10.25 Deed of Trust, Assignment of Rents, Security Agreement made by the Company to Nevada Title Company for the benefit of Trustee dated as of May 18, 1993; Showboat, Inc. Security and Pledge Agreement between the Company and the Trustee dated as of May 18, 1993; Trademark Security Agreement by SBO in favor of the Trustee dated as of May 18, 1993; Unsecured Indemnity Agreement executed by the Company in favor of the Trustee dated May 18, 1993; and Showboat Operating Company Security Agreement between SBOC and the Trustee dated as of May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.02. Exhibit Number Description - ------- ----------- 10.26 Leasehold Mortgage, Assignment of Rents, Security Agreement ("Guaranty") made by ACSI for the benefit of Trustee dated May 18, 1993; Assignment of Leases and Rents by and between ACSI and Trustee dated as of May 18, 1993; and Ocean Showboat, Inc. Security and Pledge Agreement between OSI and the Trustee dated as of May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.03. 10.27 Intercompany Note in the principal amount of $215.0 million, dated as of May 18, 1993; Assignment of Lease and Rents by and between ACSI and the Company dated as of May 18, 1993; and Issuer Collateral Assignment executed by ACSI in favor of Trustee dated May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.04. 10.28 First Amendment to the Leasehold Mortgage, Assignment of Rents and Security Agreement among AACSI and the Company dated July 9, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.01. 10.29 First Amendment to the Leasehold Mortgage, Assignment of Rents and Security Agreement among ACSI and IBJ Schroder Bank & Trust Company dated July 9, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.02. 10.30 Assignment of Rights under Agreement by ACSI, as assignee, to IBJ Schroder Bank & Trust Company dated July 9, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.03. 10.31 Form of Deed for Sale of Land for Private Redevelopment for Tract 1 and Tract 2 each dated July 7, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.04. 10.32 Use and Occupancy Agreement between ACHA and ACSI dated July 7, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.05. Exhibit Number Description - ------- ----------- 10.33 Standard Form of Agreement between Owner and Contractor (AIA Document A111) executed by ACSI and T.N. Ward Company dated July 2, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.01. 10.34 Standard Form of Agreement Between Owner and Contractor (AIA Document A111) executed by ACSI and T.N. Ward Company dated September 15, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.02. 10.35 Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated July 2, 1993 and First Amendment to Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated July 20, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.01; Second Amendment to Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated August 1, 1993; and Third Amendment to Showboat Star Partnership Agreement between Star Casino, Inc and Showboat Louisiana, Inc. dated March 1, 1994. 10.36 Management Agreement by and between Lake Pontchartrain Showboat, Inc. and Star Casino, Inc. dated May 24, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.02. 10.37 Marine Management Services Agreement between Louisiana Riverboat Services, Inc. and Showboat Star Partnership dated September 30, 1993. 10.38 Agreement between Showboat, Inc., Showboat Indiana, Inc., Showboat Operating Company, Showboat Development Company, Showboat Indiana Investment Limited Partnership and Waterfront Entertainment and Development, Inc. dated September 13, 1993; and Showboat Marina Partnership Agreement between Waterfront Entertainment and Development, Inc. and Showboat Investment Limited Partnership dated January 31, 1994. 10.39 Lease between the Company and Exber, Inc. effective January 14, 1994; and Sublease between Dodd Smith and Exhibit Number Description - ------- ----------- John D. Gaughan and Leslie C. Schwartz, dated November 5, 1966. 10.40 Lease between Showboat Star Partnership and Orleans Levee District dated February 18, 1993; First Amendment to Lease dated August 27, 1993. 10.41 Lease between Showboat Star Partnership and Orleans Levee District dated February 1, 1994. 10.42 Lease between Showboat Operating Company and Ventroy Associates executed on December 20, 1993. 21.01 List of Subsidiaries. 23.01 Consent of KPMG Peat Marwick dated March 30, 1994. (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 this undersigned, thereunto duly authorized. REGISTRANT: SHOWBOAT, INC. By: /s/ J.K. Houssels ------------------------------- J.K. HOUSSELS, President and Chief Executive Officer (principal executive 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 dates indicated. March 29, 1994 By: /s/ J.K. Houssels ---------------------------------- J.K. Houssels,President and Chief Executive Officer (principal executive officer) March 29, 1994 By: /s/ Leann K. Schneider ------------------------------------ Leann K. Schneider, Vice President- Finance and Chief Financial Officer (principal accounting officer) March 29, 1994 By: /s/ William C. Richardson ----------------------------------- William C. Richardson, Director March 29, 1994 By: /s/ John D. Gaughan ---------------------------------- John D. Gaughan, Director March 29, 1994 By: /s/ Jeanne S. Stewart ------------------------------------ Jeanne S. Stewart, Director March 29, 1994 By: /s/ Frank A. Modica ----------------------------------- Frank A. Modica, Director, Chief Operating Officer and Executive Vice President March __, 1994 By: ___________________________________ H. Gregory Nasky, Director and Secretary March 29, 1994 By: /s/ J. Kell Houssels III ------------------------------------- J. Kell Houssels III, Director and Vice President March 29, 1994 By: /s/ George A. Zettler ----------------------------------- George A. Zettler, Director March 29, 1994 By: /s/ Carolyn M. Sparks ----------------------------------- Carolyn M. Sparks, Director EXHIBIT INDEX ------------- Exhibit Sequential Number Description/1/ Page Number - ------- ----------- ----------- 3.01 Restated Articles of Incorporation of the Company dated June 28, 1988 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1988, Part IV, Item 14(a)(3), Exhibit 3.01. 3.02 Restated Bylaws of the Company dated February 25, 1993, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 3.02. 4.01 Specimen common stock certificate for the common stock of the Company, is incorporated herein by reference from the Company's Form 10-Q for the Quarter Ended March 31, 1985, Part II, Item 6(a), Exhibit 4.01. 4.02 Form of Indenture for the 9 1/4% First Mortgage Bonds due 2008 among the Company, OSI, ACSI, SBOC, and Trustee dated May 18, 1993; Guaranty in favor of the Trustee issued by OSI, ACSI and SBOC; and Form of Bond Certificate for the 9 1/4% First Mortgage Bonds due 2008 are incorporated herein by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.01. 10.01 Ground Lease between OSI and Resorts International, Inc. ("Resorts") dated October 26, 1983 is incorporated by reference herein from the Company's Form 8-K, as amended by the Form 8, filed with the Securities and Exchange Commission on November 28, 1983. Assignment and Assumption of Leases between OSI and ACSI dated December 3, 1985; First Amendment to Agreement between Resorts and ACSI dated January 15, 1985; Second Amendment to Lease Agreement between Resorts and ACSI dated July 5, 1985 are incorporated herein by reference - ----------- /1/All exhibits which are incorporated by reference are incorporated from the Company's respective periodic report, Securities and Exchange Commission File Number 1-7123. from the Form 10-K for the Year Ended June 30, 1985, Part IV, Item 14(a)(3), Exhibit 10.02. Restated Third Amendment to Lease Agreement dated August 28, 1986 between Resorts and ACSI is incorporated herein by reference from the Form 10-K for the Year Ended June 30, 1986, Part IV, Item 14(a)(3), Exhibit 10.08; Fourth Amendment to Lease Agreement by and between Resorts and ACSI dated December 16, 1986; Fifth Amendment to Lease Agreement between Resorts and ACSI dated March 2, 1987; Sixth Amendment to Lease Agreement between Resorts and ACSI dated March 13, 1987; Indemnity Agreement among Resorts, ACSI, and OSI dated January 15, 1985; Amended Indemnity Agreement among Resorts, ACSI, and OSI dated December 3, 1985 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.02; and Seventh Amendment to Lease Agreement between Resorts and ACSI dated October 18, 1988 is incorporated herein by reference from the Company's Form 8-K dated November 16, 1988, Item 7(c), Exhibit 28.01; and Eighth Amendment to Lease Agreement by and between ACSI and Resorts International, Inc. dated May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.06. 10.02 Equipment Lease Agreement by and between Tri-Continental Leasing Corporation and ACSI dated as of April 29, 1986; and Guarantee of SBO dated April 29, 1986 are incorporated herein by reference from the Company's Form 8-K dated April 21, 1986, Item 7(c), Exhibit 10.02; Progress Payment Agreement among Tri-Continental Leasing Corporation, ACSI, Tele-Measurements, Inc. dated April 29, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and Tele-Measurements, Inc. dated April 29, 1986; and Amendment to Lease Agreement dated April 10, 1986 between Tri-Continental Leasing Corporation and ACSI dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.05. Exhibit Number Description - ------- ----------- 10.03 Agreement dated June 26, 1986 between Tri-Continental Leasing Corporation and ACSI; Corporate Guaranty dated June 9, 1986 of SBO are incorporated herein by reference from the Company's Form 8-K, dated June 17, 1986, Item 7(c), Exhibit 10.01; Commitment letter to ACSI from Tri-Continental Leasing Corporation dated May 19, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and DCA Incorporated dated August 1, 1986; Progress Payment Agreement among Tri-Continental Leasing Corporation, ACSI and DCA Incorporated dated August 1, 1986; and Amendment to Lease Agreement dated May 22, 1986 between Tri-Continental Leasing Corporation and ACSI among Bell- Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.06. 10.04 Corporate Guaranty of SBO dated June 9, 1986; Equipment Lease between Tri-Continental Leasing Corporation and ACSI dated June 26, 1986; Purchase Agreement Assignment among Tri-Continental Leasing Corporation, ACSI and Bally Manufacturing Corporation dated August 1, 1986; Progress Payment Agreement among Tri-Continental Leasing Corporation, ACSI, and Bally Manufacturing Corporation dated September 1, 1986; Amendment to Lease Agreement dated May 22, 1986 between Tri- Continental Leasing Corporation and ACSI among Bell-Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated April 29, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.07. 10.05 Equipment Lease and Addendum between Bell-Atlantic Tri-Con Leasing Corporation and ACSI dated May 29, 1987; and Corporate Guaranty of SBO dated May 7, 1987 are incorporated herein by reference from the Company's Form 10-K for Exhibit Number Description - ------- ----------- the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.08. 10.06 Corporate Guaranty of SBO dated May 28, 1987; and Equipment Lease between Bell-Atlantic Tri-Con Leasing Corporation, ACSI and SBO dated August 19, 1987 are incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.09. 10.07 Tax Allocation Agreement among SBO and each of its subsidiaries dated effective May 10, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended June 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.11. First Amendment to Tax Allocation Agreement among SBO and each of its subsidiaries dated effective May 10, 1993. 10.08 Promissory Note in the principal amount of $56,801.75 between the Company and Frank A. Modica dated December 31, 1993. 10.09 Form of Indemnification Agreement between SBO and each director and officer of the Company is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1987, Part IV, Item 14(a)(3), Exhibit 10.13. 10.10 Statement regarding the Company's Incentive Bonus Plans is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.12. 10.11 Parent Services Agreement by and between Company and ACSI dated November 21, 1985 is incorporated herein by reference from the Company's Form 8-K, dated November 25, 1985, Item 7(c), Exhibit 10.01. Amendment No. 1 to Parent Services Agreement by and between the Company and ACSI dated February 1, 1987 is incorporated herein by reference from the Company's Form 10-K for the Year Ended June Exhibit Number Description - ------- ----------- 30, 1987, Part IV, Item 14(a)(3), Exhibit 10.17. Amendment No. 2 to Parent Services Agreement by and between the Company and ACSI dated December 31, 1990 is incorporated herein by reference from the Company's Form 8-K, dated December 31, 1990, Item 7(c), Exhibit 28.01; and Amendment No. 3 to Parent Services Agreement by and between the Company and ACSI dated May 8, 1991 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.14. Agreement No. 4 to Parent Services Agreement by and between the Company and ACSI dated August 17, 1993. 10.12 Closing Escrow Agreement among Housing Authority and Urban Redevelopment Agency of the City of Atlantic City, Resorts, ACSI, Trump Taj Mahal Associates Limited Partnership, and Clapp & Eisenberg, P.C. dated as of September 21, 1988; Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Realty Corp. dated as of September 21, 1988; First Amendment of Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Associates Limited Partnership, and Trump Taj Mahal Realty Corp. dated as of September 21, 1988; Settlement Agreement among ACSI, Trump Taj Mahal Associates Limited Partnership, Trump Taj Mahal Realty Corp., Resorts and the Housing Authority and Urban Renewal Redevelopment Agency of the City of Atlantic City dated October 18, 1988; Tri-Party Agreement among Resorts International, Inc., ACSI and Trump Taj Mahal Associates Limited Partnership dated October 18, 1988; Declaration of Easement and Right of Way Agreement between the Housing Authority and Redevelopment Agency of the City of Atlantic City, as grantor, and ACSI, as grantee, dated October 18, 1988; and Certifi-cate of Trump Taj Mahal Associates Limited Partnership and Resorts, dated November 16, 1988 are incorporated herein by reference from the Company's Form 8-K dated November 16, Exhibit Number Description - ------- ----------- 1988, Item 7(c), Exhibit 28.01; Revised Second Amendment to Agreement as to Assumption of Obligations with Respect to Properties among ACSI, Trump Taj Mahal Associates Limited Partnership and Trump Taj Mahal Realty Corp. dated as of May 24, 1989, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1989, Part IV, Item 14(a)(3), Exhibit 10.17. 10.13 Lease between the Company and Showboat Operating Company, dated January 1, 1989 is incorporated herein by reference from the Company's Form 8-K, dated January 1, 1989, Item 7(c), Exhibit 28.01. 10.14 Management Services Agreement between SBO and Showboat Operating Company, dated January 1, 1989, is incorporated herein by reference from the Company's Form 8-K, dated January 1, 1989, Item 7(c), Exhibit 28.03. 10.15 Promissory Note in the principal amount of $20,400.69 among SBO, R. Craig Bird and Debra E. Bird, dated August 5, 1993. 10.16 Securities Purchase Contract between the Casino Reinvestment Development Authority and ACSI dated March 29, 1988 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1988, Part IV, Items 14(a)(3), Exhibit 10.23. 10.17 Lease of Retail Store #7 among ACSI, R. Craig Bird and Debra E. Bird dated April 10, 1987; Guaranty of Lease among ACSI, R. Craig Bird and Debra E. Bird are incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1988, Part IV, Item 14(a)(3), Exhibit 10.24. 10.18 ACSI Executive Health Examinations Plan effective date January 1, 1989 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1989, Part IV, Item 14(a)(3), Exhibit 10.24. Exhibit Number Description - ------- ----------- 10.19 ACSI Executive Medical Reimbursement Plan, effective date August 15, 1991, is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.23. 10.20 SBO, Showboat Operating Company, and ACSI 1989 Long Term Incentive Plan As Amended and Restated February 25, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.23. 10.21 Letter agreement dated September 23, 1992 between Trump Taj Mahal Associates and Atlantic City Showboat, Inc. and letter agreement dated October 26, 1992 to Trump Taj Mahal Associates from Atlantic City Showboat, Inc. is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.24. 10.22 Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI, dated as of October 6, 1989; and First Amendment to Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI dated as of December 18, 1990 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1990, Part IV, Item 14(a)(3), Exhibit 10.30; and Second Amendment to Aircraft Services Agreement by and between SCG Travel, Inc. and ACSI dated as of October 28, 1991 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1991, Part IV, Item 14(a)(3), Exhibit 10.26. 10.23 Equipment Lease Agreement between Valley Leasing Company, Inc. ("Valley"), as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-1, dated August 15, 1990, Amendments to Equipment Lease Agreement between Valley, as lessor, and Showboat Exhibit Number Description - ------- ----------- Operating Company, as lessee, Lease No. 7700140-1, dated August 22, 1990, Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-1, dated August 15, 1990, Certificate of Guarantor and Authorization of Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-1, dated December 24, 1990, and Continuing Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-1; Equipment Lease Agreement between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-2, dated September 14, 1990, Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, for Lease No. 7700140-2, dated September 14, 1990, Certificate of Guarantor and Authorization of Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO, as guarantor, Lease No. 7700140-2, dated December 24, 1990, and Continuing Guaranty between Valley, as lessor, Showboat Operating Company, as lessee, and SBO as guarantor, Lease No. 7700140-2; Equipment Lease Agreement between Valley, as lessor, and Showboat Operating Company, as lessee, Lease No. 7700140-3, dated December 24, 1990, and Purchase Option between Valley, as lessor, and Showboat Operating Company, as lessee, dated December 24, 1990 are incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1990, Part IV, Item 14(a)(3), Exhibit 10.31. 10.24 SBO 1989 Directors' Stock Option Plan As Amended and Restated February 25, 1993 is incorporated herein by reference from the Company's Form 10-K for the Year Ended December 31, 1992, Part IV, Item 14(a)(3), Exhibit 10.27. 10.25 Deed of Trust, Assignment of Rents, Security Agreement made by the Company to Nevada Title Company for the benefit of Trustee dated as of Exhibit Number Description - ------- ----------- May 18, 1993; Showboat, Inc. Security and Pledge Agreement between the Company and the Trustee dated as of May 18, 1993; Trademark Security Agreement by SBO in favor of the Trustee dated as of May 18, 1993; Unsecured Indemnity Agreement executed by the Company in favor of the Trustee dated May 18, 1993; and Showboat Operating Company Security Agreement between SBOC and the Trustee dated as of May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.02. 10.26 Leasehold Mortgage, Assignment of Rents, Security Agreement ("Guaranty") made by ACSI for the benefit of Trustee dated May 18, 1993; Assignment of Leases and Rents by and between ACSI and Trustee dated as of May 18, 1993; and Ocean Showboat, Inc. Security and Pledge Agreement between OSI and the Trustee dated as of May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.03. 10.27 Intercompany Note in the principal amount of $215.0 million, dated as of May 18, 1993; Assignment of Lease and Rents by and between ACSI and the Company dated as of May 18, 1993; and Issuer Collateral Assignment executed by ACSI in favor of Trustee dated May 18, 1993 are incorporated by reference from the Company's Form 8-K, dated May 18, 1993, Item 5, Exhibit 28.04. 10.28 First Amendment to the Leasehold Mortgage, Assignment of Rents and Security Agreement among AACSI and the Company dated July 9, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.01. 10.29 First Amendment to the Leasehold Mortgage, Assignment of Rents and Security Agreement among ACSI and IBJ Schroder Bank & Trust Company dated July 9, 1993 is incorporated by Exhibit Number Description - ------- ----------- reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.02. 10.30 Assignment of Rights under Agreement by ACSI, as assignee, to IBJ Schroder Bank & Trust Company dated July 9, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.03. 10.31 Form of Deed for Sale of Land for Private Redevelopment for Tract 1 and Tract 2 each dated July 7, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.04. 10.32 Use and Occupancy Agreement between ACHA and ACSI dated July 7, 1993 is incorporated by reference from the Company's Form 8-K, dated July 7, 1993, Item 5, Exhibit 28.05. 10.33 Standard Form of Agreement between Owner and Contractor (AIA Document A111) executed by ACSI and T.N. Ward Company dated July 2, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.01. 10.34 Standard Form of Agreement Between Owner and Contractor (AIA Document A111) executed by ACSI and T.N. Ward Company dated September 15, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.02. 10.35 Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated July 2, 1993 and First Amendment to Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated July 20, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.01; Second Amendment to Showboat Star Partnership Agreement between Star Casino, Inc. and Showboat Louisiana, Inc. dated August 1, 1993; and Third Amendment to Showboat Star Exhibit Number Description - ------- ----------- Partnership Agreement between Star Casino, Inc and Showboat Louisiana, Inc. dated March 1, 1994. 10.36 Management Agreement by and between Lake Pontchartrain Showboat, Inc. and Star Casino, Inc. dated May 24, 1993 is incorporated by reference from the Company's Form 8-K, dated July 2, 1993, Item 5, Exhibit 28.02. 10.37 Marine Management Services Agreement between Louisiana Riverboat Services, Inc. and Showboat Star Partnership dated September 30, 1993. 10.38 Agreement between Showboat, Inc., Showboat Indiana, Inc., Showboat Operating Company, Showboat Development Company, Showboat Indiana Investment Limited Partnership and Waterfront Entertainment and Development, Inc. dated September 13, 1993; and Showboat Marina Partnership Agreement between Waterfront Entertainment and Development, Inc. and Showboat Investment Limited Partnership dated January 31, 1994. 10.39 Lease between the Company and Exber, Inc. effective January 14, 1994; and Sublease between Dodd Smith and John D. Gaughan and Leslie C. Schwartz, dated November 5, 1966. 10.40 Lease between Showboat Star Partnership and Orleans Levee District dated February 18, 1993. First Amendment to Lease dated August 27, 1993. 10.41 Lease between Showboat Star Partnership and Orleans Levee District dated February 1, 1994. 10.42 Lease between Showboat Operating Company and Ventroy Associates executed on December 20, 1993. 21.01 List of Subsidiaries. Exhibit Number Description - ------- ----------- 23.01 Consent of KPMG Peat Marwick dated March 30, 1994. (b) Reports on Form 8-K. ------------------- None.

276999_1993.txt

276999_1993

1993

276999

ITEM 1. BUSINESS - - ----------------- The Company is engaged in the formulation, manufacture and sale of a broad line of coatings, consisting of water-thinnable and solvent-thinnable general purpose coatings (paints, stains and clear finishes) for use by the general public, painting contractors and industrial and commercial users, primarily for the decoration and preservation of the interiors and exteriors of residential, commercial, institutional and industrial buildings and allied structures (collectively referred to as "trade sales coatings"), and production finishes coatings which are usually produced to conform to the specific requirements of manufacturers who utilize such coatings in the manufacturing process (collectively referred to as "production finishes coatings"). The production finishes coatings are primarily used in the manufacture of various types of flexible packages, beverage and food containers, tanks, roof decking, coils, furniture and shelving, window blinds and flatwood products. The production finishes coatings, like the trade sales coatings, serve both decorative and preservative functions. The Company believes that it is one of the leading manufacturers of coatings in the United States and Canada. It has never been engaged in any other type of business. Marketing and Distribution - - -------------------------- It has always been the Company's policy to actively support the continued growth and prosperity of independently owned distributors and retail outlets, through which the trade sales coatings are sold. In furtherance of that policy, the Company provides financing to such enterprises under circumstances where it is deemed to be in the best interests of the Company to do so (see, e.g., Note 4 to the Notes to Consolidated Financial Statements, Part II, Item 8 hereof). The trade sales coatings are sold under such tradmarks as Moore's -House Paint, Moorglo-, Moorgard- Latex House Paint, Moorwood-, Moorwhite- Primer, Impervo- Enamel, Moorcraft-, Impervex-, Regal- Wall Satin-, Satin Impervo-, AquaGlo-, AquaPearl-, AquaVelvet-, Regal Aquagrip-, Enhance-, Moorlife-, A Stroke of Brilliance -, Pro-Saver-, Benwood-, Utilac- and Ironclad-. Although a large variety of ready-mixed colors is available in all of these products, a substantially wider selection can be obtained through the Company's Moor-O-Matic- III Color System, which provides in-store machine capability to tint formulated bases with colorants which are manufactured by the Company. The Company believes its Moor-O-Matic- III Color System has been of significant value in promoting the sales of its trade sales coatings. Moore's- Video Color Planner and Moore's- Computer Color Matching System provide the ability to plan color schemes and to quickly match almost any color by computer. Production finishes coatings are customarily sold by the Company directly to the ultimate user. Sales - - ----- The Company considers itself to be engaged in a single line of business; i.e. the formulation, manufacture and sale of coatings. Reference is made to the information set forth under the caption, "SELECTED FINANCIAL DATA", Part II, Item 6 hereof, with respect to net sales of each of the two classes of products which comprise the aforementioned line of business. During 1993, no one customer accounted for as much as 1% of the Company's net sales. Geographic Segment Information - - ------------------------------ The Company manufactures and sells coatings in the United States, Canada and New Zealand. Transfers between geographic areas are not significant and are eliminated in consolidation. Reference is made to the information set forth in Note 8 to the Notes to Consolidated Financial Statements, Part II, Item 8 hereof, with respect to assets and operating results by geographic area. Foreign Operations - - ------------------ The Company operates in Canada and New Zealand. The Company's Canadian operations are carried on through Benjamin Moore & Co., Limited, which is an approximately 82% owned subsidiary of the Company, and Technical Coatings Co. Limited, which is a wholly-owned subsidiary of the Canadian company. The Company's New Zealand operations are carried on through Benjamin Moore & Co (NZ) Limited, which is a wholly-owned subsidiary of the Company. During 1993, revenues and profits from operations attributable to those companies (which are included in the Company's consolidated financial statements) were approximately $57,736,000 and $4,188,000, respectively. Approximately 8% of the outstanding shares of the Canadian subsidiary are owned by persons who are associated with the Company, including employees of such subsidiary. Research and Development; Quality Control - - ----------------------------------------- The Company considers its research and development and quality control activities to be among the most advanced in the industry, and of significant importance in enabling it to achieve and maintain its position as one of the leading companies in the coatings industry. The Company maintains several laboratory facilities for the development of new products and processes, the improvement of existing products and the special formulation of products to meet the specific requirements of its customers. The Central Laboratories, which is the principal such facility, is located in Flanders, New Jersey. Quality control activities are carried out in laboratories located at each manufacturing facility. The Company also maintains outdoor testing facilities at Lebanon, New Jersey, where its products, as well as those of its competitors, are evaluated for performance under varying weather conditions. Independent commercial facilities are also utilized for this purpose. As of December 31, 1993, 189 chemists and technicians were employed by the Company in research and development and quality control activities. In 1993, the Company expended approximately $13,988,000 for such activities. Competition - - ----------- The coatings industry is highly competitive and has historically been subject to intense price competition. It is estimated that there are approximately 900 coatings manufacturers in the United States, many of which are small companies which provide intense competition within regional and local markets, especially with respect to lower priced coatings and custom made specialty items which are required on a short-time delivery basis. Other manufacturers are large diversified corporations, the assets of which are substantially greater than those of the Company, which compete on a nationwide basis. The competition which the Company encounters in Canada and New Zealand is similar in nature to that which it encounters in the United States. The Company estimates that it is one of the largest manufacturers of trade sales coatings in the United States and Canada. With respect to sales of production finishes coatings, the Company's overall position in the industry is relatively small. Seasonal Aspects - - ---------------- Historically, sales of trade sales coatings have been seasonal in nature, with the heaviest concentration of such sales occurring in the second and third quarters of the year. Sales of production finishes coatings have been relatively stable throughout the year. During 1993, the percentages of the Company's sales of trade sales coatings which were made in the first, second, third and fourth quarters of the year were 20.8%, 29.2%, 29.2% and 20.8%, respectively. Production and inventory schedules are timed to coincide with the aforementioned variations. Employees - - --------- As of December 31, 1993, the Company had approximately 1,962 employees, of whom approximately 26% were salaried personnel, approximately 14% were sales representatives, and approximately 60% were hourly employees. The Company considers its relations with its employees to be excellent. Raw Materials and Supplies - - -------------------------- The Company purchases its raw material and supplies from a wide variety of sources, and does not consider its business to be dependent upon any one source of supply. However, the price and supply of some petrochemical intermediate products, which are important ingredients in the manufacture of coatings, are subject to world political and economic conditions. Certain raw materials are converted into synthetic resins which, when combined with pigments, are used in the production of both the trade sales coatings and the production finishes coatings. Patent and Trademarks - - --------------------- The Company does not rely on patents in its business. The Company does, however, rely upon formulas developed by it, and upon its technical expertise and experience in meeting the requirements of its customers. The Company owns a - 4 - large number of registered trademarks and trade names, several of which are referred to elsewhere herein, which it considers to be of significance in identifying the Company and its products. Backlog - - ------- As is typical in the industry, backlog of orders is not significant in the business of the Company. Environmental Affairs and Governmental Regulation - - ------------------------------------------------- The operations of the Company, like those of other companies engaged in similar businesses, involve the use and disposal of substances regulated under environmental protection laws. The Company believes that its operations are in compliance with applicable federal, state and local laws and regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment. Such laws and regulations have not had any material adverse effect upon the Company's capital expenditures, earnings or competitive position. The Company places importance on environmental responsibility. Its capital expenditures at new and existing facilities constructed or modified in the normal course of business incorporate designs to minimize waste. To date the Company has entered into full or partial settlement agreements with governmental authorities or private parties with respect to twelve sites under federal and state laws. Total settlement costs have been approximately $2 million. The Company is involved in thirty unsettled sites. In all cases the Company believes its share of liability for environmental clean up costs are less than 1% of such costs for each site. A total of approximately $2,312,000 has been accrued as a reserve against such future costs. These cost estimates are carefully reviewed and revised where necessary each quarter during the year. Possible insurance recoveries are not considered in estimating liabilities. Also, the Company is involved in remedial activities at three of its owned facilities as follows: 1. A water monitoring program continues at the Company's plant in Cuyahoga Heights, Ohio. No remediation activities are being conducted now. Total costs to date are $160,000. 2. Soil and shallow ground water contamination has been detected at the Company's facility at Milford, MA. The affected soils have been excavated and an interim ground water pumping extraction and treatment system has been installed. Further studies are being undertaken to assess the full extent of the water contamination. However, preliminary results indicate that the problem is moderate and is being remediated with traditional technologies. Expenditures to date have been less than $300,000. 3. The Company has expended nearly $5 million over the last nine years to assess and remediate contamination of soil and water at the Company's facility at Santa Clara, California, operated by its subsidiary, Technical Coatings Co. The Company has installed an underground trench along two sides of its property. This trench is capable of capturing the contamination and preventing its migration off the plant site. A biological treatment system treats the pumped water to acceptable cleanup levels. The treated water is used in the paint manufacturing process as cooling water before being discharged to the municipal sewer system or reinjected to the ground for recirculation. There are ongoing engineering studies to identify and develop additonal remediation techniques to address soil contamination and to clean up contaminated water more rapidly. Current operating and maintenance costs are $100,000 per year. Adjoining landowners filed suits against the Company claiming damages due to the migration, or potential migration, of the contamination located at the Company's facility at Santa Clara. In each case the plaintiff or his predecessor in title has conducted activities on its own property which resulted in contamination there. One of these suits was settled during 1993 for $75,000 and an undertaking by the Company to continue the remediation activities at the site. The anticipated liability of the Company in the other suit is not material. Accrued costs against future cleanup expenses for these three facilities are approximately $700,000. Federal and state laws require that potentially responsible parties fund remedial actions regardless of fault, legality of original disposal or ownership of a disposal site. In 1993 the Company spent approximately $571,000 on remedial cleanups and related studies compared with approximately $1,113,000 spent for such purposes in 1992. It is difficult to estimate the ultimate level of future environmental expenditures due to a number of uncertainties, including uncertainties about the current status of the law and regulations, remedial technologies and insurance recoveries of Company costs, as well as information relating to individual sites. Subject to the foregoing, Company management believes its estimates of its liability is reliable and anticipates that capital expenditures and the cost of remedial actions to comply with the current laws governing environmental protection will not have a material adverse effect upon its capital expenditures, earnings or financial position. ITEM 2. ITEM 2. PROPERTIES - - ------------------- Set forth below is certain information with respect to the Company's principal facilities: Approximate Location Principal Use Square Feet Owned/Leased - - -------- ------------- ----------- ------------ Newark, NJ Plant 267,570 Owned Melrose Park, IL Executive Offices- 145,200 Owned Central Division; Plant Toronto, ON Executive Offices- 118,792 Owned Subsidiary; Plant Milford, MA Plant 110,500 Owned Cuyahoga Heights, OH Plant 106,000 Owned Colonial Heights, VA Plant 92,800 Owned Jacksonville, FL Plant 82,400 Owned Flanders, NJ Central Laboratories, 78,000 Owned Information Resource Center, Executive Offices - Subsidiary St. Louis, MO Plant 76,750 Owned Denver, CO Plant 73,450 Owned Johnstown, NY Plant 66,400 Owned Houston, TX Plant 64,900 Owned Montreal, PQ Plant 63,500 Owned Pell City, AL Plant 62,500 Leased (1) Commerce, CA Executive Offices- 59,000 Owned Western Division; Plant Montvale, NJ Corporate Offices; 57,000 Owned Executive Offices- Eastern Division Nutley, NJ Plant 50,000 Owned Burlington, ON Plant 45,351 Owned Santa Clara, CA Plant; Warehouse 38,507 Owned __________________________________ (1) Lease expires August 1995 at which time the facility may be purchased by the Company for $1,000. The Company has a continuing option to purchase the facility at an earlier date. Approximate Location Principal Use Square Feet Owned/Leased - - -------- ------------- ----------- ------------ Aldergrove, BC Plant 36,900 Owned Mesquite, TX Plant 29,346 Owned The Company owns 9.32 acres of land in Lebanon, New Jersey, which is used as a testing facility, and maintains a New York City sales office and an administrative office in Montvale, New Jersey in rented premises. The Company also leases warehouse facilities in North Kansas City, Missouri; Golden Valley, Minnesota; Auckland and Christchurch, New Zealand and in Concord, Edmonton, Saskatoon, Calgary, Winnipeg, Dartmouth and Mount Pearl, Canada. Warehouse arrangements also exist in Portland, Oregon. All of the other facilities which are stated above as being owned by the Company are owned in fee, free and clear of any mortgages or other material encumbrances. The Company believes that its properties and equipment are well maintained and in good condition, and that the rentals paid by it for its leased properties are at competitive rates. The Company also believes that its facilities are adequate for its existing needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - - -------------------------- The Company is involved in a number of legal actions in which substantial monetary damages are sought. Management believes that the outcome of all such legal actions, individually and in the aggregate, will not have a material effect on the Company's consolidated financial position or results of operations. Also, see "Environmental Affairs and Governmental Regulation" above. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - ------------------------------------------------------------ There was no submission of matters to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET PRICE OF THE REGISTRANT'S COMMON STOCK AND RELATED - - ------------------------------------------------------------------ SECURITY HOLDER MATTERS ----------------------- There is no established public trading market for shares of the Company's common stock. The Company and its Employees' Stock Ownership Benefit Plan, although under no obligation to do so, have in the past purchased shares of the Company's common stock from shareholders in privately negotiated transactions. Usually such purchases are made at the then current fair value of the shares as determined by an independent appraisal firm engaged by the Company. There can be no assurance that such purchases will be continued. As of March 1, 1994, the Company had approximately 1,450 shareholders. The following table sets forth the high and low price for such shares in each quarter during 1993 and 1992 and the dividends paid in each such quarter. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - - -------------------------------- Selected Income Statement Data: Selected Balance Sheet Data: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION - - -------------------------------------------------------------------- AND RESULTS OF OPERATIONS - - ------------------------- OPERATING RESULTS 1993 VS. 1992 Net Sales in 1993 showed strength throughout the year and produced total sales revenues of $511,951,000, which exceeded the previous year by $28,019,000 or 5.8%. Unit gains were generated both in the United States and Canada. Upward selling price movements which were limited had little effect on the year's total sales. Except for small geographical pockets indicative of specific local conditions, the sales momentum extended to areas which had been affected by adverse economic conditions in the last few years. Most noteworthy were the recoveries in New England and other sections of the Northeast and the business upsurge in southern Florida attributable to the rebuilding following the aftermath of Hurricane Andrew. Production finishes also reflected unit growth although this market segment represents less than 10% of total sales. Cost of products sold in 1993 was $267,494,000 which was 5.2% above the prior year. Slightly lower raw material cost levels and production efficiencies were beneficial in keeping the percentage increase .6% lower than the sales increase percentage. However, selling, administrative and general expenses of $184,255,000 rose $14,164,000 or 8.3%. The largest single increase was for postretirement health benefits. An additional amount of approximately $2,529,000 was charged to earnings consisting of the annual service cost and the amortization of the transition liability as required by SFAS No. 106. In addition to general inflationary increases and other factors attributable to higher sales volume, two other significant factors contributing to the increase in expenses were the second year of a renewed emphasis on media advertising amounting to approximately $1,000,000 and start-up costs of $1,491,000 associated with the introduction of a broad new line of industrial maintenance products. Sales of the new product line were limited to a market test in 1993. A broadening of distribution is planned in 1994. Dealer business closures and slow collection continued to be prevalent and, despite tighter credit controls, resulted in high bad debt writeoffs similar to the previous year. In recent months business growth by the Company's Dealers suggest an optimistic outlook for 1994. Other income in 1993 declined $171,000 from 1992 mostly due to reduced interest income on lower short-term investments. Income before taxes and minority interest was $60,951,000, up $552,000 or .9% over 1992. The effective income tax rate in 1993 was 39.2% compared with 38.9% in 1992. Higher profits and the 1993 tax rate increase accounted for the increased provision for income taxes of $379,000 or 1.6%. - 11- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- Net income of $36,511,000 represented an improvement of $204,000 or .6% over 1992. Earnings per share in 1993 were $3.75, up $.09 over the prior year. Dividends declared per share edged upward by $.01 to $1.68 in 1993. The Company's New Zealand subsidiary which consists of a warehouse operation continued to concentrate on sales development in it first full year. Since its initial market test in 1991, there has been little effect on total sales and income. If the economic recoveries in the Northeast and New England continue into 1994 and inflationary pressures are maintained under control, optimism should prevail for growth in both sales and income. OPERATING RESULTS 1992 VS. 1991 Net Sales of $483,933,000 in 1992 surpassed the prior year by $20,961,000 or 4.5%. Without a general selling price adjustment in trade sales coatings, the increase was generated by unit gains both in the United States and Canada. The sales gains in the United States began late in the first half of the year, leveled off for a short period and resumed momentum especially in the fourth quarter. Most areas of the country showed upward movement with noticeable improvement in the southern region, the Midwest, the Northwest, and portions of the Northeast. New England indicated an end of its slide by recovering some of the volume lost in prior years. Slow areas continued to be in the Greater New York market and in California where the economies remained sluggish. Sales in Canada reflected gains throughout the year. Production finishes sales in the U.S. experienced good growth in 1992 largely due to the acquisition of a general industrial coatings line late in 1991. The acquired product line supplemented existing volume in production finishes coatings and has had no significant change in product mix. Sales of production finishes coatings in Canada were slow. Cost of products sold was $254,362,000 in 1992 which was $7,747,000 or 3.1% above 1991. As a percent of sales, cost of products sold was 52.6% in 1992 compared with 53.3% in 1991. The unit sales gains were accompanied by a decrease of approximately 3% in raw material cost levels to account for the decline in the percentage. Selling, administrative and general expenses of $170,091,000 rose $12,246,000 or 7.8% over the prior year. In addition to an inflationary effect of nearly 3.5% in operating expenses, bad debt writeoffs represented a significant increase of $1,162,000 or 17.0% over 1991. Business failures and slow collections were prevalent during the two year period. Close monitoring of accounts Receivable along with the writeoffs resulted in an improvement in the quality of the outstanding Receivables. Another major reason for the increase in expenses was the commencement of a renewed national advertising thrust directed toward MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- the consumer especially in large metropolitan areas. The relocation of private label production from Gibbsboro, New Jersey to Newark, New Jersey in the latter part of 1992 also accounted for a one-time charge of approximately $500,000. Other income in 1992 declined $759,000 from the previous year. Reduced interest rates earned on short-term securities combined with lesser amounts available for temporary investments occasioned the decrease. Net income before taxes and minority interest was $60,399,000, up $208,000 over 1991. The Company's effective income tax rate was 38.9% in 1992 as compared with 39.4% in 1991. The provision for income taxes decreased by $189,000 or .8%. Net income of $36,307,000 in 1992 was $370,000 or 1% above 1991. Earnings per share were $3.66 in 1992, and improvement of $.12 over 1991. Dividends declared per share were $1.67 compared with $1.62 in the prior year. The Company's warehouse operation in New Zealand which opened in 1991 showed some indication of growth but had little effect on either net sales or net income. FINANCIAL POSITION AND LIQUIDITY During 1993 the financial strenth of the Company continued to be evidenced in the ability of the cash flows from operations to meet operating and capital requirements. Net cash flows provided by operating activities amounted to $32,282,000 in 1993 compared with $39,972,000 in 1992 and $33,772,000 in 1991. The decrease in operating cash flows of 1993 vs. 1992 was attributable to the additional support required for accounts and notes receivable and for the higher inventories of merchandising material which is reflected in prepaid expenses. Net cash flows used in investing activities showed a significant increase in 1993 over the prior year. The completion of the property renovation for a corporate technical and administrative center in Flanders, New Jersey accounted for the increase of over $2,017,000 in capital expenditures of 1993 compared with 1992. The continued reduction in short-term investments was a reflection of the use of internal funds for the Flanders building project as well as, in part, the accounts receivable support. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- The cash flows used in financing activities declined over $4,800,000 principally due to lower requirements for the acquisition of treasury stock. Generally, the Company finances its stock repurchases from its working capital in accordance with the conditions described at Part II, Item 5 above. It is expected that any future purchases will be similarly financed. During the three years ended December 31, 1993 the Company purchased 141,048; 218,110 and 178,683 shares, respectively, of its common stock. In addition, a capital contribution of 42,000 shares was received by the Company in 1991 through a bequest of a deceased senior executive. Sales of treasury stock are made to employees under an Employees' Stock Purchase Plan. During 1992 and 1991, the Company sold 300 and 229,100 shares, respectively, to employees. In addition, the Company distributed 876; 1,432 and 2,004 shares to non-executive sales employees in 1993, 1992 and 1991, respectively. During 1993 borrowing by the Company was largely limited to short-term line of credit uses by the Canadian subsidiary. The subsidiary in New Zealand also utilized local bank loans for a majority of its capital requirements. In 1994 the Company will continue with a major expansion of its production and warehouse facility at Mesquite, Texas. The project which is expected to amount to $8,500,000, is anticipated to consist of several phases with completion in 1995. The closing of the Houston plant and the transfer of production to the Mesquite facility is planned upon completion of the building project at Mesquite. A warehouse addition at an estimated cost of $800,000 is also in progress at the Pell City, Alabama plant. The renovation of the interior offices at the general administrative offices location in Montvale, New Jersey, at a cost of approximately $1,000,000, is expected to be completed by mid 1994. In addition, the relocation of the Company's Jacksonville, Florida plant, which is located adjacent to the Gator Bowl, will commence within the next year due to the awarding of an NFL football franchise to the city. The property occupied by the plant is included in the local development project. Negotiations are being conducted with the appropriate authorities for property appraisals and a determination of relocation costs. It is likely that a limited amount of short-term bank borrowing may be necessary to supplement funds from operating cash flows to finance the several construction projects. OTHER MATTERS The Company places importance on its environmental responsibilites. Compliance with current laws concerning environmental protection has not resulted in significant capital expenditures and has MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - - --------------------------------------------------------------- RESULTS OF OPERATIONS - - --------------------- not had a material adverse effect on the Company's earnings or its financial postion. The Company does not anticipate that future costs associated with current laws governing environmental protection will have a material effect upon its capital expenditures, earnings or competitive postion. For information regarding Financial Accounting Standards that have been issued but not yet adopted by the Company refer to Note 6 of the Notes to Consolidated Financial Statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - - ---------------------------------------------------- The consolidated financial statements of the registrant and its subsidiaries, together with notes thereto and the auditors' report, are set forth on pages 17 through 34. The additional financial information set forth in Part IV and included herein should be read in conjunction with the consolidated financial statements. DELOITTE & TOUCHE - - ---------- ---------------------------------------------- Two Hilton Court Telephone: (201) 631-7000 P.O. Box 319 Facsimilie: (201) 631-7459 Parsippany, New Jersey 07054-0319 INDEPENDENT AUDITORS' REPORT Benjamin Moore & Co.: We have audited the accompanying consolidated financial statements of Benjamin Moore & Co. and its subsidiaries, listed in the index at Item 14. 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 Benjamin Moore & Co. and subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes to Consolidated Financial Statements listed in the Index at Item 14, the Company changed both its method of accounting for income taxes to conform with Statement of Financial Accounting Standards ("SFAS") No. 109 and its method of accounting for postretirement benefits other than pensions to conform with SFAS No. 106. /s/ Deloitte & Touche Deloitte & Touche March 1, 1994 - - --------------- DELOITTE TOUCHE TOHMATSU INTERNATIONAL - - --------------- BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries See Notes to Consolidated Financial Statements. BENJAMIN MOORE & CO. and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the Years Ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation --------------------- The financial statements include all majority-owned subsidiaries except for Temporary Co-Ownerships as explained in Note 4 below. All balances and transactions between subsidiaries are eliminated in consolidation. Foreign Currency Translation ---------------------------- All balance sheet accounts of foreign subsidiaries are translated to United States dollars at current exchange rates. The income statements are translated using the average exchange rates for the period. Adjustments for currency exchange rate fluctuations are excluded from net income and reflected as a separate component of shareholders' equity. Short-Term Investments ---------------------- Short-term investments consist of United States treasury bills of $14,422,837 in 1993 and $20,850,732 in 1992, stated at cost, which approximates market value, and a mutual fund of short duration portfolio of $6,260,577 in 1993 and $6,024,634 in 1992, carried at the lower of cost or market value. The carrying amount of these investments approximates fair value. Inventory --------- Inventories are valued at lower of cost, determined by the use of the last-in, first-out (LIFO) method, or market. Property, Plant and Equipment ----------------------------- The major classes of property along with the depreciation and amortization methods and estimated useful lives used are set forth below: Major expenditures for renewals and improvements are capitalized; maintenance and repairs are expensed. The cost of property retired or sold is eliminated from the asset account and, after deducting the related accumulated depreciation, any profit or loss is included in income. Intangible Assets ----------------- Intangible assets acquired during 1993 and 1991, amounting to $1,083,561 and $4,080,000, respectively, are valued at cost and are being amortized over their estimated useful lives. During 1993 and 1992 amortization of such intangibles amounted to $942,685 and $642,632, respectively. Provision for Income Taxes -------------------------- The Company and its subsidiaries file separate tax returns. The Company provides deferred income taxes on temporary differences between amounts of assets NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) and liabilities for financial reporting purposes and such amounts as measured by enacted tax laws. Tax credits are included as a reduction of income tax expense in the year the credits arise. Pension Expense --------------- It is the Company's policy to fund all qualified pension costs based on calculations made by independent actuaries. Pension expense is determined in accordance with Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions. Unrecognized net assets are being amortized over 16-2/3 years for the United States plan and 15 years for the Canadian plan. Research and Development Costs ------------------------------ Research and development and quality control expenditures are charged to income in the year incurred and amounted to $13,987,537, $12,417,319 and $11,300,763 in 1993, 1992 and 1991, respectively. Quality control expenditures aggregated $5,001,518, $4,716,561 and $4,054,769, respectively, and are included herein because a substantial portion of such expenditures is related to development projects. Accounting Change ----------------- Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The net unrecorded liability at the date of adoption is being amortized over 20 years (See Note 6). As of the same date, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Prior year financial statements have not been restated. The adoption of SFAS No. 109 resulted in an additional income tax expense of approximately $700,000 in 1993 (See Note 13). Reclassifications ----------------- Certain reclassifications have been made in the 1991 financial statements to conform to the method of presentation used in 1993. 2. ACCOUNTS AND NOTES RECEIVABLE December 31, ----------------------- 1993 1992 Trade .................................. $88,940,829 $81,337,135 Other .................................. 1,493,077 1,049,161 ----------- ----------- Total ............................. 90,433,906 82,386,296 Less allowance for doubtful accounts ... 9,674,679 7,836,301 ----------- ----------- Net ............................... $80,759,227 $74,549,995 ----------- ----------- ----------- ----------- Notes receivable due after one year amounted to $12,614,376 and $11,904,207 at December 31, 1993 and 1992, respectively, and are included in Other Assets in the accompanying balance sheet. The carrying amount of notes receivable approximates fair value. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 3. INVENTORY December 31, ----------------------- 1993 1992 Finished goods ......................... $31,223,724 $27,979,303 Raw materials .......................... 20,253,750 21,204,848 ----------- ----------- Total ............................. $51,477,474 $49,184,151 ----------- ----------- ----------- ----------- If the first-in, first-out (FIFO) method of inventory accounting, which approximates current cost, had been used, inventory would have been $15,601,000, $13,142,000 and $15,235,000 higher than reported at December 31, 1993, 1992 and 1991, respectively. Work-in-process is not significant, due to the brief production cycle, and is included with raw materials. 4. INVESTMENTS IN TEMPORARY CO-OWNERSHIPS Investments in Temporary Co-Ownerships are carried at cost. These investments, in the capital stock of retail paint stores, are non- interest bearing financing arrangements. All increases in equity from earnings accrue solely to the benefit of the independent co-owners. The Company sells its products to Temporary Co-Ownerships at the same prices and terms used in transactions with all other customers. A reasonable estimate of fair value of the investments in Temporary Co- Ownerships could not be made without incurring excessive costs. 5. PROPERTY, PLANT AND EQUIPMENT December 31, ----------------------- 1993 1992 Land................................... $ 6,985,753 $ 6,135,827 Buildings.............................. 53,769,421 46,909,858 Machinery, equipment and leasehold improvements......................... 75,353,810 71,572,295 ----------- ----------- Total............................. 136,108,984 124,617,980 Less accumulated depreciation and amortization......................... 75,839,326 69,693,745 ----------- ----------- Property, plant and equipment-net. $60,269,658 $54,924,235 ----------- ----------- ----------- ----------- Capital leases included in the above are as follows: Classes of Property December 31, ----------------------- 1993 1992 Land................................... $ 96,000 $ 96,000 Buildings.............................. 1,616,902 1,616,902 Machinery, equipment and leasehold improvements............... 3,511,123 3,406,402 ---------- ---------- Total.............................. 5,224,025 5,119,304 Less accumulated depreciation and amortization..................... 3,811,492 3,456,342 ---------- ---------- Net............................... $1,412,533 $1,662,962 ---------- ---------- ---------- ---------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 6. EMPLOYEE BENEFIT PLANS Pension Plans ------------- The Company and its subsidiaries have retirement income plans covering substantially all employees. The benefits are based upon years of service and the employee's highest average compensation during any thirty-six consecutive full calendar months of employment. The funded status and amounts recognized in the Company's balance sheet at December 31, 1993 and 1992, as determined by independent actuaries, are presented below: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Net pension costs include the following components: The discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7 percent and 4 percent, respectively in 1993 and 8 1/2 percent and 6 1/2 percent, respectively in 1992 and 1991. The expected long-term rate of return on assets, net of expenses, was 8.5 percent in 1993 and 9 percent in 1992 and 1991. Postretirement Medical and Life Insurance Plans ----------------------------------------------- The Company and its subsidiaries have two defined benefit postretirement plans that cover substantially all of the United States employees of the Company and its subsidiaries. One plan provides medical benefits, and the other provides life insurance benefits. The postretirement health care plan is contributory for employees retiring on or after January 1, 1993, with retiree contributions adjusted annually; the life insurance plan is noncontributory. The accounting for the health care plan anticipates future cost-sharing changes to the written plan that are consistent with the Company's expressed intent to increase retiree contributions each year by the same percent increase experienced by the Net Incurred Charges through 1998, after which all future cost increases will be passed onto the retirees. As of December 31, 1993, the Company has not established any specific funding policy. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table sets forth the plans' funded status reconciled with the amount shown in the Company's statement of financial position at December 31, 1993. Net periodic postretirement benefit cost for 1993 included the following components: Service cost-benefits attributed to service during the period ............. $ 368,000 Interest cost on accumulated postretirement benefit obligation ........ 1,822,000 Net amortization and deferral .............. 1,107,000 ---------- Net periodic postretirement benefit cost ... $3,297,000 For measurement purposes, the 1994 annual rate of increase in the per capita cost of covered health care benefits was assumed to be 14% for costs under age 65 and 11.1% for costs over age 65; the rates were assumed to decrease gradually to 6% for 2020 and remain 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 $957,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $61,000. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The weighted-average discount rate used in determing the accumulated postretirement benefit obligation was 7 percent. During 1993, the Company's Canadian subsidiary continued to provide certain health care and life insurance benefits for retired employees as were previously provided to substantially all employees of the Company. Substantially all of the employees of the Company's Canadian subsidiary became eligible for those benefits upon retirement at the normal retirement age. The benefits are provided through insurance companies whose premiums are based upon the benefits paid during the year. The Company recognized the cost of providing those benefits by expensing the annual insurance premiums, which amounted to approximately $54,000, $822,000 and $703,000 in 1993, 1992 and 1991, respectively. Postemployment Benefits ----------------------- In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). This new statement requires an accrual of benefits provided to former or inactive employees after employment but before retirement. The cost of these benefits is currently expensed on a pay-as-you-go basis by the Company. The Company is required to adopt this statement in 1994. It is estimated that adoption of SFAS No. 112 will result in the accrual of a liability of approximately $1,300,000 as of January 1, 1994. Employees' Stock Ownership Benefit Plan --------------------------------------- The Company also maintains a qualified Employees' Stock Ownership Benefit Plan (ESOP), covering substantially all of its United States employees. The Board of Directors of the Company is authorized to make contributions from time to time to the plan trust fund. In 1989, the Company and its ESOP entered into a leveraged transaction whereby the Company borrowed $10,000,000 from a bank and loaned such funds to the ESOP. The ESOP used the loan proceeds to purchase, as restated to reflect the 1990 stock dividend, 239,792.236 shares of the Company's common stock; 87,590 shares from estates and 152,202.236 shares from the Company's treasury stock account. The bank loan bears interest at 7.85% and is payable in ten graduated annual installments through June 30, 1999. Based upon the borrowing rates currently available to the Company for bank loans with similar terms and average maturities, the carrying value of the bank loan approximates its current fair value. The common stock purchased by the ESOP is held by the ESOP trustees as collateral for the loan from the Company to the ESOP in a restricted account. Each year the Company will make contributions to the plan, which the plan's trustees will use to repay the loan from the Company in an amount sufficient for the Company to make interest and principal payments on the loan. The collateralized shares of common stock will be released from restriction and allocated to participating employees annually, as of December 31, based upon the percentage of debt service paid during the year then ended to the projected total amount of debt service to be paid under the loan agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Contributions to the ESOP amounted to $1,160,599, $1,140,564 and $1,096,272 in 1993, 1992 and 1991, respectively. The Company's Canadian subsidiary maintains a similar plan which covers substantially all of the Company's Canadian employees. The Canadian subsidiary contributed approximately $144,000, $141,000 and $135,000 to the Canadian plan trust fund in 1993, 1992 and 1991, respectively. Stock Option Plan ----------------- During 1993 the Company adopted a Stock Option Plan. The Plan provides for the granting of non-statutory stock options to officers and other employees of the Company. Options for the purchase of 400,000 shares of common stock, par value $10 per share, may be granted. The options become fully vested over a period of up to four years. During 1993 the Company granted options to purchase 233,785 shares at an option price of $73.26 per share, which is the fair value at the date of grant as determined by independent appraisal. At December 31, 1993 none of the options were exercisable. 7. OTHER LIABILITIES AND ACCRUED EXPENSES December 31, ----------------------- 1993 1992 Income taxes payable ...................... $ 2,392,051 $ 2,382,132 Salaries, wages and commissions ........... 3,962,768 4,011,129 Customer discounts and allowances ......... 2,757,399 2,625,168 Environmental remediation costs ........... 2,311,094 2,177,619 Other ..................................... 12,672,232 10,362,003 ------------ ------------ Total ............................... $ 24,095,544 $ 21,558,051 ------------ ------------ ------------ ------------ 8. GEOGRAPHIC SEGMENT INFORMATION The Company manufactures and sells coatings for use by the general public and industrial and commercial users in the United States, Canada and New Zealand. Transfers between geographic areas are not significant and are eliminated in consolidation. Assets and operating results by geographic area are as follows: NET SALES: United States Foreign Consolidated ------------- ----------- ------------ 1993 .......... $454,215,349 $57,736,116 $511,951,465 1992 .......... $426,409,378 $57,523,335 $483,932,713 1991 .......... $404,834,192 $58,137,893 $462,972,085 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) INCOME BEFORE TAXES AND MINORITY INTEREST: United States Foreign Consolidated ------------- ----------- ------------ 1993 .......... $56,762,454 $4,188,481 $60,950,935 1992 .......... $56,342,273 $4,056,698 $60,398,971 1991 .......... $55,162,304 $5,028,192 $60,190,496 IDENTIFIABLE ASSETS: 1993 .......... $237,810,998 $38,229,141 $276,040,139 1992 .......... $228,204,051 $35,405,527 $263,609,578 1991 .......... $220,322,784 $35,251,911 $255,574,695 9. SHORT-TERM BORROWINGS Information regarding the Company's arrangements with banks in the United States, Canada and New Zealand for short-term lines of credit follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) There are no significant compensating cash balances or commitment fees that relate to the above arrangements. Due to the short maturity of these borrowings, the carrying amount approximates fair value. 10. LONG-TERM OBLIGATIONS December 31, ----------------------- 1993 1992 Loan payable (See Note 6)...................... $ 6,925,000 $ 7,775,000 Capital leases (See Note 11)................... 1,024,191 1,400,000 Total........................................ 7,949,191 9,175,000 Less payments due within one year.............. 1,471,981 1,350,000 Long-term obligations........................ $ 6,477,210 $ 7,825,000 Principal payments of $1,471,981, $1,450,806, $1,126,405, $1,200,000 and $1,300,000 are due in 1994, 1995, 1996, 1997 and 1998, respectively. 11. LEASES During 1985, the Industrial Development Board of the City of Pell City, Alabama, issued $5,000,000 ten year, First Mortgage Industrial Revenue Bonds, guaranteed by the Company, to an Alabama Bank under a mortgage and trust indenture of which the Bank is the trustee. The bonds bear interest at a floating rate equal to 79% of the Bank's lending rate. The proceeds of the bonds were used by the Industrial Development Board to finance the construction of a plant facility in Pell City, Alabama, which is being leased to the Company for a ten- year period ending September 1, 1995. At the end of the lease term, or earlier in the event of prepayment of this obligation, the plant facility which has been recorded as a capital lease, may be purchased by the Company for $1,000. The Company also leases data processing equipment, buildings, transportation equipment, autos and miscellaneous equipment under operating leases expiring at various dates. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Minimum future obligations under leases as of December 31, 1993 are as follows: Rental expense on operating leases (including amounts based on equipment usage) was approximately $8,255,642, $6,912,552 and $6,479,948 for the years ended December 31, 1993, 1992 and 1991, respectively. 12. SHAREHOLDERS' EQUITY In 1978 the Board of Directors, with shareholder approval, adopted an Employees' Stock Purchase Plan (ESPP). Under the Plan, as restated to reflect stock dividends, up to an aggregate of 800,000 shares of Common Stock held in the treasury may be offered and sold from time to time to employees of the Company and its subsidiaries at the fair value price per share as determined by an independent appraisal firm, at the date of offering. Since 1979, 509,965 shares have been sold to employees. During 1992, the Company sold 300 shares to employees. Notes receivable outstanding with respect to the above referenced Plan, as well as the ESOP note receivable, as of December 31, 1993 and 1992 are reflected in the Balance Sheets as reductions in shareholders' equity. The notes received by the Company relative to the 1991 ESPP offering are non-interest bearing. Treasury stock is reflected at acquisition value, determined by the use of the first-in, first-out (FIFO) method. Sales and distributions of treasury shares are recorded at fair value price per share. Any excess of such fair value proceeds over the FIFO cost is reflected as additional paid-in capital. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) During 1993 and 1991, the Company received capital contributions of $20,515 and 42,000 shares, respectively, through the bequest of a deceased senior executive. A reconciliation of the number of common shares outstanding is as follows: 13. INCOME TAXES The composition of the income tax provision is as follows: 1993 1992 1991 State and local income taxes .... $ 4,595,010 $ 4,749,421 $ 4,412,758 Foreign income taxes ........... 1,946,324 1,732,755 2,112,240 Federal income taxes: Current ....................... 18,310,612 17,751,496 17,984,412 Deferred ...................... (954,885) (715,644) (802,519) Total ...................... $23,897,061 $23,518,028 $23,706,891 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Deferred income taxes represent the tax effects of recognizing certain expenses in different periods for tax and financial reporting, none of which are individually significant in any year. A reconciliation of the statutory federal tax rate and effective tax rate is as follows: 1993 1992 1991 Statutory tax rate................. 35.0% 34.0% 34.0% Effect of: State and local income taxes.. 4.9 5.2 4.8 Other - net................... (.7) (.3) .6 ---- ---- ---- Effective tax rate................. 39.2% 38.9% 39.4% ---- ---- ---- ---- ---- ---- The Company does not accrue Federal income taxes on its equity in the undistributed earnings of its Canadian subsidiary, which amounted to $23,902,094, $22,358,291 and $21,429,758 at December 31, 1993, 1992 and 1991, respectively, because the Company intends to reinvest such earnings indefinitely. 14. OTHER (INCOME) EXPENSE, NET The components of other (income) and expense, net are as follows: 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 - - ------------------------------------------------------------ Reference is made to the information set forth under the captions (i) "ELECTION OF DIRECTORS" at pages 3, 4 and 5 and "Compliance with Section 16(a) of the Securities Exchange Act" at page 21 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference, and (ii) "EXECUTIVE OFFICERS" at page 36 of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - - -------------------------------- Reference is made to the information set forth under the caption "DIRECTOR COMPENSATION" and "EXECUTIVE COMPENSATION" at pages 8, 9 and 10 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND - - ---------------------------------------------------------------------- MANAGEMENT - - ---------- (a) Security Ownership of Certain Beneficial Owners Reference is made to the information set forth under the caption "PRINCIPAL SHAREHOLDERS" at pages 2 and 3 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. (b) Security Ownership of Management Reference is made to the information set forth under the caption "ELECTION OF DIRECTORS - Ownership of Securities by Nominees and Directors" at pages 5, 6 and 7 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. (c) Changes in Control To the knowledge of the Company, there are no arrangements the operation of which may at a subsequent date result in a change in control of the Company. EXECUTIVE OFFICERS ------------------ The executive officers of the Company are elected each year by the directors of the Company, and are as follows: Name Office Age - - ---- ------ --- Richard Roob....................Chairman of the Board of Directors........... 61 Maurice C. Workman.........................President.................................... 65 Benjamin M. Belcher, Jr.........Executive Vice President..................... 59 Ward C. Belcher.................Vice President-Operations.................... 47 Richard H. Delventhal...........Controller................................... 57 Yvan Dupuy......................Vice President-Sales and Marketing........... 42 William J. Fritz................Vice President-Finance and Treasurer......... 63 John J. Oberle..................Vice President-Manufacturing and Technology.. 64 John T. Rafferty................Secretary and General Counsel................ 61 Charles C. Vail.................Vice President-Human Resources............... 50 _____________________________________ All of the executive officers of the Company have during a period in excess of the past five years, been actively engaged in the business and affairs of the Company in various senior management capacities. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - - -------------------------------------------------------- Reference is made to the information set forth under the caption "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" at pages 10 and 11 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS - - ------------------------------------------------------------- ON FORM 8-K ----------- (a)(1) List of Financial Statements Included Under Item 8 -------------------------------------------------- of this Report. --------------- Independent Auditors' Report................................... 17 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991............................ 18 Consolidated Balance Sheets, December 31, 1993 and 1992.................................................... 19 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991............................................... 20 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991...................... 21 Notes to Consolidated Financial Statements for the Years Ended December 31, 1993, 1992 and 1991...................... 22-34 (2) Financial Statement Supplemental Schedule. ------------------------------------------ I.... Short-Term Investments, December 31, 1993.............. 43 II... Amounts Receivable From Related Parties, and Underwriters, Promoters and Employees Other Than Related Parties For the Year Ended December 31, 1993...................................... 44-46 VIII. Consolidated Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991.................................... 47 X.... Supplementary Consolidated Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991.......................... 48 All other schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because of the absence of conditions under which they are required or because the information required thereby is shown in the financial statements or notes thereto. The individual financial statements of the Company have been omitted because the Company is primarily an operating company and all subsidiaries are included in the consolidated financial statements being filed. In addition, in the aggregate, such subsidiaries do not have minority equity interests and/or indebtedness to any person other than the Company or its consolidated subsidiaries in amounts which together exceed 5 percent of the total assets of the Company at December 31, 1993 and 1992. (b) Reports on Form 8-K ------------------- No reports on Form 8-K have been filed by the Company during the last quarter of the fiscal year ended December 31, 1993. (c) List of Exhibits ---------------- (3) Restated Certificate of Incorporation and Bylaws of the Company. (i) Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3(a) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-1 - Registration No. 2-62626). Reference is made to the information set forth under the caption "Amendment of the Restated Certificate of Incorporation" at pages 10 and 11 of the Company's Proxy Statement dated March 22, 1985, for use in connection with its 1985 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Limitation of Liability of Directors and Officers to the Maximum Extent Permitted by New Jersey Law" at pages 10, 11, 12 and 13 of the Company's Proxy Statement dated March 28, 1988, for use in connection with its 1988 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Amendment of the Restated Certificate of Incorporation" at pages 11 and 12 of the Company's Proxy Statement dated March 21, 1989, for use in connection with its 1989 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Amendment of the Certificate of Incorporation" at pages 15, 16 and 17 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (ii) Bylaws of the Company (incorporated herein by reference to Exhibit 3(b) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-1 - Registration No. 2-62626). Reference is made to the information set forth under the caption "Indemnification of Directors, Officers and Employees" at pages 13 and 14 of the Company's Proxy Statement dated March 28, 1988, for use in connection with its 1988 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Approval of Amendments of the Company Bylaws" at pages 17 through 21 of the Company's Proxy Statement dated March 28, 1994, for use in connection with its 1994 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (10) Material Contracts (iii) (A) Employees' Stock Purchase Plan of the Company (incorporated herein by reference to Exhibit 4(a) of the Company's Registration Statement under the Securities Act of 1933, as amended, on Form S-8 - Registration No. 33-2694). Reference is made to the information set forth under the caption "Amendment of Employees' Stock Purchase Plan" at pages 11 and 12 of the Company's Proxy Statement dated March 25, 1991, for use in connection with its 1991 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. Reference is made to the information set forth under the caption "Approval of the Stock Option Plan" at pages 13, 14 and 15 of the Company's Proxy Statement dated March 22, 1993, for use in connection with its 1993 Annual Meeting of the Shareholders, which information is hereby incorporated by reference. (22) Subsidiaries of the Company..................Page 49 (24) Consent of Experts and Counsel...............Page 50 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 on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in Montvale, New Jersey, on the 30th day of March, 1994. BENJAMIN MOORE & CO. By /s/ Maurice C. Workman -------------------------- Maurice C. Workman President POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each individual whose signature appears below constitutes and appoints Maurice C. Workman and Richard Roob, and each of them, his true and lawful attorneys-in- fact and agents with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their 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 --------- ----- ---- Chairman of the Board of Directors (Principal /s/ Richard Roob Executive Officer); --------------------- Richard Roob Director March 30, 1994 President (Principal /s/ Maurice C. Workman Executive Officer); ----------------------- Maurice C. Workman Director March 30, 1994 Vice President - Finance and Treasurer (Principal Financial Officer and Principal /s/ W.J. Fritz Accounting Officer); ----------------------- William J. Fritz Director March 30, 1994 /s/ Benjamin M. Belcher, Jr. Director March 30, 1994 ---------------------------- Benjamin M. Belcher, Jr. /s/ W.C. Belcher Director March 30, 1994 ----------------------- Ward C. Belcher /s/ Charles H. Bergmann Director March 30, 1994 -------------------------- Charles H. Bergmann /s/ Yvan Dupuy Director March 30, 1994 ------------------------- Yvan Dupuy /s/ Ralph W. Lettieri Director March 30, 1994 ------------------------- Ralph W. Lettieri /s/ Lee C. McAlister Director March 30, 1994 ------------------------- Lee C. McAlister /s/ John C. Moore Director March 30, 1994 ------------------------- John C. Moore /s/ Michael C. Quaid Director March 30, 1994 ------------------------- Michael C. Quaid /s/ J. Sobie Director March 30, 1994 ------------------------- Joseph Sobie Signature Title Date --------- ----- ---- /s/ Charles C. Vail Director March 30, 1994 ------------------------- Charles C. Vail /s/ Ward B. Wack Director March 30, 1994 ------------------------- Ward B. Wack /s/ Sara B. Wardell Director March 30, 1994 ------------------------- Sara B. Wardell SCHEDULE I BENJAMIN MOORE & CO. and Subsidiaries SHORT-TERM INVESTMENTS December 31, 1993 Col. A Col. B Col. C Number of Shares or Name of Issuer and Units - Principal Amount Cost of Title of Each Issue of Bonds and Notes Each Issue - - -------------------------------------------------------------------------------- United States treasury bills ..... $ 14,422,837 $14,422,837 Infinity Mutual Funds ............ 1,251,019.018 shares 6,260,577 ----------- $20,683,414 ----------- ----------- Information required by Columns D & E is omitted since short-term investments are valued at cost, and such cost approximates market value. Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Benjamin M. Belcher, Jr.: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 13,288 5,276 5,276 2,736 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 2,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Ward C. Belcher: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 14,454 5,276 5,276 3,902 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 41,120 8,468 8,468 24,184 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 5% Stock Purchase Plan Note dated 5/2/88, due in 9 annual installments 15,451 3,615 3,104 8,732 Yvan Dupuy: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,316 2,110 2,110 1,096 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 16,448 16,448 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Yvan Dupuy: Continued Non-Interest Bearing Stock Purchase Plan Note dated 2/3/92, due in 10 annual installments 44,546 5,211 2,299 37,036 Richard H. Delventhal: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,316 2,110 2,110 1,096 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 2,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Joel J. Mayor: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 5,782 2,110 2,110 1,562 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 21,454 4,234 4,234 12,986 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 John T. Rafferty: 5% Stock Purchase Plan Note dated 8/8/89, due in 9 annual installments 38,141 6,509 6,509 25,123 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Schedule II BENJAMIN MOORE & CO. and Subsidiaries AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 COL. A COL. B COL. C COL. D COL. E Balance at end of period ------------------------ Balance at beginning Amounts Name of debtor of period Additions collected Current Not Current - - -------------------------------------------------------------------------------- Richard Roob: 5% Stock Purchase Plan Note dated 2/28/86, due in 9 annual installments 13,288 5,276 5,276 2,736 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 41,120 8,468 8,468 24,184 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 5% Stock Purchase Plan Note dated 5/2/88, due in 9 installments 15,451 3,615 3,104 8,732 Charles C. Vail: 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 12,336 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 Maurice C. Workman: 5% Stock Purchase Plan Note dated 2/28/86, due in 7 annual installments 4,244 4,244 5% Stock Purchase Plan Note dated 7/22/88, due in 9 annual installments 12,336 4,540 2,540 7,256 Non-Interest Bearing Stock Purchase Plan Note dated 1/1/91, due in 10 annual installments 99,950 7,933 7,933 84,084 SCHEDULE VIII SCHEDULE X BENJAMIN MOORE & CO. and Subsidiaries SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - - -------------------------------------------------------------------------------- COLUMN A COLUMN B - - -------------------------------------------------------------------------------- Item Charges to Costs and Expenses ---- ----------------------------- 1993 1992 1991 ---- ---- ---- Advertising costs......................$30,508,550 $27,716,894 $26,456,383

36104_1993.txt

36104_1993

1993

36104

ITEM 1 Business General . . . . . . . . . . . . . . . . . . . . . . . . . . . .80 Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential . . . . . . . . . . . . .19-20, 74-75 Investment Portfolio. . . . . . . . . . . . . . . . . . 37-38, 71 Loan Portfolio. . . . . . . . . . . . . . . . . 21, 25-33, 50, 77 Summary of Loan Loss Experience . . . . . . . . . . . . .21,25-33 Deposits. . . . . . . . . . . . . . . . . . . . . . . . 74-75, 77 Return on Equity and Assets . . . . . . . . . . . . . . . . . .76 Short-Term Borrowings . . . . . . . . . . . . . . . . . . . . .78 ITEM 2 ITEM 2 Properties. . . . . . . . . . . . . . . . . . . . . . . . . . .80 ITEM 3 ITEM 3 Legal Proceedings . . . . . . . . . . . . . . . . . . . . . .none ITEM 4 ITEM 4 Submission of Matters to a Vote of Security Holders . . . . .none PART II ITEM 5 ITEM 5 Market for the Registrant's Common Equity and Related Stockholder Matters. . . . . . . .19, 69, 76 ITEM 6 ITEM 6 Selected Financial Data . . . . . . . . . . . . . . . . . . . .13 ITEM 7 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . 12-39 ITEM 8 ITEM 8 Financial Statements and Supplemental Data. . . . . . . . .73, 81 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. . . . . . .83 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 . . . . . . . . . . . . . . . . . . .81 *FIRST BANK SYSTEM'S DEFINITIVE PROXY STATEMENT FOR THE 1994 ANNUAL MEETING OF SHAREHOLDERS IS INCORPORATED HEREIN BY REFERENCE, OTHER THAN THE SECTIONS ENTITLED "REPORT OF THE ORGANIZATION COMMITTEE ON EXECUTIVE COMPENSATION" AND "PERFORMANCE GRAPH." GENERAL --> First Bank System, Inc. (the "Company") is a regional, multi-state bank holding company headquartered in the Twin Cities of Minneapolis and St. Paul, Minnesota. The Company was incorporated in Delaware in 1929 and owns more than 97 percent of the capital stock of each of the nine commercial banks and four trust companies, having 181 banking offices in Minnesota, Colorado, Montana, North Dakota, South Dakota, Washington, and Wisconsin. The Company also has various nonbank subsidiaries engaged in financial services principally in the Upper Midwest. The banks are engaged in general commercial banking business principally in domestic markets. They range in size from $42 million to $12.3 billion in deposits and provide a wide variety of services to individuals, businesses, industry, institutional organizations, governmental entities and other financial institutions. Depository services include checking accounts, savings accounts and time certificate contracts. Ancillary services such as cash management and receivable lockbox collection are provided for corporate customers. Nine subsidiary banks and four trust companies provide a full range of fiduciary activities for individuals, estates, foundations, business corporations, and charitable organizations. The Company provides banking services through its subsidiary banks to both domestic and foreign customers and correspondent banks. These services include consumer banking, commercial lending, financing of import/export trade, foreign exchange, and investment services. The Company, through its subsidiaries, also provides services in mortgage banking, trust, commercial and agricultural finance, data processing, leasing, and brokerage services. On a full-time equivalent basis, employment during 1993 averaged a total of 12,300 employees. COMPETITION --> The commercial banking business is highly competitive. Subsidiary banks compete with other commercial banks and with other financial institutions, including savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions, and mutual funds. In recent years, competition also has increased from institutions not subject to the same regulatory restrictions as domestic banks and bank holding companies. GOVERNMENT POLICIES --> The operations of the Company's various operating units are affected by state and federal legislative changes and by policies of various regulatory authorities, including those of the several states in which they operate, the United States and foreign governments. These policies include, for example, statutory maximum legal lending rates, domestic monetary policies of the Board of Governors of the Federal Reserve System, United States fiscal policy, international currency regulations and monetary policies, and capital adequacy and liquidity constraints imposed by bank regulatory agencies. SUPERVISION AND REGULATION --> The Company is a registered bank holding company under the Bank Holding Company Act of 1956 (the "Act") and is subject to the supervision of, and regulation by, the Board of Governors of the Federal Reserve System (the "Board"). Under the Act, a bank holding company may engage in banking, managing or controlling banks, furnishing or performing services for banks it controls, and conducting activities that the Board has determined to be closely related to banking. The Company must obtain approval of the Board before acquiring control of a bank or by acquiring more than 5 percent of the outstanding voting shares of a company engaged in a "bank-related" business. Under the Act and state laws, the Company is subject to certain restrictions as to states in which the Company can acquire a bank. National banks are subject to the supervision of, and are examined by, the Comptroller of the Currency. State banks are subject to the supervision of the regulatory authorities of the states in which they are located. All subsidiary banks of the Company are members of the Federal Deposit Insurance Corporation, and as such, are subject to examination thereby. In practice, the primary federal regulator makes regular examinations of each subsidiary bank subject to its regulatory review or participates in joint examinations with other federal regulators. Areas subject to regulation by federal and state authorities include the allowance for credit losses, investment, loans, mergers, issuance of securities, payment of dividends, establishment of branches and other aspects of operations. PROPERTIES --> At December 31,1993, the Company's subsidiaries owned and operated a total of 138 facilities while leasing an additional 148 facilities, all of which are well maintained. The Company's largest facilities are located in Minneapolis, St. Paul, and Denver. In Minneapolis, First Bank National Association and the Company's corporate offices occupy parts of four buildings. Thirty-one floors of First Bank Place and two floors of Pillsbury Center are leased. The Company also occupies nine floors in the Marquette bank building and five floors in the Concourse building, both of which are owned by the Company. In St. Paul, the Company leases an Operations Center as well as one-third of the First National Bank Building and four floors in the First Trust Center. In Denver, Colorado National Bank occupies approximately 70 percent of the Colorado National Bank Building and three percent of the Park Central Building, both of which are owned by subsidiaries of Colorado National Bank. Additional information with respect to premises and equipment is presented in Notes G and 0 of Notes to Consolidated Financial Statements. EXHIBITS Financial Statements Filed Page - ---------------------------------------------------------------- First Bank System, Inc. and Subsidiaries Consolidated Financial Statements. . . . . . . . . . . . 40 Notes to Consolidated Financial Statements . . . . . . . 44 Report of Independent Auditors . . . . . . . . . . . . . 70 Schedules to the consolidated financial statements required by Article 9 of Regulation S-X are omitted since the required infor- mation is included in the footnotes or is not applicable. During the three months ended December 31, 1993, the Company filed a report on Form 8-K on October 13,1993, relating to the announcement of the Company's intention to purchase Boulevard Bancorp, Inc. The following Exhibit Index lists the Exhibits to Annual Report on Form 10-K. (1)3A Restated Certificate of Incorporation, as amended. Filed as Exhibit 3A to report on Form 10-K for fiscal year ended December 31,1989. 3B By-laws. 4 [Pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K, copies of instruments defining the rights of holders of long-term debt are not filed. First Bank System, Inc. agrees to furnish a copy thereof to the Securities and Exchange Commission upon request.] (1)1OA Agreement of Merger and Consolidation dated November 8,1992, by and among First Bank System, Inc., Central Bancorporation, Inc. and Colorado National Bankshares, Inc. Filed as Exhibit 2.1 to 8-K Report filed November 13,1992. (1)10B Stock Purchase Agreements dated as of May 30, 1990, among Corporate Partners, L.P.; Corporate Offshore Partners, L.P.; The State Board of Administration of Florida and First Bank System, Inc. and related documents. Filed as Exhibits 4.8- 4.15 to Registration Statement on Form S-3 filed on September 10, 1991. (1)(2)10C First Bank System, Inc. 1987 Stock Option Plan. Filed as Exhibit 10E to report on Form 10-K for fiscal year ended December 31,1991. (1)(2)10D First Bank System, Inc. Nonqualified Supplemental Executive Retirement Plan. Filed as Exhibit 1OF to report on Form 10- K for fiscal year ended December 31,1991. (1)(2)10E First Bank System, Inc. Executive Deferral Plan. Filed as Exhibit lOG to report on Form 10-K for fiscal year ended December 31,1991. (1)(2)10F First Bank System, Inc. Annual Incentive Plan. Filed as Exhibit 10H to report on Form 10-K for fiscal year ended December 31,1992. (1)(2)10G First Bank System, Inc. Independent Director Retirement and Death Benefit Plan. Filed as Exhibit 10I to report on Form 10-K for fiscal year ended December 31,1992. (1)(2)10H First Bank System, Inc. Deferred Compensation Plan for Directors. Filed as Exhibit 10J to report on Form 10-K for fiscal year ended December 31,1992. (1)10I Rights Agreement dated as of December 21,1988, between First Bank System, Inc. and Morgan Shareholder Services Trust Company. Filed as Exhibit 1 to 8-K Report filed January 5,1989. (1)(2)10J First Bank System, Inc. Restated Employee Stock Purchase Plan. Filed as Exhibit 10L to report on Form 10-K for fiscal year ended December 31,1991. (1)(2)10K Form of Change-in-Control Agreement between First Bank System, Inc. and certain officers of the Company. Filed as Exhibit 10M to report on Form 1O-K for fiscal year ended December 31, 1991. (1)(2)10L First Bank System, Inc. 1991 Stock Incentive Plan. Filed as Exhibit A to Definitive Proxy Statement of Annual Meeting of Shareholders on April 24,1991. (2)10M First Bank System, Inc. 1994 Stock Incentive Plan. (1)(2)10N Agreement between First Bank System, Inc. and John F. Grundhofer dated December 30,1992. Filed as Exhibit 10O to report on Form 10-K for fiscal year ended December 31,1992. (2)10O Deferred Income Agreement between First Bank System, Inc. and John F. Grundhofer dated November 1, 1993. (2)10P Description of First Bank System, Inc. Stock Option Loan Policy. 11 Statement re: Computation of Primary and Fully Diluted Net Income per Common Share. 12 Statement re: Computation of Ratio of Earnings to Fixed Charges. 13 Integrated Annual Report / Form 10-K to Shareholders for the year ended December 31,1993 (See cover page). 21 Subsidiaries of the Registrant. 23 Consent of Ernst& Young. Copies of the Exhibits will be furnished upon request and payment of the Company's reasonable expenses in furnishing the Financial Statement Schedule and Exhibits. (1) Exhibit has heretofore been filed with the Securities and Exchange Commission and is incorporated herein as an exhibit by reference. (2) Items that are management contracts or compensatory plans or arrangements required to be filed as an exhibit pursuant to Item 14(c) of this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on February 16,1994, on its behalf by the undersigned thereunto duly authorized. First Bank System, Inc. John F. Grundhofer Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on February 16,1994, by the following persons on behalf of the registrant and in the capacities indicated. JOHN F. GRUNDHOFER Chairman, President, Chief Executive Officer, and Director (principal executive officer) RICHARD A. ZONA Vice Chairman and Chief Financial Officer (principal financial officer) SUSAN E. LESTER Executive Vice President and Controller (principal accounting officer) ROGER L HALE Director DELBERT W. JOHNSON Director JOHN H. KAREKEN Director RICHARD L. KNOWLTON Director KENNETH A. MACKE Director THOMAS F. MADISON Director MARILYN C. NELSON Director WILL F. NICHOLSON, JR. Director NICHOLAS R. PETRY Director EDWARD J. PHILLIPS Director JAMES J. RENIER Director S. WALTER RICHEY DIRECTOR RICHARD L ROBINSON Director LYLE E. SCHROEDER Director EXECUTIVE OFFICERS JOHN F. GRUNDHOFER Mr. Grundhofer, 55, has been Chairman of the Board, President and Chief Executive Officer of First Bank System since 1990. Previously, he served as Vice Chairman and Senior Executive Officer for Southern California, Wells Fargo Bank N.A. WILLIAM F. FARLEY Mr. Farley, 49, has been Vice Chairman of First Bank System since 1990. His previous positions include: Partner, Headrick& Farley and President, First Bank National Association. PHILIP G. HEASLEY Mr. Heasley, 44, was named Vice Chairman in 1993 and continues to serve as President of the Retail Product Group. His previous positions include: Executive Vice President and President of the Retail Product Group and Senior Vice President, Consumer Business, Electronic Banking Division. RICHARD A. ZONE Mr. Zona, 49, has served as Vice Chairman since 1990 and Chief Financial Officer since 1989. He was previously a Partner at Ernst & Young, J. ROBERT HOFFMANN Mr. Hoffmann, 48, has been Executive Vice President and Chief Credit Officer since 1990. He previously served as Executive Vice President, Credit Administration at First Bank National Association. JOHN M. MURPHY, JR. Mr. Murphy, 52, has been Chairman and Chief Investment Officer, First Trust National Association, since 1990. Before that he was Managing Director, First Asset Management, a division of First Bank National Association. DANIEL C. ROHR Mr. Rohr, 47, has served as Executive Vice President of the Commercial Banking Group since 1990. Previously, he was Executive Vice President and Chief Credit Officer at Columbia Savings & Loan Association. ROBERT H. SAYRE Mr. Sayre, 54, has served as Executive Vice President of Human Resources since 1990. Previously, he was Executive Director at Russell Reynolds Associates, Inc. MICHAEL J. O'ROURKE Mr. O'Rourke, 49, has been Executive Vice President, Secretary and General Counsel since 1991. Previously, he was Senior Vice President, Secretary and General Counsel. SUSAN E. LESTER Ms. Lester, 37, was named Executive Vice President in 1993, in addition to her duties as Controller. Previously, she was Senior Vice President and Controller. DAVID R. EDSTAM Mr. Edstam, 46, has been Senior Vice President and Treasurer since 1989. ELIZABETH A. MALKERSON Ms. Malkerson, 44, has been Senior Vice President of Corporate Relations since 1990. Her previous position was Vice President of External Affairs. DIRECTORS COLEMAN BLOOMFIELD Chairman and Chief Executive Officer Minnesota Mutual Life Insurance Co. St. Paul, Minnesota JOHN F. GRUNDHOFER Chairman, President and Chief Executive Officer First Bank System, Inc. Minneapolis, Minnesota ROGER L. HALE President and Chief Executive Officer TENNANT Minneapolis, Minnesota *DELBERT W. JOHNSON President Pioneer Metal Finishing, Inc. Minneapolis, Minnesota JOHN H. KAREKEN Professor of Banking and Finance Curtis L. Carlson School of Management University of Minnesota Minneapolis, Minnesota RICHARD L KNOWLTON Chairman of the Board Hormel Foods Corporation Austin, Minnesota KENNETH A. MACKE Chairman and Chief Executive Officer Dayton Hudson Corporation Minneapolis, Minnesota THOMAS F. MADISON Retired President U.S. West Communications-Markets Minneapolis, Minnesota MARILYN C. NELSON Vice Chairman and Director Carlson Holdings, Inc. Minneapolis, Minnesota WILL F. NICHOLSON, JR. Chairman, President and Chief Executive Officer Colorado National Bankshares, Inc. Denver, Colorado NICHOLAS R. PETRY President The Petry Company Denver, Colorado EDWARD J. PHILLIPS Chairman and Chief Executive Officer Phillips Beverage Company Minneapolis, Minnesota JAMES J. RENIER Retired Chairman of the Board and Chief Executive Officer Honeywell Inc. Minneapolis, Minnesota S. WALTER RICHEY President and Chief Executive Officer Space Center Company St. Paul, Minnesota RICHARD L. ROBINSON Chairman and Chief Executive Officer Robinson Dairy, Inc. Denver, Colorado RICHARD L. SCHALL Retired Vice Chairman of the Board Dayton Hudson Corporation Minneapolis, Minnesota LYLE E. SCHROEDER President and Chief Executive Officer Sioux Valley Hospital Sioux Falls, South Dakota *ELECTED TO THE BOARD OF DIRECTORS EFFECTIVE JANUARY 19, 1994 FBS LOCATIONS First Bank System, Inc. primarily serves Minnesota, Colorado, Montana, North Dakota, South Dakota, and Wisconsin through 181 banking locations and 24 additional offices of nonbank subsidiaries. [GRAPHICS; MAP] - FBS Retail and commercial banking - Corporate Trust offices - Republic Acceptance offices MINNESOTA COLORADO SOUTH DAKOTA Albert Lea Arvada (2) Aberdeen Alexandria Aspen Rapid City (3) Anoka (2) Aurora (4) Sioux Falls (4) Apple Valley Boulder (2) Austin Broomfield WISCONSIN Babbitt Canon City Blaine Colorado Springs(6) Brookfield Bloomington (4) Denver (18) Brown Deer Brainerd Englewood (3) La Crosse Brooklyn Park Evergreen Milwaukee Burnsville (2) Fort Collins (2) Onalaska Cloquet Glenwood Springs Columbia Heights Golden CORPORATE TRUST OFFICES Cottage Grove Grand Junction Duluth (3) Greeley Billings, MT Eagan La Junta Boston, MA East Grand Forks Lakewood (4) Chicago, IL Eden Prairie (2) Littleton (4) Denver, CO Edina (3) Longmont Duluth, MN Fairmont Loveland Fargo, ND Forest Lake Northglenn Frederick, MD Hibbing Pueblo (4) Los Angeles, CA Hopkins Westminster (2) Milwaukee, WI Little Canada Wheatridge Portland, OR Mankato (2) San Francisco, CA Minneapolis (13) MONTANA Seattle, WA Minnetonka (2) St. Paul, MN Oakdale Billings (2) Owatonna Bozeman REPUBLIC ACCEPTANCE CORP. Plymouth (2) Butte OFFICES Ramsey Great Falls (3) Robbinsdale Havre Kansas City, MO Rochester (3) Helena Milwaukee, WI Shoreview Miles City Minneapolis, MN St. Anthony Missoula (2) St. Louis, MO St. Cloud St. Louis Park NORTH DAKOTA St. Paul (6) Virginia Bismarck (2) Wayzata Fargo (4) West St. Paul Grand Forks (2) White Bear Lake (2) Jamestown Willmar Minot (2) Woodbury CORPORATE DATA EXECUTIVE OFFICES First Bank Place 601 Second Avenue South Minneapolis, Minnesota 55402-4302 (612) 973-1111 ANNUAL MEETING The annual meeting of shareholders will be held at the Minneapolis Convention Center, 1301 Second Avenue South, Minneapolis, Minnesota 55403, at 2 p.m. on Thursday, April 28,1994. SECURITIES INFORMATION First Bank System Common Stock is traded on the New York Stock Exchange under the ticker symbol FBS and also may be found under the listing FtBkSy. The transfer agent and registrar for First Bank System is First Chicago Trust Company of New York, P.O. Box 2500, Jersey City, New Jersey 07303-2500. DIVIDEND REINVESTMENT First Bank System shareholders can take advantage of a plan that provides automatic reinvestment of dividends and/or optional cash purchases of additional shares at market price of up to $5,000 per quarter. If you would like more information, contact First Chicago Trust Company of New York, P.O. Box 13531, Newark, New Jersey 07188-0001, (800) 446-2617. INVESTMENT COMMUNITY CONTACTS John R. Danielson Senior Vice President, Investor Relations (612) 973-2261 Karin E. Glasgow Assistant Vice President, Investor Relations (612) 973-2264 General Information, Investor Relations (612) 973-2263 First Bank System, Inc. P.O. Box 522 Minneapolis, Minnesota 55480 A limited number of spiral-bound 1993 Annual Reports are available for the investment community. Please write or call Investor Relations to obtain a copy. COMMUNITY RESPONSIBILITY REPORT For information about FBS's community reinvestment activities, call FBS Community Relations, (612) 973-2433. For additional annual reports or information about the 1994 annual meeting of shareholders, please contact Corporate Relations, First Bank System, First Bank Place, Minneapolis, Minnesota 55402, (612) 973-2434. First Bank System is an Equal Employment Opportunity/Affirmative Action employer. APPENDIX OF GRAPHIC MATERIAL

53456_1993.txt

53456_1993

1993

53456

ITEM 1. BUSINESS. Jersey Central Power & Light Company (the Company), which was incorporated under the laws of New Jersey in 1925, is a wholly owned subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935 (the 1935 Act). The Company's business consists predominantly of the generation, transmission, distribution and sale of electricity. The Company is affiliated with Metropolitan Edison Company (Met-Ed) and Pennsylvania Electric Company (Penelec). The Company, Met-Ed and Penelec are referred to herein as the "Company and its affiliates." The Company is also affiliated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc. (EI), which develops, owns and operates nonutility generating facilities. All of the Company's affiliates are wholly owned subsidiaries of GPU. The Company and its affiliates own all of the common stock of the Saxton Nuclear Experimental Corporation, which owns a small demonstration nuclear reactor that has been partially decommissioned. The Company and its affiliates, GPUSC, GPUN and GPC are referred to as the "GPU System." As a subsidiary of a registered holding company, the Company is subject to regulation by the Securities and Exchange Commission (SEC) under the 1935 Act. The Company's retail rates, conditions of service, issuance of securities and other matters are subject to regulation by the New Jersey Board of Regulatory Commissioners (NJBRC). The Nuclear Regulatory Commission (NRC) regulates the construction, ownership and operation of nuclear generating stations. The Company is also subject to regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act. (See "Regulation.") Industry Developments The Energy Policy Act of 1992 (Energy Act) has made significant changes to the 1935 Act and the Federal Power Act. As a result of this legislation, the FERC is now authorized to order utilities to provide transmission or wheeling service to third parties for wholesale power transactions provided specified reliability and pricing criteria are met. In addition, the legislation amends the 1935 Act to permit the development and ownership of a broad category of independent power production facilities by utilities and nonutilities alike without subjecting them to regulation under the 1935 Act. These and other aspects of the Energy Act are expected to accelerate the changing character of the electric utility industry. The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of a competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the major credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the FERC, subject to certain criteria, to order owners of electric transmission systems, such as the Company and its affiliates, to provide third parties with transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. Movement toward opening the transmission network to retail customers is currently under consideration in several states. The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Insofar as the Company is concerned, unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including New Jersey) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which if not supported by regulators would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation," applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Corporate Realignment In February 1994, GPU announced a corporate realignment and related actions as a result of its ongoing strategic planning studies. GPU Generation Corporation (GPU Generation) will be formed to operate and maintain the fossil-fueled and hydroelectric generating units of the Company and its affiliates; ownership of the generating assets will remain with the Company and its affiliates. GPU Generation will also build new generation facilities as needed by the Company and its affiliates in the future. Involvement in the independent power generation market will continue through EI. Additionally, the management and staff of Penelec and Met-Ed will be combined but the two companies will not be merged and will retain their separate corporate existence. This action is intended to increase effectiveness and lower cost. Included in this effort will be a search for parallel opportunities at GPUN and the Company. Completion of these realignment initiatives will be subject to various regulatory reviews and approvals from the SEC, FERC, NJBRC and the Pennsylvania Public Utility Commission (PaPUC). The GPU System is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. The GPU System is seeking annual cost savings of approximately $80 million by the end of 1996 as a result of these organizational changes. Duquesne Transaction In September 1990, the Company and its affiliates entered into a series of interdependent agreements with Duquesne Light Company (Duquesne) for the purchase of a 50% ownership interest in Duquesne's 300 megawatt (MW) Phillips generating station and the joint construction and ownership of associated high voltage bulk transmission facilities. The Company and its affiliates' share of the total cost of these agreements was estimated to be $500 million, of which the Company's share was $215 million, the major part of which was expected to be incurred after 1994. In addition, the Company and Met-Ed simultaneously entered into a related agreement with Duquesne to purchase 350 MW of capacity and energy from Duquesne for 20 years beginning in 1997. The Company and its affiliates and Duquesne filed several petitions with the PaPUC and the NJBRC seeking certain of the regulatory authorizations required for the transactions. In December 1993, the NJBRC denied the Company's request to participate in the proposed transactions. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company wrote off the approximately $9 million it had invested in the project. General The Company is an electric public utility furnishing service entirely within the State of New Jersey. It provides retail service in northern, western and east central New Jersey having an estimated population of approximately 2.4 million. The electric generating and transmission facilities of the Company, Met-Ed and Penelec are physically interconnected and are operated as a single integrated and coordinated system. The transmission facilities are physically interconnected with neighboring nonaffiliated utilities in Pennsylvania, New Jersey, Maryland, New York and Ohio. The Company and its affiliates are members of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) and the Mid-Atlantic Area Council, an organization providing coordinated review of the planning by utilities in the PJM area. The interconnection facilities are used for substantial capacity and energy interchange and purchased power transactions as well as emergency assistance. During 1993, residential sales accounted for approximately 44% of the Company's operating revenues from customers and 40% of kilowatt-hour (kWh) sales to customers; commercial sales accounted for approximately 37% of operating revenues from customers and 37% of kWh sales to customers; industrial sales accounted for approximately 17% of operating revenues from customers and 21% of kWh sales to customers; and sales to a rural electric cooperative, municipalities (primarily for street and highway lighting), and others accounted for approximately 2% of operating revenues from customers and 2% of kWh sales to customers. The Company also makes interchange and spot market sales of electricity to other utilities. The revenues derived from the largest single customer accounted for less than 3% of the electric operating revenues for the year and the 25 largest customers, in the aggregate, accounted for approximately 10% of such revenues. Reference is made to "Company Statistics" on page for additional information concerning the Company's sales and revenues. The Company and its affiliates along with the other members of the PJM power pool, experienced an electric emergency due to extremely cold temperature from January 18 through January 20, 1994. In order to maintain the electric system and to avoid a total black-out, intermittent black-outs for periods typically of one to two hours were instituted on January 19, 1994 to control peak loads. In February 1994, the NJBRC, the PaPUC and the FERC initiated investigations of the energy emergency, and forwarded data requests to all affected utilities. In addition, the United States House of Representatives' Energy and Power Subcommittee, among others, held hearings on this matter. At this time, management is unable to estimate the impact, if any, from any conclusions that may be reached by the regulators. Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, Penelec successfully negotiated power supply agreements with several Company wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of the Company. Wholesale customers represent a relatively small portion of GPU System sales. Nuclear Facilities The Company has made investments in three major nuclear projects -- Three Mile Island Unit 1 (TMI-1) and Oyster Creek, both of which are operational generating facilities, and Three Mile Island Unit 2 (TMI-2), which was damaged during a 1979 accident. At December 31, 1993, the Company's net investment in TMI-1 and Oyster Creek, including nuclear fuel, was $173 million and $784 million, respectively. TMI-1 and TMI-2 are jointly owned by the Company, Met-Ed and Penelec in the percentages of 25%, 50% and 25%, respectively. Oyster Creek is owned by the Company. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. TMI-1 TMI-1, a 786 MW pressurized water reactor, was licensed by the NRC in 1974 for operation through 2008. The NRC has extended the TMI-1 operating license through April 2014, in recognition of the plant's approximate six-year construction period. During 1993, TMI-1 operated at a capacity factor of approximately 87%. A scheduled refueling outage that year lasted 36 days; the next refueling outage is scheduled for late 1995. Oyster Creek The Oyster Creek station, a 610 MW boiling water reactor, received a provisional operating license from the NRC in 1969 and a full-term operating license in 1991. In April 1993, the NRC extended the station's operating license from 2004 to 2009 in recognition of the plant's approximate four-year construction period. The plant operated at a capacity factor of approximately 87% during 1993. A scheduled refueling outage lasted 81 days and the plant returned to service on February 16, 1993. The next refueling outage is scheduled for September 1994. TMI-2 The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990, and, after receiving NRC approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U. S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the Company. In June 1993, the Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price- Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable Federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. Nuclear Plant Retirement Costs Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. The disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). See Note 2 to Financial Statements for further information regarding nuclear fuel disposal costs. In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for Oyster Creek and TMI-1 by the end of the plants' license terms, 2009 and 2014, respectively. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long-term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million, and for Oyster Creek is $175 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share is $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed site-specific studies of TMI-1 and Oyster Creek that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of each plant to range from approximately $205 to $285 million, of which the Company's share is $51 to $71 million, and $220 to $320 million, respectively (adjusted to 1993 dollars). In addition, the studies estimated the cost of removal of nonradiological structures and materials for TMI-1 and Oyster Creek at $72 million, of which the Company's share is $18 million, and $47 million, respectively. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company charges to expense and contributes to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, in 1990 the Company contributed to an external trust an amount not recoverable from customers for nuclear plant decommissioning. TMI-1 and Oyster Creek The Company is collecting revenues for decommissioning, which are expected to result in the accumulation of its share of the NRC funding target for each plant. The Company is also collecting revenues for the cost of removal of nonradiological structures and materials at each plant based on its share ($3.83 million) of an estimated $15.3 million for TMI-1 and $31.6 million for Oyster Creek. Collections from customers for decommissioning expenditures are deposited in external trusts. These external trust funds, including the interest earned, are classified as Decommissioning Funds on the balance sheet. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $13 million for TMI-1 and $80 million for Oyster Creek at December 31, 1993. Management believes that any TMI-1 and Oyster Creek retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2 The Company has recorded a liability, amounting to $57 million as of December 31, 1993, for its share of the radiological decommissioning of TMI- 2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company records escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company has also recorded a liability in the amount of $5 million for its share of incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company has recorded a liability in the amount of $18 million for its share of the nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $15 million to an external decommissioning trust. The NJBRC has granted the Company decommissioning revenues for the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. As a result of TMI-2's entering long-term monitored storage, the Company is incurring incremental storage costs currently estimated at $.25 million annually. The Company has deferred the $5 million for its share of the total estimated incremental costs attributable to monitored storage through 2014, the expected retirement date of TMI-1. The Company's share of these costs has been recognized in rates by the NJBRC. Insurance The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) and for Oyster Creek totals $2.7 billion per site. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used to stabilize the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that, in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's three reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at weekly amounts of $1.8 million and $2.6 million for Oyster Creek and TMI-1, respectively. Under its insurance policies applicable to nuclear operations and facilities, the Company is subject to retrospective premium assessments of up to $31 million in any one year, in addition to those payable under the Price-Anderson Act. Nonutility and Other Power Purchases The Company has entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. While a few of these facilities are dispatchable, most are must- run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the NJBRC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 1,194 MW of capacity and energy to the Company by the mid-to-late 1990s. As of December 31, 1993, facilities covered by these agreements having 661 MW of capacity were in service, and 215 MW were scheduled to commence operation in 1994. Payments made pursuant to these agreements were $292 million for 1993 and are estimated to aggregate $325 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are substantially in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the NJBRC, there can be no assurance that the Company will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the GPU System's energy supply needs which, in turn, has caused the Company and its affiliates to change their supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company is attempting to renegotiate, and in some cases buy out, high cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the NJBRC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. In July 1993, an NJBRC Advisory Council recommended in a report that all New Jersey electric utilities be required to submit integrated resource plans for review and approval by the NJBRC. The NJBRC has asked all electric utilities in the state to assess the economics of their purchase power contracts with nonutility generators to determine whether there are any candidates for potential buy out or other remedial measures. In response, the Company initially identified a 100 MW project now under development, which it believes is economically undesirable based on current cost projections. In November 1993, the NJBRC directed the Company and the developer to negotiate contract repricing to a level more consistent with the Company's current avoided cost projections or a contract buy out. The parties have been unable to reach agreement and on February 10, 1994 the NJBRC decided to conduct a hearing on the matter. The developer has filed a declaratory judgement action in federal court contesting the NJBRC's jurisdiction in this matter and is seeking to enjoin the NJBRC proceeding. The matter is pending before the District Court and the NJBRC. In November 1993, the NJBRC granted two nonutility generators, having a total of 200 MW under contract with the Company, a one-year extension in the in-service dates for projects which were originally scheduled to be operational in 1997. The Company is awaiting a final written NJBRC order and may appeal this decision. Also in November 1993, the Company received approval from the NJBRC to withdraw its request for proposals for the purchase of 150 MW from nonutility generators. In its petition requesting withdrawal, the Company cited, among other reasons, that solicitations for long-term contracts would have limited its ability to compete in a deregulated environment. As a result of the NJBRC's decision, in January 1994, the Company issued an all source solicitation for the short-term supply of energy and/or capacity to determine and evaluate the availability of competitively priced power supply options. The Company is seeking proposals from utility and nonutility generation suppliers for periods of one to eight years in length and capable of delivering electric power beginning in 1996. Although the intention of the solicitation is to procure short-term and medium-term supplies of electric power, the Company is willing to give some consideration to proposals in excess of eight-year terms. The Company has entered into an arrangement for a peaking generation project. The Company plans to install a gas-fired combustion turbine at its Gilbert Generating station and retire two steam units for an 88 MW net increase in peaking capacity at an expected cost of $50 million. The Company expects to complete the project by 1996. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. Rate Proceedings In December 1993, the Company filed a proposal with the NJBRC seeking approval to implement a new rate initiative designed to retain and expand the economic base in New Jersey. Under the proposed contract rate service, large retail customers could enter into contracts for existing electric service at prevailing rates, with limitations on their exposure to future rate increases. With this rate initiative, the Company would have to absorb any differential in price resulting from changes in costs not provided for in the contracts. This matter is pending before the NJBRC. Proposed legislation has been introduced in New Jersey which is intended to allow the NJBRC, at the request of an electric or gas utility, to adopt a plan of regulation other than traditional ratemaking methods to encourage economic development and job creation. This legislation would allow electric utilities to be more competitive with nonutility generators who are not subject to NJBRC regulation. Combined with other economic development initiatives, this legislation, if enacted, would provide more flexibility in responding to competitive pressures, but may also serve to accelerate the growth of competitive pressures. The Company's two operating nuclear units are subject to the NJBRC's annual nuclear performance standard. Operation of these units at an aggregate generating capacity factor below 65% or above 75% would trigger a charge or credit based on replacement energy costs. At current cost levels, the maximum annual effect on net income of the performance standard charge at a 40% capacity factor would be approximately $10 million. While a capacity factor below 40% would generate no specific monetary charge, it would require the issue to be brought before the NJBRC for review. The annual measurement period, which begins in March of each year, coincides with that used for the Levelized Energy Adjustment Clause (LEAC). The NJBRC has instituted a generic proceeding to address the appropriate recovery of capacity costs associated with electric utility power purchases from nonutility generation projects. The proceeding was initiated, in part, to respond to contentions of the New Jersey Public Advocate, Division of Rate Counsel (Rate Counsel), that by permitting utilities to recover such costs through the LEAC, an excess or "double recovery" may result when combined with the recovery of the utilities' embedded capacity costs through their base rates. In September 1993, the Company and the other New Jersey electric utilities filed motions for summary judgment with the NJBRC requesting that the NJBRC dismiss contentions being made by Rate Counsel that adjustments for alleged "double recovery" in prior periods are warranted. Rate Counsel has filed a brief in opposition to the utilities' summary judgment motions including a statement from its consultant that in his view, the "double recovery" for the Company for the 1988-92 period would be approximately $102 million. Management believes that the position of Rate Counsel is without merit. This matter is pending before the NJBRC. Construction Program General During 1993, the Company had gross plant additions of approximately $203 million attributable principally to improvements and modifications to existing generating stations and additions to the transmission and distribution system. During 1994, the Company contemplates gross plant additions of approximately $275 million. The Company's gross plant additions are expected to total approximately $253 million in 1995. The principal categories of the 1994 anticipated expenditures, which include an allowance for other funds used during construction, are as follows: (In Millions) Generation - Nuclear $ 74 Nonnuclear 54 Total Generation 128 Transmission & Distribution 135 Other 12 Total $275 In addition, expenditures for maturing debt are expected to be $60 million and $47 million for 1994 and 1995, respectively. Subject to market conditions, the Company intends to redeem during these periods outstanding senior securities pursuant to optional redemption provisions thereof should it prove economical to do so. Management estimates that approximately one-half of the Company's total capital needs for 1994 and approximately three-fourths for 1995 will be satisfied through internally generated funds. The Company expects to obtain the remainder of these funds principally through the sale of first mortgage bonds and preferred stock, subject to market conditions. The Company's bond indenture and charter include provisions that limit the amount of long-term debt, preferred stock and short-term debt the Company may issue. The interest and preferred stock dividend coverage ratios of the Company are currently in excess of indenture or charter restrictions. (See "Limitations on Issuing Additional Securities.") Present plans call for the Company to issue long- term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. The Company's 1994 construction program includes $19 million in connection with the federal Clean Air Act Amendments of 1990 (Clean Air Act) requirements (see "Environmental Matters - Air"). The 1995 construction program currently includes approximately $16 million for Clean Air Act compliance. The Company's gross plant additions exclude nuclear fuel requirements provided under capital leases that amounted to $13 million in 1993. When consumed, the currently leased material, which amounted to $86 million at December 31, 1993, is expected to be replaced by additional leased material at an average rate of approximately $36 million annually. In the event the replacement nuclear fuel cannot be leased, the associated capital requirements would have to be met by other means. In response to the increasingly competitive business climate and excess capacity of nearby utilities, the GPU System's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short- to intermediate-term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. The Company is expected to experience an average growth rate in sales to customers (exclusive of the loss of its wholesale customers) through 1998 of about 1.6% annually. The Company also expects to experience peak load growth although at a somewhat lesser rate. Through 1998, the Company's plan consists of the continued utilization of most existing generating facilities, retirement of certain older units, present commitments for power purchases and new power purchases (of short or intermediate term duration), construction of a new facility, and the utilization of capacity of its affiliates. The plan also includes the continued promotion of economical energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The Company will resist efforts to compel it to add or contract for new capacity at costs that may exceed future market prices. In addition, the Company will seek regulatory support to renegotiate or buy out contracts with nonutility generators where the pricing is in excess of projected market prices. Demand-Side Management The regulatory environment in New Jersey encourages the development of new conservation and load management programs. This is evidenced by demand- side management (DSM) incentive regulations adopted in New Jersey in 1992. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). The NJBRC approved the Company's DSM plan in 1992 reflecting DSM initiatives of 67 MW of summer peak reduction by the end of 1994. Under the approved regulation, qualified Performance Program DSM investments are recovered over a six-year period with a return earned on the unrecovered amounts. Lost revenues will be recovered on an annual basis and the Company can also earn a performance-based incentive for successfully implementing cost effective programs. In addition, the Company will continue to make certain NJBRC mandated Core Program DSM investments which are recovered annually. Financing Arrangements The Company expects to have short-term debt outstanding from time to time throughout the year. The peak in short-term debt is expected to occur in the spring, coinciding with normal cash requirements for New Jersey Unit Tax payments. GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement, which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. In 1993, the Company refinanced higher cost long-term debt in the principal amount of $394 million resulting in an estimated annualized after- tax savings of $4 million. Total long-term debt issued during 1993 amounted to $555 million. In addition, the Company redeemed $50 million of high- dividend rate preferred stock issues. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock through June, 1995. Under existing authorization, the Company may issue senior securities in the amount of $275 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Under the Company's nuclear fuel lease agreements with nonaffiliated fuel trusts, an aggregate of up to $250 million ($125 million each for Oyster Creek and TMI-I) of nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the currently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. Limitations on Issuing Additional Securities The Company's first mortgage bond indenture and/or charter include provisions that limit the total amount of securities evidencing secured indebtedness and/or unsecured indebtedness that the Company can issue, the more restrictive of which are described below. The Company's first mortgage bond indenture requires that, for any period of 12 consecutive months out of the 15 calendar months preceeding the issuance of additional bonds, net earnings available for interest shall have been at least twice the interest requirements on bonds to be outstanding immediately after such issuance. Net earnings available for interest generally consist of the excess of gross operating revenues over operating expenses (other than income taxes), plus or minus net nonoperating income or loss with nonoperating income limited to 5% of operating income. Moreover, the Company's first mortgage bond indenture restricts the ratio of the principal amount of first mortgage bonds that can be issued to not more than 60% of bondable value of property additions. In addition, the indenture, in general, permits the Company to issue additional first mortgage bonds against a like principal amount of previously retired bonds. At December 31, 1993, the net earnings requirement under the Company's mortgage indenture, as described above, would have permitted it to issue approximately $821 million of first mortgage bonds at an assumed interest rate of 8%. However, the Company had bondable value of property additions and previously retired bonds that would have permitted it to issue an aggregate of only approximately $334 million of additional first mortgage bonds. Among other restrictions, the Company's charter provides that, without the consent of the holders of two-thirds of the total voting power of the outstanding preferred stock, no additional shares of preferred stock may be issued unless, for any period of 12 consecutive months of the 15 calendar months preceding such issuance, the Company's net after tax earnings available for the payment of interest on indebtedness shall have been at least one and one-half times the aggregate of (a) the annual interest charges on indebtedness and (b) the annual dividend requirements on all shares of preferred stock to be outstanding immediately after such issuance. At December 31, 1993, these earnings restrictions would have permitted the Company to issue approximately $659 million stated value of cumulative preferred stock at an assumed dividend rate of 8%. The Company's ability to effect bank loans and issue commercial paper is limited by the provisions of its charter concerning the ratio of loans to total capitalization. The Company's charter provides that, without the consent of the holders of a majority of the total voting power of the Company's outstanding preferred stock, unsecured indebtedness having an initial maturity of less than 10 years (or within three years of maturity) cannot exceed 10% of the sum of secured indebtedness, capital stock, including premium thereon, and surplus. At December 31, 1993, these restrictions would have permitted the Company to have approximately $277 million of unsecured indebtedness outstanding. The Company has obtained authorization from the SEC to incur short-term debt (including indebtedness under the Credit Agreement, bank credit facilities and commercial paper) up to the Company's charter limitation. Regulation As a registered holding company, GPU is subject to regulation by the SEC under the 1935 Act. The Company, as a subsidiary of GPU, is also subject to regulation under the 1935 Act with respect to accounting, the issuance of securities, the acquisition and sale of utility assets, securities or any other interest in any business, the entering into, and performance of, service, sales and construction contracts, and certain other matters. The SEC has determined that the electric facilities of the Company and its affiliates constitute a single integrated public utility system under the standards of the 1935 Act. The 1935 Act also limits the extent to which the Company may engage in nonutility businesses. The Company's retail rates, conditions of service, issuance of securities and other matters are subject to regulation by the NJBRC. Moreover, with respect to the transmission of electric energy, accounting, the construction and maintenance of hydroelectric projects and certain other matters, the Company is subject to regulation by the FERC under the Federal Power Act. The NRC regulates the construction, ownership and operation of nuclear generating stations and other related matters. The Company is also subject, in certain respects, to regulation by the PaPUC in connection with its participation in the ownership and operation of certain facilities located in Pennsylvania. (See "Electric Generation and the Environment - Environmental Matters" for additional regulation to which the Company is or may be subject.) The rates charged by the Company for electric service are set by regulators under statutory requirements that they be "just and reasonable." As such, they are subject to adjustment, up or down, in the event they vary from that statutory standard. In 1989, the NJBRC issued proposed regulations designed to establish a mechanism to evaluate the earnings of New Jersey utilities to determine whether their rates continue to be just and reasonable. As proposed, the regulations would permit the NJBRC to establish interim rates subject to refund without prior hearing. There has been no activity concerning this matter since the Company filed comments with the NJBRC. Electric Generation and the Environment Fuel Of the portion of its energy requirements supplied by its own generation, the Company utilized fuels in the generation of electric energy during 1993 in approximately the following percentages: Nuclear--72%; Coal--23%; Gas--4%; and Other (primarily Oil)--1%. Approximately 58% of the Company's energy requirements in 1993 was supplied by purchases (including net interchange) from other utilities and nonutility generators. For 1994, the Company estimates that its generation of electric energy will be in the following proportions: Nuclear--64%; Coal--26%; Gas--9%; and Other (primarily Oil)--1%. The anticipated changes in 1994 fuel utilization percentages are principally attributable to the refueling outage scheduled during 1994 for the Oyster Creek nuclear generating station. Approximately 65% of the Company's 1994 energy requirements is expected to be supplied by purchases (including net interchange) from other utilities and nonutility generators. Fossil: The Company has entered into a long-term contract with a nonaffiliated mining company for the purchase of coal for the Keystone generating station of which the Company owns a one-sixth undivided interest. This contract, which expires in 2004, requires the purchase of minimum amounts of the station's coal requirements. The price of the coal is determined by a formula generally providing for the recovery by the mining company of its costs of production. The Company's share of the cost of coal purchased under this agreement is expected to aggregate $21 million for 1994. The Company's portion of the station's estimated coal requirements aggregates approximately 15 million tons over the next 20 years, of which five million tons are expected to be supplied by the nonaffiliated mine-mouth coal company under the long-term contract, with the balance supplied by spot purchases or short-term contracts. At the current time, adequate supplies of fossil fuels are readily available to the Company, but this situation could change rapidly as a result of actions over which it has no control. Nuclear: Preparation of nuclear fuel for generating station use involves various manufacturing stages for which the Company and its affiliates contract separately. Stage I involves the mining and milling of uranium ores to produce natural uranium concentrates. Stage II provides for the chemical conversion of the natural uranium concentrates into uranium hexafluoride. Stage III involves the process of enrichment to produce enriched uranium hexafluoride from the natural uranium hexafluoride. Stage IV provides for the fabrication of the enriched uranium hexafluoride into nuclear fuel assemblies for use in the reactor core at the nuclear generating station. For TMI-1, under normal operating conditions, there is, with minor planned modifications, sufficient on-site storage capacity to accommodate spent nuclear fuel through the end of its licensed life while maintaining the ability to remove the entire reactor core. While Oyster Creek currently has sufficient on-site storage capacity to accommodate, under normal operating conditions, its spent nuclear fuel while maintaining the ability to remove the entire reactor core, additional on-site storage capacity will be required at the Oyster Creek station beginning in 1996 in order to continue operation of the plant. Contract commitments, with an outside vendor, have been made for on-site incremental spent fuel dry storage capacity at Oyster Creek for 1996 and 1998. Currently, public hearings on plans to build an interim spent fuel facility at the plant are underway. Environmental Matters The Company is subject to federal and state water quality, air quality, solid waste disposal and employee health and safety legislation and to environmental regulations issued by the U.S. Environmental Protection Agency (EPA), state environmental agencies and other federal agencies. In addition, the Company is subject to licensing of hydroelectric projects by the FERC and of nuclear power projects by the NRC. Such licensing and other actions by federal agencies with respect to projects of the Company are also subject to the National Environmental Policy Act. As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including, but not limited to, acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. The consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant are unknown. Management believes the costs described above should be recoverable through the ratemaking process, but recognizes that recovery cannot be assured. Water: The federal Water Pollution Control Act (Clean Water Act) generally requires, with respect to existing steam electric power plants, the application of the best conventional or practicable pollutant control technology available and compliance with state-established water quality standards. With respect to future plants, the Clean Water Act requires the application of the "best available demonstrated control technology, processes, operating methods or other alternatives" to achieve, where practicable, no discharge of pollutants. Congress may amend the Clean Water Act during 1994. The EPA has adopted regulations that establish thermal and other limitations for effluents discharged from both existing and new steam electric generating stations. Standards of performance are developed and enforcement of effluent limitations is accomplished through the issuance by the EPA, or states authorized by the EPA, of discharge permits that specify limitations to be applied. Discharge permits, which have been issued for all of the Company's generating stations, where required, have expired. Timely reapplications for such permits have been filed as required by regulations. Until new permits are issued, the currently expired permits remain in effect. The discharge permit received by the Company for the Oyster Creek station may, among other things, require the installation of a closed-cycle cooling system, such as a cooling tower, to meet New Jersey state water quality-based thermal effluent limitations. Although construction of such a system is not required in order to meet the EPA's regulations setting effluent limitations for the Oyster Creek station (such regulations would accept the use of the once-through cooling system now in operation at this station), a closed-cycle cooling system may be required in order to comply with the water quality standards imposed by the New Jersey Department of Environmental Protection and Energy (NJDEPE) for water quality certification and incorporated in the station's discharge permit. If a cooling tower is required, the capital costs could exceed $150 million. In 1988, the NJDEPE prepared a draft evaluation that assessed the impact of cooling water intake and discharge from Oyster Creek. This evaluation concluded that the thermal impact of water discharge from Oyster Creek operation was small and localized, but that the impact of cooling water intake was inconclusive, requiring further study. In 1993, the NJDEPE advised GPUN that rather than conduct hearings, it will determine water quality standards in the context of renewing the discharge permit. The NJDEPE has indicated that water quality standards (on an interim basis) will be set as requested by GPUN and that physical or operational changes to the intake structure will not be necessary at this time. Final standards will be established based upon results of a study to determine the optimum operational schedule for the dilution pumps. The NJDEPE has proposed thermal and other conditions for inclusion in the discharge permits for the Company's Gilbert and Sayreville generating stations that, among other things, could require the Company to install cooling towers and/or modify the water intake/discharge systems at these facilities. The Company has objected to these conditions and has requested an adjudicatory hearing with respect thereto. Implementation of these permit conditions has been stayed pending action on the Company's hearing request. The Company has made filings with the NJDEPE that the Company believes demonstrate compliance with state water quality standards at the Gilbert generating station and justify the issuance of a thermal variance at the Sayreville generating station to permit the continued use of the current once-through cooling system. Based on the NJDEPE's review of these demonstrations, substantial modifications may be required at these stations, which may result in material capital expenditures. The Company is also subject to environmental and water diversion requirements adopted by the Delaware River Basin Commission and the Susquehanna River Basin Commission as administered by those commissions or the Pennsylvania Department of Environmental Resources (PaDER) and the NJDEPE. Nuclear: Reference is made to "Nuclear Facilities" for information regarding the TMI-2 accident, its aftermath and the Company's other nuclear facilities. New Jersey and Pennsylvania have each established, in conjunction with other states, a low level radioactive waste (radwaste) compact for the construction, licensing and operation of low level radwaste disposal facilities to service their respective areas by the year 2000. New Jersey and Connecticut have established the Northeast Compact. The estimated cost to license and build a low level radwaste disposal facility in New Jersey is approximately $74 million. The Company's expected $29.5 million share of the cost for this facility is to be paid annually over an eight year period ending 1999. In its February 1993 rate order, the NJBRC granted the Company's request to recover these amounts currently from customers. The facility would be available for disposal of low level waste from Oyster Creek. Similarly, Pennsylvania, Delaware, Maryland and West Virginia have established the Appalachian Compact, which will build a single facility to dispose of low level radwaste in their areas, including low level radwaste from TMI-1. The estimated cost to license and build this facility is approximately $60 million, of which the Company and its affiliates' share is $12 million. These payments are considered advance waste disposal fees and will be recovered during the facility's operation. The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the federal government. The Company's share of the total liability at December 31, 1993 amounted to $29 million. The Company made its initial payment in 1993. The remaining amount recoverable from ratepayers is $28 million at December 31, 1993. Air: The Company is subject to certain state environmental regulations of the NJDEPE, the New Jersey Department of Health and the PaDER. The Company is also subject to certain federal environmental regulations of the EPA. The PaDER, NJDEPE and the EPA have adopted air quality regulations designed to implement Pennsylvania, New Jersey and federal statutes relating to air quality. Current Pennsylvania environmental regulations prescribe criteria that generally limit the sulfur dioxide content of stack gas emissions from generating stations constructed before 1972 and stations constructed after 1971 but before 1978, to 3.7 pounds and 1.2 pounds per million BTUs of heat input, respectively. On a weighted average basis, the Company and its affiliates have been able to obtain coal having a sulfur content meeting these criteria. If, and to the extent that, the Company and its affiliates cannot continue to meet such limitations with processed coal, it may be necessary to retrofit operating stations with sulfur removal equipment that may require substantial capital expenditures as well as substantial additional operating costs. Such retrofitting, if it could be accomplished to permit continued reliable operation of the facilities concerned, would take approximately five years. As a result of the Clean Air Act, which requires substantial reductions in sulfur dioxide and nitrogen oxide (NOx) emissions by the year 2000, it may be necessary for the Company to install and operate emission control equipment at the Keystone station, in which it has a 16.67% ownership interest. To comply with Title IV of the Clean Air Act, the Company expects to expend up to $145 million by the year 2000 for the installation of scrubbers, low NOx burner technology and various precipitator upgrades, of which approximately $2 million had been spent as of December 31, 1993. The capital costs of this equipment and the increased operating costs are expected to be recoverable through the ratemaking process. The current strategy for Phase II compliance under the Clean Air Act is to install scrubbers at the Keystone station. The Company continues to review available options to comply with the Clean Air Act, including those that may result from the development of an emission allowance trading market. The Company's compliance strategy, especially with respect to Phase II, could change as a result of further review, discussions with co-owners of jointly owned stations and changes in federal and state regulatory requirements. The ultimate impact of Title I of the Clean Air Act, which deals with the attainment of ambient air quality standards, is highly uncertain. In particular, this Title has established an ozone transport or emission control region that includes 11 northeast states. Pennsylvania and New Jersey are part of this transport region, and will be required to control NOx emissions to a level that will provide for the attainment of the ozone standard in the northeast. As an initial step, major sources of NOx will be required to implement Reasonably Available Control Technology (RACT) by May 31, 1995. This will affect the Company and its affiliates' steam generating stations. PaDER's RACT regulations have been approved by the Environmental Quality Board and became effective in January 1994. Large coal-fired combustion units are required to comply with a presumptive RACT emission limitation (technology) or may elect to use a case-by-case analysis to establish RACT requirements. NJDEPE's RACT regulations became effective in December 1993. These regulations establish maximum allowable emission rates for utility boilers based on fuel used and boiler type, and on combustion turbines based on fuel used. Existing units are eligible for emissions averaging upon approval of an averaging plan by the NJDEPE. The ultimate impact of Title III of the Clean Air Act, which deals with emissions of hazardous air pollutants, is also highly uncertain. Specifically, the EPA has not completed a Clean Air Act study to determine whether it is appropriate to regulate emissions of hazardous air pollutants from electric utility steam generating units. Both the EPA and PaDER are questioning the attainment of National Ambient Air Quality Standards (NAAQS) for sulfur dioxide in the vicinity of the Chestnut Ridge Energy Complex, which includes the Keystone generating station. The EPA and the PaDER have approved the use of a nonguideline air quality model. This model is more representative and less conservative than the EPA guideline model and will be used in the development of a compliance strategy for all generating stations in the Chestnut Ridge Energy Complex. Significant sulfur dioxide reductions may be required at the Keystone generating station, which could result in material capital and additional operating expenditures. Certain other environmental regulations limit the amount of particulate matter emitted into the environment. The Company and its affiliates have installed equipment at their coal-fired generating stations and may find it necessary to either upgrade or install additional equipment at certain of their stations to consistently meet particulate emission requirements. In the fall of 1993, the Clinton Administration announced its climate change action plan that intends to reduce greenhouse gas emissions to 1990 levels by the year 2000. The climate action plan relies heavily on voluntary action by industry. The Company and its affiliates have notified the DOE that they support the voluntary approach proposed by the President and expressed their intent to work with the DOE. Title IV of the Clean Air Act requires Phase I and Phase II affected units to install a continuous emission monitoring system and quality assure the data for sulfur dioxide, NOx, opacity and volumetric flow. In addition, Title VIII requires all affected sources to monitor carbon dioxide emissions. The Clean Air Act has also expanded the enforcement options available to the EPA and the states and contains more stringent enforcement provisions and penalties. Moreover, citizen suits can seek civil penalties for violations of this Act. In 1988, the Environmental Defense Fund (EDF), the New Jersey Conservation Foundation, the Sierra Club and Pennsylvanians for Acid Rain Control requested that the NJDEPE and the NJBRC seek to reduce sulfur deposition in New Jersey, either by reducing emissions from both in-state and out-of-state sources, or by requiring that certain electricity imported into New Jersey be generated from facilities meeting minimum emission standards. The Company purchases a substantial portion of its net system requirements from out-of-state coal-fired facilities, including the 1,700 MW Keystone station in Pennsylvania. Hearings on the EDF petition were held during 1989 and 1990, and the matter is pending before the NJDEPE and the NJBRC. NJDEPE regulations establish the maximum sulfur content of oil, which may not exceed .3% for most of the Company's generating stations and 1% for the balance. In 1993, the Company made capital expenditures of approximately $2 million in response to environmental considerations and has included approximately $11 million for this purpose in its 1994 construction program. The operating and maintenance costs, including the incremental costs of low-sulfur fuel, for such equipment were approximately $42 million in 1993 and are expected to be approximately $44 million in 1994. Electromagnetic Fields: There have been a number of scientific studies regarding the possibility of adverse health effects from electric and magnetic fields (EMF) that are found everywhere there is electricity. While some of the studies have indicated some association between exposure to EMF and cancer, other studies have indicated no such association. The studies have not shown any causal relationship between exposure to EMF and cancer, or any other adverse health effects. In 1990, the EPA issued a draft report that identifies EMF as a possible carcinogen, although it acknowledges that there is still scientific uncertainty surrounding these fields and their possible link to adverse health effects. On the other hand, a 1992 White House Office of Science and Technology policy report states that "there is no convincing evidence in the published literature to support the contention that exposures to extremely low frequency electric and magnetic fields generated by sources such as household appliances, video display terminals, and local power lines are demonstrable health hazards." Additional studies, which may foster a better understanding of the subject, are currently under way. Certain parties have alleged that exposure to EMF associated with the operation of the Company's transmission and distribution facilities will produce adverse impacts upon public health and safety, and upon property values. Furthermore, regulatory actions under consideration by the NJDEPE and bills introduced in the Pennsylvania legislature could, if enacted, establish a framework under which the intensity of EMF produced by electric transmission and distribution lines would be limited or otherwise regulated. The Company cannot determine at this time what effect, if any, this matter will have on it. Hazardous/Toxic Wastes: Under the Toxic Substances Control Act (TSCA), the EPA has adopted certain regulations governing the use, storage, testing, inspection and disposal of electrical equipment that contains polychlorinated biphenyls (PCBs). Such regulations permit the continued use and servicing of certain electrical equipment (including transformers and capacitors) that contain PCBs. The Company has met all requirements of the TSCA necessary to allow the continued use of equipment containing PCBs, and has taken substantive voluntary actions to reduce the amount of PCB containing electrical equipment. Prior to 1953, the Company owned and operated manufactured gas plants in New Jersey. Wastes associated with the operation and dismantlement of these gas manufacturing plants were disposed of both on-site and off-site. Claims may be asserted against the Company for the cost of investigation and remediation of these waste disposal sites. The amount of such remediation costs and penalties may be significant and may not be covered by insurance. The Company has identified 17 such sites to date. The Company has entered into cost-sharing agreements with New Jersey Natural Gas Company and Elizabethtown Gas Company under which the Company is responsible for 60% of all costs incurred in connection with the remediation of 12 of these sites. The Company has entered into Administrative Consent Orders (ACOs) with the NJDEPE for seven of these sites and has entered into Memorandum of Agreements (MOAs) with the NJDEPE for eight of these sites. The Company anticipates entering into MOAs for the remaining sites. The ACOs specify the agreed upon obligations of both the Company and the NJDEPE for remediation of the sites. The MOAs afford the Company greater flexibility in the schedule for investigation and remediation of sites. The Company is seeking NJDEPE approval of its plans for the remediation of these sites. The NJDEPE has approved the Company's implementation program for five of these sites. At December 31, 1993, the Company has an estimated environmental liability of $35 million recorded on its balance sheet relating to these sites. The estimated liability is based upon ongoing site investigations and remediation efforts, including capping the sites and pumping and treatment of ground water. If the periods over which the remediation is currently expected to be performed are lengthened, the Company believes that it is reasonably possible that the ultimate costs may range as high as $60 million. Estimates of these costs are subject to significant uncertainties: the Company does not presently own or control most of these sites; the environmental standards have changed in the past and are subject to future change; the accepted technologies are subject to further development; and the related costs for these technologies are uncertain. If the Company is required to utilize different remediation methods, the costs could be materially in excess of $60 million. In June 1993, the NJBRC approved a mechanism for the recovery of future manufactured gas plant remediation costs through the Company's LEAC when expenditures exceed prior collections. The NJBRC decision provides for interest to be credited to customers until the overrecovery is eliminated and for future costs to be amortized over seven years with interest. At December 31, 1993, the Company has collected from customers $5.2 million in excess of expenditures of $12.8 million. The Company is currently awaiting a final NJBRC order. The Company is pursuing reimbursement of the above costs from its insurance carriers, and will seek to recover costs to the extent not covered by insurance through this mechanism. The federal Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendment and Reauthorization Act of 1986 authorize the EPA to issue an order compelling responsible parties to take cleanup action at any location that is determined to present an imminent and substantial danger to the public or to the environment because of an actual or threatened release of one or more hazardous substances. New Jersey has enacted legislation giving similar authority to the NJDEPE. Because of the nature of the Company's business, various by-products and substances are produced and/or handled that are classified as hazardous under one or more of these statutes. The Company generally provides for the treatment, disposal or recycling of such substances through licensed independent contractors, but these statutory provisions also impose potential responsibility for certain cleanup costs on the generators of the wastes. The Company has been notified by the EPA and a state environmental authority that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at six hazardous and/or toxic waste sites (including the one described below). In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which it has not as yet been named as a PRP. The Company received notification in 1986 from the EPA that it is among the more than 800 PRPs under CERCLA who may be liable to pay for the cost associated with the investigation and remediation of the Maxey Flats disposal site, located in Fleming County, Kentucky. The Company is alleged to have contributed approximately 1.55% of the total volume of waste shipped to the Maxey Flats site. On September 30, 1991, the EPA issued a Record of Decision (ROD) advising that a remedial alternative had been selected. The PRPs estimate the cost of the remedial alternative selected and associated activities identified in the ROD at more than $60 million, for which all responsible parties would be jointly and severally liable. The Company has provided for its proportionate share of this cost in its financial statements. The ultimate cost of remediation of these sites will depend upon changing circumstances as site investigations continue, including (a) the technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Management believes the costs described above should be recoverable through the ratemaking process. Franchises The Company operates pursuant to franchises in the territory served by it and has the right to occupy and use the public streets and ways of the State with its poles, wires and equipment upon obtaining the consent in writing of the owners of the soil, and also to occupy the public streets and ways underground with its conduits, cables and equipment, where necessary, for its electric operation. The Company has the requisite legal franchise for the operation of its electric business within the State of New Jersey, including in incorporated cities and towns where designations of new streets, public ways, etc., may be obtained upon application to such municipalities. The Company holds a FERC license expiring in 2013 authorizing it to operate and maintain the Yards Creek pumped storage hydroelectric station in which the Company has a 50% ownership interest. Employee Relations At February 28, 1994, the Company had 3,439 full-time employees. The nonsupervisory production and maintenance employees of the Company and certain of the Company's nonsupervisory clerical employees are represented for collective bargaining purposes by local unions of the International Brotherhood of Electrical Workers (IBEW). The Company's three-year contract with the IBEW expires on October 31, 1994. ITEM 2. ITEM 2. PROPERTIES. Generating Stations At December 31, 1993, the generating stations of the Company had an aggregate effective summer capability of 2,849,000 net kilowatts (kW), as follows: Year of Name and Location of Station Installation Net kW Nuclear: Oyster Creek, Lacey Twp., NJ 1969 610,000 Three Mile Island Unit No. 1 Dauphin County, PA (a) 1974 196,000 Gas or Oil: Gilbert, Holland Twp., NJ 1930-1949 117,000 Sayreville, Sayreville, NJ (b) 1930-1958 313,000 Other (18 combustion turbines and 1 combined cycle), various locations 1970-1989 868,000 Oil: E. H. Werner, South Amboy, NJ 1953 58,000 Other (4 combustion turbines and 4 diesel units), various locations 1968-1972 214,000 Coal: Keystone, Indiana, PA (c) 1967-1968 283,000 Pumped Storage: Yards Creek, Blairstown, NJ (d) 1965 190,000 Total 2,849,000 (a) Represents the Company's undivided 25% interest in the station. (b) Effective February 1, 1994, 84,000 kW of capability were retired. (c) Represents the Company's undivided 16.67% interest in the station. (d) Represents the Company's undivided 50% interest in the station, which is a net user rather than a net producer of electric energy. Substantially all of the Company's properties are subject to the lien of its first mortgage bond indenture. The Company's peak load was 4,564,000 kW, reached on July 9, 1993. Transmission and Distribution System At December 31, 1993, the Company owned 299 transmission and distribution substations that had an aggregate installed transformer capacity of 21,810,169 kilovoltamperes (kVA), and 2,572 circuit miles of transmission lines, of which 18 miles were operated at 500 kilovolts (kV), 570 miles at 230 kV, 228 miles at 115 kV and the balance of 1,756 miles at 69 kV and 34.5 kV. The Company's distribution system included 9,707,504 kVA of line transformer capacity, 15,459 pole miles of overhead lines and 6,362 trench miles of underground cables. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Reference is made to "Nuclear Facilities - TMI-2," "Rate Proceedings," and "Environmental Matters" under Item 1 and Note 1 to Financial Statements contained in Item 8 for a description of certain pending legal proceedings involving the Company. See Page for reference to Notes to 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. All of the Company's outstanding common stock is owned by GPU. During 1993, the Company paid $60 million in dividends on its common stock. In accordance with the Company's mortgage indenture, as supplemented, $1.7 million of the balance of retained earnings at December 31, 1993 is restricted as to the payment of dividends on its common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. See page for reference to Selected Financial Data required by this item. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See page for reference to Management's Discussion and Analysis of Financial Condition and Results of Operations required by this item. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See page for reference to Financial Statements and Quarterly Financial Data (unaudited) required by 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. Identification of Directors The current directors of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief Executive Officer 1986 D. Baldassari (b) 44 President 1982 R. C. Arnold (c) 56 Director 1989 J. G. Graham (d) 55 Vice President and Chief Financial Officer 1986 M. P. Morrell (e) 45 Vice President 1993 G. E. Persson (f) 62 Director 1983 P. H. Preis (g) 60 Vice President and Comptroller 1982 S. C. Van Ness (h) 60 Director 1983 S. B. Wiley (i) 64 Director 1982 (a) Mr. Leva became Chairman of the Board and Chief Executive Officer of the Company in 1992. He became Chairman, President and Chief Executive Officer of GPU in 1992. He is also Chairman, President, Chief Executive Officer and a director of GPUSC, Chairman of the Board, Chief Executive Officer and a director of Met-Ed, Penelec and GPC, and Chairman of the Board and a director of GPUN. Prior to assuming his current positions, Mr. Leva served as President of the Company since 1986. He is also a director of Utilities Mutual Insurance Company, the New Jersey Utilities Association, Chemical Bank NJ and Princeton Bank & Trust Company. (b) Mr. Baldassari became President of the Company and a director of GPUSC and GPUN in February 1992. Prior to assuming his current positions, Mr. Baldassari served as Vice President - Rates and a director of the Company since 1982. He also served as Vice President - Materials and Services of the Company since 1990, and as Treasurer of the Company from October 1979 through December 31, 1989. He is also a director of First Morris Bank and the New Jersey Utilities Association. (c) Mr. Arnold became Executive Vice President - Power Supply of GPUSC in 1990. He was Senior Vice President - Power Supply of GPUSC from 1987 to 1989. He is also a director of GPUSC, Met-Ed and Penelec. (d) Mr. Graham became Senior Vice President in 1989 and Chief Financial Officer of GPU in 1987. He is also Executive Vice President, Chief Financial Officer and a director of GPUSC; Vice President, Chief Financial Officer and a director of Met-Ed and Penelec; Vice President and Chief Financial Officer of GPUN; President and a director of GPC; and a director of EI. (e) Mr. Morrell was elected Vice President - Materials, Services and Regulatory Affairs of the Company and a director of the Company in 1993. Prior to assuming these positions, Mr. Morrell served as Vice President of GPU since 1989 and Treasurer of GPU since 1987, and had also served as Vice President and Treasurer of the Company, GPUSC, Met-Ed and Penelec and as Treasurer of GPUN and GPC. He is also a director of Utilities Mutual Insurance Company. (f) Mrs. Persson is owner and President of Business Dynamics Associates of Farmingdale, NJ. Prior to that, she was owner and operator of a family-owned business in Little Silver and Farmingdale, NJ since 1965. Mrs. Persson is a member of the United States Small Business Administration National Advisory Board, the New Jersey Small Business Advisory Council, the Board of Advisors of Brookdale Community College and the Board of Advisors of Georgian Court College. (g) Mr. Preis became a Vice President and a director of the Company in 1982 and Comptroller in 1979. (h) Mr. Van Ness has been affiliated with the law firm of Pico, Mack, Kennedy, Jaffe, Perrella and Yoskin of Trenton, NJ since July 1990. Prior to that time, he was affiliated with the law firm of Jamison, McCardell, Moore, Peskin and Spicer of Princeton, NJ since 1983. He also served as Commissioner of the Department of the Public Advocate, State of New Jersey, from 1974 to September 1982. Mr. Van Ness is a director of The Prudential Insurance Company of America. (i) Mr. Wiley has been a partner in the law firm of Wiley, Malehorn and Sirota of Morristown, NJ since 1973. He is also Chairman of First Morris Bank. The Company's directors are elected at the annual meeting of stockholder to serve until the next meeting of stockholder and until their respective successors are duly elected and qualified. There are no family relationships among the directors of the Company. Identification of Executive Officers The executive officers of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief Executive Officer 1992 D. Baldassari (b) 44 President 1992 C. D. Cudney (c) 55 Vice President 1982 C. R. Fruehling (d) 58 Vice President 1982 J. G. Graham (e) 55 Vice President and Chief Financial Officer 1987 E. J. McCarthy (f) 55 Vice President 1982 M. P. Morrell (g) 45 Vice President 1990 R. W. Muilenburg (h) 60 Vice President 1982 D. W. Myers (i) 49 Vice President and Treasurer 1993 P. H. Preis (j) 60 Vice President and Comptroller 1979 R. J. Toole (k) 51 Vice President 1990 J. J. Westervelt (l) 53 Vice President 1982 R. S. Cohen (m) 51 Secretary and Corporate Counsel 1986 (a) See Note (a) on page 28. (b) See Note (b) on page 28. (c) Mr. Cudney has been Vice President of the Company since 1982. Prior to that time, Mr. Cudney served as Manager - Operations of the Company since May 1975. (d) Mr. Fruehling has been Vice President of the Company since 1982. Prior to that time, Mr. Fruehling served as Director - Transmission & Distribution Engineering of the Company since October 1979. (e) See Note (d) on page 28. (f) Mr. McCarthy has been Vice President of the Company since 1982. Prior to that time, Mr. McCarthy served as Manager - Business Offices of the Company since May 1971. (g) See note (e) on page 29. (h) Mr. Muilenburg has been Vice President of the Company since 1982. Prior to that time, Mr. Muilenburg served as Manager - Corporate Communications of the Company since June 1976. (i) Mr. Myers became Vice President and Treasurer of the Company in 1993. He is also Vice President and Treasurer of GPU, GPUSC, Met-Ed, Penelec, GPUN and GPC. Prior to assuming his current positions, Mr. Myers served as Vice President and Comptroller of GPUN since 1986. (j) See Note (g) on page 29. (k) Mr. Toole has been Vice President of the Company since 1990. He has also been a Vice President of Met-Ed since 1989. Prior to that he served as Director - Generation Operations of Met-Ed and GPUSC and as Operations and Maintenance Director of TMI-1. (l) Mr. Westervelt has been Vice President of the Company since 1982. Prior to that time, Mr. Westervelt served as Director - Human Resources of the Company since April 1979. (m) Mr. Cohen has been Secretary and Corporate Counsel of the Company since 1986. The Company's executive officers are elected each year at the first meeting of the Board of Directors held following the annual meeting of stockholder. Executive officers hold office until the next meeting of directors following the annual meeting of stockholder and until their respective successors are duly elected and qualified. There are no family relationships among the Company's executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Remuneration of Executive Officers SUMMARY COMPENSATION TABLE Long-Term Annual Compensation Compensation Other Awards All Name and Annual Restricted Other Principal Compen- Stock/Unit Compen- Position Year Salary Bonus sation(1) Awards(2) sation J. R. Leva Chairman and Chief Executive Officer (3) (3) (3) (3) (3) (3) D. Baldassari 1993 $253,750 $57,000 $ - $41,850 $11,192(4) President 1992 211,480 50,000 - 35,100 8,985 1991 117,600 18,500 - 12,190 9,227 M. P. Morrell 1993(5) 144,200 26,000 1,932 15,500 5,768(6) Vice Presi- 1992 137,500 24,900 1,166 14,560 5,267 dent 1991 128,750 21,000 547 12,650 5,150 C. D. Cudney 1993 137,675 24,000 - 14,260 7,573(7) Vice Presi- 1992 132,400 20,900 - 14,300 5,741 dent 1991 125,800 19,000 - 13,340 4,994 P. H. Preis 1993 135,900 22,500 - 14,260 4,881(8) Vice Presi- 1992 130,725 20,600 - 13,780 4,285 dent and 1991 125,825 19,000 - 12,190 3,794 Comptroller E. J. McCarthy 1993 125,825 22,500 - 13,020 5,033(6) Vice Presi- 1992 121,125 19,100 - 13,000 4,845 dent 1991 116,625 18,000 - 11,270 2,744 (1) "Other Annual Compensation" is composed entirely of the above-market interest accrued on the preretirement portion of deferred compensation. (2) Number and value of aggregate restricted shares/units at the end of 1993 (dividends are paid or accrued on these restricted shares/units and reinvested): Aggregate Aggregate Shares/Units Value D. Baldassari 3,500 $95,114 M. P. Morrell 1,910 $49,348 C. D. Cudney 1,880 $48,316 P. H. Preis 1,810 $46,646 E. J. McCarthy 1,680 $43,264 (3) As noted above, Mr. Leva is Chairman and Chief Executive Officer of the Company and its affiliates, as well as Chairman and Chief Executive Officer of GPU and GPUSC. Mr. Leva is compensated by GPUSC for his overall services on behalf of the GPU System and, accordingly, is not compensated directly by the Company for his services. Information with respect to Mr. Leva's compensation is included on pages 13 to 15 of GPU's 1994 definitive proxy statement, which are incorporated herein by reference. (4) Consists of the Company's matching contributions under the Savings Plan ($9,427) and the imputed interest on employer-paid premiums for split- dollar life insurance ($1,765). (5) Mr. Morrell was elected Vice President-Materials, Services and Regulatory Affairs of the Company effective January 15, 1993. Prior to assuming this position, Mr. Morrell served as Vice President and Treasurer of the Company. (6) Consists of the Company's matching contributions under the Savings Plan. (7) Consists of the Company's matching contributions under the Savings Plan ($4,847) and above-market interest accrued on the retirement portion of deferred compensation ($2,726). (8) Consists of the Company's matching contributions under the Savings Plan ($3,805) and above-market interest accrued on the retirement portion of deferred compensation ($1,076). LONG-TERM INCENTIVE PLANS - AWARDS IN LAST FISCAL YEAR Performance Estimated future payouts Number of or other under nonstock price- shares, period until based plans(1) units or maturation Name other rights or payout Target ($ or #) D. Baldassari 1,350 5 years $29,177 M. P. Morrell 500 5 years 10,806 C. D. Cudney 460 5 years 9,942 P. H. Preis 460 5 years 9,942 E. J. McCarthy 420 5 years 9,077 (1) The 1990 Stock Plan for Employees of General Public Utilities Corporation and Subsidiaries also provides for a Performance Cash Incentive Award in the event that the annualized GPU Total Shareholder Return exceeds the annualized Industry Total Return (Edison Electric Institute's Investor- Owned Electric Utility Index) for the period between the award and vesting dates. These payments are designed to compensate recipients of restricted stock/unit awards for the amount of federal and state income taxes that will be payable upon the restricted stock/units that are vesting for the recipient. The amount is computed by multiplying the applicable gross-up percentage by the amount of gross income the recipient recognizes for federal income tax purposes when the restrictions lapse. The estimated amounts above are computed based on the number of restricted units awarded for 1993 multiplied by the 1993 year-end market value of $30.875. Actual payments would be based on the market value of GPU common stock at the time the restrictions lapse, and may be different from those indicated above. Proposed Remuneration of Executive Officers No executive officer of the Company has an employment contract with the Company. The compensation of the Company's executive officers is determined from time to time by the Board of Directors of the Company. Retirement Plans The GPU System pension plans provide for pension benefits, payable for life after retirement, based upon years of creditable service with the GPU System and the employee's career average annual compensation as defined below. Under federal law, an employee's pension benefits that may be paid from a qualified trust under a qualified pension plan such as the GPU System plans are subject to certain maximum amounts. The GPU System companies also have adopted nonqualified plans providing that the portion of a participant's pension benefits that, by reason of such limitations or source, cannot be paid from such a qualified trust shall be paid directly on an unfunded basis by the participant's employer. The following table illustrates the amount of aggregate annual pension from funded and unfunded sources resulting from employer contributions to the qualified trust and direct payments payable upon retirement in 1994 (computed on a single life annuity basis) to persons in specified salary and years of service classifications: Estimated Annual Retirement Benefits(2)(3)(4) Based Upon Career Average Compensation (1994 Retirement) 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years of Service of Service of Service of Service of Service of Service Career Average Compensation (1) $100,000 $ 29,114 $ 38,819 $ 48,524 $ 58,229 $ 67,934 $ 76,956 150,000 44,114 58,819 73,524 88,229 102,934 116,556 200,000 59,114 78,819 98,524 118,229 137,934 156,156 250,000 74,114 98,819 123,524 148,229 172,934 195,756 300,000 89,114 118,819 148,524 178,229 207,934 235,356 350,000 104,114 138,819 173,524 208,229 242,934 274,956 400,000 119,114 158,819 198,524 238,229 277,934 314,556 (1) Career Average Compensation is the average annual compensation received from January 1, 1984 to retirement and includes Base Salary, Deferred Compensation and Incentive Compensation Plan awards. The Career Average Compensation amounts for the following named executive officers differ by more than 10% from the three- year average annual compensation set forth in the Summary Compensation Table and are as follows: Messrs. Baldassari - $140,376; Morrell - $117,030; Cudney - $117,193; Preis - $124,340; and McCarthy - $115,745. (2) Years of creditable service: Messrs. Baldassari - 24; Morrell - 22; Cudney - 32; Preis - 33; and McCarthy - 33. (3) Based on an assumed retirement at age 65 in 1994. To reduce the above amounts to reflect a retirement benefit assuming a continual annuity to a surviving spouse equal to 50% of the annuity payable at retirement, multiply the above benefits by 90%. The estimated annual benefits are not subject to any reduction for Social Security benefits or other offset amounts. (4) Annual retirement benefit cannot exceed 55% of the average compensation received during the last three years prior to retirement. Remuneration of Directors Nonemployee directors receive annual compensation of $13,000, a fee of $1,000 for each Board meeting attended and a fee of $1,000 for each Committee meeting attended. The Company has in effect a deferred remuneration plan pursuant to which outside directors may elect to defer all or a portion of current remuneration. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. All of the Company's 15,371,270 outstanding shares of common stock are owned beneficially and of record by the Company's parent, General Public Utilities Corporation, 100 Interpace Parkway, Parsippany, New Jersey 07054. The following table sets forth, as of February 1, 1994, the beneficial ownership of equity securities of the Company and other GPU System companies of each of the Company's directors and each of the executive officers named in the Summary Compensation Table, and of all directors and officers of the Company as a group. The shares owned by all directors and executive officers as a group constitute less than 1% of the total shares outstanding. Title of Amount and Nature of Name Security Beneficial Ownership(1) J. R. Leva GPU Common Stock 3,912 shares - Direct D. Baldassari GPU Common Stock 945 shares - Direct R. C. Arnold GPU Common Stock 6,751 shares - Direct C. D. Cudney GPU Common Stock 1,445 shares - Direct J. G. Graham GPU Common Stock 6,411 shares - Direct 1,780 shares - Indirect E. J. McCarthy GPU Common Stock 897 shares - Direct M. P. Morrell GPU Common Stock 1,003 shares - Direct G. E. Persson GPU Common Stock None P. H. Preis GPU Common Stock 1,305 shares - Direct S. C. Van Ness GPU Common Stock None S. B. Wiley GPU Common Stock None All Directors and GPU Common Stock 28,658 shares - Direct Officers as a group 1,780 shares - Indirect (1) The number of shares owned and the nature of such ownership, not being within the knowledge of the Company, have been furnished by each individual. 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) See page for reference to Financial Statement Schedules required by this item. 1. Exhibits: 3-A Restated Certificate of Incorporation of Jersey Central Power & Light Company, as amended to date. 3-B Jersey Central Power & Light Company By-Laws, as amended. 10-A 1990 Stock Plan for Employees of General Public Utilities Corporation and Subsidiaries, incorporated by reference to Exhibit 10-B of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-B Form of Restricted Units Agreement under the 1990 Stock Plan, incorporated by reference to Exhibit 10-C of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-C Incentive Compensation Plan for Officers of GPU System Companies, incorporated by reference to Exhibit 10-E of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 12 Statements Regarding Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends. 23 Consent of Independent Accountants. (b) Reports on Form 8-K: For the month of December 1993, dated December 10, 1993, under Item 5 (Other Events). For the month of February 1994, dated February 16 and February 28, 1994, under Item 5 (Other Events). 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. JERSEY CENTRAL POWER & LIGHT COMPANY Dated: March 10, 1994 BY: /s/ D. Baldassari D. Baldassari, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date /s/ J. R. Leva March 10, 1994 J. R. Leva, Chairman (Principal Executive Officer) and Director /s/ D. Baldassari March 10, 1994 D. Baldassari, President (Principal Operating Officer) and Director /s/ R. C. Arnold March 10, 1994 R. C. Arnold, Director /s/ J. G. Graham March 10, 1994 J. G. Graham, Vice President (Principal Financial Officer) and Director /s/ M. P. Morrell March 10, 1994 M. P. Morrell, Vice President and Director /s/ P. H. Preis March 10, 1994 P. H. Preis, Vice President-Comptroller (Principal Accounting Officer) and Director /s/ G. E. Persson March 10, 1994 G. E. Persson, Director /s/ S. C. Van Ness March 10, 1994 S. C. Van Ness, Director /s/ S. B. Wiley March 10, 1994 S. B. Wiley, Director JERSEY CENTRAL POWER & LIGHT COMPANY INDEX TO SUPPLEMENTARY DATA, FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Supplementary Data Page Company Statistics Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Quarterly Financial Data Financial Statements Report of Independent Accountants Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets as of December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Statement of Capital Stock as of December 31, 1993 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Statement of Long-Term Debt as of December 31, 1993 Notes to Financial Statements Financial Statement Schedules Schedule V - Property, Plant and Equipment for the Years 1991-1993 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years 1991-1993 Schedule VIII - Valuation and Qualifying Accounts for the Years 1991-1993 Schedule IX - Short-Term Borrowings for the Years 1991-1993 Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the Financial Statements or Notes thereto. Jersey Central Power & Light Company Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations In 1993, earnings available for common stock increased $44.8 million to $141.5 million principally due to additional revenues resulting from a February 1993 retail base rate increase and higher customer sales due primarily to the significantly warmer-than-normal summer temperatures as compared with the mild weather in 1992. Also contributing to the increase in earnings was reduced reserve capacity expense. The increase in earnings was partially offset by increased other operation and maintenance expense, the write-off of approximately $9 million of costs related to the cancellation of proposed energy-related agreements, and higher depreciation expense and financing costs associated with additions to utility plant. Financing costs reflect benefits derived from the early redemption of first mortgage bonds and preferred stock. Earnings available for common stock decreased $37.3 million to $96.8 million in 1992 principally due to a reduction in customer sales resulting from the mild summer weather in 1992 as compared with 1991 when the Company's service territory experienced significantly warmer-than-normal temperatures. The earnings comparison also reflects the absence in 1992 of a nonrecurring credit with respect to a change in accounting policy resulting in the recognition of unbilled revenues in 1991 of $27.1 million. Also contributing to the decrease in earnings were increased financing costs and depreciation expense associated with additions to utility plant. These decreases in earnings were partially offset by an increase in revenues from new residential and commercial customers, a slight increase in nonweather- related usage and lower reserve capacity expense. Results for 1991 also include the recognition of certain Three Mile Island Unit 2 (TMI-2) costs. The Company's return on average common equity was 11.1% for 1993 as compared with 8.0% and 11.9% for 1992 and 1991, respectively. REVENUES: Total revenues increased 9.1% to $1.9 billion in 1993 after remaining relatively flat at $1.8 billion in 1992. The components of these changes are as follows: (In Millions) 1993 1992 Kilowatt-hour (KWh) revenues increase (decrease) (excluding energy portion) $ 37.5 $(27.1) Rate increase 108.2 - Energy revenues 13.4 28.6 Other revenues 2.7 (0.6) Increase in revenues $161.8 $ 0.9 Kilowatt-hour revenues KWh revenues increased in 1993 principally due to higher third quarter sales resulting from the significantly warmer-than-normal summer temperatures as compared with the milder weather during the same period in 1992. An increase in nonweather-related usage in the residential and commercial sectors, and a 1.4% increase in the average number of customers also contributed to the increase in kWh revenues. New customer growth occurred primarily in the residential sector, and was partially offset by a reduction in the number of industrial customers. In 1992, kWh revenues decreased primarily due to mild weather during the third quarter of 1992 as compared with warmer-than-normal weather during the same period in 1991. This decrease was partially offset by a 1.0% increase in the average number of customers and a slight increase in nonweather-related usage. New customer growth occurred in the residential and commercial categories. The increase in nonweather-related usage was reflected primarily in the residential and commercial sectors. Rate increase In February 1993, the New Jersey Board of Regulatory Commissioners (NJBRC) authorized a $123 million increase in retail base rates, or approximately 7% annually. Energy revenues Changes in energy revenues do not affect earnings as they reflect corresponding changes in the energy cost rates billed to customers and expensed. Energy revenues increased in 1993 as a result of increased kWh sales to ultimate customers partially offset by decreased sales to other utilities. In 1992, energy revenues increased as a result of the March 1992 increase in the energy cost rates in effect and a significant increase in kWh sales to other utilities. These increases were partially offset by a decrease in kWh sales in all other customer categories. The increase in 1992 reflects a 24% increase in energy revenues associated with electric sales to other utilities. Other revenues Generally, changes in other revenues do not affect earnings as they are offset by corresponding changes in expense, such as taxes other than income taxes. OPERATING EXPENSES: Power purchased and interchanged Generally, changes in the energy component of power purchased and interchanged expense do not significantly affect earnings as they are substantially recovered through the Company's energy clause. Earnings in 1993, however, were favorably impacted by a reduction in reserve capacity expense resulting from the expiration of a purchase contract with another utility and a reduction in purchases from another utility. Power purchased and interchanged also decreased in 1993 due to a decrease in nonutility generation purchases. In 1992, power purchased and interchanged increased due to an increase in nonutility generation purchases offset partially by reductions in energy and capacity purchases from other utilities and a decrease in interchange received. Other operation and maintenance Other operation and maintenance expense increased in 1993 primarily due to emergency and storm-related activities and higher-than-normal tree trimming expense. Other operation and maintenance expense also increased due to the recognition of current and previously deferred demand side management expenses as directed in the Company's rate orders, an increase in the accrual of nuclear outage maintenance costs and an increase in the amortization of previously deferred nuclear expenses. The decrease in 1992 is due to the absence of $6.8 million of estimated costs recognized in 1991 for preparing the TMI-2 plant for long-term monitored storage and $2.5 million of previously deferred cleanup costs. Excluding these amounts, other operation and maintenance expense remained relatively stable. Depreciation and amortization Depreciation and amortization expense increased in 1993 due to additions to utility plant and the recognition of additional amortization expense for deferred assets as a result of the rate case completed in 1993. The 1992 increase was due to additions to utility plant. These additions consist primarily of additions to existing generating facilities to enhance system reliability and additions to the transmission and distribution system related to new customer growth. Taxes, other than income taxes Generally, changes in taxes other than income taxes do not significantly affect earnings as they are substantially recovered in revenues. OTHER INCOME AND DEDUCTIONS: Other income, net The reduction in other income, net in 1993 is principally due to the write-off of approximately $9 million of costs related to the cancellation of proposed energy-related agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). The decrease is also due to the absence of carrying charges on certain tax payments made by the Company in 1992, which are now being recovered through rates. The increase in other income, net in 1992 is mainly attributable to an increase in miscellaneous income related to the anticipated recovery of carrying charges, offset partially by a reduction in interest income resulting from the 1991 collection of federal income tax refunds. INTEREST CHARGES AND PREFERRED DIVIDENDS: Interest on long-term debt increased in 1993 and 1992 primarily due to the issuance of additional long-term debt, offset partially by decreases associated with the refinancing of higher cost debt at lower interest rates. Other interest was favorably affected by lower short-term interest rates and a reduction in the average levels of short-term borrowings outstanding in both years. The decrease in other interest in 1992, however, was mainly the result of a lower federal income tax deficiency accrual level as tax deficiency payments relating to the 1983 and 1984 tax years were made in 1991. Preferred dividends decreased in 1993 primarily due to the redemption of an aggregate $50 million of preferred stock. Preferred dividends increased in 1992 primarily due to the issuance of preferred stock in mid-1992, partially offset by the effect of a redemption in the latter part of 1992. Liquidity and Capital Resources CAPITAL NEEDS: The Company's capital needs were $212 million in 1993, consisting of cash construction expenditures of $197 million and amounts for maturing obligations of $15 million. During 1993, construction funds were primarily used to continue to maintain and improve existing generating facilities and add to the transmission and distribution system. GPU System cash construction expenditures are estimated to be $663 million in 1994, of which the Company's share is $275 million. The expenditures consist mainly of $231 million for ongoing system development and $19 million for clean air requirements. Expenditures for maturing debt are expected to be $60 million for 1994 and $47 million for 1995. In the mid-1990s, construction expenditures may include substantial amounts for clean air requirements, the construction of new generation facilities and other Company needs. Management estimates that approximately one-half of the Company's 1994 capital needs will be satisfied through internally generated funds. The Company and its affiliates' capital leases consist primarily of leases for nuclear fuel. These nuclear fuel leases are renewable annually, subject to certain conditions. An aggregate of up to $250 million ($125 million each for Oyster Creek and Three Mile Island Unit 1) of nuclear fuel costs may be outstanding at any one time. The Company's share of nuclear fuel capital leases at December 31, 1993 totaled $86 million. When consumed, portions of the currently leased material will be replaced by additional leased material at a rate of approximately $36 million annually. In the event this nuclear fuel cannot be leased, the associated capital requirements would have to be met by other means. FINANCING: In 1993, the Company refinanced higher cost long-term debt in the principal amount of $394 million, resulting in an estimated annualized after- tax savings of $4 million. Total long-term debt issued during 1993 amounted to $555 million. In addition, the Company redeemed $50 million of high- dividend preferred stock issues. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock through June 1995. Under existing authorization, the Company may issue senior securities in the amount of $275 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short- term debt, a portion of which may be through the issuance of commercial paper. The Company's cost of capital and ability to obtain external financing is affected by its security ratings, which continue to remain above minimum investment grade. The Company's first mortgage bonds are currently rated at an equivalent of an A- rating by the three major credit rating agencies, while an equivalent of a BBB+ rating is assigned to the preferred stock issues. In addition, the Company's commercial paper is rated as having good to very good credit quality. During 1993, Standard & Poor's revised its financial benchmarking standards for rating the debt of electric utilities to reflect the changing risk profiles resulting primarily from the intensifying competitive pressures in the industry. These guidelines now include an assessment of a company's business risk. Standard & Poor's new rating structure changed the business outlook for the debt ratings of approximately one-third of the industry, including the Company, which moved from "A-stable" to "A-negative," meaning their credit ratings may be lowered. The Company was classified as "below average" in its business risk position due to the perceived credit risk associated with large purchased power requirements, relatively high rates and a sluggish local economy. Moody's announced that it expects to reduce its average credit ratings for the electric utility industry within the next three years to take into account the effects of the new competitive environment. Duff & Phelps also indicated that it intends to introduce a forecast element to its quantitative analysis to, among other things, "alert investors to the possibility of equity value reduction and credit quality deterioration." The Company's bond indenture and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short-term debt the Company can issue. The Company's interest and preferred stock coverage ratios are currently in excess of indenture or charter restrictions. The ability to issue securities in the future will depend on coverages at that time. Current plans call for the Company to issue long- term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. CAPITALIZATION: The Company supports its credit quality rating by maintaining capitalization ratios that permit access to capital markets at a competitive cost. The targets and actual capitalization ratios are as follows: Capitalization Target Range 1993 1992 1991 Common equity 47-50% 47% 47% 47% Preferred stock 7-10 7 9 9 Notes payable and long-term debt 46-40 46 44 44 100% 100% 100% 100% Recent evaluations of the industry by credit rating agencies indicate that the Company may have to increase its equity ratio to maintain its current credit ratings. COMPETITIVE ENVIRONMENT: The Push Toward Competition The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, through the federal Energy Policy Act of 1992 (Energy Act). The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk that could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the Federal Energy Regulatory Commission (FERC), subject to certain criteria, to order owners of electric transmission systems, such as the Company and its affiliates, to provide third parties transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. That authority lies with the individual states, and movement toward opening the transmission network to retail customers is currently under consideration in several states. Recent Events Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, Penelec successfully negotiated power supply agreements with the Company's wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of the Company. The Company will continue its efforts to retain and add customers by offering competitive rates. The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. In December 1993, the Company filed a proposal with the NJBRC seeking approval to implement a new rate initiative designed to retain and expand the economic base in New Jersey. Under the proposed contract rate service, large retail customers could enter into contracts for existing electric service at prevailing rates, with limitations on their exposure to future rate increases. With this rate initiative, the Company will have to absorb any differential in price resulting from changes in costs not provided for in the contracts. This matter is pending before the NJBRC. Proposed legislation has been introduced in New Jersey that is intended to allow the NJBRC, at the request of an electric or gas utility, to adopt a plan of regulation other than traditional ratemaking methods to encourage economic development and job creation. This flexible ratemaking would allow electric utilities to be more competitive with nonutility generators, who are not subject to NJBRC regulation. Combined with other economic development initiatives, this legislation, if enacted, would provide more flexibility in responding to competitive pressures, but may also serve to accelerate the growth of competitive pressures. Financial Exposure In the transition from a regulated to competitive environment, there can be a significant change in the economic value of a utility's assets. Traditional utility regulation provides an opportunity for recovery of the cost of plant assets, along with a return on investment, through ratemaking. In a competitive market, the value of an asset may be determined by the market price of the services derived from that asset. If the cost of operating existing assets results in above-market prices, a utility may be unable to recover all of its costs, resulting in "stranded assets" and other unrecoverable costs. This may result in write-downs to remove stranded assets from a utility's balance sheet in recognition of their reduced economic value and the recognition of other losses. Unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets," which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including New Jersey) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets, that if not supported by regulators, would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation," applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may be applied only to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Positioning the GPU System The typical electric utility today is vertically integrated, operating its plant assets to serve all customers within a franchised service territory. In the future, franchised service territories may be replaced by markets whose boundaries are defined by price, available capacity and transmission access. This may result in changes to the organizational structure of utilities and an emphasis on certain segments of the business among generation, transmission and distribution. In order to achieve a strong competitive position in a less regulated future, the GPU System has in place a strategic planning process. In the initial phases of the program, task forces are defining the principal challenges facing the GPU System, exploring opportunities and risks, and defining and evaluating strategic alternatives. Management is now analyzing issues associated with various competitive and regulatory scenarios to determine how best to position the GPU System for a competitive environment. An initial outcome of the GPU System ongoing strategic planning process was a realignment proposed in February 1994, of certain system operations. Subject to necessary regulatory approval, a new subsidiary, GPU Generation Corporation, will be formed to operate and maintain the GPU System's fossil-fueled and hydroelectric generating stations, which are now owned and operated by the Company and its affiliates. It is also intended to combine the remaining Met-Ed and Penelec operations without merging the two companies. The GPU System is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. MEETING ENERGY DEMANDS: In response to the increasingly competitive business climate and excess capacity of nearby utilities, the GPU System's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short- term to intermediate-term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. The Company is expected to experience an average growth rate in sales to customers (exclusive of the loss of its wholesale customers) through 1998 of about 1.6% annually. The Company also expects to experience peak load growth although at a somewhat lesser rate. Through 1998, the Company's plan consists of the continued utilization of existing generating facilities combined with present commitments for power purchases and new power purchases (of short-term or intermediate-term duration), the construction of a new facility, and the utilization of capacity of its affiliates. The plan also includes the continued promotion of economical energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The Company will resist efforts to compel it to add new capacity at costs that may exceed future market prices. In addition, the Company will seek regulatory support to renegotiate or buy out contracts with nonutility generators where the pricing is in excess of projected avoided costs. New Energy Supplies The Company's supply plan includes the addition of 533 MW of currently contracted capacity by 1998 from nonutility generation suppliers, and reflects the construction of a new peaking unit. The Company currently has uncommitted capacity needs by 1998 of approximately 500 MW, which represents essentially all the uncommitted needs of the GPU System. These capacity needs may be filled by a combination of utility and nonutility purchases (of short-term or intermediate-term duration) as well as company-owned facilities. Additions are principally to replace expiring purchase arrangements rather than to serve new customer load. In July 1993, an NJBRC Advisory Council recommended in a report that all New Jersey electric utilities be required to submit integrated resource plans for review and approval by the NJBRC. The NJBRC has asked all electric utilities in the state to assess the economics of their purchase power contracts with nonutility generators to determine whether there are any candidates for potential buy-out or other remedial measures. The Company identified a 100-MW project now under development, which it believes is economically undesirable based on current cost projections. In November 1993, the NJBRC directed the Company and the developer to negotiate contract repricing to a level more consistent with the Company's current avoided cost projections or a contract buy-out. The developer has filed a federal court action contesting the NJBRC's jurisdiction in this matter. In November 1993, the NJBRC granted two nonutility generators, having a total of 200 MW under contract with the Company, a one-year extension in the in-service date for projects originally scheduled to be operational in 1997. The Company is awaiting a final written NJBRC order. Also in November 1993, the Company received approval from the NJBRC to withdraw the Company's request for proposals for the purchase of 150 MW from nonutility generators. In its petition, the Company cited, among other reasons, that solicitations for long-term contracts would have limited its ability to compete in a deregulated environment. The Company has entered into an arrangement for a peaking generation project whereby it plans to install a gas-fired combustion turbine at its Gilbert Generating station and retire two steam units for an 88-MW net increase in capacity at an expected cost of $50 million. The Company expects to complete the project by 1996. In December 1993, the NJBRC denied the Company's petition to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. The capital costs of the GPU System's share of these transactions would have totaled approximately $500 million, of which the Company's share would have been $215 million. In January 1994, the Company issued an all source solicitation for the short-term supply of energy and/or capacity to determine and evaluate the availability of competitively priced power supply options. The Company is seeking proposals from utility and nonutility generation suppliers, for periods of one to eight years in length, that are capable of delivering electric power beginning in 1996. This solicitation is expected to fulfill a significant part of the uncommitted sources identified in the Company's supply plan. Conservation and Load Management The regulatory environment in New Jersey encourages the development of new conservation and load management programs. This is evidenced by demand- side management (DSM) incentive regulations adopted in New Jersey in 1992. DSM includes utility-sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). The NJBRC approved the Company's DSM plan in 1992 reflecting DSM initiatives of 67 MW of summer peak reduction by the end of 1994. Under the approved regulation, qualified Performance Program DSM investments are recovered over a six-year period with a return earned on the unrecovered amounts. Lost revenues will be recovered on an annual basis, and the Company can also earn a performance-based incentive for successfully implementing cost-effective programs. In addition, the Company will continue to make certain NJBRC-mandated Core Program DSM investments, which are recovered annually. ENVIRONMENTAL ISSUES: The Company is committed to complying with all applicable environmental regulations in a responsible manner. Compliance with the federal Clean Air Act Amendments of 1990 (Clean Air Act) and other environmental needs will present a major challenge to the Company through the late 1990s. The Clean Air Act will require substantial reductions in sulfur dioxide and nitrogen oxide emissions by the year 2000. The Company's current plan includes installing and operating emission control equipment at the Keystone station in which the Company has a 16.67% ownership interest. To comply with the Clean Air Act, the Company expects to expend up to $145 million by the year 2000 for air pollution control equipment. The GPU System reviews its plans and alternatives to comply with the Clean Air Act on a least-cost basis taking into account advances in technology and the emission allowance market, and assesses the risk of recovering capital investments in a competitive environment. The GPU System may be able to defer substantial capital investments while attaining the required level of compliance if an alternative such as increased participation in the emission allowance market is determined to result in the least-cost plan. This and other compliance alternatives may result in the substitution of increased operating expenses for capital costs. At this time, costs associated with the capital invested in this pollution control equipment and the increased operating costs of the affected station are expected to be recoverable through the ratemaking process, but management recognizes that recovery is not assured. For more information, see the Environmental Matters section of Note 1 to the Financial Statements. LEGAL MATTERS - TMI-2 ACCIDENT CLAIMS: As a result of the TMI-2 accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against the Company and its affiliates and GPU and are still pending. For more information, see Note 1 to the Financial Statements. EFFECTS OF INFLATION: The Company is affected by inflation since the regulatory process results in a time lag during which increased operating expenses are not fully recovered in rates. Inflation may have an even greater effect in a period of increasing competition and deregulation as the Company and the utility industry attempt to keep rates competitive. Inflation also affects the Company in the form of higher replacement costs of utility plant. In the past, the Company anticipated the recovery of these cost increases through the ratemaking process. However, as competition and deregulation accelerate throughout the industry, there can be no assurance of the recovery of these increased costs. The Company is committed to long-term cost control and is continuing to seek measures to reduce or limit the growth in operating expenses. The prudent expenditure of capital and debt refinancing programs have kept down increases in capital costs and debt levels. ACCOUNTING ISSUES: In May 1993, the Financial Accounting Standards Board issued FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," which is effective for fiscal years beginning after December 15, 1993. FAS 115 requires the recording of unrealized gains and losses with a corresponding offsetting entry to earnings or shareholder's equity. The impact on the Company's financial position is expected to be immaterial, and there will be no impact on the results of operations. FAS 115 will be implemented in 1994. REPORT OF INDEPENDENT ACCOUNTANTS To The Board of Directors Jersey Central Power & Light Company Morristown, New Jersey We have audited the financial statements and financial statement schedules of Jersey Central Power & Light Company 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 Jersey Central Power & Light Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. 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 more fully discussed in Note 1 to financial statements, the Company is unable to determine the ultimate consequences of the contingency which has resulted from the accident at Unit 2 of the Three Mile Island Nuclear Generating Station. The matter which remains uncertain is the excess, if any, of amounts which might be paid in connection with claims for damages resulting from the accident over available insurance proceeds. As discussed in Notes 5 and 7 to the financial statements, the Company was required to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", and the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. Also, as discussed in Note 2 to the financial statements, the Company changed its method of accounting for unbilled revenues in 1991. Parsippany, New Jersey COOPERS & LYBRAND February 2, 1994 Jersey Central Power & Light Company STATEMENTS OF INCOME (In Thousands) For the Years Ended December 31, 1993 1992 1991 Operating Revenues $1 935 909 $1 774 071 $1 773 219 Operating Expenses: Fuel 98 683 84 851 100 758 Power purchased and interchanged: Affiliates 23 681 24 281 30 040 Others 578 131 616 418 576 217 Deferral of energy and capacity costs, net 28 726 4 232 (27) Other operation and maintenance 460 128 424 285 433 562 Depreciation and amortization 182 945 167 022 159 747 Taxes, other than income taxes 228 690 215 507 219 611 Total operating expenses 1 600 984 1 536 596 1 519 908 Operating Income Before Income Taxes 334 925 237 475 253 311 Income taxes 77 995 43 621 50 779 Operating Income 256 930 193 854 202 532 Other Income and Deductions: Allowance for other funds used during construction 2 471 4 015 3 136 Other income, net 6 281 21 519 20 664 Income taxes (2 847) (8 268) (8 459) Total other income and deductions 5 905 17 266 15 341 Income Before Interest Charges 262 835 211 120 217 873 Interest Charges: Interest on long-term debt 100 246 92 942 85 420 Other interest 6 530 4 873 11 540 Allowance for borrowed funds used during construction (2 285) (4 056) (5 547) Total interest charges 104 491 93 759 91 413 Income Before Cumulative Effect of Accounting Change 158 344 117 361 126 460 Cumulative effect as of January 1, 1991 of accounting change for unbilled revenues, net of income taxes of $13,942 - - 27 063 Net Income 158 344 117 361 153 523 Preferred stock dividends 16 810 20 604 19 440 Earnings Available for Common Stock $ 141 534 $ 96 757 $ 134 083 The accompanying notes are an integral part of the financial statements. Jersey Central Power & Light Company BALANCE SHEETS (In Thousands) December 31, 1993 1992 ASSETS Utility Plant: In service, at original cost $3 938 700 $3 692 318 Less, accumulated depreciation 1 380 540 1 262 562 Net utility plant in service 2 558 160 2 429 756 Construction work in progress 102 178 178 902 Other, net 116 751 130 307 Net utility plant 2 777 089 2 738 965 Current Assets: Cash and temporary cash investments 17 301 140 Special deposits 7 124 8 190 Accounts receivable: Customers, net 133 407 117 755 Other 31 912 26 401 Unbilled revenues 57 943 53 588 Materials and supplies, at average cost or less: Construction and maintenance 102 659 101 187 Fuel 11 886 23 576 Deferred income taxes 28 650 57 327 Prepayments 58 057 29 727 Total current assets 448 939 417 891 Deferred Debits and Other Assets: Three Mile Island Unit 2 deferred costs 146 284 153 912 Unamortized property losses 109 478 108 825 Deferred income taxes 110 794 59 599 Income taxes recoverable through future rates 121 509 - Decommissioning funds 139 279 114 650 Special deposits 82 103 76 807 Other 333 680 216 255 Total deferred debits and other assets 1 043 127 730 048 Total Assets $4 269 155 $3 886 904 The accompanying notes are an integral part of the financial statements. Jersey Central Power & Light Company BALANCE SHEETS (In Thousands) December 31, 1993 1992 LIABILITIES AND CAPITAL Capitalization: Common stock $ 153 713 $ 153 713 Capital surplus 435 715 435 715 Retained earnings 724 194 644 899 Total common stockholder's equity 1 313 622 1 234 327 Cumulative preferred stock: With mandatory redemption 150 000 150 000 Without mandatory redemption 37 741 87 877 Long-term debt 1 215 674 1 116 930 Total capitalization 2 717 037 2 589 134 Current Liabilities: Debt due within one year 60 008 14 485 Notes payable - 5 700 Obligations under capital leases 89 631 107 331 Accounts payable: Affiliates 34 538 54 618 Other 95 509 99 666 Taxes accrued 119 337 127 406 Deferred energy credits 23 633 1 257 Interest accrued 33 804 33 294 Other 50 950 53 967 Total current liabilities 507 410 497 724 Deferred Credits and Other Liabilities: Deferred income taxes 569 966 425 157 Unamortized investment tax credits 79 902 86 021 Three Mile Island Unit 2 future costs 79 967 80 000 Other 314 873 208 868 Total deferred credits and other liabilities 1 044 708 800 046 Commitments and Contingencies (Note 1) Total Liabilities and Capital $4 269 155 $3 886 904 The accompanying notes are an integral part of the financial statements. NOTES TO FINANCIAL STATEMENTS Jersey Central Power & Light Company (the Company), which was incorporated under the laws of New Jersey in 1925, is a wholly owned subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935. The Company is affiliated with Metropolitan Edison Company (Met-Ed) and Pennsylvania Electric Company (Penelec). The Company, Met-Ed and Penelec are referred to herein as the "Company and its affiliates." The Company is also associated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns and operates nonutility generating facilities. All of the Company's affiliates are wholly owned subsidiaries of GPU. The Company and its affiliates, GPUSC, GPUN and GPC are referred to as the "GPU System." 1. COMMITMENTS AND CONTINGENCIES NUCLEAR FACILITIES The Company has made investments in three major nuclear projects -- Three Mile Island Unit 1 (TMI-1) and Oyster Creek, both of which are operational generating facilities, and Three Mile Island Unit 2 (TMI-2), which was damaged during a 1979 accident. At December 31, 1993, the Company's net investment in TMI-1 and Oyster Creek, including nuclear fuel, was $173 million and $784 million, respectively. TMI-1 and TMI-2 are jointly owned by the Company, Met-Ed and Penelec in the percentages of 25%, 50% and 25%, respectively. Oyster Creek is owned by the Company. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. TMI-2: The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990. After receiving Nuclear Regulatory Commission (NRC) approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U. S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 31, 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the Company. In June 1993, the Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price- Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable Federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. As described in the Nuclear Fuel Disposal Fee section of Note 2, the disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for Oyster Creek and TMI-1 by the end of the plants' license terms, 2009 and 2014, respectively. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long-term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million, and for Oyster Creek is $175 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share is $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed site-specific studies of TMI-1 and Oyster Creek that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of each plant to range from approximately $205 to $285 million, of which the Company's share is $51 to $71 million, and $220 to $320 million, respectively (adjusted to 1993 dollars). In addition, the studies estimated the cost of removal of nonradiological structures and materials for TMI-1 and Oyster Creek at $72 million, of which the Company's share is $18 million, and $47 million, respectively. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company charges to expense and contributes to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, in 1990 the Company contributed to an external trust an amount not recoverable from customers for nuclear plant decommissioning. TMI-1 and Oyster Creek: The Company is collecting revenues for decommissioning, which are expected to result in the accumulation of its share of the NRC funding target for each plant. The Company is also collecting revenues for the cost of removal of nonradiological structures and materials at each plant based on its share ($3.83 million) of an estimated $15.3 million for TMI-1 and $31.6 million for Oyster Creek. Collections from customers for decommissioning expenditures are deposited in external trusts and are classified as Decommissioning Funds on the balance sheet, which includes the interest earned on these funds. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $13 million for TMI-1 and $80 million for Oyster Creek at December 31, 1993. Management believes that any TMI-1 and Oyster Creek retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2: The Company and its affiliates have recorded a liability, amounting to $229 million, of which the Company's share is $57 million as of December 31, 1993, for the radiological decommissioning of TMI-2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company and its affiliates record escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company and its affiliates have also recorded a liability in the amount of $20 million, of which the Company's share is $5 million, for incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company and its affiliates have recorded a liability in the amount of $71 million, of which the Company's share is $18 million, for nonradiological cost of removal. The Company's share of the above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $15 million to an external decommissioning trust. The New Jersey Board of Regulatory Commissioners (NJBRC) has granted the Company decommissioning revenues for the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. Upon TMI-2's entering long-term monitored storage, the Company and its affiliates will incur currently estimated incremental annual storage costs of $1 million, of which the Company's share is $.25 million. The Company and its affiliates have deferred the $20 million, of which the Company's share is $5 million, for the total estimated incremental costs attributable to monitored storage. The Company's share of these costs has been recognized in rates by the NJBRC. INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) and for Oyster Creek totals $2.7 billion per site. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used to stabilize the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that, in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's three reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at $1.8 million for Oyster Creek and $2.6 million for TMI-1, per week. Under their insurance policies applicable to nuclear operations and facilities, the Company and its affiliates are subject to retrospective premium assessments of up to $52 million in any one year, of which the Company's share is $31 million, in addition to those payable under the Price-Anderson Act. ENVIRONMENTAL MATTERS As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including, but not limited to, acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the cost of which could be material. Management intends to seek recovery through the ratemaking process for any additional costs, but recognizes that recovery cannot be assured. To comply with the federal Clean Air Act Amendments of 1990, the Company and its affiliates expect to expend up to $590 million for air pollution control equipment by the year 2000, of which the Company's share is approximately $145 million. Costs associated with the capital invested in this equipment and the increased operating costs of the Company's affected station should be recoverable through the ratemaking process. The Company has been notified by the Environmental Protection Agency (EPA) and a state environmental authority that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at six hazardous and/or toxic waste sites. In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which it has not yet been named as a PRP. The ultimate cost of remediation will depend upon changing circumstances as site investigations continue, including (a) the existing technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company has entered into agreements with the New Jersey Department of Environmental Protection and Energy for the investigation and remediation of 17 formerly owned manufactured gas plant sites. One of these sites has been repurchased by the Company. The Company has also entered into various cost sharing agreements with other utilities for some of the sites. At December 31, 1993, the Company has an estimated environmental liability of $35 million recorded on its balance sheet relating to these sites. The estimated liability is based upon ongoing site investigations and remediation efforts, including capping the sites and pumping and treatment of ground water. If the periods over which the remediation is currently expected to be performed are lengthened, the Company believes that it is reasonably possible that the ultimate costs may range as high as $60 million. Estimates of these costs are subject to significant uncertainties as the Company does not presently own or control most of these sites; the environmental standards have changed in the past and are subject to future change; the accepted technologies are subject to further development; and the related costs for these technologies are uncertain. If the Company is required to utilize different remediation methods, the costs could be materially in excess of $60 million. In June 1993, the NJBRC approved a mechanism for the recovery of future manufactured gas plant remediation costs through the Company's Levelized Energy Adjustment Clause (LEAC) when expenditures exceed prior collections. The NJBRC decision provides for interest to be credited to customers until the overrecovery is eliminated and for future costs to be amortized over seven years with interest. At December 31, 1993, the Company has collected from customers $5.2 million in excess of expenditures of $12.8 million. The Company is currently awaiting a final NJBRC order. The Company is pursuing reimbursement of the above costs from its insurance carriers, and will seek to recover costs to the extent not covered by insurance through this mechanism. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Also unknown are the consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant. Management believes the costs described above should be recoverable through the ratemaking process. OTHER COMMITMENTS AND CONTINGENCIES The NJBRC has instituted a generic proceeding to address the appropriate recovery of capacity costs associated with electric utility power purchases from nonutility generation projects. The proceeding was initiated, in part, to respond to contentions of the New Jersey Public Advocate, Division of Rate Counsel (Rate Counsel), that by permitting utilities to recover such costs through the LEAC, an excess or "double recovery" may result when combined with the recovery of the utilities' embedded capacity costs through their base rates. In September 1993, the Company and the other New Jersey electric utilities filed motions for summary judgment with the NJBRC requesting that the NJBRC dismiss contentions being made by Rate Counsel that adjustments for alleged "double recovery" in prior periods are warranted. Rate Counsel has filed a brief in opposition to the utilities' summary judgment motions including a statement from its consultant that in his view, the "double recovery" for the Company for the 1988-92 period would be approximately $102 million. Management believes that the position of Rate Counsel is without merit. This matter is pending before the NJBRC. The Company's two operating nuclear units are subject to the NJBRC's annual nuclear performance standard. Operation of these units at an aggregate annual generating capacity factor below 65% or above 75% would trigger a charge or credit based on replacement energy costs. At current cost levels, the maximum annual effect on net income of the performance standard charge at a 40% capacity factor would be approximately $10 million. While a capacity factor below 40% would generate no specific monetary charge, it would require the issue to be brought before the NJBRC for review. The annual measurement period, which begins in March of each year, coincides with that used for the LEAC. In December 1993, the NJBRC denied the Company's request to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company and its affiliates wrote off the $25 million, of which the Company's share was $9 million, they had invested in the project. The Company's construction programs, for which substantial commitments have been incurred and which extend over several years, contemplate expenditures of $275 million during 1994. As a consequence of reliability, licensing, environmental and other requirements, substantial additions to utility plant may be required relatively late in their expected service lives. If such additions are made, current depreciation allowance methodology may not make adequate provision for the recovery of such investments during their remaining lives. Management intends to seek recovery of any such costs through the ratemaking process, but recognizes that recovery is not assured. As a result of the Energy Policy Act of 1992 (Energy Act) and actions of regulatory commissions, the electric utility industry appears to be moving toward a combination of competition and a modified regulatory environment. In accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (FAS 71), the Company's financial statements reflect assets and costs based on current cost- based ratemaking regulations. Continued accounting under FAS 71 requires that the following criteria be met: a) A utility's rates for regulated services provided to its customers are established by, or are subject to approval by, an independent third-party regulator; b) The regulated rates are designed to recover specific costs of providing the regulated services or products; and c) In view of the demand for the regulated services and the level of competition, direct and indirect, it is reasonable to assume that rates set at levels that will recover a utility's costs can be charged to and collected from customers. This criteria requires consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. A utility's operations can cease to meet those criteria for various reasons, including deregulation, a change in the method of regulation, or a change in the competitive environment for the utility's regulated services. Regardless of the reason, a utility whose operations cease to meet those criteria should discontinue application of FAS 71 and report that discontinuation by eliminating from its balance sheet the effects of certain actions of regulators that had been recognized as assets and liabilities pursuant to FAS 71 but which would not have been recognized as assets and liabilities by enterprises in general. If a portion of the Company's operations continues to be regulated and meets the above criteria, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. The Company has entered into a long-term contract with a nonaffiliated mining company for the purchase of coal for the Keystone generating station of which the Company owns a one-sixth undivided interest. This contract, which expires in 2004, requires the purchase of minimum amounts of the station's coal requirements. The price of the coal is determined by a formula providing for the recovery by the mining company of its costs of production. The Company's share of the cost of coal purchased under this agreement is expected to aggregate $21 million for 1994. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2130 MW in 1994, declining to 1307 MW by 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. The Company has also entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. While a few of these facilities are dispatchable, most are must-run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the NJBRC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 1,194 MW of capacity and energy to the Company by the mid-to- late 1990s. As of December 31, 1993, facilities covered by these agreements having 661 MW of capacity were in service, and 215 MW were scheduled to commence operation in 1994. Payments made pursuant to these agreements were $292 million, $316 million and $216 million for 1993, 1992 and 1991, respectively, and are estimated to aggregate $325 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are substantially in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the NJBRC, there can be no assurance that the Company will continue to be able to recover these costs throughout the terms of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the GPU System's energy supply needs which, in turn, has caused the Company and its affiliates to change their supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company and its affiliates are attempting to renegotiate, and in some cases buy out, high cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company and its affiliates may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the NJBRC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. During the normal course of the operation of its business, in addition to the matters described above, the Company is from time to time involved in disputes, claims and, in some cases, as a defendant in litigation in which compensatory and punitive damages are sought by customers, contractors, vendors and other suppliers of equipment and services and by both current and former employees alleging unlawful employment practices. It is not expected that the outcome of these matters will have a material effect on the Company's financial position or results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The Company's accounting records are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission and adopted by the NJBRC. Certain reclassifications of prior years' data have been made to conform with current presentation. REVENUES The Company recognizes electric operating revenues for services rendered and, beginning in 1991, an estimate of unbilled revenues to record services provided to the end of the respective accounting period. DEFERRED ENERGY COSTS Energy costs are recognized in the period in which the related energy clause revenues are billed. UTILITY PLANT It is the policy of the Company to record additions to utility plant (material, labor, overhead and an allowance for funds used during construction) at cost. The cost of current repairs and minor replacements is charged to appropriate operating and maintenance expense and clearing accounts, and the cost of renewals is capitalized. The original cost of utility plant retired or otherwise disposed of is charged to accumulated depreciation. DEPRECIATION The Company provides for depreciation at annual rates determined and revised periodically, on the basis of studies, to be sufficient to depreciate the original cost of depreciable property over estimated remaining service lives, which are generally longer than those employed for tax purposes. The Company used depreciation rates that, on an aggregate composite basis, resulted in annual rates of 3.59%, 3.51% and 3.51% for the years 1993, 1992 and 1991, respectively. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) The Uniform System of Accounts defines AFUDC as "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used." AFUDC is recorded as a charge to construction work in progress, and the equivalent credits are to interest charges for the pretax cost of borrowed funds and to other income for the allowance for other funds. While AFUDC results in an increase in utility plant and represents current earnings, it is realized in cash through depreciation or amortization allowances only when the related plant is recognized in rates. On an aggregate composite basis, the annual rates utilized were 7.80%, 8.19% and 8.64% for the years 1993, 1992 and 1991, respectively. AMORTIZATION POLICIES Accounting for TMI-2 and Forked River Investments: The Company is collecting annual revenues for the amortization of TMI-2 of $9.6 million. This level of revenue will be sufficient to recover the remaining investment by the year 2008. At December 31, 1993, $97 million is included in Unamortized property losses on the balance sheet for the Forked River project. The Company is collecting annual revenues for the amortization of this project of $11.2 million, which will be sufficient to recover its remaining investment by the year 2006. Because the Company has not been provided revenues for a return on the unamortized balances of its share of the damaged TMI-2 facility and the cancelled Forked River project, these investments are being carried at their discounted present values. The related annual accretion, which represents the carrying charges that are accrued as the asset is written up from its discounted value, is recorded in Other income, net. Nuclear Fuel: Nuclear fuel is amortized on a unit of production basis. Rates are determined and periodically revised to amortize the cost over the useful life. The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the federal government. The total liability at December 31, 1993 amounted to $29 million, and is primarily reflected in Deferred Credits and Other Liabilities - Other. Utilities with nuclear plants will contribute a total of $150 million annually, based on an assessment computed on prior enrichment purchases, over a 15-year period up to a total of $2.3 billion (in 1993 dollars). The Company made its initial payment to this fund in 1993. The Company has recorded an asset for remaining amounts recoverable from ratepayers of $28 million at December 31, 1993 in Deferred Debits and Other Assets - Other. NUCLEAR OUTAGE MAINTENANCE COSTS The Company accrues incremental nuclear outage maintenance costs anticipated to be incurred during scheduled nuclear plant refueling outages. NUCLEAR FUEL DISPOSAL FEE The Company is providing for estimated future disposal costs for spent nuclear fuel at Oyster Creek and TMI-1 in accordance with the Nuclear Waste Policy Act of 1982. The Company entered into contracts in 1983 with the DOE for the disposal of spent nuclear fuel. The total liability under these contracts, including interest, at December 31, 1993, all of which relates to spent nuclear fuel from nuclear generation through April 1983, amounted to $110 million, and is reflected in Deferred Credits and Other Liabilities - Other. As the actual liability is substantially in excess of the amount recovered to date from ratepayers, the Company has reflected such excess of $25 million at December 31, 1993 in Deferred Debits and Other Assets - Other. The rates currently charged to customers provide for the collection of these costs, plus interest, over a remaining period of 13 years. The Company is collecting 1 mill per kilowatt-hour from its customers for spent nuclear fuel disposal costs resulting from nuclear generation subsequent to April 1983. These amounts are remitted quarterly to the DOE. INCOME TAXES The GPU System files a consolidated federal income tax return, and all participants are jointly and severally liable for the full amount of any tax, including penalties and interest, that may be assessed against the group. Each subsidiary is allocated the tax reduction attributable to GPU expenses, in proportion to the average common stock equity investment of GPU in such subsidiary, during the year. In addition, each subsidiary will receive in current cash payments the benefit of its own net operating loss carrybacks to the extent that the other subsidiaries can utilize such net operating loss carrybacks to offset the tax liability they would otherwise have on a separate return basis (after taking into account any investment tax credits they could utilize on a separate return basis). This method of allocation does not allow any subsidiary to pay more than its separate return liability. Deferred income taxes, which result primarily from New Jersey unit tax, liberalized depreciation methods, deferred energy costs, discounted Forked River and TMI-2 investments, and unbilled revenues, are provided for differences between book and taxable income. Investment tax credits (ITC) are amortized over the estimated service lives of the related facilities. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes," which requires the use of the liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. STATEMENTS OF CASH FLOWS For the purpose of the statements of cash flows, temporary investments include all unrestricted liquid assets, such as cash deposits and debt securities, with maturities generally of three months or less. 3. SHORT-TERM BORROWING ARRANGEMENTS At December 31, 1993, the Company had no short-term notes outstanding issued under bank lines of credit (credit facilities). GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement, which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. 4. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's financial instruments, as of December 31, 1993 and 1992, are as follows: (In Millions) Carrying Fair Amount Value December 31, 1993: Cumulative preferred stock with mandatory redemption $ 150 $ 161 Long-term debt 1 216 1 276 December 31, 1992: Cumulative preferred stock with mandatory redemption 150 148 Long-term debt 1 117 1 158 The fair values of the Company's cumulative preferred stock with mandatory redemption provisions and long-term debt are estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for instruments of the same remaining maturities. 5. INCOME TAXES Effective January 1, 1993, the Company implemented FAS 109 "Accounting for Income Taxes". In 1993, the cumulative effect on net income of this accounting change was immaterial. Also in 1993, the federal income tax rate changed from 34% to 35%, retroactive to January 1, 1993, resulting in an increase in the deferred tax assets of $5 million and an increase in the deferred tax liabilities of $20 million. The tax rate change did not have a material effect on net income as the changes in deferred taxes were substantially offset by the recording of regulatory assets and liabilities. The balance sheet effect as of December 31, 1993 of implementing FAS 109 resulted in a regulatory asset for income taxes recoverable through future rates of $122 million (related to liberalized depreciation), and a regulatory liability for income taxes refundable through future rates of $43 million (related to unamortized ITC), substantially due to the recognition of amounts not previously recorded. A summary of the components of deferred taxes as of December 31, 1993 follows: (In Millions) Deferred Tax Assets Deferred Tax Liabilities Current: Noncurrent: New Jersey unit tax $ 12 Liberalized Unbilled revenue 9 depreciation: Deferred energy 8 previously flowed Total $ 29 through $80 future revenue requirements 42 $122 Noncurrent: Unamortized ITC $ 43 Decommissioning 19 Liberalized Contribution in aid depreciation 364 of construction 17 Forked River 30 Other 32 Other 54 Total $111 Total $570 The reconciliations from net income to book income subject to tax and from the federal statutory rate to combined federal and state effective tax rates are as follows: (In Millions) 1993 1992 1991 Net income $158 $117 $153 Income tax expense 81 52 73 Book income subject to tax $239 $169 $226 Federal statutory rate 35% 34% 34% Effect of difference between tax and book depreciation for which deferred taxes were not provided 2 2 2 Amortization of ITC (3) (4) (3) Other - (1) (1) Effective income tax rate 34% 31% 32% Federal and state income tax expense is comprised of the following: (In Millions) 1993 1992 1991 Provisions for taxes currently payable $42 $37 $56 Deferred income taxes: Liberalized depreciation 19 24 23 Gain/loss on reacquired debt 9 4 - Deferral of energy costs (8) - 2 Abandonment loss - Forked River (4) (4) (4) Nuclear outage maintenance costs - (3) 5 Accretion income 6 6 7 Unbilled revenues 5 (2) 8 Information system costs capitalized - 6 - New Jersey unit tax 32 3 (7) Other (14) (12) (10) Deferred income taxes, net 45 22 24 Amortization of ITC (6) (7) (7) Income tax expense $81 $52 $73 The Internal Revenue Service (IRS) has completed its examinations of the GPU System's federal income tax returns through 1986. The GPU System and the IRS have reached an agreement to settle the GPU System's claim that TMI-2 has been retired for tax purposes. When approved by the Joint Congressional Committee on Taxation, this settlement will provide refunds for previously paid taxes. The GPU System estimates that the Company and its affiliates would receive net refunds totaling $17 million, of which the Company's share is approximately $4 million, which would be credited to the Company's customers. The Company and its affiliates would also be entitled to receive net interest estimated to total $45 million (before income taxes), of which the Company's share is approximately $11 million, through December 31, 1993, which the Company would credit to income. The years 1987, 1988 and 1989 are currently under audit. 6. SUPPLEMENTARY INCOME STATEMENT INFORMATION Maintenance expense and other taxes charged to operating expenses consisted of the following: (In Millions) 1993 1992 1991 Maintenance $135 $125 $117 Other taxes: New Jersey unit tax $202 $197 $201 Real estate and personal property 6 7 7 Other 21 12 12 Total $229 $216 $220 For the years 1993, 1992 and 1991, the cost to the Company of services rendered to it by GPUSC amounted to approximately $39 million, $37 million and $36 million, respectively, of which approximately $29 million, $28 million and $27 million, respectively, was charged to income. For the years 1993, 1992 and 1991, the cost to the Company of services rendered to it by GPUN amounted to approximately $227 million, $247 million and $274 million, respectively, of which approximately $184 million, $170 million and $181 million, respectively, was charged to income. For the years 1993, 1992 and 1991, the Company purchased $23 million, $22 million and $21 million, respectively, in energy from a cogeneration project in which an affiliate has a 50 percent partnership interest. 7. EMPLOYMENT BENEFITS Pension Plans: The Company maintains defined benefit pension plans covering substantially all employees. The Company's policy is to currently fund net pension costs within the deduction limits permitted by the Internal Revenue Code. A summary of the components of net periodic pension cost follows: (In Millions) 1993 1992 1991 Service cost-benefits earned during the period $ 8.7 $ 8.1 $ 8.1 Interest cost on projected benefit obligation 29.4 27.6 25.7 Expected return on plan assets (32.1) (29.1) (27.9) Amortization (.4) (.6) (.6) Net periodic pension cost $ 5.6 $ 6.0 $ 5.3 The actual returns on the plans' assets for the years 1993, 1992 and 1991 were gains of $48.0 million, $17.5 million and $62.7 million, respectively. The funded status of the plans and related assumptions at December 31, 1993 and 1992 were as follows: (In Millions) 1993 1992 Accumulated benefit obligation (ABO): Vested benefits $ 310.7 $ 260.3 Nonvested benefits 36.2 28.2 Total ABO 346.9 288.5 Effect of future compensation levels 61.8 65.1 Projected benefit obligation (PBO) $ 408.7 $ 353.6 PBO $(408.7) $(353.6) Plan assets at fair value 425.2 384.6 PBO less than plan assets 16.5 31.0 Unrecognized net gain (10.1) (28.6) Unrecognized prior service cost 4.0 4.1 Unrecognized net transition asset (4.3) (4.8) Prepaid pension costs $ 6.1 $ 1.7 Principal actuarial assumptions(%): Annual long-term rate of return on plan assets 8.5 8.5 Discount rate 7.5 8.5 Annual increase in compensation levels 5.0 6.0 Changes in assumptions in 1993 primarily due to reducing the discount rate assumption from 8.5% to 7.5% resulted in a $36 million change in the PBO as of December 31, 1993. The assets of the plans are held in a Master Trust and generally invested in common stocks, fixed income securities and real estate equity investments. The unrecognized net gain represents actual experience different from that assumed, which is deferred and not included in the determination of pension cost until it exceeds certain levels. The unrecognized prior service cost resulting from retroactive changes in benefits is being amortized as a charge to pension cost, while the unrecognized net transition asset arising out of the adoption of Statement of Financial Accounting Standards No. 87 is being amortized as a credit to pension cost over the average remaining service periods for covered employees. Savings Plans: The Company also maintains savings plans for substantially all employees. These plans provide for employee contributions up to specified limits. The Company's savings plans provide for various levels of matching contributions. The matching contributions for the Company for 1993, 1992 and 1991 were $2.4 million, $2.1 million and $1.4 million, respectively. Postretirement Benefits Other than Pensions: The Company provides certain retiree health care and life insurance benefits for substantially all employees who reach retirement age while working for the Company. Health care benefits are administered by various organizations. A portion of the costs are borne by the participants. For 1992 and 1991, the annual premium costs associated with providing these benefits totaled approximately $4.5 million and $4.4 million, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS 106 requires that the estimated cost of these benefits, which are primarily for health care, be accrued during the employee's active working career. The Company has elected to amortize the unfunded transition obligation existing at January 1, 1993, over a period of 20 years. A summary of the components of the net periodic postretirement benefit cost for 1993 follows: (In Millions) Service cost-benefits attributed to service during the period $ 3.4 Interest cost on the accumulated postretirement benefit obligation 10.4 Expected return on plan assets (.7) Amortization of transition obligation 5.7 Net periodic postretirement benefit cost 18.8 Deferred for future recovery (9.6) Postretirement benefit cost, net of deferrals $ 9.2 The actual return on the plans' assets for the year 1993 was a gain of $.9 million. The funded status of the plans at December 31, 1993, was as follows: Accumulated Postretirement Benefit Obligation (APBO): Retirees $ 52.7 Fully eligible active plan participants 28.8 Other active plan participants 58.2 Total accumulated postretirement benefit obligation $ 139.7 APBO $(139.7) Plan assets at fair value 10.3 APBO in excess of plan assets (129.4) Unrecognized net loss 7.5 Unrecognized transition obligation 108.3 Accrued postretirement benefit liability $ (13.6) Principal actuarial assumptions (%): Annual long-term rate of return on plan assets 8.5 Discount rate 7.5 The Company intends to continue funding amounts for postretirement benefits collected from customers and other amounts with an independent trustee, as deemed appropriate from time to time. The plan assets include equities and fixed income securities. In the Company's most recent base rate proceeding, the NJBRC allowed the Company to collect $3 million annually of the incremental postretirement benefit costs, charged to expense, recognized as a result of FAS 106. Based on the final order and in accordance with Emerging Issues Task Force Issue Number 92-12, "Accounting for OPEB Costs by Rate-Regulated Enterprises," the Company is deferring the amounts above that level. A portion of the increase in annual costs recognized under FAS 106 of approximately $9.6 million is being deferred and should be recoverable through the ratemaking process. The accumulated postretirement benefits obligation was determined by application of the terms of the medical and life insurance plans, including the effects of established maximums on covered costs, together with relevant actuarial assumptions and health-care cost trend rates of 14% for those not eligible for Medicare and 11% for those eligible for Medicare for 1994, decreasing gradually to 7% in 2000 and thereafter. These costs also reflect the implementation of a cost cap of 6% for individuals who retire after December 1, 1995. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $14 million and the aggregate of the service and interest cost components of net postretirement health-care cost for 1994 by approximately $1 million. Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112) which addresses accounting by employers who provide benefits to former or inactive employees after employment but before retirement, which is effective for fiscal years beginning after December 15, 1993. The Company adopted the accrual method required under FAS 112 during 1993, which did not have a material impact on the financial position or results of operations of the Company. 8. JOINTLY OWNED STATIONS Each participant in a jointly owned station finances its portion of the investment and charges its share of operating expenses to the appropriate expense accounts. The Company participated with affiliated and nonaffiliated utilities in the following jointly owned stations at December 31, 1993: Balance (In Millions) % Accumulated Station Ownership Investment Depreciation Three Mile Island 25 $207.2 $57.5 Keystone 16.67 77.9 20.8 Yards Creek 50 24.3 6.3 9. LEASES The Company's capital leases consist primarily of leases for nuclear fuel. Nuclear fuel capital leases at December 31, 1993 and 1992 totaled $86 million and $105 million, respectively (net of amortization of $137 million and $108 million, respectively). The recording of capital leases has no effect on net income because all leases, for ratemaking purposes, are considered operating leases. The Company and its affiliates have nuclear fuel lease agreements with nonaffiliated fuel trusts. An aggregate of up to $250 million ($125 million each for Oyster Creek and TMI-1) of nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the currently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. These nuclear fuel leases are renewable annually. Lease expense consists of an amount designed to amortize the cost of the nuclear fuel as consumed plus interest costs. For the years ended December 31, 1993, 1992 and 1991 these amounts were $34 million, $36 million and $29 million, respectively. The leases may be terminated at any time with at least five months notice by either party prior to the end of the current period. Subject to certain conditions of termination, the Company and its affiliates are required to purchase all nuclear fuel then under lease at a price that will allow the lessor to recover its net investment. The Company has sold and leased back substantially all of its ownership interest in the Merrill Creek Reservoir project. The minimum lease payments under this operating lease, which has a remaining term of 39 years, average approximately $3 million annually.

829218_1993.txt

829218_1993

1993

829218

ITEM 1. BUSINESS INTRODUCTION Rexene Corporation manufactures and markets thermoplastic and petrochemical products, including low density polyethylene and polypropylene resins, plastic films and styrene, which are integral elements in the manufacture of a wide variety of industrial and consumer products. The Company is the result of a combination of three businesses operated by predecessor entities. In 1958, a subsidiary of The El Paso Company ("El Paso") constructed a styrene plant in Odessa, Texas. In 1960, El Paso and a predecessor of Dart Industries Inc. ("Dart") formed a joint venture to produce ethylene, propylene, polyethylene and polypropylene in Odessa, Texas. El Paso subsequently acquired the plastic film business of Dart in 1979 and full ownership of these businesses by 1983. In 1983 El Paso sold its petrochemical, polyolefin and plastic film business to a management-led group of investors, who consolidated the businesses under a Delaware corporation named Rexene Corporation ("Old Rexene"). In 1988, Old Rexene was sold to an investor group organized by Gilliam, Joseph & Littlejohn, an investment banking firm. In October 1991, Old Rexene filed a petition for reorganization under the federal bankruptcy laws. On September 18, 1992, Old Rexene emerged from bankruptcy in accordance with a plan of reorganization providing for the merger of Old Rexene into its wholly-owned operating subsidiary, Rexene Products Company, a Delaware corporation ("Products"), which subsequently changed its name to Rexene Corporation ("New Rexene"). See "Item 1 -- The Reorganization". The corporate headquarters of New Rexene, a Delaware corporation, is located at 5005 LBJ Freeway, Dallas, Texas 75244, and its telephone number is 214-450-9000. Unless otherwise indicated, Old Rexene, Products and New Rexene and their consolidated direct and indirect subsidiaries are sometimes collectively or separately referred to as "Rexene" or the "Company". PRINCIPAL PRODUCTS The following chart presents the net sales, excluding intercompany sales, contributed by the Company's five principal products during the periods indicated: No customer accounted for more than 10% of the Company's consolidated sales for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 or the year ended December 31, 1991. POLYETHYLENE THE PRODUCT. Polyethylene represents by volume the most widely produced thermoplastic resin in the world. The majority of polyethylene produced is low density polyethylene resin ("LDPE"). In 1993 U.S. LDPE producers sold 11.4 billion pounds in the domestic market and 1.7 billion pounds in the export market. The United States industry utilization rate for LDPE capacity in 1993 was approximately 90%. Approximately 59% of LDPE capacity is used to make high pressure LDPE ("HPLDPE") and the balance to make linear LDPE ("LLDPE"). LDPE can be extruded or molded alone or with other resins and additives into a wide variety of industrial and consumer products, including film products (e.g., bags, grocery sacks, food packaging and pallet stretch wrap, coatings, toys and bottles). Although both types of LDPE are used to make the foregoing types of products, LLDPE has some physical properties, including film strength, that make it more suitable for some uses (e.g., trash bags and stretch wrap) than HPLDPE. In contrast, HPDLPE is easier to extrude and has the advantage of higher clarity. The Company produces a variety of grades of HPLDPE, some of which are combined with other polymers to meet specific customer requirements, such as circuit board protective films. The Company does not produce LLDPE. MARKETING. Prime grade products are sold domestically primarily through the Company's sales staff. Most wide specification products are sold to brokers for resale. The Company participates in every principal market for HPLDPE, selling its HPLDPE resins under the REXENE-R- name. COMPETITION. There are currently eleven domestic producers of LDPE, all of which produce HPLDPE and six of which produce LLDPE. The largest manufacturer of LDPE is Quantum Chemical Corp. The other five largest domestic producers of LDPE include Dow Chemical U.S.A., Union Carbide Corporation, Chevron Chemical Company, Exxon Chemical Americas and Mobil Chemical Company. In 1993, Rexene accounted for approximately 3% of the United States capacity for LDPE and approximately 5% of the United States capacity for HPLDPE. Competition for sales is generally based on price for less specialized products and on price, product performance and customer service for more specialized products. The Company seeks to compete with larger polyethylene producers by providing a high level of customer service and developing resins which are responsive to customers' specific requirements. The United States demand for LDPE grew by approximately 1.2% in 1993 over 1992 and has averaged a 4.3% annual growth over the last five years. POLYPROPYLENE THE PRODUCT. Polypropylene represents another major category of thermoplastic resin and is surpassed only by polyethylene and polyvinylchloride in total volume of production. Polypropylene is produced in many grades for fiber applications, packaging and industrial films, and injection-molded products, including automobile components, medical disposables, appliance parts, housewares and other consumer products. The Company emphasizes the manufacturing of polypropylene resins for specialized applications such as medical bottles, electrical capacitor film and radiation resistant medical devices. The Company's line of impact copolymer polypropylene products is used primarily for automotive components and rigid packaging. The Company has been active in making technology improvements in process and catalyst technology and works closely with customers in developing new products to meet their specific needs. MARKETING. Domestic and Canadian sales of prime grade products are sold through the Company's sales staff. Most wide-specification products are sold to brokers for resale. The Company sells its polypropylene products under the REXENE-R- name. COMPETITION. In 1993 there were 16 domestic producers of polypropylene. In 1993, the four largest domestic producers of polypropylene were Himont Incorporated, Amoco Chemicals Corporation, Fina Oil & Chemical Company (a unit of American Petrofina, Inc.) and Exxon Chemical Americas. Competition for sales is dependent upon a variety of factors, including product price, technical support and customer service, the degree of specialization of various grades of polypropylene and the extent to which substitute materials such as wood, glass, metals and other plastics are available on a cost-effective basis. In 1993, Rexene accounted for approximately 2% of the United States capacity for polypropylene. The Company seeks to compete by focusing on specialty products responsive to customers' specific requirements. Examples of such products include radiation resistant resins for medical applications requiring radiation sterilization, capacitor resins for premium electrical grade film, and premium copolymer blow-molding resins for medical and food applications. In 1993 the United States production capacity of polypropylene was approximately 9.8 billion pounds and the United States plants operated at approximately 88% of capacity. Domestic consumption in 1993 grew by approximately 9% over 1992 levels. Growth in domestic consumption has averaged approximately 6.7% per year during the last five years. APAO THE PRODUCT. In late 1986, the Company began commercial production of Rextac-R- amorphous polyalphaolefins ("APAO"). This polymer was developed principally to replace atactic polypropylene ("APP"), a by-product of polypropylene manufacturing, with a higher quality polymer. The supply of APP has been reduced by technological developments primarily in catalyst systems in recent years. APAO is used primarily in the production of modified bitumen roofing materials; lamination; wire and cable; and adhesives and sealants, including hot melt adhesives for non-wovens, packaging, pressure sensitive and assembly applications. MARKETING. Prime grade products are sold domestically through the Company's sales staff. The Company sells its APAO products under the REXTAC-R- name. The Company supplements its sales of APAO with purchases from Ube Rexene Corporation ("URC"), a joint venture company located in Japan. In 1993 purchases from URC were approximately 4.3 million pounds. The Company expects to purchase similar quantities from URC in 1994. COMPETITION. The Company and Eastman Chemical Company are the only domestic on-purpose producers of APAO. In addition, many producers of polypropylene also produce APP, which competes with APAO for some uses. Based on management estimates, in 1993 Rexene accounted for approximately 30% of the United States capacity for APAO. The Company has a production capacity of approximately 35 million pounds per year, and is currently expanding the production capacity to 45 million pounds per year by the end of 1994. The Company seeks to compete by providing a high level of customer service and developing products which are responsive to customers' specific requirements. PLASTIC FILM THE PRODUCT. The Company, through its Consolidated Thermoplastics division ("CT Film"), is a major participant in the specialty market for high-quality cast and blown plastic film. Product applications for these films include disposable diapers, feminine hygiene products, medical products, adult incontinent products, food packaging, paper packaging, electronic component packaging, skin packaging, greenhouse film, industrial tapes and other industrial and consumer packaging applications. CT Film's products are manufactured principally with its own proprietary processes. CT Film develops specialty formulations of films to meet customer specifications for various highly specific and high value-added applications. Examples include a post consumer recycle film containing a minimum of 25% recycled materials, low gel film developed for photoresist applications, MAXILENE-R- lamination film and thin gauge barrier film for feminine hygiene products and medical applications. CT Film produces films for coextruded forming webs, linear tear films, and elastomeric films for surgical products. MARKETING. CT Film ships film nationwide from its plants in Clearfield, Utah; Harrington, Delaware; Dalton, Georgia and Chippewa Falls, Wisconsin and maintains customer relationships with a number of Fortune 500 companies. Prime grade products are sold primarily through the Company's sales staff. COMPETITION. CT Film's principal competitors include Tredegar Industries, Exxon Chemical Americas, Clopay Corporation, Blessings Company, Deerfield Plastics Company, Inc., Pierson Industries Co., and James River Corporation. The plastic film business is based on custom formulations to meet customer needs. Competition is based on the quality and properties of the film as well as price. CT Film seeks to develop innovative products to meet customer needs and seeks to compete by segmenting market niches and being responsive to customers' specific requirements. EUROPEAN OPERATIONS. In late 1993, a United Kingdom subsidiary of the Company, Rexene Corporation Ltd. ("RCL"), signed a long-term supply agreement with Kimberly-Clark Ltd. ("KCL") to supply plastic film backsheet to KCL. Film backsheet is used in the production of disposable diapers and training pants. RCL is currently constructing a manufacturing facility in Humberside County, England to supply KCL and other potential customers in Europe. The plant will have an initial production capacity of 20 million pounds and is expected to be operational in late 1994. STYRENE THE PRODUCT. Styrene is a petrochemical commodity with a variety of applications. Styrene is made from ethylene and benzene and is principally used in the manufacture of intermediate products such as polystyrene, latex, acrylonitrile butadiene styrene (ABS) resins, synthetic rubbers and unsaturated polyester resins. Through these products, styrene can be found in consumer products, including disposable cups and trays, housewares, luggage, appliances and children's toys; building products such as roof insulation, pipes and fittings; transportation products ranging from auto and boat trim to tires, recreational vehicle molding and fan belts; and textile products such as pigments, binder, paper coating and carpet backing. MARKETING. The Company sells the vast majority of its styrene directly to domestic customers, and handles export sales through international trading companies. COMPETITION. The six largest domestic producers of styrene are Arco Chemical Company, Huntsman Chemicals Corporation, Amoco Chemicals Corporation, Sterling Chemicals, Inc., Dow Chemical U.S.A. and Chevron Chemical Company. In 1993, Rexene accounted for approximately 3% of the United States capacity for styrene. Due to global capacity expansions and weak economic conditions, the domestic styrene industry operated at an approximately 87% utilization rate in 1993. Competition for sales of styrene is generally based on price. The Company anticipates that the styrene industry will continue to have overcapacity in 1994. EXPORT SALES The following chart summarizes revenues from export sales, and the percentages of net sales represented by export sales, for the periods indicated: The decrease in aggregate export sales for the year ended December 31, 1993, the three months ended December 31, 1992 and the nine months ended September 30, 1992 as compared to 1991 was due primarily to the Company's decreasing emphasis on this market because of lower selling prices and overcapacity in international markets. The majority of the Company's export sales were to foreign companies through agents and domestic offices of foreign companies, which are responsible for the actual export of the product to a variety of locations. RAW MATERIALS FOR PRINCIPAL PRODUCTS Principal raw materials consist of ethane, propane and benzene ("feedstocks") for the polymer and styrene business and polyethylene resins for the film business. The prices of feedstocks fluctuate widely based on the prices of natural gas and oil. As a result, the Company's ability to pass on increases in raw material costs to customers has a significant impact on operating results. The Company's plant in Odessa, Texas (the "Odessa Facility") obtains a combination of pure and mixed streams of natural gas liquids from multiple natural gas liquid extraction plants located in west Texas and uses such streams as feedstocks to the Company's olefins plant. The Company's feedstock supplies are currently adequate for its requirements. The Company has storage capacity for an approximately ten-day supply of feedstocks. In 1993 the Company purchased substantially all of its benzene requirements under contracts from Gulf Coast producers at prevailing contract prices, with the balance of its needs being filled with purchases on the spot market. The Odessa Facility has historically served as its own source of ethylene. Raw materials accounted for approximately 60% of the total cost of sales for the Company's five principal product groups in 1993. Ethane and propane prices are established in Mont Belvieu, Texas (Gulf Coast) according to prevailing market conditions, but the Company is able to purchase ethane and propane in West Texas at prices discounted from the reported average Mont Belvieu, Texas prices prevailing from time to time. The discounts represent a significant portion of the average cost for the producers to transport the ethane and propane to Mont Belvieu, Texas and to fractionate them into a purity product. CT Film raw materials consist principally of polyethylene resins and additives. CT Film obtains its raw materials from a variety of sources (including the Odessa Facility) and has been able to order these materials in advance as its needs dictate. CT Film has adequate storage capabilities for its raw materials. EMPLOYEES On March 1, 1994, the Company employed approximately 1,300 persons. None of the Company's employees are unionized, except for approximately 130 employees at the CT Film facility in Chippewa Falls, Wisconsin. The Company and the union are parties to a collective bargaining agreement through February 28, 1997. PATENTS, TRADE SECRETS AND TRADEMARKS The Company is the owner of many United States and foreign patents and uses trade secrets, including substantial know-how, which relate to its polyethylene, polypropylene, APAO and plastic film products. The Company has spent over $6 million for research and development during each of the last three fiscal years and anticipates spending a similar amount in 1994. See the Consolidated Statements of Operations of the Consolidated Financial Statements included in Item 8. Although patents and trade secrets are important to the Company, permitting it to retain ownership and use of its technological advances, the Company does not believe that the loss of any patent would have a material adverse effect on its financial condition. The Company also uses the technology of others under license agreements in certain of its manufacturing operations. REXENE-R- and REXTAC-R- are important trademarks for the Company's resins and are widely known among purchasers of these products. The Company is the owner of other trademarks used on or in connection with its products. The Company has been sued by Phillips Petroleum Company ("Phillips") for infringement of its crystalline and block copolymer polypropylene patents. See "Item 3 -- Legal Proceedings" below. ENVIRONMENTAL AND RELATED REGULATION GENERAL. The Company (and the industry in which it competes) is subject to extensive environmental laws and regulations and is also subject to other federal, state and local laws and regulations regarding health and safety matters. The Company believes that its business, operations and facilities generally have been and are being operated in compliance in all material respects with applicable environmental and health and safety laws and regulations, many of which provide for substantial fines, criminal sanctions, and in certain extreme circumstances, temporary or permanent plant closures for violations. Nevertheless, from time to time the Company has received notices of alleged violations of certain environmental laws, and has endeavored promptly to remedy such alleged violations. The ongoing operations of chemical manufacturing plants entail risks in these areas and there can be no assurance that material costs or liabilities will not be incurred. Further, groundwater and/or soil contamination at the Company's Odessa Facility, which is the Company's main facility, and at other sites may require remediation that could involve significant expenditures. In addition, future developments, such as increasingly strict requirements of environmental and health and safety laws and regulations and enforcement policies thereunder could bring into question the handling, manufacture, use, emission or disposal of substances or pollutants at the Company's facilities. The Company's operational expenditures for environmental remediation and waste disposal were approximately $6.4 million in 1993 and are expected to be approximately $6.9 million in 1994. In 1993 the Company also expended approximately $5.1 million relating to environmental capital expenditures. In 1994, the Company expects to spend approximately $2.9 million for environmentally-related capital expenditures, which is lower than historical levels due to timing of expenditures pertaining to several projects. Thereafter for the foreseeable future, the Company expects to incur approximately $4.0 to $5.0 million per year in capital spending to address environmental requirements. Annual amounts could vary depending on a variety of factors, such as the control measures or remedial technologies ultimately required and the time allowed to meet such requirements. The Company believes that, in light of its historical expenditures, it will have adequate resources to conduct its operations in compliance with currently applicable environmental and health and safety laws and regulations. However, in order to comply with changing licensing and regulatory standards, the Company may be required to make additional significant site or operational modifications. Further, the Company has incurred and may in the future incur liability to clean up waste or contamination at its current or former facilities, or which it may have disposed of at facilities operated by third parties. The Company recorded $23.4 million as an estimate at December 31, 1993 of its total potential environmental liability with respect to remediating site contamination, which it believes is adequate. However no assurance can be given that all potential liabilities arising out of the Company's present or past operations have been identified or that the amounts that might be required to remediate such conditions will not be significant to the Company. The Company continually reviews its estimates of potential environmental liabilities. The Company does not currently carry environmental impairment liability insurance to protect it against such contingencies because the Company has found such coverage available only at great cost and with broad exclusions. WASTEWATER. The Company currently disposes of wastewater from its Odessa Facility through injection wells operated under permits from the Texas Natural Resource Conservation Commission ("TNRCC"). In the process of renewing the permits on these deep wells, TNRCC has expressed concern over the long-term viability of the current deep well injection system. TNRCC has granted the Company a permit to drill and operate a new deeper well. Company consultants have estimated the cost of installing a new deep well injection system at $5.7 million, but the Company has not begun drilling such a well. The Company, with neighboring industrial facilities, has begun investigating the possibility of entering into an agreement with a publicly-owned treatment works to build a near-by plant to dispose of industrial waste water. Although no assurances can be given, the Company believes that it will be able to use its existing wells until it develops a satisfactory alternative waste water disposal system. Failure to develop such a system and denial of the renewal applications could have a material adverse effect on the Company's financial condition. SOLID WASTES. The Company's Odessa Facility has interim authorization as a hazardous waste treatment/storage/disposal facility under the Resource Conservation and Recovery Act ("RCRA") and has applied for a final permit, which the Company expects TNRCC to issue later this year. This permit will include a Compliance Plan requiring the company to take corrective action with regard to existing contamination at the Odessa Facility. Pursuant to this Compliance Plan, the Company must complete an investigation into the extent of onsite contamination, conduct a risk assessment to determine the level of risk it presents to human health and the environment, develop a Corrective Measures Study on the ways to remediate the contamination, and implement a remediation plan approved by TNRCC. During the investigations of contamination at the Odessa Facility, the Company discovered, and reported to TNRCC, the presence of low levels of hydrocarbons in an intermittently-flowing stream adjacent to the Odessa Facility. The company is continuing its investigations as to the source and extent of contaminants in this stream. Based upon the results of its investigations of onsite contamination, the Company does not believe that implementation of such a corrective action plan will have a material adverse effect on its financial condition. However, no assurance can be given that all conditions any corrective action plan may be required to address have been identified, or that the amounts that might be required to implement that plan will not be significant to the Company. AIR EMISSIONS. In 1990, Congress amended the Clean Air Act to require control of certain emissions not previously regulated, some of which are emitted by the Company's facilities. This legislation will require the Company (and others in the industry with such emissions) to implement certain pollution control measures in addition to those currently used. The Company cannot determine the impact of such legislation on its operations until implementing regulations are adopted, and can give no assurance at this time that the costs it may incur to comply with those regulations will not be significant. ADDITIONAL ENVIRONMENTAL ISSUES. The Federal Comprehensive Environmental Response Compensation and Liability Act, as amended ("CERCLA"), and similar laws in many states, impose liability for the clean-up of certain waste sites and for related natural resource damages, without regard to fault or the legality of the waste disposal. Liable persons generally include the site owner or operator, former site owners, and persons that disposed or arranged for the disposal of hazardous substances found at those sites. The Company formerly owned facilities which are or were in the plastics, petrochemicals or oil refinery businesses. The Company has sent wastes from its currently-owned and formerly-owned facilities to various third-party waste disposal sites. From time to time the Company receives notices from representatives of governmental agencies and private parties contending that the Company is potentially liable for a portion of the remediation at such third-party and formerly-owned sites. Although there can be no assurance, the Company does not believe that its liabilities for remediation of such sites, either individually or in the aggregate, will have a material adverse effect on the Company. The Odessa Facility is located near a wastewater treatment plant (the "South Dixie Plant") owned by the City of Odessa (the "City"). The City is implementing a plan to expand a second water treatment plant and abandon the South Dixie Plant. The City has alleged that the Company has contributed to groundwater contamination at the South Dixie Plant. If the City's allegations are correct, then the Company could be liable for some or all of the remediation at the site. Although there can be no assurance, the Company does not believe that any such costs will have a material adverse effect on the Company. THE REORGANIZATION Pursuant to a First Amended Plan of Reorganization (the "Amended Plan") under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") which was confirmed by the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") on July 7, 1992 and became effective on September 18, 1992 (the "Effective Date"), Old Rexene was merged (the "1992 Merger") into its wholly-owned operating subsidiary. As a result of its reorganization under Chapter 11 of the Bankruptcy Code (the "Reorganization"), the Company, among other things, (i) reduced the principal amount of its long-term debt by approximately $66 million by replacing $403 million of debt, which was scheduled to mature in July 1992, with $337 million of debt that becomes due in 1999 and 2002, (ii) reduced its annual cash interest requirements from approximately $74 million to a minimum amount of approximately $24 million through 1994, and (iii) issued 92.5% of the common stock in New Rexene (the "Common Stock") to the holders of such debt. On July 7, 1992, the Bankruptcy Court entered an order confirming the Amended Plan (the "Confirmation Order"). The Confirmation Order required as a condition to the consummation of the Amended Plan that, among other things, the Company and the creditors' committee (the "Committee") be satisfied with the status or any resolution of certain outstanding obligations and of certain claims. With the agreement of the Company and the Committee and upon the satisfaction or waiver of all other conditions to the effectiveness of the 1992 Merger and the Amended Plan, the 1992 Merger and the Amended Plan were consummated on September 11, 1992 and the Effective Date, respectively. Under the Amended Plan, the holders of outstanding senior notes of Old Rexene received, as of the Effective Date, pro rata as a class, (i) an equal principal amount of Increasing Rate First Priority Notes due 1999 of New Rexene at an initial interest rate of 9% per year (the "Senior Notes"), (ii) 26% of the Common Stock to be outstanding after giving effect to the Amended Plan, and (iii) $11.7 million in cash representing the prepetition interest accrued on the outstanding senior notes of Old Rexene plus interest on the prepetition interest during the Reorganization. The holders of outstanding subordinated notes of Old Rexene received, pro rata as a class, (i) $84.375 million aggregate principal amount of Increasing Rate Second Priority Notes due 2002 (with certain sinking fund requirements in 2001) of New Rexene at an initial rate of 10% per year (the "Subordinated Notes", and together with the Senior Notes, the "Notes"), (ii) 66.5% of the Common Stock to be outstanding after giving effect to the Amended Plan, and (iii) $3.1 million in cash for settlement of prepetition interest. Holders of the common stock of Old Rexene became entitled to receive 7.5% in the aggregate of the Common Stock to be outstanding after giving effect to the Amended Plan. Such holders received in exchange one share for each 40 shares of common stock of Old Rexene previously held. Substantially all other creditors with allowed claims were entitled at the Company's option either to payment in full or to have their legal, equitable and/or contractual rights survive the bankruptcy unaltered. The Company has made substantially all of the distributions contemplated by the Amended Plan. Also in connection with the consummation of the Amended Plan, the Company entered into a Loan Agreement (the "Loan Agreement") as of the Effective Date with Transamerica Business Credit Corporation as described below. The Senior Notes are secured by a first lien on all of the assets of the Company and its subsidiaries, other than (i) accounts receivable, other than intercompany receivables, (ii) inventory, (iii) cash and cash equivalents, and (iv) certain nonmaterial excluded assets (the "Collateral"). The Subordinated Notes are secured by a second lien on the Collateral. Interest is payable on the Notes semiannually on May 15 and November 15. In addition, the interest rates on the Senior and Subordinated Notes increase beginning in 1995 and 1996, respectively. The annual interest rate on the Senior Notes is 9% through November 14, 1995, 12% from November 15, 1995 through November 14, 1996 and 14% thereafter. The annual interest rate on the Subordinated Notes is 10% through November 14, 1996, 12% from November 15, 1996 to November 14, 1997 and 14% thereafter. For each interest period ending on or prior to November 15, 1994, the Company may pay up to 90% of the interest due on the Subordinated Notes by delivering additional Subordinated Notes in lieu of cash ("Pay-in-Kind"), if certain financial tests are met. With respect to the interest payments on the Subordinated Notes which have been due since the issuance of the Subordinated Notes, the Company has issued an aggregate principal amount of $11.0 million in additional Subordinated Notes. On March 1, 1994, the Board of Directors decided to exercise the Pay-in-Kind feature for the interest payment due on May 15, 1994, which will result in the issuance of approximately $4.3 million of additional Subordinated Notes. The Board of Directors will consider the advisability of exercising such feature for the interest payment on November 15, 1994. The Senior Notes and, after all Senior Notes are redeemed, the Subordinated Notes, are redeemable at the option of the Company, at any time in whole or from time to time in part, at a price equal to 100% of the principal amount to be redeemed plus accrued interest to the redemption date. In addition the Company may at any time purchase Senior Notes in the open market. In the event the Company generates "excess cash flow" from operations (as defined in the indenture governing the Senior Notes) in any fiscal year, the Company is required to make an offer to purchase Senior Notes at par in an amount equal to such excess cash flow. However, the cash purchase price of Senior Notes acquired in the open market (not previously applied as a credit) may be credited towards the excess cash flow offer requirement. In addition, in the event of asset sales exceeding $8 million in the aggregate during any four consecutive quarters, the Company is required to make an offer to purchase Senior Notes and thereafter, if applicable, Subordinated Notes at par in an amount equal to the net proceeds (as defined in the indentures governing the Notes (the "Indentures")) of such asset sales. Open market purchases cannot be credited towards the asset sale redemption requirement. The Indentures contain covenants which, among other things, (i) limit the Company's ability to incur additional indebtedness, purchases or redemption of capital stock and certain investments), (iii) limit the incurrence of liens other than certain permitted liens, (iv) restrict transactions with stockholders and affiliates, (v) require the maintenance of a minimum stockholders' equity, and (vi) limit certain investments. The Loan Agreement, as amended through 1993, provides a credit facility for general corporate purposes to the Company of up to $35 million, $15 million of which may be used for financing the operations of RCL. The Loan Agreement terminates December 31, 1996. The Company pays interest on borrowed funds at 1.5% above the prime rate. In addition, the Company pays monthly facility and collateral management fees. At December 31, 1993, the Company had outstanding borrowings under the Loan Agreement of $2 million plus $2.9 million of standby letters of credit. Funds advanced under the Loan Agreement are secured by a first lien on the Company's (i) inventory, (ii) accounts receivable, other than intercompany receivables, (iii) letters of credit and (iv) the proceeds of the above. The Loan Agreement also contains certain continuing obligations, such as maintenance of a minimum cash flow coverage ratio, as well as restrictions or prohibitions covering, among other things, the incurrence of other indebtedness, asset sales, investments, dividend payments, mergers and acquisitions. ITEM 2. ITEM 2. PROPERTIES The Company manufactures its thermoplastic resins and petrochemicals at the Odessa Facility. The Odessa Facility is located on an approximately 875-acre site in west Texas which contains plants producing polyethylene, polypropylene, APAO and styrene, as well as ethylene and propylene primarily for captive use. CT Film has four manufacturing facilities for the production of blown and cast plastic film. These facilities are located in Chippewa Falls, Wisconsin; Harrington, Delaware; Clearfield, Utah and Dalton, Georgia. The Company's executive offices are located in Dallas, Texas in leased office space aggregating approximately 45,500 square feet. Additionally, the Company owns an off-site warehouse in Odessa, Texas and a parcel of land held for sale in the La Porte and Pasadena industrial districts near Houston, Texas. The polyethylene plant in Odessa, Texas has been in operation since 1961. The plant's initial rated capacity has been expanded, primarily through technological developments and capital improvements, from 120 million pounds per year to a current rated capacity, depending upon product selection, of 405 million pounds per year. Using six high-pressure tubular reactors and one autoclave reactor, the plant is capable of producing a wide range of products including film, injection molding, extrusion coating and blow molding resins such as ethylene homopolymers and ethylene vinyl acetate copolymers. The polypropylene plant in Odessa, Texas has three separate manufacturing lines. Line I was built in 1964 with a rated capacity of approximately 28 million pounds per year and has been modified to a rated capacity of approximately 70 million pounds per year. Line II was constructed in 1967 with an initial capacity of approximately 15 million pounds of polypropylene per year but was modified in 1986 to enable the line to produce approximately 35 million pounds per year of APAO. Line III was built in 1969 and was modified to increase its rated capacity to a total of approximately 110 million pounds per year in 1988. The styrene plant in Odessa, Texas was constructed in 1958. Its original capacity has been expanded to a present rated capacity of approximately 320 million pounds per year. The olefins plant at the Odessa Facility was built in 1961 with a rated capacity of approximately 150 million pounds per year. Through modernization and expansion, the rated capacity of the olefins plant has been expanded to approximately 540 million pounds per year of ethylene and 210 million pounds per year of propylene. CT Film's Chippewa Falls plant began operations in 1948 and contains 20 blown monolayer film lines, three monolayer cast film lines and one coextrusion cast line. The total annual capacity is rated at 76 million pounds. The Harrington plant began operations in 1972 and contains seven monolayer blown film lines including a large Greenhouse film line, two monolayer cast film lines and three coextrusion cast film lines. The total annual capacity is rated at 67 million pounds. The Clearfield plant began operations in 1991 and contains four monolayer blown film lines, one coextrusion blown film line and two coextrusion cast film lines. The total annual capacity is rated at 44 million pounds. The Dalton plant began operations in 1966 and contains five monolayer blown film lines and six coextrusion blown film lines. In addition there are three printing presses, five slitter rewinders and six bag machines in the converting area. The total annual film extrusion capacity is rated at 38 million pounds. In 1993, CT Film acquired 6.5 acres of land and began construction of a 62,000 square foot film production plant in Humberside County, England. The plant will include both cast and blown film lines and is anticipated to be in operation by late 1994. ITEM 3. ITEM 3. LEGAL PROCEEDINGS BANKRUPTCY. On October 18, 1991, and pursuant to an agreement in principle detailing the terms for the Company's recapitalization, Old Rexene, Products and Poly-Pac, Inc., a wholly-owned subsidiary, filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court, case numbers 91-1058, 91-1057 and 91-1059, respectively. Pursuant to an Order Providing for Joint Administration entered by the Bankruptcy Court on October 21, 1991, the Old Rexene and Poly-Pac, Inc. cases were consolidated with the Products case for procedural purposes only. On July 7, 1992, the Bankruptcy Court entered an order confirming the Amended Plan. Thereafter, all conditions to the effectiveness of the 1992 Merger and the Amended Plan were either satisfied or waived. The 1992 Merger and the Amended Plan were then consummated on September 11, 1992 and the Effective Date, respectively. See "Item 1 -- The Reorganization", "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 2 to the Consolidated Financial Statements included in Item 8. Substantially all distributions contemplated by the Amended Plan have been made. Certain matters, including the Izzarelli Class (defined below) claims, remain pending before the Bankruptcy Court. STOCKHOLDER CLASS ACTION LITIGATION. In January 1990, a purported class action was filed in the United States District Court, Northern District of Texas, by an alleged stockholder of Rexene on behalf of purchasers of Old Rexene common stock between October 23, 1989 and December 27, 1989. The defendants in this action presently include Rexene, one of its current directors and certain of its former directors. The class has been certified with an intervenor as the class representative. The intervenor's complaint asserts claims under Section 10b-5 of the Securities Exchange Act of 1934, and state common law grounds. The plaintiff alleges that public statements made by certain directors of Rexene created a misleading impression of the Company's financial condition thereby artificially inflating the price of the common stock of Old Rexene. The plaintiff seeks compensatory damages, prejudgment interest, a recovery of costs and attorneys' fees, and such other relief as may be deemed just and proper. Discovery is ongoing. In the Company's Chapter 11 proceeding, the intervening plaintiff filed a proof of claim on behalf of herself and the purported class seeking in excess of $10 million based upon the allegations in the litigation. The Company objected to the claim and elected to leave the legal, equitable and contractual rights of the plaintiff unaltered, thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. IZZARELLI STOCK BONUS PLAN CLASS ACTION LITIGATION. In February 1991, a class action lawsuit was filed in the United States District Court for the Western District of Texas -- Midland Division (the "Trial Court") against the Company, the Rexene Products Company Stock Bonus Plan (the "Stock Bonus Plan") and Texas Commerce Bank -- Odessa (the former trustee for the Stock Bonus Plan) by two former participants in the Stock Bonus Plan (the "Izzarelli Class"). The complaint alleges that the Company amended the Stock Bonus Plan in 1987 and 1988 to deprive the Izzarelli Class of stock benefits to which they would have been entitled had the Stock Bonus Plan not been amended. The plaintiffs assert claims under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") for breach of fiduciary duties to the participants and for violation of ERISA's provision prohibiting amendments to the Stock Bonus Plan after benefits had accrued to participants. The plaintiffs seek actual damages, attorneys' fees, costs and expenses, and such further relief as may be deemed appropriate. After a trial, the Trial Court in July 1992 entered a judgment against the Company in the amount of $6.6 million (as subsequently amended) plus costs of court. In November 1992, the Trial Court awarded the Izzarelli Class $595,000 for attorneys' fees and out-of-pocket expenses. The Company has recorded an accrual of $7.4 million to reflect this judgment. The Company has appealed the judgment to the United States Court of Appeals for the Fifth Circuit. The Izzarelli Class has also filed an appeal with respect to the amount of damages awarded and the judgment in favor of Texas Commerce Bank -- Odessa. These appeals are pending. In the Bankruptcy Court, the Izzarelli Class filed proofs of claim for $27.7 million. The Izzarelli Class has pending before the Bankruptcy Court a motion to alter or amend the Confirmation Order and a motion to allow their claim based upon the judgment entered by the Trial Court. The Company believes that if the Bankruptcy Court granted these motions, the Izzarelli Class would be allowed to enforce its judgment unless the Company posted a bond or other security. Pursuant to a request by the Company, the Bankruptcy Court on November 4, 1992 entered an order continuing such motions until the resolution of the appeals which are currently pending in the Fifth Circuit Court of Appeals. The Izzarelli Class appealed the Bankruptcy Court's continuation order to the United States District Court for the District of Delaware, which dismissed the appeal on September 29, 1993. The Izzarelli Class then filed an appeal with the United States Court of Appeals for the Third Circuit, which appeal is pending. Pursuant to an agreement in December 1992 regarding the distribution of the remaining balance in an escrow account established in connection with a 1988 merger involving the Company, there is $2 million being retained in the escrow account which will be available to the Company to pay up to 50% of any portion of a final judgment or settlement in the Izzarelli Litigation which is not paid by insurance. The Company intends to pursue claims for recovery of the amount of any final judgment or settlement against its insurance carrier subject to policy limits of $10 million. Although the insurance carrier has been paying the Company's attorneys' fees in the Izzarelli Litigation, it has otherwise denied coverage and reserved all rights. PHILLIPS BLOCK COPOLYMER LITIGATION. In March 1984, Phillips filed a lawsuit against the Company in the United States District Court for the Northern District of Illinois, Eastern Division, seeking injunctive relief, an unspecified amount of compensatory damages and treble damages. The complaint alleges that the Company's copolymer process for polypropylene infringes Phillips' two "block" copolymer patents. This action has been transferred to the United States District Court for the Southern District of Texas, Houston Division. Discovery proceedings in this case have been completed. The Company has filed a motion for summary judgment. Phillips has filed a motion for partial summary judgment. Pursuant to an agreement among the parties, the Court appointed a Special Master who conducted a hearing on these motions and thereafter recommended to the Court that the Company's motion be granted and Phillips' motion be denied. Thereafter, Phillips filed motions to disqualify the Special Master, to reject the recommendation of the Special Master and to enter partial summary judgment for Phillips. The Court has entered an Order denying Phillips' motion to disqualify the Special Master. The summary judgment motions are still pending. In the Company's Chapter 11 proceedings, Phillips filed proofs of claim seeking in excess of $108 million based upon the allegations in this litigation. The Company objected to the claims and elected to leave the legal, equitable and contractual rights of Phillips unaltered, thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. PHILLIPS CRYSTALLINE LICENSE LITIGATION. In May 1990, Phillips filed a lawsuit against the Company in the United States District Court for the District of Delaware seeking injunctive relief, an unspecified amount of compensatory damages, treble damages and attorneys' fees, costs and expenses. The complaint alleges that the Company is infringing Phillips' Patent No. 4,376,851 (the " '851 Patent") for crystalline polypropylene. Pursuant to a License Agreement dated as of May 15, 1983 (the "License Agreement"), Phillips granted the Company a non-exclusive license to make, use and sell crystalline polypropylene covered by the '851 Patent. The complaint alleges that effective April 21, 1990, Phillips terminated the License Agreement because it believed that, by the terms of the License Agreement, all conditions precedent to such termination had occurred. The complaint further alleges that, without an effective License Agreement, the Company's continuing use of the '851 Patent constitutes an infringing use. An amended complaint filed in May 1990 further alleges that the Company made a material misrepresentation that induced Phillips to enter into the License Agreement and that Phillips entered into the License Agreement as a consequence of a mutual mistake of the parties. The amended complaint therefore alleges that the License Agreement is void AB INITIO. The Company filed a motion to dismiss Phillips' amended complaint for failure to state a claim. On December 30, 1993, the Court entered an Order dismissing Phillips' claim that the License Agreement was void AB INITIO, and ordered that the 1990 license termination issue be resolved at trial. Trial has been scheduled for October 19, 1994. In the Company's Chapter 11 proceedings, Phillips filed proofs of claim seeking in excess of $147 million based upon the allegations in this litigation. The Company objected to the claims and elected to leave the legal, equitable and contractual rights of Phillips unaltered thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. With respect to each of the litigation matters described above which remain pending, the Company believes that, based upon its current knowledge of the facts of each case, the Company has meritorious defenses to the various claims made and intends to defend each such suit vigorously. Although there can be no assurance of the final resolution of any of these matters, the Company does not believe that the outcome of any of these lawsuits will have a material adverse effect on the Company's financial condition. With respect to certain pending or threatened proceedings involving the discharge of materials into or protection of the environment, see "Item 1 -- Business -- Environmental and Related Regulation". The Company is also a party to various lawsuits arising in the ordinary course of business and does not believe that the outcome of any of these lawsuits will have a material adverse effect on the Company's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the Company's security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth the names, ages and offices of the Company's executive officers as of March 1, 1994: Mr. Goeschel has been Chairman of the Board of Rexene since March 1992. He also was a director of Rexene from April 1988 to May 1989. Mr. Goeschel is presently retired. He was Chairman of the Board of Tetra Technologies, Inc., a company which recycles and treats environmentally sensitive by-product and wastewater streams, and then markets end-use chemicals extracted from such streams, from November 1992 to October 1993. He is a director of Calgon Carbon Corporation, a manufacturer of activated carbon. He is also a member of the board of trustees of the Laurel Mutual Funds. Mr. Smith has been Chief Executive Officer and a director of Rexene since March 1992. From December 1991 to March 1992, he was a private consultant. From June 1991 to December 1991, he was President and Chief Operating Officer of Itex Enterprises, Inc., an environmental remediation company. Mr. Smith also served as a consultant to the Company from January 1991 to June 1991. Immediately prior thereto, he had been a director of Rexene since May 1988 and the President and Chief Executive Officer of Rexene since June 1988. Prior thereto he had held various positions with Rexene since 1976. Dr. Anderson has been President and Chief Operating Officer of Rexene since January 1991 and a director since February 1990. From May 1988 to January 1991 Dr. Anderson was Executive Vice President -- Manufacturing and Technical of Rexene. Prior thereto he had held various engineering, manufacturing and research and development positions with Rexene since 1972. Mr. McAleer has been an Executive Vice President and Chief Financial Officer of Rexene since July 1990. From 1985 to 1990, Mr. McAleer was Chief Financial Officer of Varo, Inc., a manufacturer of specialty electronics equipment. Mr. Knott has been Executive Vice President -- Sales and Market Development of Rexene since March 1992. Prior thereto, Mr. Knott was an Executive Vice President of Rexene since January 1991 and President of CT Film since February 1989. Mr. Knott held various positions with CT Film from 1985 to February 1989. Mr. Ruberto has been Executive Vice President of Rexene and President of CT Film since March 1992. Prior thereto, Mr. Ruberto had been Executive Vice President -- Sales and Market Development of Rexene since January 1991. From April 1989 to January 1991, Mr. Ruberto was Executive Vice President -- Marketing and Business Planning of Rexene. From October 1987 through March 1989, Mr. Ruberto was Vice President -- Strategic Planning of Plicon Corp., a manufacturer of flexible packaging materials. Mr. Wheeler has been Senior Vice President -- Administration of Rexene since December 1990. Prior thereto, Mr. Wheeler had been Vice President -- Human Resources and Administration of Rexene since September 1988. Mr. McNamee has been Vice President, Secretary and General Counsel of Rexene since May 1993. From September 1989 to November 1992, Mr. McNamee was Vice President and General Counsel of Ferro Corporation, a multinational manufacturer of specialty materials. From July 1985 to August 1989, Mr. McNamee was Associate General Counsel of Chevron Chemical Company, a manufacturer of petrochemicals, polyolefins and other chemical products. Mr. Perera has been Vice President of Rexene since January 1991 and Corporate Controller since February 1989. From October 1988 to February 1989, Mr. Perera was Director of External Reporting of Rexene. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Prior to the effective date of the Company's Reorganization, the common stock of Old Rexene was listed on the New York Stock Exchange. On the effective date, for every 40 shares of common stock of Old Rexene, the holders thereof became entitled to receive in exchange therefor one share of Common Stock. The Common Stock began trading on the New York Stock Exchange on a when issued basis on September 14, 1992 and on a regular way basis on October 8, 1992. The high and low daily closing sales prices of the Common Stock for each calendar quarter or portion thereof from September 14, 1992 to December 31, 1993 are as follows: The high and low daily closing sales prices of the common stock of Old Rexene for each calendar quarter or portion thereof from January 1, 1992 to September 11, 1992 are as follows: The Company did not pay dividends on its common stock during the last two fiscal years. The Loan Agreement prohibits the payment of any dividends with respect to common stock. Also, the Indentures contain substantial restrictions on the payment of any such dividends. See "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources". ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial data for the Company for the periods indicated. Information should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto included on the pages immediately following the Index to Consolidated Financial Statements appearing on page . See Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company's consolidated results of operations and financial condition should be read in conjunction with Selected Financial Data in Item 6 and the Company's Consolidated Financial Statements and Notes thereto included on the pages immediately following the Index to Consolidated Financial Statements appearing on page. RESULTS OF OPERATIONS In connection with the Reorganization more fully described in Item 1, the Company adopted as of September 30, 1992, the American Institute of Certified Public Accountants' Statement of Position No. 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" (the "Reorganization SOP"). The Company's basis of accounting for financial reporting purposes changed as a result of adopting the Reorganization SOP. Specifically, the Reorganization SOP required (i) the adjustment of the Company's assets and liabilities to reflect a reorganization value generally approximating the fair value of the Company as a going concern on an unleveraged basis, (ii) the elimination of its accumulated deficit, and (iii) adjustments to its capital structure to reflect consummation of the Amended Plan. Accordingly, the results of operations after September 30, 1992 are not comparable to results of operations prior to such date, and the results of operations for the nine months ended September 30, 1992 and the three months ended December 31, 1992 have not been aggregated. The Company's industry historically has been highly cyclical and at times production capacities have increased more rapidly than demand, thereby causing lower prices. During fiscal years 1987 and 1988, the industry experienced increased levels of demand for its products which resulted in near full capacity utilization rates and higher domestic and export prices. Further, feedstock prices were also favorable during this period. Since that time, the polyethylene, polypropylene and styrene industries in general have experienced a softening of sales prices due to a number of factors. The robust period enjoyed by the industry in 1987 and 1988 led producers to increase worldwide production capacity, resulting in excess product supply and industry-wide decreases in prices during the last four years. Therefore, the Company's operating results declined significantly between 1989 and 1993. 1993 COMPARED TO 1992 (ON A PRO FORMA BASIS) The following analysis compares the results for the year ended December 31, 1993 to the pro forma results for the year ended December 31, 1992. The pro forma information gives effect to the Reorganization as though it had occurred on September 30, 1991. The pro forma adjustments relate primarily to (i) the recording of interest expense in accordance with the terms of the Notes, (ii) the recording of depreciation of property, plant and equipment in accordance with their restated values, (iii) the recording of amortization of reorganization value in excess of amounts allocable to identifiable assets, (iv) the elimination of goodwill amortization, reorganization items and the extraordinary gain, and (v) the income tax effects for adjustments (i) through (iv) above. Results of operations for the year ended December 31, 1993 and the year ended December 31, 1992, restated on a pro forma basis for comparative purposes, are as follows (in thousands): Net sales increased $14.4 million (or 3%) for the year ended December 31, 1993 as compared to 1992 principally due to an increase in plastic film sales. Plastic film sales increased $11.8 million (or 9%) primarily due to a volume increase of 11.2 million pounds (or 7%) principally due to higher sales to the disposable diaper market and the blown coextrusion film market. APAO and excess propane and ethylene sales also contributed to the increase in sales. APAO sales increased $3.3 million (or 20%) from 1992 to 1993 principally due to an increase in sales resulting from purchases of product manufactured by the Ube Rexene Corporation joint venture located in Japan. Excess ethylene and propane sales increased $5 million due to changes in the feedstock mix at the olefin plant. These increases were partially offset by a $3 million (or 2%) decrease in polyethylene sales and a $3.1 million (or 5%) decrease in styrene sales. Polyethylene and styrene sales declined in 1993 as compared to 1992 primarily as a result of continuous pricing pressure due to an overcapacity in the industry. The Company's gross profit percentage remained constant at 13% in 1993 as compared to 1992. Gross profit for 1993 decreased $1.0 million (or 2%) as compared to 1992 principally due to a decrease in polyethylene gross profits of $4.4 million as a result of lower margins, partially offset by lower environmental remediation charges in 1993. Gross profit for 1992 reflected a charge to increase the Company's environmental remediation accrual. Polyethylene margins for 1993 were lower than 1992 margins principally as a result of higher ethylene transfer prices and lower selling prices for polyethylene. Marketing, general and administrative expenses increased $2.0 million (or 7%) from $30.6 million in 1992 to $32.6 million in 1993 principally due to an increase in marketing and related expenditures incurred to address growth opportunities for plastic film and APAO. In addition, the increase in 1993 is due to unusually low expenses in 1992 as a result of changes in estimates of incentive and benefit plan expenses and lower legal fees for general litigation resulting from the automatic stay provision of the Bankruptcy Code. Due primarily to the factors described above, operating income decreased $3.2 million (or 18%) from $17.7 million in 1992 to $14.5 million in 1993. Other, net decreased $6.6 million (or 96%) from $6.8 million in 1992 to $.2 million in 1993 principally due to a $7.4 million accrual in 1992 relating to the adverse judgment (including estimated attorneys' fees) on the class action lawsuit discussed in Note 20 to the Consolidated Financial Statements, partially offset by $1.5 million of business interruption insurance proceeds received in 1992 for an electrical outage at the Odessa Facility in May 1991. The 1993 results include an income tax benefit of $8.9 million as compared to a benefit of $8.1 million for 1992. As a result of adoption of Statement of Financial Accounting Standards 109, "Accounting for Income Taxes" on September 30, 1992, the income tax benefit for 1993 is not comparable to the income tax benefit for 1992. Due primarily to the factors described above, the net loss decreased $4.0 million (or 14%) from $29.2 million in 1992 to $25.2 million in 1993. 1992 COMPARED TO 1991 As previously discussed, as a result of the Reorganization, the Company's financial condition and results of operations subsequent to September 30, 1992 are not comparable to those of prior periods. Therefore, the following analysis compares the results for the three months ended December 31, 1992 to the pro forma results for the three months ended December 31, 1991 and compares the results for the nine months ended September 30, 1992 to the nine months ended September 30, 1991. The pro forma information gives effect to the Reorganization as though it had occurred on September 30, 1991. The pro forma adjustments relate primarily to (i) the recording of interest expense in accordance with the terms of the Notes, (ii) the recording of depreciation of property, plant and equipment in accordance with their restated values, (iii) the recording of amortization of reorganization value in excess of amounts allocable to identifiable assets, and (iv) the income tax effects for adjustments (i) through (iii) above. Results of operations for the three months ended December 31, 1992 and the three months ended December 31, 1991, restated on a pro forma basis for comparative purposes, and the results of operations for the nine months ended September 30, 1992 and the nine months ended September 30, 1991 are as follows (in thousands): THREE MONTHS ENDED DECEMBER 31, 1992 COMPARED TO THREE MONTHS ENDED DECEMBER 31, 1991 (ON A PRO FORMA BASIS) Net sales remained constant for the three months ended December 31, 1992 as compared to the three months ended December 31, 1991. Polyethylene sales increased $2.7 million (or 9%) principally due to an increase in average selling prices of 4 cents per pound (or 12%). The increase in average selling prices was due to high capacity utilization HPLDPE industry. The polyethylene sales increase was offset by a decrease in polypropylene sales of $2.7 million (or 17%) for the three months ended December 31, 1992 compared to the same period in 1991 principally due to a decrease in sales volumes of 3.1 million pounds (or 9%) and a decrease in average selling prices of 4 cents per pound (or 9%). The decreased polypropylene sales volume was primarily due to lower demand resulting from overall economic conditions and oversupply in the global polypropylene markets. The Company's gross profit percentage increased from 11% in the three months ended December 31, 1991 to 12% in the 1992 period principally due to the 4 cents per pound polyethylene price increase. Marketing, general and administrative expenses decreased $1.1 million (or 11%) from $10.1 million for the three months ended December 31, 1991 to $9.0 million for the three months ended December 31, 1992 principally due to cost reduction and containment efforts. Due primarily to the factors described above, operating income was $1.4 million for the three months ended December 31, 1992 as compared, on a pro forma basis, to an operating loss of $.5 million for the corresponding period in 1991. Other, net increased $1.5 million for the three months ended December 31, 1992 as compared to the same period in 1991 principally because of a reimbursement from an escrow account established during a merger of the Company in 1988 of approximately $1.0 million for the net cost, plus interest thereon, of defending certain lawsuits. Due primarily to the factors described above, the net loss for the three months ended December 31, 1992 decreased by $4.0 million (or 38%) to $6.5 million, as compared, on a pro forma basis, to $10.5 million for the corresponding period in 1991. NINE MONTHS ENDED SEPTEMBER 30, 1992 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1991 Net sales decreased $34.8 million (or 10%) from $350.9 million for the nine months ended September 30, 1991 to $316.1 million for the nine months ended September 30, 1992 principally due to lower styrene, polyethylene and polypropylene sales. Styrene sales decreased $16.1 million (or 25%) in the first nine months of 1992 as compared to the first nine months of 1991 due to a volume decrease of 20.3 million pounds (or 9%) and a price decrease of 4.9 cents per pound (or 17%). The decrease in styrene volumes was primarily due to lower plant utilization rates which were implemented to minimize operating losses and to focus on key customers. Polyethylene sales decreased $10.6 million (or 10%) in the first nine months of 1992 as compared to the first nine months of 1991 due to a volume decrease of 22.1 million pounds (or 8%) and a price decrease of 1.0 cent per pound (or 3%). The polyethylene volume decrease was primarily due to lower demand resulting from sluggish economic conditions during the early part of the year. Polypropylene sales decreased $5.5 million (or 10%) in the first nine months of 1992 as compared to the first nine months of 1991 due to a price decrease of 2.1 cents per pound (or 5%) and a volume decrease of 6.5 million pounds (or 5%). The decrease in polypropylene volumes was primarily due to a variety of factors including lower plant utilization rates and overall economic conditions. Plastic film sales for the first nine months of 1992 remained relatively stable as compared to the comparable period in 1991. The Company's gross profit percentage decreased from 15% for the nine months ended September 30, 1991 to 12% for the same period in 1992 principally due to the lower average selling prices discussed above and due to an increase to the Company's environmental remediation accrual. Marketing, general and administrative expenses decreased $8.5 million (or 26%) from $32.4 million for the nine months ended September 30, 1991 to $23.9 million for the nine months ended September 30, 1992 principally due to cost containment efforts and lower legal fees for general litigation because of the automatic stay provision of the Bankruptcy Code. (Also see professional fees associated with the Reorganization discussed below). Due primarily to the factors described above, operating income for the nine months ended September 30, 1992 decreased $5.2 million (or 35%) to $9.4 million, as compared to $14.6 million for the corresponding period in 1991. Interest expense on the senior and subordinated notes of Old Rexene was accrued through October 18, 1991. In addition, interest expense was accrued from October 18, 1991 to December 31, 1991 in accordance with an agreement in principle between the Company and the holders of senior and subordinated notes of Old Rexene prior to the approval of the Amended Plan. The Amended Plan eliminated postpetition interest requirements through June 30, 1992. Therefore, postpetition interest of $6.8 million accrued as of December 31, 1991 was reversed in the first quarter of 1992 and is included in other, net on the condensed consolidated statement of operations for the nine months ended September 30, 1992. Interest expense from July 1, 1992 through September 30, 1992 is included in reorganization items. (See Note 3 to the Consolidated Financial Statements). Other, net for the nine months ended September 30, 1992 includes a $7.4 million accrual relating to the adverse judgment (including estimated attorneys' fees) on the class action lawsuit discussed in Note 20 to the Consolidated Financial Statements, partially offset by the reversal of postpetition interest of $6.8 million accrued as of December 31, 1991 discussed above and $1.5 million of business interruption insurance proceeds received for an electrical outage at the Odessa Facility in May 1991. The reorganization items for the nine months ended September 30, 1992 are described in Note 3 to the Consolidated Financial Statements. In the first nine months of 1992, the Company incurred $12.6 million of professional fees associated with the Reorganization. In the first nine months of 1991, the Company incurred $9.8 million of debt restructuring costs. The Company recorded income tax expense of $2.6 million on a loss before income taxes of $28.8 million for the nine months ended September 30, 1992. There are permanent differences between the Company's income for financial reporting purposes and tax purposes resulting principally from the lower tax basis for assets purchased when the Company was sold in 1988. These permanent differences cause the effective income tax rate to be higher than the statutory income tax rate for federal and state income taxes with the effective rate being greater in periods of lower taxable income. In the third quarter of 1992, the Company recorded an extraordinary gain of $123.7 million as a result of exchanging the senior and subordinated notes of Old Rexene for the Notes and common stock under the Amended Plan. Due primarily to the factors described above, the Company had net income of $92.2 million for the nine months ended September 30, 1992 (or a net loss before extraordinary gain of $31.5 million) compared to a net loss of $31.7 million for the corresponding period in 1991. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 31, 1993, $11.3 million of cash was generated from operations. During 1992, $2.8 million was generated from operations before reorganization items for the three months ended December 31, 1992 and $10.9 million for the nine months ended September 30, 1992. The operating cash flows for 1992 were unfavorably affected by the payout of $15.8 million for prepetition liabilities and favorably affected by an income tax refund of $17.2 million received from the Internal Revenue Service. Management believes that the unrestricted cash balance of $28.3 million on December 31, 1993, together with cash flow generated from operations and the availability of financing provided by the Loan Agreement, will be sufficient to meet the Company's liquidity needs during 1994. During 1993, the Company borrowed $2.0 million under the Loan Agreement for financing construction of the United Kingdom manufacturing facility. The restricted cash at December 31, 1993 of $2.2 million consists of amounts held in a reserve account under the Amended Plan for payment of disputed claims and administrative expenses. For each interest period relating to the Subordinated Notes ending on or prior to November 15, 1994, the Company may exercise the Pay-in-Kind feature. See "Item 1 -- The Reorganization". In 1993 and 1992, the Board of Directors exercised the Pay-in-Kind feature and issued $8.1 million and $2.9 million of Subordinated Notes. On March 1, 1994, the Board of Directors decided to exercise the Pay-in-Kind feature for the interest payment due on May 15, 1994, which will result in the issuance of approximately $4.3 million of additional Subordinated Notes. The Board of Directors will consider the advisability of exercising such feature for the interest payments on November 15, 1994. The Pay-in-Kind feature expires on November 15, 1994, and the Company's annual cash interest requirements will increase approximately $10.0 million, commencing with the semi-annual interest payment due on May 15, 1995. In addition, the interest rates on the Senior and Subordinated Notes increase beginning in 1995 and 1996, respectively. The annual interest rate on the Senior Notes is 9% through November 14, 1995. Thereafter, the annual interest rate increases to 12% from November 15, 1995 through November 14, 1996 and 14% thereafter. The annual interest rate on the Subordinated Notes is 10% through November 14, 1996. Thereafter, the annual interest rate increases to 12% from November 15, 1996 through November 14, 1997 and 14% thereafter. The Company's projected cash flow generated from operations and the availability of financing provided by the Loan Agreement are anticipated to be sufficient to meet its operating and debt service requirements for the next few years. Because of recent favorable trends in the economy and financing market, the Company is exploring a restructuring of its current long-term debt to reduce future cash interest costs. A number of potential environmental liabilities exist which relate to contaminated property. See "Item 1 -- Business-Environmental and Related Regulation". In addition, a number of potential environmental costs relate to pending or proposed environmental regulations. No assurance can be given that all of the potential liabilities arising out of the Company's present or past operations have been identified or that the amounts that might be required to remediate such sites or comply with pending or proposed environmental regulations can be accurately estimated; however, the Company recorded $23.4 million as an estimate at December 31, 1993 of its total potential environmental liability with respect to remediation of contaminated sites which management believes, on the basis of its reasonable investigation and analysis, is adequate. If, however, additional liabilities with respect to environmental contamination are identified, there is no assurance that additional amounts that might be required to remediate such potential liabilities would not have a material adverse effect on the financial condition of the Company. In addition, because government and environmental groups have become increasingly concerned in recent years about environmental issues, future regulatory developments could restrict or possibly prohibit existing methods of environmental compliance, such as the disposal of waste water in deep injection wells. At this time, the Company is unable to determine the potential consequences such possible future regulatory developments would have on its financial condition. Management continually reviews on an on-going basis its estimates of potential environmental liabilities. The Company does not currently carry environmental impairment liability insurance to protect it against such contingencies because such coverage is available only at great cost and with broad exclusions. As part of its financial assurance requirements under RCRA and equivalent Texas law, the Company has deposited $10.5 million in trust to cover closure and post-closure costs and liability for bodily injury and certain types of property damage arising from sudden and non-sudden accidental occurrences at certain of the Odessa Facility's hazardous waste management units. This deposit is included in other noncurrent assets in the December 31, 1993 balance sheet. This amount deposited in trust does not cover the costs of addressing existing contamination at the Odessa Facility. The Company does not believe that in the near future it will be able to satisfy any of the alternative financial assurance methods under RCRA which would allow funds to be released from the trust. To the extent any funds are released, they would be considered for the purpose of determining the mandatory redemption requirements for Senior Notes which may arise due to excess cash flow. The Company's operational expenditures for environmental remediation and waste disposal were approximately $6.4 million in 1993 and are expected to be approximately $6.9 million in 1994. In 1993 the Company also expended approximately $5.1 million relating to environmental capital expenditures. In 1994 the Company expects to spend approximately $2.9 million for environmentally-related capital expenditures, which is lower than historical levels due to timing of expenditures pertaining to several projects. Thereafter for the foreseeable future, the Company expects to incur approximately $4.0 to $5.0 million per year in capital spending to address environmental requirements. Annual amounts could vary depending on a variety of factors, such as the control measures or remedial technologies ultimately required and the time allowed to meet such requirements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's Consolidated Financial Statements and supplementary data required by this item are included on the pages immediately following the Index to Consolidated Financial Statements and Financial Statement Schedules appearing on page 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 information required by this item will be contained in the definitive proxy statement (the "Proxy Statement") of the Company to be filed in connection with its forthcoming annual meeting of stockholders scheduled for May 24, 1994, except for the information regarding executive officers of the Company contained in Part I of this Annual Report on Form 10-K. The information required by this item to be contained in the Proxy Statement is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be contained in the Proxy Statement. Such information 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 contained in the Proxy Statement. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item will be contained in the Proxy Statement. Such information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Consolidated Financial Statements: See Index to Consolidated Financial Statements on page. 2. Financial Statement Schedules: See Index to Consolidated Financial Statements on page. 3. Exhibits: (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, as of March 17, 1994. REXENE CORPORATION Registrant By: /s/ ANDREW J. SMITH -------------------------------------- Andrew J. Smith CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below as of March 17, 1994 by the following persons on behalf of the registrant and in the capacities indicated. REXENE CORPORATION AND SUBSIDIARIES ITEMS 8 AND 14(A) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements or the notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS -- POST-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Stockholders of Rexene Corporation In our opinion, the accompanying consolidated financial statements and financial statement schedules as listed on the Index on page , present fairly, in all material respects, the financial position of Rexene Corporation and its subsidiaries (the Company) at December 31, 1993 and 1992, and the results of their operations and their cash flows for the year ended December 31, 1993 and the three months ended December 31, 1992 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 notes 2 and 3 to the consolidated financial statements, on September 18, 1992 the Company's Plan of Reorganization was consummated. Effective September 30, 1992, the Company accounted for the Chapter 11 reorganization using "fresh-start" reporting as set forth in the American Institute of Certified Public Accountants' Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Accordingly, the financial statements subsequent to the emergence from Chapter 11 have been prepared using a different basis of accounting and are therefore not comparable to the pre-emergence consolidated financial statements. PRICE WATERHOUSE Dallas, Texas February 10, 1994 REPORT OF INDEPENDENT ACCOUNTANTS -- PRE-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Stockholders of Rexene Corporation In our opinion, the accompanying consolidated financial statements and financial statement schedules as listed on the Index on page , present fairly, in all material respects, the results of Rexene Corporation and its subsidiaries' (the Company) operations and their cash flows for the nine months ended September 30, 1992 and 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 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 notes 2 and 3 to the consolidated financial statements, on October 18, 1991 the Company filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The Company's Plan of Reorganization was consummated on September 18, 1992 and, effective September 30, 1992, the Company accounted for the reorganization using "fresh-start" reporting as set forth in the American Institute of Certified Public Accountants' Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." PRICE WATERHOUSE Dallas, Texas April 12, 1993 REXENE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See notes to consolidated financial statements. REXENE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) See notes to consolidated financial statements. REXENE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS) See notes to consolidated financial statements. REXENE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See notes to consolidated financial statements. REXENE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (IN THOUSANDS) See notes to consolidated financial statements. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES IDENTITY OF REGISTRANT Rexene Corporation ("Old Rexene") was merged into its wholly-owned operating subsidiary, Rexene Products Company, on September 11, 1992 pursuant to a First Amended Plan of Reorganization (the "Amended Plan") under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code") (see note 2). Upon completion of the merger, Rexene Products Company changed its name to Rexene Corporation ("New Rexene"). Old Rexene, Rexene Products Company and New Rexene are hereinafter sometimes collectively or separately referred to as the "Company". PRINCIPLES OF CONSOLIDATION The consolidated financial statements of the Company include its wholly-owned direct and indirect subsidiaries. CASH AND CASH EQUIVALENTS Cash equivalents represent short-term investments with maturities of three months or less. Restricted cash is held in a reserve account under the Amended Plan for payment of disputed claims and administrative expenses. INVENTORIES Inventories are stated at the lower of cost or market using the first-in, first-out method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Depreciation is provided utilizing the straight-line method over the estimated useful lives of the assets, ranging from 3 to 20 years. Improvements are capitalized, while repair and maintenance costs are charged to operations as incurred. Certain interest costs are capitalized as part of major construction projects. Upon disposal of assets, the cost and related accumulated depreciation are removed from the accounts and the resulting gain or loss is included in income. REORGANIZATION VALUE IN EXCESS OF AMOUNTS ALLOCABLE TO IDENTIFIABLE ASSETS Reorganization value in excess of amounts allocable to identifiable assets is amortized on a straight-line basis over fifteen years. INTANGIBLE ASSETS Intangible assets are stated at cost and consist primarily of licensing agreements and patents which are amortized on a straight-line basis over five years. DEFERRED PREOPERATING COSTS The incremental costs of establishing a plant in the United Kingdom have been deferred. This plant is scheduled to begin production in late 1994. These deferred preoperating costs will be amortized on a straight-line basis over five years, after commencement of production. INCOME TAXES Concurrent with fresh start reporting (see note 3), on September 30, 1992 the Company adopted Statement of Financial Accounting Standard ("SFAS") 109, "Accounting for Income Taxes", which requires an asset and liability approach to financial accounting and reporting of income taxes. Prior to September 30, 1992, the Company accounted for income taxes under the deferred method, as prescribed under Accounting Principles Board ("APB") Opinion No. 11, "Accounting for Income Taxes". FOREIGN CURRENCY TRANSLATION Operations of the foreign subsidiary use the local currency of the country of operation as the functional currency. The resulting translation adjustments are not significant in 1993. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) NET LOSS PER SHARE Net loss per share is based on the weighted average number of common stock and common stock equivalents outstanding. The per share amount for the pre-emergence periods is not presented since such information is not comparable with the post-emergence periods. RECLASSIFICATIONS Certain amounts in the 1992 and 1991 consolidated financial statements have been reclassified to conform with the 1993 presentation. 2. CHAPTER 11 REORGANIZATION As a result of its reorganization under Chapter 11 of the Bankruptcy Code and the confirmation of the Amended Plan by the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"), the Company, among other things, (i) reduced the principal amount of its long-term debt by replacing $403 million of outstanding senior and subordinated notes of Old Rexene, which was scheduled to mature in July 1992, with $337 million of debt that becomes due in 1999 and 2002, (ii) reduced its annual cash interest requirements from approximately $74 million to a minimum amount of approximately $24 million through 1994, and (iii) issued 92.5% of the common stock of New Rexene to the holders of such debt. The Amended Plan was consummated on September 18, 1992 (the "Effective Date"). Under the Amended Plan, the holders of outstanding senior notes of Old Rexene received, pro rata as a class, (i) an equal principal amount of Increasing Rate First Priority Notes due 1999 of New Rexene at an initial interest rate of 9% per year (the "Senior Notes"), (ii) 26% of the common stock of New Rexene to be outstanding after giving effect to the Amended Plan, and (iii) $11.7 million in cash representing the prepetition interest accrued on the outstanding senior notes of Old Rexene plus interest on the prepetition interest during the reorganization under Chapter 11 of the Bankruptcy Code proceedings. The holders of outstanding subordinated notes of Old Rexene received, pro rata as a class, (i) $84.375 million aggregate principal amount of Increasing Rate Second Priority Notes due 2002 (with certain sinking fund requirements in 2001) at an initial interest rate of 10% per year (the "Subordinated Notes", and together with the Senior Notes, the "Notes"), (ii) 66.5% of the common stock in New Rexene to be outstanding after giving effect to the Amended Plan, and (iii) $3.1 million in cash for settlement of prepetition interest. Holders of the common stock of Old Rexene became entitled to receive 7.5% of the common stock of New Rexene to be outstanding after giving effect to the Amended Plan. The Company recorded an extraordinary gain of $123.7 million as a result of exchanging the outstanding senior and subordinated debt of Old Rexene for the Notes and the common stock of New Rexene under the Amended Plan. 3. FRESH START REPORTING In connection with the reorganization under Chapter 11 of the Bankruptcy Code described in note 2, the Company adopted as of September 30, 1992, the American Institute of Certified Public Accountants' Statement of Position No. 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" (the "Reorganization SOP"). The Company's basis of accounting for financial reporting purposes changed as a result of adopting the Reorganization SOP. Specifically, the Reorganization SOP required (i) the adjustment of the Company's assets and liabilities to reflect a reorganization value (the "Reorganization Value") generally approximating the fair value of the Company as a going concern on an unleveraged basis, (ii) the elimination of its accumulated deficit, and (iii) adjustments to its capital structure to reflect consummation of the Amended Plan. Accordingly, the results of operations after September 30, 1992 are not comparable to results of operations prior to such date, and the results of operations for the nine months ended September 30, 1992 and the three months ended December 31, 1992 have not been aggregated. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. FRESH START REPORTING (CONTINUED) The Reorganization Value was determined by independent financial advisors. At September 30, 1992, the Reorganization Value of $291 million was allocated to assets and liabilities as follows (in thousands): Current assets and liabilities were recorded at their book value, which approximated fair value. Property, plant and equipment was recorded at reorganization value, which approximated fair value in continued use, based on an independent appraisal. Intangible assets and other noncurrent assets were recorded at their net book value, which approximated fair value. Long-term debt was recorded at present values as determined by independent financial advisors. Based on the allocation of the Reorganization Value in conformity with the procedures specified by the Reorganization SOP, the portion of the Reorganization Value which was not attributed to specific tangible or identifiable intangible assets of the reorganized Company was reported as "reorganization value in excess of amounts allocable to identifiable assets". The Company recorded the following reorganization expenses and adjustments to assets and liabilities to reflect fresh start reporting in its statement of operations for the nine months ended September 30, 1992 (in thousands): REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. ACCOUNTS RECEIVABLE Accounts receivable consist of the following (in thousands): Bad debt expense for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991 is $223,000, $300,000, $327,000 and $1,175,000, respectively. 5. INVENTORIES Inventories consist of the following (in thousands): 6. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following (in thousands): Depreciation expense for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991 is $16,059,000, $3,664,000, $17,689,000 and $20,656,000, respectively. During the year ended December 31, 1993, the three months ended December 31, 1992 and the year ended December 31, 1991, $1,259,000, $312,000 and $4,685,000, respectively, of interest was capitalized in connection with construction projects. No interest was capitalized during the nine months ended September 30, 1992. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. REORGANIZATION VALUE IN EXCESS OF AMOUNTS ALLOCABLE TO IDENTIFIABLE ASSETS AND INTANGIBLE ASSETS Reorganization value in excess of amounts allocable to identifiable assets and intangible assets, net of accumulated amortization are (in thousands): 8. OTHER NONCURRENT ASSETS Other noncurrent assets consist of the following (in thousands): The deposits held in trusts for the benefit of the Texas Water Commission were established and funded to comply with the financial assurance requirements of the Resource Conservation and Recovery Act. 9. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands): 10. BANK BORROWINGS The Company entered into a loan agreement dated September 18, 1992 (the "Loan Agreement") as subsequently amended, with Transamerica Business Credit Corporation providing for a credit facility for general corporate purposes of up to $35 million, $15 million of which may be used for financing the operations of a subsidiary in the United Kingdom. The Loan Agreement includes a sub-facility of $15 million for stand-by letters of credit. The Loan Agreement terminates December 31, 1996. The Company pays interest on borrowed funds at 1.5% above the prime rate. At December 31, 1993, the Company had borrowed $2.0 million under the Loan Agreement at an annual interest rate of 7%. There were no borrowings under the Loan Agreement in 1992. At December 31, 1993 and 1992 REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. BANK BORROWINGS (CONTINUED) approximately $2.9 million and $1.1 million, respectively, of stand-by letters of credit were outstanding under the Loan Agreement. Funds advanced under the Loan Agreement are secured by a first lien on the Company's (i) inventory, (ii) accounts receivable, other than intercompany receivables, (iii) letters of credit and (iv) the proceeds of the above. The Loan Agreement also contains certain continuing obligations, such as the maintenance of a minimum cash flow coverage ratio, as well as restrictions or prohibitions covering, among other things, the incurrence of other indebtedness, asset sales, investments, dividend payments, mergers and acquisitions. 11. LONG-TERM DEBT Long-term debt consists of the following (in thousands): The long-term debt was recorded at its fair market value at the Effective Date. The resulting discount from the face amount is accreted to interest expense over the term of the Notes. The Company believes, based on its understanding of the bid and ask prices at December 31, 1993, that the aggregate fair market value of the long-term debt is approximately $36 million greater than its net book value. The Senior Notes are secured by a first lien on all of the assets of the Company and its subsidiaries, other than (i) accounts receivable, other than intercompany receivables, (ii) inventory, (iii) cash and cash equivalents, and (iv) certain nonmaterial excluded assets (the "Collateral"). Interest is payable on the Notes semiannually on May 15 and November 15. In addition, the interest rates on the Senior and Subordinated Notes increase beginning in 1995 and 1996, respectively. The annual interest rate on the Senior Notes is 9% through November 14, 1995, 12% from November 15, 1995 through November 14, 1996 and 14% thereafter. The Subordinated Notes are secured by a second lien on the Collateral. The annual interest rate on the Subordinated Notes is 10% through November 14, 1996, 12% from November 15, 1996 through November 14, 1997 and 14% thereafter. For each interest period ending on or prior to November 15, 1994, the Company may pay up to 90% of the interest due on the Subordinated Notes by delivering additional Subordinated Notes in lieu of cash ("Pay-in-Kind"), if certain financial tests are met. In 1993 and 1992, the Board of Directors exercised the Pay-in-Kind feature and issued $8.1 million and $2.9 million, respectively, of Subordinated Notes. The Pay-in-Kind feature expires on November 15, 1994, and the Company's annual cash interest requirements will increase approximately $10.0 million, commencing with the semi-annual interest payment due on May 15, 1995. The Senior Notes, and after all Senior Notes are redeemed, the Subordinated Notes, are redeemable at the option of the Company, at any time in whole or from time to time in part, at a price equal to 100% of the principal amount to be redeemed plus accrued interest to the redemption date. In addition REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. LONG-TERM DEBT (CONTINUED) the Company may at any time purchase Senior Notes in the open market. In the event the Company generates "excess cash flow" from operations (as defined in the indenture governing the Senior Notes) in any fiscal year, the Company is required to make an offer to purchase Senior Notes at par in an amount equal to such excess cash flow. However, the cash purchase price of Senior Notes acquired in the open market (not previously applied as a credit) may be credited towards the excess cash flow offer requirement. In addition, in the event of asset sales exceeding $8 million in the aggregate during any four consecutive fiscal quarters, the Company is required to make an offer to purchase Senior Notes and thereafter, if applicable, Subordinated Notes at par in an amount equal to the net proceeds (as defined in the indentures governing the Notes (the "Indentures")) of such asset sales. Open market purchases cannot be credited towards the asset sale redemption requirement. The Indentures contain covenants which, among other things (i) limit the Company's ability to incur additional indebtedness, (ii) limit restricted payments (e.g. dividends, purchases or redemption of subordinated indebtedness, purchases or redemption of capital stock and certain investments), (iii) limit the incurrence of liens other than certain permitted liens, (iv) restrict transactions with stockholders and affiliates, (v) require the maintenance of a minimum stockholders' equity, and (vi) limit certain investments. 12. OTHER NONCURRENT LIABILITIES Other noncurrent liabilities consist of the following (in thousands): Noncurrent interest payable represents non-cash interest accrued in accordance with Emerging Issues Task Force ("EITF") Issue No. 86-15, "Increasing Rate Debt". Under EITF Issue No. 86-15, aggregate interest expense is charged in equal amounts over the estimated term of the Notes (see note 15). 13. COMMITMENTS The future payments of rentals on buildings, computers, office equipment and transportation equipment under the terms of noncancellable operating lease agreements are as follows (in thousands): REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 13. COMMITMENTS (CONTINUED) Rental expense under operating leases for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991, approximated $7,630,000, $2,024,000, $6,451,000 and $7,810,000, respectively. 14. INCOME TAXES At September 30, 1992, the Company adopted SFAS 109, "Accounting for Income Taxes", concurrent with its adoption of fresh start reporting. For periods prior to the three months ended December 31, 1992, the Company accounted for income taxes under principles provided in APB 11. Therefore, the income tax benefit for the year ended December 31, 1993 and the three months ended December 31, 1992 is not comparable with the income tax expense (benefit) for the nine months ended September 30, 1992 and the year ended December 31, 1991. The current income tax benefit for the year ended December 31, 1993 includes a federal income tax benefit of $4.0 million, relating primarily to the carryback of the Company's 1993 net operating loss to the year ended December 31, 1990. The income tax benefit for the nine months ended September 30, 1992 is principally for alternative minimum taxes. During the bankruptcy proceedings in 1992, all federal income tax matters through the 1991 tax year were resolved which resulted in, among other things, a refund of $17.2 million from the Internal Revenue Service. The Company has unused net operating loss carryforwards of $1.2 million at December 31, 1993 that expire in the year 2004 and an alternative minimum tax credit carryforward of approximately $1.6 million. The utilization of the net operating loss carryforwards and tax credit carryforwards is shown as a charge equivalent to federal income taxes in 1991. Income tax (expense) benefit consists of the following (in thousands): Deferred income tax provisions under SFAS 109 result from temporary differences between the basis of assets and liabilities for financial reporting purposes. Under APB 11 the deferred income tax provisions result from timing differences in the recognition of revenues and expenses for tax and financial reporting purposes. The deferred income tax benefit for the year ended December 31, 1993 is net of a charge of $1.3 million to record the effect of the Omnibus Budget Reconciliation Act of 1993, REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. INCOME TAXES (CONTINUED) which increased the corporate federal tax rate from 34% to 35%, retroactive from January 1, 1993. The nature of the temporary differences under SFAS 109 and timing differences under APB 11 and the tax effects are as follows (in thousands): Deferred income taxes consist of the following (in thousands): The effective income tax rate differs from the amount computed by applying the federal income tax rate to income before income taxes. The federal income tax rate was 35% for the year ended REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. INCOME TAXES (CONTINUED) December 31, 1993 and 34% for the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991. The reasons for these differences are as follows (in thousands): 15. INTEREST EXPENSE Cash interest for the year ended December 31, 1993 and the three months ended December 31, 1992 consists of interest on the Senior Notes and 10% of the interest on the Subordinated Notes. The remaining 90% of the interest on the Subordinated Notes is included as non-cash interest in accordance with the Pay-in-Kind feature (see note 11). In addition, non-cash interest includes (i) accretion on the Notes (see note 11), (ii) an adjustment for EITF Issue No. 86-15 (see note 12), and (iii) an adjustment for interest capitalized in connection with construction projects (see note 6). 16. OTHER STATEMENT OF OPERATIONS INFORMATION Other, net for the nine months ended September 30, 1992 includes an accrual of $7.4 million relating to the adverse judgment in the class action lawsuit discussed in note 20 which was partially offset by a reversal of postpetition interest of $6.8 million accrued as of December 31, 1991 and $1.5 million of business interruption insurance proceeds received in 1992 for an electrical outage at the Odessa, Texas facility in May 1991. During 1991 the Company incurred $7.9 million of debt restructuring costs. Included in other income for the year ended December 31, 1991 is approximately $1 million in license fees from a joint venture with Ube Industries, Ltd. Export sales of the Company were $30,495,000, $9,295,000, $33,806,000 and $71,570,000 for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991, respectively. The majority of export sales were to foreign companies through agents and domestic offices of foreign companies, which are responsible for the actual export of the product to a variety of locations. Accordingly, amounts of export sales to specific geographic locations are not available. Maintenance and repair expenses were $27,017,000, $6,221,000, $18,244,000 and $26,665,000 for the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991, respectively. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. EMPLOYEE BENEFITS SAVINGS PLAN The Company sponsors an employee savings plan (the "Savings Plan") that is intended to provide participating employees with additional income upon retirement. Employees may contribute between 1% and 10% of their base salary up to a maximum of $8,994 annually to the Savings Plan. The Company matches a minimum of 25% of the employee's aggregate contributions up to 6% of the employee's base salary. Employee contributions are fully vested. Employer contributions are fully vested upon retirement or after five years of service. For 1993, 1992 and 1991, the Company matched 25% of the employee contributions up to the 6% limit. The Company contributed approximately $351,000, $96,000, $275,000 and $351,000 to the Savings Plan during the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991, respectively. PENSION PLANS The Company has two noncontributory defined benefit plans (the "Pension Plans") covering substantially all full time employees. Benefits provided under the Pension Plans are primarily based on years of service and the employee's final average earnings. The Company's funding policy is to contribute annually an amount based upon actuarial and economic assumptions designed to achieve adequate funding of projected benefit obligations. Net pension expense consists of the following (in thousands): The following table sets forth the funded status of the Pension Plan (in thousands): At December 31, 1993 and 1992, in determining the present value of benefit obligations, a discount rate of 7.0% and 7.5% was used, respectively. The assumption for the increase in future compensation levels was 4.5% at December 31, 1993 and 1992. At December 31, 1993 and 1992, the expected long-term rate of return on assets used in determining future service costs was 9.0%. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. EMPLOYEE BENEFITS (CONTINUED) POSTEMPLOYMENT BENEFITS Concurrent with fresh start reporting (see note 3), on September 30, 1992 the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits", which generally requires an employer to recognize the obligation to provide postemployment benefits. The obligation for postemployment benefits at December 31, 1993 and 1992 approximated $1.2 million and is included in other noncurrent liabilities. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company sponsors life and health welfare benefits plans for its current and future retirees. Concurrent with fresh start reporting (see note 3), on September 30, 1992 the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires an accrual method of accounting for certain postretirement benefits. Adoption of SFAS 106 did not have a material effect on the September 30, 1992 financial statements since the Company had recorded an estimated liability for these benefits as part of purchase accounting entries recorded in 1988. Prior to September 30, 1992, the cost of net postretirement benefits other than pensions were recognized using the pay-as-you-go basis. Net postretirement benefit cost consists of the following (in thousands): The actuarial value of postretirement benefit obligations consists of (in thousands): In 1993 and 1992, in determining the value of postretirement benefit obligations, a discount rate of 7.0% and 8.25%, respectively, was used, and in 1993 the health care trend rate used to measure the expected increase in cost of benefits was assumed to be 15% in 1994, and descending to 6.5% in 2006 and thereafter. A one percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $800,000 and would increase the net postretirement benefit cost for the year ended December 31, 1993 by approximately $90,000. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. EMPLOYEE BENEFITS (CONTINUED) STOCK OPTION PLANS FOR EMPLOYEES In July 1988, the Company adopted a stock incentive plan (the "Stock Incentive Plan") providing for the granting of stock options for, stock appreciation rights in, and the sale of restricted shares of, common stock. The number of shares of common stock issuable under the Stock Incentive Plan is limited to 87,500 shares in the aggregate. In 1993, the Company adopted a non-qualified stock option plan (the "Employee Plan") providing for the granting of 700,000 stock options for common stock to key salaried employees of the Company. Changes in stock options during the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992 and the year ended December 31, 1991, are summarized as follows: All of the data above has been adjusted to reflect a 40-for-1 reverse stock split effected in connection with the merger of Old Rexene into Rexene Products Company as described in note 1. Of the employee options outstanding at December 31, 1993, 12,500 are exercisable. NON-QUALIFIED STOCK OPTION PLAN FOR OUTSIDE DIRECTORS In 1993, the Company adopted a non-qualified stock option plan for outside directors (the "Directors Plan") providing for the granting of 225,000 stock options for common stock. The Directors Plan provided for the automatic grant as of January 1, 1993 and January 1, 1994 to each non-employee director of options to purchase 12,500 shares of common stock, other than the Chairman of the Board for whom an award on each grant date of options to purchase 16,667 shares of common stock was provided. The exercise price of the options to purchase 104,167 shares of common stock granted in each year under the Directors Plan as of January 1, 1994 and 1993 was $0.43 and $0.63 per share, respectively. STOCK OPTION FOR FORMER OFFICER In 1992, the Company granted a stock option to purchase at an aggregate exercise price of $901,120, for a five-year period, an amount equal to one percent of the common stock outstanding from the Effective Date, giving effect to the Amended Plan and other adjustments. STOCK BONUS PLAN During 1985, the Company established an employee stock bonus plan (the "Stock Bonus Plan") for the benefit of its employees. Contributions were made at the discretion of the Company. Effective REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. EMPLOYEE BENEFITS (CONTINUED) January 1, 1992, all participants (as defined) became 100% vested and participation in the Stock Bonus Plan was frozen. The Company does not intend to make further contributions to the Stock Bonus Plan (see note 20). 18. SHARE PURCHASE RIGHTS PLAN In January 1993, the Company adopted a share purchase rights plan ("Share Rights Plan") by declaring a dividend distribution on February 8, 1993 of one Common Stock Purchase Right ("Right") on each outstanding share of common stock. The Rights are exercisable only if a person or group acquires 15% or more of common stock or announces a tender offer, the consummation of which would result in ownership by a person or group of 15% or more of the common stock. Each Right entitles stockholders to purchase such number of shares of common stock at an exercise price of $25.00 as determined under formulas set out in the Share Rights Plan. If the Company is acquired in a merger or other business combination, each Right will entitle its holder to purchase, at the Rights' then-current exercise price, a number of shares of the acquiring Company's common stock having a market value of twice such price. In addition, if a person or group acquires 15% or more of the Company's common stock, each Right will entitle its holder (other than the acquiring person or group) to purchase, at the Right's then-current exercise price, a number of shares of common stock having a market value of twice such price. Following the acquisition by a person of beneficial ownership of 15% or more of the Company's common stock and prior to an acquisition of 50% or more of the common stock, the Board of Directors may exchange the Rights (other than Rights owned by the acquiring person or group), in whole or in part, at an exchange ratio of one share of common stock per Right. The Company can terminate the Rights at no cost any time prior to the acquisition of a 15% position. The termination period can be extended by the Board of Directors. The rights expire February 8, 2003. 19. RELATED PARTY TRANSACTIONS Pursuant to a letter agreement dated March 16, 1992 between the Company and its Chairman of the Board, Arthur L. Goeschel, the Company agreed to pay Mr. Goeschel, in addition to his normal director fees, a sum of $2,750 per day plus expenses for each day over five days per quarter that he spends on Company matters. Under this letter agreement, the Company paid Mr. Goeschel $107,250, $60,500 and $137,500 in additional fees for the year ended December 31, 1993, the three months ended December 31, 1992 and the nine months ended September 30, 1992, respectively. Mr. Goeschel is also a director of Calgon Carbon Corporation ("Calgon"). During the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992, and the year ended December 31, 1991, the Company purchased approximately $44,000, $36,000, $54,000 and $126,000, respectively, of materials from Calgon in the ordinary course of business. A son of Mr. Andrew J. Smith, the Chief Executive Officer and a director of the Company, became a Vice President in 1990 and a stockholder in 1993 of Orion Pacific, Inc. ("Orion"). In August 1993 the son of Mr. Smith resigned as an officer and employee of Orion. Pursuant to contractual arrangements originated in 1988, (i) the Company sells to Orion certain (a) discarded by-products which Orion extracts from Company landfills and (b) scrap products, and (ii) Orion packages and processes a portion of the Rextac amorphous polyalphaolefins ("APAO") manufactured by the Company at its plant in Odessa, Texas. During the year ended December 31, 1993, the three months ended December 31, 1992, the nine months ended September 30, 1992, and the year ended December 31, 1991, the Company sold approximately $283,000, $241,000, $671,000 and $1,005,000, respectively, of such by-product and scrap products to Orion in the ordinary course of business. For the same periods, the REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 19. RELATED PARTY TRANSACTIONS (CONTINUED) Company purchased approximately $1,551,000, $302,000, $1,033,000 and $1,087,000, respectively, of APAO processing and packaging services and miscellaneous materials from Orion. At December 31, 1993, the net payable to Orion was approximately $55,000 and at December 31, 1992, the net receivable from Orion was approximately $332,000. In 1990, Orion sold its APAO processing and packaging technology to the Company for $750,000. The Company has also agreed to pay Orion an additional $250,000 per plant for each APAO plant utilizing the technology which the Company builds outside the United States (excluding a certain joint venture plant in Japan). The Company currently licenses this technology to Orion so that Orion can continue providing these services to the Company. Mr. Ilan Kaufthal, a director of the Company, is a managing director of Wertheim Schroder & Co. Incorporated ("Wertheim"). In February 1991, an unofficial committee of holders of debt securities of the Company retained Wertheim as its financial advisor at the Company's expense. In November 1991, the official committee of unsecured creditors in the Company's bankruptcy proceeding also retained Wertheim as its financial advisor at the Company's expense. Pursuant to these engagements, the Company paid Wertheim fees of $860,000 and $1,075,000 for the nine months ended September 30, 1992 and the year ended December 31, 1991, respectively. In December 1992, the Company retained Wertheim as its financial advisor with respect to the adoption of a share purchase rights plan (see note 18) for approximately $78,000. The American International Group, Inc. ("AIG") of which Mr. Kevin Clowe, a director of the Company, is a corporate officer provides various types of insurance for the Company. During 1993, the Company paid approximately $2.8 million in premiums and fees to subsidiaries of AIG. In addition, a subsidiary of AIG is the beneficiary of a standby letter of credit of $1.2 million to ensure payment of premiums. On March 2, 1992, Mr. William Gilliam resigned as Chairman of the Board and Chief Executive Officer of the Company. In connection with Mr. Gilliam's resignation, the Company, Mr. Gilliam, and Gilliam and Company, Inc., a corporation of which Mr. Gilliam was the sole shareholder ("GCI"), with the approval of the Bankruptcy Court, entered into an agreement which, among other things, (i) terminated a management agreement (the "Management Agreement") between the Company and GCI which had been suspended during the Chapter 11 proceedings, (ii) granted to Mr. Gilliam a stock option (see note 17), and (iii) paid $500,000 to Mr. Gilliam. Under the Management Agreement, as consideration for advisory and consulting services, the Company agreed to pay GCI a fee of $1 million per year plus reimbursement of expenses. For the year ended December 31, 1991, the Company paid GCI approximately $800,000. In addition, the Company reimbursed GCI approximately $653,000 in such year for expenses primarily consisting of the operating costs for GCI aircraft used in connection with Company business. In April 1988, the Company was sold (the "1988 Merger") by its then current stockholders (the "Selling Stockholders"). Pursuant to the merger agreement for the 1988 Merger (the "1988 Merger Agreement") and a related escrow agreement, $30 million of the purchase price was deposited into an escrow account (the "Escrow Account") on behalf of the Selling Stockholders to indemnify the Company against certain contingencies. In December 1992, the Company entered into a memorandum agreement (the "Escrow Settlement Agreement") for the disposition of the principal balance of the Escrow Account and accrued interest thereon (less certain prior distributions). Pursuant to the Escrow Settlement Agreement, the Escrow Account, among other things, (i) distributed approximately $32.1 million to the Selling Stockholders, (ii) paid approximately $1 million to reimburse the Company for its net expenses (plus interest thereon) in defending certain lawsuits, (iii) retained $2.25 million as a reserve to pay certain potential expenses of the Escrow Account and (iv) retained $2 million which will be available to the Company to pay up to 50% of any portion of a final judgment or REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 19. RELATED PARTY TRANSACTIONS (CONTINUED) settlement in the Izzarelli litigation (as hereafter described in note 20) which is not paid by insurance. As a result of the Escrow Settlement Agreement, Mr. Smith, Dr. Lavon N. Anderson, the president and chief operating officer and a director of the Company, and Mr. Jack E. Knott, executive vice president of sales and market development of the Company, received approximately $660,000, $85,000 and $71,000 from the Escrow Account, respectively in 1992. Any amounts being reserved by the Escrow Account which are not utilized for their intended purpose will be available for future distribution to the Selling Stockholders. In all negotiations concerning the Escrow Account, the Selling Stockholders were represented by a committee appointed under the 1988 Merger Agreement and by counsel to such committee. Mr. Smith, Dr. Anderson and Mr. Knott were not members of such committee and did not participate in any of the negotiations between the Company and the committee. 20. CONTINGENCIES The Company is subject to extensive environmental laws and regulations concerning, for example, emissions to the air, discharges to surface and subsurface waters and the generation, handling, storage, transportation, treatment and disposal of waste and other materials. The Company believes that, in light of its historical expenditures, it will have adequate resources to conduct its operations in compliance with currently applicable environmental and health and safety laws and regulations. However, in order to comply with changing licensing and regulatory standards, the Company may be required to make additional significant site or operational modifications. Further, the Company has incurred and may in the future incur liability to clean up waste or contamination at its current or former facilities, or which it may have disposed of at facilities operated by third parties. The Company recorded $23.4 million as an estimate at December 31, 1993 of its total potential environmental liability with respect to remediating site contamination, which it believes is adequate. However, no assurance can be given that all potential liabilities arising out of the Company's present or past operations have been identified or that the amounts that might be required to remediate such conditions will not be significant to the Company. The Company continually reviews its estimates of potential environmental liabilities. STOCKHOLDER CLASS ACTION LITIGATION In January 1990, a purported class action was filed in the United States District Court, Northern District of Texas, by an alleged stockholder of the Company on behalf of purchasers of common stock of Old Rexene between October 23, 1989 and December 27, 1989. The defendants in this action presently include the Company, one of its current directors and certain of its former directors. The class has been certified with an intervenor as the class representative. The intervenor's complaint asserts claims under Section 10b-5 of the Securities Exchange Act of 1934, and state common law grounds. The plaintiff alleges that public statements made by certain directors of the Company created a misleading impression of the Company's financial condition thereby artificially inflating the price of the common stock of Old Rexene. The plaintiff seeks compensatory damages, prejudgment interest, a recovery of costs and attorneys' fees, and such other relief as may be deemed just and proper. Discovery is ongoing. In the Company's Chapter 11 proceeding, the intervening plaintiff filed a proof of claim on behalf of herself and the purported class seeking in excess of $10 million based upon the allegations in the litigation. The Company objected to the claim and elected to leave the legal, equitable and contractual rights of the plaintiff unaltered thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 20. CONTINGENCIES (CONTINUED) IZZARELLI STOCK BONUS PLAN CLASS ACTION LITIGATION In February 1991, a class action lawsuit was filed in the United States District Court for the Western District of Texas -- Midland Division (the "Trial Court") against the Company, the Stock Bonus Plan and Texas Commerce Bank -- Odessa (the former trustee for the Stock Bonus Plan) by two former employees of the Company on behalf of themselves and all other 1986 participants in the Stock Bonus Plan (the "Izzarelli Class"). The complaint alleges that the Company amended the Stock Bonus Plan in 1987 and 1988 to deprive the Izzarelli Class of stock benefits to which they would have been entitled had the Stock Bonus Plan not been amended. The plaintiffs assert claims under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") for breach of fiduciary duties to the participants and for violation of ERISA's provision prohibiting amendments to the Stock Bonus Plan after benefits have accrued to participants. The plaintiffs seek actual damages, attorneys' fees, costs and expenses, and such further relief as may be deemed appropriate. After a trial, the Trial Court in July 1992 entered a judgment against the Company in the amount of $6.6 million (as subsequently amended) plus costs of court. In November 1992, the Trial Court awarded the Izzarelli Class $595,000 for attorneys' fees and out-of-pocket expenses. The Company has recorded an accrual of $7.4 million to reflect this judgment. The Company has appealed the judgment to the United States Court of Appeals for the Fifth Circuit. The Izzarelli Class has also filed an appeal with respect to the amount of damages awarded and the judgment in favor of Texas Commerce Bank -- Odessa. These appeals are pending. In the Bankruptcy Court, the Izzarelli Class filed proofs of claim for $27.7 million. The Izzarelli Class has pending before the Bankruptcy Court a motion to alter or amend the order confirming the Amended Plan and a motion to allow their claim based upon the judgment entered by the Trial Court. The Company believes that if the Bankruptcy Court granted these motions, the Izzarelli Class would be allowed to enforce its judgment unless the Company posted a bond or other security. Pursuant to a request by the Company, the Bankruptcy Court on November 4, 1992 entered an order continuing such motions until the resolution of the appeals pending in the Fifth Circuit Court of Appeals. The Izzarelli Class has appealed the Bankruptcy Court's continuation order to the United States District Court for the District of Delaware, which dismissed the appeal on September 29, 1993. The Izzarelli Class then filed an appeal with the United States Court of Appeals for the Third Circuit. This appeal is pending. Pursuant to an agreement in December 1992 regarding the distribution of the remaining balance in an escrow account established in connection with a 1988 merger involving the Company, there is $2 million being retained in the escrow account which will be available to the Company to pay up to 50% of any portion of a final judgment or settlement in this matter which is not paid by insurance. The Company intends to pursue claims for recovery of the amount of any final judgment or settlement against its insurance carrier subject to policy limits of $10 million. Although the insurance carrier has been paying the Company's attorneys' fees, it has otherwise denied coverage and reserved all rights. PHILLIPS BLOCK COPOLYMER LITIGATION In March 1984, Phillips Petroleum Company ("Phillips") filed a lawsuit against the Company in the United States District Court for the Northern District of Illinois, Eastern Division, seeking injunctive relief, an unspecified amount of compensatory damages and treble damages. The complaint alleges that the Company's copolymer process for polypropylene infringes Phillips' two "block" copolymer patents. This action has been transferred to the United States District Court for the Southern District of Texas, Houston Division. Discovery proceedings in this case have been completed. The Company has filed a motion for summary judgment. Phillips has filed a motion for partial summary judgment. Pursuant to an agreement among the parties, the Court appointed a Special REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 20. CONTINGENCIES (CONTINUED) Master who conducted a hearing on these motions and thereafter recommended to the Court that the Company's motion be granted and Phillips' motion be denied. Thereafter, Phillips filed motions to disqualify the Special Master, to reject the recommendation of the Special Master and to enter partial summary judgment for Phillips. The Court has entered an order denying Phillips' motion to disqualify the Special Master. The summary judgment motions are still pending. In the Company's Chapter 11 proceedings, Phillips filed proofs of claim seeking in excess of $108 million based upon the allegations in this litigation. The Company objected to the claims and elected to leave the legal, equitable and contractual rights of Phillips unaltered thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. PHILLIPS CRYSTALLINE LICENSE LITIGATION In May 1990, Phillips filed a lawsuit against the Company in the United States District Court for the District of Delaware seeking injunctive relief, an unspecified amount of compensatory damages, treble damages and attorneys' fees, costs and expenses. The complaint alleges that the Company is infringing Phillips' Patent No. 4,376,851 (the "851 Patent") for crystalline polypropylene. Pursuant to a License Agreement dated as of May 15, 1983 (the "License Agreement"), Phillips granted the Company a non-exclusive license to make, use and sell crystalline polypropylene covered by the '851 Patent. The complaint alleges that effective April 21, 1990, Phillips terminated the License Agreement because it believed that, by the terms of the License Agreement, all conditions precedent to such termination had occurred. The complaint further alleges that, without an effective License Agreement, the Company's continuing use of the '851 Patent constitutes an infringing use. An amended complaint filed in May 1990 further alleges that the Company made a material misrepresentation that induced Phillips to enter into the License Agreement and that Phillips entered into the License Agreement as a consequence of a mutual mistake of the parties. The amended complaint therefore alleges that the License Agreement is void AB INITIO. The Company filed a motion to dismiss Phillips' amended complaint for failure to state a claim. On December 30, 1993, the Court entered an order dismissing Phillips' claim that the License Agreement was void AB INITIO, and ordered that the 1990 license termination issue be resolved at trial. Trial has been scheduled for October 19, 1994. In the Company's Chapter 11 proceedings, Phillips filed proofs of claim seeking in excess of $147 million based upon the allegations in this litigation. The Company objected to the claims and elected to leave the legal, equitable and contractual rights of Phillips unaltered thereby allowing this litigation to proceed as of the Effective Date without regard to the bankruptcy proceeding. With respect to each of the litigation matters described above, the Company believes that, based upon its current knowledge of the facts of each case, the Company has meritorious defenses to the various claims made and intends to defend each such suit vigorously. Although there can be no assurance of the final resolution of any of these litigation matters, the Company does not believe that the outcome of any of these lawsuits will have a material adverse effect on the Company's financial condition. The Company is also a party to various lawsuits arising in the ordinary course of business and does not believe that the outcome of any of these lawsuits will have a material adverse effect on the Company's financial position. REXENE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 21. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial information for the year ended December 31, 1993, the three months ended December 31, 1992 and the nine months ended September 30, 1992 is as follows (in thousands, except per share data): The per share amount for the pre-emergence periods is not presented because such information is not comparable with the post-emergence periods. SCHEDULE V REXENE CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) S-1 SCHEDULE VI REXENE CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) S-2 SCHEDULE VIII REXENE CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) S-3

765506_1993.txt

765506_1993

1993

765506

Item 1. Business The registrant, California Seven Associates Limited Partnership, a California limited partnership (the "Partnership"), was formed on January 30, 1985 under the laws of the State of California to acquire and operate seven apartment complexes located in California. Pursuant to a private offering, in February 1985, the Partnership sold Class B Limited Partnership Interests for an aggregate purchase price of $500,000. Commencing in March 1985, the Partnership sold Class A Limited Partnership Interests (the "Units") at a price of $150,000 each (362 Units in total), for an aggregate purchase price of $54,300,000. The selling period closed on December 15, 1985 with $54,800,000 having been raised from a total of 526 Class A and B investors. On April 30, 1986, the Partnership filed a General Form for Registration of Securities on Form 10 pursuant to the Securities Act of 1934 (Registration No. 0-14581), which was amended by Form 8 dated July 25, 1986. The General Partner of the Partnership is CIGNA Realty Resources, Inc.-Seventh (the "General Partner"), a Delaware corporation qualified to do business in the States of California and Connecticut and a wholly owned subsidiary of CIGNA Financial Partners, Inc. ("CFP"), which is in turn, a wholly owned subsidiary of Connecticut General Corporation ("CGC"), which is in turn, a wholly owned subsidiary of CIGNA Holdings, Inc., which is a wholly owned subsidiary of CIGNA Corporation ("CIGNA"), a publicly held corporation whose stock is traded on the New York Stock Exchange. The Partnership is engaged solely in the business of real estate investment. A presentation of information about industry segments is not applicable. On January 31, 1985, the Partnership acquired from IFD Properties, Inc.-First, ("IFD-First"), an affiliate of the General Partner, fee title, subject to a first mortgage note and seven deeds of trust, to seven apartment complexes (the "Investment") and related site improvements in the State of California for the aggregate purchase price, excluding acquisition fees and expenses, of $146,000,000. During 1990, one of the seven apartment complexes was sold. Of the remaining six apartment complexes (the "Project"), three were operated as conventional apartment complexes and three were operated under the R & B OAKWOOD marketing concept ("OAKWOOD") during 1993. During 1994, one of the three OAKWOOD properties will be converting to conventional operation. See Items 2 and 7 for a definition and discussion of the OAKWOOD concept. On January 17, 1994, the Sherman Oaks OAKWOOD property sustained extensive damage during the Southern California earthquake. The property was "red-tagged" by city officials, a designation issued to buildings considered totally unsafe for use. The extent of the damage is currently being reviewed and the ultimate effect on the Partnership's operations and value of the Project is unknown. The Partnership's Project is insured for earthquakes (5% deductible) and business interruption. The Project, in aggregate, is currently subject to a modified first mortgage and a related party second mortgage. See Item 7 and the Notes to Financial Statements for a description of encumbrances. Although the cost to the Partnership for the Investment was an aggregate purchase price, the General Partner allocated cost, including the assignment fee and certain capitalized fees and expenses, to each of the properties based on their appraised values at the time of purchase. The allocated cost is set forth in the table below: The Partnership's real property investments were described in Form 8 dated July 25, 1986, under Item 3 thereof, which descriptions are hereby incorporated by reference. During 1993, the United States economy showed signs of improvement as it moved from a generally jobless recovery to a sustained expansion with good and consistent job creation in all parts of the country except California. Generally apartment markets were challenged by increased levels of home ownership which left occupancies and rents relatively unchanged from a year ago. In 1993, apartment markets stabilized with minimal construction activity, occupancies in the low 90% range, and rental growth approximating inflation. The short-term outlook is for more of the same. The current wave of new household formations and mobility associated with increased confidence and economic growth is causing a strong push to higher levels of home ownership and also creating apartment demand. The biggest risk to apartment markets is a long-term shift to greater home ownership driven by aging demographics combined with low interest rates and renewed economic vitality. The somewhat lower risk to Southern California's apartment market is due to high housing prices and overall weak economy. Multifamily housing starts in 1993 were the lowest on record. Southern California followed the Northeast in the largest declines in multifamily housing starts for 1993. Although according to recent employment figures, California's economy has still not reached its bottom, a weak job recovery is expected to begin generally in California during the second half of 1994. Southern California will remain the weakest region of the State. This expected job growth for 1994 ranks California as one of the three weakest states in terms of job growth. California is estimated to have lost another 170,000 jobs during 1993, bringing total jobs lost since 1990 to 526,000. Most of these job losses have occurred in manufacturing (half of which can be attributed to the defense and aerospace industries), wholesale and retail trade, and construction. Service related jobs have actually grown by 3% since 1990, and coupled with construction, will be the main drivers behind an overall job increase in 1994. The impact of the January 17, 1994 Los Angeles earthquake on both the national and California economies, and on California's real estate markets is currently unknown. On an overall perspective, the damage from the earthquake has been estimated at $15 billion, approximately one-half the amount of the damage associated with Hurricane Andrew. As the earthquake damage is either replaced or repaired, a short-term increase in spending and construction is expected, providing a temporary boost to the Southern California economy. The rebuilding is expected to be completed by mid- 1995, contributing to an overall economic slowdown projected for 1995. At the end of January 1994, statistical data was compiled from the inspection reports prepared by the Los Angeles Department of Building and Safety. Due to the frequent occurrence and magnitude of after shocks, numerous reinspections have occurred that are not reflected in this data. By the end of January 1994, approximately 35,000 buildings had been inspected. The information available included a building status code: Green "Inspected" tags are issued to each structure which has been inspected and determined to be safe for regular use. Yellow tags marked "Limited Entry" are issued to each structure which has been determined to be partially useable, but in which some areas of the structure are still not safe for use. Red "Unsafe" tags are issued for structures which are determined to be totally unsafe for use. Absent a change in their status due to reinspection, such "red tagged" buildings will likely require significant rehabilitation or demolition. The damage to housing was a city wide problem with significant damage concentrated in the Northridge, Studio City, Canoga Park, Winnetka, Sylmur, Crenshaw, and Los Feliz areas. In multifamily housing structures, over 1,300 buildings with over 33,000 units and an estimated population over 92,000 persons are either partially or fully vacated. Approximately 11,000 multifamily buildings were estimated to have some damage. Of the 11,000, over 700 buildings with estimated damage of $500 million were reported as "red tagged". Updated reports are likely to show large increases to all categories of the initial report. A major objective of the city and property owners is to restore market stability. Many hurdles will be encountered including market value declines, complexity of reinvestment decisions, limitations on capital resources, and complexity of debt holders positions. The Sherman Oaks property, located in Los Angeles, was extensively damaged by the Los Angeles earthquake. The property was "red-tagged" by city inspectors and significant portions of the property are likely to require extensive repair or complete rebuilding. The effects of the earthquake on the housing markets of the damaged areas is unknown but generally believed to be negative in the short-term. As can be seen from the preliminary numbers, the competition for residential multifamily once the area is rebuilt will be extraordinarily intense. As a result of the extensive repair or complete rebuilding, the newness factor will push the market toward homogeneity. Each owner will have to compete for an entirely new tenant base. In addition, the pool of available residents will most likely be much less than available capacity as attracting prospective tenants to the area is perceived as difficult in the short-term. The competitive submarket for the Sherman Oaks property is defined as the area bordered by Burbank Boulevard to the north, Cold Water Canyon Avenue to the east, Ventura Boulevard to the south, and Victory Boulevard to the west. The primary market in which the property is located contains very little commercial activity. The market is mature and affluent, growing at a much slower pace than Los Angeles as a whole. Very little vacant land is available for construction of new apartments except what has become available through the demolition of single family homes and small duplex and fourplex buildings. In their place are constructed much higher density buildings. The primary market suffered very extensive damage as a result of the earthquake. If repaired, the Sherman Oaks property will face strong competition, all of which will be attempting to lease newly refurbished or rebuilt buildings. Inversely, many smaller multifamily buildings may be unable to repair or replace which could actually improve the competitive position and increase rates. Most of these buildings will have lost their previous tenant base and will be faced with a negative market psychology resulting from the earthquake. Regardless of the earthquake, Los Angeles has been experiencing a significant downturn in its economy since 1990. With a population of over nine million, Los Angeles is the largest metropolitan area in the country. Los Angeles accounts for approximately 30% of California's total non-farm employment base. The economic structure is diverse with high-tech defense- oriented manufacturing, apparel and textile manufacturing, entertainment and service industries, and international trade. Los Angeles has benefitted from defense contracts and the earlier surging housing and commercial construction markets, but these successes, in turn, have made the area particularly vulnerable to the protracted economic downturn. Los Angeles' economy is expected to continue to contract through most of 1994 before posting any type of modest increases in 1995. Improving prospects for the trade, business, service, and entertainment industries will be overwhelmed by the steady job declines in manufacturing. Los Angeles will rank as one of the weakest large metro economies over the next year. The West Los Angeles property's primary market is defined as Olympic Boulevard to the north, Overland Avenue to the east, Culver Boulevard to the south, and Centinela Boulevard to the west. Population growth in the immediate vicinity is forecast to grow very slowly due to a slight decrease in the total number of households. The West Los Angeles property is showing a strong shift in demographics as its economic base changes and average income levels have fallen. Like Sherman Oak's primary market, the West Los Angeles market is mature and has seen a significant amount of residential properties replaced with buildings able to occupy a greater number of tenants. Unlike Sherman Oaks, however, the West Los Angeles market has significantly more hotel and corporate-type competition. The property is 70% furnished, which caters to a more short-term renter. Competition from hotels remains fierce and soft real estate markets and increasing vacancies within the conventional market has led many conventional operators to enter the corporate market. As a result of the increased competition, the West Los Angeles property has reduced its price 8% on studios, 17% on one bedroom units, and 10% on two bedroom units since 1991. The West Los Angeles property's age and quality falls below average levels compared to its immediate market. The soft market conditions have also led to reduced rates, increased concessions, and more flexibility in credit policies for conventional apartment units. The San Diego property is located in the Mission Bay area of San Diego. San Diego ranks as the sixth largest city in the United States. The city's climate and location provide for a diverse economic base including tourism, international trade (increasing rapidly, especially with Mexico), agriculture, military and government, manufacturing and services. Although the area still has a large military presence, its economic base has diversified substantially over the past two decades. Aerospace, electronic components, instruments, wholesale trade and business services are the key components to the economic base. San Diego is also the center for a growing cluster of biotechnology industries. As with California in general, San Diego's economy remains weak. Employment has continued to decline, led by weakness in the construction, manufacturing, and trade industries. Large aerospace firms continue to aggressively reduce work forces. Construction and trade, already greatly reduced from the collapsed commercial real estate market and tepid consumer spending, fell 7% and 2.5%, respectively, during 1993. One positive sign for San Diego that is negative for multifamily housing has been the increase of home sales and residential construction activity. The economy for San Diego is expected to remain weak throughout 1994, with some strengthening possibly occurring in 1995. By 1995, cuts in commercial construction, defense, and financial services should be ending and San Diego will be poised to take advantage of expanding tourist industries, residential construction, and NAFTA. The promise of additional trade should boost the demand for transportation, business, and financial services. The submarket in which the Mission Bay property operates has reported a 3% vacancy factor while San Diego County reported a 5.5% vacancy. The Mission Bay submarket has increased occupancy while other less affluent areas have experienced drops. Rents have generally been lowered to regain lost occupancies and the use of rent concessions has been widespread. The property's attractive beach area location, combined with the renovation program and competitive rates, has allowed Mission Bay to effectively compete for market share. The Mission Bay property has moved more towards unfurnished apartments and the conventional apartment business. During 1994, the property will completely convert to conventional apartment units from OAKWOOD. The property's rental rates are generally priced $50 to $100 below newer, higher graded competitors, although a lack of supply of two bedroom units has allowed the Mission Bay property to set these prices very close to the upscale competition. As the market strengthens, the competition is expected to raise rates allowing the Mission Bay property another opportunity to attract price sensitive tenants. The Anaheim property is located in Orange County's largest city. Orange County is the third largest metropolitan area in California and the fifteenth in the country. Anaheim's population has increased by 28% since 1980 and it is ranked as one of the wealthiest regions in the nation. Anaheim is a major center for finance, business, accounting, and legal services. Manufacturing comprises 20% of the employment base with concentrations in high-tech industries. Anaheim also receives a disproportionate share of prime defense contract awards. The city's favorable long-term outlook led to an overbuilt rental market which, when combined with weakened economic conditions, led to an extremely competitive environment. During 1992, economic conditions weakened in Orange County as approximately 90,000 jobs were lost, including more than a third of the defense-related base. Because the defense industry generates so many other jobs in the area, such as construction and retail trade, the overall impact on the economy has been substantial. Anaheim's recession-plagued economy appears to have stabilized somewhat from the significant declines experienced in 1992. Although weakness in manufacturing has accounted for the overall downward trend in the region's economy, gains in the service sector have worked to offset the overall drop. The Anaheim property has not been directly impacted by the defense industry layoffs and downsizing due to the property's relatively far commuting distance to the large defense contracting companies. The property's resident profile is more focused on the service industry. Although the property has exposure to out-migration trends which have continued throughout California, movement to home ownership should not negatively impact occupancy levels as home prices remain high, despite a 7% deflation in median home prices to $217,000. A new 285 unit property was added to the competitive market in 1992 and initial leaseup was completed in 1993. There are currently no new plans or permits for multifamily construction outstanding in the area. Overall, occupancy in the Anaheim market remained fairly stable over the year and is not expected to increase substantially due to weak population gains forecast for the short-term. The Anaheim property has comparable monthly rates to its local competition and slightly higher per square foot rates due to the slightly smaller floor plans. Huntington Beach is located in the northwest quadrant of Orange County and is considered a "beach-side" community. The area continues to be zoned as primarily residential with several pockets of commercial use, specifically retail and office space. During 1993, soft economic conditions and high unemployment resulted in out- migration from Orange County leading to depressed occupancy levels and pressure to lower rental rates. The property's submarket consists of eight properties within a three mile radius which are generally conventional buildings with a corporate base of less than 10%. The Huntington Beach property converted to conventional apartments in 1992 from OAKWOOD, with corporate units comprising 5% of the property at year end. Local competition vacancies are averaging 3% to 10% and are anticipated to remain in that range based on the population base and the lack of new construction. The Huntington Beach property is estimated to have a 9% vacancy rate for 1994. Several competitors are very similar in age, averaging eighteen years old, and are all adjacent properties. Price differentials in the submarket have been attributed to age, location, and the extent of the rehabilitation of the units. During 1993, the Huntington Beach property adopted an effective rent strategy while the competition still offers free rent up front. At the Huntington Beach property, the monthly rents were lowered, effectively spreading the up front concession over the term of the lease. This strategy has positioned the property at the lowest advertised monthly rent in the area, stabilized occupancy, and increased its market share. No new construction activity is in progress or currently planned for the near future. The Upland property is located in the southwest corner of San Bernardino County in a region known as the Inland Empire. Classified as a bedroom community, this region's past growth has been in response to the high cost of housing in the Los Angeles and Orange counties. Economic weakness in the Los Angeles and Orange counties has reduced their relative cost of both single family and multifamily housing, thereby increasing competition for the Inland Empire. The Upland property, along with the local competition, has slowly lost residents as a result of military base closures and relocations. Defense cutbacks have necessitated corporate downsizing which has also led to relocations and out-migration trends. Overall, the area's short-term prospects remain weak given the continuing recession in the Los Angeles region. Lower housing costs compared to Los Angeles and Anaheim will allow the Inland Empire region opportunities for migration and population growth as the neighboring communities recover in the next two to five years. Vacancy rates at the property are consistent with these trends as well as the market's overall inability to increase rates. The property's overall rental rates remain competitive for both one and two bedroom floor plans. Approximate occupancy levels for the properties on a quarterly basis are set forth in the table in Item 2 Item 2. Properties The Partnership owns directly (subject to first and second mortgage loans) the properties described in Item 1 hereof. See Notes to Financial Statements for a description of unaffiliated management agreements. The Partnership has engaged one of the two management companies to manage three of the remaining six properties pursuant to the "OAKWOOD" marketing concept (see Item 7 below). During 1994, one of the three remaining OAKWOODS will convert to conventional operations. One of the four components of the OAKWOOD concept provides that apartments will be leased in accordance with month-to-month, six-month, or one-year rental agreements with a minimum 30-day stay. Though a portion of the apartments are operated under the OAKWOOD concept, the Partnership has reserved a number of furnished and unfurnished units for longer-term leases to meet total market needs. Leases are generally for a term of one year or less. In the opinion of the General Partner, the Partnership's properties continue to be adequately insured. The following is a listing of approximate physical occupancy levels by quarter for the Partnership's investment properties during 1989, 1990, 1991, 1992 and 1993 (a): Item 3. Item 3. Legal Proceedings The information disclosed in Notes to Financial Statements-Litigation, included herein, is incorporated by reference. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Security Holder Matters As of December 31, 1993, there were approximately 536 record holders of Units, including the Initial Limited Partner, the Class A Limited Partners, and the seven Class B Limited Partners. The Revenue Act of 1987 adopted provisions which have an adverse impact on investors in a "publicly traded partnership" ("PTP"). A PTP is a partnership whose interests are traded on an established securities market or readily tradable on a secondary market (or the substantial equivalent thereof). Units of Registrant are not listed or quoted for trading on an established securities exchange. However, CFP will, upon request, provide a Limited Partner desiring to sell or transfer Units with a list of secondary market firms which may provide a means for matching potential sellers with potential buyers of Units, if any. Frequent sales of Units utilizing these services could cause the Registrant to be deemed a PTP. If Registrant were classified as a PTP, (i) Registrant may be taxed as a corporation, or (ii) income derived from an investment in Registrant would be treated as non-passive income. In June 1988, the IRS issued Notice 88-75 in which it established alternative safe harbors that allow interests in a partnership to be transferred or redeemed in certain circumstances without causing the partnership to be characterized as a PTP. One such safe harbor, applicable to a partnership in which all interests were issued in a private offering, exempts a partnership from PTP characterization (regardless of how many Units in such partnership are traded) if either (A) the partnership does not have more than 500 partners, or (B) the initial offering price of each unit of partnership interest is at least $20,000 and the partnership agreement provides that no unit of partnership interest may be subdivided for resale into units smaller than a unit the initial offering price of which would have been at least $20,000. Registrant has more than 500 partners, and although the initial offering price of the Units was at least $20,000, the partnership agreement does not contain a provision prohibiting the subdivision of Units for resale into Units with a price of less than $20,000. Thus, Registrant cannot avail itself of this exception to potential classification as a PTP. Consequently, the Registrant has adopted a policy prohibiting transfers of Units in secondary market transactions unless, notwithstanding such transfers, Registrant will satisfy at least one of the alternative safe harbors contained in the IRS Notice. Such a restriction could impair the ability of an investor to liquidate his investment. It is unlikely that any funds will be available for distribution, including proceeds from the sale of any remaining Partnership property. Proceeds from the sale of the Torrance property in 1990 were used to reduce mortgage principal and accrued interest, thus reducing the ongoing debt service requirements of the Partnership (see the Notes to Financial Statements). Any cash flow that is available for distribution with respect to any year or portion thereof will be distributed 99% to the Limited Partners and 1% to the General Partner. Reference is made to Notes to Financial Statements for a description of payments to the State of Connecticut on behalf of limited partners and charged to limited partner capital accounts. Item 6. Item 6. Selected Financial Data (a) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources The Partnership was formed on January 30, 1985 in the State of California for the purpose of acquiring from IFD Properties, Inc.-First (an affiliate of the General Partner) and operating seven apartment complexes located in such state. CFP had entered into a purchase and sale agreement, dated as of January 15, 1985, with IFD Properties, Inc.-First to acquire the fee estate in the Investment. On January 30, 1985, CFP assigned all its rights under the agreement to the Partnership. Pursuant to the agreement, the Partnership acquired the Investment on January 31, 1985 for the aggregate purchase price of $146,000,000. The Partnership accepted title to the Investment subject to the existing first mortgage note and the seven deeds of trust, held by The Travelers Insurance Company and in February 1985 obtained from Brookside Savings & Loan Association, Los Angeles, California, a nine-year second mortgage loan in the principal amount of $20,000,000. The Partnership is currently operating under the second modification of the first mortgage. The second mortgage was refinanced by a combination of debt forgiveness by Brookside Savings and Loan Association, Partnership reserves, and a $14,000,000 related party mortgage note in 1990. Reference is made to the Notes to Financial Statements for a description of the mortgage debt, modifications and refinance thereto. In conjunction with the first mortgage's initial modification, the Partnership established a $1 million escrow account in the name of the lender which had earned approximately $206,000 in interest as of the date of the second modification. As a requirement of the second modification, $706,000 was applied toward deferred interest. In October 1990, concurrent with the first mortgage's second modification and second mortgage refinance, the Partnership sold the Torrance property for a gross sales price of $20,750,000. After closing costs, the Partnership netted approximately $19,787,000. Of that amount, $19,000,000 was required to be paid to the first mortgage lender; $14,000,000 was applied to principal, and $5,000,000 was applied to deferred interest. Of the remaining amount, $730,000 was retained by the first mortgage lender and added to the existing escrow account for funding operating deficits and capital expenditures. Closing costs for the Torrance sale include a real estate advisory fee of $518,750 earned by an affiliate of the General Partner. The affiliate has deferred payment of this fee in order that the Partnership may utilize the funds for operations. This fee remained unpaid at December 31, 1993. In April 1986, pursuant to a loan agreement, the Partnership obtained from ContiTrade Services Corporation an 8% working capital loan in the principal amount of $36,649,813 (of which the Partnership received loan proceeds of $35,200,000 after deducting a $1,449,813 discount). A portion of the loan, approximately $32,900,000, was used to repay interim indebtedness secured in conjunction with the acquisition of the Project and the remainder was added to Partnership cash reserves. The loan served as a vehicle to help fund Partnership cash needs as limited partners made staged payments on capital contributions. In 1991, virtually all the limited partners made their last payment and, subsequently, the Partnership paid the final payment on the working capital loan. The difference between the limited partner note payments received and the final working capital loan payment made of approximately $500,000 was added to reserves to be used for the operational needs of the Partnership. Reference is made to the Notes to Financial Statements for a description of limited partner capital contributions. The mortgage escrow account, established with the first mortgage lender in conjunction with the debt modifications, was closed in 1992. The Partnership withdrew $523,000 on April 13, 1992 for renovation projects at the West Los Angeles and Sherman Oak properties. On October 23, 1992, the remaining balance, $870,000, was withdrawn for renovation projects at the San Diego, Sherman Oaks, and West Los Angeles properties, and for 1992 operating deficits. On January 17, 1994, the Sherman Oaks property sustained extensive damage during the Southern California earthquake. Its net book value was $17,677,130 at December 31, 1993. The property was "red-tagged" by city officials; a designation issued to buildings considered totally unsafe for use. The extent of the damages is currently being reviewed and the ultimate effect on the Partnership's operations and equity value of the Project is unknown. The Partnership's Project is insured for earthquakes and business interruption. The insurance policy carries a 5% deductible. The Partnership's cash reserves would not be adequate to fund the deductible should the insurance proceeds be used to rebuild the property. In the case of a total loss, the first mortgage lender has discretion as to the decision to rebuild or apply the proceeds to reduce the outstanding debt obligation. Due to the Partnership's lack of capital, the Partnership would be limited to applying any insurance proceeds to the outstanding first mortgage balance, attempting to finance the deductible with one of the existing lenders, or financing the deductible with a new lender (possibly requiring a priority position). Due to the preliminary stage of the survey and analysis, the outcome cannot yet be reasonably concluded. At December 31, 1993 the Partnership had $1,440,476 in cash and cash equivalents which will be used for payment of working capital and accrued liabilities. The Partnership's accrued liabilities at December 31, 1993 include the January 4, 1994 first mortgage debt service payment of $716,667 and tenant security deposits of $473,000. Remaining reserves are to be used for working capital. The cash flow deficit from property operations, inclusive of debt service, was $1,224,000 for 1993 compared with $1,600,000 for 1992. The lower deficit was a result of withholding $443,450 in debt service payments due the second mortgage lender. Property operations for 1994 have been estimated to be sufficient to cover first mortgage debt service and necessary capital expenditures exclusive of the Sherman Oaks normal property operations but inclusive of collections representing reimbursement for loss of operations (net operating income) from the business interruption insurance. The rehabilitation projects at West Los Angeles, Sherman Oaks and Mission Bay East were almost complete at the end of 1993. West Los Angeles had budgeted for 86 units but only completed 34. The property has budgeted another 29 units at a cost of $19,200 for 1994. Mission Bay has approximately 60 units left to rehabilitate which have been deferred to 1995 with minimal impact expected on earnings. Capital expenditures for the Project, exclusive of Sherman Oaks, are planned at approximately $289,000 for items needed for safety and structural integrity, as well as items needed for leasing, such as appliance replacement. Expenditures will be limited to those which can be funded from property operations after first mortgage debt service. Results for 1993 continued to draw on Partnership reserves after debt service and capital expenditures. Due to depressed property operations and lack of equity beyond the mortgage holders, the Partnership withheld its November 1, 1993 and subsequent second mortgage debt service payments. Although the second mortgage lender has acknowledged the default, the Partnership has not yet received notice of acceleration. The Partnership is currently discussing a remedy to the default which could include cash flow debt service payments. The Partnership also continues to hold open discussions with the first mortgage lender for possible further note modification prior to the debt maturity in May 1995. If the Partnership is unable to modify the first mortgage note prior to debt maturity or a debt modification allows no potential benefit to the Partners, the Project may be subject to foreclosure. If the second mortgage remains in default, the Partnership could lose the properties through foreclosure with no cash available to investors. A foreclosure would result in an income allocation to the Partners; although, if limited partners had been suspending passive loss allocations as required by the Tax Reform Act of 1986, the suspended losses available are estimated to be more than the potential foreclosure income allocation, resulting in an available net loss. In a year in which the Partnership disposes of the Project and the Partnership is subsequently dissolved, suspended losses will be available for use by investors to offset ordinary income. For a discussion of the markets effecting each of the properties' operations, reference is made to Item 1. Business. During 1992, the Partnership enacted strategies to improve 1993's net cash flow from operations over 1992 results. Amberway and Pacifica Club converted from OAKWOOD to conventional operations. Remaining OAKWOODS unfurnished a number of units and reduced administrative costs. The changes were an attempt to stabilize occupancy and reduce expenses. Arbor Park was converted to conventional operations during 1991. Although rental rates on conventional units are lower than OAKWOOD units, a more stabilized occupancy and administrative cost savings were expected to more than offset the rate reduction for the year. During the second quarter, two of the conventionally run properties, Pacifica Club and Arbor Park, had problems with maintaining or increasing occupancy coupled with delinquent rents. Due to market pressures, virtually all of the competition has been offering up front rental concessions, such as the free rent for the first month. During May and June, up front concessions offered throughout the first two quarters at Pacifica Club and Arbor Park were dropped and the properties switched to an effective rent strategy. Monthly rents were lowered, effectively spreading the up front concession over the term of the lease. The market in which Pacifica Club operates remains very competitive. For the third quarter, over 80% of the property's vacancy was made up of one bedroom units as renters double up and seek two bedroom units to save expenses. During the fourth quarter, discounts were offered at Pacifica Club's one bedroom units, which further stabilized occupancy. The effective rent strategy has begun to work at Pacifica Club as evidenced by the property's occupancy percentage growth by the end of the year. Although down approximately 3% for the year, Pacifica Club's rental income increased approximately 11% over the prior quarter and the same quarter of the prior year. The effective rent strategy has also assisted in the leasing efforts at Arbor Park. Occupancy has been maintained with a 5% increase in rental income from last quarter. Revenues are down approximately 5% year-to-date compared to last year. The Partnership's other conventional property, Amberway, has reported very strong occupancy and increased levels of rental income. Average occupancy at Amberway for 1993 was 93% compared with the average for 1992 of 84%. In late May, the property began a program to increase rental rates which improved rental income for the year. Overall, expenses at the three properties were down due to the conversion, but Amberway's repair and maintenance expenses were up because of a painting project which was required to enhance curb appeal. As expected, the newly painted property has attracted a greater number of tenants at higher rates. Net operating income at Pacifica Club, Arbor Park, and Amberway for this year versus last year was up $27,000 or 2%, down $141,000 or 15%, and up $170,000 or 19%, respectively. For 1994, the Partnership plans estimate an overall increase in net operating income at the conventional properties as a result of the painting expenses incurred in 1993 at both Amberway and Arbor Park. Rental income is estimated to remain relatively flat due to continued weaknesses in the California markets. At the OAKWOODS, the strategy of unfurnishing was expected to create more lease base and, therefore, greater stability and reduced turnover. At Sherman Oaks, the implementation of the strategy has been limited as corporate demand was strong throughout the year. The conventional business was slow, but the corporate business allowed Sherman Oaks to report revenues within 3% of the prior year. Rental rates have decreased significantly at West Los Angeles as the result of severe competition and the depressed economy. Rental income is down $139,000 or 4% from the prior year. Increasing the conventional lease base to 26% in 1993 helped increase rental income by $100,000 for the second half of the year. The unfurnishing appears to stabilize occupancy and will be increased to 30% in 1994. The San Diego market has been firming slightly, but rates still have not improved. Rental income is up 1% from the previous year due to a very strong fourth quarter. OAKWOOD administrative costs have been reduced at Sherman Oaks, West Los Angeles, and Mission Bay East, but have been offset by increases in furniture rental, repairs and maintenance, and utilities. In December, a recommendation to convert the Mission Bay property to conventional operations was approved. The property is the lowest quality OAKWOOD in the San Diego market and has found it difficult to compete within this market niche. In addition, a majority of the Mission Bay property's OAKWOOD has been naval industry related. This business is expected to decline through 1994, shrinking the property's primary source of OAKWOOD business. It is anticipated that the conversion from OAKWOOD to conventional operations will save approximately $205,000 in expenses while maintaining revenues at 1993 levels. Overall, occupancy has been increasing, the properties are realizing administrative cost savings, and rental rates are beginning to stabilize and increase. However, heavy rains in the first quarter, the decrease in Southern California tourism, and the weak economy all contributed to sustained depressed results. Overall, net operating income for the 1993 was within 1% of 1992. Results of Operations The Investment was acquired and R & B Apartment Management Company engaged for the purpose of managing the Investment pursuant to the OAKWOOD marketing concept which R & B originated. Three of the remaining six properties are operated under this concept with one scheduled for conversion to conventional operations in 1994. The OAKWOOD concept has four components: (1) studio, one bedroom, and two bedroom furnished apartments; (2) month to month, six month and one year rental agreements with a minimum 30-day stay; (3) optional houseware package with maid service; (4) middle-to-upper income level tenants who are in need of temporary housing. The concept has proven popular with corporate clients for temporary housing, relocation, and new employees. R & B has also found Southern California to be well suited to the OAKWOOD concept as it has a sizable affluent population which frequently leases on a short-term basis. The soft market conditions in Southern California during the past three years have led to increased competition for corporate tenants and also reduced popularity of this concept as corporations have trimmed expenditures and the region has lost jobs. Consequently, the Partnership converted three properties to conventional apartments in 1991 and 1992 and began unfurnishing more units at the remaining OAKWOODS to stabilize occupancy. In 1994, one of the remaining OAKWOODS will also convert to conventional operations. Results - 1993 compared with 1992 Total 1993 rental income was $17,266,927 compared to $17,476,053 in 1992. The 1993 rental income decline of $209,126 or 1.2% was primarily the result of continued weakness in the Southern California economy and increased competition, both of which have had an adverse impact on occupancy and, subsequently, rental rates. These factors have combined to support the Partnership's decision to convert a number of the properties to conventional apartments and unfurnish more units at the remaining OAKWOOD properties to maintain occupancy and market share. The West Los Angeles and Sherman Oaks properties have traditionally had the highest percentage of corporate rental activity and, therefore, were the hardest hit by the slowdown in corporate rentals in the prior year. The decision to discount rates and unfurnish some of the units has helped to stabilize occupancy. Throughout the first three quarters of the year, Sherman Oaks was able to maintain approximately the same rental income level, down only $42,000 through September; however, decreased demand in the fourth quarter resulted in a decrease to rental income of $111,000 for the year. The West Los Angeles property showed some improvement for the current year fourth quarter versus the 1992 fourth quarter, but revenues were still down $139,000 compared to the prior year due to the depressed economy. Higher fourth quarter occupancy at Mission Bay East, due to strong corporate demand, resulted in a $50,000 increase in rental income over the twelve month period. At the conventional properties, rental income decreased at Pacifica Club and Arbor Park and increased at Amberway for the year ended December 31, 1993, as compared to 1992. Rental income at Pacifica Club has dropped $62,000 for the year and Arbor Park's revenue fell $82,000, both the result of lower rates. These decreases were offset by a $134,000 increase at Amberway due to increased rates and higher average occupancy. Occupancy has been stabilizing and has improved from the prior year at both Pacifica Club and Amberway. Other income increased for the year ended December 31, 1993, as compared with 1992, due mainly to $49,000, $52,000 and $35,000 of redecorating fees resulting from new laundry contracts received at Amberway, Pacifica Club and Arbor Park, respectively. The increase in property operating expenses for the year ended December 31, 1993, as compared with 1992, was partially due to increased furniture rental expense at West Los Angeles and Sherman Oaks resulting from the decision to rent rather than purchase replacement furniture as part of the rehabilitation projects. Repairs and maintenance expenses increased in the first quarter at West Los Angeles, Sherman Oaks, and Amberway as a result of damage incurred from the heavy rains in Southern California in early 1993. Painting projects were completed at Amberway and Arbor Park to enhance curb appeal. In addition, repairs and maintenance increased at Sherman Oaks due to pipe damage. Utilities increased at each of the properties except Amberway due to increases in utility rates and the conversion to more conventional apartments. Property taxes are down for the year ended December 31, 1993, as compared with 1992, due to a $49,604 property tax refund received for Mission Bay East for fiscal year 1993 (July 1, 1992 to June 30, 1993), as well as decreased assessments at Mission Bay East and Pacifica Club. Base management fees were generally lower due to overall decreases in revenue. However, the decrease was offset by an incentive management fee of approximately $46,000 earned for Mission Bay East in 1993 compared to an incentive fee of $36,000 earned in 1992 for Sherman Oaks. The decrease in property administrative expense for the year ended December 31, 1993, as compared with 1992, was the result of reduced corporate administrative expenses at the three remaining OAKWOOD properties and also at the converted properties. Cost cutting efforts at each of the Partnership's properties also contributed to lower administrative expenses. These decreases were partially offset by an increase in bad debts at Amberway and increased payroll related expenses at Arbor Park. The decrease in interest income in 1993 as compared with 1992 was due to the decrease in the average cash balance invested as a result of cash flow deficits. In addition, during 1992 the cumulative balance in the mortgage escrow account was withdrawn to fund capital improvement projects. Depreciation increased for the year ended December 31, 1993, as compared with 1992, due to the additions associated with the rehabilitation projects at the three OAKWOOD properties. Amortization decreased for the year ended December 31, 1993, as compared with 1992 due to deferred loan costs becoming fully amortized during 1993. Results - 1992 compared with 1991 Rental income decreased in 1992, as compared with 1991, due to a weak economy and intensified competition in Southern California resulting in lower occupancy, reduced corporate demand, and downward pressure on rental rates. The Partnership reduced rental rates to maintain occupancy and market share, converted some OAKWOODS to conventional apartments and unfurnished a portion of the remaining OAKWOODS to create more stability. The West Los Angeles and Sherman Oaks properties have traditionally had the highest percentage of corporate rental activity and, therefore, were initially the hardest hit by the slowdown in corporate rentals. These properties accounted for the majority of the 1991 decreases and did not begin to rebound until the second half of 1992. Rental income at these properties decreased approximately $28,000 in 1992, despite an increase of approximately $128,000 for the fourth quarter resulting from the rehabilitation project and a weak prior year fourth quarter. Rental rates were discounted at Amberway and Pacifica during the first quarter of 1992 to help increase falling occupancy. The rates were further reduced when the properties were converted to conventional apartments. The rate reductions have resulted in a stabilization of occupancy. Rental income for Amberway decreased $173,000 for the year despite a $44,000 increase for the fourth quarter. Occupancy and rental rates have not stabilized sufficiently to allow Pacifica Club to reverse the falling revenue trend. Rental income for the property decreased $342,000 for the year and $73,000 for the fourth quarter. Rental rate discounts and free rent concessions were implemented in 1992 in an effort to maintain occupancy levels at Arbor Park. Increasing vacancy in Los Angeles and Orange counties has put downward pressure on rates. For 1992, as compared with 1991, rental income decreased approximately $102,000. Rental rate decreases were also used to boost falling occupancy levels at Mission Bay East during the past three quarters of 1992. The resulting decline in rental income has more than offset gains made in the first quarter relating to leftover rentals from the America's Cup Challenger eliminations. Rental income decreased at this property by approximately $270,000 for 1992. The decrease in other income for 1992, as compared with 1991, was mainly the result of an overall decrease in occupancy. This decrease was partially offset by slight increases in facility rentals at several properties and a slight increase in furniture rental income at Amberway. The increase in property operating expense for the year ended December 31, 1992, as compared with 1991, was mainly due to increased furniture rental expense at Sherman Oaks and West Los Angeles. A decision was made to rent rather than purchase replacement furniture as part of the rehabilitation projects. Additional increases were the result of increased repairs and maintenance expense of approximately $100,000 at Amberway and Pacifica Club. This increase was partially offset by savings in repairs and maintenance expense of approximately $59,000 at West L.A. as a result of the rehabilitation project. The remaining increase was the result of relatively minor increases in insurance expense and utilities at the Partnership's properties. The decrease in management fee expense for the year ended December 31, 1992, as compared with 1991, was the result of significantly lower rental income in 1992 as mentioned above. Included in management fees for 1992 was an incentive management fee of approximately $36,000 relative to Sherman Oaks. The decrease in property administrative expense for the year ended December 31, 1992, as compared with 1991, was mainly the result of reduced corporate chargebacks from the management company and strong cost cutting efforts. Significant areas of savings included payroll, fringe, advertising and promotion. Corporate chargebacks related to the OAKWOOD concept were eliminated at Amberway and Pacifica Club when they were converted to conventional apartments, resulting in decreased administrative costs of approximately $247,000. Through negotiations with the management company, corporate chargebacks were also eliminated at Sherman Oaks and reduced at West L.A., resulting in reduced administrative costs of approximately $160,000. Most of the remaining decreases were the result of savings of approximately $32,000 at Mission Bay East from a 10% staff reduction and strong cost cutting efforts at Arbor Park coupled with continued savings from the conversion to conventional apartments, resulting in savings of approximately $127,000. Depreciation and amortization expense decreased for the year ended December 31, 1992, as compared with 1991, despite the capital additions over the prior two years. The decrease was the result of the expiration of the useful lives of certain components of the Partnership's investment properties and a 1991 adjustment of approximately $210,000 to amortize the remaining balance of the deferred costs associated with the Brookside debt retired in 1990. Interest income and expense decreased for the year ended December 31, 1992, as compared with 1991, due to the receipt of the final investor note payment along with the repayment of the working capital loan in 1991. Interest income was also affected by reduced cash balances, as the result of operating deficits, and reduced interest rates in the current year. The decrease in management and administrative fees to affiliates for the year ended December 31, 1992, as compared with 1991, was mainly due to the expiration of the partnership administrative and management fee effective January 1, 1992. The decrease in general and administrative expense for the year ended December 31, 1992, as compared with 1991, was the result of higher professional fees in the prior year associated with the allocation of 1990 sales proceeds for tax purposes. Inflation Since inflation has been at a low rate during 1993, 1992 and 1991, the effect inflation and changing prices have had on current revenue and income from operations has been minimal. Inflation in future periods may increase rental rates (from leases to new tenants or renewals of leases to existing tenants) assuming no major changes in normal market conditions. At the same time, it is anticipated that property operating expenses will be similarly affected. Assuming no major changes in occupancy levels, increases in rental income are expected to cover inflation driven increases in the cost of operating the Project and property taxes. Inflation may also result in capital appreciation of the Project over a period of time as rental rates and development costs increase. Item 8. Item 8. Financial Statements and Supplementary Data California Seven Associates Limited Partnership, a California limited partnership Index Page Report of Independent Accountants 21 Financial Statements: Balance Sheets, December 31, 1993 and 1992 22 Statements of Operations, For the Years Ended December 31, 1993, 1992 and 1991 23 Statements of Partners' Deficit, For the Years Ended December 31, 1993, 1992 and 1991 24 Statements of Cash Flows, For the Years Ended December 31, 1993, 1992 and 1991 25 Notes to Financial Statements 26 Schedules: X - Supplementary Statements of Operations Information, For the Years Ended December 31, 1993, 1992 and 1991 34 XI - Real Estate and Accumulated Depreciation, December 31, 1993 35 Schedules not filed: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. Report of Independent Accountants To the Partners of California Seven Associates Limited Partnership In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of California Seven Associates Limited Partnership at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. 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 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. The accompanying financial statements have been prepared assuming that the Partnership will continue as a going concern. As discussed in Note 11 to the financial statements, the Partnership has sustained negative cash flows and is in default on its second mortgage loan obligation. These conditions raise substantial doubt about the Partnership's ability to continue as a going concern. The Partnership's plans in regard to these matters are described in Note 5 and 11. The financial statements do not include any adjustments that might result from the outcome of these uncertainities. As discussed in Note 10, on January 17, 1994, the Sherman Oaks property sustained extensive damage from an earthquake. The property is considered unsafe for use and is currently not occupied. The extent of the damage is currently being reviewed and the ultimate effect on the Partnership's operations is unknown at this time. (Price Waterhouse) Hartford, Connecticut February 16, 1994 California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements 1.Organization and Basis of Accounting California Seven Associates Limited Partnership, a California limited partnership, (the "Partnership") was formed to acquire and operate apartment complexes located in California. The General Partner of the Partnership is CIGNA Realty Resources, Inc. - Seventh (the "General Partner"), a Delaware corporation qualified to do business in the States of California and Connecticut and an indirect wholly owned subsidiary of CIGNA Corporation. The Partnership is currently in default on its second mortgage loan obligation and could lose its investment in property and improvements through foreclosure. The Partnership's records are maintained on the accrual basis of accounting in accordance with generally accepted accounting principles for financial reporting purposes and are adjusted for federal income tax reporting. The net effect of the adjustments as of December 31, 1993, 1992 and 1991, principally relating to differences in depreciation methods and accounting for capital transactions and limited partner capital contribution notes receivable, are summarized as follows: California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued 2.Summary of Significant Accounting Policies a)Property and Improvements: Property and improvements are carried at cost less accumulated depreciation. The cost represents the initial purchase price and subsequent capitalized costs, including certain acquisition expenses. Depreciation on property and improvements is calculated on the straight-line method based on the estimated useful lives of the various components (5 to 30 years). Repair and maintenance expenses are charged to operations as incurred. As a result of inherent changes in market values of real estate property and improvements, the Partnership reviews potential impairment annually. The undiscounted future cash flows for each property, as estimated by the Partnership, is compared to the carrying value. If the carrying value is greater than the sum of the estimated future undiscounted cash flows, and deemed permanent, an impairment loss is recognized currently. b)Cash and Cash Equivalents: Short-term investments with a maturity of three months or less at the time of purchase are generally reported as cash equivalents. c)Mortgage Escrow Account: Mortgage escrow account consisted of funds escrowed as required by the first mortgage lender to be used for capital improvements and operating deficits at the Partnership's properties. During 1992, the cumulative balance was withdrawn and the account was closed. The funds were used for 1991 and 1992 capital improvement projects and operating deficits. d)Deferred Charges: Deferred charges consisted of costs incurred in the organization of the Partnership, which were amortized using the straight-line method over sixty months, and costs of obtaining financing and surety for the working capital loan which were amortized over the life of the loan. The balance at December 31, 1992 consisted of costs incurred obtaining mortgage financing, which were fully amortized by December 31, 1993. e)Mortgage Notes: Discounts on long-term mortgage notes were amortized as interest expense over the term of the related note using the interest method. f)Partners' Deficit: Offering costs comprised of sales commissions and other issuance expenses have been charged to the partners' capital accounts as incurred. g)Income Taxes: No provision for income taxes has been made as the liability for such taxes is that of the partners rather than the Partnership. h)Basis of Presentation: Certain amounts in the 1992 financial statements have been reclassified to conform with 1993 presentation. California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued 3. Property and Improvements At December 31, 1993 the Partnership owned six properties located in California totaling 2,135 units with leases generally for a term of one year or less. All properties are pledged as security for the long-term debt. The Partnership is currently in default on its second mortgage loan obligation and could lose its investment in property and improvements through foreclosure. The Sherman Oaks property sustained extensive damage from the January 17, 1994 Southern California earthquake. Preliminary indications are that structural damage is considerable and the property may not be salvageable. The Partnership's properties are covered by insurance, including earthquake (5% deductible) and business interruption. The Partnership's insurance company has been notified and engineers are surveying the property. Damage estimates are expected to be completed in April 1994. In the case of a total loss, the first mortgage lender has discretion as to the decision to rebuild or apply the proceeds to reduce the outstanding debt obligation. The financial statements do not include any adjustments for possible losses resulting from the earthquake. 4. Deferred Charges Deferred charges at December 31, 1993 and 1992 consist of the following: 1993 1992 Costs of obtaining financing $ 1,740,994 $ 1,740,994 Accumulated amortization (1,740,994) (1,541,948) $ -- $ 199,046 5. Notes, Mortgages and Loan Modifications The following table summarizes outstanding debt as of December 31, 1993 and 1992: 1993 1992 First mortgage loan (including cumulative deferred interest of $11,433,903 at December 31, 1993 and 1992). $ 97,433,903 $ 97,433,903 Second mortgage loan with affiliate of General Partner. The Partnership is currently in default on this mortgage note. 14,000,000 14,000,000 Assignment note, which bears interest at 16% per annum, payable to an affiliate of the General Partner. As of December 31, 1993, the balance remained deferred and unpaid. 550,000 550,000 Total notes and mortgages payable $ 111,983,903 $ 111,983,903 California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued One of the six properties securing the Partnership's mortgage notes was extensively damaged in the January 17, 1994 Southern california earthquake. The effect on the Partnership's debt obligations is currently unknown. Partnership property is held subject to a first mortgage loan with an original principal balance of $100,000,000. Interest thereon initially accrued and compounded at 12.75% per annum. Pursuant to an eighteen month payment modification agreement negotiated during 1987, interest only payments calculated at 10% were due monthly through January 1, 1989. The difference between the pay rate and the coupon rate accumulated as deferred interest. Interest was charged on accumulated deferred interest at 12.75% per annum. In conjunction with the modification, a $1 million escrow account was established in the name of the lender, to provide the lender additional collateral to secure the Partnership's obligations under the loan. Effective with the August 1, 1989 payment, a temporary arrangement reduced monthly payments to interest only at 10.5% and then to 10% effective with the May 1, 1990 payment. The differences between the negotiated rates and the coupon rate of 12.75% continued to accrue. In October 1990, simultaneously with the sale of the Torrance property, the Partnership completed a permanent modification of the first mortgage loan. Terms included a reduced interest rate from the coupon of 12.75% to 10%, an extension of the due date from December 1993 to May 1995 and a fixing of deferred interest at $17,140,361 as of May 1, 1990 with no additional interest accruals on deferred interest. As an additional requirement of the modification, $14,000,000 of the sales proceeds from the Torrance property was used to reduce the principal and $5,000,000 was used to reduce the deferred interest balance. No gain or loss was recorded on the first mortgage modification. In addition, $706,458 of the escrow account, including accumulated interest of $206,458, was applied against the deferred interest balance. Also, as part of the Torrance property sale, $730,000 of the sales proceeds was required to be deposited in the escrow account to be used for operating deficits and capital expenditures. The Partnership property was also held subject to a $20,000,000 variable rate second mortgage loan scheduled to mature on December 31, 1993. The interest rate was adjusted monthly to 2% above the Five Year Treasury Constant Matrix Index as published by the Federal Reserve Board (the "current accrual rate"). Pursuant to debt modification agreements signed in 1987 and 1989, interest only payments, calculated at 8.64%, were due monthly from August 1, 1987 until January 1, 1990. Beginning February 1, 1990, interest only payments calculated at 9% were due monthly until maturity. The difference between interest accruing on the note and interest paid during this period was deferred. During the term of the mortgage, the interest rate could not exceed 17.5% per annum. On October 26, 1990, the Partnership refinanced its $20,000,000 second mortgage loan. At the time of the refinance, the Partnership owed Brookside Savings $20,310,706 of principal, including deferred interest, and $419,328 of unpaid current interest payable. The Partnership maintained a $200,000 debt escrow account for the benefit of Brookside Savings, established as a result of the 1987 debt modification agreement. The Partnership negotiated a discounted payoff with Brookside Savings for $14,419,328 plus forfeiture of the debt escrow account of $200,000. The Partnership utilized the proceeds from a new second mortgage of $14,000,000, obtained from an affiliate of the General Partner, plus $419,328 of Partnership reserves to pay off the Brookside Savings mortgage. The difference between the payoff amount, including the escrow account, and the total amounts outstanding netted a $6,110,706 extraordinary gain from debt forgiveness in the 1990 Statement of Operations. The term of the replacement second mortgage require monthly interest only payments at 12.67% with a maturity date concurrent with the first mortgage, as modified. California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued Effective November 1, 1993, the Partnership began withholding the interest payment on its second mortgage note. Although the second mortgage holder has acknowledged the default, the Partnership has not received notice of acceleration. If the Partnership remains in default, the properties could be lost through foreclosure. The Partnership is discussing a possible remedy to the default, which could include cash flow debt service payments. 6. Limited Partner Capital The initial Limited Partner contributed $100 to the capital of the Partnership. Pursuant to a private offering, the Partnership sold Limited Partnership Interests to seven Class B Limited Partners for an aggregate purchase price of $500,000. The Partnership also sold 362 Class A partnership Units at a Unit price of $150,000 each ($54,300,000 in total). Of these Units, 1.5 Units were purchased for cash, 14.4 Units were purchased pursuant to a three-year note option and 346.1 Units were purchased pursuant to a seven-year note option. The three and seven-year note options provided for the sale of Units upon receipt at subscription of $45,000 and $18,343 per Unit, respectively, with the balance due of $105,000 and $131,657 per Unit, respectively, being evidenced by a secured recourse promissory note bearing interest at the rate of 12% per annum. Interest payments were due in semi-annual installments on each March 1 and December 1, beginning on December 1, 1985. In the fourth quarter of 1993, the investor note receivable balance of $6,821 on .333 unit was collected. During 1991, the State of Connecticut enacted new income tax legislation, a part of which effects partnerships. The portfolio income allocations made by the Partnership to the limited partners are considered Connecticut based income and subject to Connecticut tax. On July 14, 1993, the Partnership filed its 1992 Form CT-1065 Partnership tax return with the State of Connecticut. The Partnership has elected to pay the tax due on the limited partners' share of portfolio income and, therefore, paid tax due of $6,322 directly to the State of Connecticut. The Partnership also accrued the 1993 estimated payment of $2,343 as of December 31, 1993. These amounts were treated as reductions of partners' capital and reported as distributions in the accompanying financial statements. 7. Transactions with Affiliates Fees and other expenses incurred by the Partnership to the General Partner or its affiliates during the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 Interest on assignment note $ 88,000 $ 88,000 $ 88,000 Asset management fee 179,118 180,964 190,524 Administration and management fee -- -- 74,150 General partner salary 150,000 150,000 150,000 Reimbursement (at cost) for out-of-pocket expenses 30,508 34,906 35,231 Payment of all fees and expenses, other than reimbursement for out-of- pocket expenses, has been deferred by the General Partner and its affiliates. California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued 8. Management Agreements On January 31, 1985, the Partnership entered into a Management Agreement with R & B Apartment Management Company ("R & B"). The term of the agreement was approximately ten years with provisions to extend the term as defined in the Management Agreement. Generally, the management fee was equal to 5.0% of the gross rental receipts collected. A portion of the Annual Management Fee was subject to deferral based on certain operating results, but not to exceed, in total, $2,000,000 or exceed, in any one year, one-half of the Annual Management Fee otherwise payable in such year. As of December 31, 1989, the maximum was reached. Upon termination of the Management Agreement or upon sale, any deferral of the Annual Management Fee will be recoverable, without interest, provided investors have received their investment plus an 8% return. R & B is entitled to an additional fee equal to 10% of the amount by which net sales, as defined, exceeds the deferred R & B management fee. In 1991, the management agreement was renegotiated for the five remaining OAKWOOD format properties and the one conventional format property. For the OAKWOOD properties, a base amount was set using 1991 as a base year. For 1991, the actual net operating income was compared to the base. For 1992 to 1995, the fee was to be 5% provided R&B achieved a 5% annual growth in net operating income from the 1991 base. If the annual growth target wasn't met, R&B would only receive a 3% fee. In 1991, the base net operating income was not reached and R & B's fee was reduced by 40% to 3% of gross rental receipts. For the conventional property, Arbor Park, the fee was set at 4% of gross revenues. On May 1, 1992, the Huntington Beach and Anaheim properties were converted from the OAKWOOD concept to conventional apartment operations. In conjunction with Anaheim's conversion, R&B was replaced as the property management company by Prometheus. The property management fee for these properties has been changed to 3% of gross receipts plus an additional 1% incentive fee based on certain revenue and expense goals. The Partnership also renegotiated the management fee on the remaining OAKWOOD properties, West Los Angeles, Sherman Oaks and Mission Bay East, to an incentive base fee of 3% with the potential for an additional 1% if net operating income objectives are met. R&B has also agreed to absorb all corporate allocation costs relating to the OAKWOOD program for Sherman Oaks and to a reduction in the corporate allocation percentage at West Los Angeles. 9. Partnership Agreement Generally, distribution of operating cash flow, allocations of net income or losses from operations, and loss on dispositions, as reported on the Partnership's Federal income tax returns, will be allocated 99% to the Limited Partners and 1% to the General Partner. All allocations among the Limited Partners of net income or loss will be made in the proportion that the capital contribution made or required to be made by each Limited Partner bears to the total capital contributions made or required to be made by all Limited Partners except as noted in the Partnership Agreement Section 6 (e) and 6(f). California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued In general, gains from dispositions shall be allocated first to the Class B Limited Partners in proportion to their respective negative capital accounts and then to the other Partners in proportion to their respective negative capital accounts. Thereafter, gains from dispositions shall be allocated in accordance with Partnership Agreement Section 6(g)(i) through (iv). Proceeds from capital transactions will be distributed generally to each Limited Partner equivalent to aggregate capital contributions; then, to each Limited Partner, equal to 8% per annum of his aggregate capital contribution; then, to the General Partner equivalent to its aggregate capital contribution; then, of the balance, 75% to the Limited Partners and 25% to the General Partner. Paragraph 6(u) of the Partnership Agreement limits the allocation of losses recognized for Federal income tax purposes to partners where such allocation would cause their negative capital account to be in excess of their share of minimum gain as defined in such paragraph. Those losses not allocated to the Limited Partners are allocated to the General Partner. Paragraph 6(v) contains minimum gain chargeback and qualified income offset provisions in accordance with Treasury Regulation 1.704-1T(b)(4)(iv)(e), - 1T(b)(4)(iv)(h)(4), and - 1(b)(2)(ii)(d). 10. Contingency On January 17, 1994, The Sherman Oaks property sustained extensive damage during the Southern California earthquake. The property was "red- tagged" by city officials; a designation issued to buildings considered totally unsafe for use. The extent of the damages is currently being reviewed and the ultimate effect on the Partnership's operations is unknown. The carrying value of the Sherman Oaks property amounted to approximately $17,700,000 at December 31, 1993. The Partnership's Project is insured for earthquakes (5% deductible) and business interruption. The Partnership's cash reserves would not be adequate to fund the deductible should the insurance proceeds be used to rebuild the property. In the case of a total loss, the first mortgage lender has discretion as to the decision to rebuild or apply the proceeds to reduce the outstanding debt obligation. Due to the Partnership's lack of capital, the Partnership would be limited to applying any insurance proceeds to the outstanding first mortgage balance, attempting to finance the deductible with one of the existing lenders, or financing the deductible with a new lender (possibly requiring a priority position). Due to the preliminary stage of the survey and analysis, the outcome cannot yet be reasonably concluded. The financial statements do not include any adjustments for possible losses resulting from the earthquake. 11. Liquidity The Partnership's cash flow from operations after debt service and capital improvements has been in a continual deficit position. As a result of cash flow deficits and the lack of investor equity, the Partnership began withholding payment of debt service on its second mortgage and remains in default at December 31, 1993. Future capital expenditures will be limited to those needed for safety and structural integrity. Additional expenditures will be limited to those which can be funded from property operations after first mortgage debt service. The General Partner has estimated 1994 operations to be sufficient to cover first mortgage debt service and necessary capital expenditures, exclusive of Sherman Oaks normal property operations, but inclusive of collections representing reimbursement for loss of operations (net operating income) from business interruption insurance. Dependant on the timing of the California Seven Associates Limited Partnership, a California limited partnership Notes to Financial Statements - Continued insurance reimbursement, the General Partner may have to take further steps to preserve the Partnership's cash such as aging payables past 30 days, partial remittances on the first mortgage debt or arranging unsecured short-term borrowings. 12. Litigation In California Seven Associates, Limited Partnership , et al v. SBD Group, Inc., et al [Case no. 716034 (Superior Court of the State of California, Orange County)] Plaintiff continues to seek payment of $154,194.58 plus interest and fees from Defendant. The lawsuit stems from Defendants refusal to forward rental payments which accrued while Plaintiff owned the property (Torrance Oakwood 20900 Anza, City of Torrance). A Mandatory Settlement Conference, followed by a jury trial has been set for July. Plaintiff intends to file a motion for Summary Judgement prior to the trial date. Plaintiffs in a suit brought against the Partnership and its General Partner [Theodore D. Cohen, et al v. California Seven Associates, et al., No. 657925 (Orange County, CA, May 16, 1991)]. The Partnership, its General Partner, and other defendants have denied liability in the Cohen case and will, if necessary, continue to defend this suit. Given the numerous issues that remain to be resolved during the motion, discovery and trial phases of this action, the likelihood of an unfavorable outcome or the extent of any possible liability cannot be assessed at this time. Settlement has been reached in principle in Alan P. Johnson v. California Seven Associates, et al., [No. 654593 (Superior Court, San Diego, CA, January 15, 1993)]. It is anticipated that the settlement will be documented in March 1994. The settlement will not involve any funds from the Partnership or General Partner. 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 General Partner of the Partnership, CIGNA Realty Resources, Inc.-Seventh, a Delaware corporation, is an indirectly, wholly owned subsidiary of CIGNA Corporation, a publicly held corporation whose stock is traded on the New York Stock Exchange. The General Partner has responsibility for and control over the affairs of the Partnership. The directors and executive officers of the General Partner as of February 28, 1994 are as follows: Name Office Served Since R. Bruce Albro Director May 2, 1988 Philip J. Ward Director May 2, 1988 John Wilkinson Director September 7, 1993 John D. Carey President, Controller September 7, 1993, September 4, 1990 Verne E. Blodgett Vice President, Counsel April 2, 1990 Joseph W. Springman Vice President, Assistant Secretary September 7, 1993 David C. Kopp Secretary September 29, 1989 Gail B. Marcus Treasurer August 25, 1992 There is no family relationship among any of the foregoing directors or officers. There are no arrangements or understandings between or among said officers or directors and any other person pursuant to which any officer or director was selected as such. The foregoing directors and officers are also officers and/or directors of various affiliated companies of CIGNA Realty Resources, Inc. - Seventh, including CIGNA Financial Partners, Inc. (the parent of CIGNA Realty Resources, Inc. - Seventh), CIGNA Investments, Inc., CIGNA Corporation (the parent of CIGNA Investments, Inc.), and Connecticut General Corporation (the parent of CIGNA Financial Partners, Inc.). The business experience of each of the directors and executive officers of the General Partner of the Partnership is as follows: R. BRUCE ALBRO - DIRECTOR Mr. Albro, age 51, a Senior Managing Director of CII, joined Connecticut General's Investment Operations in 1971 as a Securities Analyst in Paper, Forest Products, Building and Machinery. Subsequently, he served as a Research Department Unit Head, as an Assistant Portfolio Manager, then as Director of Equity Research and a member of the senior staff of CIGNA Investment Management Company, and as a Portfolio Manager in the Fixed Income area. He then headed the Marketing and Merchant Banking area for CII. Prior to his current assignment of Division Head, Portfolio Management Division, he was an insurance portfolio manager, and prior to that, he was responsible for Individual Investment Product Marketing. In addition, Mr. Albro currently serves as President of the CIGNA Funds Group and other CIGNA affiliated mutual funds. Mr. Albro received a Master of Arts degree in Economics from the University of California at Berkeley and a Bachelor of Arts degree in Economics from the University of Massachusetts at Amherst. PHILIP J. WARD - DIRECTOR Mr. Ward, age 45, is Senior Managing Director and Division Head of CIGNA Investment Management (CIM), in charge of the Real Estate Investment Division of CIM. He was appointed to that position in December 1985. Mr. Ward joined Connecticut General's Mortgage and Real Estate Department in 1971 and became an officer in 1976. Since joining the company he has held real estate investment assignments in Mortgage and Real Estate Production and in Portfolio Management. Prior to his current position, Mr. Ward held assignments in CII, responsible for the Real Estate Production area, CIGNA Realty Advisors, Inc. and Congen Realty Advisory Company, all wholly-owned subsidiaries of CIGNA Corporation and/or Connecticut General. Mr. Ward has held various positions with the General Partner. His experience includes all forms of real estate investments, with recent emphasis on acquisitions and joint ventures. Mr. Ward is a 1970 graduate of Amherst College with a Bachelor of Arts degree in Economics. He is a member of the Society of Industrial and Office Realtors, the National Association of Industrial and Office Parks, the Urban Land Institute, and a Trustee of the International Council of Shopping Centers. JOHN WILKINSON - DIRECTOR Mr. Wilkinson, age 50, Senior Vice President and Chief Financial Officer of the CIGNA Individual Insurance Division. He was appointed to that position in January 1992. Mr. Wilkinson joined the company in 1970, and became an officer in 1978. In 1981, he joined CIGNA Individual Financial Services Division (now CIGNA Individual Insurance) and was appointed Vice President in 1988 in that Division. Mr. Wilkinson continued to work in the Insurance Marketing area, as Vice President until he was appointed to his current position. Mr. Wilkinson is a 1965 graduate of the U.S. Naval Academy. He is a Registered Principal of CIGNA Financial Advisors, Inc., a Fellow of the Society of Actuaries, a member of the American Academy of Actuaries, a Chartered Life Underwriter, and Chartered Financial Planner. JOHN D. CAREY, PRESIDENT, CONTROLLER Mr. Carey, age 30, joined CIGNA in 1990. Prior to joining CIGNA, he held the position of manager at KPMG Peat Marwick in the audit department and was a member of the Real Estate Focus Group. His experience includes accounting and financial reporting for public and private real estate limited partnership syndications. Mr. Carey is a graduate of Central Connecticut State University with a Bachelor of Science Degree and is a Certified Public Accountant. VERNE E. BLODGETT - VICE PRESIDENT, COUNSEL Mr. Blodgett, age 56, is an Assistant General Counsel of CIGNA Corporation. He joined Connecticut General Life Insurance Company in 1975 as an investment attorney and has held various positions in the Legal Division of Connecticut General Life Insurance Company prior to his appointment as Assistant General Counsel in 1981. Mr. Blodgett received a Bachelor of Arts degree from Yale University and graduated with honors from the University of Connecticut School of Law. He is a member of the Connecticut Bar and the American Bar Association. JOSEPH W. SPRINGMAN - VICE PRESIDENT, ASSISTANT SECRETARY Joseph W. Springman, age 52, Managing Director and Department Head responsible for asset management. He joined CIGNA's Real Estate operations in 1970. He has held positions as an officer or director of several real estate affiliates of CIGNA. His past real estate assignments have included Development and Engineering, Property Management, Director, Real Estate Operations, Portfolio Management and Vice President, Real Estate Production. Prior to assuming his asset management post, Mr. Springman was responsible for production of real estate and mortgage investments. He received a Bachelor of Science degree from the U.S. Naval Academy. DAVID C. KOPP - SECRETARY Mr. Kopp, age 48, is Secretary of CII, Corporate Secretary of Connecticut General Life Insurance Company, and Assistant Corporate Secretary and Assistant General Counsel, Insurance and Investment Law of CIGNA Corporation. He also serves as an officer of various other CIGNA Companies. He joined Connecticut General Life Insurance Company in 1974 as a commercial real estate attorney and held various positions in the Legal Department of Connecticut General Life Insurance Company prior to his appointment as Corporate Secretary in 1977. Mr. Kopp is an honors graduate of Northern Illinois University and served on the law review at the University of Illinois College of Law. He is a member of the Connecticut Bar Association and is Past President of the Hartford Chapter, American Society of Corporate Secretaries. GAIL B. MARCUS - TREASURER Ms. Marcus, age 37, is Treasurer of CII and Assistant Vice President of Treasury Operations and Services. She also serves as Treasurer of Connecticut General Life Insurance Company and various CIGNA subsidiaries. She joined Connecticut General Life Insurance Company in 1980 and held a number of positions in systems and Corporate Staff before joining the Group Pension Division in 1986 as Assistant Vice President, Customer Service. Ms. Marcus assumed her current responsibilities in Treasury in 1990. She is an honors graduate of Wesleyan University and holds an MBA from the Wharton School at the University of Pennsylvania. Item 11. Item 11. Executive Compensation Officers and directors of the General Partner receive no current or proposed direct compensation from the Partnership in such capacities. However, certain officers and directors of the General Partner received compensation from the General Partner and/or its affiliates (but not from the Partnership) for services performed for various affiliated entities, which may include services performed for the Partnership, but such compensation was not material in the aggregate. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management No person or group is known by the Partnership to own beneficially more than 5% of the outstanding Units of interest of the Partnership. There exists no arrangement, known to the Partnership, the operation of which may at a subsequent date result in a change in control of the Partnership. As of February 28, 1994, the individual directors and the directors and officers, as a group, of the General Partner beneficially owned Partnership Units and shares of the common stock of CIGNA, parent of the General Partner, as set forth in the following table: Item 13. Item 13. Certain Relationships and Related Transactions In consideration for the assignment to the Partnership of the right to acquire the Project pursuant to the agreement of sale, the Partnership paid CFP the sum of $l,400,000, $300,000 of which was paid to CFP during 1985 in cash from the first available cash of the Partnership, which was the Partners' Capital Contributions, and $l,100,000 of which was paid by executing and delivering to CFP an assignment note. The assignment note bears interest at 16.0% per annum. Interest earned during 1993 totaled $88,000. Interest earned since 1989 of $440,000 remained unpaid at December 31, 1993. The principal balance of $550,000 has been deferred by CFP and remains unpaid and is included in the notes and mortgages payable of the accompanying financial statements. The Partnership and CFP have entered into an agreement (the "Partnership Administration and Management Service Agreement") pursuant to which CFP performs administrative and management services for the Partnership for an aggregate fee (the "Partnership Administration and Management Fee") of $543,000, representing one percent (l.0%) of the equity raised from the Class A Limited Partners. This fee was to be paid over the course of the seven-year investor note option which concluded in 1991. The Partnership Administration and Management Fee was for monitoring the payments of the Limited Partners on the Limited Partners' notes. The amounts due for 1990 and 1991 of $260,050 remained unpaid at December 31, 1993. In addition, pursuant to the Partnership Administration and Management Services Agreement, the Partnership paid a salary to the General Partner of $200,000 in 1985 and $150,000 annually thereafter for managing the day-to-day operations of the Partnership and for performing administrative services for the Partnership, including, without limitation, mailing tax information to the Limited Partners, and soliciting their consents when required under the Limited Partnership Agreement and other investor communications, managing the Partnership's banking arrangements, balancing the Partners' capital accounts, filing the Partnership's tax returns, and exposing its assets to creditors as a general partner. In 1993, the General Partner earned a salary of $150,000. The amounts due for 1989 through 1993 of $750,000 remained unpaid at December 31, 1993. The Partnership has entered into an agreement with CFP (the "Partnership Incentive Management Agreement") pursuant to which CFP will attempt to maximize cash flow to the Limited Partners by increasing revenues and minimizing expenses. Pursuant to the Partnership Incentive Management Agreement, commencing in 1991, CFP will be paid an annual fee (the "Incentive Management Fee") of nine percent (9.0%) of the cash flow, but only to the extent that actual cash flow exceeds projected cash flow. It is not expected that any such fee will be paid. Pursuant to an agreement between the Partnership and CII (the "Real Estate Advisory Services Agreement"), on the sale of the Project, CII will receive a real estate advisory fee equal to 3.5% of the gross sales price of the property, from which amount third party brokerage commissions to the extent of one percent (l.0%) may be paid. In 1990, CII earned a 2.5% real estate advisory fee on the gross sales price of the Torrance Property. The amount of the fee was $518,750 (which remained unpaid at December 31, 1993). The Partnership has entered into an asset management agreement (the "Asset Management Agreement") with CII pursuant to which CII performs certain functions relating to the supervision of the management of the assets of the Partnership and supervision of unaffiliated property management companies. For these services, CII will receive a fee (the "Asset Management Fee") equal to two percent (2.0%) per annum of gross revenue for the years 1985-1990 (inclusive) and one percent (l.0%) per annum of gross revenues thereafter. CII earned $179,118 for its services in 1993. At December 31, 1993 the Partnership owed CII $2,319,045 for the 1987 through 1993 fees. The General Partner and its affiliates may be reimbursed for their direct expenses incurred in the offering, organization and administration of the Partnership. In 1993, the General Partner and its affiliates were due reimbursement for such out of pocket administrative expenses in the amount of $30,508 of which $659 was unpaid as of December 31, 1993. 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 in Item 8. 2. Financial Statement Schedules (a) Supplementary Statements of Operations Information. See Index to Financial Statements in Item 8. (b) Real Estate and Accumulated Depreciation. See Index to Financial Statements in Item 8. 3. Exhibits 3.1 Form 8, Amendment No. 1 to Form 10 Registration Statement dated July 25, 1986. 3.2 Certificate of Limited Partnership of California Seven Associates Limited Partnership, dated January 30, 1985, incorporated by reference to Exhibit 3.1 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 3.3 Second Amended and Restated Limited Partnership Agreement of California Seven Associates Limited Partnership, dated as of February 14, 1985, incorporated by reference to Exhibit 3.2 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 4.1 Form of Seven-Year Negotiable Promissory Note of the Class A Limited Partner, incorporated by reference to Exhibit 4.2 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 4.2 Second Amended and Restated Limited Partnership Agreement defining the rights of the Limited Partners, dated as of February 14, 1985 (See pp. 3-18 - 3-26 of Exhibit 3.2), incorporated by reference to Exhibit 4.6 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.1 Mortgage Note from IFD Properties, Inc.-First to The Travelers Insurance Company, as Mortgagee, dated as of December 20, 1984, incorporated by reference to Exhibit 10.1 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.2 Deed of Trust from IFD Properties, Inc.-First to The Travelers Insurance Company, dated as of December 20, 1984, relating to the Los Angeles Property, incorporated by reference to Exhibit 10.2 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.3 Security Agreement between IFD Properties, Inc.-First and The Travelers Insurance Company, dated as of December 20, 1984, incorporated by reference to Exhibit 10.3 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.4 Purchase and Sale Agreement between IFD Properties, Inc.-First and CIGNA Financial Partners, Inc., dated as of January 15, 1985, incorporated by reference to Exhibit 10.4 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.5 Assignment and Assumption Agreement between CIGNA Financial Partners, Inc. and the Registrant, dated January 30, 1985, incorporated by reference to Exhibit 10.5 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.6 Transfer and Assignment Agreement between CIGNA Financial Partners, Inc. and the Registrant, dated January 30, 1985, incorporated by reference to Exhibit 10.6 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.7 Mortgage Note from the Registrant to Brookside Savings & Loan Association, as Mortgagee, dated February 15, 1985, incorporated by reference to Exhibit 10.7 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.8 Deed of Trust and Assignment of Rents from the Registrant to Brookside Savings & Loan Association, dated February 15, 1985, incorporated by reference to Exhibit 10.8 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.9 Real Estate Advisory Services Agreement between the Registrant and CIGNA Capital Advisers, Inc., dated as of February 1, 1985, incorporated by reference to Exhibit 10.9 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.10 Promissory Note from the Registrant to CIGNA Financial Partners, Inc., dated as of January 30, 1985, incorporated by reference to Exhibit 10.10 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.11 Partnership Administration and Management Services Fee Agreement between the Registrant and CIGNA Financial Partners, Inc., dated as of March 1, 1985, incorporated by reference to Exhibit 10.13 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.12 Agreement between the Registrant and CIGNA Financial Partners, Inc., dated as of December 1, 1985, incorporated by reference to Exhibit 10.14 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.13 Incentive Management Agreement between the Registrant and CIGNA Financial Partners, Inc., dated as of March 1, 1985, incorporated by reference to Exhibit 10.15 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.14 Asset Management Agreement between the Registrant and CIGNA Capital Advisers, Inc., dated as of March 1, 1985, incorporated by reference to Exhibit 10.16 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.15 Organization Agreement between the Registrant and CIGNA Financial Partners, Inc., dated as of March 1, 1985, incorporated by reference to Exhibit 10.17 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.16 Working Capital Loan Arrangement Agreement between the Registrant and CIGNA Financial Partners, Inc., dated as of March 1, 1985, incorporated by reference to Exhibit 10.18 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.17 Management Agreement between IFD Properties, Inc.-First and R&B Enterprises, dated as of January 30, 1985, incorporated by reference to Exhibit 10.19 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.18 Assignment and Assumption of Management Agreement between IFD Properties, Inc.-First and the Registrant, dated January 31, 1985, incorporated by reference to Exhibit 10.20 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.19 Inducement Agreement between Industrial Indemnity Company and the Registrant, incorporated by reference to Exhibit 10.21 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.20 Surety Bonds of Industrial Indemnity Company, incorporated by reference to Exhibit 10.22 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.21 Indemnification Agreement between the Registrant, CIGNA Realty Resources, Inc.,-Seventh and Industrial Indemnity Company, dated March 21, 1986, incorporated by reference to Exhibit 10.23 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.22 Loan Agreement between the Registrant and ContiTrade Services Corporation, dated as of April 10, 1986, incorporated by reference to Exhibit 10.24 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.23 Promissory Note from the Registrant to ContiTrade Services Corporation, dated as of April 10, 1986, incorporated by reference to Exhibit 10.25 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.24 Pledge and Assignment Agreement between the Registrant and ContiTrade Services Corporation, dated as of April 10, 1986, incorporated by reference to Exhibit 10.26 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.25 Letter Agreement between the Registrant and ContiTrade Services Corporation, dated as of April 10, 1986, incorporated by reference to Exhibit 10.27 to Form 10 Registration Statement under the Securities Act of 1934, File No. 0-13458. 10.26 Modification Agreement between the Registrant, IFD Properties, Inc.-First and The Travelers Insurance Company, dated as of August 1, 1987, incorporated by reference to Exhibit 10.26 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 10.27 Security Agreement between the Registrant and The Travelers Insurance Company, effective as of August 1, 1987, incorporated by reference to Exhibit 10.27 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 10.28 Agreement for purchase and sale dated October 26, 1990 between the Registrant and SBD Group Inc. for the sale of the Registrant's Torrance Property, incorporated by reference to Exhibit 10.28 to Registrants Annual Report on Form 10Q for the quarterly period ended September 30, 1990. 10.29 Second Note Modification Agreement between IFD Properties, Inc., -First, the Registrant and the Travelers Insurance Company, dated May 1, 1990. 10.30 Promissory Note between the Registrant and Congen Properties, Inc. as Mortgagee, dated October 26, 1990. (b) No reports on Form 8-K were filed during the last quarter of the fiscal year. 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. California Seven Associates Limited Partnership a California Limited Partnership By: CIGNA Realty Resources, Inc.-Seventh, General Partner Date: March 30, 1994 By: /s/ John D. Carey John D. Carey, President 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 (with respect to the General Partner) and on the date indicated. /s/ Philip J. Ward Date: March 30, 1994 Philip J. Ward, Director /s/ R. Bruce Albro Date: March 30, 1994 R. Bruce Albro, Director /s/ John Wilkinson Date: March 30, 1994 John Wilkinson, Director /s/ John D. Carey Date: March 30, 1994 John D. Carey, President, Controller (Principal Executive Officer) (Principal Accounting Officer) /s/ Gail B. Marcus Date: March 30, 1994 Gail B. Marcus, Treasurer (Principal Financial Officer)

909783_1993.txt

909783_1993

1993

909783

Item 1. Business. (a) Developments since January 1, 1993. In July 1993, Talley Manufacturing and Technology, Inc. ("the Company", or "Talley Manufacturing"), a wholly owned subsidiary of Talley Industries, Inc., ("Talley") was formed with the issuance of 1,000 shares of common stock. The formation of the Company was in connection with an offering, in October, 1993, of Senior Notes by the Company and Senior Discount Debentures by Talley. Concurrently with the issuance of these securities, Talley contributed the capital stock of its operating subsidiaries (other than its real estate operations) to the Company, which also assumed a substantial portion of Talley's indebtedness and liabilities. At the same time, the Company entered into a new credit facility with certain institutional lenders. The Senior Notes were guaranteed by substantially all of the Company's subsidiaries. For an additional discussion see "Basis of Presentation" on page of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. The terms of the new debt agreements are summarized below in Section (e) of this Item 1. The Company completed the sale of the net assets of its precision potentiometer business for $2.8 million in July 1993 as part of the program to reduce outstanding debt. (b) Financial Information about Industry Segments. A segment description along with tables showing sales and operating income for each of the last five years, and identifiable assets for each of the last three years attributable to each of the Company's four business segments in continuing operations, including the year ended December 31, 1993, are incorporated by reference to the material appearing in the Notes to Consolidated Financial Statements on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. For an additional discussion of segment operations, see also "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. (c) Narrative Description of Business. General The Company is a diversified manufacturer of a wide range of proprietary and other specialized products for defense, industrial and commercial applications. Through its Government Products and Services segment, the Company manufactures an extensive array of propellant devices and electronic components for defense systems and commercial applications and provides naval architectural and marine engineering services. The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW, Inc. ("TRW") which provides the Company with a quarterly royalty payment through April 30, 2001 for any airbag manufactured and sold by TRW worldwide and for any other airbag installed in a vehicle manufactured or sold in North America. The Company's Industrial Products segment manufactures and distributes stainless steel products, high-voltage ceramic insulators used in power transmission and distribution systems, and specialized welding equipment and systems. The Company's Specialty Products segment manufactures and sells aerosol insecticides, air fresheners and sanitizers for the commercial and agricultural markets, and custom designed metal buttons for military and commercial uniforms and upscale fashion apparel. (1) Government Products and Services Segment. The Company's Government Products and Services segment provides a wide range of products and services for government programs. The vast majority of the Company's products are smaller components of larger units and systems and are generally designed to enhance safety or improve performance. A significant portion of the Company's government revenue represents the replacement of existing Company products. Products manufactured by the Company which have significant replacement requirements include items having finite shelf lives, such as propellants for pilot ejection seats, as well as products regularly consumed in training and combat situations. Many of the Company's existing products and its new product development efforts are focused on mobile, tactical and "smart" military weapons and systems. Solid Propellant Devices and Related Products A majority of the products manufactured by the Company's Government Products and Services segment are based upon the Company's core technologies and expertise in the design and manufacture of propellants and related products. Propellants are solid fuels which, when ignited, produce a specified thrust or volume of gas for a designated period. The Company's propellant products are typically custom designs developed by the Company in response to customers' technical requirements and specifications. The following sets forth a brief summary of several of the solid propellant devices and related products manufactured by the Company: o Pilot Ejection Systems. The Company manufactures ejection seats and related propellant devices for aircraft ejection systems in high performance military aircraft. The Company also manufactures escape systems for a number of foreign aircraft. o Rocket Motors. The Company manufactures a wide range of rocket motors and rocket catapults. These products include booster rockets for decoy missiles, as well as for unmanned vehicles. The Company also manufactures rocket catapults for its aircraft escape systems. o Gas Generators. The Company manufactures a broad range of solid propellant gas generators. These products provide pneumatic power for guidance and control systems, hydraulic systems, and safe and arming devices on a wide range of missile systems. o Extended Range Munitions Components. The Company's extended range munitions components utilize propellant technologies to dramatically extend the range of U.S. artillery. The Company's base burner assembly utilizes a solid propellant drag reduction system to extend the range of existing howitzer artillery. o Dispersion Systems. The Company pioneered the use of airbag technologies for modern munitions delivery systems. The Company's dispersion systems utilize airbag assemblies to eject submunitions (i.e., small bombs or missiles) from missile systems. o Weapons Systems. The Company is actively involved in the development of the next generation of light-weight disposable shoulder-launched weapons. These weapon systems include the M72 E-Series light anti-armor weapon and a light-weight disposable version of a U.S. Marine Corps shoulder-launched weapon system. The Company has also contracted with the U.S. Army to develop new warhead and launcher technology for the next generation of shoulder-launched weapon systems. o Ejector Racks. Over 8,000 ejector racks manufactured by the Company are currently installed on various U.S. helicopters. These ejection racks enable helicopter pilots to discard munitions, missiles or extra fuel in emergency situations. o Countermeasure Systems. The Company manufactures several training and combat countermeasure systems for naval, aircraft and submarine applications. Countermeasure systems are designed to divert incoming weapons from their targets. o Insensitive Munitions. The Company is currently developing new propellant products which are being qualified to meet certain rigorous safety requirements. These munitions are generally insensitive to shock, puncture, and high temperature and pressure. o Electro Explosive Devices ("EED"). Electro-explosive devices manufactured by the Company include rocket motor igniters, explosive bolts and separation nuts and booster cartridges, as well as initiators for these and other components. High Reliability Electronic Products The Company designs and manufactures specialized electronic display and monitoring devices, electromechanical instruments and components, and high performance cable assemblies which are used by the aerospace and defense industries. The Company's products are designed to perform at a high level of reliability, conform to tight tolerance specifications and withstand harsh operating environments. The following sets forth a brief summary of the primary electronic products manufactured by the Company: o Air Traffic Control Systems. The Company has supplied electronic displays to the FAA for over 20 years for use in certain air traffic control applications, and is currently the sole supplier of video mapper systems to the FAA. The Company's proprietary video mappers superimpose accurate, high resolution electronic map images, including ground topography and weather, onto radar screens which are used by both commercial and military air traffic controllers to coordinate the position of aircraft. o Airborne Flight Data Recorders. The Company is the sole manufacturer of flight data recorders that are used on military aircraft. These flight data recorders are used to evaluate training simulations and record flight information, and are designed to maintain data integrity in the event of a crash. o Safe and Arming Devices. The Company manufactures electronic and electromechanical devices which are used to safely control, arm and fire warheads on torpedoes and missiles. These products are designed to meet a high standard for safety requirements. o Indicators. The Company is a producer of elapsed time indicators, event counters and fault indicators, with a significant share of the domestic aerospace market. The Company's indicator products are capable of functioning with a high degree of accuracy and are built to withstand the harsh operating environment present in aerospace applications. o Interconnect Products. The Company also designs, manufactures and sells high quality interconnect products and accessories for military, aerospace and commercial marketplaces. These products include high voltage silicone wire and cable, multi- pin high and low voltage connector and cable assembly interconnection systems, and triax and coax high voltage connections and cable assemblies. The major applications for these products include medical equipment, radar and CRT displays, satellite detectors and power supplies. Naval Architecture and Marine Engineering Services The Company's naval architecture and marine engineering business provides a broad range of consulting services for the U.S. Navy, as well as for commercial clients and shipyards. The Company's naval design and engineering business has provided services for over 35 years and possesses domestic and international experience in all phases of the design process for military and commercial ships. These services include initial feasibility and conceptual studies, contract design, and detail design and engineering for new and retrofitted ships. The Company also provides the engineering services necessary to physically integrate combat systems and electronics into Navy ships and provides program management and logistics support services to the Navy and commercial customers. The Company maintains separate segments to meet the different technical, performance and administrative needs of its customers. Direct contracts with the U.S. Navy currently account for approximately 60% of the Company's naval architecture and marine engineering revenue, with an additional 20% attributable to subcontracts under Navy contracts. The remaining 20% of revenues are derived from commercial shipyards or industrial customers for ship and other marine design services. The majority of the Company's contracts with the U.S. Navy are cost plus a fixed fee. Under these contracts, the Company is reimbursed for its actual costs plus a percentage fee based on the estimated costs in the original contract. The demand for design services for the U.S. Navy is largely driven by the number of new ship classes being developed or older classes being retrofitted, versus the actual number of ships within a class being built or operated. The majority of engineering and detail design costs are incurred with the introduction of a new class of ship or the retrofit of one or more ships of an existing class. Although the current administration has announced its intention to reduce the number of ships within the U.S. Naval fleet, the magnitude of this reduction is still uncertain. Marketing The Company markets its government products and services directly to the Department of Defense, other U.S. government departments and agencies, and other contractors. The Company's marketing strategy focuses on those contracts and programs which are likely to be emphasized in the current defense environment and for which the Company has a competitive advantage in technology and expertise. The Company's technical sales personnel are strategically located across the country for easy access to its customers. The Company also uses independent sales agents to market its products to various foreign governments and to sell its electronic component products. In addition, the Company enters into joint marketing agreements with foreign manufacturers to provide access to markets not available to the Company. Competition Competition for the Company's government products and services varies widely. The markets for several of the Company's products and services are highly competitive, and many of the Company's competitors have greater financial resources than the Company. However, the Company also competes in a variety of small niche markets. Production of the products within these markets frequently requires government certification, which can be costly and time-consuming to obtain. Once a contract has been awarded, the relatively small size of these markets often discourages additional suppliers from obtaining certification. Within these markets the Company is frequently a sole supplier, and therefore faces little or no competition. A wide variety of industrial companies compete with the Company in the market for propellant devices, with particularly intense competition in the markets for gas generators and dispersion systems. The market for the Company's electronics components products is highly competitive. Competition is particularly intense among Texas Instruments, IBM and Raytheon for air traffic control equipment. The Company is the sole supplier of data acquisition and display systems for the B-1, B-2, T-45 and military aircraft, but there is significant competition for other applications. The Company believes that it shares the market for aerospace elapsed time indicators, fault indicators and events counters primarily with one competitor, Airpax, a North American Phillips company. The Company believes that its safe and arming devices compete with companies such as KDI, Motorola, Quantic and Magnavox. The Company believes that its market for naval architectural and marine engineering services is served by the Company and a small number of other major firms including M. Rosenblatt & Son, Inc., Gibbs & Cox, Inc., Advanced Marine Enterprises, Incorporated, George G. Sharp, Inc. and CDI Marine Company. These companies actively compete with each other, and to a lesser extent with smaller design firms, for U.S. Navy programs, foreign contracts and subcontracts with private shipyards. Government Contract Matters Substantially all of the Company's government defense contracts are fixed-price contracts except for the Company's naval architecture and marine engineering contracts which are generally cost reimbursable. Although the Company's fixed-price contracts generally permit the Company to retain unexpected profits if costs are less than projected, the Company bears the risk that increased or unexpected costs may reduce profit or cause the Company to sustain losses on a particular contract. From time to time the Company accepts fixed-price contracts for products that have not been previously developed. In such cases, the Company is subject to the risk of delays and cost over-runs. Under U.S. Government regulations, certain costs, including financing and interest costs and foreign marketing expenses, are not allowable. The U.S. Government also regulates the methods under which costs are allocated to Government contracts. With respect to U.S. Government contracts that are obtained pursuant to an open bid process and therefore result in a firm fixed price, the Government has no right to renegotiate any profits earned thereunder. In Government contracts where the price is negotiated at a fixed price rather than on a cost-plus basis, as long as the financial and pricing information supplied to the Government is current, accurate and complete, the Government similarly has no right to renegotiate any profits earned thereunder. However, if the Government later conducts an audit of the contractor and determines that such data was inaccurate, or incomplete or not current in overstating the costs, and that the contractor thereby made an excessive profit, the Government may initiate an action to recover the amount of any significantly overstated costs plus applicable profit or fee and interest. If the submission of inaccurate, incomplete or not current data was knowingly made, then the Government may seek to recover an additional penalty equal to the amount of the overstated costs; and if the submission was willful or intentional the Government may seek additional penalties and damages. U.S. Government contracts are, by their terms, subject to termination by the Government either for its convenience or for default of the contractor. Fixed-price contracts provide for payment upon termination for items delivered to and accepted by the Government. If the termination is for convenience, fixed-price contracts provide for payment of the contractor's costs incurred plus the costs of settling and paying claims by terminated subcontractors, other settlement expenses and a reasonable profit on its incurred performance costs. However, if a fixed- price contract termination is for default, (i) the contractor is paid such amount as may be agreed upon for completed and partially completed products and services accepted by the Government, (ii) the Government is not liable for the contractor's costs with respect to unaccepted items and is entitled to repayment of advance payments and progress payments, if any, related to the terminated portions of the contracts and (iii) the contractor may be liable for excess costs incurred by the Government in procuring undelivered products and services from another source. Foreign defense contracts generally contain comparable provisions relating to termination at the convenience of the government. Companies supplying defense-related products and services to the U.S. Government are subject to certain additional business risks unique to that industry. These risks include: the ability of the Government to unilaterally suspend the Company from new contracts pending resolution of alleged violations of certain procurement laws or regulations; procurements which are dependent upon appropriated funds by the Government; changes in the Government's procurement policies (such as a greater emphasis on competitive procurements or cancellation of programs due to budgetary changes); the possibility of inadvertent Government disclosure of a contractor's proprietary information to third parties; and the possible need to bid on programs in advance of design completion. A reduction in expenditures by the Government for the Company's products and services, lower margins resulting from increasingly competitive procurement policies, a reduction in the volume of contracts or subcontracts awarded to the Company, incomplete, inaccurate or non-current data allegations, terminations or cancellations of programs, or substantial cost over-runs could have an adverse effect on the Company's results of operations. Backlog The backlog of firm orders in the Government Products and Services segment amounted to approximately $128 million at December 31, 1993, $143 million at December 31, 1992 and $155 million at December 31, 1991. The backlog in 1991 and 1992 included a major non-recurring program for extended range munitions. The Company estimates that approximately $105 million of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. (2) Airbag Royalties Segment. As an outgrowth of the research and development efforts in its core propellant businesses, the Company was a pioneer in the development of the automotive airbag. Airbags supplied by the Company were installed by General Motors in approximately 12,000 automobiles during the 1970's and were the first airbags installed in any significant number of automobiles. While the Company's program with General Motors was successful, low market awareness and acceptance prevented the airbag from attaining wide-spread popularity for a number of years. During this period, Talley continued to develop and refine its airbag technology, while establishing relationships with certain U.S. and foreign automakers and suppliers. As demand for airbags increased in the 1980's, the Company's technology, manufacturing expertise and strong customer relationships made it a leading supplier of automobile airbags, and the Company designed and constructed a highly automated production facility that began producing airbags in volume during 1988. In 1989, the Company sold its automotive airbag business to TRW, in part because TRW's offer involved not only an attractive cash price for the business, but also an opportunity to participate in the future growth of the industry. This participation comes through a unique royalty agreement under which royalties are payable both on TRW's worldwide airbag sales and on its competitors' airbags installed in vehicles manufactured or sold in North America. At the closing of the 1989 sale of TRW, the Company received $97.8 million in cash and entered into the 12-year Airbag Royalty Agreement. The Airbag Royalty Agreement requires TRW to pay the Company quarterly royalties through April 30, 2001 (the "Airbag Royalty") based upon the following formula: (i) $1.14 for each airbag "unit" (inflator plus one or more components) manufactured and sold by TRW worldwide (the per-unit amount increases by $.01 on May 1 of each year); (ii) 75% of the per-unit amount for each inflator manufactured and sold separately by TRW worldwide; and (iii) $0.55 for each airbag unit supplied by any other airbag manufacturer and installed in any vehicle manufactured or sold in North America. The Company will receive the Airbag Royalty for any airbag using a gas-generating composition; the higher royalty amount for TRW airbags applies regardless of whether the specific technology used is that which was originally licensed by the Company to TRW. The Company also is entitled to receive royalties from TRW for technology licenses and similar arrangements under which TRW makes its airbag technology available to third parties. Royalties to the Company from such arrangements have not been significant to date. The terms of the Airbag Royalty Agreement allow the Company to participate in the rapidly expanding market for airbags. A continued increase in the use of dual vehicle airbags is expected as a consequence of several factors, including: (i) government legislation mandating the use of dual airbags in all cars, light trucks, sport utility vehicles and vans sold in the U.S. on a phased-in basis; (ii) increasing consumer demand as a result of the demonstrated effectiveness of airbags at saving lives and preventing serious injury, and the convenience of airbags as compared with automatic seatbelts; and (iii) the decreasing price of airbags as competition and production volumes increase. The U.S. government has passed legislation mandating that airbags be installed as standard equipment according to the following schedule: (i) 95% of 1997 model year cars (100% of 1998 models) are to be equipped with driver and passenger side airbags for the front seat, and (ii) 80% of 1998 model-year light trucks, vans and sport utility vehicles (100% of 1999 models) are to be equipped with driver and passenger side airbags for the front seat. (3) Industrial Products Segment. The Company's Industrial Products segment operates in three product areas: stainless steel, high-voltage ceramic insulators and other specialized industrial products. Demand for the Company's products is directly related to the level of general economic activity and therefore has been negatively impacted by the recent recession. The Company's operations are technologically advanced and its products are highly competitive in terms of quality, brand recognition and price. The Company's stainless steel mini-mill has utilized its state-of-the-art computer automation, strict quality controls, and strong engineering and technical capabilities to maintain its position as a low cost, high quality producer. Stainless Steel The Company operates a state-of-the-art stainless steel mini- mill which purchases stainless steel billets and converts them into a variety of sizes of hot rolled and cold finished bar and rod. The facility utilizes computer automation and quality control processes that have resulted in a high standard of product quality, service and deliveries. Located in South Carolina, the mini-mill has relatively low labor and power costs and is situated close to major north-south and east-west interstate highways. The Company recently installed three annealing furnaces, a new pickling line and a new cold-drawing facility which will enable the Company to convert certain shaped bars to smaller sizes with close tolerances. Prior to these enhancements, the Company either subcontracted these processes out or was not able to meet customers' custom finishing requests. The Company sells its products to over 25 independent steel distributors, including two distributors which are owned by the Company, and to a lesser extent to industrial end-users. The Company-owned distributors sell stainless steel sheet, angle and plate, and also provide certain cutting, grinding and boring services. The Company's U.S. distributor, which resells approximately 25% of the mini-mill's production currently, has five distribution depots in South Carolina, New Jersey, Pennsylvania, Illinois and Texas. The Canadian distributor, which sells principally flat stainless steel products (not produced by the mini-mill), has two locations, in Ontario and Quebec. High-Voltage Ceramic Insulators The Company's high-voltage ceramic insulator business manufactures and sells electrical insulators and related items for use in power transmission and distribution systems, principally to electric utilities, municipalities and other government units, as well as to electrical contractors and OEMs. High-voltage ceramic insulators are required to perform with high levels of reliability and typically require product certification from electric utilities to be used for new or replacement applications. Demand for these products is influenced by the level of economic activity, particularly housing starts, with a fairly stable minimum demand level due to normal replacement and repair cycles. The Company's primary customers include OEMs as well as many of the major utilities throughout the U.S. and the world. Other Specialized Industrial Products The Company designs, manufactures and sells specialized advanced-technology welding equipment and systems, power supply systems and humidistats, and also provides contract assembly and manufacturing for OEMs. The Company's welding equipment and systems are highly-engineered and advanced technologically, and the Company holds over 30 patents for these products. The Company's product line includes patented welding systems which can be remotely controlled for use in radioactive and other contaminated environments. These products are sold to the utility, pipeline, shipbuilding, aerospace and specialty construction industries. The power supply systems manufactured by the Company are principally low-wattage systems and are sold to OEMs in the telecommunications, medical, computer and other industrial markets. The power supply market is highly competitive, with more than 500 manufacturers in the U.S. The Company also manufactures and sells humidistats. Humidistats are used to regulate humidity levels and are principally sold to home appliance manufacturers. Marketing The Company markets its industrial products to domestic and foreign business organizations and government entities. These organizations vary in size, complexity and purchasing structures. The Company's sales and marketing efforts use a combination of direct sales, independent distributors and OEM arrangements. Competition The Company's Industrial Products businesses are highly competitive, with competition typically based on price, quality, delivery time, engineering expertise and customer service. The Company's competitors include major domestic and international companies, many of which have financial, technical, marketing, manufacturing, distribution and other resources substantially greater than those of the Company, as well as smaller competitors which focus on specific market niches. Backlog The backlog of firm orders in the Industrial Products segment totalled approximately $19 million at December 31, 1993, $12 million at December 31, 1992 and $8 million at December 31, 1991. The Company estimates that substantially all of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. Increases are attributed to a major steel mill competitor exiting the market along with an increase in demand from new and current customers. (4) Specialty Products Segment. The Company's Specialty Products segment is focused on two primary markets: insect and odor control for the industrial maintenance supply, pest control and agricultural markets, and custom designed metal buttons for the military and commercial uniform and upscale fashion markets. Insect and Odor Control The Company offers a complete line of insecticides, air fresheners and sanitizers for sale through distributors to the industrial maintenance supply, pest control and agricultural markets. The Company's insecticide products are sold under the Q-Mist and CBM trademarks to pest control distributors who sell to pest control professionals. The Company's insecticide formulations focus on using natural active ingredients including pyrethrin (derived from the chrysanthemum flower), boric acid and sassafras. The Company offers a complete line of insecticides to control the most common crawling and flying insects. The insecticides are mixed and packaged at the Company's Louisiana manufacturing plant and formulated into aerosol, liquid and powder form. Air freshening and sanitizing products are formulated and packaged for specific air freshening and sanitizing situations, which vary based on room size, type of odor to be treated, and desired fragrance. In addition, the products are designed for one of four different delivery methods: (i) metered, automatic aerosols for areas up to 6,000 cubic feet, (ii) fan delivered solids for areas up to 1,500 cubic feet, (iii) manual aerosols for immediate air freshening and (iv) passive solids for small enclosed areas. In addition to manufacturing odor and insect control formulations, the Company also manufactures and sells metered and fan driven dispensers for these products. Metered dispensers utilize a timing mechanism to deliver aerosol spray at programmable time intervals. Fan driven dispensers utilize battery operated fans to distribute the scent of selected air fresheners. Custom Metal Buttons The Company designs and manufactures a wide range of custom metal buttons for the military and commercial uniform and upscale fashion markets. The Company also produces insignias, cuff links and other accessories as a complement to its button products. The buttons are individually stamped from custom designed hand carved steel dies. The use of hand carved steel dies and the brass stamping process allow the Company to produce button designs with extremely fine detail and high resolution. The Company custom designs and produces metal buttons for the U.S. military based on detailed military specifications. The Company has seen the volume of military sales decline in recent years as a result of reductions in military personnel. Management expects future modest reductions in military button sales as military force reductions continue. Military sales currently account for less than 20% of the Company's button revenues. The market for commercial uniform buttons includes local police, fire departments and other civil servants. The Company continues to increase its presence in the fashion apparel market by working with apparel manufactures on custom button designs for their manufactured garments. Marketing The Company utilizes 1,700 independent distributors to market its insect and odor control products to the various pest control and sanitation companies that service the industrial maintenance supply and commercial pest control industry. The agricultural market is served by over 100 independent agricultural products distributors. The Company has a three person marketing staff which is responsible for working with and overseeing the distributors who carry its products. The Company's button business maintains a three person sales force which is responsible for obtaining new and maintaining existing customer relationships. Sales representatives are focused on either the military uniform, commercial uniform or fashion apparel markets. The Company's advertising for its Specialty Products businesses is limited to product brochures and ads in various trade publications. Competition Competitors for the Company's pest and odor control products consist of numerous small companies as well as divisions of large corporations. Because pest and odor control is a broad market, competitors include a range of chemical, manufacturing and pet care companies. Competition for pest control products is based on product efficiency, quality, price and the ability to offer a broad range of product formulations. Competitors for the Company's custom button business consist principally of four companies, all of which are similar in size. The Company maintains the strongest position in the military and commercial uniform market, while three of the Company's competitors dominate the fashion market. Backlog The backlog of firm orders in the Specialty Products segment totalled approximately $1.4 million at December 31, 1993, $2.5 million at December 31, 1992 and $2.5 million at December 31, 1991. The Company estimates that substantially all of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. (5) Other General information. Research and Development. During the years ended December 31, 1993, 1992 and 1991, the Company's consolidated expenditures for Company-sponsored research and development activities were approximately $3.1 million, $3.9 million and $4.2 million, respectively. For the same reporting periods, customer- sponsored research and development expenditures were $11.6 million, $2.4 million and $4.0 million, respectively. Environmental Protection. The Company does not anticipate that compliance with various laws and regulations relating to the protection of the environment will have any material effect upon its capital expenditures, earnings or competitive position. (Also see Item 3 "Legal Proceedings" and "Commitments and Contingencies" note to the consolidated financial statements, included in a separate section of this report). Employees. As of December 31, 1993, the Company employed 2,607 persons, approximately 12% of whom are represented by unions. Proprietary Rights. Various of the Company's businesses are dependent in part upon unpatented know-how and technologies, including the solid propellent businesses. While various patents, trademarks and tradenames are held by the Company and are used in its businesses, none is critical to any segment, and the Company's business is not dependent upon them to a material extent. (d) Financial Information about Foreign and Domestic Operations and Export Sales. Information required by this item is incorporated by reference to the Notes to Consolidated Financial Statements appearing under the heading "Segment Operations" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. (e) Provisions of New Debt Agreements. On October 22, 1993 the Company, together with its parent holding company, Talley, completed a major debt refinancing program. Talley Manufacturing issued $115 million of Senior Notes, due 2003, with an interest rate of 10.75% and completed a secured credit facility with two institutional lenders. Talley received gross proceeds of $70 million from the issuance of Senior Discount Debentures. The $115 million gross proceeds of the public offering, plus the initial borrowings under the secured credit facility, and the proceeds of the Talley Senior Discount Debentures after payment of underwriting and other fees and expenses associated with these financings, were used to repay substantially all of the Company's and Talley's previously outstanding debt. The indentures for the Senior Notes and the loan agreement relating to the secured credit facility contain covenants requiring specified fixed charge coverage ratios, working capital levels, capital expenditure limits, net worth levels and certain other restrictions on dividends, other payments and incurrence of debt. Substantially all of the receivables, inventory and property, plant and equipment of Talley Manufacturing and its subsidiaries are pledged as collateral in connection with the secured credit facility. In addition, the subsidiaries of Talley Manufacturing have guaranteed Talley Manufacturing's obligations under the Senior Notes and the secured credit facility and Talley has guaranteed the Senior Notes on a subordinated basis. The capital stock of the Company has been pledged by Talley to secure the Senior Discount Debentures issued by Talley. The Senior Notes mature on October 15, 2003 and Talley Manufacturing is required to make mandatory sinking fund payments of $11.5 million on October 15, in each of 2000, 2001 and 2002. Interest is payable semi-annually, commencing April 15, 1994. The secured credit facility consists of a five year revolving credit facility of up to $50 million and a five year $20 million term loan facility; however, upon the occurrence of certain specified events at any time following the third anniversary of the facility, the agent thereunder may elect to terminate the facility. The term facility requires monthly amortization payments based on a seven year amortization schedule. Item 2. Item 2. Properties. The Company's operations are conducted at a number of manufacturing and assembly facilities of various sizes and a number of warehouse, office and sales facilities located in 18 states in the United States, as well as warehouse, office and sales facilities in Canada and the Netherlands. The principal facilities of the Government Products and Services segment include over 750,000 square feet of manufacturing and assembly facilities, as well as an additional 200,000 square feet of warehouse, office and sales facilities. The principal manufacturing and assembly facilities for this segment are located in Mesa, Arizona; Phoenix, Arizona; Rolling Meadows, Illinois; and Toledo, Ohio. The majority of these facilities are owned by the Company. The Company owns the plants and equipment at two of the Arizona facilities, and leases the underlying land from the State of Arizona under long-term leases of 10 years and 40 years. The Company's naval architectural and engineering services are provided out of several offices, with the major ones located in New York, New York; Arlington, Virginia; Newport News, Virginia; Ocean Springs, Mississippi; and Pascagoula, Mississippi, all of which are leased. Facilities used by the Industrial Products segment include over 800,000 square feet of manufacturing and assembly plants and related office, warehouse and sales space, located in Davidson, North Carolina; Carey, Ohio; Knoxville, Tennessee; Hartsville, South Carolina; and eight sales and warehouse facilities in New Brunswick, New Jersey; Hermitage, Pennsylvania; Chicago, Illinois; Houston, Texas; Charlotte, North Carolina; Toronto and Montreal, Canada, and the Netherlands. The operations of the Specialty Products segment are conducted in several facilities consisting of approximately 214,000 square feet of manufacturing and warehouse space in four locations: Waterbury, Connecticut; Randolph, Vermont; Biddeford, Maine; and Independence, Louisiana, together with 13,000 square feet of office space in Waterbury, Connecticut. All of these facilities are owned by the Company with the exception of eight Industrial Products segment sales and warehouse facilities and three Specialty Products segment warehouses which are leased. In total, approximately two-thirds of all the facilities (by square footage) are owned by the Company and have been pledged as collateral to secure the credit facility. The Company's facilities, which are continually added to or modernized, are generally considered to be in good condition and adequate for the business operations currently being conducted. Item 3. Item 3. Legal Proceedings. Information required by this item is incorporated by reference to the Notes to Consolidated Financial Statements appearing under the heading "Commitments and Contingencies" on page to of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this 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 quarter ended December 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The Company's stock is wholly owned by its parent, Talley Industries, Inc., and is not traded. Dividends can be and are made when necessary by Talley Manufacturing. Subject to restrictions by debt agreements, dividends may be declared and paid (See "Management's Discussion and Analysis" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report, for further discussion). Item 6. Item 6. Selected Financial Data. The information required by this item is incorporated by reference to the material under the captions "Summary of Operations" and "Selected Financial Data" on pages and of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this item is incorporated by reference to the material on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. Item 8. Item 8. Financial Statements and Supplementary Data. The Consolidated Financial Statements, together with the report thereon by Price Waterhouse, are included in a separate section of this report. (See "Index to Financial Statements and Schedules" on page). The Company's stock is wholly owned by the parent company, Talley, and accordingly, quarterly financial results are not provided. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. The Company's Independent Accountants during the two most recent fiscal years have neither resigned, declined to stand for re-election nor been dismissed. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Information under this item has been omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. (c) Compliance with Section 16(a) of the Exchange Act. Information under this item has been omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. Item 11. Item 11. Executive Compensation. Information under this item has been omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information under this item has been omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. Item 13. Item 13. Certain Relationships and Related Transactions. Information under this item has been omitted pursuant to conditions set forth in General Instruction (J)(1)(a) and (b) of Form 10-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)-1 Financial Statements A list of the financial statements included herein is set forth in the Index to Financial Statements and Schedules submitted as a separate section of this Report. (a)-2 Financial Statement Schedules A list of the financial statement schedules included herein is contained in the accompanying Index to Financial Statements and Schedules submitted as a separate section of this Report. (a)-3 Exhibits Exhibits listed in the Exhibit Index on the pages preceding the exhibits of this report are filed as a part of this report. (b) Reports on Form 8-K There were no reports on Form 8-K 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. TALLEY INDUSTRIES, INC. By Mark S. Dickerson March 22, 1994 Mark S. Dickerson Phoenix, Arizona 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. William H. Mallender Director, Chairman William H. Mallender of the Board Principal Executive Officer March 22, 1994 Jack C. Crim Director, President Jack C. Crim Chief Operating Officer March 22, 1994 Kenneth May Vice President, Kenneth May Controller Principal Accounting Officer March 22, 1994 Daniel R. Mullen Vice President, Daniel R. Mullen Treasurer Principal Financial Officer March 22, 1994 Neil W. Benson Director March 22, 1994 Neil W. Benson Director Paul L. Foster Townsend W. Hoopes Director March 22, 1994 Townsend W. Hoopes Fred Israel Director March 22, 1994 Fred Israel John D. MacNaughton, Jr. Director March 22, 1994 John D. MacNaughton, Jr. Emiel T. Nielsen, Jr. Director March 22, 1994 Emiel T. Nielsen, Jr. Joseph A. Orlando Director March 22, 1994 Joseph A. Orlando John W. Stodder Director March 22, 1994 John W. Stodder Donald J. Ulrich Director March 22, 1994 Donald J. Ulrich David Victor Director March 22, 1994 David Victor Alex Stamatakis Director March 22, 1994 Alex Stamatakis SUPPLEMENTAL INFORMATION 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 supplemental information is required. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES The following documents are filed as part of this report: Page in This Report (1) Financial Statements: Management's Discussion and Analysis of Financial Condition and Results of Operations....................................F-2 Consolidated Statement of Operations - Years ended December 31, 1993, 1992 and 1991.........................................F-10 Consolidated Balance Sheet - December 31, 1993 and 1992.......................F-11 Consolidated Statement of Changes in Stockholder's Equity - Years ended December 31, 1993, 1992 and 1991.................F-13 Consolidated Statement of Cash Flows - Years ended December 31, 1993, 1992 and 1991.........................................F-14 Notes to Consolidated Financial Statements, including Summary of Segment Operations..........F-15 Summary of Operations..............................F-36 Report of Independent Accountants'.................F-37 Selected Financial Data and Supplemental Data......F-38 Financial Statement Schedules: III - Condensed Financial Information of Registrant..................................F-41 VIII - Valuation and Qualifying Accounts and Reserves....................................F-47 IX - Short-Term Borrowings.......................F-48 All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. Separate financial statements for 50% or less owned companies accounted for by the equity method have been omitted because each such company does not constitute a significant subsidiary. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction In July 1993, the Company was formed as a wholly-owned subsidiary of Talley Industries, Inc. ("Talley"). The formation was in connection with an offering of debt securities described below. Concurrently with the offering, Talley contributed the capital stock of its operating subsidiaries (other than its real estate operations) to the Company, which also assumed a substantial portion of Talley's debt and liabilities. The discussion below compares the results of operations of the Company for 1993 with the results of operations of the same businesses prior to their transfer by Talley to the Company. On October 22, 1993 the Company completed the refinancing of substantially all of its debt. The Company issued $115 million in Senior Notes and obtained a secured credit facility. Talley issued Senior Discount Debentures with gross proceeds of $70 million. The $185 million proceeds from the public offerings, plus initial borrowings under the secured credit facility, were used to repay substantially all of the Company's and Talley's outstanding debt. As part of the program to reduce outstanding debt, in July 1993 the Company also sold its precision potentiometer business. Results of operations improved significantly over 1992 as the Company benefited from efforts to restructure the Company's operations and control costs. The expanding demand for automotive airbags has increased the Company's airbag royalties, which has been another major factor in the improved results. For the year ended December 31, 1993 and 1992 the Company had net earnings of $4.7 million and $4.7 million, respectively. Interest expense decreased by $5.6 million due primarily to a significant paydown of debt in November, 1992. The 1993 results include an extraordinary loss of $1.1 million as a result of termination of an interest rate swap agreement and the payoff of the underlying debt. Revenues in 1993 were $318.1 million, compared to $319.6 million in 1992. Improvement in revenues from the Company's steel operations of $13.7 million were offset by decreases in certain defense contract revenues. The reduction in defense contract revenue is primarily associated with a scheduled pricing reduction under the extended range munitions program, following the recovery of the Company's investment in a new production facility associated with this program. Revenue also decreased as a result of the July 1993 sale of the Company's precision potentiometer business and the May 1992, sale of the specialty advertising business. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction, continued The gross profit percentage on sales and services from continuing operations decreased in 1993 from 25.3% in 1992 to 23.4%, a level more consistent with historical results. Revenue for the year ended December 31, 1992 decreased $11.3 million when compared to 1991. The net earnings of $4.7 million in 1992 compares to a net loss of $4.9 million in the prior year, a year that included a $5.0 million restructuring charge. The gross profit percentage from continuing operations increased from 23.8% in 1991 to 25.3% in 1992. The 1992 percentage is above historical levels due to the mix of contracts and product line sales. Government Products and Services Revenue from the Government Products and Services segment in 1993 decreased $12.8 million or 7.0% compared with 1992. Operating income decreased $1.7 million or 6.7%. The decrease in revenue and operating income resulted primarily from a scheduled pricing reduction under the extended range munitions program, following the recovery of the Company's investment in a new production facility. While pricing declined, unit sales of extended range munitions were slightly higher than the comparable period in 1992. Revenues from naval engineering services have improved due to increases in design requirements for three U.S. Naval projects. U.S. Defense spending is projected to decline over the next several years as part of the current Administration's pledge to focus national spending and reduce the federal budget deficit. However, management believes that its defense businesses are relatively well-positioned within their respective markets and are focused on products consistent with the current military philosophy, which emphasizes "smart", tactical weapons and lighter, more mobile fighting forces. In addition, management believes that the diversity of the Company's programs and significant sales of replacement products should reduce the impact of cutbacks in, or the elimination of, any individual program or system. Revenue and operating income for the year ended December 31, 1992 increased by $14.2 million and $2.2 million, respectively, when compared to 1991. The increase is associated with increased production and sales of extended range munitions and rocket motors. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Airbag Royalties Revenue from airbag royalties increased from $5.6 million in 1992 to $9.6 million in 1993. The improvement was due to an increase in airbags manufactured and sold. The timing and amount of increases in the airbag royalty stream are dependent on several factors, such as the number of vehicles manufactured or sold in the United States, the timing of U.S. car makers' compliance with legislative mandates and the market shares of the licensee (both foreign and domestic), which are beyond the control of the Company. Discontinuance of such royalty payments for any reason would have an adverse impact on the Company's future earnings. (See also "Commitments and Contingencies" note to the consolidated financial statements.) Royalty income from automotive airbags increased from $3.2 million in 1991 to $5.6 million in 1992. Industrial Products The Industrial Products segment had increased revenue of $12.3 million, or 12.9%, and increased operating income of $2.5 million in 1993 when compared to 1992. The increase in revenue is primarily related to the improved demand for stainless steel bars and rods. Operating results increased due to sales increases and cost reduction and streamlining efforts at the Company's steel and ceramic insulator operations. In 1992, revenue decreased $22.6 million and operating income decreased $.9 million, respectively, when compared to 1991, due to softness in many of the markets served by the industrial segment. Specialty Products The Specialty Products segment had decreases in revenue and operating income in 1993 when compared to 1992 of $4.9 million and $.1 million, respectively. The decrease in earnings was primarily due to the May 1992 disposition of the specialty advertising business. The specialty advertising business had sales of $4.5 million prior to the May 1992 disposition, compared to sales of $13.6 million for the year ended December 31, 1991. Revenue and operating income in 1992 decreased $5.3 million and $.3 million, respectively, over 1991, as a result of the disposition of the specialty advertising business. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Other Matters In 1993, other income, net of other expenses was $.7 million, which compares to $.7 million in 1992 and $1.3 million in 1991. Interest income, which is one of the major components of other income, and is related to the balance in notes receivable and short-term investments, was $.3 million in 1993, $1.9 million in 1992 and $2.2 million in 1991. The effective tax rate on the earnings from operations for 1993 is higher than the United States statutory rate due to higher state income taxes, resulting from losses in states where no benefits will be realized due to regulations on carryback and carryforward provisions for such losses. The income tax provision in 1992 on pretax earnings is less than the statutory rate due to a reversal of an accrual for taxes previously accrued due to a favorable state tax ruling. Substantially all operations of the Company are located within the United States. The Company operates a steel distribution system in Canada which had sales in 1993 of $11.6 million or 3.6% of consolidated revenue and nominal earnings before income taxes of $3,000. Foreign exchange gains and losses for each of the last three years have not been material. The general lack of inflationary pressures in areas where the Company and its subsidiaries operate also limited the impact of changing prices on the Company's sales and income from operations for the three years ended December 31, 1993. During the first quarter of 1993 the Company adopted the Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Company is amortizing an unrecognized transition obligation of approximately $2.0 million over 20 years for the single subsidiary affected by the new pronouncement. For the year ended December 31, 1993 the amortization of the unrecognized transition obligation was approximately $188,000. Current service costs and interest costs for the year were $16,000 and $96,000, respectively. Other pronouncements issued by the Financial Accounting Standards Board with future effective dates are either not applicable or not material to the consolidated financial statements of the Company. As more fully explained in the Commitments and Contingencies note to the Consolidated Financial Statements, litigation between the Company and TRW, the buyer of the Company's airbag business and licensee of the Company's patented and unpatented technology related thereto, has been pending since 1989. In mid-February 1994 TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Other Matters, continued TRW filed a new declaratory judgment action asserting claims already made in the existing action and further claiming the Company, through the actions of a subsidiary, breached a non- compete provision of the Asset Purchase Agreement by rendering services to competitors of TRW, and requesting among other things a court order that a contemporaneous notice and payment that TRW sent to the Company are valid, entitling it to terminate the airbag royalty and obtain a paid up license for the Company's airbag technology. The Company intends to resist the claims in all the TRW litigation vigorously, and believes that it has valid defenses against each and that no such claim gives TRW any right to terminate or reduce the airbag royalty payment obligation. A subsidiary of the Company has been named as a potentially responsible party by the Environmental Protection Agency ("EPA") under the Comprehensive Environmental Response Compensation and Liability Act in connection with the remediation of the Beacon Heights Landfill in Beacon Falls, Connecticut and has been identified as a potentially responsible party by another company in connection with the Laurel Park Landfill in Naugatuck, Connecticut. Management's review indicates that the Company sent ordinary rubbish and off-specification plastic parts to these landfills and did not send any hazardous wastes to either site. With respect to the Beacon Heights Landfill, a coalition of potentially responsible parties has entered into a consent decree with the EPA to remediate the site. This coalition has in turn brought an action against other potentially responsible parties, including a subsidiary of the Company, to contribute to the cleanup costs. The court hearing this case recently entered an order granting a motion for summary judgment in the Company's favor, which order the Beacon Heights Coalition has indicated it intends to appeal. The Laurel Park Landfill remediation program has not advanced as far as the program at Beacon Heights. A coalition of potentially responsible parties, not including the subsidiary of the Company, has entered into a consent decree and is undertaking remediation of the site. The Laurel Park Coalition has thus far been unsuccessful in its attempts to name the subsidiary in an action for contribution to the remediation costs. Based upon management's review and the status of these proceedings, management believes that these claims will not result in a material adverse impact on the results of operations or the financial position of the Company. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Other Matters, continued In March 1992, a trucking company spilled approximately 500 gallons of solvent on the ground at a facility in Athens, Georgia, formerly operated by a subsidiary of the Company. The current owner of the site initiated emergency response action, ultimately including excavation and off-site disposal of contaminated soil. The current owner has brought an action against the trucking company, seeking reimbursement for emergency response costs and related damages from the spill. In March 1993 the trucking company brought the Company into the litigation pending in United States District Court for the Middle District of Georgia, claiming that an unspecified portion of the remediation costs claimed by the current owner was due to pre-existing soil and groundwater contamination. The Company has denied any liability to the trucking company and is separately conducting an investigation of the alleged contamination in cooperation with the current owner of the site. The Company has determined from this investigation that it may face some liability with respect to pre-existing contamination of the site. Based upon remediation estimates received, management believes that any reasonably anticipated losses from the alleged contamination will not result in a material adverse impact on the results of operations or the financial position of the Company. Liquidity and Capital Resources In October 1993, the Company and its parent Talley Industries, Inc. completed a refinancing of substantially all of their existing senior and senior subordinated debt. This refinancing program included an offering of $185 million of debt securities, consisting of $70 million gross proceeds of Senior Discount Debentures due 2005, issued by Talley Industries, Inc. to yield 12.25% and $115 million of Senior Notes due 2003, with an interest rate of 10.75% issued by the Company. In connection with this refinancing, the Company also obtained a secured credit facility with institutional lenders. If one of the lenders shall not have sold at least $20 million of its percentage interest in the maximum amount of the facility within 120 days after the closing of the facility, the maximum will be reduced by $10 million. At December 31, 1993 availability under the facility, based primarily on inventory and receivable levels, was $57.1 million, of which $46.7 million was borrowed. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources, continued The proceeds from the offering and the initial borrowings under the secured credit facility were used to repay substantially all of the Company's previously outstanding debt. The Company anticipates that the new capital structure will support the long- term growth of the Company's core businesses and permit the implementation of its strategy to use proceeds received from the increasing airbag royalties and from continuing operations to reduce its total indebtedness. The Company is permitted (and intends) to distribute cash to its parent, for specified purposes and under certain other circumstances. These distributions will be made using funds available from operations and the secured credit facility. The payments include (but are not limited to) certain airbag royalties in excess of $10 million in any year (or in excess of such greater amount as would be required for the Company to meet a specified fixed charge coverage ratio) which will be used to redeem the Senior Discount Debentures issued by Talley and an annual distribution of up to $1.3 million ($1.7 million for the period from the issue date of the new indebtedness through December 31, 1994) for a period of five years to fund certain carrying and other costs associated with Talley's real estate operations. The Company may also redeem $8.0 million in preferred stock of the Company purchased by Talley from proceeds of the recent refinancing. In addition, the Company is a party to a cost sharing agreement and a tax sharing agreement which will require the Company to reimburse Talley for certain ongoing general and administrative expenses and to make certain tax payments to Talley. The Company believes that the combination of cash flow from operations, funds available under the credit facility described above (or any successor facility) and increasing revenue from airbag royalties (to the extent retained by the Company as described above) will provide sufficient liquidity to meet its working capital, debt service and other capital requirements and to meet its other ongoing business needs over the next five years. At December 31, 1993, the Company had $6.4 million in cash and cash equivalents and $84.9 million in working capital. During 1993 the Company generated $5.4 million of cash flow from operating activities. This amount reflects an increase in accounts receivable of $8.4 million, a decrease in inventories of $1.2 million, an increase in accounts payable and accrued expenses totalling $8.9 million and an increase in other assets of $7.7 million. The increase in other assets is primarily deferred debt costs related to the Company's October 1993 refinancing efforts. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources, continued The Company used $2.3 million of cash for investing activities during the year, the result of the $2.8 million received from the sale of the precision potentiometer business and $.3 million proceeds from the sale of property and equipment, offset by $5.3 million in capital expenditures. Proceeds from the Company's fourth quarter new financing of approximately $163 million were used to repay substantially all of the Company's outstanding debt. Proceeds from the issuance of preferred stock to the Company's parent totalled $8.0 million and there was a net decrease of $3.2 million in the investment in the Company by the parent company. Borrowings and pay downs under revolving credit facilities, of approximately equal amounts, are also included in financing activities. The accompanying notes are an integral part of the financial statements. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Consolidated Balance Sheet December 31, 1993 1992 ASSETS Cash and cash equivalents $ 6,417,000 $ 10,118,000 Accounts receivable, net of allowance for doubtful accounts of $1,091,000 in 1993 and $867,000 in 1992 60,376,000 48,466,000 Inventories 64,808,000 67,400,000 Deferred income taxes 900,000 1,446,000 Prepaid expenses 9,367,000 7,769,000 Total current assets 141,868,000 135,199,000 Long-term receivables, net 7,093,000 12,242,000 Property, plant and equipment, at cost, net of accumulated depreciation of $82,240,000 in 1993 and $77,381,000 in 1992 49,489,000 51,401,000 Intangibles, at cost, net of accumulated amortization of $13,883,000 in 1993 and $12,619,000 in 1992 44,928,000 47,081,000 Deferred charges and other assets 8,465,000 1,835,000 Total assets $251,843,000 $247,758,000 TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES December 31, 1993 1992 LIABILITIES AND STOCKHOLDER'S EQUITY Current maturities of long-term debt $ 2,176,000 $ 10,857,000 Accounts payable 23,095,000 19,368,000 Accrued expenses 31,652,000 27,881,000 Total current liabilities 56,923,000 58,106,000 Long-term debt 160,002,000 161,283,000 Deferred income taxes 12,320,000 11,086,000 Other liabilities 4,196,000 6,335,000 Commitments and contingencies - - Stockholder's equity: Preferred stock, $1 par value, authorized 100 shares; issued: 8 shares of Series A (-0- in 1992) 8 - Common stock, $1 par value, authorized 1,000; shares issued: 1,000 shares (-0- in 1992) 1,000 - Capital in excess of par value 15,752,992 10,948,000 Foreign currency translation adjustments (370,000) - Retained earnings 3,018,000 - Total stockholder's equity 18,402,000 10,948,000 Total liabilities and stockholder's equity $251,843,000 $247,758,000 The accompanying notes are an integral part of the financial statements. Notes to Consolidated Financial Statements Significant Accounting Policies Basis of Presentation In July 1993, Talley Manufacturing and Technology, Inc. (the Company), a wholly-owned subsidiary of Talley Industries, Inc., was formed with the issuance of 1,000 shares of common stock. The formation of the Company was in anticipation of an offering of Senior Notes by the Company and Senior Discount Debentures by Talley. Concurrently with the issuance of these securities, Talley contributed the capital stock of its operating subsidiaries (other than its real estate operations held for orderly sale) to the Company, which also assumed a substantial portion of Talley's indebtedness and liabilities. At the same time, the Company entered into a new credit facility with certain lenders. The net proceeds from the Senior Notes, the Senior Discount Debentures and the new credit facility were used to repay substantially all of the indebtedness of the Company and its subsidiaries, including indebtedness assumed from Talley and certain indebtedness remaining with Talley. With the completion of the reorganization of entities under the common control of Talley described above and the new financing, the Company owns all of the capital stock of the operating subsidiaries of Talley (other than the real estate operations held for orderly sale). Accordingly, all corporate costs, assets and liabilities are included in the Company's financial statements and interest expense includes the interest on indebtedness of the operating subsidiaries and all indebtedness assumed by the Company in connection with the reorganization. In connection with the reorganization, Talley and the Company entered into a Tax Sharing Agreement and Cost Sharing Agreement. The financial statements of Talley Manufacturing and Technology, Inc. have been prepared using the historical amounts included in the Talley Industries, Inc. and subsidiaries consolidated financial statements giving effect to the reorganization described above. With the exception of the net assets of the real estate operations held for orderly sale and certain debt and related interest expense, the consolidated financial statements of Talley are substantially identical to the Company. Inasmuch as the Company is a wholly-owned subsidiary of Talley Industries, Inc., per share data has not be included as a part of the results of operations. Although the financial statements of Talley Manufacturing and Technology, Inc. separately report its assets, liabilities (including contingent liabilities) and stockholder's equity, legal title to such assets and responsibilities for such liabilities was not affected by such attribution during periods prior to the reorganization. Accordingly, the Talley Industries, Inc. consolidated financial statements and related notes should be read in connection with these financial statements. Notes to Consolidated Financial Statements Significant Accounting Policies (continued) Principles of Consolidation: The consolidated financial statements include the accounts of the Company and all of its subsidiaries, all of which are wholly- owned. All companies are consolidated in the financial statements. All material intercompany transactions have been eliminated. Cash and Cash Equivalents: The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash equivalents, which consist primarily of commercial paper and money market funds are stated at cost plus accrued interest, which approximates market. Inventories: Inventories are valued at the lower of cost or market. Cost is determined by the first-in, first-out method for substantially all commercial inventories. Costs accumulated under government contracts are stated at actual cost, net of progress payments, not in excess of estimated realizable value. Revenue Recognition: Sales are generally recorded by the Company when products are shipped or services performed. Sales under government contracts are recorded when the units are shipped and accepted by the government or as costs are incurred on the percentage-of-completion method. Applicable earnings are recorded pro rata based upon total estimated earnings at completion of the contracts. Anticipated future losses on contracts are charged to income when identified. Airbag royalties are recognized on an accrual basis, based on production of airbag units by the licensee and production and sales of vehicles for units not produced by the licensee. Property and Depreciation: Property, plant and equipment are recorded at cost and include expenditures which substantially extend their useful lives. Expenditures for maintenance and repairs are charged to earnings as incurred. With the exception of items being depreciated under composite lives, profit or loss on items retired or otherwise disposed of is reflected in earnings. When items being depreciated Notes to Consolidated Financial Statements Significant Accounting Policies (continued) Property and Depreciation, continued: under composite lives are retired or otherwise disposed of, accumulated depreciation is charged with the asset cost and credited with any proceeds with no effect on earnings; however, abnormal dispositions of these assets are reflected in earnings. Depreciation of plant and equipment, other than buildings and improvements on leased land, is computed primarily by the straight-line method over the estimated useful lives of the assets. Depreciation of buildings on leased land and amortization of leasehold improvements and equipment are computed on the straight-line method over the shorter of the terms of the related leases or the estimated useful lives of the buildings or improvements. Income Taxes: During 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes", retroactive to January 1, 1992. This pronouncement requires a Company to recognize deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in a Company's financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. United States income taxes are provided on the portion of earnings remitted or expected to be remitted from foreign subsidiaries. Prior to 1992, the provision for income taxes was based on income and expenses included in the accompanying consolidated statements of operations. Differences between taxes so computed and taxes payable under applicable statutes and regulations were classified as deferred taxes arising from timing differences. The Company is included in the consolidated U.S. income tax return of Talley Industries, Inc. Accordingly, the provision for income taxes is determined on a consolidated basis. The allocation of the income tax provision for the Company has been determined on a separate return basis. Notes to Consolidated Financial Statements Significant Accounting Policies (continued) Intangibles: The excess cost of investments in subsidiaries over the equity in net assets at acquisition date is being amortized using the straight-line method over periods not in excess of 40 years. Interest Rate Swap Agreements: 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. Terminations of such agreements may result in a gain or loss based on interest rates in effect and the calculated market value on the termination date. Such gain or loss would be amortized as a rate adjustment to the underlying debt obligation. Inventories Inventories are summarized as follows: (balances in thousands) 1993 1992 Raw material and supplies $ 10,293 $ 11,909 Work-in-process 9,584 8,622 Finished goods 26,470 24,919 Inventories substantially applicable to fixed-price government contracts in process, reduced by progress payments of $9,110,000 and $8,344,000 in 1993 and 1992, respectively 18,461 21,950 $ 64,808 $ 67,400 Long-Term Receivables Long-term receivables consist of the following: (balances in thousands) 1993 1992 Notes receivable, including accrued interest and income tax refunds $ 7,093 $ 12,242 Amounts due within one year, included in accounts receivable - - $ 7,093 $ 12,242 Notes to Consolidated Financial Statements Long-Term Receivables, continued Long-term receivables include an income tax receivable of $4,264,000 and one note of $2,829,000. The final maturity of the note is March 1995 with an interest rate of 9.5%. Property, Plant and Equipment Property, plant and equipment, is summarized as follows: (in thousands) 1993 1992 Machinery and equipment $ 97,051 $ 97,957 Buildings and improvements 32,059 29,903 Land 2,619 922 $131,729 $128,782 Depreciation of property, plant and equipment for continuing operations was $8,271,000, $8,634,000, and $9,214,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Long-Term Debt Long-term debt consists of the following: (balances in thousands) 1993 1992 10-3/4% Senior Notes, due 2003 $115,000 $ - Notes, interest based on prime or other variable market rates, due 1998 20,000 126,347 Revolving credit facilities 26,743 17,616 Subordinated notes, interest based on prime or LIBOR - 20,000 12.8% note - 2,954 8-1/8% debentures - 3,894 Capitalized leases and other 435 1,329 162,178 172,140 Less current maturities 2,176 10,857 Long-term debt $160,002 $161,283 Notes to Consolidated Financial Statements Long-Term Debt, continued On October 22, 1993 the Company completed a major debt refinancing program. The Company issued $115,000,000 of Senior Notes, due 2003, with an interest rate of 10.75% and also completed a secured credit facility with two institutional lenders. In connection with the new debt, the Company's parent, Talley Industries, Inc., also received gross proceeds of $70,000,000 from the issuance of Senior Discount Debentures. The $115,000,000 gross proceeds of the public offering, plus an initial borrowing under the secured credit facility, and certain distribution from its parent, after payment of underwriting and other fees and expenses associated with these financings, were used to repay substantially all of the Company's previously outstanding debt. The indenture for the Senior Notes and the loan agreement relating to the secured credit facility contain covenants requiring specified fixed charge coverage ratios, working capital levels, capital expenditure limits, net worth levels, cash flow levels and certain other restrictions on dividends, other payments and incurrence of debt. Substantially all of the receivables, inventory and property, plant and equipment of the Company and its subsidiaries are pledged as collateral in connection with the secured credit facility. In addition, the subsidiaries of the Company have guaranteed its obligations under the Senior Notes and the secured credit facility. The Company's parent, Talley Industries, Inc., has guaranteed the Senior Notes on a subordinated basis. Distributions from the subsidiaries of the Company are also limited by tangible net worth and cash flow covenants. The capital stock of the Company has been pledged by the Company to secure the Senior Discount Debentures. The Senior Notes will mature on October 15, 2003 and Talley Manufacturing will be required to make mandatory sinking fund payments of $11,500,000 on October 15, in each of 2000, 2001 and 2002. Interest is payable semi-annually, commencing April 15, 1994. The secured credit facility consists of a five year revolving credit facility of up to $40,000,000 and a five year $20,000,000 term loan facility. The balance outstanding under the revolving credit facility at December 31, 1993 was $26,743,000. Upon the occurrence of certain specified events at any time following the third anniversary of the facility, the agent thereunder may elect to terminate the facility. The five-year term facility requires monthly amortization payments based on a seven year amortization schedule, with the balance due upon expiration in October 1998. The credit facility interest rate is prime plus one percent or an optional variable rate based on LIBOR with an additional fee of one quarter of one percent on unused amounts under the revolving facility. Notes to Consolidated Financial Statements Long-Term Debt, continued Aggregate maturities of long-term debt for the years ending December 31, 1994 through December 31, 1998, are $2,176,000, $3,216,000, $3,233,000, $3,094,000 and $35,461,000, respectively. Cash payments for total interest, net of amounts capitalized, during 1993, 1992 and 1991 were $14,378,000, $21,257,000 and $21,309,000, respectively. Accrued interest expense at December 31, 1993, 1992 and 1991 was $2,404,000, $3,106,000 and $4,662,000, respectively. Included in deferred charges at December 31, 1993 are debt costs of $7,874,000. The costs were incurred in 1993 in connection with the newly issued debt and are being amortized over the life of the respective debt instruments. Amortization of debt expense in 1993 was $890,000, including $234,000 related to the new debt. Total capitalized lease obligations on buildings and equipment included in long-term debt at December 31, 1993 is $436,000, of which $124,000 is due within one year. Leases Rental expense (reduced by rental income from subleases of $340,000 in 1993, $693,000 in 1992 and $741,000 in 1991 amounted to $5,622,000 in 1993, $6,660,000 in 1992 and $7,153,000 in 1991. Aggregate future minimum rental payments required under operating leases having an initial lease term in excess of one year for years ending December 31, 1994 through December 31, 1998 are $4,410,000, $4,087,000, $3,079,000, $2,026,000 and $1,921,000, respectively, with $1,285,000 payable in future years. Minimum operating lease payments have not been reduced by future minimum sublease rentals of $653,000. Aggregate future minimum payments under capital leases for years ending December 31, 1994 through December 31, 1997 are $172,000, $170,000, $170,000 and $18,000, respectively, with no payments in later years. Minimum capital lease payments have not been reduced by future minimum sublease rentals of $755,000. The present value of net minimum lease payments is $436,000 after deduction of $94,000, representing interest and estimated executory costs. The net book value of leased buildings and equipment under capital leases at December 31, 1993 and 1992 amounted to $324,000 and $435,000, respectively. Employee Benefit Plans The Company and its subsidiaries have pension plans covering a majority of their employees. Normal retirement age is 65, but provisions are made for early retirement. For subsidiaries with defined benefit plans, benefits are generally based on years of service and salary levels. Contributions to the respective defined contribution plans are based on each participant's annual pay and age. Notes to Consolidated Financial Statements Employee Benefit Plans, (continued) Pension expense in 1993, 1992 and 1991 was $5,394,000, $4,085,000 and $5,999,000, respectively. The Company generally contributes the greater of the amounts expensed or the minimum statutory funding requirements. Pension costs for continuing operations for defined benefit plans include the following components: (in thousands) 1993 1992 1991 Service cost-benefits earned during the year $ 1,594 $ 1,251 $ 2,664 Interest cost on projected benefit obligation 2,504 2,327 2,090 Actual return on assets (5,712) (3,313) (8,985) Net amortization and deferral 3,173 550 7,296 Net pension cost $ 1,559 $ 815 $ 3,065 The following table sets forth the aggregate funded status of defined benefit plans at December 31, 1993: Assets Exceed Accumulated Accumulated Benefits (in thousands) Benefits Exceed Assets Fair value of plan assets $39,879 $1,535 Projected benefit obligation 36,524 1,948 Projected benefit obligation (in excess of) or less than plan assets 3,355 (413) Unrecognized net loss (gain) (3,826) (143) Unrecognized prior service cost (279) 5 Unrecognized net liability 725 551 Unfunded accumulated benefit obligation - (413) Accrued pension liability $ (25) $ (413) Accumulated benefits $36,524 $1,948 Vested benefits $30,996 $1,932 In accordance with Statement of Financial Accounting Standards No. 87 "Employers' Accounting for Pensions," the Company has accrued a liability of $413,000 representing the unfunded accumulated benefit obligation, and has recognized an equal amount as an intangible asset. Notes to Consolidated Financial Statements Employee Benefit Plans (continued) Assumptions used in 1993 to develop the net periodic pension costs were: Assumed discount rate 7.0% Assumed rate of compensation increase 5.0% Expected rate of return on plan assets 9.0% Assets of the Company's pension plans consist of marketable equity securities, guaranteed investment contracts and corporate and government debt securities. The total value of defined benefit plan assets exceed total vested benefits by $8,486,000. Effective January 1, 1984, the Company established an employee stock purchase plan for eligible U.S. employees. Each eligible employee who elects to participate may contribute 1% to 5% of his or her pretax compensation from the Company. The Company contributes an amount equal to 50% of the employee contributions. During 1991, 1992 and 1993 the Company also made discretionary contributions. Pursuant to a 1986 amendment to the Plan which gives the Administration Committee authority to direct the trustee to borrow funds to purchase Company securities, a promissory note for $2,000,000 was executed on April 17, 1989 to purchase 141,500 shares of Talley Industries, Inc. Common stock. Company contributions to the Plan were used, in part, by the Employee Stock Ownership Plan (ESOP) to make loan and interest payments. As the loan is repaid, a portion of the Common stock acquired by the Plan is allocated to each employee in amounts based on the beginning of month balances of the respective participant's accounts. Total Company contributions during 1993 and 1992 were $692,000 and $781,000, respectively. On October 22, 1993, the loan was paid down as part of a debt refinancing program. As a result, the Company's parent, Talley Industries, Inc., acquired the securities not allocated to the Plan. Interest expense for 1993 and 1992 was $26,000 and $48,000, respectively. Any dividends received on the shares held by the ESOP are reinvested in shares of Company stock. No dividends were received during 1992 and 1993. Health care and life insurance benefits are presently provided to a small number of retired employees of one of the Company's subsidiaries. The cost of retiree health care and life insurance benefits are minor in amount and are recognized as benefits are paid. The Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in the first quarter of 1993, as required by the pronouncement. The transition obligation of approximately $2.0 million is being amortized over a 20 year period. The amortization of the unrecognized transition obligation for the single subsidiary affected by the new pronouncement was $188,000 in 1993. Current service costs and interest costs for 1993 were approximately $16,000 and $96,000, respectively. Notes to Consolidated Financial Statements Income Taxes Earnings before income taxes and the provision (credit) for income taxes consists of the following: (balances in thousands) 1993 1992 1991 Earnings (loss) before income taxes: United States $ 12,193 $ 7,511 $ (4,826) Foreign 3 (528) (355) $ 12,196 $ 6,983 $ (5,181) Current tax expense (credit): United States $ 3,856 $ 5,212 $ (3,051) Foreign 59 (285) 49 State and local 581 921 (604) 4,496 5,848 (3,606) Deferred tax expense (credit): United States (232) (953) 1,806 Foreign 8 94 (112) State and local 2,120 (2,677) 1,635 1,896 (3,536) 3,329 $ 6,392 $ 2,312 $ (277) In 1992, the Company adopted the Statement of Financial Accounting Standards No. 109 "Accounting For Income Taxes". The adoption of SFAS No. 109 changes the Company's method of accounting for income taxes from the deferred method to an asset and liability approach. The adoption had no effect on earnings in 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. Temporary differences and carryforwards which give rise to a significant portion of deferred tax assets and liabilities for 1993 and 1992, are as follows: (balances in thousands) 1993 1992 Gross deferred tax assets: Net operating losses and tax credit carryforward $ 1,727 $ 1,332 Debt restructuring charges - 3,195 Accrued expenses 6,794 5,658 Other 1,430 1,153 Valuation allowance for deferred tax assets (4,946) (4,111) Net deferred tax asset 5,005 7,227 Gross deferred tax liabilities: Depreciation 7,642 8,396 Accrued expenses 7,606 6,163 Other 1,177 2,308 Gross deferred tax liability 16,425 16,867 Net deferred tax liabilities $11,420 $ 9,640 Notes to Consolidated Financial Statements Income Taxes (continued) The sources of significant timing differences for 1991 which gave rise to deferred taxes and their effects were as follows: (balances in thousands) 1991 Depreciation $ (911) Restructuring 972 Other 3,268 $ 3,329 Reasons for the differences between the amount of income tax determined by applying the applicable statutory federal income tax rate to pretax income from continuing operations are: 1993 1992 1991 Computed tax at statutory U.S. tax rates $ 4,147 $ 2,374 $ (1,762) State and local taxes 1,781 (1,158) 680 Goodwill amortization 376 406 447 Other 88 690 358 $ 6,392 $ 2,312 $ (277) United States income taxes have not been provided on $2,800,000 of undistributed earnings of subsidiaries incorporated outside the United States, since it is the Company's intent to reinvest such earnings. Net cash receipts for income taxes during 1993, 1992 and 1991 were $828,000, $10,491,000 and $7,332,000, respectively. During the second quarter of 1992, the Company was granted a favorable state income tax ruling and, as a result, recognized a tax benefit of $3,508,000. Notes to Consolidated Financial Statements Commitments and Contingencies TRW Claims. Litigation between the Company and TRW, Inc. ("TRW") has been pending in the United States District Court in Phoenix, Arizona since November 1989. Certain of the claims in the litigation have previously been resolved by two arbitration proceedings, but other claims remain outstanding. The outstanding claims repeat allegations from the arbitration regarding deficiencies in the airbag plant, insufficient real estate to permit construction of certain additional facilities and misrepresentations concerning the airbag plant capacity. During the second quarter of 1992, an arbitration panel made its determination on the TRW's $34.0 million plant claims and awarded TRW a judgment of $5.1 million, which has been paid by the Company. Based on the outcome of the 1992 arbitration decision and on remaining claims are not well founded and were resolved by the 1992 arbitration decision. After submission to arbitration, discovery into TRW's remaining claims was stayed. Other than for the amounts claimed in the arbitration, TRW has not claimed a specific dollar amount with respect to these issues in the 1989 action. It is not possible, therefore, to quantify any damages claimed or to predict with certainty the ultimate outcome. In April 1993, a second arbitrator made his determination on the TRW accounting claims and denied any award. In mid-February 1994 TRW filed a new declaratory judgment action asserting claims already made in the existing action and further claiming the Company, through the actions of a subsidiary, breached a non-compete provision of the Asset Purchase Agreement by rendering services to competitors of TRW, and requesting among other things a court order that a contemporaneous notice and payment that TRW sent to the Company are valid, entitling it to terminate the airbag royalty obligation and obtain a paid up license for the Company's airbag technology. Based on interviews with Company and subsidiary personnel, review of relevant documents, and consultation with counsel, the Company believes that TRW's notice and attempted payment are without any merit and believes that various legal and factual defenses are available to the allegations and claims made by TRW. The Company has not had any discovery into the motives and claimed basis for this latest move by TRW, nor has it decided the manner or magnitude of the claims that it will make against TRW, including, but not limited to, loss of royalties due to mismanagement of TRW's airbag business. The Company intends to resist the claims in all the TRW litigation vigorously, and believes that it has valid defenses against each and that no such claim gives TRW any right to terminate or reduce the airbag royalty payment obligations. Notes to Consolidated Financial Statements Commitments and Contingencies (continued) Environmental. A subsidiary of Talley Manufacturing has been named as a potentially responsible party by the Environmental Protection Agency ("EPA") under the Comprehensive Environmental Response Compensation and Liability Act in connection with the remediation of the Beacon Heights Landfill in Beacon Falls, Connecticut and has been identified as a potentially responsible party by another company in connection with the Laurel Park Landfill in Naugatuck, Connecticut. Management's review indicates that the Company sent ordinary rubbish and off-specification plastic parts to these landfills and did not send any hazardous wastes to either site. Two coalitions of potentially responsible parties have entered into consent decrees with the EPA to remediate the sites. The Beacon Heights Coalition has in turn brought an action against other potentially responsible parties, including one of the Company's subsidiaries, to contribute to cleanup costs. The court hearing this case recently entered an order granting a motion for summary judgment in the Company's favor, which order the Beacon Heights Coalition has indicated it intends to appeal. The Laurel Park Landfill remediation program has not advanced as far as the program at Beacon Heights. A coalition of potentially responsible parties, not including the subsidiary of the Company, has entered into a consent decree and is undertaking remediation of the site. The Laurel Park Coalition has thus far been unsuccessful in its attempts to name the subsidiary in an action for contribution to the remediation costs. Based upon management's review and the status of these proceedings, management believes that any reasonably anticipated losses from these claims will not result in a material adverse impact on the results of operations or the financial position of the Company. In March 1992, a trucking company spilled approximately 500 gallons of solvent on the ground at a facility in Athens, Georgia, formerly operated by a subsidiary of the Company. The current owner of the site initiated emergency response action, ultimately including excavation and off-site disposal of contaminated soil. The current owner has brought an action against the trucking company, seeking reimbursement for emergency response costs and related damages from the spill. In March 1993 the trucking company brought the Company into the litigation pending in United States District Court for the Middle District of Georgia, claiming that an unspecified portion of the remediation costs claimed by the current owner was due to pre-existing soil and groundwater contamination. The Company has denied any liability to the trucking company and is separately conducting an investigation of the alleged contamination Notes to Consolidated Financial Statements Commitments and Contingencies (continued) Environmental, continued. in cooperation with the current owner of the site. The Company has determined from this investigation that it may face some liability with respect to pre-existing contamination of the site. Based upon remediation estimates received, management believes that any reasonably anticipated losses from the alleged contamination will not result in a material adverse impact on the results of operations or the financial position of the Company. In September 1990, the Department of Environmental Quality of the State of Arizona brought a civil action against a subsidiary of Talley Manufacturing claiming violations of various environmental regulations. The subsidiary met with agency officials to resolve the dispute, and in connection therewith paid $0.5 million as civil penalty. The subsidiary also agreed to certain restrictions and procedures imposed by the State of Arizona relating to the disposal of hazardous waste; the Company does not anticipate that the agreed restrictions and procedures will interfere with operations or result in any significant expense. Tax. The Arizona Department of Revenue issued Notices of Correction of Income Tax dated March 17, 1986 to the Company for the fiscal year ending March 31, 1983. These Notices pertain to whether subsidiaries of the Company must file separate income tax returns in Arizona rather than allowing the Company to file on a consolidated basis. The amount of additional Arizona income tax alleged to be due as a result of the Notices of Correction was $0.4 million plus interest. In May 1992 the Arizona Tax Court granted judgment in favor of the Company and against the Department on all claims asserted against the Company. In October 1992 the Tax Court entered judgment in favor of the Company awarding the Company approximately $0.6 million for the Arizona income taxes the Company overpaid for its fiscal year ending March 31, 1983 together with interest and attorneys' fees. The judgment entered by the Tax Court was appealed by the Department and is currently pending before the Arizona Court of Appeals. In May 1993, the Arizona Department of Revenue issued assessments with respect to calendar years 1984 through 1989 alleging that the Company owes additional Arizona income tax and interest in the amount of $16.6 million. Management's preliminary review of the assessments indicates that they were calculated on essentially the same basis used by the Department in its previous claims for income tax due with respect to its fiscal year ended March 31, 1983. However, due to a change in the applicable law for tax years commencing after 1985, the outcome of the litigation Notes to Consolidated Financial Statements Commitments and Contingencies (continued) Tax, continued. currently pending involving 1983 is not necessarily indicative of the merits or possible outcome of the claims made by the Arizona Department of Revenue for the periods commencing after 1985. Nevertheless, the Company intends to vigorously litigate the recent assessments. Notwithstanding such change in the law, based upon the 1992 rulings of the Arizona Tax Court in favor of the Company, advice from its counsel and the Company's income tax reserves, management believes that these assessments will not result in a material adverse impact on the results of operations or the financial position of the Company. Fair Value of Financial Instruments The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those instruments. On October 22, 1993 the Company completed the refinancing of substantially all of the Company's debt as more fully explained in the long-term debt note to the financial statements. Consequently, at December 31, 1993 the estimated fair value of long-term debt is approximately equal to the carrying value. The Company has the right to receive royalty payments under a license agreement executed in April, 1989 in connection with the sale of its airbag operations to TRW, Inc. Under the agreement, the Company is entitled to receive royalties for the twelve year period commencing May 1, 1989 and ending April 30, 2001. The rates at which these royalties are to be paid are: $1.14 for each airbag unit manufactured and sold anywhere in the world by TRW and its subsidiaries (this amount increases by $.01 per unit on May 1 of each year of the royalty term); 75% of the per-unit amount specified above for each inflator manufactured and sold anywhere in the world by TRW and subsidiaries; and $.55 for each airbag unit supplied by companies other than TRW for use in a vehicle manufactured or sold in North America. The fair value of the royalty stream is dependent upon automobile production, the number of produced vehicles with airbag systems and the market share of TRW, Inc.; accordingly, the fair value cannot be estimated. Royalties recognized in the year ending December 31, 1993 were $9,606,000. Research and Development Costs Research and development costs were $3,122,000, $3,904,000 and $4,223,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Notes to Consolidated Financial Statements Extraordinary Loss As a result of the termination of the interest swap agreement and the payoff of the underlying debt in 1993, the Company recognized an extraordinary loss of $1,102,000, net of taxes of $568,000. Acquisitions and Dispositions As part of its restructuring plans the Company sold the net assets of its precision potentiometer business in July 1993, for a cash purchase price of $2,756,000, which approximated the book value of the net assets sold. On May 19, 1992 the Company sold the net assets of its specialty advertising subsidiary for $7,866,000, which was approximately $400,000 below its book value. In connection with restructuring efforts the Company recorded 1991 fourth quarter pretax charges to earnings of $5,000,000. Restructuring costs were for restructuring fees to lenders and professional services in connection with the Company's restructuring of its debt and costs incurred as a part of downsizing of, or relocations of, subsidiary operations in connection with cost control efforts. The excess of cost over tangible and identifiable intangible assets acquired, net of amortization at December 31, 1993, 1992, and 1991 was $43,696,000, $45,501,000, and $50,299,000, respectively. Related Party Transactions In each of the last three years the Company and its subsidiaries incurred legal fees payable to the law firm of one of the Company's directors. During 1993, 1992 and 1991 total billings for the firm were $715,000, $1,045,000 and $422,000, respectively, and were for foreign and domestic services relating to litigation and general corporate matters. Fees were paid to a second law firm in 1993 of $329,000. A 1993 addition to the Company's board of directors was a partner in such firm until he retired in June 1993. Recently Issued Accounting Standards At the beginning of 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The new standard requires that companies use the accrual method of accounting to expense the estimated cost of providing postretirement health-care and other benefits over the years of each employee's active service. Notes to Consolidated Financial Statements Recently Issued Accounting Standards (continued) In 1992, the Company elected early adoption of the provisions of Statement of Accounting Standard No. 109, "Accounting For Income Taxes", which is more fully explained in the "Significant Accounting Policies" and "Income Taxes" Notes to Consolidated Financial Statement. Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" was issued in November 1992 and requires adoption no later than fiscal years beginning after December 15, 1993. This Statement establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. The Company does not presently provide any material postemployment benefits defined in this pronouncement. Other pronouncements issued by the Financial Accounting Standards Board or other rule making body, with future effective dates, are either not applicable or not material to the consolidated financial statements of the Company. Segment Operations The Company is a diversified manufacturer of a wide range of proprietary and other specialized products for defense, industrial and commercial applications. Through its Government Products and Services segment, the Company manufactures an extensive array of propellant devices and electronic components for defense systems and commercial applications and provides naval architectural and marine engineering services. The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW, which provides the Company with a quarterly royalty payment through April 30, 2001 for any airbag manufactured and sold by TRW worldwide and for any other airbag installed in a vehicle manufactured or sold in North America. The Company's Industrial Products segment manufactures and distributes stainless steel products, high-voltage ceramic insulators used in the power transmission and distribution systems, and specialized welding equipment and systems. The Company's Specialty Products segment manufactures and sells aerosol insecticides, air fresheners and sanitizers, and custom designed metal buttons. Government Products and Services The Company's Government Products and Services segment provides a wide range of products and services for government programs. The vast majority of the Company's products are smaller components of larger units and systems and are generally designed to enhance safety or improve performance. A significant portion of the Company's government revenue represents the replacement of existing Company products. Notes to Consolidated Financial Statements Segment Operations, (continued) Government Products and Services, continued The Company manufactures proprietary propellant products which, when ignited, produce a specified thrust or volume of gas within a desired time period. Propellant products manufactured include ballistic devices for aircraft ejection systems, rocket motors, extended range munitions components and dispersion systems. The Company's propellant devices are currently used on ejection seats on high performance domestic and foreign military aircraft. Rocket motors manufactured by the Company include a complete line of rocket boosters and propulsion systems used for reconnaissance, surveillance, and target acquisition. The Company's extended range munitions components utilize propellant technologies to significantly extend the range of existing U.S. artillery. Naval architecture and marine engineering services provided by the Company include detail design and engineering services for new military and commercial construction as well as a significant amount of maintenance and retrofit work for existing ships. The Company's Government Products and Services segment also manufactures specialized electronic display and monitoring devices and high performance cable connection assemblies. Direct sales to the U.S. Government and its agencies, primarily from the Government Products and Services segment accounted for approximately 24%, 32% and 28% of the Company's sales from continuing operations for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 the amount billed but not paid by customers under retainage provisions in long-term contracts was $1,402,000 and $1,659,000, respectively. The $1,402,000 receivable under retainage provisions is expected to be collected in 1994 through 1997 in the amounts of $288,000, $100,000, $168,000 and $846,000, respectively. Amounts in process but unbilled at December 31, 1993 and 1992 were $5,425,000 and $6,396,000, respectively. Airbag Royalties The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW. The Company entered into the Airbag Royalty Agreement as part of the 1989 sale of its automotive airbag manufacturing business. The terms of the Airbag Royalty Agreement require TRW to make quarterly royalty payments to the Company through April 30, 2001 for any airbag units manufactured and sold worldwide by TRW as well as for any other airbags installed in vehicles manufactured or sold in North America. Notes to Consolidated Financial Statements Segment Operations, (continued) Industrial Products The Company's Industrial Products segment operates in three product areas: stainless steel, high-voltage ceramic insulators and automated welding equipment. Demand for these products is directly related to the level of general economic activity. Through its stainless steel operation, the Company operates a state-of-the-art mini-mill which converts purchased stainless steel billets into a variety of sizes of both hot rolled and cold finished bar and rod. The Company's stainless steel mini-mill has utilized advanced computer automation, strict quality controls, and strong engineering and technical capabilities to maintain its position as a low cost, high quality producer. In addition to its stainless steel manufacturing operation, the Company distributes stainless steel and other specialty steel products through seven locations in the U.S. and Canada. The Industrial Products segment also manufactures and distributes high-voltage ceramic insulators for electric utilities, municipalities and other governmental units, as well as for electrical contractors and OEMs. In addition, the Company manufactures specialized advanced-technology welding systems, power supply systems and humidistats for the utility, pipeline and OEM markets. Specialty Products The Company's Specialty Products segment is focused on two distinct markets: aerosol insecticides, air fresheners and sanitizers servicing the industrial maintenance supply, pest control and agricultural markets, and custom designed metal buttons for the military and commercial uniform and upscale fashion markets. The majority of the Company's aerosol insecticides are proprietary formulations of natural active ingredients. The Company's U.S. operations had export sales of $26,672,000, $16,216,000 and $30,095,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Substantially all facilities and operations of the Company's continuing operations are located within the United States. The Company operates a steel distribution system located in Canada with sales for the year ended December 31, 1993 and total assets at December 31, 1993 of $11.6 million and $8.0 million, respectively. Foreign exchange losses included in earnings for the years ended December 31, 1993, 1992 and 1991 were not material. The foreign currency translation adjustment included in stockholder's equity was $(370,000) at December 31, 1993. Sales between segments are not significant and have been eliminated. Operating income is total revenue less operating expenses and excludes general Corporate expenses, non-segment interest income and interest expense. Interest income associated with segment assets is included in segment operations income. Corporate assets consist principally of cash and cash equivalents, notes receivable, income taxes receivable and a building. Notes to Consolidated Financial Statements Segment Operations (continued) The tables which follow show assets, depreciation and amortization and capital expenditures by segment: (in thousands) 1993 1992 1991 Assets by Segment Government Products and Services $114,347 $113,385 $119,489 Airbag Royalties 3,704 1,644 2,260 Industrial Products 86,879 83,904 95,656 Specialty Products 27,951 27,190 38,825 232,881 226,123 256,230 Corporate 18,961 21,635 73,948 $251,842 247,758 330,178 Depreciation and Amortization by Segment Government Products and Services $ 4,163 $ 4,235 $ 4,227 Airbag Royalties - - - Industrial Products 4,427 4,616 4,739 Specialty Products 1,138 1,319 1,785 9,728 10,170 10,751 Corporate 342 395 444 $ 10,070 $ 10,565 $ 11,195 Capital Expenditures by Segment Government Products and Services $ 1,648 $ 2,122 $ 4,766 Airbag Royalties - - - Industrial Products 2,842 1,045 804 Specialty Products 754 1,101 936 5,244 4,268 6,506 Corporate 102 296 61 $ 5,346 $ 4,564 $ 6,567 Report of Independent Accountants To the Board of Directors and Shareholder of Talley Manufacturing and Technology, Inc. In our opinion, the consolidated financial statements listed in the index appearing on page present fairly, in all material respects, the financial position of Talley Manufacturing and Technology, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial 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, the 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 the notes to the financial statements titled "Employee Benefit Plans" and "Significant Accounting Policies" the Company changed its method of accounting for postretirement benefits other than pensions in 1993 and changed its method of accounting for income taxes in 1992. PRICE WATERHOUSE Phoenix, Arizona February 22, 1994 TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Subsidiaries/Divisions Government Products and Services Electrodynamics, Inc., Rolling Meadows, Illinois. John W. Kravcik, President. John J. McMullen Associates, Inc., New York, New York. P. Thomas Diamant, President. Rowe Industries, Inc., Toledo, Ohio. Haywood W. Bower, Chairman of the Board. Talley Defense Systems, Inc., Mesa, Arizona. Edward T. Ryan, Jr., President. Universal Propulsion Company, Inc., Phoenix, Arizona. Harold G. Watson, President. Industrial Products Amcan Specialty Steels, Inc., Hermitage, Pennsylvania. Bruce Olson, President. Diversified Stainless Steel of Canada, Inc., Downsview, Ontario, Canada. Frank Szabo, President. Porcelain Products Co., Carey, Ohio. Haywood W. Bower, President. Talley Metals Technology, Inc., McBee, South Carolina. Donald Bailey, President. Dimetrics, Davidson, North Carolina. Arthur M. Squicciarini, President. Specialty Products Waterbury Companies, Inc., Waterbury, Connecticut. Michael J. Tragakiss, President. TALLEY MANUFACTURING AND TECHNOLOGY, INC. AND SUBSIDIARIES Directors and Corporate Management DIRECTORS William H. Mallender - Chairman of the Board and Chief Executive Officer Jack C. Crim - President and Chief Operating Officer Neil W. Benson - Chartered Accountant, Lewis Golden & Co. Paul L. Foster - Professor of Finance, Saint Joseph's University Townsend Hoopes - Retired, formerly President, Association of American Publishers, Inc. Fred Israel - Retired, formerly Senior Partner Israel and Raley John D. MacNaughton, Jr. - President, The MacNaughton Co. Emiel T. Nielsen, Jr. - Retired, formerly Vice Chairman, FMC Corporation Joseph A. Orlando - Independent financial consultant Alex Stamatakis - Chairman of the Board, Stamatakis Industries, Inc. John W. Stodder - Vice Chairman, Jostens, Inc. Donald J. Ulrich - Owner and Vice Chairman, Ventura Coastal Corporation David Victor - Member, Meyer, Hendricks, Victor, Osborn & Maledon CORPORATE MANAGEMENT William H. Mallender - Chairman of the Board and Chief Executive Officer Jack C. Crim - President and Chief Operating Officer William E. Bonnell - Vice President - Human Resources Mark S. Dickerson - Vice President, General Counsel and Secretary Kenneth May - Vice President and Controller Daniel R. Mullen - Vice President and Treasurer George W. Poole - Vice President - Government Relations SCHEDULE III Page 1 of 6 TALLEY MANUFACTURING AND TECHNOLOGY, INC. (Registrant Only) STATEMENT OF CONDITION (BALANCE SHEET) DECEMBER 31, 1993 1992 Assets Current assets: Cash and cash equivalents $ 2,069,000 $ 7,472,000 Due from affiliates 1,648,000 23,021,000 Accounts receivable 11,078,000 13,032,000 Deferred income taxes - 371,000 Prepaid expenses 1,552,000 975,000 Total current assets 16,347,000 44,871,000 Investment in and advances to affiliates 122,844,000 163,624,000 Long-term receivables 2,829,000 3,829,000 Property, plant and equipment, at cost, net of accumulated depreciation of $1,532,000 in 1993 and $1,403,000 in 1992 682,000 846,000 Deferred charges and other assets 9,062,000 2,373,000 Deferred income taxes - 291,000 Total assets $151,764,000 $215,834,000 See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 2 of 6 TALLEY MANUFACTURING AND TECHNOLOGY, INC. (Registrant Only) STATEMENT OF CONDITION (BALANCE SHEET) DECEMBER 31, 1993 1992 Liabilities and Stockholder's Equity Current liabilities: Current maturities of long-term debt $ 88,000 $ 7,762,000 Due to affiliates 2,000 70,048,000 Accounts payable 4,545,000 2,855,000 Accrued expenses 3,549,000 5,651,000 Deferred income taxes 5,182,000 - Total current liabilities 13,366,000 86,316,000 Deferred income taxes 4,411,000 - Long-term debt 115,121,000 114,142,000 Other liabilities 464,000 4,428,000 Stockholder's equity: Preferred stock, $1 par value, authorized 100 shares - Series A: Issued 8 shares 8 - Common stock, $1 par value, authorized 1,000 shares 1,000 - Capital in excess of par value 15,752,992 10,948,000 Foreign currency translation adjustments (370,000) - Retained earnings 3,018,000 - Total stockholder's equity 18,402,000 10,948,000 Total liabilities and stockholder's equity $151,764,000 $215,834,000 See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 3 of 6 TALLEY MANUFACTURING AND TECHNOLOGY, INC. (Registrant Only) STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 Selling, general and administrative expenses $ 13,045,000 $ 9,381,000 $ 8,940,000 Administrative allocations to subsidiaries (16,643,000) (19,218,000) (22,549,000) (3,598,000) (9,837,000) (13,609,000) Restructuring costs - - (5,000,000) Other income (expense), net 264,000 3,253,000 (1,692,000) (3,862,000) (13,090,000) (6,917,000) Interest expense 16,323,000 21,789,000 25,808,000 Interest charges to subsidiaries, net (167,000) (494,000) (3,572,000) 16,156,000 21,295,000 22,236,000 (12,294,000) (8,205,000) (15,319,000) Income tax benefit (3,600,000) (5,564,000) (4,460,000) Loss before earnings of subsidiaries and extraordinary gains (8,694,000) (2,641,000) (10,859,000) Extraordinary loss, net of taxes (1,102,000) - - Earnings from subsidiaries 14,498,000 7,312,000 5,955,000 Net earnings (loss) $ 4,702,000 $ 4,671,000 $ (4,904,000) See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 5 of 6 TALLEY MANUFACTURING AND TECHNOLOGY, INC. (Registrant Only) Notes to Financial Statements The following notes supplement information provided in the notes accompanying the consolidated financial statements. 1. Basis of Presentation Investments in and advances to affiliates represents interest in majority-owned subsidiaries and associated companies. The investments are accounted for on the equity method and, accordingly, the carrying value approximates the Company's equity in the recorded value of the underlying net assets. In July 1993, Talley Manufacturing and Technology, Inc. ("the Company"), a wholly owned subsidiary of Talley Industries, Inc., ("Talley") was formed with the issuance of 1,000 shares of common stock. The formation of the Company was in anticipation of an offering, in October, 1993, of Senior Notes by the Company and Senior Discount Debentures by Talley. Concurrently with the issuance of these securities, Talley contributed the capital stock of its operating subsidiaries (other than its real estate subsidiaries) to the Company, which also assumed a substantial portion of Talley's indebtedness and liabilities. (See Basis of Presentation note to the Company's consolidated financial statements). Certain reclassifications have been made in the prior year Statement of Operations to be consistent with current year classifications. 2. Long-Term Debt December 31, Long-term debt consists of the following: 1993 1992 (balances in thousands) 10-3/4% Senior Notes, due 2003 $115,000 $ - Notes, interest based on prime or other variable market rate - 116,852 8-1/8% debentures - 3,894 Capitalized leases and other 209 1,158 115,209 121,904 Less current maturities 88 7,762 Long-term debt $115,121 $114,142 The Company and Talley Industries, Inc. completed a major debt refinancing program on October 22, 1993. The proceeds from the new financing were used to repay substantially all of the Company's debt. (See Long-term debt note to the Company's consolidated financial statements). Aggregate maturities of long-term debt for the years ended December 31, 1994 through 1998 are $88,000, $101,000, $114,000, $-0- and $-0-, respectively. SCHEDULE III Page 6 of 6 TALLEY MANUFACTURING AND TECHNOLOGY, INC. (Registrant Only) Notes to Financial Statements 3. Income Taxes The parent company and its domestic subsidiaries file a consolidated federal income tax return. The provision for income taxes represents the difference between amounts attributable to each subsidiary, generally determined on a separate return basis, and the tax computed on a consolidated basis. During 1992, the Company adopted the provisions of the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" retroactive to January 1, 1992. This accounting pronouncement requires a change from the deferred to the liability method of computing deferred income taxes. This change had no effect on reported net earnings or loss for 1992 or prior years. 4. Dividends Received The registrant received dividends, net of contributions from consolidated subsidiaries, unconsolidated subsidiaries and 50 percent or less owned persons accounted for by the equity method during the years ended December 31, 1993, 1992 and 1991 of $97,475,000, $8,251,000 and $928,000, respectively. EXHIBIT INDEX 3.1 Certificate of Incorporation of Talley Manufacturing and Technology, Inc., attached as Exhibit 3(d) to Talley's Registration Statement on Form S-1 dated October 15, 1993, incorporated herein by this reference. 3.2 By-laws of Incorporation of Talley Manufacturing and Technology, Inc., attached as Exhibit 3(e) to the Company's Form S-1 dated October 15, 1993, incorporated herein by this reference. 4.1 Certificate of Designation, Preferences and Rights of Series A Preferred Stock of Talley Manufacturing and Technology, Inc., attached as Exhibit 4(e) to the Company's Form S-1 dated October 15, 1993, incorporated herein by reference. 4.2 Indenture Agreement among Talley Manufacturing and Technology, Inc., the Subsidiary Guarantors (as defined), Talley Industries, Inc. and Bank One, Columbus, N.A., a national banking association, as Trustee, dated as of October 15, 1993 relating to the 10-3/4% Senior Notes due 2003 issued by Talley Manufacturing and Technology, Inc. and the exhibits thereto, attached as Exhibit 4.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.1 Form of Indemnification Procedures Agreement between Talley Manufacturing and each of its directors, attached as Exhibit 10(jj) to Amendment No. 1 to Form S-1 dated September 10, 1993, incorporated herein by reference. 10.2 Tax Sharing Agreement among Talley Industries, Inc., Talley Manufacturing and Technology, Inc. and each of their respective subsidiaries, dated as of October 22, 1993, attached as Exhibit 10.3 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.3 Restructuring, Assumption and Cost sharing Agreement among Talley Industries, Inc., Talley Manufacturing and Technology, Inc. and Talley Real Estate Company, Inc. dated as of October 22, 1993, attached as Exhibit 10.4 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.4 Loan and Security Agreement among Talley Manufacturing and Technology, Inc., the Lenders listed therein and Transamerica Business Credit Corporation, as Agent dated October 22, 1993, attached as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.5 Airbag Collateral Security, Intercreditor and Agency Agreement dated as of October 22, 1993 among Talley Manufacturing and Technology, Inc., Talley Technology, Inc., Talley Defense Systems, Inc., Talley Automotive Products, Inc., Talley Metals Technology, Inc. and Transamerica Business Credit Corporation as Agent and as collateral agent for the Lenders (as defined) and the Senior Note Trustee, Lenders and Bank One, Columbus, N.A., a national banking association, as Trustee for the holders of the 10-3/4% Senior Notes due 2003 issued by Talley Manufacturing and Technology, Inc., attached as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.6 Form of Subsidiary Loan Agreement dated as of October 22, 1993 between Talley Manufacturing and Technology, Inc. and each of certain subsidiaries, attached as Exhibit 99.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.7 Subsidiary Loan and Security Agreement dated as of October 22, 1993 between Talley Manufacturing and Technology, Inc. and Talley Technology, Inc., attached as Exhibit 99.2 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.8 Form of Subsidiary Continuing Guaranty and Security Agreement dated as of October 22, 1993 between Transamerica Business Credit Corporation, a Delaware corporation and each of certain subsidiaries, attached as Exhibit 99.3 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 21* Subsidiaries of the Registrant. 23.1* Consent of Company's Independent Public Accountants to the incorporation by reference of their reports for the current year accompanying the financial statements included in the Registrant's Forms S-1 Registration Statements. * Documents marked with an asterisk are filed with this report.

814361_1993.txt

814361_1993

1993

814361

ITEM 1. BUSINESS OVERVIEW The Timberland Company was incorporated in Delaware on December 20, 1978, and is the successor to Abington Shoe Company, which was incorporated in Massachusetts in 1933 (The Timberland Company, together with its subsidiaries, is referred to herein as "Timberland" or the "Company," unless the context indicates otherwise). The Company designs, develops, manufactures and markets men's and women's premium quality footwear, apparel and accessories under the Timberland [Registered]1 brand. These products are sold primarily through better-grade department stores and other retail stores in the United States and in more than 50 countries worldwide. In addition, the Company sells its products through specialty stores devoted exclusively to Timberland [Registered] products which are operated or licensed by it in the United States, Europe, South America, Mexico, Australia, New Zealand and Asia. Timberland also sells its products through Company-operated factory outlet stores in the United States. The Company has built its product lines to reflect classic rugged styles which provide durability and quality. In marketing its products, the Company has consistently stressed the workmanship and detailing incorporated into its products, which are designed to provide lasting protection from the elements. During 1993, the Company implemented a strategic decision to attempt to lead the market by pre-emptively reducing prices for certain of its products and to improve the price/value proposition for the consumer. By continuing to improve its manufacturing and logistics process, the Company believes that it will be able to more efficiently respond to consumer demand, to provide high quality products at competitive prices and to increase its sales. The Company increased its sales from $291.4 million in 1992 to $418.9 million in 1993. CURRENT PRODUCTS The Company's two major product categories are footwear (shoes and boots) and apparel and accessories. During 1993, net sales attributable to the footwear category totaled $349.5 million, as compared to $242.6 million and $188.3 million in 1992 and 1991, respectively. During 1993, net sales attributable to the apparel and accessories category totaled $69.4 million, as compared to $48.8 million and $37.8 million in 1992 and 1991, respectively. During 1993, the Company did not have sales to a single customer which equaled or exceeded 10% of the Company's total net sales. FOOTWEAR Timberland offers men's and women's shoes and sandals featuring hand-sewn construction, premium waterproof leather or water resistant fabric uppers and selected use of waterproof fabric bootie construction. The Company's shoes and sandals are based on classic styling and are designed for durability. In 1993, the Company introduced a variety of new boat shoes, a variety - ---------------------------------- 1 TIMBERLAND is a registered trademark of The Timberland Company. of new styles in its waterproof Weatherbuck Collection and a new turf sandal, as well as other new sandal styles. In 1973, Timberland's predecessor, Abington Shoe Company, produced the first pair of waterproof "mini-buck" leather boots under the Timberland [Registered] brand. The Company now offers a variety of styles of boots for men and women, including hikers and lightweight trail boots. In 1993, the Company introduced a variety of new lightweight trail boots and bush hikers, including an outdoor, multipurpose boot featuring a stretch waterproof fabric internal fit system. APPAREL AND ACCESSORIES Timberland offers premium-quality apparel, consisting of rugged outerwear, sweaters, shirts, pants, shorts and skirts. Incorporated into many of such products are premium waterproof leathers, waterproof fabric, rust-proof hardware, canvas, denim and other quality performance materials. During 1993, in response to consumer demand, the Company redesigned its women's line of apparel to better coordinate its sportswear and outerwear. The Company also continued to offer its men's line of rugged apparel, with an emphasis on performance-wear designed to protect against the elements. Timberland's accessories collection includes luggage, briefcases, wallets, handbags, belts, caps, hats, gloves and socks. For 1993, introductions in the accessories collection included a variety of new styles in each of its lines. TIMBERLAND'S STRATEGY During 1993, the Company pursued its strategy for growth by capitalizing on its core business and continuing to expand its domestic and international presence through building increased consumer awareness of the Timberland [Registered] brand. Timberland believes that its integrated brand strategy, which is to showcase the Timberland [Registered] brand as an integrated source of footwear, apparel and accessories, is best carried out in specialty stores and in concept shops or corners. Specialty stores are stores owned or licensed by the Company which sell only Timberland [Registered] products. Concept shops or corners are areas of third-party stores dedicated exclusively to the presentation and merchandising of Timberland [Registered] products. The Company continued to promote consumer demand for its products in 1993 through advertising campaigns which emphasized the workmanship and detailing of its footwear, apparel and accessories and the protection which these products offer against the elements. Timberland believes that the premium quality, durability, functionality and classic styling of its products, combined with its reputation for high-performance products and increased consumer awareness of the Timberland [Registered] brand, will continue to increase consumer demand for its products. Advertising through print and television campaigns is used to present Timberland as an integrated, world-class source of quality footwear, apparel and accessories for the rugged outdoors. The Company reinforces this advertising with a variety of in-store promotions, point-of-purchase displays and a cooperative advertising program with its retailers, as well as retail sales clerk training and other incentive programs and promotional campaigns. In response to consumers' heightened sensitivity to maximum value, the Company is also exploring new ways in which it can improve the price/value proposition to its customers. The Company believes that the continuing implementation of its modular manufacturing program will assist in providing the consumer with the highest quality footwear at the best prices (see "Business -- Manufacturing"). During 1993, the Company lowered its prices on a variety of styles in a number of product lines. The Company is committed to maintaining a solid price/value relationship for its consumers. The Company intends to continue its growth through a combination of internal development and the development of business relationships with independent manufacturers, suppliers, distributors and retailers capable of reinforcing the Company's image and standards. The Company may, from time to time, consider the possibility of acquiring other companies which produce or distribute quality footwear, apparel, accessories or related products which complement the Company's product lines. DISTRIBUTION U.S. OPERATIONS In 1993, 1992 and 1991, 71%, 63%, and 59%, respectively, of the Company's net sales were generated in the United States. The Company's strategy is to distribute its products through specialty stores and through retailers who reinforce the Timberland image of quality, performance and service. The Company's customer accounts within the United States range from better-grade department stores and retail stores to sporting goods stores, marinas and specialty retailers. These accounts are serviced through a combination of field and corporate-based sales teams. The Company's principal showroom in the United States for wholesale customers is located on Fifth Avenue in New York City. Its regional showrooms are located in Chicago, Dallas, Atlanta, Denver and Seattle. The showrooms located in Denver and Seattle were opened in 1993. In 1993, the Company's domestic retail operations accounted for 8% of the net sales of the Company compared to 10% in 1992 and 11% in 1991. The Company operates nine Timberland [Registered] specialty stores located in Atlanta; Boston; Chicago; Dallas; Newport, Rhode Island; New York City; San Francisco; Sausalito, California; and Washington, D.C. The Company opened the San Francisco, Dallas and Chicago specialty stores in 1993 and opened the specialty store in Atlanta in February 1994. The specialty stores showcase the Timberland [Registered] brand as an integrated source of footwear, apparel and accessories. These stores also provide sales and consumer-trend information which assists the Company in developing its marketing strategies, including point-of-purchase materials. In addition, the training and customer service programs established in the Company's specialty stores serve as a model which may be adopted by the Company's other retail accounts. The Company also operates ten factory outlet stores located in the United States, which typically sell factory-second and close-out product offerings. The Company carries material amounts of inventory in order to meet delivery and any other requirements of its customers. The Company established distribution facilities in Wilmington, Massachusetts in 1993 and in Danville, Kentucky in early 1994. Currently, orders are filled primarily from the Company's Hampton, New Hampshire distribution center and the Wilmington center. The Company plans to make the Danville facility another principal distribution center in 1994. The Company's long-term distribution strategy is to centralize its points of distribution in order to cut costs and increase responsiveness to consumer demand. INTERNATIONAL In 1993, international sales accounted for 29% of Timberland's net sales compared to 37% in 1992 and 41% in 1991. Timberland sells its products internationally through distributors, commission agents and seven subsidiaries. The Company's subsidiaries located in England, France, Germany, Spain, Austria, Australia and New Zealand provide sales, administrative and, in certain instances, warehousing support for the sale of Timberland [Registered] products to retailers in their respective countries, and in certain instances, to distributors and commission agents in other countries. Internationally, retail distribution of the Company's products occurs through better-grade department stores, retail stores and specialty stores. Timberland operates international specialty stores in London; Munich; Dusseldorf; Vienna; Paris; Lyon, France; Sydney, Australia and Auckland, New Zealand. Additionally, the Company grants licenses to operate international specialty stores to certain third parties. In December 1993, the Company entered into a nonbinding Memorandum of Understanding with its Italian distributor outlining the contemplated termination of the distributor's distribution rights and acquisition of certain of its assets. Net sales to this distributor represented 4% of the Company's consolidated revenues in 1993. Timberland intends to assume the distribution of its own products in Italy, effective on the termination date. Reference is hereby made to the information set forth in footnote 9, entitled "Industry Segment and Geographical Area Information," appearing on page 21 of the Company's 1993 Annual Report to Stockholders, which information is incorporated herein by reference. ADVERTISING AND MARKETING The Company designs its domestic advertising campaigns to emphasize quality, lasting protection from the elements and classic rugged style, placing advertisements in popular, fashion and sports-focused national periodicals and newspapers. The Company uses its retail specialty stores and concept shops as effective vehicles to promote its integrated brand strategy, by showcasing an integrated presentation of Timberland [Registered] products in settings designed to complement the Timberland style. In an effort to broaden consumer exposure during 1993, Timberland aired television advertisements in an expanded number of major United States metropolitan areas. In 1993, the Company's print advertising continued to win national awards. All advertising of the Company's product lines is designed to reflect Timberland's basic theme of extending the rugged, functional qualities of Timberland's original boots into a broad range of footwear, apparel and accessories products, as well as to express the Company's position on certain important social issues. Internationally, the Company participates in a variety of direct and cooperative advertising efforts. This advertising uses and adapts for the international markets many of the same promotional themes that are used in the United States. During 1993, Timberland was again the primary sponsor of the annual 1,049-mile Iditarod [Registered]2 sled dog race from Anchorage to Nome, Alaska and continued its "Tough Enough" for The Last Great Race on Earth [Registered] 2 promotional program to build upon its association with this unique event. The Company outfitted five Iditarod mushers entirely in Timberland [Registered] outerwear, apparel and footwear, including five-time Iditarod winner Rick Swenson. Through its sponsorship of the Iditarod [Registered] race and similar events, the Company seeks to promote the Timberland image of superior product quality and performance beyond its traditional advertising and promotional efforts. The Company also sponsors, at times in conjunction with its international distributors and subsidiaries, individual sailors and sailing teams from various countries, including the United States and New Zealand. In 1993, the Company continued to publish Elements[Registered]3, a color print magazine, which features articles by prominent writers about their outdoor experiences. The topics covered include sailing, hiking and the Iditarod [Registered] sled dog race. Elements [Registered] is distributed biannually to the Company's preferred domestic and international consumers. SEASONALITY In 1993, as has traditionally been the case, the Company's sales were higher in the last two quarters of the year than in the first two quarters. The Company expects this sales trend to continue in 1994. BACKLOG At December 31, 1993, Timberland's backlog of orders from its customers was approximately $69 million compared to $60 million at December 31, 1992. While all orders in the backlog are subject to cancellation by the customers, the Company expects that the majority of such orders will be filled in 1994. The Company does not believe that its backlog of orders at year end is representative of the orders which will be filled during 1994, due to the shift towards "at once" orders being adopted by many retailers. MANUFACTURING The Company manufactures the majority of its footwear products in its own factories. The Company also uses independent manufacturers to provide the additional production capacity and flexibility to meet increased consumer demand. During 1993, approximately 70% of the Company's footwear products were manufactured in the Company's leased facilities located in - ---------------------------------- 2 IDITAROD and THE LAST GREAT RACE ON EARTH are registered trademarks of the Iditarod Trail Committee, Inc. 3 ELEMENTS is a registered trademark of The Timberland Company. Tennessee, North Carolina, Puerto Rico and the Dominican Republic, compared to 79% during 1992. The remainder of the Company's footwear unit volume was sourced from manufacturers in the Far East, Europe and North America. The Company sources all of its apparel and accessories from independent manufacturers located in Europe, the Far East and North America. As a result, the apparel and accessories operations of the Company are substantially dependent upon foreign operations with unaffiliated parties and are subject to the usual risks of doing business abroad. These risks potentially include political or labor disturbances, expropriation, acts of war and other similar events. The Company believes that, because it manufactures the majority of its footwear in the United States, the Company has less exposure to potential U.S. import restrictions and duties than do many of its competitors which import the majority of their products from the Far East, South America and Europe. With respect to the Company's operations in the Dominican Republic, the Company is subject to the usual risks of doing business abroad. During 1993, the Company began implementation of certain cost savings programs, such as modular manufacturing, to enhance materials management and reduce manufacturing cycle times. The modular manufacturing program aims to improve quality, productivity and asset utilization by rearranging certain manufacturing facilities and functions. Another expected benefit of modular manufacturing is the reduction of the amount of inventory that the Company must carry to meet delivery and other requirements of its customers. RAW MATERIALS The Company purchases its raw materials from a number of domestic and foreign sources. The Company has three suppliers located in the United States that, together, supply more than 70% of the Company's requirements for leather. The Company has no reason to believe that leather will not continue to be available from these or alternative sources. TRADEMARKS AND TRADE NAMES; PATENTS; RESEARCH & DEVELOPMENT The Company's principal trademarks and trade names are Timberland[Registered] and the Timberland stylized tree design logo [Logo]4, which have been registered in the United States and in certain foreign countries. Other Company trademarks are HydroTech[Registered]4, Elements[Registered], Weathergear[Registered]4 and More Quality Than You May Ever Need[Registered]4. The Company regards these trademarks and trade names as valuable assets and believes that they are important factors in marketing its products, particularly in the case of the Timberland[Registered] brand which is essential to the Company's integrated brand strategy. It is the policy of the Company to defend its trademarks and trade names against infringement to the fullest extent practicable under the laws of the United States and other countries. In addition, the Company seeks to protect and defend vigorously its patents, designs, proprietary rights and copyrights under applicable laws. The Company conducts research, design and development efforts for its footwear, apparel and accessories. In connection with these efforts, the Company continues to explore innovative ways to bring new products from the design stage to the marketplace in the most expedient manner possible. While Timberland continues to be a leader in product innovation, its expenses relating to research, design and development have not represented a material expenditure relative to other expenses of the Company. Timberland tests a number of its products under actual field conditions in order to evaluate performance characteristics. The Company receives product evaluation information from a broad range of users, frequently referred to as "Team Timberland." These users include mushers who participate in the Iditarod[Registered] sled dog race and a number of world class sailors. Through these and other relationships, Timberland is able to measure the performance of its products in the outdoors and to obtain ideas for improving its products' performance based upon the experience and competitive needs of these athletes. COMPETITION The Company does not believe that it has any major competitors who offer a full complement of products which directly compete with Timberland's integrated brand. The Company does, however, have a variety of separate major competitors in sales of its separate lines of footwear, apparel and accessories. The Company's footwear lines are marketed in a highly competitive environment, and the footwear industry is subject to rapid changes in consumer preference. Although the footwear industry is fragmented to a great degree, many of the Company's competitors are larger and have substantially greater resources than the Company. - ---------------------------------- 4 [Logo], HYDROTECH, WEATHERGEAR and MORE QUALITY THAN YOU MAY EVER NEED are registered trademarks of The Timberland Company. The Company's major competitors for its boot products are located principally in the United States. The Company has at least four major competitors in classic boot sales, at least two major competitors in sport boot sales and at least seven major competitors in hiking boot sales. In the boat shoe market, the Company faces competition from at least three companies located in the United States. Other casual shoes produced by the Company face competition from at least four other primary competitors in the United States. Internationally, the Company faces competition from many manufacturers of footwear. As in the United States, some of these manufacturers attempt to copy the Company's styles. Each of the Company's lines of men's and women's apparel faces competition from at least four major apparel companies, the majority of which are located in the United States. Timberland's accessories face strong competition primarily from three companies in the United States. Product performance and quality, including continuing technological improvements, product identity through marketing and promotion, and product design, styling and pricing are all important elements of competition in the footwear, apparel and accessories markets served by the Company. Although changing fashion trends generally affect demand for particular footwear, apparel and accessories products, the Company believes that demand for its products is less sensitive to changing trends in fashion because its products are designed primarily for functionality and performance. ENVIRONMENTAL MATTERS 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, have not had, nor are they expected to have, any material effect on the capital expenditures, earnings or competitive position of the Company. EMPLOYEES At December 31, 1993, the Company had approximately 6,700 employees worldwide. Management considers its employee relations to be good. None of the Company's employees is represented by a labor union, and the Company has never suffered a material interruption of business caused by labor disputes. ITEM 2. ITEM 2. PROPERTIES The Company owns property in Hampton, New Hampshire, currently housing its principal executive offices. This facility is used for offices as well as warehousing and distribution of certain of the Company's products. In connection with the purchase financing for such property, industrial revenue bonds are outstanding in the principal amount of $5,345,000, due in 2014. The bonds bear interest at 6.75% through November 30, 1994, and thereafter at rates adjusted every five years, through maturity. The bonds are collateralized by a mortgage on such real estate and by a security interest on specified equipment at the Company's headquarters and distribution center. The Company also leases office space in two additional buildings in Hampton, New Hampshire, under leases expiring in January 1997. Although its headquarters facilities currently meet the Company's immediate needs, the Company is examining the continued suitability and adequacy of such facilities. The Company leases approximately 389,000 square feet of production facilities, which are located in Mountain City, Tennessee; Boone, North Carolina; Isabela, Puerto Rico and Santiago, Dominican Republic. These production facilities are occupied under eleven leasing arrangements which expire at various times from April 1994 to February 1997. The Company is currently negotiating an extension of the leasing arrangement that expires in April 1994. Although its production facilities are adequate and suitable to meet the Company's current needs, the Company is examining the continued suitability and adequacy of its production facilities. (Also see "Business -- Manufacturing.") The Company leases ten factory outlet stores located in the United States; nine domestic specialty stores; six domestic showrooms; and eight international specialty stores. (Also see "Business -- Distribution.") The Company's international subsidiaries also lease office and warehouse space to meet their individual requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in litigation and various legal matters, including U.S. customs claims, which have arisen in the ordinary course of business. Management believes that the ultimate resolution of any existing matter will not have a material effect on the Company's financial statements. On February 15, 1994, a complaint was filed by Michael Germano in United States District Court for the district of New Hampshire in which the Company and one of its officers were named as defendants in a purported class action lawsuit brought on behalf of purchasers of the Company's stock between November 15, 1993 and February 10, 1994. The suit alleges material misstatements and omissions in the Company's public filings and statements in 1993. The named plaintiff contends he suffered damages as a result of his December 1993 purchase of 50 shares of the Company's Class A Common Stock. To date, the court has not approved the formation of a class nor has the plaintiff specified damages sought in this action. While the suit is in its preliminary stages, based on an initial review, and after consultation with counsel, management believes the allegations are without merit. Accordingly, management does not expect the outcome of such litigation to have a material adverse effect on the Company's financial statements. The Company intends to defend this proceeding vigorously. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this report, no matter was submitted to a vote of security holders through the solicitation of proxies or otherwise. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The following information is submitted as to the executive officers of the Company: All executive officers serve at the discretion of the Board of Directors. Sidney W. Swartz has served the Company as Chairman of the Board, Chief Executive Officer and President since June 1986, when he and his family trust became the sole stockholders of the Company. During the prior 20 years, Mr. Swartz, as the owner of 50% of the Company, was responsible for the manufacturing, marketing, distribution and financial aspects of the Company. Jeffrey B. Swartz has served the Company as Executive Vice President since March 1990 and Chief Operating Officer since May 1991. From June 1986 to February 1990, Mr. Swartz served the Company in a variety of positions, including Senior Vice President of International Operations, Vice President-Operations/Manufacturing, Vice President-International and General Manager of International Business. Jeffrey Swartz is the son of Sidney W. Swartz. Keith D. Monda joined the Company in December 1993 as Senior Vice President-Finance and Administration and Chief Financial Officer. From May 1990 to December 1993, Mr. Monda was Executive Vice President of Finance and Administration of J. Crew Group, Inc.; from July 1989 to May 1990, he was Senior Vice President and Chief Financial Officer of Bunge Corporation (an integrated food company); and from April 1986 to July 1989, he was Vice President of Finance and Chief Financial Officer of the chemical division of Pfizer, Inc. Kenneth A. Snyder joined the Company in June 1990 as Divisional Vice President of Domestic Sales. In February 1991, Mr. Snyder assumed the office of Senior Vice President-Domestic Sales. From October 1989 until May 1990, Mr. Snyder was Vice President of Sales of New Balance Athletic Company; and from November 1988 until September 1989, he was Vice President of Sales of Stride Rite Corporation. Edmund J. Feeley joined the Company in February 1993 as Senior Vice President-Manufacturing and Operations. From May 1990 to January 1993, Mr. Feeley was a Principal of Booz, Allen and Hamilton, a general management and consulting firm, where he had also been a Senior Associate from May 1987 to April 1990. Jane E. Owens joined the Company as Vice President and General Counsel in September 1992. From June 1990 until August 1992, Ms. Owens was counsel for Reebok International Ltd.; and from March 1988 until June 1990, she was a partner in the law firm of Gaston & Snow. Edward J. Suleski, Jr. joined the Company in February 1992 as its International Controller. In June 1992, Mr. Suleski was appointed Corporate Controller for the Company, and in March 1994, he was named Chief Accounting Officer. From September 1988 to February 1992, Mr. Suleski held various positions with Wang Laboratories, Inc., including Senior Finance Manager for North American Operations Accounting and Reporting, Senior Finance Manager, Eastern Region Pricing and Contracts and Financial Controller for Wang Ireland, Ltd. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders under the caption "Quarterly Market Information and Related Matters" on page 13 and is incorporated herein by reference. The closing sales price of the Registrant's Class A Common Stock on March 15, 1994 was $34.125. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders under the caption "Five Year Summary of Selected Financial Data" on page 10 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 is included in the Registrant's 1993 Annual Report to Stockholders under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 11 and 12 and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders on pages 14 through 23 and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On August 11, 1992, the Audit Committee of the Board of Directors of the Company recommended to the Board of Directors that the Company appoint Deloitte & Touche as the Company's independent accountants. By Unanimous Consent dated August 12, 1992, the Board of Directors appointed Deloitte & Touche as the Company's independent accountants to replace Arthur Andersen & Co. for fiscal year 1992. The Company's management did not consult with Deloitte & Touche on any accounting, auditing or reporting matter prior to their appointment as independent accountants for the Company. During the two fiscal years ended December 31, 1991 and the interim period subsequent to December 31, 1991, there had been no disagreements with Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure or any reportable events. Arthur Andersen's report on the Company's financial statements for such two years contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to the information set forth under the caption, "Executive Officers of the Registrant," in Item 4A of Part I of this report and to information under the captions, "Information with Respect to Nominees" and "Executive Compensation," in the Registrant's definitive proxy statement (the "Registrant's 1994 Proxy Statement") relating to its 1994 Annual Meeting of Stockholders, to be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended December 31, 1993, which information is incorporated herein by reference. Reference is also made to the information set forth in the Registrant's 1994 Proxy Statement with respect to compliance with Section 16(a) of the Exchange Act, which information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to the information set forth in the Registrant's 1994 Proxy Statement under the caption "Executive Compensation," which information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to the information set forth under the caption, "Security Ownership of Certain Beneficial Owners and Management," in the Registrant's 1994 Proxy Statement which information is incorporated herein by reference. For purposes of calculating the aggregate market value of the Class A Common Stock on March 15, 1994, the shares owned by The Sidney W. Swartz 1982 Family Trust have not been considered owned by an affiliate. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the information set forth under the caption, "Certain Relationships and Related Transactions," in the Registrant's 1994 Proxy Statement, which information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Financial Statements and Financial Statement Schedules. 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 have therefore been omitted. (b) No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. - ------------------------------- (1) Filed as exhibits to Registration Statement on Form S-1, numbered 33-14319, and incorporated herein by reference. (2) Filed on September 30, 1987, as an exhibit to Registration Statement on Form S-8, numbered 33-17552, and incorporated herein by reference. (3) Filed on December 21, 1987, as an exhibit to Registration Statement on Form S-8, numbered 33-19183, and incorporated herein by reference. (4) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1987, and incorporated herein by reference. (5) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1988, and incorporated herein by reference. (6) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1989, and incorporated herein by reference. (7) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1990, and incorporated herein by reference. (8) Filed on July 9, 1991, as an exhibit to Registration Statement on Form S-8, numbered 33-41660, and incorporated herein by reference. (9) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1991, and incorporated herein by reference. (10) Filed as exhibits to the Annual Report on Form 10-K for the fiscal year ended December 31, 1992, and incorporated herein by reference. Pursuant to Item 4(iii) of Item 601, Regulation S-K, the Registrant has filed as Exhibits only the instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries with respect to which the total amount of securities authorized thereunder exceeds 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. The Registrant agrees to furnish to the Commission upon its request copies of other instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries, with respect to which the total amount of securities authorized does not exceed 10% of such assets. The Registrant also agrees to furnish to the Commission upon its request copies of any omitted schedule or exhibit to any Exhibit filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE TIMBERLAND COMPANY March 22, 1994 By: /s/ Sidney W. Swartz ----------------------------- Sidney W. Swartz, President Pursuant to the requirements of the Securities Exchange of 1934, as amended, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Item 14(d) INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of The Timberland Company: We have audited the consolidated financial statements of The Timberland Company as of December 31, 1993 and 1992, and for the years then ended, and have issued our report thereon dated Feruary 15, 1994; such consolidated financial statments and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of The Timberland Company, 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 1993 and 1992 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 Boston, Massachusetts February 15, 1994 Item 14(d) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Timberland Company: We have audited the consolidated statements of income, changes in stockholders' equity and cash flows of The Timberland Company (a Delaware corporation) and subsidiaries for the year ended December 31, 1991 (incorporated by reference in this Form 10K). 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 the cash flows of The Timberland Company and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index above for the year ended December 31, 1991, 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. /s/ Arthur Andersen & Co. Boston, Massachusetts, February 12, 1992. EXHIBIT INDEX ------------- (3) Articles of incorporation and by-laws 3.2 By-Laws, as amended May 19, 1993, filed herewith (10) Material Contracts 10.2 The Company's 1987 Stock Option Plan, as amended, filed herewith 10.5 The Timberland Company Long Term Incentive Plan for Senior Management, filed herewith 10.6 The Timberland Company Annual Bonus Plan for Exempt Employees, filed herewith EXHIBIT INDEX ------------- 10.9(e) (ii) Amendment dated July 16, 1993 to Lease Dated July 20, 1992 among Louise Minges, Mitchell Minges and The Timberland Company, filed herewith 10.9(k) Lease dated as of February 1, 1994 between Melville Corporation and The Timberland Company, filed herewith EXHIBIT INDEX ------------- 10.9(l) Lease dated as of June 29, 1993 between Timberland Dominicana, S.A. and Santiago Norte, S.A. (Pisano) Industrial Park, filed herewith 10.9(m) Lease dated as of November 30, 1993 between Timberland Dominicana, S.A. and Santiago Norte, S.A. (Pisano) Industrial Park, filed herewith 10.9(n) Lease dated as of December 16, 1993 between Timberland Dominicana, S.A. and Santiago Norte, S.A. (Pisano) Industrial Park, filed herewith 10.9(o) Lease dated as of March 8, 1993 between Watauga Committee of 100, Inc. and The Timberland Company, filed herewith 10.9(p) Lease dated as of March 31, 1993 between Talbot Operations, Inc. and The Timberland Company, filed herewith 10.11 (i) Credit Agreement dated as of May 13, 1993 among The Timberland Company, Morgan Guaranty Trust Company of New York, for itself and as Administrative Agent, ABN AMRO Bank N.V., The First National Bank of Boston, Barclays Bank PLC and The Northern Trust Company (the "May Credit Agreement"), filed herewith (ii) Amendment dated November 15, 1993 to the May Credit Agreement, filed herewith 10.12 Credit Agreement dated as of November 15, 1993 among The Timberland Company, certain banks listed therein and The Chase Manhattan Bank, N.A. as Agent, filed herewith EXHIBIT INDEX ------------- 10.13 (ii) Amendment dated September 15, 1993 to the Senior Note Agreements, filed herewith (13) Annual Report to security holders 13. Portions of 1993 Annual Report to Stockholders, as incorporated herein by reference, filed herewith (16) Letter Regarding Change in Certifying Accountant 16. Letter dated March 21, 1994 from Arthur Andersen & Co. regarding change in certifying accountant, filed herewith (21) Subsidiaries 21. List of subsidiaries of the Registrant, filed herewith (23) Consent of experts and counsel 23.1 The Consent of Deloitte & Touche to the incorporation by reference of their report included in Registrant's Annual Report to Stockholders for the fiscal years ended December 31, 1993 and 1992, filed herewith 23.2 The Consent of Arthur Andersen & Co. to the incorporation by reference of their report included in Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1991, filed herewith

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ITEM 1. BUSINESS FIFTH THIRD BANCORP ORGANIZATION Registrant was organized in 1974 under the laws of the State of Ohio. It began operations in 1975 upon reorganization of its principal subsidiary The Fifth Third Bank. The executive offices of the Registrant are located in Cincinnati, Ohio. The Registrant is a multi-bank holding company as defined in the Bank Holding Company Act of 1956, as amended, and is registered as such with the Board of Governors of the Federal Reserve System. Registrant is also a unitary savings and loan holding company and is registered with the Office of Thrift Supervision. Registrant has thirteen wholly-owned subsidiaries: The Fifth Third Bank; The Fifth Third Bank of Columbus; The Fifth Third Bank of Northwestern Ohio, National Association; The Fifth Third Bank of Southern Ohio; The Fifth Third Bank of Western Ohio, National Association; Fifth Third Community Development Company; Fifth Third Trust Co. & Savings Bank, FSB; Fountain Square Management Co.; Fifth Third Bank of Central Kentucky, Inc.; Fifth Third Bank of Northern Kentucky, Inc.; The Fifth Third Bank of Central Indiana; The Fifth Third Bank of Southeastern Indiana; and Fountain Square Insurance Company. Unless the context otherwise indicates the term "Company" as used herein means the Registrant and the term "Bank" means its wholly-owned subsidiary, The Fifth Third Bank. As of December 31, 1993, the Company's consolidated total assets were $11,966,000,000 and capital accounts totalled $1,197,646,000. The Bank has four wholly-owned subsidiaries: Midwest Payment Systems, Inc.; Fifth Third Securities, Inc.; The Fifth Third Company; and The Fifth Third Leasing Company. PRIOR ACQUISITIONS The Company is the result of mergers and acquisitions over the years involving 25 financial institutions throughout Ohio, Indiana, Kentucky, and Florida. The Company during 1993 made the following acquisitions: On January 22, 1993, the Company purchased $54 million in deposits from Home Savings of America. The three offices were located in Oxford, Fremont, and Chillicothe Ohio and were acquired by The Bank, The Fifth Third Bank of Northwestern Ohio, National Association and the Fifth Third Bank of Southern Ohio, respectively. On February 26, 1993, the Company purchased $106 million in deposits of six Cincinnati banking offices of First National Bank of Dayton which were acquired by the Bank. On October 18, 1993, the Company purchased $131 million in deposits from World Savings and Loan Association. The two branches located in Norwalk and Sandusky, Ohio were acquired by The Fifth Third Bank of Northwestern Ohio, National Association and the three branches located in Piqua and Sidney, Ohio were acquired by The Fifth Third Bank of Western Ohio, National Association. Page 3 On December 23, 1993, the Company acquired The TriState Bancorp with consolidated assets of approximately $342 million. TriState's subsidiary, First Financial Savings Association, F.A., which had six branches in Cincinnati, was merged with the Bank. OTHER OPERATIONS The Company has other operations conducted through non-bank entities as follows: Fountain Square Insurance Company, a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in credit life, accident and health insurance underwriting and reinsurance activities. Fifth Third Community Development Company, a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in development and rehabilitation of real estate, investment in business ventures, and related activities specifically designed to address the needs in housing, employment, and public facilities of low and moderate income persons and communities. Fountain Square Management Co., a wholly-owned subsidiary of the Company, was formed for the purpose of engaging in real estate management of the Fifth Third Center and other Company owned properties. Fifth Third Company, a wholly-owned subsidiary of the Bank, owns a 32-story office tower and 5-story office building and parking garage known as the Fifth Third Center and the William S. Rowe Building, respectively. The Company occupies 70% of the buildings and leases the remainder to commercial and retail tenants. Fifth Third Securities, Inc., a wholly-owned subsidiary of the Bank, is a registered broker-dealer, through which the Company operates its securities brokerage business. Fifth Third Leasing Company, a wholly-owned subsidiary of the Bank, is engaged in the business of leasing personal property. Midwest Payment Systems, Inc., a wholly-owned subsidiary of the Bank, engages in providing merchant processing, electronic funds transfers and other data processing services. THE FIFTH THIRD BANK ORGANIZATION The present Bank is the result of mergers and acquisitions over the years involving thirty-one Cincinnati financial institutions, the oldest of which was The Bank of Ohio Valley, organized June 17, 1858. Other major banks involved in the mergers were The Fifth National Bank, The Third National Bank and The Union Trust Company. Sixty-three of the Bank's banking centers are located in Hamilton County, Ohio; with its other banking centers in the following counties: Butler County - 12; Clermont County - 5; Cuyahoga Co 3; Lake County - 5; Montgomery County - 12; and Warren County - 7. Page 4 As of December 31, 1993, the Bank's total assets were $6,875,027,000 including total loans and leases of $4,847,723,000. On that date, total deposits were $4,605,082,000 and capital accounts totalled $518,088,000. The Bank in 1993 opened 10 new banking centers, purchased or acquired through merger 12 banking centers, transferred 2 banking centers to an affiliate and closed 3 banking centers. The Bank has 34 Bank Marts(R), non-traditional centers located in select grocery stores, which combine location accessibility with extended hours on Saturday and Sunday afternoons. The Bank provides full service banking to individuals, industry and governmental agencies through each of its 118 banking centers. The Company, through its Affiliates and the Bank, provides a full line of banking services including Retail, Commercial, Trust & Investment, and Data Processing. RETAIL BANKING Retail Banking is responsible for operating the 102 banking centers in southwestern Ohio. The Affiliate Division is responsible for the operations of the Company's other nine banks throughout Ohio, Kentucky, Indiana and Florida. The banking centers offer full service banking to individuals, industry and governmental agencies providing customers with easy accessibility to banking services. The Bank operates banking centers which are open seven days a week (which are referred to under the federally registered trademark as "Bank Marts") in select Kroger, FINAST and Marsh Supermarkets and retirement centers, providing the ultimate in convenience for the busy consumer of the '90s. Convenience and personal service, delivered along with a comprehensive package of banking products continue to reinforce the Company's marketing position. The Bank makes a strong impact on the southwestern Ohio retail banking market through a great variety of services, including personal checking accounts and savings programs, certificates of deposit, money market accounts, individual retirement accounts and Keogh plans. Consumer Banking includes the Bankcard, Installment Loan, Leasing and Residential Mortgage Loan Departments, services individual as well as corporate customers, offering a broad range of credit programs for all retail customers including credit card banking under the VISA and MasterCard designation, as well as private label cards, installment loans, student loans, and secured and unsecured personal loans. The Residential Mortgage Loan Department provides FHA, VA and conventional as well as adjustable rate mortgage loans to individuals, and is active in originating mortgages for sale in the secondary market. The Affiliate banks are headquartered in major geographic areas and make a strong impact on the banking market in the region. These banks provide full service banking including consumer lending, commercial lending, and trust and investment services making a major contribution to the Company's strong growth. Twenty-three of the Company's new banking centers were opened or purchased by the Affiliate banks bringing the total to 171 banking centers. The Affiliate banks had a strong year with 1993 net income increasing 24.4 percent over 1992. The Affiliates Division is also responsible for identifying acquisition candidates and for coordinating the merging of the acquired institutions and branches into the Company. The Company's Annual Report has a full discussion of announced acquisitions expected to occur in 1994. Page 5 COMMERCIAL BANKING Commercial Banking experienced solid growth in commercial loan and lease outstandings during 1994 with significant improvement in credit quality. The Company's strong capital base and consistent earnings performance allow flexibility to work with its borrowers. A sound lending philosophy, aggressive calling, cross-selling techniques and a strong focus on customer service allowed Commercial Banking to experience strong growth. Commercial Banking provides a variety of services to meet the needs of the Bank's corporate customers. Available are all types of commercial loans, including lines of credit, revolving credits, term loans, real estate mortgage loans and other specialized loans including asset-based financing as well as various types of commercial leases. The Company further serves the requirements of large and small industrial and commercial enterprises by providing cash management services including freight payment, payroll programs, merchant banking services, cashiering, lockbox and other automated services. Relationship banking continues to be the focus, with emphasis on product packages and cross-selling to produce outstanding results. The Bank through its Financial Institutions Department, serves as correspondent for numerous banks principally located in the four state area of Ohio, Kentucky, Indiana and West Virginia. The Bank offers a wide variety of services to its correspondent banks, including check clearance, loan participation, automated data processing services as well as investment, trust, pension and profit sharing services. The Bank through the International Department, assists local businesses and customers in carrying out their import-export activities and provides letters of credit, foreign exchange, banker's acceptance financing and other related international banking services. TRUST & INVESTMENT SERVICES The Trust & Investment Group is customer driven offering a full range of trust and investment services for individuals, corporations and not-for-profit organizations. The Company offers investment management to all its customers. For those who prefer to choose their own investment options, Fifth Third Securities, Inc., the Bank's brokerage subsidiary, offers full-service brokerage to both institutional and retail customers. For the year ended December 31, 1993, the Trust & Investment Services, primarily within the Bank, had over $38 billion in assets under care, of which approximately $7 billion is under management. The Personal Trust Department offers a diverse range of investment and financial services, including Investment Management, Private Banking, Tax and Real Estate Services, Trust Services, Estate Planning and a Foundation Office. These services are tailored to suit any individual's needs. Corporations and non-profit organizations also benefit from the Bank's wide range of services, including Investment Management, Employee Benefits, Corporate Trust, Stock Transfer, Securities Custody, Mutual Funds, Custody and Endowments. Page 6 The Bank is the Investment Advisor of the Fountain Square Funds. The Fountain Square Funds is a family of mutual funds consisting of three money market funds and six stock and bond funds. At December 31, 1993 the Fountain Square Funds' assets were approximately $1 billion. DATA PROCESSING Midwest Payment Systems, Inc. ("MPS") a subsidiary of the Bank, provides computer services and electronic funds transfer services for the Bank as well as for other retail and financial institutions. MPS is one of the nation's leading providers of electronic funds transfer (EFT) services, servicing customers nationwide and a source of substantial fee income. MPS is active in the Point of Sale (POS) business, where it has become a national force in credit card authorization and data capture. MPS is committed to growth as a single- source solution for financial institutions, retail businesses and governmental entities. MPS offers an online automated teller machine (ATM) network, known as the JEANIE(R) network, and serves as the transaction switch processor for several regional ATM Networks including MONEY(SM) Station of Ohio located principally in Ohio where the JEANIE network members participate, the Kentucky regional ATM Network called the QUEST Network, and a shared ATM Network operating in Chicago, Illinois called CASH(SM) Station. It also provides other electronic banking services to financial institutions throughout the United States and online credit card authorization and data capture for retail merchants at the point of sale. ____________________ (R) Registered Trademark with U.S. Pat. & T.M. Office (SM) Service Mark owned by Money Station, Inc. (SM) Service Mark owned by Cash Station, Inc. FINANCE The Finance Group consists of the Treasury and Accounting Groups. The Treasury Group's responsibilities primarily include monitoring and managing the Company's net interest income in response to changes in economic conditions and interest rate movements. The Treasury Group monitors changes in the Company's financial risk exposures and coordinates strategies with various business units, and manages and monitors the Bank's and the Company's money market funding, asset liability management, institutional security dealer sales, investor relations areas, and monitors the affiliate banks' investment portfolios. COMPETITION There are hundreds of commercial banks, savings and loans and other financial service providers in Ohio, Kentucky, Indiana and Florida, and adjoining states, thus providing strong competition to the Company's subsidiaries. With respect to correspondent banking, the Bank's area of competition includes most of Kentucky and southern Ohio and parts of Indiana and West Virginia. The Company's subsidiaries compete for deposits with commercial banks, savings and loan associations and other competitors such as brokerage houses and for retail and commercial business with banks in other areas of the country, many of which possess greater financial resources. With respect to the data processing services, the Bank competes with other third party service providers such as Deluxe Data Services, EDS and Electronic Payment Systems. Page 7 The earnings of the Company are affected by general economic conditions as well as by the monetary policies of the Federal Reserve Board. Such policies, which include regulating the national supply of bank reserves and bank credit, can have a major effect upon the source and cost of funds and the rates of return earned on loans and investments. The Federal Reserve influences the size and distribution of bank reserves through its open market operations and changes in cash reserve requirements against member bank deposits. REGULATION AND SUPERVISION The Company, as a bank holding company, is subject to the restrictions of the Bank Holding Company act of 1956, as amended. This Act provides that the acquisition of control of a bank is subject to the prior approval of the Board of Governors of the Federal Reserve System. The Company is required to obtain the prior approval of the Federal Reserve Board before it can acquire control of more than 5% of the voting shares of another bank. The Act does not permit the Federal Reserve Board to approve an acquisition by the Company, or any of its subsidiaries, of any bank located in a state other than Ohio, unless the acquisition is specifically authorized by the law of the state in which such bank is located. The Bank, as a state member bank, is subject to regulation by the Superintendent of Banks of the State of Ohio, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation. The Company and any other subsidiaries which it now owns or may hereafter acquire are considered affiliates of the Bank as that term is defined in the Securities Act of 1933, as amended. The Company's other affiliate state banks are primarily subject to the laws of the state in which each is located, the Board of Governors of the Federal Reserve System and/or the Federal Deposit Insurance Corporation. The affiliate banks which are organized under the laws of the United States are primarily subject to regulation by the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Company and its banking affiliates are subject to certain restrictions on loans by the Bank, on investments by the Bank in their stock and on its taking such stock and securities as collateral for loans to any borrower. The Company and affiliates of the Bank are also subject to certain restrictions with respect to engaging in the underwriting and public sale and distribution of securities. In addition, any such affiliates of the Bank will be subject to examination at the discretion of supervisory authorities. The Company as a saving and loan holding company and its savings and loan subsidiary is subject to examination and regulation by the Office of Thrift Supervision. The Bank Holding Company Act limits the activities which may be engaged in by the Company and its subsidiaries to ownership of banks and those activities which the Federal Reserve Board has deemed or may in the future find to be so closely related to banking as to be a proper incident thereto. Page 8 Those activities presently authorized by the Federal Reserve Board include the following general activities: (1) the making or servicing of loans or other extensions of credit; (2) operating as an industrial bank, Morris Plan Bank, or industrial loan company according to state law without the accepting of demand deposits and without the making of commercial loans; (3) performing the functions and activities of a trust company; (4) acting with certain limitations as investment or financial advisor; (5) leasing personal property and equipment; (6) the making of equity and debt investments in projects or corporations designated primarily to promote community welfare; (7) providing bookkeeping and data processing services for the internal operations of the bank holding company and its subsidiaries; and providing to others data processing and transmission services and facilities for banking, financial or related economic data; (8) acting as insurance agent or broker under certain circumstances and with respect to certain types of insurance, including underwriter for credit life insurance, credit accident insurance and health insurance which is directly related to extensions of credit by the bank holding company system; (9) providing limited courier services for the internal operations of the holding company, for checks exchanged among banking institutions, and for audit and accounting media of a banking or financial nature used in processing such media; (10) providing management consulting advice to non-affiliate banks under certain limitations; (11) the retail sale of money orders with a face value of $1,000 or less, of travelers checks and of U.S. Savings Bonds; (12) performing appraisals of real estate; (13) acting as intermediary in arranging financing of commercial or industrial income-producing real estate; (14) providing securities brokerage services, (restricted to buying and selling securities solely as agent for customers), related securities activities and incidental activities; (15) underwriting and dealing in government obligations and money market instruments; (16) foreign exchange advisory and transactional services; (17) acting as futures commission merchant; (18) providing investment advice on financial futures and options on futures; (19) providing consumer financial counseling; (20) providing tax planning and preparation; (21) providing check guaranty services; (22) operating a collection agency; and (23) operating a credit bureau. For details and limitations on these activities, reference should be made to Regulation Y of the Federal Reserve Board, as amended. Further, under the 1970 amendment of this Act and the regulations of 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 or provisions of any property or service. EMPLOYEES As of December 31, 1993, there were no full time employees of the Company. Affiliates of the Company employed 5,294 employees of whom 860 were officers and 1,162 were part-time employees. STATISTICAL INFORMATION Pages 10 to 17 contain statistical information on the Company and its subsidiaries. Page 9 SECURITIES PORTFOLIO The securities portfolio as of December 31 for each of the last five years, and the maturity distribution and weighted average yield of securities as of December 31, 1993, are incorporated herein by reference to the securities tables on page 30 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. The weighted average yields for the securities portfolio are yields to maturity weighted by the par values of the securities. The weighted average yields on securities exempt from income taxes are computed on a taxable equivalent basis. The taxable equivalent yields are net after-tax yields to maturity divided by the complement of the full corporate tax rate (35%). In order to express yields on a taxable equivalent basis, yields on obligations of states and political subdivisions have been increased as follows: Under 1 year 2.43% 1 - 5 years 2.73% 6 - 10 years 2.65% Over 10 years 3.09% Total securities 2.64% The Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Debt and Equity Securities," effective December 31, 1993. This Statement requires securities to be classified as held to maturity, available for sale or trading. Only those securities classified as held to maturity are reported at amortized cost, with those available for sale and trading reported at fair value with unrealized gains and losses included in stockholders' equity or income, respectively. Refer to pages 19 and 20 in the Company's 1993 Annual Report to Stockholders for a summary of the investment portfolio classifications at December 31, 1993. The investment portfolio has increased in size during the past year due in part to the securitization and transfer to securities of $291,586,000 in residential mortgage loans. The investment portfolio is comprised largely of fixed and variable rate mortgage-backed securities. These AAA rated securities are backed by first mortgages on single-family homes predominately underwritten to the standards of and guaranteed by the government sponsored agencies of GNMA, FNMA and FHLMC. They differ from traditional debt securities primarily in that they have uncertain maturity dates, and are priced based on estimated prepayment rates on the underlying mortgages. The estimated average life of the portfolio is three years and six months, which is very short by industry standards and minimizes our exposure to the risk of rising interest rates. The Company holds no securities which would be classified as high risk under the new FFIEC guidelines on mortgage-backed securities. The Company had sales of securities available for sale of approximately $230 million during 1993. This activity resulted in $6.5 million in realized securities gains, less than 2.2% of income before income taxes, and represented 12.2% of total security gains, realized and unrealized, as of December 31, 1993. AVERAGE BALANCE SHEETS The average balance sheets are incorporated herein by reference to Table 1 on pages 26 and 27 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ANALYSIS OF NET INTEREST INCOME AND NET INTEREST INCOME CHANGES The analysis of net interest income and the analysis of net interest income changes are incorporated herein by reference to Table 1 and Table 2 and the related discussion on pages 26 through 28 of the Company's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. Reserve for Credit Losses - ------------------------- The reserve for credit losses is established through charges to operations by a provision for credit losses. Loans and leases which are determined to be uncollectible are charged against the reserve and any subsequent recoveries are credited to the reserve. The amount charged to operations is based on several factors. These include the following: 1. Analytical reviews of the credit loss experience in relationship to outstanding loans and leases to determine an adequate reserve for credit losses required for loans and leases at risk. 2. A continuing review of problem or at risk loans and leases and the overall portfolio quality. 3. Regular examinations and appraisals of the loan and lease portfolio conducted by the Bank's examination staff and the banking supervisory authorities. 4. Management's judgement with respect to the current and expected economic conditions and their impact on the existing loan and lease portfolio. The amount provided for credit losses exceeded actual net charge-offs by $18,224,000 in 1993, $20,629,000 in 1992 and $5,001,000 in 1991. Management reviews the reserve on a quarterly basis to determine whether additional provisions should be made after considering the factors noted above. Based on these procedures, management is of the opinion that the reserve at December 31, 1993 of $135,097,000 is adequate. Maturity Distribution of Domestic Certificates of Deposit of $100,000 and Over - ------------------------------------------------------------------------------ at December 31, 1993 ($000's) ----------------------------- Under 3 months $174,719 3 to 6 months 70,717 7 to 12 months 45,625 Over 12 months 14,469 -------- Total certificates - $100,000 and over $305,530 ======== Note: Foreign office deposits are denominated in amounts greater than $100,000. Purchase of Deposits - -------------------- On January 22, 1993, the Company purchased $54 million of deposits as well as the facilities of three Home Savings of America offices in Oxford, Chillicothe and Fremont, Ohio. On February 26, 1993, the Company purchased $106 million in deposits and the facilities of six First National Bank of Dayton locations in Cincinnati. On October 18, 1993, the Company purchased $131 million in deposits and the facilities of five World Savings and Loan Association branches in western and northwestern Ohio. Funds Borrowed - -------------- Funds borrowed is comprised of various short-term sources of funds. A summary of the average outstanding, maximum month-end balance and weighted average interest rate for the years ended December 31 follows ($000's): 1993 1992 1991 ---- ---- ---- Average outstanding $1,275,568 1,173,253 766,860 Maximum month-end balance $1,602,217 1,436,203 1,042,566 Weighted average interest rate 3.00% 3.47 5.59 Return on Equity and Assets - --------------------------- The following table presents certain operating ratios: 1993 1992 1991 ------ ------ ------ Return on assets (A) 1.80% 1.74 1.68 Return on equity (B) 18.2% 17.3 16.6 Dividend payout ratio (C) 31.8% 33.0 33.7 Equity to assets ratio (D) 9.92% 10.07 10.11 - ----------------------------------------- (A) net income divided by average assets (B) net income divided by average equity (C) dividends declared per share divided by fully diluted net income per share (D) average equity divided by average assets ITEM 2. ITEM 2. PROPERTIES The Company's executive offices and the main office of the Bank are located on Fountain Square Plaza in downtown Cincinnati, Ohio. On August 17, 1983, these facilities, located in a 32-story office tower and a 5-story office building and parking garage known as the Fifth Third Center and the William S. Rowe Building, respectively, were purchased by a subsidiary of the Bank, as a 65% partner in a partnership with two other partners. The Bank's subsidiary has acquired the interest of the other two partners and now owns 100% of the Fifth Third Center and the William S. Rowe Building. The Bank operates 118 banking centers, of which 53 are owned and 65 are leased. These leases have various expiration dates to the year 2013. Properties owned by the Bank are free from mortgages and encumbrances. The Company has nine other affiliate banks, four located in Ohio, two in Kentucky, two in Indiana, and one in Florida. The affiliate banks operate 171 banking centers, of which 99 are owned and 72 are leased. OHIO BANKS The Fifth Third Bank of Columbus opened 7 new banking centers, 3 of which were Bank Marts. The Fifth Third Bank of Columbus, with its main office in the Fifth Third Center, Columbus, Ohio, now has 35 locations. The Fifth Third Bank of Northwestern Ohio, National Association, opened 1 new banking center and purchased 3 banking centers. The Fifth Third Bank of Northwestern Ohio, National Association, with its main office located in Toledo, Ohio, now has 49 locations. The Fifth Third Bank of Western Ohio, National Association, purchased 3 banking centers (2 of which were later closed), and closed 1 banking center. The Fifth Third Bank of Western Ohio, National Association, with its main office located in Piqua, Ohio, now has 28 locations. The Fifth Third Bank of Southern Ohio purchased 1 banking center, and had 2 banking centers transferred from the Bank. The Fifth Third Bank of Southern Ohio, with its main office located in Hillsboro, Ohio, now has 13 locations. KENTUCKY BANKS Fifth Third Bank of Northern Kentucky, Inc., opened 3 new banking centers. The Fifth Third Bank of Northern Kentucky, with its main office located in Covington, Kentucky, now has 18 locations. Fifth Third Bank of Central Kentucky, Inc., opened 2 new banking centers. The Fifth Third Bank of Central Kentucky, Inc., with its main office in Lexington, Kentucky, now has 6 locations. INDIANA BANKS The Fifth Third Bank of Central Indiana opened 4 new banking centers, 2 of which were Bank Marts. The Fifth Bank of Central Indiana, with its main office in Indianapolis, Indiana, now has 15 locations. The Fifth Third Bank of Southeastern Indiana did not open or close any banking centers in 1993. The Fifth Third Bank of Southeastern Indiana, with its main office located in Greensburg, Indiana, has 6 locations. FLORIDA SAVINGS BANK Fifth Third Trust Co. & Savings Bank, FSB, relocated its banking center to a new full-service location in 1993. The Fifth Third Trust Co. & Savings Bank, FSB, has its main office and banking center located in Naples, Florida. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not parties to any material legal proceedings other than routine litigation incidental to its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None EXECUTIVE OFFICERS The names, ages and positions of the Executive Officers of the Company as of January 31, 1994 are listed below along with their business experience during the past 5 years. Officers are appointed annually by the Board of Directors at the meeting of Directors immediately following the Annual Meeting of Stockholders. CURRENT POSITION and Name and Age Business Experience During Past 5 Years George A. Schaefer, Jr., 48 PRESIDENT AND CEO. President and Chief Executive Officer of the Company and the Bank since January, 1991. Previously, Mr. Schaefer was President and COO of the Company and Bank since April, 1989. Formerly, Mr. Schaefer had been Executive Vice President of the Company and the Bank. George W. Landry, 53 EXECUTIVE VICE PRESIDENT. Executive Vice President of the Company and Bank since November, 1989. Previously, Mr. Landry was Group Vice President of the Bank. Stephen J. Schrantz, 45 EXECUTIVE VICE PRESIDENT. Executive Vice President of the Company and Bank since November, 1989. Previously, Mr. Schrantz was Senior Vice President of the Bank. Michael D. Baker, 43 SENIOR VICE PRESIDENT. Senior Vice President of the Company since March, 1993, and of the Bank since July, 1987. P. Michael Brumm, 46 SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER. CFO of the Company and Bank since June, 1990, and Senior Vice President of the Bank. Robert P. Niehaus, 47 SENIOR VICE PRESIDENT. Senior Vice President of the Company since March 1993, and Senior Vice President of the Bank. Previously, Mr. Niehaus was Vice President of the Company. Michael K. Keating, 38 SENIOR VICE PRESIDENT, GENERAL COUNSEL AND SECRETARY. Senior Vice President and General Counsel of the Company since March, 1993 and Senior Vice President and Counsel of the Bank since November, 1989, and Secretary of the Company and the Bank since January, 1994. Previously, Mr. Keating was Vice President, Counsel and Assistant Secretary of the Bank and Counsel of the Company. Mr. Keating is a son of Mr. William J. Keating, Director. Neal E. Arnold, 33 TREASURER. Treasurer of the Company and the Bank since October, 1990 and Senior Vice President of the Bank since April, 1993. Previously, Mr. Arnold was Vice President of the Bank since October, 1990. Previously, Mr. Arnold was CFO and Senior Vice President with First National Bank of Grand Forks, North Dakota. Gerald L. Wissel, 37 AUDITOR. Auditor of the Company and the Bank since March 1990 and Senior Vice President of the Bank since November 1991. Previously, Mr. Wissel was Vice President of the Bank since March 1990. Mr. Wissel was formerly with Deloitte and Touche, independent public accountants. Roger W. Dean, 31 CONTROLLER. Controller of the Company and Vice President of the Bank since June, 1993. Previously, Mr. Dean was with Deloitte & Touche, independent public accountants. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated herein by reference to Page 1 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated herein by reference to page 35 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. 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 pages 26 through 34 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated herein by reference to pages 15 through 25 and page 35 of Registrant's 1993 Annual Report to Stockholders attached to this filing 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 information required by this item concerning Directors is incorporated herein by reference under the caption "ELECTION OF DIRECTORS" of the Registrant's 1994 Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated herein by reference under the caption "EXECUTIVE COMPENSATION" of the Registrant's 1994 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 under the captions "CERTAIN BENEFICIAL OWNERS, ELECTION OF DIRECTORS, AND EXECUTIVE COMPENSATION" of the Registrant's 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated herein by reference under the caption "CERTAIN TRANSACTIONS" of the Registrant's 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 PAGE 1. Index to Financial Statements 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 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 * * Incorporated by reference to pages 15 through 25 of Registrant's 1993 Annual Report to Stockholders attached to this filing as Exhibit 13. 2. Financial Statement Schedules The schedules for Registrant and its subsidiaries are omitted because of the absence of conditions under which they are required, or because the information is set forth in the consolidated financial statements or the notes thereto. 3. Exhibits EXHIBIT NO. 3- Amended Articles of Incorporation and Code of Regulations ** 10(a)- Fifth Third Bancorp Unfunded Deferred Compensation Plan for Non-Employee Directors *** 10(b)- Fifth Third Bancorp 1990 Stock Option Plan **** 10(c)- Fifth Third Bancorp 1987 Stock Option Plan ***** 10(d)- Fifth Third Bancorp 1982 Stock Option Plan ****** 10(e)- Fifth Third Bancorp Stock Option Plan for Employees of The Fifth Third Bank of Miami Valley, National Association ******* 10(f)- Fifth Third Bancorp Stock Option Plan for Employees of The Fifth Third Bank of Eastern Indiana ******** 10(g)- Indenture effective November 19, 1992 between Fifth Third Bancorp, Issuer and NBD Bank, N.A., Trustee ********* 10(h)- Fifth Third Bancorp Amended and Restated Stock Option Plan for Employees and Directors of The TriState Bancorp ********** 10(i)- Fifth Third Bancorp 1993 Discount Stock Purchase Plan *********** 11- Computation of Consolidated Net Income Per Share for the Years Ended December 31, 1993, 1992, 1991, 1990 and 1989 13- Fifth Third Bancorp 1993 Annual Report to Stockholders 21- Fifth Third Bancorp Subsidiaries 23- Independent Auditors' Consent b) Reports on Form 8-K NONE. ____________________ ** Incorporated by reference to Registrant's Registration Statement, Exhibits 3.1 and 3.2, on Form S-4, Registration No. 33-19965 which is effective. *** Incorporated in this Form 10-K Annual Report by reference to Form 10-K filed for fiscal year ended December 31, 1985. **** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 34075, which is effective. ***** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 13252, which is effective. ****** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 2-98550, which is effective. ******* Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 20888, which is effective. ******** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission on November 18, 1992 a Form 8-K Current Report as an exhibit to a Registration Statement on Form S-8, Registration No. 33-30690, which is effective. ********* Incorporated by reference to Registrant's filing with the Securities and Exchange Commission on November 18, 1992 a Form 8-K Current Report dated November 16, 1992 and as Exhibit 4.1 to a Registration Statement on Form S-3, Registration No. 33-54134, which is effective. ********** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 51679, which is effective. *********** Incorporated by reference to Registrant's filing with the Securities and Exchange Commission as an exhibit to a Registration Statement on Form S-8, Registration No. 33- 60474, which is effective. 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. FIFTH THIRD BANCORP (Registrant) /s/George A. Schaefer, Jr. February 15, 1994 George A. Schaefer, Jr. President and CEO (Principal Executive Officer) Pursuant to requirements of the Securities Exchange Act of 1934, this report has been signed on February 15, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. /s/P. Michael Brumm /s/Roger W. Dean P. Michael Brumm Roger W. Dean Senior Vice President and CFO Controller (Chief Financial Officer) (Principal Accounting Officer) /s/John F. Barrett /s/Richard T. Farmer /s/Robert B. Morgan John F. Barrett Richard T. Farmer Robert B. Morgan Director Director Director /s/John D. Geary /s/Michael H. Norris J. Kenneth Blackwell John D. Geary Michael H. Norris Director Director Director Milton C. Boesel, Jr.Ivan W. Gorr Brian H. Rowe Director Director Director /s/Clement L. Buenger/s/Joseph H. Head, Jr. /s/George A. Schaefer, Jr. Clement L. Buenger Joseph H. Head, Jr. George A. Schaefer, Jr. Director Director Director /s/Nolan W. Carson /s/Joan R. Herschede /s/John J. Schiff, Jr. Nolan W. Carson Joan R. Herschede John J. Schiff, Jr. Director Director Director /s/Thomas L. Dahl /s/William G. Kagler Thomas L. Dahl William G. Kagler Stephen Stranahan Director Director Director /s/Gerald V. Dirvin /s/William J. Keating /s/Dennis J. Sullivan, Jr. Gerald V. Dirvin William J. Keating Dennis J. Sullivan, Jr. Director Director Director /s/James D. Kiggen /s/Dudley S. Taft Thomas B. Donnell James D. Kiggen Dudley S. Taft Director Director Director

49423_1993.txt

49423_1993

1993

49423

ITEM 1. BUSINESS - ----------------- General Aquarion Company ("Aquarion") is a holding company whose subsidiaries are engaged both in the regulated utility business of public water supply and in various nonutility businesses. Aquarion's utility subsidiary, Bridgeport Hydraulic Company ("BHC"), and its subsidiary, Stamford Water Company ("SWC", together with BHC, the "Utilities") collect, treat and distribute water to residential, commercial and industrial customers, to other utilities for resale and for private and municipal fire protection. The Utilities provide water to customers in 22 communities with a population of approximately 492,000 people in Fairfield, New Haven and Litchfield Counties in Connecticut, including communities served by other utilities to which water is available on a wholesale basis for back-up supply or peak demand purposes through the Regional Pipeline. BHC is the largest investor-owned water company in Connecticut and, with its SWC subsidiary, is among the 10 largest investor-owned water companies in the nation. The Utilities are regulated by several Connecticut agencies, including the Connecticut Department of Public Utility Control (the "DPUC"). Aquarion is also engaged in various nonutility activities. The Company conducts an environmental testing laboratory business through its Industrial and Environmental Analysts group of subsidiaries (collectively, "IEA"). IEA performs testing to determine the nature and quantity of contamination in sampled materials, including hazardous wastes, soil, air and water. IEA provides a range of environmental analytical testing capabilities, including routine and customized analysis of organic and inorganic contaminants. IEA's testing services are conducted at six regional environmental testing laboratories in Connecticut, Florida, Illinois, Massachusetts, New Jersey and North Carolina. IEA's laboratories are subject to governmental regulation at both state and federal levels. IEA's clients include engineering consulting firms, industrial and commercial corporations and federal, state and local governmental entities. The laboratories located in North Carolina, New Jersey and Connecticut participate in the U.S. Environmental Protection Agency's Contract Laboratory Program. Aquarion owns Timco, Inc. ("Timco"), a small forest products and electricity cogeneration company based in New Hampshire. At Timco's sawmill complex, lumber is cut and packaged for sale to wholesalers and retailers. The cogeneration plant produces electricity which is sold to a public utility and low cost steam for drying the lumber and heating some of the sawmill buildings. Aquarion Company is also engaged in several small utility management service businesses through its Hydrocorp, Inc. ("Hydrocorp") and Aquarion Management Services, Inc. ("AMS") subsidiaries and owns Main Street South Corporation ("MSSC"), a small real estate subsidiary formed in 1969 to assist the Utilities in marketing surplus land. The Company was incorporated in Delaware as The Hydraulic Company in 1969 to become the parent company to BHC, a Connecticut corporation founded in 1857. The corporate name was changed to Aquarion Company in April 1991. The Company's executive offices are located at 835 Main Street, Bridgeport, Connecticut 06601-2353 and its telephone number is (203) 335-2333. Recent Developments Rates. In filing its rate application with the Connecticut Department of Public Utility Control (DPUC) in February 1993, BHC had requested a 35 percent water service rate increase designed to provide a $17,500,000 increase in annual water service revenues and a return on common equity of 12.75 percent. Prior to the final decision, BHC lowere request by a total of $1,400,000 by restructuring long-term debt to reduce annual interest costs and by reducing property taxes and other miscellaneous expenses. The request included the replacement of a construction work in progress water service rate surcharge (CWIP rate surcharge) previously granted to BHC pursuant to DPUC regulations to recover 90 percent of the carrying costs of capital used in its Easton Lake Filtration Construction Project mandated by the federal Safe Drinking Water Act of 1974 (the "SDWA"). During 1993 and 1992, BHC derived revenues of $1,937,000 and $1,532,000, respectively, from the CWIP rate surcharge. Effective August 1, 1993, the DPUC awarded BHC a 20.7 percent water service rate increase designed to provide a $10,400,000 annual increase in revenues and a 11.6 percent return on common equity. The DPUC approved a 22.5 percent water services rate increase for SWC effective August 28, 1991, designed to increase annual revenues by $2,276,000 and provide a 12.85 percent return on its common equity. Effective January 1, 1991, BHC was awarded a 15 percent rate increase designed to increase annual revenues by $6,983,000 and provide a 13.25 percent return on its common equity. There is no certainty that any given rate increase will produce the intended level of revenues or the allowed return on equity. See "Public Water Supply--Rates and Regulation." Pending Utility Acquisition. Aquarion has proposed to acquire The New Canaan Water Company and Ridgefield Water Supply Company for Aquarion common stock with a market value of $3,500,000 on or about the closing date. The acquisition and a related property exchange have been approved by the DPUC but remain contingent upon certain other regulatory approvals satisfactory to the parties. Proceedings to obtain the regulatory approvals are pending. The parties have agreed to extend their acquisition agreement and the related property exchange agreement until March 31, 1994. There is no certainty that the parties will agree to further extensions if the transaction has not closed by that time. See "Industry Segment Information." Sale of Facilities. On March 15, 1993 IEA sold its Vermont laboratory which performed qualification and certification of and consulting for high purity gas delivery systems and ultrapure water systems, as well as some microbiological testing. In addition, in October 1993 IEA sold the assets of its air testing division to TRC, Inc. of Hartford, Connecticut. See "Environmental Laboratories." Other. Native Americans who allege that they constitute the Golden Hill Paugussett Tribe of Indians (the "Paugussett Indians") have taken an appeal to the U.S. Court of Appeals for the Second Circuit for the dismissal by the U.S. District Court in Connecticut of their suit seeking to restore claimed rights to certain lands in various towns in Fairfield and New Haven Counties. Newspaper reports during 1993 indicated that they have announced plans to claim further lands, including all land in the municipalities of Monroe, Shelton and Trumbull. BHC, which has not been named as a defendant to date, owns land in these communities, including land it considers surplus. It is not possible at this time to determine whether any further suit will be filed or, if so, whether BHC will be named a defendant, nor is it possible to determine what effect, if any, the filing of any such suit might have on the marketability of real property in these communities or, should the Paugussett Indians prevail, whether there would be any effect on the operations of BHC. Utility Construction Program The Utilities are engaged in a continuing construction program mandated by legislative and regulatory requirements, as well as for infrastructure replacements. The Utilities expended $16,300,000, $21,727,000 and $13,969,000 in 1993, 1992 and 1991, respectively, for plant additions and modifications of existing plant facilities, excluding an allowance for funds used during construction ("AFUDC"). The expenditures were made primarily for installations of water mains, service connections and meters and such special projects as the Easton Lake and the Litchfield Division supply and distribution system improvements. Utility capital expenditures for 1993 aggregated $16,300,000 and budgeted expenditures for 1994, most of which management believes should not be postponed, are approximately $34,200,000. Approximately half of these expenditures will be devoted to compliance with the SDWA, which requires filtration or alternative water treatment measures for BHC's major, unfiltered surface water supplies. The total capital cost of water filtration or alternative treatment measures for such supplies through December 31, 1993 was approximately $28,400,000, of which $26,800,000 related to construction of the Easton Lake filtration facility. Management estimates that the total of such costs from 1994 through 1996 will approximate $50,000,000, without adjustment for inflation, including $15,300,000 expected to be incurred in 1994. Approximately $48,000,000 of the projected 1994 through 1996 water treatment costs will be incurred in construction of the filtration facility for the Hemlocks reservoir. The remaining $2,000,000 of estimated filtration expenditures over the next four years is budgeted for SDWA-related facilities for BHC's Lakeville and Norfolk Reservoirs. Part of the cost associated with the Hemlocks facility is expected to be offset by CWIP rate surcharges which, at the DPUC's discretion, permit the recovery of 90 percent of the carrying cost of capital used in construction of SDWA-mandated water treatment facilities. Management cannot predict whether future federal, state or local regulation may require additional capital expenditures. The Company's ability to finance its future construction programs depends in part on future rate relief and the level of CWIP rate surcharges. In light of the Company's substantial need for additional funds, the Company will need additional debt and equity capital to finance future utility construction. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Capital Resources and Liquidity" and "Business--Public Water Supply--Rates and Regulation." Industry Segment Information The Company's operations are grouped into four industry segments: public water supply; environmental laboratories and utility management services; forest products; and real estate. The consolidated operating revenues of the Company for the year ended December 31, 1993 were derived from the following sources: 66 percent from public water supply, 22 percent from environmental laboratories and utility management services, 12 percent from forest products, and less than 1 percent from real estate, including both MSSC and surplus utility land sales. For additional information concerning each segment for each of the years ended December 31, 1993, 1992 and 1991, see "Note 11" of "Notes to Consolidated Financial Statements" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Public Water Supply Service Area. The Utilities are engaged in the collection, treatment and distribution of water for public and private use to residential, commercial, and industrial users, and for municipal and private fire protection services in 22 communities in parts of Fairfield, Litchfield and New Haven counties in Connecticut. The Utilities also sell, as requested, water for redistribution to customers of the First and Second Taxing Districts' Water Departments of the City of Norwalk, Connecticut, Connecticut-American Water Company, and NCWC through the Southwest Regional Pipeline in Fairfield County. The communities served by the Utilities as of December 31, 1993, have a population of approximately 492,000, and the total number of customer accounts as of that date was approximately 123,900. The Utilities' service areas, primarily residential in nature, have experienced an average growth in accounts of approximately 1 percent per year over the last ten years. Industrial use has declined significantly in that time period, and the residential characteristics of the area have changed, indicating an increase in the percentage of apartment dwellings and condominium units. Management does not anticipate any significant growth in residential consumption in the foreseeable future, and expects continued decline in industrial use. The operating revenues of the Utilities for the twelve months ended December 31, 1993 were derived from the following sources: 59 percent from residential customers, 17 percent from commercial customers, 5 percent from industrial customers, 14 percent from fire protection customers, and 5 percent from other sources. Seasonality. The business of the Utilities is subject to seasonal fluctuations and weather variations. The demand for water during the warmer months is generally greater than during the cooler months, primarily due to additional water requirements of industrial and residential cooling systems, and various private and public outdoor uses such as lawn and golf course sprinkling. From year to year and season to season, demand will vary with rainfall and temperature levels. Water Supply. Water is available from both surface and subsurface sources. During 1993, approximately 97 percent of the water supplied by the Utilities was provided by impounding reservoirs, 2 percent by producing wells and 1 percent by purchased water. As of December 31, 1993, the Utilities' reservoirs, well fields and interconnections with other water utilities had an aggregate safe daily yield of 112.3 million gallons. Safe yield is an estimate of the supply capability during an extended drought. The average daily demand for water from the Utilities in 1993 was 69.3 million gallons per day ("MGD"). The reservoirs of the Utilities have an aggregate storage capacity of 29.4 billion gallons. All of the Utilities' reservoirs and active wells are located on property owned by the Utilities. Management believes it has an adequate water supply to satisfy the current and projected needs of its customers within its territorial service area through at least the year 2040. During historical drought periods in the northeastern United States, the Utilities have been able to accommodate the needs of their own customers and to offer relief to supplement the supplies to neighboring communities by water sales to utilities with which it has pipeline interconnections. Supply and distribution needs of the Utilities undergo constant review, and the Utilities continue to explore and develop additional ground water supplies and study alternative surface water sources to meet anticipated future water requirements. The Connecticut Water Diversion Policy Act, enacted in 1982, prohibits any future diversions of surface or ground water without a permit from the DEP. Although this law "grandfathers" existing surface and ground water supplies which existed when it was enacted, any subsequent water diversion which might be effected by the Utilities is subject to a lengthy permit application process and approval by the DEP. Diversion permits granted pursuant to this law are subject to renewal when their terms, which typically run from five to ten years, expire. Rates and Regulation. The Utilities are incorporated under and operate as public water utilities by virtue of authority granted by Special Acts adopted by the Connecticut legislature (the "Acts"). These Acts have granted a non-exclusive franchise, unlimited in duration, to provide public water supply to private and public customers in designated municipalities and adjacent areas. The Acts also authorize the Utilities to lay their mains and conduits in any public street, highway, or public ground; to use the water of certain rivers, streams, or other waters in Fairfield, Litchfield and New Haven counties and from certain locations along and in the Housatonic River and its tributaries, subject to such consents and approvals as may be required by law; and to exercise the po domain in connection with lands, springs, streams or ponds and any rights or interests therein which are expedient to or necessary for furnishing public water supply. In the event of the exercise of such condemnation powers, the Utilities must pay appropriate compensation to those injuriously affected by such taking. The Utilities are subject to regulation by the DPUC, which has jurisdiction with respect to rates, service, accounting procedures, issuance of securities, dispositions of utility property and other related matters. Rates charged by each of BHC and SWC are subject to approval by the DPUC. The Utilities continually review the need for increases of water rates, and historically have sought rate relief in a timely manner in light of increases in operating costs, additional investment in utility plant and related financing costs, as well as other factors. For information concerning rate increases granted in 1993 and 1991, see "Item 1. Business. Recent Developments, Rates.", above. The DPUC may allow a surcharge to be applied to rates in order to provide a current cash return to water utilities on the major portions of CWIP applicable to facilities, including filtration plants, required for compliance with the SDWA. See "Environmental Regulations." The surcharge is adjusted quarterly, subject to DPUC approval, to reflect increased CWIP expenditures for SDWA facilities. In connection with BHC's construction of filtration facilities at its Easton Lake Reservoir, the DPUC granted BHC an initial .94 percent CWIP rate surcharge in September 1990, which amount was incrementally increased on a quarterly basis to 7.35 percent at the time new rates became effective and the Easton facility became operational and subject to general ratemaking regulations. There is no CWIP surcharge in effect at present, although BHC intends to apply for a CWIP surcharge with respect to its planned filtration facilities when appropriate. Aquarion is neither an operating utility company nor a "public service company" within the meaning of the Connecticut General Statutes and is not presently subject to general regulation by the DPUC. DPUC approval is necessary, however, before Aquarion may acquire or exercise control over any Connecticut public service company. DPUC approval is also required before any other entity can acquire or exercise, or attempt to exercise, control of Aquarion. Connecticut regulations govern the sale of water company land and treatment of land sale proceeds. See "Item 2. ITEM 2. PROPERTIES ------------------- The Company BHC owns a 20,000 square foot headquarters building and a 44,370 square foot Operations Center in Bridgeport, and leases an additional 22,000 square feet of office, laboratory and garage space in Bridgeport for utility operations. SWC owns its 13,618 square foot headquarters and operations facility in Stamford, Connecticut. Aquarion owns nonutility land totaling approximately 99 acres in Easton and Litchfield, Connecticut. Property At December 31, 1993, BHC owned in the aggregate 11 active reservoirs and approximately 1,640 miles of water mains, of which approximately 77 miles have been laid in the past five years. In addition, SWC owned 5 active reservoirs at year end. The rights to locate and maintain water transmission and distribution mains are secured by charter, easement and permit and are generally perpetual. Water is delivered to the distribution system from four major and several smaller reservoirs and forty-two producing wells. Eight additional reservoirs are used for storage purposes and are interconnected with the distribution reservoirs. BHC owns two dual media filtration plants for treatment of its Trap Falls and Easton Lake reservoir systems, which plants have capacities of 25 and 20 MGD, respectively. SWC owns a 24 MGD rapid-sand and activated-carbon filtration plant for treatment of its entire reservoir system. BHC owns approximately 19,000 acres of real property located in Fairfield, New Haven, and Litchfield Counties, Connecticut, most of which consists of reservoirs and surrounding watershed. All but 1,360 specified acres of such property are subject to the first lien arising under the BHC Indenture securing its First Mortgage Bonds. SWC owns approximately 2,400 acres of real property located in Stamford and New Canaan, Connecticut, and in Pound Ridge and Lewisboro, New York, which consist almost exclusively of reservoirs and surrounding watershed, pumps, standpipes and building facilities. The DPHAS regulates public water company lands according to a three-tiered classification system. Class I lands cannot be sold, leased or transferred. The DPHAS may authorize a transfer or change in use of Class II lands only upon a finding that there will be no adverse impact upon the public water supply and that any use restrictions required as a condition of transfer are enforceable against subsequent owners and occupants of the lands. Class III lands, which are non-watershed, are not presently subject to regulation by the DPHAS. BHC has identified approximately 2,300 acres of land it believes are surplus to its water supply needs, and therefore would qualify as Class III land. All of this Class III land, which includes approximately 570 acres which have never been in rate base, is available for sale, although all of it may not be marketable. Up to 530 additional acres could become available if the DPHAS approves the abandonment of a former reservoir system in New Haven County and reclassifies existing watershed property as Class III land, as requested by the Company. Real property may not be sold or transferred by a water utility without the prior approval of the DPUC an with other restrictions imposed by Connecticut law. State laws and regulations govern, among other things, to whom certain water company lands may be transferred, with preference given to other water companies, the municipality in which the property is located and the State of Connecticut, in that order. Additionally, the disposition of the proceeds of any permissible sale is subject to state law. Until changed by statute in 1988, it had been the practice of the DPUC to apply gains from the sale of surplus water company land that had ever been in the rate base as an offset against operating expenses, thereby substituting profits from the sale of such land for revenues which would otherwise be provided through rates. Legislation enacted in 1988, the Equitable Sharing Statute, required the DPUC to "equitably allocate" the economic benefits of the net proceeds from the sales of Class III land which was previously in the utility's rate base between the Company's ratepayers and its shareholders. Ratepayers do not share in gains from the sale of land which has never been in rate base. The Equitable Sharing Statute was clarified by a 1990 amendment which provides that the economic benefits from the sale of former-rate-base, Class III land which promotes a perpetual public interest in open space or recreational use shall be allocated "substantially in favor" of shareholders when 25 percent or more of the land sold is to be used for open space or recreational purposes. Two decisions involving 1990 land sales, resulted in allocations of the respective gain on the sales of 75 percent and 43 percent, respectively, to BHC's shareholder. In November 1993 the DPUC gave BHC approval to sell 25.78 acres of surplus, off-watershed land in Shelton, Connecticut. BHC plans to subdivide the land into eleven building lots. BHC also received approval from the DPUC in December 1993 to sell 34.55 acres of surplus, off-watershed land in Weston, Connecticut. BHC plans to subdivide the land into ten building lots. Each case involves former rate base land, and 25 percent of the land to be sold will be conveyed to the host municipality to be preserved as open space. Under the terms of both decisions, approximately two-thirds of the net proceeds from the land sales will be allocated to shareholders and the remaining one-third allocated to ratepayers through amortization into BHC's rate base over a five year period. All such net proceeds must be used for reinvestment in utility plant. The Company leases all of its laboratory facilities, except for the Massachusetts laboratory, which it owns. Aquarion owns 50 percent of Key Partners III, a partnership which owns IEA's North Carolina laboratory and headquarters facility. The smallest of IEA's laboratories occupies approximately 6,750 square feet. The largest, located in Cary, North Carolina, occupies approximately 30,000 square feet. The Company believes that the laboratory facilities owned or leased are adequate for its present and anticipated future needs and that the amounts paid for all the leases into which it has entered are reasonable. ITEM 3. ITEM 3. LEGAL PROCEEDINGS -------------------------- The registrant has nothing to report for this item. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY ------------------------------------------------------------ The registrant has nothing to report for this item. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED --------------------------------------------------------------- STOCKHOLDER MATTERS ------------------- Page 45 of the Company's Annual Report to Shareholders for the year ended December 31, 1993 is incorporated by reference herein pursuant to Rule 12b-23 of the Securities and Exchange Act of 1934 (the "Act") and to Instruction G(2) to Form 10-K. Aquarion has declared and paid quarterly dividends on its common stock without interruption since its organization in 1969, and prior thereto, BHC paid dividends annually on its common stock without interruption since 1890. Dividends, when declared, are normally paid on the 30th day of January, April, July and October. The earnings of Aquarion are derived from its investments in its subsidiaries, particularly BHC. Aquarion's future ability to pay dividends to holders of its Common Stock is dependent upon the continued payment by BHC of dividends to Aquarion. BHC's ability to pay dividends will depend upon timely and adequate rate relief, compliance with restrictions under certain of the BHC debt instruments and other factors. In addition, no dividends on BHC's common stock can be paid during any period in which BHC's preferred stock dividends are in arrears. Dividends on Aquarion common stock can be paid only out of net profits and surplus of the Company. Aquarion's ability to pay dividends is further restricted by the terms of Aquarion's 8 1/2 percent unsecured Senior Notes due January 1994 , which were replaced by a 5.95% unsecured Senior Note due January 1999 and 7.8 percent unsecured Senior Notes due June 1997 (the "Aquarion Notes"). As of December 31, 1993, the applicable restrictions would have permitted payment of additional dividends on Aquarion's common stock of up to $31,000,000. While Aquarion's Board of Directors intends to continue the practice of declaring cash dividends on a quarterly basis, no assurance can be given as to future dividends or dividend rates since they will be determined in light of a number of factors, including earnings, cash flow, and Aquarion and BHC's financial requirements. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations--Capital Resources and Liquidity." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ------------------------------------- See Page 1 ("Selected Financial Data") and Pages 44 - 45 ("Supplemental Financial Data") of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL ---------------------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS ----------------------------------- See Page 1 ("Selected Financial Data") and Pages 17 - 23 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA --------------------------------------------------------- The consolidated financial statements, together with the report thereon of Price Waterhouse, dated January 31, 1994, appearing on Pages 24 - 22 and Page 1 ("Selected Financial Data") and Pages 44 - 45 ("Supplemental Financial Data") of the accompanying 1993 Annual Report to Shareholders of Aquarion Company are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(2) to Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON -------------------------------------------------------------- ACCOUNTING AND FINANCIAL DISCLOSURE ----------------------------------- The registrant has nothing to report for this item. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ---------------------------------------------------------------- The information as to directors required by Item 10 is set forth at Pages 2 - 8 of the Company's Definitive Proxy Statement, dated March 21, 1994 relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act, and is incorporated by referenced herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. Executive Officers The executive officers of the registrant are listed below. These officers were elected to the offices indicated on April 27, 1993, except as otherwise noted, for a term expiring with the 1994 annual meeting of directors. Except as indicated, all have been with registrant and its predecessors in an executive capacity for more than five years. There are no family relationships among members of the executive officers. There were no arrangements or undertakings between any of the officers listed below and any other person pursuant to which he or she was selected as an officer. Served as Office, Business Experience Officer Executive Officer Age During Past Five Years Since ----------------- --- ------------------------ ----- Jack E. McGregor 59 President (since 1988) 1985 Chief Executive Officer (since January 1990) Chief Operating Officer (1988 to January 1990) and Executive Vice President (1985 to 1988) of the Company. Director of People's Bank and Physicians Health Services, Inc. Director and Member of Executive Committee, National Association of Water Companies. Trustee of Fairfield University and Yale-New Haven Hospital. Richard K. Schmidt, Ph.D 49 Senior Vice President 1992 (since April 1993) of the Company; President and Chief Executive Officer of IEA (since March 1992); formerly President and Chief Operating Officer (1984-1992) of Mechanical Technology, Inc. James S. McInerney 56 Senior Vice President 1989 (since April 1992) of the Company; President (since April 1991) and Chief Operating Officer (since January 1990) of BHC, and Chairman and Chief Executive Officer (since January 1990) of Stamford Water Company. Executive Vice President (1990 to April 1991) and Vice President (1989) of BHC and President, Stamford Water Company (1977 to January 1990). Mr. McInerney is a Director, President or Vice President of certain of the Company's other subsidiaries. Served as Office, Business Experience Officer Executive Officer Age During Past Five Years Since ----------------- --- ------------------------ ----- Janet M. Hansen 51 Senior Vice President 1983 (since April 1993), Chief Financial Officer (since April 1992) and Treasurer (since 1988) of the Company and Vice President (since 1989), Chief Financial Officer (since April 1991) and Treasurer (since 1985) of BHC; Mrs. Hansen is Vice President and Treasurer (since April 1991) of IEA and Chairman of the Board and Chief Executive Officer (since April 1992) of Timco. Mrs. Hansen is also Vice President, Chief Financial Officer and Treasurer of certain of the Company's other subsid- iaries. Director of Gateway Bank. Larry L. Bingaman 43 Vice President, Corporate 1990 Relations and Secretary (since April 1993); Vice President, Marketing and Communications (since 1990) of the Company; Formerly Director of Communications for United Technologies' Sikorsky Aircraft Division (1989 to June 1990). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ------------------------------------ Pages 8 - 13 of the Company's Definitive Proxy Statement, dated March 21, 1994, relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND ----------------------------------------------------------------- MANAGEMENT ---------- Pages 5 - 6 of the Company's Definitive Proxy Statement, dated March 21, 1994, relating to the proposed Annual Meeting of Shareholders to be held on April 26, 1994, filed with the Commission pursuant to Regulation 14a under the Act, are incorporated by reference herein pursuant to Rule 12b-23 of the Act and Instruction G(3) to Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ------------------------------------------------------------ The registrant has nothing to report for this item. 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: Page in Annual Report* ------------- (1) Consolidated Statements of Income for the three years ended December 31, 1993 24 Consolidated Balance Sheets at December 31, 1993 and 1992 25-26 Consolidated Statements of Cash Flows for the three years ended December 31, 1993 27 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 28 Notes to Consolidated Financial Statements 29-41 Report of Independent Accountants 42 Selected Financial Data 1 Supplemental Financial Information 44-45 * Incorporated by reference from the indicated pages of the 1993 Annual Report to Shareholders. ____________________ (2) Financial Statement Schedules: Report of Independent Accountants on Financial Statement Schedules, see Page hereto. Index to Additional Financial Information, see Page hereto. The Financial Statement Schedules above should be read in conjunction with the Consolidated Financial Statements in the 1993 Annual Report to Shareholders. All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. (b) Reports on Form 8-K. The Company did not file a report on Form 8-K for the fourth quarter of the year ended December 31, 1993. (c) Exhibits: Each document referred to below is incorporated by reference to the files of the Commission, unless the reference is preceded by an asterisk (*). Each management contract, compensatory plan or arrangement required to be filed as an exhibit hereto is preceded by a double asterisk (**). 3(a) Restated Certificate of Incorporation of Aquarion, as amended.(1) 3(b) By-laws of Aquarion, as amended. (6) 4(a) Rights Agreement between Aquarion and The Chase Manhattan Bank, N.A. setting forth description of Preferred Stock Purchase Rights distributed to holders of Aquarion Common Stock.(6) 10(a) First Mortgage Indenture of BHC dated June 1, 1924.(2) 10(b) Seventeenth Supplemental Mortgage of BHC dated as September 1, 1960.(2) 10(c) Nineteenth Supplemental Mortgage of BHC dated as of August 1, 1965.(1) 10(d) Twentieth Supplemental Mortgage of BHC dated as of November 1, 1968.(1) 10(e) Loan Agreement of BHC dated as of October 15, 1984.(1) 10(f) Loan and Trust Agreement as of November 1, 1984.(1) 10(g) Note Agreement of Aquarion dated December 28, 1990.(3) 10(h) Note Agreement of BHC dated January 24, 1991.(3) 10(i) Note Agreement of Aquarion dated as of May 19, 1992. **10(j) Aquarion Long-Term Incentive Plan.(1) 10(k) Joint Venture Agreement betwee Brennan, Jr., William A. Brennan and Main Street South Corporation dated February 23, 1979.(4) **10(l) Employment Agreement between Aquarion and James S. McInerney, dated June 1, 1990. **10(m) Employment Agreement between Aquarion and Janet M. Hansen dated November 1, 1992. **10(n) Agreement between Aquarion and William S. Warner dated October 15, 1989.(5) **10(o) Employment Agreement between Aquarion and Jack E. McGregor dated January 1, 1990.(5) **10(p) Form of Stock Option Award Agreement for options granted pursuant to Long-Term Incentive Plan.(5) 10(q) Purchase Agreement dated July 28, 1989 by and among Frederick T. Doane, Heike A. Doane and Aquarion.(3) 10(r) Purchase Agreement dated July 10, 1990 by and among Robert L. MacDonald and Aquarion.(3) 10(s) Stock Purchase Agreement dated November 5, 1990 between Paul B. Priest, A C Laboratories, Inc. and Aquarion.(3) 10(t) Stock Purchase Agreement dated as of December 7, 1990 between Aquarion and the sellers listed on Schedule 2. 1 thereof.(3) **10(u) Employment Agreement between Aquarion and Larry L. Bingaman dated June 11, 1990.(3) 10(v) Amendment dated September 12, 1991 to the Stock Purchase Agreement dated as of December 7, 1990.(1) 10(w) Purchase and Sale Agreement dated September 12, 1991, by and among YWC Technologies, Inc., Bird Corporation, YWC, Inc., Interim Dewatering Services, Inc., Ad+Soil, Inc. and Aquarion.(1) 10(x) Agreement for Construction Management Services dated April 18, 1991 between BHC and Gilbane Building Company.(1) **10(y) Employment Agreement between Industrial and Environmental Analysts, Inc. and Dr. Richard K. Schmidt dated April 1, 1992. **10(z) Employment Agreement between Industrial and Environmental Analysts, Inc. and David C. Houle dated September 1, 1992. 10(aa) Loan Agreement of BHC dated as of June 1, 1990.(6) 10(bb) First Mortgage Bonds, Series C and Preferred Stock, 1968 Series, Purchase Agreement of SWC dated July 1968. 10(cc) Revolving Credit Agreement dated May 14, 1993.(7) 10(dd) Loan Agreement of BHC dated as of June 1, 1993. (7) 10(ee) Forward Purchase Agreement of BHC (1994A Series) dated June 9, 1993.(7) 10(ff) Loan Agreement of SWC dated September 1, 1993. *10(gg) Loan Agreement of BHC dated December 1, 1993. *10(hh) Note Agreement of Aquarion dated January 4, 1994. *13(a) Annual Report to Shareholders for the year ended December 31, 1993. *22(a) Subsidiaries of Aquarion *24(a) Consent of Independent Accountants for Aquarion Company is contained in Report of Independent Accountants on page hereof. *25(a) Power of Attorney. ____________________ (1) Filed as part of Aquarion's Form 8 Amendment to its Form 10-Q for the quarter ended September 30, 1991, filed February 19, 1992. (2) Filed as an Exhibit to BHC's Registration Statement on Form S-1, File Number 2-23434, dated April 26, 1965. (3) Filed as part of the Annual Report of the Company on Form 10-K for the year ended December 31, 1990. (4) Filed as part of the Amendment No. 1 to the Company's Registration Statement as Form S-7, File No. 2-74305, dated November 5, 1981. (5) Filed as part of the Company's Annual Report on Form 10-K for the year ended December 31, 1989. (6) Filed as part of the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (7) Filed as part of the Company's Quarterly Report on Form 10-Q for the quarter ended June 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. Aquarion Company ________________ (Registrant) Date ---- By /s/Janet M. Hansen March 23, 1994 ------------------------------------------------ Janet M. Hansen Senior Vice President, Treasurer and Chief Financial Officer (Principal Financial and 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. By * March 23, 1994 ------------------------------------------------ William S. Warner Chairman of the Board of Directors and Director By * March 23, 1994 ------------------------------------------------ Jack E. McGregor President, Chief Executive Officer and Director By March 23, 1994 ------------------------------------------------ George W. Edwards, Jr. Director By ------------------------------------------------ Geoffrey Etherington Director By * March 23, 1994 ------------------------------------------------ Norwick R.G. Goodspeed Director By * March 23, 1994 ------------------------------------------------ Janet D. Greenwood Director By * March 23, 1994 ------------------------------------------------ Donald M. Halsted, Jr. Director By ------------------------------------------------ Eugene D. Jones Director By * March 23, 1994 ------------------------------------------------ Larry L. Pflieger Director By * March 23, 1994 ------------------------------------------------ G. Jackson Ratcliffe Director By * March 23, 1994 ------------------------------------------------ John A. Urquhart Director *By /s/Janet M. Hansen ------------------------------------------------ Janet M. Hansen Attorney-in-fact INDEX TO ADDITIONAL FINANCIAL INFORMATION ----------------------------------------- The consolidated financial statements, together with the report of Price Waterhouse thereon, dated January 31, 1994, appearing on Pages 24 - 45 of the accompanying 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. With the exception of the aforementioned information and the information incorporated in Items 1, 5, 6, 7 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. The following financial information should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders. Financial Statement Schedules not included in this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. ADDITIONAL FINANCIAL INFORMATION -------------------------------- Page ---- Property, plant and equipment (Schedule V) for the years 1993, 1992 and 1991 Accumulated depreciation, depletion and amortization of property, plant and equipment (Schedule VI) for the years 1993, 1992 and 1991 Supplementary income statement information (Schedule X) for the years 1993, 1992 and 1991 REPORT OF INDEPENDENT ACCOUNTANTS ON ------------------------------------ FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Board of Directors of Aquarion Company Our audits of the consolidated financial statements referred to in our report dated January 31, 1994 appearing on Page 42 of the 1993 Annual Report to Shareholders of Aquarion Company, (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/Price Waterhouse --------------------- Price Waterhouse Stamford, Connecticut January 31, 1994 EXHIBIT 22(a) ------------- Subsidiaries of the Registrant ------------------------------ Bridgeport Hydraulic Company, incorporated in the State of Connecticut Stamford Water Company, incorporated in the State of Connecticut Main Street South Corporation, incorporated in the State of Connecticut Timco, Inc., incorporated in the State of Connecticut Hydrocorp, Inc., incorporated in the State of Delaware Industrial and Environmental Analysts, Inc., incorporated in the State of Vermont Industrial and Environmental Analysts, Inc. - Massachusetts, incorporated in the State of Massachusetts Industrial and Environmental Analysts, Inc. - New Jersey, incorporated in the State of Delaware Industrial and Environmental Analysts, Inc. - Illinois, incorporated in the State of Delaware Industrial and Environmental Analysts, Inc. - Florida,incorporated in the State of Florida SRK Holding, Inc., incorporated in the State of Connecticut THC Acquisition Corp., incorporated in the State of Delaware YWC, Inc., incorporated in the State of Connecticut Aquarion Management Services, Inc., incorporated in the State of Delaware EXHIBIT 24(a) ------------- Consent of Independent Accountants ---------------------------------- The Consent of Independent Accountants for Aquarion Company is contained in the Report of Independent Accountants on page of this Form 10-K.

58696_1993.txt

58696_1993

1993

58696

Item 1. Business (a) General Development of Business. Lennar Corporation (together with its subsidiaries, the "Company") is a full service real estate company. It is primarily engaged in homebuilding, in the development and management of commercial and residential income-producing properties and other real estate related assets and in real estate related financial services. In 1992, the Company, through its Investment Division (formerly referred to as the Asset Management Division) began acquiring portfolios of commercial real estate assets, including real estate related loans, which it believed it could liquidate at a profit. During 1992, Lennar Florida Partners, a partnership between a subsidiary of the Company and the Morgan Stanley Real Estate Fund was formed to acquire and manage a portfolio of assets which it purchased from the Resolution Trust Corporation. During 1993, the Company acquired an interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. This partnership also selected the Company to manage its portfolio of commercial real estate assets. The Company shares in the profits and losses of these partnerships and also receives fees for the management and disposition of the partnerships' assets. The Company has also invested in smaller portfolios of real estate assets for its own account. The Company believes that there will continue to be opportunities to acquire, restructure and manage these types of portfolios on its own and in partnerships. Also, during 1993, the Company expanded its Homebuilding Division by entering the Houston, Texas and the Port St. Lucie, Florida markets. (b) Financial Information about Industry Segments. The Company operates principally in two industry segments. The first of these is reported in the Company's financial statements as the "real estate" segment and includes the activities of the Company's Homebuilding and Investment Divisions, as well as the support staff functions of the parent company (Lennar Corporation). The second industry segment is reported as "financial services" and includes certain activities of Lennar Financial Services ("LFS"), but excludes its limited-purpose finance subsidiaries. The financial information related to these industry segments is contained in the financial statements included in this Report. (c) Narrative Description of Business. HOMEBUILDING The Company and its predecessor have been building homes since 1954. The Company believes that, since its acquisition of Development Corporation of America in 1986, it has each year delivered more homes in Florida than any other homebuilder. The Company has been building homes in Arizona since 1972, where it currently is one of the leading homebuilders. In 1991, the Company began building homes in the Dallas/Fort Worth area of Texas and in 1993 it began building homes in Houston, Texas and Port St. Lucie, Florida. The Company has constructed and sold over 100,000 homes to date. The Company's homebuilding activities in Florida are principally conducted through Lennar Homes, Inc. In Arizona and Texas, they are conducted through Lennar Homes of Arizona, Inc. and Lennar Homes of Texas, Inc., respectively. The Company is involved in all phases of planning and building in its residential communities, including land acquisition, site planning, preparation of land, improvement of undeveloped and partially developed acreage, and design, construction and marketing of homes. The Company subcontracts virtually all segments of development and construction to others. The Company sells single-family attached and detached homes and condominiums in buildings generally one to five stories in height. Homes sold by the Company are primarily in the moderate price range for the areas in which they are located. They are targeted primarily at first time homebuyers, first time move-up homebuyers and, in some communities, retirees. The average sales price of a Lennar home was $111,100 in fiscal 1993. Current Homebuilding Activities The table on the following page summarizes information about the Company's recent homebuilding activities: Property Acquisition The Company continuously considers the purchase of, and from time to time acquires, land for its development and sales programs. It generally does not acquire land for speculation. In some instances, the Company acquires land by acquiring options enabling it to purchase parcels as they are needed. Although some of the Company's land is held subject to purchase money mortgages or is mortgaged to secure $50 million of term loans, most of the Company's land (including most of the land on which it currently is building or expects to build during the next year) is not subject to mortgages. The Company believes its land inventory gives it a competitive advantage, particularly in Florida. Construction and Development The Company supervises and controls the development and building of its own residential communities. It employs subcontractors for site improvements and virtually all of the work involved in the construction of homes. In almost all instances, the arrangements between the Company and the subcontractors commit the subcontractors to complete specified work in accordance with written price schedules. These price schedules normally change to meet changes in labor and material costs. The Company does not own heavy construction equipment and generally has only a small labor force used to supervise development and construction and perform routine maintenance and minor amounts of other work. The Company generally finances construction with its own funds or borrowings under its unsecured working capital lines, not with secured construction loans. Marketing The Company always has an inventory of homes under construction. A majority of these homes are sold (i.e., the Company has received executed sales contracts and deposits) before the Company starts construction. Subsidiaries of the Company employ salespersons who are paid salaries, commissions or both to make onsite sales of the Company's homes. The Company also sells through independent brokers. The Company advertises its residential communities through local media and sells primarily from models that it has designed and constructed. In addition, the Company advertises its retirement communities in areas in which potential retirees live. Mortgage Financing The Company's financial services subsidiaries make conventional, FHA-insured and VA-guaranteed mortgage loans available to qualified purchasers of the Company's homes. Because of the availability of mortgage loans from the Company's financial services subsidiaries, as well as independent mortgage lenders, the Company believes access to financing has not been, and is not, a significant problem for most purchasers of the Company's homes. Competition The housing industry is highly competitive. In its activities, the Company competes with other developers and builders in and near the areas where the Company's communities are located, including a number of homebuilders with nationwide operations. The Company has for the past twenty years been one of the largest homebuilders in South Florida and for the past several years has delivered more homes in the State of Florida than any other homebuilder. Further, the Company is a leading homebuilder in Arizona and is establishing a market position in Dallas and Houston, Texas. Nonetheless, the Company is subject to intense competition from a large number of homebuilders in all of its market areas. INVESTMENT DIVISION The Company has been engaged for more than 20 years in developing and managing commercial and residential income-producing properties. The Company has also, on a number of occasions, developed properties under arrangements with financial institutions which had acquired the properties through foreclosures or similar means. This Division also leases land to businesses which construct their own facilities. Currently, through its Investment Division, the Company owns and manages more than 2,800 rental apartment units (which are approximately 94% occupied) and approximately 1,400,000 square feet of low rise office buildings, warehouses and neighborhood retail centers (which are approximately 85% occupied), as well as a 297 room hotel, a mobile home park, and golf and other recreational facilities in various communities. In 1992, the Investment Division began acquiring, on its own and through partnerships, pools of real estate assets which it believes it can liquidate at a profit and from which it can generate rental, interest and other income during the liquidation process which is anticipated to last several years. Its first transaction of this type was the acquisition by a partnership between a subsidiary of the Company and The Morgan Stanley Real Estate Fund, L.P. from the Resolution Trust Corporation, of a portfolio consisting of more than 1,000 mortgage loans and 65 properties, many of which had been acquired through foreclosure of mortgage loans or by similar means. In addition to the Company's participating in the purchase, the Investment Division is overseeing the partnership's management of this portfolio. In July 1993, Lennar invested $29 million to acquire a 9.9% equity interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. The partnership selected the Company to manage its portfolio of commercial real estate assets. The management agreement provides for reimbursement to the Company for the direct costs of management and for the payment of fees tied directly to the cash flow performance of the partnership. Additionally, in 1993, the Company purchased a pool of 10 assets from the Resolution Trust Corporation which consisted of commercial properties, performing loans and non performing loans which were collateralized by income-producing properties. During 1993, the Company purchased the former partners' interest in three of its joint ventures which were formed to develop and build homes, or to develop land or other properties for investment or sale to other builders or developers. The activities related to these former joint ventures have been consolidated into the accounts of the Company as of the respective dates of acquisition. FINANCIAL SERVICES The Company's financial services subsidiaries originate mortgage loans, service mortgage loans which they and other lenders originate, purchase and re-sell mortgage loan pools, arrange title insurance and provide closing services for homebuyers. Mortgage Origination Through three of the financial services subsidiaries, Universal American Mortgage Company, AmeriStar Financial Services, Inc. and Lennar Funding Corporation, the Company provides conventional, FHA- insured and VA-guaranteed mortgage loans from twenty-one offices located in Florida, California, Arizona, Texas, North Carolina, Illinois and Oregon. The Company entered the mortgage banking business in 1981 primarily to provide financing to Lennar homebuyers. In 1993, loans to buyers of the Company's homes represented approximately 10% of the Company's $1.3 billion of loan originations. The Company sells the loans it originates in the secondary mortgage market, generally on a non-recourse basis, but usually retains the servicing rights. One of the principal reasons for originating loans is to increase the mortgage servicing portfolio. Until new loan originations can be pooled for sale, they are financed with borrowings under the financial services subsidiaries' $200 million lines of credit (secured by the loans and by certain servicing rights) or from the parent if that will reduce consolidated borrowing costs. In most instances, the Company hedges against any exposure to interest rate fluctuations. Mortgage Servicing The Company obtains significant revenues from servicing loans originated by its financial services subsidiaries before and after the loans are sold in the secondary market. In addition, the Company from time to time purchases servicing rights from others (it is approved as a servicer by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and other mortgage investors). Additionally, the Company sometimes purchases and sells mortgage loan pools and retains servicing rights. At November 30, 1993, it had a servicing portfolio of approximately 47,000 loans with an unpaid principal balance of approximately $3.4 billion. Revenues from servicing mortgage loans include servicing fees, late charges and other ancillary fees and all, or in some states part, of the interest on sums held in escrow for tax, insurance and other payments. However, proposed Federal legislation, if enacted, would establish uniform regulations regarding payment of interest on escrow accounts and otherwise regulate escrow accounts in ways which would reduce the benefit a mortgage servicer derives from those accounts. Purchase and Sale of Loan Pools The Company, from time to time, purchases pools of mortgage loans originated by financial institutions and then re-sells the loans in the secondary market. The benefits to the Company from these transactions include gains from the sales of the loans and retention of the right to service the loans after they are sold in the secondary market. Insurance and Closing Services The Company arranges title insurance for and provides closing services to customers of the Company and others from offices in Florida. OTHER ACTIVITIES The limited-purpose finance subsidiaries of LFS have placed mortgages and other receivables as collateral for various long-term financings. These subsidiaries pay the debt service on the long-term borrowings primarily from the cash flows generated by the related pledged collateral. The Company believes that the cash flows generated by these subsidiaries will be adequate to meet the required debt payment schedules. REGULATION Homes and residential communities built by the Company must comply with state and local regulations relating to, among other things, zoning, treatment of waste, construction materials which must be used, certain aspects of building design and minimum elevation of properties and other local ordinances. These include laws in Florida and other states requiring use of construction materials which reduce the need for energy- consuming heating and cooling systems. The State of Florida has also adopted a law which requires that commitments to provide roads and other offsite infrastructure be in place prior to the commencement of new construction. The provisions of this law are currently being implemented and administered by individual counties and municipalities throughout the state and may result in additional fees and assessments or building moratoriums. It is difficult at this time to predict the impact of this law on future operations, or what changes may take place in the law in the future. However, the Company believes that most of its Florida land presently meets the criteria under the law, and it has the financial resources to provide for development of the balance of its land in compliance with the law. As a result of Hurricane Andrew, there have been changes to various building codes within Florida. These changes have resulted in higher construction costs. To date, these additional costs have been recoverable through increased selling prices without any apparent significant adverse effect on sales volume. Virtually all areas of the United States have adopted regulations intended to assure that construction and other activities will not have an adverse effect on local ecology and other environmental conditions. These regulations have had an effect on the manner in which the Company has developed certain properties and may have a continuing influence on the Company's development activities in the future. In order to make it possible for purchasers of some of the Company's homes to obtain FHA-insured or VA-guaranteed mortgages, the Company must construct those homes in compliance with regulations promulgated by those agencies. The Company has registered condominium communities with the appropriate authorities in Florida. It has registered some of its Florida communities with authorities in New Jersey and New York. Sales in other states would require compliance with laws in those states regarding sales of condominium homes. Both the Company's title insurance agency and general insurance agency subsidiaries must comply with the applicable insurance laws and regulations. EMPLOYEES At November 30, 1993, the Company employed 1,660 individuals, of whom 457 were management, supervisory and other professional personnel, 181 were construction supervisory personnel, 238 were real estate salespersons, 136 were hospitality personnel and 648 were professional support personnel, accounting, office clericals and skilled workers. Some of the subcontractors utilized by the Company may employ members of labor unions. The Company does not have collective bargaining agreements relating to its employees. Item 2. Item 2. Properties. For information about properties owned by the Company for use in its residential and commercial activities, see Item 1. The Company maintains its executive offices, financial services subsidiary headquarters, Investment Division headquarters, Dade County homebuilding division offices and Dade County mortgage and title company branch offices at 700 and 730 Northwest 107th Avenue, Miami, Florida in office buildings built and owned by the Company. These offices occupy approximately 58,000 square feet. Other regional offices or financial services branch offices are located either in Company-owned communities or retail centers, or in leased office facilities. Item 3. Item 3. Legal Proceedings. The Company is a defendant in various lawsuits brought by condominium and homeowner associations in communities constructed by the Company. Although the specific allegations in the lawsuits differ, in general, each of the lawsuits asserts that the Company failed to construct the community involved in accordance with plans and specifications and applicable construction codes, and each of them seeks reimbursement for sums the plaintiff association claims it will have to spend to remedy the alleged construction deficiencies. Associations in other communities have threatened similar suits. The Company views suits of this type as a normal incident to the business of building homes. The Company does not believe that these lawsuits or threatened lawsuits will have a material effect upon the Company. During 1993, the Company settled two lawsuits and a number of claims in which owners of approximately 550 homes built by the Company sought damages as a result of Hurricane Andrew. There still remain approximately 125 additional homeowners who have asserted claims. Other homeowners or homeowners' insurers are not precluded from making similar claims against the Company. Four insurance companies have contacted the Company seeking reimbursement for sums paid by them with regard to homes built by the Company and damaged by the storm. There are two pending lawsuits in which homeowners or homeowners' insurers seek relatively minor damages. Other claims of this type may be asserted. The Company's insurers have asserted that their policies cover some, but not all, aspects of these claims. However, to date, the Company's insurers have made all payments required under settlements. Even if the Company were required to make any payments with regard to Hurricane Andrew related claims, the Company believes that the amount it would pay would not be material to the results of operations or financial position of the Company. 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 fiscal 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following people were the executive officers of Lennar Corporation on February 7, 1994: Mr. Leonard Miller has been the Chief Executive Officer and a director of the Company since it was founded. Mr. Cole was, until December, 1983, a member of Mershon, Sawyer, Johnston, Dunwody & Cole, a firm of attorneys in Miami, Florida. Since then he has been of counsel to that firm and has been a consultant to the Company on business and legal affairs, as well as Chairman of the Company's Executive Committee and the Company's Secretary and General Counsel. Messrs. Bolotin, Pekor, Kronick, Ames, Krasnoff and Saleda have each held substantially their present positions with the Company for more than five years. Mr. Stuart Miller (who is the son of Leonard Miller) has held various executive positions with the Company for more than five years. Mr. Timmons has been employed by the Company since 1992. Prior to joining Lennar Corporation Mr. Timmons was employed as a Financial Auditor with Burger King Corporation and KPMG Peat Marwick. Mr. Saiontz (who is the son-in-law of Leonard Miller) has held substantially the same position with the Company for more than five years. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters. The Company's common stock is traded on the New York Stock Exchange under the symbol LEN. The following table sets forth, for the periods indicated, the high and low sales prices as reported on the New York Stock Exchange Composite Tape and per share cash dividends paid by the Company. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS OVERVIEW Lennar's earnings increased in 1993 to $52.5 million ($2.27 per share) from 1992 earnings of $29.1 million ($1.42 per share) on total revenues in 1993 of $666.9 million compared to $429.4 million of revenues in 1992. Fiscal 1992 earnings had increased from 1991 earnings of $21.1 million ($1.05 per share), and revenues in 1992 had increased from 1991 revenues of $325.7 million. REAL ESTATE OPERATIONS Homebuilding The Homebuilding Division constructs and sells single family attached and detached and multi-family homes. These activities accounted for 87%, 86% and 84% of total real estate operations revenues for the fiscal years ended November 30, 1993, 1992 and 1991, respectively. Revenues from the sale of homes increased 71% in 1993 and 37% in 1992, due primarily to the number of homes delivered (4,634, 3,039 and 2,480 in 1993, 1992 and 1991, respectively). Additionally, the average price of a home delivered in 1993 increased 9% to $111,100 from $101,700 in 1992, having increased 9% during 1992 from $93,100 in 1991. The higher average sales prices were due to price increases for existing products, as well as a proportionately greater number of sales of higher-priced homes. In fiscal 1993, new sales orders increased by 31% when compared to 1992, which had increased by 40% over 1991. The 1993 increase resulted in an increase of 18% in the Company's backlog of home sales contracts to 2,105 at November 30, 1993, as compared to a backlog of 1,788 contracts a year earlier. The dollar value of contracts in backlog increased 39% to $264.3 million at November 30, 1993 from $190.7 million a year earlier. Gross profits from the sales of homes, as a percentage of total homebuilding revenues, averaged 12.3% in 1993, 12.1% in 1992 and 10.2% in 1991. The increases in the gross profit percentages were mainly attributable to the higher volume of homes delivered in both years as construction and selling overhead were absorbed by a greater number of home deliveries. Start-up costs, construction overhead and selling costs are expensed as incurred and included in cost of homes sold. The increase in 1993 gross profits was achieved despite start-up costs in the Company's new homebuilding operations in Houston, Texas and Port St. Lucie, Florida and increases in lumber prices on homes which were under contract for sale at the time of the price increases. Gross profit percentages are not significantly different for the various types of homes which the Company builds. During 1993, 1992 and 1991, interest costs of $19.7 million, $16.8 million and $14.2 million, respectively, were incurred, and $17.1 million, $15.0 million and $14.2 million, respectively, were capitalized by the Company's real estate operations. Previously capitalized interest charged to cost of sales was $13.1 million in 1993, $9.5 million in 1992 and $9.3 million in 1991. Interest amounts incurred in 1993 were higher than those incurred in 1992 and 1991 due to higher debt levels in both the real estate and financial services operations. The higher debt at November 30, 1993 is a reflection of the expansion of both the real estate and financial services operations along with the assumption of debt related to the Company's acquisition of partners' interests in various joint ventures. The higher amount of interest charged to cost of sales in 1993, when compared to 1992 and 1991, is a result of the higher volume of homes delivered. This increase was partially offset by lower interest rates and the increase in land and construction inventories as the Company's business volume increased. The amount of interest capitalized by the Company's real estate operations in any one year is a function of the assets under development, outstanding debt levels and interest rates. In August 1992, Hurricane Andrew, which had winds believed to be substantially in excess of those contemplated by the South Florida Building Code, severely damaged a wide range of homes, commercial structures and schools, and substantially destroyed a United States Air Force base in south Dade County, Florida. Damage was incurred at several communities which were in the process of being built by the Company and at several of the Company's commercial properties. In the third quarter of fiscal 1992, the Company made an unusual charge against pre-tax earnings of $7.6 million ($4.9 million after taxes or $.24 per share) to provide for the damage to Company properties and other associated costs, net of insurance recoveries, due to the storm. During 1993, the Company was involved in the repairing or rebuilding of homes in south Dade County communities that were damaged by Hurricane Andrew. Revenues and costs related to this activity are included in other sales and revenues and cost of other sales and revenues. These activities did not have a significant impact on the Company's net earnings during 1993 and were substantially completed by November 30, 1993. Investment The Investment Division (formerly referred to as Asset Management), is involved in the development, management and leasing, as well as the acquisition and sale, of commercial and residential rental properties and land. During 1992 and 1993, the Company became a participant in two partnerships which manage portfolios of mortgage loans, real properties and business loans. The Company shares in the profits or losses of the partnerships and also receives fees for the management and disposition of the partnerships' assets. These partnerships are capitalized primarily by long-term debt of which none is guaranteed by the Company. Other sales and revenues which include, for the most part, the activities of the Investment Division increased in 1993 to $79.8 million from $50.8 million in 1992. The higher revenues were partially the result of additional management fees and earnings from the Company's two Investment Division partnerships. Additionally, rental income on operating properties owned directly by the Company increased during 1993 due to the addition of operating properties, increased occupancy rates and rent increases. As previously discussed, 1993 amounts also include revenues from the repair or rebuilding of homes damaged by Hurricane Andrew in the amount of $13.7 million. Other sales and revenues increased from $42.9 million in 1991 to $50.8 million in 1992 primarily as a result of increases in rental income, revenues from the Company's hotel operation and management fees. Gross profits from other sales and revenues increased to $33.9 million in 1993 from $23.2 million in 1992 and $14.4 million in 1991. These increases were due primarily to increases in earnings and management fees from the Company's partnerships as well as increases in rental income. These increases were partially offset by lower sales of real estate in 1993 when compared to the prior two periods. General and administrative expenses increased during 1993 to $28.1 million from $20.4 million in 1992. In 1991, these expenses totaled $17.3 million. The increase in general and administrative expenses in 1993, as compared to 1992, was due primarily to increases in personnel and other costs resulting from the expansion of the Company's operations. However, as a percentage of real estate revenues, these expenses decreased in 1993 to 4.7%, compared to 5.8% in 1992 and 6.6% in 1991. FINANCIAL SERVICES Financial services activities are conducted primarily through five subsidiaries of Lennar Financial Services, Inc. ("LFS"). LFS subsidiaries perform mortgage servicing activities, and arrange mortgage financing, title insurance and closing services for a wide variety of borrowers and homebuyers. Financial services' earnings before income taxes decreased to $12.9 million in 1993, from $14.0 million and $13.2 million in 1992 and 1991, respectively. The decrease in 1993 earnings was the result of fewer sales of packages of home mortgage loans. Gains recorded on these dispositions contributed $0.7 million, $2.0 million, and $4.1 million to earnings in 1993, 1992 and 1991, respectively. Also contributing to the decrease in earnings in financial services were lower earnings from servicing and origination activities. Earnings from these activities have decreased due to higher costs associated with the expansion of loan origination activities and increased mortgage payoffs. The aforementioned decreases in earnings were partially offset by increases in interest income and gains on bulk sales of mortgage loan servicing rights which contributed $3.3 million to earnings in 1993. There were no bulk sales of mortgage servicing rights in 1992 or 1991. INCOME TAXES The provision for income taxes was 36.0% of pre-tax income in 1993, 35.7% in 1992 and 36.0% in 1991. The 1993 provision was higher than that of 1992 due to the increase in the federal tax rate from 34% to 35% during the Company's fiscal year. This increase was partially offset by additional differences between book and tax basis deductions during 1993. Fiscal 1991 had fewer book and tax basis deductions when compared to the other two periods. IMPACT OF ECONOMIC CONDITIONS Real estate development during 1993, both nationally and in Florida, continued to be affected by the reduced number of thrift institutions and more restrictive credit criteria of commercial banks. The Company does not, however, borrow from thrift institutions to finance any of its activities. Instead, the Company finances its land acquisition and development activities, construction activities, mortgage banking activities and general operating needs primarily from its own base of $467.5 million of equity at November 30, 1993, as well as from commercial bank borrowings. The Company has maintained excellent relationships with the commercial banks participating in its financing arrangements, and has no reason to believe that such relationships will not continue in the future. The availability of financing based on corporate banking relationships may provide a competitive advantage to the Company. The Company anticipates that there will be adequate mortgage financing available for the purchasers of its homes during 1994 through the Company's own financial services subsidiaries as well as external sources. Low interest rates during 1993 increased demand for the Company's homes. In addition, the Company's financial services subsidiaries originated a larger volume of new mortgage loans and benefited from reduced borrowing costs. The Company's mortgage servicing operations were adversely affected by lower interest rates as an increased number of borrowers prepaid their mortgage loan. The prepayment of a loan results in the termination of the future stream of servicing revenue from such loans and reduces the value of the Company's servicing portfolio. The Company expects the refinancing trend to slow during 1994 and believes that the lower interest rate loans originated during 1993 will be less susceptible to refinancing and will therefore increase the stability and value of its servicing portfolio. Total revenues and earnings in 1994 will be affected by both the new sales order rate during the year and the backlog of home sales contracts at the beginning of the year. The Company is entering fiscal 1994 with a backlog of $264.3 million, which is 39% higher than at the beginning of the prior fiscal year. Revenues and earnings will also be positively affected by the increased activities of the Company's Investment Division partnerships as 1994 will be the first year in which both partnerships will contribute a full fiscal year of earnings. Inflation can have a long-term impact on the Company because increasing costs of land, materials and labor result in a need to increase the sales prices of homes. In addition, inflation is often accompanied by higher interest rates, which can have a negative impact on housing demand and the costs of financing land development activities and housing construction. In general, in recent years the increases in these costs have followed the general rate of inflation and hence have not had a significant adverse impact on the Company. GOVERNMENT REGULATIONS Governmental bodies in the areas where the Company conducts its business have at times imposed laws and other regulations that affect the development of real estate. These laws and regulations are often subject to change. The State of Florida has adopted a law which requires that commitments to provide roads and other offsite infrastructure be in place prior to the commencement of new construction. This law is being administered by individual counties and municipalities throughout the State and may result in additional fees and assessments, or building moratoriums. It is difficult to predict the impact of this law on future operations, or what changes may take place in the law in the future. The Company may have a competitive advantage in that it believes that most of its Florida land presently meets the criteria under the law, and it has the financial resources to provide for development of the balance of its land in compliance with the law. As a result of Hurricane Andrew, there have been changes to the various building codes within Florida. These changes have resulted in higher construction costs. The Company believes these additional costs have been recoverable through increased selling prices without any significant, adverse effect on sales volume. FINANCIAL CONDITION AND CAPITAL RESOURCES Lennar meets its short-term financing needs for its real estate activities with cash generated from operations and funds available under its unsecured revolving credit agreement. During 1993, the Company entered into a new $175 million unsecured revolving credit agreement with nine banks. The agreement currently extends until July 29, 1996, however, on each annual anniversary date of the agreement each bank has the option to participate in a one year extension. On December 3, 1993, this agreement was expanded to $190 million by admitting an additional bank. At November 30, 1993, there was $129.7 million outstanding under this agreement as compared to $44.9 million outstanding under a similar agreement as of the same date in the prior year. During 1993, a net of $68.5 million of cash was used in the Company's operations, compared to a net of $72.3 million used by operations in 1992. Cash of $87.4 million was used in 1993 to increase inventories through construction of homes, land purchases and land development. This compares to $54.5 million of cash used in 1992 to increase inventories. Additionally, $49.7 million in cash was used in 1993 to increase loans held for sale or disposition by the financial services subsidiaries, compared to $65.3 million used to increase the balance of these loans in 1992. Partially offsetting these uses of cash in 1993 was $27.2 million of cash provided by an increase in accounts payable and accrued liabilities in 1993, compared to an increase of $15.3 million in 1992. This resulted from a significant increase in real estate accounts payable due to the increased volume of homebuilding activities, and a large increase in mortgage fundings payable due to a higher volume of loan originations in the last few days of the year. Net cash used in investing activities increased during 1993 to $58.3 million from $48.7 million in 1992. In 1993, investing activities included a $21.4 million use of cash for the acquisition of additional operating properties. In addition, $20.2 million of cash was used to increase investments in and advances to partnerships and joint ventures. This increase includes $28.8 million of cash used for the acquisition of a 9.9% equity interest in a new Investment Division partnership. The increase in investments in and advances to partnerships and joint ventures was partially offset by capital distributions from the Investment Division partnership entered into in 1992. During 1993, the Company further strengthened its financial position with a successful public offering of 3,450,000 additional shares of common stock which generated net proceeds to the Company of approximately $97 million. The proceeds were used for the expansion of the Company's operations as well as the investing activities discussed above. REAL ESTATE OPERATIONS The Company finances its land acquisitions with its revolving lines of credit or purchase money mortgages or buys land under option agreements, which permit the Company to acquire portions of properties when it is ready to build homes on them. The financial risk of adverse market conditions associated with longer term land holdings is managed by strategic purchasing in areas that the Company has identified as desirable growth markets along with careful management of the land development process. The Company believes that its land inventories give it a competitive advantage, especially in Florida, where developers face government constraints and regulations which will limit the number of available homesites in future years. Based on its current financing capabilities, the Company does not believe that its land holdings have any adverse effect on its liquidity. The Company has also borrowed on a secured term loan basis in order to supplement its short-term borrowings. These term loans, which are collateralized principally by certain real estate held for future use and operating properties, amounted to $50 million at November 30, 1993 and are due in 1996. Total secured borrowings, which include the term loan debt, as well as mortgage notes payable on certain operating properties and land, were $108.4 million at fiscal year-end 1993 and $132.8 million at November 30, 1992. A significant portion of inventories, land held for investment, model homes and operating properties remained unencumbered at the end of the current fiscal year. Total real estate operations borrowings increased to $242.2 million at November 30, 1993 from $177.7 million at November 30, 1992. However, due to increased equity, the real estate debt-to-equity ratio improved to 51.8% at the end of fiscal 1993, compared to 55.6% one year earlier. The increase in real estate debt is attributable to increases in construction in progress, land inventories, partnership investments, and the assumption of liabilities upon the purchase of three former real estate joint ventures. FINANCIAL SERVICES Lennar Financial Services subsidiaries finance their mortgage loans held for sale on a short-term basis by either pledging them as collateral for borrowings under two lines of credit totaling $200 million or borrowing funds from Lennar in instances where, on a consolidated basis, the overall cost of funds is minimized. Total borrowings under the two lines of credit were $167.6 million and $144.4 million at November 30, 1993 and 1992, respectively. This increase is due mainly to the $52.7 million increase in loans held for sale or disposition described below. LFS subsidiaries dispose of the mortgage loans they originate or purchase and convert the majority of such mortgage loans to cash within thirty to sixty days of origination or purchase. At November 30, 1993, the balance of loans held for sale or disposition was $243.1 million, compared with $190.4 million one year earlier. The increase represents greater mortgage production by LFS' mortgage banking subsidiaries. LIMITED-PURPOSE FINANCE SUBSIDIARIES Limited-purpose finance subsidiaries of LFS have placed mortgage loans and other receivables as collateral for various long-term financings. These subsidiaries pay the debt service on the long-term borrowings primarily from the cash flows generated by the related pledged collateral; and therefore, the related interest income and interest expense, for the most part, offset one another in each of the three years ended November 30, 1993. The Company believes that the cash flows generated by these subsidiaries will be adequate to meet the required debt payment schedules. Based on the Company's current financial condition and credit relationships, Lennar believes that its operations and borrowing resources will provide for its current and long-term capital requirements at the Company's anticipated levels of growth. NEW ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", becomes effective for fiscal years beginning after December 15, 1992, and SFAS No. 112, "Employers' Accounting for Postemployment Benefits", becomes effective for fiscal years beginning after December 15, 1993. Neither SFAS No. 106 nor SFAS No. 112 will have a material impact on the Company's financial statements. SFAS No. 109, "Accounting for Income Taxes", must be adopted by the Company in fiscal 1994. SFAS No. 109 requires a change from the deferred method under APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred income taxes are recognized for future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in the period that includes the enactment date. Upon adoption of SFAS No. 109, the Company plans to apply the provisions of the Statement without restating prior years' financial statements. It is estimated that the adoption of SFAS No. 109 will result in a reduction of the net deferred tax liability by approximately $5.0 million and that this amount will be reported separately as the cumulative effect of a change in the method of accounting for income taxes in the consolidated statement of earnings for the year ending November 30, 1994. KPMG PEAT MARWICK CERTIFIED PUBLIC ACCOUNTANTS ONE BISCAYNE TOWER TELEPHONE 305 358-2300 TELEFAX 305 577 0544 SUITE 2900 2 SOUTH BISCAYNE BOULEVARD MIAMI, FL 33131 INDEPENDENT AUDITORS' REPORT The Board of Directors Lennar Corporation: We have audited the accompanying consolidated balance sheets of Lennar Corporation and subsidiaries as of November 30, 1993 and 1992, and the related consolidated statements of earnings, cash flows and stockholders' equity for each of the years in the three-year period ended November 30, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14(a)2. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the 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 Lennar Corporation and subsidiaries as of November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended November 30, 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 January 18, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------- Lennar Corporation and Subsidiaries November 30, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of Lennar Corporation and all wholly-owned subsidiaries (the "Company"). The Company's investments in partnerships and joint ventures are accounted for by the equity method. All significant intercompany transactions and balances have been eliminated. REVENUE RECOGNITION Revenues from sales of homes are recognized when the sales are closed and title passes to the new homeowners. Revenues from sales of other real estate (including the sales of land and operating properties) are recognized when a significant down payment is received, the earnings process is complete, and the collection of any remaining receivables is reasonably assured. INVENTORIES Inventories are stated at the lower of accumulated costs or market. Market value is evaluated at the community level and is defined as the estimated proceeds upon disposition less all future costs to complete and sell. Inventory adjustments to market value in 1993, 1992 and 1991 were not material to the Company. Start-up costs, construction overhead and selling expenses are expensed as incurred and are included in cost of homes sold. Homes held for sale are classified as construction in progress until delivered. Land, land development, amenities and other costs are accumulated by specific area and allocated proportionately to homes within the respective area. CAPITALIZATION OF INTEREST AND REAL ESTATE TAXES Interest and real estate taxes attributable to land, homes and operating properties are capitalized and added to the cost of those properties as long as the properties are being actively developed. During 1993, 1992 and 1991 interest costs of $19.7 million, $16.8 million and $14.2 million, respectively, were incurred, and $17.1 million, $15.0 million and $14.2 million, respectively, were capitalized by the Company's real estate operations. Previously capitalized interest charged to cost of sales was $13.1 million in 1993, $9.5 million in 1992 and $9.3 million in 1991. OPERATING PROPERTIES AND EQUIPMENT Operating properties and equipment are recorded at cost. Depreciation is calculated to amortize the cost of depreciable assets over their estimated useful lives using the straight-line method. The range of estimated useful lives for operating properties is 15 to 40 years and for equipment is 2 to 10 years. WARRANTIES Warranty liabilities are not significant as the Company subcontracts virtually all segments of construction to others and its contracts call for the subcontractors to repair or replace any deficient items related to their trade. Extended warranties are offered in some communities through independent homeowner warranty insurance companies. The costs of these warranties are expensed in the period the homes are delivered. - --------------------------------------------------------------------------- INCOME TAXES The Company and its subsidiaries file a consolidated federal income tax return. Income taxes are accounted for under the Accounting Principles Board Opinion ("APB") No. 11, however, the Company will be required to adopt Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which supersedes APB No. 11 effective December 1, 1993. NET EARNINGS PER SHARE Net earnings per share is calculated by dividing net earnings by the weighted average number of the total of common shares and Class B common shares outstanding during the year. The weighted average number of shares outstanding was 23,139,000, 20,495,000 and 20,114,000 in 1993, 1992 and 1991, respectively. FINANCIAL SERVICES Mortgage loans held for sale or disposition by Lennar Financial Services Inc. ("LFS") are recorded at the lower of cost or market, as determined on an aggregate basis. Discounts recorded on these loans are presented as a reduction of the carrying amount of the loans and are not amortized. LFS enters into forward sales and option contracts to protect the value of loans held for sale or disposition from increases in market interest rates. Adjustments are made to these loans based on changes in the market value of these hedging contracts. When LFS sells loans or mortgage-backed securities in the secondary market, a gain or loss is recognized to the extent that the sales proceeds exceed, or are less than, the book value of the loans or the securities. Loan origination fees, net of direct origination costs, are deferred and recognized as a component of the gain or loss when loans are sold. LFS generally retains the servicing on the loans and mortgage-backed securities it sells. LFS recognizes servicing fee income as those services are performed. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standard No. 107, "Disclosures about Fair Value of Financial Instruments", requires companies to disclose the estimated fair value of their financial instrument assets and liabilities. The estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. The fair values are significantly affected by the assumptions used including the discount rate and estimates of cash flow. Accordingly, the use of different assumptions may have a material effect on the estimated fair values. The estimated fair values presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. RECLASSIFICATION Certain prior year amounts in the consolidated financial statements have been reclassified to conform with the 1993 presentation. - --------------------------------------------------------------------------- 2. LINES OF BUSINESS The Company operates principally in two lines of business: (1) real estate, which includes the activities of the parent company (Lennar Corporation), the Homebuilding Division and the Investment Division (formerly referred to as Asset Management); and (2) financial services, which includes certain activities of LFS, but excludes the limited-purpose finance subsidiaries. The Homebuilding Division constructs and sells single-family (attached and detached) and multi-family homes. The Investment Division is involved in the development, management and leasing, as well as the acquisition and sale, of commercial and residential properties and land. This division also manages and participates in partnerships with financial institutions. Financial services activities are conducted primarily through five LFS Subsidiaries: Universal American Mortgage Company ("UAMC"), AmeriStar Financial Services, Inc., Universal Title Insurors, Inc., Lennar Funding Corporation and Loan Funding, Inc. These subsidiaries arrange mortgage financing, title insurance, and closing services for Lennar homebuyers and others, acquire, package and resell home mortgage loans, and perform mortgage loan servicing activities. The limited-purpose finance subsidiaries of LFS have placed mortgages and other receivables as collateral for various long-term financings. These limited-purpose finance subsidiaries are not considered a part of the financial services operations for lines of business purposes and, as such, are reported separately. - --------------------------------------------------------------------------- 3. UNUSUAL ITEM - HURRICANE DAMAGE On August 24, 1992, the South Florida area was hit by a severe hurricane which affected a portion of the Company's Dade County real estate operations. The results of operations for the year ended November 30, 1992 include an unusual charge of $7.6 million, before income taxes, representing the cost of the damage to the Company's inventories, properties and similar costs associated with the destruction caused by Hurricane Andrew. - --------------------------------------------------------------------------- 4. RESTRICTED CASH Cash includes restricted deposits of $4,154,000 and $2,041,000 as of November 30, 1993 and 1992, respectively. These balances are comprised primarily of escrow deposits held related to condominium purchases and security deposits from tenants of commercial and apartment properties. - --------------------------------------------------------------------------- 5. SUMMARY OF NONCASH INVESTING AND FINANCING ACTIVITIES During the first quarter of 1993, the Company acquired a portfolio of loans from the Resolution Trust Corporation for $24.8 million. Of this amount, $5.0 million was paid in cash, and the Company issued a non-recourse note in the amount of $19.8 million for the remainder. Also, during 1993, the Company purchased the other partners' interests in three of its joint ventures. As a result, the operations of these ventures were consolidated into the accounts of the Company as of the respective dates of acquisition. The net result of these transactions was to decrease investments in and advances to partnerships and joint ventures by $34.9 million, increase all other assets by $73.7 million and increase liabilities by $38.8 million. - --------------------------------------------------------------------------- 7. INVESTMENTS IN AND ADVANCES TO PARTNERSHIPS AND JOINT VENTURES (CONTINUED) During 1993, the Company acquired a 9.9% equity interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. This partnership has selected the Company to manage its portfolio of commercial real estate assets. During 1992, Lennar Florida Partners, a partnership between a subsidiary of the Company and The Morgan Stanley Real Estate Fund, L.P., was formed to acquire and manage a portfolio of mortgage loans, business loans and real property. The Company's initial contribution to this partnership amounted to 25% of the partnership's total equity. After the partners have recovered their investment, plus a return, the Company will be entitled to 50% of the partnership's cash flows. The Company shares in the profits or losses of both partnerships, and also receives fees for the management and disposition of the assets. The outstanding debt of the partnerships is not guaranteed by the Company. The Company acquired the other partners interest in three of its joint ventures during 1993. As a result, the operations of the ventures have been consolidated into the accounts of the Company as of the respective dates of acquisition. - --------------------------------------------------------------------------- 9. MORTGAGE NOTES AND OTHER DEBTS PAYABLE (CONTINUED) On July 29, 1993, the Company entered into a new $175 million unsecured revolving credit agreement with nine banks. The agreement was expanded to $190 million on December 3, 1993 by admitting an additional bank. The term of the agreement is three years. On every anniversary date of the agreement each bank has the option to participate in a one year extension. The interest rate under this agreement fluctuates with market rates and was 4.8% at November 30, 1993. At November 30, 1993, the Company was party to interest rate swap agreements which replaced the floating interest rates on $45 million of debt, with fixed rates ranging from 8.7% to 10.2%. These agreements expire in 1994 and 1996. The minimum aggregate principal maturities of mortgage notes and other debts payable required during the five years subsequent to November 30, 1993, assuming that the revolving credit agreement is not extended, are as follows (in thousands): 1994-$23,027; 1995-$5,551; 1996-$180,284; 1997- $8,439 and 1998-$12,419. All of the notes secured by land contain collateral release provisions for accelerated payment which may be made as necessary to maintain construction schedules. The fair value of interest rate swaps at November 30, 1993 was $3.5 million. The estimated fair values represent a net unrealized loss. The value is based on dealer quotes and generally represents an estimate of the amount the Company would pay to terminate the agreement at the reporting date, taking into account current interest rates and the credit worthiness of the counterparties. The fair values of the Company's fixed rate borrowings are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates of similar type of borrowing arrangements. The fair values of these borrowings at November 30, 1993 approximated their carrying value. The interest rates on variable rate borrowings are tied to market indices. Accordingly, fair value approximates their carrying value. - ---------------------------------------------------------------------------- The Financial Services Division finances its activities through its two bank lines of credit, which amount to $200 million, or borrowings from Lennar Corporation, when on a consolidated basis the Company can minimize its cost of funds. The two lines of credit expire in March and July 1994, unless otherwise extended. Borrowings under these agreements were $167.6 million and $144.4 million at November 30, 1993 and 1992, respectively, and were collateralized by mortgage loans with outstanding principal balances of $155.9 million and $137.4 million, respectively, and by servicing rights to approximately $2.2 billion and $1.8 billion, respectively, of loans serviced by LFS. There are several interest rate pricing options which fluctuate with market rates. The borrowing rate has been reduced to the extent that custodial escrow balances exceeded required compensating balance levels. The effective interest rate on these agreements at November 30, 1993 was 2.4%. The Financial Services Division is party to financial instruments in the management of its exposure to interest rate fluctuations. Forward sales contracts and options are used by the division to hedge mortgage loans held for sale and in its pipeline of loan applications in process. By hedging in the instruments that the division will create, market interest rate risk is reduced. Gains and losses on these hedging transactions have not been material to the Company. Exposure to credit risk is managed through evaluation of trading partners, limits of exposure, and monitoring procedures. At November 30, 1993 and 1992, the Financial Services Division was a party to approximately $212 million and $183 million, respectively, of forward sales contracts and options. Certain of the division's servicing agreements require it to pass through payments on loans even though it is unable to collect such payments and, in certain instances, be responsible for losses incurred through foreclosure. Exposure to this credit risk is minimized through geographic diversification and review of the mortgage loan servicing created or purchased. Management believes that it has provided adequate reserves for expected losses based on the net realizable value of the underlying collateral. Provisions for these losses have not been material to the Company. The division is also subject to prepayment risk on the servicing portfolio. Exposure to prepayment risk is managed by the division's ongoing evaluation of prepayment possibilities, and by the Company's active involvement in the refinancing business. The fair value of loans held for sale at November 30, 1993 approximated carrying value. The fair value was based on quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics, net of the difference between the settlement value and the quoted market values of forward commitments and options to buy and sell mortgage-backed securities. - --------------------------------------------------------------------------- 12. LIMITED-PURPOSE FINANCE SUBSIDIARIES In prior years, limited-purpose finance subsidiaries of LFS placed mortgages and other receivables as collateral for various long-term financings. These limited-purpose finance subsidiaries pay the principal of, and interest on, these financings primarily from the cash flows generated by the related pledged collateral which includes a combination of mortgage notes, mortgage- backed securities and funds held by trustee. The fair value of the collateral for the bonds and notes payable at November 30, 1993 was $135.5 million and was based on quoted market prices for similar securities. BONDS AND NOTES PAYABLE At November 30, 1993 and 1992, the balances outstanding for the bonds and notes payable were $121.4 million and $174.2 million, respectively. The borrowings mature in years 2013 through 2018 and carry interest rates ranging from 5.1% to 14.3%. The annual principal repayments are dependent upon collections on the underlying mortgages, including prepayments, and cannot be reasonably determined. The fair value of the bonds and notes payable at November 30, 1993 was $128.0 million and was based on quoted market prices for similar securities. - --------------------------------------------------------------------------- 14. CAPITAL STOCK COMMON STOCK The Company has two classes of common stock. The common stockholders have one vote for each share owned, in matters requiring stockholder approval, and during 1993 received quarterly dividends of $.03 per share. Class B common stockholders have ten votes for each share of stock owned and during 1993 received quarterly dividends of $.025 per share. As of November 30, 1993, Mr. Leonard Miller, Chairman of the Board and President of the Company, owned 6.6 million shares of Class B common stock, which represents approximately 79% voting control of the Company. STOCK OPTION PLANS The Lennar Corporation 1980 Stock Option Plan ("1980 Plan") expired on December 8, 1990. However, under the terms of the 1980 Plan, certain options granted prior to the plan termination date are still outstanding. Unless exercised or cancelled, the last options granted under the 1980 Plan will expire in December 1995. - --------------------------------------------------------------------------- The Lennar Corporation 1991 Stock Option Plan ("1991 Plan") provides for the granting of options to certain key employees of the Company to purchase shares at prices not less than market value as of the date of the grant. No options granted under the 1991 Plan may be exercisable until at least six months after the date of the grant. Thereafter, exercises are permitted in varying installments, on a cumulative basis. Each stock option granted will expire on a date determined at the time of the grant, but not more than 10 years after the date of the grant. - --------------------------------------------------------------------------- EMPLOYEE STOCK OWNERSHIP/401(K) PLAN The Employee Stock Ownership / 401(k) Plan ("Plan") provides shares of stock to employees who have completed one year of continuous service with the Company. All contributions for employees with five years or more of service are fully vested. The Plan was amended in 1989 to add a cash or deferred program under Section 401(k) of the Internal Revenue Code. Under the 401(k) portion of the Plan, employees may make contributions which are invested on their behalf, and the Company may also make contributions for the benefit of employees. The Company records as compensation expense an amount which approximates the vesting of the contributions to the Employee Stock Ownership portion of the Plan, as well as the Company's contribution to the 401(k) portion of the Plan. This amount was (in thousands): $361 in 1993, $366 in 1992 and $356 in 1991. In 1993, 1992 and 1991, 9,200, 39 and 5,968 shares, respectively, were contributed to participants' accounts. Additionally, in 1992 and 1991, 8,716 and 5,340 shares, respectively, were credited to participants' accounts from previously forfeited shares. RESTRICTIONS ON PAYMENT OF DIVIDENDS Other than as required to maintain the financial ratios and net worth requirements under the revolving credit and term loan agreements, there are no restrictions on the payment of common stock dividends by the Company. The cash dividends paid with regard to a share of Class B common stock in a calendar year may not be more than 90% of the cash dividends paid with regard to a share of common stock in that calendar year. Furthermore, there are no agreements which restrict the payment of dividends by subsidiaries to the Company. As of November 30, 1993, the Company's share of undistributed earnings from partnerships was not significant. 15. COMMITMENTS AND CONTINGENT LIABILITIES The Company and certain subsidiaries are parties to various claims, legal actions and complaints arising in the ordinary course of business. In the opinion of management, the disposition of these matters will not have a material adverse effect on the financial condition of the Company. During 1993, the Company settled two lawsuits and a number of claims in which owners of approximately 550 homes built by the Company sought damages as a result of Hurricane Andrew. There still remain approximately 125 additional homeowners who have asserted claims. Other homeowners or homeowners' insurers are not precluded from making similar claims against the Company. Four insurance companies have contacted the Company seeking reimbursement for sums paid by them with regard to homes built by the Company and damaged by the storm. Other claims of this type may be asserted. The Company's insurers have asserted that their policies cover some, but not all, aspects of these claims. However, to date, the Company's insurers have made all payments required under settlements. Even if the Company were required to make any payments with regard to Hurricane Andrew related claims, the Company believes that the amount it would pay would not be material. 15. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) The Company is subject to the usual obligations associated with entering into contracts for the purchase, development and sale of real estate in the routine conduct of its business. The Company is committed, under various letters of credit, to perform certain development and construction activities in the normal course of business. Outstanding letters of credit under these arrangements totaled approximately $41.0 million at November 30, 1993. Quarterly and year-to-date computations of per share amounts are made independently. Therefore, the sum of per share amounts for the quarters may not agree with per share amounts for the year. - --------------------------------------------------------------------------- Item 9. Disagreements on Accounting and Financial Disclosure. Not applicable. *************************************************************************** PART III Item 10. Directors and Executive Officers of the Registrant. Information about the Company's directors is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Information about the Company's executive officers is contained in Part I of this Report under the caption "Executive Officers of the Registrant". Item 11. Executive Compensation. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Item 12. Security Holdings of Certain Beneficial Owners and Management. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Item 13. Certain Relationships and Related Transactions. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Documents filed as part of this Report. 1. The following financial statements are included in Item 8:

278243_1993.txt

278243_1993

1993

278243

ITEM 1. BUSINESS La Quinta Inns, Inc. ("La Quinta" or the "Company") is a leader in the upper economy segment of the lodging market. Founded in 1968, the La Quinta chain's 221 inns are located in 29 states with concentrations in Texas, Florida and California. As of January 31, 1994, the Company owned interests in and operated all but one of its inns. The Company maintains a minority interest in nine inns which it manages pursuant to long-term management contracts and has one licensed inn. La Quinta is incorporated under the laws of Texas and maintains its executive offices at Weston Centre, 112 East Pecan Street, P.O. Box 2636, San Antonio, Texas 78299-2636, telephone (210) 302-6000. PRODUCT La Quinta inns appeal to guests who desire high-quality rooms and convenient locations at attractive prices and whose needs do not include banquet and convention facilities, in-house restaurants, cocktail lounges or room service. As a result of the cost savings associated with the elimination of these management intensive facilities and services, the Company believes it is able to offer its guests an excellent value -- convenient locations and room quality comparable to mid-priced full service hotels at a lower price. La Quinta inns contain an average of 130 spacious, quiet and comfortably furnished rooms with an average of 300 square feet. Each inn features a choice of rooms for non-smokers and smokers, complimentary continental breakfast, free unlimited local telephone calls, remote-control television with Showtime or The Movie Channel, telecopy services, same day laundry and dry cleaning service, 24-hour front desk and message service and free parking. La Quinta inns are generally located near interstate highways, major traffic arteries or destination areas such as airports and convention centers. Food service to La Quinta guests generally is provided by adjacent free-standing restaurants. La Quinta's strategy is to continue its growth as a high-quality provider in the upper economy segment of the hotel industry, focusing on enhancing revenues, cash flow and profitability. Specifically, the Company's strategy centers upon: CONTINUED FOCUS ON UPPER ECONOMY SEGMENT - The upper economy segment of the lodging industry is characterized by inns that provide for the basic needs of cost-conscious business travelers who desire high-quality rooms and convenient locations. Because the Company competes primarily in the upper economy segment, management's attention is totally focused on meeting the needs of La Quinta's target customers. The upper economy segment is one of the fastest growing segments in the lodging industry, growing over 5% annually, since 1989. LA QUINTA MANAGEMENT OF INNS - In contrast to many of its competitors, La Quinta manages and has ownership interests in virtually all of its inns. La Quinta manages all but one of the 221 inns in the chain. At January 31, 1994, the Company owned 100% of 166 inns and 40% or more of an additional 45. As a result, the Company believes it is able to achieve a higher level of consistency in both product quality and service than its competition. In addition, La Quinta's position as one of the few primarily owner-operated chains enables La Quinta to offer new services, direct expansion, effect pricing and to make other marketing decisions on a system-wide or local basis as conditions dictate, usually without consulting third-party owners, management companies or franchisees as required of most other lodging chains. The Company's management of the inns also enables it to control costs and allocate resources effectively to provide excellent value to the consumer. IMAGE ENHANCEMENT PROGRAM - In 1993, La Quinta has undertaken a comprehensive chainwide image enhancement program intended to give its properties a new, fresh, crisp appearance while preserving their unique character. The program features new signage displaying a new logo as well as exterior and lobby upgrades including brighter colors, more extensive lighting, additional landscaping, enhanced guest entry and a full lobby renovation with contemporary furnishings and seating area for continental breakfast. Thirty nine properties completed the reimaging process in 1993 with program completion targeted for June 1994. REGIONALLY FOCUSED GROWTH - La Quinta acquired eleven existing lodging facilities and converted them to the La Quinta brand in 1993 and anticipates expanding in a similar manner in 1994. COMPETITION Inns operated and licensed by La Quinta are in competition with other major lodging brands. Each La Quinta inn competes in its market area with numerous full service lodging brands, especially in the mid-priced range, and with numerous other hotels, motels and other lodging establishments. Chains such as Hampton Inns, Red Roof Inns, Fairfield Inns and Drury Inns are direct competitors of La Quinta. Other well-known competitors include Holiday Inns, Ramada Inns, Quality Inns, and Travelodge. There is no single competitor or group of competitors of La Quinta that is dominant in the lodging industry. Competitive factors in the industry include reasonableness of room rates, quality of accommodations, degree of service and convenience of locations. Demand is affected by normally recurring seasonal patterns. At most La Quinta inns demand is higher in the spring and summer months (March through August) than in the balance of the year. Overall occupancy levels may also be affected by the number of new inns opened by the Company and the length of time such inns have been in operation. The lodging industry in general, including La Quinta, may be adversely affected by national and regional economic conditions and government regulations. The demand for accommodations at a particular inn may be adversely affected by many factors including changes in travel patterns, local and regional economic conditions and the degree of competition with other inns in the area. STRUCTURE AND OWNERSHIP The Company is a combined entity comprised of La Quinta Inns, Inc., which owns and operates 211 inns, four subsidiaries and 16 combined unincorporated partnerships and joint ventures. The combined unincorporated partnerships and joint ventures own 45 inns operated by the Company. The Company manages 9 inns, 99% owned by CIGNA which are accounted for using the equity method in the Company's financial statements. During 1993, the Company acquired, in separately negotiated transactions, limited partners' interests in 14 of the Company's combined unincorporated partnerships and joint ventures which owned 44 La Quinta inns. The Company purchased the ownership interests for an aggregate purchase price of $87,897,000 which included cash at closing, the assumption of $22,824,000 of existing debt attributable to certain limited partners' interests, and $29,878,000 in notes to certain sellers. The Board of Directors of the Company authorized three-for-two stock splits effective in October 1993 and March 1994. References to the Company's common stock prior to the October split is described herein as "pre-split" and references to the Company's common stock after the March split is described herein as "post split". On October 27, 1993, the Company entered into a definitive Partnership Acquisition Agreement (the "Merger Agreement") with La Quinta Motor Inns Limited Partnership ("the Partnership" or "LQP") and other parties, pursuant to which the Company, through wholly-owned subsidiaries, would acquire all units of the Partnership (the "Units") that it did not beneficially own at a price of $13.00 net per Unit in cash. The Merger Agreement provided for a tender offer (the "Offer") for all of the Partnership's outstanding Units at a price of $13.00 net per Unit in cash, which Offer commenced on November 1, 1993 and expired at midnight on November 30, 1993. The Offer resulted in the purchase of 2,805,190 Units (approximately 70.6% of the outstanding Units) by the Company through its wholly-owned subsidiary, LQI Acquisition Corporation. As a result of a contribution of additional units previously owned by the Company subsequent to the Offer, LQI Acquisition Corporation beneficially owned 3,257,890 Units (approximately 82% of the Units) at December 31, 1993. Pursuant to the Merger Agreement, a Special Meeting of Unitholders was then held on January 24, 1994 to approve the merger of a subsidiary of LQI Acquisition Corporation with and into the Partnership, with the Partnership as the surviving entity. As a result of this merger which was approved by the requisite vote of Unitholders on January 24, 1994, all of the Partnership's outstanding Units other than Units owned by the Company or any direct or indirect subsidiary of the Company were converted into the right to receive $13.00 net in cash without interest. The following table describes the composition of inns in the La Quinta chain at: JOINT VENTURES AND PARTNERSHIPS. La Quinta historically financed its development, in part, through partnerships and joint ventures with large insurance companies or financial institutions. Under the terms of the joint venture and partnership agreements, available cash flow is generally used to pay debt and provide for capital improvements, with remaining cash flow being distributed to the partners in accordance with their respective ownership interests. In 1993 La Quinta began to purchase the interests in the unincorporated joint ventures and partnerships, acquiring 14 by the end of the year. In addition, the Company successfully completed the acquisition of LQP in January 1994. See further discussions above. In March of 1990, the Company entered into the La Quinta Development Partners, L.P. ("LQDP" or the "Development Partnership") with AEW Partners, L.P. ("AEW Partners"). La Quinta Inns, Inc. is the general partner and owns a 40% ownership interest and AEW Partners is the limited partner and owns a 60% ownership interest. This partnership was established for the purpose of owning, operating, acquiring and developing inns. La Quinta originally contributed 18 inns with a deemed value of $44,000,000 (net of existing debt assumed by LQDP) and $4,000,000 in cash. AEW Partners contributed $3,000,000 and a promissory note ("the AEW Note") to the Development Partnership in the amount of $69,000,000. Under the terms of the agreement, proceeds from the AEW Note are to be used for the construction of inns or for the acquisition and conversion of existing inns into the La Quinta brand. In 1993, the AEW Partners fully paid the balance of the AEW Note. At December 31, 1993, the Development Partnership had acquired and converted 19 inns (nine during 1993). Under the terms of the Development Partnership agreement, AEW Partners currently has the ability to convert 66 2/3% of its ownership interest in the Development Partnership to 3,535,976 (post-split) shares of the Company's common stock. Such number of shares is reduced as distributions are made out of the Development Partnership to AEW Partners. The partnership units may be converted at any time prior to December 31, 1998. As of December 31, 1993, no partnership units had been converted. Shares of the Company's common stock issuable upon conversion are antidilutive at December 31, 1993. Under the terms of a management agreement between the Company and the Development Partnership, La Quinta earns management, national advertising, chain services and license fees for the use of its name and services. La Quinta is also entitled to receive acquisition and conversion fees for its services in finding inns suitable for acquisition and in managing the conversion of such inns. La Quinta is also entitled to receive fees on project costs of inns constructed by the Development Partnership. MANAGED INNS. In 1987, the Company formed two joint ventures with investment partnerships managed by CIGNA Investments, Inc. ("CIGNA I" and "CIGNA II"). The Company maintains a 1% ownership interest in each of these ventures and manages the inns pursuant to long-term management contracts. As of December 31, 1993, the ventures owned nine inns and six free-standing restaurants operated by third parties. La Quinta receives licensing, management, national advertising and chain services fees for the use of its brand name and services from management of the inns. The Company accounts for its ownership interest in these entities using the equity method. LICENSING The Company selectively licensed the name "La Quinta" to others for operations in the United States until February 1977, at which time La Quinta discontinued its domestic licensing program to unrelated third parties. One inn remains in operation under a franchise agreement. During 1990, the Company entered into a licensing agreement with Desarrollos Turisticos Vanguardia S.A. de C.V. ("Desarrollos") for expansion of the La Quinta chain into Saltillo, Coahuila, Mexico. In February 1994, one inn developed under the license agreement opened for operation. Under the arrangement, the inn is owned by the licensee and managed by La Quinta under a separate management agreement. The Company is currently reviewing other potential management/licensing arrangements within Mexico and other Latin American countries. "La Quinta -R-" and "teLQuik -R-" have been registered as service marks by La Quinta with the U.S. Patent and Trademark Office, and in Mexico, Canada and the United Kingdom. OPERATIONS Management of the La Quinta chain is coordinated from the Company's headquarters in San Antonio, Texas. Centralized corporate services and functions include marketing, accounting and reporting, purchasing, quality control, development, legal, reservations and training. Inn operations are currently organized into Eastern and Western divisions with each division headed by a Divisional Vice President. Regional Managers report to the Divisional Vice Presidents and are each responsible for approximately 13 inns. Regional Managers are responsible for the service, cleanliness and profitability of the inns in their regions. Individual inns are typically managed by resident managers who live on the premises. Managers receive inn management training which includes an emphasis on service, cleanliness, cost controls, sales and basic repair skills. Because La Quinta's professionally trained managers are substantially relieved of responsibility for food service, they are able to devote their attention to assuring friendly guest service and quality facilities, consistent with chain-wide standards. On a typical day shift, they will supervise one housekeeping supervisor, eight room attendants, two laundry workers, two general maintenance persons and three front desk service representatives. At December 31, 1993, La Quinta employed approximately 6,100 persons, of whom approximately 88% were compensated on an hourly basis. Approximately 240 individuals were employed at corporate and 5,850 were employed in inn management and services. The Company's employees are not currently represented by labor unions. Management believes its ongoing labor relations are good. MARKETING La Quinta's primary media focus is on business travelers, who account for over half of La Quinta's rooms rented. The Company's core market consists of business travelers who visit a given area several times per year. For example, typical customers include salespersons covering a regional territory, government and military personnel and technicians. The profile of a typical La Quinta customer is a college educated business traveler, age 25 to 54, from a two income household who has a middle management, white collar occupation or upper level blue collar occupation. In addition, the Company's target markets include vacation travelers and retired travelers. The Company focuses on reaching its target markets by utilizing advertising, direct sales, programs which provide incentives to repeat travelers, and other marketing programs targeted at specific customer segments. The Company advertises primarily through network and local radio, cable television networks and print advertisements which focus on value. The Company utilizes the same campaign concept throughout the country with minor modifications made to address regional differences. The Company also utilizes billboard advertisements along major highways which announce a La Quinta inn's presence in upcoming towns. The Company markets directly to companies and other organizations through its direct sales force of 24 sales representatives and managers. This sales force calls on companies which have a significant number of individuals traveling in the regions in which La Quinta operates and which are capable of producing a high volume of room nights. La Quinta enjoys a large amount of repeat business. Based on internal surveys conducted in 1993, management estimates the average customer spent approximately 14 nights per year in a La Quinta inn during the year ended December 31, 1993. The Company focuses a number of marketing programs on maintaining the high number of repeat visits. La Quinta promotes a "Returns Club" for repeat guests. This club provides its members with preferred status and rates when checking into a La Quinta inn and offers rewards for frequent stays. The Returns Club currently has over 140,000 members. The Company provides a reservation system, "teLQuik" -R-, which currently accounts for reservations for approximately 50% of room occupancy. The teLQuik system allows customers to make reservations toll free or from special reservations phones placed in the lobbies of all La Quinta inns. The teLQuik system enables guests to make their next night's reservations from their previous night's La Quinta inn. In 1994, the Company completed a new reservation center which is a part of its program to improve operating results by providing state-of-the-art technology in processing reservations more efficiently. La Quinta, through its national sales managers, markets its reservation services to travel agents and corporate travel planners who may access teLQuik through the five major airline reservation systems. ASSET MANAGEMENT La Quinta's asset management strategy is founded on the importance of ownership of all or a significant portion of each of its inns. See "Structure and Ownership" on this Form 10-K. Management believes that Company ownership and management of La Quinta inns enables the Company to achieve more consistency in quality and service than its competitors. Historically, the Company financed a large part of its development through partnerships and joint ventures with large insurance companies and other financial institutions, while managing the inns. However, during 1993, the Company acquired in separately negotiated transactions limited partners' interests in 14 of the Company's combined unincorporated partnerships and joint ventures that owned 44 La Quinta inns. The Company also completed the acquisition of 100% of the limited partners' interests in an additional 31 inns owned by a subsidiary of LQP in January of 1994, after acquiring 82% of LQP during 1993. Additionally, the Company acquired eleven existing inns during 1993. Currently, the Company owns 100% of 166 inns and between 40%-80% of 45 other inns. The Company manages an additional nine La Quinta inns in which it owns a 1% interest. La Quinta's current development program focuses on the acquisition of competitor properties at discounts to replacement costs. At current prices, acquisition and conversion of existing properties is more cost effective than new construction. In 1993, La Quinta acquired and is converting a total of eleven inns, nine were purchased through the Development Partnership and two were purchased as wholly-owned, with an aggregate of 1,611 rooms, at an average cost of approximately $28,000 per room. ITEM 2. ITEM 2. PROPERTIES La Quinta inns appeal to guests who desire high-quality rooms and whose needs do not include banquet and convention facilities, in-house restaurants, cocktail lounges or room service. La Quinta inns contain an average of 130 rooms and provide spacious, quiet and comfortably furnished rooms with an average of 300 square feet, a choice of rooms for non-smokers and smokers, complimentary continental breakfast, free unlimited local telephone calls, remote-control television with Showtime or The Movie Channel, telecopy services, same-day laundry and dry cleaning service, 24-hour front desk and message service and free parking. To maintain the overall quality of La Quinta's inns and to remain competitive in its service-oriented environment, each inn undergoes refurbishments and capital improvements as needed. Typically, refurbishing has been provided at intervals of between five and seven years, based on an annual review of the condition of each inn. In each of the years ended December 31, 1993, 1992 and 1991, the Company spent approximately $32,600,000 (of which $15,400,000 was spent on the image enhancement program described below), $15,500,000 and $13,800,000, respectively, on capital improvements to existing inns. As a result of these expenditures, the Company believes it has been able to maintain a chainwide quality of rooms and common areas at its properties unmatched by any other national economy hotel chain. In 1993, the Company undertook an image enhancement program intended to give its properties a new, fresh, crisp appearance while preserving their unique character. The program features new signage displaying a new logo as well as exterior and lobby upgrades including brighter colors, additional landscaping, enhanced guest entry and a full lobby renovation with contemporary furnishings and seating area for continental breakfast. Of the chain's 221 inns, 97 began the image enhancement program during 1993, of which 39 were complete as of December 31, 1993. Twenty properties begin the reimaging process every six to eight weeks with program completion targeted for June 1994. Signs displaying the Company's new logo were in place at substantially all properties at December 31, 1993. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Commitments." At December 31, 1993, there were 221 inns located in 29 states, with concentrations in Texas, Florida and California. The states and cities in which the inns are located are set forth in the following table: Typically, food service for La Quinta guests is provided by adjacent, free standing restaurants. At December 31, 1993, the Company had an ownership interest in 124 restaurant buildings adjacent to its inns. These restaurants generally are leased pursuant to build-to-suit leases that require the operator to pay, in addition to minimum and percentage rentals, all expenses, including building maintenance, taxes and insurance. The Company's inns and restaurants were substantially pledged to secure all long-term debt maturing in various years from 1994 to 2015 (See note 2 of Notes to Combined Financial Statements). ITEM 3. ITEM 3. LEGAL PROCEEDINGS On October 18, 1993, the Company announced that its Board of Directors had authorized its officers to enter into negotiations with La Quinta Motor Inns Limited Partnership (the "Partnership") regarding the acquisition of all units of the Partnership which it did not currently own, at a price of up to $12 per unit. See "Structure and Ownership" on this Form 10-K. On October 18, 1993, the Board of Directors of the General Partner of the Partnership elected three independent directors (the "Special Committee"), among other things, to negotiate the sale of Units to the Company. On October 18, 1993, two separate lawsuits were filed in Delaware Court of Chancery on behalf of the Partnership's unitholders against the Company, the Partnership, La Quinta Realty Corp., a subsidiary of the Company, and general partner of the Partnership (the "General Partner") and certain directors and officers of the General Partner (collectively, the "Defendants"). The lawsuits are captioned GREENBERG V. SCHULTZ, ET AL., C.A. No. 13199 and GORIN BROTHERS, INC., V. SCHULTZ, ET. AL., C.A. No. 13200 (collectively, the "Actions"). The complaints in the Actions allege, among other things, that Defendants breached their fiduciary duties to Unitholders by offering grossly inadequate consideration to entrench themselves in control of the Partnership, by failing to solicit competing bids, and by making inadequate public disclosure regarding the transaction. The complaints additionally allege that the Company used unequal knowledge and economic power, given its affiliation with the General Partner, to the detriment of the Unitholders. The independence of the members of the Special Committee was also questioned, allegedly resulting in the lack of arm's length negotiations and the lack of any independent appraisal or evaluation. The complaints in the Actions sought, among other things, (i) a declaration that the Defendants breached their fiduciary duties to members of the alleged class, (ii) an order preliminarily and permanently enjoining consummation of the proposed transaction, (iii) the award of compensatory damages, and (iv) the award of costs and disbursements. On October 27, 1993, the parties reached a settlement in principle in these actions. The settlement is subject to certain conditions, including court approval. On March 15, 1994, the Delaware Court of Chancery entered an Order and Final Judgment ("Judgment") which approved the settlement and dismissed the cases. All persons and entities who were owners of Units of the Partnership at October 18, 1993 and their transferees and successors in interest, immediate and remote (the "Class"), are bound by the Judgment. The Company and all other defendants were discharged from any and all liability under any claims which were or could have been brought by plaintiffs or any member of the Class regarding the acquisition and merger of the Partnership. The appeal period on the Judgment will run on April 14, 1994. In September 1993, a former officer of the Company filed suit against the Company and certain of its directors and their affiliate companies. The suit alleges breach of an employment agreement, misrepresentation, wrongful termination, self-dealing, breach of fiduciary duty, usurpation of corporate opportunity and tortious interference with contractual relations. The suit seeks compensatory damages of $2,500,000 and exemplary damages of $5,000,000. The Company believes that the claims are wholly without merit and intends to vigorously defend against this suit. Actions for negligence or other tort claims occur routinely as an ordinary incident to the Company's business. Several lawsuits are pending against the Company which have arisen in the ordinary course of the business, but none of these proceedings involves a claim for damages (in excess of applicable excess umbrella insurance coverages) involving more than 10% of current assets of the Company. The Company does not anticipate any amounts which it may be required to pay as a result of an adverse determination of such legal proceedings and the matters discussed above, individually or in the aggregate, or any other relief granted by reason thereof, will have a material adverse effect on the Company's financial position or results of operations. The Company has established a paid loss program (the "Paid Loss Program") for inns owned and managed by the Company, which includes excess umbrella policies for commercial general liability insurance, automobile liability insurance, fire and extended property insurance, workers' compensation and employer's liability insurance for losses above the deductible limits, and such other insurance as is customarily obtained for similar properties and which may be required by the terms of loan or similar documents with respect to the inns. In connection with the general liability, workers' compensation and automobile coverages, all inns participate in the Paid Loss Program, under which claims and expenses are shared pro rata, with excess umbrella insurance being maintained to cover losses, claims and costs in excess of the deductible limits per matter of $500,000 for general liability, $250,000 for workers' compensation and $250,000 for automobile coverage. All pro rata expenses and premiums under the Paid Loss Program with respect to inns owned by persons other than the Company constitute direct operating expenses of said inns under the terms of the respective management agreements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the year covered by this Annual Report on Form 10-K, no matter was submitted to a vote of Registrant's security holders through the solicitation of proxies or otherwise. 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 Stock Exchange. The range of the high and low sale prices, as adjusted for the three-for-two stock split in October 1993 and the three-for-two stock split in March 1994, of the Company's Common Stock for each of the quarters during the years ended December 31, 1993 and 1992 is set forth below: The Company paid cash dividends in both the third and fourth quarters of 1993 in the amount of $.025 per share under its quarterly dividend policy as authorized by the Board of Directors. The Company increased its cash dividend by 50 percent in conjunction with the March 1994 three-for-two stock split to an annual rate of $.10 per share on post-split common shares. For restrictions on the Company's present or future ability to pay cash dividends, see note 2 of Notes to Combined Financial Statements. The declaration and payment of dividends in the future will be determined by the Board of Directors based upon the Company's earnings, financial condition, capital requirements and such other factors as the Board of Directors may deem relevant. As of February 28, 1994, the approximate number of holders of record of the Company's Common stock was 915. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's financial statements include the accounts of the Company's wholly-owned subsidiaries and unincorporated partnerships and joint ventures in which the Company has at least a 40% interest and over which it exercises substantial legal, financial and operational control. Investments in other entities in which the Company has less than a 40% ownership interest and over which the Company has the ability to exercise significant influence, but does not have control, are accounted for using the equity method. During 1993, the Company acquired, in separately negotiated transactions, limited partners' interests in 14 of the Company's combined unincorporated partnerships and joint ventures which owned 44 inns. The Company purchased the ownership interests for an aggregate purchase price of $87,897,000 which included cash at closing, the assumption of $22,824,000 of existing debt attributable to certain limited partners' interests, and $29,878,000 in notes to certain sellers. As a result of the following transactions, the operations of LQP for the month of December 1993 were included in the combined financial statements of the Company. On October 27, 1993, the Company entered into a definitive Partnership Acquisition Agreement (the "Merger Agreement") with LQP and other parties, pursuant to which the Company, through wholly-owned subsidiaries, would acquire all units of the Partnership (the "Units") that it did not beneficially own at a price of $13.00 net per Unit in cash. The Merger Agreement provided for a tender offer (the "Offer") for all of the Partnership's outstanding Units at a price of $13.00 net per Unit in cash, which Offer commenced on November 1, 1993 and expired at midnight on November 30, 1993. The Offer resulted in the purchase of 2,805,190 Units (approximately 70.6% of the outstanding Units) by the Company through its wholly-owned subsidiary, LQI Acquisition Corporation. As a result of a contribution of additional units previously owned by the Company subsequent to the Offer, LQI Acquisition Corporation beneficially owned 3,257,890 Units (approximately 82% of the Units) at December 31, 1993. Pursuant to the Merger Agreement, a Special Meeting of Unitholders was then held on January 24, 1994 to approve the merger of a subsidiary of LQI Acquisition Corporation with and into the Partnership, with the Partnership as the surviving entity. As a result of this merger which was approved by the requisite vote of Unitholders on January 24, 1994, all of the Partnership's outstanding Units other than Units owned by the Company or any direct or indirect subsidiary of the Company were converted into the right to receive $13.00 net in cash without interest. In 1993, the Company completed the acquisition of eleven inns and began renovating and converting them to the La Quinta brand. Of these inns, nine were purchased through the Development Partnership and two were purchased as wholly-owned properties. Although these inns remained open for business during conversion construction, hotel operations are disrupted during the typical three-to-four month construction period. Conversion of these inns will be completed during the first quarter of 1994. References to "Company Inns" are to inns owned by the Company or by unincorporated partnerships and joint ventures in which the Company owns at least a 40% interest. References to "Managed Inns" are to those inns in which the Company owns less than a 40% interest and which are managed by the Company under long-term management contracts. "Managed Inns" include nine inns held in two joint ventures with CIGNA Investments, Inc. ("CIGNA") for the year ended December 31, 1993 and the 31 inns of the LQP through November 30, 1993. "Managed Inns" were accounted for using the equity method. The following chart shows certain historical operating statistics and revenue data. References to the percentages of occupancy and the average daily rate refer to Company Inns. Managed Inns and the La Quinta licensed inn are excluded from occupancy and average daily rate statistics for all periods for purposes of comparability. All financial data is related to Company Inns unless otherwise specified. During 1991, the Company implemented certain changes in its operations and organization which resulted in charges of $7,952,000. Such charges included severance costs resulting from a reduction in work force and the termination of four executive officers of the Company, charges related to the write-down of computer equipment and other assets and costs associated with the Company's cost reduction study. During 1992, the Company made additional changes in operations and organization based on a comprehensive review of the Company by its senior management team and recognized charges of approximately $39,751,000. These charges included a provision for the write-down of partnership investments, land, severance and other employee- related costs and other charges which affected corporate expenses and partners' equity in earnings and losses, as more fully described below. YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 TOTAL REVENUES increased to $271,850,000 in 1993 from $254,122,000 in 1992, an increase of $17,728,000 or 7.0%. Of the total revenues reported in 1993, 95.1% were revenues from inns, 2.4% were revenues from restaurant rentals and other revenue and 2.5% were revenues from management services. INN REVENUES are derived from room rentals and other sources such as charges to guests for long-distance telephone calls, fax machine use and laundry services. Inn revenues increased to $258,529,000 in 1993 from $239,826,000 in 1992, an increase of $18,703,000 or 7.8%. The increase in inn revenues was due primarily to an increase in average room rate, an increase in the number of available rooms and the acquisition of LQP. The average room rate increased to $46.36 in 1993 from $44.33 in 1992, an increase of $2.03 or 4.6%, while occupancy declined .5 percentage points. As anticipated, the Company's image enhancement program caused temporary construction related disruption in normal business operations and occupancies at properties which underwent the process. Newly acquired inns remain open during conversion construction which also disrupts the hotel operations during the typical three-to-four month construction period. Also, management's decision to discontinue a coupon promotion used in 1992 had a positive impact on room rate and had the effect of reducing occupancy in 1993. Available rooms for 1993 were 8,226,000 as compared to 7,916,000 for 1992, an increase of 310,000 available rooms, or 3.9%. The increase in the number of available rooms was due to the acquisitions of 11 inns during the year ended December 31, 1993 and the acquisition of LQP in December of 1993. The acquisition of LQP in December 1993 added $2,758,000 to inn revenues. RESTAURANT RENTAL AND OTHER REVENUES includes rental payments from restaurants owned by the Company and leased to and operated by third parties. Restaurant rental and other revenues also include the Company's interest in the earnings (accounted for using the equity method) of two CIGNA joint ventures through the year ended December 31, 1993 and LQP, up to December 1, 1993, and miscellaneous other revenues, such as third party rental revenue from an office building which also housed the Company's corporate offices through May 1993. Restaurant rental and other decreased to $6,464,000 in 1993 from $7,208,000 in 1992, a decrease of $744,000 or 10.3%, primarily due to a reduction in earnings related to investments accounted for on the equity method. MANAGEMENT SERVICES REVENUE is primarily related to fees earned by the Company for services rendered in conjunction with Managed Inns. Management service revenue decreased to $6,857,000 in 1993 from $7,088,000 in 1992, a decrease of $231,000 or 3.3%. Management fees decreased due to there being two less franchisees and the consolidation of LQP in December 1993 eliminating the related management fees charged by the Company to LQP for that month. DIRECT EXPENSES include costs directly associated with the operation of Company Inns. In 1993, approximately 42% of direct expenses were represented by salaries, wages, and related costs. Other major categories of direct expenses include utilities, repairs and maintenance, property taxes, advertising and room supplies. Direct expenses increased to $148,915,000 ($27.79 per occupied room) in 1993 compared to $135,790,000 ($26.17 per occupied room) in 1992, an increase of $13,125,000 or 9.7%. As a percentage of total revenues, direct expenses increased to 54.8% in 1993 from 53.4% in 1992. The increase in direct expense resulted primarily from the Company's implementation of a complimentary continental breakfast at all La Quinta inns during the first quarter of 1993, (which amounted to $1.08 per occupied room). Newly acquired inns typically incur more direct expenses as a percentage of revenue during the first twelve months of operations compared to the inns which have been operating as a La Quinta for more than a twelve month period. The Company acquired 11 inns during 1993 and did not acquire or convert any inns in the 1992 period. Direct expenses incurred by LQP in December 1993 were $2,048,000. CORPORATE EXPENSES include the costs of general management, office rent, training and field supervision of inn managers and other marketing and administrative expenses. The major components of corporate expenses are salaries, wages and related expenses and information systems. Corporate expenses decreased to $19,450,000 ($1.96 per available room, including Managed Inns) in 1993 from $21,055,000 ($2.16 per available room before non-recurring charges, including Managed Inns) in 1992 before non-recurring charges, a decrease of $1,605,000 or 7.6%. As a percent of total revenues, corporate expenses decreased to 7.2% in 1993 from 8.3% in 1992 before non-recurring charges. The 1992 corporate expenses included a non-recurring charge to increase the allowance for certain notes receivable, based upon estimates of the value of the real estate held as collateral for such notes and evaluations of the financial condition of certain borrowers, and a provision related to the settlement of certain litigation. The PROVISION FOR WRITE-DOWN OF PARTNERSHIP INVESTMENTS, LAND AND OTHER in 1992 includes charges related to the write-down of certain joint venture interests, land previously held for future development, computer equipment and other assets, as more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations--Year Ended December 31, 1992 Compared to Year Ended December 31, 1991." SEVERANCE AND OTHER EMPLOYEE RELATED COSTS in 1992 consisted of costs related to the severance of certain executive officers and other employees, executive search fees and relocation costs for new officers. PERFORMANCE STOCK OPTION relates to the costs of stock options which became exercisable when the average price of the Company's stock reached $30 per share (pre-split) for twenty consecutive days. Performance stock option expense and certain other options were accelerated as a result of this condition being met. See note 5 to the Combined Financial Statements. DEPRECIATION, AMORTIZATION AND ASSET RETIREMENTS decreased to $23,711,000 in 1993 from $24,477,000 in 1992, a decrease of $766,000 or 3.1%. The decrease in depreciation, amortization and asset retirements was due to assets which became fully depreciated during 1993 and the write-off of computer equipment and signage in the prior year. Replacement and installation of new computer equipment and signs was substantially completed in the latter part of 1993. OPERATING INCOME increased to $75,367,000 in 1993 from $34,575,000 in 1992, an increase of $40,792,000. Operating income before a non-recurring, non-cash charge of approximately $4,407,000 to recognize compensation expense related to the vesting of performance stock options, increased to $79,774,000 in 1993 from $73,112,000 in 1992 before write-downs, severance and employee related costs and other non-recurring charges, an increase of $6,662,000 or 9.1%. INTEREST INCOME primarily represents earnings on the note receivable from AEW Partners (the "AEW Note") and on the short-term investment of Company funds in money market instruments prior to their use in operations or acquiring inns. Interest income decreased to $5,147,000 in 1993 from $6,041,000 in 1992, a decrease of $894,000 or 14.8%. The decrease in interest income is primarily attributable to principal reductions on the AEW Note of $16,700,000 and $19,300,000 in September and December 1993 respectively, and the corresponding reduction in interest earned thereon. As of December 31, 1993 the AEW Note had been fully collected. INTEREST ON LONG-TERM DEBT decreased to $31,366,000 in 1993 from $33,087,000 in 1992, a decrease of $1,721,000 or 5.2%. The decrease in interest expense is attributable to the early extinguishment of approximately $117,000,000 of certain high interest rate debt with proceeds from the 9 1/4% Senior Subordinated Notes due 2003 and bank financing which more than offset interest on borrowings to purchase limited partners' interests. In addition, certain Industrial Revenue Bond issues were refinanced to obtain more favorable interest rates. PARTNERS' EQUITY IN EARNINGS AND LOSSES reflects the interests of partners in the earnings and losses of the combined joint ventures and partnerships which are owned at least 40% and controlled by the Company. Partners' equity in earnings and losses decreased to $12,965,000 in 1993 from $15,081,000 in 1992, a decrease of $2,116,000 or 14.0%. The decrease in partners' equity in earnings and losses is attributable to the acquisition of limited partners' interests in 14 combined unincorporated partnerships and joint ventures partially offset by increases in the earnings of the Development Partnership. As of December 31, 1993, the Development Partnership operated 37 inns compared to 28 inns as of December 31, 1992. NET GAIN (LOSS) ON PROPERTY AND INVESTMENT TRANSACTIONS decreased to a loss of ($4,347,000) in 1993 from a gain of $282,000 in 1992. The loss in 1993 includes a $4,900,000 loss related to the Company's conveyance to the mortgagee of the title on the property in which the Company's headquarters were located. INCOME TAXES for 1993 were calculated using an estimated effective tax rate of 39%. For the reasons discussed above, the Company reported EARNINGS (LOSS) BEFORE EXTRAORDINARY ITEMS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE OF $19,420,000 in 1993 compared with ($7,796,000) in 1992, an increase of $27,216,000. The Company reported EXTRAORDINARY ITEMS, NET OF INCOME TAXES of ($619,000) in 1993 compared with ($958,000) in 1992. The 1993 extraordinary loss consisted of ($6,007,000), ($3,664,0000) net of income taxes, related to the early extinguishment and refinancing of certain debt partially offset by an extraordinary gain of $4,991,000, $3,045,000 net of income taxes, resulting from the Company's transfer of ownership to the mortgagee of property in which the Company's headquarters were located. The cumulative effect of a change in accounting for income taxes of $1,500,000 or $.05 per share in 1993 was the result of the implementation of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes." For the reasons discussed above, the Company reported NET EARNINGS of $20,301,000 in 1993 compared with a net loss of ($8,754,000) in 1992, an increase of $29,055,000. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 TOTAL REVENUES increased to $254,122,000 in 1992 from $240,888,000 in 1991, an increase of $13,234,000 or 5.5%. Of the total revenues reported in 1992, 94.4% were revenues from inns, 2.8% were revenues from restaurant rentals and other revenue and 2.8% were revenues from management services. INN REVENUES increased to $239,826,000 in 1992 from $227,096,000 in 1991, an increase of $12,730,000 or 5.6%. The increase in inn revenues was due primarily to an increase in average room rate, an increase in the number of available rooms and a slight increase in the percentage of occupancy. The average room rate increased to $44.33 in 1992 from $43.11 in 1991, an increase of $1.22 or 2.8%. The increase in room rate for 1992 was primarily attributable to rate increases made in selected stronger markets in January and June. The percentage of occupancy increased to 65.6% in 1992 from 64.8% in 1991. Available rooms for 1992 were 7,916,000 as compared to 7,817,000 for 1991, an increase of 99,000 available rooms or 1.3%. The increase in the number of available rooms was due to the acquisition of two inns in the fourth quarter of 1991 and the conversion of a licensed inn to a wholly-owned inn in 1992. RESTAURANT RENTAL AND OTHER increased slightly to $7,208,000 in 1992 from $6,910,000 in 1991. Management service revenue increased to $7,088,000 in 1992 from $6,882,000 in 1991, an increase of $206,000 or 3.0%. In 1992, approximately 44% of DIRECT EXPENSES were represented by salaries, wages and related costs. Direct expenses were $135,790,000 ($26.17 per occupied room) in 1992 compared to $135,443,000 ($26.75 per occupied room) in 1991, an increase of $347,000 or 0.3%. As a percentage of total revenues, direct expenses decreased to 53.4% in 1992 from 56.2% in 1991. The increase in total direct expenses was primarily due to increases in property taxes, insurance and employee health care claims expenses. However, the increase was partially offset by decreases in workers' compensation insurance resulting from new safety programs implemented by the Company, supplies and advertising expenses. CORPORATE EXPENSES increased to $21,055,000 ($2.16 per available room, including Managed Inns) in 1992 before $2,906,000 of non-recurring charges from $19,683,000 ($2.04 per available room, including Managed Inns) in 1991, an increase of $1,372,000 or 7.0%. As a percent of total revenues, corporate expenses before non-recurring charges increased to 8.3% in 1992 from 8.2% in 1991. The 1992 non-recurring charge was primarily attributable to an increase of $2,696,000 in the allowance for certain notes receivable, related to inns sold by the company prior to 1985, based on estimates of the value of the real estate held as collateral for such notes and evaluations of the financial condition of certain borrowers. The increase in corporate expense was partially related to a provision for settlement of certain litigation. During 1992, the Company recorded NON-RECURRING CASH AND NON-CASH CHARGES of approximately $39,751,000. Of these charges $28,383,000 are included as a provision for write-down of partnership investments, land and other; $6,936,000 related to severance and other employee related costs; and the remaining $4,432,000 affected corporate expenses and partners' equity in earnings and losses. All of these charges resulted from certain changes being made in the Company's operations and organization based on a comprehensive review by the Company's senior management team. During 1991, the Company recognized non-recurring cash and non-cash charges of $7,952,000 resulting from certain changes made in the Company's operations and organization. Of those charges, approximately $4,097,000 were for severance related costs for former employees which resulted from a reduction in the work force of approximately 72 employees, 50 of which were employed at the Company's headquarters and the termination of four executive officers of the Company under the various provisions of their severance agreements. Of the remaining charges, approximately $2,165,000 related to the write-down of computer equipment and other assets and approximately $1,690,000 represented costs associated with the Company's study to enhance shareholder value. DEPRECIATION, AMORTIZATION AND ASSET RETIREMENTS decreased to $24,477,000 in 1992 from $34,921,000 in 1991, a decrease of $10,444,000 or 29.9%. Approximately $9,200,000 of the decrease was due to the Company's change in the depreciable lives of the building assets from 30 years to 40 years, effective January 1, 1992. OPERATING INCOME decreased to $34,575,000 in 1992 from $42,889,000 in 1991, a decrease of $8,314,000 or 19.4%, primarily due to certain charges recorded in 1992, as more fully described above. Operating income before non-recurring charges and the effect of a change in estimated useful lives of buildings increased to $63,914,000 in 1992 from $50,841,000 in 1991 an increase of $13,073,000 or 25.7%. The net impact of these charges and adjustments on operating income for 1992 amounted to a net charge of $29,339,000 compared with $7,952,000 for 1991. As a percentage of total revenues, operating income decreased to 13.6% in 1992 from 17.8% in 1991. INTEREST INCOME decreased to $6,041,000 in 1992 from $8,442,000 in 1991, a decrease of $2,401,000 or 28.4% The decrease in interest income is primarily attributable to a $14,866,000 reduction in principal on the AEW Note in March 1992 and the corresponding reduction in interest earned thereon. INTEREST ON LONG-TERM DEBT decreased to $33,087,000 in 1992 from $38,713,000 in 1991, a decrease of $5,626,000 or 14.5%. The decrease in interest expense is related to the refinancing of approximately $42,000,000 in industrial revenue bond issues in 1992 and 1991 to obtain more favorable interest rates, the decline in the prime interest rate and the reduction of the average outstanding balance on the Company's Credit Facility due to improving operating cash flow. PARTNERS' EQUITY IN EARNINGS AND LOSSES increased to $15,081,000 in 1992 from $9,421,000 in 1991, an increase of $5,660,000 or 60.1%. The increase in partners' equity in earnings and losses is primarily attributable to a decrease in depreciation expense related to the change in building lives of properties owned by the combined partnerships and joint ventures from 30 years to 40 years and to the increase in earnings of the Development Partnership. As of December 31, 1992, the Development Partnership operated 28 inns compared to 26 inns as of December 31, 1991. Partners' equity in earnings and losses in 1992 was also impacted by a $1,214,000 adjustment to reallocate losses of a joint venture to the Company. NET GAIN (LOSS) ON PROPERTY AND INVESTMENT TRANSACTIONS increased to $282,000 in 1992 from a loss of ($1,012,000) in 1991. The majority of the 1991 loss was the result of write-downs on four properties partially offset by gains on three land condemnations. The Company's effective tax rate for 1992 was primarily affected by deferred tax benefits that had not been recognized related to certain charges incurred during the year. For the reasons discussed above, the Company reported a LOSS BEFORE EXTRAORDINARY ITEMS of ($7,796,000) in 1992 compared with the earnings before extraordinary items of $1,398,000 in 1991, a decrease of $9,194,000. The Company reported EXTRAORDINARY ITEMS, NET OF INCOME TAXES of ($958,000) in 1992 compared with ($1,269,000) in 1991. The extraordinary items reported in each period were primarily a result of the refinancing of three industrial revenue bond issues totaling $12,910,000 in principal in 1992 and nine industrial revenue bond issues totaling $28,950,000 in principal in 1991. Extraordinary items in 1992 also relate to the early extinguishment of the Company's 10% Convertible Subordinated Debentures due 2002. For the reasons discussed above, the Company reported a NET LOSS of ($8,754,000) in 1992 compared with net earnings of $129,000 in 1991, a decrease of $8,883,000. CAPITAL RESOURCES AND LIQUIDITY The Company has historically financed its development program through partnerships with financial institutions, a public debt offering and borrowings under the Company's Credit Facilities. During the years ended December 31, 1993 and 1992, the Company funded a majority of its development program through the Development Partnership. The Company's inns and adjacent restaurant land and buildings are substantially pledged to secure long-term debt of the Company. Distributions of cash, if any, from the Company's joint ventures and partnerships are made from cash available after payment of operating expenses, debt service, capital expenditures and acquisition and development of new inns. At December 31, 1993, the Company had $23,848,000 of cash and cash equivalents, an increase of $10,987,000 from December 31, 1992. The increase was due to the collection of $19,300,000 on AEW Partners' obligation to the Development Partnership in December 1993. In July 1993, the Company completed negotiations on a new $40,000,000 Secured Line of Credit and $30,000,000 Secured Term Credit Facility. On December 22, 1993, the Company completed negotiations on an additional $30,000,000 Secured Line of Credit which bore interest at the prime rate plus 1/2%. The additional Line of Credit matured upon the closing of the amendment to the $40,000,000 Secured Line of Credit and $30,000,000 Secured Term Credit Facility more fully discussed below. At December 31, 1993 the Company had approximately $31,380,000 available on its credit facility. In January 1994, the Company completed negotiations to amend the $40,000,000 Secured Line of Credit and increase the Secured Term Credit Facility from $30,000,000 to $145,000,000. Borrowings under the $40,000,000 secured line of credit, which will expire May 30, 1997 will be made at varying interest rates of LIBOR plus 1 3/4%, the prime rate, or certificate of deposit rate plus 1 7/8%. Borrowings under the $145,000,000 Secured Term Credit Facility, which will expire May 31, 2000, will be made through October 31, 1994 and will bear interest at varying interest rates of LIBOR plus 2%, the prime rate plus 1/4%, or certificate of deposit rate plus 2 1/8%. Amounts borrowed under the Secured Term Credit Facility will require semi-annual principal payments commencing November 30, 1994 through May 31, 2000. In February 1994, the Company used the Secured Term Credit Facility to retire $65,742,000 of 11.25% mortgage debt assumed through the acquisition of LQP, which would have matured in November 1994. As of February 28, 1994, the Company had $27,125,000 available on its credit facility. At December 31, 1993, the AEW Note to the Development Partnership had been fully collected. The Company anticipates that substantially all of its development activity in 1994 will occur through the Development Partnership by using the Partnership's available cash and cash from operations and that no distributions of cash will be made to partners. Net cash provided by operating activities increased to $77,364,000 in 1993 from $60,543,000 in 1992, an increase of $16,821,000 or 27.8%. The increase was due to increased inn revenues and an increase in accounts payable and accrued expenses due to the timing of payment. Net cash provided by operating activities increased to $60,543,000 in 1992 from $54,056,000 in 1991, an increase of $6,487,000 or 12.0%. The majority of the increase was due to an increase in inn revenues as a result of increased occupancy and average room rates. Net cash used by investing activities increased to $145,027,000 in 1993 from $15,166,000 in 1992, an increase of $129,861,000. The increase was related to the acquisition of LQP, the acquisition of partners' interest in 14 unincorporated joint ventures and partnerships, the acquisition of eleven inns and capital expenditures related to the Company's image enhancement program. Net cash used by investing activities decreased to $15,166,000 in 1992 from $35,083,000 in 1991, a decrease of $19,917,000 or 56.8%. This decrease resulted from no inns being acquired during 1992 compared to three inns and a partner's interest in an additional five inns in 1991. Net cash provided by financing activities was $78,650,000 in 1993 compared to net cash used by financing activities of ($40,471,000) in 1992. The increase in cash provided by financing activities was the result of the issuance of the 9 1/4% Senior Subordinated Notes due 2003, the collection of the AEW Note and the decrease in distributions to partners partially offset payments on long-term debt. Net cash used by financing activities increased to $40,471,000 in 1992 from $24,428,000 in 1991, an increase of $16,043,000 or 65.7%. This increase was primarily impacted by a reduction of the Company's average outstanding balance on the Credit Facility. COMMITMENTS In accordance with the unincorporated partnership or joint venture agreements executed by the Company, La Quinta is committed to advance funds necessary to cover operating expenses of a joint venture. In addition, four other unincorporated partnerships and joint ventures executed promissory notes in which the Company guaranteed to fund amounts not to exceed $4,985,000 in the aggregate. The estimated additional cost to complete the conversion and renovation of inns for which commitments have been made is $36,455,000 at December 31, 1993, of which includes amounts for the Company's image enhancement program that were in process or under contract. Funds on hand, committed and anticipated from cash flow are sufficient to complete these projects. The Company has undertaken a comprehensive chainwide image enhancement program intended to give its properties a new, fresh, crisp appearance while preserving their unique character. The program features new signage displaying a new logo as well as exterior and lobby upgrades including brighter colors, more extensive lighting, additional landscaping, enhanced guest entry and full lobby renovation with contemporary furnishings and seating area for continental breakfast. In the first quarter of 1993, the Company began its property and image enhancement program on the La Quinta inns it manages or owns. The Company anticipates that $36,379,000 will be needed to complete the project, including $27,493,000 related to work which was in process or under contract at December 31, 1993. The Company intends to fund its image enhancement program through funds generated from operations and available on its Credit Facility. The Company does not anticipate the funding of this program will have an adverse effect on its ability to fund its operations. Under the terms of a Partnership agreement between the Company and AEW Partners, the Company maintains a reserve for renovating, remodeling and conversion of the inns in the Development Partnership based on 5% of gross room revenue of the Partnership which includes certain amounts required by loan agreements. At December 31, 1993 and 1992 the Company had $3,833,000 and $3,920,000, respectively, of restricted cash which is classified as investments. In accordance with the requirements of an escrow agreement related to a pool of mortgage notes executed by the Company and a third party lender, the Company is required to make annual deposits into an escrow account for the purpose of establishing a reserve for the replacement of furnishings, fixtures and equipment used on or incorporated into the mortgaged properties. The Company shall be relieved of its obligation to make such annual deposits for any year in which the escrow account has an aggregate balance of $2,431,000. At December 31, 1993 and 1992, the Company had reserved $2,431,000 and $5,754,000, respectively. In 1993, the Company entered into a ten year operating lease for its corporate headquarters in San Antonio. In addition, the Company entered into a ten year lease in December 1993 to house the Company's reservation facilities. Funds on hand, anticipated from future cash flows and available on the Company's Credit Facility are sufficient to fund operating expenses, debt service and other capital requirements through at least the end of 1994. The Company will evaluate from time to time the necessity of other financing alternatives. SEASONALITY Demand, and thus room occupancy, is affected by normally recurring seasonal patterns and, in most La Quinta inns, is higher in the spring and summer months (March through August) than in the balance of the year. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". This Statement requires the use of the asset and liability method of accounting for deferred income taxes and was implemented in 1993. The impact of the Statement's implementation has been disclosed in note 4 of Notes to Combined Financial Statements. INFLATION The rate of inflation as measured by changes in the average consumer price index has not had a material effect on the revenues or net earnings (loss) of the Company in the three most recent years. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LA QUINTA INNS, INC. COMBINED BALANCE SHEETS (in thousands, except share data) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- See accompanying notes to combined financial statements. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- LA QUINTA INNS, INC. COMBINED BALANCE SHEETS (in thousands, except share data) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- See accompanying notes to combined financial statements. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- LA QUINTA INNS, INC. COMBINED STATEMENTS OF OPERATIONS (in thousands, except per share data) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- See accompanying notes to combined financial statements. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- LA QUINTA INNS, INC. COMBINED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- See accompanying notes to combined financial statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. COMBINED STATEMENTS OF CASH FLOWS (in thousands) - ---------------------------------------------------------------------------- See accompanying notes to combined financial statements. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS AND BASIS OF PRESENTATION The Company develops, owns and operates inns. The combined financial statements include the accounts of subsidiaries (all wholly-owned) and unincorporated partnerships and joint ventures in which the Company has at least a 40% interest and exercises substantial legal, financial and operational control. All significant intercompany accounts and transactions have been eliminated in combination. Investments in other unconsolidated affiliates in which the Company has less than a 40% ownership interest and over which the Company has the ability to exercise significant influence are accounted for using the equity method. Certain reclassifications of prior period amounts have been made to conform with the current period presentation. PARTNERS' CAPITAL Partners' capital at December 31, 1992 is shown net of a $35,908,000 note receivable to La Quinta Development Partners, L.P. ("LQDP" or the "Development Partnership") representing a portion of the initial capital contribution to LQDP by AEW Partner's L.P. Collections on this note are reflected as an increase to partners' capital. In 1993, the outstanding balance of this note was fully collected. PROPERTY AND EQUIPMENT Depreciation and amortization of property and equipment for 1993 and 1992 are computed using the straight-line method over the following estimated useful lives: Buildings............................................ 40 years Furniture, fixtures and equipment.................... 4-10 years Leasehold and land improvements...................... 10-20 years Maintenance and repairs are charged to operations as incurred. Expenditures for improvements are capitalized. During the third quarter of 1992, the Company changed the estimated useful lives of its buildings from 30 years to 40 years effective January 1, 1992, based on a review of the depreciable lives of its assets. CASH EQUIVALENTS All highly liquid investments with a maturity of three months or less at the date of acquisition are considered cash equivalents. DEFERRED CHARGES Deferred charges consist primarily of issuance costs related to Senior Subordinated Notes due 2003, Industrial Development Revenue Bonds ("IRB"), loan fees, preopening and organizational costs. Issuance costs are amortized over the life of the related debt using the interest method. Preopening costs are amortized over two years, organizational costs over five years and loan fees over the respective terms of the loans using the straight-line method. SELF-INSURANCE PROGRAMS The Company uses a paid loss retrospective self-insurance plan for general and auto liability and workers' compensation. Predetermined loss limits have been arranged with insurance companies to limit the Company's per occurrence cash outlay. - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- The Company maintains a self-insurance program for major medical and hospitalization coverage for employees and dependents which is partially funded by payroll deductions. Payments for major medical and hospitalization to individual participants less than specified amounts are self-insured by the Company. Claims for benefits in excess of these amounts are covered by insurance purchased by the Company. Provisions have been made in the combined financial statements which represent the expected future payments based on estimated ultimate cost for incidents incurred through the balance sheet date. INCOME TAXES Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using currently enacted tax rates in effect for the years in which the differences are expected to reverse. In 1993, the Company recorded an adjustment to income of $1,500,000 which represents the net decrease of the deferred tax liability at January 1, 1993. Such amount has been reflected in the combined statement of operations for the year ended December 31, 1993 as the cumulative effect of an accounting change. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. The deferred method under APB Opinion 11 was applied in 1992 and prior years. EARNINGS (LOSS) PER SHARE Earnings (loss) per share are computed on the basis of the weighted average number of common and common equivalent (dilutive stock options) shares outstanding in each year after giving retroactive effect to the stock splits effected as stock dividends as discussed in note 5 of these Combined Financial Statements. Shares of the Company's common stock issuable upon conversion of the Development Partnership Units are antidilutive at December 31, 1993 and prior years. Primary and fully diluted earnings (loss) per share are not significantly different. PROPERTIES HELD FOR SALE Properties held for sale are stated at the lower of cost or estimated net realizable value. Charges to reduce the carrying amounts of properties held for sale to estimated net realizable value are recognized in income. The Company recorded charges of $9,926,000 in 1992 and $2,145,000 in 1991 in the statements of operations related to the write-down of properties held for sale. At December 31, 1993, the Company had a $40,000,000 Secured Line of Credit, renegotiated in July 1993, and a $30,000,000 Secured Term Credit Facility with participating banks. On December 22, 1993, the Company completed negotiations on an additional $30,000,000 Secured Line of Credit which bore interest at the prime rate plus 1/2%. At December 31, 1993, the Company had $31,380,000 available on its Secured Term and Line of Credit. In January 1994, the Company completed negotiations to amend the $40,000,000 Secured Line of Credit and increase its Secured Term Credit Facility from $30,000,000 to $145,000,000. Borrowings under the $40,000,000 Secured Line of Credit, which will expire May 30, 1997 will be made at varying interest rates of LIBOR plus 1 3/4%, the prime rate, or certificate of deposit rate plus 1 7/8%. Borrowings under the $145,000,000 Secured Term Credit Facility, which will expire May 31, 2000, will be made through October 31, 1994 and will bear interest at varying interest rates of LIBOR plus 2%, the prime rate plus 1/4%, or certificate of deposit rate plus 2 1/8%. Amounts borrowed under the Secured Term Credit Facility will require semi-annual principal payments commencing November 30, 1994 through May 31, 2000. The Company pays a commitment fee of .5% per annum on the undrawn portion of the credit line. The annual maturities reflect the payment terms of the amended and restated Secured Line of Credit and Secured Term Credit Facility. Commitment fees totaled $164,000, $105,000 and $71,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Annual maturities for the four years subsequent to December 31, 1994 are as follows: Interest paid during the years ended December 31, 1993, 1992 and 1991 amounted to $27,913,000, $32,523,000 and $38,320,000, respectively. In December 1993, the Company assumed the outstanding mortgage notes payable of La Quinta Motor Inns Master Limited Partnership ("LQP") totaling $65,962,000 (see note 14). The notes bear interest at 11 1/4% and mature on November 1, 1994. Subsequent to December 31, 1993, the Company paid off the entire outstanding balance with proceeds from its renegotiated Secured Term Credit Facility. In 1993, the Company recognized an extraordinary loss of $986,000 ($602,000 net of income taxes) related to the prepayment fees for the early retirement of this debt. In 1993, the Company completed an offering of $120,000,000 in principal amount of 9 1/4% Senior Subordinated Notes due 2003. The proceeds of the financing and the Secured Term Credit Facility were used to partially fund the acquisitions of partners' interests in certain consolidated partnerships and joint ventures and to prepay approximately $106,000,000 of existing indebtedness. In addition, the Company refinanced three issues of IRBs totaling $11,200,000 in 1993. In 1992, the Company refinanced three issues of IRBs totaling $12,910,000 and retired its 10% Convertible Subordinated Debentures due 2002. The Company reported extraordinary items, net of income taxes, of $3,062,000 and $958,000 in 1993 and 1992, respectively, related to these refinancings and retirements. In May 1993, the Company conveyed title to the property in which its corporate headquarters was located to the lender holding a $10.1 million non-recourse mortgage on the property. Completion of this transaction resulted in the elimination of the liability for the non-recourse mortgage on the Company's balance sheet. The Company recognized a loss on property transactions of $4,900,000 related to the write-down of the property to its estimated fair value and an extraordinary gain of $4,991,000, $3,045,000 net of income taxes, for the difference between the carrying amount of the debt and the estimated fair value of the building. The Company is obligated by agreements relating to seventeen issues of IRBs in an aggregate amount of $55,515,000 to purchase the bonds at face value prior to maturity under certain circumstances. The bonds have floating interest rates which are indexed periodically. Bondholders may, when the rate is changed, put the bonds to the designated remarketing agent. If the remarketing agent is unable to resell the bonds, it may draw upon an irrevocable letter of credit which secure the IRBs. In such event, the Company would be required to repay the funds drawn on the letters of credit within 24 months. As of December 31, 1993 no draws had been made upon any such letters of credit. The schedule of annual maturities shown above includes these IRBs as if they will not be subject to repayment prior to maturity. Assuming all bonds under such IRB arrangements are presented for payment prior to December 31, 1994 and the remarketing agents are unable to resell such bonds, the maturities of long-term debt shown above would increase by $42,210,000 for the year ending December 31, 1995. In January 1992, the Company entered into several five year interest rate swap agreements with a commercial bank in order to manage exposure to fluctuations in interest rates on certain floating rate long-term obligations. The agreement effectively changes the Company's interest rate exposure on approximately $39,050,000 and $13,218,000 of certain floating rate IRBs outstanding at December 31, 1993 to fixed rates of 5.26% and 6.5%, respectively. Net payments or receipts due under these agreements are included as adjustments to interest expense. The Company is exposed to credit loss in the event of nonperformance by the other party to the interest rate swap agreements, however, the Company does not anticipate nonperformance by the counterparty. The Secured Line of Credit, Secured Term Credit Facility and certain agreements associated with IRBs are governed by a uniform covenant agreement. The most restrictive covenants preclude the following: payment of cash dividends in excess of defined limits, limitations on the incurrence of debt, mergers, sales of substantial assets, loans and advances, certain investments or any material changes in character of business. The agreement contains provisions to limit the total dollar amounts of certain investments and capital expenditures. The Company's 9 1/4% Senior Subordinated Notes are governed by a Trust Indenture dated May 15, 1993. The Trust Indenture contains certain covenants for the benefit of holders of the notes, including, among others, covenants placing limitations on the incurrence of debt, dividend payments, certain investments, transactions with related persons, asset sales, mergers and the sale of substantially all the assets of the Company. At December 31, 1993, the Company was in compliance with all restrictions and covenants. (3) UNINCORPORATED VENTURES AND PARTNERSHIPS Summary financial information with respect to unincorporated ventures and partnerships included in the combined financial statements follows. In 1993 the Company acquired several unincorporated ventures and partnerships which are included in the December 1992 financial information for the balance sheet and statement of operations which are not included in the balance sheet at December 31, 1993 or statement of operations for a full year in 1993. LQP was not included in the balance sheet or income statement for 1992, however, as a result of the acquisition of Units by the Company the financial information below includes assets and liabilities at December 31, 1993 and operations for the month of December 31, 1993 (also see note 14): (4) INCOME TAXES As discussed in note 1, the Company adopted SFAS 109 effective January 1, 1993. Income tax expense attributable to income from continuing operations consists of: The effective tax rate varies from the statutory rate for the following reasons: The following are cash transactions relating to the Company's income taxes: For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of income and expense for income tax and financial reporting purposes. The sources and tax effects of those timing differences are presented below: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of December 31, 1993 are presented below: LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The valuation allowance at December 31, 1993 represents the tax benefit of certain future deductible amounts which are not expected to offset future taxable amounts resulting from the reversal of existing taxable temporary differences. The Company anticipates that the reversal of existing taxable temporary differences will provide sufficient taxable income to realize the tax benefits of the remaining deferred tax assets. The valuation allowance decreased by $6,816,000, principally as a result of the acquisition of a substantial portion of the units of the La Quinta Motor Inns Limited Partnership as more fully described in Note 14 of these notes to Combined Financial Statements. At December 31, 1993, the Company had targeted jobs tax credit carryforwards for Federal income tax purposes of approximately $411,000 (expiring 2007 through 2009) which are available to reduce future Federal income taxes. In addition, the Company had alternative minimum tax credit carryforwards of approximately $2,781,000 which are available to reduce future regular Federal income taxes over an indefinite period. (5) SHAREHOLDERS' EQUITY The Board of Directors authorized three-for-two stock splits effective in October 1993 and March 1994. Earnings per share, the weighted average number of shares outstanding, shareholders' equity and the following information have been adjusted to give effect to each of these distributions. In January 1994, the Company announced that its Board of Directors authorized the purchase of up to $10,000,000 of its common stock. Such purchases would be made from time to time in the open market as deemed appropriate by the Company. The Company's stock option plans cover the granting of options to purchase an aggregate of 6,155,996 common shares. Options granted under the plans are issuable to certain officers, certain employees and Board Members generally at prices not less than fair market value at date of grant. Options are generally exercisable in four equal installments on successive anniversary dates of the date of grant and are exercisable thereafter in whole or in part. Outstanding options not exercised expire ten years from the date of grant. Upon exercise, the excess of the option price received over the par value of the shares issued, net of expenses and including the related income tax benefits, is credited to additional paid-in capital. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- In 1993, the Company recognized compensation expense of $4,407,000 related to performance stock options for the difference between the option price at the date of grant and a predetermined level when it became probable that the Company's stock would trade at that predetermined level. Beginning in 1992, the Company recognized $367,000 in compensation expense for the difference between the market price and option price on date of grant related to a portion of these options which vested in annual increments. Under the terms of the La Quinta Development Partners, L.P. ("LQDP" or the "Development Partnership") partnership agreement, AEW Partners, L.P. ("AEW Partners") has the ability to convert 66 2/3% of its 60% ownership in the Development Partnership currently to 3,535,976 shares (post-split) of the Company's common stock after giving retroactive effect to the stock splits effected as stock dividends. Shares of the Company's common stock issuable upon conversion of the Development Partnership Units are antidilutive at December 31, 1993. AEW partner's units in LQDP may be converted over the seven year period beginning December 31, 1991. As of December 31, 1993, AEW Partners had not converted any of its ownership in the Development Partnership into the Company's common stock. (6) PENSION PLAN The Retirement Plan and Trust of La Quinta Inns, Inc. (the "Plan") is a defined benefit pension plan covering all employees. The Plan was amended in 1993 to allow highly compensated employees to rejoin the Retirement Plan as active participants. Benefits accruing under the Plan are determined according to a career average benefit formula which is integrated with Social Security benefits. For each year of service as a participant in the Plan, an employee accrues a benefit equal to one percent of his or her annual compensation plus .65 percent of compensation in excess of the Social Security covered compensation amount. The Company's funding policy for the Retirement Plan is to annually contribute the minimum amount required by federal law. The Supplemental Executive Retirement Plan and Trust ("SERP") continues to cover a select group of management employees. Benefits under the SERP are determined by a formula which considers service and total compensation; the results of the formula-derived benefit are then reduced by the participant's pension entitlement from the qualified Retirement Plan. In accordance with the provisions of Statement of Financial Standards No. 87 - - Employer's Accounting for Pensions, the Company has recorded an additional minimum liability of $4,092,000 at December 31, 1993. This provision represents the excess of the accumulated benefit obligation over the fair value of plan assets and accrued pension liability at the measurement date. An amount of $1,702,000 was recognized as an intangible asset to the extent of unrecognized prior service cost and the balance of $2,390,000 ($1,458,000 net of income tax) is recorded as a reduction of shareholders' equity. The following table sets forth the funded status and amounts recognized in the Company's combined financial statements for the Plan at December 31, 1993 and 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following table sets forth the funded status of the SERP and amounts recognized in the Company's financial statements for the SERP: At December 31, 1993, the Company had accumulated $1,144,000 in a trust account intended for use in settling benefits due under the SERP. These funds, which are included in investments on the accompanying balance sheets, are not restricted for the exclusive benefit of SERP participants and their beneficiaries. The SERP funds are invested primarily in equity investments. However, in the event of a change in the Company's control, as defined, such funds would become restricted for the exclusive benefit of SERP participants and their beneficiaries. Net pension cost includes the following components: The assumptions used in the calculations shown above were: (7) OPERATING LEASES LESSEE The Company leases a portion of the real estate and equipment used in operations. Certain ground lease arrangements contain contingent rental provisions based upon revenues and also contain renewal options at fair market values at the conclusion of the initial lease terms. In 1993, the Company entered into two ten year operating leases for its corporate headquarters in San Antonio and its reservation facilities. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Future annual minimum rental payments required under operating leases that have initial or remaining noncancellable lease terms in excess of one year at December 31, 1993 follow: Total rental expense for operating leases was $2,840,000, $1,976,000 and $2,359,000 for the years ended December 31, 1993, 1992 and 1991, respectively. LESSOR The Company leases 107 restaurants it owns to third parties. The leases are accounted for as operating leases expiring during a period from 1994 to 2016 and provide for minimum rentals and contingent rentals based on a percentage of annual sales in excess of stipulated amounts. The following is a summary of restaurant property leased at December 31, 1993. Minimum future rentals to be received under the noncancellable restaurant leases in effect at December 31, 1993 follow: Contingent rental income amounted to $811,000, $854,000, and $669,000 for the years ended December 31, 1993, 1992 and 1991, respectively. (8) NON-RECURRING, CASH AND NON-CASH CHARGES During 1992, the Company recognized charges of $39,751,000 ($27,946,000 net of income taxes and partners' equity) resulting from certain changes being made in the Company's operations and organization based on a review by the Company's senior management team. Of those charges, $28,383,000 relate to the write-down of certain joint venture interests, land, computer equipment, and other assets. During the third quarter of 1992, the senior management team re-evaluated the Company's investments in joint venture arrangements and shortly thereafter completed negotiations that resulted in amendments to the agreements related to certain joint venture arrangements and the write-down of the Company's investments in those ventures. The write-down of the land, computer equipment and other assets resulted - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- primarily from the Company's decisions to sell certain land that had previously been held for future development and to replace the Company's existing computer systems and certain other assets. In addition, the Company recognized $6,936,000 and $4,097,000 for the years ended December 31, 1992 and 1991, respectively, in severance and other employee related charges. Those charges relate to severance benefits for certain terminated employees, costs of hiring and relocating new management and other employee related costs resulting from personnel changes. The remaining $4,432,000 of the charges recognized in 1992 affected various corporate expenses and partners' equity in earnings and losses. (9) COMMITMENTS In accordance with the unincorporated partnership or joint venture agreements executed by the Company, La Quinta is committed to advance funds necessary to cover operating expenses of a joint venture. In addition, four other unincorporated partnerships and joint ventures executed promissory notes in which the Company guaranteed to fund amounts not to exceed $4,985,000 in aggregate. The estimated additional cost to complete the conversion and renovation of inns for which commitments have been made is $36,455,000 at December 31, 1993, which includes amounts for the Company's image enhancement program that were in process or under contract. Funds on hand, committed and anticipated from cash flow are sufficient to complete these projects. The Company has undertaken an image enhancement program intended to give its properties a new, fresh, crisp appearance while preserving their unique character. The program features new signage displaying a new logo as well as exterior and lobby upgrades including brighter colors, additional landscaping, enhanced guest entry and full lobby renovation with contemporary furnishings and seating area for continental breakfast. In the first quarter of 1993, the Company began its property and image enhancement program on its La Quinta inns it manages or owns. The Company anticipates that an additional $36,687,000 will be needed to complete the project, including $27,493,000 related to work which was in process or under contract at December 31, 1993. The Company intends to fund its image enhancement program through funds generated from operations and available on its Credit Facility. The Company does not anticipate the funding of this program will have an adverse effect on its ability to fund its operations. Under the terms of a Partnership agreement between the Company and AEW Partners, the Company maintains a reserve for renovating, remodeling and conversion of the inns in the Development Partnership based on 5% of gross room revenue of the Partnership which includes certain amounts required by loan agreements. At December 31, 1993 and 1992 the Company had $3,833,000 and $3,920,000, respectively, of restricted cash which is classified as investments. In accordance with the requirements of an escrow agreement related to a pool of mortgage notes executed by the Company and a third party lender, the Company is required to make annual deposits into an escrow account for the purpose of establishing a reserve for the replacement of furnishings, fixtures and equipment used on or incorporated into the mortgaged properties. The Company shall be relieved of its obligation to make such annual deposits for any year in which the escrow account has an aggregate balance of $2,431,000. At December 31, 1993 and 1992, the Company had reserved $2,431,000 and $5,754,000, respectively. (10) CONTINGENCIES LITIGATION In connection with the Company's tender offer for the units of limited partnership interest of LQP (see note 14), two separate lawsuits were filed in Delaware Court of Chancery on behalf of the Partnership's unitholders against the Company, the Partnership, La Quinta Realty Corp., a subsidiary of the Company, and general partner of the Partnership (the "General Partner") and certain directors and officers of the General Partner. On October 27, 1993, the parties reached a settlement in principle in these actions. The settlement is subject to certain - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- conditions, including court approval. On March 15, 1994, the Delaware Court of Chancery entered an Order and Final Judgment ("Judgment") which approved the settlement and dismissed the cases. All persons and entities who were owners of Units of the Partnership at October 18, 1993 and their transferees and successors in interest, immediate and remote (the "Class"), are bound by the Judgment. The Company and all other defendants were discharged from any and all liability under any claims which were or could have been brought by plaintiffs or any member of the Class regarding the acquisition and merger of the Partnership. The appeal period on the Judgment will run on April 14, 1994. In September 1993, a former officer of the Company filed suit against the Company and certain of its directors and their affiliate companies. The suit alleges breach of an employment agreement, misrepresentation, wrongful termination, self-dealing, breach of fiduciary duty, usurpation of corporate opportunity and tortious interference with contractual relations. The suits seeks compensatory damages of $2,500,000 and exemplary damages of $5,000,000. The Company intends to vigorously defend against this suit. The Company is also party to various lawsuits and claims generally incidental to its business. The ultimate disposition of these and the above discussed matters are not expected to have a significant adverse effect on the Company's financial position or results of operations. SEVERANCE AND EMPLOYMENT AGREEMENT The Company entered into a five year employment agreement which includes a severance provision granting the executive the right to receive certain benefits, including among others, 3.0 times annual base salary and bonus if there occurs a termination (as defined in the agreement) within the five year term of the agreement, or resignation (as defined in the agreement). The maximum contingent liability under the severance provisions of this agreement is $1,627,000. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (11) QUARTERLY FINANCIAL DATA (UNAUDITED) The unaudited combined results of operations by quarter are summarized below: In the fourth quarter of 1993, the Company recorded an adjustment of $1,273,000 ($777,000 net of income taxes) to decrease its expense related to the self- insurance program for major medical and hospitalization coverage due to decreases in actual claims and estimates of incurred but not reported claims. (12) RELATED PARTY TRANSACTIONS LQM OPERATING PARTNERS, L.P. In October 1986, the Company sold 31 inns to LQM Operating Partners, L.P. ("the Operating Partnership") which is owned and controlled by La Quinta Motor Inns Limited Partnership ("LQP"), a publicly traded master limited partnership. At December 31, 1992, approximately $1,425,000 net of partners' equity, remained deferred on this sale associated with debt assumed by the Partnership. A pre-tax gain on sale of assets of approximately $230,000, $220,000 and $592,000, net of partners' equity, related to this transaction was recognized in the years ended December 31, 1993, 1992 and 1991. The deferred gain balance remaining at December 1, 1993 was treated as a purchase price adjustment upon LQI Acquisition Corporation's acquisition of approximately 82% of the units of limited partnership interest in the LQP. (See note 14 to Combined Financial Statements). - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- MANAGEMENT SERVICES FEE All inns owned by LQP (through November 30, 1993) and by the two joint ventures (the "Ventures") between the Company and investment partnerships managed by CIGNA Investments, Inc. (collectively the "Managed Inns") operate under the La Quinta name and are managed by the Company in accordance with long-term management agreements. The Company earns management and licensing fees as well as fees for chain services such as bookkeeping, national advertising and reservations. OTHER RECURRING TRANSACTIONS La Quinta pays all direct operating expenses on behalf of the partnerships and ventures and is reimbursed for all such payments. EMPLOYMENT AGREEMENT In October 1991, the Company and its Chairman of the Board entered into an Employment Agreement (the "Employment Agreement"), providing for his employment as the Chairman of the Board of the Company for five years from the date thereof. Under the terms of the Employment Agreement, he is entitled to receive as compensation certain benefits, including, among others, (i) an annual base salary, (ii) incentive compensation awards as a result of his participation in the Company's long-term and short-term incentive bonus plans or programs, and (iii) the amount of $2,200,000, which was treated as prepaid compensation for financial statement purposes. The Employment Agreement generally provides that 20% of the prepaid compensation is earned on each anniversary thereof, with the exception that in the case of the executive's (a) voluntary resignation (except for a voluntary resignation within one year following a change in control or after a constructive termination without cause) or (b) termination for cause, then the remaining unamortized balance will become due and payable over the remaining term in equal monthly installments. As a result of changes in management and reorganization of duties, the remaining compensation of $1,760,000 related to this Employment Agreement was included in the 1992 non-recurring cash and non-cash charges, described in note 8 to these Combined Financial Statements. In March 1994 the Chairman retired from the Company and resigned from the Board of Directors and received certain compensation and benefits as defined in the Employment Agreement. (13) FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the value of each class of financial instruments for which it is practical to estimate that value: CASH AND CASH EQUIVALENTS For those short-term instruments, the carrying amount is a reasonable estimate of fair value. NOTES RECEIVABLES The carrying value for notes receivable approximates the fair value based on the estimated underlying value of the collateral. INVESTMENTS The fair value of some investments is estimated based on quoted market prices for these or similar investments. For other securities, the carrying amount is a reasonable estimate of fair value. LONG-TERM DEBT The fair value of the Company's long-term debt is estimated based on the current market prices for the same or similar issues or on the current rates available to the Company for debt of the same maturities. INTEREST RATE SWAP AGREEMENTS The fair value of interest rate swap agreements represents the estimated amount the Company would pay to terminate the agreements, taking into consideration current interest rates and the current creditworthiness of the counterparties. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTAS INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The estimated fair values of the Company's financial instruments are summarized as follows: (14) ACQUISITION OF PARTNERS' INTERESTS On October 27, 1993, the Company entered into a definitive Partnership Acquisition Agreement (the "Merger Agreement") with La Quinta Motor Inns Limited Partnership ("the Partnership" or "LQP") and other parties, pursuant to which the Company, through wholly-owned subsidiaries, would acquire all units of the Partnership (the "Units") that it did not beneficially own at a price of $13.00 net per Unit in cash. The Merger Agreement provided for a tender offer (the "Offer") for all of the Partnership's outstanding Units at a price of $13.00 net per Unit in cash, which Offer commenced on November 1, 1993 and expired at midnight on November 30, 1993. The Offer resulted in the purchase of 2,805,190 Units (approximately 70.6% of the outstanding Units) by the Company through its wholly-owned subsidiary, LQI Acquisition Corporation. As a result of a contribution of additional units previously owned by the Company subsequent to the Offer, LQI Acquisition Corporation beneficially owned 3,257,890 Units (approximately 82% of the Units) at December 31, 1993. Pursuant to the Merger Agreement, a Special Meeting of Unitholders was then held on January 24, 1994 to approve the merger of a subsidiary of LQI Acquisition Corporation with and into the Partnership, with the Partnership as the surviving entity. As a result of this merger which was approved by the requisite vote of Unitholders on January 24, 1994, all of the Partnership's outstanding Units other than Units owned by the Company or any direct or indirect subsidiary of the Company were converted into the right to receive $13.00 net in cash without interest. The acquisition has been accounted for as a purchase and the results of LQP's operations have been included in the Company's combined results of operations since December 1, 1993. LQI Acquisition Corporation obtained funds to acquire the Units as a result of a capital contribution by La Quinta. In order to make such a capital contribution to LQI Acquisition Corporation, the Company borrowed approximately $45.9 million under its existing credit facility as more fully described in note 2. During 1993, the Company purchased in separately negotiated transactions, the limited partners' interests in 14 of the Company's combined unincorporated partnerships and joint ventures, which own 44 inns, for an aggregate price of $87,897,000 which included cash at closing, the assumption of $22,824,000 of existing debt attributable to the limited partners' interest, and $29,878,000 of notes to the sellers. The Company was the general partner and owned the remainder of the ownership interests in each of these partnerships and ventures. The Company intends to continue to operate the properties as La Quinta inns. The following unaudited pro forma information reflects the combined results of operations of the Company as if the acquisition of the 82% interest in LQP and the limited partners' interests in the 14 combined partnerships and joint ventures had occurred at the beginning of 1993 and 1992. The pro forma information gives effect to certain adjustments, including additional depreciation expense on property and equipment based on their fair values, increased interest expense on additional debt incurred, elimination of related party revenues and expenses, and extraordinary losses on early extinguishment of debt. The pro forma results are not necessarily indicative of operating results that would have occurred had the acquisitions been consummated as of the beginning of 1993 and 1992, nor are they necessarily indicative of future operating results. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LA QUINTA INNS, INC. NOTES TO COMBINED FINANCIAL STATEMENTS - (Continued) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders La Quinta Inns, Inc.: We have audited the combined balance sheets of La Quinta Inns, Inc. as of December 31, 1993 and 1992 and the related combined statements of operations, shareholders' 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 combined financial statements, we also have audited the financial statement schedules as listed in Item 14(a)(2) of Form 10-K. These combined financial statements and financial statement schedules are the responsibility of the Company'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 La Quinta Inns, Inc. 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 Note 1 to the combined financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 in 1993. KPMG PEAT MARWICK San Antonio, Texas January 31, 1994, except as to the first paragraph of note 5, which is as of February 9, 1994 Schedule V LA QUINTA INNS, INC. Property, Plant and Equipment (in thousands) Schedule VI LA QUINTA INNS, INC. Accumulated Depreciation and Amortization of Property, Plant and Equipment (in thousands) Schedule X LA QUINTA INNS, INC. Supplemental Income Statement Information (in thousands) 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 (A) DIRECTORS OF REGISTRANT There is incorporated in this Item 10 by reference that portion of the Company's definitive Proxy Statement, dated on or about April 15, 1994, which Registrant intends to file not later than 120 days after the end of the fiscal year covered by this Form 10-K, appearing under the captions "Election of Directors," and "Meetings and Committees of the Board of Directors." (B) EXECUTIVE OFFICERS OF THE REGISTRANT Certain information is set forth below concerning the executive officers of the Company, each of whom has been elected to serve until the regular annual meeting of the Board of Directors following the next Annual Meeting of Shareholders and until his/her successor is duly elected and qualified. Gary L. Mead 46 President and Chief Executive Officer and Director Michael A. Depatie 37 Sr. Vice President - Finance, Chief Financing Officer William C. Hammett, Jr. 47 Sr. Vice President - Accounting & Administration Thomas W. Higgins 46 Sr. Vice President - Operations R. John Kaegi 45 Sr. Vice President - Marketing Steven T. Schultz 47 Sr. Vice President - Development John F. Schmutz 46 Vice President - General Counsel and Secretary Gary L. Mead has been Director, President and Chief Executive Officer of the Company since March 1992. He served as Executive Vice President - Finance of Motel 6 G.P., Inc., the managing general partner of Motel 6, L.P., from October 1987 to January 1991. Michael A. Depatie has been Senior Vice President - Finance, Chief Financing Officer of the Company since July 1992. He served as Senior Vice President, Summerfield Hotel from May 1989 to July 1992. He served as Managing General Partner of PacWest Capital Partners from April 1988 to April 1989. He served as Vice President - Finance of The Residence Inn Company from July 1984 to July 1986 and Senior Vice President - Finance from July 1986 to March 1988. William C. Hammett, Jr. has been Senior Vice President - Accounting and Administration since June 1992. He served as Executive Vice President - Finance of Motel 6 G.P., Inc., from February 1991 to June 1992. He served as Vice President-Controller of Motel 6 G.P., Inc. from September 1988 to February 1991. He served as Controller of Spartan Food Systems from August 1973 to September 1988. Thomas W. Higgins has been Senior Vice President - Operations of the Company since September 1992. He served as Vice President - Human Resources of the Company from June 1992 to September 1992. He served as Vice President - Human Resources of Motel 6 G.P., Inc. from May 1988 to June 1992. He served as Director of Training/Employment of General Mills from October 1986 to May 1988. R. John Kaegi has been Senior Vice President - Marketing of the Company since July 1992. He served as Senior Vice President - Marketing and Strategic Planning of KinderCare Learning Centers, Inc. from December 1989 to July 1992. He served as Vice President - Marketing of KinderCare Learning Centers, Inc. from July 1987 to December 1989. He served as Director Field Marketing of Holiday Inns, Inc. from November 1985 to July 1987. Steven T. Schultz has been Senior Vice President - Development of the Company since June 1992. He served as Senior Vice President - Development of Embassy Suites from October 1986 to June 1992. John F. Schmutz has been Vice President - General Counsel and Secretary of the Company since June 1992. He served as Vice President - General Counsel of Sbarro, Inc. from May 1991 to June 1992. He served as Vice President - Legal of Hardee's Food Systems, Inc. from April 1983 to May 1991. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There are incorporated in this Item 11 by reference those portions of the Company's definitive Proxy Statement, dated on or about April 15, 1994, which Registrant intends to file not later than 120 days after the end of the fiscal year covered by this Form 10-K, appearing under the captions "Executive Compensation," "Compensation Pursuant to Plans," "Other Compensation," "Compensation of Directors," and "Termination of Employment and Change of Control Arrangements." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There are incorporated in this Item 12 by reference those portions of the Company's definitive Proxy Statement, dated on or about April 15, 1994, which Registrant intends to file not later than 120 days after the end of the fiscal year covered by this Form 10-K, appearing under the captions "Principal Shareholders" and "Security Ownership of Management". ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is incorporated in this Item 13 by reference that portion of the Company's definitive Proxy Statement, dated on or about April 15, 1994, which Registrant intends to file not later than 120 days after the end of the fiscal year covered by this Form 10-K, appearing under the caption "Certain Relationships and Related Transactions." 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 Combined Financial Statements of the Company appearing in Item 8 are as follows: Combined Balance Sheets at December 31, 1993 and 1992 Combined Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Combined Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Combined Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Combined Financial Statements Independent Auditors' Report on financial statements and schedules (2) Financial Statement Schedules Schedule V - Property, Plant and Equipment - For the years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment - For the years ended December 31, 1993, 1992 and 1991. Schedule X - Supplemental Income Statement Information-For the years ended December 31, 1993, 1992 and 1991. All other schedules for which provision is made in the applicable regulation to the Securities and Exchange Commission are not required under the related instructions or are inapplicable and have been omitted. (3) The following exhibits are filed as a part of this Report: (3)(a) Restated Articles of Incorporation of La Quinta Inns, Inc., as amended on May 21, 1993. (8) (3)(b) Amended and Restated By-Laws of La Quinta Inns, Inc. (1) (10)(a) La Quinta Inns, Inc. 1978 Non-Qualified Stock Option Plan, as amended. (2) (10)(b) La Quinta Inns, Inc. 1984 Stock Option Plan. (3) (10)(c) Amendment No. 1 to La Quinta Inns, Inc. 1984 Stock Option Plan. (4) (10)(d) Amendment No. 2 to La Quinta Inns, Inc. 1984 Stock Option Plan. (5) (10)(e) Amended and Restated La Quinta Inns, Inc. 1984 Stock Option Plan, as of November 21, 1991. (1) (10)(f) La Quinta Development Partners, L.P. Amended and Restated Agreement of Limited Partnership, dated March 21, 1990, by and between Registrant and AEW Partners, L.P. (6) (10)(g) La Quinta Development Partners, L.P. Contribution Agreement, dated March 21, 1990, by and between Registrant and AEW Partners, L.P. (6) (10)(h) Management and Development Agreement by and between Registrant and La Quinta Development Partners, L.P., dated March 21, 1990. (6) (10)(i) Supplemental Executive Retirement Plan and Trust Agreement of Registrant, dated April 20, 1990, by and between Registrant and Frost National Bank. (7) (10)(j) La Quinta Inns, Inc. Deferred Compensation Plan, effective June 1, 1987. (7) (10)(k) Form of Bonus Agreement dated February 22, 1991, by and between Registrant and each of Messrs. Sam Barshop, David B. Daviss, Alan L. Tallis and Francis P. Bissaillon. (7) (10)(l) Form of Indemnification Agreement, made and entered into as of November 15, 1990 and thereafter (with respect to persons who became directors of Registrant after such dates), by and between Registrant and each of its directors. (7) (10)(m) Form of Indemnification Agreement, made and entered into as of November 15, 1990 and thereafter (with respect to persons who became directors of Registrant after such dates), by and between Registrant and each of its officers. (7) (10)(n) Registration Rights Agreement, dated as of July 31, 1991 by and between Registrant and Sam Barshop and his wife, Ann Barshop. (1) (10)(o) Employment Agreement, dated as of October 1, 1991, by and between Registrant and Sam Barshop. (1) (10)(p) Employment Agreement, dated as of March 3, 1992, by and between Registrant and Gary L. Mead. (1) (10)(q) Non-Qualified Stock Option Agreement, dated as of March 3, 1992, between Registrant and Gary L. Mead. (1) (10)(r) Registration Rights Agreement, dated as of March 3, 1992, between Gary L. Mead. (1) (10)(s) Second Amended and Restated Master Convenant Agreement dated June 15, 1993. (8) (10)(t) $126,795,786.64 Credit Agreement dated June 15, 1993. (8) (10)(u) Indenture dated May 15, 1993 Re: $120,000,000 9 1/4% Senior Subordinated Notes due 1003. (8) (10)(v) Partnership Acquisition Agreement dated October 27, 1993, among the Partnership, the General Partner, La Quinta, LQI Acquisition Corporation and LQI Merger Corporation. (9) (10)(w) $241,844,955.21 Amended and Restated Credit Agreement Among La Quinta Inns, Inc. Certain lenders and NationsBank of Texas, N.A. as Administrative Lender dated January 25, 1994 filed herewith. (10)(x) Third Amended and Restated Master Covenant Agreement dated as of January 25, 1994 filed herewith. (11) Statement regarding computation of per share earnings filed herewith. (22) Subsidiaries of La Quinta Inns, Inc. as of March 3, 1994 filed herewith. (23) Registrant's definitive Proxy Statement, dated on or about April 15, 1994, to be filed by Registrant within 120 days after the end of the fiscal year covered by this Form 10-K. (24) Consent by KPMG Peat Marwick dated March 23, 1994 to incorporation by reference of their reports dated January 31, 1994, except as to the first paragraph of note 5, which is as of February 9, 1994, in various Registration Statements filed herewith. (25) Powers of Attorney filed herewith. (b) Reports on Form 8-K. Registrant filed two Current Reports on Form 8-K, dated November 3, 1993 and December 15, 1993 with the Securities and Exchange Commission. The Report dated November 3, 1993 was filed under Items 5 and 7 describing the Merger Agreement between La Quinta Inns, Inc. and La Quinta Motor Inns Limited Partnership ("the Partnership"). The report dated December 15, 1993 was filed under Items 2 and 7 describing the acquisition of the Partnership, the Partnership's December 31, 1992 Consolidated Financial Statements and pro forma information for the year ended December 31, 1992 and the nine month period ended September 30, 1993. - ---------------------------- (1) Previously filed as an exhibit to the Registrant's Registration Statement on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference. (2) Previously filed as an exhibit to the Registrant's Registration Statement on Form S-8 (No. 2-65645) and incorporated herein by reference. (3) Previously filed as an exhibit to the Registrant's Registration Statement on Form 10-K for the year ended May 31, 1984 and incorporated herein by reference. (4) Previously filed as an exhibit to the Registrant's Registration Statement on Form S-8 (No. 2-97266) and incorporated herein by reference. (5) Previously filed as an exhibit to the Registrant's Registration Statement and incorporated herein by reference. (6) Previously filed as an exhibit to the Registrant's Registration Statement for the Transition Period Report on Form 10-K for the seven months ended December 31, 1989 and incorporated herein by reference. (7) Previously filed as an exhibit to the Registrant's Registration Statement on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference. (8) Previously filed as an exhibit to Registrant's Registration Statement on Form 10-Q for the period ended June 30, 1993. (9) Previously filed to the Registrant's Schedule 14D-1 filed November 1, 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. LA QUINTA INNS, INC. (Registrant) By:----------------------------------- William C. Hammett, Jr. Senior Vice President Chief Accounting Officer By:----------------------------------- Michael A. Depatie Senior Vice President Chief Financing Officer Date: Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities and on the date indicated. Signature Title Gary L. Mead President and Chief Executive Officer, Director William C. Hammett, Jr. Sr. Vice President - Accounting and Administration Thomas M. Taylor Chairman of the Board Michael A. Depatie Sr. Vice President - Finance Joseph F. Azrack Director Philip M. Barshop Director William H. Cunningham Director Barry K. Fingerhut Director George Kozmetsky Director Donald J. McNamara Director Peter Sterling Director

45876_1993.txt

45876_1993

1993

45876

Item 1. Business: (a) Description of Business: The operations of Harsco Corporation (Harsco or the Company) are broadly diversified and include products serving thousands of customers engaged in steel, industrial, commercial, construction and infrastructure, and defense applications. These operations fall into three operating Groups: Industrial Services and Building Products, Engineered Products and Defense. The Company primarily serves its customers through its own salaried sales forces and independent manufacturers' representatives, commission agents and distributors. Harsco utilizes both Company-owned and leased sales offices and warehouses. There were several significant changes in products, services, and markets, but not in methods of distribution during the 1993 fiscal year. In February 1993, the Company purchased certain assets of the Wayne Corporation, a manufacturer of school buses located in Richmond, Indiana for approximately $2.1 million. In a defense conversion activity, production of these school buses was transferred to the BMY-Wheeled Vehicles Division in Marysville, Ohio, and Wayne Wheeled Vehicles was formed. Harsco entered into six new contracts for metal reclamation and specialized steel mill services in Mexico in 1993. In addition, the Company initiated service at a steelmaking location in Canada to provide environmental recycling of steel production residual materials, which is a new service developed through the Company's research and development efforts. On August 31, the Company completed the largest acquisition in Harsco's history by purchasing all of the outstanding capital stock of MultiServ International, N.V., the leading international provider of specialized steel mill services, for a consideration of $384 million. MultiServ's operations were combined with the Company's Heckett Division, and Harsco is now the world leader in the provision of specialized steel mill services to over 130 locations in 27 countries on six continents. Harsco acquired Electroforjados Nacionales, S.A. de C.V., a producer of steel and fiberglass grating products, with annual revenues of about $10 million, located in Queretaro, Mexico during the fourth quarter. The Company also restructured and renamed the Patent Scaffolding Division to Patent Construction Systems Division to better describe the range of products and to emphasize a wide array of services in the construction marketplace. In January 1994, Harsco and FMC Corporation formed a joint venture, United Defense, L.P., by combining the BMY-Combat Systems Division with FMC's Defense Systems Group. Harsco obtained a 40% ownership in United Defense, L.P., which expects to achieve $1 billion in revenues in 1994. The Company's operations are conducted through 10 divisions, each of which has its own executive, supervisory and operating personnel. Each division has general responsibility for its own activities, including marketing. At the Company's headquarters, an executive management group, most of whom have been associated with the Company for many years, manages and provides leadership for business activities. This management group is responsible for establishing basic Company policy and strategic direction, especially in the areas of long-range planning, capital expenditures and finance, and, in addition, makes available to operating personnel technical assistance in a number of specialized fields. (b) Financial Information about Industry Groups: Financial information concerning Industry Groups is included in Note 12 to the consolidated financial statements of the 1993 Annual Report to Shareholders under Exhibit 13. (c) Narrative Description of Business: (1) A narrative description of the businesses by Operating Group is as follows: Industrial Services and Building Products The major product classes in this Group are metal reclamation and scaffolding, shoring and concrete forming equipment. Other classes include: slag abrasives, steel mill services, rental of plant equipment, roofing granules and miscellaneous. Under metal reclamation the Company provides specialized services to steel producers worldwide which includes metal reclamation, scrap handling, cleaning of slag pits, handling of raw material and molten slag, filling and grading of specified areas and the renting of various types of plant equipment. Highly specialized recovery and cleaning equipment, installed and operated on the property of steel producers, together with standard materials handling equipment, including drag lines, cranes, bulldozers, tractors, hauling equipment, lifting magnets and buckets, are employed to reclaim metal. The customer uses this metal in lieu of steel scrap and makes periodic payments to the Company based upon the amounts of metal reclaimed. The nonmetallic residual slag is graded into various sizes at on-site Company-owned processing facilities and sold commercially. Graded slag is used as an aggregate material in asphalt paving applications, railroad ballast and building blocks. The Company also provides in-plant transportation and other specialized services. The Company obtained a significant amount of new business in 1993, including six new contracts in Mexico to provide a variety of services at mini-mills and large, integrated producers. In Germany, the Company received a new contract for in-plant transportation services and expanded the scope of services performed in Holland to include responsibility for blast furnace and steel slag products. The Heckett MultiServ Division was established, effective January 1, 1994 and is the world leader in providing specialized steel mill services to over 130 locations in 27 countries, including Brazil, China, Russia and Slovakia, spanning six continents. Heckett MultiServ locations account for some 30 percent of the world's steelmaking capacity. Slag abrasives and roofing granules are products derived from utility coal slag and are processed at 15 locations in 12 states. Slag abrasives are used for industrial surface preparation and cleaning of bridges, ship hulls and various structures. Roofing granules are sold to roofing shingle manufacturers. In research and development activities, the Company continued to test market a dust suppressant product, designed to improve dusting conditions during the transfer of abrasives. In another project, Harsco, in an effort to identify future alternative materials for colored roofing granules, continued extensive lab testing, including coloring and weathering exposure. Harsco anticipates that the demand for slag abrasives will strengthen in 1994 because of increased activity in the infrastructure repair and rebuild market, particularly in the Northeast. The Group's scaffolding, shoring and concrete forming operations include steel and aluminum support systems that are leased or sold to customers through a North American network of some 35 branch offices. The Division was renamed Patent Construction Systems, effective in December, to better describe the range of products and to emphasize a wide array of services in the construction marketplace. In addition, Patent Plant Services, headquartered in New Orleans, was organized to enhance marketing efforts and long-term scaffolding service contracts to paper mills, refineries, chemical and petrochemical applications and power plants. Several large orders were received from refineries in 1993. During the second half, the Company introduced the Pro 1000 Scaffold Hoist_, part of the motorized swinging scaffold line, which will be marketed worldwide. For 1993, percentages of consolidated net sales of certain product classes were as follows: metal reclamation, 15%; scaffolding, shoring and concrete forming equipment, 6%; and five others, including mill services, rental of plant equipment, roofing granules, slag abrasives and miscellaneous, 7% Engineered Products Major product classes in this Group are gas control and containment, grating, pipe fittings, process equipment and railway maintenance equipment. Other classes include composite products, metal fabrication, wear products and miscellaneous. Gas containment products include propane tanks, cryogenic equipment, high pressure cylinders, and composite products, while gas control products include valves and regulators serving a variety of markets. The cryogenics facility in Germany achieved ISO 9000 certification during the first quarter of 1993, which will enhance product quality and international marketing opportunities. At the cylinder plant in Harrisburg, Pennsylvania, installation of a new high-efficiency billet furnace was underway at year-end. During the fourth quarter of 1993, Harsco formed a long-term commercial agreement with INFLEX, S.A., a manufacturer of a broad line of industrial cylinders, including NGV fuel tanks, located in Buenos Aires, Argentina. Early in 1994, the Division name was changed from Plant City Steel to Taylor-Wharton Gas Equipment to reflect the Company's broader strategic objective of continuing to grow this business through selective international acquisitions in a wide product range. Several new proprietary products were brought to market in the gas control product class in 1993. Production was underway on the innovative new propane valve for 20-pound cylinders on gas grills in Canada during the first quarter, and the full program started in September. A disposable refrigerant valve, developed to meet evolving environmental market demands, was also introduced, as was a unique scuba mouthpiece. The Company's product class of railroad maintenance equipment includes track machinery, which services private and government-owned railroads and urban transit systems. This machinery is classified in the categories of sleeper renewal, spike driving, Hy-Rail, rail grinding, tamping, ballast maintenance, track renewal, track geometry, utility vehicle and rail and overload line equipment. Fairmont Tamper completed work on a Pony Track Renewal System for Japan Railways East, under a contract valued at over $5 million, which was delivered in January 1994, and will be used to upgrade railroad track in that country over a course of 140 kilometers. The Company witnessed increased demand for products in China and Mexico, which included an order for over 25 HY-RAIL units, valued at more than $5 million. At year-end, the backlog was significantly ahead of that at December 31, 1992. Harsco's diverse product class of process equipment includes these product lines: heat transfer equipment, mass transfer equipment, air-cooled heat exchangers, process equipment, protective linings and wear products, including bar, plate and fabrication, and manganese products. Demand for the Thermific boiler, first introduced in 1988, was again at a record level, paced by the institutional building and retrofit market. Two new commercial water heaters were brought to market early in the year, and the lab blender redesign program was completed near year-end. Plans were underway to achieve ISO 9000 certification for major lines, which will aid in international marketing. In wear products, the Company conducted a research and development project to achieve enhanced weld requirements for product improvement. Harsco manufactures a varied line of industrial grating products at numerous plants in North America. The Company produces riveted, pressure-locked and welded grating in steel and aluminum, used mainly in industrial flooring applications for power, paper, chemical, refining and processing applications, among others. The Company also produces varied products for bridge and decking uses, as well as fiberglass grating used principally in the process industries. Production operations at a facility in Canada were phased out late in 1993, although sales and service continue in that country. A state-of-the-art slitting machine, the most powerful of its type in this country, was fully operational at the facility in Channelview, Texas during the first quarter. During the fourth quarter, the Company completed the acquisition of Electroforjados Nacionales, S.A. de C.V. (ENSA), a producer of steel and fiberglass grating products located in Queretaro, Mexico. ENSA, with annual sales of about $10 million, and the Company's other grating operations were consolidated into the Queretaro facility. The Division now operates at 13 facilities in North America. The Company is a major supplier of pipe fittings for the plumbing, industrial, hardware and energy industries and produces a variety of product lines, including forged and stainless steel fittings, conduit fittings, nipples and couplings. During the first quarter, machinery, tooling and equipment were installed at the facility in Houston for the new line of swaged nipples and bull plugs, primarily serving industrial and energy-related applications, which went on stream during the second half. Also during the same quarter, production ceased at a plant in Detroit, but service there is ongoing. The Division headquarters was relocated to another facility in the metropolitan Columbus, Ohio region. For 1993, percentages of consolidated net sales of certain product classes were as follows: gas control and containment, 13%; grating products, 6%; pipe fittings, 6%; process equipment, 5%; railway maintenance equipment, 6%; and four others, including structural composites, specialty metal fabrications, wear products and miscellaneous, 4%. Defense The Defense Group had two divisions at year-end 1993, which were BMY-Combat Systems and BMY-Wheeled Vehicles. In 1993, this Group led the Company in earnings. In January 1994, Harsco and FMC Corporation completed the joint venture, first announced in December 1992, to combine the BMY-Combat Systems Division with FMC's Defense Systems Group. The new partnership, known as United Defense, L.P., was effective on January 1, 1994 and expects to achieve annual sales of about $1 billion in 1994. Harsco holds a 40 percent ownership in United Defense, L.P., and FMC will manage the business. United Defense, L.P. produces tracked vehicles, including self-propelled howitzers, ammunition resupply units, military earthmovers and battle tank recovery vehicles for the U.S. Government and several international customers. Research and development programs are also performed, and United Defense, L.P. is a coproducer of tracked vehicles with the Republic of Korea. Additional products of United Defense, L.P. include the Bradley Fighting Vehicle and its derivatives, the Armored Gun System, the Multiple Launch Rocket System carrier, and the M113 Armored Personnel Carrier family of vehicles. The partnership also makes naval guns and launching systems, military track for armored vehicles and provides overhaul and conversion services. In 1993, BMY-Combat Systems delivered 70 M109A6 Paladin Howitzers to the U.S. Government. Deliveries of this vehicle are scheduled through 1994, and the Company will continue to participate in the production of Paladin Howitzers through the defense business partnership, United Defense, L.P. In 1993, the Company continued its nine-year coproduction contract for M109 SPH vehicle kits with the Republic of Korea and delivered 110 Howitzer kits. BMY-Combat Systems delivered 57 Armored Combat Earthmover (ACE) kits in 1993 to the Republic of Korea, and deliveries are scheduled into 1995. In October, the Company received a new contract from the U.S. Government for production of these M9 ACE units, valued at about $78 million. The Company delivered 68 M88A1 Recovery Vehicles for international customers in 1993. In October, the Company leased a facility in Fayette County, Pennsylvania to expand its role in military vehicle maintenance and support activities. BMY-Wheeled Vehicles produces various models of the five-ton truck and other commercial vehicles. In 1993, the BMY-Wheeled Vehicles Division delivered 861 five-ton trucks to the U.S. Government and international customers. The Company has produced over 25,000 of these units in various configurations and anticipates the receipt of additional orders in 1994. The Division will restart the production line in 1994 to accommodate foreign production booked as of year-end. In February 1993, the Company acquired certain assets from the Wayne Corporation, a manufacturer of school buses, for approximately $2.1 million, and production of these buses was transferred to the Marysville facility. This is a significant defense conversion effort on the part of Harsco to use the skills of a work force in another highly-regulated industry. The Company will continue to seek additional commercial opportunities for production at that location. For 1993, percentages of consolidated net sales of certain product classes were as follows: tracked vehicles, 24% and wheeled vehicles, 8%. (1) (i) The products and services of Harsco can be divided into a number of classes. The product classes that contributed 10% or more as a percentage of consolidated net sales in either of the last three fiscal years are as set forth in the following table. (1) (ii) New products and services are added from time to time; however, currently none require the investment of a material amount of the Company's assets. (1) (iii) The manufacturing requirements of the Company's operations are such that no unusual sources of supply for raw materials are required. The raw materials used by the Company include steel and aluminum which usually are readily available. (1) (iv) While Harsco has a number of trademarks, patents and patent applications, it does not consider that any material part of its business is dependent upon them. (1) (v) Harsco furnishes building products and materials and a wide variety of specialized equipment for commercial, industrial, public works and residential construction which are seasonal in nature. In 1993, construction related operations accounted for 9% of total sales. (1) (vi) The practices of the Company relating to working capital items are not unusual compared with those practices of other manufacturers servicing mainly industrial and commercial markets. Under the Defense Group, due to the nature of long-term contracts, sizable amounts of inventory are carried by the Company; however, these are partially funded through progress payments by the U.S. Government and advance payments by Foreign Governments. See Note 3 to consolidated financial statements and "Advances on long-term contracts" on the balance sheets in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. (1) (vii) Other than in the Defense Group of the Company's business, whose principal customer has been the U.S. Government, as further described under the Defense Group, no material part of the business of the Company is dependent upon a single customer or a few customers, the loss of any one of which would have a material adverse effect upon the Company. Sales to U.S. Government agencies in 1993, 1992 and 1991 amounted to 21%, 35% and 44% of the total sales, respectively. (1) (viii) Backlog of orders stood at $146,751,000 and $738,978,000 as of December 31, 1993 and 1992, respectively. It is expected that approximately 22% of the total backlog at December 31, 1993, will not be filled within 1994. Excluded from the 1993 backlog is $397,939,000 contributed to United Defense, L.P. There is no significant seasonal aspect to the Company's backlog. (1) (ix) Under the terms and regulations applicable to government contracts, the Government has the right to terminate its contracts with the Defense Group in accordance with procedures specified in the regulations and, under certain circumstances, has the right to renegotiate profits. In 1993, this group accounted for 32% of total sales. (1) (x) The various fields in which Harsco operates are highly competitive and the Company encounters active competition in all of its activities from both larger and smaller companies who produce the same or similar products or services or who produce different products appropriate for the same uses. (1) (xi) The expense for internal product improvement and product development activities was $5,156,000, $4,590,000 and $3,647,000 in 1993, 1992 and 1991, respectively. Customer-sponsored research and development expenditures were $23,008,000, $17,889,000 and $8,872,000, in 1993, 1992 and 1991, respectively. (1) (xii) The Company has become subject, as have others, to more stringent air and water quality control legislation. The Clean Air Act Amendments of 1990 will impose greater costs on the Company and most other domestic manufacturers in the future but the effect on the Company's business is not yet determinable. In general, the Company has not experienced substantial difficulty in complying with these environmental regulations in the past and does not anticipate making any major capital expenditures for environmental control facilities in 1994 or 1995. While the Company expects that environmental regulations may expand, and its expenditures for air and water quality control will continue, it cannot predict the effect on its business of such expanded regulations. Additional information regarding environmental consideration is incorporated by reference to Note 1 and Note 10 to the Consolidated Financial Statements under Exhibit No. 13. (1) (xiii) As of December 31, 1993, the Company had approximately 14,200 employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales: Financial information concerning foreign and domestic operations and export sales is included in Note 12 to consolidated financial statements in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. Item 2. Item 2. Properties: Information as to the principal plants owned and operated by Harsco is summarized in the following table: * This property is under a lease-purchase agreement, with purchase price at a nominal amount. Harsco also operates the following plants which are leased: Harsco operates from a number of other plants, branches, warehouses and offices in addition to the above. In particularly, the Company has over 130 locations related to metal reclamation in twenty-seven countries, however since these facilities are on the property of the steel mill being serviced they are not listed. The Company considers all of its properties to be in satisfactory condition. Item 3. Item 3. Legal Proceedings: Information regarding legal proceedings is incorporated by reference to Note 10 to the Consolidated Financial Statements, under Exhibit 13. Item 4. Item 4. Submission of Matters to a Vote of Security Holders: There were no matters that were submitted during the fourth quarter of the year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters: Harsco common stock is traded on the New York, Pacific, Boston, and Philadelphia Stock Exchanges under the symbol HSC. At the end of 1993, there were 24,967,801 shares outstanding. In 1993, the stock traded in a range of 45-35 and closed at a year-end high of 40 5/8 . For additional information regarding Harsco common stock market price, dividends declared, and numbers of shareholders see Part II, Item 6. Item 6. Selected Financial Data: Five-year selected financial data is included under Exhibit 13. Item 7. Item 7. Management's Discussion of Financial Condition and Results of Operations: Management's Discussion of Financial Condition and Results of Operations is included in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. Item 8. Item 8. Financial Statements and Supplementary Data: The financial statements and supplementary data is included in selected portions of the 1993 Annual Report to Shareholders under 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: (a) Identification of Directors: Information regarding the identification of directors and positions held is incorporated by reference to the Proxy Statement dated March 25, 1994. M. W. Gambill informed the Board of Directors that he is retiring as non-executive Chairman of the Board and Director effective April 1, 1994. Upon his retirement as Chief Executive Officer on January 1, 1994, the Company entered into a Retirement and Consulting Agreement with Mr. Gambill. Under the Agreement, Mr. Gambill will receive monthly compensation at the rate of $370,000 per annum ending June 9, 1995. Mr. Gambill's age and employment background are as follows. Name Age M. W. Gambill 63 Principal Occupation or Employment Served as non-executive Chairman of the Board since January 1, 1994 and is a Director. Chairman of the Board and Chief Executive Officer from May 1, 1991 to January 1, 1994. From 1987 to 1991, President and Chief Executive Officer. From 1985 to 1987 served as President and Chief Operating Officer and from 1984 to 1985 served as Executive Vice President of the Corporation and from 1975 to 1984 served as President of the Heckett Division of the Corporation. Mr. Gambill is a director of York International Corporation. (b) Identification of Executive Officers: Set forth below, as of March 24, 1994, are the executive officers (this excludes certain corporate officers who are not deemed "executive officers" within the meaning of applicable Securities and Exchange Commission regulations) of the Company and certain information with respect to each of them. The executive officers were elected to their respective offices on April 27, 1994, or at various times during the year as noted. All terms expire on April 30, 1994. There are no family relationships between any of the officers. Corporate Officers: Name Age D. C. Hathaway 49 Principal Occupation or Employment President and Chief Executive Officer effective January 1, 1994, and has been elected Chairman of the Board effective April 1, 1994. Director since 1991. From May 1, 1991 to December 31, 1993, served as President and Chief Operating Officer. From 1986 to 1991 served as Senior Vice President-Operations of the Corporation. Served as Group Vice President from 1984 to 1986 and as President of the Dartmouth Division of the Corporation from 1979 until October 1984. Name Age W. D. Etzweiler 58 Principal Occupation or Employment Senior Vice President and Chief Operating Officer - Commercial and Industrial Products of the Corporation effective January 25, 1994. From 1992 to January 24, 1994, served as Senior Vice President - Operations of the Corporation. Served as President of the Corporation's Patterson-Kelley Division from 1982 to 1991, Vice President Sales and Marketing of the Patterson-Kelley Division from 1979 to 1982, Vice President of Marketing for the Patterson-Kelley Division from 1971 to 1979, and various manager positions with the Patterson-Kelley Division from 1966 to 1971. Name Age B. W. Taussig 54 Principal Occupation or Employment Senior Vice President and Chief Operating Officer - Defense of the Corporation effective January 25, 1994. From 1992 to January 24, 1994, served as Senior Vice President - Operations of the Corporation. Served as President of the BMY Defense Group from July 1, 1991 to year-end, as President of the BMY Combat Systems Division from 1989 to 1991, and as Vice President Business Development of the BMY Combat Systems Division from July 1989 to November 1989. From 1984 to 1989, was Vice President and General Manager of the Naval Systems Division of FMC Corporation, where he was responsible for a unit manufacturing defense products with 3,100 employees and sales of approximately $350 million per year. Name Age L. A. Campanaro 45 Principal Occupation or Employment Senior Vice President-Finance and Chief Financial Officer of the Corporation effective December 1, 1992 and served as Vice President and Controller from April 1, 1992 to November 30, 1992. Served as Vice President of the BMY-Wheeled Vehicles Division from February 1, 1992 to March 31, 1992, and previously served as Vice President and Controller of the BMY-Wheeled Vehicles Division from 1988 to 1992, Vice President Cryogenics of the Plant City Steel Division from 1987 to 1988, Senior Vice President Taylor-Wharton Division from 1985 to 1987, Vice President and Controller of Taylor-Wharton from 1982 to 1985, and Director of Auditing of the Corporation from 1980 to 1982. Name Age P. C. Coppock 43 Principal Occupation or Employment Senior Vice President, General Counsel, Secretary and Chief Administrative Officer of the Corporation effective January 1, 1994. Served as Vice President, General Counsel and Secretary of the Corporation from May 1, 1991 to December 31, 1993. From 1989 to 1991 served as Secretary and Corporate Counsel and as Assistant Secretary and Corporate Counsel from 1986 to 1989. Served in various Corporate Attorney positions for the Corporation since 1981. Name Age S. D. Fazzolari 41 Principal Occupation or Employment Vice President and Controller of the Corporation effective January 25, 1994. Served as Controller of the Corporation from January 26, 1993 to January 24, 1994. Previously served as Director of Auditing from 1985 to January 25, 1993, and served in various auditing positions from 1980 to 1985. Item 11. Item 11. Executive Compensation: Information regarding compensation of executive officers and directors is incorporated by reference to the Sections entitled "Executive Compensation and Other Information", and "Directors' Compensation" of the Proxy Statement dated March 25, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management: Information regarding security ownership of certain beneficial owners and management is incorporated by reference to the section entitled "Share Ownership of Management" of the Proxy Statement dated March 25, 1994. Item 13. Item 13. Certain Relationships and Related Transactions: Information regarding certain relationships and related transactions is incorporated by reference to the section entitled "Employment Agreements with Officers of the Company" of the Proxy Statement dated March 25, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K: The following portions of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference under Exhibit 13: The consolidated financial statements and notes thereto, the related report of Coopers & Lybrand, independent accountants, Management's Discussion of Financial Condition and Results of Operations, Selected Financial Data for the years 1989 through 1993, Market for Registrant's Common Stock and Related Security Holder Matters, and the supplemental financial data, Three-Year Summary of Quarterly Results. Exhibit Number (a) 1. Consolidated Financial Statements: Consolidated Balance Sheets December 31, 1993 and 1992 Consolidated Statements of Income for the years 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity for the years 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants Management's Discussion of Financial Condition and Results of Operations Selected Financial Data for the Years 1989 through 1993 Three-Year Summary of Quarterly Results (a) 2. Consolidated Financial Statement Schedules: Report of Independent Accountants on Consolidated Financial Statement Schedules V. Property, Plant and Equipment for the years 1993, 1992 and 1991 VI. Accumulated Depreciation of Property, Plant and Equipment for the years 1993, 1992 and 1991 VIII. Valuation and Qualifying Accounts and Reserves for the years 1993, 1992 and 1991 IX. Short-Term Borrowings for the years 1993, 1992 and 1991 X. Supplementary Income Statement Information for the years 1993, 1992 and 1991 Schedules other than those listed above are omitted for the reason that they are either not applicable or not required or because the information required is contained in the financial statements or notes thereto. Condensed financial information of the registrant is omitted since there are no substantial amounts of "restricted net assets" applicable to the Company's consolidated subsidiaries. Financial statements of 50% or less owned associated companies are not submitted inasmuch as (1) the registrant's investment in and advances to such companies do not exceed 20% of the total consolidated assets, (2) the registrant's proportionate share of the total assets of such companies does not exceed 20% of the total consolidated assets, (3) the registrant's equity in the income before income taxes of such companies does not exceed 20% of the total consolidated income before income taxes. Exhibits other than those listed above are omitted for the reason that they are either not applicable or not material. The foregoing Exhibits are available from the Secretary of the Company upon receipt of a fee of $10 to cover the Company's reasonable cost of providing copies of such Exhibits. (b) The Company filed a Report on Form 8-K dated January 8, 1993 reporting that the Company had received the decision of The Armed Services Board of Contract Appeals in case ASBCA No. 36805 concerning the Company's claim for reimbursement of after-imposed Retail Federal Excise Tax paid on sales to the United States Government of certain five-ton trucks under a 1986 contract. The decision holds that, as a result of the extension of the Federal Excise Tax law beyond its original October 1, 1988 expiration date, Harsco is entitled to payment of a price adjustment to the contract to reimburse Federal Excise Tax paid on vehicles to be delivered after October 1, 1988. The Company filed a Report on Form 8-K dated July 8, 1993 reporting that the Company had signed a definitive purchase agreement with the shareholders representing the majority of the shares of MultiServ International, N.V. for the acquisition of all of the outstanding capital stock of MultiServ International, N.V. The Company filed a Report on Form 8-K dated August 31, 1993 reporting that the Company had acquired all of the outstanding capital stock of MultiServ International, N.V. 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. HARSCO CORPORATION Date March 18, 1994 By /S/ Leonard A. Campanaro Leonard A. Campanaro Senior Vice President-Finance 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 CAPACITY DATE Chairman (Malcolm W. Gambill) President & Chief Executive (Derek C. Hathaway) Officer Senior Vice President-Finance and (Leonard A. Campanaro) Chief Financial Officer (Principal Financial Officer) Vice President and Controller (Salvatore D. Fazzolari) (Principal Accounting Officer) Director (Jeffrey J. Burdge) Director (Robert L. Kirk) Director (James E. Marley) Director (Frank E. Masland III) Director (Robert F. Nation) Director (Nilon H. Prater) Director (DeWitt C. Smith, Jr.) Director (Roy C. Smith) Director (Andrew J. Sordoni III) Director (Dr. Robert C. Wilburn) 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. HARSCO CORPORATION Date March 18, 1994 By /S/ Leonard A. Campanaro Leonard A. Campanaro Senior Vice President-Finance 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 CAPACITY DATE /S/ Malcolm W. Gambill Chairman March 23, 1994 (Malcolm W. Gambill) /S/ Derek C. Hathaway President & Chief Executive March 24, 1994 (Derek C. Hathaway) Officer /S/ Leonard A. Campanaro Senior Vice President-Finance and March 24, 1994 (Leonard A. Campanaro) Chief Financial Officer (Principal Financial Officer) /S/ Salvatore D. Fazzolari Vice President and Controller March 25, 1994 (Salvatore D. Fazzolari) (Principal Accounting Officer) /S/ Jeffrey J. Burdge Director March 18, 1994 (Jeffrey J. Burdge) /S/ Robert L. Kirk Director March 18, 1994 (Robert L. Kirk) /S/ James E. Marley Director March 18, 1994 (James E. Marley) /S/ Frank E. Masland III Director March 18, 1994 (Frank E. Masland III) /S/ Robert F. Nation Director March 18, 1994 (Robert F. Nation) /S/ Nilon H. Prater Director March 18, 1994 (Nilon H. Prater) /S/ DeWitt C. Smith, Jr. Director March 18, 1994 (DeWitt C. Smith, Jr.) /S/ Roy C. Smith Director March 18, 1994 (Roy C. Smith) /S/ Andrew J. Sordoni III Director March 18, 1994 (Andrew J. Sordoni III) /S/ Dr. Robert C. Wilburn Director March 18, 1994 (Dr. Robert C. Wilburn) REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Harsco Corporation Our report on the consolidated financial statements of Harsco Corporation and subsidiary companies, which includes explanatory paragraphs regarding (i) uncertainties concerning the Company's involvement in various disputes regarding Federal Excise Tax and other contract matters primarily relating to the five-ton truck contract and the ultimate outcome of the Company's claims against the Government relating to certain contracts and (ii) changes in the Company's method of accounting for income taxes and postretirement benefits other than pensions, has been incorporated by reference in this Form 10-K from page 56 of the 1993 Annual Report to Shareholders of Harsco Corporation. In connection with our audits of such consolidated financial statements, we have also audited the related consolidated financial statement schedules listed in the index (Item 14(a) 2.) on page 20 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 Philadelphia, Pennsylvania February 1, 1994, except as to the first and third paragraphs of Note 10, for which the dates are February 25, 1994 and March 4, 1994, respectively. SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NOTE: For domestic and foreign facilities, property, plant and equipment is depreciated over the estimated useful lives of the assets using principally the straight-line method. The estimated useful lives of various classes of assets are as follows: SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE VI. ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS (dollars in thousands) SCHEDULE IX. SHORT-TERM BORROWINGS (dollars in thousands) SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION (dollars in thousands) COLUMN A COLUMN B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $55,947 $47,670 $47,826

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1993

105839

ITEM 1. BUSINESS Allegheny Power System, Inc. (APS), incorporated in Maryland in 1925, is an electric utility holding company that derives substantially all of its income from the electric utility operations of its direct and indirect subsidiaries (Subsidiaries), Monongahela Power Company (Monongahela), The Potomac Edison Company (Potomac Edison), West Penn Power Company (West Penn), and Allegheny Generating Company (AGC). The properties of the Subsidiaries are located in Maryland, Ohio, Pennsylvania, Virginia, and West Virginia, are interconnected, and are operated as a single integrated electric utility system (System), which is interconnected with all neighboring utility systems. The three electric utility operating Subsidiaries are Monongahela, Potomac Edison, and West Penn (Operating Subsidiaries). Monongahela, incorporated in Ohio in 1924, operates in northern West Virginia and an adjacent portion of Ohio. It also owns generating capacity in Pennsylvania. Monongahela serves about 340,700 customers in a service area of about 11,900 square miles with a population of about 710,000. The seven largest communities served have populations ranging from 10,900 to 33,900. On December 31, 1993, Monongahela had 1,962 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, glass sand, natural gas, rock salt, and other natural resources. Its service area's principal industries produce coal, chemicals, iron and steel, fabricated products, wood products, and glass. There are two municipal electric distribution systems and two rural electric cooperative associations in its service area. Except for one of the cooperatives, they purchase all of their power from Monongahela. Potomac Edison, incorporated in Maryland in 1923 and in Virginia in 1974, operates in portions of Maryland, Virginia, and West Virginia. It also owns generating capacity in Pennsylvania. Potomac Edison serves about 354,300 customers in a service area of about 7,300 square miles with a population of about 782,000. The six largest communities served have populations ranging from 11,900 to 40,100. On December 31, 1993, Potomac Edison had 1,152 employees. Its service area is generally rural. Its service area's principal industries produce aluminum, cement, fabricated products, rubber products, sand, stone, and gravel. There are four municipal electric distribution systems in its service area, all of which purchase power from Potomac Edison, and six rural electric cooperatives, one of which purchases power from Potomac Edison. There are also several large federal government installations served by Potomac Edison. - 2 - West Penn, incorporated in Pennsylvania in 1916, operates in southwestern and north and south central Pennsylvania. It also owns generating capacity in West Virginia. West Penn serves about 646,700 customers in a service area of about 9,900 square miles with a population of about 1,399,000. The 10 largest communities served have populations ranging from 11,200 to 38,900. On December 31, 1993, West Penn had 2,043 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, limestone, and other natural resources. Its service area's principal industries produce steel, coal, fabricated products, and glass. There are two municipal electric distribution systems in its service area, which purchase their power requirements from West Penn, and five rural electric cooperative associations, located partly within the area, which purchase virtually all of their power through a pool supplied by West Penn and other nonaffiliated utilities. AGC, organized in 1981 under the laws of Virginia, is jointly owned by the Operating Subsidiaries as follows: Monongahela, 27%; Potomac Edison, 28%; and West Penn, 45%. AGC has no employees, and its only operating assets are a 40% undivided interest in the Bath County (Virginia) pumped- storage hydroelectric station, which was placed in commercial operation in December 1985, and its connecting transmission facilities. AGC's 840-megawatt (MW) share of capacity of the station is sold to its three parents. The remaining 60% interest in the Bath County Station is owned by Virginia Electric and Power Company (Virginia Power). APS has no employees. Its officers are employed by Allegheny Power Service Corporation (APSC), a wholly-owned subsidiary of APS. On December 31, 1993, the Subsidiaries and APSC had 6,025 employees. The Subsidiaries in the past have experienced and in the future may experience some of the more significant problems common to electric utilities in general. These include increases in operating and other expenses, difficulties in obtaining adequate and timely rate relief, restrictions on construction and operation of facilities due to regulatory requirements and environmental and health considerations, including the requirements of the Clean Air Act Amendments of 1990 (CAAA), which among other things, require a substantial annual reduction in utility emissions of sulfur dioxides and nitrogen oxides. Additional concerns include proposals to restructure and, to some extent, deregulate portions of the industry and increase competition, particularly as a result of the National Energy Policy Act of 1992 (EPACT). EPACT may increase competition by allowing the formation of Exempt Wholesale Generators (EWGs), with the approval of the FERC, and providing mandatory access to the interconnected electric grid for wholesale transactions. It further provides for expansion of the grid where constraints are determined to exist - at the expense of the requestor of such transmission service and provided necessary authority to construct such facilities can be obtained. EPACT permits utility generation facilities to qualify as EWGs and allows sales to nonaffiliated and to affiliated utilities provided state commissions approve such transactions. (See ITEM 1. SALES, ELECTRIC FACILITIES and REGULATION for a further discussion of the impact of EPACT.) - 3 - In an effort to meet the challenges of the new competitive environment in the industry, APS is considering forming a new nonutility subsidiary, subject to regulatory approval, to pursue new business opportunities which have a meaningful relationship to the core utility business. APS would also consider establishing or acquiring its own EWGs, if that is feasible, particularly in view of the possible constraints imposed by regulations under the Public Utility Holding Company Act of 1935 (PUHCA) on nonexempt public utility holding companies such as APS and its Subsidiaries. Further concerns of the industry include possible restrictions on carbon dioxide emissions, uncertainties in demand due to economic conditions, energy conservation, market competition, weather, and interruptions in fuel supply because of weather and strikes. (See ITEM 1. CONSTRUCTION AND FINANCING, RATE MATTERS, and ENVIRONMENTAL MATTERS for information concerning the effect on the Subsidiaries of the CAAA.) SALES In 1993, consolidated kilowatthour (kWh) sales to the Operating Subsidiaries' retail customers increased 3.3% from those of 1992, as a result of increases of 6.5%, 5.2% and 0.3% in residential, commercial and industrial sales, respectively. The increased Kwh sales in 1993 reflect both growth in number of customers and higher use. Consolidated revenues from residential, commercial, and industrial sales increased 11.4%, 9.8%, and 5.6%, respectively, primarily because of several rate increases effective in 1993 as described in ITEM 1. RATE MATTERS, increases in fuel and energy cost adjustment clause revenues, and increased kWh sales. Consolidated kWh sales to and revenues from nonaffiliated utilities decreased 30.2% and 25.5%, respectively, due to increased native load, decreased demand, and price competition. The System's all-time peak load of 7,153 MW occurred on January 18, 1994. The peak loads in 1993 and 1992 were 6,678 MW and 6,530 MW, respectively. The increased 1994 peak was due in part to record cold temperatures throughout the Operating Subsidiaries' service areas and would have been higher except for voluntary curtailments. The average System load (Yearly Net Power Supply divided by number of hours in the year) was 4,674 megawatthours (MWh) and 4,526 MWh in 1993 and 1992, respectively. More information concerning sales may be found in the statistical sections and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Consolidated electric operating revenues for 1993 were derived as follows: Pennsylvania, 44.8%; West Virginia, 28.4%; Maryland, 20.2%; Virginia, 5.0%; Ohio, 1.6% (residential, 35.1%; commercial, 18.4%; industrial, 28.9%; nonaffiliated utilities, 14.9%; and other, 2.7%). The following percentages of such revenues were derived from these industries: iron and steel, 6.0%; chemicals, 3.3%; fabricated products, 3.3%; aluminum and other nonferrous metals, 3.2%; coal mines, 3.1%; cement, 1.8%; and all other industries, 8.2%. The coal mine percentage decreased in 1993 principally due to the coal strike. More information concerning the coal strike may be found in ITEM 1. FUEL SUPPLY. Revenues from each of 16 industrial customers exceeded $5 million, including one coal customer of both Monongahela and West Penn with total revenues exceeding $15 million, three steel customers with revenues exceeding $26 million each, and one aluminum customer with revenues exceeding $63 million. - 4 - During 1993, Monongahela's kWh sales to retail customers increased 0.3% as a result of increases of 6.4% and 4.7% in residential and commercial sales, respectively, and a decrease of 4.4% in industrial sales, primarily due to the coal strike and lower sales to one iron and steel customer because of increased use of its own generation. Revenues from such customers increased 9.2%, 7.8% and 0.7%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 7.8%. Monongahela's all- time peak load of 1,667 MW occurred on December 21, 1989. (For a discussion of the coal strike, See ITEM 1. FUEL SUPPLY.) Monongahela's electric operating revenues were derived as follows: West Virginia, 94.0% and Ohio, 6.0% (residential, 28.8%; commercial, 17.3%; industrial, 29.2%; nonaffiliated utilities, 13.4 %; and other, 11.3%). Revenues from each of five industrial customers exceeded $8 million, including one coal customer with revenues exceeding $13 million and one steel customer with revenues exceeding $26 million. The decreases in the revenues of these customers from 1992 levels were primarily due to the coal strike. During 1993, Potomac Edison's kWh sales to retail customers increased 6.3% as a result of increases of 8.4%, 7.1%, and 4.3% in residential, commercial, and industrial sales, respectively. Revenues from such customers increased 12.7%, 11.8%, and 11.8%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 23.1%. Potomac Edison's all-time peak load of 2,595 MW occurred on January 19, 1994. Potomac Edison's electric operating revenues were derived as follows: Maryland, 66.6%; West Virginia, 16.8%; and Virginia 16.6% (residential, 38.5%; commercial, 17.5%; industrial, 24.7%; nonaffiliated utilities, 15.2%; and other, 4.1%). Revenues from one industrial customer, the Eastalco aluminum reduction plant near Frederick, Maryland, amounted to $63.4 million (8.9% of total electric operating revenues). Minimum annual charges to Eastalco under an electric service agreement which continues through March 31, 2000, with automatic extensions thereafter unless terminated on notice by either party, were $19.3 million in 1993. Said agreement may be canceled before the year 2000 upon 90 days notice of a governmental decision resulting in a material modification of the agreement. During 1993, West Penn's kWh sales to retail customers increased 3.1% as a result of increases of 5.2%, 4.4% and 0.8% in residential, commercial, and industrial sales, respectively. Revenues from residential, commercial, and industrial customers increased 11.5%, 9.6%, and 5.4%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 24.3%. West Penn's all- time peak load of 3,068 MW occurred on January 18, 1994. - 5 - West Penn's electric operating revenues were derived as follows: Pennsylvania, 100% (residential, 33.1%; commercial, 18.0%; industrial, 28.5%; nonaffiliated utilities, 14.1%; and other, 6.3%). Revenues from each of three steel customers exceeded $10 million, including two with revenues exceeding $31 million each. On average, the Operating Subsidiaries are the lowest or among the lowest cost producers of electricity in their regions and therefore the Operating Subsidiaries' delivered power prices should compete favorably with those of potential alternate suppliers who use cost-based pricing. However, the Operating Subsidiaries are experiencing cost increases due to compliance with the CAAA and purchases from Public Utility Regulatory Policies Act of 1978 (PURPA) projects. (See page 7 for a discussion of PURPA projects, and ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings concerning PURPA capacity.) In 1993, the Operating Subsidiaries provided approximately 13.3 billion kWh of energy to nonaffiliated utility companies, of which 1.5 billion kWh were generated by the Subsidiaries and the rest were transmitted from electric systems located primarily to the west. These sales included a long-term transaction under which the Operating Subsidiaries purchased 450 MW of firm capacity and its associated energy from Ohio Edison Company for resale to Potomac Electric Power Company, both nonaffiliated utilities. The transaction began in mid-1987 and will continue through 2005, unless terminated earlier. Sales to nonaffiliated utility companies vary with the needs of those companies for imported power; the availability of System generating facilities, fuel, and regional transmission facilities; and the availability and price of competitive sources of power. System sales decreased in 1993 relative to 1992 primarily because of continued decreased demand, increased Operating Subsidiaries' native load, coal conservation because of the coal strike, and increased willingness of other suppliers to make sales at lower prices. Further decreases in kWh sales to nonaffiliated utilities are expected in 1994 and beyond. Substantially all of the revenues from kWh sales to nonaffiliated utilities are passed on to retail customers and as a result have little effect on net income. The Operating Subsidiaries reactivated a peak diversity exchange arrangement with Virginia Power effective June 1993 which continues indefinitely. The Operating Subsidiaries will annually supply Virginia Power with 200 MW during each June, July, and August, in return for which Virginia Power will supply the Operating Subsidiaries with 200 MW during each December, January, and February, at least through February 1997. Thereafter, specific amounts of annual diversity exchanges beyond those currently established are to be mutually determined no less than 34 months prior to each year for which an exchange is to take place. The total number of MWh to be delivered by each to the other over the term of the arrangement is expected to be equal. - 6 - The Operating Subsidiaries and Duquesne Light Company (Duquesne Light) in 1991 entered into an exchange arrangement under which the Operating Subsidiaries will supply Duquesne Light with up to 200 MW for a specified number of weeks, generally during each March, April, May, September, October, and November. In return, Duquesne Light will supply the Operating Subsidiaries with up to 100 MW, generally during each December, January, and February. The total number of MWh delivered by each utility to the other over the term of the arrangement is expected to be the same. West Penn supplies power to the Borough of Tarentum (Tarentum) using in part leased distribution facilities from Tarentum under a 30 year lease agreement terminating in 1996. In June 1993, Tarentum, which in that year had a load of 6.5 MW and revenues of $1.8 million, notified West Penn of its intention to exercise its option to end the lease agreement. The termination of the lease agreement and resulting transfer and sale of electric facilities will result in Tarentum becoming a municipal customer which will purchase electricity on a wholesale basis from West Penn or another supplier. The sale of electric facilities will require Pennsylvania Public Utility Commission approval. The System provides wholesale transmission services to applicants under its Federal Energy Regulatory Commission (FERC) approved Standard Transmission Service tariff. The tariff provides that such service is subordinate in priority to native load and reliability requirements of interconnected systems to avoid adverse effects on regional reliability in general and on the reliability of the Operating Subsidiaries' service to their retail and full- requirements wholesale customers in particular. (See ITEM 1. ELECTRIC FACILITIES for a discussion of stress on the System's transmission system.) Transmission services requiring special arrangements or long-term commitments have been and continue to be negotiated through mutually acceptable bilateral agreements. Substantially all of the revenues from transmission service sales are passed on to retail customers and as a result have little effect on net income. EPACT permits wholesale generators, utility-owned and otherwise, and wholesale consumers to request from System and other owners of bulk power transmission facilities a commitment to supply transmission services. Generators include nonaffiliated utilities and nonutility generators (NUG) of electricity (including classifications of generators known as Independent Power Producers (IPP) and EWGs). Consumers of wholesale power include qualifying nonaffiliated utilities or groups of utilities including the many small electric systems owned by municipalities and rural electric cooperative associations in the service areas of the Operating Subsidiaries. Many of these small systems currently purchase substantially all of their power from the Operating Subsidiaries. Under EPACT, these small systems may now seek an order from the FERC to force the Operating Subsidiaries to wheel power over the System to them from sources outside the System service area. All of the small electric wholesale customers in the Operating Subsidiaries' service areas which might avail themselves of this opportunity produced $42 million of total revenues in 1993. - 7 - Under PURPA, certain municipalities and private developers have installed, are installing or are proposing to install hydroelectric and other generating facilities at various locations in or near the Operating Subsidiaries' service areas with the intent of selling some or all of the electric capacity and energy to the Operating Subsidiaries at rates provided under PURPA and approved by appropriate state commissions. The System's total generation capacity includes 292 MW of on-line PURPA capacity. Payments for PURPA capacity and energy in 1993 totaled approximately $105 million at an average cost to the System of 5.04 cents per kWh. The System projects an additional 180 MW of PURPA capacity to come on-line in future years. In addition, lapsed purchase agreements totaling 203 MW and other PURPA complaints totaling 520 MW (none of which are included in the System's integrated resource plan as of August 20, 1993), are the subject of pending litigation. (See ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings in Pennsylvania, Maryland, and West Virginia affecting PURPA capacity.) In the future, ratings of the Operating Subsidiaries' first mortgage bonds and preferred stock may be affected by increased concern of rating agencies that purchased power contracts are a risk factor deserving consideration in assessing the credit- worthiness of electric utilities. ELECTRIC FACILITIES The following table shows the System's December 31, 1993, generating capacity, based on the maximum monthly normal seasonal operating capacity of each unit. The System-owned capacity totaled 7,991 MW, of which 7,089 MW (88.7%) are coal-fired, 840 MW (10.5%) are pumped-storage, and 62 MW (0.8%) are hydroelectric. The term "pumped-storage" refers to the Bath County station which stores energy for use principally during peak load hours by pumping water from a lower to an upper reservoir, using the most economic available electricity, generally during off-peak hours. During the generating cycle, power is produced by water falling from the upper to the lower reservoir through turbine generators. The average age of the System-owned coal-fired stations shown below, based on generating capacity at December 31, 1993, was about 23.6 years. In 1993, their average heat rate was 10,020 Btu's/kWh, and their availability factor was 87.0%. - 8 - - 9 - (a) Excludes 361 MW of West Penn oil-fired capacity, which was placed on cold reserve status as of June 1, 1983. Current plans call for the reactivation of these units within the next five years. (b) Where more than one year is listed as a commencement date for a particular source, the dates refer to the years in which operations commenced for the different units at that source. (c) The installation of flue-gas desulfurization equipment (See ITEM 1. ENVIRONMENTAL MATTERS) is expected to reduce the net generating capacity of each unit by about 3%. (d) Capacity entitlement through percentage ownership of AGC. (e) The FERC issued an annual license to West Penn for Lake Lynn for 1994. A relicensing application has been filed with the FERC for Lake Lynn and a license with a 30 to 50 year term is expected to be issued in late 1994. Potomac Edison's license for hydroelectric facilities, Dam #4 and Dam #5 will expire in 2003. Potomac Edison has received 30 year licenses, effective January 1994, for the Shenandoah, Warren, Luray and Newport projects. (f) Nonutility generating capacity available through contractual arrangements pursuant to PURPA. - 10 - SYSTEM MAP The Allegheny Power System Map (System Map), which has been omitted, provides a broad illustration of the names and approximate locations of the System's major generation and transmission facilities, both existing and under construction, in a five state region which includes portions of Pennsylvania, Ohio, West Virginia, Maryland and Virginia. Additionally, Extra High Voltage substations are displayed. By use of shading, the System Map also provides a general representation of the service areas of Monongahela (portions of West Virginia and Ohio), Potomac Edison (portions of Maryland, Virginia and West Virginia), and West Penn (portions of Pennsylvania). Power Stations shown on the System Map which appear within the Monongahela service area are Willow Island, Pleasants, Harrison, Rivesville, Albright, and Fort Martin. The single Power Station appearing within the Potomac Edison service area is R. Paul Smith. The Bath County Power Station appears on the map just south of the westernmost portion of Potomac Edison's service area formed by the borders of Virginia and West Virginia. Power Stations appearing within the West Penn service area are Armstrong, Mitchell, Hatfield's Ferry, Springdale and Lake Lynn. The System Map also depicts transmission facilities which are (i) owned solely by the Operating Subsidiaries; (ii) owned by the Operating Subsidiaries in conjunction with other utilities; or (iii) owned solely by other utilities. The transmission facilities portrayed range in capacity from 138kV to 765kV. Additionally, interconnections with other utilities are displayed. - 11 - The following table sets forth the existing miles of tower and pole transmission and distribution lines and the number of substations of the Subsidiaries as of December 31, 1993: (a) The System has a total of 5,203 miles of underground distribution lines. (b) The substations have an aggregate transformer capacity of 37,512,771 kilovoltamperes. (c) Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Power owns the remainder. The System has 11 extra-high-voltage (345 kV and above) (EHV) and 29 lower-voltage interconnections with neighboring utility systems. The interregional EHV transmission system, including System facilities, continues to experience periods of heavy loading in a west-to-east direction. Increases in customer load, power transfers by the Subsidiaries and by nonaffiliated entities, and parallel flows caused by transactions to which the Operating Subsidiaries are not a party, all contribute to the heavy west-to-east power flows. In late 1992 and early 1993, a substantial amount of reactive power sources (shunt capacitors) were added to neighboring eastern utilities' EHV systems. These capacitors complement the capacitors added in 1991 and 1992 on the System and together they serve to increase transfer capability by improving voltage on the transmission system during heavy loading periods. While the additional capacitors installed by the Subsidiaries' eastern neighbors have enhanced transfer capability, the interregional transmission facilities are still expected periodically to operate up to their reliability limits; therefore, restrictions on transfers may still be necessary at times as was the case in recent years. Under certain provisions of EPACT, wholesale generators, utility-owned or otherwise, may seek from System and other owners of bulk power transmission facilities a commitment to supply power transmission services, so long as the FERC finds reliability and native load and existing contractual customers are not adversely affected (See discussion under ITEM 1. SALES and REGULATION). Such demand on the System for transmission service may add periodically to heavy power flows on the System's facilities. - 12 - The Operating Subsidiaries have, to date, provided managed contractual access to the System's transmission facilities via the provisions of their Standard Transmission Service tariff, or the terms and conditions of bilateral contracts with purchasers of transmission service. As a result of EPACT, the FERC is investigating the continued desirability of traditional methods of pricing and providing transmission service. The FERC may choose to maintain existing methods, implement new methodologies which the Operating Subsidiaries and their ratepayers may or may not find to be beneficial, or a combination thereof. The Operating Subsidiaries are participating fully in the FERC proceedings with the principal intent of safeguarding the reliability of the System's transmission facilities, and the rights and interests of its native load customers. The outcome of those deliberations cannot be predicted. RESEARCH AND DEVELOPMENT The Operating Subsidiaries spent $4.6 million, $2.7 million, and $2.8 million in 1993, 1992, and 1991, respectively, for research programs. Of these amounts, $3.2 million and $0.6 million were for Electric Power Research Institute (EPRI) dues in 1993 and 1992, respectively. The Operating Subsidiaries plan to spend approximately $7.5 million for research in 1994, with EPRI dues representing $5.9 million of that total. The Operating Subsidiaries joined EPRI, an industry- sponsored research and development institution, effective October 1, 1992, contingent upon the approval by state commissions of recovery of the dues in rates, which approval was subsequently received in all jurisdictions except Ohio and West Virginia, where the matter is pending. Ongoing participation in EPRI depends upon continued approval by state commissions of recovery of dues in rates. Dues are based on a three-year, new-member ramping formula. Independent research conducted by the Operating Subsidiaries in 1993, which will be completed or continued in 1994, concentrated on environmental protection, generating unit performance, future generating technologies, delivery systems, and customer-related research. Two U.S. Department of Energy Clean Coal Technology nitrogen oxide control projects, which the Operating Subsidiaries cofounded, have recently been completed. Based upon the results of one of the projects, retrofitting of low nitrogen oxide cell burners at the Hatfield's Ferry Power Station units has been undertaken at much lower costs than would otherwise have been required. - 13 - Research is also being directed to help address major issues facing the Operating Subsidiaries including electric and magnetic field (EMF) risk, waste disposal, greenhouse gas, client-server information system prospects, renewable resources, fuel cells, new combustion turbines and other cogeneration technologies. In addition, evaluation of technical proposals for business opportunities is also ongoing. EMF research includes monitoring work done by EPRI, Department of Energy (DOE), the Environmental Protection Agency (EPA) and other government researchers. It also includes monitoring literature, law and litigation, and standards as developed. This research enables the Operating Subsidiaries to evaluate any potential health risks to employees and customers which may exist. Research activities related to alleged global climate change include monitoring government activity, studying possible joint implementation activities in connection with the Clinton Climate Change Action Plan, and studying demand- side management, electro- technologies and possible joint implementation plans. The Operating Subsidiaries also made research grants to regional colleges and universities to encourage the development of technical resources related to current and future utility problems. CONSTRUCTION AND FINANCING Construction expenditures by the Subsidiaries in 1993 amounted to $574 million and for 1994 and 1995 are expected to aggregate $500 million and $400 million, respectively. In 1993, these expenditures included $240 million for compliance with the CAAA. The 1994 and 1995 estimated expenditures include $161 million and $53 million, respectively, to cover the costs of compliance with the CAAA. (See ITEM 1. ENVIRONMENTAL MATTERS.) Allowance for funds used during construction (AFUDC) (shown below) has been reduced for carrying charges on CAAA expenditures that are being collected through currently approved surcharges or in base rates. - 14 - * Includes allowance for funds used during construction for 1993, 1994 and 1995 of: Monongahela $5.8, $4.1 and $1.9; Potomac Edison $7.1, $5.7 and $2.7; and West Penn $8.6, $12.7 and $6.2. These construction expenditures include major capital projects at existing generating stations, including the construction of flue-gas desulfurization equipment (scrubbers) at the Harrison Power Station, upgrading distribution lines and substations, and the strengthening of the transmission and subtransmission systems. It is anticipated that the Harrison scrubber project will be completed on schedule and that the final costs will be approximately 24% below the original budget. Primary factors contributing to the reduced cost are: a) the absence of any major construction problems to date; b) financing and material and equipment costs lower than expected; and c) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. In order to avoid unnecessary and uneconomic additional outages, power station construction and long-range maintenance schedules and the expenditures associated therewith will have to be coordinated over the next several years with outages to meet the in-service dates of the new emission control facilities. - 15 - On a System basis, total expenditures for 1993, 1994, and 1995 include $270 million, $191 million, and $93 million, respectively, for construction of environmental control technology. The Operating Subsidiaries continue to study ways to reduce or meet future increases in customer demand, including aggressive demand- side management programs, new and efficient electric technologies, construction of various types and sizes of generating units and increasing the efficiency and availability of System generating facilities, reducing company electrical use and transmission and distribution losses, and where feasible and economical, acquisition of reliable long- term capacity from other electric systems and from nonutility developers. The Operating Subsidiaries are implementing demand-side management activities. Potomac Edison and West Penn are engaged in state commission supported or ordered evaluations of demand-side management programs (See ITEM 1. REGULATION for a further discussion of these programs). Several jurisdictions have adopted mechanisms which provide for recovery of the costs of such activities, some return on the related investment, the associated revenue reductions and a performance incentive, either on a current basis or through deferral to a base rate case. Current forecasts, which reflect demand-side management efforts and other considerations and assume normal weather conditions, project average annual winter and summer peak load growth rates of 1.47% and 1.28%, respectively, in the period 1994-2004. After giving effect to the reactivation of West Penn capacity in cold reserve (see page 9), peak diversity exchange arrangements described in ITEM 1. SALES above, demand- side management and conservation programs, and the capacity of an anticipated new PURPA plant, the System's integrated resource plan indicates that new System-owned generating capacity will not be required until the year 2000 or beyond. If future customer demand materially exceeds that forecast or anticipated supply-side resources do not become available or demand-side management efforts do not succeed, or under extremely adverse weather conditions, the Operating Subsidiaries may be unable at times to meet all of their customers' requirements for electric service. In connection with their construction and demand- side management programs, the Operating Subsidiaries must make estimates of the availability and cost of capital as well as the future demands of their customers that are necessarily subject to regional, national, and international developments, changing business conditions, and other factors. The construction of facilities and their cost are affected by laws and regulations, lead times in manufacturing, availability of labor, materials and supplies, inflation, interest rates, and licensing, rate, environmental, and other proceedings before regulatory authorities. As a result, future plans of the Operating Subsidiaries, as well as their projected ownership of future generating stations, are subject to continuing review and substantial change. - 16 - The Subsidiaries have financed their construction programs through internally generated funds, first mortgage bond, debenture, medium-term note and preferred stock issues, pollution control and solid waste disposal notes, instalment loans, long-term lease arrangements, equity investments by APS (or, in the case of AGC, by the Operating Subsidiaries), and, where necessary, interim short-term debt. Effective January 1994, the Operating Subsidiaries also have available a $300 million multi-year credit facility. The future ability of the Subsidiaries to finance their construction programs by these means depends on many factors, including rate levels sufficient to provide internally generated funds and adequate revenues to produce a satisfactory return on the common equity portion of the Subsidiaries' capital structures and to support their issuance of senior and other securities. APS obtains most of the funds for equity investments in the Operating Subsidiaries through the issuance and sale of its common stock publicly and through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In May 1993, Monongahela, Potomac Edison, and West Penn issued $10.68 million, $13.99 million, and $18.04 million, respectively, in solid waste disposal notes to Harrison County, West Virginia. Harrison County in turn issued $24.67 million of 6-1/4% and $18.04 million of 6.3% tax-exempt 30-year solid waste disposal revenue bonds. The Operating Subsidiaries are using the proceeds from the issuance to finance certain solid waste disposal facilities which comprise a portion of the scrubbers located at the Harrison Power Station. On November 3, 1993, the holders of more than two-thirds of the shares of APS common stock voted to split the common stock by amending the charter to reclassify each share of common stock, par value $2.50, issued or unissued, into two shares of common stock, par value $1.25 each. The stock split became effective on November 4, 1993. All references to APS common stock herein reflect the two-for-one stock split. On October 14, 1993, APS issued and sold 2,400,000 shares of its common stock in an underwritten offering with net proceeds to APS of $64.1 million, and in 1993 sold 1,364,846 shares of its common stock for $36.1 million through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In October 1993, Potomac Edison and West Penn issued and sold to APS 2,500,000 and 5,000,000 additional shares of each of their common stock, respectively, at a price of $20 per share. During 1993, the rate for West Penn's 400,000 shares of market auction preferred stock, par value $100 per share, reset approximately every 90 days at 2.62%, 2.55%, 2.595% and 2.7%. The rate set at auction on January 14, 1994, was 2.52%. In August 1993, Potomac Edison redeemed the remaining $404,600 of 4.70% Series B Preferred Stock outstanding. - 17 - In 1993, the Subsidiaries issued $651.9 million of securities having interest rates between 4.95% and 7.75%, to refund outstanding debt with rates of 7.0% to 9.75%, with an annual after-tax savings in interest cost of almost $9 million. In February 1993, Potomac Edison issued $45 million of 7-3/4%, 30-year first mortgage bonds to refund $25 million, 8-5/8% series due 2007 and $15 million, 8-5/8% series due 2003. In March 1993, West Penn issued $61.5 million of 10-year, 4.95% Pollution Control Revenue Notes to refund $30 million, 9-3/4% series due 2003 and $31.5 million, 9-1/2% series due 2003. In March 1993, AGC issued $50 million of 5- 3/4% medium-term notes due in 1998 to refund $50 million, 8% debentures due in 1997. In March 1993, Potomac Edison issued $75 million of 5-7/8% first mortgage bonds due 2000 to refund $72 million of four series due 1998-2002 with rates ranging from 7% to 8- 3/8%. In April 1993, Monongahela, Potomac Edison and West Penn issued $7.05 million, $8.6 million, and $7.75 million, respectively, in 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia. Monongalia County, in turn issued $23.4 million of 5.95%, 20-year Pollution Control Revenue Bonds to refund $23.4 million of three series due in 2013 with rates ranging from 9.375% to 9.5%. In April 1993, Monongahela issued $65 million of 5-5/8% first mortgage bonds due in 2000 to refund $60 million of three series due 1998-2002 with rates ranging from 7.5% to 8.125%. In June 1993, West Penn issued $102 million of 5-1/2% first mortgage bonds due in 1998 to refund $102 million of three series due 1997-1999 with rates ranging from 7% to 7-7/8%. Also in June 1993, West Penn issued $80 million of 6-3/8% first mortgage bonds due 2003 to refund $75 million of two series due 2001-2002 with rates of 7-5/8% and 8-1/8%. In September 1993, AGC issued $50 million of 5-5/8% debentures due 2003 and $100 million of 6-7/8% debentures due 2023 to refund $50 million, 8-3/4% debentures due 2017 and $100 million, 9-1/8% debentures due 2016. At December 31, 1993, APS had $67.5 million and Monongahela had $63.1 million outstanding in short-term debt, and AGC had $50.87 million outstanding in commercial paper and notes payable to affiliates, while Potomac Edison and West Penn had short-term investments of $4.6 million and $24.9 million, respectively. The Subsidiaries' ratios of earnings to fixed charges for the year ended December 31, 1993, were as follows: Monongahela, 3.49; Potomac Edison, 3.34; West Penn, 3.49; and AGC, 2.88. APS and the Subsidiaries' consolidated capitalization ratios as of December 31, 1993, were: common equity, 46.1%; preferred stock, 6.5%; and long- term debt, 47.4%. APS and the Subsidiaries' long-term objective is to maintain the common equity portion above 45%, reduce the long-term debt portion toward 45%, and maintain the preferred stock ratio for the balance of the capital structure. In January 1994, the Operating Subsidiaries jointly entered into an aggregate $300 million multi- year credit agreement with eighteen lenders. Each Operating Subsidiary's borrowings under the agreement are limited to its pro rata share of the stock of AGC, which stock was pledged to secure the credit agreement. The Operating Subsidiaries' percentage ownership of AGC and resulting borrowing limitations are: Monongahela 27%, $81,000,000; Potomac Edison 28%, $84,000,000; and West Penn 45%, $135,000,000. The agreement may be used as a supplement to or in lieu of public financings and short-term debt programs. - 18 - During 1994, Monongahela, Potomac Edison and West Penn plan to issue up to $50 million, $75 million, and $105 million, respectively, of new securities, consisting of both debt and preferred and common equity, for general corporate purposes, including their construction programs. In addition, the Operating Subsidiaries may engage in tax-exempt solid waste disposal financings to the extent funds are available to Harrison County from the West Virginia cap allocation. APS plans to fund Operating Subsidiaries' sales of common stock to it through the issuance of short-term debt and the sale of APS' common stock through its Dividend Reinvestment and Stock Purchase Plan and Employee Stock Ownership and Savings Plan. The Operating Subsidiaries, if economic and market conditions make it desirable, may refund during 1994 up to $550 million of first mortgage bonds, up to $100 million of preferred stock, and up to $78 million of pollution control revenue notes through tender offers or optional redemptions. FUEL SUPPLY System-operated stations burned approximately 15.7 million tons of coal in 1993. Of that amount, 67% was cleaned (6.7 million tons) or used in stations equipped with scrubbers (3.9 million tons). Use of desulfurization equipment and cleaning and blending of coal make burning local higher-sulfur coal practical, and in 1993 about 96% of the coal received at System stations came from mines in West Virginia, Pennsylvania, Maryland, and Ohio. The Operating Subsidiaries do not mine or clean any coal. All raw, clean or washed coal is purchased from various suppliers as necessary to meet station requirements. Long-term arrangements, subject to price change, are in effect and will provide for approximately 12 million tons of coal in 1994. The System depends on short-term arrangements and spot purchases for its remaining requirements. Through the year 1999, the total coal requirements of present System-operated stations are expected to be met with coal acquired under existing contracts or from known suppliers. The Operating Subsidiaries will meet the requirements of Phase I of the CAAA by installing scrubbers at Harrison Power Station. This will allow the continued use of local, high-sulfur coal there. A long-term contract for the supply of lime for use in the scrubber operation and for fixation of the scrubber byproduct has been negotiated and is expected to be signed in early 1994. It is expected that the use of lime will increase the costs of operating the station. For each of the years 1989 through 1992, the average cost per ton of coal burned was, respectively, $34.64, $35.97, $36.74 and $36.31. For the year 1993, the cost per ton decreased to $36.19, and in December 1993 the cost per ton was $36.45. - 19 - The labor agreement between the United Mine Workers of America (UMWA) and the Bituminous Coal Operators' Association (BCOA) expired on February 1, 1993. As a result, the UMWA initiated selective strikes against BCOA member companies on February 2, 1993. In late May and early June, numerous mines which serve the Operating Subsidiaries' power stations were closed down to various degrees. The UMWA and BCOA agreed to a new five year contract on December 14, 1993, and mining operations resumed at most mines during the week of December 20, 1993. The Operating Subsidiaries continued to meet customer needs during this approximately seven-month period through the use of existing low cost inventories, additional spot and substitute contract coal purchases, and some conservation measures, primarily at the Harrison Power Station. The Operating Subsidiaries own coal reserves estimated to contain about 125 million tons of high- sulfur coal recoverable by deep mining. There are no present plans to mine these reserves and, in view of economic conditions now prevailing in the coal market, the Operating Subsidiaries plan to hold the reserves as a long-term resource. RATE MATTERS Rate case decisions in Pennsylvania and Maryland were issued for West Penn and Potomac Edison in May and February, 1993. West Penn On May 14, 1993, the Pennsylvania Public Utility Commission (PUC) issued an order in West Penn's base rate case effective May 18, 1993, authorizing an increase in revenues of $61.6 million, of which $26.1 million was for recovery of carrying charges (return on investment and taxes) associated with West Penn's CAAA compliance plan through June 30, 1993. West Penn had originally filed for a base rate increase designed to produce $101.4 million. West Penn received all maintenance expenses that it had requested, and a return on equity (ROE) of 11.5%. West Penn filed a petition on January 12, 1994 with the PUC requesting authorization to accrue post in-service carrying charges on the Harrison scrubbers and to defer related depreciation and operating and maintenance expenses until they are recognized in rates. West Penn cannot predict the outcome of this proceeding. West Penn plans to file an application with the PUC on or about March 31, 1994, for a base rate increase to recover the remaining carrying charges on investment, depreciation and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the new rates will become effective on or about December 31, 1994. West Penn cannot predict the precise amount to be requested or the outcome of this proceeding. On February 20, 1992, the Commonwealth Court of Pennsylvania affirmed the PUC's December 13, 1990, decision relating to West Penn's challenge to the PUC's methodology for calculation of ROE. Three industrial customers also appealed to the Commonwealth Court that part of the PUC order which failed to allocate capacity costs of PURPA projects on a demand basis in West Penn's Energy Cost Rate. On June 25, 1992, the Commonwealth Court reversed the PUC's decision on this issue and remanded the case to the PUC for further proceedings. West Penn and other parties have negotiated a settlement on capacity costs of PURPA projects and other demand-related costs in West Penn's Energy Cost Rate, which settlement does not affect West Penn's revenues. The settlement agreement was approved by the PUC and was implemented in 1993. - 20 - Monongahela On January 18, 1994, Monongahela filed an application with the West Virginia Public Service Commission (West Virginia PSC) for a base rate increase designed to produce $61.3 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Monongahela cannot predict the outcome of this proceeding. Monongahela filed a petition on January 11, 1994, with the Public Utilities Commission of Ohio (PUCO) requesting authorization to accrue post-in-service carrying charges on the Harrison scrubbers until its investment in such scrubbers is recognized in rates. The petition also requested authorization for Monongahela to defer depreciation, and operating and maintenance expenses, including property taxes (but not including fuel costs) with respect to the scrubbers until the recovery of the deferrals can be addressed in Monongahela's next base rate case or otherwise, as the PUCO may deem appropriate. Monongahela is currently awaiting a decision on this petition. If the petition is approved, Monongahela will file its Ohio base rate case in early 1995. Potomac Edison The Maryland Public Service Commission (Maryland PSC) issued a final order in Potomac Edison's base rate case on February 24, 1993, authorizing an annual increase of $11.3 million, effective February 25, 1993, which included CAAA carrying charges through February 28, 1993. The original filing in July of 1992 was designed to produce approximately $23.0 million in additional annual revenues. Subsequent adjustments reduced this request to $17.6 million. Potomac Edison received most of the maintenance expenses that it had requested and a ROE of 11.9%. On April 30, 1993, Potomac Edison filed with the Virginia State Corporation Commission (SCC) for a rate increase designed to produce $10.0 million in additional annual revenues. The new rates went into effect on September 28, 1993, subject to refund. Hearings have been held and a final SCC decision is expected by April 1994. Potomac Edison cannot predict the outcome of this proceeding. - 21 - On January 14, 1994, Potomac Edison filed an application with the West Virginia PSC for a base rate increase designed to produce $12.2 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Potomac Edison cannot predict the outcome of this proceeding. On or about April 15, 1994, and June 30, 1994, Potomac Edison plans to file new rate cases in Maryland and Virginia, respectively. The amounts of the requested increases have not yet been determined, but they will include recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the Maryland decision will be rendered in late 1994, and the Virginia decision in mid-1995. However, in both jurisdictions, it is expected that increases will be effective in late 1994. Monongahela and Potomac Edison Pursuant to its order of December 12, 1991, approving Monongahela and Potomac Edison's plan for compliance with Phase I of the CAAA, the West Virginia PSC authorized recovery by Monongahela and Potomac Edison of $5.6 million and $1.4 million, respectively, of carrying charges on Phase I CAAA compliance costs through March 31, 1993, effective July 1, 1993. This brings the annual Phase I CAAA recovery for Monongahela and Potomac Edison to $8.7 million and $2.2 million, respectively. Pursuant to the order, Monongahela and Potomac Edison will submit requests for recovery of carrying charges through March 31, 1994, on Phase I CAAA compliance costs in the annual energy cost review proceedings with any increase to be effective July 1, 1994. The annual values of all CAAA revenues authorized in these proceedings will be removed from this collection process effective when full Phase I CAAA costs are included in base rates as a result of the 1994 rate case filings. AGC Through February 29, 1992, AGC's ROE was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties filed to reduce the ROE to 10%. Hearings were completed in June 1992, and a recommendation has been issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the other parties argue should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate filed a joint complaint with the FERC against AGC claiming that both the existing ROE of 11.53% and the ROE recommended by the ALJ of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53% with rates subject to refund beginning April 1, 1994. AGC cannot predict the outcome of these proceedings. - 22 - FERC West Penn, Potomac Edison, and Monongahela implemented settlement agreements in 1993 covering wholesale rates in effect for their municipal, co-op, and borderline agreement customers subject to the jurisdiction of the FERC. Each included carrying charges for work in progress on the scrubbers at the Harrison Power Station, additional expenses for postretirement benefits other than pensions (see below), and future automatic rate changes resulting from changes to taxes or tax rates (federal, state and local for Monongahela and West Penn, and federal for Potomac Edison). The amounts of the increases and the effective dates for West Penn, Potomac Edison, and Monongahela were $1.6 million on June 15, 1993; $1.5 million on September 15, 1993; and $0.6 million on December 1, 1993, respectively. It is anticipated that additional filings to include recovery of the remaining carrying charges on investment, depreciation, as well as all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense for each Operating Subsidiary will be made in 1994 with increases to be effective around the end of 1994. Postretirement Benefits Other Than Pensions (SFAS No. 106) The Operating Subsidiaries and APSC adopted SFAS No. 106 as of January 1, 1993. This requires all companies to accrue for the cost of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years that the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Operating Subsidiaries and APSC for retired employees and their dependents were recovered in rates on a pay-as-you-go basis. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for FERC wholesale customers effective on the rate case effective date described above under ITEM 1. RATE MATTERS, FERC. Regulatory actions have been taken by the PUCO and Virginia PSC, which indicate that substantial recovery is probable. The West Virginia PSC considers recovery of SFAS No. 106 costs on a case- by-case basis and therefore Monongahela and Potomac Edison cannot predict the outcome of such proceedings. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. Recovery of these costs in Ohio will be requested in the next base rate case which is expected to be filed in early 1995. The Operating Subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. The Operating Subsidiaries have recorded regulatory assets relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates. The Operating Subsidiaries do not anticipate that SFAS No. 106 will have a substantial effect on consolidated net income. - 23 - ENVIRONMENTAL MATTERS The operations of the Subsidiaries are subject to regulation as to air and water quality, hazardous and solid waste disposal, and other environmental matters by various federal, state, and local authorities. Meeting known environmental standards is estimated to cost the Subsidiaries about $361 million in capital expenditures over the next three years, including $254 million for compliance with Phase I of the CAAA, described below, and initial cost for anticipated compliance with Phase II. The full costs of compliance with Phase II cannot be estimated at this time, but may be substantial. Additional legislation or regulatory control requirements, if enacted, may well require modifying, supplementing, or replacing equipment at existing stations at substantial additional cost. Air Standards The Operating Subsidiaries meet applicable standards as to particulates and opacity at major stations with high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, and, at times, reduction of output. From time to time minor excursions of opacity normal to fossil fuel operations are experienced and are accommodated by the regulatory process. In February 1994, three notices of violation were received by the Operating Subsidiaries from the West Virginia Division of Environmental Protection (WVDEP) regarding opacity excursions for three power stations in West Virginia. The Operating Subsidiaries are working with the WVDEP to resolve the alleged violations. It is not anticipated that the alleged violations will result in substantial penalties. At the major stations (other than Mitchell Unit No. 3 and Pleasants, which have scrubbers), the Operating Subsidiaries meet current emission standards as to sulfur dioxide by using low-sulfur coal, by purchasing cleaned coal to lower the sulfur content, or by blending low-sulfur with higher sulfur coal. The CAAA, among other things, require an annual reduction in total utility emissions within the United States of 10 million tons of sulfur dioxide and two million tons of nitrogen oxides from 1980 emission levels, to be completed in two phases, Phase I and Phase II. Five coal-fired System plants are affected in Phase I and the remaining five coal-fired plants and any coal-fired plants or units reactivated in the future will be affected in Phase II. Installation of scrubbers at the Harrison Power Station is the strategy undertaken by the Operating Subsidiaries to meet the required sulfur dioxide emission reductions for Phase I (1995). Continuing studies will determine the compliance strategy for Phase II (2000). It is expected that burner modifications at all power stations will satisfy the nitrogen oxide emission reduction requirements for the acid rain (Title IV) provisions of the CAAA. Additional post-combustion controls may be mandated in Maryland and Pennsylvania for ozone nonattainment (Title I) reasons. Continuous emission monitoring equipment has been installed on all Phase I units and is being installed on Phase II units. Studies to evaluate cost effective options to comply with Phase II of the CAAA, including those which may be available from the use of Operating Subsidiaries' banked emission allowances and from the emission allowance trading market, are continuing. - 24 - In an effort to introduce market forces into pollution control, the CAAA created sulfur dioxide emission allowances. An allowance is defined as an authorization for an owner to emit one ton of sulfur dioxide into the atmosphere during or following a specified calendar year. Subject to regulatory limitations, allowances (including bonus and extension allowances) not used by an owner for its own compliance may be sold or "banked" for future use or sale. Through an industry allowance pooling agreement, the Operating Subsidiaries will receive a total of approximately 570,000 bonus and extension allowances during Phase I. These allowances are in addition to the Table A allowances of approximately 356,000 per year. As a result of EPA's 1993 auctioning of a number of Table A allowances retained from each utility's annual allotment, approximately 16,000 allowances were sold for the Operating Subsidiaries. Such auctions will be held every year for the foreseeable future and allowances sold thereby will result in a prorational allocation of revenues back to the Operating Subsidiaries. If some allowances offered at auction remain unsold, the balance will also be prorationally rebated to the utilities which contributed them. The proceeds from these auctions are expected to be relatively minimal and the Operating Subsidiaries plan to credit these proceeds against the capital cost of emission compliance activities, subject to regulatory approval. Other allowance trading activities may be undertaken by the Operating Subsidiaries once certain tax questions are answered and once studies to determine Phase II compliance strategy are completed. In 1989, the West Virginia Air Pollution Control Commission approved the construction of a cogeneration facility in the vicinity of Rivesville, West Virginia. Emissions impact modeling for that facility raised concerns about the compliance status of Monongahela's Rivesville Station with the National Ambient Air Quality Standards (NAAQS) for sulfur dioxide. Pursuant to a consent order, Monongahela agreed to collect on- site meteorological data and conduct additional dispersion modeling in order to demonstrate compliance. The modeling study and a compliance strategy recommending construction of a new "good engineering practices" (GEP) stack was submitted to the WVDEP in June 1993. Costs associated with the GEP stack are approximately $7 million. Monongahela is awaiting action by the WVDEP. - 25 - Under an EPA-approved consent order with Pennsylvania, West Penn completed construction of a GEP stack at the Armstrong Station in 1982 at a cost of over $13 million with the expectation that EPA's reclassification of Armstrong County to "attainment status" under NAAQS for sulfur dioxide would follow. As a result of the 1985 revision of its stack height rules, EPA refused to reclassify the area to attainment status. West Penn appealed the EPA's decision. In 1988, the U. S. Court of Appeals for the Third Circuit dismissed West Penn's appeal for lack of jurisdiction, stating that West Penn's request for reconsideration before EPA made EPA's denial a non-final agency action. West Penn's request for reconsideration before EPA remains pending. West Penn cannot predict the outcome of this proceeding. Water Standards Under the National Pollutant Discharge Elimination System (NPDES) permitting procedures, permits for all System-owned stations are in place. However, in proposed NPDES renewal permits for some stations which are currently being sought, some conditions are being appealed through the regulatory process since the Operating Subsidiaries believe the effluent limitations being applied are overly stringent. The Operating Subsidiaries continue to work with the appropriate state agencies to resolve these issues. In the meantime, the existing permits remain in effect during the appeal process. The EPA and states are now implementing stormwater runoff regulations for controlling discharges from industrial and municipal sources as well as construction sites. Stormwater discharges have been identified and included in NPDES renewals, but controls have not yet been required. Since the current round of permit renewals began in 1993, monitoring requirements have been imposed, with pollution reduction plans and additional control of some discharges anticipated. Pursuant to the National Groundwater Protection Strategy, which supplements existing West Virginia groundwater protection policy, West Virginia has adopted a Groundwater Protection Act. This law establishes a statewide antidegradation policy which could require the Operating Subsidiaries to undertake reconstruction of existing landfills and surface impoundments as well as groundwater remediation, and may affect herbicide use for right-of-way maintenance in West Virginia. Groundwater protection standards were approved and implemented in 1993 (based on EPA drinking water criteria) which established compliance limits which cannot be exceeded. The Operating Subsidiaries anticipate that some facilities will not be able to meet the new compliance limits. Variance requests and requests for stays of implementation have been made for all affected facilities. However, variance rules have not yet been promulgated and action on the requests has not been taken. Therefore, it is not possible to predict the difficulty and costs associated with obtaining variances. If variances are not granted, costs may be incurred by the Operating Subsidiaries for groundwater remediation. Such costs, if any, cannot be predicted at this time. - 26 - The Pennsylvania Department of Environmental Resources (PADER) developed a Groundwater Quality Protection Strategy which established a goal of nondegradation of groundwater quality. However, the strategy recognizes that there are technical and economic limitations to immediately achieving the goal and further recognizes that some groundwaters need greater protection than others. The PADER is beginning to implement the strategy by promulgating changes to the existing rules that heretofore did not consider the nondegradation goal. The full extent of the impact of the strategy on the Operating Subsidiaries cannot be anticipated at this time. In 1993, two notices of violation were received by the Operating Subsidiaries from the WVDEP regarding excursions above limits contained in NPDES permits for discharge of leachate from fly ash landfills in West Virginia. One violation notice was withdrawn by the state agency and the other was resolved without payment of substantial penalty. On January 27, 1994 and February 9, 1994, the Operating Subsidiaries received two separate notices of violation from PADER regarding excursions above limits contained in the NPDES permit for discharge of leachate from Hatfield's Ferry Power Station fly ash landfill. One violation notice was resolved without payment of substantial penalty. The Operating Subsidiaries are working with the PADER to resolve the other alleged violation. It is not anticipated that the alleged violation will result in substantial penalties. Hazardous and Solid Wastes Pursuant to the Resource Conservation and Recovery Act of 1976 and the Hazardous and Solid Waste Management Amendments of 1984 (RCRA), EPA regulates the disposal of hazardous and solid waste materials. Pennsylvania, West Virginia, Maryland, Ohio, and Virginia have also enacted hazardous and solid waste management legislation. With the installation of the scrubbers at the Harrison Power Station, approximately 2.8 million tons per year of scrubber sludge, consisting principally of limestone and ash, will be generated and disposed of in a disposal facility owned and operated by the Operating Subsidiaries. The expected capacity of the site is 30 years. Pleasants Power Station processes its scrubber sludge using a wet-fixation and slurry system, with the treated sludge disposed of in a properly permitted sludge pond. Mitchell and Harrison Power Stations process their scrubber sludge by a dry-fixation process with the stabilized sludge disposed of in a properly permitted landfill. Coal combustion byproducts from all other facilities are either sold for beneficial reuse or landfilled in properly permitted and currently adequate disposal facilities owned and operated by the Operating Subsidiaries. The Operating Subsidiaries are in the process of permitting additional capacity to meet future disposal needs. - 27 - Costs are being incurred as the Operating Subsidiaries progress with implementation of both West Virginia's and Pennsylvania's 1992 solid waste regulatory changes. A predominant portion of the costs are attributable to two major factors: 1) liner systems for new disposal sites and the expansion portion of existing disposal sites, and 2) the assessment of groundwater impacts via monitoring wells. Because past operating practices, while in compliance with then existing regulations, may not meet the current criteria, as measured by new standards, it is possible that groundwater remediation may be required at some of the Operating Subsidiaries' facilities. In addition, under West Virginia's Solid Waste Rules, it is possible that certain active disposal sites may have to be retrofitted with liner systems to address potential groundwater degradation. The draft permit renewal from WVDEP for the currently active disposal site at Albright Power Station requires, on a portion of the site, retrofitting with a new liner system with possible removal of already placed coal combustion byproducts. The Operating Subsidiaries are working to have this proposed permit condition removed; however if it is not, it is anticipated that this condition will be appealed. EPA regulations on the burning of hazardous waste in utility boilers are expected to be amended in 1994 making the practice cost prohibitive for the Operating Subsidiaries. Until such time as the regulations are amended, the Operating Subsidiaries will continue to minimize their hazardous waste and to burn small quantities of hazardous waste generated in accordance with EPA boiler and industrial furnace disposal rules. Once such regulations are amended, the low volume wastes will be disposed of in incinerators or landfills which are owned by third parties. None of the Operating Subsidiaries are required to obtain hazardous waste treatment, storage or disposal permits under RCRA. With a continued effort to reduce hazardous waste, disposal costs and potential environmental liability should be minimized. Potomac Edison has received a notice from the Maryland Department of the Environment (MDE) regarding a remediation ordered under Maryland law at a facility previously owned by Potomac Edison. The MDE has identified Potomac Edison as a potentially responsible party under Maryland law. Remediation is currently being implemented by the current owner of the facility in Frederick, Maryland. It is not anticipated that Potomac Edison's share of remediation costs, if any, will be substantial. Emerging Environmental Issues Title I of the CAAA establishes an ozone transport region consisting of 11 northeast states including Maryland and Pennsylvania. Sources within the region will be required to reduce nitrogen oxide emissions, a precursor of ozone, to a level conducive to attainment of the ambient ozone standard. The first step for Title I compliance will result in the installation of low nitrogen oxide burners and potentially overfire air at all Pennsylvania and Maryland stations by 1995. This is compatible with Title IV nitrogen oxide reduction requirements. Modeling studies being conducted by the states will determine if a second step of reductions will be necessary which could require installation of post- combustion control technologies. - 28 - Title III of the CAAA requires EPA to conduct studies of toxic air pollutants from utility plants to determine if emission controls are necessary. EPA's reports are expected to be submitted to Congress in late 1995. The impact of Titles I and III on the Operating Subsidiaries is unknown at this time. Both the CWA and the RCRA are expected to be reauthorized in 1994. It is anticipated that coal combustion byproducts will continue to be regulated as nonhazardous waste, minimizing the Operating Subsidiaries' disposal costs. An additional issue which could impact the Operating Subsidiaries and which is undergoing intense study, is the effect, if any, of electric and magnetic fields. The financial impact of this issue on the Operating Subsidiaries, if any, cannot be assessed at this time. In connection with President Clinton's Climate Change Action Plan concerning greenhouse gases, the Operating Subsidiaries expressed by letter to the DOE in August 1993, their willingness to work with the DOE on implementing voluntary, cost-effective courses of action that reduce or avoid emission of greenhouse gases. Such courses of action must take into account the unique circumstances of each participating company, such as growth requirements, fuel mix and other circumstances. Furthermore, they must be consistent with the Operating Subsidiaries' integrated resource planning process and must not have an adverse effect on competitive position in terms of costs and rates or be unacceptable to their regulators. Some 63 other utility systems submitted similar letters. REGULATION APS and the Subsidiaries are subject to the broad jurisdiction of the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935 (PUHCA). APS is also subject to the jurisdiction of the Maryland PSC as to certain of its activities. The Subsidiaries are regulated as to substantially all of their operations by regulatory commissions in the states in which they operate and also by the DOE and the FERC. In addition, they are subject to numerous other city, county, state, and federal laws, regulations, and rules. EPACT became law on October 24, 1992. This broad legislation, among other things, amends PUHCA to permit utilities subject to PUHCA to compete in the wholesale generation business with other wholesale generators which it exempts from PUHCA; to ease restrictions on financing for that purpose; and to permit investment in foreign utilities. EPACT also amends the Federal Power Act to permit the FERC to order, under specified circumstances, access to transmission systems (including those of the System) so long as it would not unreasonably impair reliability nor adversely affect its existing wholesale, retail and transmission customers. It also amends PURPA to encourage states to study and regulate various matters, including the capital structures of EWGs, integrated resource planning, and the amount of purchased power that electric utilities should have in their generation mix. EPACT also sets forth waste disposal standards, new nuclear licensing procedures, and contains provisions promoting alternate transportation fuels, research on environmental issues, and increased energy from renewables (See discussion of EPACT in ITEM 1. BUSINESS, SALES and ELECTRIC FACILITIES). - 29 - Pursuant to the requirements of Section 712 of EPACT, the Maryland, Ohio, Pennsylvania, Virginia, and West Virginia commissions issued orders regarding four broad economic and regulatory policy issues related to the purchase of wholesale power. All of the commissions decided to evaluate these issues on a case- by-case basis or within their existing regulatory framework, instead of establishing generic standards. On January 24, 1994, the Maryland PSC issued an order which instituted a proceeding for the purpose of determining whether to implement standards which, under EPACT, a state commission must consider in order to encourage integrated resource planning and investments in conservation and energy efficiency by electric utilities. The order provides for the filing of initial and reply comments and for a hearing on May 3, 1994. Potomac Edison intervened and will be submitting comments in this proceeding. Under EPACT, the FERC has initiated several proceedings, one of the most significant being the request for comments on transmission pricing, including pricing as it may apply to parallel power flows. The Operating Subsidiaries have developed and submitted a pricing philosophy intended to meet certain goals, including reliable operation of the transmission system and protection of native load customers, while promoting accurate price signals and offering third- party transmission service at the lowest reasonable rates. Other FERC initiatives included the issuance of guidelines governing open access transmission requests and rules governing the establishment of Regional Transmission Groups. The Operating Subsidiaries founded and continue to participate in, along with other utilities, an organization whose primary purpose is to develop a mutually acceptable method of resolving the inequities imposed on transmission network owners by parallel power flows. The SEC has also issued regulations and proposed regulations to implement EPACT, including the integration of EPACT with PUCHA and the effect of EPACT on nonexempt PUCHA companies such as APS and its Subsidiaries. In July 1993, the PUC directed the Bureau of Conservation, Economics and Energy Planning to develop competitive bidding regulations to replace, at least in part, the existing state PURPA regulations. In November 1993, West Penn filed a petition with the PUC requesting an Order that, pending the revision and replacement of the existing state PURPA regulations, any proceedings or orders regarding purchase by West Penn of capacity from a qualifying facility under PURPA shall be based on competitive bidding. The Office of Consumer Advocate, the Office of Small Business Advocate, the West Penn Power Industrial Intervenors, and West Penn's two largest industrial customers have intervened in support of West Penn's position. Several PURPA developers and a group purporting to represent PURPA interests have filed in opposition to certain parts of the petition. West Penn cannot predict the outcome of this proceeding. - 30 - On October 8, 1993, the West Virginia PSC issued proposed regulations concerning bidding procedures for capacity additions for electric utilities and invited comment by December 7, 1993. A number of interested parties, including Monongahela and Potomac Edison, filed comments. The West Virginia PSC has taken no further action since the filing of comments. On December 17, 1992, the PUCO issued proposed rules concerning competitive bidding for supply-side resources, transmission access for winning bidders and incentives for the recovery of the cost of purchased power. The PUCO invited comments by March 3, 1993 and reply comments by March 24, 1993. A number of interested parties, including Monongahela, submitted comments. The PUCO has taken no further action following the filing of comments. Maryland and Virginia have not mandated compulsory competitive bidding at this date. The Omnibus Budget Reconciliation Act of 1993 increased the marginal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. As a result, the Operating Subsidiaries' income tax expense for 1993 increased by about $3 million. On June 13, 1990, the Maryland PSC began an investigation to determine whether Potomac Edison's methodology for calculating avoided costs under PURPA is appropriate. On October 11, 1991, the Maryland PSC incorporated this review of avoided costs into a collaborative process already formed between its Staff, the Maryland Department of Natural Resources, Potomac Edison, Eastalco Aluminum, the Maryland Energy Administration, and the Office of People's Counsel. Although the group's primary mission was to avoid litigation by working cooperatively to develop demand- side management programs, the issue of avoided costs was addressed because avoided costs are needed for determining the cost-effectiveness of programs. These negotiations culminated in a Settlement Agreement which was signed by the six parties and filed with the Maryland PSC on October 14, 1993. The Hearing Examiner issued a proposed order accepting the Settlement Agreement on November 17, 1993. The proposed order became final on December 17, 1993, thereby concluding this proceeding. In October 1990, the PUC ordered Pennsylvania's major electric utilities, including West Penn, to file programs for demand-side management designed to reduce customer demand for electricity and to reduce the need for additional generating capacity. The PUC's order proposed that the affected utilities receive full recovery of the costs of approved programs, as well as financial incentives for implementing such programs, including recovery of lost revenues. West Penn filed its proposed programs with the PUC. On December 13, 1993, the PUC entered an order which provides for the recovery of program costs either through a surcharge or deferral to a base rate case; the recovery of revenues lost due to the implementation of demand-side management programs through a base rate case; and the award of incentives for good program performance or the assessment of penalties for poor performance. Two parties to this proceeding have petitioned the PUC for reconsideration and clarification and the Pennsylvania Industrial Energy Coalition has filed an appeal with the Commonwealth Court of Pennsylvania. West Penn cannot predict the final outcome of this proceeding. - 31 - During 1993, Potomac Edison continued its participation in the Collaborative Process for demand- side management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and Potomac Edison's largest industrial customer. Potomac Edison received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993 Potomac Edison had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. ITEM 2. ITEM 2. PROPERTIES Substantially all of the properties of the Operating Subsidiaries are held subject to the lien securing each company's first mortgage bonds and, in many cases, subject to certain reservations, minor encumbrances, and title defects which do not materially interfere with their use. Some properties are also subject to a second lien securing certain solid waste disposal and pollution control notes. The indenture under which AGC's unsecured debentures and medium-term notes are issued, prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures and medium-term notes are contemporaneously secured equally and ratably with all other indebtedness secured by such lien. Transmission and distribution lines, in substantial part, some substations and switching stations, and some ancillary facilities at power stations are on lands of others, in some cases by sufferance, but in most instances pursuant to leases, easements, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases no examination of titles has been made as to lands on which transmission and distribution lines and substations are located. Each of the Operating Subsidiaries possesses the power of eminent domain with respect to its public utility operations. (See also ITEM 1. BUSINESS and SYSTEM MAP.) - 32 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS In 1979, National Steel Corporation (National Steel) filed suit against certain Subsidiaries in the Circuit Court of Hancock County, West Virginia, alleging damages of approximately $7.9 million as a result of an order issued by the West Virginia PSC requiring curtailment of the plaintiff's use of electric power during the United Mine Workers' strike of 1977-8. A jury verdict in favor of the defendants was rendered in June 1991. National Steel has filed a motion for a new trial, which is still pending before the Circuit Court of Hancock County. The Subsidiaries believe the motion is without merit; however, they cannot predict the outcome of this case. In 1987, West Penn entered into separate agreements with developers of four PURPA projects: Milesburg (43 MW), Burgettstown (80 MW), Shannopin (80 MW) and Point Marion (2 MW). The agreements provided for the purchase of each project's power over 30 years or more at rates generally approximating West Penn's avoided costs at the time the agreements were negotiated, as defined by PURPA. Yearly capacity payments under the four agreements would total in excess of $50 million. Each agreement was subject to prior PUC approval of the pass-through to West Penn's customers of the total cost incurred under each agreement, on a current basis. In 1987 and 1988, West Penn filed a separate petition with the PUC for each agreement requesting an appropriate PUC order, and various parties intervened. Since that time, all four agreements have been, in varying degrees, the subject of complex and continuing regulatory and judicial proceedings. During 1993, West Penn entered into a settlement agreement with Point Marion and that project has been terminated. On November 24, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Milesburg project which upheld the decision of the Commonwealth Court concerning the time frame for the calculation of avoided cost and upheld the decision that the PUC had the authority under PURPA to revise and reinstate a lapsed power purchase contract. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. On December 30, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Shannopin project which upheld the decision of the Commonwealth Court affirming the PUC's authority under PURPA to revise voluntarily negotiated power purchase contracts. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. As of December 31, 1993, petitions for allowance of an appeal of the decision of the Pennsylvania Commonwealth Court on the Burgettstown project were pending before the Pennsylvania Supreme Court. West Penn cannot predict the outcome of these proceedings. On October 28, 1993, South River Power Partners, L.P. ("South River") filed a complaint against West Penn with the PUC. The complaint seeks to require West Penn to purchase 240 MW from a proposed coal-fired PURPA project which South River proposes to build in Fayette County, Pennsylvania. South River's proposed initial price for this power would be over $0.09 per kWh. West Penn is opposing this complaint as the power is not needed and the price is in excess of avoided cost. The Pennsylvania Consumer Advocate, the Small Business Advocate, the PUC Trial Staff and various industrial customers have also intervened in opposition to the complaint. West Penn cannot predict the outcome of this proceeding. - 33 - Two previously reported complaints had been filed with the West Virginia PSC by developers of cogeneration projects in Marshall and Barbour Counties, West Virginia to require Monongahela and Potomac Edison to purchase capacity from the projects. These two cases were consolidated. The West Virginia PSC on March 5, 1993, found that: Monongahela had no need for additional capacity; Potomac Edison will need new combustion turbine generating capacity beginning in 1996; and Potomac Edison's avoided cost estimate, which is substantially below the costs sought by the developers of the projects, is reasonable. The developers have asked the West Virginia PSC to consider issues not resolved in the March 5, 1993 order. On June 25, 1993 the West Virginia PSC found that Potomac Edison had a PURPA obligation to purchase power from qualifying facilities properly interconnected to the System in Monongahela's service territory and ordered negotiations by Monongahela and Potomac Edison with the two PURPA developers. On August 9, 1993, the West Virginia PSC deconsolidated the two cases. Following the West Virginia Supreme Court's denial of a petition for review of this order, both developers requested the start of negotiations. Monongahela and Potomac Edison cannot predict the outcome of these proceedings. On November 16, 1992, Potomac Edison and the developer of a proposed cogeneration project located in Cumberland, Maryland, requested that the Maryland PSC approve an amendment to a previously approved agreement for the sale of 180 MW of capacity and associated energy from the project to Potomac Edison. The amendment provides for the relocation of the proposed project within the Cumberland area; a delay of one year in the project's earliest in-service date to October 1, 1996, without increase in the initial capacity rate (which otherwise escalates annually at one-half the rate of actual inflation); and other changes consistent with the site and in-service date modifications. The Maryland PSC commenced an investigation of the amendment in December 1992. After hearings, the parties reached a settlement which was approved by the Maryland PSC on March 17, 1993. The settlement agreement resulted in a further delay of the project's in-service date to October 1, 1999, modified the initial capacity rate with only a slight escalation, and provided that Potomac Edison would pay, and recover from customers by a surcharge, a portion of the project's costs resulting from the delay. On December 22, 1993, the Maryland PSC approved the surcharge and these costs are being recovered from customers effective January 1, 1994. As previously reported, effective March 1, 1989, West Virginia enacted a new method for calculating the Business and Occupation Tax (B & O Tax) on electricity generated in that state, which disproportionately increased the B & O Tax on shipments of electricity to other states. In 1989, West Penn, the Pennsylvania Consumer Advocate, and several West Penn industrial customers filed a joint complaint in the Circuit Court of Kanawha County, West Virginia seeking to have the B & O Tax declared illegal and unconstitutional on the grounds that it violates the Interstate Commerce Clause and the Equal Protection Clause of the federal Constitution and certain provisions of federal law that bar the states from imposing or assessing taxes on the generation or transmission of electricity that discriminate against out-of-state entities. In 1991, West Penn amended the complaint to include a 1990 increase in the rate of the B & O Tax. The trial was held in July 1993 and briefs have been filed. West Penn cannot predict the outcome of this litigation. - 34 - As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shot- gun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Operating Subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the Operating Subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at Subsidiary-operated stations were employed by third- party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Operating Subsidiaries believe potential liability of the Operating Subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the Operating Subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. On March 4, 1994, the Operating Subsidiaries received notice that the EPA had identified them as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), with respect to the Jack's Creek/Sitkin Smelting Superfund Site ("Site"). The Operating Subsidiaries are among some 880 PRPs that have been identified at the Site. EPA is planning to issue a Proposed Plan and Record of Decision in September 1994 delineating the remedy selected for the Site. At this time it is not possible to determine what liability, if any, the Operating Subsidiaries may have regarding the Site. - 35 - In 1970, the Operating Subsidiaries filed with the Federal Power Commission (FPC) an application for a license to build a 1,000-MW energy-storage facility near Davis, West Virginia. In 1977, FPC issued a license for the project, but various parties, including the State of West Virginia and the U.S. Department of Interior, filed appeals, which are now pending before the U.S. Court of Appeals for the District of Columbia. The U.S. Army Corps of Engineers (Corps) denied a dredge and fill permit for the project, which decision was appealed. The U.S. District Court for the District of Columbia decided that the Corps had no jurisdiction in the matter. The Corps filed an appeal with the U.S. Court of Appeals for the District of Columbia. In 1987, the appellate Court decided that the Corps did have jurisdiction and remanded the case to the U.S. District Court for further consideration of the Corps' denial of the permit. The U. S. Supreme Court refused to review that decision. In 1988, the U.S. District Court reversed the Corps' denial of the dredge and fill permit. The District Court's decision, which has now been appealed, found, among other things, that the Operating Subsidiaries were denied an opportunity to review and comment upon written materials and other communications used by the Corps in making its decision, and as a result the Court remanded the matter to the Corps for further proceedings. Negotiations are ongoing to settle this matter. The Operating Subsidiaries cannot predict the outcome of these proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The holders of 46,537,924 shares of common stock of APS voted at a special meeting held on November 3, 1993 to amend APS' charter to reclassify each share of common stock, par value $2.50 per share, issued or unissued, into two shares of common stock, par value $1.25 each. The holder of 259,451 shares voted against the proposal and the holders of 296,598 shares abstained. The charter amendment became effective at the close of business on November 4, 1993. The amount of APS' stated capital was not changed as a result of the amendment. The holder of the common stock of Monongahela on December 13, 1993, waived the holding of a meeting and consented in writing to the amendment of its Charter to reflect the redemption of 50,000 shares of $9.64 series cumulative preferred stock. No other company submitted matters to a vote of shareholders during the fourth quarter. - 36 - Executive Officers of the Registrants The names of the executive officers of each company, their ages, the positions they hold and their business experience during the past five years appears below: (a) All officers and directors are elected annually. - 37 - (a) All officers and directors are elected annually. - 48 - (a) All officers and directors are elected annually. - 39 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS APS. AYP is the trading symbol of the common stock of APS on the New York, Chicago, and Pacific Stock Exchanges. The stock is also traded on the Amsterdam (Netherlands) and other stock exchanges. As of December 31, 1993, there were 63,396 holders of record of APS' common stock. The tables below show the dividends paid and the high and low sale prices of the common stock for the periods indicated: The high and low prices in 1994 were 26-1/2 and 24-1/8 through February 3. The last reported sale on that date was at 25. Monongahela, Potomac Edison, and West Penn. The information required by this Item is not applicable as all the common stock of these Subsidiaries is held by APS. AGC. The information required by this Item is not applicable as all the common stock of AGC is held by Monongahela, Potomac Edison, and West Penn. - 40 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Page No. APS D-1 Monongahela D-3 Potomac D-5 West Penn D-7 AGC D-9 D-1 D-2 (a) Reflects a two-for-one common stock split effective November 4, 1993. (b) Capability available through contractual arrangements with nonutility generators. (c) Preliminary. D-3 D-3 (a) Capability available through contractual arrangements with nonutility generators. D-5 D-6 D-7 D-8 (a) Capability available through contractual arrangements with nonutility generators. D-9 - 41 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page No. APS M-1 Monongahela M-9 Potomac M-18 West Penn M-27 AGC M-36 M-1 APS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED NET INCOME Earnings per share were $1.88 in 1993 and were $1.83 and $1.80 in 1992 and 1991. Consolidated net income was $215.8 million, $203.5 million, and $194.0 million. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. All per share amounts have been adjusted to reflect the November 4, 1993, two-for-one stock split (See Note F to the consolidated financial statements). SALES AND REVENUES KWh sales to and revenues from residential, commercial, and industrial customers are shown on page D-2. Such kWh sales increased 3.3% and 1.5% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $ 46.6 $ 9.1 Fuel and energy cost adjustment clauses (a) 57.0 37.9 Rate increases (b): Pennsylvania 25.2 5.8 Maryland 12.7 11.7 West Virginia 5.3 12.4 Virginia 2.5 1.8 Ohio 2.1 1.7 47.8 33.4 Other 6.2 .1 $157.6 $80.5 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) See ITEM 1. RATE MATTERS for further information on rate changes. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were approximately normal, cooling degree days increased 69% over 1992 and were 25% over normal, contributing to the 1993 kWh sales increases. The subsidiaries experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M -2 KWh sales to industrial customers increased .3% in 1993 and 2.9% in 1992. The relatively flat industrial sales growth in 1993 followed record industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From subsidiaries' generation 1.2 3.2 5.8 From purchased power 11.2 14.6 12.4 12.4 17.8 18.2 Revenues (in millions): From subsidiaries' generation $ 28.5 $ 91.7 $158.5 From sales of purchased power 318.2 373.8 366.5 $346.7 $465.5 $525.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by subsidiaries' generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the subsidiaries' ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989--a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $14 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M -3 OPERATING EXPENSES Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with other utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA) and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Purchased power: For resale to other utilities $280.9 $344.0 $332.7 From PURPA generation 105.2 94.0 68.9 Other 33.8 12.7 29.0 Total power purchased 419.9 450.7 430.6 Power exchanges, net (2.5) .7 (1.4) $417.4 $451.4 $429.2 The amount of power purchased from other utilities for use by subsidiaries and for resale to other utilities depends upon the availability of the subsidiaries' generating equipment, transmission capacity, and fuel, and their cost of generation and the cost of operations of other utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to other utilities is described under SALES AND REVENUES above. The cost of power purchased for use by the subsidiaries, including power from PURPA generation, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the subsidiaries' regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net income. The increases in purchases from PURPA generation reflect additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $5 million. The subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates and will be requesting recovery of substantially all of the remainder in 1994 rate cases. During 1992, the subsidiaries implemented significant changes to their benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 20% greater than 1993 amounts. M-4 Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other postemployment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The subsidiaries currently accrue for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The subsidiaries are also experiencing, and expect to continue to experience, increased expenditures due to the aging of their power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the Clean Air Act Amendments of 1990 (CAAA). Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note I to the consolidated financial statements) and the replacement of aging equipment at the subsidiaries' power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $4 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($5 million) and increased property taxes ($2 million). These increases were offset by decreased West Virginia Business and Occupation taxes (B&O taxes) due to decreased generation in that state. The 1992 increase resulted from increased property taxes ($4 million), increases in gross receipts taxes ($3 million), and increased capital stock taxes ($2 million), offset by decreased B&O taxes ($2 million). The net increase of $13 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($9 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($3 million). The net decrease in 1992 of $4 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the consolidated financial statements provides a further analysis of income tax expenses. M-5 The combined increase of $4 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. Fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the levels of short-term debt maintained by the companies. The decrease in dividends on preferred stock of subsidiaries reflects the 1992 redemption of three series totaling $25 million with dividend rates of 9.4% to 9.64% and the 1993 redemption of an additional $2 million of 4.7% to $7.16 series, offset by the 1992 sale of $40 million of market auction preferred stock with an average dividend rate of 2.6%. LIQUIDITY AND CAPITAL RESOURCES SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". System companies need cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for their construction programs. To meet these needs, the companies have used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the companies' cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. CAPITAL REQUIREMENTS Construction expenditures for 1993 were $574 million and for 1994 and 1995 are estimated at $500 million and $400 million, respectively. These estimates include $161 million and $53 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA discussed under ITEM 1. ENVIRONMENTAL MATTERS. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for M-6 compliance with both Phase I and Phase II of the CAAA. The subsidiaries are estimating amounts of approximately $1.4 billion, which includes $482 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the subsidiaries have additional capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note G to the consolidated financial statements). INTERNAL CASH FLOWS Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $270 million in 1993. Regulatory commission orders received in Maryland, Pennsylvania, Virginia, and West Virginia provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and requested and new rate cases planned in 1994, internal generation of cash can be expected to increase. The increase in other investments reflects the 1993 cash surrender values for secured benefit plans and a related prepayment. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($54 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the subsidiaries' regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. FINANCINGS In October 1993, the Company issued 2,400,000 shares of its common stock for $64.1 million. Also during 1993, the Company issued 1,364,846 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRISP), and Employee Stock Ownership and Savings Plan (ESOP) for $36.1 million. During 1993 the subsidiaries issued $43 million of 6.25% to 6.3% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $634 million of debt securities having interest rates of 7% to 9.75% through the issuance of $652 million of securities having interest rates of 4.95% to 7.75%. The costs M-7 associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $44 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long-term securities. Short-term debt increased from $11.2 million in 1992 to $130.6 million in 1993. The subsidiaries canceled or postponed approximately $152 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its subsidiaries established an internal money pool whereby surplus funds of the Company and certain subsidiaries may be borrowed on a short-term basis by the Company's subsidiaries. This has contributed to the decrease in the 1993 temporary cash investment amounts. Allegheny Generating Company in 1992 replaced its $65.7 million of commercial paper with $50.9 million of money pool borrowings and $2.4 million of four-year, 6.05%-6.10% medium-term notes. Allegheny Generating Company has available an established program to replace money pool borrowings with medium-term notes or commercial paper. At December 31, 1993, unused lines of credit with banks were $149 million. In addition, a multi-year credit program was established in January 1994, which provides that the subsidiaries may borrow on a standby revolving credit basis up to $300 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the subsidiaries plan to issue about $230 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $728 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The subsidiaries may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company plans to fund the subsidiaries' sale of common stock through the issuance of short-term debt and DRISP/ESOP common stock sales. The subsidiaries anticipate that they will be able to meet their future cash needs through internal cash generation and external financings as they have in the past and possibly through alternative financing procedures. M-8 ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES In the normal course of business, the subsidiaries are subject to various contingencies and uncertainties relating to their operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note I to the consolidated financial statements. All of the state jurisdictions in which the subsidiaries operate have enacted hazardous and solid waste management legislation. While the subsidiaries do not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The subsidiaries are incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the subsidiaries. As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison, and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at subsidiary-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the subsidiaries believe potential liability of the subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. M-9 Monongahela MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $61.7 million, $58.3 million, and $54.1 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-3 and D-4 Such kWh sales increased .3% in 1993 and decreased 1.0% in 1992. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase (Decrease) from Prior Year 1993 1992 (Millions of Dollars) Increased (decreased) kWh sales $ 6.6 $(5.3) Fuel and energy cost adjustment clauses (a) 11.8 12.3 Rate increases (b): West Virginia 4.1 12.1 Ohio 2.1 1.6 6.2 13.7 Other .2 (1.3) $24.8 $19.4 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a surcharge in West Virginia for recovery of carrying charges on expenditures to comply with the Clean Air Act Amendments of 1990 (CAAA), designed to produce $3.1 million on an annual basis effective on July 1, 1992, which was increased to $8.7 million on an annual basis effective on July 1, 1993, and a rate increase in Ohio, designed to produce $3.3 million on an annual basis, which became effective on July 21, 1992. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were only 6% above normal, cooling degree days increased 54% over 1992, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-10 KWh sales to industrial customers decreased 4.4% in 1993 and .7% in 1992. The 1993 decrease was primarily due to continuing declines in sales to coal and primary metals customers. Coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. Lower sales to primary metals customers was due in part to one iron and steel customer's increased use of its own generation. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .3 1.0 1.8 From purchased power 2.8 3.6 3.1 3.1 4.6 4.9 Revenues (in millions): From Company generation $ 8.4 $ 26.7 $ 48.5 From sales of purchased power 77.6 92.9 91.5 $86.0 $119.6 $140.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWH) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The increase in other revenues in 1993 and 1992 resulted from continued increases in sales of capacity, energy, and spinning reserve to other affiliated companies because of additional capacity and energy available from new PURPA projects in both years. This increase was offset in part in 1993 by an agreement with the Federal Energy Regulatory Commission to record in 1993 about $3 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. About 90% of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on net income. M-11 Operating Expenses Fuel expenses decreased 3% in 1993 and 9% in 1992. Both decreases were primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $ 68.6 $ 85.5 $ 83.0 From PURPA generation 55.7 37.4 13.2 Other 8.1 3.1 7.2 Power exchanges, net (.6) .3 (.5) Affiliated transactions: AGC capacity charges 23.3 24.2 25.1 Energy and spinning reserve charges .5 2.8 5.3 $155.6 $153.3 $133.3 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The increases in purchases from PURPA generation reflects additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. Energy and spinning reserve charges decreased in 1993 and 1992 primarily because of additional generation available from new PURPA projects. M-12 The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, will increase future employee benefit costs for postretirement benefit expenses. The Company is currently recovering approximately 50% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 and early 1995 rate cases. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-13 Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes (B&O taxes) ($1 million) due to decreased generation in that state. The 1992 decrease resulted from decreased B&O taxes ($2 million) and prior period B&O tax adjustments ($2 million), offset somewhat by increases in gross receipts and property taxes ($2 million). The net increase of $6 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($4 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $3 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures primarily associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to decrease as the Company completes its Phase I compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used M-14 internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $141 million and for 1994 and 1995 are estimated at $103 million and $83 million, respectively. These estimates include $39 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $400 million, which includes $122 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, was about $69 million for 1993. A regulatory commission order has been received in West Virginia authorizing procedures to provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and new rate cases planned in 1994 and early 1995, internal generation of cash can be expected to increase. M-15 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($13 million). The five- year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $10.68 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $67 million of debt securities having interest rates of 7.5% to 9.5% through the issuance of $72 million of securities having interest rates of 5.625% to 5.95%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. Short-term debt, including notes payable to affiliates under the money pool, increased from $8.0 million in 1992 to $63.1 million in 1993. The Company canceled or postponed approximately $69 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $100 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $81 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $50 million of new equity securities and, if economic and market conditions make it desirable, may refinance up to $285 million of first M-16 mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. As of January 1994, the Company has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the M-17 Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of the Company. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by the Company for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-18 Potomac MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $73.5 million, $67.5 million, and $58.2 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-5 and D-6. Such kWh sales increased 6.3% and 2.0% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $24.4 $ 7.7 Fuel and energy cost adjustment clauses (a) 19.1 10.4 Rate increases (b): Maryland 12.7 11.7 Virginia 2.5 1.8 West Virginia 1.1 .3 16.3 13.8 Other 2.9 .2 $62.7 $32.1 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a rate increase in Maryland, designed to produce $11.3 million on an annual basis, which became effective on February 25, 1993, and a rate increase in Virginia, designed to produce $10.0 million on an annual basis, which became effective on September 28, 1993, subject to refund. The Maryland surcharge for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance investment of $1.7 million effective on June 4, 1992, which was increased to $3.9 million effective on December 3, 1992, was rolled into base rates effective with the February 1993 increase. Rate increases also include a CAAA surcharge in West Virginia designed to produce $.8 million on an annual basis effective July 1, 1992, which was increased to $2.2 million on an annual basis effective July 1, 1993. The increased kWh sales to residential and commercial customers in 1993 reflect both higher use and growth in number of customers. While 1993 heating degree days showed only a slight increase over 1992, and were only 7% M-19 above normal, cooling degree days increased 82% over 1992 and were 12% over normal, contributing to the 1993 kWh sales increases. The Company experienced a normal winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. KWh sales to industrial customers increased 4.3% in 1993 and 2.0% in 1992. The increase in both years occurred in almost all industrial groups, the most significant of which in 1993 was from sales to cement customers. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.0 1.8 From purchased power 3.5 4.4 3.8 3.9 5.4 5.6 Revenues (in millions): From Company generation $8.6 $27.5 $47.4 From sales of purchased power 99.5 113.6 114.3 $108.1 $141.1 $161.7 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $4 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M-20 Operating Expenses Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities, capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $87.9 $104.6 $103.7 Other 10.5 3.7 8.9 Power exchanges, net (.8) .2 (.4) Affiliated transactions: AGC capacity charges 28.0 29.6 31.3 Other affiliated capacity charges 28.4 21.9 23.4 Energy and spinning reserve charges 51.1 41.2 37.6 $205.1 $201.2 $204.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power purchased from nonaffiliates for use by the Company and affiliated energy and spinning reserve charges are mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The 1993 increase in other purchased power reflects efforts to conserve coal because of selective work stoppages by the United Mine Workers of America for most of the year. M-21 While the Company does not currently purchase generation from qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), several projects have been proposed, and an agreement has been reached with one facility to commence purchasing generation in 1999. This project and others may significantly increase the cost of power purchases passed on to customers. The increase in affiliated capacity and energy and spinning reserve charges in 1993 was due to growth of kWh sales to retail customers and an increase in affiliated energy available because of energy purchased by an affiliate from new PURPA projects in 1992 and 1993. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $1.5 million. The Company is currently recovering approximately 90% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 rate cases. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. M-22 The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes due to decreased generation in that state ($1 million). The 1992 increase was due to increased property ($1 million) and gross receipts ($1 million) taxes. The net increase of $2 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($3 million) and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million), offset by plant removal tax deductions for which deferred taxes were not provided ($1 million). The net increase in 1992 was primarily due to an increase in income before taxes. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stock, M-23 and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. During 1993, the Company continued its participation in the Collaborative Process for Demand-Side Management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and the Company's largest industrial customer. The Company received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993, the Company had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. Capital Requirements Construction expenditures for 1993 were $179 million and for 1994 and 1995 are estimated at $136 million and $106 million, respectively. These estimates include $40 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $350 million, which includes $153 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has M-24 additional annual capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $75 million in 1993. Regulatory commission orders received in all of the state jurisdictions and the FERC provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and new rate cases planned in 1994, internal generation of cash can be expected to increase. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($14 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $13.99 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $121 million of debt securities having interest rates of 7% to 9.5% through the issuance of $129 million of securities having interest rates of 5.875% to 7.75%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $9 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $36 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. M-25 At December 31, 1993, the Company had SEC authorization to issue up to $115 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $84 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $75 million of new debt securities and, if economic and market conditions make it desirable, may refinance up to $231 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-26 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in five generating plants, including four operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-27 West Penn MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Net Income Consolidated net income was $102.1 million, $98.2 million, and $101.2 million in 1993, 1992, and 1991, respectively. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases, offset in part by higher expenses. Higher retail revenues in 1992 from a surcharge to recover increases in various state taxes and greater kWh sales were more than offset by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-7 and D-8. Such kWh sales increased 3.1% and 2.7% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $15.5 $ 6.7 Fuel and energy cost adjustment clauses (a) 26.2 15.2 Rate increases (b) 25.2 5.8 Other 3.1 1.3 $70.0 $29.0 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) Reflects a base rate increase on an annual basis of about $61.6 million in Pennsylvania effective May 18, 1993, including $26.1 million for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance costs, and in 1992 also reflects a surcharge effective August 24, 1991, to recover Pennsylvania tax increases. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days remained about the same as 1992, and were only 6% below normal, cooling degree days increased 70% over 1992 and were 46% over normal, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-28 KWh sales to industrial customers increased .8% in 1993 and 6.3% in 1992. The relatively flat industrial sales growth in 1993 followed increases in industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.3 2.3 From purchased power 5.0 6.5 5.4 5.4 7.8 7.7 Revenues (in millions): From Company generation $11.5 $37.5 $62.5 From sales of purchased power 141.0 167.2 160.7 $152.5 $204.7 $223.2 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The decrease in other revenues in 1993 and 1992 resulted from continued decreases in sales of energy and spinning reserve to an affiliated company because of additional energy available to it from new PURPA projects commencing in both years. The 1993 decrease was also due in part to an agreement with the Federal Energy Regulatory Commission to record in 1993 about $6 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. Most of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. M-29 Operating Expenses Fuel expenses decreased 4% in each of the years of 1993 and 1992 primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $124.5 $153.9 $146.0 From PURPA generation 49.6 56.5 55.6 Other 15.2 5.9 12.9 Power exchanges, net (1.2) .3 (.5) Affiliated transactions: AGC capacity charges 42.3 43.5 44.1 Energy and spinning reserve charges 4.7 3.5 3.8 Other affiliated capacity charges .7 .6 .6 $235.8 $264.2 $262.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net M-30 income. The decrease in purchases from PURPA generation in 1993 was due to a planned generating outage at one PURPA project. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and in 1993 also from employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $3.1 million. The Company is currently recovering all of SFAS No. 106 expenses in rates. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 5% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-31 Depreciation expense increases resulted primarily from additions to electric plant and in 1993 also from a change in depreciation rates and net salvage amortization as a result of the May 1993 rate order. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the consolidated financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $2 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($3 million) offset in part by decreased West Virginia Business and Occupation taxes (B&O taxes) ($2 million) due to decreased generation in that state. The 1992 increase resulted from increased property and capital stock taxes ($4 million), increased B&O taxes ($1 million), and increases in gross receipts taxes ($1 million). The net increase of $7 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($6 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $4 million resulted primarily from a decrease in income before taxes. Note B to the consolidated financial statements provides a further analysis of income tax expenses. The combined increase of $.3 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the consolidated financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such M-32 as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $251 million and for 1994 and 1995 are estimated at $258 million and $208 million, respectively. These estimates include $82 million and $33 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable ruling of the Pennsylvania PUC allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $700 million, which includes $207 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the consolidated financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $119 million in 1993. A regulatory commission order has been received from the PUC which provides for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and a new rate case planned in 1994, internal generation of cash can be expected to increase. M-33 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($27 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $18.04 million of 6.30% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $246 million of debt securities having interest rates of 7% to 9.75% through the issuance of $251 million of securities having interest rates of 4.95% to 6.375%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $47 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $170 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $135 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $105 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $212 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction program, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the consolidated financial statements. Pennsylvania has enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-35 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System- operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in four generating plants, including three operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-36 AGC MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As described under Liquidity and Capital Resources, revenues are determined under a cost of service formula rate schedule. Therefore, if all other factors remain equal, revenues are expected to decrease each year due to a normal continuing reduction in the Company's net investment in the Bath County station and its connecting transmission facilities upon which the return on investment is determined. Revenues for 1993 and 1992 decreased due to a reduction in interest charges and net investment, and reduced operating expenses which are described below. Additionally, revenues for 1993 and 1992 were reduced by the recording of estimated liabilities for possible refunds pending final Federal Energy Regulatory Commission (FERC) decisions in rate case proceedings (see Liquidity and Capital Resources). The net investment (primarily net plant less deferred income taxes) decreases to the extent that provisions for depreciation and deferred income taxes exceed net plant additions. The decrease in operating expenses in 1993 resulted from a decrease in federal income taxes due to a decrease in income before taxes ($1.9 million) offset by an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($.5 million), partially offset by an increase in operation and maintenance expense. The decrease in operating expenses in 1992 resulted primarily from reduced federal income taxes because of a decrease in income before taxes, partially offset by increases in taxes other than income. The increase in taxes other than income in 1992 was due to increased property taxes. The decreases in interest on long-term debt in 1993 and 1992 were the combined result of decreases in the average amount of and interest rates on long-term debt outstanding. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company's only operating assets are an undivided 40% interest in the Bath County (Virginia) pumped-storage hydroelectric station and its connecting transmission facilities. The Company has no present plans for construction of any other major facilities. M-37 Pursuant to an agreement, the Parents buy all of the Company's capacity in the station priced under a "cost of service formula" wholesale rate schedule approved by the FERC. Under this arrangement, the Company recovers in revenues all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment. Through February 29, 1992, the Company's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. On March 1, 1990, the ROE decreased from 12% to 11.25%, and on March 1, 1991, it was increased to 11.53%. In December 1991, the Company filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. In 1993, the Company issued $50 million of 5.75% medium-term notes due 1998, $50 million of 5.625% debentures due 2003, and $100 million of 6.875% debentures due 2023 to refund $50 million 8% debentures due 1997, $50 million 8.75% debentures due 2017, and $100 million 9.125% debentures due 2016. The Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. - 42 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Financial Statement Schedules - All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Power System, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Power System, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 APS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company and its subsidiaries (companies) are subject to regulation by the Securities and Exchange Commission. The subsidiaries are subject to regulation by various state bodies having jurisdiction and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company and its subsidiaries are summarized below. CONSOLIDATION: The Company owns all of the outstanding common stock of its subsidiaries. The consolidated financial statements include the accounts of the Company and all subsidiary companies after elimination of intercompany transactions. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures followed by Monongahela Power Company in West Virginia, revenues include service rendered but unbilled at year end. Certain increases in rates being collected by subsidiaries are subject to final commission approvals, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used by the subsidiaries for computing AFUDC in 1993, 1992, and 1991 averaged 9.37%, 9.19%, and 8.84%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4% of average depreciable property in 1993 and 3.3% in each of the years 1992 and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INVESTMENTS: The investment in subsidiaries consolidated represents the excess of acquisition cost over book equity (goodwill) prior to 1966. Goodwill is not being amortized because, in management's opinion, there has been no reduction in its value. Other investments primarily represent the cash surrender values and prepayments of purchased life insurance contracts on certain qualifying management employees under an executive life insurance plan and a supplemental executive retirement plan (Secured Benefit Plan). Payment of future premiums will fully fund these benefits. INCOME TAXES: Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The subsidiaries have a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The subsidiaries also provide partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the subsidiaries adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the subsidiaries adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before preferred dividends and income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the subsidiaries recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $ 105 289 Unbilled revenue 38 363 Tax interest capitalized 22 236 Contributions in aid of construction 17 176 State tax loss carryback/carryforward 14 560 Other 21 658 219 282 Deferred tax liabilities: Book vs. tax plant basis differences, net 1 051 500 Other 42 122 1 093 622 Total net deferred tax liabilities 874 340 Less portion above included in current liabilities 645 Total long-term net deferred tax liabilities $ 873 695 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the subsidiaries have recorded regulatory assets for an amount equal to the $562 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $108 million increase in deferred tax assets to reflect the subsidiaries' obligation to pass such tax benefits on to their customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. NOTE C--DIVIDEND RESTRICTION: Supplemental indentures relating to most outstanding bonds of subsidiaries contain dividend restrictions under the most restrictive of which $461,539,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on their common stocks, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by a subsidiary as a capital contribution or as the proceeds of the issue and sale of shares of such subsidiary's common stock. The benefits earned to date and funded status at December 31 using a measurement date of September 30 were as follows: In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. NOTE E--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The subsidiaries adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the subsidiaries for retired employees and their dependents were recorded in expense in the period in which they were paid and were $6,553,000 and $5,691,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost--benefits earned $ 2 000 Interest cost on accumulated postretirement benefit obligation 11 300 Actual return on plan assets (24) Amortization of unrecognized transition obligation 7 300 Other net amortization and deferral 24 SFAS No. 106 postretirement cost 20 600 Regulatory deferral (4 790) Net postretirement cost $15 810 The benefits earned to date and funded status at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $115 019 Fully eligible employees 24 135 Other employees 55 255 Total obligation 194 409 Plan assets at market value in short-term investment fund 4 646 Accumulated postretirement benefit obligation in excess of plan assets 189 763 Less: Unrecognized cumulative net loss from past experience different from that assumed 41 450 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 138 200 Postretirement benefit liability at September 30, 1993 10 113 Fourth quarter 1993 contributions and benefit payments 4 549 Postretirement benefit liability at December 31, 1993 $ 5 564 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $145,500,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $13.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $1.0 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for the FERC wholesale customers effective in mid-to-late 1993. Regulatory actions have been taken by the Virginia and Ohio regulatory commissions which provide support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The subsidiaries have recorded regulatory assets at December 31, 1993, of $4.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. NOTE F--STOCKHOLDERS' EQUITY: COMMON STOCK: In November 1993, the common shareholders approved a two-for-one split of the Company's common stock which was effective November 4, 1993. The stock split reduced the par value of the common stock from $2.50 per share to $1.25 per share and increased the number of authorized shares of common stock from 130,000,000 to 260,000,000. The number of common stock shares outstanding and per share information for all periods reflect the two-for-one split. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. The holders of West Penn Power Company's auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. MANDATORILY REDEEMABLE PREFERRED STOCK: The Potomac Edison Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. That subsidiary has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, The Potomac Edison Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. NOTE G--LONG-TERM DEBT: Maturities for long-term debt for the next five years are: 1994, $26,000,000; 1995, $28,000,000; 1996, $43,575,000; 1997, $48,262,000; and 1998, $185,400,000. Substantially all of the properties of the subsidiaries are held subject to the lien securing each subsidiary's first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Commercial paper borrowings issuable by Allegheny Generating Company are backed by a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. However, to the extent that funds are available from the companies, Allegheny Generating Company borrowings are made through an internal money pool as described in Note H. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $2,129,923,000 and $2,033,103,000, respectively, based on actual market prices or market prices of similar issues. NOTE H--SHORT-TERM DEBT: To provide interim financing and support for outstanding commercial paper, lines of credit have been established with several banks. The companies have fee arrangements on all of their lines of credit and no compensating balance requirements. At December 31, 1993, unused lines of credit with banks were $149,175,000. In addition to bank lines of credit, in 1992 the companies established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, a multi-year credit program was established which provides that the subsidiaries may borrow up to $300 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of notes payable to banks ($75,825,000) and commercial paper ($54,811,000) and at the end of 1992 consisted of a note payable to a bank ($11,205,000). The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. NOTE I--COMMITMENTS AND CONTINGENCIES: CONSTRUCTION PROGRAM: The subsidiaries have entered into commitments for their construction programs, for which expenditures are estimated to be $500 million for 1994 and $400 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: The companies are subject to laws, regulations, and uncertainties as to environmental matters discussed under ITEM 1. ENVIRONMENTAL MATTERS. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The subsidiaries are estimating expenditures of approximately $1.4 billion, which includes $482 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $161 million and $53 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the subsidiaries will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION: In the normal course of business, the companies become involved in various legal proceedings. The companies do not believe that the ultimate outcome of these proceedings will have a material effect on their financial position. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Monongahela Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Monongahela Power Company (a subsidiary of Allegheny Power System, Inc.) 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. 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 A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 1,500,000 shares, outstanding as follows (Note G): Monongahela NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures in West Virginia, revenues include service rendered but unbilled at year end. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 8.69%, 8.23%, and 6.17%, respectively. In accordance with FERC guidelines, the 1991 rate was based solely on borrowed funds because the Company's average outstanding short-term debt was greater than the average construction work in progress balance. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.8% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $18 043 Unbilled revenue 4 181 Tax interest capitalized 2 430 Contributions in aid of construction 2 058 Vacation pay 1 958 Advances for construction 1 601 Other 4 455 34 726 Deferred tax liabilities: Book vs. tax plant basis differences, net 205 829 Other 23 411 229 240 Total net deferred tax liabilities 194 514 Less portion above included in current liabilities 2 048 Total long-term net deferred tax liabilities $192 466 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $158 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,482,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 27% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.3 million, $8.3 million, and $8.9 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 30%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $2,390,000 and $2,029,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 478 Interest cost on accumulated postretirement benefit obligation 2 819 Actual return on plan assets (5) Amortization of unrecognized transition obligation 1 772 Other net amortization and deferral 5 SFAS No. 106 postretirement cost 5 069 Regulatory deferral (1 981) Net postretirement cost $3 088 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $32 469 Fully eligible employees 4 348 Other employees 14 664 Total obligation 51 481 Plan assets at market value in short-term investment fund 1 230 Accumulated postretirement benefit obligation in excess of plan assets 50 251 Less: Unrecognized cumulative net loss from past experience different from that assumed 14 161 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 34 059 Postretirement benefit liability at September 30, 1993 2 031 Fourth quarter 1993 contributions and benefit payments 997 Postretirement benefit liability at December 31, 1993 $ 1 034 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $35,800,000 (transition obligation), is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $3.5 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.2 million. Recovery of SFAS No. 106 costs has been authorized for FERC wholesale customers effective in December 1993. Recovery has been requested in a rate case filed in West Virginia for which a final commission decision is expected in 1994. Regulatory action has been taken by the Ohio regulatory commission which provides support that substantial recovery is probable. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million for West Virginia and Ohio where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: In September 1992, the Company issued and sold to its parent, 800,000 shares of its common stock at $50 per share. Other paid-in capital decreased $4,000 in 1992 as a result of a preferred stock redemption. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994 and 1995, none; 1996, $18,500,000; 1997, $15,500,000; and 1998, $20,100,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $65 million of 5-5/8% 7-year first mortgage bonds to refund a $10 million 8-1/8% issue due in 1999, a $30 million 7-7/8% issue due in 2002, and a $20 million 7-1/2% issue due in 1998. The Company also issued $7.05 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund a $7.05 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $485,713,000 and $461,663,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Debt: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $100 million including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $81 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of $63.1 million of notes payable to banks and at the end of 1992 consisted of money pool borrowings from affiliates of $8.03 million. The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $103 million for 1994 and $83 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $400 million, which includes $122 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $39 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 27% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of The Potomac Edison Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Potomac Edison Company (a subsidiary of Allegheny Power System, Inc.) 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. 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 A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Potomac NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. Revenues of $63.4 million from one industrial customer, Eastalco Aluminum Company, were 8.9% of total electric operating revenues in 1993. Certain increases in rates being collected by the Company in Virginia are subject to final commission approval, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.97%, 9.92%, and 9.93%, respectively. AFUDC is not recorded for construction applicable to the state of Virginia, where construction work in progress is included in rate base. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.6% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $17 922 Unbilled revenue 12 556 Contributions in aid of construction 10 530 Tax interest capitalized 9 056 State tax loss carryback/carryforward 5 770 Advances for construction 1 303 Other 3 279 60 416 Deferred tax liabilities: Book vs. tax plant basis differences, net 183 892 Other 10 122 194 014 Total net deferred tax liabilities 133 598 Less portion above included in current liabilities 571 Total long-term net deferred tax liabilities $133 027 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $74 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,730,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 28% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.6 million, $8.6 million, and $9.2 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 35%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long- term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,790,000 and $1,564,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 35%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 383 Interest cost on accumulated postretirement benefit obligation 3 042 Actual return on plan assets (7) Amortization of unrecognized transition obligation 1 986 Other net amortization and deferral 7 SFAS No. 106 postretirement cost 5 411 Regulatory deferral (846) Net postretirement cost $4 565 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 189 Fully eligible employees 7 741 Other employees 14 635 Total obligation 57 565 Plan assets at market value in short-term investment fund 1 375 Accumulated postretirement benefit obligation in excess of plan assets 56 190 Less: Unrecognized cumulative net loss from past experience different from that assumed 15 695 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 37 995 Postretirement benefit liability at September 30, 1993 2 500 Fourth quarter 1993 contributions and benefit payments 1 132 Postretirement benefit liability at December 31, 1993 $1 368 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $40,000,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.0 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.3 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993 and for the FERC wholesale customers effective in September 1993. Regulatory action has been taken by the Virginia regulatory commission which provides support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The Company has recorded regulatory assets at December 31, 1993, of $.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL The Company issued and sold common stock to its parent, at $20 per share, 2,500,000 shares in October 1993, 4,000,000 shares in September 1992, and 1,250,000 shares in September 1991. Other paid-in capital decreased $2,000 in 1992 as a result of preferred stock transactions. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. MANDATORILY REDEEMABLE PREFERRED STOCK: The Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. The Company has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, the Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, $16,000,000; 1995, none; 1996, $18,700,000; 1997, $800,000; and 1998, $1,800,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $45 million of 7-3/4% 30-year first mortgage bonds and $75 million of 5-7/8% 7-year first mortgage bonds to refund a $25 million 8-5/8% issue due in 2007, a $15 million 8-5/8% issue due in 2003, a $20 million 8-3/8% issue due in 2001, a $15 million 7-5/8% issue due in 1999, a $12 million 7-1/2% issue due in 2002, and a $25 million 7% issue due in 1998. The Company also issued $8.6 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund an $8.6 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $566,070,000 and $538,211,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $115 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $84 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $4.6 million and $38 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $136 million for 1994 and $106 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $350 million, which includes $153 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $40 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 28% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of West Penn Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of West Penn Power Company (a subsidiary of Allegheny Power System, Inc.) 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. 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 A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock of the Company (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 3,097,077 shares, outstanding as follows (Note G): West Penn NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries (the companies). REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.40%, 9.25%, and 9.46%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4%, 3.3%, and 3.2% of average depreciable property in 1993, 1992, and 1991, respectively. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The companies join with the parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $40 455 Unbilled revenue 21 626 Tax interest capitalized 10 750 State tax loss carryback/carryforward 8 790 Contributions in aid of construction 4 588 Other 7 416 93 625 Deferred tax liabilities: Book vs. tax plant basis differences, net 507 214 Other 8 437 515 651 Total net deferred tax liabilities 422 026 Add portion above included in current assets 1 974 Total long-term net deferred tax liabilities $424 000 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $326 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $41 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $285,914,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 45% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $12.2 million, $13.8 million, and $14.8 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Consolidated Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 25%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,907,000 and $1,721,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 25%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 939 Interest cost on accumulated postretirement benefit obligation 4 389 Actual return on plan assets (9) Amortization of unrecognized transition obligation 2 817 Other net amortization and deferral 9 SFAS No. 106 postretirement cost 8 145 Regulatory deferral (1 963) Net postretirement cost $6 182 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 748 Fully eligible employees 9 030 Other employees 18 378 Total obligation 63 156 Plan assets at market value in short-term investment fund 1 510 Accumulated postretirement benefit obligation in excess of plan assets 61 646 Less: Unrecognized cumulative net loss from past experience different from that assumed 3 362 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 53 746 Postretirement benefit liability at September 30, 1993 4 538 Fourth quarter 1993 contributions and benefit payments 1 960 Postretirement benefit liability at December 31, 1993 $2 578 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $56,600,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.3 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.4 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Pennsylvania effective in May 1993 and for the FERC wholesale customers effective in June 1993. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million relating to SFAS No. 106 costs in Pennsylvania incurred prior to the May rate order, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. The Company will seek to recover these costs in its next base rate case. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: The Company issued and sold common stock to its parent, at $20 per share, 5,000,000 shares in October 1993, and 1,750,000 shares in December 1991. Other paid-in capital decreased $145,000 in 1993 and $550,000 in 1992 as a result of the underwriting fees and commissions and miscellaneous expenses associated with the Company's sale of $40 million of preferred stock in 1992. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 per share. The holders of the Company's market auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, none; 1995, $27,000,000; 1996 and 1997, none; and 1998, $103,500,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $102 million of 5-1/2% 5-year first mortgage bonds to refund a $25 million 7% issue due in 1997, a $25 million 7-7/8% issue due in 1999, and a $52 million 7-1/8% issue due in 1998, and sold $80 million of 6-3/8% 10-year first mortgage bonds to refund a $35 million 7-5/8% issue due in 2002 and a $40 million 8-1/8% issue due in 2001. The Company also issued $7.75 million of 5.95% 20-year Pollution Control Revenue Notes to refund a $7.75 million 9-3/8% issue due in 2013, and issued $61.5 million of 10-year 4.95% Pollution Control Revenue Notes to refund a $30 million 9-3/4% series and a $31.5 million 9-1/2% series due in 2003. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $823,333,000 and $783,379,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $170 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $135 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $24.9 million and $20.9 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $258 million for 1994 and $208 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $700 million, which includes $207 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $82 million and $33 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 45% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Generating Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Generating Company (an Allegheny Power System, Inc. affiliate) 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. 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 A and B to the financial statements, the Company changed its method of accounting for income taxes in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 AGC NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company was incorporated in Virginia in 1981. Its common stock is owned by Monongahela Power Company - 27%, The Potomac Edison Company - 28%, and West Penn Power Company - 45% (the Parents). The Parents are wholly-owned subsidiaries of Allegheny Power System, Inc. and are a part of the Allegheny Power integrated electric utility system. The Company is subject to regulation by the Securities and Exchange Commission (SEC) and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, and consist of a 40% undivided interest in the Bath County pumped-storage hydroelectric station and its connecting transmission facilities. The cost of depreciable property units retired plus removal costs less salvage are charged to accumulated depreciation. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 2.1% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged to operating expenses. INCOME TAXES: The Company joins with its parents and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are deferred. Prior to 1987, provisions for federal income tax were reduced by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes. Note B - Income Taxes: Details of federal income tax provisions are: In 1993, the total provision for income taxes ($13,262,000) was less than the amount produced by applying the federal income tax statutory rate to financial accounting income before income taxes ($14,155,000), due primarily to amortization of deferred investment credit ($1,316,000). Federal income tax returns through 1989 have been examined and substantially settled. The Company adopted SFAS No. 109 as of January 1, 1993, and in doing so recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets Unamortized investment tax credit $ 28 869 Deferred tax liabilities Book vs. tax plant basis differences, net 154 565 Other 152 154 717 Total net deferred tax liabilities $125 848 It is expected the FERC will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $4 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $29 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Long-Term Debt: The Company had long-term debt outstanding as follows: The Company has a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. Amounts borrowed are guaranteed by the Parents in proportion to their equity interest. Interest rates are determined at the time of each borrowing. The revolving credit agreement serves as support for the Company's commercial paper. In addition to bank lines of credit, the Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At the end of 1993, the Company had outstanding $29,500,000 of money pool borrowings from affiliates. Maturities for long-term debt for the next five years are: 1994, 10,000,000; 1995, $1,000,000; 1996, $6,375,000; 1997, $61,462,000; and 1998, $60,000,000. The estimated fair value of debentures and medium- term notes at December 31, 1993 and 1992, was $233,445,000 and $249,850,000 respectively, based on actual market prices or market prices of similar issues. The carrying amount of commercial paper and notes payable to affiliates approximates their fair value because of the short maturity of those instruments. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Classified as long-term debt by Allegheny Generating Company (AGC). Charges for maintenance and depreciation other than amounts shown in the consolidated statement of income were not material. Charges for maintenance and depreciation other than amounts shown in the statement of income were not material. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Internal arrangement for borrowing funds on a short-term basis. - 43 - - 44 - ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE For APS and the Subsidiaries, none. - 45 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS APS, Monongahela, Potomac Edison, West Penn, and AGC. Reference is made to the Executive Officers of the Registrants in Part I of this report. The names, ages, and the business experience during the past five years of the directors of the System companies are set forth below: (1) See Executive Officers of the Registrants in Part I of this report for further details. (a) Eleanor Baum. Dean of the Albert Nerken School of Engineering of The Cooper Union for the Advancement of Science and Art. Director of United States Trust Company, Commissioner of the Engineering Manpower Commission, and a fellow of the Institute of Electrical and Electronic Engineers and the Society of Women Engineers. Ms. Baum filed one late report on Form 4 concerning one purchase transaction in 1993. (b) William L. Bennett. Co-Chairman, Director and Chief Executive Officer of Noel Group, Inc. Formerly, General partner, Discovery Funds, a venture capital affiliate of Rockefeller & Company, Inc. Chairman of the Board of TDX Corporation. Director of Forschner Group, Inc., Global Natural Resources Inc., Lincoln Snacks Company, Simmons Outdoor Corporation and VISX, Inc. (c) Phillip E. Lint. Retired. Formerly, partner, Price Waterhouse. (d) Edward H. Malone. Retired. Formerly, Vice President of General Electric Company and Chairman, General Electric Investment Corporation. Director of Fidelity Group of Mutual Funds, General Re Corporation, Mattel, Inc., and Corporate Property Investors, a real estate investment trust. (e) Frank A. Metz, Jr. Retired. Formerly, Senior Vice President, Finance and Planning, and Director, International Business Machines Corporation. Director of Monsanto Company and Norrell Corporation. (f) Clarence F. Michalis. Chairman of the Board of Directors of Josiah Macy, Jr. Foundation, a tax-exempt foundation for medical research and education. Director of Schroder Capital Funds Inc. (g) Steven H. Rice. Business consultant and attorney-at-law. Formerly, President and Chief Operating Officer and Director of The Seamen's Bank for Savings. Director and member of the Investment and Audit Committees of Royal Group, Inc. (The Royal Insurance Companies). Director and Vice Chairman of the Board of The Stamford (CT) Federal Savings Bank. (h) Gunnar E. Sarsten. President and Chief Operating Officer of Morrison Knudsen Corporation. Formerly, President and Chief Executive Officer of United Engineers & Constructors International, Inc., a subsidiary of the Raytheon Company, and Deputy Chairman of the Third District Federal Reserve Bank in Philadelphia. (i) Peter L. Shea. Managing director of Hydrocarbon Energy, Inc., a privately owned oil and gas development drilling and production company. - 46 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION During 1993, and for 1992 and 1991, the annual compensation paid by each of the System companies, APS, APSC, Monongahela, Potomac Edison, West Penn, and AGC directly or indirectly for services in all capacities to such companies to their Chief Executive Officer and each of the four most highly paid executive officers of each such company whose cash compensation exceeded $100,000 was as follows: (a) APS has no paid employees. All salaries and bonuses are paid by APSC. (b) Bonus amounts are determined and paid in April of the year in which the figure appears and are based upon performance in the prior year. (c) Amounts constituting less than 10% of the total annual salary and bonus are not disclosed. All officers did receive miscellaneous other items amounting to less than 10% of total annual salary and bonus. (d) Effective January 1, 1992, the basic group life insurance provided employees was reduced from two times salary during employment, which reduced to one times salary after 5 years in retirement, to a new plan which provides one times salary until retirement and $25,000 thereafter. Executive officers and other senior managers remain under the prior plan. In order to pay for this insurance for these executives, during 1992 insurance was purchased on the lives of each of them. Effective January 1, 1993, APS started to provide funds to pay for the future benefits due under the supplemental retirement plan (Secured Benefit Plan) as described in note (a) on p. 53. To do this, APS purchased, during 1993, life insurance on the lives of the covered executives. The premium costs of both the 1992 and 1993 policies plus a factor for the use of the money are returned to APS at the earlier of (a) death of the insured or (b) the later of age 65 or 10 years from the date of the policy's inception. The figures in this column include the present value of the executives' cash value at retirement attributable to the current year's premium payment for both the Executive Life Insurance and Secured Benefit Plans (based upon the premium, future valued to retirement, using the policy internal rate of return minus the corporation's premium payment), as well as the premium paid for the basic Group Life Insurance program plan and the contribution for the 401(k) plan. For 1993, the figure shown includes amounts representing (a) the aggregate of life insurance premiums and dollar value of the benefit to the executive officer of the remainder of the premium paid on the Group Life Insurance program and the Executive Life Insurance and Secured Benefit Plans and (b) 401(k) contributions as follows: Mr. Bergman $42,392 and $4,497; Mr. Garnett $19,509 and $4,497; Mr. Skrgic $14,181 and $4,497; Ms. Gormley $11,152 and $4,294; and Mr. Jones $8,382 and $4,497, respectively. (e) These amounts as previously reported did not include the following amounts representing the dollar value of the benefit to the executive officer of the remainder of the premium paid on the Executive Life Insurance Plan: Mr. Bergman $786; Mr. Garnett $210; Mr. Skrgic $218; Ms. Gormley $232; and Mr. Jones $519. (f) See Executive Officers of the Registrants for other positions held. (g) Although less than 10% of total annual salary and bonus, Mr. Skrgic received a $15,000 housing allowance in 1993, 1992 and 1991. (h) The incentive plan was not in effect for these officers in 1991. (i) Includes $15,000 housing allowance for both 1993 and 1992 and miscellaneous other items totaling $2,423 and $2,457 for 1993 and 1992, respectively. - 47 - - 48 - - 49 - - 50 - Summary Compensation Tables AGC Annual Compensation (a) Name All Other and Compen- Principal sation Position Year Salary($) Bonus($) ($) (a) AGC has no paid employees. - 51 - DEFINED BENEFIT OR ACTUARIAL PLAN DISCLOSURE Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) APS (b) Klaus Bergman, President* $235,270 and Chief Executive Officer (c) Stanley I. Garnett, II, 112,320 Vice President, Finance (c) Peter J. Skrgic, 126,000 Vice President (c) Kenneth M. Jones, 90,004 Vice President and Comptroller (c) Nancy H. Gormley, 78,404 Vice President (c) Monongahela Klaus Bergman, $ Chief Executive Officer (c)(d) Benjamin H. Hayes, 113,364 President Thomas A. Barlow, 70,788 Vice President Robert R. Winter, 67,896 Vice President Richard E. Myers, 67,200 Comptroller * Elected Chairman of the Board effective January 1, 1994. - 52 - Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) Potomac Edison Klaus Bergman, $ Chief Executive Officer (c)(d) Alan J. Noia, 133,200 President Robert B. Murdock, 80,677 Vice President James D. Latimer, 75,298 Vice President Thomas J. Kloc, 68,591 Comptroller West Penn Klaus Bergman, $ Chief Executive Officer (c)(d) Jay S. Pifer, 111,463 President Thomas K. Henderson, 73,127 Vice President Charles S. Ault, 71,100 Vice President Charles V. Burkley, 66,442 Comptroller Allegheny Generating Company No paid employees. - 53 - (a) Assumes present insured benefit plan and salary continue and retirement at age 65 with single life annuity. Under plan provisions, the annual rate of benefits payable at the normal retirement age of 65 are computed by adding (i) 1% of final average pay up to covered compensation times years of service up to 35 years, plus (ii) 1.5% of final average pay in excess of covered compensation times years of service up to 35 years, plus (iii) 1.3% of final average pay times years of service in excess of 35 years. Covered compensation is the average of the maximum taxable Social Security wage bases during the 35 years preceding the member's retirement, except that years before 1959 are not taken into account for purposes of this average. The final average pay benefit is based on the member's average total earnings during the highest-paid 60 consecutive calendar months or, if smaller, the member's highest rate of pay as of any July 1st. Effective July 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. The maximum amount will be reduced to $150,000 effective July 1, 1994 as a result of The Omnibus Budget Reconciliation Act of 1993. Benefits for employees retiring between 55 and 62 differ from the foregoing. Pursuant to a supplemental plan (Secured Benefit Plan), senior executives of Allegheny Power System companies who retire at age 60 or over with 40 or more years of service are entitled to a supplemental retirement benefit in an amount that, together with the benefits under the basic plan and from other employment, will equal 60% of the executive's highest average monthly earnings for any 36 consecutive months. The supplemental benefit is reduced for less than 40 years service and for retirement age from 60 to 55. It is included in the amounts shown where applicable. In order to provide funds to pay such benefits, effective January 1, 1993 the Company purchased insurance on the lives of the plan participants. The Secured Benefit Plan has been designed that if the assumptions made as to mortality experience, policy dividends, and other factors are realized, the Company will recover all premium payments, plus a factor for the use of the Company's money. All executive officers are participants in the Secured Benefit Plan. This does not include benefits from an Employee Stock Ownership and Savings Plan (ESOSP) established as a non-contributory stock ownership plan for all eligible employees effective January 1, 1976, and amended in 1984 to include a savings program. Under the ESOSP for 1993, all eligible employees may elect to have from 2% to 7% of their compensation contributed to the Plan as pre-tax contributions and an additional 1% to 6% as post-tax contributions. Employees direct the investment of these contributions into one or more of five available funds. Each System company matches 50% of the pre-tax contributions up to 6% of compensation with common stock of Allegheny Power System, Inc. Effective January 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. Effective January 1, 1994, the amount was reduced to $150,000 as a result of The Omnibus Budget Reconciliation Act of 1993. Employees' interests in the ESOSP vest immediately. Their pre-tax contributions may be withdrawn only upon meeting certain financial hardship requirements or upon termination of employment. (b) APS has no paid employees. These executives are employees of APSC. (c) See Executive Officers of the Registrants for other positions held. (d) The total estimated annual benefits on retirement payable to Mr. Bergman for services in all capacities to APS, APSC and the Subsidiaries is set forth in the table for APS. Compensation of Directors In 1993, APS directors who were not officers or employees of System companies received for all services to System companies (a) $16,000 in retainer fees, (b) $800 for each committee meeting attended, except Executive Committee meetings which are $200, and (c) $250 for each Board meeting of each company attended. Under an unfunded deferred compensation plan, a director may elect to defer receipt of all or part of his or her director's fees for succeeding calendar years to be payable with accumulated interest when the director ceases to be such, in equal annual installments, or, upon authorization by the Board of Directors, in a lump sum. - 55 - ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - 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. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 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 the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - 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. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 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 the registrant and in the capacities and on the dates indicated. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 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 the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

29854_1993.txt

29854_1993

1993

29854

Item 1. Business Douglas & Lomason Company (the "Company" or the "Registrant") is a major supplier of original equipment parts to the North American automotive industry. Automotive products, which have accounted for approximately 93% of the Company's total sales during each of the last three years, include fully trimmed seating, seating components and mechanisms, and decorative and functional body trim parts. These products are manufactured primarily for the three major U.S. automotive manufacturers and other original equipment suppliers. The Company also manufactures material handling systems and custom truck bodies and trailers. These products have accounted for approximately 7% of the Company's total sales during each of the last three years. The Registrant classifies its business into two segments: automotive products and industrial and commercial products. Exclusive of automotive products, no segment accounts for 10 percent or more of consolidated revenues or profits. A summary of certain segment information appears in note (6) of notes to consolidated financial statements on page 24 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. AUTOMOTIVE PRODUCTS Seating Seating systems and components account for the principal portion of the Company's automotive business. The Company is one of the three major independent manufacturers and assemblers of seating systems and components for the North American automotive industry. Seat assemblies produced by the Company satisfy the seat requirements of a full range of vehicles. The Company currently supplies complete seats to customer assembly plants on a "just-in-time" (JIT) "sequenced parts delivery" (SPD) basis for passenger cars, light and medium duty trucks, and vans. The Company's seat frame business has grown significantly over the 47 years it has been supplying seating systems and components to the North American automotive industry. The Company believes it is currently one of the largest independent manufacturers of seat frames in North America. The seat frames manufactured by the Company are incorporated by it into complete seats and sold to vehicle assembly plants and are also sold separately to other seat assemblers. The Company believes that it is recognized as one of the most vertically integrated independent seat manufacturers in North America. The Company is capable of producing seat frames, manual seat mechanisms, foam, covers, suspension systems, and plastic seat trim at its manufacturing facilities. The Company believes that opportunities for growth may emerge in foreign transplant operations in North America and from the expanding trend toward seat assembly outsourcing in Europe. The Company has established technical and business relationships with two Japanese partners to facilitate the exchange of technical information and to establish business relationships with foreign automakers. In 1988, the Company formed a 50/50 joint venture company with Namba Press Works Co., Ltd. of Japan. This company, named Bloomington-Normal Seating Company, is located in Normal, Illinois and manufactures seating systems for Diamond-Star Motors, a subsidiary of Mitsubishi Motors Corporation. The Company also has a license agreement with Imasen Electric of Japan for the manufacture of manual seat adjuster mechanisms. Body Trim Components The Company has been supplying decorative body trim components to the automotive industry since 1902. These products include body side, wheel opening and structural B-pillar moldings, head and tail lamp bezels, bumpers, including those back filled with Azdel, and window and door sealing systems. The Company has the capability of processing large quantities of metal, plastic and composite material parts through injection molding, pressing, rolling, laminating and extruding systems and finishing parts through anodizing and painting. The Company produces a variety of injection molded and extruded plastic moldings including bi-laminate body side and deck lid moldings. These moldings can be finished in a variety of ways such as with a high gloss, in body colors including metallics, or with encapsulated colorful graphics. Product Engineering The Company pursues new products and processes through a 120 person product engineering staff. This staff is customer-focused in that all new projects must be based on a customer's requirements. This facilitates the development of products in shorter lead time and matches products more closely to consumer requirements. Sales and Customers Sales coverage by the Company of the North American automotive industry is maintained by an experienced direct sales staff consisting of 18 account managers, divided into separate and distinct customer-focused groups. The sales group is supported by fully developed program management teams incorporating simultaneous engineering techniques. The percent of sales to total automotive sales of seating systems and body trim components to the three major automotive manufacturers during the past three years is as follows: Sales percentages include sales to other seat assemblers for ultimate sale to the above customers. INDUSTRIAL AND COMMERCIAL PRODUCTS This segment of the Company's business accounted for approximately 7% of total Company sales in each of the three years ended December 31, 1993. Industrial and commercial products include: Material Handling Equipment. The Company designs and manufactures material handling equipment such as conveyors, bagging and packaging machines, pulleys and rollers. The Company also produces related equipment such as elevators, bag flatteners, automatic palletizers and bag placers. These products are sold to the agriculture, mining and transportation industries. Custom Truck Bodies and Trailers. The Company serves the food and beverage industry through the design and manufacture of delivery truck bodies and trailers for soft drinks, beer, bottled water, bakery products, milk and ice cream, meats, frozen foods and other products. These units include side-loading aluminum bodies and trailers, and steel, aluminum or reinforced fiberglass refrigerated truck bodies and trailers. Competition The Company is one of the three major independent seat suppliers to the North American automotive industry. The Company's primary independent competitors are Johnson Controls Inc.'s Automotive Products Group and Lear Seating Inc. The Company also competes with captive seating suppliers, namely: Inland Fisher-Guide Division of General Motors Corporation and the Plastic Trim Products Division of Ford Motor Company. The Company's body trim business competes with a significant number of major competitors. There are 10 to 12 with a full range of material, process and product capabilities similar to the Company's and several competitors with specialized niche products. GENERAL Raw materials purchased by the Registrant consisting of carbon steel, aluminum, stainless steel, plastics, and fabric are generally available from numerous independent sources. Management believes that the trend in its material costs is upward. While the Registrant owns several patents and patent rights, patent protection is not materially significant to its business. To the best of the Registrant's knowledge, its permits are in compliance with all federal, state and local environmental protection provisions. The number of persons employed by the Registrant at December 31, 1993 was 5,697. The Registrant does not consider its business seasonal except to the extent that automotive changeovers to new models affect business conditions. Item 2. Item 2. Properties The corporate offices of the Company and the product engineering staff are located in Farmington Hills, Michigan in two buildings containing approximately 81,000 square feet. Information as to the Company's 20 principal facilities in operation as of December 31, 1993 is set forth below: The Company believes that substantially all of its property and equipment is in good condition and adequate for its present requirements. Item 3. Item 3. Legal Proceedings There are no material legal proceedings pending against the Registrant or its subsidiaries. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not applicable Executive Officers of the Registrant The names and ages of all executive officers of the Registrant are as follows: Officers of the Registrant are elected each year at the Annual Meeting of the Board of Directors to serve for the ensuing year or until their successors are elected and qualified. All of the executive officers of the Registrant named above have held various executive positions with the Registrant for more than five years except: Mr. Nicholson who has been President and Chief Executive Officer of PVS Chemicals, Inc. and a Director of the Company for more than five years; Mr. Hampton who has been a partner with the law firm of Dickinson, Wright, Moon, Van Dusen and Freeman for more than five years; Mr. Hill who joined the Company in October 1992 after serving in various positions with General Motors Corporation for more than five years, the most recent of which was Director for the Quality Network of the Delco Chassis Division; and Mr. Pniewski who joined the Company in January 1994 after serving in various positions with Ford Motor Company for more than twenty years, the most recent of which was Vehicle Seat Systems Engineering Manager in the Plastics and Trim Products Division. There is no family relationship between any of the foregoing persons. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters The information set forth under the caption "Shareholder Information" on page 29 the 1993 Annual Report of the Registrant is incorporated by reference herein. As of December 31, 1993 there were 806 holders of record of the Registrant's Common Stock. Item 6. Item 6. Selected Financial Data The information set forth under the caption "Selected Financial and Other Data" on page 17 the 1993 Annual Report of the Registrant is incorporated by reference herein. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 16 and 17 of the 1993 Annual Report of the Registrant is incorporated by reference herein. Item 8. Item 8. Financial Statements and Supplementary Data The information set forth on pages 18 through 27 of the 1993 Annual Report of the Registrant is incorporated by reference herein. 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 caption "Information About Directors and Nominees for Directors" on pages 3 and 4 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein for information as to directors of the Registrant. Reference is made to Part I of this Report for information as to executive officers of the Registrant. Item 11. Item 11. Executive Compensation The information set forth under the caption "Executive Compensation" on pages 6, 7 and 8 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information set forth under the caption "Security Ownership" on pages 1 and 2 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. Item 13. Item 13. Certain Relationships and Related Transactions The information set forth in footnotes (2) and (3) under the caption "Executive Compensation" and in the last paragraph under the caption "Retirement Plan" on pages 6 and 7 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as a part of this report: 1. Financial Statements The following consolidated financial statements of Douglas & Lomason Company and subsidiaries included in the Douglas & Lomason Company 1993 Annual Report to its Shareholders for the year ended December 31, 1993 are incorporated herein by reference: Consolidated Balance Sheets at December 31, 1993 and 1992. Consolidated Statements of Earnings for each of the years in the three year period ended December 31, 1993. Consolidated Statements of Shareholders' Equity for each of the years in the three year period ended December 31, 1993. Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993. Notes to Consolidated Financial Statements. The consolidated financial information for the years ended December 31, 1993, 1992, and 1991 set forth under "Index to Consolidated Financial Statements and Schedules." EXHIBITS (The Exhibit marked with one asterisk below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1983; the Exhibit marked with two asterisks below was filed as an Exhibit to the Form 10-Q Report of the Registrant for the quarter ended June 30, 1988; the Exhibit marked with three asterisks below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1989; the Exhibits marked with four asterisks below were filed as Exhibits to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1991; and the Exhibit marked with five asterisks below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1992, and are incorporated herein by reference, the Exhibit numbers in brackets being those in such Form 10-K or 10-Q Reports). (3)(a) Restated Articles of Incorporation of Registrant. (3)(b) By-Laws of the Registrant. (4)(a)** Term Loan Agreement dated as of May 20, 1988 between Registrant and the Banks named in Section 2.1 thereof [1]. (4)(a)(1)**** Amendments to Term Loan Agreement dated as of May 20, 1988. [(4)(a)(1)] (4)(b)**** Term Loan Agreement dated as of December 19, 1991 between Registrant and NBD Bank, N.A. and Manufacturers Bank, N.A., as amended. [(4)(b)] (10)(a)* 1982 Incentive Stock Option Plan of the Registrant [10](1) (10)(b)*** 1990 Stock Option Plan of the Registrant [(10)(b)](1) (10)(c)**** Joint Venture Agreement dated as of July 25, 1986 between Registrant and Namba Press Works Co., Ltd. [(10)(c)] (13) Portions of 1993 Annual Report of Registrant. (22)***** Subsidiaries of the Registrant. [(22)] (24) Consent of KPMG Peat Marwick. (b) Reports on Form 8-K. The Registrant has not filed any reports on Form 8-K during the last quarter of the period covered by this report. (1) This document is a management contract or compensatory plan. SIGNATURES Pursuant to the requirements of the 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. DOUGLAS & LOMASON COMPANY By: /s/H. A. Lomason II ------------------------------- H. A. Lomason II Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) By: /s/James J. Hoey ------------------------------- James J. Hoey Senior Vice President and Chief Financial Officer (Principal Financial Officer) By: /s/Melynn M. Zylka ------------------------------- Melynn M. Zylka Treasurer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 29, 1994. Signature Title --------- ----- /s/James E. George Director ---------------------- James E. George /s/H. A. Lomason II Director ---------------------- H. A. Lomason II /s/Dale A. Johnson Director ---------------------- Dale A. Johnson /s/Charles R. Moon Director ---------------------- Charles R. Moon /s/James B. Nicholson Director ---------------------- James B. Nicholson Director ---------------------- Richard N. Vandekieft /s/Gary T. Walther Director ---------------------- Gary T. Walther DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES The consolidated balance sheets of the Company 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 years in the three-year period ended December 31, 1993, together with the related notes and the report of KPMG Peat Marwick, independent Certified Public Accountants, all contained in the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. The following additional financial data should be read in conjunction with the financial statements in the 1993 Annual Report to Shareholders. All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. Financial statements and related schedules of the Registrant have been omitted because the Registrant is primarily an operating company and the subsidiaries included in the consolidated financial statements are totally held. Independent Auditors' Report The Board of Directors and Shareholders Douglas & Lomason Company: Under date of January 31, 1994, we reported on the consolidated balance sheets of Douglas & Lomason Company 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 years in the three- year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related 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. As discussed in notes 1 and 8 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. /s/ KPMG Peat Marwick Detroit, Michigan January 31, 1994 Schedule V DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Property, Plant, and Equipment Years ended December 31, 1991, 1992, and 1993 (Expressed in thousands of dollars) Schedule VI DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Accumulated Depreciation of Property, Plant, and Equipment Years ended December 31, 1991, 1992, and 1993 (Expressed in thousands of dollars) Schedule VIII DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended December 31, 1992, 1991, and 1990 (Expressed in thousands of dollars) Schedule IX DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Short-Term Borrowings Years ended December 31, 1992, 1991, and 1990 (Expressed in thousands of dollars, except for percentages) Schedule X DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992, and 1991 (Expressed in thousands of dollars) Other disclosures under Rule 12-11 are omitted because the individual amounts do not exceed 1 percent of total consolidated net sales.

850429_1993.txt

850429_1993

1993

850429

Item 1. BUSINESS Description of Business Tredegar Industries, Inc. ("Tredegar") was formed under the laws of the Commonwealth of Virginia as a subsidiary of Ethyl Corporation ("Ethyl") on June 1, 1988. On July 10, 1989, Ethyl distributed all of the outstanding Tredegar common stock, no par value (the "Common Stock"), to the holders of Ethyl common stock at the close of business on that day. Since July 10, 1989, Tredegar has been a publicly held operating company. Tredegar is engaged directly or through subsidiaries in plastics, metal products, energy and other businesses (primarily software and rational drug design research). Tredegar's Energy segment is composed of its coal subsidiary, The Elk Horn Coal Corporation ("Elk Horn"), and oil and gas properties located in Western Canada. On February 4, 1994, Tredegar sold its remaining oil and gas properties. In addition, in November 1993, Tredegar announced that it is pursuing the sale of Elk Horn. Assuming Elk Horn can be sold on terms agreeable to Tredegar, the sale is expected to be completed by mid-1994. Tredegar's Energy segment has been reported as discontinued operations. The following discussion of Tredegar's businesses should be read in conjunction with the information contained in the "Financial Review" section of the Annual Report referred to in Item 7 below. Plastics The Plastics segment is composed of the Film Products division ("Film Products"), Tredegar Molded Products Company ("Molded Products") and Fiberlux, Inc. ("Fiberlux"). Film Products and Molded Products manufacture a wide range of products including specialty films, injection-molded products and custom injection molds. Broad application for these products is found in films for packaging, industrial, agricultural and disposable personal products, including diapers, and in molded products for industrial, household, personal-care, medical and electronics products. Fiberlux produces vinyl extrusions, windows and patio doors. These products are produced at various locations throughout the United States and are sold both directly and through distributors. Tredegar also has films plants located in the Netherlands and Brazil, where it produces films primarily for the European and Latin American markets, respectively. The Plastics segment competes in all of its markets on the basis of the quality and prices of its products and its service. Film Products Film Products produces films for two major market categories: disposables and industrial. Disposables. Film Products is the largest U.S. supplier of embossed and permeable films for disposable personal products. In each of the last three years, this class of products accounted for more than 20% of the consolidated revenues of Tredegar. Film Products supplies embossed films to domestic and international manufacturers for use as backsheet in such disposable products as baby diapers, adult incontinent products, feminine hygiene pads and hospital underpads. Film Products' primary customer for embossed films for backsheet is The Procter & Gamble Company ("P&G"), the leading disposable diaper manufacturer. Film Products also sells embossed films to several producers of private label products. Film Products competes with several foreign and domestic film products manufacturers in the backsheet market. In response to environmental concerns, Film Products has been involved in the development of new materials to replace the existing backsheet for disposable diapers with a more environmentally friendly material. In 1991, Film Products' U.S. disposable diaper backsheet volume declines due to downgauging (i.e., making thinner films) were offset by higher volume from increased P&G market share. In 1992, Film Products' U.S. disposable diaper backsheet volume declined significantly due to lower P&G market share. The economic recession caused many consumers to seek lower priced private label diapers. In 1993, P&G's U.S. diaper market share stabilized resulting in backsheet volumes roughly equal to 1992. On an international basis, 1993 backsheet sales were slightly higher than 1992. Overall, 1993 backsheet volumes were higher than 1992 but below 1990 and 1991 levels. Film Products supplies permeable films to P&G for use as topsheet in adult incontinent products, feminine hygiene products and hospital underpads. The processes used in manufacturing these films were developed jointly by Film Products and P&G and are covered by applicable patents held by P&G and Tredegar. Film Products also sells significant amounts of permeable films to international affiliates of P&G. In 1991, permeable film volumes improved over 1990 due to higher international sales, primarily in the Far East. In 1992, volumes improved over 1991 due to higher sales in all geographic areas. In 1993, permeable film volumes declined in the U.S. and Far East, partially offset by increases in Europe and Latin America. Overall, 1993 permeable film volumes were below 1992 and level with 1991. P&G also purchases molded plastic products from Molded Products. P&G and Tredegar have had a successful long-term relationship based on cooperation, product innovation and continuous process improvement. The loss or significant reduction of business associated with P&G would have a material adverse effect on Tredegar's business. Industrial. Film Products produces a line of oriented films under the name MONAX(R). These are high strength, high moisture barrier films that allow both cost and source reduction opportunities over current packaging mediums. During 1994, Film Products will concentrate on increasing awareness of MONAX(R) film and the development of heat sealable versions that can be used by end- users in food, industrial, and medical packaging markets. Film Products also produces coextruded and monolayer permeable formed films under the name of VisPore(R). These films are used to regulate fluid transmission in many industrial, medical, agricultural and packaging markets. Specific examples include rubber bale wrap, filter plies for surgical masks and other medical applications, permeable ground cover and cook-in-bag for rice and pasta. Differentially embossed monolayer and coextruded films are also produced by Film Products. Some of these films are extruded in a Class 10,000 clean room and act as a disposable, protective coversheet for photopolymers used in the manufacture of circuit boards. Other films, sold under the name of ULTRAMASK(R), are used as masking films that protect polycarbonate, acrylics and glass from damage during fabrication, shipping and handling. In January 1994, Film Products announced its intention to sell or close its Flemington, New Jersey, plant in order to exit the non-strategic conventional films business (single layer, blown polyethylene film used primarily for general purpose industrial packaging). Raw Materials. The primary raw materials for films produced by Film Products are low-density and linear low-density polyethylene resins, which Film Products obtains from domestic and foreign suppliers at competitive prices. Tredegar's management believes that there will be an adequate supply of polyethylene resins in the immediate future. Changes in resin prices, and the timing thereof, could have a significant impact on the profitability of this division. Research and Development. Film Products has a technical center in Terre Haute, Indiana. Film Products holds 35 U.S. patents and nine U.S. trademarks. Expenditures for research and development have averaged approximately $3.3 million per year during the past three years. Molded Products Molded Products manufactures five major categories of products: packaging products, industrial products, parts for medical products, parts for electronics products and injection-mold tools. Packaging products represent more than half of Molded Products' business. Packaging Products. The packaging group produces deodorant canisters, lip balm sticks, custom jars, plugs, fitments and closures, primarily for toiletries, cosmetics, pharmaceuticals and personal hygiene markets. Molded Products is the leading U.S. producer of lip balm sticks. Molded Products competes with various large producers in the packaging market. Industrial Products. Molded Products produces molded plastic parts for business machines, media storage products, cameras, appliances and various custom products. In the business machine area, closer tolerances, made possible by computer-aided design and manufacturing (CAD/CAM) and modern resins, have led to expanded high-performance applications. Molded Products works closely with customers in the design of new industrial products and systems. The market for such products is very competitive. Parts for Medical and Electronics Products. Effective July 31, 1993, Molded Product's subsidiary, Polestar Plastics Manufacturing Company, acquired the assets of a custom molder of precision parts for the medical and electronics markets. Products supplied to the medical market include, among others, disposable plastic parts for laparoscopic surgery instruments, staple guns, needle protector devices and syringe housings. Products supplied to the electronics market include, among others, connectors for computer cables and circuit boards. Injection-Mold Tools. Molded Products' tooling group produces injection molds for internal use and for sale to other custom and captive molders. Molded Products operates one of the largest independent tool shops in the United States in St. Petersburg, Florida. Raw Materials. Polypropylene and polyethylene resin are the primary raw materials used by Molded Products. Molded Products also uses polystyrene resins. Molded Products purchases these raw materials from domestic suppliers at competitive prices. Changes in resin prices, and the timing thereof, could have a significant impact on the profitability of this division. Molded Products' management believes that there will be an adequate supply of these resins in the immediate future. Research and Development. Molded Products owns eight U.S. patents and has spent an average of $.3 million each year for the last three years for research and development. Molded Products maintains a technical center as part of its St. Petersburg, Florida, complex. Fiberlux Fiberlux is a leading U.S. producer of rigid vinyl extrusions, windows and patio doors. Fiberlux products are sold to fabricators and directly to end users. The subsidiary's primary raw material, polyvinyl chloride resin, is purchased from producers in open market purchases and under contract. No critical shortages of polyvinyl chloride resins are expected. Metal Products The Metal Products segment is composed of The William L. Bonnell Company, Inc. ("Bonnell"), Capitol Products Corporation ("Capitol") and Brudi, Inc. ("Brudi"). Bonnell and Capitol ("Aluminum Extrusions") produce soft alloy aluminum extrusions primarily for the building and construction industry, and for transportation and consumer durables markets. Brudi, acquired by Tredegar in April 1991, primarily produces steel attachments and uprights for the forklift truck market. Aluminum Extrusions Aluminum Extrusions manufactures plain, anodized and painted aluminum extrusions for sale directly to fabricators and distributors that use aluminum extrusions in the production of curtain walls, moldings, architectural shapes, running boards, tub and shower doors, boat windshields, window components and furniture, among other products. Sales are made primarily in the United States, principally east of the Rocky Mountains. Sales are substantially affected by the strength of the building and construction industry, which accounts for a majority of product sales. Raw materials for Aluminum Extrusions, consisting of aluminum ingot, aluminum scrap and various alloys, are purchased from domestic and foreign producers in open market purchases and under short-term contracts. Profit margins for products in Aluminum Extrusions are sensitive to significant fluctuations in aluminum ingot and scrap prices, which account for more than 40 percent of product cost. Tredegar does not expect critical shortages of aluminum or other required raw materials and supplies. Aluminum Extrusions competes primarily based on the quality and prices of its products and its service with a number of national and regional manufacturers in the industry. Brudi Headquartered in Ridgefield, Washington, Brudi is the second largest supplier of uprights and attachments for the forklift truck segment of the domestic materials handling industry. Brudi markets its products and services, which include in-house engineering and design capabilities, primarily to dealers and original equipment manufacturers of forklift trucks. Markets served include warehousing and distribution, food, fiber, primary metals, pharmaceuticals, beverage and paper. Brudi products are made primarily from steel, which is purchased on the open market and under contract from domestic producers. Tredegar does not foresee critical shortages of steel or other required raw materials and supplies. During 1992, Brudi acquired the assets of a materials handling company in Halifax, United Kingdom to serve the European market. Energy The Energy segment is composed of Elk Horn and oil and gas properties located in Western Canada. On February 4, 1994, Tredegar sold its remaining oil and gas properties. In addition, in November 1993, Tredegar announced that it is pursuing the sale of Elk Horn. Assuming Elk Horn can be sold on terms agreeable to Tredegar, the sale is expected to be completed by mid- 1994. Tredegar's Energy segment has been reported as discontinued operations. Coal Elk Horn, an approximately 97 percent owned subsidiary, obtains income from royalties by leasing part of its Eastern Kentucky mineral rights (approximately 142,000 acres) for mining coal. The coal is generally characterized as high-volatility, bituminous A-rank with low sulphur content. Based on recent changes to the methodology used in classifying coal reserves, Elk Horn estimates that, as of January 1, 1993, its proven and probable raw recoverable reserves (reserves before any losses due to beneficiation) approximate 124 million tons and 86 million tons, respectively. During the last five years, Elk Horn's reserves have been mined at volumes ranging from 4 million to 6.2 million tons per year. Elk Horn leases its mineral rights to coal operators, who mine the coal and pay royalties based on their sales revenues. Elk Horn also uses independent contractors to mine coal. Elk Horn sells coal on the open market on the basis of price and quality. In January 1991, Elk Horn entered the coal trading business through a new subsidiary. The Elk Horn Coal Sales Corporation facilitates the sale of coal to customers from Elk Horn's production and from independent operators mining non-Elk Horn reserves throughout Central Appalachia. Tredegar is negotiating the sale of Elk Horn's coal trading business independently from its other coal operations. Oil and Gas Tredegar sold its remaining oil and gas properties on February 4, 1994 for approximately $8 million. This transaction resulted in a gain of approximately $6.1 million ($3.9 million after income taxes), which will be recognized in 1994. Other Businesses The Other segment is composed primarily of investments in high- technology businesses and related research. In December 1992, Tredegar acquired APPX Software, Inc. (formerly Kennedy & Company, Inc.) ("APPX Software"), a supplier of flexible software development environments and business applications software. Headquartered in Richmond, Virginia, APPX Software's leading product is a proprietary application software development tool called APPX(R). APPX enables software designers and programmers to develop and modify business applications software much faster than customary programming techniques. APPX can run on a variety of computers and is designed to adapt to changing hardware environments. The market for software products is very competitive and characterized by short product life cycles. During 1992, Molecumetics, Ltd., a subsidiary of Tredegar ("Molecumetics"), commenced operation of its rational drug design research laboratory in Seattle, Washington. Molecumetics provides proprietary chemistry for the synthesis of small molecule therapeutics and vaccines. Using synthetic chemistry techniques, researchers can fashion small molecules that imitate the bioactive portion of larger and more complex molecules. For customers in the pharmaceutical and biotechnology industries, these synthetically-produced compounds offer significant advantages over naturally occurring proteins in fighting diseases because they are smaller and more easily absorbed in the human body, less subject to attack by enzymes, more specific in their therapeutic activity, and faster and less expensive to produce. APPX Software owns four U.S. copyrights. Molecumetics has filed a number of patent applications with respect to its technology. Businesses included in the Other segment spent $5.6 million in 1993 and $1.9 million in 1992 for research and development. Miscellaneous Patents, Licenses and Trademarks. Tredegar considers patents, licenses and trademarks to be of significance to its Plastics segment and its APPX Software and Molecumetics subsidiaries. Tredegar routinely applies for patents on significant patentable developments with respect to all of its businesses. Tredegar and its subsidiaries now own numerous patents with remaining terms ranging from 1 to 16 years. In addition, the Plastics segment and certain of Tredegar's other subsidiaries have licenses under patents owned by third parties. Research and Development. During 1993, 1992 and 1991, approximately $9.1 million, $5.0 million and $4.5 million, respectively, was spent on company- sponsored research and development activities in connection with the businesses of Tredegar and its subsidiaries. See "Business of Tredegar - Plastics and Other Businesses." Backlog. Backlogs are not material to Tredegar. Government Regulation. Laws concerning the environment that affect or could affect Tredegar's domestic operations include, among others, the Clean Water Act, the Clean Air Act, the Resource Conservation Recovery Act, the Occupational Safety and Health Act, the National Environmental Policy Act, the Toxic Substances Control Act, the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), regulations promulgated under these acts, and any other federal, state or local laws or regulations governing environmental matters. The operations of Tredegar and its subsidiaries are in substantial compliance with all applicable laws, regulations and permits. In order to maintain substantial compliance with such standards, Tredegar may be required to incur expenditures, the amounts and timing of which are not presently determinable but which could be significant, in constructing new facilities or in modifying existing facilities. Municipal, state and federal governments continue to consider restrictions on the disposal of plastic products. Several states have enacted such restrictions. The Plastics segment is conducting research into source reduction through improved product quality and reduced plastic product content and into the development of degradable films at its Terre Haute, Indiana, research and development facility. At present, Tredegar cannot determine the likely impact of proposed restrictions on the Plastics segment. From time to time the Environmental Protection Agency (the "EPA") may identify Tredegar or one of its subsidiaries as a potentially responsible party with respect to a Superfund site under CERCLA. To date, Tredegar, indirectly, is potentially responsible with respect to four Superfund sites. As a result, Tredegar may be required to expend amounts on remedial investigations and actions at such Superfund sites. Responsible parties under CERCLA may be jointly and severally liable for costs at a site, although typically costs are allocated among the responsible parties. In addition, Tredegar, indirectly, is potentially responsible for one New Jersey Spill Site Act location. Another New Jersey site is being investigated pursuant to the New Jersey Environmental Cleanup Responsibility Act. Capital expenditures for pollution abatement and OSHA projects were about $.4 million, $.8 million and $3.6 million in 1993, 1992 and 1991, respectively. In 1991, approximately $2.3 million in capital expenditures was related to the finishing operations in Aluminum Extrusions. Future capital expenditures for pollution abatement and OSHA projects are expected to approximate 1993 and 1992 levels. Employees. Tredegar and its subsidiaries employ approximately 3,500 people. Tredegar considers its relations with its employees to be good. Item 2. Item 2. PROPERTIES General Most of the improved real property and the other assets of Tredegar and its subsidiaries are owned, and none of the owned property is subject to an encumbrance material to the consolidated operations of Tredegar and its subsidiaries. Tredegar considers the condition of the plants, warehouses and other properties and assets owned or leased by Tredegar and its subsidiaries to be generally good. Additionally, Tredegar considers the geographical distribution of its plants to be well-suited to satisfying the needs of its customers. Tredegar believes that the capacity of its plants to be adequate for immediate needs of its businesses. Tredegar's plants generally have operated at 70-85 percent of capacity. Tredegar's corporate headquarters offices are located at 1100 Boulders Parkway, Richmond, Virginia 23225. Plastics The Plastics segment has the following principal plants and facilities: Location Principal Operations Carbondale, Pennsylvania Production of plastic films Flemington, New Jersey* Fremont, California* LaGrange, Georgia Manchester, Iowa New Bern, North Carolina Tacoma, Washington Terre Haute, Indiana (2) (technical center and production facility) Kerkrade, the Netherlands Sao Paulo, Brazil Alsip, Illinois Production of molds and molded Excelsior Springs, Missouri plastic products South Grafton, Massachusetts St. Petersburg, Florida (3) (technical center and two production facilities) Phillipsburg, Pennsylvania State College, Pennsylvania Pawling, New York Production of vinyl extrusions, Purchase, New York (headquarters) windows and patio doors South Bend, Indiana *Tredegar has announced the closing or other disposition of these plants during 1994. Metal Products The Metal Products segment has the following principal plants and facilities: Location Principal Operations Carthage, Tennessee Production of aluminum Kentland, Indiana extrusions, finishing Newnan, Georgia Ridgefield, Washington Production of uprights Kelso, Washington and attachments Adelaide, Australia Halifax, United Kingdom Energy See page 5 Other Businesses APPX Software leases office space in Richmond, Virginia. Molecumetics leases its laboratory space in Bellevue, Washington. Item 3. Item 3. LEGAL PROCEEDINGS None Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None Executive Officers of Tredegar Set forth below are the names, ages and titles of the executive officers of Tredegar: Name Age Title John D. Gottwald 39 President and Chief Executive Officer Richard W. Goodrum 65 Executive Vice President and Chief Operating Officer Norman A. Scher 56 Executive Vice President, Chief Financial Officer and Treasurer Michael W. Giancaspro 39 Vice President, Corporate Planning Steven M. Johnson 43 Vice President, Corporate Development Anthony J. Rinaldi 56 Vice President and General Manager, Film Products Frederick P. Woods 49 Vice President, Personnel Except as described below, each of these officers has served in such capacity since July 10, 1989. Each will hold office until his successor is elected or until his earlier removal or resignation. The business experience during the past five years of the executive officers is set forth below. John D. Gottwald. Mr. Gottwald was Corporate Vice President-Aluminum, Plastics and Energy of Ethyl from January 1, 1989, until July 10, 1989. Richard W. Goodrum. Mr. Goodrum was the Divisional Vice President-Aluminum, Plastics, and Energy of Ethyl from January 1, 1989, until July 10, 1989. Norman A. Scher. Until July 10, 1989, Mr. Scher was a partner in the law firm of Hunton & Williams, where he was a member of the firm's corporate and securities team. He was an assistant managing partner in the firm for many years, and since 1982 had primary responsibility for financial and planning activities. Michael W. Giancaspro. Mr. Giancaspro served as Director of Corporate Planning from March 31, 1989, until February 27, 1992, when he was elected Vice President, Corporate Planning. Mr. Giancaspro was Plant Manager of Ethyl Film Products' Carbondale plant from April 1988 until March 1989. Steven M. Johnson. Mr. Johnson served as Secretary of the Corporation until February, 1994. Mr. Johnson served as Vice President, General Counsel and Secretary from July 10, 1989, until July, 1992, when his position was changed to Vice President, Corporate Development and Secretary. Mr. Johnson served as counsel to the law firm of Hunton & Williams in Richmond, Virginia, from March, 1989, until July 10, 1989. Anthony J. Rinaldi. Mr. Rinaldi was elected Vice President on February 27, 1992. Mr. Rinaldi has served as General Manager of Tredegar Film Products since July 1, 1991. During 1991, he also served as Managing Director of European operations. Mr. Rinaldi served as Director of Sales and Marketing for Tredegar Film Products from July 10, 1989 to June, 1991. In 1985, Mr. Rinaldi became Director of Sales & Marketing for Ethyl Film Products. Frederick P. Woods. Mr. Woods served as Vice President, Employee Relations until December, 1993, when his position was changed to Vice President, Personnel. Mr. Woods served as Director of Employee Relations for Ethyl from February 1, 1988, until July 10, 1989. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information contained on page 40 of the Annual Report under the captions "Dividend Information," "Stock Listing" and "Market Prices of Common Stock and Shareholder Data" 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 page 14 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 on pages 16 through 24 and page 26 of the Annual Report is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements contained on pages 28 through 31, the notes to financial statements contained on pages 32 through 39, the report of independent accountants on page 27, and the information under the caption "Selected Quarterly Financial Data (Unaudited)" on pages 25 and 26 of the Annual Report are incorporated herein by reference. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained on pages 2 through 4 of the Proxy Statement under the caption "Election of Directors" concerning directors and persons nominated to become directors of Tredegar is incorporated herein by reference. See "Executive Officers of Tredegar" at the end of Part I above for information about the executive officers of Tredegar. The information contained on page 6 of the Proxy Statement under the caption "Stock Ownership" is incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION The information contained on pages 9 through 15 of 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 on pages 5 through 8 of the Proxy Statement under the caption "Stock Ownership" 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) Documents: (1) Financial statements - the following consolidated financial statements of the registrant are included on pages 27 to 39 in the Annual Report and are incorporated herein by reference in Item 8. Report of independent accountants. Consolidated balance sheets as of December 31, 1993 and 1992. Consolidated statements of income, shareholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. Notes to financial statements. (2) See Index to Financial Statement Schedules on page S-1. (3) Exhibits 3.1 Amended and Restated Articles of Incorporation of Tredegar (filed as Exhibit 3.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 3.2 Amended By-laws of Tredegar 4.1 Form of Common Stock Certificate (filed as Exhibit 4.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.2 Rights Agreement dated as of June 15, 1989, between Tredegar and NationsBank of Virginia, N.A. (formerly Sovran Bank, N.A.), as Rights Agent (filed as Exhibit 4.4 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.2.1 Amendment and Substitution Agreement (Rights Agreement) dated as of July 1, 1992, by and among Tredegar, NationsBank of Virginia, N.A. (formerly Sovran Bank, N.A.) and American Stock Transfer & Trust Company 4.3 Competitive Advance and Revolving Credit Agreement dated as of June 16, 1989, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.3.1 First Amendment to the Competitive Advance and Revolving Credit Agreement dated as of September 15, 1990, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.2.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) 4.3.2 Second Amendment to the Competitive Advance and Revolving Credit Agreement, dated as of December 6, 1991, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.4.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 4.3.3 Third Amendment to the Competitive Advance and Revolving Credit Agreement, dated as of June 8, 1992, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.4.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference) 4.3.4 Fourth Amendment, dated as of August 20, 1993, to the Competitive Advance and Revolving Credit Agreement among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference) 4.4 Loan Agreement dated as of June 8, 1992, among Tredegar, the Banks named therein and LTCB Trust Company, as Agent (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by reference) 4.4.1 Accession Agreement dated August 3, 1992, among Tredegar, the Banks named in the Loan Agreement dated as of June 8, 1992 and LTCB Trust Company, as Agent (filed as Exhibit 4.5.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference) 4.5 Loan Agreement dated June 16, 1993 between Tredegar and Metropolitan Life Insurance Company (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference) 10.1 Reorganization and Distribution Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.2 Employee Benefits Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.3 Tax Sharing Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.4 Master Services Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.4 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.4.1 Amendment to Master Services Agreement dated as of November 1, 1990, between Tredegar and Ethyl (filed as Exhibit 10.4.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) 10.5 Indemnification Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.5 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.6 Tredegar 1989 Incentive Stock Option Plan (included as Exhibit A to the Prospectus contained in the Form S-8 Registration Statement No. 33-31047, and incorporated herein by reference) *10.7 Tredegar Bonus Plan (filed as Exhibit 10.7 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.8 Savings Plan for the Employees of Tredegar (filed as Exhibit 4 to the Form S-8 Registration Statement No. 33-29582, and incorporated herein by reference) *10.9 Tredegar Retirement Income Plan (filed as Exhibit 10.9 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) *10.10 Agreement dated as of June 1, 1989, between Tredegar and Norman A. Scher (filed as Exhibit 10.10 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.11 Stock and Warrant Purchase Agreement dated as of February 15, 1991, by and between Tredegar Investments, Inc. and Clinical Technologies Associates, Inc. (now Emisphere Technologies, Inc.) (filed as Exhibit 10.11 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 10.11.1 Agreement dated as of October 23, 1992, by and among Tredegar Investments, Inc., Emisphere Technologies, Inc., Michael M. Goldberg, M.D. and Sam J. Milstein, Ph.D. (filed as Exhibit 10.11.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 10.11.2 Letter Agreement dated December 30, 1992, by and between Tredegar Investments, Inc. and Emisphere Technologies, Inc. (filed as Exhibit 10.11.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) *10.12 Tredegar 1992 Omnibus Stock Incentive Plan (filed as Exhibit 10.12 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) *10.13 Tredegar Industries, Inc. Retirement Benefit Restoration Plan *10.14 Tredegar Industries, Inc. Savings Plan Benefit Restoration Plan 11 Computations of earnings per share 13 Tredegar Annual Report to Shareholders for the year ended December 31, 1993 (See Note 1) 21 Subsidiaries of Tredegar 23.1 Consent of Independent Accountants *The marked items are management contracts or compensatory plans, contracts or arrangements required to be filed as exhibits to this Form 10-K. (b) Reports on Form 8-K None (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. 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 a part of Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TREDEGAR INDUSTRIES, INC. (Registrant) Dated: February 25, 1994 By /s/ John D. Gottwald John D. Gottwald 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 indicated on February 25, 1994. Signature Title /s/ John D. Gottwald President (John D. Gottwald) (Principal Executive Officer and Director) /s/ N. A. Scher Executive Vice President, (Norman A. Scher) Treasurer and Director (Principal Financial Officer) /s/ D. Andrew Edwards Corporate Controller (D. Andrew Edwards) (Principal Accounting Officer) /s/ R. W. Goodrum Executive Vice President and (Richard W. Goodrum) Director /s/ Phyllis Cothran Director (Phyllis Cothran) /s/ Bruce C. Gottwald Director (Bruce C. Gottwald) /s/ Floyd D. Gottwald, Jr. Director (Floyd D. Gottwald) /s/ Andre B. Lacy Director (Andre B. Lacy) /s/ James F. Miller Director (James F. Miller) /s/ Emmett J. Rice Director (Emmett J. Rice) /s/ W. Thomas Rice Director (W. Thomas Rice) TREDEGAR INDUSTRIES, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES Page Report of Independent Accountants on Financial Statement Schedules S-2 Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 S-3 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 S-4 Report of Independent Accountants on Financial Statement Schedules To the Board of Directors and Shareholders of Tredegar Industries, Inc.: Our report on the consolidated financial statements of Tredegar Industries, Inc. and Subsidiaries has been incorporated by reference in this Form 10-K from page 27 of the 1993 Annual Report to Shareholders of Tredegar Industries, Inc. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page S-1 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand Richmond, Virginia January 17, 1994 Depreciation is computed on the straight-line basis over the estimated useful lives of the related assets, resulting in annual depreciation rates of: Land improvements: 5% - 10% Buildings: 2.5% - 5% Machinery and equipment: 5% - 33.3% (1) Continuing operations. (2) Reclassifications. (3) Acquisitions of businesses. (4) Write-up of assets to their pre-tax amounts in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." (5) Sales of businesses and assets. (6) Adjustment for fully-depreciated divested assets. (1) Continuing operations. (2) Reclassifications. (3) Sales of businesses and assets. (4) Acquisitions of businesses. (5) Adjustment for fully-depreciated divested assets. EXHIBIT INDEX Page 3.1 Amended and Restated Articles of Incorporation of Tredegar (filed as Exhibit 3.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 3.2 Amended By-laws of Tredegar 4.1 Form of Common Stock Certificate (filed as Exhibit 4.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.2 Rights Agreement dated as of June 15, 1989, between Tredegar and NationsBank of Virginia, N.A. (formerly Sovran Bank, N.A.), as Rights Agent (filed as Exhibit 4.4 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.2.1 Amendment and Substitution Agreement (Rights Agreement) dated as of July 1, 1992, by and among Tredegar, NationsBank of Virginia, N.A. (formerly Sovran Bank, N.A.) and American Stock Transfer & Trust Company (filed as Exhibit 4.2.1 to Tredegar's Annual Report on Form 10- K for the year ended December 31, 1992, and incorporated herein by reference) 4.3 Competitive Advance and Revolving Credit Agreement dated as of June 16, 1989, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 4.3.1 First Amendment to the Competitive Advance and Revolving Credit Agreement dated as of September 15, 1990, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.2.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) 4.3.2 Second Amendment to the Competitive Advance and Revolving Credit Agreement, dated as of December 6, 1991, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.4.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 4.3.3 Third Amendment to the Competitive Advance and Revolving Credit Agreement, dated as of June 8, 1992, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4.4.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 4.3.4 Fourth Amendment to the Competitive Advance and Revolving Credit Agreement, dated as of August 20, 1993, among Tredegar, the Banks named therein and Chemical Bank, as Agent (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference) 4.4 Loan Agreement dated as of June 8, 1992, among Tredegar, the Banks named therein and LTCB Trust Company, as Agent (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by reference) 4.4.1 Accession Agreement dated August 3, 1992, among Tredegar, the Banks named in the Loan Agreement dated as of June 8, 1992 and LTCB Trust Company, as Agent (filed as Exhibit 4.5.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference) 4.5 Loan Agreement dated June 16, 1993 between Tredegar and Metropolitan Life Insurance Company (filed as Exhibit 4 to Tredegar's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference) 10.1 Reorganization and Distribution Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.2 Employee Benefits Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.3 Tax Sharing Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.3 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.4 Master Services Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.4 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.4.1 Amendment to Master Services Agreement dated as of November 1, 1990, between Tredegar and Ethyl (filed as Exhibit 10.4.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) 10.5 Indemnification Agreement dated as of June 1, 1989, between Tredegar and Ethyl (filed as Exhibit 10.5 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.6 Tredegar 1989 Incentive Stock Option Plan (included as Exhibit A to the Prospectus contained in the Form S-8 Registration Statement No. 33-31047, and incorporated herein by reference) *10.7 Tredegar Bonus Plan (filed as Exhibit 10.7 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) *10.8 Savings Plan for the Employees of Tredegar (filed as Exhibit 4 to the Form S-8 Registration Statement No. 33-29582, and incorporated herein by reference) *10.9 Tredegar Retirement Income Plan (filed as Exhibit 10.9 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference) *10.10 Agreement dated as of June 1, 1989, between Tredegar and Norman A. Scher (filed as Exhibit 10.10 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference) 10.11 Stock and Warrant Purchase Agreement dated as of February 15, 1991, by and between Tredegar Investments, Inc. and Clinical Technologies Associates, Inc. (now Emisphere Technologies, Inc.) (filed as Exhibit 10.11 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 10.11.1 Agreement dated as of October 23, 1992, by and among Tredegar Investments, Inc., Emisphere Technologies, Inc., Michael M. Goldberg, M.D. and Sam J. Milstein, Ph.D. (filed as Exhibit 10.11.1 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 10.11.2 Letter Agreement dated December 30, 1992, by and between Tredegar Investments, Inc. and Emisphere Technologies, Inc. (filed as Exhibit 10.11.2 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) *10.12 Tredegar 1992 Omnibus Stock Incentive Plan (filed as Exhibit 10.12 to Tredegar's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) *10.13 Tredegar Industries, Inc. Retirement Benefit Restoration Plan *10.14 Tredegar Industries, Inc. Savings Plan Benefit Restoration Plan 11 Computations of earnings per share 13 Tredegar Annual Report to Shareholders for the year ended December 31, 1993 (See Note 1) 21 Subsidiaries of Tredegar 23.1 Consent of Independent Accountants *The marked items are management contracts or compensatory plans, contracts or arrangements required to be filed as exhibits to this Form 10-K.

103973_1993.txt

103973_1993

1993

103973

ITEM 1. BUSINESS Vulcan Materials Company and its subsidiaries (together called the "Company") are principally engaged in the production, distribution and sale of construction materials ("Construction Materials") and industrial chemicals ("Chemicals"). Construction Materials and Chemicals may each be considered both a segment (or a line of business) and a class of similar products. The Company believes it is the nation's leading producer of construction aggregates. All of the Company's products are marketed under highly competitive conditions, including competition in price, service and product performance. There are a substantial number of competitors in both Construction Materials and Chemicals. No material part of the business of either segment of the Company is dependent upon a single customer or upon a few customers, the loss of any one of which would have a materially adverse effect on the segment. The Company's products are sold principally to private industry. Although large amounts of construction materials are used in public works, relatively insignificant sales are made directly to federal, state, county or municipal governments, or agencies thereof. The Company estimates that capital expenditures for environmental control facilities for the current fiscal year (1994) and the succeeding fiscal year (1995) will be approximately $10,301,000 and $11,820,000, respectively. Environmental and zoning regulations have made it increasingly difficult for the construction aggregates industry to expand existing quarries and to develop new quarry operations. Although it cannot be predicted what policies will be adopted in the future by governmental bodies regarding environmental controls, the Company anticipates that future environmental control costs will not have a materially adverse effect upon its business. Environmental regulations also have a restrictive effect upon the chemicals industry, both as to production and markets, especially the production of and markets for certain chemicals which are subject to regulation as ozone depleting chemicals. Regulatory developments under current law in the United States ultimately will result in the discontinuance of the production of carbon tetrachloride, which is used to produce chlorofluorocarbons (CFCs), and in the elimination of the market for methyl chloroform for emissive uses. However, the Company's manufacturing flexibility will allow it to manufacture other products without producing carbon tetrachloride and to serve other markets. The Clinton Administration, through the United States Environmental Protection Agency ("EPA"), has announced that it would seek authorization from Congress to conduct a study over the next three years which would develop a strategy for substituting, reducing, or prohibiting the use of chlorine and chlorinated compounds. The proposed study is one of several Administration recommendations dealing with the reauthorization of the Clean Water Act. It is uncertain whether legislation dealing with chlorine and chlorinated compounds will be enacted or, if enacted, what the terms of such legislation will be. Accordingly, the impact, if any, of any such legislation on the Company's Chemicals business cannot be predicted at this time. The Company's principal sources of energy are electricity, natural gas and diesel fuel. The Company does not anticipate any material difficulty in obtaining the required sources of energy or in obtaining the raw materials which it uses. The Company conducts research and development activities for both of its business segments. The Construction Materials research and development laboratory is located near Birmingham, Alabama. The research and development laboratory for Chemicals is located at the Wichita, Kansas, plant site. In general, the Company's research and development effort is directed to applied technological development for the use of its Construction Materials products and for the manufacture or processing of its Chemicals products. The Company spent approximately $5,401,000 in 1991, $5,435,000 in 1992, and $6,073,000 in 1993 on research and development activities for its two business segments. In 1993, the Company employed an average of approximately 6,300 people. As of December 31, 1993, about 22% of the Company's employees were represented by a number of national unions. The Company considers its relationship with its employees and their various representatives to be good. Results of any individual quarter are not necessarily indicative of results to be expected for the year, due principally to the effect that weather can have on the sales and production volume of the Construction Materials segment. Normally, the highest sales and earnings of the Construction Materials segment are attained in the third quarter and the lowest are realized in the first quarter. In 1987, the Company commenced a joint venture known as the Crescent Market Project (the "Project") with a Mexican partner, Grupo ICA, to supply construction aggregates principally to the United States Gulf Coast from a quarrying operation on the Yucatan Peninsula of Mexico through a wholly-owned subsidiary, Vulcan Gulf Coast Materials, Inc. The construction phase of the Project is now complete. Substantially all shipments from the Yucatan quarry are made by two self-unloading vessels owned by the Project. CONSTRUCTION MATERIALS The Company's construction aggregates business consists of the production and sale of crushed stone, sand, gravel, rock asphalt and crushed slag (a by-product of steel production). Crushed stone constituted approximately 74% of the dollar volume of the Construction Materials segment's 1993 sales. Construction aggregates of suitable characteristics are employed in virtually all types of construction, including highway construction and maintenance, and in the production of asphaltic and portland cement concrete mixes. They also are widely used as railroad track ballast. Each type of aggregate is sold in competition with other types of aggregates and in competition with other producers of the same type of aggregate. Because of the relatively high transportation costs inherent in the business, competition is generally limited to the areas in relatively close proximity to production facilities. Noteworthy exceptions are the areas along the rivers served by the Company's Reed businesses, which serve markets located along the Mississippi and Tennessee-Tombigbee river systems and the Gulf Coast, areas served by rail-connected quarries, and the areas along the Gulf Coast served by ocean-going vessels that transport stone from the quarrying operation in Mexico. The Company's construction aggregates are sold principally in portions of most of the southeastern states, portions of Texas, northern and central Illinois, northern Indiana, east central Iowa and southern Wisconsin. The Company, directly or through joint ventures, operates 128 domestic permanent and portable plants at quarries located in 14 states for the production of crushed limestone and granite with estimated reserves totaling approximately 7.4 billion tons. The foregoing estimates of reserves are of recoverable stone of suitable quality for economic extraction, based on drilling and studies by the Company's geologists and engineers, recognizing reasonable economic and operating restraints as to maximum depth of overburden and stone excavation. Not included are reserves at the Company's inactive and undeveloped sites. In 1993, the Company, directly or through joint ventures, operated 13 sand and gravel plants, five slag plants and individual plants producing rock asphalt, mineral filler, pulverized limestone and fine grind products. Estimates of sand and gravel reserves, made on a basis comparable to the estimates of stone reserves set forth above, total approximately 45 million tons. Other Construction Materials products and services include asphaltic concrete, ready-mixed concrete, trucking services, barge transportation, coal handling services, a Mack Truck distributorship, paving construction, dolomitic lime, emulsified asphalt, industrial sand and several other businesses. Shipments of all construction aggregates from the Company's domestic operations in 1993 totaled approximately 125 million tons, with crushed stone shipments to customers accounting for 117 million tons. CHEMICALS The principal chemicals produced by the Company at its three chloralkali plants described in Item 2, below, are chlorine, caustic soda (sodium hydroxide), muriatic acid, caustic potash (potassium hydroxide) and chlorinated hydrocarbons. In addition, the Company manufactures and sells anhydrous hydrogen chloride and hydrogen. Chlorine and various hydrocarbons (primarily ethylene and methanol) are used to produce the Company's line of chlorinated hydrocarbons, including carbon tetrachloride, methylene chloride, perchloroethylene, chloroform, methyl chloride, ethylene dichloride, methyl chloroform and pentachlorophenol. In October 1993, the Company authorized the construction of two additional plants at the Port Edwards facility. Construction began in February 1994, on a plant which will produce potassium carbonate. Potassium carbonate is used in the manufacture of screen glass, rubber antioxidants and other chemicals. Construction has also begun on a sodium hydrosulfide plant at Port Edwards. Sodium hydrosulfide is used in the pulp and paper industry as well as others. The potassium carbonate facility is scheduled to be completed during the fourth quarter of 1994. The sodium hydrosulfide facility is scheduled to be completed by the middle of 1994. In January 1994, the Company acquired the business and assets of Peroxidation Systems Inc., which are being operated through a wholly-owned subsidiary named Vulcan Peroxidation Systems Inc. ("Vulcan PSI"). Vulcan PSI provides equipment, chemicals and services to the municipal, industrial and environmental water treatment markets. In June 1992, the Company acquired the sodium chlorite business of Olin Corporation ("Olin"). Pursuant to the Acquisition Agreement ("Agreement"), the Company agreed to purchase the total output of the Olin sodium chlorite plant until such time as the Company completed a sodium chlorite plant at its Wichita facility. In February 1994, that plant was completed and, in accordance with the Agreement, the Olin facility will be decommissioned by the middle of 1994. During 1993, further progress was made by the Company in its evaluation and development of a possible joint venture to produce soda ash. Definitive capital cost estimates were completed and efforts now are focused on obtaining environmental permits. The Company competes throughout the United States with numerous companies, including some of the largest chemical companies, in the production and sale of its lines of chemicals. The Company also competes for sales to customers located outside of the United States, with sales to such customers currently accounting for approximately 11% of the Company's chemicals sales. Principal markets for the Company's chemical products and services include pulp and paper, energy, food and pharmaceutical, chemical processing, fluorocarbons and water treatment. Chlorine is used by the paper-making industry in pulp and paper bleaching, while caustic soda is used primarily in the kraft and sulfite pulping process. The Company supplies hydrochloric acid, caustic soda beads, caustic potash and fracturing sand to the energy industry for use in oil well stimulation and gas extraction. Caustic soda also is used to demineralize water for steam production at electrical energy facilities and to remove sulfur from gas and coal. Hydrochloric acid, caustic soda, methylene chloride and caustic potash are used by the food and pharmaceutical industries. The Company's sales to the chemical processing industry serve companies that produce organic and inorganic chemical intermediates and finished products ranging from clay-based catalysts to agricultural herbicides. Products sold to this market include hydrochloric acid, caustic soda beads, chlorine and liquid caustic soda. The Company sells carbon tetrachloride, perchloroethylene, chloroform and methyl chloroform to the fluorocarbons market. The Company's chlorine also is used in water and sewage treatment, and its caustic soda and caustic potash are used in the production of soaps and detergents. Sodium chlorite is used as a water disinfection and purification chemical where it has strong positions in both municipal and industrial markets. It also is used as an industrial bleaching agent, in cleaning applications for the electronics industry, as a biocide in the fruit processing industry and in various applications in the oil industry. Vulcan PSI markets equipment, chemicals, and services for the purification and decontamination of water and the control of hydrogen sulfide accumulations in wastewater treatment facilities. Calcium chloride, produced at the Company's Wichita complex, has a multitude of uses including de-icing of roads, dust control, road stabilization and oil well completion. The Company's underground reserves of salt, which is a basic raw material in the production of chlorine and caustic soda, are located at or near its Wichita, Kansas, and Geismar, Louisiana, plants. The Company purchases salt for its Port Edwards, Wisconsin, plant. Ethylene and methanol, the other major raw materials used in the Company's Chemicals operations, are purchased from several different suppliers. Sources of salt, ethylene and methanol are believed to be adequate for the Company's operations. The Company is subject to the corrective action requirements of the Resource Conservation and Recovery Act ("RCRA"). Under these requirements, the EPA must identify facilities subject to RCRA's hazardous waste permitting provisions where practices in the past have caused releases of hazardous waste or constituents thereof. The owner of any such facility is then required to conduct a Remedial Facility Investigation ("RFI") defining the nature and extent of any such releases described by the EPA. If the RFI results determine that constituent concentrations from any such release exceed action levels specified by the EPA, the facility owner is further required to perform a Corrective Measures Study ("CMS") identifying feasible technological alternatives for addressing these releases. Depending upon the results reported to the EPA in the RFI and CMS, the EPA subsequently may require Corrective Measures Implementation ("CMI") by the facility owner - essentially, implementation of a cleanup plan developed by the EPA based on the RFI and CMS. The Company expects to incur RFI/CMS costs over the next several years at its Geismar, Port Edwards and Wichita Chemicals manufacturing facilities. For each of these three facilities, the RFI/CMS results will determine whether the EPA subsequently requires CMI to address releases at the facility, and the scope and cost of any such CMI. With respect to those RFI/CMS costs that currently can be reasonably estimated, the Company has determined that its accrued reserves are adequate to cover such costs. However, the total costs which ultimately may be incurred by the Company in connection with discharging its obligations under RCRA's corrective action requirements cannot reasonably be estimated at this time. FINANCIAL RESULTS BY BUSINESS SEGMENTS Net sales, earnings, identifiable assets and related financial data for each of the Company's business segments for the three years ended December 31, 1993, are reported on page 51 (Note 11 of the Notes to Financial Statements) and on pages 26 and 27 (under the caption "Segment Financial Data") in the Company's 1993 Annual Report to Shareholders, which pages are incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES CONSTRUCTION MATERIALS The Company's current estimate of approximately 7.4 billion tons of stone reserves is approximately 150 million tons less than the estimate reported at the end of 1992. Although increases in the Company's reserves have resulted from the acquisition of quarry sites in Tennessee and Texas, these increases have been more than offset by 1993 production tonnage and revisions in mining plans. Management believes that the quantities of reserves at the Company's stone quarries are sufficient to result in an average quarry life of more than 65 years at present operating levels. The locations of the Company's domestic stone quarries are shown on page 9 of the Company's 1993 Annual Report to Shareholders, which page is incorporated herein by reference. Of the 128 domestic stone quarries which the Company operates directly or through joint ventures, 37 are located on owned land, 23 are on land owned in part and leased in part, and 68 are on leased land. While some of the Company's leases run until reserves at the leased sites are exhausted, generally the Company's leases have definite expiration dates which range from 1994 to 2085. Most of the Company's leases have options to extend them well beyond their current terms. Due to transportation costs, the marketing areas for most quarries in the construction aggregates industry are limited, often consisting of a single metropolitan area or one or more counties or portions thereof. The following table itemizes the Company's 10 largest active stone quarries in terms of the quantity of stone reserves, with nearby major metropolitan areas shown in parentheses: The locations of the 13 sand and gravel operations which the Company operates directly or through joint ventures are shown on page 9 of the Company's 1993 Annual Report to Shareholders, which page is incorporated herein by reference. The estimated average life of these operations, calculated in the same manner as in the chart set out above, is approximately 9 years. Approximately 52% of the Company's estimated 45 million tons of sand and gravel reserves are located on owned land, with the remaining 48% located on leased land. CHEMICALS Facilities for the production of chemicals are owned and operated by the Company at Wichita, Kansas; Geismar, Louisiana; and Port Edwards, Wisconsin. Vulcan PSI leases its headquarters in Tucson, Arizona, as well as eleven offices in nine other states and one in Langen, Germany. With a few exceptions, the Geismar and Wichita facilities produce the full line of products manufactured in the Company's Chemicals business. The Port Edwards plant produces chlorine, caustic soda, muriatic acid and caustic potash. All of the plant facilities at Wichita are located on a 1,396-acre tract of land owned by the Company. The facilities are situated approximately 10 miles southwest of Wichita. Mineral rights for salt are held by the Company under two leases that are automatically renewable from year to year unless terminated by the Company and under several other leases which may be kept in effect so long as production from the underlying properties is continued. The Company operates an electric power cogeneration facility at the Wichita plant site which generates approximately one-third of the plant's electricity and two-thirds of its process steam requirements. In addition, the Company owns 160 acres of water reserves and 320 acres of salt reserves. The facilities at Geismar, Louisiana, are located on a 1,126-acre tract of land owned by the Company. Included in the facilities at the Geismar plant is an electric power cogeneration facility owned by the Company which supplies substantially all of the electricity and process steam required by the plant. Mineral rights for salt are held under a long-term lease expiring in 1997 with an option to renew for an additional 10 years. The plant facilities at Port Edwards, Wisconsin, are located on a 25-acre tract of land, the surface rights to which are owned by the Company. Currently, the Company purchases its salt requirements for the Port Edwards facility from regional sources of supply. The Company's Chemicals facilities are designed to permit a high degree of flexibility as to feedstocks, product mix and by-product ratios; therefore, actual plant production capacities vary according to these factors. Management does not believe, however, that there is material excess in production capacity at the Company's Chemicals facilities. OTHER PROPERTIES The Company's corporate offices are located in an office complex near Birmingham, Alabama. Headquarters staff of the Chemicals and Southern divisions, and of Vulcan Gulf Coast Materials, Inc., also are located in this complex. The space is occupied pursuant to a lease which runs through December 31, 1998. The Company has the option of extending this lease for two five-year periods. The Company's space in this complex is leased at an approximate annual rental, as of December 31, 1993, of $1,131,000, which is subject to limited escalation. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a defendant in various lawsuits incident to the ordinary course of business. It is not possible to determine with precision the probable outcome or the amount of liability, if any, under these lawsuits; however, in the opinion of the Company and its counsel, the disposition of these lawsuits will not adversely affect the consolidated financial statements of the Company to a material extent. In the course of its Construction Materials and Chemicals operations, the Company is subject to occasional governmental proceedings and orders pertaining to occupational health and safety and protection of the environment, such as proceedings or orders relating to noise abatement, air emissions or water discharges. As part of its continuing program of environmental stewardship, however, the Company has been able to resolve such proceedings and to comply with such orders without any materially adverse effect on its business. In May 1985, the Company received a letter from the United States Environmental Protection Agency ("EPA") regarding remedial actions at a chemical waste disposal site located in Ascension Parish, Louisiana. Records indicate that the Company generated a portion of the waste placed at the site and the EPA has deemed the Company a potentially responsible party ("PRP") with respect to the site under the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). On September 30, 1988, the EPA issued a Unilateral Administrative Order ("UAO") to the Company and other respondents. This UAO purported to require the respondents to clean up the site in accordance with a remedial plan developed by EPA's contractor. On February 5, 1991, following a review and revision process by the EPA, the EPA issued a revised UAO which included its final remedial plan. This revised UAO named the same respondents, including the Company, that were named in the EPA's initial UAO. In a letter dated April 9, 1991, the Company and three other companies that also generated waste placed at the site gave notice to the EPA that the signatory companies intend to comply with all lawful terms and conditions of the revised UAO. In December 1988, the Company and other PRPs received a letter from the EPA demanding reimbursement for approximately $1,540,000 in past costs and administrative expenses incurred by the EPA in connection with the foregoing matter. Effective June 8, 1992, the Company and other PRPs entered into a Site Participation Agreement ("Agreement") allocating among the parties those costs which are anticipated to be incurred or which might be incurred in connection with the remediation activity at the site and those costs which may be recovered by the EPA or other agencies in connection with their past response work or oversight work at the site. Moreover, in June 1992, the EPA orally informed the Company and other PRPs that it would seek to recover its response and oversight costs incurred to date, and toward that end has made a supplemental Information Request, pursuant to Section 104(e) of CERCLA, seeking information to support such recovery of costs. The Company responded to the supplemental Information Request on July 14, 1992. The demand by EPA for recovery of costs includes the amount previously demanded from the Company and the other parties in December 1988. Cleanup of the site will take an extended period, but the majority of the costs likely will be incurred in the first three years after commencement of site work, which began in late 1992. It is estimated that the parties, including the Company, to the aforementioned Agreement will incur a total cost of $34,700,000 to perform the work required by EPA's final remedial plan and payment of the EPA's past costs. The Company has reviewed this cost estimate and the information currently available to the Company relative to EPA's most recent request for recovery of its costs. On the basis of this review and the information currently available, the Company has determined that its accrued reserve should be adequate to cover its allocated share of currently anticipated site remediation costs and those response and oversight costs which may be recovered by the EPA. The Company will continue to review relevant cost information as it becomes available, particularly information relative to the EPA's request for recovery of its costs. The Company has begun to make payments from its accrued reserve pursuant to the Agreement. In June 1986 and December 1989, lawsuits were filed in Louisiana federal and state courts by over 100 people who live in the vicinity of the above-described waste disposal site and who claimed damages for mental anguish, personal injuries and/or diminution in property value as a result of alleged releases from said site. These suits named as defendants the owners and operators of the site and 17 chemical companies, including the Company, alleged to have contributed some part of the waste at the site. The lawsuits were consolidated into a single action in the United States District Court for the Middle District of Louisiana. All claims in the consolidated action subsequently either were dismissed or settled prior to trial, except that the heirs of a deceased plaintiff have reserved the right later to file a wrongful death action. The Company has received a letter dated August 2, 1991, from the State of New Jersey Department of Environmental Protection and Energy ("NJDEPE") concerning a site located in Newark, New Jersey, which the Company previously owned and upon which the Company operated a chemicals production facility from the early 1960s until 1974. The NJDEPE's letter contends that hazardous substances and pollutants contaminate the site and that a Remedial Investigation/Feasibility Study ("RI/FS") is required in order to determine the nature and extent of such contamination and to develop a remedial action plan with respect thereto. The Company has conducted a preliminary investigation with respect to this matter and the merits of the NJDEPE's contentions. Based upon its preliminary investigation and review, in a September 18, 1991, letter to the NJDEPE, the Company questioned the factual and legal bases for the NJDEPE's contention that the Company should bear some responsibility for remediating the site and asked the NJDEPE to reconsider its tentative position and decide that the Company should not be a responsible party at this site. On November 11, 1991, the Company received from the NJDEPE "a Directive and Notice to Insurers" (the "Directive"). It is not clear that the Directive was intended to be directly responsive to the factual and legal assertions made by the Company in its letter to the NJDEPE dated September 18, 1991. In this Directive, nevertheless, the NJDEPE purports to direct the Company to pay within thirty (30) days to the NJDEPE $1,000,000 to be used by the NJDEPE to conduct an RI/FS at the site. The NJDEPE also asserts that it may have the right to cause a lien to be placed against the real and personal property of the Company to secure the payment of any such amounts. If the Company fails to comply with the Directive, and it is later determined that the Company did not have sufficient grounds for such non-compliance, the Company could be subject to liability in an amount equal to three times the cost of the work performed by the NJDEPE and statutory penalties in an amount not to exceed $50,000 per day. Although the NJDEPE has not withdrawn its Directive, the NJDEPE has informally agreed that it will not need to enforce its Directive as long as the Company participates in the RI/FS for this site. On August 20, 1993, two other allegedly responsible parties, Safety-Kleen Environsystems Company and Bristol-Meyers Squibb Company (collectively, the "Respondents"), entered into an Administrative Consent Order ("ACO") issued by the NJDEPE concerning the site. The ACO contains certain findings of fact by the NJDEPE and enforceable provisions governing the conduct by the Respondents of an RI/FS for the site and remedial actions, if any, resulting therefrom. Under a separate agreement with Respondents and certain successors, the Company will share in the cost of the RI/FS. The Respondents estimate a cost of $250,000 to complete the RI. The cost of the FS depends upon the results of the RI. Depending, in turn, upon the results of the RI/FS, it is possible that the NJDEPE will require site remediation under the ACO. In that event, it is also possible that the Respondents or the NJDEPE will assert that the Company should bear some responsibility in connection with such remediation. At this time, however, it is impossible to predict the ultimate outcome of this matter. The Company received a letter dated October 21, 1991, from Chevron USA, Inc. ("Chevron"), in which Chevron contends that hazardous substances and pollutants contaminate a site owned by Chevron and located in Woodbridge Township, Middlesex County, New Jersey. The Company sold the site to Chevron in 1958 and owned and operated a detinning facility adjacent to the Chevron site until 1964. Chevron has advised the Company that, in response to the identification of the site as a former solid waste management unit and pursuant to the corrective action provisions of the Resource Conservation and Recovery Act ("RCRA"), Chevron is investigating the feasibility of corrective action and is seeking assistance from parties who may have been responsible for some or all of the contamination at the site. The Company and other allegedly responsible parties who received similar correspondence from Chevron and who previously owned or operated facilities on or adjacent to the site have had meetings with Chevron to discuss the status of the site. The parties have received information from Chevron relative to the contamination of the site, but have not verified this information by independent sampling. Given the information available to the Company regarding this site, the extent to which the Company's former operations may have contributed to contamination at the site cannot now be established or confirmed. For these reasons, it is impossible at this time for the Company to predict the outcome of this matter or the existence or extent of any liability of the Company with respect to this matter. On January 3, 1992, the Company received a General Notice Letter from the EPA regarding alleged releases or threatened releases of hazardous substances at a hazardous waste treatment, storage and disposal site in Greer, South Carolina, which was operated by Aqua-Tech Environmental, Inc., a South Carolina corporation. The EPA's letter advised that the Company may be considered a PRP under Section 107(a) of CERCLA. The Company confirmed that in 1987 it sent cylinders containing titanium tetrachloride to the site for disposal. On April 20, 1992, the Company became a party to a PRP Agreement whereby the signatories thereto agreed to cooperate in responding as a PRP group to the EPA. On April 24, 1992, the EPA issued a UAO to many of the PRPs, including the Company, directing that a removal action with respect to hazardous wastes on-site be undertaken by them. The UAO covers only the removal action; the EPA is considering whether to place the site on the National Priorities List for remediation purposes. On May 1, 1992, the Steering Committee of the PRP group notified the EPA of the intent of the participating PRPs to undertake the removal work required by the UAO. Work at the site began on May 4, 1992. To date, 179 PRPs have agreed to participate in the removal action and to share the costs of the removal action according to a series of interim allocations. The PRP group's consultant has estimated the cost of the removal action to be $14,000,000. Interim allocations raising this amount have been made among the PRP group. The Company has paid over $116,000 pursuant to these interim allocations. The only identified waste of the Company which remained at the site and required removal was one container which cost $355 to remove and dispose of. Because the Company already has paid more than its share of removal costs, the Company has withdrawn from further participation in the removal action as a member of the PRP group. It is impossible at this time to estimate whether the Company will recoup amounts previously paid for the removal action. Additional costs for the assessment and remediation of any contamination at the site have not been estimated. Moreover, the extent to which the site is contaminated and the extent to which the wastes the Company sent to the site may have contributed to any such contamination have not been estimated or confirmed. However, the Company does not believe that its potential share of any costs related to the site will adversely affect the consolidated financial statements of the Company to a material extent. On October 23, 1992, the Company received a letter from the EPA pursuant to Section 104(e) of CERCLA requesting information regarding waste generated by the Company and disposed at a sanitary landfill in Muskego, Wisconsin, which is operated by Waste Management of Wisconsin ("Muskego Landfill"). The Company responded to this request by stating that it had no knowledge of the generation of any solid waste by the Company's former aluminum recycling facility in Oak Creek, Wisconsin, which would have been disposed of in the Muskego Landfill. Nevertheless, the Company received on January 14, 1993, a UAO pursuant to Section 106(a) of CERCLA directing that the Company and 45 other respondents/PRPs perform remedial design and remedial action work with respect to the Muskego Landfill, which has been placed on the National Priorities List by the EPA for cleanup of the release of hazardous substances. The Company and other PRPs have formed a PRP Group to respond to the UAO and to formulate allocations for Waste Management's past response costs, totaling approximately $5,600,000, a remedial design study for the first phase of remediation, costing approximately $470,000, and first phase remedial work, costing an estimated $10,500,000. The Company has paid $4,800 toward administrative costs for the PRP Group and $6,000 for its share of the remedial design study. The Company's potential share of the ultimate cleanup cost cannot be determined precisely at this time, and the Company is engaged in negotiations as a member of the PRP Group with regard to a lump-sum payment in settlement of the Company's share of the costs relating to the first phase of remediation. However, the Company does not believe that its share of the costs for the first phase will exceed $20,000. Moreover, the Company does not believe that its potential share of such costs or of any additional costs for the second phase of remediation involving groundwater will adversely affect the consolidated financial statements of the Company to a material extent. During the spring of 1992, representatives of the EPA conducted certain inspections of the Company's chemicals manufacturing plant in Geismar, Louisiana. Subsequent to completing those inspections, on March 18, 1993, a Complaint, Compliance Order, and Notice of Opportunity for Hearing (the "Multimedia Complaint and Order") was issued to the Company by the EPA. In the Multimedia Complaint and Order, the EPA makes certain findings of fact and law, and based upon such findings, alleges multiple count violations of RCRA, CERCLA and the Clean Air Act, for which violations EPA seeks civil penalties in the total amount of $298,650. The Multimedia Complaint and Order also purports to impose upon the Company a civil compliance order requiring the Company to implement certain actions pertaining to hazardous wastes stored for longer than a year and to implement a tracking plan for plant wastes to ensure accurate determination, identification and labeling of hazardous and nonhazardous wastes generated and stored in containers at the plant. On April 30, 1993, the Company filed its Answer to Complaint and Compliance Order and Request for Hearing (the "Answer") with the EPA, including a request for an adjudicatory hearing as provided in the Multimedia Complaint and Order on all factual and legal issues raised by the Company in its Answer. Subsequent to the filing of its Answer, the Company and EPA have been engaged in negotiations regarding the settlement of this matter, which negotiations remain on-going. On March 9, 1994, the Company received a letter from the EPA concerning alleged releases or threatened releases of hazardous substances at the Jack's Creek/Sitkin Smelting Superfund Site located in Mifflin County, Pennsylvania, near the town of Maitland. The Sitkin Smelting Company operated a secondary smelting facility at the site from 1958 until declaring bankruptcy in 1977. The EPA's letter states that the Company may be considered a PRP pursuant to Section 107(a) of CERCLA. The EPA advised that it may order some or all of the PRPs to undertake response actions at the site and that PRPs may also be liable for costs the EPA incurs or has incurred in responding to any releases or threatened releases at the site. The EPA has already undertaken certain response actions at the site, and has completed an RI/FS. The Company is among the 880 PRPs that EPA has identified as having sold and shipped a total of approximately 307 million pounds of material to the business operated on the site. The EPA's documents indicate that the Company's shipments occurred between 1972 and 1977, totalled approximately 1.8 million pounds, and represent .84% of the total weight of the materials sent to this smelting facility. These shipments consisted primarily of sales of brass and metal parts which the Company believes were co-products of its former metals operation. The Company is currently conducting an investigation of this matter and anticipates participating in a meeting of PRPs who may form a steering committee to negotiate on behalf of all the PRPs the apportionment of the response costs with the EPA. The Company's share, if any, of past and future response costs associated with the site will be the subject of on-going discussions with other PRPs and the EPA. However, based on the limited information currently available to it, the Company does not believe that its ultimate share of such costs will adversely affect the consolidated financial statements of the Company to a material extent. As reported in the Company's Form 8-K Current Report dated June 12, 1992, an antidumping petition was filed on May 20, 1992, with the International Trade Commission ("ITC"), by two stone producers and a distributor in southeast Texas alleging that a U.S. industry was being injured by imports of crushed limestone from Mexico. The companies involved in the Crescent Market Project quarry and crush limestone from Mexico's Yucatan Peninsula for sale along the U.S. Gulf Coast. On June 29, 1992, the ITC, in a 5-0 vote (with one commissioner not participating), determined that a U.S. industry was not being injured by the importation of crushed limestone from Mexico. This ruling was appealed to the United States Court of International Trade ("CIT") where the determination of the ITC was sustained and the action was dismissed. The judgment of the CIT has now been appealed to the United States Court of Appeals for the Federal Circuit. Oral argument occurred on February 9, 1994, and a decision is now pending. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993 to the Company's security holders through the solicitation of proxies or otherwise. ITEM 4a. EXECUTIVE OFFICERS OF THE REGISTRANT The names, positions and dates of birth of the executive officers (as defined in 17 CFR 240.3b-7) of the Company are as follows: Birth Name Position Date Herbert A. Sklenar Chairman, Chief Executive Officer and Director 6/07/31 William J. Grayson, Jr. Executive Vice President, Construction Materials 10/16/30 R. Morrieson Lord Senior Vice President, Human Resources 11/02/30 Richard K. Carnwath Vice President, Planning and Development 7/13/48 William F. Denson, III Vice President-Law and Secretary 8/01/43 Daniel F. Sansone Vice President-Finance and Treasurer 8/04/52 E. Starke Sydnor Assistant General Counsel 11/30/43 Peter J. Clemens, III Senior Vice President, West - Construction Materials Group 12/17/43 Harold D. Lambert Senior Vice President - Construction Materials Group 5/15/28 Robert L. Mayville Senior Vice President, Business Development and Operations Services - Construction Materials Group 10/03/34 Guy K. Mitchell, Jr. Senior Vice President, East - Construction Materials Group 12/08/48 Guy M. Badgett, III President, Southeast Division 4/28/48 Michael J. Ferris President, Chemicals Division 10/20/44 William L. Glusac President, Southwest Division 8/07/50 Donald M. James President, Southern Division 1/20/49 Daniel J. Leemon President, Midsouth Division 5/14/38 Thomas R. Ransdell President, Vulcan Gulf Coast Materials, Inc. 6/25/42 James W. Smack President, Mideast Division 4/01/43 Christopher G. White President, Midwest Division 5/16/40 The principal occupations of the executive officers during the past five years have been set forth below: Herbert A. Sklenar was elected President and Chief Executive Officer in May 1986. He was elected to his present position in May 1992. William J. Grayson, Jr., was elected Executive Vice President, Construction Materials Group, in February 1987. R. Morrieson Lord was elected Senior Vice President, Human Resources, in April 1979. Richard K. Carnwath was elected Vice President, Planning and Development, in July 1985. William F. Denson, III, was elected Secretary in April 1981 and continues to serve in that capacity. He served as Assistant General Counsel from May 1988 until May 1992, when he was appointed Vice President and Assistant General Counsel. He was elected to his present position as Vice President-Law effective January 1, 1994. Daniel F. Sansone joined the Company as Controller in January 1988 and was promoted to Vice President and Controller in May 1991. He was elected to his present position as Vice President-Finance and Treasurer effective January 1, 1994. E. Starke Sydnor became Assistant General Counsel in May 1988 and was elected a corporate officer in May 1992. Peter J. Clemens, III, served as Senior Vice President, Finance, from October 1983 until January 1, 1994, when he became Senior Vice President-West, Construction Materials Group. Harold D. Lambert served as President, Midsouth Division, from January 1970 until July 1993. He was appointed to his present position as Senior Vice President, Construction Materials Group effective August 1, 1993. Robert L. Mayville was appointed President, Mideast Division, in September 1985. In May 1991, he was appointed Senior Vice President, Business Development and Operations Services-Construction Materials Group. Guy K. Mitchell, Jr., served as Vice President, North Carolina, Mideast Division, until July 1989, when he was appointed President, Chattanooga Division. In May 1991, he was appointed Senior Vice President-East, Construction Materials Group. Guy M. Badgett, III, served as Vice President, Midsouth Division, until April 1991, when he was appointed Executive Vice President. He was appointed to his present position as President, Southeast Division, in July 1992. Michael J. Ferris was appointed President, Chemicals Division, in May 1987. William L. Glusac served as Vice President, East Tennessee and Kentucky, Midsouth Division, until March 1990, when he was appointed Executive Vice President, Southwest Division. In April 1991, he was appointed President, Southwest Division. Donald M. James joined the Company as Senior Vice President and General Counsel in December 1992 and was appointed to his present position as President, Southern Division, effective January 1, 1994. He was a partner with the Birmingham law firm of Bradley, Arant, Rose and White prior to joining the Company. Daniel J. Leemon was appointed President, Midwest Division, in 1984, and assumed the additional position of Chairman, Southwest Division, in December 1989. He was promoted to Senior Vice President-West, Construction Materials Group, in May 1991. He served in this position through July 1993, and was appointed to his present position as President, Midsouth Division, effective August 1, 1993. Thomas R. Ransdell was elected President of Vulcan Gulf Coast Materials, Inc., in 1987. James W. Smack served as Vice President-Virginia, Mideast Division, until May 1991, when he was appointed President, Mideast Division. Christopher G. White served as Vice President, Operations, Midwest Division, until he was appointed Executive Vice President of that Division in 1990. He served in the latter position until he was appointed President, Midwest Division, in May 1991. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS "Common Stock Market Prices and Dividends" on page 28 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA "Selected Financial Data" on page 25 of the Company'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 "Management's Discussion and Analysis" on pages 29 through 37 and "Financial Terminology" on page 53 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information relative to this item is included in the Company's 1993 Annual Report to Shareholders on the pages shown below, which are incorporated herein by reference: Page Financial Statements and Notes 40-51 Management's Responsibility for Financial Reporting and Internal Control 52 Independent Auditors' Report 52 Supplementary Information-Quarterly Financial Data (Unaudited) 38 With the exception of the aforementioned information and the information incorporated by reference in Items 1, 3, 5, 6, 7 and 14, the Company's 1993 Annual Report to Shareholders is not deemed filed as part of this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No information is required to be included in this report pursuant to Item 304 of Regulation S-K which requires disclosure of certain information if the registrant has changed accountants under specified circumstances. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Within 120 days of the close of the Company's fiscal year on December 31, 1993, the Company will file a definitive proxy statement with the Securities and Exchange Commission pursuant to Regulation 14A (the Company's "1994 Proxy Statement"). The information under the headings "Election of Directors," "Nominees for Election to the Board of Directors" and "Directors Continuing in Office" included in the 1994 Proxy Statement are incorporated herein by reference. For the information required by Item 401 of Regulation S-K concerning executive officers of the registrant, reference is also made to the information provided in Part I, Item 4a, of this Annual Report on Form 10-K. No information is required to be included in this report pursuant to Item 405 of Regulation S-K which requires disclosure of certain information concerning compliance with Section 16(b) of the Securities Exchange Act of 1934. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information under the headings "Compensation of Directors," "Executive Compensation," "Shareholder Return Performance Presentation," "Retirement Income Plan" and "Employee Special Severance Plan" included in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the headings "Security Ownership of Certain Beneficial Owners" and "Security Holdings of Management" included in the Company's 1994 Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS No information is required to be included in this report pursuant to Item 404 of Regulation S-K, which requires disclosure of certain information with respect to certain relationships or related transactions of the directors and management. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) FINANCIAL STATEMENTS The following financial statements are included in the Company's 1993 Annual Report to Shareholders on the pages shown below and are incorporated herein by reference: Page Consolidated Statements of Earnings 40 Consolidated Balance Sheets 41 Consolidated Statements of Cash Flows 42 Consolidated Statements of Shareholders' Equity 43 Notes to Financial Statements 44-51 Management's Responsibility for Financial Reporting and Internal Control 52 Independent Auditors' Report 52 Supplementary Information-Quarterly Financial Data (Unaudited) 38 (a) (2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for the years ended December 31, 1993, 1992 and 1991 are included in Part IV (see Exhibits 99.1 through 99.5) of this report on the indicated pages: Schedule VI Property, Plant and Equipment Schedule VII Allowance for Depreciation, Depletion and Amortization Schedule IX Valuation and Qualifying Accounts and Reserves Schedule X Short-Term Borrowings Schedule XI 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 provided in the financial statements or notes thereto. Financial statements (and summarized financial information) of 50% or less owned entities accounted for by the equity method have been omitted because they do not, considered individually or in the aggregate, constitute a significant subsidiary. (a) (3) EXHIBITS The exhibits required by Item 601 of Regulation S-K and indicated below, other than Exhibits (11) and (12) which are on pages and of this report, are either incorporated by reference herein or accompany the copies of this report filed with the Securities and Exchange Commission and the New York Stock Exchange. Copies of such exhibits will be furnished to any requesting shareholder of the Company upon payment of the costs of copying and transmitting the same. (3)(a) Certificate of Incorporation (Restated 1988) of the Company. Exhibit 3(a) to the Company's 1988 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (3)(b) By-laws of the Company, as restated February 2, 1990, and as last amended February 12, 1993. Exhibit (3)(b) to the Company's 1992 Form 10-K Annual Report is incorporated herein by reference. (4) Exhibits 1 and 4 to the Form S-3 filed with the Securities and Exchange Commission by the Company on May 2, 1991, and registering $200,000,000 in debt securities is incorporated herein by reference. Form 8-K Report filed with the Securities and Exchange Commission by the Company on May 14, 1991, is incorporated herein by reference. The Company hereby agrees to furnish the Securities and Exchange Commission, upon request, all instruments defining the rights of holders of its other long-term debt or that of any of its consolidated subsidiaries. (10)(a) The Management Incentive Plan of the Company, as last amended and restated. Exhibit 10(a) to the Company's 1989 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (10)(b) The 1981 Long-Range Performance Share Plan of the Company, as last amended and restated. Exhibit 10(b) to the Company's 1989 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (10)(c) The 1991 Long-Range Performance Share Plan of the Company. Exhibit A to the Company's definitive proxy statement for the annual meeting of its shareholders held May 16, 1991 ("1991 Proxy Statement"), is incorporated herein by reference (File No. 1-4033). (10)(d) The Plan for Directors Emeriti and Other Eligible Directors, as last amended and restated. Exhibit 10(c) to the Company's 1990 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (10)(e) The Unfunded Supplemental Benefit Plan for Salaried Employees. Exhibit 10(d) to the Company's 1989 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (10)(f) The Deferred Compensation Plan for Directors Who Are Not Employees of the Company, as last amended and restated on December 8, 1992. Exhibit A to the Company's definitive proxy statement for the annual meeting of its shareholders held May 20, 1993 is incorporated herein by reference. (10)(g) The 1983 Long-Term Incentive Plan, as last amended and restated. Exhibit 10(f) to the Company's 1989 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (10)(h) The Stock Plan for Nonemployee Directors. Exhibit B to the Company's 1991 Proxy Statement is incorporated herein by reference (File No. 1-4033). (10)(i) The Employee Special Severance Plan of the Company. Exhibit 10(g) to the Company's 1989 Form 10-K Annual Report is incorporated herein by reference (File No. 1-4033). (11) Computation of Earnings Per Share for the five years ended December 31, 1993. (page of this report) (12) Computation of Ratio of Earnings to Fixed Charges for the five years ended December 31, 1993. (page of this report) (13) The Company's 1993 Annual Report to Shareholders. (pages 29 through 95 of the bound exhibits) (21) List of the Company's subsidiaries as of December 31, 1993. (page 96 of the bound exhibits) (24) Powers of Attorney for all directors whose names are signed to this Annual Report on Form 10-K pursuant to such Powers of Attorney. (pages 97 through 106 of the bound exhibits) Information, financial statements and exhibits required by Form 11-K with respect to the Company's Thrift Plan for Salaried Employees, Construction Materials Divisions Hourly Employees Savings Plan and Chemicals Division Hourly Employees Savings Plan, for the fiscal year ended December 31, 1993, will be filed as one or more amendments to this Form 10-K on or before June 29, 1994, as permitted by Rule 15d-21 under the Securities Exchange Act of 1934. (b) REPORTS ON FORM 8-K On November 16, 1993, the Company filed a Form 8-K Report with the Securities and Exchange Commission with respect to the projected segment earnings for 1994. INDEPENDENT AUDITORS' REPORT Vulcan Materials Company: We have audited the accompanying consolidated balance sheets of Vulcan Materials Company and its subsidiary companies as of December 31, 1993, 1992 and 1991, and the related consolidated statements of earnings, shareholders' equity, and cash flows for the years then ended, and have issued our report thereon dated February 4, 1994; such financial statements and report are included in your 1993 Annual Report to the Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Vulcan Materials Company and its subsidiary companies, listed in Item 14. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these schedules based on our audits. In our opinion, such supplemental schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. /s/ Deloitte & Touche Birmingham, Alabama February 4, 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. VULCAN MATERIALS COMPANY (Registrant) March 29, 1994 By /s/ H. A. Sklenar Date H. A. Sklenar 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. Signature Title Date /s/ H. A. Sklenar Chairman, Chief Executive March 29, 1994 H. A. Sklenar Officer and Director (Principal Executive Officer) /s/ D. F. Sansone Vice President-Finance March 29, 1994 D. F. Sansone and Treasurer (Principal Financial Officer and Principal Accounting Officer) The following directors: Marion H. Antonini Director Livio D. DeSimone Director John K. Greene Director Richard H. Leet Director Douglas J. McGregor Director Ann D. McLaughlin Director James V. Napier Director Donald B. Rice Director Orin R. Smith Director By /s/ William F. Denson, III March 29, 1994 William F. Denson, III Attorney-in-Fact for each of the nine directors listed above

717867_1993.txt

717867_1993

1993

717867

ITEM 1. BUSINESS. Jefferies Group, Inc. is a holding company which, through its four primary subsidiaries, Jefferies & Company, Inc., Investment Technology Group, Inc., Jefferies International Limited and Jefferies Pacific Limited, is engaged in securities brokerage and trading, corporate finance and other financial services. The term "Company" refers, unless the context requires otherwise, to Jefferies Group, Inc., its subsidiaries, predecessor entities, and W & D Securities, Inc. The Company was originally incorporated in 1973 as a holding company for Jefferies & Company, Inc. and was reincorporated in Delaware on August 10, 1983. The Company and its various subsidiaries maintain offices in Los Angeles, New York, Short Hills, Chicago, Dallas, Boston, Atlanta, New Orleans, Houston, San Francisco, Stamford, London and Hong Kong. As of December 31, 1993, the Company and its subsidiaries had 610 full-time employees, including 339 representatives registered with the National Association of Securities Dealers, Inc. ("NASD"). The Company's executive offices are located at 11100 Santa Monica Boulevard, Los Angeles, California 90025, and its telephone number is (310) 445-1199. JEFFERIES & COMPANY, INC. Jefferies & Company, Inc. ("Jefferies") was founded in 1962 and is engaged in equity, convertible debt and taxable fixed income securities brokerage and trading and corporate finance. Jefferies is one of the leading national firms engaged in the distribution and trading of blocks of equity securities and conducts such activities primarily in the "third market." The term "third market" refers to transactions in listed equity securities effected away from national securities exchanges. Jefferies' revenues are derived primarily from commission revenues and market-making or trading as principal in equity, taxable fixed income and convertible securities with or on behalf of institutional investors, with the balance generated by corporate finance and other activities. INVESTMENT TECHNOLOGY GROUP, INC. Investment Technology Group, Inc. ("ITG") is a leading provider of automated securities trade execution and analysis services to institutional equity investors. ITG's two principal services are POSIT(R), the largest automated stock crossing system operated during trading hours, and QuantEX(R), a proprietary decision support system with integrated trade analysis, routing and management capabilities. These services employ proprietary software to enhance customers' trading efficiencies, access to market liquidity and portfolio analysis capabilities. To supplement ITG's POSIT(R) and QuantEX(R) services, ITG's ISIS service uses a database of securities, price and liquidity information to provide enhanced decision support in all aspects of its customers' trade execution and analysis activities. POSIT(R), which is accessed through direct computer links or by communicating with ITG's trading desk, allows customers to place confidential buy and sell orders on approximately 7,000 different equity securities and portfolios of equity securities. POSIT(R) analyzes these buy and sell orders and determines the maximum number of securities which may be matched or "crossed" among participants. After determining the optimal cross, POSIT(R) executes trades at the midpoint of the primary market best bid and offer for each security at the time of the cross. Participants using direct computer links are automatically notified of completed crosses. ITG currently offers three scheduled daily crosses and can also accommodate additional crosses in response to customer demand. The system operates on a confidential basis, allowing customers to trade large blocks of equity securities at reduced transaction fees while minimizing the price impact of the trade. ITG derives revenue by collecting transaction fees on each share which is crossed through the system. Average daily share volume on POSIT(R) has grown from approximately 288,000 shares in 1988 to approximately 6.3 million shares in 1993. During the last quarter of 1993, average daily share volume was approximately 8.3 million shares. In addition to its traditional customer base of quantitative and passive investors, POSIT(R) has recently begun to serve fundamental institutional investors, broker-dealers and international institutional investors. The system is currently used by approximately 200 customers, including corporate and government pension plans, insurance companies, bank trust departments, investment advisors and mutual funds. QuantEX(R) is a proprietary trade execution and analysis system that operates on Sun Microsystems workstations provided to customers by ITG. The integrated trade analysis, routing and management capabilities of QuantEX(R) provide valuable support to investment managers in the development and implementation of portfolio trading strategies and allow securities traders to organize, process and manage large trading lists. The automation of these functions enables users to analyze and trade large portfolios of securities faster and more effectively than by other traditional means. QuantEX(R) allows an investment manager to develop a series of rules based upon the manager's strategy for trading equity securities and applies these rules to a continuous flow of current market information in order to generate real-time decision support. Through its direct routing capabilities, QuantEX(R) also allows investment managers and securities traders to route orders to POSIT(R), major national and regional stock exchanges, OTC market makers, ITG's trading desk or selected broker-dealers. QuantEX(R)'s trade management function automatically tracks and summarizes trades routed through QuantEX(R). ITG generally derives revenue by collecting a transaction fee on each share which is routed for trading through QuantEX(R). In March, 1994, the Company formed a new subsidiary, Investment Technology Group, Inc. (the "ITG Holding Company") for the purpose of eventually holding 100% of the stock of the broker-dealer subsidiary Investment Technology Group, Inc. whose name was then changed to ITG Inc. On March 15, 1994, the ITG Holding Company filed with the Securities and Exchange Commission a Registration Statement with respect to the offer of 3,700,000 shares of its common stock (which includes 450,000 shares subject to an over-allotment option granted to the underwriters), in an initial public offering (the "Offering"). The filing indicated an anticipated offering price of between $12 and $14 per share. Immediately prior to the consummation of the offering, the ITG Holding Company will issue 15,000,000 shares of its common stock in exchange for all of the issued and outstanding shares of common stock of ITG held by the Company. As a result of these transactions, ITG will become a wholly-owned subsidiary of the ITG Holding Company which will become a wholly-owned subsidiary of the Company. ITG has conducted, and will continue to conduct, the business activities of the ITG Holding Company. Following the offering, the Company will own 80.2% of the outstanding common stock of the ITG Holding Company. In addition, immediately prior to the offering, the ITG Holding Company will enter into an intercompany borrowing agreement with the Company permitting the borrowing by the ITG Holding Company of up to $15,000,000. Any outstanding balance will be due March 31, 1999, and will accrue interest at 1.75% above the one month London Interbank Offering Rate. Immediately prior to the Offering, the ITG Holding Company will declare a dividend payable to its sole stockholder, the Company, in an amount of approximately $17.0 million, which dividend will be paid by the issuance of a note in the full amount of such dividend and may be increased or decreased based on the actual proceeds of the Offering. Any future payment of dividends will be at the discretion of the ITG Holding Company's Board of Directors and will depend on the ITG Holding Company's financial condition, results of operations, capital requirements and other factors deemed relevant by such Board of Directors. However, the ITG Holding Company anticipates that all future earnings will be retained by the ITG Holding Company for working capital and that the ITG Holding Company will not pay any dividends to its stockholders. JEFFERIES INTERNATIONAL LIMITED AND JEFFERIES PACIFIC LIMITED Jefferies International Limited ("JIL"), a broker-dealer subsidiary of the Company, was incorporated in 1986 in England. JIL is a member of The International Stock Exchange and The Securities and Futures Authority. JIL introduces customers trading in U.S. securities to Jefferies and also trades as a broker-dealer in international equity and convertible securities and American Depositary Receipts ("ADRs"). Jefferies Pacific Limited ("JPL"), a broker subsidiary of the Company, was incorporated in 1992 in Hong Kong. JPL presently introduces foreign customers trading in U.S. securities to Jefferies. JPL commenced operations in 1993 and has not yet generated material revenues. W & D SECURITIES, INC. W & D Securities, Inc. ("W & D") provides execution services primarily on the NYSE and other exchanges to Jefferies and ITG. In order to comply with regulatory requirements of the NYSE that generally prohibit NYSE members and their affiliates from executing, as principal and, in certain cases, as agent, transactions in NYSE-listed securities off the NYSE, the Company gave up its formal legal control of W & D, effective January 1, 1983, by exchanging all of the W & D common stock owned by it for non-voting preferred stock of W & D. The common stock of W & D is presently held by an officer of W & D who has agreed with the Company that, at the option of the Company, he will sell such stock to the Company for nominal consideration. In the event that the Company were to regain ownership of such common stock, the Company believes that the NYSE would assert that W & D would be in violation of the NYSE's rules unless similar arrangements satisfactory to the NYSE were made with respect to the ownership of the common stock. While the NYSE has generally approved the above arrangements, there can be no assurance that it will not raise objections in the future. In light of these arrangements and the high proportion of the equity of W & D represented by the non-voting preferred stock held by the Company, W & D is consolidated as a subsidiary of the Company for financial purposes. The Company believes that it can make satisfactory alternative arrangements for executing transactions in listed securities on the NYSE if it were precluded from doing so through W & D. COMMISSION BUSINESS A substantial portion of the Company's revenues is derived from customer commissions on brokerage transactions in equity (primarily listed) and debt securities for domestic and international investors such as investment advisors, banks, mutual funds, insurance companies and pension and profit sharing plans. Such investors normally purchase and sell securities in block transactions, the execution of which requires special marketing and trading expertise. The Company is one of the leading national firms in the execution of equity block transactions, and believes that its institutional customers are attracted by the quality of the Company's execution (with respect to considerations of quantity, timing and price) and its competitive commission rates, which are negotiated on the basis of market conditions, the size of the particular transaction and other factors. In addition to domestic equity securities, the Company executes transactions in taxable fixed income securities, domestic and international convertible securities, international equity securities, ADRs, options, preferred stocks, financial futures and other similar products. Most of the Company's equity account executives are electronically interconnected through a system permitting simultaneous verbal and graphic communication of trading and order information by all participants. The Company believes that its execution capability is significantly enhanced by this system, which permits its account executives to respond to each other and to negotiate order indications directly with customers rather than through a separate trading department. PRINCIPAL TRANSACTIONS In the regular course of business, the Company takes securities positions as a market-maker to facilitate customer transactions and for investment purposes. In making markets and when trading for its own account, the Company exposes its own capital to the risk of fluctuations in market value. Trading profits (or losses) depend primarily upon the skills of the employees engaged in market-making and position taking, the amount of capital allocated to positions in securities and the general trend of prices in the securities markets. The Company monitors its risk by maintaining its securities positions at or below certain pre-established levels. These levels reduce certain opportunities to realize profits in the event that the value of such securities increases. However, they also reduce the risk of loss in the event of a decrease in such value and result in controlled interest costs incurred on funds provided to maintain such positions. Equities. The Equities Division makes markets in over 400 over-the-counter equity and ADR securities, operates six specialist posts on the Pacific Stock Exchange ("PSE") and two specialist posts on the Boston Stock Exchange ("BSE"), and trades securities for its own account, as well as to accommodate customer transactions. Taxable Fixed Income. The Taxable Fixed Income Division trades high grade and non-investment grade public and private debt securities. The Division specializes in trading and making markets in over 300 unrated or less than investment grade corporate debt securities and accounts for these positions at market value. At December 31, 1993, the aggregate long and short market value of these positions was $34.1 million and $5.2 million, respectively. Risk of loss upon default by the borrower is significantly greater with respect to unrated or less than investment grade corporate debt securities than with other corporate debt securities. These securities are generally unsecured and are often subordinated to other creditors of the issuer. These issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. There is a limited market for some of these securities and market quotes are generally available from a small number of dealers. Convertible Securities and Warrants. The Company also trades domestic and international convertible securities and warrants and assists corporate and institutional clients in identifying attractive investments in these securities and warrants. Arbitrage. The Company engages in arbitrage for its own account. The Company currently conducts arbitrage activities through a relationship with an independent management firm pursuant to which the Company delegates to the manager investment decisions involving the purchase and/or sale of securities in one of the Company's proprietary trading accounts. The manager receives a fee equal to a percentage of the profits in the account after a deduction of all costs, expenses, commissions and interest charges applicable to the trading activity in the account. The Company also engages in international arbitrage involving securities listed or traded in both domestic and foreign markets. In addition, the Company has invested in a limited partnership which conducts arbitrage activity. CORPORATE FINANCE Jefferies' Corporate Finance Department offers corporations a full range of advisory as well as debt and equity financing services which include private placements and public offerings of debt and equity securities, debt refinancings, recapitalizations, mergers and acquisitions advice, exclusive sales advice, structured financings and securitizations, consent and waiver solicitations, and company and bondholder representations in corporate restructurings. Investment banking activity involves both economic and regulatory risks. An underwriter may incur losses if it is unable to sell the securities it is committed to purchase or if it is forced to liquidate its commitments at less than the agreed-upon purchase price. In addition, under the Securities Act of 1933 and other laws and court decisions with respect to underwriters' liability and limitations on indemnification of underwriters by issuers, an underwriter is subject to substantial potential liability for material misstatements or omissions in prospectuses and other communications with respect to underwritten offerings. Further, underwriting commitments constitute a charge against net capital and the Company's underwriting commitments may be limited by the requirement that it must, at all times, be in compliance with the Uniform Net Capital Rule 15c3-1 of the Securities and Exchange Commission (the "Commission"). The Company intends to continue to pursue opportunities for its corporate customers which may require it to finance and/or underwrite the issuance of securities. Under circumstances where the Company is required to act as an underwriter or to trade on a proprietary basis with its customers, the Company may assume greater risk than would normally be assumed in certain other principal transactions. INTEREST The Company earns interest on its securities portfolio and on its operating and segregated balances. The Company also derives net interest income in connection with its stock borrow/stock loan and margin lending activities. Stock Borrow/Stock Loan. In connection with both its trading and brokerage activities, the Company borrows securities to cover short sales and to complete transactions in which customers have failed to deliver securities by the required settlement date, and lends securities to other brokers and dealers for similar purposes. The Company also has a stock borrow versus stock loan business with other brokers. From this activity, the Company derives interest revenues and interest expenses. Margin Lending. Customers' transactions are executed on either a cash or margin basis. In a margin transaction, the Company extends credit to the customer, collateralized by securities and cash in the customer's account, for a portion of the purchase price, and receives income from interest charged on such extensions of credit. In permitting a customer to purchase securities on margin, the Company is subject to the risk that a market decline could reduce the value of its collateral below the amount of the customer's indebtedness and that the customer might otherwise be unable to repay the indebtedness. In addition to monitoring the creditworthiness of its customers, the Company also considers the trading liquidity and volatility of the securities it accepts as collateral for its margin loans. Trading liquidity and volatility may be dependent, in part, upon the market on which the security is traded, the number of outstanding shares of the issuer, events affecting the issuer and/or securities markets in general, and whether or not there are any legal restrictions on the sale of the securities. Certain types of securities have historical trading patterns which may assist the Company in making its evaluation. Historical trading patterns, however, may not be good indicators over relatively short time periods or in markets which are affected by unusual or unexpected developments. The Company considers all of these factors at the time it agrees to extend credit to customers and continues to review its extensions of credit on an ongoing basis. The majority of the Company's margin loans are made to United States citizens or to corporations which are domiciled in the United States. The Company may extend credit to investors or corporations who are citizens of foreign countries or who may reside outside the United States. The Company believes that should such foreign investors default upon their loans with the Company and should the collateral for those loans be insufficient to satisfy the investors' obligations to the Company, the Company may experience more difficulty in collecting investors' outstanding indebtedness than would be the case if investors were citizens or residents of the United States. Although the Company attempts to minimize the risk associated with the extension of credit in margin accounts, there is no assurance that the assumptions on which the Company bases its decisions will be correct or that the Company is in a position to predict factors or events which will have an adverse impact on any individual customer or issuer, or the securities markets in general. COMPETITION All aspects of the business of the Company are intensely competitive. The Company competes directly with numerous other brokers and dealers, investment banking firms and banks. In addition to competition from firms currently in the securities business, there has been increasing competition from others offering financial services. These developments and others have resulted, and may continue to result, in significant additional competition for the Company. Member firms of the NYSE generally are prohibited from effecting transactions when acting as principal and, in certain cases, as agents, in listed equity securities off the NYSE, and therefore, unlike Jefferies and ITG, are precluded from effecting such transactions in the third market. Such firms may execute certain transactions in listed equity securities in the third market for customers, although typically they do not do so. Since firms which the Company regards as its major competitors in the execution of transactions in equity securities for institutional investors are members of the NYSE, any removal of these prohibitions could adversely affect the Company's business. REGULATION The securities industry in the United States is subject to extensive regulation under both federal and state laws. The Commission is the federal agency responsible for the administration of federal securities laws. In addition, self-regulatory organizations, principally the NASD and the securities exchanges, are actively involved in the regulation of broker-dealers. These self-regulatory organizations conduct periodic examinations of member broker-dealers in accordance with rules they have adopted and amended from time to time, subject to approval by the Commission. Securities firms are also subject to regulation by state securities commissions in those states in which they do business. Jefferies is registered as a broker-dealer in 50 states and the District of Columbia. ITG is registered as a broker-dealer in 49 states and the District of Columbia. W & D is registered as a broker-dealer in 23 states. 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 Commission 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 Commission, self-regulatory organizations and state securities commissions may conduct administrative proceedings which can result in censure, fine, suspension, expulsion of a broker-dealer, its officers or employees, or revocation of broker-dealer licenses. 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. As registered broker-dealers, Jefferies, ITG and W & D are required by law to belong to the Securities Investor Protection Corporation ("SIPC"). In the event of a member's insolvency, the SIPC fund provides protection for customer accounts up to $500,000 per customer, with a limitation of $100,000 on claims for cash balances. Net Capital Requirements. Every registered broker-dealer doing business with the public is subject to the Commission's Uniform Net Capital Rule (the "Rule"), which specifies minimum net capital requirements. Jefferies Group, Inc. is not a registered broker-dealer and is therefore not subject to the Rule; however, its United States broker-dealer subsidiaries are subject thereto. The Rule provides that a broker-dealer doing business with the public shall not permit its aggregate indebtedness to exceed 15 times its adjusted net capital (the "primary method") or, alternatively, that it not permit its adjusted net capital to be less than 2% of its aggregate debit balances (primarily receivables from customers and broker-dealers) computed in accordance with such Rule (the "alternative method"). Jefferies, ITG and W & D use the alternative method of calculation. Compliance with applicable net capital rules could limit operations of Jefferies or ITG, such as underwriting and trading activities, that require use of significant amounts of capital, and may also restrict loans, advances, dividends and other payments by Jefferies or ITG to the Company. A significant operating loss or an extraordinary charge against net capital could adversely affect the ability of Jefferies or ITG to expand or even maintain their present level of business. Net capital changes from day to day, but as of December 31, 1993, Jefferies' net capital of $76.0 million exceeded its minimum net capital requirements by $66.8 million. ITG's net capital of $1.9 million exceeded its minimum net capital requirements by $1.7 million. W & D's net capital of $821,000 exceeded its minimum net capital requirements by $671,000. See note 12 of Notes to Consolidated Financial Statements. ITEM 2. ITEM 2. PROPERTIES. The Company maintains sales offices in Los Angeles, New York, Short Hills, Chicago, Dallas, Boston, Atlanta, New Orleans, Houston, San Francisco, Stamford, London and Hong Kong. In addition, the Company maintains operations offices in Los Angeles and New York. The Company leases all of its office space which management believes is adequate for the Company's business. For information concerning leasehold improvements and rental expense, see notes 1, 5 and 10 of Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Many aspects of the Company's business involve substantial risks of liability. In the normal course of business, the Company and its subsidiaries have been named as defendants or co-defendants in lawsuits involving primarily claims for damages. The Company's management believes that pending litigation will not have a material adverse effect on the Company. 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 SECURITY HOLDER MATTERS The Company's Common Stock trades in the NASDAQ National Market System under the symbol JEFG. The following table sets forth for the periods indicated, the range of high and low representative bid prices per share for the Common Stock as reported by NASDAQ, which prices do not include retail mark-ups, mark-downs or commissions and represent prices between dealers and not necessarily actual transactions. There were approximately 283 holders of record of the Company's Common Stock at December 31, 1993. In 1988, the Company instituted a policy of paying regular quarterly cash dividends. There are no restrictions on the Company's present ability to pay dividends on Common Stock, other than the applicable provisions of the Delaware General Corporation Law. Dividends per Common Share (declared and paid): ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected data presented below as of and for each of the years in the five-year period ended December 31, 1993, are derived from the consolidated financial statements of Jefferies Group, Inc. and subsidiaries, which financial statements have been audited by KPMG Peat Marwick, independent auditors. Such data should be read in connection with the consolidated financial statements contained on pages 14 through 31. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's principal activities, securities brokerage and the trading of and market-making in securities, are highly competitive and extremely volatile. Total assets increased $857.4 million from $531.0 million at December 31, 1992 to $1,388.4 million at December 31, 1993. The increase is mostly due to an increase in receivables from brokers and dealers related to stock borrow balances. The increased stock borrow balances are a result of an increase in payable to customers and payable to brokers and dealers (related to stock loan). Total liabilities increased $840.4 million from $393.5 million at December 31, 1992 to $1,233.9 million at December 31, 1993. The increase is mostly due to the before-mentioned increases in payable to customers and payable to brokers and dealers. In addition, accrued expenses and other liabilities increased $45.9 million to $92.8 million in 1993 due to bonuses, accruals related to deferred compensation and accrued federal and state taxes. The earnings of the Company are subject to wide fluctuations since many factors over which the Company has little or no control, particularly the overall volume of trading and the volatility and general level of market prices, may significantly affect its operations. The following provides a summary of revenues by source for the past three years. 1993 COMPARED TO 1992 Total revenues for 1993 increased $82.7 million, or 35%, as compared to 1992. The increase was primarily due to a $48.6 million, or 203%, increase in corporate finance activity and a $18.7 million, or 65%, increase in ITG activity. Commission revenues increased $31.4 million, or 29%, interest revenues increased $4.9 million, or 29%, and other revenues increased $880,000, or 54%, while principal transactions decreased $3.0 million, or 3%. The increase in corporate finance was due to increased activity in underwriting, private placement and financial advisory fees, including approximately $16 million in fees from one underwriting transaction. The increase in commissions was mostly attributable to increases in transactions conducted through POSIT(R) and QuantEX(R), two of the Company's investment technology products. Interest revenues increased primarily due to an increase in stock borrow balances. The increase in other revenues was mostly due to income related to the termination of an office lease and foreign currency transaction gains. Principal trading decreased mostly due to a reduction in trading gains of the Taxable Fixed Income Division partially offset by the improved performance of the Company's Over-The-Counter Division. Total expenses for 1993 increased $69.0 million, or 34%, as compared to 1992. The increase in total expenses was due to an increase of $49.3 million, or 42%, in compensation and benefits, an increase of $10.8 million, or 40%, in other expense, an increase of $4.2 million, or 32%, in interest expense, an increase of $2.1 million, or 15%, in floor brokerage and clearing fees, and an increase of $2.0 million, or 12%, in telecommunications and data processing services. Compensation and benefits increased mostly due to an increase in profitability-based compensation (including a $4 million increase in expense related to ITG's performance share plan. See notes 9 and 14 of Notes to Consolidated Financial Statements.), payouts related to higher commission revenues and additional personnel. Other expense increased mostly due to increases in four items; travel and entertainment expenses, soft dollar expenses, research and consulting and royalties related to POSIT(R) revenues. These four items not only represent the majority of the increase from 1992 to 1993, but these items also represent the majority of other expense. Interest expense increased due to increases in customer credit balances and stock loan balances related to the increase in stock borrow balances. Floor brokerage and clearing fees increased due to increased volumes of business executed on the various exchanges. Telecommunications and data processing services increased due to an increase in the number of offices. Occupancy and equipment rental expenses remained relatively unchanged as compared to the 1992 period. As a result of the above, earnings before income taxes and cumulative effect of change in accounting principle increased from $33.7 million in 1992 to $47.3 million in 1993. The $13.7 million increase was chiefly due to the increase in revenues from corporate finance activity and investment technology commissions. Earnings before cumulative effect of change in accounting principle were up 47% to $27.6 million, as compared to $18.7 million in the 1992 period. The effective tax rate was approximately 42% for 1993 compared to 44% for the 1992 period. An adjustment of prior years' estimated tax liabilities, to actual, resulted in the lower tax rate for the 1993 period. The cumulative effect of the change in accounting for income taxes required by Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" was a $1.4 million benefit. This increased net earnings to $28.9 million, which represents an increase of $10.2 million, or 55%, over the 1993 period. Primary earnings per share were $5.63 on 5.1 million shares in 1993 compared to $3.82 on 4.9 million shares in 1992. Fully diluted earnings per share were $4.88 on 6.2 million shares in 1993 compared to $3.08 on 6.7 million shares in 1992. The cumulative effect of the change in accounting principle increased earnings per share in 1993 by $.26 on primary shares and $.22 on fully diluted shares. 1992 COMPARED TO 1991 Total revenues for 1992 increased $39.5 million, or 20%, as compared to 1991. The increase was primarily due to a $22.4 million, or 27%, increase in commission revenues. Principal transactions increased $16.4 million, or 23%, and corporate finance increased $7.1 million, or 43%, while interest revenues decreased $7.1 million, or 30%. The increase in commissions was across the board with notable increases in POSIT(R) and QuantEX(R), the Company's computerized investment technology products. The increase in principal trading was mostly due to the Company's Over-The-Counter and International Convertible Departments. The increase in corporate finance resulted primarily from participation in a greater number of transactions. The decrease in interest revenues was due primarily to a decrease in interest rates, although customer margin debit balances also decreased. Total expenses for 1992 increased $23.7 million, or 13%, as compared to 1991. The increase in total expenses was due to an increase of $26.0 million, or 28%, in compensation and benefits, an increase of $2.2 million, or 19%, in floor brokerage and clearing fees, and an increase of $1.0 million, or 6%, in telecommunications and data processing services. These were partially offset by a decrease of $2.7 million, or 17%, in interest expense, a decrease of $2.2 million, or 7%, in other expense, and a decrease of $641,000, or 5%, in occupancy and equipment rental. Compensation and benefits increased mostly due to profitability-based compensation. In connection with the acquisition of Integrated Analytics Corporation ("IAC") in 1991, the Company hired certain employees of IAC. Several of these employees participate in a performance share plan consisting of a phantom equity interest in ITG as determined by a formula based primarily on ITG earnings and vesting requirements. The Company expensed approximately $3.6 million under this plan in 1992. For more information on the performance share plan, see notes 9 and 14 of Notes to Consolidated Financial Statements. Additionally, the increase in compensation and benefits related to increased commission revenues and increased headcount. Floor brokerage and clearing fees increased primarily because of increased volumes of business executed on the various exchanges. Telecommunications and data processing services increased due to increased trade volume and ongoing system development. Interest expense decreased due to lower interest rates. Other expense decreased mostly due to a reduction in bad debt and legal expenses. Occupancy and equipment rental decreased primarily due to a reduction in moving related expenses. As a result of the above, earnings before income taxes increased from $17.8 million in 1991 to $33.7 million in 1992. The $15.8 million increase in earnings was chiefly due to the increase in revenues from commissions and principal transactions. Net earnings were $18.7 million, an increase of $8.9 million, or 90%, compared to 1991. The effective tax rate was 44.4% in 1992 and 44.7% in 1991. Primary earnings per share were $3.82 on 4.9 million shares in 1992 compared to $1.74 on 5.7 million shares in 1991. Fully diluted earnings per share were $3.08 on 6.7 million shares in 1992 compared to $1.57 on 7.5 million shares in 1991. LIQUIDITY AND CAPITAL RESOURCES A substantial portion of the Company's assets are liquid, consisting of cash or assets readily convertible into cash. The majority of securities positions (both long and short) in the Company's trading accounts are readily marketable and actively traded. Receivables from brokers and dealers are primarily current open transactions or securities borrowed transactions which can be settled or closed out within a few days. Receivables from customers, officers and directors include margin balances and amounts due on uncompleted transactions. Most of the Company's receivables are secured by marketable securities. The Company's assets are financed by equity capital, subordinated debt, customer free credit balances, bank loans and other payables. Bank loans represent secured and unsecured short-term borrowings (usually overnight) which are generally payable on demand. Secured bank loans are collateralized by a combination of customer, noncustomer and firm securities. The Company has always been able to obtain necessary short-term borrowings in the past and believes that it will continue to be able to do so in the future. Additionally, the Company has letters of credit outstanding which are used in the normal course of business to satisfy various collateral requirements in lieu of depositing cash or securities. Jefferies is subject to the net capital requirements of the Commission, the NASD, the BSE, and the PSE, which are designed to measure the general financial soundness and liquidity of broker-dealers. Jefferies consistently has operated in excess of the minimum requirements. At December 31, 1993, Jefferies had regulatory net capital, after adjustments as required by the Commission's Uniform Net Capital Rule, of $76.0 million, which exceeded the minimum net capital requirements by $66.8 million. At December 31, 1993, ITG had regulatory net capital, after adjustments as required by the Commission's Uniform Net Capital Rule, of $1.9 million, which exceeded the minimum net capital requirements by $1.7 million. At December 31, 1993, W & D had regulatory net capital, after adjustments as required by the Commission's Uniform Net Capital Rule, of $821,000, which exceeded the minimum net capital requirements by $671,000. Jefferies, ITG and W & D use the alternative method of calculating their regulatory net capital. In 1992, the Company repurchased 479,339 shares of its Common Stock at prices ranging from $14.375 to $19. Also in 1992, the Company exchanged $10.7 million of new subordinated 8 7/8% non-convertible notes, due 1997, for $10.7 million face amount of its 7% convertible subordinated notes due 2010, which were convertible into 466,521 shares of the Company's Common Stock. The new notes provide for mandatory redemption in 1995 and 1996 of one-third of the principal face amount, respectively. Although the exchange did not reduce the number of primary shares outstanding, it reduced the Company's fully diluted shares outstanding by approximately 7%. In October 1993, the Company called for redemption all of its 8 1/2% Convertible Subordinated Debentures and all of its 7% Convertible Subordinated Notes. Holders of $29,731,000 aggregate principal amount of 8 1/2% Convertible Subordinated Debentures and $1,690,000 aggregate principal amount of 7% Convertible Subordinated Notes elected to convert their securities into an aggregate of 1,366,092 shares of the Company's Common Stock. Also in 1993, the Company repurchased 351,837 shares of its Common Stock at prices ranging from $23.375 to $36.50. The repurchased shares of Common Stock are presently being held as treasury shares. EFFECTS OF INFLATION Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. Increases in the Company's expenses, such as employee compensation, rent and communications, due to inflation may not be readily recoverable in the prices of services offered by the Company. In addition, to the extent that inflation results in rising interest rates and has other adverse effects on securities markets and on the value of securities held in the inventory, it may adversely affect the Company's financial position and results of operations. EFFECTS OF CHANGES IN FOREIGN CURRENCY RATES The Company maintains a foreign securities business in its foreign offices (London and Hong Kong) as well as in some of its domestic offices. Most of these activities are hedged by related foreign currency liabilities or by forward exchange contracts. However, the Company is still subject to some foreign currency risk. A change in the foreign currency rates could create either a foreign currency transaction gain/loss (recorded in the Company's Consolidated Statement of Earnings) or a foreign currency translation adjustment to the Stockholders' Equity section of the Company's Consolidated Statement of Financial Condition. For an assessment of risk, see Part I, Item 1, Business sections "Principal Transactions," "Corporate Finance," "Interest," and "Competition" and see Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations sections "Effects of Inflation" and "Effects of Changes in Foreign Currency Rates." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS REPORT The Board of Directors and Stockholders JEFFERIES GROUP, INC.: We have audited the accompanying consolidated statements of financial condition of Jefferies Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, changes in 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 Companys 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 Jefferies 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 note 1 to the consolidated financial statements, the Company changed its accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standard Boards Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Los Angeles, California KPMG PEAT MARWICK January 28, 1994, except as to note 14 to the consolidated financial statements, which is as of March 15, 1994. JEFFERIES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. JEFFERIES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. JEFFERIES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. JEFFERIES GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) Supplemental disclosure of noncash financing activities: In September 1993, the Company called for redemption of all of its then outstanding convertible subordinated debentures and notes. Holders of $29,731,000 face value of 8 1/2% Convertible Subordinated Debentures and $1,690,000 face value of 7% Convertible Subordinated Notes elected to convert their debentures and notes into 1,366,092 shares of the Company's Common Stock. In 1993, the Company recognized an additional minimum pension liability of $1,063,000 related to the Company's pension plan, which resulted in an increase to accrued expenses and other liabilities and an offsetting decrease in stockholders' equity. See accompanying notes to consolidated financial statements. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of Jefferies Group, Inc. (Company) and all wholly owned subsidiaries, including Jefferies & Company, Inc. (Jefferies) and Investment Technology Group, Inc. (ITG). The accounts of W & D Securities, Inc. (W & D) are also consolidated because of the nature and extent of the Company's ownership interest in W & D. The Company and its subsidiaries are primarily engaged in equity and taxable fixed income securities brokerage and trading. Operations of the Company include agency and principal transactions and other securities-related financial services. All significant intercompany accounts and transactions are eliminated in consolidation. SECURITIES TRANSACTIONS Starting January 1, 1993, all securities transactions (related commission revenue and expense) are recorded on a trade-date basis, which does not materially differ from the Company's previously used settlement-date basis. RECEIVABLE FROM, AND PAYABLE TO, CUSTOMERS, OFFICERS AND DIRECTORS Receivable from, and payable to, customers includes amounts receivable and payable on cash and margin transactions. Securities owned by customers and held as collateral for these receivables are not reflected in the accompanying consolidated financial statements. Receivable from officers and directors represents balances arising from their individual security transactions. Such transactions are subject to the same regulations as customer transactions. SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED Securities owned and securities sold, not yet purchased, are valued at market value, and unrealized gains and losses are reflected in revenues from principal transactions. PREMISES AND EQUIPMENT Premises and equipment are depreciated using the straight-line method over the estimated useful lives of the related assets (generally five to ten years). Leasehold improvements are amortized using the straight-line method over the term of related leases or the estimated useful lives of the assets, whichever is shorter. AMORTIZATION OF INTANGIBLES The excess of cost over net assets acquired is amortized on a straight-line basis over ten years. INCOME TAXES The Company files a consolidated U.S. Federal income tax return which includes all qualifying subsidiaries. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable. Deferred income taxes are provided for temporary differences in reporting certain items, principally state income taxes, depreciation, deferred compensation and unrealized gains and losses on securities owned. Tax credits are recorded as a reduction of income tax expense when realized. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Statement 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1993, the Company adopted Statement 109 and has reported the cumulative effect of that change in the method of accounting for income taxes in the 1993 statement of earnings. Pursuant to the deferred method under APB Opinion 11 which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. CASH AND CASH EQUIVALENTS The Company generally invests its excess cash in U.S. Treasury notes purchased under agreements to resell to a financial institution. At December 31, 1993 and 1992, such cash equivalents amounted to $4,500,000 and $4,000,000, respectively, and were held in the Company's safekeeping account at a bank. Cash equivalents are part of the cash management activities of the Company and generally mature within 90 days. EARNINGS PER COMMON SHARE Primary earnings per share of common stock are computed by dividing net earnings by the average number of shares of common stock and common stock equivalents outstanding during the period. Fully diluted earnings per share of common stock have been further adjusted for conversion of convertible subordinated debt, if dilutive. FOREIGN CURRENCY TRANSLATION In accordance with SFAS 52, "Accounting for Foreign Currency Translation," the Company's foreign revenues, costs and expenses are translated at average current rates during each reporting period. Foreign currency transaction gains and losses are currently included in the statement of earnings. Gains and losses resulting from translation of financial statements are excluded from the statement of earnings and are recorded directly to a separate component of stockholders' equity. RECLASSIFICATIONS Certain reclassifications have been made to the prior year's amounts to conform to the current year's presentation. (2) ACQUISITION In 1991, the Company completed the acquisition of a controlling interest in Integrated Analytics Corporation (IAC), a developer and marketer of computer software for use in the securities industry, through stock purchases for $6,100,000 in cash. Excess of purchase price over the fair value of net assets acquired of $6,300,000 is being amortized using the straight-line method over ten years. At December 31, 1993, excess of JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) purchase price over net assets acquired remaining was $4,271,000 and is included in other assets. In connection with the acquisition, the Company also entered into an agreement with certain IAC employees providing for payment of compensation tied to the earnings of the Company's technology group. For more information regarding the agreement, see note 9. (3) RECEIVABLE FROM, AND PAYABLE TO, CUSTOMERS, OFFICERS AND DIRECTORS The following is a summary of the major categories of receivables from customers, officers and directors as of December 31, 1993 and 1992 (in thousands of dollars): Interest is paid on free credit balances in accounts of customers who have indicated that the funds will be used for investment at a future date. The rate of interest paid on such free credit balances varies between the thirteen-week treasury bill rate and 1% below that rate, depending upon the size of the customers' free credit balances. Uncollectible accounts expense amounted to $708,000, $1,080,000 and $2,338,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and is included in other expense. (4) SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED The following is a summary of the market value of major categories of securities owned and securities sold, not yet purchased, as of December 31, 1993 and 1992: JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (5) PREMISES AND EQUIPMENT The following is a summary of premises and equipment as of December 31, 1993 and 1992 (in thousands of dollars): Depreciation and amortization expense amounted to $4,350,000, $4,909,000 and $4,524,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Included in furniture, fixtures and equipment is leased computer and office equipment totaling $5,046,000 and related accumulated amortization of $2,927,000. (6) BANK LOANS Bank loans represent short-term borrowings that are payable on demand and generally bear interest at the brokers' call loan rate. At December 31, 1993, secured and unsecured firm loans amounted to $25,928,000 and $20,000,000, respectively. The secured loans were fully collateralized by firm securities having a market value of $41,888,000. The Company did not have any loans outstanding at December 31, 1992. (7) SUBORDINATED DEBT The following summarizes subordinated debt outstanding at December 31, 1993 and 1992 (in thousands of dollars): In 1992, the Company issued $10,730,000 face value of 8 7/8% Subordinated Notes in exchange for 7% Convertible Subordinated Notes having the same face value. In September 1993, the Company called for redemption of all of its then outstanding convertible subordinated debentures and notes. Holders of $29,731,000 face value of 8 1/2% Convertible Subordinated Debentures and $1,690,000 face value of 7% Convertible Subordinated Notes elected to convert their debentures and notes into 1,366,092 shares of the Company's Common Stock. Beginning October 1, 1995, the 8 7/8% Notes have sinking fund requirements to redeem $3,577,000 annually through October 1, 1997. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (8) INCOME TAXES As discussed in note 1, the Company adopted Statement 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes of $1,358,000 is determined as of January 1, 1993 and is reported separately in the consolidated statement of earnings for the year ended December 31, 1993. Prior years financial statements have not been restated to apply the provisions of Statement 109. Total income tax expense for the year ended December 31, 1993 was allocated as follows (in thousands of dollars): Income tax expense for the years ended December 31, 1993, 1992 and 1991 consists of the following: Income tax expense differed from the amounts computed by applying the Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991 as a result of the following: JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) For the years ended December 31, 1993, 1992 and 1991, deferred tax benefits of $7,438,000, $1,103,000 and $1,533,000 resulted from temporary differences in the recognition of income and expense for income tax and financial reporting purposes. The sources and tax effects of those timing differences are presented below: The deferred tax benefit of $7,438,000 for the year ended December 31, 1993 included a $101,000 benefit from adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates. The cumulative 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 of dollars): There was no valuation allowance for deferred tax assets as of January 1, 1993 and no allowance added during the year ended December 31, 1993. Management believes the existing net deductible temporary differences will reverse during periods in which the Company generates net taxable income. However, there can be no assurance that the Company will generate any earnings or any specific level of continuing earnings in future years. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Certain subsidiaries have net operating losses which cannot be used by other members of the consolidated group in the aggregate amount of $720,000. For Federal tax purposes, all net operating losses are due to expire in 2006. (9) BENEFIT PLANS PENSION PLAN The Company has a defined benefit pension plan which covers substantially all employees of the Company and its subsidiaries. The plan is subject to the provisions of the Employee Retirement Income Security Act of 1974. The following table sets forth the plans funded status and amounts recognized in the Company's accompanying consolidated statement of financial condition: The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.50% and 5.00%, respectively, in 1993 and 8.25% and 5.00%, respectively, in 1992. The expected long-term rate of return on assets was 8.40%. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) STOCK OPTION PLANS The Company has a qualified stock option plan pursuant to which it has reserved an aggregate of 700,000 shares of common stock for issuance upon the exercise of options to be granted under the plan to employees of the Company and its subsidiaries. Pursuant to a voluntary exchange in 1987, substantially all of the options originally issued under this plan were exchanged for nonqualified replacement options. Options under the plan are granted for terms of up to ten years at a price not less than 100% of fair market value at the date of the grant (five years and 110% of fair market value in the case of an employee owning more than 10% of the combined voting power of all classes of stock of the Company). Options granted under the qualified stock option plan are intended to qualify as incentive stock options within the meaning of Section 422A of the Internal Revenue Code of 1954. The Company has a nonqualified stock option plan pursuant to which it has reserved an aggregate of 650,000 shares of common stock for issuance upon the exercise of options granted under the plan to employees of the Company and its subsidiaries. The option price and period is determined by the Board of Directors or committee thereof and is not limited by the qualified stock option plan. Options granted under the nonqualified stock option plan are not intended to qualify as incentive stock options. Under the qualified and nonqualified stock option plans, tandem stock appreciation rights may be granted, permitting an employee to receive, in lieu of exercise of the related option, an amount equal to the difference between the value covered by the related option and the option exercise price. The following is a summary of the transactions under the stock option plans for the years ended December 31, 1993 and 1992: At December 31, 1993, 475,460 options were exercisable, and 116,039 options were available for future grants under the stock option plans. As of December 31, 1993, of the total options outstanding, 487,126 are nonqualified. In April 1992, ITG granted an option to certain key employees which allows the purchase of up to 10% of the equity interest in ITG for $2,000,000 through May 1995. This grant did not give rise to any compensation expense. Additionally, each director, who is not also an employee of the Company, has a nonqualified option to purchase 5,000 shares of the Company's Common Stock at exercise prices of $13.25 through $35.25 per share. OTHER BENEFIT PLANS The Company incurs expenses related to various benefit plans covering substantially all employees, including an Employee Stock Ownership Plan (ESOP), an Employee Stock Purchase Plan (ESPP) and a JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) profit sharing plan, which includes a salary reduction feature designed to qualify under Section 401(k) of the Internal Revenue Code. During 1988, the Company established an ESOP which purchased 856,327 shares of its common stock for $9,000,000 funded by a loan from the Company. As of December 31, 1992, the balance of the loan had been paid. The loan was being repaid over five years at an annual interest rate of 8.02%. The Company made contributions to the ESOP sufficient to fund principal and interest payments. During 1992 and 1991, the ESOP repaid $1,301,000 and $1,458,000, respectively, of the outstanding balance substantially through a Company contribution. In 1993, the Parent created a Capital Accumulation Plan for certain officers and key employees of the Company. Participation in the plan is optional, with those who elect to participate agreeing to defer graduated percentages of their compensation. The Company made employee benefit plan contributions of $3,945,000 in 1993 and $1,654,000 and $1,799,000 in 1992 and 1991, respectively, which include the ESOP contributions as described above. PERFORMANCE SHARE PLAN In connection with the 1991 acquisition of IAC, the Company has a Performance Share Plan awarding ownership in ITG in the form of a phantom equity interest to key employees, of which a 12.7% interest is outstanding at December 31, 1993. The plan covers a ten-year period ending December 31, 2001. The plan award, and related compensation expense, is calculated based on 9.6 times adjusted ITG earnings, less a strike price based on a total ITG valuation of $5.8 million. Employees can initiate redemption of up to 25% of granted shares per year on a noncumulative basis. The Company can call up to 15% of granted shares per year on a noncumulative basis, at a value based on 12 times adjusted ITG earnings. Adjusted ITG earnings consist of current year ITG net earnings ($3,389,000 in 1993) plus the after-tax effect of Performance Share Plan expense ($4,233,000 in 1993) and certain other items ($706,000 in 1993) and amounted to $8,328,000 in 1993. The Company has expensed approximately $7,559,000 under this plan in 1993, of which approximately $64,000 has been paid out for early redemption. The plan is fully vested at December 31, 1993. Assuming the Company does not intend to call the shares and there is no change in the amount of phantom shares outstanding, future compensation expense under the Performance Share Plan in any given year through 2001, net of tax, will be approximately 68% of the change in adjusted ITG earnings from the previous years adjusted ITG earnings. Therefore, in any given year between 1994 and 2001 there will only be additional compensation expense to the extent that adjusted earnings in that year exceed the previous years adjusted earnings. If the Company should decide to call some shares, compensation expense would increase, reflecting an adjusted earnings multiple equal to 12 times rather than 9.6 times earnings. See note 14 for subsequent event. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (10) LEASES As lessee, the Company leases certain premises and equipment under noncancelable agreements expiring at various dates through 2004. Assets under capitalized leases are capitalized using interest rates appropriate at the inception of the lease. Future minimum lease payments for assets under capital leases at December 31, 1993 follow: Future minimum lease payments for all noncancelable operating leases at December 31, 1993 are as follows: Rental expense, net of subleases, for the Company was $5,118,000 in 1993, $5,110,000 in 1992 and $4,628,000 in 1991. (11) OFF-BALANCE SHEET RISK In the normal course of business, the Company is involved in the execution, settlement and financing of various customer and principal securities transactions. Customer activities are transacted on a cash, margin or delivery-versus-payment basis. Securities transactions are subject to the risk of counterparty or customer nonperformance. However, transactions are collateralized by the underlying security, thereby reducing the associated risk to change in the market value of the security through settlement date or to the extent of margin balances. The Company also has contractual commitments arising in the ordinary course of business for bank loans, stock loaned, securities sold, not yet purchased, repurchase agreements, future purchases and sales of foreign currency, securities transactions on a when-issued basis and underwriting. Each of these financial instruments contains varying degrees of off-balance sheet risk whereby the market values of the securities underlying the financial instruments may be in excess of the contract amount. The settlement of these transactions is not expected to have a material effect upon the Company's accompanying consolidated financial statements. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In the normal course of business, Jefferies had letters of credit outstanding aggregating $21,145,000 at December 31, 1993 to satisfy various collateral requirements in lieu of depositing cash or securities. (12) NET CAPITAL REQUIREMENTS As registered broker-dealers, Jefferies, ITG and W & D are subject to the Securities and Exchange Commission Uniform Net Capital Rule (Rule 15c3-1), which requires the maintenance of minimum net capital. Jefferies, ITG and W & D have elected to use the alternative method permitted by the Rule, which requires that they each maintain minimum net capital, as defined, equal to the greater of $150,000 or 2% of the aggregate debit balances arising from customer transactions, as defined. At December 31, 1993, Jefferies had net capital of $75,966,000, which was 17% of aggregate debit balances and $66,815,000 in excess of required net capital. At December 31, 1993, ITG had net capital of $1,852,000, which was $1,702,000 in excess of required net capital. At December 31, 1993, W & D had net capital of $821,000, which was $671,000 in excess of required net capital. (13) CONTINGENCIES The Company is involved in various legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the Company's financial statements. (14) SUBSEQUENT EVENTS The Company formed a new subsidiary (the ITG Holding Company) in March 1994 for the purpose of eventually holding 100% of the stock of ITG (stockholders' equity at December 31, 1993 of $13,049,000). On March 15, 1994, the ITG Holding Company filed with the Securities and Exchange Commission a Registration Statement for the offer of 3,700,000 shares of its common stock (which includes 450,000 shares subject to an overallotment option granted to the underwriters) in an initial public offering. The filing indicated an anticipated offering price of between $12 and $14 per share. Immediately prior to the consummation of the offering, the ITG Holding Company will issue 15,000,000 shares of its common stock in exchange for all 10,000,000 shares issued and outstanding of ITG common stock held by the Company. Following the offering, the Company will own 80.2% of the outstanding common stock of the ITG Holding Company. In addition, immediately prior to the offering, the ITG Holding Company will also issue a note in the amount of approximately $17,000,000 in payment of a dividend to the Company. In conjunction with the offering, certain management employment agreements, the Performance Share Plan and noncompensatory ITG stock options (as described in note 9), will be terminated in exchange for $40,500,000 in cash and the Company's Common Stock, based on an assumed offering price of $13.00 per share, of which $9,400,000 has been accrued at December 31, 1993. Any increase or decrease in the net proceeds of the offering upon determination of the actual offering price will result in an increase or decrease in such amount. Additionally, noncompensatory options to purchase 2,684,000 shares of the ITG Holding Company's common stock will be granted to senior management and other employees at an exercise price equal to the initial public offering price. The Company believes expense from the termination of the Performance Share Plan will be offset by gain from the offering. JEFFERIES GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Summarized financial information of ITG as of December 31, 1993 follows: 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 with respect to this item will be contained in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to this item will be contained in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with respect to this item will be contained in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with respect to this item will be contained in the Proxy Statement for the 1994 Annual Meeting of Stockholders, which is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K All other Schedules are omitted because they are not applicable or because the required information is shown in the financial statements or notes thereto. - --------------- *Filed herewith. ALL OTHER EXHIBITS ARE OMITTED BECAUSE THEY ARE NOT APPLICABLE. (b) No reports on Form 8-K have been filed by the Registrant. (c) Index to Exhibits. See list of exhibits at Item 14(a)3 above and exhibits following. Exhibits 10.1 to and including 10.11 are management contracts or compensatory plans or arrangements. (d) Financial Statement Schedules See list of Schedules at Item 14(a)2 above and schedules following. JEFFERIES GROUP, INC. AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 - --------------- (1) Computed by dividing the sum of the daily average balances for each month by 12 months in the year. (2) Computed by dividing the actual interest expenses by the average amount outstanding during the period. 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. JEFFERIES GROUP, INC. By FRANK E. BAXTER ----------------------------------- Dated: March 31, 1994 Frank E. Baxter, Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated. INDEX TO EXHIBITS - --------------- *Filed herewith.

22620_1993.txt

22620_1993

1993

22620

Item 1. Business General Commonwealth Gas Company (the Company) is engaged in the distribution and sale of natural gas at retail to approximately 232,000 customers in a 1,067 square mile area which includes 49 communities in eastern, southeastern and central Massachusetts. The approximate year-round population of this service area is 1,128,000. The Company, which was organized in 1851 under the laws of the Commonwealth of Massachusetts, operates under the jurisdiction of the Massachusetts Department of Public Utilities (DPU), which regulates retail rates, accounting, issuance of securities and other matters. The Company is a wholly-owned subsidiary of Commonwealth Energy System ("System"), which, together with its subsidiaries, is collectively referred to as "the system." Since the date of its organization the Company has, from time to time, acquired the property and franchises of, or merged with, other gas companies. The Company is the only gas distribution utility in its service area and, by virtue of its existing franchises, no other gas distribution utility may extend its operations into the Company's service area without the authorization of the DPU. Alternative sources of energy are available to customers within the service territory, but competition from these sources has not been a significant factor affecting the Company's firm gas sales to existing customers. Even with the higher cost of storage and liquefied natural gas (LNG), which is required to supplement pipeline supply, the overall long-term cost of gas has been competitive with the cost of alternative fuel sources for most of the Company's customers. Operating revenues are derived primarily from residential, commercial and industrial customers. Capital expenditures are required to bring gas into areas of anticipated growth and both the distribution capability and gas supply must be available when new development begins or potential customers will seek alternative sources of fuel. Certain large industrial customers who have dual fuel capability, can convert from gas to alternative fuels under terms of contracts which permit interruption of their service upon short notice. The Company reserves the right to reduce or interrupt the supply of gas at any time. Gas Supply (a) General In April 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (Order 636) which became effective on November 1, 1993 and requires interstate pipelines to unbundle existing gas sales contracts into separate components (gas sales, transportation and storage services). Order 636 provides mechanisms that will allow customers such as the Company to reduce the level of firm services from the pipelines and "broker" excess capacity on a temporary or permanent basis. Order 636 also requires pipelines to provide transportation services that allow customers to receive the same COMMONWEALTH GAS COMPANY level of service they had with the bundled contracts. In the past, the Company purchased the majority of its gas supplies from either Tennessee Gas Pipeline Company (Tennessee) or Algonquin Gas Transmission Company (Algonquin), supplemented with third-party firm gas purchases and firm transportation from various pipelines. Presently, the Company has only transportation, storage, and balancing contracts with these pipelines (and other upstream pipelines that bring gas from the supply wells to the final transporting pipelines), and contracts with a variety of independent vendors for firm gas supply. Twelve new firm gas supply contracts have been negotiated with suppliers and filed with the DPU. During the interim, the Company is operating under short-term firm agreements with these same vendors to provide firm supplies under similar terms and conditions as the long-term agreements, which are presently under review. Approvals are expected during the first half of 1994. In addition to firm transportation and gas supplies mentioned above, the Company utilizes contracts for underground storage and LNG facilities to meet its winter peaking demands. The underground storage contracts are a combination of existing agreements and new agreements which are the result of Order 636 requirements for total service unbundling. The LNG facilities, described below, are used to liquefy and store pipeline gas during the warmer months for use during the heating season. During 1993, over 99% of the gas utilized by the Company was delivered by the interstate pipeline system, the remaining small quantity (approximately 360,000 MMBTU) was delivered as liquid LNG from Distrigas of Massachusetts. The Company entered into a multi-party agreement to assume a portion of Boston Gas Company's contracts to purchase Canadian gas supplies from Alberta Northeast (ANE), and have the volumes delivered by the Iroquois Gas Transmission System and Tennessee pipelines. The ANE gas supply contract was filed with the DPU and hearings were completed in April 1993. The Company is currently awaiting an order from the DPU. The Company began transporting gas on its distribution system in 1990 for end-users. There are currently only eleven customers using this transportation service, accounting for only 1,623 BBTU of throughput in 1993 which represented approximately 3.5% of system throughput. (b) Hopkinton LNG Facility A portion of the Company's gas supply during the heating season is provided by Hopkinton LNG Corp. (Hopkinton), a wholly-owned subsidiary of the System. The facility consists of a liquefaction and vaporization plant and three above-ground cryogenic storage tanks having an aggregate capacity of 3 million MCF of natural gas. In addition, Hopkinton owns a satellite vaporization plant and two above-ground cryogenic storage tanks located in Acushnet, Massachusetts with an aggregate capacity of 500,000 MCF of natural gas and are filled with LNG trucked from Hopkinton. The Company has a contract for LNG service with Hopkinton extending through 1996, thereafter renewable year to year with notice of termination due five years in advance. Contract payments include a demand charge sufficient COMMONWEALTH GAS COMPANY to cover Hopkinton's fixed charges and an operating charge which covers liquefaction and vaporization expenses. The Company furnishes pipeline gas during the period April 15 to November 15 each year for liquefaction and storage. As the need arises, LNG is vaporized and placed in the distribution system of the Company. Based upon information presently available regarding projected growth in demand and estimates of availability of future supplies of pipeline gas, the Company believes that its present sources of gas supply are adequate to meet existing load and allow for future growth in sales. Rates and Regulation (a) Automatic Adjustment Clauses The Company has a Standard Seasonal Cost of Gas Adjustment rate schedule (CGA) which provides for the recovery, from firm customers, of purchased gas costs not recovered through base rates. These schedules, which require DPU approval, are estimated semi-annually and include credits for gas pipeline refunds and profit margins applicable to interruptible sales. Actual gas costs are reconciled annually as of October 31, and any difference is included as an adjustment in the calculation of the decimals for the two subsequent six-month periods. The DPU and the Massachusetts Energy Facilities Siting Council (the Council) were merged in 1992. The Council is now a division of the DPU. Periodically, the Company is required to file a long-range forecast of the energy needs and requirements of its market area and annual supplements thereto with the Council. To approve a long-range forecast, the Council must find, among other things, that the Company's plans for construction of new gas manufacturing or storage facilities and certain high-pressure gas pipelines are consistent with current health, environmental protection, resource use and development policies as adopted by the Commonwealth of Massachusetts. The Company filed a long-range forecast with the Council on July 20, 1990 and updated aspects of the filing in March 1991. This forecast was combined with the DPU review of the ANE contract. Both dockets remain pending before the DPU. (b) Gas Demand, Take-or-Pay Costs and Transition Costs The Company is obligated, as part of its pipeline transportation contracts and supplier gas purchase contracts, to pay monthly demand charges which are recovered from customers through the CGA. In June 1991, Tennessee filed a settlement with the FERC dealing with a variety of contract restructuring issues, including the allocation of take-or- pay costs to Tennessee's customers, including the Company. This comprehensive settlement was approved and implemented on July 1, 1992. As part of the settlement, the allocation of take-or-pay costs was changed from a deficiency basis to a contract demand basis which increased the Company's allocation. Future take-or-pay costs will be included in Tennessee's Temporary Gas Inventory Charge and transition costs under Tennessee's restructuring pursuant to Order 636. COMMONWEALTH GAS COMPANY Algonquin made a series of filings with the FERC to recover from its customers take-or-pay charges imposed on it by its upstream suppliers. Algonquin billed the Company for gas supply inventory charges from Texas Eastern and others through the Algonquin commodity rate. With the implementation of Order 636, Algonquin allocated the remaining costs utilizing a formula based on actual purchases for the twelve months prior to May 1, 1993. The Company's allocation was in excess of $5 million. The Company successfully appealed Algonquin's allocation method to the FERC. The change in allocation, combined with issues being settled in Algonquin's current rate case will reduce the Company's allocated share by $1.5 million to $2.5 million. As a direct result of implementation of Order 636, most pipeline companies are incurring transition costs which include the cost of restructuring gas supply contracts, the value of facilities that were supporting the gas sales function and are no longer used and useful for transportation only services, the cost of contracts with upstream pipeline companies and various miscellaneous costs. For additional information on these transition costs refer to Note 5(c) of Notes to Financial Statements filed under Item 8 of this report. The Company is collecting take-or-pay and other contract restructuring costs from its customers through the CGA as permitted by the DPU. The remaining take-or-pay costs to be billed to the Company from both Algonquin and Tennessee are estimated at approximately $431,000 as of December 31, 1993, subject to change upon FERC approval. (c) Most Recent Rate Case Proceeding On April 16, 1991, the Company requested a $27.7 million (11.3%) revenue increase in a filing with the DPU using a test year ended December 31, 1990. On September 16, 1991, the DPU approved a settlement of the revenue requirements portion of the filing authorizing a $22.8 million increase in annual revenues, approximately 82% of the original request. The agreement included a return on equity, for accounting purposes, of 13%. The DPU later ruled on the rate design portion of the request and new rates went into effect on November 1, 1991. The increase was necessitated by the rising costs of providing service to customers and substantial expenditures to upgrade, improve and maintain the Company's distribution system. Environmental Matters The Company is a potentially responsible party (PRP) in the Sullivan's Ledge Superfund site in New Bedford, Massachusetts. In 1990, the Company agreed to a settlement regarding this site and its share of clean-up costs is presently estimated to be $1.8 million and is reflected on the accompanying Balance Sheets. Sampling work at the site indicates that a more extensive clean-up than originally contemplated may be required, although the financial impact of these findings is not presently known. The settling parties for the site are now pursuing claims against a number of non-settling PRPs, and any amounts recovered through those claims will be applied to offset the settling parties' liabilities. The Company is evaluating a former gas manufacturing plant site in COMMONWEALTH GAS COMPANY Worcester, Massachusetts, and a proposal for a comprehensive assessment of this site has been prepared. It is possible that this site may require substantial remediation work due to the suspected presence of hazardous substances. However, the cost of remediation cannot be estimated at this time. The Company anticipates recovery of costs associated with the clean-up of such sites from its customers through a procedure established in a generic order issued by the DPU, wherein such costs are recovered through an element of the existing CGA. These costs are expected to be recovered over a seven- year amortization period without a return on the unamortized balance. Construction and Financing Information concerning the Company's financing and construction programs is contained in Note 5(a) of the Notes to Financial Statements filed under Item 8 of this report. Employees The Company has 765 regular employees, 526 (68.8%) are represented by three collective bargaining units with agreements in effect until September 15, 1995, March 31, 1996 and June 30, 1996. Employee relations have generally been satisfactory. Item 2. Item 2. Properties The Company's principal gas properties consist of distribution mains, services and meters necessary to maintain reliable service to customers. At the end of 1993, the gas system included 2,739 miles of gas distribution lines, 161,192 services and 237,318 customer meters together with the necessary measuring and regulating equipment. In addition, the Company owns a central headquarters and service building in Southborough, Massachusetts, five district office buildings and various natural gas receiving and take stations. The Company's property is subject to encumbrances under its Indenture of Trust and First Mortgage Bonds. Item 3. Item 3. Legal Proceedings The Company is not a party to any pending material legal proceeding. COMMONWEALTH GAS COMPANY PART II. Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Principal Market Not applicable. The Company is a wholly-owned subsidiary of Commonwealth Energy System. (b) Number of Shareholders at December 31, 1993 One (c) Frequency and Amount of Dividends Declared in 1993 and 1992 1993 1992 Per Share Per Share Declaration Date Amount Declaration Date Amount January 28, 1993 $2.17 April 16, 1992 $3.00 April 15, 1993 3.75 July 16, 1992 1.00 July 15, 1993 .50 $4.00 $6.42 (d) Future dividends may vary depending upon the Company's earnings and capital requirements as well as financial and other conditions existing at that time. COMMONWEALTH GAS COMPANY Item 7. Item 7. Management's Discussion and Analysis of Results of Operations The following is a discussion of certain significant factors which have affected operating revenues, expenses and net income during the periods included in the accompanying Statements of Income and is presented to facilitate an understanding of the results of operations. This discussion should be read in conjunction with the Notes to Financial Statements filed under Item 8 Item 8. Financial Statements and Supplementary Data The Company's financial statements required by this item are filed herewith on pages 13 through 31 of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. COMMONWEALTH GAS COMPANY FORM 10-K DECEMBER 31, 1993 Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Commonwealth Gas Company: We have audited the accompanying balance sheets of COMMONWEALTH GAS COMPANY (a Massachusetts corporation and wholly-owned subsidiary of Commonwealth Energy System) 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 Commonwealth Gas Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, effective January 1, 1993, the Company changed its method of accounting for costs associated with 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 listed in the index to financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Arthur Andersen & Co. Boston, Massachusetts, February 17, 1994. COMMONWEALTH GAS COMPANY INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PART II. FINANCIAL STATEMENTS Balance Sheets at December 31, 1993 and 1992 Statements of Income for the Years Ended December 31, 1993, 1992 and Statements of Retained Earnings 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 Financial Statements PART IV. SCHEDULES V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VI Accumulated Depreciation of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 VIII Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992 and 1991 IX Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991 SCHEDULES OMITTED All other schedules are not submitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto. COMMONWEALTH GAS COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS 1993 1992 (Dollars in Thousands) PROPERTY, PLANT AND EQUIPMENT, at original cost $323 607 $304 877 Less - Accumulated depreciation 77 155 72 766 246 452 232 111 Add - Construction work in progress 400 565 246 852 232 676 CURRENT ASSETS Cash 1 297 10 Accounts receivable - Affiliated companies 173 221 Customers, less reserves of $3,162,000 in 1993 and $2,890,000 in 1992 33 066 28 302 Unbilled revenues 29 068 29 070 Inventories, at average cost - Natural gas 25 810 17 906 Materials and supplies 1 979 2 139 Prepaid taxes - Property 2 629 2 329 Income 1 812 6 690 Other 992 1 179 96 826 87 846 DEFERRED CHARGES Order 636 transition costs 21 938 - Other 11 067 7 084 33 005 7 084 $376 683 $327 606 COMMONWEALTH GAS COMPANY BALANCE SHEETS DECEMBER 31, 1993 AND 1992 CAPITALIZATION AND LIABILITIES 1993 1992 (Dollars in Thousands) CAPITALIZATION Common Equity - Common stock, $25 par value - Authorized and outstanding - 2,857,000 shares in 1993 and 2,407,000 in 1992, wholly-owned by Commonwealth Energy System (Parent) $ 71 425 $ 60 175 Amounts paid in excess of par value 27 739 20 989 Retained earnings 7 840 6 994 107 004 88 158 Long-term debt, including premiums, less current sinking fund requirements and maturing debt (Note 3) 95 400 64 050 202 404 152 207 CURRENT LIABILITIES Interim Financing (Note 3) - Notes payable to banks 40 975 52 475 Advances from affiliates 2 835 8 540 43 810 61 015 Other Current Liabilities - Current sinking fund requirements 3 650 3 650 Accounts payable - Affiliated companies 1 811 1 610 Other 32 944 38 712 Refundable gas costs (Note 1) 13 253 7 824 Customer deposits 1 440 1 441 Accrued local property and other taxes 2 940 2 583 Accrued interest 774 781 Other 4 447 3 617 61 259 60 218 105 069 121 233 DEFERRED CREDITS Accumulated deferred income taxes 30 176 27 120 Unamortized investment tax credits 6 270 6 480 Order 636 transition costs 13 133 - Other 19 631 20 565 69 210 54 165 COMMITMENTS AND CONTINGENCIES (Notes 5 and 8) $376 683 $327 606 The accompanying notes are an integral part of these financial statements. COMMONWEALTH GAS COMPANY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) GAS OPERATING REVENUES $304 129 $297 233 $258 235 OPERATING EXPENSES Cost of gas sold 167 607 164 871 152 890 Other operation 71 380 69 126 62 926 Maintenance 11 929 11 611 11 608 Depreciation 8 939 8 270 7 910 Amortization 1 629 3 224 2 861 Taxes - Income (Note 2) 9 843 8 578 1 355 Local property 4 865 4 608 3 008 Payroll and other 2 779 2 632 2 755 278 971 272 920 245 313 OPERATING INCOME 25 158 24 313 12 922 OTHER INCOME (EXPENSE) 637 297 (111) INCOME BEFORE INTEREST CHARGES 25 795 24 610 12 811 INTEREST CHARGES Long-term debt 6 345 7 004 7 523 Other interest charges 3 170 2 769 2 176 Allowance for borrowed funds used during construction (19) (18) (8) 9 496 9 755 9 691 NET INCOME $ 16 299 $ 14 855 $ 3 120 The accompanying notes are an integral part of these financial statements. COMMONWEALTH GAS COMPANY STATEMENTS OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) Balance at beginning of year $ 6 994 $ 1 767 $ 4 063 Add (Deduct) Net income 16 299 14 855 3 120 Cash dividends on common stock (15 453) (9 628) (5 416) Balance at end of year $ 7 840 $ 6 994 $ 1 767 The accompanying notes are an integral part of these financial statements. COMMONWEALTH GAS COMPANY STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 (Dollars in Thousands) OPERATING ACTIVITIES Net income $16 299 $14 855 $ 3 120 Effects of non-cash items - Depreciation and amortization 11 363 12 100 11 296 Deferred income taxes 8 018 1 478 453 Investment tax credits (210) (217) (224) Change in working capital exclusive of cash and interim financing - Accounts receivable and unbilled revenues (4 714) (4 544) (13 472) Prepaid income taxes 4 878 729 147 Local property and other taxes, net 57 136 85 Accounts payable and other (6 873) 3 032 (9 620) Uncollected postretirement benefits costs (3 062) - - Uncollected Order 636 costs (8 805) - - All other operating items (9 065) (3 003) (2 276) Net cash provided by (used for) operating activities 7 886 24 566 (10 491) INVESTING ACTIVITIES Additions to property, plant and equipment (exclusive of AFUDC) (23 272) (20 437) (17 122) Allowance for borrowed funds used during construction (19) (18) (8) Net cash used for investing activities (23 291) (20 455) (17 130) FINANCING ACTIVITIES Sale of common stock to Parent 18 000 - - Payment of dividends (15 453) (9 628) (5 416) Proceeds from (payment of) short-term borrowings (11 500) 14 875 6 675 Proceeds from (payment of) affiliate borrowings (5 705) 3 275 5 265 Retirement of long-term debt through sinking funds (3 650) (3 657) (3 913) Long-term debt issues refunded - (9 110) - Long-term debt issues 35 000 - 25 000 Net cash provided by (used for) financing activities 16 692 (4 245) 27 611 Net increase (decrease) in cash 1 287 (134) (10) Cash at beginning of period 10 144 154 Cash at end of period $ 1 297 $ 10 $ 144 Supplemental Disclosures of Cash Flow Information Cash paid (received) during the period for: Interest (net of amounts capitalized) $ 8 797 $ 9 377 $ 8 733 Income taxes $ 3 133 $ 6 167 $ (668) The accompanying notes are an integral part of these financial statements. COMMONWEALTH GAS COMPANY NOTES TO FINANCIAL STATEMENTS (1) Significant Accounting Policies (a) General and Regulatory Commonwealth Gas Company (the Company) is a wholly-owned subsidiary of Commonwealth Energy System. The parent company is referred to in this report as the "System" and together with its subsidiaries, is referred to as "the system." The Company is regulated as to rates, accounting and other matters by the Massachusetts Department of Public Utilities (DPU). The System is an exempt holding company under the provisions of the Public Utility Holding Company Act of 1935 and, in addition to its investment in the Company, has interests in other utility companies and several non-regulated companies. The Company has established various regulatory assets in cases where the DPU has permitted, or is expected to permit, recovery of specific costs over time. At December 31, 1993, principal regulatory assets included in deferred charges were $21.9 million for transition costs associated with FERC Order No. 636 and $3.1 million for postretirement benefits costs. In addition, a regulatory liability related to income taxes, amounting to $10 million, was reflected in deferred credits. (b) Reclassifications Certain prior year amounts are reclassified from time to time to conform with the presentation used in the current year's financial statements. (c) Transactions with Affiliates Operating revenues include sales of gas to affiliated companies as follows: (Dollars in Thousands) 1993 Cost Margin Total Cambridge Electric $1 311 $ 76 $1 387 Cambridge Electric $1 784 $ 334 $2 118 Commonwealth Electric 100 5 105 $1 884 $ 339 $2 223 Cambridge Electric $4 207 $ 501 $4 708 Commonwealth Electric 1 195 93 1 288 $5 402 $ 594 $5 996 The margin realized on these sales together with that realized from non- affiliate interruptible sales is credited to firm customers through the Cost of Gas Adjustment Clause (CGA). COMMONWEALTH GAS COMPANY Other intercompany transactions include payments by the Company for management, accounting, data processing and other services provided by COM/Energy Services Company. In addition, the Company incurred costs paid to affiliate Hopkinton LNG Corp. for liquefaction and vaporization services that amounted to $9,587,000, $8,683,000 and $8,319,000 in 1993, 1992 and 1991, respectively. Transactions with other system companies are subject to review by the DPU. (d) Operating Revenues Customers are billed for their use of gas on a cycle basis throughout the month. To reflect revenues in the proper period, the estimated amount of unbilled sales revenue is recorded each month. The Company is permitted to bill customers currently for total gas costs, certain conservation and load management costs and environmental costs through adjustment clauses. Amounts recoverable under the adjustment clauses are subject to review and adjustment by the DPU. The amount of such costs incurred by the Company but not yet reflected in customers' bills is recorded as unbilled revenues. However, as of December 31, 1993 and 1992, the Company had overcollected $13,253,000 and $7,824,000, respectively, which is reflected as a liability in the accompanying Balance Sheets. These overcollected amounts, which include interest, are returned to customers in subsequent months. (e) Depreciation Depreciation is provided using the straight-line method at rates intended to amortize the original cost and the estimated cost of removal less salvage of properties over their estimated economic lives. The Company's composite depreciation rate, based on average depreciable property in service, was 2.95% in 1993, 2.90% in 1992 and 2.94% in 1991. (f) Maintenance Expenditures for repairs of property and replacement and renewal of items determined to be less than units of property are charged to maintenance expense. Additions, replacements and renewals of property considered to be units of property are charged to the appropriate plant accounts. Upon retirement, accumulated depreciation is charged with the original cost of property units and the cost of removal less salvage. (g) Allowance for Funds Used During Construction Under applicable rate-making practices, the Company is permitted to include an allowance for funds used during construction (AFUDC) as an element of its depreciable property costs. This allowance is based on the amount of construction work in progress that is not included in the rate base on which the Company earns a return. An amount equal to the AFUDC capitalized in the current period is reflected in the accompanying Statements of Income. While AFUDC does not provide funds currently, these amounts are recoverable in revenues over the service life of the constructed property. The amount of AFUDC recorded was at a weighted average rate of 3.5% in 1993, 4.25% in 1992 and 6.25% in 1991. COMMONWEALTH GAS COMPANY (2) Income Taxes For financial reporting purposes, the Company provides federal and state income taxes on a separate return basis. However, for federal income tax purposes, the Company's taxable income and deductions are included in the consolidated income tax return of the System and it makes tax payments or receives refunds on the basis of its tax attributes in the tax return in accordance with applicable regulations. The following is a summary of the provisions for income taxes for the years ended December 31, 1993, 1992 and 1991: 1993 1992 1991 (Dollars in Thousands) Federal - Current $1 619 $6 093 $ 964 Deferred 6 956 1 422 283 Investment tax credits (210) (217) (224) 8 365 7 298 1 023 State - Current 416 1 224 162 Deferred 1 278 343 170 1 694 1 567 332 10 059 8 865 1 355 Amortization of regulatory liability relating to deferred income taxes (216) (287) - Total federal and state income taxes $ 9 843 $ 8 578 $ 1 355 Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect in the year in which the differences are expected to reverse. Accumulated deferred income taxes consisted of the following in 1993 and 1992: COMMONWEALTH GAS COMPANY 1993 1992 (Dollars in Thousands) Liabilities Property-related $37 230 $34 483 Order 636 transition costs, net 3 450 - Postretirement benefits plan 1 422 - All other 1 419 1 763 43 521 36 246 Assets Investment tax credit 4 047 4 021 Pension plan 2 284 1 843 Regulatory liability 3 006 3 342 Inventory repricing 2 946 3 980 All other 2 785 3 428 15 068 16 614 Accumulated deferred income taxes, net $28 453 $19 632 The net year-end deferred income tax liability above is net of a current deferred tax asset of $1,723,000 in 1993 and $7,488,000 in 1992 which was included in prepaid income taxes in the accompanying Balance Sheets. The following table, detailing the significant timing differences for 1991 which resulted in deferred income taxes, is required to be disclosed pursuant to accounting standards in effect prior to adoption of SFAS No. 109: (Dollars in Thousands) Accelerated depreciation for tax purposes $ 2 775 Capitalized interest during construction (20) Contributions in aid of construction (163) Capitalized leases (310) Repricing LNG inventory (1 025) Provision for bad debts (120) Pension costs and deferred compensation (302) Conservation and load management 167 Other (549) Deferred income tax provision $ 453 The total income tax provision set forth on the previous page represents 38% in 1993, 37% in 1992 and 30% in 1991 of income before such taxes. The following table reconciles the statutory federal income tax rate to these percentages: 1993 1992 1991 Statutory federal income tax rate 35% 34% 34% Increase (Decrease) from statutory rate: State tax net of federal tax benefit 4 5 5 Amortization of investment tax credits (1) (1) (5) Amortization of excess deferred reserves - (1) (3) Other - - (1) 38% 37% 30% COMMONWEALTH GAS COMPANY As a result of the Revenue Reconciliation Act of 1993, the Company's federal income tax rate was increased to 35% effective January 1, 1993. (3) Long-Term Debt and Interim Financing (a) Long-Term Debt Long-term debt outstanding, exclusive of current maturities, current sinking fund requirements and related premiums and discounts, collateralized by substantially all of the Company's property, is as follows: Original Balance December 31, Issue 1993 1992 (Dollars in Thousands) First Mortgage Bonds - 8.99%, Series H, due 1996 $10 000 $10 000 $10 000 8.99%, Series I, due 2001 40 000 25 400 29 050 9.95%, Series J, due 2020 25 000 25 000 25 000 7.11%, Series K, due 2033 35 000 35 000 - $95 400 $64 050 Under terms of its indenture, the Company is required to make periodic sinking fund payments for retirement of outstanding long-term debt. The Company may purchase its outstanding bonds in advance of sinking fund requirements under favorable conditions. The required sinking fund payments and balances of maturing debt issues for the five years subsequent to December 31, 1993 are as follows: Sinking Fund Maturing Debt Year Requirements Issues Total (Dollars in Thousands) 1994 $3 650 $ - $ 3 650 1995 3 650 - 3 650 1996 3 650 10 000 13 650 1997 3 650 - 3 650 1998 3 650 - 3 650 (b) Notes Payable to Banks The Company and other system companies maintain both committed and uncommitted lines of credit for the financing of their construction programs, on a short-term basis, and for other corporate purposes. As of December 31, 1993, system companies had $115 million of committed lines of credit that will expire at varying intervals in 1994. These lines are normally renewed upon expiration and require annual fees ranging from zero to .1875% of the individual line. At December 31, 1993, the uncommitted lines of credit totaled $70 million. Interest rates on the outstanding borrowings generally are at an adjusted money market rate. The Company's notes payable to banks totaled $40,975,000 and $52,475,000 at December 31, 1993 and 1992, respectively. COMMONWEALTH GAS COMPANY (c) Advances from Affiliates The Company had short-term notes payable to the System totaling $355,000 and $5,780,000 at December 31, 1993 and 1992, respectively. These notes are written for a term of eleven months and twenty-nine days. Interest is at the prime rate (6% at December 31, 1993 and 1992) and is adjusted for changes in the rate during the term of the notes. The Company is a member of the COM/Energy Money Pool (the Pool), an arrangement among the subsidiaries of the System, whereby short-term cash surpluses are used to help meet the short-term borrowing needs of the utility subsidiaries. In general, lenders to the Pool receive a higher rate of return than they otherwise would on such investments, while borrowers pay a lower interest rate than that available from banks. The Company had borrowings from the Pool of $2,480,000 and $2,760,000 at December 31, 1993 and 1992, respectively. (d) Disclosures about Fair Value of Financial Instruments As required by Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the fair value of certain financial instruments included in the accompanying Balance Sheets as of December 31, 1993 and 1992 are as follows: 1993 1992 (Dollars in Thousands) Carrying Fair Carrying Fair Value Value Value Value Long-Term Debt $99 050 $111 718 $67 700 $74 964 The carrying amount of cash, notes payable to banks and advances from affiliates approximates the fair value because of the short maturity of these financial instruments. The estimated fair value of long-term debt is based upon quoted market prices of the same or similar issues or on the current rates offered for debt with the same remaining maturity. The fair values shown above do not purport to represent the amounts at which those obligations would be settled. (4) Employee and Postretirement Benefits (a) Pension The Company has a noncontributory pension plan covering substantially all regular employees who have attained the age of 21 and have completed a year of service. Pension benefits are based on an employee's years of service and compensation. The Company makes monthly contributions to the plan consistent with the funding requirements of the Employee Retirement Income Security Act of 1974. COMMONWEALTH GAS COMPANY Components of pension expense were as follows: 1993 1992 1991 (Dollars in Thousands) Service cost $ 1 904 $ 1 720 $ 1 632 Interest cost 6 037 5 478 5 179 Return on plan assets (10 821) (7 278) (13 853) Net amortization and deferral 6 317 3 001 10 387 Total pension expense 3 437 2 921 3 345 Transfers from affiliated companies, net 37 77 72 Less: Amounts capitalized and deferred 328 371 334 Net pension expense $ 3 146 $ 2 627 $ 3 083 The following economic assumptions were used to measure year-end obligations and the estimated pension expense for the subsequent year: 1993 1992 1991 Discount rate 7.25% 8.50% 8.50% Assumed rate of return 8.50 8.50 8.50 Rate of increase in future compensation 4.50 5.50 5.50 Pension expense reflects the use of the projected unit credit method which is also the actuarial cost method used in determining future funding of the plan. The funded status of the Company's pension plan (using a measurement date of December 31) is as follows: 1993 1992 (Dollars in Thousands) Accumulated benefit obligation: Vested $(61 668) $(50 331) Nonvested (8 297) (2 649) $(69 965) $(52 980) Projected benefit obligation $(85 269) $(66 893) Plan assets at fair market value 79 553 71 045 Projected benefit obligation less (greater) than plan assets (5 716) 4 152 Unamortized transition obligation 4 955 5 574 Unrecognized prior service cost 5 115 2 773 Unrecognized gain (9 141) (16 317) Accrued pension cost $ (4 787) $ (3 818) Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect pension expense in future years. The increase in the accumulated benefit obligation and the projected benefit obligation from December 31, 1992 to December 31, 1993 was primarily due to a reduction of the discount rate in light of current interest rates. COMMONWEALTH GAS COMPANY (b) Other Postretirement Benefits Through December 31, 1992, the Company provided postretirement health care and life insurance benefits to all eligible retired employees. Employees became eligible for these benefits if their age plus years of service at retirement equaled 75 or more provided, however, that such service was performed for the Company or another subsidiary of the System. As of January 1, 1993, the Company eliminated postretirement health care benefits for those non-bargaining employees who were less than 40 years of age or had less than 12 years of service at that date. Under certain circumstances, eligible employees are now required to make contributions for postretirement benefits. Certain bargaining employees are also participating under these new eligibility requirements. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No.106). This new standard requires the accrual of the expected cost of such benefits during the employees' years of service and the recognition of an actuarially determined postretirement benefit obligation earned by existing retirees. The assumptions and calculations involved in determining the accrual and the accumulated postretirement benefit obligation (APBO) closely parallel pension accounting requirements. The cumulative effect of implementation of SFAS No. 106 as of January 1, 1993 was approximately $34 million which is being amortized over 20 years. Prior to 1993, the cost of postretirement benefits was recognized as the benefits were paid. The cost of retiree medical care and life insurance benefits under the traditional pay-as-you-go method totaled $1,910,000 in 1992 and $1,603,000 in 1991. In 1993, the Company began making contributions to various voluntary employee beneficiary association (VEBA) trusts that were established pursuant to section 501(c)9 of the Internal Revenue Code (the Code). The Company also made contributions to a sub-account of its pension plan pursuant to section 401(h) of the Code to satisfy a portion of its postretirement benefit obligation. The Company contributed approximately $3,780,000 to these trusts during 1993. The net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components: (Dollars in Thousands) Service cost $ 535 Interest cost 2 858 Return on plan assets (203) Amortization of transition obligation over 20 years 1 700 Net amortization and deferral 22 Total postretirement benefit cost 4 912 Less: Amounts capitalized and deferred 3 196 Net postretirement benefit cost $ 1 716 COMMONWEALTH GAS COMPANY The funded status of the Company's postretirement benefit plan using a measurement date of December 31, 1993 is as follows: (Dollars in Thousands) Accumulated postretirement benefit obligation: Retirees $(20 779) Active participants (14 999) (35 778) Plan assets at fair market value 3 296 Projected postretirement benefit obligation greater than plan assets (32 482) Unamortized transition obligation 32 304 Unrecognized gain 178 $ - In determining its estimated APBO and the funded status of the plan, the Company assumed a discount rate of 7.25%, an expected long-term rate of return on plan assets of 8.5%, and a medical care cost trend rate of 9%, which gradually decreases to 5% in the year 2007 and remains at that level thereafter. The estimate also reflects a trend rate of 14.9% for reimbursement of Medicare Part B premiums which decreases to 5% by 2007 and a dental care trend rate of 5% in all years. A one percent change in the medical trend rate would have a $479,000 impact on the Company's annual expense (interest component-$357,000; service cost-$122,000) and would change the accumulated benefit obligation by approximately $4.4 million. Plan assets consist primarily of fixed income and equity securities. Fluctuations in the fair market value of plan assets will affect postretirement benefit expense in future years. The DPU's policy on postretirement benefits is to allow in rates the maximum tax deductible contributions made to trusts that have been established specifically to pay postretirement benefits. The Company intends to seek recovery in their next rate proceeding. While the Company is unable to predict the outcome of these rate proceedings, it believes the DPU will authorize similar rate treatment as provided to Cambridge Electric and other Massachusetts electric and gas companies for the recovery of the cost of these benefits. Further, based on recent DPU action and discussions with regulators, the Company believes that it is appropriate to record the difference between the amount included in rates and SFAS No. 106 costs as a regulatory asset. At December 31, 1993, this deferral amounted to approximately $3,062,000. (c) Savings Plan The Company has an Employees Savings Plan that provides for Company contributions equal to contributions by eligible employees of up to four percent of each employee's compensation rate. Effective January 1, 1993, the rate was increased to five percent for those employees no longer eligible for postretirement benefits other than pensions. The Company's contribution was $1,444,000 in 1993, $1,284,000 in 1992 and $1,207,000 in 1991. COMMONWEALTH GAS COMPANY (5) Commitments and Contingencies (a) Construction and Financing Program The Company is engaged in a continuous construction program presently estimated at $112.4 million for the five-year period 1994 through 1998. Of that amount, $21.9 million is estimated for 1994. The program is subject to periodic review and revision because of factors such as changes in business conditions, rates of customer growth, effects of inflation, equipment delivery schedules, licensing delays, availability and cost of capital and environmental factors. The Company expects to finance future expenditures on an interim basis with internally generated funds and short-term borrowings which are ultimately expected to be repaid with the proceeds from the issuance of long-term debt and/or equity securities. (b) LNG Service Contract The Company has contracted with Hopkinton LNG Corp., a wholly-owned subsidiary of the System, for liquefaction and vaporization services over a period ending in 1996, thereafter renewable year to year with notice of termination due five years in advance. The Company is obligated to pay demand charges throughout the contract periods in addition to charges for operating costs. (c) FERC Order No. 636 On April 8, 1992, the Federal Energy Regulatory Commission (FERC) issued Order No. 636 (Order 636), requiring interstate pipelines to unbundle (separate) existing gas sales contracts into separate components (gas sales, transportation and storage services). Order 636 provides mechanisms that will allow customers such as the Company to reduce the level of firm services from pipelines and permits the "brokering" of excess capacity on a temporary or permanent basis. Order 636 also requires pipelines to provide transportation services which allow customers to receive the same level of service they had with bundled contracts. Pipelines were required to be operating under Order 636 by November 1, 1993. As a result of implementing Order 636, each pipeline company is allowed to collect certain "transition costs" from their customers. The Company has been billed a total of approximately $16.9 million from Tennessee Gas Pipeline Company, Algonquin Gas Transmission Company and Texas Eastern Transmission Company through December 31, 1993. It is anticipated that as much as $45 million in transition costs could be sought by these suppliers through a series of FERC filings over the 12 to 24 month period that began on June 1, 1993. The largest element of the aforementioned transition costs results from the pipelines' need to buy out gas supply contracts entered into prior to Order 636. The total amount of such costs ultimately billed to the Company will vary depending on the success of the pipelines in negotiating settlements with their former suppliers, and final review by the FERC. The Company is actively reviewing the prudency of transition costs billed in order to minimize costs to its customers. The Company has recorded its estimated liability based on amounts incurred by the respective pipelines as of December 31, 1993. COMMONWEALTH GAS COMPANY On October 29, 1993, the Company received preliminary DPU authorization to recover these costs, with carrying charges, through the CGA over a four- year period that began in November 1993. As a result, a regulatory asset totaling $21.9 million, net of $400,000 recovered during the fourth quarter, was recorded as of December 31, 1993 and reflected in deferred charges. In addition, a related liability of $13.1 million was reflected in deferred credits. Also, approximately $7.9 million of the amount paid to the pipeline companies relates to gas inventory costs being allocated new storage services under Order 636. The Company will recover these inventory costs through the CGA. (6) Gas Refunds During 1993, 1992 and 1991, the Company received refunds from its gas suppliers in settlement of several rate cases which had been pending before the FERC. Operating revenues and the cost of gas sold have been reduced by the amounts refunded to firm customers totaling $6,965,000 in 1993, $7,012,000 in 1992 and $9,409,000 in 1991. (7) Lease Obligations The Company leases equipment and office space under arrangements that are classified as operating leases. These lease agreements are for terms of one year or longer. Leases currently in effect contain no provisions which prohibit the Company from entering into future lease agreements or obligations. Future minimum lease payments, by period and in the aggregate, of non- cancelable operating leases consisted of the following at December 31, 1993: Operating Leases (Dollars in Thousands) 1994 $ 3 183 1995 2 879 1996 1 994 1997 600 1998 159 Beyond 1998 477 Total future minimum lease payments $ 9 292 Total rent expense for all operating leases, except those with terms of a month or less, amounted to $3,435,000 in 1993, $3,171,000 in 1992 and $3,059,000 in 1991. There were no contingent rentals and no sublease rentals for the years 1993, 1992 and 1991. (8) Environmental Matters The Company is subject to laws and regulations administered by federal, state and local authorities relating to the quality of the environment. These regulations authorize federal and state regulatory agencies to identify COMMONWEALTH GAS COMPANY and remediate hazardous waste sites and to seek recovery from statutorily liable parties (usually referred to as potentially responsible parties or PRPs), or to order these PRPs to undertake the clean-up themselves. (Refer to "Environmental Matters" filed under Item 1 of this report for additional information.) COMMONWEALTH GAS COMPANY PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Index to Financial Statements Financial statements and notes thereto of the Company together with the Report of Independent Public Accountants, are filed under Item 8 of this report and listed on the Index to Financial Statements and Schedules (page 14). (a) 2. Index to Financial Statement Schedules Filed herewith at page(s) indicated are financial statement schedules of the Company: Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (pages 40-42). Schedule VI - Accumulated Depreciation of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 (page 43). Schedule VIII - Valuation and Qualifying Accounts - Years Ended December 31, 1993, 1992 and 1991 (page 44). Schedule IX - Short-Term Borrowings - Years Ended December 31, 1993, 1992 and 1991 (page 45). (a) 3. Exhibits: Notes to Exhibits - a. Unless otherwise designated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Securities and Exchange Commission file numbers indicated in parentheses. b. If applicable, as designated by an asterisk, certain documents previously filed by the Company have been disposed of by the Commission pursuant to its Records Control Schedule and are hereby being refiled by the Company. c. During 1981, New Bedford Gas and Edison Light Company sold its gas business and properties to the Company and changed its corporate name to Commonwealth Electric Company. d. The following is a glossary of acronyms used throughout the Exhibit Index: COMMONWEALTH GAS COMPANY AGT Algonquin Gas Transmission Company CE Commonwealth Electric Company CEC Canal Electric Company CEL Cambridge Electric Light Company CES Commonwealth Energy System CG Commonwealth Gas Company CNG CNG Transmission Corporation CRC Citizens Resources Corporation HOPCO Hopkinton LNG Corp. NBGEL New Bedford Gas and Edison Light Company TET Texas Eastern Transmission Corporation TGP Tennessee Gas Pipeline Company TGT Tennessee Gas Transmission Corporation Exhibit Index: Exhibit 3. Articles of incorporation and by-laws. 3.1.1 Articles of incorporation of CG (Exhibit 1 to the CG 1991 Form 10- K, File No. 2-1647). 3.1.2 By-laws of CG, as amended (Exhibit 2 to the CG 1992 Form 10-K, File No. 2-1647). Exhibit 4. Instruments defining the rights of security holders, including indentures. 4.1. Indentures of Trust or Supplemental Indenture of Trust (as filed by the Registrant, except First Supplemental which was filed by the System) 1. Original Indenture on Form S-1 (Feb., 1949) (Exhibit 7(a), File No. 2-7820). 2. First Supplemental on Form S-1 (Mar., 1950) (Exhibit 7(a), File No. 2-8418). 3. Second Supplemental on Form S-1 (Nov., 1952) (Exhibit 4(a)(2), File No. 2-10445). 4. Third Supplemental on Form S-1 (Nov., 1952) (Exhibit 4(a)(3), File No. 2-10445). 5. Fourth Supplemental on Form S-9 (Oct. 1954) (Exhibit 2(b)(5), File No. 2-15089). 6. Fifth Supplemental on Form S-9 (Mar., 1956) (Exhibit 2(b)(6), File No. 2-15089). 7. Sixth Supplemental on Form S-9 (Apr., 1957) (Exhibit 2(b)(7), File No. 2-15089). 8. Seventh Supplemental on Form S-9 (June 1959) (Exhibit 2(b)(8), File No. 2-20532). 9. Eighth Supplemental on Form S-9 (Sept. 1961) (Exhibit 2(b)(9), File No. 2-20532). 10. Ninth Supplemental on Form 8-K (Aug. 1962) (Exhibit A, File No. 2- 1647). 11. Tenth Supplemental on Form 10-K (1970) (Exhibit 2, File No. 2- 1647). COMMONWEALTH GAS COMPANY 12. Eleventh Supplemental on Form S-1 (June, 1972) (Exhibit 4(b)(2), File No. 2-48556). 13. Twelfth Supplemental on Form S-1 (Aug., 1973) (Exhibit 4(b)(3), File No. 2-48556). 14. Thirteenth Supplemental on Form 10-K (1992) (Exhibit 1, File No. 2-1647). 15. Fourteenth Supplemental on Form 10-K (1990) (Exhibit 1, File No. 2-1647). 16. Fifteenth Supplemental on Form 10-K (1982) (Exhibit 1, File No. 2- 1647). 17. Sixteenth Supplemental on Form 10-K (1986) (Exhibit 1, File No. 2- 1647). 18. Seventeenth Supplemental on Form 10-K (1990) (Exhibit 2, File No. 2-1647). Exhibit 10. Material Contracts. 10.1. Natural Gas Purchase Contracts. 10.1.1 Natural gas purchase contracts between AGT and NBGEL dated October 28, 1969 and August 14, 1968 for Firm and Winter Service, respectively (Exhibits 1 and 2 to the CG 1984 Form 10-K, File No. 2-1647). 10.1.2 Natural gas purchase contracts between AGT and CG dated July 10, 1972 for Firm and Winter Service applicable to Rate Schedule WS-1 (Exhibits 3 and 4 to the CG 1984 Form 10-K, File No. 2-1647). 10.1.3 Gas Service Contract between HOPCO and NBGEL dated September 1, 1971 for the performance of liquefaction, storage and vaporization services and the operation and maintenance of an LNG Facility located at Acushnet, MA (Exhibit 8 to the CG 1984 Form 10-K, File No. 2-1647). 10.1.3.1 Supplement 1 to Gas Service Contract between HOPCO and NBGEL dated September 1, 1973 and September 14, 1977 (Exhibit 5(c)5 to the CES Form S-16 (June 1979), File No. 2-64731). 10.1.4 Gas Service Contract between HOPCO and CG dated September 1, 1971 for the performance of liquefaction, storage and vaporization services and the operation of LNG facilities located in Hopkinton, MA (Exhibit 9 to the CG 1984 Form 10-K, File No. 2-1647). 10.1.4.1 Amendments to 10.1.3 and 10.1.4 as amended December 1, 1976 (Exhibits 2 and 3 to the CG 1986 Form 10-K, File No. 2-1647). 10.1.4.2 Supplement 2 to 10.1.4 dated September 30, 1982 (Exhibit 2 to the CG 1992 Form 10-K, File No. 2-1647). 10.1.5 Supplement 1 to Gas Service Contract between HOPCO and CG dated September 14, 1977 (Exhibit 5(c)6 to the CES Form S-16 (June 1979), File No. 2-64731). COMMONWEALTH GAS COMPANY 10.1.6 Firm Storage Service Transportation Contract by and between TGT and CG providing for firm transportation of natural gas from Consolidated Gas Transmission Corporation dated December 15, 1985 (Exhibit 1 to the CG 1985 Form 10-K, File No. 2-1647). 10.1.7 Agency Agreement for Certain Transportation Arrangements by and between CG and CRC whereby CRC arranges for a third party transportation of natural gas acquired by CG dated April 14, 1986 (Exhibit 1 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.1.8 Natural Gas Sales Agreement between CG and CRC dated April 14, 1986 (Exhibit 2 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.1.9 Gas Sales Agreement by and between Enron Gas Marketing, Inc. and CG relating to the sale and purchase of natural gas on an interruptible basis, dated June 17, 1986 (Exhibit 3 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.1.10 Agency Agreement for Certain Transportation Arrangements dated June 18, 1985 and Gas Purchase and Sales Agreement dated August 6, 1985 by and between CG and Tenngasco Corporation and other related entities (Exhibit 4 to the CG Form 10-Q (June 1986), File No. 2- 1647). 10.1.11 Service Agreement dated December 14, 1985 and an amendment thereto dated May 15, 1986 by and between TET and CG to receive, transport and deliver to points of delivery natural gas for the account of the CG dated December 14, 1985 (Exhibit 5 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.1.12 Gas Transportation Agreement by and between TET and CG to receive transport and deliver on an interruptible basis, certain quantities of natural gas for the account of CG dated January 31, 1986 (Exhibit 6 to the CG Form 10-Q (June 1986), File No. 2-1647). 10.1.13 Gas Sales Agreement by and between Texas Eastern Gas Trading Company and CG providing for the sale of certain quantities of natural gas to CG dated May 15, 1986 (Exhibit 7 to the CG Form 10- Q (June 1986), File No. 2-1647). 10.1.14 Service Agreement Applicable to Rate Schedule between AGT and CG dated April 11, 1985 for the purchase of certain quantities of natural gas acquired by AGT from Consolidated Gas Supply Corporation (Exhibit 2 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.1.15 Service Agreement Applicable to Rate Schedule between AGT and CG dated April 11, 1985 for the purchase of certain quantities of natural gas acquired by AGT from National Fuel Gas Supply Corporation (Exhibit 3 to the CG Form 10-Q (March 1987), File No. 2-1647). COMMONWEALTH GAS COMPANY 10.1.16 Service Agreement Applicable to Rate Schedule between AGT and CG dated December 26, 1985 for the purchase of certain quantities of natural gas acquired by AGT from TET (Exhibit 4 to the CG Form 10-Q (March 1987), File No. 2-1647). 10.1.17 Service Agreement Applicable to Rate Schedule TS-3 between TET and CG dated April 16, 1987 for Firm natural gas service (Exhibit 1 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.1.18 Natural Gas Sales Agreement between Summit Pipeline and Producing Company and CG dated April 16, 1987 (Exhibit 2 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.1.19 Natural Gas Sales Agreement between Natural Gas Supply Company and CG dated May 12, 1987 (Exhibit 3 to the CG Form 10-Q (June 1987), File No. 2-1647). 10.1.20 Natural Gas Sales Agreement between Stellar Gas Company and CG dated April 15, 1988 (Exhibit 1 to the CG Form 10-Q (March 1988), File No. 2-1647). 10.1.21 1986 Consolidating Supplement to CG Service Contract and NBGEL by and between CG and HOPCO dated December 31, 1986 amending and consolidating the CG Service Contract and the New Bedford Gas Service Contract both as amended December 1, 1976 and supplemented September 14, 1977 (Exhibit 2 to the CG Form 10-Q (March 1988), File No. 2 -1647). 10.1.22 Natural Gas Sales Agreement between Amalgamated Gas Pipeline Company and CG dated April 5, 1988 (Exhibit 1 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.1.23 Natural Gas Sales Agreement between Gulf Ohio Pipeline Corporation and CG dated May 18, 1988 (Exhibit 2 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.1.24 Natural Gas Sales Agreement between Phillips Petroleum Company and CG dated May 18, 1988 (Exhibit 3 to the CG Form 10-Q (June 1988), File No. 2-1647). 10.1.25 Service Agreement dated May 19, 1988, by and between TET and CG, whereby TET agrees to receive, transport and deliver natural gas to CG (Exhibit 1 to the CG Form 10-Q (September 1988), File No. 2- 1647). 10.1.26 Natural Gas Sales Agreement between TXO Gas Marketing Corp. and CG dated April 25, 1988 (Exhibit 1 to the CG 1988 Form 10-K, File No. 2-1647). 10.1.27 Gas Transportation Agreement by and between AGT and CG to receive, transport and deliver certain quantities of natural gas on a firm basis for the account of CG dated December 1, 1988 (Exhibit 2 to the CG 1988 Form 10-K, File No. 2-1647). COMMONWEALTH GAS COMPANY 10.1.28 Natural Gas Sales Agreement between Enermark Gas Gathering Corporation and CG dated January 6, 1989 (Exhibit 3 to the CG 1988 Form 10-K, File No. 2-1647). 10.1.29 Gas Sales Agreement between BP Gas Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated March 31, 1989 with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (March 1989), File No. 2 -1647). 10.1.30 Gas Sales Agreement between Tejas Power Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated February 21, 1989 with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (March 1989), File No. 2-1647). 10.1.31 Gas Sales Agreement between Catamount Natural Gas, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated April 5, 1988, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.1.32 Gas Sales Agreement between Transco Energy Marketing Company (seller) and CG (purchaser) for the purchase of spot market gas, dated March 1, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.1.33 Gas Storage Agreement between Steuben Gas Storage Company and CG (customer) for the storage and delivery of customer's natural gas to and from underground gas storage facilities, dated May 23, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.1.34 Gas Sales Agreement between V.H.C. Gas Systems, L.P. (seller) and CG (purchaser) for the purchase of spot market gas, dated June 2, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (June 1989), File No. 2-1647). 10.1.35 Gas Sales Agreement between End-Users Supply System (seller) and CG (purchaser) for the purchase of spot market gas, dated June 29, 1989, with a contract term of at least one year (Exhibit 1 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.1.36 Gas Sales Agreement between Entrade Corporation (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 2 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.1.36.1 Amendment to 10.1.36 dated August 28, 1989 (Exhibit 5 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.1.37 Gas Sales Agreement between Fina Oil and Chemical Company (seller) and CG (purchaser) for the purchase of spot market gas, dated July 10, 1989, with a contract term of at least one year (Exhibit 3 to the CG Form 10-Q (September 1989), File No. 2-1647). COMMONWEALTH GAS COMPANY 10.1.38 Gas Sales Agreement between Mobil Natural Gas, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated August 14, 1989, with a contract term of at least one year (Exhibit 4 to the CG Form 10-Q (September 1989), File No. 2-1647). 10.1.39 Gas Sales Agreement between PSI, Inc. (seller) and CG (purchaser) for the purchase of spot market gas, dated September 25, 1989, with a contract term of at least one year (Exhibit 1 to the CG 1989 Form 10-K, File No. 2-1647). 10.1.40 Gas Sales Agreement between Hadson Gas Systems (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least six years (Exhibit 1 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.1.41 Gas Sales Agreement between Odeco Oil Company (seller) and CG (purchaser) for the purchase of firm gas, dated August 15, 1990, with a contract term of at least five years (Exhibit 2 to the CG Form 10-Q (September 1990), File No. 2-1647). 10.1.42 AGT, CG, and Distrigas of Massachusetts Corporation have entered into an agreement in connection with the deliveries of regasified liquified natural gas into the Algonquin J-system dated August 1, 1990 (Exhibit 3 to the CG Form 10-Q (September 1990), File No. 2- 1647). 10.1.43 Gas Sales Agreement between TEX/CON Marketing Gas Company (seller) and CG (purchaser) for the purchase of firm gas, dated September 12, 1990, with a contract term of five years (Exhibit 3 to the CG 1990 Form 10-K, File No. 2-1647). 10.1.44 Transportation Agreement between AGT and CG to provide for firm transportation of natural gas on a daily basis, dated December 1, 1988 (Exhibit 3 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.45 Transportation Assignment Agreement between AGT and CG regarding Rate Schedule ATAP Agreement No. 9020016 which provides for the assignment, on an interruptible basis, of firm service rights on TET's system under Rate Schedule FT-1, dated January 3, 1990, for a term ending October 31, 1999 (Exhibit 4 to the CG 1991 Form 10- K, File No. 2-1647). 10.1.46 Gas Sales Agreement between AGT and CG to reduce the volume of Rate Schedule, dated October 15, 1990 (Exhibit 5 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.47 Transportation Agreement between AGT and CG for Rate Schedule AFT- 1, Agreement No. 90103, dated November 1, 1990 (Exhibit 6 to the CG 1991 Form 10-K, File No. 2-1647). COMMONWEALTH GAS COMPANY 10.1.48 Transportation Assignment Agreement between AGT and CG regarding Rate Schedule ATAP Agreement No. 90202, which provides for the assignment, on a firm basis, of firm service rights on TET's system under Rate Schedule FT-1, dated November 1, 1990 (Exhibit 7 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.49 Gas Sales Agreement Between TGP and CG under TGP's CD-6 Rate Schedules dated September 1, 1991, (Exhibit 8 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.50 Transportation Agreement between TGP and CG dated September 1, 1991 (Exhibit 9 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.51 Transportation Agreement between CNG and CG to provide for transportation of natural gas on a daily basis from Steuben Gas Storage Company to TGP, dated September 24, 1991 (Exhibit 10 to the CG 1991 Form 10-K, File No. 2-1647). 10.1.52 Service Line Agreement by and between CG and Milford Power Limited Partnership dated March 12, 1992 for a term ending January 1, 2013 (Exhibit 1 to the CG Form 10-Q (March 1992), File No. 2-1647). 10.2 Other Agreements. 10.2.1 Pension Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Filed as Exhibit 1 to the System's Form 10-Q (September 1993), File No. 1-7316). 10.2.2 Employees Savings Plan for Employees of Commonwealth Energy System and Subsidiary Companies as amended and restated January 1, 1993 (Filed as Exhibit 2 to the System's Form 10-Q (September 1993), File No. 1-7316). (b) Reports on Form 8-K. No reports on Form 8-K were filed during the three months ended December 31, 1993. SCHEDULE VIII COMMONWEALTH GAS COMPANY VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Balance Provision Deductions Balance Beginning Charged to Accounts at End Description of Year Operations Recoveries Written Off of Year Allowance for Doubtful Accounts Year Ended December 31, 1993 $ 2 890 $ 5 585 $1 079 $ 6 392 $ 3 162 Year Ended December 31, 1992 $ 2 271 $ 5 678 $ 1 063 $ 6 122 $ 2 890 Year Ended December 31, 1991 $ 1 878 $ 5 208 $ 952 $ 5 767 $ 2 271 SCHEDULE IX COMMONWEALTH GAS COMPANY SHORT-TERM BORROWINGS (A) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Maximum Weighted Weighted Month-End Average Average Category of Average Amount Amount Interest Aggregate Balance Interest Outstanding Outstanding Rate Short-Term at End Rate at End During During the During the Borrowings of Period of Period the Period Period(B) Period(C) December 31, 1993 Notes Payable to Banks $40 975 3.3% $74 225 $49 133 3.3% Notes Payable to System $ 355 6.0% $ 9 630 $ 2 375 6.0% COM/Energy Money Pool $ 2 480 3.2% $18 640 $ 8 370 3.2% December 31, 1992 Notes Payable to Banks $52 475 3.8% $52 475 $29 460 4.0% Notes Payable to System $ 5 780 6.0% $ 6 260 $ 2 825 6.2% COM/Energy Money Pool $ 2 760 3.4% $ 2 760 $ 1 406 3.7% December 31, 1991 Notes Payable to Banks $37 600 5.6% $39 025 $17 365 6.3% Notes Payable to System $ 3 725 6.5% $ 3 725 $ 679 7.5% COM/Energy Money Pool $ 1 540 4.6% $ 1 540 $ 458 5.7% (A) Refer to Note 3 of Notes to Financial Statements filed under Item 8 of this report for the general terms of each category of short-term borrowings. (B) The average amount outstanding during the period is determined by averaging the level of month-end principal balances outstanding for the prior thirteen-month period ending December 31. (C) The weighted average interest rate during the period is determined by averaging the interest rates in effect on all loans transacted for the twelve-month period ended December 31. COMMONWEALTH GAS COMPANY FORM 10-K 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. COMMONWEALTH GAS COMPANY (Registrant) By: WILLIAM G. POIST William G. Poist, 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. Principal Executive Officers: WILLIAM G. POIST March 30, 1994 William G. Poist, Chairman of the Board and Chief Executive Officer KENNETH M. MARGOSSIAN March 28, 1994 Kenneth M. Margossian, President and Chief Operating Officer Principal Financial Officer: JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Financial Vice President and Treasurer Principal Accounting Officer: JOHN A. WHALEN March 28, 1994 John A. Whalen, Comptroller A majority of the Board of Directors: WILLIAM G. POIST March 30, 1994 William G. Poist, Director JAMES D. RAPPOLI March 30, 1994 James D. Rappoli, Director KENNETH M. MARGOSSIAN March 28, 1994 Kenneth M. Margossian, Director

203077_1993.txt

203077_1993

1993

203077

Item 1. BUSINESS GENERAL St. Jude Medical, Inc. (the "Company") develops, manufactures and markets medical devices for cardiovascular applications. Its principal product is a mechanical heart valve prosthesis. Based on market information obtained by Company personnel as well as information provided by various industry sources, the Company believes it is the market share leader in the mechanical segment of the worldwide heart valve replacement market. The Company's products are distributed worldwide through a combination of direct sales personnel and independent manufacturers' representatives. The Company operates through three divisions to focus on the management and growth of its established businesses. The St. Jude Medical Division is responsible for the Company's heart valves (mechanical and tissue) and annuloplasty ring products. The Cardiac Assist Division is responsible for the Company's intra-aortic balloon pump and centrifugal pump systems. The International Division is responsible for marketing, sales and distribution of the Company's products in Europe, Africa and the Middle East. Typically, the Company's net sales are somewhat stronger in the first and second quarters and weaker in the third quarter. This results from a tendency by patients to defer, if possible, heart valve replacements during the summer months and from the seasonality of the Western European market where summer vacation schedules normally result in lower orders. Manufacturer representatives place large orders randomly which can distort the net sales pattern noted above. HEART VALVES General. The Company manufactures and markets a bileaflet pyrolytic carbon coated prosthetic heart valve which it designed and first sold in 1977. The purpose of a heart valve is to facilitate the one-way flow of blood through the arteries and heart and prevent significant back flow of blood into the heart. Though the human heart has four valves, the two that are most commonly replaced by prosthetic valves are the aortic and mitral valves. Heart valve replacement may be required where the heart valve has congenital defects, is diseased or is malfunctioning. To-date, over 500,000 St. Jude Medical(R) mechanical heart valves have been implanted worldwide. The first prosthetic heart valves were used in the 1960s and were mechanical valves made primarily of inert materials, such as plastics and fabrics. Mechanical valves were followed by the development of tissue valves made from the heart valve of a pig or the pericardial tissue of a calf. Mechanical valves, especially those utilizing pyrolytic carbon, offer the advantage of longevity because of the durable nature of pyrolytic carbon. These valves also are less susceptible than tissue valves to calcium build-up which may cause valve malfunctions. The primary advantage of tissue valves is that they generally require little or no patient anticoagulant drug therapy to reduce the possibility of clotting. Such therapy is presently indicated for mechanical valves. Physicians will select either a tissue or a mechanical valve depending upon the patient's requirements and the physician's preference. Physician tendency to prescribe mechanical valves rather than tissue valves has resulted in the mechanical segment becoming a larger percentage of the total market through time. In the early 1980s, the heart valve market was evenly split between mechanical valves and tissue valves. In 1993, the Company estimates that mechanical valves were approximately 70% of the market, which is consistent with the 1992 mechanical heart valve share of the total heart valve market. Mechanical Valves. The Company's mechanical heart valve consists of four basic components: two leaflets; the valve body or orifice; and the sewing cuff. St. Jude Medical(R) mechanical heart valves are sold in sizes ranging from 17mm to 33mm in diameter with nine sizes available for the mitral position and eight for the aortic position. The St. Jude Medical(R) mechanical heart valve was the first mechanical valve to utilize 100% pyrolytic carbon coating in the fabrication of the valve body and leaflets. The two leaflets and the valve body are fabricated from a graphite substrate, coated with pyrolytic carbon and then polished. Pyrolytic carbon is utilized because of its extremely hard and durable nature and excellent compatibility with blood. Until 1986, all pyrolytic carbon components were purchased from CarboMedics, Inc. of Austin, Texas ("CMI"). The Company provides a wide range of mechanical heart valve products. Depending upon physician preference, sewing cuffs are made from either polyester fiber or polytetrafluoroethylene fiber. In November 1992, the Company received Food and Drug Administration ("FDA") approval to market its Hemodynamic Plus mechanical heart valve series which provide optimum hemodynamics in patients with a small valvular annulus. In February 1994, the Company received FDA approval to market its collagen impregnated aortic valved graft which combines its aortic heart valve with a collagen impregnated graft and is utilized to replace the aortic heart valve and reconstruct the ascending aorta. In 1982, the Company commenced research in the field of pyrolytic carbon technology, including an effort to determine whether it could manufacture its own heart valve components. This research was deemed necessary to maintain and improve its technological and competitive position within the heart valve industry and to reduce its dependence on its sole supplier. In 1986, the Company's initial production efforts were successful and the Company began selling mechanical heart valves internationally utilizing self-manufactured pyrolytic carbon coated components. Since then, the Company has sold over 90,000 valves made from its own pyrolytic carbon coated components and has made significant improvements in its manufacturing process. The Company is able to produce its own heart valve components pursuant to a license agreement with CMI. See "Suppliers." In May 1991, the Company received FDA approval to domestically market the St. Jude Medical(R) mechanical heart valve as assembled with self-manufactured pyrolytic carbon coated components. With this approval, the Company believes it is the only mechanical heart valve manufacturer with two sources of pyrolytic carbon components. Tissue Valves. The Company acquired the assets and business of BioImplant Canada, Inc., a Canadian manufacturer of tissue heart valves, in 1986. The tissue valve purchased from BioImplant was first implanted in 1978. The BioImplant tissue valve is available in six aortic sizes (21mm through 28mm) and five mitral sizes (27mm through 34mm). The product incorporates a flexible medical grade plastic stent (frame) to provide tissue support and improve handling characteristics during implantation. It is sold outside the United States and is not approved for commercial marketing in the United States. In late 1992, the Company, together with Dr. Tirone David, introduced in the Canadian and selected Western European markets the Toronto SPV tissue heart valve. This is a stentless heart valve which offers the potential for superior hemodynamic performance and increased durability as compared to the current stented designs. The Company filed an IDE application for this valve in 1993 and received FDA approval to begin clinical trials under an IDE in the United States in February 1994. In 1992, the Company, in a joint venture with Hancock Jaffe Laboratories, initiated a program to develop an advanced stented tissue heart valve. The Company expects the first human implant of this valve to take place in the first half of 1994. The joint venture expects to file an IDE application with the FDA by the end of 1994. The Company cannot presently predict the timing or likelihood of obtaining IDE approval for this product. A pre-market approval application for these tissue valve products is expected to be filed with the FDA approximately two years following receipt of IDE approval. See "Government Regulation." ANNULOPLASTY RINGS Annuloplasty rings are prosthetic devices used to repair diseased or damaged mitral heart valves which are determined by the surgeon to be repairable. The Company received FDA authorization to market this product in early 1991. The BiFlex(tm) annuloplasty ring is made from tubular, knitted polyester fabric. It is available in three sizes, 25mm, 30mm and 35mm. The ring can be adjusted either symmetrically or asymmetrically before, during or after placement to produce the desired valve annulus size and configuration. INTRA-AORTIC BALLOON PUMP In December 1988, the Company acquired the assets and business of Aries Medical, Inc., Woburn, Massachusetts, a manufacturer of an intra-aortic balloon pump ("IABP") system. The IABP is a cardiac assist device used to provide temporary support to a weakened or unstable heart. It is used to stabilize heart function before and after open-heart surgery and certain angioplasty procedures. While there are a variety of cardiac assist devices under development, IABPs are the least invasive and the most widely used, commercially available type of cardiac assist device currently on the market. The Model 700 IABP system consists of a control console and a single-use, balloon-tipped catheter. In IABP therapy, the catheter is inserted percutaneously (through the skin), usually into the femoral artery (the chief artery of the thigh). The physician then threads the catheter through the circulatory system to position the balloon in the descending thoracic aorta. Once the balloon is properly positioned, the control console is used to adjust the function of a pump that synchronizes the balloon's inflation and deflation with the contraction and relaxation of the heart's left ventricle. Properly applied, this therapy increases the heart's output and the supply of oxygen- rich blood to the heart while reducing the heart muscle's workload (thereby decreasing the heart muscle's oxygen demand). Over three quarters of annual expenditures on IAB products are for the single-use balloon catheters used with the control consoles. To take advantage of the higher volume portion of the IAB market, the Company's catheters are adaptable for use on competitive IABP consoles. In 1993, the Company introduced its RediGuard 2.0 catheter which eases the guiding and placement process. CENTRIFUGAL PUMP In April 1989, the Company acquired technology relating to a centrifugal pump system from Symbion, Inc., of Salt Lake City, Utah. Centrifugal pumps are used to replace a patient's cardiac function during open heart surgery. Centrifugal pumps are less traumatic to the blood than conventional roller pumps and centrifugal designs reduce the risk of air and tubing emboli entering the blood stream. The Company's Lifestream centrifugal pump system consists of a single-use pump, a control console, a motor drive, flow transducer and probe used to control blood flow. In 1990, the Company introduced the centrifugal pump system after receiving FDA authorization to market the system domestically under the 510(k) pre-market notification procedure for cardiopulmonary bypass products. The Company entered into a distribution agreement with COBE Cardiovascular Inc. (COBE) late in 1992 which was amended in late 1993. This three-year agreement requires COBE to purchase from the Company specified minimum amounts of pumps and flow probes for the domestic, Canadian and Australian markets. The pumps and flow probes will be made part of COBE's sterile custom packs for use in various surgical procedures. Late in 1993, the Company entered into a non-exclusive distribution agreement with COBE for selected European markets. This agreement allows COBE to include the Company's pumps and flow probes in COBE's custom pack units which are distributed in these markets. SUPPLIERS In April 1990, the Company entered into an agreement with CarboMedics, Inc. ("CMI") which covers the supply of heart valve carbon components from 1991 through 1998. Under the agreement, the Company agreed to purchase at least 70% of its carbon component requirements from CMI in 1991, with lesser requirements ranging downward to 48% of its needs in 1995 and, thereafter, 20% of its needs through 1998. In return for the Company's agreement to increase its minimum purchases from those required under an earlier agreement, CMI agreed to price concessions in the current agreement. Prices are fixed under the agreement and escalate through 1995, whereupon the parties have agreed to negotiate prices for the years 1996 through 1998. Prices are adjusted upward if the Company's purchases are less than 95% of scheduled quantities for each year and downward if purchases are 110% or more than such scheduled quantities. If CMI is unable or fails to perform under the agreement, the license permits the Company to meet its own requirements during the supply interruption. The agreement can be extended for additional one year terms after 1998 and the prices the Company would pay in 1999 and beyond will be adjusted annually by a formula established in the agreement. The formula is based upon certain components of the producer price index for intermediate goods published by the United States Department of Labor. In addition, CMI has agreed that it will not discriminate against the Company in the setting of future prices and terms for its supply of heart valve components. See "Patents and Licenses." The Company and CMI are also parties to a patent license agreement pursuant to which the Company can produce its own heart valve components. The license does not provide for an interchange of carbon technology between the two companies but does grant the Company a non-exclusive worldwide license to make carbon coated heart valve components. Royalties were paid on all Company produced heart valve components manufactured prior to September 1993 after which time the license was fully paid. The Company purchases raw material and other items from numerous suppliers for use in connection with the production of its products. The Company maintains sizeable inventories of up to three years of its projected requirements for certain materials, some of which are available only from single source vendors. In 1992, the Company was advised that certain of such vendors were planning to terminate sales of products to customers that manufacture implantable medical devices in an effort to reduce potential product liability exposure. Some vendors have modified their position and have indicated a willingness to either temporarily continue to provide product until such time as an alternative vendor or product can be qualified or to reconsider the supply relationship. While the Company believes that alternative sources of raw materials are available and that there is sufficient lead time in which to qualify such other sources, any supply interruption could have a material adverse effect on the Company's ability to manufacture its products. MARKETING The Company sells its products directly and through independent manufacturers' representative organizations in the United States and throughout the world. The international representatives purchase products and resell them to hospitals. No representative organization or single customer accounted for more than 10% of 1993 net sales. Early in 1987 in the United States, the Company began a phased conversion from a distributor-based sales organization to a direct employee-based sales organization. The domestic conversion was completed in 1989. The Company initiated a direct sales presence in the United Kingdom in January 1990 and commenced direct sales activities in several other European countries in January 1991. In addition, the Company initiated a direct sales presence in the United States for its Cardiac Assist Division in 1991. Such efforts allow Company personnel to interface directly with customers. In the normal course of its business, claims may be made by former distributors whose agreements are terminated or not renewed. The Company is currently involved in distributor litigation and does not regard such litigation as material to its business. Payment terms, worldwide, are consistent with local practice. Orders are shipped as they are received and, therefore, no material back orders exist. COMPETITION The heart valve business is highly competitive. Presently, there are four significant heart valve manufacturers in addition to the Company: Baxter International, Medtronic, Sorin Biomedica and CarboMedics. All competitors offer both tissue and mechanical valves. See "Patents and Licenses." In the domestic market, the Company competes primarily with Medtronic and Baxter. CarboMedics, Inc. received FDA authorization to market its bileaflet mechanical heart valve in the U.S. in the third quarter 1993. Internationally, the Company competes with the principal competitors as well as other smaller manufacturers. Mechanical heart valves currently being marketed by established companies sell domestically in a price range from $3,000 to $4,300. The Company's mechanical heart valve sells at the high end of the domestic price range. When sold outside the United States, valve prices vary significantly by country depending on the country's economic climate and its government reimbursement policies and, in certain instances, mark-ups by international distributors. The Company does not believe the price of its mechanical valve is a significant disadvantage in the domestic market because the valve price represents a relatively small proportion of the overall cost of heart valve surgery. Health care reform and increased competition in the domestic market is putting downward pressure on pricing. Resistance to valve price increases and price limitations imposed by government funded customers is not uncommon overseas. The Company believes price considerations will continue to be a factor in its ability to compete in certain foreign markets. See "Government Regulation." The Company, Medtronic, Sorin Biomedica and Baxter International are the principal participants in the annuloplasty ring market. The primary competitive factors include product performance and ease of implantation. The Company's fully- flexible BiFlex(tm) annuloplasty ring has two adjustable segments which allow the ring to be easily shaped to the valve annulus. Currently, there are five significant IABP manufacturers: the Company, Datascope, the Mansfield Division of Boston Scientific, C.R. Bard and Kontron Instruments, a division of Arrow International. While Datascope is the leading market competitor, all competitors have significant experience in the manufacture and marketing of intra-aortic balloon pump systems. Product performance, ease of use, price and service are the principal competitive factors. Manufacturers of roller pump systems and centrifugal pumps include the Company, Medtronic, 3M, Pfizer, and Gambro. The principal competitive factors in the blood pump market include product performance, safety and price. While roller pump systems are less expensive, centrifugal pump systems offer superior product performance and higher patient safety levels. RESEARCH AND DEVELOPMENT The Company is focusing on the development of new products and improvements to existing products. In addition, research and development expense reflects the Company's efforts to obtain FDA approval of certain products and processes and to maintain the highest quality standards of existing products. The Company's expenditures for research and development were $10,972,000 (4.3% of net sales), $11,478,000 (4.8%) and $8,110,000 (3.9%) in 1993, 1992 and 1991, respectively. GOVERNMENT REGULATION The medical devices manufactured and marketed by the Company are subject to regulation by the FDA and, in some instances, by state and foreign governmental authorities. Under the Federal Food, Drug and Cosmetic Act (the "Act"), and regulations thereunder, manufacturers of medical devices must comply with certain policies and procedures that regulate the composition, labeling, testing, manufacturing, packaging and distribution of medical devices. Medical devices are subject to different levels of government approval requirements, the most comprehensive of which requires the completion of an FDA approved clinical evaluation program and submission and approval of a pre-market approval ("PMA") application before a device may be commercially marketed. The Company's mechanical heart valve was subject to this level of approval. Tissue valves are also subject to this level of approval. The annuloplasty ring, IABP and the centrifugal pump are currently marketed under the 510(k) pre- market notification procedure of the Act. The FDA has advised that companies marketing IABPs will be required to make PMA filings in the future. The Company is preparing to make such a filing and cannot predict when the FDA will call for PMA submission. The FDA has called for a PMA submission for centrifugal pumps. The Company has petitioned the FDA to downclass centrifugal pumps to Class II which, if successful, would eliminate the need to file a PMA. If unsuccessful, the Company is prepared to make a PMA filing. Diagnostic-related groups ("DRG") reimbursement schedules regulate the amount the United States government will reimburse hospitals for the inpatient care of persons covered by Medicare. While the Company has not been aware of significant domestic price resistance directly as a result of DRG reimbursement policies, changes in current DRG reimbursement levels could have an adverse effect on its domestic pricing flexibility. Various proposals to adjust the health care delivery system in the United States are under consideration by the United States Government. Certain specific areas under review include the uninsured population, the rate of growth of health care expenses and the overall size of the health care portion of the total budget consumed by health care costs. It is possible that changes to the existing health care system will be proposed and implemented in 1994. The Company cannot predict the effect, if any, such changes will have on the Company's operating results. PATENTS AND LICENSES The Company's policy is to protect the intellectual property rights in its work on heart valves and other biomedical devices. Where appropriate, the Company applies for United States and foreign patents. In those instances where the Company has acquired technology from third parties, it has sought to obtain rights of ownership to the technology through the acquisition of underlying patents or exclusive licenses. While the Company believes design, development, regulatory and marketing aspects of the medical device business represent the principal barriers to entry into such business, it also recognizes that its patents and license rights may make it more difficult for its competitors to market products similar to those produced by the Company. The Company can give no assurance that any of its patent rights, whether issued, subject to license or in process, will not be circumvented or invalidated. Further, there are numerous existing and pending patents on medical products and biomaterials. Although the Company is unaware of any violation by it of the patent or proprietary rights of others, there can be no assurance that the Company's existing or planned products do not or will not infringe such rights or that others will not claim such infringement. The Company believes it would be able to maintain, against future challenges, the validity of its mechanical heart valve patents and its right thereto. No assurance can be given that the Company will be able to prevent competitors with designs similar to its mechanical heart valve from challenging the Company's patents or from entry into the marketplace. The Company is aware that certain companies, including CMI, have developed mechanical heart valves which have designs similar to the Company's mechanical heart valve design. In 1990, the Company granted CMI a non-exclusive worldwide license to manufacture and sell the CMI mechanical heart valve in return for the payment of royalties in the period from 1991 through July 1998 for those CMI valves sold in the ten countries where the Company has patent protection. The license limits through 1995 the number of valves CMI may sell in the United States. Sorin Biomedica S.p.A. ("Sorin") has also developed a bileaflet heart valve which has a design similar to the Company's mechanical heart valve design and has entered selected international markets with its valve. The Company has commenced litigation against Sorin in France and Germany alleging that the design of the Sorin heart valve infringes the Company's heart valve patents in those countries. Sorin has challenged the validity of the Company's French and German patents. PRODUCT LIABILITY The Company carries insurance coverage for both domestic and international products liability occurrences in amounts which it believes are adequate. In 1986 and 1987, the Company was unable to obtain suitable insurance coverage in amounts it deemed adequate and, therefore, adopted a self-insurance program and established reserves to cover products liability claims pertaining to those years. The Company would be financially responsible for any uninsured claims or claims which exceed its insurance coverage. The Company's products are not marketed with any express warranty provisions. CMI has made no warranty on the valve components it manufactures on behalf of the Company and the Company has agreed to hold CMI harmless in the event claims are made or damages are assessed against CMI as a result of any valve-related litigation. From time to time, the Company receives communications from persons who have received heart valve implants concerning various claims which are generally surgery related. Also, claims relating to the Company's other products have been received. On occasion, these claims evolve into litigation and, in some instances, plaintiffs have sought punitive damages in addition to compensatory damages. In many states, the courts have held that in certain circumstances corporations may not receive insurance proceeds to pay punitive damages awarded in the course of litigation. While the Company believes the likelihood of an award of punitive damages in product liability litigation is remote, any uninsured award of such damages could have an adverse impact on the Company. EMPLOYEES As of December 31, 1993, the Company had 722 full-time employees. It has never experienced a work stoppage as a result of labor disputes and none of its employees is represented by a labor organization. INDUSTRY SEGMENT AND INTERNATIONAL OPERATIONS The medical products and service industry is the single industry segment in which the Company operates. The Company's domestic and foreign net sales, operating profit and identifiable assets, and its export sales to customers are described in Note 6 to the consolidated financial statements on page 28 of the 1993 Annual Report to Shareholders and are incorporated by reference herein. The Company's foreign business is subject to such special risks as exchange controls, currency devaluation, dividend restrictions, the imposition or increase of import or export duties and surtaxes, and international credit or financial problems. Since its international operations require the Company to hold assets in foreign countries denominated in local currencies, many assets are dependent for their U.S. dollar valuation on the values of a number of foreign currencies in relation to the U.S. dollar. The Company may from time to time enter into purchase and sales contracts in the forward markets for various foreign currencies with the objective of protecting U.S. dollar values of assets and commitments denominated in foreign currencies. Item 2. Item 2. PROPERTIES The Company's principal plant and executive offices are located in St. Paul, Minnesota. Its facilities are as follows: OWNED LEASED LOCATION SQUARE FEET LOCATION SQUARE FEET Domestic Domestic St. Paul, MN 119,000 Caguas, PR 22,000 St. Paul, MN 30,000 Chelmsford, MA 34,000 St. Paul, MN 80,000 St. Paul, MN 9,100 Foreign Foreign Quebec, Canada 8,000 Vienna, Austria 150 Brussels, Belgium 11,000 Paris, France 3,100 Dusseldorf, Germany 4,000 Tokyo, Japan 350 Breda, Netherlands 400 Madrid, Spain 3,000 Basel,Switzerland 250 Coventry, U.K. 2,400 In management's opinion, all buildings and machinery and equipment are in good condition and suitable for their purposes and are maintained and repaired on a basis consistent with sound operations. Management believes that adequate property and casualty insurance is in force with respect to all property. Item 3. Item 3. LEGAL PROCEEDINGS The Company is a named defendant in a purported class action captioned Weisburgh, et al. v. St. Jude Medical, Inc. et al. filed July 2, 1992 in the United States District Court for the District of Minnesota, and later amended. The second amended complaint also names as defendants certain officers and directors alleged to control the Company. The plaintiff purports to represent a class consisting of all persons who purchased common stock of the Company during the period from December 17, 1991 through July 2, 1992. The second amended complaint alleges that the defendants deceived the investing public regarding the Company's finances, financial condition and present and future prospects and induced the plaintiff class to purchase the Company's common stock during the period prior to July 2, 1992 at inflated prices. The second amended complaint asserts claims for federal securities fraud, common law fraud and negligent misrepresentation. The second amended complaint seeks damages (including punitive damages) in an unspecified amount, attorney's fees, costs and expenses. On March 2, 1993, the Company and the other defendants moved to dismiss all claims for failure to state a claim for relief and failure to plead fraud with particularity. In its Order dated May 28, 1993, the court denied the defendant's motion at that time, but directed the plaintiffs to file a second amended complaint, with more particularized allegations of fraud. The plaintiffs have filed a second amended complaint, and on June 28, 1993, the Company and the other defendants moved to dismiss the second amended complaint for failure to state a claim for relief and failure to plead fraud with particularity. The plaintiff has moved for a class certification. Both motions are under advisement. The Company believes that the second amended complaint is without merit and intends to pursue a vigorous defense of the action. The Company is unaware of any other pending legal proceedings which it regards as likely to have a material adverse effect on its business. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. Item 4A. EXECUTIVE OFFICERS OF THE COMPANY NAME AGE POSITION* Ronald A. Matricaria 51 President and Chief Executive Officer (1993) Lawrence A. Lehmkuhl 56 Former President and Chief Executive Officer (1985) Eric W. Sivertson 43 President, St. Jude Medical Division (1992) Todd F. Davenport 43 President, St. Jude Medical International Division (1992) Stephen L. Wilson 41 Vice President, Finance and Chief Financial Officer (1990) Robert S. Elgin 46 Vice President, Operations St. Jude Medical Division (1990) *Dates in brackets indicate period during which officers began serving in such capacity. Executive officers serve at the pleasure of the Board of Directors and are elected annually for one year terms. Mr. Matricaria is a director of the Company and his business experience is set forth in the Company's definitive Proxy Statement dated March 28, 1994 under the Section "Election of Directors." The information is incorporated herein by reference. Mr. Lehmkuhl is a director of the Company and his business experience is set forth in the Company's definitive Proxy Statement dated March 28, 1994 under the section "Election of Directors." The information is incorporated herein by reference. Mr. Sivertson joined the Company in June 1985 as Director of Marketing. In 1986 he became Director of International Sales and held that post until April 1988. He was appointed Vice President of Sales and Marketing in May 1988 and held that position until he was appointed as President of the International Division in February 1990. In August 1992, Mr. Sivertson was appointed President of the St. Jude Medical Division. Prior to joining the Company, Mr. Sivertson spent eight years with American Hospital Supply Corporation in various management positions, including Vice President of Marketing for the Converters Division. Mr. Davenport joined the Company in August 1992 as President, St. Jude Medical International Division. Prior to joining the Company, Mr. Davenport served for two years as Vice President Marketing and Sales for the Edwards Critical-Care Division of Baxter International, Inc., a manufacturer, marketer and distributor of various hospital supply products. From 1986 to 1990, Mr. Davenport was employed by Abiomed, Inc., a cardiac assist device manufacturer and marketer, and most recently was that company's Vice President and General Manager. Prior to joining Abiomed, he spent eleven years in various management positions with Cordis Corporation, a catheter device manufacturer. Mr. Wilson joined the Company in May 1990 as Vice President, Finance and Chief Financial Officer. Prior to joining the Company, Mr. Wilson was Vice President and Controller of The Foxboro Company, a manufacturer and marketer of products for the automation of industrial processes, where he had been employed for five years. Prior to that, he was the Controller of Brown & Sharpe Manufacturing Company, a manufacturer and marketer of metrology products and machine tools, and previously was with Coopers & Lybrand. Mr. Elgin joined the Company in January 1990 as Vice President, Operations of the St. Jude Medical Division. Prior to joining the Company, Mr. Elgin served as the Vice President of Manufacturing for the V. Mueller Division of Baxter International, Inc. From 1982 to 1990, Mr. Elgin held various management positions with American Hospital Supply Corporation and Baxter International, Inc. Mr. Elgin spent nine years in various management capacities with Colt Industries Inc. prior to joining American Hospital Supply Corporation. PART II Item 5. Item 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The information set forth under the captions "Supplemental Market Price Data" and "Cash Dividends" on page 33 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA The information set forth under the caption "Ten Year Summary of Selected Financial Data" on pages 30 and 31 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 17, 18, 19 and 20 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Company and Report of Independent Auditors set forth on pages 21 through 29 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference: Consolidated Statements of Income - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Balance Sheets - December 31, 1993 and December 31, 1992 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, December 31, 1992 and December 31, Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Information on executive officers is set forth in Part I, Item 4A hereto. Item 11. Item 11. EXECUTIVE COMPENSATION The information set forth under the caption "Executive Compensation and Other Information" and "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" and "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) List of documents filed as part of this Report (1) Financial Statements The following consolidated financial statements of the Company and Report of Independent Auditors as set forth on pages 21 through 29 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference: Consolidated Statements of Income - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Balance Sheets - December 31, 1993 and December 31, Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements (2) Financial Statement Schedules The following financial statement schedules are filed as part of this Form 1O-K Report: Schedule Number Description Page Number I Marketable Securities - Other Investments 24 VIII Valuation and Qualifying Accounts 25 X Supplementary Income Statement Information 26 The report of the Company's Independent Auditors with respect to the above-listed financial statements and financial statement schedules appears on page 23 of this Report. All other financial statements and schedules not listed have been omitted because the required information is included in the Consolidated Financial Statements or the Notes thereto, or is not applicable. (3) Exhibits Exhibit Index Page Number 3.1 Articles of Incorporation are incorporated by --- reference to Exhibit 3(a) of the Company's Form 8 filed on August 20, 1987 amending the Company's quarterly report on Form 1O-Q for the quarter ended June 30, 1987 3.2 Bylaws are incorporated by reference to --- Exhibit 3B of the Company's Form S-3 Registration Statement dated September 25, 1986 (Commission File No. 33-8308) 4.1 Amended and Restated Rights Agreement dated as --- of June 26, 1990 between the Company and Norwest Bank Minneapolis, N.A., as Rights Agent including the Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock is incorporated by reference to Exhibit 1 of the Company's Form 8 Amendment 2 to Form 8-A dated July 6, 1990 10.1 Employment letter dated as of March 9, 1993, 28 between the Company and Ronald A. Matricaria* 10.2 Supplemental Executive Retirement Plan and 36 Trust agreement dated April 12, 1993, between the Company and Ronald A. Matricaria* 10.3 Supply Contract and Patent License Agreement --- dated September 6, 1985 between the Company and CarboMedics, Inc. is incorporated by reference to the Company's 8-K Report dated September 20, 1985 10.4 Form of Indemnification Agreement that the --- Company has entered into with officers and directors. Such agreement recites the provisions of Minnesota Statutes Section 302A.521 and the Company's Bylaw provisions (which are substantially identical to the Statute) and is incorporated by reference to Exhibit 1O(d) of the Company's Form 1O-K Annual Report for the year ended December 31, 1986* 10.5 Form of Employment Agreement that the Company --- has entered into with officers relating to severance matters in connection with a change in control is incorporated by reference to the Company's Form 10-K Annual Report for the year ended December 31, 1988* 10.6 Retirement Plan for members of the Board of --- Directors, as amended, is incorporated by reference to exhibit 10.5 of the Company's Form 10-K Annual Report for the year ended December 31, 1992* 10.7 Deferred Compensation Plan dated December 2, --- 1986 is incorporated by reference to the Company's Form 10-K Annual Report for the year ended December 31, 1987* 10.8 Supplemental Executive Retirement Plan 75 agreement dated September 30, 1988, and as restated on April 9, 1993, between the Company and Lawrence A. Lehmkuhl* 10.9 1989 Restricted Stock Plan is incorporated by --- reference to the Company's Form S-8 Registration Statement dated June 6, 1989 (Commission File No. 33-29085)* 10.10 Management Incentive Compensation Plan* 81 10.11 Supply Contract dated April 17, 1990 between --- the Company and CarboMedics, Inc. (portions of this exhibit have been deleted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2) is incorporated by reference to the Company's Form 8 filed on April 19, 1990 amending the Company's Form 10-K Annual Report for the year ended December 31, 1989 11 Computation of Earnings Per Share 90 13 1993 Annual Report to Shareholders. Except 91 for those portions of such report expressly incorporated by reference in this Form 1O-K Report, the Annual Report is not deemed to be "filed" with the Securities and Exchange Commission 21 Subsidiaries of the Company 127 23 Consent of Independent Auditors 128 *Management contract or compensatory plan or arrangement. (b) Reports on Form 8-K during the quarter ended December 31, 1993 Reports on Form 8-K filed by the Company during the fourth quarter 1993: Form 8-K dated December 1993 Item 2. Acquisition or Disposition of Assets - Acquisition of Electromedics, Inc. (c) Exhibits: Reference is made to Item 14(a)(3). (d) Schedules: Reference is made to Item 14(a)(2). For the purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned Company hereby undertakes as follows, which undertaking shall be incorporated by reference into Company's Registration Statements on Form S-8 Nos. 33-9262 (filed October 3, 1986), 33-29085 (filed June 6, 1989), 33-41459 (filed June 28, 1991) and 33-48502 (filed June 10, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Company pursuant to the foregoing provisions, or otherwise, the Company has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the 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 Company of expenses incurred or paid by a director, officer or controlling person of the Company in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Company will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Sections 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. ST. JUDE MEDICAL, INC. Date: March 24, 1994 By /s/ Ronald A. Matricaria Ronald A. Matricaria President and Chief Executive Officer (Principal Executive Officer) By /s/ Stephen L. Wilson Stephen L. Wilson Vice President, Finance and Chief Financial Officer (Principal Financial and 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 date indicated. /s/ Lawrence A. Lehmkuhl Chairman of the March 24, 1994 Lawrence A. Lehmkuhl Board of Directors /s/ Ronald A. Matricaria Director March 24, 1994 Ronald A. Matricaria /s/ Frank A. Ehmann Director March 24, 1994 Frank A. Ehmann /s/ Thomas H. Garrett III Director March 24, 1994 Thomas H. Garrett III /s/ Charles V. Owens, Jr. Director March 24, 1994 Charles V. Owens, Jr. /s/ James S. Womack Director March 24, 1994 James S. Womack /s/ William R. Miller Director March 24, 1994 William R. Miller /s/ Roger G. Stoll Director March 24, 1994 Roger G. Stoll - ----------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 OF ST. JUDE MEDICAL, INC. FOR CALENDAR YEAR ENDED DECEMBER 31, 1993 - ------------------------------------- FINANCIAL STATEMENT SCHEDULES - ----------------------------------------------------------------------------- Report of Independent Auditors We have audited the consolidated financial statements of St. Jude Medical, 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 February 4, 1994. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. [signature] Ernst & Young February 4, 1994 ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS (1) Reserve adjustments or uncollectible accounts written off, net of recoveries. (2) Settlements paid. (3) Deducted from accounts receivable on the balance sheet. (4) Included in accrued expenses on the balance sheet. ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Dollars in Thousands) COL. A COL. B Charged to Costs Item and Expenses Year Ended December 31 1993 1992 1991 Royalties $6,754 $7,203 $5,607 Amortization of intangible assets $4,458 $4,202 $4,237 Each of the following items are less than 1% of net sales and are not required to be reported: *Maintenance and repairs *Taxes, other than payroll and income taxes *Advertising costs - ----------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 OF ST. JUDE MEDICAL, INC. FOR CALENDAR YEAR ENDED DECEMBER 31, 1993 - ------------------------------------- EXHIBITS - ----------------------------------------------------------------------------- March 9, 1993 Mr. Ronald A. Matricaria 840 Wedgewood Lane Carmel, IN 46032 Dear Mr. Matricaria: We write to set forth our agreement with respect to your employment as the President and Chief Executive Officer of St. Jude Medical, Inc. (the "Company"). This letter shall be effective and shall bind the Company from and after the date hereof, but shall be operative only upon your acceptance by executing this letter and upon your actual commencement of employment with the Company on or before April 12, 1993. 1. Employment. The Company hereby agrees to employ you, and you agree to be employed by the Company, on the terms and conditions hereinafter set forth. You will serve as the Company's President and Chief Executive Officer and, in addition, at no additional compensation, be elected as a member of the Board of Directors, and in such other directorships, Board committee memberships and offices of the Company and its subsidiaries to which you may from time to time be elected or appointed by the Chairman of the Board. You agree to serve the Company faithfully and, to the best of your ability, to promote the Company's interest, and to devote your full working time, energy and skill to the Company's business. You will assume all of the duties and responsibilities as President and Chief Executive Officer immediately upon your employment. As President, you will report directly to the Board of Directors although you will normally work with the Chairman of the Board as its representative. You will be solely responsible for determining job description, compensation and promotion of all employees other than corporate officers in accordance with any salary and personnel policies established from time to time by the Board of Directors. You shall recommend to the Board, after consultation with the Chairman, job descriptions, compensation and promotion of all corporate officers. You will discharge your duties at all times in accordance with any and all policies established by the Board of Directors and will report to, and be subject to the direction of, the Board of Directors. I will, upon your commencement of employment, assume the sole duties of Chairman of the Board, but will be available for a period of up to 60 days to assist you in your assuming the position of President and Chief Executive Officer. It is the spirit of our agreement that I will not be involved in day to day management and that I will move off- site after a reasonable transition time. 2. Compensation. (a) As full compensation for all of your services (including services as director, Board committee member or officer of the Company and its subsidiaries) during your term of employment hereunder, you shall, beginning with the 1993 calendar year, receive a base salary at the rate of Four Hundred Thousand Dollars ($400,000) per annum, payable in bi-weekly installments. (b) Nothing in this agreement shall prevent the Company's Board of Directors from at any time increasing the compensation to be paid to you, if the Board shall deem it advisable to do so in order to compensate you fairly for services to be rendered. It is the parties' contemplation that the Board of Directors will effect such increases from time to time, to the extent justified by all the circumstances, including increases in the cost of living, the value of your services, and the Company's results of operations and financial position. 3. Bonus. (a) You shall be eligible to earn bonus compensation for each fiscal year of the Company during your term of employment hereunder in an amount to be determined in accordance with an incentive compensation plan for you as established by the Company's Board of Directors. Under the plan, you will have an opportunity to earn bonus compensation of up to 100% of your base compensation each fiscal year upon achievement of various established targets based on personal and corporate performance to be mutually agreed upon by you and the Board of Directors. Bonus compensation payable to you will be paid following approval of the fiscal year results by the Audit Committee of the Board. (b) Notwithstanding the foregoing, unless you voluntarily resign from or are terminated for good cause by the Company before December 31, 1993, the Company will pay you a bonus for 1993 equal to $358,250, representing 3/12ths of the bonus target you would have earned from your previous employer for 1993 and 9/12ths of the $400,000 bonus target for 1993 under the incentive compensation plan described above. Such bonus shall be paid at the same time as other corporate officer bonuses for 1993 are paid or payable. 4. Fringe Benefits. (a) You will be included in the Company's Executive Officer Perquisite Plan (PERK) during the term of your employment hereunder and the value of such perquisites shall be at least $24,000 during 1993. You shall also be eligible to participate in any and all Company sponsored insurance (including medical, dental, life and disability insurance), profit sharing and other fringe benefit programs that it maintains for any of its executive officers, subject to the terms of each such plan or program. Notwithstanding this, you will be entitled to three weeks of vacation in 1993 upon completion of six months of employment and four weeks of vacation in each calendar year thereafter. (b) The Company will provide for your relocation to Minneapolis-St. Paul in accordance with the terms of a relocation plan comparable to your current employer's plan including, but not limited to home purchase, temporary living and relocation of your family and household goods. 5. Expenses. During the term of your employment hereunder, the Company will reimburse you for your reasonable travel and other expenses incident to your rendering of services hereunder, in conformity with its regular policies regarding reimbursement of expenses as in effect from time to time. Payments to you under this paragraph will be made upon presentation of expense vouchers in such detail as the Company may from time to time require. 6. Term. (a) The term of your employment hereunder shall continue until the earliest of the following dates: (i) December 31, 1997; (ii) the last day of any month in which you die; (iii) if you shall be unable to substantially perform under this agreement by reason of physical or mental disability for a period of six consecutive months, on the last day of any month in which the Company shall have elected to terminate your employment hereunder by notice to you; and (iv) the date on which the Company terminates your employment hereunder for "good cause." (v) the date on which you voluntarily terminate your employment. (b) For purposes of this agreement, the Company shall have "good cause" if you have acted in bad faith or with dishonesty, you have willfully violated any law of any domestic or international government to which the Company is bound, or willfully failed to follow instructions of the Company's Board of Directors, you have performed duties with gross negligence or you have otherwise materially breached this agreement; provided, however, that in the case of your willful failure to follow instructions or other material breach hereof not involving bad faith, dishonesty or willful violation of law, the Company shall give you written notice of such failure or other breach and you shall have 21 days to correct same. (c) For purposes of this agreement, "good reason" shall mean the Company, without your express written consent, (i) substantially and materially reducing the principal duties, responsibilities and reporting obligations of your position as President and CEO, (ii) reducing your annual compensation as described in Paragraph 2 (including any increases given under Paragraph 2(b) or reducing your bonus described in Paragraph 3 or (iii) failing to provide you with benefits at least as favorable to those enjoyed by you under any of the Company's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, savings plans or vacation plans in which you were eligible to participate at the beginning of your term of employment with the Company, provided, however, that nothing herein will restrict the Company from altering, amending or terminating any benefit plan so long as any such change applies to executive officers generally. 7. Payments Due Upon Termination. If prior to such scheduled expiration of your employment as provided in Paragraph 6(a), your employment is terminated by the Company before December 31, 1997 for any reason other than your death, disability or because your employment has been terminated for "good cause," then and in such event the Company shall pay you as severance, in monthly installments, at the rate of your base compensation then in effect and the actual bonus paid for the immediately preceding fiscal year. Such payments shall continue until the earlier of: (a) 24 months following the date of your termination, or (b) December 31, 1997. You shall continue to be obligated under Paragraph 12 hereunder for as long as you receive payments under this paragraph and for a period of one year thereafter. 8. Change in Control. You and the Company agree to enter into a separate "Employment Agreement" in substantially the form previously presented to you pursuant to which you will be entitled to receive severance pay and benefits as provided therein in the event of a "change in control" as defined therein. Your rights under such Employment Agreement are in lieu of your rights under Paragraph 7. Accordingly, if you elect to receive the benefits afforded you under such Employment Agreement, you may not receive compensation under Paragraph 7 hereof. 9. Stock Option. You will receive two non-qualified options to purchase up to 400,000 shares of Company common stock in the following manner: (a) 200,000 shares shall be exercisable at a rate of 20% per year on each anniversary of your date of employment, with the final 20% exercisable on December 31, 1997. In addition, all or any of the 200,000 shares will be exercisable immediately if you die or become disabled while employed by the Company. This option shall be governed by the terms of a "Non-Qualified Stock Option Agreement" substantially in the form previously presented to you. If, prior to the third anniversary of your date of employment, your employment is terminated by the Board of Directors other than for "good cause" as defined in Paragraph 6(b) above or by you for "good reason" as defined in Paragraph 6(c) above, death or disability, any shares of stock under the option above that are not then exercisable shall become exercisable immediately upon your termination. In that event, if the share price on the date of exercise is not less than the purchase price in the option agreement, you agree to immediately exercise the option for the number of shares that vest solely as a result of your termination under this paragraph and to sell to the Company such shares at the closing price on the date of exercise. The Company shall pay you for such shares within 10 days of the date of your exercise. (b) 200,000 shares shall be contingent on achievement of annual increases in market valuation of the Company for the five calendar years commencing in 1993 as follows: (i) The number of whole Shares that the Optionee shall earn and that shall become exercisable immediately following the determination of Actual Market Value for any year shall be equal to one percent (1%) of the excess of the Actual Market Value of the Company over the Target Market Value for the immediately prior calendar year divided by the Purchase Price contained in the Option Agreement. (ii) Actual Market Value shall equal the number of shares issued and outstanding as reported on the Company's year end balance sheet, multiplied by the closing price of the Company's Common Stock as reported on NASDAQ-NMS for the last trading day of the calendar year; provided, however, that if there is any change in the financial results of the Company by the Audit Committee of the Board of Directors, the Actual Market Value shall be determined based upon the average of the closing price for the first five trading days in the month following the date the Company's annual audited financial results are released to the public. (iii) The Target Market Value for each year shall be as follows: $1,900,511,770 as of December 31, 1993 2,181,787,511 as of December 31, 1994 2,463,238,101 as of December 31, 1995 2,827,797,340 as of December 31, 1996 3,266,105,928 as of December 31, 1997 Provided, however, that the Target Market Value shall never be less than the highest Actual Market Value for any prior year during the performance period. This Option shall be governed by a "Non-Qualified Stock Option Agreement" substantially in the form previously presented to you. 10. Pension Benefit. (a) In addition to the compensation to be provided in Paragraph 2 above, the Company shall deposit in an irrevocable "vesting trust" an amount of $2,500,000 representing the actuarial present value of a monthly benefit of $16,800, beginning October 1, 1996, during your life and, upon your death, 50% to your surviving spouse, such payments adjusted every fourth year at a rate equal to 50% of the cumulative four year CPI-U, less any payments you will receive from your previously employer's retirement plan. This amount represents the value of the benefit you would have received from your previous employer's plan had you remained in its employment until October 1, 1996. (b) The Company shall within 30 days of the date of your employment, deposit this amount in the vesting trust, it being the intent of the Company that such trust shall afford a measure of security for the payment of these retirement benefits and to provide for the additional net tax liability you will incur upon the vesting of the trust. Under the terms of the trust, the amount of the tax liability will be distributed to you in 1996 necessary to pay any taxes then due, and the remainder to be paid to you in monthly installments equal to the after tax benefit described above. The trust will vest on October 1, 1996, but will not vest in the event that you voluntarily terminate your employment before September 30, 1996 other than for "good reason" defined above or the Company terminates your employment for "good cause" as defined above. With the consent of the Company and you, the trust may purchase an noncancellable annuity contract after October 1, 1996, to provide for such payments to you. 11. Retiree Benefits. On your first day of employment, shall receive an award of 10,000 shares of restricted Company stock that will vest at a rate of 25% per year on each anniversary date of issue. This is intended to compensate you for giving up the health coverage for you and your spouse during your life and your spouse's life, offered by your current employer to its retirees as of the date of the agreement. 12. Non-Compete and Confidentiality. (a) During the term of your employment hereunder and for a period of one year thereafter (or such later date as specified in Paragraph 7), you will not, directly or indirectly, engage in or be interested in any business which is then manufacturing or developing products either marketed by the Company or under development by the Company during the term of your employment, including but not limited to cardiac valve prostheses, vascular grafts, oxygenators, centrifugal blood pump and intra-aortic balloon pump. For the purposes of this paragraph, you will be considered to have been engaged or interested in a business if you engage or are interested in such business as a stockholder, director, officer, employee, agent, broker, partner, individual proprietor, lender, consultant or in any other capacity, except that nothing herein contained will prevent you from owning less than 3% of any class of equity or debt securities listed on a national securities exchange or traded in any established over-the- counter securities market. (b) During the term of your employment hereunder and thereafter, you shall not disclose any confidential information or take any other action proscribed in the "Confidentiality Agreement" substantially in the form previously presented to you. 13. General Provisions. (a) This agreement may not be amended or modified except by written agreement of the parties. (b) In the event that any provision or portion of this agreement shall be determined to be invalid or unenforceable for any reason, the remaining provisions of this agreement shall remain in full force and effect to the fullest extent permitted by law. (c) This agreement shall bind and benefit the parties hereto and their respective successors and assigns, but no right or obligation of Executive hereunder may be assigned without the Company's written consent. (d) This agreement has been made in and shall be governed and construed in accordance with the laws of the State of Minnesota. ____________________________________ If the foregoing correctly sets forth your understanding of our agreement, please so indicate by signing and returning to us a copy of this letter. Very truly yours, ST. JUDE MEDICAL, INC. [signature] Lawrence A. Lehmkuhl Chairman Accepted and agreed to: [signature] Ronald A. Matricaria ST. JUDE MEDICAL, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN AND TRUST April 12, 1993 TABLE OF CONTENTS Page ARTICLE 1 NAME AND PURPOSE . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1 Name . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.2 Purpose. . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE 2 DEFINITIONS AND INTERPRETATIONS. . . . . . . . . . . . . . . . . . . 2 2.1 General Definitions. . . . . . . . . . . . . . . . . . . . 2 ARTICLE 3 PARTICIPATION IN THE PLAN. . . . . . . . . . . . . . . . . . . . . . 7 3.1 Eligibility. . . . . . . . . . . . . . . . . . . . . . . . 7 3.2 Designation of Beneficiary . . . . . . . . . . . . . . . . 7 ARTICLE 4 CONTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4.1 St. Jude Contributions . . . . . . . . . . . . . . . . . . 8 4.2 Reversion to St. Jude. . . . . . . . . . . . . . . . . . . 9 4.3 Contribution Does Not Vest . . . . . . . . . . . . . . . . 9 4.4 Valuation of the Trust Fund. . . . . . . . . . . . . . . . 9 ARTICLE 5 INVESTMENT OF CONTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . 9 5.1 Investment Powers. . . . . . . . . . . . . . . . . . . . . 9 5.2 Written Investment Policy. . . . . . . . . . . . . . . . . 10 5.3 Appointment of Investment Manager. . . . . . . . . . . . . 10 5.4 Executive's Right to Direct Investments. . . . . . . . . . 11 ARTICLE 6 VESTING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 6.1 Vesting of Executive in Trust Fund . . . . . . . . . . . . 12 6.2 Executive's Forfeiture of Interest in Trust Fund . . . . . 12 6.3 Notice and Dispute Resolution. . . . . . . . . . . . . . . 12 ARTICLE 7 PAYMENTS OF BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . 13 7.1 Notice . . . . . . . . . . . . . . . . . . . . . . . . . . 13 7.2 Amount of Benefits and Valuation . . . . . . . . . . . . . 14 7.3 Notice of Benefit Commencement . . . . . . . . . . . . . . 14 7.4 Modes of Payment to Executive After Full Vesting . . . . . 14 7.5 Time for Payment . . . . . . . . . . . . . . . . . . . . . 16 7.9 Medium of Payment. . . . . . . . . . . . . . . . . . . . . 16 7.7 Payment to Executive to Satisfy Taxes. . . . . . . . . . . 16 7.8 Facility of Payment. . . . . . . . . . . . . . . . . . . . 17 ARTICLE 8 CLAIMS PROCEDURE . . . . . . . . . . . . . . . . . . . . . . . . . . 17 8.1 Claims for Benefits. . . . . . . . . . . . . . . . . . . . 17 8.2 Dispute of Benefits. . . . . . . . . . . . . . . . . . . . 17 8.3 Arbitration or Judicial Review of Dispute. . . . . . . . . 18 ARTICLE 9 COMMITTEE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.1 Appointment. . . . . . . . . . . . . . . . . . . . . . . . 19 9.2 Action of the Committee. . . . . . . . . . . . . . . . . . 19 9.3 Meetings . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.4 Records. . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.5 Powers . . . . . . . . . . . . . . . . . . . . . . . . . . 20 9.6 Compensation . . . . . . . . . . . . . . . . . . . . . . . 21 9.7 Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . 21 9.8 Powers Denied. . . . . . . . . . . . . . . . . . . . . . . 21 9.9 Action When There is a Vacancy . . . . . . . . . . . . . . 21 9.10 Settlement of Claims. . . . . . . . . . . . . . . . . 21 9.11 Discretionary Powers . . . . . . . . . . . . . . . . . . . 21 9.12 Employment of Professionals and Assistants . . . . . . . . 22 9.13 Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 ARTICLE 10 TRUSTEE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 10.1 Duty and Liability of Trustee. . . . . . . . . . . . . . . 22 10.2 General Scope of Powers. . . . . . . . . . . . . . . . . . 23 10.3 Powers Discretionary . . . . . . . . . . . . . . . . . . . 26 10.4 Annual Account . . . . . . . . . . . . . . . . . . . . . . 26 10.5 Person Dealing with Trustee. . . . . . . . . . . . . . . . 26 10.6 Prohibited Transactions. . . . . . . . . . . . . . . . . . 26 10.7 Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . 27 10.8 Resignation and Appointment. . . . . . . . . . . . . . . . 27 10.9 Removal of Trustee . . . . . . . . . . . . . . . . . . . . 27 10.10 Continuation of the Trust . . . . . . . . . . . . . . 28 ARTICLE 11 CLAIMS AGAINST THE TRUST FUND. . . . . . . . . . . . . . . . . . . . 28 11.1 Anti-Alienation of Benefits. . . . . . . . . . . . . . . . 28 11.2 Qualified Domestic Relations Orders. . . . . . . . . . . . 28 11.3 Independent Fund . . . . . . . . . . . . . . . . . . . . . 30 ARTICLE 12 RIGHTS OF ST. JUDE TO AMEND, DISCONTINUE OR TERMINATE. . . . . . . . 30 12.1 Amendment. . . . . . . . . . . . . . . . . . . . . . . . . 30 12.2 Termination of Plan. . . . . . . . . . . . . . . . . . . . 31 12.3 Termination of Trust . . . . . . . . . . . . . . . . . . . 31 ARTICLE 13 SUCCESSOR EMPLOYER AND MERGER OR CONSOLIDATION OF PLANS. . . . . . . 31 13.1 Successor Employer . . . . . . . . . . . . . . . . . . . . 31 13.2 Merger and Consolidation . . . . . . . . . . . . . . . . . 32 ARTICLE 14 MISCELLANEOUS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 14.1 Liability of St. Jude. . . . . . . . . . . . . . . . . . . 32 14.2 Indemnification. . . . . . . . . . . . . . . . . . . . . . 32 14.3 No Guarantee of Employment . . . . . . . . . . . . . . . . 33 14.4 Governing Law. . . . . . . . . . . . . . . . . . . . . . . 33 14.5 Binding Effect . . . . . . . . . . . . . . . . . . . . . . 33 ST. JUDE MEDICAL, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN AND TRUST This Agreement, establishing the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust, is adopted by St. Jude Medical, Inc., a Minnesota corporation, ("St. Jude"), and Norwest Bank Minnesota, N.A. (the "Trustee") and is effective as of April 12, 1993. W I T N E S S E T H : WHEREAS, St. Jude desires to establish a retirement plan (the "Plan") for the benefit of Ronald A. Matricaria ("the Executive"); WHEREAS, Norwest Bank Minnesota, N.A. has agreed to serve as Trustee of the Trust established hereunder; NOW, THEREFORE, the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust is established to read as follows: ARTICLE 1 NAME AND PURPOSE 1.1 Name. The name of the Plan set forth in this instrument is the St. Jude Medical, Inc. Supplemental Executive Retirement Plan, and the name of the trust which is part of that Plan and the terms of which are set forth in this instrument is the St. Jude Medical, Inc. Supplemental Executive Retirement Trust. 1.2 Purpose. The purpose of the Plan is to provide retirement income to the Executive and his family. The purpose of the Trust is to facilitate the administration of the Plan for the exclusive benefit of the Executive and his Beneficiaries. ARTICLE 2 DEFINITIONS AND INTERPRETATIONS 2.1 General Definitions. (1) "Alternate Payee" shall mean a: (a) spouse; (b) former spouse; (c) child; or (d) other dependent of the Executive who is recognized by a Qualified Domestic Relations Order as having a right to receive all, or a portion of, the Executive's Beneficial Interest under the Plan. An Alternate Payee is treated as a Beneficiary for all purposes under the Plan. (2) "Anniversary Date" shall mean each December 31, beginning December 31, 1993. (3) "Beneficial Interest" shall mean all of the assets of the Trust Fund which are distributable to the Executive or his Beneficiary in accordance with the terms of the Plan. (4) "Beneficiary" shall mean the Executive's spouse and his natural or adopted children, or a trust established by the Executive solely for their benefit, who are entitled to receive benefits that may be payable upon or after the Executive's death. (5) "Board of Directors" shall mean the elected Board of Directors of St. Jude Medical, Inc. (6) "Change in Control" shall mean a Change in Control as defined in that certain Employment Agreement between the Executive and St. Jude dated as of April 12, 1993. (7) "Code" shall mean the Internal Revenue Code of 1986, and amendments thereto. (8) "Committee" shall mean the Compensation Committee of the Board of Directors of St. Jude, or its successor, the members of which are named fiduciaries of the Plan within the meaning of Section 402 of the Employee Retirement Income Security Act of 1974. In no event shall the Executive be a member of such Committee at any time prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. (9) "Disability" shall mean a physical or mental condition of the Executive resulting from a bodily injury or disease or mental disorder which renders him incapable of continuing employment with St. Jude. Disability of the Executive shall be determined by the Committee in accordance with uniform principles consistently applied, upon the basis of such medical and other evidence which the Committee deems necessary and desirable. (10) "Earliest Retirement Age" shall mean, for purposes of a Qualified Domestic Relations Order, the earlier of: (a) the date on which the Executive is entitled to a distribution under the Plan; or (b) the later of the day the Executive attains age 50, or the earliest date on which the Executive could begin receiving his Beneficial Interest under the Plan if the Executive separated from service. Earliest Retirement Age shall also mean a date earlier than (i) or (ii) if such date is specified in the Qualified Domestic Relations Order. (11) "Effective Date" shall mean April 12, 1993. (12) "ERISA" shall mean the Employee Retirement Income Security Act of 1974, as amended, and any successor thereto, and any regulations promulgated thereunder. (13) "Good Cause," as grounds for the termination of the Executive's employment by St. Jude, shall mean: (a) prior to a Change in Control, any act by which the Executive in bad faith or with dishonesty, willfully violates any law of any domestic or international government to which St. Jude is bound, willfully fails to follow instructions of the Company's Board of Directors, performs duties with gross negligence or otherwise materially breaches the employment agreement between the Executive and St. Jude; provided, however, that in the case of the Executive's willful failure to follow instructions or other material breach of said employment agreement not involving bad faith, dishonesty or willful violation of law, St. Jude shall give the Executive written notice of such failure or other breach and the Executive shall have 21 days to correct same. (b) after a Change in Control, the conviction of the Executive by a court of competent jurisdiction for felony criminal conduct. (14) "Good Reason", as grounds for the voluntary termination of employment by the Executive, shall mean: (a) prior to a Change in Control, any act by which St. Jude, without the express written consent of the Executive: (i) substantially and materially reduces the principal duties, responsibilities and reporting obligations of the Executive in his position as President and CEO; (ii) reduces the Executive's annual compensation as described in the written employment agreement between St. Jude and the Executive or (iii) fails to provide the Executive with benefits at least as favorable to those enjoyed by the Executive under any of St. Jude's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, savings plans or vacation plans in which the Executive was eligible to participate in the beginning of his term of employment with St. Jude, provided, however, that nothing herein will restrict St. Jude from altering, amending or terminating any benefit plan so long as any such change applies to executive officers generally. (b) after a Change in Control, without Executive's express written consent, any of the following acts by St. Jude: (i) the assignment to Executive of any duties inconsistent with Executive's status or position with St. Jude, or a substantial alteration in the nature or status of Executive's responsibilities from those in effect immediately prior to the Change in Control; (ii) a reduction by St. Jude in Executive's annual compensation in effect immediately prior to a Change in Control; (iii) the relocation of St. Jude's principal executive offices to a location more than fifty miles from St. Paul, Minnesota or St. Jude requiring Executive to be based anywhere other than St. Jude's principal executive offices except for required travel on St. Jude's business to an extent substantially consistent with Executive's business travel obligations immediately prior to the Change in Control; (iv) the failure by St. Jude to continue to provide Executive with benefits at least as favorable to those enjoyed by Executive under any of St. Jude's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, or savings plans in which Executive was partici- pating immediately prior to the Change in Control, the taking of any action by St. Jude which would directly or indirectly materially reduce any of such benefits or deprive Executive of any material fringe benefit enjoyed at the time of the Change in Control, or the failure by St. Jude to provide Executive with the number of paid vacation days to which Executive is entitled immediately prior to the Change in Control, provided, however, that St. Jude may amend any such plan or programs as long as such amendments do not reduce any benefits to which Executive would be entitled upon termination; (v) the failure of St. Jude to obtain a satisfactory agreement from any successor to assume and agree to perform that certain Employment Agreement between the Executive and St. Jude dated as of April 12, 1993; or (vi) any purported termination of Executive's employment which is not made pursuant to a Notice of Termination satisfying the requirements of the Employment Agreement described in paragraph (v) above. (15) "Plan" shall mean the St. Jude Medical, Inc. Supplemental Executive Retirement Plan for Ronald A. Matricaria. (16) "Plan Year" shall mean the 12 consecutive months ending on December 31 of each year. (17) "Qualification Procedures" shall mean written procedures adopted by the Committee to: (a) determine whether domestic relations orders meet the requirements for Qualified Domestic Relations Orders; and (b) to administer distributions under such orders. The procedures shall be implemented within a reasonable time after receipt of a domestic relations order by the Committee. Qualification Procedures must permit an Alternate Payee to designate a representative for receipt of copies of notices sent to the Alternate Payee with respect to a Qualified Domestic Relations Order. (18) "Qualified Domestic Relations Order" shall mean a judgment, decree or order, including approval of a property settlement agreement, that relates to provision of child support, alimony payments, or marital property rights to an Alternate Payee, is made pursuant to state domestic relations law (including a state community property law) and creates an Alternate Payee's right to all or a portion of the benefits payable to the Executive under the Plan. A Qualified Domestic Relations Order must satisfy all of the requirements of Section 414(p) of the Code and must specify: (a) the name and last known mailing address of each Alternate Payee; (b) the amount or percentage of the Executive's benefits to be paid to the Alternate Payee or the manner in which the amount is to be determined; (c) the number of payments or period for which payments are required; and (d) each plan to which the order relates. An order does not qualify under this definition if it requires the Committee to provide a benefit or option not available under the Plan, requires the Plan to provide increased benefits or requires payment of benefits to an Alternate Payee that are required to be paid to another Alternate Payee under a previously existing Qualified Domestic Relations Order. (19) "Qualified Joint and Survivor Annuity" shall mean if the Executive has a Spouse at the time of the commencement of benefits, an annuity for the life of the Executive with a survivor annuity for the life of his Spouse which can be purchased with the Executive's Beneficial Interest. A Qualified Joint and Survivor Annuity for the Executive if he is unmarried at the time of the commencement of benefits shall mean an annuity for the life of such Executive and which can be purchased with his Beneficial Interest. (20) "Qualified Preretirement Survivor Annuity" shall mean an annuity for the life of the Executive's surviving Spouse, purchased with the Executive's Beneficial Interest as of the date of the Executive's death. (21) "St. Jude" shall mean St. Jude Medical, Inc., a Minnesota corporation, and its successors and assigns. (22) "Spouse" shall mean the person to whom the Executive is married on the date payments actually commence under the Plan. (23) "Termination of Employment" of the Executive shall mean complete severance from the service of St. Jude. (24) "Trust" shall mean the St. Jude Medical, Inc. Supplemental Executive Retirement Trust. (25) "Trust Fund" or "Fund" shall mean the total of contributions made hereunder, or the investments purchased, increased by profits, income, refunds and recoveries received, and decreased by investment losses and expenses incurred in the administration of the Trust and by benefits released or paid. (26) "Trustee" shall mean the undersigned Trustee or Trustees or any duly appointed successor Trustee. ARTICLE 3 PARTICIPATION IN THE PLAN 3.1 Eligibility. The Executive is the sole employee of St. Jude eligible to participate in the Plan. 3.2 Designation of Beneficiary. Upon commencement of participation in the Plan, the Executive shall complete, sign and file with the Committee a designation of Beneficiary on a form to be provided by the Committee. On said form, the Executive shall designate a Beneficiary (or Beneficiaries), which may be an individual or a trust established solely for the individual, to whom shall be paid any sum which may be payable on account of the Executive's death after the Executive becomes fully vested in the Plan as provided in Article 6 (reserving, however, to the Executive the power to change the designation of Beneficiary from time to time) and where applicable, a particular form of benefit. The Executive's Spouse shall be the Beneficiary of the entire vested and nonforfeitable benefit payable upon the death of the Executive unless the Executive's Spouse irrevocably consents in writing to the designation of another Beneficiary. Such spousal consent shall identify the specific alternate Beneficiary, and where applicable, a particular form of benefit, acknowledge the effect of such designation, and be witnessed by a Plan representative or a notary public. Any subsequent change by the Executive in the designation of a Beneficiary shall require specific written consent by the Executive's Spouse unless the Spouse has previously consented in writing to voluntarily waive the right to consent to subsequent Beneficiary changes, and such consent acknowledges the Spouse's right to otherwise limit consent to a specific Beneficiary. However, the designation of a Beneficiary other than the Executive's Spouse shall be effective if the Committee determines that the foregoing consent may not be obtained because there is no Spouse, because the Spouse cannot be located, or because of other circumstances described in regulations issued by the Secretary of the Treasury. A divorce before the payment commencement date shall terminate all rights of the Executive's ex-spouse to any benefits under this Plan, unless the Executive expressly designates or redesignates the ex- spouse as Beneficiary or as otherwise provided under a Qualified Domestic Relations Order. If the Executive shall fail to validly designate a Beneficiary, or if no designated Beneficiary survives the Executive, the following designated persons shall be the Beneficiaries in the order named: (a) the Executive's spouse, if living; or (b) the Executive's lawful children, if living, including any lawfully adopted children. In the event the last survivor of the Executive, his Spouse, and his children dies prior to the date all assets are distributed from this Plan and Trust, any amount then remaining in the Trust shall revert to St. Jude. Notwithstanding anything herein to the contrary, in the event St. Jude, directly or through insurance, provides a death benefit payment to Executive's Beneficiaries pursuant to that certain Supplement to his employment letter agreement, dated May 5, 1993, no benefits shall be due or paid under this Plan. ARTICLE 4 CONTRIBUTIONS 4.1 St. Jude Contributions. St. Jude shall contribute to the Trust the sum of Two Million Five Hundred Thousand Dollars ($2,500,000.00) within 30 days of the Effective Date of the Plan. In addition, until such time as the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall pay any and all reasonable Trustee fees and any additional expenses, including but not limited to, any taxes on the income of the Trust, incurred in connection with the administration of the Plan and Trust. St. Jude shall reimburse the Trust, as an additional contribution, any amount which the Trust is required to pay in federal, state and local income or other taxes imposed upon the Trust during the period prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall have no further responsibility or obligation to pay any expenses of the Trust or the Trustee. 4.2 Reversion to St. Jude. Except as provided for in Section 3.2 or 6.2, principal or income of this Trust shall not be paid or revert to St. Jude or be used for any purpose whatsoever other than the exclusive benefit of the Executive or his Beneficiaries. 4.3 Contribution Does Not Vest. The fact that a contribution has been made as hereinbefore provided will not of itself operate to vest in the Executive any right, title or interest in the Trust. Vesting will be accomplished only at the times and on the contingencies hereinafter set forth. 4.4 Valuation of the Trust Fund. The Trustee shall determine the fair market value of the Trust Fund as of the Anniversary Date of each Plan Year. All accounts, books and records maintained pursuant to this Section 4.4 shall be opened to inspection and audit at all reasonable times by St. Jude and by the Executive. ARTICLE 5 INVESTMENT OF CONTRIBUTIONS 5.1 Investment Powers. Except as otherwise provided in this Article, during the term of the Trust, the Trustee shall have the exclusive authority and discretion to invest and reinvest the principal and income of the Trust in real and personal property of any kind. The Trustee shall not be limited by the laws of any state proscribing or limiting the investment of trust funds by trustees, either as to types of investments or as to diversification of investments. Notwithstanding the foregoing, until such time as the Executive becomes fully vested in the Plan as provided in Article 6, the Trustee shall invest the Trust Funds only in one or more of the following investments: (a) obligations of or guaranteed by the United States of America; (b) securities traded on a national securities exchange or the NASDAQ national market; (c) commercial paper obligations receiving the highest rating from either Moody's Investors Services, Inc. or Standard & Poor's Corporation or a similar rating service; (d) certificates of deposit, bank repurchase agreements or bankers acceptances (including those of the trustee or of its affiliates) of commercial banks the securities of which or the securities of the holding company of which are rated in the highest category by a nationally- recognized credit agency; (e) an annuity or insurance policy of a company licensed to do business in Minnesota; (f) registered investment funds, including such funds of an affiliate of the Trustee; or (g) a commingled common money-market, stock or bond fund operated by the Trustee. 5.2 Written Investment Policy. The Trustee shall invest the Trust Fund in accordance with the written investment policy set forth as Exhibit A attached hereto and incorporated herein. Except as otherwise provided in Section 5.3, the Committee shall have no further power or authority with respect to the investment of the Trust assets. 5.3 Appointment of Investment Manager. Prior to the date the Executive becomes fully vested in the Plan as provided in Article 6, the Committee may, with the consent of the Executive, appoint one or more parties that are investment managers as defined in ERISA, to have power to manage, acquire, or dispose of all or part of the Trust Fund, and thereafter, the Committee may, with the consent of the Executive, remove such investment manager and appoint a successor. The appointment of any such investment manager and investment of the Trust Fund pursuant to such appointment shall be subject to the following: (a) Written notice of each such appointment shall be given to the Trustee a reasonable time in advance of the date that the investment manager first exercises the power granted to it. Such notice shall state what portion of the Trust Fund is to be invested by the manager and shall direct the Trustee to segregate such portion of the Trust Fund into a separate account for such investment manager. (b) The Trustee shall not act on any direction or instruction of the investment manager until the Trustee has been furnished with an acknowledgment in writing by the investment manager that it is a fiduciary with respect to the Plan. (c) There shall be a written agreement between St. Jude and each investment manager. The Trustee shall receive a copy of each agreement and all amendments thereto and shall give written acknowledgment of receipt of same. 5.4 Executive's Right to Direct Investments. The Executive shall not be permitted to direct the investment of the Trust Fund prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Executive shall have the sole authority to instruct the Trustee as to investments (including the acquisition, sale or retention of specific assets), disbursements or any other matter which comes within the investment powers granted to the Trustee under this Plan, provided, however, that the Executive shall not direct the investment of the Trust Fund in any investment in which the Executive, any family member or any affiliate of the Executive has an interest. When the Executive does instruct the Trustee, the Trustee shall have no responsibility or accountability for making any investment, for retaining any investment or for doing any other act directed by the Executive other than to comply with the instructions of the Executive. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Trustee may rely upon any instruction from the Executive given to it in writing and shall be under no duty to inquire as to the action taken. ARTICLE 6 VESTING 6.1 Vesting of Executive in Trust Fund. The Executive shall have a fully vested and nonforfeitable interest in the assets of the Trust Fund and earnings thereon, upon the occurrence of any one of the following events: (a) involuntary Termination of Employment of the Executive by St. Jude for reasons other than Good Cause; (b) voluntary Termination of Employment from St. Jude by the Executive for Good Reason; (c) the Executive's continued employment with St. Jude until October 1, 1996; or (d) October 1, 1996 if, prior to October 1, 1996, the Executive is rendered incapable of continuing his employment with St. Jude due to a Disability and the Executive survives to October 1, 1996. 6.2 Executive's Forfeiture of Interest in Trust Fund. The Executive shall forfeit any and all right, title and interest in and to the Trust Fund upon the occurrence of any one of the following events prior to October 1, 1996: (a) involuntary Termination of Employment of the Executive by St. Jude for Good Cause; (b) voluntary Termination of Employment from St. Jude by the Executive for reasons other than Good Reason; or (c) the Executive dies prior to October 1, 1996. If at any time the Executive's rights to the Trust Fund are forfeited, the purpose of the Trust will be deemed to have been accomplished and all liabilities of the Trust shall be deemed satisfied, the Trust shall terminate and all the assets in the Trust shall revert to St. Jude. 6.3 Notice and Dispute Resolution. Within 30 days after the occurrence of an event specified in this Article resulting in either the full vesting of Executive in accordance with Section 6.1 or the forfeiture by Executive in accordance with Section 6.2, St. Jude and the Executive shall jointly notify the Trustee of such occurrence in writing. If either St. Jude or the Executive disagree as to the occurrence of an event or the consequences of such event, each party shall immediately notify the Trustee that a dispute as to the Executive's rights under the Plan exists. Upon such notice, the Trustee shall not make any payment to the Executive, his Beneficiaries or to St. Jude until such time as the parties resolve such dispute or until the Trustee is ordered to pay or begin payments to one or the other of the parties or by a court of competent jurisdiction. Any such dispute between St. Jude and the Executive as to the occurrence of an event giving rise to full vesting or forfeiture under this Article (including, but not limited to, any determination with respect to Executive's Disability) shall be resolved by the parties in accordance with Article 8. ARTICLE 7 PAYMENTS OF BENEFITS 7.1 Notice. The Trustee shall furnish the Executive or Beneficiary with a written statement of the terms, conditions and forms of payment from the Trust available to him no less than 30 nor more than 90 days prior to the first day of the first period for which an amount is paid as an annuity or any other form under Section 7.5 of the Plan. The statement shall explain: (a) the terms and conditions of the Qualified Joint and Survivor Annuity; (b) the Executive's right to make, and the effect of, an election to waive the Qualified Joint and Survivor Annuity form of benefit; (c) if the Executive is married at the time, the right of the Executive's Spouse to consent to the above election; and (d) the right to make, and the effect of, a revocation of a previous election to waive the Qualified Joint and Survivor Annuity. The Trustee shall furnish the Executive and his Spouse, if any, with a statement explaining the Qualified Preretirement Survivor Annuity in a form similar to the form described above. 7.2 Amount of Benefits and Valuation. Benefits under the Plan shall be paid solely from the Trust Fund and the amount payable to the Executive shall be based on the fair market value of the assets of the Trust as of the time for distribution. 7.3 Notice of Benefit Commencement. Upon receipt of a notice of benefit commencement, the Trustee shall, within 10 days of receipt of such notice, provide notice to St. Jude of such commencement, and the terms thereof and St. Jude shall, within 30 days after receipt of such notice, inform the Trustee whether or not St. Jude disputes such benefit commencement. If St. Jude disputes such commencement, the Trustee shall not pay any amount to the Executive except in accordance with Section 6.3. It shall be the responsibility of the Trustee to verify that the Executive's Beneficial Interest from the Trust shall be due and payable in accordance with the terms of the Plan and Trust. 7.4 Modes of Payment to Executive After Full Vesting. (a) The Executive's Beneficial Interest shall be paid at the time specified in Section 7.5 in the form of a Qualified Joint and Survivor Annuity unless the Executive elects subject to the provisions of this Subsection to waive the Qualified Joint Survivor Annuity or to receive another form of benefit as provided under paragraph (b). An election to waive the Qualified Joint and Survivor Annuity shall be made (or revoked) within 90 days prior to the date on which payment of his Beneficial Interest begins, and shall be effective only if: (i) the Executive's Spouse consents in writing to such election, and the Spouse's consent acknowledges the effect of such election and the consent is witnessed by a Plan representative or a notary public; or (ii) it is established to the satisfaction of the Trustee that the Spouse's consent may not be obtained because there is no Spouse, because the Spouse cannot be located, or because of such other circumstances that the Secretary of the Treasury may prescribe by regulation. Any consent by the Spouse under paragraph (i) above (or establishment that the consent of the Spouse cannot be obtained under paragraph (ii) above) shall be effective only with respect to such Spouse. If the Executive dies before payment of his Beneficial Interest has commenced and has a surviving Spouse, payment of benefits shall take place as provided in Subsection (c) below. (b) If the Executive is unmarried on the date on which payment of his Beneficial Interest begins, as specified in Section 7.5, or if the Executive has elected to waive the Qualified Joint and Survivor Annuity as provided above, the Executive's Beneficial Interest in the Plan shall be paid under one or more of the following modes of settlement selected by the Executive, or by the Executive's designated Beneficiary if the Executive dies before commencement of benefits: (i) by payment of nonperiodic lump sum amounts; provided, however, that the cumulative payments during the first 12 month period commencing on the date on which the Executive becomes fully vested as provided in Article 6 shall not exceed 1/10th of the value of the Trust Fund as of the most recent Anniversary Date (excluding any amount payable under Section 7.7(a)) and thereafter, a fraction of the value of the Trust Fund as of the most recent Anniversary Date, the denominator of which is reduced by one for each subsequent 12 month period, and further provided that any amount not distributed in any year shall be available for distribution in any later year; (ii) by payment in the form of annual or more frequent installments of as nearly equal amounts as may be conveniently determined over a period of not less than 10 years; or (iii) by payment in any other form of annuity over the life of the Executive, the joint lives of the Executive and his Beneficiary or over a period certain of not less than 10 years. (c) If the Executive dies before commencement of his Beneficial Interest and leaves a surviving Spouse, the Executive's Beneficial Interest shall be paid to his surviving Spouse in the form of a Qualified Preretirement Survivor Annuity, unless the Executive had otherwise elected as provided herein, subject to the following rules: (i) Payment of such benefit shall commence within 60 days after the Executive's death, unless the surviving Spouse elects a later date in accordance with this Article, but in no event later than the date the Executive would have reached age 70.5. (ii) The Executive's surviving Spouse may elect in writing to receive such benefit in any of the forms permitted under Subsection (b). (iii) The Executive may elect to waive the Qualified Preretirement Survivor Annuity. Designation under Section 3.2 of a Beneficiary or Beneficiaries other than the Executive's Spouse shall be deemed a waiver of the Qualified Preretirement Survivor Annuity, subject to the Spouse's consent in accordance with that Section. (iv) The Trustee shall provide the Executive with a written explanation of the Qualified Preretirement Survivor Annuity containing comparable information to that required in regard to the Qualified Joint and Survivor Annuity under Section 8.1. The decision of the Executive as to the mode of settlement shall be final and the Trustee shall not be liable to the recipient (or to any heir, Beneficiary, or representative of the Executive, or of the recipient if other than the Executive) for such decision notwithstanding the fact that another mode of settlement would have resulted in a greater benefit. Any distribution to a Beneficiary shall be in accordance with this Article and shall be determined as if the Beneficiary were the Executive. 7.5 Time for Payment. Except as otherwise set forth below, payment of the Executive's Beneficial Interest in the Plan to the Executive, or his Beneficiary, to be made or begin as soon as administratively feasible following the date the Executive becomes fully vested in the Plan as provided in Article 6, or on such later date as elected by the Executive. 7.9 Medium of Payment. Any payment of benefits from the Plan to the Executive or his Beneficiary shall be made in cash, except that, with the consent of the Executive or his Beneficiary, such a payment may be in the form of a nontransferable, noncancellable annuity contract upon termination of the Plan and Trust. 7.7 Payment to Executive to Satisfy Taxes. Notwithstanding anything in this Article to the contrary: (a) The Trustee shall, upon request of the Executive, distribute to the Executive such amount of the Trust Fund as the Executive represents as necessary to pay any and all federal, state and local taxes which are assessed against the Executive as a result of the Executive's becoming fully vested in the Plan in accordance with Article 6. The Trustee may request reasonable proof of the amount requested by the Executive. The Trustee shall make payment to the Executive as soon as administratively feasible following verification of such amount, but in no event later than the date such taxes are otherwise due from Executive. Such distribution shall not be credited against or reduce any amount otherwise payable under Section 7.4. (b) In addition to any amounts payable under the preceding paragraph, following the Executive's becoming fully vested in the Plan in accordance with Article 6, the Trustee shall, upon request of the Executive, pay to the Executive part or all of any interest, gains or earning on the Trust Fund for the Plan Year. Such distribution shall be credited against, and reduce, any amount otherwise payable under Section 7.4. 7.8 Facility of Payment. In case of incompetency of the Executive or Beneficiary entitled to receive any distribution under the Plan, and if the Trustee shall be advised of the existence of such condition, the Trustee shall direct distribution to any one of the following: (a) to the duly appointed guardian, conservator, or other legal representative of the Executive or Beneficiary; or (b) to a person or institution entrusted with the care or maintenance of the incompetent Executive or Beneficiary, provided such person or institution has satisfied the Trustee that the payment will be used for the best interest and assist in the care of the Executive or Beneficiary and; provided further, that no prior claim for said payment has been made by a duly appointed guardian, conservator, or other legal representative of the Executive or Beneficiary. Any payment made in accordance with the foregoing provisions of this Section shall constitute a complete discharge of any liability or obligation of St. Jude, the Trustee, and the Trust Fund. ARTICLE 8 CLAIMS PROCEDURE 8.1 Claims for Benefits. At any time after the Executive becomes fully vested in the Plan as provided in Article 6, the Executive or, if the Executive is deceased, his Beneficiary may make a claim for Plan benefits, by filing a written request with the Trustee on a form to be furnished to him for such purpose. The Executive or Beneficiary shall also furnish such additional information as may be reasonably necessary to pay the Executive's Beneficial Interest in accordance with the terms of the Plan and Trust. 8.2 Dispute of Benefits. Any dispute between the Executive and St. Jude as to the occurrence of an event described in Article 6 and the effect of such event or any other dispute under the Plan shall be resolved first by the Board of Directors of St. Jude. The Board of Directors shall furnish to the Executive a notice of its decision, meeting the requirements stated below within 30 days after receipt of a notice of dispute from the Executive. If special circumstances require more than 30 days to process the claim, this period may be extended for up to an additional 30 days by giving written notice to the Executive before the end of the initial 30-day period, stating the special circumstances requiring the extension and the date by which a decision is expected. Failure to provide a notice of decision in the time specified shall constitute a denial of the claim, and the Executive shall be entitled to the rights specified in Section 8.3. The notice to be provided to the Executive in the event the claim for benefits is denied, shall be in writing and shall set forth the following: (a) the specified reason or reasons for the denial of a benefit; (b) specific reference to pertinent Plan provisions on which the denial is based. 8.3 Arbitration or Judicial Review of Dispute. If the Executive is dissatisfied with the decision of the Board of Directors of St. Jude under Section 8.2, the Executive shall have the right, in addition to all other rights and remedies provided by law, at his election, either to seek arbitration in St. Paul, Minnesota, under the rules of the American Arbitration Association, by serving a notice to arbitrate upon St. Jude or to institute a judicial proceeding, in either case within 60 days after having received notice of denial of benefits under this Plan, or within such longer period as may reasonably be necessary for the Executive to take action in the event of his Disability during such 60 day period. If arbitration is elected, each party shall select one arbitrator and a third arbitrator shall be selected by St. Jude from a list submitted to it by the Executive. Each party shall bear its own costs and expenses, including attorney and expert witness fees, in any arbitration or judicial proceeding. All decisions of the Committee or the Board of Directors with respect to Executive's rights to his Beneficial Interest under the Plan shall be subject to review de novo by the court or arbitrators. ARTICLE 9 COMMITTEE 9.1 Appointment. The Compensation Committee of the Board of Directors of St. Jude is designated as the administrator of the Plan and its members are "named fiduciaries." Such Committee shall be responsible for the administration of the Plan prior to and until such time as the Executive shall become fully vested in the Plan as provided in Article 6, at which time the authority and control of the Committee otherwise provided in this Plan shall cease. The Executive shall not be a member of this committee at any time prior to the date on which he becomes fully vested in the Plan as provided in Article 6. 9.2 Action of the Committee. The Committee may authorize one or more of its members or any agent to execute or deliver any instrument on behalf of the Committee. 9.3 Meetings. The Committee shall hold such meetings upon such notice and at such place or places and at such time or times as it may from time to time determine. A majority of members then serving on the Committee shall constitute a quorum for the conduct of business and the affirmative vote of a majority of the members present at any meeting shall be necessary to approve action taken at the meeting. Action by the Committee may be taken without a formal meeting by the written authorization of all the members thereof. 9.4 Records. The Committee shall keep all records appropriate for the performance of its powers and duties under the Plan and may keep appropriate written records of its meetings. 9.5 Powers. Prior to the date the Executive becomes fully vested in the Plan, the Committee shall have full power and authority to do each and every act and thing which it is specifically required or permitted to do under the provisions of the Plan and in addition thereto shall have the following discretionary powers and duties in connection with the administration of the Plan: (a) to adopt from time to time such bylaws, procedures and forms as the Committee considers appropriate in the operation and administration of the Plan and Trust; (b) to determine that an event giving rise to full vesting by the Executive as provided in Article 6 shall have occurred; (c) to establish rules and procedures needed for its administration of the Plan; (d) to receive information and review copies of all Trust accountings; (e) to exercise general administration of the Plan except to the extent responsibilities are expressly conferred on others; (f) to be the designated agent of the Plan for the service of legal process; (g) to determine conclusively for all parties all questions arising in the interpretation or administration of the Plan; (h) to employ a qualified investment manager to manage all or part of the Plan assets; (i) to allocate fiduciary duties and responsibilities (other than Trustee responsibilities) among members of the Committee or other named fiduciaries appointed by the Committee to act in such capacity and to designate persons other than named fiduciaries to carry out fiduciary responsibilities (other than Trustee responsibilities) under the Plan to the extent that it is deemed advisable by the Committee. For purposes of this subparagraph, Trustee responsibility shall mean any responsibility provided in the Trust to manage or control the assets of the Plan, other than power of the Committee to appoint an investment manager in accordance with Section 402(c)(3) of ERISA. Before the Committee delegates any duties or responsibilities as provided herein, it must first obtain approval for such delegation from the Board of Directors of St. Jude. The Committee shall periodically review the performance of any person to whom it has delegated such responsibilities. In no event shall the Committee delegate any authority to the Executive prior to the date he becomes fully vested in the Plan as provided in Article 6. It is intended under this Plan and Trust that each fiduciary shall be responsible for the proper exercise of its own powers, duties, responsibilities and obligations under this Plan and the Trust, and shall not be responsible for any act or failure to act of another fiduciary. 9.6 Compensation. No member of the Committee shall receive any compensation from the Trust for his services. 9.7 Indemnity. St. Jude shall indemnify each member of the Committee against any and all claims, loss, damages, expenses (including counsel fees approved by the Committee), and liability (including any amounts paid in settlement with the Committee's approval) arising from any loss or damage or depreciation which may result in connection with the execution of his duties or the exercise of his discretion or from any other action or failure to act hereunder, except when the same is judicially determined to be due to gross negligence or willful misconduct of such member. 9.8 Powers Denied. No action of the Committee shall: (a) alter the amount of the contribution otherwise payable to the Plan; (b) increase the duties or liabilities of the Trustee without its written consent; or (c) cause the funds contributed to this Trust or the assets of this Trust to ever revert to or be used or enjoyed by St. Jude, except as provided in this Plan. 9.9 Action When There is a Vacancy. If at any time there should be a vacancy on the Committee, then pending the appointment of a successor to fill such vacancy, the remaining members shall have the power to act on behalf of the Committee. 9.10 Settlement of Claims. The Committee shall have the power to accept, compromise, arbitrate, or otherwise settle any obligation, liability or claim, but it shall not be obligated to do so unless, in its sole judgment, it is in the interest of the Plan or Trust to do so. 9.11 Discretionary Powers. Whenever in this Plan and Trust discretionary powers are given to the Committee, it shall have absolute discretion, and its decision shall be binding upon all persons affected thereby. 9.12 Employment of Professionals and Assistants. The Committee shall have the power: (a) to secure such legal, medical, and actuarial advice or assistance as it deems necessary or desirable in carrying out the provisions of the Plan; (b) to appoint or employ such other advisors or assistants as it deems necessary or desirable to carry out its duties. The Committee shall have full discretion to employ any person or firm that it deems qualified to supply any of the required services set forth above; provided, however, that the person or firm so employed shall be independent of the control of St. Jude and, where required, shall have all necessary licenses to practice his profession. 9.13 Bond. Until such time as the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall obtain and maintain a fidelity bond that shall cover every fiduciary of the Plan and every person who handles funds or other property of the Plan ("Plan official"). Each fiduciary and Plan official shall be bonded in an amount which is not less than 10% of the assets of the Plan. Said bond will insure the Plan against loss by reason of acts of fraud or dishonesty on the part of every fiduciary and Plan official, directly or through connivance with others. ARTICLE 10 TRUSTEE 10.1 Duty and Liability of Trustee. The Trustee shall discharge its duties with respect to this Plan solely in the interests of the Executive and his Beneficiaries and for the exclusive purpose of providing benefits to the Executive and his Beneficiaries and defraying reasonable expenses of administering the Plan. The Trustee shall have generally all of the powers of owners with respect to securities or properties held in the Trust Fund, but shall not be liable for any losses incurred upon investments, except to the extent such Trustee failed to diversify the investments of the Plan so as to minimize the risk of large losses (unless under the circumstances it is clearly prudent not to do so), or failed to manage the investments of the Plan with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. Except to the extent such duties may be expressly allocated to the Trustee, the Trustee in its capacity as such shall have no authority or responsibility with respect to the operation and administration of the Plan. 10.2 General Scope of Powers. Except as otherwise provided in Article 5, the Trustee shall have all powers necessary for the performance of its duties. In extension, but not in limitation of the rights, powers and discretion conferred upon the Trustee by virtue of any statute or rule of law, or conferred upon the Trustee by other provisions of this Plan and Trust, the Trustee shall have and may exercise from time to time in the administration of the Trust herein created and for the purpose of distribution after the termination thereof and for the purpose of distributing the Executive's Beneficial Interest after vesting thereof, and without order or license of any court, any one or more of the following rights, powers and discretion: (a) To Determine Executive's Beneficial Interests. To compute and determine the interest of the Executive and Beneficiaries in the Trust Fund, and any such computation or determination made in good faith shall be binding and conclusive upon all parties to this Plan and Trust and upon all persons interested or who may become interested in the Trust Fund. (b) To Carry Securities in Nominee Form. To purchase, hold and carry investments for the Trust Fund in the name of the Trustee, or in the name of any nominee or nominees selected by the Trustee, without Trust designation in any said case, and to invest funds of the Trust in deposits, including savings accounts, savings certificates, and similar interest-bearing instruments or accounts, in itself or its affiliates, provided that such deposits bear a reasonable rate of interest. (c) To Exercise Powers of Owners in Cases of Reorganization, Merger and the Like. To institute, participate and join in any plan of reorganization or readjustment or merger or consolidation of any corporation, the securities of which are held by the Trust Fund, or to use any other means of protecting or dealing with any investments of the Trust Fund, and in general, to exercise each and every other power or right with respect to each investment of the Trust Fund as individuals generally have and enjoy with respect to their own investments and securities, including the power to give proxies, with or without power of substitution or revocation, and to deposit securities with any protective committee or with a trustee or with depositories designated by any such committee or by any such trustee or by any court. (d) To Segregate Funds for Proper Purposes. To segregate any parts or portion of the Trust Fund for the purposes of administration thereof, or for purposes of distribution, or for any other purpose deemed proper by the Trustee. (e) To Sue and Defend and be Indemnified on that Account. To institute or defend any proceedings at law or in equity concerning the Trust Fund or the assets thereof at the sole cost and expense of the Trust Fund, and of the several Beneficial Interests involved or concerned therein, but the Trustee shall be under no duty or obligation to institute, maintain, or defend any suit, action or other legal proceedings except and unless the Trustee shall have been indemnified to the Trustee's satisfaction against all expenses and liabilities which the Trustee may sustain or anticipate by reason thereof. (f) To Sell or Otherwise Dispose of Assets. To sell, exchange, or otherwise dispose of any investment of the Trust Fund for such price and on such terms as the Trustee in the Trustee's absolute discretion shall elect, without regard to whether the time of payment provided in any said sale shall be greater than the probable or actual duration of the Trust herein created or not. (g) To Employ Agents, Servants and Attorneys. To select and employ or retain such agents, servants, or attorneys as the Trustee from time to time may deem necessary or advisable in connection with the management and operation of the Trust herein created, and to pay the fees, commissions, or salaries incurred on account thereof as an expense of administration of the Trust. (h) To Value Assets and the Trust Fund. To fix and determine, at the current fair market value thereof, the value of the Trust Fund annually and from time to time as may be necessary or advisable, in the Trustee's opinion, for any of the purposes of this Plan and Trust, including power to fix and determine the then fair market value of each and every item constituting the Trust, the items composing the same, and any such computation, determination, or action of the Trustee made in good faith shall be binding and conclusive upon all parties to this Plan and Trust and upon St. Jude, and the Executive and his Beneficiary. (i) To Determine Complex Questions of Income and Principal. To determine, in accordance with sound business or accounting practices, with respect to any receipt of the Trust Fund and without regard to statutes or rules of law that otherwise would be controlling, the part or portion thereof which is income and the part or portion thereof which is principal, and to charge or credit to principal or income, as the Trustee may from time to time elect (without duty or obligation to exercise this power uniformly in all cases) any premiums paid or received or discounts received or allowed in connection with, or any gain or loss resulting from the purchase, sale, call, redemption or payment of any security or investment acquired, held, or disposed of by the Trust Fund. (j) To Require Settlement and Allowance of Accounts Before Making Distribution. In making distribution of any Beneficial Interest, to demand and receive from the Executive or Beneficiary such verification as the Trustee in its sole discretion shall require before the Trustee shall be obligated to pay, distribute, or make available any part thereof to the Executive or Beneficiary. (k) Form and Method of Accounting. To select and determine the appropriate forms, methods and books of account for use by the Trustee in the management and administration of the Trust herein created and for the purpose of accounting for the same. (l) Compensation. To receive reasonable compensation for the Trustee's services as Trustee hereunder, and to pay from out of the Trust Fund all costs, fees, expenses, taxes, and other charges and expenses of administration and distribution of the Trust Fund to the extent that they are not paid directly by St. Jude as provided in Section 4.1, and the Trustee shall further be entitled to reimburse itself for or on account of any said item of disbursement from and out of the Trust Fund from time to time held by the Trustee. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, all compensation and other expenses of the Trustee shall be paid solely from the Trust Fund. (m) To Pay any Taxes on the Trust Fund. To pay when due any taxes of any kind levied or assessed against the Trust Fund under the existing or future laws of the United States and any state or local taxing authority. To the extent required by law, the Trustee shall withhold from any payment to the Executive or Beneficiary any amount of taxes required by law, or such larger amounts as may be requested by the Executive or Beneficiary. The Trustee shall cooperate with St. Jude or the Executive who shall be primarily responsible for filing any return required by any tax authority in connection with the operation of the Plan. (n) To Hold and Deposit Funds. To hold uninvested such cash funds as may appear reasonably necessary to meet the anticipated cash requirements of the Plan from time to time, and to deposit such funds or any part thereof, either separately or together with other trust funds under the control of the Trustee, in its own deposit department or to deposit the same in its name as Trustee in such other depositories as he may select. 10.3 Powers Discretionary. Each of the foregoing rights, powers and discretion conferred upon the Trustee and each and every power possessed by trustees generally by virtue of any statute or rule of law or other provisions of this Plan and Trust shall be discretionary powers exercisable by the Trustee, and the Trustee shall in no event be or become liable to anyone on account of the exercise of any said power by him in good faith. 10.4 Annual Account. The Trustee shall account annually for the Trust Fund and for its various transactions in connection therewith to the Committee. 10.5 Person Dealing with Trustee. No purchaser at any sale made by the Trustee hereunder, and no person, firm, or corporation dealing with the Trustee shall be obligated to see to the application of any money or property paid or delivered to the Trustee. All persons dealing with the Trustee may act in reliance upon the signature of the Trustee and shall not be bound to inquire as to whether or not said signature represents valid action by the Trustee. 10.6 Prohibited Transactions. Except as may be expressly permitted by law, no Trustee or other fiduciary hereunder shall permit the Plan to engage, directly or indirectly, in any of the following transactions with a disqualified person (as defined in Section 4975 of the Code): (a) sale or exchange, or leasing, of any property between the Plan and a disqualified person; (b) lending of money or other extension of credit between the Plan and a disqualified person; (c) furnishing of goods, services or facilities between the Plan and a disqualified person; (d) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the Plan; (e) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of the Plan in his own interest or for his own account; or (f) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the Plan in connection with a transaction involving the income or assets of the Plan. 10.7 Indemnity. St. Jude shall indemnify, save and hold harmless, the Trustee from any and all loss, damage and liability which the Trustee may incur or sustain, arising out of the performance of its nondiscretionary duties under the Plan to the extent directed by the Committee, except to the extent that they result from the willful misconduct or gross negligence or lack of good faith of the Trustee, or such actions are otherwise contrary to the terms of the Plan or ERISA. Except to the extent otherwise required under ERISA or other applicable law, the Trustee shall not be liable for the acts or omissions of third parties. 10.8 Resignation and Appointment. The Trustee, or any successor Trustee, must accept its appointment in writing. The Trustee, or any successor Trustee, may resign as Trustee of this Trust at any time by giving 30 days' notice of resignation by registered mail to St. Jude, or if the Executive has become fully vested in the Plan, the Executive, or such shorter notice as may be agreed to by St. Jude or the Executive, as appropriate. Upon such resignation becoming effective, the resigning Trustee shall render to St. Jude an account of its administration of the Trust during the period following that covered by the most recent account, and shall perform all acts necessary to transfer the assets of the Trust to its successor Trustee. In the event of the resignation of the original or any successor Trustee, St. Jude, or if the Executive has become fully vested in the Plan, the Executive, shall have the power to appoint a successor Trustee. Any successor Trustee shall be a corporate Trustee with the authority to operate in the State of Minnesota and with assets under trust of at least $500,000,000. No successor Trustee shall be or become liable for any action or default of a prior Trustee. 10.9 Removal of Trustee. St. Jude, or if the Executive has become fully vested in the Plan, the Executive may remove a Trustee or any successor Trustee upon 30 days' notice of removal by registered mail to the Trustee, or such shorter notice as may be agreed to by the Trustee in the event the Trustee has breached its duties under this Plan. In case of such removal, the Trustee shall be under the same duty to account for and transfer assets of the Trust to a successor as hereinabove provided in the case of the resignation of a Trustee; and St. Jude or if the Executive has become fully vested in the Plan, the Executive shall have the same power to appoint a successor Trustee as provided in Section 10.8. 10.10 Continuation of the Trust. Resignation, disqualification, liability or removal of a Trustee shall not terminate the Trust; and any successor Trustee shall have all powers, duties and discretion herein conferred upon the original Trustee. ARTICLE 11 CLAIMS AGAINST THE TRUST FUND 11.1 Anti-Alienation of Benefits. Except as otherwise provided herein, neither the Executive nor any Beneficiary shall have any transmissible interest in the Trust Fund or in his Beneficial Interest therein, either before or after the vesting thereof, or in any of the assets comprising the same prior to actual payment and distribution thereof to him, nor shall such person have any power to alienate, dispose of, pledge or encumber the same, while in the possession or control of the Trustee, nor shall the Trustee recognize any assignment thereof, either in whole or in part, nor shall the interest of the Executive or Beneficiary be subject to attachment, garnishment, execution or other legal process while in the hands of the Trustee. 11.2 Qualified Domestic Relations Orders. Notwithstanding any provision to the contrary herein, the Committee may assign the interest of the Executive in the Plan to an Alternate Payee pursuant to a Qualified Domestic Relations Order if such order is received prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. In the event the Plan receives a Qualified Domestic Relations Order with respect to the Executive's interest in the Trust Fund, the following provisions shall apply: (a) The Committee shall promptly give written notification to the Executive and to the Alternate Payee of receipt of a domestic relations order and of Plan Qualification Procedures. The Committee shall then proceed with Qualification Procedures to determine whether the order is a Qualified Domestic Relations Order and shall notify the Executive and Alternate Payee (or the Alternate Payee's designated representative) of its determination. (b) Disputed funds shall be disposed of as follows: (i) During the period in which the Qualification Procedures are in progress, the Committee shall separately account for any amounts which would be payable to an Alternate Payee if the domestic relations order is determined to be a Qualified Domestic Relations Order. (ii) If the order is determined to be a Qualified Domestic Relations Order within the 18-month period beginning on the date on which the first payment would be required to be made under the order, the Committee shall pay the amounts designated in the Order, together with earnings or losses, if required, to the Alternate Payee. (iii) If the Committee determines that the order is not a Qualified Domestic Relations Order, or if the 18-month period described in paragraph (i) above elapses and the qualification dispute has not been resolved, the Committee shall pay such amounts, together with earnings or losses, if required, to the persons who would have received the amounts if the order had not been issued. (iv) If an order is qualified after expiration of the 18-month period described in paragraph (i) above, payment of benefits to an Alternate Payee shall proceed prospectively and the Plan shall not be liable to an Alternate Payee for benefits attributable to the period prior to qualification. (c) The Committee shall obey a Qualified Domestic Relations Order requiring that benefits be paid to an Alternate Payee beginning on a date on or after the Executive's Earliest Retirement Age, even though the Executive does not have a Termination of Employment on that date. (d) Payment of benefits pursuant to a Qualified Domestic Relations Order shall be made only as permitted under the Plan. (e) To the extent permitted by law and except as otherwise provided under a Qualified Domestic Relations Order, the Committee may, on a uniform basis, charge the reasonable and necessary expenses associated with the review of a domestic relations order and the implementation of a Qualified Domestic Relations Order as an expense of the Trust. 11.3 Independent Fund. In the event St. Jude shall at any time go out of business, cease to exist, be dissolved, either voluntarily or involuntarily, or have a receiver or trustee in bankruptcy appointed for it, or be merged or consolidated into or with another company, no part of the Trust Fund created hereunder or the Executive's Beneficial Interest shall in any manner whatsoever be or become subject to the rights or claims of any of its creditors, but the Trust herein created from its inception shall be a separate entity, aside and apart from St. Jude and its assets, and except as provided in Section 6.2, St. Jude shall have no claim or right to repossess any part of the funds or properties of the Trust or of the income derived therefrom. ARTICLE 12 RIGHTS OF ST. JUDE TO AMEND, DISCONTINUE OR TERMINATE 12.1 Amendment. Except as herein limited, prior to the date the Executive becomes fully vested in the Plan as provided in Article 6, the Board of Directors of St. Jude shall have the right to amend this Plan and Trust at any time to the extent necessary to satisfy the requirements of ERISA. Such amendment will be stated in an instrument in writing executed by St. Jude. Upon delivery of such instrument to the Trustee, this Plan and Trust shall be deemed to have been amended in the manner therein set forth, and the Executive shall be bound thereby; provided, however: (a) that no amendment shall increase the duties or liabilities of the Trustee without its written consent; (b) that no amendment shall have the effect of vesting in St. Jude any interest in or control over any of the funds or properties subject to the terms of the Trust; (c) that no amendment shall modify the vesting requirements hereunder; and (d) that no amendment shall reduce the Executive's Beneficial Interest. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Plan and Trust shall not be amended except upon written agreement of both the Executive and the Board of Directors of St. Jude. 12.2 Termination of Plan. This Plan shall continue indefinitely as a contractual obligation of St. Jude until such time as the purposes herein are accomplished, at which time the Plan shall terminate. From and after the date Executive becomes fully vested in the Plan as provided in Article 6, the Plan and Trust shall not be terminated except by written agreement of both the Executive and the Board of Directors of St. Jude. 12.3 Termination of Trust. The term of the Trust herein created shall be for such time as may be necessary to accomplish the purposes set forth herein and in no event shall the term exceed the limits prescribed by the laws of the jurisdiction to which the Trust is subject. In the event such limit should be reached at any time, or for any reason, prior to the accomplishment of the purposes for which the Trust is created, the Trust shall be deemed to have terminated upon the attainment of such limit. The Board of Directors of St. Jude reserves the right to terminate the Trust at any time after the Executive's rights in the Plan are fully vested with the consent of the Executive, provided that all assets in the Trust Fund are distributed to the Executive and his Beneficiaries in the form of a nontransferable, noncancellable annuity contract. ARTICLE 13 SUCCESSOR EMPLOYER AND MERGER OR CONSOLIDATION OF PLANS 13.1 Successor Employer. In the event of the dissolution, merger, consolidation or reorganization of St. Jude, provision may be made by which the Plan and Trust will be continued by the successor; and, in that event, such successor shall be substituted for St. Jude under the Plan. The substitution of the successor shall constitute an assumption of Plan liabilities by the successor and the successor shall have all of the powers, duties and responsibilities of St. Jude under the Plan. 13.2 Merger and Consolidation. This Plan shall not be merged into or consolidated with, or the assets and liabilities of the Trust Fund transferred in whole or in part to another trust fund held under any other plan or deferred compensation plan maintained or to be established for the benefit of and other employees of St. Jude. ARTICLE 14 MISCELLANEOUS 14.1 Liability of St. Jude. All benefits payable under the Plan shall be paid or provided for solely from the Trust. Upon the deposit of funds into the Trust as provided in Section 4.1, St. Jude shall have no further responsibility for contributions or otherwise to provide for the Beneficial Interest of the Executive under this Plan and Trust. From and after the date the Executive becomes fully vested in the Plan in accordance with Article 6, St. Jude's authority under this Plan and Trust shall be limited to the enforcement of the limitations on distributions set forth in Article 7 and to approving the termination of the Plan and Trust upon satisfaction of all of its liabilities to Executive. 14.2 Indemnification. St. Jude shall be responsible to comply with any and all applicable requirements of ERISA, including, but not limited to, all reporting and disclosure imposed upon the Employer during the term of the Plan and Trust, and St. Jude shall indemnify and hold harmless the Executive from any liability resulting from any act or omission by St. Jude as Employer in connection with the Plan and Trust. Executive shall indemnify and hold harmless St. Jude from any loss or liability arising out of ERISA or otherwise resulting from any act or omission of Executive required or permitted hereunder. 14.3 No Guarantee of Employment. Nothing contained in this Plan and Trust shall be deemed to give the Executive the right to be retained in the employ of St. Jude or to interfere with the right of the Executive to terminate his employment with St. Jude at any time. 14.4 Governing Law. This Plan and Trust shall be construed, administered, and governed in all respects under the laws of the State of Minnesota to the extent not preempted by federal law. 14.5 Binding Effect. This Plan and Trust shall be binding upon and inure to the benefit of the heirs, personal representatives, successors and assigns of any and all of the parties hereto. IN WITNESS WHEREOF, St. Jude Medical, Inc. has caused the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust to be executed by its officer, who has been duly authorized by its Board of Directors; Norwest Bank Minnesota, N.A. has executed this Plan and Trust and hereby accepts its appointment as Trustee; and Executive has executed this Plan and Trust, as of the Effective Date. ST. JUDE MEDICAL, INC. [signature] By: Lawrence A. Lehmkuhl Its Chairman of the Board NORWEST BANK MINNESOTA, N.A. [signature] By Jeanne M. Whitehill Its Assistant Vice President [signature] By Christine Kaehler Its Vice President EXECUTIVE: Ronald A. Matricaria EXHIBIT A WRITTEN INVESTMENT POLICY PURSUANT TO SECTION 5.2 The general investment objectives for the Plan are: 1. To outperform inflation and to equal or exceed the total return of the Standard & Poor's 500 Index. 2. To establish a diversified investment portfolio consisting of equities, fixed income and cash investments that are diversified among securities and industries and are of acceptable quality and diversification. 3. To maximize the pretax return for the total portfolio within reasonable and prudent levels of risk. The general philosophy for the investment program follows: A. The investment program should achieve performance results over a full market cycle that compare favorably to major market indices. B. A particular security class may underperform appropriate market indices in strong markets because of the need to maintain a moderate risk posture in both equity and fixed income investments. C. The Plan should have better than average performance in a weak or declining market by outperforming appropriate market indices because it expects to avoid significant exposure to market declines. D. There should be consistency of results allowing negative returns for both equities and fixed income assets so long as the appropriate market indices are also negative; provided, however, that the Plan in the aggregate should outperform appropriate market indices during periods of negative market results. SUPPLEMENTARY EXECUTIVE RETIREMENT PLAN AGREEMENT THIS AGREEMENT, between St. Jude Medical, Inc., a Minnesota corporation ("St. Jude") and Lawrence A. Lehmkuhl of St. Paul, Minnesota ("Mr. Lehmkuhl"), restating and superseding that certain Supplementary Executive Retirement Plan Agreement dated September 30, 1988, is made and entered into as of the 9th day of April, 1993. WHEREAS, St. Jude and Mr. Lehmkuhl entered into a Supplementary Executive Retirement Plan Agreement effective September 30, 1988 (the "1988 Agreement") to provide Mr. Lehmkuhl with a meaningful pension benefit upon his retirement, taking into account the benefits to which Mr. Lehmkuhl is otherwise due under St. Jude's qualified pension plan and other sources; and WHEREAS, Mr. Lehmkuhl intends to resign as an employee of St. Jude and assume the duties as Chairman of the Board of Directors of St. Jude, whereupon he would forfeit any benefits under the 1988 Agreement, unless St. Jude terminates the Agreement before such termination of employment or otherwise agrees to provide such benefit to Mr. Lehmkuhl; and WHEREAS, paragraph 12 of the 1988 Agreement reserved to St. Jude the power to amend or terminate the Agreement at any time by action of its Board of Directors; and WHEREAS, St. Jude desires to continue to provide Mr. Lehmkuhl the benefits otherwise accrued under the 1988 Agreement at the time of his termination of employment and to restate and modify the 1988 Agreement as set forth herein. THEREFORE, pursuant to the authority reserved to St. Jude in paragraph 12 of the 1988 Agreement, the 1988 Agreement is hereby restated in it entirety to read as follows: 1. Purpose. The purpose of this Agreement is to provide an unfunded deferred compensation for Mr. Lehmkuhl, who is a member of a select group of management employees of St. Jude as that term is used in the Employee Retirement Income Security Act of 1974, as amended in accordance with the terms of the 1988 Agreement. 2. Definitions. The following capitalized terms shall have the meanings specified in this section: a. "Accrued Benefit" shall mean the amount payable to Mr. Lehmkuhl or his named beneficiaries, which represents the present value of Mr. Lehmkuhl's Pension Benefit less his Benefit Offset described in Section 3 discounted at an annual rate of 6% from his Normal Retirement Date to the date of the determination, as set forth on the attached Exhibit A. b. "Actuarial Equivalent" shall mean a lump sum amount payable as of Mr. Lehmkuhl's Normal Retirement Date based on reasonable mortality tables and interest rate consistently applied. c. "Benefit Offset" shall mean the sum of the following retirement benefits (including any death benefit payable upon the death of Mr. Lehmkuhl) expressed as: (i) $3,000, representing the accrued benefit under the American Hospital Supply Corporation Employee Pension Plan and any other deferred compensation plan of American Hospital Supply Corporation or its affiliates to which Mr. Lehmkuhl may be entitled; (ii) $3,476, representing the assumed life annuity value of the account balance under the St. Jude Medical, Inc. Retirement Savings Plan and Trust attributable to contributions other than Mr. Lehmkuhl's cash or deferred contributions or rollover contributions; and (iii) $1,806, representing the assumed Social Security benefits to which Mr. Lehmkuhl is entitled, whether or not Mr. Lehmkuhl is or has been receiving such benefits prior to age 65. d. "Normal Retirement Date" shall mean the date on which Mr. Lehmkuhl attains age 65. e. "Pension Benefit" shall mean $13,225, payable monthly during Mr. Lehmkuhl's life, beginning with the month Mr. Lehmkuhl attains his Normal Retirement Date, which amount represents 50% of Mr. Lehmkuhl's average monthly base salary for the 12 months prior to July 1, 1993. 3. Retirement Pension Benefit. If Mr. Lehmkuhl attains his Normal Retirement Date, St. Jude shall pay to Mr. Lehmkuhl the Actuarial Equivalent of the Pension Benefit, less Mr. Lehmkuhl's Benefit Offset and less the cash surrender value owned by or transferred to Mr. Lehmkuhl (including any policy loans taken by Mr. Lehmkuhl) of any Policy maintained pursuant to that certain Split-Dollar Agreement dated September 30, 1988, as restated April 9, 1993, together with the amount provided in Section 6. Such amount shall be payable in a single lump sum within 60 days following Mr. Lehmkuhl's attainment of his Normal Retirement Date. In the event the cash surrender value of such policy exceeds the Actuarial Equivalent of the Pension Benefit less the Benefit Offset, no payment shall be due hereunder. 4. Pre-Retirement Death Benefit. In the event Mr. Lehmkuhl dies prior to his Normal Retirement Date, St. Jude shall pay to Mr. Lehmkuhl's named beneficiary or beneficiaries his Accrued Benefit as of the date of his death, less the cash surrender value owed by or transferred to Mr. Lehmkuhl (including any policy loans taken by Mr. Lehmkuhl) of any Policy maintained pursuant to that certain Split Dollar Agreement dated September 30, 1988, as restated April 9, 1993. The Pre-Retirement Death Benefit shall be payable in a single lump sum within 60 days following Mr. Lehmkuhl's date of death. 5. Designation of Beneficiary. Mr. Lehmkuhl may designate a beneficiary or beneficiaries and may change such designation at any time by written notice to St. Jude in the form attached hereto, which shall be effective only upon receipt by St. Jude. In the event Mr. Lehmkuhl fails to name a beneficiary, or if any and all designated beneficiaries have predeceased Mr. Lehmkuhl, payment of any benefits shall be made to Mr. Lehmkuhl's spouse, if living, otherwise to Mr. Lehmkuhl's surviving children in equal shares, and if no spouse or children survive Mr. Lehmkuhl, to the executor or administrator of Mr. Lehmkuhl's estate. 6. Additional Payment for Taxes. In addition to the amount payable under Sections 3 or 7 of this Agreement, St. Jude shall pay to Mr. Lehmkuhl such additional compensation as is necessary, after taking into account all federal, state and local taxes payable by Mr. Lehmkuhl as a result of the receipt of such additional compensation, such that the payment received under Sections 3 or 7 represents an after tax amount. 7. Merger, Consolidation or Sale of Assets. In the event of a merger, consolidation or sale of substantially all of the assets of St. Jude where St. Jude is not the surviving corporation, Mr. Lehmkuhl's Accrued Benefit shall be immediately payable to Mr. Lehmkuhl in a lump sum within 60 days of the effective date of such merger, consolidation or sale of assets, together with the amount provided in Section 6; provided that such tax payment shall never exceed the tax otherwise payable at Normal Retirement Age as if this Agreement had continued in effect until such date. 8. Assignment of Benefits. Neither Mr. Lehmkuhl, nor his spouse or beneficiary may assign or alienate the benefits payable under this Agreement, whether voluntary or involuntary, or directly or indirectly. 9. No Funding. This Agreement shall not be funded by St. Jude and neither Mr. Lehmkuhl, his spouse nor beneficiaries shall have any right, title, or interest in any of St. Jude's assets or have any greater rights than an unsecured general creditor of St. Jude in any respect with regard to benefits payable under this Agreement. 10. Claims and Arbitration Procedure. The Board of Directors of St. Jude shall make all determinations concerning rights to benefits under this Agreement; provided that the Chairman shall not participate in any matter before the Board regarding this Agreement. Any decision by the Board of Directors of St. Jude denying a claim by Mr. Lehmkuhl for benefits under this Agreement shall be stated in writing and delivered or mailed to Mr. Lehmkuhl (or beneficiary). Such decision shall set forth the specific reasons for the denial, as well as specific reference to the provisions of this Agreement upon which denial is based. In addition, St. Jude shall afford a reasonable opportunity to Mr. Lehmkuhl (or his beneficiary) for a full and fair review of the decision denying such claim, provided that such request for a review is received by St. Jude within 60 days of the date of receipt of such denial. If any claim arising under this Agreement is not resolved under the preceding paragraph or any other dispute arises under the terms of this Agreement, the Board of Directors of St. Jude and Mr. Lehmkuhl agree to submit the claim or dispute to arbitration proceedings held in accordance with the rules of the American Arbitration Association. Judgment upon the award rendered by the arbitrators may be entered in any court having jurisdiction thereof. Pending final resolution of the dispute, St. Jude and Mr. Lehmkuhl shall continue to comply with the provisions of this Agreement not in dispute. The expenses of the arbitration shall be borne equally by the parties to the arbitration, provided that each party shall pay for and bear the costs of its own experts, evidence and legal counsel. Such arbitration shall be held in Minneapolis, Minnesota. 11. Amendment and Termination. St. Jude may amend and may terminate this Agreement at any time by the action of its Board of Directors in the event of a change in the laws providing for the deferral of income taxes on amounts deferred under this Agreement. Any amendment to or termination of this Agreement shall not decrease the obligations of St. Jude to pay a benefit equal to the benefit that would have been provided to Mr. Lehmkuhl upon his Normal Retirement Date, and further provided that upon termination of this Agreement, the Board of Directors of St. Jude may, in its sole discretion, pay to Mr. Lehmkuhl his Accrued Benefit at time of the termination of this Agreement. 12. Construction of Agreement. This Agreement shall be construed according to the laws of the State of Minnesota. IN WITNESS WHEREOF, St. Jude has caused this Agreement, which restates and supersedes the 1988 Agreement, to be executed on behalf of the corporation and Mr. Lehmkuhl has executed this Agreement as of the day and date first above written. ST. JUDE MEDICAL, INC. By Thomas H. Garrett III Its Secretary ___________________________ Lawrence A. Lehmkuhl CALCULATION OF ACCRUED BENEFIT AND DEATH BENEFIT UNDER SERP Calendar Year Accrued Benefit Under SERP Agreement 1993 $371,275 1994 393,552 1995 417,165 1996 442,194 1997 468,726 1998 496,850 1999 526,661 2000 558,260 2001 591,756 2002 627,261 ST. JUDE MEDICAL, INC. DESIGNATION OF BENEFICIARY Pursuant to the terms of an Executive Supplemental Retirement Agreement, dated April 9, 1993, between St. Jude Medical and Lawrence A. Lehmkuhl, I hereby designate the following beneficiary(ies) to receive any payments which may be due under such Agreement after my death: Primary Beneficiary 1. [ ] My spouse, ______________________________________, if my spouse survives me. 2. [ ] My descendants, per stirpes, who survive me. (The share of a deceased child will be distributed to the deceased child's children.) 3. [ ] My children who survive me in equal shares. (The children of a deceased child will not be entitled to their parent's share.) 4. [ ] Other: _______________________________________________________________ Name Relationship Contingent Beneficiary(ies) --------------------------------------------------------------- Name Relationship --------------------------------------------------------------- Name Relationship The Primary Beneficiary named above shall be the designated beneficiary referred to in Article 4 of said Agreement if he or she is living at the time a death benefit payment thereunder becomes due and payable, and the Contingent Beneficiary named above shall be the designated beneficiary referred to in Article 4 of said Agreement only if he or she is living at the time a death or retirement benefit payment becomes payable and the Primary Beneficiary is not then living. Upon acknowledgement by St. Jude this designation hereby revokes any prior designation which may have been in effect. Date:______________________________ _______________________________ ______________________________ (Witness) Lawrence A. Lehmkuhl Acknowledged By: ______________________________ Title Received By (Company Use Only): ______________________________ ST. JUDE MEDICAL, INC. MANAGEMENT INCENTIVE COMPENSATION PLAN MANAGEMENT INCENTIVE COMPENSATION PLAN The Management Incentive Compensation Plan (MICP) is designed to reward management for achieving annual performance goals. MICP intents include: Reinforce strategically important operational objectives Establish stretch goals related to profitability, and Provide additional compensation based on achieving significant company, division, organizational unit and individual goals The Plan serves St. Jude's interests by motivating its management and providing annual compensation opportunities which are comparable to those found among similar organizations within the industry. 1994 CHANGES The MICP contains several changes for 1994 which are detailed in later sections of this document. These changes include: Incorporating the Technical Incentive Compensation Plan (TICP) into the MICP Establishing the lowest level of Plan eligibility at grade levels A15 and E15 Assigning performance measures which are most directly within participants' control Calculating MICP awards by adding results from each performance measure rather than multiplying results across performance measures For 1994, setting 10% of payout aside subject to president/ CEO discretion Redefining base salary as annual base compensation paid during the Plan year, excluding commissions, special awards, bonuses, and perquisites. PLAN SUMMARY Individual MICP awards for division participants are based on achievement of corporate earnings per share (EPS), division income before taxes (IBT), and local/individual performance objectives (MBO). Individual MICP awards for corporate participants are based on achievement of corporate EPS and individual performance objectives. Awards are calculated and distributed during the first quarter of the subsequent year following Audit Committee approval of year end results and subject to approval by the president/CEO, the Compensation Committee of the Board and the Board of Directors. Funding for the Plan is based on percent of corporate EPS goal achieved. The president/CEO and the Compensation Committee of the Board set the corporate EPS target annually based on the Company's operating plan, subject to approval by the Board of Directors. TARGET AWARD LEVELS Target award levels vary by participant grade level. Award levels range from 20% of base salary at the A15/E15 level to 50% of base salary at the A24 level, and 100% for the president/CEO. MANAGEMENT INCENTIVE COMPENSATION PLAN TARGET AWARD LEVELS Grade Level Management Group Percent of Base ----------------------------------------------------- A26 President/CEO 100% A24 Officers 50% A20-A22 Officers 40% A18-A19 Officers/Directors 30% E/A16-E/A17 Directors/Managers 25% E/A15 Managers 20% In the event that performance measures are exceeded, awards may exceed the above-stated target award levels. Such overachievement awards will be based on a percentage of the participants' bonus to a maximum of 25% of the bonus. PERFORMANCE MEASURES The Plan uses three performance measures to determine MICP awards: corporate EPS, division IBT, and local/individual performance objectives. The Plan assigns performance measures which are most directly within participants' ability to influence them. For example, division presidents directly impact division performance which in turn impacts the consolidated results of the Company. Division presidents, therefore, have been assigned MICP performance measures which are exclusively tied to corporate and division results. Corporate participants directly impact overall corporate results and, therefore, have performance measures largely based on corporate EPS. Performance measures for division participants, including country managers, are largely based on division and local/individual performance objectives. PERFORMANCE MEASURES & WEIGHTS BY ORGANIZATIONAL LEVEL CORPORATE DIVISION LOCAL/INDIVIDUAL Earnings Per Income Before Performance Levels: Share (EPS) Taxes (IBT) Objectives - ----------------------------------------------------------------- CEO 100% - - Division Presidents 50% 50% Corporate Participants 70% - 30% Division Participants 30% 40% 30% Country Managers 20% 30% 50% INDIVIDUAL OBJECTIVES Corporate EPS and division IBT goals are established prior to the start of each Plan year by the president/CEO, the Compensation Committee of the Board, and the Board of Directors. The process for setting participants' local/individual performance objectives begins with the operating plan as approved by the Board of Directors. Based on the operating plan, the president/CEO provides direct staff with annual objectives for application within their specific functional area. All MICP participants will incorporate these objectives to the extent they apply in their functional area. The six-to-seven most essential individual performance objectives are listed on the 1994 Local/Individual Performance Objectives form (see Appendix A) and submitted for approval to the division president and/or the president/CEO. Once approved, objectives are reviewed quarterly to ensure milestones are met and any changes are reviewed by the president/CEO. The year-end achievement level for local/individual performance objectives must be approved by the division president or corporate vice presidents, with final approval by the president/CEO. ELIGIBILITY Employees in grade level 15 and above positions as of January 1 of the Plan year are eligible to participate in MICP, subject to president/CEO approval. New employees hired into grade level 15 and above positions after January 1 but before October 1 of the Plan year are eligible to participate on a pro rata basis. Current employees promoted into grade level 15 and above positions between January 1 and October 1 of the Plan year will be eligible to participate, or participate at a higher level, on a pro rata basis. Individuals hired or promoted into grade level 15 and above positions after October 1 of the Plan year will be ineligible for participation during the remainder of the Plan year. FURTHER INFORMATION This information summarizes the Management Incentive Compensation Plan. It is not intended to be an all inclusive document. The Compensation Committee of the Board and the Board of Directors has final discretion on all employee incentive programs. If you have any questions regarding this Plan, please contact the division human resource manager or Corporate Compensation. DEFINITION OF TERMS The following terms as used in the Plan shall have the meaning as set forth below: PERFORMANCE MEASURES - Performance measures for corporate EPS, division IBT and local/individual performance objectives are based on the operating plan. The Board may amend the performance measures to reflect material adjustments in or changes to the Company's accounting policies; to reflect changes due to foreign currency translations, to reflect material corporate changes such as mergers, acquisitions, or divestitures; and to reflect such other events having a material impact on the performance measures. BASE SALARY - Annual base compensation paid during the Plan year, excluding commissions, special awards, bonuses, and perquisites. PARTICIPANT - Any employee or position which shall have been designated by the Board as a participant in the Plan for the year or during the year. ELIGIBILITY - If a management position is qualified to participate in the MICP, individuals will be eligible on January 1 of the Plan year. Any individuals hired or promoted into an MICP position on or before October 1 of the Plan year shall be eligible to participate on a pro rata basis effective with the date in which the individual is hired or promoted. Individuals hired or promoted into an MICP position after October 1 will not be eligible to participate in the Plan until the following year. PLAN YEAR - Shall mean the fiscal year of the corporation. FUNDING - Funding levels are determined by percent of corporate EPS goal achieved. AWARDS - The actual amount to be paid to a participant based upon achievement of corporate, division and local/individual performance objectives (as applied). TARGET AWARD LEVELS - The percent of base salary for which a participant is eligible, based on grade level. For instance, an A15 participant is eligible for a 20% target award. OVERACHIEVEMENT AWARDS - Achievement in excess of 100% of Corporate EPS and division IBT performance measures may qualify the participant for an additional award based on a percentage of the normal award. DESIGNATION OF PARTICIPANTS - The minimum level of MICP eligibility is at grade level A15 or E15. Each eligible employee at grade 15 or above shall be furnished with a copy of the Plan as it applies to him/her and shall be notified of the level of incentive for which he/she is eligible. PAYMENT OF AWARDS - Individual awards will not be paid until the president/CEO and Compensation Committee of the Board of Directors approve each participant's individual award and the Audit Committee approves year-end results. PROMOTIONS - Awards for individuals promoted to either a higher level MICP position or from a non-MICP position to an MICP position prior to October 1 of the Plan year will be pro- rated effective the day in which the individual is promoted into the new position. DEMOTIONS - For individuals demoted from one MICP level position to another, the lower MICP level will be effective the day in which the demotion occurs. For individuals demoted into a non-MICP position, MICP award will be pro- rated based on the length of time in the MICP position. TERMINATION OF EMPLOYMENT - In the event that any participant shall cease to be a full-time employee during any year in which s/he is participating in the Plan, such participant shall be entitled to receive no incentive compensation for such Plan year. If s/he terminates after the Plan year, but prior to the award payment, payment is at the discretion of the president/CEO. AMENDMENT OF THE PLAN - The Board, may, from time to time, make amendments to the Plan as it believes appropriate and may terminate the Plan at any time, provided that no such amendment or termination will affect the right of any participant to receive incentive compensation in accordance with the terms of the Plan for the portion of any year up to the date of the amendment or termination. MISCELLANEOUS - Nothing contained in the Plan shall be construed to confer upon any employee any right to continue in the employ of the Company or the Company's right to terminate his/her employment at any time. 1994 MICP PERFORMANCE MEASURES CORPORATE Corporate performance funds MICP awards. The award level for the president/CEO is 100% based on Corporate performance. Corporate performance impacts MICP awards for other participants as follows: division presidents (50%), division participants (30%), corporate participants (70%), and country managers (20%). 1994 CORPORATE PERFORMANCE (YEAR-END EARNINGS PER SHARE) Percent of Funding Goal Achieved Percentage - ------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 95% 55% 94% 50% 0% Under the 1994 program, payment of 10% of a participant's target award will be subject to the president/CEO discretion. LOCAL/INDIVIDUAL PERFORMANCE OBJECTIVES Division and corporate participant MICP awards are 30% based on local/individual performance. Country managers MICP award is 50% based on local country performance. 1994 LOCAL/INDIVIDUAL PERFORMANCE LOCAL/INDIVIDUAL PERFORMANCE OBJECTIVES Percent of Award Measure Achieved Percentage - ---------------- ---------- 100% 100% 99% 99% 98% 98% 97% 97% 96% 96% 95% 95% 94% 94% 93% 93% 92% 92% 91% 91% 90% 90% 85%-89% 85% 80%-84% 80% <80% 0% DIVISION GOALS Division performance directly impacts corporate EPS. Division presidents have 50% of their MICP award based on division performance, other division participants have 40% of their MICP award based on division performance, and country managers have 30% of their MICP award based on division performance. 1994 ST. JUDE MEDICAL DIVISION INCOME BEFORE TAXES (IN THOUSANDS) Percent of Award Measure Achieved Percentage - ---------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 91-95% 55% 85-90% 50% Under 85% 0% 1994 CARDIAC ASSIST DIVISION INCOME/LOSS BEFORE TAXES (IN THOUSANDS) Percent Measure Award Achieved Percentage - ---------------- ---------- 307% 115% 276% 110% 245% 105% 215% 100% 184% 95% 153% 90% 123% 85% 100% 80% 50% 75% 0% 70% -150% 65% -200% 60% Under -200% 0% 1994 ST. JUDE MEDICAL INTERNATIONAL DIVISION INCOME BEFORE TAXES (IN THOUSANDS) Percent of Award Measure Achieved Percentage - ---------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 91-95% 55% 85-90% 50% Under 85% 0% ESTABLISHMENT OF 1994 INDIVIDUAL PERFORMANCE OBJECTIVES In establishing individual performance objectives, the following guidelines should be used: Each objective should be concise, clear and measurable (based on time, cost, and task accomplishment) Each objective should be a precise, written statement which is discussed and agreed upon by the individual and manager Individual objectives should measure accomplishment and not effort Individuals should normally have 6-to-7 objectives in total Before receiving an MICP award, it will be necessary for immediate managers to: Submit written measurable objectives using the attached format prior to commencement of the Plan year (or two weeks after receipt of this material) to the division president and/or the president/chief executive officer for review and approval Submit a documented quarterly evaluation of results against established objectives to the division president and/or the president /chief executive officer by the second Monday following each calendar quarter closes Any modifications or adjustments to the original objectives must be reviewed by the participant and his/her manager and then submitted to the division president or the president/chief executive officer for their respective approvals Submit the final year-end results against objectives by January 9, 1995, to the division president and the president/chief executive officer for their respective approvals All proposed MICP awards will be reviewed for approval by the Compensation Committee of the Board of Directors ACKNOWLEDGEMENT 1994 MANAGEMENT INCENTIVE COMPENSATION PLAN This is to acknowledge that I have read and understand the terms and conditions of the attached Management Incentive Compensation Plan for the 1994 Plan year. NAME: __________________________________ DATE: ___________________________________ EXHIBIT 11 ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 EXHIBIT 11 - COMPUTATION OF EARNINGS PER SHARE ST. JUDE MEDICAL, INC. Annual Report Leader in Quality Products for Tomorrow's Health Care [photo] Financial Highlights 1 Letter to Shareholders 2 Q&A with the CEO 4 Review of Operations 6 Mission Statement 16 Management's Discussion and Analysis 17 Report of Management 21 Report of Independent Auditors 21 Consolidated Financial Statements 22 Notes to Consolidated Financial Statements 26 Ten-Year Summary of Selected Financial Data 30 Directors and Officers 32 Investor Information 33 ABOUT THE COMPANY St. Jude Medical, Inc. is a multinational manufacturer and marketer of the world's leading mechanical heart valve. The Company serves physicians worldwide with the highest quality medical devices for cardiovascular applications. Since the introduction of the St. Jude Medical(R) mechanical heart valve in 1977, more than 500,000 have been successfully implanted. St. Jude Medical is headquartered in St. Paul, Minnesota, and has operations in Chelmsford, Massachusetts; St. Hyacinthe, Canada; Caguas, Puerto Rico; and Brussels, Belgium; as well as sales and service offices throughout the United States, Japan and Europe. The Company's products are sold in more than 75 countries and its customers include more than 1,500 open heart centers worldwide. At December 31, 1993, St. Jude Medical employed 722 people in 11 countries. St. Jude Medical, Inc. common stock is traded on the over-the-counter market's National Market System under the symbol STJM. Listed options are traded on the Chicago Board Options Exchange under the symbol SJQ. OUR PRODUCTS *St. Jude Medical(R) mechanical heart valve. *St. Jude Medical(R) mechanical heart valve Hemodynamic Plus series. *BioImplant(R) tissue heart valve. *Toronto SPVtm tissue heart valve. *BiFlex(tm)annuloplasty ring. *Collagen-impregnated aortic valved graft. *Model 700 intra-aortic balloon pump system. *RediFurl(R), RediGuardtm and TaperSeal(R) intra-aortic balloon catheters. *Lifestream(R) centrifugal pump system. *Isoflow(R) centrifugal pump. THE COVER: JUDI GAVIN OF PRINCETON, NEW JERSEY What difference has a St. Jude Medical(R) mechanical heart valve made in the life of Judi Gavin, 41-year-old competitive A level tennis player, certified scuba diver and skier? "I now feel like I have a Maserati engine in a Yugo body," Gavin says. She was born with congenital aortic stenosis, a narrowing of the aortic valve. When she was a child, her condition was discovered by her father, Angelo Migliori, M.D., now a retired cardiologist -- and his daughter's frequent tennis partner. Despite shortness of breath, Gavin developed an extremely active lifestyle. But her condition progressively worsened, forcing her to have surgery to replace her aortic valve at age 35. Gavin recalls: "I was concerned about the effects a St. Jude valve would have on my life. But knowing what I know now, I'd have had the surgery years before I did. I feel better than I ever have. Four months after my surgery, I won the tennis tournament at my club for the third consecutive year. I can still scuba dive to depths of 90 feet. And I love to ski from the top of a mountain to the bottom without stopping, which I could never do before. I've also taken up aerobic exercises." Gavin works full time as a manager in IBM's Latin America organization. She volunteers with the Women's Heart Research Foundation, from whom she received the 1993 Ambassador Award. She has written and plans to publish a book for children with serious illnesses. FINANCIAL HIGHLIGHTS (Dollars in thousands, except per share amounts) Year ended December 31 1993 1992 % Change INCOME STATEMENT Net sales $252,642 $239,547 5 Operating profit 131,288 122,258 7 Net income 109,643 101,658 8 Earnings per share 2.32 2.12 9 PROFIT MARGINS Gross 75.7% 74.8% Operating 52.0 51.0 Net 43.4 42.4 BALANCE SHEET Cash and marketable securities $368,991 $338,690 9 Property, plant and equipment, net 47,185 35,433 33 Total assets 526,817 469,750 12 Shareholders' equity 484,241 429,039 13 FINANCIAL CONDITION Current ratio 11.0/1 10.8/1 Shareholders' equity to total liabilities 11.4/1 10.5/1 Return on average net operating assets 68.2% 75.0% [photo] Ronald A. Matricaria President and Chief Executive Officer [caption]: "We have an ambitious but achievable vision for St. Jude Medical to become a globally significant medical device company built on several major technology platforms, including our heart valve business." TO OUR SHAREHOLDERS St. Jude Medical accomplished a great deal in 1993's tumultuous health care environment. Most significantly, we moved decisively to set the stage for diversification so that we can achieve improved future growth and maximize long-term shareholder value. Through diversification, we can mitigate risks associated with reliance on a single product line and fuel our growth. After many months of work, we have developed St. Jude Medical's first comprehensive diversification strategy, which will guide us to swift and intelligent action with regard to appropriate opportunities. During 1993, we also strengthened our world leadership position in the mechanical heart valve business and achieved record financial performance. We are continuously improving and strengthening our core business to become the most innovative and efficient company in all facets of the heart valve market. RECORD FINANCIAL PERFORMANCE During 1993, sales grew to $252.6 million, up 5.5 percent from $239.5 million in 1992. Net income reached $109.6 million, an increase from the year-earlier level of $101.7 million. Earnings per share totaled $2.32 versus $2.12 for 1992, an increase of 9.4 percent. Our 1993 first half year-over-year income statement comparisons were very favorable. However, during the third and fourth quarters, sales and earnings felt the impact of foreign currency exchange rate changes, increasing worldwide competition and reduced domestic market demand. Our gross margin continued to improve, moving from 74.8 percent in 1992 to 75.7 percent in 1993, as we increased manufacturing efficiency in both our St. Jude Medical and Cardiac Assist divisions. Net after-tax margin reached 43.4 percent, up from 42.4 percent in 1992. Our vertical integration strategy continued to unfold as we reduced reliance on our major outside supplier and completed construction of a new, highly efficient manufacturing plant. Under the contract with our supplier, we will have the opportunity by 1999 to be completely self-sufficient in producing the main components for the St. Jude Medical(R) mechanical heart valve. St. Jude Medical's strong balance sheet offers us considerable opportunity and financial flexibility to achieve our diversification objectives. At the end of 1993, cash totaled $369.0 million, or 70 percent of total assets of $526.8 million. We have no debt. During the year, we repurchased 1.2 million shares of the Company's stock for a total of 1.4 million shares repurchased since 1992. We continued to pay a $.10 per share quarterly cash dividend. CORE BUSINESS ACHIEVEMENTS During 1993, we were pleased with strong market acceptance of our new Hemodynamic Plus (HP) mechanical heart valve. We made significant progress in tissue valve products -- our single greatest opportunity to accelerate growth in the heart valve business. The initial human implants of the tissue valve developed by The Heart Valve Company, our 50-50 joint venture with Hancock Jaffe Laboratories, are planned for the first half of 1994 in Europe. We continue to make excellent progress in international marketing of the Toronto SPVtm (Stentless Porcine Valve) and we recently received Food and Drug Administration (FDA) approval to enter clinical trials in the United States with this product. St. Jude Medical's Cardiac Assist Division is investing in new products to increase worldwide market share. In 1993, we introduced a new intra-aortic balloon catheter, the RediGuardtm 2.0, which we believe is the best on the market today. 1994 GOALS During 1994, we will continue to build our core heart valve business and effectively deal with increased competition. We are thoroughly prepared, from both product superiority and marketing perspectives, to meet our biggest competitive challenge this year -- the U.S. market entry of mechanical valve manufacturer, CarboMedics, Inc. We will become more efficient, focusing in 1994 on bringing our new heart valve component manufacturing facility on line and beginning the FDA qualification process. We will continue to research, develop and introduce new products and would expect to achieve international market share gains. We plan a 1994 international introduction of a new rotatable mechanical heart valve, which surgeons prefer in certain cases. We also will move forward aggressively to implement our diversification strategy. THE FUTURE We have an ambitious but achievable vision for St. Jude Medical to become a globally significant medical device company built on several major technology platforms, including our heart valve business. In the near term, we seek one technology platform with a fully developed world leadership capability, and another representing an emerging technology with potential for eventual market leadership. Over the next several years, we will create shareholder value through diversification and by investing in research and development, vertical integration and new service and distribution capabilities. Much of our future growth will come from acquisitions, joint ventures, research and development partnerships, and investments in technology-based companies. During 1993, we invested in InControl, Inc. of Redmond, Washington, which is developing a product to treat atrial fibrillation. We also signed a license and supply agreement with California-based Telios Pharmaceuticals, Inc., which has developed biocompatible product coatings designed to improve tissue ingrowth. We recently made an investment in Advanced Tissue Sciences, Inc. of La Jolla, California, and separately signed an agreement to pursue the joint development of tissue engineered heart valves. A WORD OF THANKS We would like to extend our sincere thanks to William G. Hendrickson, who retired from our Board of Directors in July 1993 after 12 years as chairman. Dr. Hendrickson provided us with strong leadership and insight during a period of tremendous growth and profitability. The gold standard we carry into the future is our core heart valve business, which has lengthened and improved the lives of more than 500,000 people. We look forward, with you, to an exciting future of growth and change for St. Jude Medical. Sincerely, [signature] RONALD A. MATRICARIA President and Chief Executive Officer [signature] LAWRENCE A. LEHMKUHL Chairman of the Board March 15, 1994 [photo] [caption]: Lawrence A. Lehmkuhl Chairman of the Board [photo] [caption]: "I support the concept of managed competition and the idea that competitive forces should be allowed to work freely. However, I do not believe that the government should be the nation's health care manager." HEALTH CARE REVOLUTION: Q&A WITH RON MATRICARIA In March 1993, St. Jude Medical's Board of Directors named Ronald A. Matricaria to the position of president and chief executive officer, assigning him the responsibility for leading the Company to a new level of growth and prosperity. Prior to joining St. Jude Medical, Mr. Matricaria spent 23 years with Eli Lilly and Company. He most recently was executive vice president of the Pharmaceutical Division and president of North American Operations. He brings significant medical device and international marketing experience through his previous positions as president of the company's Medical Device Division and president of Lilly International. Under his leadership, Eli Lilly's medical device sales grew from several hundred million dollars to more than $1 billion. Previously, Mr. Matricaria was president and CEO of Cardiac Pacemakers, Inc., a wholly owned Eli Lilly subsidiary. Q: What are the major changes taking place in the health care industry, and how will they affect investors? A: First, it is important to realize that we are in the midst of a revolution in the way health care products and services are delivered and purchased. These changes are taking place not only here in the United States but in a number of major countries around the world. Change is underway, and no investor should believe that we will return to business as usual. In the United States, health care reform is a major political issue as well as a budgetary one. While we continue to have the best health care system in the world, it does need some constructive reform. Health care inflation clearly has started to slow, but the overall expenditure level is still too high as a percentage of our country's gross domestic product. As a health care consumer, I have concerns about whether the best quality care will be available to my family in a few years. And I am concerned that we retain incentives that encourage our best and brightest young people to continue to become health care professionals. Q: Specifically, what are your views on the Clinton Administration's health care reform plan? A: As a citizen, taxpayer and medical company CEO, I support the concept of managed competition and the idea that competitive forces should be allowed to work freely. However, I do not believe that the government should be the nation's health care manager. Details of the Clinton proposal indicate that more than 10 percent of the budget would be used to pay for additional bureaucracy -- a national health care board, health care alliances, approved health planning, regional health care committees and more. I clearly think the administration is on the wrong track in terms of the specific legislation they are recommending. Having said that, I think our elected representatives are having a significant impact on changes that are underway simply by continuing to talk about reform. [photo] [photo] Q: What trends and changes do you anticipate for your specific segment of the market -- medical devices for cardiovascular applications? A: Among the changes already in process are shifts in buying patterns, industry consolidation, increased competition and pricing pressures worldwide and a changing regulatory environment that requires new partnership efforts between medical device companies and the FDA. Perhaps the single most important change is a greater demand for data that will prove our products are cost-effective. St. Jude Medical's pricing philosophy is in line with these trends, and we are holding our price increases well below many measures of health care inflation. We are working on many fronts to build value for our shareholders within the context of these changes. It is important to note that medical devices account for only a few cents of every health care dollar. We are not one of the health care system's problems; we are part of the solution in that we provide proven medical devices which save and enhance lives in a cost-effective manner. Q: How is St. Jude Medical positioned to succeed in this environment? A: For several reasons, I believe we are well-positioned for any post-reform environment. First, all of our products are life sustaining or life enhancing. Second, our heart valve product line is recognized as the standard of excellence in the industry. We are the cardiovascular surgeon's first, and many times only, choice. Third, the valve itself represents just a small percentage of the total cost of a heart valve replacement procedure; over the next several years, we will continue to improve our cost competitiveness. Fourth, the number of cardiovascular procedures will continue to increase because the worldwide population is aging and cardiovascular disease remains the leading cause of death in the United States and Europe. In addition, universal coverage may soon provide all consumers with insurance to cover such procedures. These reasons are connected to our markets and our products. Looking inside the Company, we are confident because we have assembled an experienced, talented and dedicated team of employees and have developed a sound strategic framework for diversification and future growth. We have tremendous financial strength and are recognized for our unparalleled product quality and clinical documentation, which will be increasingly important in the future. The bottom line is that we have the ability and commitment to diversify and continuously improve to stay ahead and take advantage of change. [photo] [caption]: "We are working on many fronts to build value for our shareholders within the context of these changes. . . we provide proven medical devices which save and enhance lives in a cost-effective manner." REVIEW OF OPERATIONS [photo] [caption]: St. Jude Medical(R) mechanical heart valve Hemodynamic Plus series [photo] [caption]: Collagen-impregnated aortic valved graft Strengthening Leadership in Our Core Heart Valve Business In 1977, we began marketing the St. Jude Medical(R) mechanical heart valve to cardiac surgeons who treat patients needing valve replacement for a wide range of heart conditions. For more than 16 years, our original bileafet pyrolytic carbon coated valve has set the industry standard and is the cardiovascular surgeon's first choice in mechanical heart valves. Today's worldwide market for prosthetic heart valves is approximately $500 million, with 4 to 5 percent annual unit growth. We feel we have the superior product in the market and through product additions and enhancements, as well as increasing distribution through a direct sales force, St. Jude Medical has steadily increased its market share to the current level of 48 percent of the worldwide heart valve market. During 1993, we were pleased to achieve excellent acceptance of our Hemodynamic Plus (HP) series of mechanical heart valves. Compared with other mechanical heart valves, the HP series offers superior blood flow and reduces the heart's workload for patients with small valvular openings. On January 20, 1994, we celebrated the 500,000th implant of our mechanical heart valve product. Also, we recently received FDA approval for U.S. marketing of our new collagen-impregnated aortic valved graft (CAVG), which is used to replace the aortic heart valve and reconstruct the ascending aorta. Recipients of the St. Jude Medical(R) mechanical heart valve often can resume all the activities they enjoyed prior to any valve deficiency. WORLD'S MOST INNOVATIVE HEART VALVE COMPANY Our long-term goal is to be known as the world's most innovative company in all sectors of the heart valve market, and specifically to: *Increase worldwide market share; *Further reduce our manufacturing costs for the future's demanding health care environment; *Provide a full line of mechanical and tissue valve products; *Participate in new heart valve developments involving synthetics and recellularization technology; *Strengthen our internal research and development capability; and *Continue to expand our heart valve line to provide products that offer the best fit, durability and hemodynamics for all valve replacement patients. NEW CARBON COMPONENT MANUFACTURING CAPABILITIES Our new carbon component manufacturing facility near our St. Paul, Minnesota, headquarters will increase St. Jude Medical's ability to control our own destiny, increasing our manufacturing capacity and self-sufficiency and enhancing our future mechanical heart valve cost advantage. Training of personnel and the FDA qualification process for the new facility are top 1994 priorities, with full on-line FDA approval expected in 1995. This facility will produce top quality components at higher volumes and a lower cost than our current facility. The new, 65,000-square-foot plant is designed for cellular manufacturing, with smaller batch sizes and shorter lead times. Space utilization is twice as efficient as in the existing plant. Special features include state-of-the-art equipment, paperless record keeping and immediate feedback to equipment operators for superior quality control. [photo] [caption]: Our new, world-class manufacturing plant will enable us to become totally self-sufficient in the production of the St. Jude Medical(R) mechanical heart valve's carbon components. We will become the lowest cost manufacturer of mechanical heart valves, while enhancing product quality and customer service levels. Monitoring progress at the new facility are, from left: Robert Eno, Operations Manager; Robert Elgin, Vice President, Operations; and Michael Serie, Plant Manager. Woodridge Carbon Technology Center [photo] [caption]: Linda Stack, 46, became the 500,000th St. Jude Medical(R) mechanical heart valve recipient on January 20, 1994. The St. Paul, Minnesota, resident is a materials control analyst for 3M. Her recovery program includes daily walks with her dog Max. "I had rheumatic fever as a child, but did well until I started experiencing fatigue and respiratory problems four years ago. Since then, Dr. Arom has replaced two of my heart valves with St. Jude mechanical heart valves and I feel great. In fact, I have a trip to Glacier National Park planned for next summer." [photo] [caption]: "Linda's aortic stenosis progressed faster than we thought. She needed both a mitral valve and an aortic valve replacement in what was a relatively short time period, especially for someone so young. In both cases, I was happy that I was able to give her the best mechanical heart valve available today." Dr. Kit V. Arom performed Linda Stack's surgery, implanting the 500,000th St. Jude mechanical heart valve. He participated in initial clinical testing of the St. Jude valve and currently is conducting a 15-year patient follow-up study. His surgical group has implanted nearly 3,000 St. Jude valves. [photo] [caption]: "Receiving a St. Jude Medical heart valve has extended my life. With my wife expecting our second child, I feel great about the future. And I continue to run five miles a day, lift weights and play pick-up basketball." Bill Gurtin, 33, pictured with wife, Kay, and 3-year-old son, Grant. An investment advisor in Chicago, Bill received his implant on February 22, 1993. REVIEW OF OPERATIONS GROWTH OPPORTUNITIES IN TISSUE VALVES The single greatest opportunity to accelerate core business growth is to become a significant player in the tissue valve market, today estimated at $150 million. Mechanical valves currently comprise 70 percent of all implants, primarily because of their superior durability. Because tissue valves normally do not require anticoagulant medication, the market will grow as new technology improves their durability. St. Jude Medical's goal is to reach the U.S. market with approved tissue products within the next several years. In addition to our long-term, next generation heart valve project, we have a joint venture with Hancock Jaffe Laboratories, under the direction of Warren Hancock and Norman Jaffe, Ph.D., two of the world's leading tissue valve experts. The first human implants of this valve are planned for the first half of 1994 in Europe. We expect very favorable results regarding valve implantability and performance. St. Jude Medical also is collaborating with Canadian cardiac surgeon Dr. Tirone David on the U.S. approval of a new stentless aortic tissue valve, the Toronto SPVtm. Stentless valves, which do not have frames, require demanding surgical techniques but are designed to offer potentially superior hemodynamic performance in the aortic position. We received an Investigational Device Exemption (IDE) from the FDA in February 1994, and will begin our U.S. clinical trials of the Toronto SPV before the end of April. INTERNATIONAL EXPANSION Today, our customers include more than 1,500 open heart centers worldwide. While we sell our products in more than 75 countries, approximately 80 percent of our revenues currently come from the United States and eight European countries where we have direct sales forces. However, non-direct foreign market sales will be increasingly important to our future growth as markets such as China, the Pacifc Rim, Latin America, the Middle East, Africa and Eastern Europe continue to develop. We are working to expand our international presence by building relationships with top cardiovascular surgeons and supporting clinical studies in overseas markets. Key accomplishments for St. Jude Medical International in 1993 included: *The launch of an important new randomized multicenter clinical study in Germany. This research, involving 4,500 patients over the course of five years, is designed to confirm that lower doses of anticoagulant medication are sufficient for use with the St. Jude Medical(R) mechanical heart valve. *Significant progress towards achieving our Total Quality Management goals, which will result in exceeding ISO 9000 standards and obtaining the CE mark necessary to market our products in Europe by 1998. *Significant market share gains in the Middle East and Africa. *Strategic alliances in Germany and Spain with well-established companies marketing a full line of cardiovascular devices, which enable us to respond quickly to market changes. During 1994, we anticipate international revenue gains from increasing our mechanical heart valve market share, from increased sales of the Toronto SPV, from our first human implants of the tissue heart valve developed by Hancock Jaffe Laboratories and from the introduction of additional cardiac assist products. We will continue to pursue strategic alliances in the increasingly competitive European market, tailoring approaches to each country's changing reimbursement and regulatory environment. [photo] [caption]: Tissue heart valve developed by Hancock Jaffe Laboratories [photo] [caption]: Toronto SPVtm tissue heart valve [photo] [caption]: Model 700 intra-aortic balloon pump system [photo] [caption]: RediFurl(R), RediGuardTM and TaperSeal(R) intra-aortic balloon catheters [photo] [caption]: Lifestream(R) centrifugal pump system and Isoflow(R) centrifugal pump We also will conduct intensive sales training and clinical symposia in our non-direct markets where distributors will work with us to launch new cardiac assist products, together with new mechanical and tissue heart valve devices. NEW CARDIAC ASSIST PRODUCTS Our Cardiac Assist Division markets two major categories of products associated with open heart surgery to cardiologists and perfusionists. Intra-aortic balloon pump (IABP) systems, which include balloon-tipped catheters and electro-mechanical control consoles, take on part of the heart's workload before and after open heart surgery and complicated coronary balloon angioplasty. Centrifugal pump systems, comprising electro-mechanical control consoles, motor drives and pumps through which the blood circulates, completely take over for the heart during open heart procedures. To increase our market share worldwide, we are introducing new products and building our reputation for superior customer service. During 1993, we successfully introduced a refined IAB catheter product, the RediGuardtm 2.0, which eases the process of guiding and correctly placing the catheter. We also significantly expanded our direct sales force in the United States in 1993 and increased our worldwide cardiac assist presence through our distribution agreement with COBE(R) Cardiovascular Inc., which supplies customized packages of products to perfusionists. Goals for 1994 include introducing our new ArmorGlidetm coating for catheters which will allow for easier insertion, and launching our new Model 800 IABP console. DIVERSIFICATION PLANNING At St. Jude Medical, we understand the importance of knowing our destination. For that reason, before making any major diversification moves, we thoroughly analyzed our business and opportunities for creating shareholder value. The strategic diversification planning process sets the stage for us to achieve our vision of becoming a globally significant medical device company with several major technology platforms, including our heart valve business. It has four phases: 1) An extensive survey, or shareholder profile, told us about shareholder and investment community attitudes toward diversification, various types of acquisitions and growth versus profitability. 2) A core competency assessment identified what we do well, what we can do to improve our existing businesses and what strengths we can transfer or leverage in alliances with other companies. Our management team and consultant advisors identified 191 primary capabilities, which were narrowed to 48 critical cross-functional capabilities. We zeroed in on 15 potential core competencies, then on eight true core competency opportunities for St. Jude Medical which were identified based on passing tests regarding value to customers, barriers to competition and leverageability to other markets. Our true core competency opportunities focus primarily on blood handling and processing, device development and manufacturing, clinical trials and regulatory approval processes. [photo] [caption]: "I like the St. Jude Medical(R) mechanical heart valve's overall design, which resists blood clot formation, its low profile, and rapid opening and closing action, which resemble the human heart valve. Japanese follow-up studies achieve excellent compliance and are very thorough, so Japan is the ideal country to evaluate the valve; we've seen absolutely no structural deterioration in 14 years of implants." Dr. Hitoshi Koyanagi, professor and chairman of the Department of Cardiovascular Surgery at Tokyo Women's Medical College in Japan, has implanted more than 1,800 St. Jude Medical(R) mechanical heart valves since the product's Japanese introduction in 1978. [photo] [caption]: St. Jude Medical's diversification efforts are moving forward from a solid strategy that grew out of a four-part planning process, including a shareholder profile, core competency assessment, therapeutic class review and specific opportunity analysis. [caption]: Members of St. Jude Medical's senior management team conduct a strategic planning session (from left:) Stephen Wilson, Vice President, Finance and Chief Financial Officer; John Berdusco, Vice President, Administration; John Alexander, Vice President, Corporate Development; and Diane Johnson, Vice President and General Counsel. REVIEW OF OPERATIONS 3) A therapeutic class review of the medical devices and supplies market identifies the companies, technologies and products within the markets that show the most promise. This ongoing process analyzes the relative size, growth rates and competition within various segments of the medical devices and supplies market. 4) A specific opportunity analysis continually evaluates the best companies, products and technologies within the most attractive therapeutic classes and within the context of the shareholder profile and core competency assessment, so that our focus is on diversifying in a manner that creates long-term value for our shareholders. SPECIFIC OPPORTUNITIES During 1993 and early 1994, four situations demonstrated our ability to quickly respond to new opportunities. First, we announced an equity investment in InControl, Inc. of Redmond, Washington, which is working with leading medical researchers on a product that would be the first device to diagnose and treat atrial fibrillation, automatically restoring normal rhythm to an improperly beating atrium of the heart. We believe that InControl's promising technology represents an important market opportunity. Second, we signed an exclusive license and supply agreement with Telios Pharmaceuticals, Inc. of San Diego, California, to utilize Telios' proprietary cell adhesion technology. Its PepTite-2000tm biocompatible coating is expected to promote human tissue ingrowth on the sewing cuffs of heart valves, aortic valved grafts and annuloplasty rings. Third, in December we made a fully valued offer to purchase Colorado-based Electromedics, Inc. However, while the company's open heart surgery products fit with our existing Cardiac Assist Division business, we did not choose to participate in a controlled auction process. The agreement was terminated because it did not make sense from a shareholder value point of view for St. Jude Medical to pay what would have been required to make the acquisition. Finally, in January 1994, we announced an investment in Advanced Tissue Sciences, Inc. and a separate agreement to pursue tissue engineered heart valves. As part of this agreement, St. Jude Medical obtained exclusive rights to license technology resulting from this alliance. As we pursue specific diversification transactions, we are focused on building our reputation and competencies in cardiovascular products -- an area we know and where we have an established customer base. We relate each opportunity to our planning process to ensure it has the potential to create shareholder value and truly makes sense for our long-term success. [photo] [caption]: Diversification Planning Shareholder Profile Core Competency Assessment Therapeutic Class Review Specific Opportunity Analysis OUR MISSION MISSION STATEMENT ST. JUDE MEDICAL, INC. IS COMMITTED TO HELPING OUR CUSTOMERS WORLD-WIDE SAVE LIVES, RESTORE HEALTH, AND IMPROVE THE QUALITY OF LIFE IN THEIR PATIENTS THROUGH THE DESIGN, MANUFACTURE, AND MARKETING OF THE HIGHEST QUALITY CARDIOVASCULAR MEDICAL DEVICES AND SERVICES. WE WILL ACCOMPLISH OUR MISSION BY: * PROVIDING THE MOST INNOVATIVE AND HIGHEST VALUE-ADDED PRODUCTS WHICH CREATE A CLINICAL BENEFIT; * EMPHASIZING QUALITY AND INNOVATION IN THE DESIGN, MANUFACTURE, AND DISTRIBUTION OF OUR PRODUCTS; * DEVELOPING AND MAINTAINING SUPERIOR RELATIONSHIPS WITH OUR CUSTOMERS AND THE COMMUNITY; * PROVIDING A CHALLENGING AND REWARDING WORK ENVIRONMENT WHICH ENABLES OUR EMPLOYEES TO REACH THEIR FULLEST POTENTIAL. BY ACHIEVING OUR MISSION WE WILL CREATE ADDITIONAL VALUE IN THE COMPANY AND GREATER REWARDS FOR OUR SHAREHOLDERS. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Dollars in thousands, except per share amounts) INTRODUCTION St. Jude Medical, Inc. designs, manufactures and markets medical devices for cardiovascular applications. The Company is the world's leading supplier of mechanical heart valves which account for more than 90% of the Company's net sales. Other products manufactured and sold by the Company include two types of tissue heart valves, annuloplasty rings, intra-aortic balloon pump systems and centrifugal pump systems. The Company's fiscal year is the 52 or 53 week period ending the Saturday nearest to December 31. Fiscal years 1993 and 1991 included 52 weeks and fiscal 1992 included 53 weeks. RESULTS OF OPERATIONS The Company posted record net sales and net income for the eighth consecutive year in 1993 as net sales increased 5% to $252,642 and net income increased 8% to $109,643. Shown below for the periods indicated are the percentage relationships of certain items in the consolidated statements of income to net sales and the percentage change of the dollar amounts of such items as compared with the prior period. NET SALES: Net sales totalled $252,642 in 1993, a 5% increase over 1992 net sales. The increase principally resulted from higher mechanical heart valve unit sales in the Company's international markets which were partially offset by lower domestic unit sales. The decrease in domestic unit sales was attributable to one less operating week in 1993 as compared to 1992 as well as to hospital inventory reductions and fewer procedures caused by managed care and the anticipation of health care reform. Domestic mechanical heart valve net sales increased slightly in 1993 despite the lower unit sales as prices increased due to the introduction of an expanded product line and general price increases. International mechanical heart valve net sales in 1993 increased substantially, particularly in the emerging country markets where selling prices are lower than in the developed country markets. Therefore, the higher revenue resulting from increased unit sales was somewhat offset by lower average selling prices. In addition, net sales in 1993 were negatively impacted by the appreciation of the U.S. dollar from 1992 levels in relation to the eight foreign currencies in which the Company directly markets its products. This foreign currency exchange situation decreased 1993 net sales by $4,670 relative to 1992. [graph] [description]: Net Sales (in millions) International and United States sales compared over the years 1991, 1992 and 1993. Cardiac assist device and tissue heart valve net sales in 1993 increased over 1992 levels. These increases were partially offset by decreased biological vascular graft net sales as a result of the discontinuance of the product line in mid-1992. In 1993, net sales in the international markets increased to 43% of total net sales from 42% in 1992 despite the unfavorable impact of foreign currency exchange rates. The increase was attributable to higher growth rates within these markets and the Company's ability to further penetrate these markets. Net sales in 1992 of $239,547 were 14% higher than 1991 levels. The increase primarily resulted from higher mechanical heart valve unit sales in all geographic markets as well as price increases implemented at the beginning of 1992. In addition, net sales of all other Company products, except the biological vascular graft, increased over 1991 levels. COST OF SALES: Cost of sales as a percentage of net sales decreased in 1993 to 24.3% from 25.2% in 1992. The improvement was principally attributable to higher levels of lower cost self-manufactured pyrolytic carbon components for the mechanical heart valve. In addition, cessation of royalty payments associated with the acquisition of the intra-aortic balloon pump system and increased manufacturing efficiencies associated with higher levels of cardiac assist device production, reduced cost of sales in 1993. These improvements were partially offset by a lower 1993 mechanical heart valve average selling price as compared to 1992 which resulted from unfavorable foreign currency translation and from a higher level of lower margin sales into the emerging country markets. In 1992, cost of sales as a percentage of net sales decreased 3.8 percentage points from the 1991 level. The improvement resulted from reduced costs of mechanical heart valve components purchased from the Company's supplier, higher levels of lower cost self-manufactured mechanical heart valve components, favorable foreign currency translation effects and higher pricing. The margin improvements were partially offset by higher sales levels of lower margin non-mechanical heart valve products. The Company expects cost of sales as a percentage of net sales to increase in 1994 from the 1993 level as a result of a larger increase in international sales versus domestic sales, particularly into lesser developed countries. Selling prices in these faster growth markets are significantly lower than in the markets served by the Company's direct sales forces because sales are made through distributors rather than directly to hospitals and because lesser developed countries are typically more price sensitive due to their economic condition. In addition, the cost of mechanical heart valve components purchased from the Company's supplier will increase in 1994. Also, the Company anticipates its sales of lower margin non-mechanical heart valve products will increase in 1994. Increased competition together with governmental and third-party payor pressures to reduce health care costs may limit the Company's pricing flexibility. SELLING, GENERAL AND ADMINISTRATIVE: Selling, general and administrative expense in 1993 increased $3,479, or 8%, over 1992. The Company expanded its domestic sales force and marketing department during 1993 in order to better serve its customers and to better compete against a new mechanical heart valve competitor in the domestic market. In addition, the Company increased its support of clinical studies to further document the advantages of the Company's products. The Company is aggressively pursuing ISO 9000 certification which raised the 1993 expense level as compared to 1992. The appreciation of the U.S. dollar partially offset the increases noted above. During 1992, selling, general and administrative expense increased $5,275, or 13%, over 1991. The increase mainly resulted from higher commissions associated with higher sales levels, expenses associated with several new product introductions, and increased support of symposia, research papers and follow-up clinical studies. RESEARCH AND DEVELOPMENT: Research and development expense decreased $506, or 4%, in 1993. Expenditures in 1993 were primarily associated with mechanical heart valve product line expansion, tissue heart valve development programs, a new intra-aortic balloon pump console and intra-aortic balloon catheter product improvements. During 1993, funding of the Hancock Jaffe Laboratories joint venture development of a tissue heart valve decreased from the 1992 level due to the completion of certain phases of the project. In 1992, research and development expense increased $3,368, or 42%, over 1991. The increase was principally associated with new product development for mechanical heart valves, tissue heart valves and cardiac assist products. Significant product development efforts included the Hemodynamic Plus (HP) series of mechanical heart valves, the tissue valve developed by Hancock Jaffe Laboratories and the Toronto SPVtm. [graph] [description]: Increase in cash and marketable securities (in millions) shown over the course of 1991, 1992 and 1993. OTHER INCOME: Other income decreased $262, or 2%, from 1992. While cash and marketable securities increased $30,301 during 1993, the additional interest received on the higher investment balances was significantly reduced by the lower average investment rates of return. The additional week of operations in 1992 added approximately $280 to 1992 investment income. Due to a significant shift in the relationship between European currencies in 1993, the loss associated with foreign currency transactions increased to $526 from $43 in 1992. In addition, losses relating to joint ventures and partnerships were $243 higher in 1993 than 1992. INCOME TAX PROVISION: The Company's 1993 effective income tax rate of 24.5% was one percentage point below the 1992 and 1991 rate of 25.5%. The decrease was attributable to the derivation of a higher percentage of the Company's income from the Company's Puerto Rican operations. The relatively low rate as compared to the U.S. statutory rate stems from the reduced taxes on profits generated by the Company's Puerto Rican operations as well as from other income generated by the Company's tax advantaged investments. [graph] [description]: Increase in cash flow from operations (in millions) shown over the course of 1991, 1992 and 1993. NET INCOME: Net income in 1993 of $109,643, or $2.32 per share, increased 8% over the $101,658, or $2.12 per share, reported in 1992 which had risen 21% over 1991 net income. The appreciation of the U.S. dollar against foreign currencies in 1993 as compared to 1992 decreased net income in 1993 by $2,488, or $.05 per share. During 1993, the Company repurchased 1,177,700 shares of its common stock for $35,239. This repurchase reduced 1993 interest income by approximately $650 and average shares outstanding by approximately 600,000 shares. The net effect of the repurchase was an increase in 1993 earnings per share of $.02. OUTLOOK: The Company's core mechanical heart valve business remains strong as the Company has maintained or slightly increased its market share in the developed country markets and has continued to penetrate the emerging country markets. The Company estimates it held a 48% share of the worldwide heart valve market for 1993. The health care industry is in the midst of dramatic change worldwide. Business consolidations and alliances are expected to increase industry efficiencies and strengthen the bargaining position of large providers of health care services. Specifically, domestic health care reform is putting downward pressure on pricing and appears presently to be having the effect of reducing the number of open heart procedures. In addition, during 1993 hospital consolidations and inventory reduction programs reduced the demand for the Company's products. During the third quarter 1993, a competitor received Food and Drug Administration (FDA) approval to market its bileafet mechanical heart valve in the United States. The Company cannot predict the impact that this new competitor may have on its domestic market position. Internationally, the Company has successfully competed against many competitors for many years. The Company expects these international markets to grow at rates which exceed the domestic market rate of growth and the Company anticipates it will continue to gain share in these highly competitive markets. The Omnibus Budget Tax Reconciliation Act of 1993 (the "Act") significantly reduces the tax benefits which were previously available from income generated by the Company's Puerto Rican operations under Internal Revenue Code (IRC) Section 936. Under the new legislation, the Puerto Rican tax benefit will be reduced by 40% in 1994 and an additional 5% per year in years 1995 through 1998 at which time the benefit will have been reduced by 60% from current levels. The Company's 1994 tax provision may increase by as much as five percentage points as a result of this legislation. The impact on 1994 earnings is expected to be approximately $.15 per share. Also, the Act increased domestic corporate income tax rates effective January 1, 1993, by 1% which will increase future tax provisions. There are additional changes to IRC Section 936 regulations being proposed by the Internal Revenue Service which, if enacted, would further negatively impact the Company's effective income tax rate. The Company continues to seek diversification opportunities in the form of acquisitions, joint ventures, partnerships and investments in emerging technology companies, as well as through internal research and development. The Company cannot predict the size or timing of such diversification activities. FINANCIAL CONDITION SUMMARY: The Company's financial condition at December 31, 1993, was strong. Cash and marketable securities totalled $368,991, or 70% of total assets. The Company had no outstanding debt. Working capital, the difference between current assets and current liabilities, continued to increase. The following key measurements are indicative of the excellent liquidity and strong financial position maintained by the Company. LIQUIDITY: Cash flow from operations in 1993 continued to provide sufficient funds to meet working capital and investment needs. Cash and marketable securities increased in 1993 by $30,301 to the level of $368,991 at December 31, 1993. Accounts receivable decreased $2,535 during the year. At December 31, 1993, days sales outstanding (the number of days worth of sales that are in accounts receivable) decreased to 58 days from 65 days at the end of 1992. The decrease was principally attributable to focused collection efforts in several European countries. In particular, Spanish accounts receivable decreased $965 during 1993 and totalled $5,397 at the end of 1993. Inventories increased $5,407 during 1993. The increase was primarily attributable to the extension of the mechanical heart valve product line as well as to the purchase of raw materials considered essential to the Company's operations. Purchases of property, plant and equipment in 1993 of $16,422 were principally associated with building a new manufacturing facility for the production of mechanical heart valve components. This building was completed in 1993; therefore, property, plant and equipment expenditures are anticipated to decrease substantially in 1994. Other assets of $29,722 increased by $11,043 in 1993 as investments were made in several entities including InControl, Inc., an emerging technology cardiac rhythm management company; The Heart Valve Company, a joint venture with Hancock Jaffe Laboratories; and two health care limited partnerships. The Company expects future working capital and capital spending to be financed by funds provided by operations. CAPITAL: During 1993, the Company used $35,239 of its cash flow to repurchase 1,177,700 shares of its common stock. The Company may repurchase approximately 1,000,000 additional shares under the current authorization from the Board of Directors. Future repurchases will depend upon diversification objectives, market conditions, cash position and other factors. Although the Company has no debt or outside credit lines, the Company is prepared to utilize debt to finance its diversification program. The Company's strong cash flow generating capabilities will enable the Company to acquire sufficient capital to finance anticipated acquisitions. Cash dividends paid to shareholders were $18,786 in 1993, an increase of $4,516 from 1992. The Company initiated the cash dividend in the second quarter 1992 and maintained a $.10 per share quarterly cash dividend through 1993. [graph] [description]: Increase in shareholders' equity over the course of 1991, 1992 and 1993. OTHER MATTERS: As a medical device manufacturer, the Company is exposed to product liability claims. Such product liability claims may be asserted against the Company in the future which are presently unknown to management. The Company believes its insurance coverage will be adequate to protect the Company against any material loss. In the United States, several proposals to "reform" health care are under consideration. The Company has already experienced some change, as noted above, as a result of the discussion of reform. Any legislated health care reform could have a material impact on the Company's operations. REPORT OF MANAGEMENT The management of St. Jude Medical, Inc. is responsible for the preparation, integrity and objectivity of the accompanying financial statements. The financial statements have been prepared in accordance with generally accepted accounting principles and include amounts which reflect management's best estimates based on its informed judgement. Management is also responsible for the accuracy of the related data in the annual report and its consistency with the financial statements. In the opinion of management, the Company's accounting systems and procedures, and related internal controls, provide reasonable assurance that transactions are executed in accordance with management's intention and authorization, that financial statements are prepared in accordance with generally accepted accounting principles, and that assets are properly accounted for and safeguarded. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal control, and that the cost of such systems should not exceed the benefits to be derived therefrom. These systems are periodically reviewed and modified in response to changed conditions. St. Jude Medical, Inc. also recognizes its responsibility for fostering a strong ethical climate so that the Company's affairs are conducted according to the highest standards of personal and business conduct. This responsibility is reflected in the Company's business ethics policy which is publicized throughout the organization. The adequacy of the Company's internal accounting controls, the accounting principles employed in its financial reporting and the scope of independent and internal audits are reviewed by the Audit Committee of the Board of Directors, consisting solely of outside directors. The independent certified public accountants and internal auditors meet with, and have confidential access to, the Audit Committee to discuss the results of their audit work. [signature] Ronald A. Matricaria President and Chief Executive Officer [signature] Stephen L. Wilson Vice President, Finance and Chief Financial Officer REPORT OF INDEPENDENT AUDITORS Board of Directors St. Jude Medical, Inc. St. Paul, Minnesota We have audited the accompanying consolidated balance sheets of St. Jude Medical, Inc. 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 consolidated financial position of St. Jude Medical, Inc. and subsidiaries at December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. [signature] Ernst & Young Minneapolis, Minnesota February 4, 1994 CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share amounts) NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Significant intercompany transactions and balances have been eliminated in consolidation. Certain reclassifcations of previously reported amounts have been made to conform with the current year presentation. ACCOUNTING PERIOD: The Company's fiscal year is the 52 or 53 week period ending the Saturday nearest December 31. Fiscal years 1991 and 1993 included 52 weeks and fiscal year 1992 included 53 weeks. TRANSLATION OF FOREIGN CURRENCIES: All assets and liabilities of the Company's foreign subsidiaries are translated at exchange rates in effect on reporting dates and differences due to changing translation rates are charged or credited to "cumulative translation adjustment" in shareholders' equity. Income and expenses are translated at rates which approximate those in effect on transaction dates. CASH EQUIVALENTS: Cash equivalents, consisting of liquid investments with a maturity of three months or less when purchased, are stated at cost which approximates market. MARKETABLE SECURITIES: Marketable securities, consisting of investment grade municipal debt instruments, bank certificates of deposit and Puerto Rico industrial development bonds, are stated at cost which approximates market. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. Under this pronouncement, debt securities that the Company has both the positive intent and ability to hold to maturity are carried at amortized cost. Debt securities that the Company does not have the positive intent and ability to hold to maturity and all marketable equity securities are classified as either available-for-sale or trading and are carried at fair value. Unrealized holding gains and losses on securities classified as available-for-sale are carried as a separate component of shareholders' equity. Unrealized holding gains and losses on securities classified as trading are reported in earnings. Presently, the Company classifies its marketable securities as available-for-sale and carries them at amortized cost. The Company will apply the new pronouncement starting in the first quarter 1994. The Company anticipates that the majority of its marketable security holdings will be classified as available-for-sale and that any shareholders' equity adjustments will be immaterial. INVENTORIES: Inventories are stated at the lower of cost or market. Cost is determined under the first-in, first-out method. Allowances are made for slow-moving, obsolete, unsalable or unusable inventories. PROPERTY, PLANT AND EQUIPMENT AND DEPRECIATION: Property, plant and equipment are stated at cost and are depreciated on the straight line method over their estimated useful lives ranging from three to 32 years. Accelerated depreciation is used by the Company for tax accounting purposes only. REVENUE RECOGNITION: The Company's general practice is to recognize revenues from sales of products as shipped and services as performed. RESEARCH AND DEVELOPMENT: Research and development expense includes all expenditures for general research into scientific phenomena, development of useful ideas into merchantable products and continuing support and upgrading of various products. All such expense is charged to operations as incurred. EARNINGS PER SHARE: Primary and fully diluted earnings per share are computed by dividing net income for the year by the weighted average number of shares of common stock and common stock equivalents outstanding. NOTE 2 - INCOME TAXES During 1993, the Company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." The statement requires use of the asset and liability approach for financial accounting and reporting for income taxes. The cumulative effect of the accounting change was not material. The components of income before taxes were as follows: 1993 1992 1991 Domestic $140,303 $133,477 $102,143 Foreign 4,919 2,977 10,566 Income before taxes $145,222 $136,454 $112,709 The components of the income tax provision were as follows: 1993 1992 1991 Current: Federal $21,682 $21,892 $15,030 State and Puerto Rico 12,400 11,272 8,896 Foreign 1,953 1,907 4,138 Total current 36,035 35,071 28,064 Deferred: Prepaid 274 (807) 404 Deferred (730) 532 273 Total deferred (456) (275) 677 Income tax provision $35,579 $34,796 $28,741 Deferred tax assets (liabilities) were comprised of the following at December 31, 1993: Net deferred income tax asset: Accruals not currently deductible $ 2,557 Other 287 Deferred income tax asset $ 2,844 Net deferred income tax liability: Depreciation and amortization $(2,925) Other 1,261 Deferred income tax liability $(1,664) The Company's effective income tax rate varied from the statutory U.S. federal income tax rate of 35% in 1993 and 34% in prior years as follows: The Company's effective income tax rate is favorably affected by Puerto Rican tax exemption grants which result in Puerto Rican earnings being partially tax exempt through the year 2003. Consolidated U.S. federal income tax returns fled by the Company have been examined by the Internal Revenue Service through the year 1989. The Company's 1990 and 1991 federal income tax returns are presently under audit. The Company has not recorded deferred income taxes applicable to undistributed earnings of foreign subsidiaries ($4,190 at December 31, 1993) because distribution of these earnings generally would not require additional taxes due to available foreign tax credits. The Company made income tax payments of $28,385, $22,709 and $21,872 in 1993, 1992 and 1991, respectively. NOTE 3 - STOCK PLANS Under the terms of the Company's various stock plans, 1,801,118 shares of common stock have been reserved for issuance to directors, officers and employees upon the grant of restricted stock or the exercise of stock options. The stock options are exercisable over periods up to 10 years from date of grant and may be "incentive stock options" or "non-qualified stock options" and may have stock appreciation rights attached. At December 31, 1993, there were a maximum of 514,000 shares available for grant and 1,287,118 options outstanding, of which 498,831 were exercisable. Stock option activity was as follows: Options Price Outstanding Per Share Balance at December 31, 1991 1,077,297 $ 1.31-50.25 Granted 242,000 28.81-48.25 Cancelled (60,000) 4.59-48.25 Exercised (436,654) 1.31-27.69 Balance at December 31, 1992 822,643 4.59-50.25 Granted 602,250 27.25-35.63 Cancelled (88,050) 21.94-50.25 Exercised (49,725) 4.59-22.63 Balance at December 31, 1993 1,287,118 4.59-49.63 Pursuant to the terms of the Company's various stock plans, optionees can use cash, previously owned shares or a combination of cash and previously owned shares to reimburse the Company for the cost of exercising the option. Shares are acquired from the optionee at the fair market value of the stock on the transaction date. All options have been granted at not less than fair market value at dates of grant. When stock options are exercised, the par value of the shares issued is credited to common stock and the excess of the proceeds over the par value is credited to additional paid-in capital. When non-qualified options are exercised, the Company realizes income tax benefits based on the difference between the fair value of the common stock on the date of exercise and the stock option exercise price. These tax benefits do not affect the income tax provision, but rather are credited directly to additional paid-in capital. Under the terms of the Company's shareholder rights agreement, upon the occurrence of certain events which result in a change in control as defined by the agreement, registered holders of common shares are entitled to purchase one-tenth of a share of Series A Junior Participating Preferred Stock at a stated price, or to purchase either the Company's shares or shares of the acquiring entity at half their market value. NOTE 4 - RETIREMENT PLANS The Company has a defined contribution profit sharing plan, including features under Section 401(k) of the Internal Revenue Code, which provides retirement benefits to substantially all full-time U.S. employees. Under the 401(k) portion of the plan, eligible employees may contribute a maximum of 10% of their annual compensation with the Company matching the first 3%. The Company's level of contribution to the profit sharing portion of the plan is determined based on its earnings per share. The Company has additional defined contribution pension plans for employees outside the United States. The benefits under these plans are based primarily on compensation levels. Total retirement plan expense was $1,265, $1,487 and $1,177 in 1993, 1992 and 1991, respectively. NOTE 5 - SUPPLY OF HEART VALVE COMPONENTS The Company has a long-term contract for supply of pyrolytic carbon components used in its mechanical heart valve prosthesis. Under the terms of the contract, the Company has agreed to purchase decreasing percentages of its component requirements from the supplier through 1998. After 1995, provisions of the contract retain the supplier as a back-up component source, whereby the Company will purchase a minimum of 20% of its needs through 1998. The contract specifies an increasing, but annually fixed pricing structure in effect through 1995, whereupon the parties have agreed to negotiate prices for the years 1996 through 1998. Subsequent to 1998, annual renewal clauses may take effect as appropriate. As part of this contract, the Company has granted the supplier a license to produce and sell the supplier's bileafet mechanical heart valve in countries where patents have been issued covering the St. Jude Medical(R) mechanical heart valve. Under this portion of the contract, the supplier will pay royalties to the Company through 1998. Under a separate agreement, the Company paid a royalty to the supplier based on the number of mechanical heart valves the Company produced from its self-manufactured carbon components through August 1993. NOTE 6 - GEOGRAPHIC AREA The Company operates in the medical products industry and is segmented into two geographic areas--the United States and Canada (including all export sales to unaffiliated customers except to customers in Europe, the Middle East and Africa) and Europe (including export sales to unaffiliated customers in the Middle East and Africa). Sales between geographic areas are made at transfer prices which approximate prices to unaffiliated third parties. Export sales from the United States and Canada to unaffiliated customers were $29,926, $25,748 and $21,643 for 1993, 1992 and 1991, respectively. Net sales by geographic area were as follows: United States and Canada Europe Eliminations Net Sales Customer sales $172,713 $79,929 $ -- $252,642 Intercompany sales 59,908 -- (59,908) -- $232,621 $79,929 $(59,908) $252,642 Customer sales $165,551 $73,996 $ -- $239,547 Intercompany sales 55,893 -- (55,893) -- $221,444 $73,996 $(55,893) $239,547 Customer sales $148,792 $61,045 $ -- $209,837 Intercompany sales 48,772 -- (48,772) -- $197,564 $61,045 $(48,772) $209,837 Operating profit by geographic area was as follows: United States and Canada Europe Corporate Total 1993 $99,092 $41,046 $(8,850) $131,288 1992 $92,613 $38,341 $(8,696) $122,258 1991 $77,937 $32,066 $(9,356) $100,647 Identifiable assets by geographic area were as follows: United States and Canada Europe Corporate Total 1993 $92,083 $40,947 $393,787 $526,817 1992 $73,333 $46,669 $349,748 $469,750 1991 $70,608 $31,794 $272,691 $375,093 Corporate expenses consist principally of non-allocable general and administrative expenses. Corporate identifiable assets consist principally of cash and cash equivalents and marketable securities. NOTE 7 - OTHER INCOME Other income consisted of the following: 1993 1992 1991 Interest income $14,635 $13,840 $11,359 Dividend income 14 49 313 Gain on sale of investments 54 350 456 Joint venture and partnership losses (243) -- -- Foreign exchange losses (526) (43) (66) Other income $13,934 $14,196 $12,062 NOTE 8 - OTHER ASSETS Other assets as of December 31, 1993 and 1992, net of accumulated amortization of $17,422 and $12,964, respectively, consisted of the following: 1993 1992 Investments in companies, joint ventures and partnerships $15,259 $ 3,092 Payments made to former distributors 4,237 6,371 Intangibles and other assets 10,226 9,216 Other assets $29,722 $18,679 Investments in companies, joint ventures and partnerships are stated at cost. Pursuant to various transition agreements, payments made to former distributors are being amortized over their benefit periods of from four to five years. Intangibles and other assets, which consist principally of the excess of cost over net assets of certain acquired businesses and technology purchased in connection with the acquisition of certain businesses, are being amortized over periods ranging from five to 15 years. NOTE 9 - QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly data for 1993 and 1992 was as follows: Quarter First Second Third Fourth Year Ended December 31, 1993: Net sales $68,154 $66,944 $58,946 $58,598 Gross profit $51,225 $50,617 $44,948 $44,510 Net income $29,189 $28,843 $25,972 $25,639 Earnings per share $ .61 $ .61 $ .55 $ .55 Year Ended December 31, 1992: Net sales $60,055 $57,008 $58,281 $64,203 Gross profit $44,173 $42,796 $44,044 $48,284 Net income $25,054 $24,891 $25,292 $26,421 Earnings per share $ .52 $ .52 $ .53 $ .55 Primary and fully diluted per share results are the same for all quarters in 1993 and 1992. TEN-YEAR SUMMARY OF SELECTED FINANCIAL DATA (Dollars in thousands, except per share amounts) *$.39 on a fully diluted basis. Earnings per share and share data have been adjusted for 100% stock dividends paid in 1990, 1989 and 1986. [graph] Description: Gross Margin (as a percentage of sales) over the years 1984 - 1993. [graph] Description: Operating Margin (as a percentage of sales) over the years 1984 - - 1993. [graph] Description: Net Sales Per Employee (dollars in thousands) over the years 1984 - 1993. [graph] Description: Net Income Per Employee (dollars in thousands) over the years 1984 - 1993. DIRECTORS Lawrence A. Lehmkuhl (3) Chairman St. Jude Medical, Inc. St. Paul, Minnesota Ronald A. Matricaria President and Chief Executive Officer St. Jude Medical, Inc. St. Paul, Minnesota Frank A. Ehmann (1) (3) Consultant RCS Health Care Partners, L.P. San Francisco, California Thomas H. Garrett, III (1) Attorney Lindquist & Vennum Minneapolis, Minnesota William R. Miller (2) Director of Various Companies New York, New York Charles V. Owens (1) Chairman Genesis Labs, Inc. Minneapolis, Minnesota Roger G. Stoll, Ph.D. (2) (3) Chief Executive Officer and President Ohmeda, Inc. Liberty Corner, New Jersey James S. Womack (2) Chairman Sheldahl, Inc. Northfeld, Minnesota (1) Denotes members of the Audit Committee (2) Denotes members of the Compensation Committee (3) Denotes members of the Technology Committee OFFICERS Ronald A. Matricaria President and Chief Executive Officer Todd F. Davenport President, International Division Robert J. Helbling President, Cardiac Assist Division Eric W. Sivertson President, St. Jude Medical Division John J. Alexander Vice President, Corporate Development Andrew K. Balo Vice President, Regulatory Affairs and Quality Assurance St. Jude Medical Division John P. Berdusco Vice President, Administration Robert S. Elgin Vice President, Operations St. Jude Medical Division Diane M. Johnson Vice President and General Counsel J. Gary Jordan Vice President, Sales and Marketing St. Jude Medical Division Stephen L. Wilson Vice President, Finance and Chief Financial Officer INVESTOR INFORMATION TRANSFER AGENT American Stock Transfer & Trust Company 6201 15th Avenue Brooklyn, NY 11219 718-921-8293 800-937-5449 Correspondence regarding stock holdings, dividend checks and changes of address should be directed to the transfer agent. LEGAL COUNSEL Lindquist & Vennum Minneapolis, Minnesota INDEPENDENT AUDITORS Ernst & Young Minneapolis, Minnesota INVESTOR INFORMATION Investors, shareholders and security analysts seeking additional information about the Company should call Investor Relations at (612) 481-7555. A copy of the Company's annual report to the Securities and Exchange Commission on Form 10-K or other financial reports will be provided free of charge to any shareholder upon written request to Investor Relations, St. Jude Medical, Inc., One Lillehei Plaza, St. Paul, Minnesota 55117-9983 ANNUAL MEETING OF SHAREHOLDERS The annual meeting of shareholders will be held at 8:15 a.m. on Wednesday, May 4, 1994, at the Lutheran Brotherhood Auditorium, Lutheran Brotherhood Building, 625 Fourth Avenue South, Minneapolis, Minnesota. SHAREHOLDER MAILINGS When shares owned by one shareholder are held in different forms of the same name (e.g., John Doe, J. Doe) or when new accounts are established for shares purchased at different times, duplicate mailings of shareholder information results. The Company, by law, is required to mail to each name on the shareholder list unless the shareholder requests that duplicate mailings be eliminated or consolidates all accounts into one. Such requests should be directed, in writing, to American Stock Transfer, 6201 15th Avenue, Brooklyn, New York, 11219. St. Jude Medical, Inc. mails quarterly reports only to registered shareholders. Shareholders can obtain the Company's results each quarter by calling a toll-free number (800- 552-7664) and listening to a recorded message. RESEARCH COVERAGE The following firms currently provide research coverage of St. Jude Medical, Inc.: Bear, Stearns & Co., New York, New York Dain Bosworth Incorporated, Minneapolis, Minnesota Goldman Sachs & Co., New York, New York Hambrecht & Quist Incorporated, New York, New York Kemper Securities Group, Inc., Chicago, Illinois Lehman Brothers, New York, New York Mabon Securities Corp., New York, New York Merrill Lynch & Co., New York, New York Morgan Keegan & Company, Inc., Memphis, Tennessee Morgan Stanley & Co. Incorporated, New York, New York Olde Discount, Detroit, Michigan PaineWebber Incorporated, New York, New York Piper, Jaffray Incorporated, Minneapolis, Minnesota Raymond James & Associates, Inc., St. Petersburg, Florida Robert W. Baird Co., Incorporated, Milwaukee, Wisconsin 13D Research Services, Brewster, New York Value Line Inc., New York, New York Vector Securities International, Inc., Deerfeld, Illinois Wertheim Schroder, New York, New York Wessels, Arnold & Henderson, Minneapolis, Minnesota SUPPLEMENTAL MARKET PRICE DATA The common stock of St. Jude Medical, Inc. is traded on the NASDAQ National Market System under the symbol STJM. The range of high and low prices per share for the Company's common stock for 1993 and 1992 are set forth below. As of February 9, 1994, the Company had 5,391 shareholders of record. Year Ended December 31 1993 1992 Quarter High Low High Low First $42.50 $28.75 $55.50 $42.50 Second $39.00 $27.25 $50.75 $34.00 Third $39.50 $25.50 $38.25 $27.50 Fourth $29.75 $25.00 $43.25 $30.25 Price data reflect actual transactions. In all cases, prices shown are inter-dealer prices and do not reflect mark-ups, markdowns or commissions. CASH DIVIDENDS St. Jude Medical, Inc. initiated a cash dividend in the second quarter 1992 and maintained a $.10 per share quarterly cash dividend through 1993. TRADEMARKS St. Jude Medical(R), BiFlex(R), BioImplant(R), Toronto SPVtm, RediFurl(R), RediGuardtm, TaperSeal(R), SureGuidetm, Lifestream(R), and Isoflow(R) are trademarks of St. Jude Medical, Inc. [logo] St. Jude Medical, Inc. One Lillehei Plaza St. Paul, MN 55117 612/483-2000 Telex 298453 Fax 612/490-4333

7314_1993.txt

7314_1993

1993

7314

ITEM 1. BUSINESS. Arkla, Inc. (the "Company") was incorporated in 1928 under the laws of the State of Delaware and is principally engaged in the distribution and transmission of natural gas including gathering, storage and marketing of natural gas. See "Natural Gas Distribution" and "Natural Gas Pipeline". The Company previously conducted operations in the exploration and production of natural gas and the radio communications business, but on December 31, 1992, and July 31, 1992, respectively, the Company completed the sale of its exploration and production subsidiary, Arkla Exploration Company ("AEC"), to Seagull Energy Corporation ("Seagull") and completed the sale of its radio communications subsidiary, E.F. Johnson Company ("Johnson"). This terminated the Company's activities in the exploration and production business and in the radio communication business. The Company has also participated in several other acquisitions, dispositions and mergers in recent years, see "Mergers, Acquisitions and Dispositions". The revenue, operating profit and identifiable assets of the natural gas segment exceed 90% of the respective totals for the Company. Accordingly, the Company is not required to report on a "segment" basis, although the Company is organized into, and the following business discussions focus on, two operating units -- Natural Gas Distribution and Natural Gas Pipeline -- to reflect the natural division of the Company's operations. NATURAL GAS DISTRIBUTION. The Company's natural gas distribution business is conducted through its three divisions, Arkansas Louisiana Gas Company ("ALG"), Entex and Minnegasco, and their affiliates. Through these divisions and their affiliates, the Company engages in both the natural gas distribution sales and transport businesses. ALG provides service in approximately 624 communities in the states of Arkansas, Louisiana, Oklahoma, Texas and Kansas. The largest communities served through ALG are the metropolitan areas of Little Rock, Arkansas, and Shreveport, Louisiana. In 1993, approximately 71% of ALG's total throughput was composed of sales of gas at retail and approximately 29% was attributable to transportation services. For the same period, in excess of 95% of ALG's supplies were obtained from Arkla Energy Resources Company ("AER Co."), and Mississippi River Transmission Corporation ("MRT"), or through transportation agreements with Arkla Energy Marketing Company ("AEM"). In May of 1993, ALG, AER Co. and UtiliCorp United Inc. ("UtiliCorp", an affiliate of Peoples Natural Gas Company) entered into a definitive agreement pursuant to which the Company expects to sell to UtiliCorp, subject to Federal Energy Regulatory Commission ("FERC") approval, the Kansas distribution properties of ALG together with certain related pipeline assets of AER Co. Upon completion, this sale will terminate the Company's distribution and transmission operations in Kansas. Entex provides service in approximately 502 communities in the states of Texas, Louisiana and Mississippi. The largest community served by Entex is the metropolitan area of Houston, Texas. In 1993, approximately 87% of Entex's total throughput was composed of sales of gas at retail and approximately 13% was attributable to transportation services. For the same period, Entex's principal suppliers of gas were Enron Gas Services Corporation, MidCon Texas Pipeline Co., Koch Gateway Pipeline Company, and certain affiliates of each such company. No other supplier accounted for in excess of 10% of Entex's purchases. During a portion of 1993, Minnegasco provided service in 285 communities in the states of Minnesota, Nebraska and South Dakota. The major communities served by Minnegasco in 1993 included Minneapolis, Minnesota and its suburbs; Lincoln, Nebraska; and Sioux Falls, South Dakota. In February 1993, Minnegasco completed the sale of its Nebraska distribution system to UtiliCorp for $75.3 million in cash. In August of 1993, Minnegasco completed the exchange of its South Dakota distribution properties plus $38 million in cash for the Minnesota distribution properties of Midwest Gas, a division of Midwest Power System Inc. ("Midwest"). The UtiliCorp and Midwest transactions terminated Minnegasco's distribution operations outside of Minnesota. In 1993, approximately 95% of Minnegasco's total throughput was composed of sales of gas at retail and approximately 5% was attributable to transportation services. For the same period, Minnegasco's principal pipeline service providers were Northern Natural Gas Company, Viking Gas Transmission Company, Minnesota Intrastate Transmission System and Natural Gas Pipeline Company of America. For the same period, Minnegasco's principal suppliers of gas were Pan Alberta Gas, AEM, Northern Natural and Western Gas Marketing. No other supplier of natural gas accounted for more than 10% of Minnegasco's purchases. The following table summarizes by state the number of communities and the estimated number of customers served by the Company as of December 31, 1993: SERVICE AREA LOCATIONS COMMUNITIES SERVED NUMBER OF CUSTOMERS Texas 365 1,160,947 Minnesota 204 599,067 Arkansas 383 422,187 Louisiana 179 261,456 Oklahoma 94 115,523 Mississippi 91 115,841 Kansas 14 23,001 ----- --------- Total 1,330 2,698,022 The following table summarizes the estimated number of customers served by each of the divisions as of December 31, 1993 and 1992: (1) The estimated number of Minnegasco customers for 1992 includes customers in Nebraska and South Dakota. The Nebraska distribution properties were sold in February of 1993, and the South Dakota distribution properties were exchanged for additional Minnesota distribution properties in August of 1993. The Company's approximately 53,523 linear miles of gas distribution mains vary in size from one-half inch to 24 inches. Generally, in each of the cities, towns and rural areas it serves, the Company owns the underground gas mains and service lines, metering and regulating equipment located on customers' premises, and the district regulating equipment necessary for pressure maintenance. With a few exceptions, the measuring stations at which the Company receives gas from its suppliers are owned, operated and maintained by suppliers, and the distribution facilities of the Company begin at the outlet of the measuring equipment. These facilities include odorizing equipment usually located on the land owned by suppliers and district regulator installations, in most cases located on small parcels of land which are leased or owned by the Company. Throughput information for each of the distribution divisions is as follows: Consolidated revenue, throughput and customer data of the distribution divisions are as follows: In almost all of the communities in which it provides service, the city or other relevant governmental body has granted the Company a franchise to serve, and its service is subject to the terms and conditions of the franchise. In most instances the Company's franchise is not exclusive. The rates at which the Company provides service at retail to its residential and commercial customers are, in all instances, subject to regulation by the relevant state public service commissions and, in Texas also by municipalities. The services provided by the Company to its industrial customers are largely unregulated in Texas and Louisiana, and are subject to regulatory supervision of differing degrees in each of the other states. See "Regulation." NATURAL GAS PIPELINE. The Company's transmission activities are conducted by the Arkla Pipeline Group ("APG"). In March 1993, the Company transferred assets, liabilities and service obligations of Arkla Energy Resources ("AER"), a division of the Company, into a newly-formed wholly-owned subsidiary of Arkla, Inc., AER Co., pursuant to an order from FERC approving the transfer. As a result, APG now includes AER Co., an interstate pipeline subsidiary of the Company, MRT, an interstate pipeline subsidiary of the Company and AEM, a subsidiary which serves as the Company's principal natural gas supply aggregator and marketer, and affiliate companies associated with each. Through these subsidiaries, APG engages in both the natural gas sales and transportation businesses. During 1994, the Company plans to spend approximately $39 million to upgrade certain facilities in order to increase deliverability to other interstate pipelines at inteconnects near Perryville, Louisiana. The upgrades are intended to facilitate the creation of a natural gas marketing "hub". On June 30, 1993, the Company completed the sale of its intrastate pipeline business as conducted by Louisiana Intrastate Gas Corporation and its subsidiaries, LIG Chemical Company, LIG Liquids Corporation and Tuscaloosa Pipeline (the "LIG Group"), to a subsidiary of Equitable Resources, Inc. ("Equitable") for $191 million in cash. The Company acquired the LIG Group in July of 1989. The LIG Group operated a natural gas pipeline system located wholly within Louisiana. Its total throughput was 103.4 million MMBtu for the six months ended June 30, 1993. During 1993, the Company also evaluated strategic alternatives with respect to its interstate pipeline business, ranging from contractual alliances to the sale of all or a portion of such business. In July 1993, based on its evaluation, the Company's Management and Board of Directors concluded that it is in the best interests of the Company's stockholders for the Company to retain full ownership and operating control of its interstate pipeline business. In October 1993, the Company made a filing with the FERC which, if approved, would allow the Company to transfer the natural gas gathering assets of AER Co. into a wholly-owned subsidiary to be called Arkla Gathering Services Company ("Arkla Gathering"). Arkla Gathering, if authorized by the FERC, will own and operate 3,500 miles of gathering pipeline which collect gas from more than 200 separate systems in major producing fields in Arkansas, Oklahoma, Louisiana and Texas. While the scope of the FERC's jurisdiction over Arkla Gathering is unclear, the Company believes that it would not generally be subject to traditional cost-of-service rate regulation. Effective as of December 31, 1993, the Company completed a comprehensive settlement agreement with certain subsidiaries of Samson Investment Company pursuant to which a number of outstanding contractual arrangements between the parties were terminated or substantially modified (see "Natural Gas Pipeline" under "Material Changes in the Results of Continuing Operations", included in the 1993 Annual Report to Stockholders and incorporated herein by reference). AER Co. owns and operates a natural gas pipeline system located in portions of Arkansas, Louisiana, Mississippi, Missouri, Kansas, Oklahoma, Tennessee and Texas. As described above under "Natural Gas Distribution", in May of 1993 AER Co. entered into a definitive agreement pursuant to which it expects to sell to UtiliCorp its pipeline assets in Kansas, including the Winfield, Kansas Storage field described below, subject to FERC approval. At December 31, 1993, the AER Co. system consisted of approximately 6,612 miles of transmission lines and approximately 3,500 miles of gathering lines. The AER Co. pipeline system extends generally in an easterly direction from the Anadarko Basin area of the Texas Panhandle and western Oklahoma through the Arkoma Basin area of eastern Oklahoma and Arkansas to the Mississippi River. Additional pipelines extend from east Texas to north Louisiana and central Arkansas, and from the mainline system in Oklahoma and Arkansas to south central Kansas and southwest Missouri. The system has extensive gas gathering facilities throughout the Anadarko and Arkoma Basins, and in east Texas and north Louisiana and also operates various product extraction plants and compressor facilities related to its gas transmission business. AER Co.'s bundled firm and interruptible sales services were eliminated on September 1, 1993 when it "unbundled" these services into the separate components of gas supply, transmission, and storage pursuant to FERC Order 636, see "Regulatory". AER Co.'s peak day gas handled during the 1993/94 heating season was approximately 2.43 billion cubic feet ("Bcf"). The system transports gas for third parties as an "open access" transporter, makes sales of gas directly to end users located along its system, and delivers gas to the Company's distribution divisions for retail sales. In 1993, AER Co.'s throughput totaled 617.5 Bcf which consisted of 9% sales service and 91% transportation service. Approximately 21% of the total throughput was attributable to services provided to ALG, 10% was attributable to services provided to MRT, and 27% was attributable to gas marketed by AEM to other parties. No other customer or supplier accounted for more than 10% of AER Co.'s throughput. The MRT system consists of approximately 2,200 miles of pipeline serving principally the greater St. Louis area in Missouri and Illinois. This pipeline system includes the "Main Line System," the "East Line," and the "West Line." The Main Line System includes three transmission lines extending approximately 435 miles from Perryville, Louisiana, to the greater St. Louis area. The East Line, also a main transmission line, extends approximately 94 miles from southwestern Illinois to St. Louis. The West Line extends approximately 140 miles from east Texas to Perryville, Louisiana. The system also incudes various other branch, lateral, transmission and gathering lines and compressor stations. During 1993, MRT's throughput totaled 317.6 Bcf which consisted of 19% sales service and 81% transportation service. Approximately half of MRT's total 1993 volumes were delivered to its traditional markets along its system in Missouri, Illinois and Arkansas with the remaining volumes delivered to off-system customers. MRT's bundled firm and interruptible sales services were eliminated on November 1, 1993 when it "unbundled" those services into the separate components of gas supply, transmission, and storage pursuant to FERC Order 636, see "Regulatory". MRT's peak day delivery during the 1993/94 heating season to its traditional market was approximately 950,000 MMBtu, which consisted of 100% transportation volumes. MRT's largest customer is Laclede Gas Company, which serves metropolitan St. Louis and to which MRT provides service under several long-term firm transportation and storage agreements and an agency agreement. The Company owns and operates seven gas storage fields. Four storage fields are associated with AER Co.'s pipeline and have a combined maximum deliverability of approximately 600 million cubic Feet ("mmcf") per day and a working gas capacity of approximately 20.3 Bcf. AER Co. also owns a 10% interst in Koch Gateway Pipeline Company's Bistineau storage field which provides an additional 100 mmcf/per day of deliverability and additional working gas capacity of 8 Bcf. The two largest AER Co. storage fields are located in Oklahoma: the Ada field - capable of delivering approximately 330 mmcf per day, and the Chiles Dome field - capable of delivering approximately 200 mmcf per day. The other AER Co. storage fields, Ruston and Collinson, are located near Ruston, La. and Winfield, Kansas. Three storage fields are associated with MRT's pipeline and have a maximum aggregate deliverability of approximately 750 mmcf per day and a working gas capacity of approximately 31 Bcf. The substantial portion of such capacity is located in two fields in north central Louisiana, near Ruston. The other MRT storage field is located at St. Jacob, Illinois. The Company utilizes its gas storage fields primarily to meet peak demands during winter months. AEM markets gas on both a short-term (spot) and long-term basis. Pricing may be market-based or fixed. Fixed priced sales (or purchases) are hedged using gas futures contracts or other derivative hedging tools. See Notes 1 and 3 of Notes to Consolidated Financial Statements. AEM supplies are purchased from others on both a short-term and long-term basis. Most supplies are priced on a market sensitive basis. Sales for 1993 were 245 Bcf of which approximately 72% was to unaffiliated parties. Customers are located both on the AER Co. system and other pipelines. Gas is transported to customers using both firm and interruptible transportation. All of the APG entities are primarily supplied by gas purchased directly in the field from producers, and in the case of MRT and AEM, also from marketers. During 1993, APG's largest suppliers were Arco Oil and Gas Company, Ward Gas Marketing and Premier Gas Company, which accounted for 8.4%, 5.5%, and 3.7% of APG's purchases, respectively. During 1993, MRT acquired approximately 44% of its supplies from affiliated companies. Substantially all of the gas purchased by AER Co. and AEM is delivered by the suppliers directly into the facilities of AER Co. In excess of 90% of the gas purchased for resale or transportation by MRT is delivered through various transportation arrangements, primarily with Natural Gas Pipeline Company of America, Trunkline Gas Company, and AER Co. During 1993, approximately 65% of MRT's supplies were transported by AER Co. As a result of the transfer of assets, liabilities and service obligations from AER to AER Co., the FERC now has jurisdiction over its interstate pipeline business, including transportation services and certain of AER Co.'s transactions with affiliates of the Company, which historically were subject to state regulatory oversight. The FERC has jurisdiction over MRT with regard to its interstate pipeline business. Sales and services provided by AEM are generally not subject to any form of regulation. See "Regulation." The Company sold LIG to Equitable in June, 1993. LIG's results of operations have been excluded from the following data. LIG's operating revenues were $151.1 million for the six months ended June 30, 1993 and $296.2 million and $278.9 million for 1992 and 1991, respectively. LIG's total throughput was 103.4 million MMBtu for the six months ended June 30, 1993 and 244.1 million MMBtu and 240.2 million MMBtu for 1992 and 1991, respectively. Consolidated throughput and revenues for APG are as follows: Year Ended December 31(1) 1993 1992 1991 ---- ---- ---- Throughput (million MMBtu) Sales 174.8 150.0 229.1 Transportation 780.1 752.5 629.8 Order 636 elimination (24.2)(2) -- -- ----- ----- ----- Total 930.7 902.5 858.9 ===== ===== ===== Revenues (in millions of dollars) Sales $ 874.2 $ 752.9 $ 890.9 Transportation 138.7 102.0 106.7 -------- -------- -------- Total $1,012.9 $ 854.9 $ 997.6 ======== ======== ======== (1) Reported on a consolidated basis for the group. Does not include services provided by one member of the group to another, but includes services provided by members of the group to the Company's distribution division. Generally, sales by AEM of gas transported through AER Co. are treated as transportation, while sales by MRT of gas received through transportation from AER Co. are treated as sales. (2) Prior to the implementation of unbundled services pursuant to FERC Order 636, AER's and MRT's sales rate covered all related services, including transportation to the customer's facility. Under FERC Order 636, when AER and MRT act as a merchant, the sales transaction is independent of (and may not include) the transportation of the volume sold. Therefore, when the sold volumes are also transported by AER and MRT, the throughput statistics will include the same physical volumes in both the sales and transportation categories, requiring an elimination to prevent the overstatement of actual total throughput. During the 1980s, the Company, as most other pipelines, was compelled to resolve a number of significant disputes with its suppliers under contracts which allegedly required the Company to take or, if not taken pay for, quantities of gas in excess of its available sales markets and/or at prices generally above the levels required by such markets. These disputes, generally referred to as "take-or-pay" claims, have been resolved in a number of ways, including both buy-out/buy-downs and payments for gas in advance of its delivery. While the majority of such claims have been settled, the Company is committed, under certain of these settlements, to make additional payments although such commitments are not material to the Company's capital requirements in any year and, in the aggregate, are exceeded by cash inflows under other such agreements. In the third quarter of 1989, the Company recorded a pre-tax Special Charge of $269 million related to these claims. The amount shown as "Gas Purchased in Advance of Delivery" in the Company's Consolidated Balance Sheet and the component of "Investments and Other Assets" bearing the same caption (See Note 1 of Notes to Consolidated Financial Statements) represents, in substantial part, amounts paid to suppliers in conjunction with the above referenced settlements. These prepayments for gas were made at varying prices but have been reduced to their estimated net realizable value (which approximates fair value) and, to the extent that the Company is unable to realize at least this amount through sale of the gas as delivered over the life of these agreements, its earnings will be adversely affected, although such impact is not expected to be material in any individual year. In addition, the Company's Consolidated Balance Sheet includes an accrual representing its estimate of the amount it will be required to pay in settlement of all remaining claims, including those not yet asserted. While the Company can provide no assurance that such accrual will ultimately prove adequate, in the opinion of Management the shortfall, if any, will be immaterial. The Company is committed under certain agreements to purchase certain quantities of gas in the future. At December 31, 1993, the Company had the following gas take commitments under its agreements which are not variable-market-based priced: Volume Value Price ------ ----- ----- (millions ($ in millions) ($/MMBtu) of MMBtu) 1994 20.6 $52.6 $2.55 1995 18.7 46.3 2.48 1996 14.9 37.3 2.50 1997 13.9 33.6 2.43 Beyond 1997 17.8 $39.3 $2.21 At December 31, 1993, the Company had the following gas take commitments under its agreements which are variable-market-based priced, valued using an average spot price of approximately $2.05/MMBtu: Average Volume Value Price ------ ----- ------ (millions of ($ in millions) ($/MMBtu) MMBtu) 1994 75.7 $154.8 $2.04 1995 11.3 23.9 2.11 1996 5.4 11.6 2.15 1997 4.0 8.4 2.12 Beyond 1997 6.7 $14.2 $2.12 To minimize the risk from market fluctuations in the price of natural gas and related transportation, the Company enters into futures transactions, swaps and purchases options in order to hedge certain commitments to buy and sell natural gas (see Notes 1 and 3 of Notes to Consolidated Financial Statements). To the extent the Company does not have or believes that it may not retain markets for the above volumes of gas which are expected to generate total consideration which equals or exceeds the amounts it is obligated to pay for such volumes, it has established financial reserves. The adequacy of these reserves over the life of the relevant agreements depends upon, among other factors, the spot price of gas at the time such volumes are purchased for resale and the extent to which the Company's existing markets are affected by FERC Order 636, including actions which may be taken by Local Distribution Companies in response to such Order. While the Company can provide no assurance that its reserves will ultimately prove adequate, based on the information currently available, the Company does not anticipate that it will incur losses in conjunction with delivery and resale of the above volumes which are materially in excess of previously recorded financial reserves. MARKET FACTORS. The Company's business is generally affected by a number of market factors, including competition, seasonality and the general economic climate. Increasingly, the activities of the Company's transmission and marketing units are most significantly affected by national trends in these areas. On the other hand, the results of the Company's distribution units continue to be influenced most significantly by local trends in these factors. Historically, competition in the sale and transportation of natural gas was limited due to the pervasive nature of the regulation of the industry and the long-term nature of the service obligations assumed by its participants. As a result, the Company's results of operations were largely determined by local factors, including the effects of local regulation. Over the past few years, however, regulatory and economic developments have significantly reduced the influence of such factors, particularly with respect to the Company's transmission and marketing operations. At the federal level, regulations governing natural gas transmission and marketing have been redesigned in order to promote intense competition between natural gas transporters and marketers. From an economic perspective, in recent years the energy industry, including the natural gas industry, has been characterized by a surplus of product deliverability (and, in the case of natural gas transportation in certain locations during certain seasons, a surplus of capacity), which also has increased the level of competition. Currently, the Company generally faces competition in all aspects of its operations, both from other companies engaged in the natural gas business and from companies providing other energy products. This has an effect both on the quantity of the services sold by the Company and the prices it receives. At all levels of the industry in which the Company is engaged, competition generally occurs on the basis of price, the ability to meet individual customer requirements, access to supplies and markets and reliability. In the current environment, the ability of the Company to respond to this competition is tied directly to its ability to maintain operational flexibility, achieve low operating costs and maintain continued access to reliable sources of competitively priced gas and a broad range of gas markets. The level of competition is especially intense in connection with the services provided by the Company's transmission and marketing units. As a result of fundamental changes in the regulatory environment over the past few years, the natural gas and gas transportation markets in which the Company's pipeline units compete have become increasingly national in scope. In many instances, the gas transported through the Company's pipelines and sold by the Company's marketing units is bound for customers located outside of the Company's historic service areas, where it competes for market share with gas produced from other regions of the United States and, in certain instances, Canada. With respect to the services provided in the Company's historic service areas, the Company's transmission and marketing units are only one of several pipeline systems and natural gas marketers providing service in all or a part of the area. The competitors in such areas are also participants in other markets and as a result, the availability and price of their services are determined by broader factors than simply local conditions. The Company also faces competition in these areas from new entrants. These developments have had the effect of increasing the number of competitors and competitive options faced by the Company. As a consequence, changes in the market for natural gas and gas transportation services at the national level increasingly influence the demand and prices paid for the natural gas and gas transportation services offered by the Company. Additionally, to the extent that the customers served by those units are relatively large volume customers using gas to meet industrial or electric power generation requirements, the Company faces significant competition from fuel oil, waste products used as a source of fuel for the generation of process heat or steam, energy conservation products, and, with respect to electric generation customers, low cost energy available to such customers from other electric generators. Largely as a result of increasing competition, the Company discontinued the application of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" to AER Co.'s transactions and balances in 1992, see Note 10 of Notes to Consolidated Financial Statements included in the Company's 1993 Annual Report to Stockholders and incorporated herein by reference. These trends in competition are expected to continue, although not necessarily at the same rate as in the past. The Company's distribution units also face competition. As with customers served by the Company's transmission and marketing units, over the last few years the Company's small industrial and large commercial customers served through its distribution units increasingly have been the target of other companies engaged in the natural gas business seeking to sell gas directly or transport third-party gas to such customers served through its distribution units through new facilities, thereby bypassing the facilities installed by the Company to serve such customers. The Company has met such competition by adopting new programs which, in some instances, have provided its competitors with access to its sales customers, but through the use of the Company's facilities. The Company also faces competition with respect to such customers from fuel oil, electricity, energy conservation products, and in certain instances, liquid petroleum gas. While with certain limited exceptions, the Company currently is not in direct competition with any other distributors of natural gas with respect to its existing small commercial and residential customers, the Company nevertheless faces significant competition for such customers from electric utilities and providers of energy conservation products. Moreover, while the Company currently holds franchises in almost all of the communities which it serves, such franchises generally are not by their terms exclusive and competition has been experienced in certain instances as the Company has sought to extend service from existing service areas to geographically adjacent areas. In addition to competition, the Company's business also is affected at all levels by seasonality and general economic conditions. Because one of the significant markets for natural gas is use in space heating, demand for natural gas and gas transportation services is generally seasonal in nature. In recent years, the Company's transmission and marketing units have increased the volume of their off-season sales by expanding their markets to include additional industrial users of gas, gas-fired electric generators, and customers seeking gas in the summer to fill storage. Even with increased summer demand, however, the price of natural gas and gas transportation services continues to be seasonal in nature, with prices significantly lower in the summer than in winter. While the Company's distribution units also have sought to increase the level of their off-season sales, the opportunity to do so within their historic service areas is limited. General economic conditions also significantly influence the demand for gas. The national demand for gas has increased in recent years and currently is expected to continue to increase in future years. This, in turn, at certain times and in certain market segments has influenced the price for natural gas and gas transportation services. However, this increased demand for gas is somewhat tied to the overall state of economic activity and there can be no assurance that current levels of demand will continue or that, if they continue, they will necessarily have a significant effect on the price of or demand for the Company's products or services. From the perspective of the Company's local distribution units, the economic conditions prevailing in the Company's historic service areas continue to have a significant effect on the results of their operations. Unlike the Company's transmission and marketing units, the local distribution units are not readily able to redirect their activities to other markets when the demand for gas in their local service areas declines. In recent years, the level of economic activity in the areas served by these units has remained relatively stable. REGULATION. The Company's business operations are significantly affected by regulation. This regulation occurs at all levels -- federal, state and local - -- and has the effect, among other things, of: (i) requiring that the Company seek and obtain certain approvals before it may undertake certain acts, (ii) regulating the level of rates which the Company may charge for certain of its services and products, and (iii) imposing certain conditions on the Company's conduct of its business. The Company is most affected by the regulations of the FERC. In 1992, the FERC promulgated its Order 636, a comprehensive revision of its regulations regarding the sale and transportation of natural gas. Of significance to the Company, Order 636 requires interstate pipelines to adopt new terms and conditions of service which (i) eliminate the ability of those pipelines to make sales of gas on terms more advantageous than those which can be offered by other sellers of gas, (ii) provide holders of firm transportation capacity entitlements on those pipelines with the ability essentially to assign those entitlements to third parties, (iii) provide holders of transportation capacity entitlements on those pipelines with the ability freely to change the points at which they deliver gas to or receive gas from such pipelines, subject only to certain operational limitations, and (iv) eliminate the right of local distribution companies to require service from those pipelines in the absence of a contract. As promulgated by the FERC, Order 636 is to be implemented through the adoption by each interstate pipeline of conforming changes to the pipeline's tariffs. AER made several compliance filings in 1993 and implemented restructured services effective September 1, 1993. MRT also made several Order 636 compliance filings in 1993 and implemented restructured services on its system November 1, 1993. Pursuant to its restructuring tariff and the requests of its customers, MRT allocated all of its firm system capacity, including firm storage capacity, to its pre-Order 636 sales and transportation customers. In addition to firm and interruptible transportation and storage services, MRT provides unbundled sales and/or agency services in accordance with Order 636 to the majority of MRT's former bundled firm sales customers. These changes are likely to increase the level of competition faced by the Company's transmission and marketing units. Third-party sellers of gas will be in a position to compete on an equal footing with the Company's pipelines and marketing units in the sale of long-term, firm supplies of gas. Holders of firm transportation capacity entitlements on the Company's pipelines will be in a position to market their unused capacity rights in direct competition with unused capacity offered by the Company. In addition, Order 636 requires that pipelines offer their services on an "unbundled" basis -- that is, customers must be offered the opportunity to purchase gathering, storage and transmission services separately, rather than as a "bundled" package. As a result, customers will be in a position to pick and choose among the Company's transportation products depending on those customers' individual needs and the availability and pricing of alternate supplies of such services. In past periods, pipelines have incurred substantial costs as similar changes in the direction of the FERC's regulations have resulted in significant economic dislocations in the industry. While pipelines were permitted to recover a portion of those costs in their rates, a significant portion ultimately was absorbed by the pipelines without recovery. In an effort to avoid a similar outcome in this instance, Order 636 provides that pipelines will be permitted to include in the calculation of their future rates any similar "transition costs" incurred as a result of the changes required by Order 636. In addition, Order 636 authorizes pipelines to formulate their future rates in a manner which is intended to minimize the economic effect which otherwise might result from permitting holders of firm capacity transportation entitlements to compete directly with the pipeline for transportation customers. However, competitive and other economic conditions may prevent pipelines from charging the maximum rates which are designed to reflect all of these costs. The changes to the industry brought about by Order 636 also have affected and will continue to affect the business environment in which the Company's local distribution units operate in those geographical areas where gas supplies are delivered on interstate pipelines. The impact is less pronounced in the case of Entex, where a significant portion of supplies are delivered on intrastate pipelines. The Order has increased, and in some cases likely will continue to increase, the number and diversity of potential suppliers and products available to meet the supply needs of each unit. In addition, the requirement that pipelines "unbundle" their services permits the Company's distribution units to avoid the purchase -- and, thus, the cost -- of services which they do not require. On the other hand,the elimination of the right of local distribution companies to require service from interstate pipelines in the absence of a contract will expose local distributors to an increased risk of supply disruption and the potential for increased review from some state regulatory agencies. In addition, the ability of holders of firm transportation capacity entitlements to assign their capacity rights to other parties, coupled with the ability of those holders to change the points at which that capacity is used, likely will increase the competitive pressures faced by local distributors. This is because such provisions will expand the incentives for and capabilities of third parties to build new facilities from nearby pipelines which bypass the existing facilities of the incumbent local distributors. Under Order 636, the Company's distribution units have incurred increased costs as a result of the recovery by their pipeline suppliers through their rates of those pipelines' Order 636-related "transition costs". In some cases, the recovery of transition costs remains unresolved. In addition, the ratemaking provisions of Order 636 have increased the fixed costs incurred by distribution companies in reserving firm transportation capacity on their pipeline suppliers. While the Company's distribution units generally expect to be able to recover all of these increased costs in their retail rates, the resulting increases may adversely affect their competitive posture relative to alternate fuels and suppliers. The Company is unable to predict at present the extent, if any, to which Order 636 will have an effect on the Company's various operating units. Moreover, the Company notes that nearly all of the regulations promulgated by the FERC in this area since 1985 have been the subject of a substantial amount of litigation, including appeals to various courts, and that several of those regulations have been further modified as a result of such litigation. In line with that history, Order 636 currently is the subject of both further requests for modification and court appeals. Until such time as all such requests for modifications and appeals are resolved, considerable uncertainty will remain in the industry. In addition to those matters arising out of Order 636, the Company also is involved in other significant proceedings before the FERC. In one such set of proceedings, AER Co. and MRT currently are seeking approval to sell approximately 250 mmcf per day of capacity in AER Co.'s Line AC and certain other facilities to ANR Pipeline Company (ANR Pipeline). During 1992, the FERC approved the sale, subject however to certain conditions. In AER Co.'s opinion, certain of these conditions broaden the scope of the rights to be conveyed to ANR Pipeline substantially beyond those contemplated by AER Co. in the calculation of the purchase price. As a result, AER Co. and MRT have requested that the FERC reconsider that portion of its order, and AER Co., MRT and ANR Pipeline have deferred the closing of the transaction pending the outcome of that request. During 1993, the parties entered into agreements amending the proposed transaction and have requested FERC approval of the amended transaction. The Company currently cannot predict with certainty either the outcome of, nor the timing of the FERC's action on its request. This sale by AER Co. and MRT to ANR Pipeline is also subject to approval by the Federal Trade Commission. As circumstances warrant, both AER Co. and MRT regularly seek authorization from the FERC for changes in their rates. Both AER Co. and MRT currently are before the FERC seeking increases in their FERC jurisdictional rates. At the state and local level, the primary effect of regulation of the Company relates to the rates charged by the Company's various distribution units for the services they provide to their customers. These services generally include both transportation and sale services. Currently, Minnegasco and ALG have applications for an increase in their local rates pending, respectively, before the appropriate Minnesota, Arkansas, and Oklahoma regulatory agencies. In addition to regulation of the Company's distribution rates, state and local regulatory bodies also issue the franchises and certificates of public convenience and necessity which govern most services provided by the Company at retail. Regulations at both the federal and state levels also have other effects on the competitive environment in which the Company operates. Historically, the regulatory regimes applicable at both the federal and state level restricted the amount of facilities which could be installed to serve a given customer. Customarily, these regulations did not allow for the construction of "duplicate" facilities by a second supplier to a given customer if the customer already was being adequately served by its existing supplier. Since the mid-1980's, however, these regulatory restrictions gradually have been eroded and other companies competing for the sale or transportation of gas to customers presently served or capable of being served through facilities owned by the Company have been permitted to use existing facilities owned by others or to construct new facilities, thereby entirely bypassing the Company's facilities. In certain instances, these proposals require the advance approval of various regulatory bodies before they may be implemented. In the past, certain such proposals have been approved and, when approved and implemented, have resulted in reductions in the level of services provided by the Company to its customers. In other situations, proposals to bypass facilities owned by the Company have not been approved. The Company is not able at present to predict either the outcome of any current or future proceedings or the effect, if any, which they ultimately may have on the Company. Certain business activities of the Company in the United States are subject to existing federal, state and local laws and regulations governing environmental quality and pollution control. During 1988, the Company implemented a plan to contain and dispose of polychlorinated biphenyls ("PCB's") which, upon inspection, were found to exist in certain isolated sections of the MRT system. The Company advised the Environmental Protection Agency ("EPA") of the results of MRT's review and its remediation plan. MRT's remediation efforts were completed in 1992 and the EPA has made an inspection of MRT's facilities without raising any additional issues. With the acquisition of DEI in November 1990, the Company acquired Minnegasco, a natural gas distribution company headquartered in Minneapolis, Minnesota, which owns or is otherwise associated with a number of sites where manufactured gas plants ("MGPs") were previously operated. From the late 1800s to 1960, Minnegasco and its predecessors manufactured gas at a site in Minnesota, located in Minneapolis near the Mississippi River, (the "Minneapolis Site") which site is on Minnesota's Permanent List of Environmental Priorities. Minnegasco is working with the Minnesota Pollution Control Agency to implement an appropriate response action. At this time, however, the specific method and extent of required remediation are not known for the entire site. There are six other former MGP sites in Minnesota in the service territory in which Minnegasco operated at December 31, 1993. Of these six sites, Minnegasco believes that three were neither owned nor operated by Minnegasco, two were owned at one time by Minnegasco but were operated by others and are currently owned by others, and one is presently owned by Minnegasco but was operated by others. In addition, there are seven former MGP sites in Nebraska and two in South Dakota in the service territory in which Minnegasco operated at December 31, 1992, but as part of the sale of the Nebraska operations (see "Natural Gas Distribution"), the buyer has assumed liability for five Nebraska sites. Minnegasco had previously disposed of the other two Nebraska sites. The South Dakota sites were not operated by Minnegasco or its predecessors. Minnegasco believes it is not liable for remediation of the Nebraska and South Dakota sites. At December 31, 1993, Minnegasco has deferred $1.3 million related to the Minneapolis Site and has estimated a range of $23 million to $89 million for the possible remediation of the Minnesota sites. At December 31, 1993, the Company has an accrual of $26.8 million to cover the probable costs of remediation. In connection with its 1992 rate case, Minnegasco was allowed to recover through rates over five years, without carrying costs, the deferred costs at December 31, 1992, and was allowed $3.1 million annually to cover on-going clean-up costs. In accordance with SFAS 71, a regulatory asset has been recorded equal to the amount accrued. The Company is pursuing recovery of costs from its insurers and other potentially responsible parties. In addition to the Minnesota MGP sites described above, the Company's distribution divisions are investigating the possibility that the Company or predecessor companies may be or may have been associated with other MPG sites in the service territories of the distribution divisions. At the present time, the Company is aware of some plant sites in addition to the Minnesota sites and is investigating certain other locations. While the Company's evaluation of these other MGP sites is in its preliminary stages, it is likely that some compliance costs will be identified and become subject to reasonable quantification. To the extent that such potential costs are quantified, as with the Minnesota remediation costs for MGP described herein, the Company expects to provide an appropriate accrual and seek recovery for such remediation costs through rates. In addition, the Company, as well as other similarly situated firms in the industry, is investigating the possibility that it may elect or be required to perform remediation of various sites where meters containing mercury were disposed of improperly, or where mercury from such meters may have leaked or been disposed of improperly. While the Company's evaluation of this issue is in its preliminary stages, it is likely that compliance costs will be identified and become subject to reasonable quantification. To the extent that such potential costs are quantified, the Company will provide an appropriate accrual and, to the extent justified based on the circumstances within each of the Company's regulatory jurisdictions, set up regulatory assets in anticipation of recovery through the ratemaking process. The Company is also subject to laws and regulations concerning pipeline operations and occupational safety, the administration of certain employee benefit plans, and certain other matters. Compliance with these regulations to date has not had a material direct impact on the capital expenditures, earnings or the competitive position of the Company. Inasmuch as such laws and regulations are frequently amended or reinterpreted, the Company is unable to predict the future impact of complying with present or future regulations. Other legislative proposals affecting the industry recently have been and may be introduced before the Congress and state legislatures, and the FERC and various state agencies currently have under consideration various policies and proposals, in addition to those discussed above, that may affect the natural gas industry. It is not possible to predict what actions, if any, the Congress, the FERC or the states will take on these matters, or the effect any such legislation, policies, or proposals may have on the activities of the Company. MERGERS, ACQUISITIONS AND DISPOSITIONS. All levels of the natural gas industry -- transmission and marketing, distribution, and exploration and production -- have undergone a number of acquisitions, divestitures and combinations in recent years, and the Company has been a party to several such transactions, including, as previously described, the exchange of Minnegasco's South Dakota distribution properties in August of 1993, the sale of the LIG Group in June of 1993 and the sale of Minnegasco's Nebraska distribution properties in February 1993, and as described more fully below, the sale of the Company's exploration and production business in December 1992, the sale of Dyco Petroleum and the acquisition of The Hunter Company in 1991, its merger with Diversified Energies, Inc. ("DEI") the parent company of Minnegasco in 1990, its acquisition of the LIG Group in 1989 and its merger with Entex in 1988. As previously described, the Company has executed a definitive agreement pursuant to which it expects to sell its Kansas distribution property and certain related pipeline assets in the first half of 1994. The Company reviews possible transactions from time to time and may engage in other business combinations in the future that are not specifically described herein. On December 31, 1992, the Company completed the sale of the stock of AEC to Seagull for approximately $397 million in cash (including $7.3 million removed from AEC just prior to closing). This sale terminated the Company's activities in the exploration and production business and, accordingly, in 1992 the Company reclassified the results of operations of AEC to discontinued operations herein and in the accompanying Consolidated Financial Statements. The Company previously conducted operations in the radio communications business through Johnson and EnScan, Inc. ("EnScan"), which were acquired in conjunction with the merger with DEI. In early 1992, EnScan merged with Itron, Inc. ("Itron") of Spokane, Washington, of which, after Itron's 1993 issuance of additional common stock in its initial public offering, the Company now owns common stock representing ownership of approximately 18.5% (recorded at approximately $34 million) of the combined enterprise, which is managed by Itron. Based on recent price quotations on the NASDAQ, the market value of the Company's interest is approximately $35.2 million. It is currently the Company's intention to dispose of its investment in the combined enterprise over the next several years at times to be determined principally by economic factors in the markets available for sale or exchange of such interests. In July 1992, the Company sold the stock of Johnson for total consideration of approximately $40 million, receiving cash proceeds of approximately $15 million at closing and retaining an investment currently valued at approximately $5 million. In addition to the EnScan and Johnson transactions described above, during recent years, the Company has disposed of substantially all of its non-gas related businesses, including, in late 1992 the sale of the principal assets of Arkla Products Company, which was originally sold as a part of the 1984 sale of Arkla Industries and conducted operations for the Company in the gas grill manufacturing business after it was reacquired by the Company due to Preway Inc.'s default on certain revenue bonds for which the Company was secondarily liable. Prior to its merger with the Company in 1988, Entex similarly disposed of substantially all of its non-gas related assets through the sale in 1986 of certain of the assets of Allied Materials Corporation, and the sale in 1987 of the stock of University Savings Association, Entex Petroleum, Inc., and Big Chief Drilling Company, and certain of the Entex coal properties, with its remaining non-gas subsidiary, Datotek, disposed of by the Company in 1990. For a further discussion of certain of these matters, see Note 8 of Notes to Consolidated Financial Statements included in the Company's 1993 Annual Report to Stockholders incorporated herein by reference. EMPLOYEES. The Company employs approximately 6,907 persons and has retirement plans for the majority of its employees and maintains contributory group life, medical, dental and disability insurance plans for its employees, as well as certain other benefit plans for its retirees. ITEM 2. ITEM 2. PROPERTIES. The Company is of the opinion that it has generally satisfactory title to the properties owned and used in its businesses, subject to the liens for current taxes, liens incident to minor encumbrances, and easements and restrictions which do not materially detract from the value of such property or the interests therein or the use of such properties in its businesses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. On October 15, 1992, the Resolution Trust Corporation ("RTC") filed suit in United States District Court for the Southern District of Texas, Houston Division, against the Company for alleged harm resulting from the 1989 failure of University Savings Association ("USA"), a thrift institution in Houston, Texas. The RTC claims that the Company is liable as a successor-in-interest to Entex, Inc. which merged with the Company in 1988, after Entex's sale of USA in 1987. The suit alleges that certain former officers and directors of USA are responsible for a breach of contract, breaches of fiduciary duties, negligence and gross negligence in conducting USA's business affairs. The RTC also alleges that Entex, which owned University until 1987, was responsible for some of that alleged wrongdoing, as well as for having allegedly misrepresented facts to state and federal regulators in connection with the sale of USA to certain USA officers and directors in 1987. Compensatory damages of at least $535 million were originally alleged in the case. Arkla, Entex and the defendant directors filed answers denying the material allegations of the suit and interposing certain defenses. On June 3, 1993, the court dismissed a number of claims discussed above, though it allowed the RTC to file an amended complaint with respect to some of the dismissed claims. On July 9, 1993, the Court entered an order denying a motion filed by the RTC to reconsider the Court's order dated June 3, 1993. On August 12, 1993, in response to the Court order allowing the RTC to replead certain claims, the RTC filed its second amended complaint in which compensatory damages of at least $520 million are alleged. Arkla, Entex and the defendant directors have filed various motions in response to the second amended complaint. Based on a review of the amended complaint and on a review of the materials in Entex's possession related to USA, the Company believes it has meritorious defenses to the RTC claims and intends to vigorously pursue such defenses in this suit. Discovery in the case is continuing, but the Company is not yet able to determine the effect, if any, on the results of operations or financial position of the Company which will result from resolution of this matter. On August 6, 1993, the Company, its former exploration and production subsidiary ("E&P") and Arkoma Production Company ("Arkoma"), a subsidiary of E&P, were named as defendants in a lawsuit (the "State Claim") filed in the Circuit Court of Independence County, Arkansas. This complaint alleges that the Company, E&P and Arkoma, acted to defraud ratepayers in a series of transactions arising out of a 1982 agreement between the Company and Arkoma. On behalf of a purported class composed of the Company's ratepayers, plaintiffs have alleged that the Company, E&P and Arkoma are responsible for common law fraud and violation of an Arkansas law regarding gas companies, and are seeking a total of $100 million in actual damages and $300 million in punitive damages. On November 1, 1993, the Company filed a motion to dismiss the claim. The court has not ruled on this motion. The underlying facts forming the basis of the allegations in the State Claim also formed the basis of allegations in a lawsuit (the "Federal Claim") filed in September 1990 in the United States District Court for the Eastern District of Arkansas, by the same plaintiffs. In August 1992, the Court entered an order granting the Company's motion to dismiss the Federal Claim, and the order was affirmed by the United States Court of Appeals, Eighth Circuit in April 1993. This dismissal did not bar the plaintiffs from filing the State Claim in a state court based on allegations of violation of state law. Since the State Claim is based on essentially the same underlying factual basis as the Federal Claim, the Company believes the State Claim is without merit, intends to vigorously defend this lawsuit and does not believe that the outcome 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. None. REGULATION S-K, ITEM 401(B). EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information concerning the "executive officers" of the Company (as defined by the Securities and Exchange Commission) as of March 10, 1994: PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required hereunder applicable to market, number of security holders and dividend history is shown on page 43 of the 1993 Annual Report to Stockholders, which information is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data required hereunder is included on page 26 of the 1993 Annual Report to Stockholders, which data is incorporated herein by reference. For information, if any, concerning accounting changes, business combinations or dispositions of business operations that materially affect the comparability of the information reflected in selected financial data, see Notes to Consolidated Financial Statements on pages 48 through 64 of the 1993 Annual Report to Stockholders, which information is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The required information is included on pages 26 through 43 of the 1993 Annual Report to Stockholders, which pages are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Company and auditor's reports are set forth on pages 44 through 65 of the 1993 Annual Report to Stockholders, which pages are incorporated herein by reference. Statement of Consolidated Income for the years ended December 31, 1993, 1992, and 1991. Consolidated Balance Sheet as of December 31, 1993 and 1992. Statement of Consolidated Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Statement of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Accountants. The required supplementary data concerning quarterly results of operations is set forth on page 66 of the 1993 Annual Report to Stockholders, which page is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information appearing under the caption "Election of Directors And Beneficial Ownership of Common Stock For Officers and Directors" set forth in the Company's definitive proxy statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "1934 Act") is incorporated herein by reference. See also "Regulation S-K, Item 401(b)" appearing in Part I of this Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the captions "Executive Compensation" set forth in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 10, 1994, to be filed pursuant to Regulation 14A under the 1934 Act is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the following captions set forth in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 10, 1994 to be filed pursuant to Regulation 14A under the 1934 Act is incorporated herein by reference: "Voting" and "Election of Directors And Beneficial Ownership of Common Stock For Officers and Directors." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under the caption "Compensation Committee Interlocks and Insider Participation", "Executive Compensation" and "Certain Transactions with Management" set forth in the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 10, 1994 to be filed pursuant to Regulation 14A under the 1934 Act 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 Included under Item 8 are the following financial statements: Statement of Consolidated Income for the years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheet as of December 31, 1993 and 1992. Statement of Consolidated Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Statement of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Accountants. (A)(2) FINANCIAL STATEMENT SCHEDULES Page ---- Report of Independent Accountants 26 Schedule V - Property, Plant and Equipment 27 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 28 Schedule VIII - Valuation and Qualifying Accounts 29 Schedule IX - Short Term Borrowings 30 Schedule X - Supplementary Income Statement Information 31 All other schedules for which provision is made in applicable regulations of the Securities and Exchange Commission have been omitted because the information is disclosed in the Financial Statements or because such schedules are not required or are not applicable. (A)(3) EXHIBITS * (Asterisk indicates exhibits incorporated by reference herein). Pursuant to Item 601(b)(4)(iii), the Company agrees to furnish to the Commission upon request a copy of any instrument with respect to long-term debt not exceeding 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. *3.1 Restated Certificate of Arkla, Inc., dated December 1, 1990, incorporated herein by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year 1990. 3.2 By-Laws of Arkla, Inc., dated March 10, 1993. *4.1 Indenture, dated as of December 1, 1986, between the Company and Citibank, N.A., as Trustee, incorporated herein by reference to Exhibit 4.14 to the Company's Annual Report on Form 10-K for the year 1986. *4.2 Indenture, dated as of March 1, 1987, between the Company and The Chase Manhattan Bank, N.A., as Trustee, authorizing 6% Convertible Subordinated Debentures Due 2012, incorporated herein by reference to Exhibit 4.20 to the Company's Registration Statement on Form S-3 (Registration No. 33-14586). *4.3 Indenture, dated as of April 15, 1990, between the Company and Citibank, N.A., as Trustee, incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-3 filed on May 1, 1990 (Registration No. 33-23375) *10.1 Copy of Deferred Compensation Agreement incorporated herein by reference to Exhibit 10.2 to the Company's Annual Report on Form 10-K for the year 1988. *10.2 Copy of Deferred Stock Appreciation Agreement incorporated herein by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for the year 1988. *10.3 Executive Supplemental Medical Plan (Page 13 of Proxy Statement, Annual Meeting of Stockholders, May 12, 1987, and incorporated herein by reference). *10.4 1982 Nonqualified Stock Option Plan with Appreciation Rights (Form S-8, Registration No. 2-84830, dated July 1, 1983, and incorporated herein by reference). *10.5 Nonqualified Executive Disability Income Plan incorporated herein by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-K for the year 1988. *10.6 Nonqualified Unfunded Executive Supplemental Income Retirement Plan incorporated herein by reference to the Company's Annual Report on Form 10-K for the year 1988. *10.7 Unfunded Nonqualified Retirement Income Plan incorporated herein by reference to Exhibit 10.10 to the Company's Form 10-K for the year 1985. *10.8 Annual Incentive Award Plan incorporated herein by reference as maintained in the files of the Commission, File No. 1-3751. *10.9 Long-Term Incentive Compensation Plan (Form S-8, Registration No. 33-10806, dated December 12, 1986, and incorporated herein by reference). *10.10 Service Agreement, by and between Mississippi River Transmission Corporation and Laclede Gas Company, dated August 22, 1989 incorporated herein by reference to Exhibit 10.20 to the Company's Annual Report on Form 10-K for the year 1989. *10.11 Agreement and Plan of Merger, dated as of July 30, 1990, between Arkla, Inc., Diversified Energies, Inc. and Minnegasco, Inc., incorporated by reference to Exhibit A to the Company's Registration Statement on Form S-4 (Reg. No. 33-27428) *10.12 Employment Agreement, dated September, 1989, between the Company and Jimmy L. Terrill, incorporated herein by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the year 1989. *10.13 Employment Agreement, dated July 11, 1990, between Arkla, Inc. and Michael B. Bracy, incorporated herein by reference to Exhibit 10.19 to the Company's Annual Report on Form 10-K for the year 1990. 10.14 Employment Agreement, dated September 4, 1992, between Arkla, Inc. and William A. Kellstrom. 10.15 Employment Agreement, dated February 3, 1993 between Arkla, Inc. and Howard E. Bell. *10.16 Employment Agreement, dated January 20, 1993, between Arkla, Inc. and Daniel L. Dienstbier, incorporated herein by reference to Exhibit 10.19 to the Company's Annual Report on Form 10-K for the year 1992. 10.17 Amendment to Employment Agreement, dated July 20, 1993, between Arkla, Inc. and Daniel L. Dienstbier. 12 Computation of Ratio of Earnings to Fixed Charges. 13 The portions of the Annual Report to Stockholders for the year ended December 31, 1993 incorporated by reference into this Form 10-K. 21 Subsidiaries of the Company. 23.1 Consent of Coopers & Lybrand. 24 Powers of Attorney from each Director of Arkla, Inc. whose signature is affixed to this Form 10-K. (B) REPORTS ON FORM 8-K FILED DURING THE LAST QUARTER OF THE PERIOD COVERED BY THIS REPORT None REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors and Stockholders Arkla, Inc. Our report on the consolidated financial statements of Arkla, Inc. and Subsidiaries has been incorporated by reference in this Form 10-K from page 65 of the 1993 Annual Report to Stockholders of Arkla, Inc. In connection with our audits of such financial statements, we have also audited the related financial statement scheduled listed in the index 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. /s/ COOPER & LYBRAND Houston, Texas March 24, 1994 ARKLA, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands of dollars) (1) Principally due to the sale of Louisiana Intrastate Gas Corporation. (2) Principally due to the sale of Nebraska & South Dakota distribution properties. (3) Principally due to the discontinuance of SFAS 71 for Arkla Energy Resources. (4) To reflect the sale of Radio Communications. (5) Principally due to the sale of Arkla Products. ARKLA, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands of dollars) (1) Principally due to the sale of Louisiana Intrastate Gas Corporation. (2) Principally due to the sale of Nebraska & South Dakota distribution properties. (3) Principally due to the sale and leaseback of assets. (4) To reflect the sale of Radio Communications. ARKLA, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (in thousands of dollars) (1) Beginning balance restated to conform to current year presentation. (2) Valuation allowance associated with state net operating loss carryforward benefits ("NOL's") of Arkla Exploration Company which was sold in 1992. ARKLA, INC. AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (in thousands of dollars) (1) Average amount outstanding during the period is computed by dividing the total daily outstanding balance by 365. (2) Average interest rate for the year is computed by dividing the actual short-term interest expense by the average short-term debt. (3) Prior to the creation of the new facility described below, under the terms of a credit agreement with a major money center bank, as agent, and various other commercial banks, a $670 million commitment had been available to the Company on a revolving basis to April 30, 1993. The borrowings under this facility bore interest at a rate mutually agreed upon by the Company and the banks, and could be paid and reborrowed in whole or in part. A commitment fee of 1/2% per year was paid on the unused portion of the facility. There were no borrowings under this facility at December 31, 1992. In late March, 1993, the Company established a revolving credit facility which is expected to be the Company's principal source of short-term liquidity. The new facility makes a total commitment of $400 million available to the Company through June 30, 1995. Borrowings under the new facility will bear interest at various rates at the option of the Company. These rates vary with current domestic or Eurodollar money market rates and are subject to adjustment based on the rating of the Company's senior securities by the major rating agencies (debt ratings). In addition, the Company will pay a facility fee to each bank each year, currently 1/2% on the total commitment and subject to decrease based on the Company's debt rating and each bank's level of participation and will pay an incremental rate of 1.5% on outstanding borrowings in excess of $200 million. (4) All rates represent the effective rate to the Company. ARKLA, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands of dollars) SIGNATURES Pursuant to the requirements of Section 13 and 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ARKLA, INC. (Registrant) By /s/ T. Milton Honea (T. Milton Honea) Chairman of the Board, President and Chief Executive Officer By /s/ Michael B. Bracy (Michael B. Bracy) Executive Vice President (Principal Financial Officer) By /s/ Jack W. Ellis, II (Jack W. Ellis, II) Vice President and Corporate Controller (Principal Accounting 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. Signature Title Date - --------- ----- ---- /s/ T. MILTON HONEA Director March 28, 1994 (T. Milton Honea) /s/ MICHAEL B. BRACY* Director (Michael B. Bracy) /s/ JOE E. CHENOWETH* Director (Joe E. Chenoweth) /s/ O. HOLCOMBE CROSSWELL* Director (O. Holcombe Crosswell) /s/ WALTER A. DeROECK* Director (Walter A. DeRoeck) /s/ DONALD H. FLANDERS* Director (Donald H. Flanders) /s/ JAMES O. FOGLEMAN* Director (James O. Fogleman) /s/ JOHN P. GOVER* Director (John P. Gover) /s/ ROBERT C. HANNA* Director (Robert C. Hanna) /s/ MYRA JONES* Director (Myra Jones) /s/ SIDNEY MONCRIEF* Director (Sidney Moncrief) /s/ LARRY C. WALLACE* Director (Larry C. Wallace) /s/ D. W. WEIR, SR.* Director (D. W. Weir, Sr.) *By /s/ T. Milton Honea March 28, 1994 (T. Milton Honea) Attorney-in-Fact) SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-3751 ARKLA, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION) EMPLOYER IDENTIFICATION (I.R.S. NO. 72-0120530) 1600 SMITH, 11TH FLOOR, HOUSTON, TEXAS 77002 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) (713) 654-5100 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS

812305_1993.txt

812305_1993

1993

812305

ITEM 1. BUSINESS. GENERAL References herein to the Company include Beverly Enterprises, Inc. and its wholly-owned subsidiaries. The business of the Company consists principally of operating nursing facilities, including subacute units, pharmacies and pharmacy-related outlets. Additional operations include retirement and congregate living projects and home health care entities. The Company is the largest operator of nursing facilities in the United States. At January 31, 1994, the Company operated 774 nursing facilities with 82,680 licensed beds. The facilities are located in 34 states and the District of Columbia, and range in capacity from 20 to 388 beds with average occupancy of 88.6%, 88.4% and 88.2% during the years ended December 31, 1993, 1992 and 1991, respectively. In addition, at January 31, 1994, the Company operated 23 subacute units, 41 pharmacies and pharmacy-related outlets, 42 retirement and congregate living projects containing 2,554 units and five home health care entities. See "Item 2. ITEM 2. PROPERTIES. At January 31, 1994, the Company operated 774 nursing facilities and 42 retirement and congregate living projects in 34 states and the District of Columbia. Most of the Company's 351 leased nursing facilities are subject to "net" leases which require the Company to pay all taxes, insurance and maintenance costs. Most of the Company's leases have original terms from ten to fifteen years and contain at least one renewal option, which could extend the original term of the leases by five to fifteen years. Many of the Company's leases also contain purchase options. The Company considers its physical properties to be in good operating condition and suitable for the purposes for which they are being used. A substantial portion of the nursing facilities and retirement centers owned by the Company is included in the collateral securing the obligations under its various banking arrangements. See "Part II, Item 8 -- Note 4 of Notes to Consolidated Financial Statements." The following is a summary of the Company's nursing home facilities, retirement and congregate living projects, pharmacies and home health centers at January 31, 1994: - --------------- (1) The Company is currently negotiating the disposition of all of its nursing home facilities in the state of Oregon as part of its continuing efforts under the 1992 restructuring program. See "Part II, Item 8 -- Note 2 of Notes to Consolidated Financial Statements." ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are various lawsuits and regulatory actions pending against the Company arising in the normal course of business, some of which seek punitive damages. The Company does not believe that the ultimate resolution of these matters will 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. 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 AND DIRECTORS The table below sets forth, as to each executive officer and director of the Company, his name, positions with the Company and age. Each executive officer and director of the Company holds office until a successor is elected, or until the earliest of death, resignation or removal. Each executive officer is elected or appointed by the Board of Directors. The information below is given as of March 15, 1994. - --------------- (1) Member of the Finance Committee. (2) Member of the Quality Assurance Committee. (3) Member of the Audit Committee. (4) Member of the Compensation Committee. (5) Member of the Nominating Committee. Mr. Banks has been President and a director of the Company since 1979 and has served as Chief Executive Officer since May 1989 and Chairman of the Board since March 1990. Mr. Banks is a director of Nationwide Health Properties, Inc., Ralston Purina Company, Wal-Mart Stores, Inc., Wellpoint Health Networks, Inc., and trustee for the University of the Ozarks and Occidental College. Mr. Hendrickson joined the Company in 1988 as a Division President. He was elected Vice President of Marketing in May 1989, and Executive Vice President of Operations and Marketing in February 1990. Mr. Hendrickson was President and Chief Operating Officer of Care Enterprises Inc., from 1984 to 1987, and Chairman of the Board and Chief Operating Officer of Hallmark Health Services, Inc. from 1987 through 1988. Mr. Kayne joined the Company in 1979. He was elected Vice President of Professional Services in 1983, Vice President of the Company and President of Pharmacy Corporation of America ("PCA"), a wholly-owned subsidiary of the Company, in 1985, and Executive Vice President of the Company in February 1990. Mr. Moore joined the Company as Executive Vice President -- Managed Care in December 1992. Mr. Moore was employed at Aetna Life and Casualty from 1963 to 1992 and was elected Senior Vice President in 1990. Mr. Stephens joined the Company as a staff accountant in 1969. He was elected Assistant Vice President in 1978, Vice President of the Company and President of the Company's Central Division in 1980, and Executive Vice President -- Development in February 1990. Mr. Stephens is a director of City National Bank in Fort Smith, Arkansas, Beverly Japan Corporation, Western Arkansas Counseling and Guidance Center, Inc. and Harbortown Properties, Inc. Mr. Woltil joined the Company in 1982 as Technical Accounting Manager. From 1984 to 1990 he served in various financial positions. He was elected Vice President -- Financial Planning and Control in January 1990, Senior Vice President and Chief Financial Officer in March 1992 and Executive Vice President, Finance in January 1993. Mr. Clarke joined the Company in 1987 as a Director of Government Program Compliance. He was elected Vice President in 1989 and Senior Vice President -- Quality Assurance in December 1991. Mr. Clarke is a director of St. Edward Mercy Medical Center. Mr. Hollingsworth joined the Company in June 1985 as Assistant Treasurer. He was elected Treasurer in 1988, Vice President in 1990 and Senior Vice President in March 1992. Mr. Hollingsworth is a director of Sparks Regional Medical Center. Mr. Pommerville first joined the Company in 1970 and left in 1976. Mr. Pommerville rejoined the Company as Vice President and General Counsel in 1984 and was elected Secretary in February 1990 and Senior Vice President in March 1990. Mr. Small joined the Company in January 1986 as Reimbursement Manager, was promoted to Division Controller in September 1986, Director of Finance for the California Region in 1989, and elected Vice President -- Reimbursement in September 1990. Mr. Tabakin joined the Company in October 1992 as Vice President, Controller and Chief Accounting Officer. From 1980 to 1992, Mr. Tabakin was with Ernst & Young, in Norfolk, Virginia. Mr. Anthony served as a member of the United States Congress and was Chairman of the Democratic Congressional Campaign Committee from 1987 through 1990. In 1993, he became a partner in the Winston & Strawn law firm. Mr. Anthony serves as a director of Anthony Forest Products Company. He has been a director of the Company since January 1993. Mr. Bradbury is Chairman, President, Chief Executive Officer and a director of Worthen Banking Corporation. He joined Worthen in 1985 as Assistant to the President, and prior thereto was a Vice President in the Corporate Finance Department of Stephens Inc., and Manager of its Bank Services Division. He has been a director of the Company since July 1989. Mr. Greene's principal occupation has been that of a director and consultant to various U.S. and international businesses since 1986. He is a director of ASARCO, Inc., a number of mutual funds of Alliance Capital Management Corporation, American Reliance Group Inc., Buck Engineering Company and Bank Leumi. He has been a director of the Company since January 1991. Mr. Jacoby is Executive Vice President, Chief Financial Officer and a director of Stephens Group, Inc. Mr. Jacoby has held the indicated positions with Stephens Group, Inc. since 1986, and prior to that time, served as Manager of the Corporate Finance Department and Assistant to the President of Stephens Inc. Mr. Jacoby is a director of Medicus Systems, Inc., the Delta Queen Steamboat Company and Delta and Pine Land Company, Inc. He has been a director of the Company since February 1987. Mr. Menk is Chairman of Black Mountain Gas Company. He retired in 1982 as Chairman and Chief Executive Officer of International Harvester Company, the predecessor to Navistar International Corporation. He has been a director of the Company since July 1989. Mr. Weinstein has been Managing Partner of Genesis Merchant Group, a holding company for Genesis Merchant Group Securities, since 1989 and was President of WIG, Inc. from 1987 to 1989. From 1982 to 1987, Mr. Weinstein was Managing Partner of Montgomery Securities. Mr. Weinstein is a director of DHL Corporation. He has been a director of the Company since March 1989. Mr. Joe T. Ford, Chairman, President and Chief Executive Officer of ALLTEL Corporation, and a director of The Dial Corp and LDDS Communications, Inc., was a director of the Company since January 1991. On February 28, 1994, Mr. Ford resigned from the Company's Board of Directors. In connection with the issuance of the Series A preferred stock to Stephens Group, Inc., the Company agreed to use its best efforts to cause a designee of Stephens Group, Inc. to be elected to the Company's Board of Directors so long as Stephens Group, Inc. owned 500,000 of the Series A preferred stock and was the sole owner of all outstanding Series A preferred stock. Mr. Jacoby is the designee of Stephens Group, Inc. pursuant to such agreement. The Series A preferred stock was redeemed on January 3, 1994. During 1993, there were six meetings of the Board of Directors. Each director attended 75% or more of the meetings of the Board and committees on which he served. In 1993, directors, other than Mr. Banks, received a retainer fee of $18,000 for serving on the Board and an additional fee of $1,000 for each Board or committee meeting attended. Mr. Banks, the current Chairman of the Board, President and Chief Executive Officer of the Company, received no additional cash compensation for serving on the Board or its committees. During 1993, the Retirement Plan for Outside Directors was approved and implemented whereby, upon retirement, as defined, each director is eligible to receive an amount equal to the annual retainer fee for each year of service on the Board up to a maximum of ten years, with no survivor benefits. These benefits are paid on a monthly basis beginning on the date of retirement. The Company paid $10,500 under such plan during the year ended December 31, 1993. EMPLOYEE STOCK PURCHASE PLAN The Beverly Enterprises 1988 Employee Stock Purchase Plan (as amended and restated) enables all full-time employees having completed one year of continuous service to purchase shares of the Company's $.10 par value common stock at the current market price through payroll deductions. The Company makes contributions in the amount of 30% of the participant's contribution. Each participant specifies the amount to be withheld from earnings per two-week pay period, subject to certain limitations. The total charge to the Company's statement of operations for the year ended December 31, 1993 related to this plan was approximately $1,493,000. At December 31, 1993, there were approximately 4,600 participants in the plan. Merrill Lynch & Co., Merrill Lynch World Headquarters, North Tower, World Financial Center, New York, New York 10281, was appointed broker to open and maintain an account in each participant's name and to purchase shares of common stock on the New York Stock Exchange for each participant. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is listed on the New York and Pacific Stock Exchanges. The table below sets forth, for the periods indicated, the range of high and low sales prices of the common stock. The Company is subject to certain restrictions under its banking arrangements related to the payment of cash dividends on its common stock. During 1993 and 1992, no cash dividends were paid on the Company's common stock and none are anticipated to be paid during 1994. At March 11, 1994, there were 7,295 record holders of the common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table of selected financial data should be read in conjunction with the Company's consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. - --------------------- (1) The Company reported restructuring costs, extraordinary charge and cumulative effect of change in accounting for income taxes in 1992, and reported a redemption premium and extraordinary charge in 1993. See Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OPERATING RESULTS Twelve Months 1993 Compared to Twelve Months 1992 Net income was $57,924,000 for the twelve months ended December 31, 1993, compared to a net loss of $10,108,000 for the same period in 1992. Income before income taxes and extraordinary charge for 1993 was $89,953,000 compared to income before income taxes, extraordinary charge and cumulative effect of a change in accounting for income taxes in 1992 of $8,384,000. The results for 1992 included a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operations of certain facilities. During 1993, the Company recorded a $2,345,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with certain debt that was repaid with a portion of the net proceeds from issuance of the Series B preferred stock (as defined herein) as well as certain bond refundings. During 1992, the Company recorded $8,835,000 of extraordinary charges, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the repayment of certain debt. In addition, during 1992, the Company adopted Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes," which resulted in the recording of a $5,454,000 cumulative effect adjustment. The Company's annual effective tax rate was 33% for the twelve months ended December 31, 1993, compared to 50% for the same period in 1992. The higher annual effective tax rate in 1992 resulted from the $57,000,000 pre-tax charge mentioned above which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. In addition, the 1993 annual effective tax rate was lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. Net operating revenues and operating and administrative costs increased approximately $274,000,000 and $252,100,000, respectively, for the twelve months ended December 31, 1993, as compared to the same period in 1992. These increases consist of the following: increases in net operating revenues and operating and administrative costs for facilities which the Company operated during each of the twelve-month periods ended December 31, 1993 and 1992 ("same facility operations") of approximately $265,700,000 and $261,700,000, respectively; increases in net operating revenues and operating and administrative costs of approximately $71,400,000 and $64,000,000, respectively, due to the acquisition of 14 facilities in 1993 and 16 facilities in 1992; and decreases in net operating revenues and operating and administrative costs of approximately $63,100,000 and $73,600,000, respectively, due to the disposition of, or lease terminations on, 43 facilities in 1993 and 23 facilities in 1992. The increase in net operating revenues for same facility operations for the twelve months ended December 31, 1993, as compared to the same period in 1992, was due to the following: approximately $143,200,000 due to increased ancillary revenues as a result of providing additional ancillary services to the Company's private and Medicare patients; approximately $103,200,000 due primarily to increases in Medicaid room and board rates, and to a lesser extent, private and Medicare room and board rates; approximately $12,900,000 due to an improvement in the Company's patient mix; and approximately $11,900,000 due to increases in pharmacy revenues and various other items. The Company's Medicare, private and Medicaid census for same facility operations was 11%, 19%, and 69%, respectively, for the twelve months ended December 31, 1993, compared to 10%, 19%, and 70%, respectively, for the same period in 1992. These increases in net operating revenues were partially offset by approximately $5,500,000 due to one less calendar day during 1993, as compared to 1992. The increase in operating and administrative costs for same facility operations for the twelve months ended December 31, 1993, as compared to the same period in 1992, was due to the following: approximately $106,700,000 due to increased wages and related expenses principally due to higher wages and greater benefits intended to attract and retain qualified personnel and the hiring of therapists on staff as opposed to contracting for their services; approximately $117,100,000 due to additional ancillary costs (excluding wages and related expenses) associated with the increase in ancillary services provided to the Company's private and Medicare patients; approximately $15,100,000 due to an increase in the provision for reserves on patient, notes and other receivables primarily as a result of an increase in the Company's private and Medicare revenues, as well as, reductions in the provision for doubtful notes in 1992 due to the reacquisition of certain facilities, which did not recur in 1993; approximately $5,300,000 due to increases in supplies and other variable costs required to meet the needs of the Company's higher-acuity patients; and approximately $17,500,000 due primarily to increases in pharmacy-related costs, utilities and property-related expenses, which include taxes (other than income and payroll taxes), insurance and various other items. Ancillary revenues are derived from providing services to residents beyond room and board care. These services include occupational, physical, speech, respiratory and IV therapy, as well as, sales of pharmaceutical products and other services. The Company's overall ancillary revenues for the twelve months ended December 31, 1993 were $618,804,000 and represented 22% of total revenues, as compared to $458,281,000 of ancillary revenues for the same period in 1992 which represented 18% of total 1992 revenues. Although the Company is pursuing further growth of ancillary revenues, through expansion of specialty services, such as rehabilitation and subacute care, there can be no assurance that such growth will continue. Growth in ancillary revenues, as well as increases in Medicare census, have also resulted in higher costs for the Company due to the higher acuity services being provided to these patients. The Company's overall ancillary costs, excluding wages and related expenses, were $347,515,000 for the twelve months ended December 31, 1993, compared to $248,156,000 for the same period in 1992. Although there was no significant overall fluctuation in interest income or interest expense in 1993 as compared to 1992, several offsetting items influenced these amounts. Interest income increased approximately $1,300,000 due to interest earned on $100,000,000 of the net proceeds from issuance of the Series B preferred stock, which was significantly offset by lower investment yield rates and a decrease in the Company's notes receivable. Interest expense increased approximately $2,000,000 due to the issuance and assumption of long- term obligations in conjunction with the acquisitions of certain nursing facilities, which was significantly offset by the repayment of approximately $45,000,000 of debt with a portion of the net proceeds from issuance of the Series B preferred stock and the conversion of approximately $46,000,000 in principal amount of the Company's 9% Debentures (as defined herein) into common stock. Depreciation and amortization expense decreased approximately $1,900,000 as compared to the same period in 1992 primarily due to the disposition of, or lease terminations on, certain nursing facilities and a reduction in debt issue costs associated with the repayment of certain debt, partially offset by additional depreciation and amortization on acquired facilities. The Company's future operating performance will continue to be affected by the issues facing the nursing home industry as a whole, including the maintenance of occupancy, the availability of nursing personnel, the adequacy of funding of governmental reimbursement programs, the demand for nursing home care and the nature of any health care reform measures that may be taken by the federal government, as discussed below, as well as by any state governments. The Company's ability to control costs, including its wages and related expenses which continue to rise and represent the largest component of the Company's operating and administrative expenses, will also significantly impact its future operating results. As a general matter, increases in the Company's operating costs result in higher patient rates under Medicaid programs in subsequent periods. However, the Company's results of operations will continue to be affected by the time lag in most states between increases in reimbursable costs and the receipt of related reimbursement rate increases. Medicaid rate increases, adjusted for inflation, are generally based upon changes in costs for a full calendar year period. The time lag before such costs are reflected in permitted rates varies from state to state, with a substantial portion of the increases taking effect up to 18 months after the related cost increases. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 ("OBRA - 93") was signed into law. OBRA - 93 includes certain changes in the Medicare program effective October 1, 1993, including, among other things, the elimination of the return on equity provision of the program. The Company cannot currently predict the future impact this change will have on its financial condition and results of operations; however, for the nine months ended September 30, 1993 (prior to the effective date of OBRA - 93) and for the year ended December 31, 1992, the Company recognized pre-tax income of approximately $8,900,000 for each of such periods as a result of the Medicare return on equity provision. In addition, OBRA - 93 increased corporate income tax rates by one percent retroactive to January 1, 1993. This rate change did not have a material effect on the Company's financial position or results of operations in 1993 and is not expected to have a material effect in the future. The Clinton Administration has made health care reform one of its top priorities. The White House Task Force on Health Care Reform studied the issue of health care reform and presented its report and recommendations to the Administration. The Administration proposed health care reform legislation to Congress in October 1993. Various other legislative and industry groups continue to study numerous health care issues, including access, delivery and financing of long-term health care. These and other groups' recommendations will likely impact the form and content of future health care reform legislation. As a result, the Company is unable to predict the type of legislation or regulations that may be adopted affecting the long-term care industry and their impact on the Company. There can be no assurance that any health care reform will not adversely affect the Company's financial position or results of operations. The Company does not provide significant postretirement health care, life insurance or other benefits to employees. Accordingly, the requirements of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," did not materially impact the Company's consolidated financial position or results of operations. The Company does not provide significant postemployment health care, life insurance or other benefits to employees. Accordingly, the requirements of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," will not materially impact the Company's consolidated financial position or results of operations when implemented in 1994. Twelve Months 1992 Compared to Twelve Months 1991 Net loss was $10,108,000 for the twelve months ended December 31, 1992, as compared to net income of $29,172,000 for the same period in 1991. During the fourth quarter of 1992, the Company recorded a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operation of 33 nursing facilities with historically poor financial performance, and to replace, relocate or sell certain other assets (the "1992 restructuring program"). Income before income taxes, extraordinary charge and cumulative effect of a change in accounting for income taxes for the twelve months ended December 31, 1992 was $8,384,000 compared to $41,582,000 for the same period in 1991, and income before extraordinary charge and cumulative effect of a change in accounting for income taxes was $4,181,000 for 1992, compared to $29,172,000 in 1991. These reductions, as compared to the prior year, resulted from the $57,000,000 pre-tax restructuring charge discussed above. During the first quarter of 1992, the Company recorded a $4,523,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with certain debt that was repaid with the proceeds of a $100,000,000 Bank Credit Facility (as defined herein). At the end of the fourth quarter of 1992, the Company obtained substantial commitments to refinance the remaining debt outstanding under a 1990 credit agreement. Accordingly, in the fourth quarter of 1992, the Company recorded a $4,312,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of such remaining debt. Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes." As permitted by the Statement, the Company elected not to restate the financial statements of prior years. The cumulative effect as of January 1, 1992 of adopting the Statement was to increase net loss for the year ended December 31, 1992 by $5,454,000. The Company's annual effective tax rate was 50% for the twelve months ended December 31, 1992 as compared to 30% for the same period in 1991. The higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge discussed above which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. In addition, the 1991 annual effective tax rate was lower than the statutory rate due to various items including a settlement of certain tax issues related to the audit of prior years' tax returns by the Internal Revenue Service. Net operating revenues and operating and administrative costs increased approximately $295,800,000 and $272,800,000, respectively, for the twelve months ended December 31, 1992, as compared to the same period in 1991. These increases consist of the following: increases in net operating revenues and operating and administrative costs for facilities which the Company operated during each of the twelve-month periods ended December 31, 1992 and 1991 ("same facility operations") of approximately $281,800,000 and $263,400,000, respectively; increases in net operating revenues and operating and administrative costs of approximately $64,500,000 and $55,800,000, respectively, due to the acquisition of 16 facilities in 1992 and 35 facilities in 1991; and decreases in net operating revenues and operating and administrative costs of approximately $50,500,000 and $46,400,000, respectively, due to the disposition of, or lease terminations on, 23 facilities in 1992 and 28 facilities in 1991. The increase in net operating revenues for same facility operations for the twelve months ended December 31, 1992, as compared to the same period in 1991, was due to the following: approximately $140,200,000 due to increased ancillary revenues as a result of providing additional ancillary services to the Company's private and Medicare patients; approximately $119,500,000 due primarily to increases in Medicaid patient rates, and to a lesser extent, private and Medicare patient rates; approximately $21,800,000 due to an improvement in the Company's patient mix principally due to an increase in Medicare census; approximately $5,100,000 due to one additional calendar day for the twelve months ended December 31, 1992, as compared to the same period in 1991; and approximately $6,200,000 due to various other items. The Company's Medicare, private and Medicaid census for same facility operations was 10%, 19% and 70%, respectively, for the twelve months ended December 31, 1992, as compared to 7%, 20%, and 72%, respectively, for the same period in 1991. The Company's average occupancy for same facility operations was 88.6% for the twelve months ended December 31, 1992 as compared to 88.5% for the same period in 1991. The increases in net operating revenues were partially offset by approximately $11,000,000 of Medicare and Medicaid adjustments during the twelve months ended December 31, 1991, which did not recur in the twelve months ended December 31, 1992. The increase in operating and administrative costs for same facility operations for the twelve months ended December 31, 1992, as compared to the same period in 1991, was due to the following: approximately $117,600,000 due to increased wages and related expenses principally due to higher wages and greater benefits intended to attract and retain qualified personnel, increased staffing levels in the Company's nursing facilities to cover increased patient acuity, and the hiring of therapists on staff as opposed to contracting for their services, including a partial offset due to a decrease in registry (temporary personnel) costs for the same period of approximately $5,600,000; approximately $72,400,000 due to increases in contracted professional services primarily as a result of additional ancillary services such as physical therapy provided to the Company's private and Medicare patients; approximately $58,100,000 due to increases in supplies and other variable costs primarily due to additional supplies required to meet the needs of the Company's patients, including a partial offset of approximately $11,800,000 due to reductions in the provision for doubtful notes which primarily resulted from the reacquisition of certain facilities; and approximately $15,300,000 due primarily to increases in property-related expenses, including rent, taxes (other than income and payroll taxes), insurance and various other items. Interest expense decreased approximately $6,000,000 as compared to the same period in 1991 primarily due to declining interest rates on the Company's variable rate debt, and to a lesser extent the repurchase of Senior Secured Notes and the repayment of indebtedness under a 1990 credit agreement as a result of the sale of common stock on April 4, 1991. Interest income decreased approximately $5,500,000 as compared to the same period in 1991 primarily due to lower investment yield rates and decreases in notes receivable and invested funds. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Company had approximately $73,773,000 in cash and cash equivalents and net working capital of approximately $151,869,000. The Company anticipates that approximately $25,368,000 of its existing cash at December 31, 1993, while not legally restricted, will be utilized for funding insurance claims, and the Company does not expect to use such cash for other purposes. The Company had $50,000,000 of unused commitments under its Bank Revolving Credit Facility and $15,000,000 of unused commitments under its Commercial Paper Program as of December 31, 1993. Net cash provided by operating activities for the year ended December 31, 1993, was approximately $130,877,000, an increase of approximately $32,311,000 from the prior year primarily as a result of certain income tax payments made during the twelve months ended December 31, 1992 which did not recur in 1993 and an increase in deferred taxes in 1993 over 1992. The Company also experienced an increase in collections on accounts receivable in 1993 as compared to 1992, which amount was primarily used to pay accounts payable and other accrued expenses. Net cash provided by financing activities during the year ended December 31, 1993 was approximately $38,872,000. The Company repaid approximately $99,899,000 of long-term obligations primarily with approximately $45,000,000 of the net proceeds from the Preferred Stock offering (as discussed below), a portion of the proceeds from a $20,000,000 Senior Secured Term Loan Facility, a portion of the proceeds from issuance of $50,000,000 of First Mortgage Bonds (as discussed below) and a portion of the proceeds from issuance of $25,000,000 of 8.75% Notes (as discussed below). Net cash used for investing activities during the year ended December 31, 1993 was approximately $145,573,000. The Company primarily used cash generated from operations to fund capital expenditures and construction totaling approximately $95,364,000 and primarily used proceeds from the issuance of long-term obligations to fund the acquisition of nursing facilities, including certain previously leased facilities. In April 1993, the Company registered with the Securities and Exchange Commission $100,000,000 aggregate principal amount of First Mortgage Bonds (the "First Mortgage Bonds Registration Statement") which are to be offered from time to time as separate series in amounts, at prices and on terms to be determined at the time of sale. Pursuant to such registration, the Company issued two series of First Mortgage Bonds in 1993. On April 22, 1993, the Company issued $20,000,000 aggregate principal amount of 8.75% First Mortgage Bonds (the "Series A Bonds") due July 1, 2008. On July 22, 1993, the Company issued $30,000,000 aggregate principal amount of 8.625% First Mortgage Bonds (the "Series B Bonds") due October 1, 2008. In November 1993, the Company filed a Registration Statement with the Securities and Exchange Commission to amend the First Mortgage Bonds Registration Statement to allow the Company to issue senior unsecured notes, subordinated unsecured notes, or other evidences of indebtedness, as well as First Mortgage Bonds, (collectively, the "Debt Securities") for the remaining $50,000,000 available under the First Mortgage Bonds Registration Statement. On December 22, 1993, the Company issued $25,000,000 aggregate principal amount of 8.75% Notes (the "8.75% Notes"), which are unsecured obligations of the Company, due December 31, 2003. The Company used the net proceeds from issuance of the Series A Bonds, the Series B Bonds and the 8.75% Notes to finance the purchase of nine nursing facilities, to finance construction of a new nursing facility, to refinance certain existing indebtedness with respect to 20 nursing facilities, which debt had a weighted average annual interest rate of 12.1%, and for general corporate purposes. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock") through a public offering (the "Preferred Stock offering") for net proceeds of approximately $145,000,000. On January 3, 1994, the Company used approximately $100,000,000 of such net proceeds to redeem all of the Company's cumulative convertible preferred stock (the "Series A preferred stock"). The Series A preferred stock dividend rate was scheduled to increase from 1% to 10% on January 1, 1994. The remainder of the net proceeds was used to repay approximately $45,000,000 of the Term Loan under the Bank Credit Facility. The $20,000,000 excess (the "redemption premium") paid above the $80,000,000 original recorded value of the Series A preferred stock was charged to the Company's retained earnings during the twelve months ended December 31, 1993. Although such amount did not impact the Company's net income, for accounting purposes the $20,000,000 redemption premium was treated as a reduction to income available to common stockholders in the calculation of earnings per share for the twelve-month period ended December 31, 1993. During the twelve months ended December 31, 1993, the Board of Directors approved the redemption of approximately $46,000,000 in principal amount of the Company's 9% convertible subordinated debentures (the "9% Debentures"). By the close of business on August 18, 1993, all of the 9% Debentures had been converted to common stock of the Company. Outstanding shares of the Company's common stock increased by approximately 7,131,800 shares as a result of the conversion of the 9% Debentures. Primarily as a result of the Preferred Stock offering and the use of the net proceeds therefrom, and the conversion of the 9% Debentures into shares of the Company's common stock, the Company's debt to equity ratio improved to 1 to 1 at December 31, 1993, as compared to 1.2 to 1 at December 31, 1992. In January 1994, the Company sold or subleased 27 nursing facilities (2,344 beds) in the state of Texas for cash proceeds of approximately $31,000,000. In addition, on January 26, 1994, an option grant for 1,000,000 common shares at $12.00 per share was exercised in full and the Company received $12,000,000 in cash proceeds. The Company intends to file a Registration Statement with the Securities and Exchange Commission to register such 1,000,000 shares. The Company believes that working capital from operations, borrowings under its banking arrangements and Commercial Paper Program, proceeds from issuance of Debt Securities, refinancings of certain existing indebtedness, and proceeds from the sale of facilities and the exercise of the option grant discussed above will be adequate to repay its debts due within one year of approximately $42,873,000, to make normal recurring capital additions and improvements for the twelve months ending December 31, 1994 of approximately $100,000,000, to make selective acquisitions, including the purchase of previously-leased facilities, and to meet working capital requirements. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Stockholders Beverly Enterprises, Inc. We have audited the accompanying consolidated balance sheets of Beverly Enterprises, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We 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 Beverly Enterprises, 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 consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 7 to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes. Little Rock, Arkansas February 4, 1994 BEVERLY ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS) - --------------- (1) Amount represents the liquidation value of the Series B preferred stock. The Series A preferred stock was outstanding at December 31, 1993 with funds designated for its redemption. The Series A preferred stock was redeemed on January 3, 1994. See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation References herein to the Company include Beverly Enterprises, Inc. and its wholly-owned subsidiaries. The consolidated financial statements of the Company, which provides long-term health care including the operation of nursing facilities and subacute units, pharmacies, retirement living projects, and home health care centers, include the accounts of the Company and all of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents Cash and cash equivalents include time deposits and certificates of deposit with original maturities of three months or less. Property and Equipment Property and equipment is stated at cost less accumulated depreciation or, where appropriate, the present value of the related capital lease obligations less accumulated amortization. Depreciation and amortization are computed by the straight-line method over the estimated useful lives of the assets. Intangible Assets Operating and leasehold rights and licenses (stated at cost less accumulated amortization of $23,059,000 in 1993 and $24,314,000 in 1992) are being amortized over the lives of the related assets (principally 40 years) and leases (principally 10 to 15 years), using the straight-line method. Goodwill (stated at cost less accumulated amortization of $21,183,000 in 1993 and $19,248,000 in 1992) is being amortized over 40 years or, if applicable, the life of the lease using the straight-line method. On an ongoing basis, the Company reviews the valuation and amortization of intangible assets. As part of this ongoing review, the Company takes into consideration any events or circumstances that could impair the carrying value of such assets. Insurance The Company insures general liability and workers' compensation risks, in most states, through insurance policies with third parties, some of which may be subject to reinsurance agreements between the insurer and Beverly Indemnity, Ltd., a wholly-owned subsidiary of Beverly California Corporation, which is a wholly-owned subsidiary of the Company. The liabilities for estimated incurred losses are discounted at 10% in 1993 and 1992 to their present value based on expected loss payment patterns determined by independent actuaries. The discounted insurance liabilities are included in the consolidated balance sheet captions as follows (in thousands): On an undiscounted basis, the total insurance liabilities as of December 31, 1993 and 1992 were $132,333,000 and $137,605,000, respectively. As of December 31, 1993, the Company has deposited approximately $50,365,000 in funds that are restricted for the payment of insured claims. These funds are BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) invested primarily in United States government securities with maturity dates ranging primarily from one to five years and are carried at cost, which approximates market value, and are included in the consolidated balance sheet captions "Prepaid expenses and other" and "Designated and restricted funds." In addition, the Company anticipates that approximately $25,368,000 of its existing cash at December 31, 1993, while not legally restricted, will be utilized for funding insurance claims and the Company does not expect to use such cash for other purposes. Revenues The Company's revenues are derived primarily from providing long-term health care services. Approximately 80.1% in 1993, 79.9% in 1992 and 78.8% in 1991 of the Company's room and board revenues were derived from funds under federal and state medical assistance programs, and approximately $267,035,000, $249,413,000 and $196,082,000 of the Company's patient accounts receivable at December 31, 1993, 1992, and 1991, respectively, are due from such programs. These revenues and receivables are reported at their estimated net realizable amounts and are subject to audit and retroactive adjustment. Provisions for estimated third-party payor settlements are provided in the period the related services are rendered and are adjusted in the period of settlement. Concentration of Credit Risk The Company has significant accounts receivable, notes receivable and other assets whose collectibility or realizability is dependent upon the performance of certain governmental programs, primarily Medicaid and Medicare. These receivables and other assets represent the only concentration of credit risk for the Company. The Company does not believe there are significant credit risks associated with these governmental programs. The Company believes that an adequate provision has been made for the possibility of these receivables and other assets proving uncollectible and continually monitors and adjusts these allowances as necessary. Earnings per share Primary earnings per share for the year ended December 31, 1993 was computed by dividing net income after deduction of preferred stock dividends and the $20,000,000 redemption premium on the Series A preferred stock, discussed below, by the weighted average number of shares of common stock outstanding during the period and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. Fully diluted earnings per share for the year ended December 31, 1993 was computed as above and assumed conversion of the Company's 9% convertible subordinated debentures and other notes. Conversion of the Company's 7.625% convertible subordinated debentures would have an anti-dilutive effect and, therefore, was not assumed. During the year ended December 31, 1993, the Company charged retained earnings for the $20,000,000 excess (the "redemption premium") to be paid to redeem the Company's cumulative convertible preferred stock (the "Series A preferred stock") above its $80,000,000 original recorded value. Although this amount did not impact the Company's net income, for accounting purposes the $20,000,000 redemption premium was treated as a reduction to income available to common stockholders in the calculation of earnings per share for the year ended December 31, 1993. Primary and fully diluted earnings per share for the year ended December 31, 1992 were computed by dividing net income after deduction of preferred stock dividends by the weighted average number of shares of common stock outstanding during the period and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Primary earnings per share for the year ended December 31, 1991 was computed by dividing net income by the weighted average number of shares of common stock and dilutive common stock equivalents outstanding during the period. Common stock equivalents included the Company's Series A preferred stock and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. Fully diluted earnings per share for the year ended December 31, 1991 was computed as above and assumed conversion of the Company's other notes. Conversion of the Company's 7.625% and 9% convertible subordinated debentures would have an anti-dilutive effect and, therefore, were not assumed. Other Certain prior year amounts have been reclassified to conform with the 1993 presentation. 2. ACQUISITIONS AND DISPOSITIONS During the year ended December 31, 1992, the Company recognized a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operation of 33 nursing facilities with historically poor financial performance, and to replace, relocate or sell certain other assets (the "1992 restructuring program"). This charge included the estimated operating losses to be incurred by these 33 facilities during the anticipated period required to implement the program. Certain transactions which were reserved as part of the 1992 restructuring program were not completed by the originally anticipated one-year implementation period; however, the Company anticipates that the remaining transactions will be substantially completed during the first six months of 1994. The Company evaluates the reserves established in connection with the remaining transactions on a regular basis, and believes the current reserves are adequate. During the year ended December 31, 1993, the Company acquired three nursing facilities (328 beds) and leasehold interests in eight nursing facilities (829 beds) and one retirement living project (69 units), all of which were previously managed by the Company, in addition to one nursing facility (60 beds) and one retirement living project (187 units) not previously operated by the Company. The acquisitions of such facilities, and certain other assets, were accounted for as purchases and were consummated with approximately $6,915,000 cash, approximately $18,232,000 assumed and acquired debt, approximately $858,000 of security and other deposits and approximately $454,000 reduction in receivables. In addition, the Company acquired 25 nursing facilities (2,706 beds) and two retirement living projects (435 units), which were previously leased by the Company, for approximately $38,381,000 cash (including approximately $5,000,000 borrowed under the Company's revolving credit agreement), approximately $5,541,000 issuance of debt, approximately $42,285,000 assumed and acquired debt and approximately $2,313,000 of security and other deposits. The operations of these facilities were immaterial to the Company's financial position and results of operations. During the year ended December 31, 1993, the Company sold or terminated the leases on 40 nursing facilities (4,511 beds) (20 of such facilities were included in the 33 facilities discussed above) and three retirement living projects (230 units) (two of which were included in the 33 facilities discussed above). The Company recognized pre-tax losses of approximately $3,769,000 as a result of these dispositions, which was primarily included in the $57,000,000 pre-tax restructuring charge discussed above. In addition, the Company sold certain other assets for pre-tax gains of approximately $4,850,000. Dispositions of such facilities and other assets were consummated for approximately $9,583,000 cash and approximately $5,460,000 assumption of debt. The operations of these facilities were immaterial to the Company's financial position and results of operations. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 2. ACQUISITIONS AND DISPOSITIONS -- (CONTINUED) In January 1994, the Company sold or subleased 27 nursing facilities (2,344 beds) in the state of Texas for cash proceeds of approximately $31,000,000. The sale and sublease of these nursing facilities will not have a material impact on the Company's financial position or results of operations, and the operations of these facilities were immaterial to the Company. During the year ended December 31, 1992, the Company acquired 15 nursing facilities (1,669 beds), one retirement living project (24 units) and other assets, accounted for as purchases. The acquisitions were consummated with approximately $6,112,000 cash, approximately $25,639,000 issuance of debt, approximately $20,221,000 assumed and acquired debt and approximately $13,230,000 reduction in notes receivable, which the Company previously took as partial payment for the original sale of certain of the nursing facilities and interest receivable thereon. In addition, the Company acquired 14 nursing facilities (1,450 beds), which were previously leased by the Company, for approximately $12,809,000 cash, approximately $8,340,000 issuance of debt, approximately $11,325,000 assumed and acquired debt and approximately $841,000 of security and other deposits. In addition, the Company sold or terminated the leases on 22 nursing facilities (2,379 beds) (five of such facilities were included in the 33 facilities discussed above) and one retirement living project (77 units) (which was included in the 33 facilities discussed above) for approximately $1,282,000 cash and approximately $4,610,000 notes. The Company recognized pre-tax losses of approximately $5,394,000 as a result of these dispositions, a portion of which was included in the $57,000,000 pre-tax restructuring charge discussed above. The operations of these facilities were immaterial to the Company's financial position and results of operations. During the year ended December 31, 1991, the Company acquired 35 nursing facilities (2,963 beds), accounted for as purchases, including 16 leased facilities, and other assets. The acquisitions were consummated with approximately $5,265,000 cash, approximately $26,777,000 assumed and acquired debt, approximately $1,682,000 security deposits and approximately $21,956,000 reduction in notes receivable, which the Company previously took as partial payment for the original sale of certain of the nursing facilities. In addition, the Company acquired seven nursing facilities (841 beds), which were previously leased by the Company, for approximately $14,521,000 cash and approximately $630,000 of security deposits. The Company sold or terminated the leases on 28 nursing facilities (3,775 beds) for approximately $1,155,000 cash and approximately $601,000 notes and recognized pre-tax losses of approximately $7,450,000 as a result of these dispositions, a portion of which was included in the $128,104,000 pre-tax restructuring charges taken as a result of an asset disposition program in 1989. The operations of these facilities were immaterial to the Company's financial position and results of operations. 3. PROPERTY AND EQUIPMENT Following is a summary of property and equipment and related accumulated depreciation and amortization by major classifications at December 31 (in thousands): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 3. PROPERTY AND EQUIPMENT -- (CONTINUED) The Company provides depreciation and amortization using the straight-line method over the following estimated useful lives: land improvements -- 5 to 15 years; buildings -- 35 to 40 years; building improvements -- 5 to 20 years; leasehold improvements -- 5 to 20 years or term of lease, if less; furniture and equipment -- 5 to 15 years. Capitalized lease assets are amortized over the remaining initial terms of the leases. Depreciation and amortization expense related to property and equipment for the years ended December 31, 1993, 1992 and 1991 was $71,730,000, $68,214,000 and $65,051,000, respectively. 4. LONG-TERM OBLIGATIONS Long-term obligations consist of the following at December 31 (dollars in thousands except per share amounts): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) By December 31, 1992, the Company had obtained substantial commitments to refinance the remaining debt outstanding under a 1990 credit agreement. Accordingly, in 1992, the Company recorded a $4,312,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of this debt. On March 3, 1993, the Company closed such refinancing and entered into a $20,000,000 Credit Agreement (the "Nippon Credit Agreement") and a $135,000,000 Credit Agreement (the "Morgan Credit Agreement"). The Nippon Credit Agreement provides for a seven-year term loan (the "Nippon Term Loan"). The proceeds from the Nippon Term Loan were used to repay the remaining balance outstanding under a term loan provided by the 1990 credit agreement, and to fund, among other things, the purchase of certain previously-leased facilities. The Morgan Credit Agreement originally provided for a $35,000,000 Working Capital Revolving Credit Facility (the "Revolver") and a $100,000,000 Letter of Credit Facility (the "LOC Facility"). Effective September 30, 1993, the Morgan Credit Agreement was amended to increase the Revolver to $50,000,000 and to decrease the LOC Facility to $85,000,000. The Revolver and the LOC Facility replaced the Company's revolving credit facility and letter of credit facility originally entered into under the 1990 credit agreement. The Nippon Term Loan bears interest at the Prime Rate, as defined, plus 1.50% or Adjusted LIBOR plus 2.50%, at the Company's option, and requires interest-only payments for the first three years. Amounts outstanding under the Revolver bear interest at Adjusted LIBOR plus 1.25% or the Base Rate, as defined, plus .25%, at the Company's option, until maturity on February 15, 1996. At December 31, 1993, there were no outstanding borrowings under the Revolver. The Company pays certain commitment fees and commissions with respect to the Revolver and the LOC Facility. The Nippon Credit Agreement is secured by a mortgage interest in 13 nursing facilities with a net book value totaling approximately $16,392,000 at December 31, 1993, and a security interest in certain personal property. The Morgan Credit Agreement is secured by a mortgage interest in 61 nursing facilities with net book value totaling approximately $78,836,000 at December 31, 1993, a security interest in certain personal property and a security interest in the stock of substantially all of the Company's operating subsidiaries. These credit agreements each impose on the Company certain financial tests and certain restrictive covenants. During 1992, the Company executed a $100,000,000 Bank Credit Facility (the "Bank Credit Facility") which provides for a seven-year term loan (the "Term Loan"). The Company incurred an extraordinary charge in 1992 of $4,523,000, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of certain debt that was repaid with a portion of the proceeds from the Bank Credit Facility. A portion of the net proceeds from the Preferred Stock offering (as discussed below) was used to repay approximately $45,000,000 of the Term Loan during 1993. Accordingly, in 1993, the Company recorded a $2,345,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with such debt as well as certain bond refundings. The Term Loan bears interest at Adjusted LIBOR plus 2.50% or the Prime Rate, as defined, plus 1.50%, at the Company's option, and requires interest-only payments for the first three years. The Bank Credit Facility is secured by a mortgage interest in 68 nursing facilities and retirement centers with net book value totaling approximately $130,358,000 at December 31, 1993, and a security interest in certain personal property and imposes on the Company certain financial tests and restrictive covenants. As of December 31, 1993, the Company had $17,750,000 of fixed rate senior secured notes (the "Senior Secured Notes") outstanding which were previously issued in conjunction with a refinancing in 1990. The Senior Secured Notes have interest payable semi-annually at 14.25%, require a sinking fund payment on December 15, 1996 and mature on December 15, 1997. The Senior Secured Notes are secured by a mortgage interest in 20 nursing facilities with net book value totaling approximately $28,156,000 at December 31, 1993, BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) and a security interest in certain personal property and impose on the Company certain financial tests and certain restrictive covenants. In April 1993, the Company registered with the Securities and Exchange Commission $100,000,000 aggregate principal amount of First Mortgage Bonds (the "First Mortgage Bonds Registration Statement") which are to be offered from time to time as separate series in amounts, at prices and on terms to be determined at the time of sale. Pursuant to such registration, the Company issued two series of First Mortgage Bonds in 1993. On April 22, 1993, the Company issued $20,000,000 aggregate principal amount of 8.75% First Mortgage Bonds (the "Series A Bonds") due July 1, 2008. On July 22, 1993, the Company issued $30,000,000 aggregate principal amount of 8.625% First Mortgage Bonds (the "Series B Bonds") due October 1, 2008. In November 1993, the Company filed a Registration Statement with the Securities and Exchange Commission to amend the First Mortgage Bonds Registration Statement to allow the Company to issue senior unsecured notes, subordinated unsecured notes, or other evidences of indebtedness, as well as First Mortgage Bonds, (collectively, the "Debt Securities") for the remaining $50,000,000 available under the First Mortgage Bonds Registration Statement. On December 22, 1993, the Company issued $25,000,000 aggregate principal amount of 8.75% Notes (the "8.75% Notes"), which are unsecured obligations of the Company, due December 31, 2003. The Company used the net proceeds from issuance of the Series A Bonds, the Series B Bonds and the 8.75% Notes to finance the purchase of nine nursing facilities, to finance construction of a new nursing facility, to refinance certain existing indebtedness with respect to 20 nursing facilities, which debt had a weighted average annual interest rate of 12.1%, and for general corporate purposes. As of December 31, 1993, $50,000,000 was outstanding under the Company's Commercial Paper Program, pursuant to which eligible receivables of selected nursing facilities are sold to Beverly Funding Corporation ("Beverly Funding"), a wholly-owned subsidiary of the Company. The commercial paper has due dates ranging primarily from one to three months, and is backed by a commercial paper liquidity facility due December 31, 1995. The Company's maximum borrowing level under the program is $65,000,000. At December 31, 1993, Beverly Funding had total assets of approximately $75,951,000 which cannot be used to satisfy claims of the Company or any of its subsidiaries. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock") through a public offering (the "Preferred Stock offering") for net proceeds of approximately $145,000,000. On January 3, 1994, the Company used approximately $100,000,000 of such net proceeds to redeem all of the Company's Series A preferred stock. The remainder of the net proceeds was used to repay approximately $45,000,000 of the Term Loan under the Bank Credit Facility. Had the Preferred Stock offering been completed prior to January 1, 1993, and the net proceeds from the offering applied as discussed above, the pro forma net income per share for the twelve months ended December 31, 1993 would have been $.66. During the twelve months ended December 31, 1993, the Board of Directors approved the redemption of approximately $46,000,000 in principal amount of the Company's 9% convertible subordinated debentures (the "9% Debentures"). By the close of business on August 18, 1993, all of the 9% Debentures had been converted to common stock of the Company. Outstanding shares of the Company's common stock increased by approximately 7,131,800 shares as a result of the conversion of the 9% Debentures. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) Maturities and sinking fund requirements of long-term obligations, including capital leases, for the years ending December 31 are as follows (in thousands): Many of the capital and operating leases contain at least one renewal option (which could extend the term of the leases by five to fifteen years), purchase options, escalation clauses and provisions for payments by the Company of real estate taxes, insurance and maintenance costs. The industrial development revenue bonds were originally issued prior to 1985 primarily for the construction or acquisition of nursing facilities. The funds generated from certain of the initial bond issues are designated for facility construction and are maintained in interest bearing accounts (designated funds) until used. Bond reserve funds are also included in designated funds. These funds are invested primarily in certificates of deposit and in United States government securities and are carried at cost, which approximates market value. Net capitalized interest relating to construction was not material in 1993, 1992 or 1991. 5. COMMITMENTS AND CONTINGENCIES The future minimum rental commitments required by all noncancelable operating leases with initial or remaining terms in excess of one year as of December 31, 1993, are as follows (in thousands): Total future minimum rental commitments above include approximately $24,606,000 of minimum sublease rentals due in the future under noncancelable subleases. Rent expense on operating leases for the years ended December 31 was as follows: 1993 -- $133,567,000; 1992 -- $138,623,000; 1991 -- $140,330,000. Sublease rent income was approximately $3,226,000, $3,289,000 and $2,592,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Contingent rent, based primarily on revenues, was approximately $20,000,000, $19,000,000 and $17,800,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Effective August 1, 1992, the Company entered into an agreement to outsource its management information systems functions for a period of seven years, with an option to renew based on mutual agreement BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 5. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) among the parties. The future minimum commitments required under such agreement as of December 31, 1993, are as follows: 1994 -- $7,941,000; 1995 -- $7,941,000; 1996 -- $7,941,000; 1997 -- $7,941,000; 1998 -- $7,941,000; thereafter -- $4,632,000. The Company incurred approximately $10,179,000 under such agreement during the year ended December 31, 1993. The Company is contingently liable for approximately $71,674,000 of long-term obligations maturing on various dates through 2019, as well as annual interest of approximately $6,155,000 principally related to the Company's sale of nursing facilities and retirement living projects. In addition, the Company has working capital guarantees resulting from the disposition of facilities totaling $3,000,000. The Company operates the facilities or projects related to approximately $53,292,000 of the principal amount for which it is contingently liable, pursuant to long-term agreements accounted for as operating leases or management contracts. In addition, the Company is contingently liable for various operating leases that were assumed by purchasers and are secured by the rights thereto. There are various lawsuits and regulatory actions pending against the Company arising in the normal course of business, some of which seek punitive damages. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on the Company's consolidated financial position or results of operations. 6. STOCKHOLDERS' EQUITY The Company had 300,000,000 shares of authorized $.10 par value common stock at December 31, 1993 and 1992. The Company is subject to certain restrictions under its banking arrangements related to the payment of cash dividends on its common stock. The Company had 25,000,000 shares of authorized $1 par value preferred stock at December 31, 1993 and 1992, a portion of which has been issued as described below. The Board of Directors has authority, without further stockholder action, to set rights, privileges and preferences for any unissued shares of preferred stock. In December 1986, the Company issued 999,999 shares of its preferred stock ("the Series A preferred stock") with a stated and liquidation value of $100 per share to a wholly-owned subsidiary of Stephens Group, Inc. On January 3, 1994, the Company used approximately $100,000,000 of the net proceeds from the Preferred Stock offering (as defined below) to redeem the Series A preferred stock. The Series A preferred stock dividend rate was scheduled to increase from 1% to 10% on January 1, 1994. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock"), with a liquidation value of $50 per share through a public offering (the "Preferred Stock offering"). As of December 31, 1993, the Series B preferred stock is convertible into 11,252,813 shares of the Company's common stock. The holders of the Series B preferred stock are entitled to receive out of legally available funds, when and as declared by the Company's Board of Directors, quarterly cash dividends equal to $2.75 per share (aggregate of $8,250,000 per annum). Except as required by law, holders of the Series B preferred stock have no voting rights unless dividends on the Series B preferred stock have not been paid in an aggregate amount equal to at least six full quarters (whether or not consecutive), in which case holders of the Series B preferred stock will be entitled to elect two additional directors to the Company's Board of Directors to serve until such dividend arrearage is eliminated. The Company paid all required quarterly dividends on the Series B preferred stock during 1993. The Series B preferred stock is exchangeable, in whole or in part (but in no more than two parts), at the option of the Company, on any dividend payment date beginning November 1, 1995, for the Company's 5 1/2% BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 6. STOCKHOLDERS' EQUITY -- (CONTINUED) Convertible Subordinated Debentures due August 1, 2018 (the "5 1/2% Debentures"), at the rate of $50 principal amount of 5 1/2% Debentures for each share of the Series B preferred stock. The Series B preferred stock is redeemable at any time on and after August 1, 1996, in whole or in part, only at the option of the Company, initially at a redemption price of $51.925 per share, and thereafter at prices decreasing ratably annually to $50 per share on and after August 1, 2003, plus accrued and unpaid dividends. The Series B preferred stock is not a common stock equivalent and is accounted for only in the computation of fully diluted earnings per share. During 1993, the Beverly Enterprises, Inc. 1993 Long-Term Incentive Stock Plan was approved. Such plan, as amended and restated (the "1993 Incentive Stock Plan"), became effective July 1, 1993 and will remain in effect until June 30, 2003, subject to the earlier termination by the Board of Directors. The Company has 3,000,000 common shares authorized for issuance, subject to certain adjustments, under the 1993 Incentive Stock Plan in the form of nonqualified stock options, incentive stock options, restricted stock, performance awards and other stock unit awards. Incentive stock options must be granted at a purchase price equal to market price at date of grant. Nonqualified stock options may be granted at no less than 85% of market price on the date of grant. All grants made at less than market price must be in lieu of cash payments. All options are exercisable no sooner than one year from the grant date and expire 10 years from the grant date. Restricted stock awards are outright stock grants which have a minimum vesting period of one year for performance-based awards, and three years for other awards. Performance awards and other stock unit awards will be granted based on the achievement of certain performance or other goals and will carry certain restrictions, as defined. The Compensation Committee of the Board of Directors is responsible for administering the 1993 Incentive Stock Plan and will have complete discretion in determining the number of shares or units to be granted, setting performance goals and applying other restrictions to awards, as needed, under the plan. The Company has 2,400,000 common shares authorized for issuance under its 1985 Beverly Nonqualified Stock Option Plan. Under the plan, options are granted at a purchase price equal to market price at date of grant, become exercisable no sooner than one year after date of grant and expire no later than twelve years after date of grant, as determined by a committee appointed by the Board of Directors. In addition to options, the plan provides for outright grants of common stock, subject to forfeiture provisions. As a condition precedent to the release of such shares, the employee must be continuously employed with the Company from and after the date of grant and remain employed on share release dates. Commencing one year after the grant date, the shares will be released in accordance with a schedule determined at the time of grant. During 1991, the Company terminated its Amended and Restated 1981 Beverly Incentive Stock Option Plan and its Amended and Restated 1981 Beverly Stock Option Plan. No new options or restricted shares may be granted under these plans. The terminations of these plans did not affect any of the options or restricted shares previously granted pursuant to the plans. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 6. STOCKHOLDERS' EQUITY -- (CONTINUED) The following table summarizes stock option and restricted stock data relative to the Company's 1981, 1985 and 1993 option plans for the years ended December 31: - --------------- (1) Includes 2,108,743 options exercisable at December 31, 1993. As of December 31, 1993, the Company had 1,000,000 common shares authorized for issuance under a separate option grant at an option price of $12.00 per share. On January 26, 1994, such option was exercised in full and the Company received $12,000,000 in cash proceeds from such transaction. The Company intends to file a Registration Statement with the Securities and Exchange Commission to register such 1,000,000 shares. The Beverly Enterprises 1988 Employee Stock Purchase Plan (as amended and restated) enables all full-time employees having completed one year of continuous service to purchase the Company's common shares at the current market price through payroll deductions. The Company makes contributions in the amount of 30% of the participant's contribution. Each participant specifies the amount to be withheld from earnings per two-week pay period, subject to certain limitations. The total charges to the Company's consolidated statements of operations for the years ended December 31, 1993, 1992 and 1991 related to this plan were approximately $1,493,000, $1,102,000, and $850,000, respectively. 7. 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 Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes." As permitted by the Statement, the Company elected not to restate the financial statements of prior years. The cumulative effect as of January 1, 1992 of adopting the Statement was to increase net loss for the year ended December 31, 1992 by $5,454,000. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 7. INCOME TAXES -- (CONTINUED) The provision for taxes on income before extraordinary charge and cumulative effect of change in accounting for income taxes consists of the following for the years ended December 31 (in thousands): The Company's annual effective tax rate was 33% for the year ended December 31, 1993, as compared to 50% for the same period in 1992. The Company's annual effective tax rate in 1993 is lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. In addition, the higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge (as discussed herein) which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. A reconciliation of the provision for income taxes computed at the statutory rate to the Company's annual effective tax rate is summarized as follows (dollars in thousands): In accordance with Statement No. 109, deferred income taxes for 1993 and 1992 reflect the impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 7. INCOME TAXES -- (CONTINUED) and the amounts used for income tax purposes. The tax effects of temporary differences giving rise to the Company's deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows (in thousands): At December 31, 1993, the Company had targeted jobs tax credit carryforwards of $29,118,000 for income tax purposes which expire in years 2003 through 2008. For financial reporting purposes, the targeted jobs tax credit carryforwards have been utilized to offset existing net taxable temporary differences reversing during the carryforward periods. However, due to taxable losses in prior years, future taxable income has not been assumed and a valuation allowance of $15,097,000 and $17,611,000 for the years ended December 31, 1993 and 1992, respectively, has been recognized to offset the deferred tax assets related to those carryforwards. The valuation allowance decreased $2,514,000 from January 1, 1993 due to the utilization of targeted jobs tax credits. The components of the benefit from deferred income taxes for the year ended December 31, 1991 are as follows (in thousands): The caption "Prepaid expenses and other" includes prepaid federal and state income taxes of $5,279,000 at December 31, 1992. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 8. RELATED PARTY TRANSACTIONS During 1993 and 1992, the Company declared and paid all required quarterly dividends to the holder of its Series A preferred stock which amounted to $1,000,000 per year. During 1991, the Company declared and paid all current dividends and all dividends in arrears to such preferred shareholder which amounted to $4,000,000. An affiliate of the Company's Series A preferred shareholder provides certain investment services relating to the disposition of certain assets of the Company, and has provided underwriting and placement services on the Company's public and private offerings. The Company did not require such services in 1993 and 1992. Fees paid by the Company for such services amounted to approximately $1,421,000 for the year ended December 31, 1991. As of December 31, 1991, an affiliate of the Company's Series A preferred shareholder held $5,000,000 of the Company's 14.25% fixed rate Senior Secured Notes which were repurchased in February 1992 for $5,850,000. 9. FAIR VALUES OF FINANCIAL INSTRUMENTS Financial Accounting Standards Statement No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and Cash Equivalents The carrying amount reported in the consolidated balance sheets for cash and cash equivalents approximates its fair value. Notes Receivable (Including Current Portion) For variable-rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Investment in a Real Estate Mortgage Investment Conduit (REMIC) The fair value of the Company's REMIC investment, which is included in the consolidated balance sheet caption "Other, net," is based on information obtained from the REMIC servicer. Invested Funds Designated for the Redemption of Series A preferred stock The carrying amounts reported in the consolidated balance sheets for these invested funds approximate their fair value. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 9. FAIR VALUES OF FINANCIAL INSTRUMENTS -- (CONTINUED) Long-term Obligations (Including Current Portion) The carrying amounts of the Company's Commercial Paper, Term Loan, Bank Term Loan and certain other variable-rate borrowings approximate their fair values. The fair values of the remaining long-term obligations are estimated using discounted cash flow analyses, based on the Company's incremental borrowing rates for similar types of borrowing arrangements. The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows (in thousands): It was not practicable to estimate the fair value of the Company's off-balance-sheet guarantees (See Note 5). In order to consummate certain dispositions and other transactions, the Company has agreed to guarantee the debt assumed or acquired by the purchaser or the performance under a lease, by the lessor. The Company does not charge a fee for entering into such agreements. 10. ADDITIONAL INFORMATION Effective July 31, 1987, Beverly Enterprises, a California corporation ("Beverly California"), became a wholly-owned subsidiary of Beverly Enterprises, Inc., a Delaware corporation ("Beverly Delaware"). Beverly Delaware (the parent) provides financial, administrative and legal services to Beverly California for which Beverly California is charged management fees. The following summarized financial information is being reported because Beverly California's 7.625% convertible subordinated debentures due March 2003 and its zero coupon notes (collectively, the "Debt Securities") and the Senior Secured Notes are publicly held. Beverly Delaware is co-obligor of these Debt Securities and guarantor of the Senior Secured Notes. Summary financial information for Beverly California is as follows (in thousands): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 10. ADDITIONAL INFORMATION -- (CONTINUED) In addition to Beverly Delaware, one of its direct wholly-owned subsidiaries and each of Beverly California's material wholly-owned subsidiaries (collectively, the "Subsidiary Guarantors") have guaranteed the obligations of Beverly California under the Senior Secured Notes. Separate financial statements of Beverly California and the Subsidiary Guarantors are not considered to be material to holders of the Senior Secured Notes since the guaranty of each of the Subsidiary Guarantors is joint and several and full and unconditional (except that liability thereunder is limited to an aggregate amount equal to the largest amount that would not render its obligations thereunder subject to avoidance under Section 548 of the Bankruptcy Code of 1978, as amended, or any comparable provisions of applicable state law) and the aggregate net assets, earnings and equity of the Subsidiary Guarantors and Beverly California together, after adjustment for intercompany management fees, are substantially equivalent to the net assets, earnings and equity of Beverly Delaware on a consolidated basis. BEVERLY ENTERPRISES, INC. SUPPLEMENTARY DATA (UNAUDITED) QUARTERLY FINANCIAL DATA (IN THOUSANDS EXCEPT PER SHARE DATA) The following is a summary of the quarterly results of operations for the years ended December 31, 1993 and 1992. Operating results for the first quarter of 1992 have been restated to reflect the cumulative effect of a change in accounting for income taxes. The annual effective tax rates for 1993 and 1992 were 33% and 50%, respectively. The Company's annual effective tax rate in 1993 is lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. In addition, the higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge (as discussed herein) which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. Where fully diluted earnings per share would be anti-dilutive, primary earnings per share were used. 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. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1 and 2. The Consolidated Financial Statements and Consolidated Financial Statement Schedules The consolidated financial statements and consolidated financial statement schedules listed in the accompanying index to consolidated financial statements and financial statement schedules are filed as part of this annual report. 3. Exhibits The exhibits listed in the accompanying index to exhibits are filed as part of this annual report. (b) Reports on Form 8-K The Company filed Current Reports on Form 8-K and Form 8-K/A, each dated January 4, 1994, which reported under Item 5 that the Company's Registration Statement No. 33-50965 became effective on November 17, 1993, and filed under Item 7 the Underwriting Agreement dated December 21, 1993, and the First Supplemental Indenture for the Notes dated December 30, 1993, pursuant to such Registration Statement. BEVERLY ENTERPRISES, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A)) 2. Consolidated financial statement schedules for each of the three years in the period ended December 31, 1993: Consolidated financial statement schedule as of December 31, 1993: All other schedules are omitted because 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. BEVERLY ENTERPRISES, INC. 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 employee loans are non-interest bearing and are payable in full on date due. (1) Unsecured. (2) Amount represents an equity interest in debtor's personal residence and can be repurchased by the debtor at face value at any time during the option period. At the end of this period, the cost to debtor to repurchase the Company's interest will be based upon a fair market value appraisal (exercise of purchase option). (a) Includes a $15,070 reduction in the amount owed to the debtor under a consulting agreement. BEVERLY ENTERPRISES, INC. SCHEDULE V -- PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) BEVERLY ENTERPRISES, INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) BEVERLY ENTERPRISES, INC. SCHEDULE VII -- GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 The guarantees detailed above include principal amounts of industrial development revenue bonds, lines of credit and mortgages. Such guaranteed long-term obligations mature on various dates through 2019. The annual aggregate amount of interest guaranteed (including fees for letters of credit issued in connection with the bonds) is approximately $6,155,000. In addition, the Company has working capital guarantees resulting from the disposition of facilities totaling $3,000,000. The guaranteed obligations relate principally either to the Company's sale of nursing facilities and retirement living projects or to bonds issued for the construction of retirement living projects or nursing facilities. Consistent with the long-term care industry, the operators of the facilities for which the Company guarantees obligations are dependent on their participation in certain governmental programs. The Company operates the facilities or projects related to approximately $53,292,000 of the principal amount for which it is contingently liable, pursuant to long-term agreements accounted for as operating leases or management agreements. In addition, the Company is contingently liable for various operating leases that were assumed by purchasers and are secured by the rights thereto. BEVERLY ENTERPRISES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - --------------- * Includes amounts classified in long-term other assets as well as current assets. BEVERLY ENTERPRISES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Amounts for maintenance and repairs and advertising costs are not presented as such amounts are less than 1% of total revenues. BEVERLY ENTERPRISES, INC. INDEX TO EXHIBITS (ITEM 14(A)) - --------------- * Exhibits 10.1 through 10.22 are the management contracts, compensatory plans, contracts and arrangements in which any director or named executive officer participates. 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. BEVERLY ENTERPRISES, INC. Registrant Dated: March 17, 1994 By: DAVID R. BANKS ------------------------------- David R. Banks Chairman of the Board, President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities and on the dates indicated:

850422_1993.txt

850422_1993

1993

850422

ITEM 1. BUSINESS THE COMPANY'S BACKGROUND Hyster-Yale Materials Handling, Inc. ("Hyster-Yale" or the "Company") was formed as a Delaware corporation in May 1989 in connection with the acquisition of Hyster Company ("Hyster") by NACCO Industries, Inc. ("NACCO"). NACCO directly owns approximately 97% of Common Stock, par value $1.00 per share ("Common Stock") of the Company, which is a holding company that owned directly 100% of the common stock of Hyster Company ("Hyster") and 100% of the common stock of Yale Materials Handling Corporation ("Yale"). On January 1, 1994, Yale was merged into Hyster and Hyster changed its name to NACCO Materials Handling Group, Inc. ("NMHG"). This action is the final step in the Company's strategy to combine the administrative, design, engineering and manufacturing capabilities into a unified group. NMHG will continue to market the two full lines of forklifts and related service parts under the Hyster(R) and Yale(R) brand names. SIGNIFICANT EVENTS DEBT RESTRUCTURING. In August 1993, NACCO and the Company's two minority shareholders, Sumitomo Heavy Industries Ltd. of Japan ("Sumitomo") and Jungheinrich Aktiengesellschaft, a German manufacturer of forklift trucks, ("Jungheinrich"), made a proportional capital contribution of $53.8 million in the form of previously purchased 12-3/8% subordinated debentures of the Company with a face value of $23.7 million and a purchase value by NACCO of $25.5 million and a cash contribution of $28.3 million. The cash contribution enabled the Company to call approximately $26.5 million face value of subordinated debentures at a price of 107.5. This, and the capital contribution by NACCO of previously purchased subordinated debentures, allowed the Company to retire approximately $50.2 million face value of these debentures. As part of this transaction, the Company amended its existing senior bank credit agreement. This amendment permits equity infusions by existing stockholders to be used for cash purchases of debentures and, after August 1994, permits use of internally generated funds to retire up to $75.0 million of additional subordinated debentures if certain debt to capitalization ratios are achieved. In addition, the amendment modifies the bank loan amortization schedule and provides for favorable performance-based interest rate incentives. THE FORKLIFT TRUCK INDUSTRY Forklift trucks are used in both manufacturing and warehousing environments. The materials handling industry, especially in industrialized nations, is generally a mature industry. In the most recent business cycle - 1 - the North American market for forklift trucks reached its lowest level in 1991, and it increased in both 1992 and 1993 over prior year levels. The European and Japanese markets generally have been in decline since 1990. The forklift truck industry historically has been cyclical. Fluctuations in the rate of orders for forklift trucks reflect the capital investment decisions of the customers, which in turn depend upon the general level of economic activity in the various industries served by such customers. COMPANY OPERATIONS NMHG maintains product differentiation between Hyster(R) and Yale(R) brands of forklift trucks and distributes its products through separate worldwide dealer networks. Nevertheless, opportunities have been identified and addressed to improve the Company's results by integrating overlapping operations and taking advantage of economies of scale in design, manufacturing and purchasing. NMHG completed a series of plant and parts depot consolidations with the closure of its Wednesfield, England manufacturing plant in early 1992. NMHG now provides all design, manufacturing and administrative functions. Products are marketed and sold through two separate groups which retain the Hyster and Yale identities. In Japan, NMHG has a 50% owned joint venture with Sumitomo named Sumitomo Yale Company Limited ("S-Y"). S-Y performs certain design activities and produces lift trucks and components which it markets in Japan and which are exported for sale by NMHG and its affiliates in the U.S. and Europe. PRODUCT LINES NMHG manufactures a wide range of forklift trucks under both the Hyster(R) and Yale(R) brand names. The principal categories of forklift trucks include electric rider, electric narrow-aisle and electric motorized hand forklift trucks primarily for indoor use, and internal combustion engine ("ICE") forklift trucks for indoor or outdoor use. Forklift truck sales accounted for approximately 80%, 79%, and 77% of NMHG's net sales in 1993, 1992 and 1991, respectively. NMHG also derives significant revenues from the sale of service parts for its products. Profit margins on service parts are greater than those on forklift trucks. The large population of Hyster(R) and Yale(R) forklift trucks now in service provides a market for service parts. In addition to parts for its own forklift trucks, NMHG has a program (termed UNISOURCE(TM) in North America and MULTIQUIP(TM) in Europe) designed to supply Hyster dealers with replacement parts for most competing brands of forklift trucks. NMHG has a similar program (termed PREMIER(TM)) for its Yale dealers in the Americas and the United Kingdom. Accordingly, NMHG dealers can offer their mixed fleet customers a "one stop" supply source. Certain of these parts are manufactured by and purchased from third party component makers, NMHG also manufactures some of these parts through reverse-engineering of its competitors' parts. Service parts accounted for approximately 20%, 21%, and 23% of NMHG's net sales in 1993, 1992 and 1991, respectively. - 2 - COMPETITION The forklift truck industry is highly competitive. The worldwide competitive structure of the industry is fragmented by product line and country. The principal methods of competition among forklift truck manufacturers are product performance, price, service and distribution networks. The forklift truck industry competes with alternative methods of materials handling, including conveyor systems, automated guided vehicle systems and hand labor. Global competition is also affected by a number of other factors, including currency fluctuations, variations in labor costs and effective tax rates, and the costs related to compliance with applicable regulations, including export restraints, antidumping provisions and environmental regulations. Although there is no official source for information on the subject, the Company believes it is one of the top three manufacturers of forklift trucks in the world. NMHG's position is strongest in North America, where it believes it is the leader in unit sales of electric rider and ICE forklift trucks and has a significant share of unit sales of electric narrow-aisle and electric motorized hand forklift trucks. Although the European market is fragmented and competitive positions vary from country to country, NMHG believes that it has a significant share of unit sales of electric rider and ICE forklift trucks in Western Europe. In Japan, although its share is currently small, NMHG has a distribution system through S-Y. TRADE RESTRICTIONS A. UNITED STATES Since June 1988, Japanese-built ICE forklift trucks, imported into the U.S., with lifting capacities between 2,000 and 15,000 pounds, including finished and unfinished forklift trucks, chassis, frames, and frames assembled with one or more component parts, have been subject to an antidumping duty order. Antidumping duty rates in effect through 1993 range from 4.48% to 56.81% depending on manufacturer or importer. The antidumping duty rate applicable to imports from S-Y is 51.33%, and is likely to continue unchanged for the foreseeable future, unless S-Y and NMHG decide to participate in proceedings to have it reduced. NMHG does not currently import for sale in the United States any forklift trucks or components subject to the antidumping duty order. This antidumping duty order will remain in effect until the Japanese manufacturers and importers satisfy the U.S. Department of Commerce ("Commerce") that they have not individually sold merchandise subject to the order in the United States below foreign market value for at least three consecutive years, or unless Commerce or the U.S. International Trade Commission finds that changed circumstances exist sufficient to warrant the order's revocation. If the United States Congress approves legislation implementing the Uruguay Round of GATT negotiations, the antidumping order will be reviewed for possible revocation in the year 2000. All of NMHG's major Japanese competitors have either built or acquired manufacturing or assembly facilities in the United States. The Company cannot predict with any - 3 - certainty if there will be any negative effects to the Company resulting from the Japanese sourcing of their forklift products in the United States. B. EUROPE From 1986 through 1993, Japanese forklift truck manufacturers were subject to informal export restraints on Japanese-manufactured electric rider, electric narrow-aisle, and ICE forklift trucks shipped to Europe. Discussions are continuing between European community and Japanese government officials; however, these informal restraints are expected to continue in 1994. Several Japanese manufacturers have announced either that they have established, or intend to establish, manufacturing or assembly facilities within the European community. The Company also cannot predict with any certainty if there will be any negative effects to NMHG resulting from the Japanese sourcing of their forklift products in Europe. C. AUSTRALIA In 1987 an Australian producer of forklift trucks filed an anti-dumping action against imports from Japan. Voluntary price undertakings were negotiated with all major Japanese producers including S-Y. The S-Y undertaking expired in 1991. The Australian producer filed a legal challenge to the validity of the price undertakings. Meanwhile, in 1991 this same producer filed an antidumping action against imports from the United Kingdom. In this action Hyster Europe was found to be dumping and duties were imposed on imports from the Company's Craigavon, Northern Ireland and Irvine, Scotland factories. Hyster Australia challenged this finding and in the interim sourced its product elsewhere. In the summer of 1993 both of these anti-dumping actions were terminated. PRODUCT DESIGN AND DEVELOPMENT NMHG spent $20.7 million, $21.9 million, and $19.2 million on product design and development activities in 1993, 1992 and 1991, respectively. The Hyster(R) and Yale(R) products are differentiated for the specific needs of their respective customer bases. NMHG continues to pursue opportunities to improve product cost by engineering new Hyster(R) and Yale(R) brand products with component commonality. Certain product design and development activities with respect to ICE forklift trucks and some components are performed in Japan by S-Y. S-Y spent approximately $4.0 million, $3.7 million and $3.8 million on product design and development in 1993, 1992 and 1991, respectively. BACKLOG As of December 31, 1993, NMHG's backlog of unfilled orders for forklift trucks was approximately 12,100 units, or $206 million. This compares to the backlog as of December 31, 1992 of approximately 12,100 units, or $203 million. Backlog represents unit orders to NMHG's manufacturing plants from independent dealerships, retail customers and contracts with the U.S. Government. Although these orders are believed to be firm, such orders may be subject to cancellation or modification. - 4 - SOURCES NMHG has adopted a strategy of obtaining its raw materials and principal components on a global basis from competitively priced sources. NMHG is dependent on a limited number of suppliers for certain of its critical components, including diesel and gasoline engines and cast-iron counterweights used on certain forklift trucks. There would be a material adverse effect on NMHG if it were unable to obtain all or a significant part of such components, or if the cost of such components were to increase significantly under circumstances which prevented NMHG from passing on such increases to its customers. DISTRIBUTION The Hyster(R) and Yale(R) brand products are distributed through separate highly developed worldwide dealer networks. The Company believes that both dealer networks contribute significantly to its competitive position in the industry and intends to keep the separate networks intact and to continue to market products separately under the Hyster(R) and Yale(R) brand names. Each also sells directly to certain major accounts. In Japan, forklift truck products are distributed by S-Y. In 1991, Yale reached a ten-year agreement with Jungheinrich to continue distribution of Yale brand products in Germany and Austria and to provide to Jungheinrich certain ICE and electric-powered products for sale in other major European countries under the Jungheinrich brand name. FINANCING OF SALES Hyster U.S. dealer and direct sales are supported by leasing and financing services provided by Hyster Credit Company, a division of AT&T Commercial Finance Corporation, pursuant to an operating agreement which expires in 2000. NMHG is a minority stockholder of Yale Financial Services, Inc., a subsidiary of General Electric Capital Corporation, which offers Yale U.S. dealers wholesale and retail financing and leasing services. Such retail financing and leasing services are also available to Yale national account customers. EMPLOYEES As of February 28, 1994, NMHG had approximately 5,000 employees. Employees in the Danville, Illinois manufacturing and parts depot operations are unionized, as are tool room employees located in Portland, Oregon. A three-year contract for the Danville union employees was signed in 1991 which will expire in June 1994. A new one-year contract was signed in 1993 with the Portland tool room union which will expire in October 1994. Employees at the facilities in Berea, Kentucky; Sulligent, Alabama; and Greenville and Lenoir, North Carolina are not represented by unions. - 5 - In Europe, shop employees in the Craigavon, Northern Ireland facility are unionized. Employees in the Irvine, Scotland and Nijmegen, The Netherlands facilities are not represented by unions. The employees in Nijmegen have organized a works council, as required by Dutch law, which performs a consultative role on employment matters. NMHG's management believes its current labor relations with both union and non-union employees are good. GOVERNMENT REGULATION NMHG's manufacturing facilities, in common with others in industry, are subject to numerous laws and regulations designed to protect the environment, particularly with respect to disposal of plant waste. NMHG's products are also subject to various industry and governmental standards. NMHG's management believes that such requirements have not had a material adverse effect on its operations. PATENTS, TRADEMARKS AND LICENSES NMHG is not materially dependent upon patents or patent protection. The Hyster(R) trademark is currently registered in approximately 51 countries. The Yale(R) trademark, which is used on a perpetual royalty-free basis in connection with the manufacture and sale of forklift trucks and related components, is currently registered in approximately 100 countries. NMHG's management believes that its business is not dependent upon any individual trademark registration or license, but that the Hyster(R) and Yale(R) trademarks are material to its business. ITEM 2. ITEM 2. PROPERTIES The following table summarizes certain information with respect to the principal manufacturing, distribution and office facilities owned or leased by NMHG and its subsidiaries. - 6 - NMHG intends to sell its Flemington, New Jersey facility and intends to either lease back a portion of the office space in this facility or to rent suitable office space in the same area. NMHG also intends to sell one of its facilities located in Danville, Illinois which is currently vacant. There is no certainty that any such transactions will occur. Each of NMHG's principal U.S. facilities is encumbered as security for the obligations under the Company's bank financing. The facilities in Berea, Kentucky and Sulligent, Alabama are leased pursuant to industrial development bond financings which permit NMHG to acquire the properties for nominal amounts upon redemption or repayment of the bonds. - 7 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceeding except ordinary routine litigation incidental to its business. Certain of such routine litigation includes claims for punitive damages; however, the management of the Company believes that none of such litigation, individually or in the aggregate, will have a material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders of the Company. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no established public trading market for the Company's Common Stock. On February 28, 1994 there were three holders of record of the Company's Common Stock. The Company has not paid any dividends on shares of its Common Stock since its organization in 1989, and it is not anticipated that any dividends will be declared or paid with respect to the Common Stock in the foreseeable future. The Company's ability to pay dividends with respect to the Common Stock is restricted under the terms of its existing debt instruments and agreements. The information set forth in Note I to the Consolidated Financial Statements in Part IV, pages through, of this Form 10-K is incorporated herein by reference. - 8 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data below for 1989 includes Yale for the period beginning January 1, 1989 to May 26, 1989 and for the Company for the period subsequent to May 26, 1989. Certain prior year amounts have been restated to reflect the new method of accounting for income taxes and goodwill amortization has been reclassified as operating expense. Information with respect to selected financial data is set forth below. - 9 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION 1993 VS. 1992 FINANCIAL REVIEW 1993 results reflected the strengthening North American market offset by continued weakness in most of Europe and Japan. Increased demand in North America lifted prices slightly versus the prior year but competitive pressures continued to restrain significant margin growth. The improving economy in the United States also helped parts sales and, along with tight cost controls, resulted in increased operating profit. The success of new products introduced in 1993 raised sales to a higher average sales value however, margins have not increased proportionately due to mix swings to lower margin countries. Manufacturing costs were higher in 1993 due to start-up costs associated with new product introductions and under absorbed overhead in Europe. The Pound Sterling weakened considerably against the U.S. Dollar in 1993 causing sales and operating profit to be translated at lower amounts. The strong Yen in 1993 contributed to higher costs for products and parts sourced from Japan. Backlog of orders at December 31, 1993 was approximately 12,100 forklift truck units which was level with December 31, 1992. While order demand has grown, continued process improvements have shortened product delivery schedules. The forklift truck industry historically has been cyclical and the level of economic activity in the various industries in which the Company's customers participate has a corresponding impact on the forklift truck market. OTHER Interest expense was $40.4 million in 1993 versus $44.2 million in 1992. The decrease was due to lower market interest rates and a debt refinancing which included an equity infusion that lowered debt and reduced the Company's effective interest rate. The Company entered into unsecured interest rate swaps for a majority of its floating rate debt to provide near-term protection against significant increases in interest rates. The Company will continue to evaluate its interest rate exposure. In the second quarter of 1993, the Company sold its former manufacturing site in Wednesfield, England for $3.3 million. The net pretax gain from the sale was $2.1 million. Other-net in 1993 primarily included $3.9 million of loss from the Company's 50% equity interest in Sumitomo-Yale which had a larger loss in 1993 versus 1992 due to the strong Yen and weak European and Japanese markets. Other-net in 1992 also included foreign exchange gains which were not repeated in 1993 as the Company began hedging its income statement exposures. PROVISION FOR INCOME TAXES As discussed in Note J to the consolidated financial statements, the Company adopted SFAS No. 109 as of January 1, 1993 and has restated prior periods. The effective income tax rate change from 1992 to 1993 is not meaningful due to a pretax loss in 1993 coupled with a tax provision. The Company has non-deductible goodwill amortization related to the Hyster acquisition which increased the effective tax rate above statutory rates and resulted in a tax provision in 1993 despite a loss before income taxes. In addition, the Company began providing for U.S. taxes in 1993 on certain foreign earnings taxed at overall lower rates in anticipation of future repatriations. Due to higher levels of pre-tax income in 1992, the nondeductible expenses had a smaller impact on the effective tax rate in 1992. EXTRAORDINARY CHARGE An extraordinary charge of $3.3 million net of $2.0 million in tax benefits, was recorded in the second quarter of 1993 and represents the write-off of premiums and unamortized debt issuance costs associated with the retirement of approximately $50.2 million face value of 12-3/8% Subordinated Debentures. The Company retired the debentures as a result of a contribution by NACCO of previously purchased subordinated debentures with a face value of $23.7 million, and a cash infusion of $28.3 million ($26.7 million from NACCO) which enabled the Company to call approximately $26.5 million face value of subordinated debentures at a price of 107.5. 1992 VS. 1991 FINANCIAL REVIEW 1992 results reflect economic improvement in North America partially offset by weaker markets in Europe and the Far East. Price discounting continued to be prevalent in the forklift market and mix changes to lower margin products, especially in Europe, restricted sales and operating profits. Manufacturing costs decreased due to reductions in overhead from continued savings realized from the consolidation of operations and higher overall volumes. Operating expenses increased as marketing programs for existing and new products and new product development programs were implemented in 1992. OTHER Interest income decreased substantially from 1991 as a result of lower cash balances in Europe and lower market interest rates. Interest expense was $44.2 million for 1992 compared to $49.5 million for 1991. Lower 1992 interest expense was due to reduced debt levels and lower interest rates. Other-net primarily includes income or loss from operations and the after-tax gain or losses of business units classified as assets held for sale, equity in the earnings of unconsolidated subsidiaries, and foreign currency gains and losses. The increase in other-net in 1992 compared to 1991 resulted from increased foreign currency exchange gains and reduced losses from retail branch operations classified as net assets held for sale, the last of which was sold in May 1992. PROVISION FOR INCOME TAXES The effective income tax rate decreased to 70.7% in 1992 from 128.5% in 1991. Expenses not deductible for tax purposes (primarily goodwill), were approximately level with 1991. Due to higher income in 1992, these expenses accounted for a substantially lower percentage of pretax income than in 1991. ENVIRONMENTAL MATTERS The Company's manufacturing operations, like those of other companies engaged in similar businesses, involve the use, disposal and clean-up of substances regulated under environmental protection laws. Compliance with these increasingly stringent standards results in higher expenditures for both capital improvements and operating costs. Hyster-Yale's policies stress environmental responsibility and compliance with these regulations. Based on current information, management does not expect compliance with these regulations to have a material adverse effect on its financial condition or results of operations. 1994 OUTLOOK The forklift truck industry historically has been cyclical. The economic conditions in the various markets in which the industry's customers operate affect demand. Current external economic forecasts and recent factory order information indicate an improving economy in North America. However, Europe and Japan continue to be plagued by recessionary pressures. While no near-term economic recovery is forecast for these regions, improvements in the North American economy and favorable worldwide interest rates should eventually lead to a global recovery. The Company will continue to introduce new products in 1994. Improved profitability is dependent on successful continuing efforts to reduce costs. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operations was $34.1 million in 1993 compared with operating cash flow used of $25.8 million in 1992. The increase in cash provided by operations resulted primarily from reduced working capital requirements. Inventories dropped significantly from 1992 to 1993, generating cash, and accounts payable was higher due to timing, and extended trade terms with Sumitomo-Yale. Reduced tax payments in 1993 also benefited cash flow. Expenditures for property, plant and equipment were $20.2 million in 1993 versus $24.3 million in 1992. The majority of these expenditures were for manufacturing efficiencies and tooling for new products. The principal sources of financing capital expenditures were internally generated funds. Capital expenditures in 1994 will be approximately $25 million, a portion of which will be financed from economic development capital grants from local governments. The Company amended its existing senior bank credit agreement in connection with the retirement of a portion of its subordinated debentures as discussed in Note B to the consolidated financial statements of this Form 10-K. This amendment permits equity infusions to be used for cash purchases of subordinated debentures and, after August 1994, permits use of internally generated funds to retire additional subordinated debentures. In addition, the amendment modifies the bank loan repayment schedules and provides the Company with more favorable performance based interest rate incentives. The amendment to the bank loan repayment schedule reduced the required payments in 1994 and 1995 by $35.0 million and $16.0 million, respectively. In addition, the original 1996 installment has been increased by $0.7 million and the amended schedule requires a $50.5 million payment in 1997. As disclosed in the Company's quarterly report on Form 10-Q for the quarter ending June 30, 1993, an extraordinary charge of $3.3 million net of $2.0 million in related tax benefits was recognized for the write-off of premiums and unamortized debt issuance costs associated with retirement of approximately $50.2 million face value of Hyster-Yale's subordinated debentures. Because of the increased cash flow from operations and equity infusion from NACCO, the Company reduced debt during 1993 and has available all of its revolving credit faculty of $100.0 million at December 31, 1993. The Company believes it can adequately meet all of its current and long-term commitments and operating needs from operating cash flow and funds available under committed credit agreements. During 1993, the Company repatriated $18.3 million of earnings from certain foreign subsidiaries. The taxes were previously provided for financial reporting purposes. Future distributions of unremitted earnings may be affected by changes in currency exchange rates and foreign and U.S. tax rates. Foreign currency exchange gains (losses) were $(0.1) million, $5.7 million and $1.5 million in 1993, 1992, and 1991, respectively. The Company began hedging foreign currency exposure in 1993 to mitigate the majority of income statement exposure. Stockholders' equity will still be affected by translation of foreign country financial statements where the functional currency is not the U.S. dollar. The translation loss recorded in stockholders' equity was $ 2.2 million and $20.2 million in 1993 and 1992 respectively. EFFECTS OF INFLATION The Company attempts to minimize the impact of inflation on production and operating costs through productivity improvements and cost reduction programs. The LIFO method is used to value domestic inventories. Under this method, cost of goods sold reported in the financial statements approximates current cost. Therefore, net income for 1993 adjusted for inflation would not be materially different from net income reported in the consolidated financial statements. RECENTLY ISSUED BUT NOT YET ADOPTED ACCOUNTING STANDARDS In November 1992, Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Post Employment Benefits" ("SFAS 112") was issued. The Company will be required to adopt this new method of accounting for benefits paid to former or inactive employees after employment but before retirement no later than 1994. See Note L of the Company's consolidated financial statements for discussion of the effects of this new accounting standard. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item 8 is set forth at pages through of the Financial Statements and Supplementary Data contained in Part IV hereof. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. - 15 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - 16 - - 17 - Alfred M. Rankin, Jr. and Claiborne R. Rankin are brothers and are nephews of Frank E. Taplin, Jr. and are cousins of David F. Taplin (who is the son of Frank E. Taplin, Jr.) and Britton T. Taplin (who is a nephew of Frank E. Taplin, Jr.). - 18 - - 19 - - 20 - - 21 - - 22 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the annual, long-term and all other compensation for services in all capacities to the Company of the five persons who were, as of December 31, 1993, the Chief Executive Officer and the Company's four most highly compensated executive officers other than the Chief Executive Officer (the "Named Executive Officers"). - 23 - Committee, and annual interest of $12,419 paid on a $200,000 promissory note previously held by him ("Mr. Eklund's Promissory Note"), which note bore interest at a rate equal to a 13-week U.S. Treasury Bill plus 2%, with a cap of 12%, compounded quarterly, which was payable by Yale on February 28, 1995 and which note represented the balance due to Mr. Eklund under the Yale Materials Handling Corporation 1985 Employee Incentive Plan that was terminated effective January 1, 1990. The principal and accrued interest of Mr. Eklund's Promissory Note were pre-paid in 1992. See note (6) below. The amount listed for 1991 consists of an annual interest payment on Mr. Eklund's Promissory Note of $21,360, and the use of a car, valued at $5,845. (5) For Messrs. Muller, Decker and Ryan the amounts paid in 1993 of $18,226, $12,265 and $9,013, respectively, are cash payments in lieu of perquisites. For Mr. Pollock the following amounts represent the value of the use of a car: 1993 - $2,574, 1992 - $3,477 and 1991 - $4,020. For Messrs. Muller and Ryan the value of the use of a car for 1991 was $1,272 and $6,089, respectively. Mr. Pollock was reimbursed $11,354 in 1991 for tax return preparation fees covering the years 1987 through 1991. (6) The amount listed was paid in cash to Mr. Eklund upon the pre-payment of Mr. Eklund's Promissory Note. See Note 4 above. (7) For Mr. Eklund, the amounts listed include: for 1993, 1992 and 1991, $15,370, $14,963 and $909, respectively, consisting of Company contributions under the NACCO Materials Handling Group Profit Sharing Plan (formerly known as the Hyster-Yale Profit Sharing Plan); for 1992 and 1991, $9,464 and $23,402, respectively, consisting of deferred payments under the Yale Short-Term Incentive Compensation Deferral Plan earned by Mr. Eklund for 1985 and 1986; for 1993 and 1992, $9,014 and $5,690, respectively, consisting of Company allocations under the NACCO Materials Handling Group Unfunded Benefit Plan (formerly known as the Hyster-Yale Unfunded Deferred Compensation Plan), and for 1991, $185,075 for reimbursement by Hyster-Yale of relocation expenses. (8) For Mr. Pollock the amounts listed were contributed by the Company to match before-tax contributions made under the Hyster-Yale Profit Sharing Plan (formerly known as the Hyster Employees' Savings Plan). (9) For Messrs. Muller, Decker and Ryan the amounts listed consist of contributions made by the Company to the Hyster-Yale Profit Sharing Plan (formerly known as the Yale Materials Handling Corporation Employee Profit Sharing and Stock Ownership Plan). LONG-TERM INCENTIVE PLAN The following table sets forth information about awards to the Named Executive Officers for the calendar year 1994, and estimated payouts in the future under the long-term incentive plan of the Company. - 25 - Messrs. Eklund, Muller and Pollock were awarded 21,690, 3,958 and 3,121 book value appreciation units, respectively, and effective April 1, 1993, Mr. Decker was awarded 31,192 of such units. Also, Messrs. Muller and Ryan were awarded 31,739 and 4,237 of such units effective on July 1, 1993 and October 1, 1993, respectively. For units granted as of January 1, 1993, at target return on equity over ten years, Messrs. Eklund, Pollock and Muller's book value appreciation units would entitle them to cash payments on December 31, 2002 of $632,480, $91,008 and $115,415, respectively, which amounts may be greater or less, depending upon whether NMHG's book value has increased or decreased in comparison to the target for book value growth over the period. The NMHG Long-Term Plan has no specified maximum payout. Similarly, for units granted as of July 1 and October 1 of 1993, at target return on equity Mr. Decker would be entitled to a cash payment of $907,063 on March 31, 2003, and Messrs. Muller and Ryan would be entitled to cash payments of $910,909 and $118,848 on June 30, 2003 and September 30, 2003, respectively. Mr. Eklund was previously awarded 65,000 book value appreciation units effective on January 1, 1990, which units will vest on December 31, 1999. Effective January 1, 1990, Messrs. Pollock, Muller and Ryan were also awarded 35,620, 15,154 and 15,154 units, respectively, which will also vest on December 31, 1999. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Dennis W. LaBarre, a director and member of the Nominating, Organization and Compensation Committee of the Company, is a partner in the law firm of Jones, Day, Reavis & Pogue. Such firm provided legal services on behalf of the Company during 1993 on a variety of matters, and it is anticipated that such firm will provide such services in 1994. Alfred M. Rankin, Jr. and Ward Smith who are directors of NACCO and the Company and members of the Compensation Committee of the Company, were President and Chairman of the Board, respectively, of the Company for a brief period of time in 1989. PENSION PLAN HYSTER-YALE PENSION PLANS Mr. Pollock is covered by the non-contributory defined benefit cash balance plan (qualified and non-qualified) of the Company. Messrs. Eklund, Decker, Muller and Ryan have never been covered by any defined benefit pension plans of the Company, Hyster or Yale. Each year, effective as of January 1, 1992, an amount is credited to a notional account for each covered employee equal to a percentage of the employee's compensation (including bonuses and salary deferrals) for such year, in accordance with an age-based formula that is integrated with Social Security. The notional account balances are then credited with interest each year until the employee's normal retirement date (generally, age 65) at a stated rate of interest. The notional account balances are paid in the form of a lump sum payment or converted to an annuity to provide monthly benefit payments. The estimated annual pension benefit (including prior plan benefits, if any) for Mr. Pollock under the cash balance plan, which would be payable on a straight life annuity basis at normal retirement age, is $89,300. - 26 - COMPENSATION OF DIRECTORS The Company's directors are compensated for their service to the Company in accordance with the current practices of NACCO. Directors and officers of the Company who are employees of NACCO will be compensated principally by NACCO and will participate in employee benefit plans of NACCO. Currently, two directors of the Company (Messrs. Ward Smith and Alfred M. Rankin, Jr.) are employed by NACCO and receive their compensation and employee benefits from NACCO. Officers of the Company who are also directors receive no additional compensation for their services as a director. Mr. Eklund is both an officer and a director of the Company. Mr. Eklund receives his salary and benefits from the Company. The directors of the Company who are also directors of NACCO are currently compensated by NACCO with respect to their Company Board of Directors activities, and the Company reimburses NACCO for a pro rata share (with NACCO and two other subsidiaries of NACCO) of the compensation paid by NACCO to its directors who are also directors of NACCO. Each NACCO director who is not an officer of NACCO receives a retainer of $24,000 for each calendar year of service on the NACCO and subsidiary Board of Directors. In addition, each such director receives $500 for attending each meeting of the NACCO or subsidiary Board of Directors and each meeting of a committee thereof. Such fees for attendance at Board meetings and committee meetings may not exceed $1,000 per day. In addition, the chairman of each committee of the NACCO or subsidiary Board of Directors receives $4,000 for each calendar year for service as committee chairman. Directors of the Company who are neither directors of NACCO nor officers of the Company are paid by the Company $9,000 for each calendar year, plus $500 for attending each meeting of the Company Board of Directors and each meeting of a committee thereof (such fees for attendance at Board of Directors' meetings and multiple committee meetings do not exceed $1,000 per day). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT THE COMPANY The Company currently has 10,000 authorized shares of Common Stock which is the only authorized class of Company capital stock, of which 5,598.857 shares are currently issued and outstanding. NACCO Industries, Inc., a Delaware corporation, with its headquarters located at 5875 Landerbrook Drive, Mayfield Heights, Ohio 44124-4017, is the beneficial owner of 5,435.826 shares (97%) of Common Stock. No officer or director of the Company beneficially owns any shares of the Common Stock. In connection with the financing of the acquisition of Hyster, all of the Company's Common Stock owned beneficially by NACCO was pledged to lenders to secure the Company's obligations under a Credit Agreement entered into to finance the acquisition. BENEFICIAL OWNERSHIP OF NACCO SECURITIES Set forth in the following table is the indicated information with respect to beneficial ownership of Class A Common Stock, par value $1.00 per - 27 - share ("Class A Common") and Class B Common Stock, par value $1.00 per share ("Class B Common"), of NACCO, by the directors and Named Executive Officers of the Company and all executive officers and directors of the Company as a group as of January 15, 1994. Each share of Class A Common is entitled to one vote on all matters brought before a meeting of NACCO's stockholders, while each share of Class B Common is entitled to ten votes on each such matter. Beneficial ownership of Class A Common and Class B Common has been determined for this purpose in accordance with Rule 13d-3 of the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which provides, among other things, that a person is deemed to be the beneficial owner of Class A Common or Class B Common if such person, directly or indirectly, has or shares voting power or investment power in respect of such stock or has the right to acquire such ownership within sixty days. Accordingly, the amounts shown in the table do not purport to represent beneficial ownership for any purpose other than compliance with SEC reporting requirements. Further, beneficial ownership as determined in this manner does not necessarily bear on the economic incidence of ownership of Class A Common or Class B Common. - 28 - - 29 - such shares of Class A Common and 7,000 of such shares of Class B Common. The Class B Common held by the foregoing trust is subject to the Stockholders' Agreement described in note (4). (4) A Schedule 13D filed with the SEC with respect to Class B Common on March 24, 1990, and amended on April 11, 1990 by Amendment No. 1, on March 18, 1991 by Amendment No. 2, on March 23, 1992 by Amendment No. 3 and on March 10, 1993 by Amendment No. 4, and amended and restated on March 30, 1994 by Amendment No. 5 (the "Schedule 13D"), reported that the following individuals and entities, together in certain cases with related revocable trusts and custodianships: Clara Taplin Rankin, Alfred M. Rankin, Jr., Victoire G. Rankin, Helen P. Rankin, Clara T. Rankin, Thomas T. Rankin, Matthew M. Rankin, Claiborne R. Rankin, Chloe O. Rankin, Roger F. Rankin, Bruce T. Rankin, Frank E. Taplin, Jr., Margaret E. Taplin, Martha S. Kelly, Susan S. Panella, Jennifer T. Jerome, Caroline T. Ruschell, David F. Taplin, Thomas E. Taplin, Beatrice B. Taplin, Thomas E. Taplin, Jr., Theodore D. Taplin, Britton T. Taplin, Frank F. Taplin, and National City Bank, as trustee of certain irrevocable trusts for the benefit of certain individuals named above, their family members and others (collectively, together with such individuals, revocable trusts and custodianships, the "Signatories"), are parties with NACCO and Society National Bank (successor by merger to Ameritrust Company National Association), as depository, to a Stockholders' Agreement, dated as of March 15, 1990, as amended, covering the shares of Class B Common beneficially owned by each of the Signatories (the "Stockholders' Agreement"). The Stockholders' Agreement requires that each Signatory, prior to any conversion of such Signatory's shares of Class B Common into Class A Common or prior to any sale or transfer of Class B Common to any permitted transferee (under the terms of the Class B Common) who has not become a Signatory, to offer such shares to all of the other Signatories on a pro rata basis. A Signatory may sell or transfer all shares not purchased under the right of first refusal as long as they first are converted into Class A Common prior to their sale or transfer. Accordingly, the Signatories may be deemed to have acquired beneficial ownership of all of the Class B Common subject to the Stockholders' Agreement, an aggregate of 1,542,757 shares, as a "group" as defined under the Exchange Act. The shares subject to the Stockholders' Agreement constitute 87.38% of the Class B Common outstanding on January 15, 1994, or 62.03% of the combined voting power of all Class A Common and Class B Common outstanding on such date. Certain Signatories own Class A Common, which is not subject to the Stockholders' Agreement. Under the Stockholders' Agreement, NACCO may, but is not obligated to, buy any of the shares of Class B Common not purchased by the Signatories following the trigger of the right of first refusal. The Stockholders' Agreement does not restrict in any respect how a Signatory may vote such Signatory's shares of Class B Common. The Class B Common shown in the foregoing table as beneficially owned by named persons who are Signatories is subject to the Stockholders' Agreement. (5) While Mr. Jones, a director of the Company, is a Trustee of Fidelity Funds, he has not exercised and does not presently intend to exercise - 30 - any voting or investment power over any of the 951,829 shares of Class A Common in which a Schedule 13G filed with the SEC for NACCO on February 14, 1992 and amended on February 16, 1993 by Amendment No. 1 and amended and restated on February 14, 1994 by Amendment No. 2 reported that FMR Corp. and certain related parties, including Fidelity Funds, have a beneficial ownership interest. (6) Represents shares in a certain trust of which Mr. Rankin, Jr. became a trustee on February 9, 1994, and a certain trust of which he became a trustee on March 10, 1994, succeeding his father, Alfred M. Rankin, who died on January 23, 1994. (7) Includes the following shares which such persons have, or had, within 60 days after January 15, 1994, the right to acquire upon the exercise of stock options: Mr. Smith, 2,500 shares of Class A Common; Mr. Rankin, Jr., 25,000 shares of Class A Common, and all executive officers and directors of the company as a group, 27,500 shares of Class A Common. (8) Includes 16,261 shares of Class A Common and 4,688 shares of Class B Common owned by members of Mr. Rankin's immediate family for which Mr. Rankin serves as custodian, as to which Mr. Rankin disclaims beneficial ownership. (9) Includes 178 shares of Class A Common owned on behalf of Messrs. Eklund, Muller and Ryan by the Yale Materials Handling Corporation Employee Profit Sharing and Stock Ownership Plan, as to which the individuals exercise voting power. (10) Includes 20 shares of Class A Common owned by a member of the immediate family of an executive officer as to which such executive officer disclaims beneficial ownership. Frank E. Taplin, Jr. and Thomas E. Taplin (who was, as of December 31, 1993, the beneficial owner of an aggregate of 584,114 shares of Class A Common and, as of January 15, 1994, 317,000 shares of Class B Common) are brothers, and Clara Taplin Rankin (who was, as of December 31, 1993, the beneficial owner of an aggregate of 640,741 shares of Class A Common and, as of January 15, 1994, 335,568 shares of Class B Common) is their sister. Britton T. Taplin is the son of Thomas E. Taplin and the nephew of Frank E. Taplin, Jr. and Clara Taplin Rankin. David F. Taplin is the son of Frank E. Taplin, Jr. and the nephew of Thomas E. Taplin and Clara Taplin Rankin. Clara Taplin Rankin is the mother of Alfred M. Rankin, Jr. and Claiborne R. Rankin. The combined beneficial ownership of such persons equals 2,106,385 shares or 29.19% of Class A Common and 1,156,857 shares or 65.52% of Class B Common outstanding on January 15, 1994. The combined beneficial ownership of all directors of the Company, together with Clara Taplin Rankin, Thomas E. Taplin and all of the executive officers of the Company whose beneficial ownership of Class A Common and Class B Common (including shares which would be held by such directors if they exercised certain stock options) must be disclosed in the foregoing table in accordance with Rule 13d-3 under the Exchange Act, equals 2,136,776 shares or 29.61% of Class A Common and 1,157,357 shares or 65.55% of Class B Common outstanding on January 15, 1994 (including shares which would be outstanding if certain stock options were exercised by such - 31 - directors). Such shares of Class A Common and Class B Common represent 55.12% of the combined voting power of all Class A Common and Class B Common outstanding on such date (including those shares which would be outstanding if the stock options referred to above were exercised). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS As a result of its ownership of in excess of 97% of the Company's stock, NACCO controls the Company and has the power to elect the Company's entire Board of Directors and to make certain strategic decisions concerning the Company (including decisions relating to mergers, consolidations or the sale of all or substantially all of the assets of the Company) without the approval of other stockholders. However, the Company has operated and conducted its day-to-day business autonomously. TAX AGREEMENT So long as the Company continues to meet the definition of an included corporation for Federal income tax purposes, as that definition may change from time to time, NACCO intends to include the Company in the consolidated Federal income tax returns of NACCO. NACCO and the Company are parties to an income tax share agreement providing for the allocation of Federal income tax liabilities. Under the agreement, the Company will be compensated by NACCO for certain of its tax attributes (e.g., any available tax credits), while all Federal income tax deficiencies and refunds relating to the Company for prior and future years are charged or credited to the Company as they are finally determined. Under this arrangement, the Company will pay to NACCO an amount equal to the taxes that would be payable by the Company if it were a corporation filing a separate return. A similar arrangement currently exists between NACCO and NMHG and between NACCO and each of its other subsidiaries. DIRECTORS' AND OFFICERS' LIABILITY INSURANCE AND OTHER NACCO SERVICES NACCO provides directors' and officers' liability insurance to the Company's directors and officers, with the Company reimbursing NACCO for a portion of such costs. The Company may also make use and be charged for the use of NACCO's corporate airplane. NACCO is also expected to provide certain legal, accounting and insurance services to the Company for which it will be reimbursed. OTHER Mr. Yoshinori Ohno is President of S-Y. S-Y manufactures semi-complete or complete industrial lift trucks which are purchased by NMHG, Yale Europe and Jungheinrich. S-Y also markets in Japan industrial truck products it manufactures and which it imports from NMHG. For a discussion of inter-affiliate transactions involving S-Y see Note F, Investments, on pages and F- 14. - 32 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) and (2) The response to Item 14(a)(1) and (2) is set forth beginning at page of this Annual Report on Form 10-K. (a)(3) Listing of Exhibits - See the exhibit index beginning at page X-1 of this Annual Report on Form 10-K. (b) The Company has not filed any Current Reports on Form 8-K during the fourth quarter of 1993. (c) The response to Item 14(c) is set forth beginning at page X-1 of this Annual Report on Form 10-K. (d) Financial Statement Schedules - The response to Item 14(d) is set forth beginning at page of this annual Report on Form 10-K. 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. Neither an annual report nor a proxy statement covering the Company's last fiscal year has been circulated or is going to be circulated to security holders. - 33 - SIGNATURES Pursuant to the requirements of Section 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Hyster-Yale Materials Handling, Inc. By: REGINALD R. EKLUND ------------------------------------- Reginald R. Eklund President and Chief Executive Officer Date: March 21, 1994 - 34 - 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. - 35 - Bergen I. Bull March 29, 1994 -------------------------------- Bergen I. Bull, Attorney-in-Fact - 36 - ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14 (A) (1) AND (2), AND ITEM 14 (D) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 HYSTER-YALE MATERIALS HANDLING, INC. PORTLAND, OREGON FORM 10-K ITEM 14 (A) (1) AND (2) HYSTER-YALE MATERIALS HANDLING, INC. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Hyster-Yale Materials Handling, Inc. and subsidiaries are included in Item 8: Report of Independent Accountants for years ended December 31, 1993, 1992 and 1991 Consolidated balance sheets--December 31, 1993 and December 31, 1992 Consolidated statements of income--Years ended December 31, 1993, 1992 and Consolidated statements of cash flows--Years ended December 31, 1993, 1992 and 1991 Consolidated statements of stockholders' equity--Years ended December 31, 1993, 1992 and 1991 Notes to consolidated financial statements--December 31, 1993 The following consolidated financial statement schedules of Hyster-Yale Materials Handling, Inc. and subsidiaries are included in Item 14 (d): Schedule V -- Property, plant and equipment Schedule VI -- Accumulated depreciation and amortization of property, plant and equipment Schedule VIII -- Valuation and qualifying accounts (accounts not required or not material have been omitted) 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. Report of Independent Public Accountants To the Board of Directors and Stockholders of Hyster-Yale Materials Handling, Inc.: We have audited the accompanying consolidated balance sheets of Hyster-Yale Materials Handling, Inc. (an indirect, majority-owned subsidiary of NACCO Industries, Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated 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 consolidated 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 materials respects, the financial position of Hyster-Yale Materials Handling, 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 A to the consolidated financial statements, the Company has given retroactive effect to the change in its method of accounting for income taxes. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in the list of financial statements and financial statement schedules are presented for purposes of complying with the Securities and Exchange commission's rules and are not a required part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in our audit of the basic consolidated financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole. Portland, Oregon February 4, 1994 Arthur Andersen & Co. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE A--ACCOUNTING POLICIES BASIS OF PRESENTATION: The accompanying consolidated financial statements of Hyster-Yale Materials Handling, Inc. and subsidiaries (the Company) include the accounts of Hyster-Yale Materials Handling, Inc. (Hyster-Yale), a 97% owned subsidiary of NACCO Industries, Inc. (NACCO), and its wholly-owned subsidiaries Hyster Company (Hyster) and Yale Materials Handling Corporation (Yale). Effective January 1, 1994 Yale was merged into Hyster with the resulting company renamed NACCO Materials Handling Group, Inc. which continues to be a wholly-owned subsidiary of Hyster-Yale. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) #109, "Accounting for Income Taxes." The Company elected to retroactively apply its provisions to January 1, 1989 and has restated the accompanying comparative consolidated financial statements (see Note J). PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Hyster-Yale and its majority-owned domestic and international subsidiaries except for a Brazilian subsidiary. Income from Companhia Hyster, the Brazilian subsidiary, will be recognized when cash is received in the form of a dividend. Investments in Sumitomo-Yale Company, Ltd. (S-Y), a 50% owned joint venture and Yale Financial Services, Inc. (YFS, Inc.), a 20% owned joint venture are accounted for by the equity method. All significant intercompany accounts and transactions among the consolidated companies are eliminated in consolidation. CASH AND CASH EQUIVALENTS: The Company considers cash equivalents to be investments purchased with a maturity of three months or less. INVENTORIES: Inventories are stated at the lower of cost or market. Cost has been determined under the last-in, first-out (LIFO) method for domestic inventories and under the first-in, first-out (FIFO) method with respect to all other inventories. Costs for inventory valuation include labor, material and manufacturing overhead. PROPERTY, PLANT AND EQUIPMENT: Depreciation of plant and equipment is computed using the straight-line method over the estimated useful service lives for purposes of financial reporting. For tax purposes, an accelerated method is generally used. Maintenance and repairs are expensed as incurred. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE A--ACCOUNTING POLICIES--CONTINUED GOODWILL Goodwill, which represents the excess purchase price paid over the fair value of the net assets acquired in the acquisition of Hyster Company, is amortized on a straight-line basis over 40 years. Amortization was $10.8 million in each of 1993, 1992, and 1991 respectively after restatement for SFAS 109 (see Note J). Accumulated amortization was $49.6 million and $38.7 million at December 31, 1993 and 1992. Management regularly evaluates its accounting for goodwill considering such factors as historical and future profitability and believes that the asset is realizable and the amortization period is still appropriate. DEFERRED FINANCING COSTS: Deferred financing costs from the acquisition of Hyster Company are being amortized over the term of the related indebtedness. Amortization of deferred financing costs was $1.9 million in 1993 and $2.1 million in 1992 and 1991. In addition, $1.4 million of deferred financing costs were written-off in conjunction with the extraordinary charge (see Note B). PRODUCT DEVELOPMENT COSTS: Expenditures associated with the development of new products and changes to existing products are expensed as incurred. These costs amounted to $20.7, $21.9 and $19.2 million in 1993, 1992 and 1991, respectively. FOREIGN CURRENCY: The financial statements of the Company's foreign operations are translated into United States dollars at year-end exchange rates as to assets and liabilities and at weighted average exchange rates as to revenues and expenses. Gains and losses that do not impact cash flows are excluded from net income. Effects of changes in exchange rates on foreign financial statements is designated as "foreign currency translation adjustment" and included as a separate component of stockholders' equity. The Company enters into forward foreign exchange contracts to hedge certain foreign currency denominated receivables and payables, certain foreign currency commitments and certain net investments in foreign subsidiaries. Gains and losses on hedges of foreign currency denominated receivables and payables are reported currently in income. Gains and losses with respect to firm commitments are deferred and are recognized as part of the cost of the underlying transaction. Gains or losses on hedges of net investments in foreign subsidiaries are included in the foreign currency translation adjustment. INTEREST RATE SWAP AGREEMENTS: The differential between the floating interest rate and the fixed interest rate which is to be paid or received is accrued as interest rates change and is recognized over the life of the agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE A--ACCOUNTING POLICIES--CONTINUED FINANCIAL INSTRUMENTS: Fair value of financial instruments, except for the senior subordinated debentures and interest rate swaps, approximated their carrying values at December 31, 1993. Fair values are determined from quoted market sources and through management estimates. RECLASSIFICATION: Operating profit in prior periods' consolidated financial statements has been restated to reflect the reclassification of goodwill amortization as a component of operating expenses. Certain other amounts in the prior periods consolidated financial statements have been reclassified to conform to the current period's presentation. NOTE B--EXTRAORDINARY CHARGE An extraordinary charge of $3.3 million, net of $2.0 million in related tax benefits, was recognized for the write-off of premiums and unamortized debt issuance costs associated with the retirement of approximately $50.2 million face value of the Company's 12 3/8% subordinated debentures. The retirement of these subordinated debentures was done in connection with a capital contribution and a restructuring of other bank debt discussed below. In August 1993, NACCO and the two minority shareholders made a proportional capital contribution of $53.8 million in the form of previously purchased Hyster-Yale 12 3/8% subordinated debentures with a face value of $23.7 million and a purchase value by NACCO of $25.5 million and a cash contribution of $28.3 million. As part of this transaction, the Company amended its existing senior bank credit agreement. This amendment permits equity infusions to be used for cash purchases of subordinated debentures and, after August 1994, permits use of internally generated funds to retire additional subordinated debentures. In addition, the amendment modifies the bank loan amortization schedule and provides for favorable performance based interest rate incentives. See Note I for additional discussion of the amended senior credit agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE D--ACCOUNTS RECEIVABLE Allowances for doubtful accounts of $4.9 and $4.3 million at December 31, 1993 and 1992, respectively, were deducted from accounts receivable. The cost of inventories has been determined by the last-in first-out (LIFO) method for 61% of such inventories as of December 31, 1993 and 1992, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE F--INVESTMENTS The Company owns a 50% interest in S-Y. S-Y operates a facility in Japan from which the Company purchases certain components and internal combustion engine and electric forklift trucks. Following is a summary of unaudited condensed financial information on a separate company basis (before elimination of intercompany profits) pertaining to S-Y. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 The Company generated commission income on certain S-Y sales. Commission income was $1.4, $2.2 and $2.3 million in 1993, 1992 and 1991, respectively. The Company also reimbursed S-Y $0.5 million for engineering assistance during 1993. Depreciation charged to income was $18.8, $19.0 and $19.1 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE I--SHORT-TERM AND LONG-TERM OBLIGATIONS The Company has entered into a Credit Agreement with a group of banks to provide financing for a portion of the acquisition of Hyster and working capital needs of Hyster-Yale. The Credit Agreement is secured by all domestic assets and the pledge of stock of certain subsidiaries. The Credit Agreement provides for a term note in an aggregate principal amount of $375.0 million and a long-term revolving credit facility which permits advances and secured letters of credit to the Company from time to time up to an aggregate principal amount of $100.0 million through expiration in 1997. There were no borrowings outstanding under the revolving credit facility at December 31, 1993. Borrowings under the revolving credit facility, which were classified as long-term, were $25.5 million at December 31, 1992. The commitment fee on the unused portion of the revolving credit facility is currently at 0.5% per annum. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE I--SHORT-TERM AND LONG-TERM OBLIGATIONS--CONTINUED Under an amendment to the Credit Agreement negotiated in July 1993, the term note now requires quarterly payments expiring May 31, 1997. The term note and the revolving credit facility bear interest at an effective lender's prime rate plus .75% or LIBOR plus 1.875% subject to reductions as discussed below. The average effective interest rates on the term note and the revolving credit facility were 6.45% and 7.85% in 1993 and 1992, respectively. The amendment provides for favorable performance based interest rate incentives based on achievement of varying debt to capitalization rates and/or earnings measures. In addition, the amendment permits the use of internally generated funds to repurchase additional subordinated debentures up to $75.0 million based on achieving certain debt to capitalization ratios. The Company is currently eligible to repurchase up to $25.0 million on or after August 1, 1994. The Company has entered into unsecured interest rate swap agreements. At December 31, 1993 and 1992, the Company had outstanding interest rate swap agreements with commercial banks, having total notional principal amounts of $125.0 and $45.0 million, respectively. The interest rate swap agreements mature at varying lengths from six-months to two years and effectively change the Company's floating interest rat e exposure on $125.0 million of the term note to an average fixed rate of 6.65%. These agreements are with major commercial banks and the exposure to credit loss in the event of nonperformance by the banks is minimal. The Company evaluates its exposure to floating rate debt on an ongoing basis. The Credit Agreement contains covenants related to minimum net worth, working capital, debt to equity, and interest and fixed charge coverage ratios. In addition, the Credit Agreement limits capital spending, investments, sales of certain assets and dividends. As of December 31, 1993, the Company was in compliance with all the covenants in the Credit Agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE I--SHORT-TERM AND LONG-TERM OBLIGATIONS--CONTINUED The senior subordinated debentures in the amount of $149.8 million are payable in 1999 and bear interest at 12.375%. There is a mandatory sinking fund payment on August 1, 1998 of $100.0 million. As of August 1, 1993, the debentures were redeemable at a price of 107.5. As of August 1, 1994, the debentures can be called at a price of 105. As discussed above, there are call restrictions in the Credit Agreement. At December 31, 1993, the market value of the 12.375% senior subordinated debentures was $161 million. The interest rate swap agreements have a negative market value of $1.1 million at December 31, 1993. Foreign subsidiaries had unused credit lines at December 31, 1993 of up to $15.5 million, to the extent that borrowings under these credit lines would not cause the subsidiaries to exceed any of various restrictive covenants. These credit lines are in various currencies and bear interest at rates that range from 6.5% to 8.25% at December 31, 1993. A portion of the 1994 payments on the term note may be made utilizing the existing, long-term revolving credit facility. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE J--INCOME TAXES As discussed in Note A, "Accounting Policies", the Company has adopted SFAS 109 effective January 1, 1993 and has retroactively applied its provisions to January 1, 1989. Accordingly, net goodwill has been adjusted as of January 1, 1991 to reflect the cumulative impact of applying this Standard. No adjustment was required to retained earnings as of January 1, 1991 and there was no effect on net income in 1991 or 1992. The adjustment to goodwill, an increase of $25.1 million, represents the cumulative impact of SFAS 109 on purchase accounting for the acquisition of Hyster as of January 1, 1991. SFAS 109 requires, among other things, the measurement of deferred tax assets and liabilities based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. Deferred income tax expense or benefit is based on the changes in the assets or liabilities from period to period. The prior method of accounting for income taxes measured deferred income tax expense or benefit based on timing differences between the recording of income and expenses for financial reporting purposes and for purposes of filing federal income tax returns at income tax rates in effect when the difference arose. This Note contains disclosures relative to income taxes for the periods presented in the accompanying consolidated financial statements calculated under the provisions of SFAS 109 with prior periods restated as appropriate. The Company is included in the consolidated federal income tax return of NACCO. The Company and NACCO are parties to an income tax sharing agreement providing for the allocation of federal income tax liabilities. Under this arrangement, the Company will pay to NACCO an amount equal to the income taxes that would be payable by the Company if it were a corporation filing a separate return. Therefore, the currently payable federal portion of the provision for income taxes is payable to NACCO. The Company files separate state income tax returns. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE J--INCOME TAXES--CONTINUED Domestic income (loss) before income taxes includes expenses related to interest on acquisition indebtedness, goodwill and deferred financing fee amortization of approximately $47.6, $51.7 and $60.1 million in 1993, 1992 and 1991, respectively. The Company has provided for estimated United States and foreign income taxes, less available tax credits and deductions, which would be incurred on the remittance of undistributed earnings in its foreign subsidiaries in excess of earnings deemed to be indefinitely reinvested. It is management's intent to provide income taxes on all future accumulations of undistributed earnings for those foreign subsidiaries where it is anticipated that distribution of earnings is likely to occur. Accumulated earnings at December 31, 1993 of international subsidiaries which have been indefinitely reinvested totaled $45.2 million. Determination of the amount of unrecognized deferred tax liability on these unremitted earnings is not practicable. The amount of withholding taxes that would be payable upon remittance of all undistributed foreign earnings would be $3.9 million. These withholding taxes, subject to certain limitations, may be used to reduce U.S. income taxes. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 During 1993 the Company and the IRS settled all outstanding issues on the federal income tax returns for the years 1981-1986. This final settlement did not result in a material adverse effect on the Company's financial position or results of operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE K--POSTRETIREMENT BENEFITS The Company maintains a variety of post retirement plans covering a majority of its employees. A portion of the employees are participants in the defined benefit plans discussed below. Most of the remaining covered employees participate in the profit sharing portion of the Company's defined contribution plan also described below. In addition, all eligible employees are included in the 401(k) portion of the defined contribution plan. Total post retirement expense for the Company was $7.0, $6.8 and $5.3 million for the years 1993, 1992 and 1991, respectively. Included in these amounts is the expense associated with government sponsored plans in which the Company's international subsidiaries participate. Each defined benefit plan has a formula which is used to determine benefits upon retirement. Most formulas take into account age, compensation, and success of the Company in meeting certain goals although certain hourly employee's formulas are based primarily on years of service. The Company's funding policy is to contribute annually the minimum contribution calculated by the independent actuaries. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE K--POSTRETIREMENT BENEFITS--CONTINUED The Company maintains a defined contribution retirement plan for U.S. employees which includes a profit sharing portion and a 401(k) portion. Contributions to the profit sharing plan are based on a formula which takes into account age, compensation, and success of the Company in meeting certain goals. Contributions vest over a five-year period. Under the 401(k) portion, eligible employees may contribute up to 17% of their compensation and the Company matches an amount equal to 66-2/3% of the participants initial 3% before tax contribution. Participants are at all times fully vested in their contributions and those made by the Company. NOTE L --OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS The Company and certain of its subsidiaries have health care and life insurance plans which provide benefits to eligible retired employees. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106) "Accounting for Postretirement Benefits Other Than Pensions". The impact of the adoption was not material to the results of operations or financial condition of the Company. The Company continues to fund these benefits on a "pay as you go" basis, with the retirees paying a portion of the costs. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 The assumed health care cost trend rate for measuring the postretirement benefit obligation was 11% in 1993 and 12% in 1992, gradually reducing to 6% in years 2001 and after. The weighted average discount rate utilized was 7.5% in 1993 and 8.25% in the 1992 valuation. If the assumed health care trend rate were increased by 1%, the effect on the APBO and expense would be immaterial. In November, 1992, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS 112), was issued. The Company will be required to adopt this new method of accounting for benefits paid to former or inactive employees after employment but before retirement (postemployment benefits) no later than 1994. SFAS 112 requires, among other things, that the expected cost of these benefits be recognized when they are earned or become payable (accrual method) when certain conditions are met rather than the current method which recognizes these costs when they are paid (pay as you go). The Company does not expect this standard to materially impact its financial condition or results of operations. NOTE M--LONG-TERM INCENTIVE COMPENSATION PLAN The Company has a Long-Term Incentive Compensation Plan for officers and key management employees of the Company and its subsidiaries. Awards under this plan represent book value appreciation units and entitle the recipient, subject to vesting and other restrictions, to receive cash equal to the difference between the base period price for the units and the book value price as of the quarter date coincident or immediately preceding the date of disbursement. Awards vest and are payable ten years from date of grant or earlier under certain conditions. As of December 31, 1993, awards have been granted to 109 employees and officers. The amount charged (credited) to expense was $(0.2), $(1.0) and ($0.5) million in 1993, 1992 and 1991, respectively. The total amount accrued at December 31, 1993 and 1992 for these awards is $0.3 and $0.5 million, respectively, and is recorded as a long-term liability. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Aggregate rental expense for operating leases included in the consolidated statements of income was $4.2, $3.4 and $4.1 million in 1993, 1992 and 1991, respectively. NOTE O--CONTINGENCIES The Company is subject to recourse or repurchase obligations under various financing arrangements for certain independently-owned retail dealerships. Also, certain dealer loans are guaranteed by the Company. Total amounts subject to recourse, guarantee or repurchase obligation at December 31, 1993 were $72.4 million. When the Company is the guarantor of the principal amount financed, a security interest is usually maintained in assets of parties for whom the Company is guaranteeing debt. Losses anticipated under the terms of the recourse or repurchase obligations have been provided for and are not significant. The Company had $127.5 million of forward foreign exchange contracts outstanding at December 31, 1993, with maturities of twelve months or less. These contracts are typically with major international financial institutions. The Company's risk in these transactions is the cost of replacing, at current market rates, these contracts in the event of default by the financial institution. Management believes the risk of incurring such losses is remote and any losses therefrom would be immaterial. The Company is the defendant in various product liability and other legal proceedings incidental to its business. The majority of this litigation involves product liablility claims. The Company has recorded a reserve for potential product liability losses at December 31, 1993 of $41.1 million, of which $8.0 million is estimated to be payable in 1994. While the resolution of litigation cannot be predicted with certainty, management believes that the reserves are adequate and no material adverse effect upon the financial position or results of operations of the Company will result from such legal actions. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 NOTE P--SEGMENT INFORMATION The Company's business consists of the engineering, manufacturing and marketing of materials handling machinery and equipment, under the Hyster and Yale trade names. The Company's products are manufactured in plants at five locations in the United States and six international plants located in Scotland, Northern Ireland, The Netherlands, Brazil, Australia and Japan. Service parts are distributed through parts depots located in the United States, Europe, Australia and Brazil. Generally, product assembled abroad is comprised of parts and components manufactured or purchased locally and from U.S. plants at established transfer prices. The transfer price of production parts and completed units is established by a procedure designed to equate to an arm's-length price. However, for purposes of the following financial statement disclosure, transfers between geographic areas are presented at standard cost. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 In addition to product sourced from plants abroad, export sales from the United States plants to unaffiliated customers were $53.8, $44.9, and $38.3 million in 1993, 1992 and 1991, respectively. Total sales into markets outside the United States were $311.5, $326.1 and $321.9 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HYSTER-YALE MATERIALS HANDLING, INC. AND SUBSIDIARIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 SCHEDULE IX SCHEDULE X EXHIBIT INDEX (3) Articles of Incorporation and Bylaws. (i) Certificate of Incorporation of the Company is incorporated herein by reference to Exhibit 3.1 of the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement 33-28812). (ii) Bylaws of the Company are incorporated herein by reference to Exhibit 3.2 of the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement No. 33-28812). (iii) Certificate of Amendment to Certificate of Incorporation of the Company, dated May 24, 1989, is incorporated herein by reference to Exhibit 3.3 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (iv) Certificate of Amendment to Certificate of Incorporation of the Company, dated June 7, 1989, is incorporated herein by reference to Exhibit 3.4 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (4) Instruments defining the rights of security holders, including indentures. (i) The Company by this filing agrees, upon request, to file with the Securities and Exchange Commission the instruments defining the rights of holders of long-term debt of the Company and its subsidiaries where 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. (ii) Indenture, dated as of August 3, 1989, between the Company and United Trust Company of New York, Trustee, with respect to the 12-3/8% Senior Subordinated Debentures due August 1, 1999 is incorporated herein by reference to Exhibit 4(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 33-28812. (10) Material Contracts. (i) Intentionally omitted. (ii) Operating Agreement, dated as of July 31, 1979, by and between Eaton Corporation and Sumitomo Heavy Industries Ltd. is incorporated herein by reference to Exhibit 10.4 of the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement No. 33-28812). X-1 (iii) Memorandum Agreement, dated as of November 19, 1982, by and between Eaton Corporation, Eaton International, Inc., Sumitomo Heavy Industries, Ltd. and Sumitomo Yale Company Ltd. is incorporated herein by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement No. 33-28812). (iv) Litigation Agreement, dated as of December 31, 1983, between Eaton Corporation and Yale, as amended, is incorporated herein by reference to Exhibit 10.6 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (v) Third Amended and Restated Operating Agreement, dated as of November 21, 1985, as amended, between Hyster Company and Hyster Credit Corporation is incorporated herein by reference to Exhibit 10.7 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (vi) Master Sale Leaseback Agreement, dated as of December 19, 1985, between Hyster Credit Corporation and Hyster is incorporated herein by reference to Exhibit 10.8 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (vii) Existing Fleet Sale Leaseback Agreement, dated as of December 19, 1985, between Hyster Credit Corporation and Hyster is incorporated herein by reference to Exhibit 10.9 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (viii) Intentionally omitted. (ix) Credit Agreement, dated May 26, 1989, among the Company, Yale, Hyster, the Lenders party thereto and Citicorp North America, Inc. (individually and as Agent) is incorporated herein by reference to Exhibit 10.11 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (x) Lease Agreement between Brunswick and Glynn County Development Authority and Hyster, dated as of September 1, 1988 is incorporated herein by reference to Exhibit 10.12 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). X-2 (xi) Lease Agreement between the Industrial Development Board of the Town of Sulligent and Hyster, dated as of June 1, 1970, is incorporated herein by reference to Exhibit 10.13 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xii) Lease Agreement between the City of Berea, Kentucky and Hyster, dated as of July 15, 1974, is incorporated by reference herein to Exhibit 10.14 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). * (xiii) Hyster-Yale Materials Handling, Inc. Long-Term Incentive Compensation Plan, dated as of January 1, 1990, is incorporated herein to Exhibit 10(lxxxix) of the NACCO Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 1-9172. * (xiv) Hyster-Yale Materials Handling, Inc. Annual Incentive Compensation Plan, dated as of January 1, 1990, is incorporated herein to Exhibit 10(lxxxviii) of the NACCO Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 1-9172. (xv) Termination and Release Agreement, dated as of May 26, 1989, among Eaton Corporation, Eaton Credit Corporation and Eaton Leasing Corporation and Yale is incorporated herein by reference to Exhibit 10.16 to Amendment No. 1 filed June 9, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xvi) Exhibits and Schedules to Credit Agreement, dated May 26, 1989, among the Company, Yale, Hyster, the Lenders party thereto and Citicorp North America, Inc. is incorporated herein by reference to Exhibit 10.17 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xvii) Security Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.18 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xviii) Security Agreement, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.19 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). X-3 (xix) Security Agreement, dated as of May 26, 1989, by the Company in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.20 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xx) Trademark and License Security Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.21 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxi) Trademark and License Security Agreement, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.22 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxii) Patent and License Security Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.23 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxiii) Patent and License Security Agreement, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.24 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxiv) Aircraft Security Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.25 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxv) Hyster Pledge Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.26 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). X-4 (xxvi) Instrument of Pledge, dated as of May 26, 1989, by Hyster and Hyster, B.V. in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.27 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxvii) Deed of Charge, dated as of May 26, 1989, by Hyster Europe Limited and Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.28 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxviii) Brazilian Pledge Agreement, dated as of May 26, 1989, by Hyster and Hyster Overseas Capital Corporation in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.29 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxix) Australian Pledge Agreement, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.30 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxx) Pledge Agreement, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.31 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxi) Yale Pledge Agreement, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.32 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxii) Deed of Charge, dated as of May 26, 1989, by Yale and Yale Materials Handling Limited in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.33 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). X-5 (xxxiii) Holding Pledge Agreement, dated as of May 26, 1989, by the Company in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.34 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxiv) NACCO I Pledge Agreement, dated as of May 26, 1989, by Acquisition I in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.35 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxv) Guaranty, dated as of May 26, 1989, by Hyster in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.36 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxvi) Guaranty, dated as of May 26, 1989, by Yale in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.37 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxvii) Guaranty, dated as of May 26, 1989, by the Company in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.38 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxviii) Guaranty and Security Agreement, dated as of May 26, 1989, by Acquisition I in favor of Citicorp North America, Inc. (as agent for the Lenders party to the Credit Agreement) is incorporated herein by reference to Exhibit 10.39 to Amendment No. 3 filed July 18, 1989 to the Company's Registration Statement on Form S-1 (Registration Statement No. 33-28812). (xxxix) Agreement and Plan of Merger, dated as of April 7, 1989, among NACCO Industries, Inc., Yale Materials Handling Corporation, Acquisition I, ESCO Corporation, Hyster Company and Newesco, is incorporated herein by reference to Exhibit 2.1 to the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement Number 33-28812). X-6 (xl) Agreement and Plan of Merger, dated as of April 7, 1989, among NACCO Industries, Inc., Yale Materials Handling Corporation, Acquisition I, ESCO Corporation, Hyster Company and Newesco, is incorporated herein by reference to Exhibit 2.2 to the Company's Registration Statement on Form S-1 filed May 17, 1989 (Registration Statement Number 33-28812). (xli) Amendment No. 1 to the Credit Agreement, dated as of August 21, 1989, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xli) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 33-28812. (xlii) Amendment No. 2 to the Credit Agreement, dated as of November 7, 1989, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xlii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 33-28812. (xliii) Amendment No. 3 to the Credit Agreement, dated as of January 31, 1990, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xliii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 33-28812. (xliv) Amendment No. 4 to the Credit Agreement, dated as of June 27, 1990, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xc) to NACCO's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 1-9172. (xlv) Amendment No. 5 to the Credit Agreement, dated as of March 27, 1991, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xlv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. (xlvi) Amendment No. 6 to the Credit Agreement, dated as of October 22, 1991, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(xlvi) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. X-7 * (xlvii) The Yale Materials Handling Corporation Unfunded Deferred Compensation Plan, dated as of December 15, 1989, is incorporated herein by reference to Exhibit 10(xliv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 33-28812. (xlviii) Amendment to the Third Amended and Restated Operating Agreement, dated as of January 31, 1990, between Hyster and PacifiCorp Credit, Inc. is incorporated herein by reference to Exhibit 10(xlvi) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 33-28812. (xlix) Amendment to the Third Amended and Restated Operating Agreement, dated as of January 31, 1990, between Hyster and AT&T Commercial Finance Corporation is incorporated herein by reference to Exhibit 10(xlvii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 33-28812. (l) Amendment to the Third Amended and Restated Operating Agreement, dated as of November 7, 1991, between Hyster and AT&T Commercial Finance Corporation is incorporated herein by reference to Exhibit 10(l) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. (li) Intentionally omitted. (lii) Intentionally omitted. (liii) Intentionally omitted. (liv) Intentionally omitted. * (lv) Amendment No. 8 to The Yale Materials Handling Corporation Employee Profit Sharing and Stock Ownership Plan is incorporated herein by reference to Exhibit 10(lv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. * (lvi) Amendment No. 9 to The Yale Materials Handling Corporation Employee Profit Sharing and Stock Ownership Plan is incorporated herein by reference to Exhibit 10(lvi) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. (lvii) Intentionally omitted. X-8 (lviii) Marketing Agreement, dated as of January 1, 1992, by and between Yale Materials Handling Corporation and Jungheinrich Aktiengellschaft (AG) is incorporated herein by reference to Exhibit 10(lviii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File Number 33-28812. * (lix) Termination and Cancellation Agreement, dated as of December 16, 1992, between Yale Materials Handling Corporation and Reginald R. Eklund is incorporated herein by reference to Exhibit 10(lix) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lx) The Hyster-Yale Unfunded Benefit Plan dated as of February 10, 1993, is incorporated herein by reference to Exhibit 10(lx) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. (lxi) Intentionally omitted. * (lxii) The Hyster-Yale Profit Sharing Plan, amended and restated as of November 11, 1992, is incorporated herein by reference to Exhibit 10(lxii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxiii) Instrument of Merger of Defined Contribution Plans, effective as of November 1, 1992, is incorporated herein by reference to Exhibit 10(lxiii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxiv) Instrument of Merger, Amendment and Termination of the Yale Materials Handling Corporation Profit Sharing Retirement Plan, effective as of November 1, 1992, is incorporated herein by reference to Exhibit 10(lxiv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxv) The Hyster-Yale Cash Balance Plan, as amended and restated, effective as of April 1, 1992, is incorporated herein by reference to Exhibit 10(lxv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxvi) Master Trust Agreement dated as of October 1, 1992, is incorporated herein by reference from Exhibit 10(cv) of NACCO's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 1-9172. X-9 * (lxvii) Instrument of Amendment and Merger, effective as of November 1, 1992, of the July 1, 1986 Trust Agreement between Bergen Bull and Roger Jensen and Hyster Company into the Master Trust Agreement dated October 1, 1992 by and between State Street Bank and Trust Company and NACCO, is incorporated herein by reference to Exhibit 10(lxvii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxviii) Tenth Amendment to the Yale Materials Handling Corporation Employee Profit Sharing and Stock Ownership Plan, effective April 1, 1992, is incorporated herein by reference to Exhibit 10(lxviii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxix) Eleventh Amendment to the Yale Materials Handling Corporation Profit Sharing Retirement Plan, effective as of April 1, 1992, is incorporated herein by reference to Exhibit 10(lxix) to the Company's Annual Report on Form 10-K for the fiscal ear ended December 31, 1992, Commission File Number 33-28812. * (lxx) Twelfth Amendment to the Yale Materials Handling Corporation Profit Sharing Retirement Plan, effective as of November 1, 1992, is incorporated herein by reference to Exhibit 10(lxx) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxxi) The Yale Materials Handling Corporation Deferred Incentive Compensation Plan, dated March 1, 1984, also known as the Yale Materials Handling Corporation Short-Term Incentive Deferral 1992, is incorporated herein by reference to Exhibit 10(lxxi) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxxii) Release and Settlement Agreement between the Company and J. Phillip Frazier, dated as of August 31, 1992, is incorporated herein by reference to Exhibit 10(lxxii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. * (lxxiii) Separation Terms and Conditions Agreement between the Company and Jerry R. Findley, dated July 15, 1992, is incorporated herein by reference to Exhibit (lxxiii) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. X-10 (lxxiv) Amendment Number 7 to the Credit Agreement, dated as of May 19, 1992, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(lxxiv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. (lxxv) Amendment Number 8 to the Credit Agreement, dated as of January 14, 1993, among Citicorp North America, Inc., the Company, Yale Materials Handling Corporation and Hyster Company is incorporated herein by reference to Exhibit 10(lxxv) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 33-28812. (lxxvi) Amended and Restated Credit Agreement, dated July 30, 1993, among Hyster-Yale Materials Handling, Inc., Hyster Company, Yale Materials Handling Corporation, the Lender's party thereto and Citicorp North America, Inc. (individually and as Agent) is incorporated herein by reference to Exhibit 10(lxxvi) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, Commission File Number 33-28812. (lxxvii) Termination of Lease and Bill of Sale dated October 1, 1993 between Brunswick and Glynn County Development Authority and Hyster Company is attached hereto as Exhibit 10(lxxvii). (lxxviii) Agreement and Plan of Merger dated as of December 20, 1993 between Hyster Company, an Oregon corporation, and Hyster Company, a Delaware corporation, is attached hereto as Exhibit 10(lxxviii). (lxxix) Agreement and Plan of Merger dated as of December 20, 1993 between Yale Materials Handling Corporation, a Delaware corporation, Hyster Company, a Delaware corporation, and Hyster-Yale Materials Handling, Inc., a Delaware corporation, is attached hereto as Exhibit 10(lxxix). X-11 (lxxx) Reaffirmation Amendment and Acknowledgement Agreement dated July 30, 1993 among Hyster-Yale Materials Handling, Inc., Yale Materials Handling Corporation, Hyster Company, NACCO Industries, Inc. and Citicorp North America, Inc., individually and as Agent for the various Lenders, is attached hereto as Exhibit 10(lxxx). (lxxxi) Amendment No. 1 dated as of December 31, 1993 to the Amended and Restated Credit Agreement dated as of July 30, 1993 among Hyster-Yale Materials Handling, Inc., Yale Materials Handling Corporation, Hyster Company, the Lenders party thereto, and Citicorp North America, Inc.,individually and as Agent, is attached hereto as Exhibit 10(lxxxi). (lxxxii) Reaffirmation, Amendment and Acknowledgement Agreement dated as of December 31, 1993 among Hyster-Yale Materials Handling, Inc., Yale Materials Handling Corporation, Hyster Company and Citicorp North America, Inc., as Agent for the Lenders, is attached hereto as Exhibit 10(lxxxii). (lxxxiii) Reaffirmation, Amendment and Acknowledgement Agreement dated as of January 1, 1994 among Hyster-Yale Materials Handling, Inc., NACCO Materials Handling Group, Inc. and Citicorp North America, Inc., as Agent for the Lenders, is attached hereto as Exhibit 10(lxxxiii). * (lxxxiv) Amendment No. 1 dated as of May 13, 1993 to the Hyster-Yale Profit Sharing Plan is attached hereto as Exhibit 10(lxxxiv). * (lxxxv) Amendment No. 2 dated effective January 1, 1994 to the Hyster-Yale Profit Sharing Plan is attached hereto as Exhibit 10(lxxxv). * (lxxxvi) Amendment No. 1 dated as of May 27, 1993 to the Hyster-Yale Cash Balance Plan is attached hereto as Exhibit 10(lxxxvi). X-12 * (lxxxvii) Amendment No. 2 dated effective January 1, 1994 to the Hyster-Yale Cash Balance Plan is attached hereto as Exhibit 10(lxxxvii). * (lxxxviii) Amendment No. 1 effective as of May 12, 1993 to the Hyster-Yale Long-Term Incentive Compensation Plan is attached hereto as Exhibit 10(lxxxviii). * (lxxxix) Amendment No. 1 effective January 1, 1994 to the Hyster-Yale Unfunded Benefit Plan is attached hereto as Exhibit 10(lxxxix). * (lxxxx) Amendment No. 1 effective as of December 31, 1993 to the Hyster-Yale Annual Incentive Compensation Plan is attached hereto as Exhibit 10(lxxxx). * (lxxxxi) Thirteenth Amendment dated February 15, 1993 to the Yale Materials Handling Corporation Profit Sharing Retirement Plan is attached hereto as Exhibit 10(lxxxxi). * (lxxxxii) Master Trust Agreement for Defined Benefit Plans between NACCO Industries, Inc. and State Street Bank and Trust Company dated January 1, 1994 is incorporated herein by reference to Exhibit 10(cxxxviii) to NACCO Industries, Inc. report on Form 10-K for the year ended December 31, 1993, Commission File Number 1-9172. * (lxxxxiii) Amendment No. 2 effective as of December 31, 1993 to the Hyster-Yale Long-Term Incentive Compensation Plan is attached hereto as Exhibit 10(lxxxxiii). (21) Subsidiaries of the Registrant. (i) The subsidiaries of the Company are attached hereto as Exhibit 21(i). X-13 (24) Powers of Attorney (i) A manually signed copy of a power of attorney for Owsley Brown II is attached hereto as Exhibit 24(i). (ii) A manually signed copy of a power of attorney for John J. Dwyer is attached hereto as Exhibit 24(ii). (iii) A manually signed copy of a power of attorney for Robert M. Gates is attached hereto as Exhibit 24(iii). (iv) A manually signed copy of a power of attorney for E. Bradley Jones is attached hereto as Exhibit 24(iv). (v) A manually signed copy of a power of attorney for Dennis W. LaBarre is attached hereto as Exhibit 24(v). (vi) A manually signed copy of a power of attorney for Yoshinori Ohno is attached hereto as Exhibit 24(vi). (vii) A manually signed copy of a power of attorney for Alfred M. Rankin, Jr. is attached hereto as Exhibit 24(vii). (viii) A manually signed copy of a power of attorney for Claiborne R. Rankin is attached hereto as Exhibit 24(vii). (ix) A manually signed copy of a power of attorney for John C. Sawhill is attached hereto as Exhibit 24(ix). X-14 (x) A manually signed copy of a power of attorney for Ward Smith is attached hereto as Exhibit 24(x). (xi) A manually signed copy of a power of attorney for Britton T. Taplin, is attached hereto as Exhibit 24(xi). (xii) A manually signed copy of a power of attorney for Frank E. Taplin, Jr. is attached hereto as Exhibit 24(xii). (xiii) A manually signed copy of a power of attorney for Richard B. Tullis is attached hereto as Exhibit 24(xiii). * Management Contract or Compensation Plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of this Annual Report on Form 10-K. X-15

854087_1993.txt

854087_1993

1993

854087

ITEM 1. BUSINESS Fairwood Corporation, formerly MHS Holdings Corporation ("Fairwood" or the "Company"), is a privately-held Delaware corporation organized in 1988 by investors including Citicorp Venture Capital Limited ("CVCL") for the purpose of acquiring all of the common stock of Mohasco Corporation ("Mohasco"). In 1988 Fairwood, through its wholly-owned subsidiary MHS Acquisition Corporation ("Acquisition"), acquired by tender offer a majority of the common stock of Mohasco. In September 1989, Acquisition was merged with Mohasco (the "Merger") and Mohasco thereby became a wholly-owned subsidiary of Fairwood. The principal executive offices of the Company are located at c/o Mohasco Corporation, 4401 Fair Lakes Court, Suite 100, Fairfax, Virginia 22033. The Company's primary asset is all of the common stock of Mohasco. On December 31, 1988, Mohasco sold all of the issued and outstanding capital stock of its wholly owned subsidiaries, Mohasco Carpet Corporation ("Carpet") and Cort Furniture Rental Corporation ("Rental"). In connection with the sale of the capital stock of Rental, the Company received an aggregate amount of approximately $151.1 million, in the form of promissory notes and assumption of long-term indebtedness and lease obligations of Rental. Approximately $21.0 million of the promissory notes was prepaid in December 1989 and the balance was prepaid in January 1990. In an effort to better meet the service and delivery requirements of West Coast customers and to further penetrate the large West Coast regional market, the Company opened an upholstered furniture manufacturing plant in Ontario, California in the last quarter of 1990 and expanded this operation by adding a warehouse in 1992. Correspondingly, the Company's Clinton, North Carolina plant was closed in 1991 due to a shift in the geographical demand for the Company's upholstered furniture and such plant is under contract for sale. Clinton production was shifted to New Albany and Okolona, Mississippi and Ontario, California. On March 10, 1992, Mohasco, the Company's principal operating subsidiary, entered into two Agreements and Plans of Merger, which provided for the disposition of two wholly owned subsidiaries, Chromcraft Corporation ("Chromcraft") and Peters-Revington Corporation ("Peters-Revington") to Chromcraft Revington, Inc., an affiliate. The mergers were consummated on April 23, 1992 and the proceeds of the disposition were used by Mohasco to repay long-term debt owed to Court Square Capital Limited ("CSCL"), an affiliate of CVCL, under Mohasco's Credit Agreement with CSCL (the "Credit Agreement"). Through its subsidiaries, the Company manufactures upholstered stationary and motion furniture, furniture mechanisms for motion furniture, such as sleepers, recliners and rockers and mechanisms for office furniture, hospital beds and related health care products. - 2 - OPERATIONS The Company, through its subsidiary, Mohasco, and Mohasco's subsidiaries, serves selected segments of the highly diversified $19+ billion residential furniture market. The Company's operations engage in the manufacture and sales of a diversified line of upholstered furniture under several brand names, as well as furniture mechanisms. While most of its products are moderately priced and designed to appeal to a wide range of furniture buyers, certain products have been successfully targeted to a more selective, higher priced market. The products are sold nationally to furniture retailers and department stores mainly through commissioned sales forces. Mohasco entered the furniture industry through a series of acquisitions commencing in 1964. There are currently three separate operating companies, organized as two subsidiaries of Mohasco. Each company markets and manufactures one or more specific brands of furniture. The Stratford Company ("Stratford") makes and sells mid-priced upholstered stationary and motion furniture under the brand names of Stratford, Stratolounger, Stratopedic and Avon. The Barcalounger Company ("Barcalounger") manufactures and sells higher-priced motion furniture and is well known for its high-quality recliners. Super Sagless Corporation ("Super Sagless") is a major fabricator of recliner, incliner, rocker, glider and sleeper mechanisms which are sold throughout the furniture industry. In 1992, Super Sagless added the tilt swivel for office chairs to its line of mechanisms and entered the hospital bed market with a portable hospital bed for home use as well as a line of beds for hospitals and related products. The furniture industry is affected to a substantial degree by style, value and fashion. The subsidiaries of Mohasco participate in important furnishings market showings held during the year in a number of larger cities to acquaint retailers with the significant number of new products introduced each year. The Company frequently reviews its product lines to evaluate whether minor or major restyling of such lines is warranted. To generate new product and style ideas based upon consumer and retailer response, the companies maintain in-house design staffs and contract with outside designers. The designers consult with manufacturing management to analyze the economic feasibility of producing new products based on their designs. The marketing strategy of Stratford is to maintain and increase its market share in the upholstered furniture market by anticipating trends in furniture fashions and responding to the many changes in consumer and retailer demand. Stratford's goal is to provide moderate pricing and to offer selling support at the retail level for customers in the form of sales aids, promotions, advertising plans and programs as well as training for the retail customers' salespeople. Accordingly, management must develop product lines with appealing style, in various targeted price ranges that provide good value via efficient production methods and technologies. This adaptive process requires market sensitivity, a close and empathetic relationship with retailers, and tight controls with flexibility in the manufacturing process. Stratford is extremely proud of its reputation as an innovator in modular and motion upholstery furniture designs and the high-quality tailoring of its products compared to similarly and higher-priced competitive furniture. Barcalounger targets a selected market for its high-end recliner chair and living room motion furniture. Barcalounger sells mainly to furniture stores - 3 - that carry more expensive products and provide interior design services directly or indirectly. Barcalounger gives extensive warranties for its products. The value and fine quality of their furniture is apparent as only hardwood frames are used and only the finest leathers and fabrics are offered. Barcalounger has significant brand recognition and has a reputation of having one of the best product lines in terms of value, quality, design and service in the more expensive segment of the motion furniture industry. They have the distinction of introducing the latest technology in motion mechanisms which they design, develop and tool for their own exclusive use. Approximately 30%, 25% and 28% in 1993, 1992 and 1991, respectively, of Super Sagless' production of mechanisms were sold to other Mohasco subsidiaries and the remainder were sold to other furniture manufacturers who do not manufacture their own mechanisms. The health care product line is sold to dealers. Super Sagless operates a large metal fabrication plant with low, well controlled costs. Super Sagless' marketing strategy is to press this advantage to expand their sales to motion furniture and office chair manufacturing while continuing to seek other related metal fabrication sales in other industries and developing and expanding their health care product line business. Stratford and Barcalounger are well known in the furniture industry which is characterized by a large number of relatively small manufacturers. The following are among the Company's larger competitors: Masco Corporation, Interco Industries, La-Z-Boy, Sealy, LADD Furniture, and Bassett. Competition is intense at all levels, stressing price, style, fabric and product finish. FACTORS AFFECTING THE HOME FURNISHINGS INDUSTRY The furniture industry as a whole is affected by demographics, household formations, the level of personal discretionary income, household mobility and the rate of new home construction. There exists a substantial replacement market that is relatively less affected by these factors. RESEARCH AND DEVELOPMENT Since the furniture industry is characterized by active competition among a large number of companies, many of which also have substantial facilities and resources, the Company believes that the maintenance of high product quality and the development of new products are essential to maintaining its competitive position. In support of these goals, the Company conducts research and development activities which are decentralized and directed by the individual operating companies. The operating divisions, excluding Chromcraft and Peters-Revington, expended a total of $22,030,000 in the past five years for research and development programs of which $4,043,000, $3,853,000 and $4,325,000 were expended in 1993, 1992 and 1991, respectively. EMPLOYEES The Company and its subsidiaries employed 3,539 persons at December 31, 1993. Mohasco has a long record of generally harmonious relations with employees. - 4 - BACKLOG The backlog of orders among the Company's furniture operations was approximately $26,345,000 at December 31, 1993 and approximately $24,110,000 at December 31, 1992. It is expected that the backlog at December 31, 1993 will be filled in the current year. The Company does not consider backlog to be a significant indicator of the sales outlook for its products beyond the period of a few months. SEASONALITY AND CUSTOMERS There are seasonal factors which affect the Company's business. Spring and fall are generally considered periods of increased interest by consumers in interior furnishings since these are periods of increased real estate activity involving relocation of families. The Christmas holiday season and other special occasions usually generate increased sales of some of the Company's furniture lines. On the other hand, inclement weather in mid-winter generally discourages the purchase of interior furnishings. Similarly, the closedown of a portion of the Company's activities for vacation periods of one or two weeks in July has a limiting effect on production as well as sales. The Company maintains adequate levels of inventory to meet seasonal demands. Sears accounted for approximately sixteen, thirteen and nine percent of the Company's furniture sales during the years 1993, 1992 and 1991, respectively. Export sales have not been significant. ENVIRONMENTAL AND RAW MATERIALS In 1993, there were no significant effects upon the capital expenditures, earnings and competitive position of the Company and its subsidiaries occasioned by compliance with provisions of federal, state and local laws regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment. Raw materials purchased by the Company are all procured in the open market from a number of suppliers. In general, no major difficulties have been experienced in obtaining raw materials. PATENTS Patents are not a significant consideration in the manufacture of most of the Company's products. The Company does not believe that its operating income is materially dependent on any one patent or license or group of related patents or licenses. ITEM 2. ITEM 2. PROPERTIES The furniture manufacturing activities of the Company are conducted in modern facilities of suitable construction. These facilities are in good operating condition, reasonably maintained and contain reasonably modern equipment. All of the principal items of machinery and equipment located in these facilities are owned by the subsidiaries of Mohasco. - 5 - The Company's subsidiaries also lease showroom and warehouse space throughout the United States for display and storage of products. Mohasco owned until March 1993 an office building located in Fairfax, Virginia. Office space is now leased. The Company believes that the plants and facilities, in the aggregate, are adequate, suitable and of sufficient capacity for purposes of conducting its current business. As of December 31, 1993, the Company's subsidiaries have twelve plants and furniture facilities located in three states, California, North Carolina and Mississippi, occupying a total of approximately 3.0 million square feet. Of these plants and facilities, a total of approximately .1 million square feet of floor space is owned by the subsidiaries of Mohasco. A total of 2.9 million square feet is leased under long-term leases with various municipalities and counties with various expiration dates extending to 2048. Substantially all of the assets of Mohasco and its subsidiaries are subject to a lien in favor of CSCL granted in connection with the Credit Agreement. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Internal Revenue Service ("IRS") has completed the audit examination of the consolidated Federal income tax returns of the Company and its subsidiaries, including Mohasco (the "Consolidated Group"), for the years ended December 31, 1988 through December 31, 1991, and has delivered to the Company a "30-day letter" and Revenue Agent's Report ("RAR") proposing to adjust the Company's taxable income in the years in issue and in prior years to which net operating losses of the Consolidated Group were carried back. The cumulative proposed deficiency in Federal income tax arising from the proposed adjustments is approximately $63 million, before applicable statutory interest. The Company estimates that the aggregate proposed liability would, together with statutory interest through the year ended December 31, 1993, and net of any applicable deduction for such interest, total $90 million. The principal issues addressed in the RAR are (i) the proposed disallowance of approximately $164 million of interest expense claimed by the Consolidated Group with respect to debt incurred in connection with the 1988 acquisition of Mohasco by the Company under the theory that such debt should be recharacterized as equity for tax purposes, (ii) the proposed disallowance of approximately $18 million of investment banking, legal and other fees incurred by the Consolidated Group and deducted in the years in issue under the theory that such expenses are capital in nature and related theories, and (iii) the proposed disallowance of approximately $4 million of compensation expense deducted by the Consolidated Group under the theory that such expense constitutes non-deductible "golden parachute" payments. The Company believes that the proposed adjustments are in error and intends to contest vigorously this matter. Under available administrative procedures, the Company will protest the proposed adjustments and request a conference or conferences with the IRS Appeals division. Depending upon the outcome of discussions of the issues with the IRS Appeals division, the Company may litigate one or more of the issues. On October 14, 1993, Mohasco was served with a complaint filed in U.S. District Court in Philadelphia by third party plaintiffs against Mohasco and its former subsidiary, Sloane Blabon Corporation, which engaged in the linoleum business, U.S. vs. Berks Associates, et al., Civ. No. 91-4868, U.S.D.C., E.D. PA. - 6 - The original complaint in the case was filed by the Environmental Protection Agency against Berks Associates and others to recover over $200 million from twelve defendants (not including Mohasco) for costs incurred or to be incurred in connection with the investigation and remediation of a Super Fund site in Douglasville, PA. The original defendants then sued over 600 third party defendants to share in the liability, if any. Sloane Blabon is alleged to have disposed of benzine at the site from 1949 through May, 1953, when Sloane Blabon sold the relevant assets to Congoleum Corporation. During that period, Sloane Blabon disposed of substantial quantities of benzine to Berks Associates at the Douglasville site. The Company does not believe its disposals were toxic as alleged. The damages sought from Sloane Blabon and Mohasco are unspecified. On November 1, 1993, the Company filed a Notice and Certification denying the charges. The Company believes the charges are without merit and that it has valid defenses to the claims. At present, no trial date has been set. As of the date hereof, there are certain other legal proceedings pending, which arise out of the normal course of the Company's business, the financial risk of which is not considered material in relation to the consolidated financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREOWNER MATTERS The Registrant's common stock is privately held. At year end 1993 and 1992, there were three shareowners of the Company's common stock. No dividends were declared on the Company's common stock in 1993 and 1992. The ability of the Company to pay dividends and make distributions in respect of its common stock is restricted by instruments relating to the Company's debt. Futhermore, the ability of Mohasco and its subsidiaries to transfer monies to the Company (including without limitation by dividend or distribution) is restricted by instruments relating to Mohasco's and its subsidiaries' debt, including the Credit Agreement. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" and Note 4 to the Company's Consolidated Financial Statements set forth in Item 8. Common stock purchase warrants issued by the Registrant in connection with the Merger are held by the public. The common stock purchase warrants become exercisable in September 1994. See Note 4 to the Company's Consolidated Financial Statements set forth in Item 8. The warrant exercise price is $1 per share (subject to adjustment). There is no established market for the Registrant's common stock purchase warrants. - 7 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FAIRWOOD CORPORATION AND SUBSIDIARIES Five Year Summary of Financial Data (Dollar Amounts in Millions Except Per Share Data) The Company acquired Mohasco in a purchase transaction deemed to be effective as of July 3, 1988. In 1992, the excess of purchase cost over fair value of assets acquired in the purchase of Mohasco was written off due to the determined unrecoverability of these costs. Also in 1992, operations data includes the activities of Chromcraft and Peters-Revington for the period ended April 23, 1992. Accordingly, the data presented for 1993 and 1992 is not comparable with one another or prior periods. The provision for income taxes associated with Rental's prepayment of promissory notes in 1989 and 1990 are reflected in discontinued operations. For additional information, see the Company's Consolidated Financial Statements included with this report, including Notes 3 and 12 thereto regarding certain tax and liquidity matters. - 8 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following table indicates the percentage of sales accounted for by certain items in the Consolidated Statements of Operations. 1993 VS 1992 Net sales of approximately $261.4 million for 1993 decreased slightly from 1992 net sales of approximately $267.0 million, due to the disposition of Chromcraft and Peters-Revington in April 1992. Excluding Chromcraft and Peters-Revington, net sales for 1993 were approximately $261.4 million as compared to approximately $231.5 million for 1992, an increase of approximately 13%, primarily due to an increase in the number of units sold of upholstered furniture in 1993. Cost of sales decreased in 1993 to approximately $221.5 million from approximately $233.8 million in 1992, primarily due to the disposition of Chromcraft and Peters-Revington. Excluding Chromcraft and Peters-Revington, cost of sales were approximately $221.5 million and $206.9 million for 1993 and 1992, respectively, or 84.7% and 89.4% of sales for 1993 and 1992, respectively. The 4.7% reduction in cost of sales as a - 9 - percentage of sales from 1992 to 1993, while sales increased approximately 13%, was primarily due to favorable manufacturing variances associated with higher volume of production and cost reduction and quality improvement programs at all subsidiary company manufacturing facilities. These programs include the streamlining of work flows, utilization of cellular production techniques, establishment of focused factory systems and implementation of benchmarking methods to lower and control both unit and factory overhead costs. Selling, administrative and general expenses decreased to approximately $38.0 million in 1993 from approximately $51.7 million in 1992, in part due to the disposition of Chromcraft and Peters-Revington. Excluding Chromcraft and Peters-Revington, selling, administrative and general expenses were approximately $38.0 million and $46.5 million for 1993 and 1992, respectively. This decrease in selling, administrative and general expenses from 1992 to 1993 is primarily due to more effective utilization of resources and reduction of personnel due to the consolidation of administrative functions. Other expenses, net, decreased approximately $2.4 million to approximately $4.3 million in 1993 from approximately $6.7 million in 1992, primarily due to recording in 1992 anticipated losses in connection with the sale, completed in March 1993, of the Company's Fairfax, Virginia office building, and the transfer of corporate functions to the operating companies, which were partially offset by 1993 losses on sales of property and costs associated with divested operations. 1992 VS 1991 Net sales for 1992 decreased from 1991 sales of approximately $341.4 million to approximately $267.0 million, primarily due to the disposition of Chromcraft and Peters-Revington. Excluding Chromcraft and Peters-Revington, net sales for 1992 were approximately $231.5 million compared to approximately $225.3 million for 1991, an increase of approximately 2.8% primarily due to the number of units sold of upholstered furniture in 1992. Cost of sales for 1992 decreased to approximately $233.8 million from approximately $290.9 million in 1991, primarily due to the disposition of Chromcraft and Peters-Revington. Excluding Chromcraft and Peters-Revington, cost of sales were approximately $206.9 million and $203.8 million for 1992 and 1991, respectively, or 89.4% and 90.5% of sales for 1992 and 1991, respectively. The improvement in the percentage of sales is primarily due to favorable manufacturing variances associated with higher volume of production and a cost reduction program. Selling, administrative and general expenses decreased to approximately $51.7 million in 1992 from approximately $62.4 million in 1991, primarily due to the disposition of Chromcraft and Peters-Revington. Excluding Chromcraft and Peters-Revington, selling, administrative and general expenses were approximately $46.5 million and $46.4 million in 1992 and 1991, respectively. Other expenses increased approximately $5.8 million to approximately $6.7 million in 1992 from approximately $.9 million in 1991, primarily due to anticipated losses in connection with the sale, completed in March 1993, of the Company's Fairfax, Virginia office building and the transfer of many corporate functions to the operating companies. - 10 - A restructuring charge of approximately $85.9 million in 1992 was due to the write-off of the excess of purchase cost over the fair value of assets acquired in the 1988 purchase of Mohasco due to the unrecoverability of these costs. The Company determined that the write up in assets resulting from the 1988 purchase was unrecoverable due to the continuing significant losses of the operating companies, and a lower of cost or market analysis of the Company's assets. PROVISION FOR INCOME TAXES An income tax refund receivable, included in other accounts and notes receivable on the balance sheet, of approximately $1.4 million was recorded in 1993 due to an operating loss carryback. A cumulative effect of change in accounting principle of $2.1 million was recorded in 1993, which is described in Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements. Due to the taxable income generated as a result of the disposition of Chromcraft and Peters-Revington, the Company provided for taxes of approximately $4.5 million in 1992, which were partially offset by the utilization of a net operating loss carry-forward of approximately $1.9 million, shown as an extraordinary item on the Consolidated Statements of Operations, yielding a net provision of approximately $2.6 million. The Company had a tax benefit of approximately $7.4 million in 1991 due to an operating loss carryback. Please refer to Note 3, Income Taxes, in the Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Capital requirements for operations during 1993 and 1992 were provided by financing channels and operating cash flow. The Company had working capital of approximately $43.3 million and $23.1 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the Company had long-term debt of approximately $386.0 million of which $.2 million was current. Long-term debt at December 31, 1992 was approximately $330.8 million of which $.1 million was current. In April 1992, the proceeds to Mohasco from the disposition of Chromcraft and Peters-Revington were used to repay secured, senior debt of Mohasco and its subsidiaries in the approximate amount of $83 million. All outstanding debt at December 31, 1993 and 1992, excluding the merger debentures and capitalized lease obligations, is payable to CSCL, which is an indirect subsidiary of Citicorp, a bank holding company, and an affiliate of CVCL. The Company will attempt either to refinance, or negotiate an extension of, the debt payable to CSCL when due, although there can be no assurance that such attempts will be successful. Interest on the revolving credit loan of Mohasco and its subsidiaries is payable quarterly at 1 1/2% above the prime rate, which prime rate was 6.0% at December 31, 1993. Interest on the senior subordinated debentures of Mohasco is payable semi-annually at 18%. Interest on the senior subordinated pay-in-kind debentures and merger debentures of Fairwood is payable semi-annually at 15 1/2% and 16 7/8%, respectively. The Company has the option until April 1, 1995 to pay interest on its senior subordinated pay-in-kind debentures and merger debentures either by cash or by the distribution of additional securities. Additional securities were issued in lieu of the cash payments of interest due April 1, 1993 and October 1, 1993 on both the senior subordinated pay-in-kind debentures and merger debentures. Accordingly, the principal amount of the Company's senior subordinated pay-in-kind debentures and merger debentures increased by $12.6 million and $8.0 million, respectively, since December 31, 1992. For further details on financing and debt see Note 4 to Consolidated Financial Statements. Capital additions were approximately $4.2 million, $3.2 million and $4.4 million for the years 1993, 1992 and 1991, respectively. Additions for 1994 are budgeted at approximately $5.1 million, primarily for the purchase of new manufacturing equipment. - 11 - Mohasco is expected in 1994 to service debt from its cash flow from operations and available credit facilities. Throughout 1993, 1992 and 1991, Mohasco funded interest obligations related to long-term indebtedness through increased borrowings from CSCL. However, during 1992 the proceeds to Mohasco from the disposition of Chromcraft and Peters-Revington of approximately $83 million were used to repay debt of Mohasco and its subsidiaries. The Company is dependent upon CSCL for funding of its debt service costs. Instruments relating to the revolving credit facility and senior subordinated debentures have been amended and certain provisions thereof waived at various times through March 1994 to provide more favorable terms to Mohasco and, in certain instances, to avoid defaults thereunder. Under the Credit Agreement, relating to the revolving credit facility, Mohasco and its subsidiaries are generally restricted from transferring monies to the Company (including without limitation by dividend or distribution) with the exception of amounts for (a) specified administrative expenses of the Company not exceeding $275,000 per year and (b) payment of income taxes. Futhermore, Mohasco is subject to additional restrictions on transferring monies to the Company (including without limitation by dividend or distribution) under its senior subordinated debentures, which generally require the satisfaction of certain financial conditions for such transfers. Fairwood is subject to additional restrictions on payment or transfer of monies (including without limitation by dividend or distribution) under its senior subordinated pay-in-kind debentures and merger debentures, which generally require the satisfaction of certain financial conditions for such transfers. The Company anticipates that funds provided by operations and available credit facilities will be adequate in 1994 for the capital addition program, working capital requirements and any cash payments then due on the Company's debt. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements and supplementary data are filed as a part of this report: Independent Auditors' Report Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for the Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Common Stock and Other Shareowners' Equity (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 - 12 - Independent Auditors' Report The Shareowners and Board of Directors Fairwood Corporation and Subsidiaries: We have audited the consolidated financial statements of Fairwood Corporation 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 Fairwood Corporation 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 3 to the consolidated financial statements, the Company has been notified by the Internal Revenue Service of proposed adjustments to its Federal income tax returns for the years 1988 through 1991. Such adjustments would result in a net tax cost to the Company of approximately $90 million, including interest, through the year ended December 31, 1993. The Company has indicated that it disagrees with the proposed adjustments and intends to contest vigorously the positions taken by the Internal Revenue Service. The ultimate outcome of these proposed adjustments cannot presently be determined. Accordingly, no provision for any liability that may result upon ultimate resolution of these proposed adjustments has been recognized in the accompanying consolidated financial statements. As discussed in Notes 1 and 3 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, as of January 1, 1993. /s/ KPMG Peat Marwick KPMG Peat Marwick Washington, D.C. February 7, 1994, except as to note (4) which is as of March 25, 1994 - 13 - FAIRWOOD CORPORATION AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1993 and 1992 (In thousands except share data) See accompanying notes to consolidated financial statements. - 14 - FAIRWOOD CORPORATION AND SUBSIDIARIES Consolidated Statements of Operations See accompanying notes to consolidated financial statements. - 15 - FAIRWOOD CORPORATION AND SUBSIDIARIES Consolidated Statements of Common Stock and Other Shareowners' Equity (Deficit) Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to consolidated financial statements. - 16 - FAIRWOOD CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows See accompanying notes to consolidated financial statements. - 17 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements represent a consolidation of the financial statements of Fairwood Corporation ("Fairwood" or the "Company"), and Mohasco Corporation ("Mohasco") and all of its subsidiaries. All inter- company balances, transactions and profits have been eliminated in consolidation. Inventories All inventories (materials, labor and overhead) are valued at the lower of cost or market using the last-in, first-out (LIFO) method. A LIFO liquidation occurred during 1992 and 1991 but did not result in any significant reduction of cost of sales. The components of inventory at December 31 are as follows: See "Restructuring Charge". Property, Plant and Equipment Depreciation and amortization of property, plant and equipment is provided principally on a straight-line basis over the estimated useful lives as follows: buildings and buildings capitalized under long-term leases from 30 to 45 years; machinery and equipment from 3 to 14 years; and leasehold improvements over the term of related leases. Long-term leases for manufacturing and warehousing facilities which were constructed by various local governmental bodies have been capitalized. Statements of Cash Flows Cash and cash equivalents include cash in banks and highly liquid short-term investments having a maturity of three months or less on the date of purchase. - 18 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, ("Statement 109"). Statement 109 requires a change from the deferred method of accounting for income taxes to the asset and liability method. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date of the change in tax rates. Effective January 1, 1993, the Company adopted Statement 109. The adoption of Statement 109 resulted in a cumulative effect adjustment of $2,100,000 which reduced the net loss for 1993, and which is reflected in the 1993 statement of operations. Under the deferred method, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting and tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Restructuring Charge In December 1992, the excess of purchase cost over the fair value of assets acquired in the 1988 and 1989 purchase of Mohasco was written off due to the unrecoverability of these costs. The charge includes the following costs: The Company determined that the write up in assets resulting from the purchase was unrecoverable due to the continuing significant losses of the operating companies, and a lower of cost or market analysis of the Company's assets. - 19 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (2) Divestitures The disposition of Chromcraft Corporation ("Chromcraft") and Peters- Revington Corporation ("Peters-Revington") to Chromcraft Revington, Inc., an affiliate, occurred in April 1992. The proceeds from the disposition amounted to approximately $83.1 million, approximately $30.9 million greater than the net book value of the net assets of Chromcraft and Peters-Revington. Due to the affiliated nature of the transaction, the $30.9 million was accounted for as contributed capital. The proceeds were used to repay long-term debt owed Court Square Capital Limited ("CSCL"), an affiliate, under Mohasco's Credit Agreement with CSCL (the "Credit Agreement") relating to Mohasco's revolving credit facility. The disposition generated taxable income which resulted in a tax provision for the year 1992. During the four months ended April 23, 1992, Chromcraft and Peters- Revington generated net earnings of approximately $700,000. For 1991 Chromcraft and Peters-Revington generated net earnings of approximately $1,900,000. - 20 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (3) Income Taxes As discussed in note 1, the Company adopted Statement 109 as of January 1, 1993, which resulted in a cumulative effect adjustment of $2,100,000 which decreased the net loss for the year 1993. The effect of Statement 109 on the provision for income taxes for the year 1993 was not material. Components of the provision for income taxes (benefit) are summarized, in thousands, as follows: The differences between the actual taxes (benefit) and taxes (benefit) computed at the U.S. Federal Income tax rate of 34% are summarized as follows: - 21 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements The tax effects of temporary differences as of December 31, 1993, in thousands, are as follows: The valuation allowance for deferred tax assets as of January 1, 1993 was $7,047,000. The net change in the total valuation allowance for the year ended December 31, 1993 was an increase of $19,320,000. At December 31, 1993, the Company's net operating loss carryforwards of approximately $48,356,000 expire in 2008. Certain timing differences exist which cause current income taxes actually payable to differ from the amounts provided as follows: Current deferred income tax benefits of $2,827,000 at December 31, 1993 are included in other current assets in the accompanying consolidated balance sheets. The Internal Revenue Service ("IRS") has examined the Company's Federal income tax returns for the years 1988 through 1991 and is challenging certain deductions, of which the most significant involves an effort to recharacterize interest deductions as dividend distributions. The IRS has delivered proposed adjustments that approximate a net tax cost of $90 million, including interest through the year ended December 31, 1993. The Company believes the IRS's position with respect to these issues is incorrect and plans to contest vigorously the proposed adjustments. The Company cannot predict the ultimate outcome nor the impact on its financial statements, if any. - 22 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (4) Long-term Debt In conjunction with the Company's acquisition of Mohasco by merger on September 22, 1989, certain bridge loans were refinanced with new debt, and in exchange for the approximately 6.85% of Mohasco common stock then outstanding, the Company issued $33.5 million of subordinated pay-in-kind merger debentures and 918,170 warrants (as discussed below) to purchase, in the aggregate, 142,900 shares of the Company's Class A common stock. The assets of Mohasco and its subsidiaries are pledged as security for a portion of the new debt. Certain instruments related to the new debt were amended through March 1994. Among other things, these amendments extended certain debt due dates, increased certain debt limits and credit lines and modified selected financial covenant tests. Certain provisions of these instruments were waived at various times through April 1993. Proceeds from the disposition of Chromcraft and Peters-Revington were used to repay a portion of the new secured debt owed CSCL. The outstanding debt at December 31 was as follows (in thousands): All outstanding debt at December 31, 1993 with the exception of the merger debentures and other is payable to CSCL. Substantially all of the Company's debt instruments restrict the payment of dividends and the Credit Agreement with CSCL, relating to Mohasco's revolving credit facility, contains certain financial covenant tests. The Company plans to attempt to refinance, or negotiate an extension of, the debt payable to CSCL when due. The Company has the option until April 1, 1995 to pay interest on the senior subordinated pay-in-kind debentures and merger debentures either by cash or by the distribution of additional securities. Through October 1, 1993, the Company has issued additional securities in lieu of cash payments of interest. The aggregate maturities of long-term debt (including capitalized lease obligations) during the next five years and thereafter are as follows: $150,000 in 1994; $160,000 in 1995; $240,597,000 in 1996; $180,000 in 1997; $190,000 in 1998; and $144,690,000 subsequent to 1998. The warrants issued with the merger debentures, discussed above, are exercisable during the one-year period beginning on the earliest to occur of: (1) 180 days after the public offering by the Company of common stock meeting certain conditions, (2) the closing of a merger, consolidation or other business combination or a purchase of assets in which the Company is the surviving corporation meeting certain conditions, or (3) September 22, 1994. The warrant exercise price is $1 per share (subject to adjustment). - 23 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (5) Redeemable Preferred Stock The Company issued 1,000 shares of junior preferred stock, par value $.01, in exchange for $100,000, which are held by CSCL. Dividends are accrued at $18 per share annually. As of December 31, 1993, dividends payable are approx- imately $110,000. (6) Common Stock Holders of Class A common stock are entitled to convert their shares to an equal number of Class B common stock and holders of Class B common stock are entitled to convert their shares to an equal number of Class A common stock. (7) Employee Benefit Plans All salaried employees, excluding certain key executives, and hourly paid employees of the Company with one year of service were covered by non-contribu- tory defined benefit retirement plans through May 31, 1993, at which time further benefit accruals ceased. Benefits for the plans are determined using the projected unit credit actuarial cost method. The cost of the retirement plans is accrued annually; funding is in accordance with actuarial requirements of the plans, subject to the Employee Retirement Income Security Act of 1974. Pension expense, in thousands, is as follows: - 24 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Information with respect to the retirement plans for 1993 and 1992 has been determined by consulting actuaries. The following table sets forth the plans' funded status at December 31, 1993 and September 30, 1992, respectively, and reconciles amounts recognized in the consolidated balance sheets at December 31, 1993 and 1992, respectively (in thousands): As a result of the disposition of Chromcraft and Peters-Revington in April 1992, all employees of Chromcraft and Peters-Revington were vested in their retirement benefits under the plans. Effective June 1, 1993, the following defined contribution plans were adopted by the Company's operating companies: BARCALOUNGER RETIREMENT PLAN, designed to provide income at retirement, covers all Barcalounger employees with one or more years of service and is non-contributory. Annual company contributions are based on individual participant's earnings and length of service. For the period June 1, 1993 to December 31, 1993, company contributions were $115,000. BARCALOUNGER SAVINGS PLAN, designed to provide a savings vehicle for Barcalounger employees with one or more years of service who may elect to participate by saving on a before-tax and/or after-tax basis in one or more of four investment funds available. Annual company contributions match 25% of participants' contributions of up to four percent of earnings. For the period June 1, 1993 to December 31, 1993, company matching contributions were $35,000. STRATFORD RETIREMENT PLAN, designed to provide income at retirement, covers all Stratford employees with one or more years of service and is non-contributory. Annual company contributions are based on individual participant's earnings and length of service. For the period June 1, 1993 to December 31, 1993, company contributions were $630,000. - 25 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements SUPER SAGLESS RETIREMENT-SAVINGS PLAN is a retirement income plan fully financed by the company combined with an employee savings plan. All employees with one or more years of service are participants in the retirement income part of the plan and also may elect to invest on a before-tax and/or after-tax basis in one or more of four funds available in the savings part of the plan. Annual company contributions to the retirement income part of the plan are based on individual particpant's earnings and length of service and the company matches 100% of participants' before-tax savings of up to two percent of earnings in the savings part of the plan. For the period June 1, 1993 to December 31, 1993, aggregate company contributions to the plan were $492,000. The Company also maintained a non-qualified retirement plan for certain key executives, who were excluded from participation in Mohasco's Salaried Retirement Plan. Benefits of the executive retirement plan were substantially the same as the Salaried Retirement Plan. The executive retirement plan ceased benefit accruals in December 1992. The cost of this plan was approximately $751,000 in 1992 and $520,000 in 1991. As of December 31, 1993, the plan liabilities are approximately $401,000, and are included in other long-term liabilities. Under various incentive compensation plans, certain employees earned bonuses for reaching specific performance criteria amounting to $964,000 in 1993, $346,000 in 1992 and $1,038,000 in 1991. The Company has an investment plan for all employees. The plan previously covered all employees but, since the adoption of the Barcalounger and Super Sagless plans, noted above, now covers all employees not covered by such plans. Since the time of adoption of the Barcalounger and Super Sagless plans, Barcalounger and Super Sagless participants' account balances were transferred to the Barcalounger and Super Sagless plans. Company contributions to the Company's investment plan were $50,000 in 1993, $177,000 in 1992 and $606,000 in 1991. - 26 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (8) Rental Commitments The Company and its subsidiaries lease certain manufacturing and ware- housing facilities (capitalized leases), equipment (primarily transportation equipment), and warehouse and showroom facilities (operating leases). Future minimum lease payments at December 31, 1993 under all non-cancellable leases are as follows: It is expected that, in the normal course of business, non-cancellable leases that expire will be renewed or replaced. Rental expense was as follows: - 27 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (9) Supplemental Income Statement Information Amounts charged to costs and expenses in the consolidated financial statements include the following: (10) Financial Information by Industry Segments The Company is engaged in only one segment of business, the manufacture of furniture. Sears Roebuck and Co. accounted for approximately sixteen percent, thirteen percent and nine percent of the Company's sales in each of the years 1993, 1992 and 1991, respectively. (11) Contingencies There were contingent liabilities at December 31, 1993 consisting of purchase commitments and legal proceedings arising in the ordinary course of business. The financial risk involved in connection with all contingent liabilities, except the proposed adjustments delivered by IRS, see note 3, is not considered material in relation to the consolidated financial position of the Company. - 28 - FAIRWOOD CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (12) Liquidity Mohasco is expected to service its long-term debt under the Credit Agreement, relating to the revolving credit facility, and senior subordinated debentures from its cash flow from operations and available credit facilities. Interest on Fairwood's senior subordinated pay-in-kind debentures and merger debentures is expected to be paid by distribution of additional securities through September 1994. Fairwood has substantially no assets other than the common stock of Mohasco, and Mohasco and its subsidiaries have pledged substantially all of their assets to secure their obligations under the Credit Agreement. Throughout 1993, 1992 and 1991, Mohasco did not generate sufficient funds from operations to fully meet its interest obligations related to its long-term indebtedness. Mohasco funded these interest obligations through increased borrowings from CSCL under the Credit Agreement. However, during 1992 the proceeds to Mohasco from the disposition of Chromcraft and Peters-Revington of approximately $83 million were used to repay debt of Mohasco and its subsidiaries under the Credit Agreement. The Company is dependent upon CSCL for funding of its debt service costs. CSCL has in the past increased its revolving credit line to Mohasco under the Credit Agreement which has enabled Mohasco to meet its debt service obligations. Under the Credit Agreement, Mohasco and its subsidiaries are generally restricted from transferring monies to the Company with the exception of amounts for (a) specified administrative expenses of the Company not exceeding $275,000 per year and (b) payment of income taxes. The senior subordinated debentures, senior subordinated pay-in-kind debentures and merger debentures also have certain restrictions as to payment and transfer of monies. Management believes that cash flow from operations and funding from CSCL will be adequate for its working capital requirements and any cash payments due on the Company's debt through December 31, 1994. - 29 - 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 DIRECTORS AND EXECUTIVE OFFICERS The name, age and position or principal occupation during the past five years of each member of the Board of Directors and executive officer of the Company are set forth below. Directors serve for a term of one year and until their successors are elected and qualified. Officers are elected annually by the Board of Directors to serve for the ensuing year and until their respective successors are elected. - 30 - The following are subsidiary presidents and may be deemed to be executive officers of the Company. There are no family relationships among any of the Company's directors or officers. The following is a brief account of the business experience during the past five years of each of the subsidiary presidents: Mr. Lake has been employed by the Company since September 1991 in his present position. From prior to 1989 to February 1991 he was Vice President and General Manager of Clark Components N.A. Mr. Shaughnessy has been employed by the Company since July 1992 in his present position. From February 1991 to July 1992 he was Vice President, Marketing, Outboard Marine Corporation, from June 1990 to February 1991 he worked as a consultant and from prior to 1989 to June 1990 he was Senior Vice President, Navistar. In connection with services provided by The Finley Group, a management consulting firm, Mr. Stephens, a principal of that firm, has acted as president of a number of companies; he was president from September 1989 to January 1990 of Southwest Elevator Corporation, from January 1990 to January 1991 of Munford, Inc., from January 1991 to October 1991 of Specialty Paperboard, Inc., from January 1992 to October 1992 of Docktor Pet, Inc. and from October 1992 to April 1993 as President and Chief Executive Officer of the Barcalounger Division of Mohasco Upholstered Furniture Corporation. While continuing in his role as President and Chief Executive Officer of the Barcalounger division, in April 1993, Mr. Stephens became a direct consultant to the Company and in January 1994 an employee of Mohasco Upholstered Furniture Corporation. Prior to joining The Finley Group in September 1989, Mr. Stephens was a partner with Deloitte & Touche, a public accounting firm. - 31 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION EXECUTIVE OFFICERS' COMPENSATION Information concerning the compensation earned by the above named executive officers is set forth in the Summary Compensation Table. SUMMARY COMPENSATION TABLE (1) 1993 and 1991 amounts represent company contributions to the Investment Plan. 1992 includes $150,510 distribution under the Executive Retirement Plan, $5,400 excess of book value over purchase price of company car, and $1,925 company contribution to Salaried Investment Plan. (2) Deferred executive incentive award given in 1989 and payable in 1992. No deferred awards have been given since 1989. (3) 1993 includes $12,916 distribution under the Executive Retirement Plan, $1,518 company contribution to the Super Sagless Retirement-Savings Plan, and $1,375 company contribution to Investment Plan. 1992 amount represents the company contribution to Investment Plan. (4) For the period October 1992 to April 1993, $155,682 was paid to The Finley Group for services it rendered through Mr. Stephens. For the period May 1993 to December 1993, $200,000 was paid to Mr. Stephens as a consultant. EMPLOYMENT AGREEMENT Mohasco entered into an employment agreement with Mr. Sganga, who is named in the summary compensation table, effective December 15, 1993, which provides for an annual salary, plus such bonuses as may be awarded in the discretion of the Board of Directors. This agreement will remain in effect through December 31, 1995 unless terminated sooner with or without cause by the Board of Directors. If employment is terminated without cause, other than due to death or disability or other incapacity, Mr. Sganga will be entitled to receive a severance payment in an amount equal to the lesser of (i) $150,000 and (ii) an amount equal to sum of the base salary payments that he would have received had he remained in the employ of the Company until December 31, 1995. No severance will be paid if termination is for cause, or due to death, disability or other incapacity. - 32 - RETIREMENT PLAN Messrs. Sganga, Lake, Shaughnessy and Stephens, who are named in the Summary Compensation Table, are not participants in the Salaried and Sales Employees Retirement Plan of Mohasco, which ceased further benefit accruals as of May 31, 1993. Mohasco adopted in 1990 a non-qualified non-contributory Executive Retirement Plan for certain of its executives in the operating companies and corporate office, including Messrs. Sganga and Lake. Participants in this plan are not eligible to participate in the Mohasco Salaried and Sales Employees Retirement Plan. Executives designated as participants begin to accrue retirement benefits following completion of one year of employment. Benefits accrued under the plan are reduced by any benefits to which the individual may be entitled under a prior or current defined benefit pension or supplemental retirement plan of Mohasco. In December 1992, benefit accruals were ceased to the Executive Retirement Plan and Messrs. Sganga and Lake received payment in full settlement of the accrued benefit obligation under the plan. Mr. Sganga received $150,510 in 1992 and Mr. Lake received $12,916 in 1993. Messrs. Shaughnessy and Stephens were not eligible to participate in the Executive Retirement Plan. SALARIED INVESTMENT PLAN Officers of Mohasco are eligible to participate in its tax-qualified Investment Plan for Salaried and Sales Employees. Directors who are not officers are not eligible. Mohasco may, but is not obligated to, contribute up to 100% of any savings of a participant not exceeding 4% of salary. The full value of a participant's investment in the plan becomes payable upon retirement, disability or death. Upon termination of employment for other reasons, a participant is entitled to the accumulated value of his or her savings, and to varying amounts of Mohasco's contributions depending on years of membership in the plan, with 100% thereof payable if years of membership are 5 or more. During 1993, such contributions for Mr. Sganga were $1,907 and for Mr. Lake were $1,375. In June 1993, the following defined contribution plans were adopted: Barcalounger Retirement Plan, Barcalounger Savings PLan, Stratford Retirement Plan, and Super Sagless Retirement-Savings Plan. Please refer to note 7, Employee Benefit Plans, in the Notes to Consolidated Financial Statements. The company contribution for Mr. Lake in the Super Sagless Retirement-Savings Plan was $1,518. Mr. Shaughnessy is not a member of the Stratford Retirement Plan and Mr. Stephens was not eligible for membership in the Barcalounger Retirement Plan nor the Barcalounger Savings Plan. INCENTIVE PLAN Mohasco maintains an executive incentive (bonus) plan implemented to provide individual awards for attainment of specified business objectives. Under the executive incentive plan, each of Mohasco's profit centers is assigned certain business goals annually, which for 1993 were based on earnings and cash flow. Awards are made to profit center participants based upon the extent to which their respective profit centers attain their goals. Total awards made for the 1993 Plan Year were $964,000, including awards of $172,975 for Mr. Lake and $141,934 for Mr. Shaughnessy. DIRECTORS' COMPENSATION As of the date of this Annual Report on Form 10-K, the Company has not determined what compensation directors who are not officers of the Company will receive for their service as director. No compensation was paid to directors for their services as directors in 1993. - 33 - COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Company's board of directors does not have a separate compensation committee. Accordingly, the entire board of directors considers executive compensation matters, except that any executive officer who is a director does not take part in executive compensation matters regarding that executive officer. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL STOCKHOLDERS The Company's common stock consists of both voting stock and non-voting stock. The table below sets forth, as of February 28, 1994, certain information regarding each person who owns of record or beneficially 5% or more of the outstanding shares of common stock. Such beneficial owners own their shares directly and have sole voting and investment power with respect to their shares. - --------------------------- * Owns 999,800 shares of the Company's Class B Non-Voting Common Stock and 300 shares of the Company's Class A Voting Common Stock. Under the Company's Certificate of Incorporation, the Class B Non-Voting Common Stock is convertible into Class A Voting Common Stock, so long as the holder of the Class B Stock would be permitted to hold the resulting Class A Stock under applicable law. On December 31, 1990, CVCL and Holdings entered into an Agreement and Plan to Relinquish Control pursuant to which CVCL converted 200 shares of Class B Stock into 200 shares of Class A Stock and increased its ownership of the outstanding Class A Stock from 33-1/3% to 60%. Under this Agreement, CVCL is required to convert a sufficient number of shares of Class A Stock into Class B Stock to reduce CVCL's ownership of Class A Stock such that CVCL will no longer be presumed to have control of Holdings under the regulations of the Small Business Administration upon the earlier of (i) the date on which the Company's ratio of earnings before interest, taxes and depreciation to interest expense on a consolidated basis has been 1.5 to 1 for three consecutive fiscal quarters or (ii) December 31, 1997 (or such later date as may be consented to by the Small Business Administration). The Agreement has been accepted by the Small Business Administration. CVCL is a subsidiary of Citibank, N.A., a national bank which is owned by Citicorp a publicly owned bank holding company, and is an affiliate of CSCL. OWNERSHIP BY DIRECTORS AND OFFICERS As of February 28, 1994, no shares of the Company's common stock were beneficially held by any director or officer. - 34 - ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS As further described in the Company's financial statements in Item 8, a large majority of the Company's long-term debt at December 31, 1993 is payable to CSCL, an affiliate of CVCL, the Company's majority shareowner. M. Saleem Muqaddam, a director of the Company, is a vice president of CVCL and CSCL. During 1993, the largest aggregate amount of indebtedness outstanding that was payable to CSCL was approximately $332.1 million; as of February 28, 1994, the aggregate amount of such indebtedness was approximately $330.1 million. See Note 4, Long-term Debt, in the Notes to Consolidated Financial Statements set forth in Item 8. On December 13, 1989 and January 18, 1990 Rental, a wholly-owned subsidiary of Cort Holdings Corporation ("Cort Holdings"), paid to Mohasco, in cash, approximately $21.5 million and $131.2 million, respectively, as prepayment on all remaining indebtedness outstanding on the promissory notes issued as part of the consideration for the sale of Rental in December 1988. At the time of the payments, CVCL and certain of its affiliates were significant investors in the Company, Mohasco, Rental and Cort Holdings. 399 Venture Partners, Inc., an affiliate of CVCL, owns approximately 49% of Chromcraft Revington, Inc. M. Saleem Muqaddam, vice president of CVCL and director of the Company, is a director of Chromcraft Revington, Inc. - 35 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 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. - 36 - 3. EXHIBITS -------- Exhibits are listed by numbers corresponding to the Exhibit Table of Item 601 in Regulation S-K (3.1) Certificate of Incorporation of the Registrant, as amended (incorporated by reference to Exhibit 3.3 of the Registrant's Registration Statement on Form S-4 (the "Form S-4")). (3.2) By-Laws of the Registrant (incorporated by reference to Exhibit 3.4 of the Form S-4). (3.3) Certificate of Amendment of Certificate of Incorporation, dated March 22, 1993 (incorporated by reference to Exhibit 3.3 of the Registrant's annual report on Form 10-K for the year ended December 31, 1992 (the "1992 Form 10-K")) (4.1) Indenture, dated as of August 15, 1989, between Fairwood Corporation, formerly MHS Holdings Corporation (the "Company") and Bankers Trust Company, as Trustee, relating to the 16-7/8% Subordinated Pay-In-Kind Debentures due 2004 (the "Merger Debentures"), (incorporated by reference to Exhibit 4.1 of the Registrant's third quarter report on Form 10-Q for the quarter ended September 30, 1989 (the "1989 Third Quarter 10-Q")). (4.2) Form of Merger Debentures, included as Exhibit A to Exhibit 4.1, (incorporated by reference to Exhibit 4.2 of the 1989 Third Quarter 10-Q). (4.3) Pledge and Security Agreement, dated as of August 15, 1989, made by the Company to Bankers Trust Company, as Trustee, (incorporated by reference to Exhibit 4.3 of the 1989 Third Quarter 10-Q). (4.4) Warrant Agreement, dated as of August 15, 1989, between the Company and Pittsburgh National Bank, as Warrant Agent, (incorporated by reference to Exhibit 4.4 of the 1989 Third Quarter 10-Q). (4.5) Form of Warrants, included as Exhibit A to Exhibit 4.4, (incorporated by reference to Exhibit 4.5 of the 1989 Third Quarter 10-Q). (4.6) 15-1/2% Senior Subordinated Pay-In-Kind Debentures of the Company, dated as of September 22, 1989, issued to Citicorp Capital Investors Ltd. (incorporated by reference to Exhibit 4.6 of the 1989 Third Quarter 10-Q). (4.7) Pledge and Security Agreement, dated September 22, 1989, made by the Company to Citicorp Capital Investors Ltd., as Agent, (incorporated by reference to Exhibit 4.7 of the 1989 Third Quarter 10-Q). (4.8) Credit Agreement dated as of September 22, 1989 among Mohasco Corporation ("Mohasco"), Mohasco Upholstered Furniture Corporation, Chromcraft Corporation, Super Sagless Corporation, Choice Seats Corporation and Peters Revington Corporation and Citicorp Capital Investors Ltd. (the "Credit Agreement"), (incorporated by reference to Exhibit 4.8 of the Registrant's annual report on Form 10-K for the year ended December 31, 1989 (the "1989 Form 10-K")). (4.9) Amendment, dated December 15, 1989, to the Credit Agreement, (incorporated by reference to Exhibit 4.9 of the 1989 Form 10-K). (4.10) Amendment, dated March 13, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.10 of the 1989 Form 10-K). - 37 - (4.11) Notice of Election and Waiver, dated March 13, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.11 of the Registrant's annual report on Form 10-K for the year ended December 31, 1990 (the "1990 Form 10-K")). (4.12) Term Note B, dated March 13, 1990, issued to Court Square Capital Limited, (incorporated by reference to Exhibit 4.12 of the 1989 Form 10-K). (4.13) Agreement and Waiver, dated August 15, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.13 of the 1990 Form 10-K). (4.14) Agreement and Waiver, dated September 5, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.14 of the 1990 Form 10-K). (4.15) Agreement and Waiver, dated September 15, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.16 of the 1990 Form 10-K). (4.16) Waiver and Amendment, dated September 15, 1990, to the Credit Agreement and letter, dated September 15, 1990, related thereto, (incorporated by reference to Exhibit 4.16 of the 1990 Form 10-K). (4.17) Waiver and Fourth Amendment, dated as of December 31, 1990, to the Credit Agreement, (incorporated by reference to Exhibit 4.17 of the 1990 Form 10-K). (4.18) Revolving Credit Note, dated September 22, 1989, amended and restated as of September 15, 1990, issued to Court Square Capital Limited, and Endorsement No. 1 thereto, dated as of December 31, 1990, (incorporated by reference to Exhibit 4.18 of the 1990 Form 10-K). (4.19) Increasing Rate Senior Subordinated Debentures of Mohasco Corporation dated as of September 22, 1989 issued to Citicorp Capital Investors Ltd. (the "Senior Subordinated Debentures"), (incorporated by reference to Exhibit 4.13 of the 1989 Form 10-K). (4.20) Amendment, dated March 30, 1990, to the Senior Subordinated Debentures, (incorporated by reference to Exhibit 4.14 of the 1989 Form 10-K). (4.21) Second Amendment, dated as of December 31, 1990, to the Senior Subordinated Debentures, (incorporated by reference to Exhibit 4.21 of the 1990 Form 10-K). (4.22) Endorsement No. 1, dated as of December 31, 1990, to the Senior Subordinated Debentures, (incorporated by reference to Exhibit 4.22 of the 1990 Form 10-K). (4.23) Waiver, dated as of June 29, 1991, to the Credit Agreement, (incorporated by reference to Exhibit 4.23 of the Registrant's annual report on Form 10-K for the year ended December 31,1991 (the "1991 Form 10-K")). (4.24) Waiver, dated as of October 31, 1991, to the Credit Agreement, (incorporated by reference to Exhibit 4.24 of the 1991 Form 10-K). (4.25) Letter Agreement, dated as of October 31, 1991, between the Company and Manufacturers Hanover, as Warrant Agent and letter from Pittsburgh National Bank, dated October 28, 1991, related thereto, (incorporated by reference to Exhibit 4.25 of the 1991 Form 10-K). (4.26) Waiver and Fifth Amendment, dated as of March 27, 1992, to Credit Agreement, (incorporated by reference to Exhibit 4.26 of the 1991 Form 10-K). - 38 - (4.27) Third Amendment, dated as of March 27, 1992, to the Senior Subordinated Debentures, (incorporated by reference to Exhibit 4.27 of the 1991 Form 10-K). (4.28) Endorsement No. 2, dated as of March 27, 1992, to the Senior Subordinated Debentures, (incorporated by reference to Exhibit 4.28 of the 1991 Form 10-K). (4.29) Sixth Amendment, dated as of April 23, 1992, to Credit Agreement, (incorporated by reference to Exhibit 4.1 of the Registrant's second quarter report on Form 10-Q for the quarter ended June 27, 1992 (the "1992 Second Quarter 10-Q")). (4.30) Seventh Amendment, dated as of April 23, 1992, to Credit Agreement, (incorporated by reference to Exhibit 4.2 of the 1992 Second Quarter 10-Q). (4.31) Eighth Amendment, dated as of September 26, 1992, to Credit Agreement, (incorporated by reference to Exhibit 4.1 of the Registrant's third quarter report on Form 10-Q for the quarter ended September 26,1992 (the "1992 Third Quarter 10-Q")). (4.32) Waiver and Ninth Amendment, dated as of February 4, 1993, to Credit Agreement, (incorporated by reference to Exhibit 4.32 of the 1992 Form 10-K. (4.33) Tenth Amendment, dated as of March 22, 1993, to Credit Agreement, (incorporated by reference to Exhibit 4.33 of the 1992 Form 10-K. (4.34) Recision of Waiver, dated as of April 30, 1993, to Credit Agreement, (incorporated by reference to Exhibit 4.1 of the Registrant's first quarter report on Form 10-Q for the quarter ended April 3, 1993 (the "1993 First Quarter 10-Q")). (4.35) Eleventh Amendment, dated as of March 25, 1994, to Credit Agreement. (4.36) Fourth Amendment, dated as of January 3, 1994, to the Senior Subordinated Debentures. (10.1) Employment Agreement, between Mohasco and Robert W. Hatch, dated September 21, 1989, (incorporated by reference to Exhibit 10.1 of the 1989 Form 10-K). (10.2) Supplemental Executive Retirement Agreement, between Mohasco and Robert W. Hatch, dated September 27, 1990, (incorporated by reference to Exhibit 10.2 of the 1990 Form 10-K). (10.3) Mohasco Executive Retirement Plan, (incorporated by reference to Exhibit 10.5 of the 1990 Form 10-K). (10.4) Mohasco Corporation Executive Incentive Plan, (incorporated by reference to Exhibit 10.6 of the 1990 Form 10-K). (10.5) Amendment, dated December 31, 1991, to the Mohasco Executive Retirement Plan, (incorporated by reference to Exhibit 10.6 of the 1991 Form 10-K). (10.6) Merger Agreement dated March 10, 1992 among Chromcraft Revington, Inc., Chromcraft Merger Subsidiary, Inc., Mohasco Corporation, Chromcraft Corporation and the Company, (incorporated by reference to Exhibit 10.1 of the March 17, 1992 Form 8-K). (10.7) Merger Agreement dated March 10, 1992 among Chromcraft Revington, Inc., PR Merger Subsidiary, Inc., Mohasco Corporation, Peters-Revington Corporation and the Company, (incorporated by reference to Exhibit 10.2 of the March 17, 1992 Form 8-K). (10.8) Employment Agreement, between Mohasco and John B. Sganga, dated December 15, 1993. (21.1) List of Subsidiaries of the Registrant. - 39 - The Company agrees to furnish the Securities and Exchange Commission, upon request, a copy of any instrument defining the rights of holders of long term debt of the Company and its consolidated subsidiaries. (B) REPORTS ON FORM 8-K No reports were filed on Form 8-K for the three months ended December 31, 1993. - 40 - Schedule V FAIRWOOD CORPORATION AND SUBSIDIARIES Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (In Thousands) Notes: (1) Represents the difference between expenditures for new construction during the year and the cost of completed projects transferred to appropriate captions. (2) Includes adjustments relating to the disposition of Chromcraft and Peters-Revington of $24,371 and restructuring charge of $9,618. - 41 - Schedule VI FAIRWOOD CORPORATION AND SUBSIDIARIES Accumulated Depreciation and Amortization of Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (In Thousands) Notes: (1) Represents adjustments relating to the disposition of Chromcraft and Peters-Revington. - 42 - Schedule VIII FAIRWOOD CORPORATION AND SUBSIDIARIES Valuation and Qualifying Accounts and Reserves Years ended December 31, 1993, 1992 and 1991 (In Thousands) - 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. FAIRWOOD CORPORATION By: /s/ John B. Sganga --------------------------- John B. Sganga Chief Financial Officer, Executive Vice President, Secretary and Treasurer Date: March 29, 1994 -------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. Title ----- /s/ John B. Sganga Director and Chief - --------------------------- John B. Sganga Financial Officer, Executive Vice President, Secretary and Treasurer (principal executive, financial and accounting officer) - 44 - SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 1994 by the following person on behalf of the Registrant and in the capacity indicated. Title ----- /s/ M. Saleem Muqaddam Director - -------------------------------- M. Saleem Muqaddam - 45 - SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 1994 by the following person on behalf of the Registrant and in the capacity indicated. Title ----- /s/ Randolph I. Thornton, Jr. Director - ---------------------------------- Randolph I. Thornton, Jr. - 46 - SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 29, 1994 by the following person on behalf of the Registrant and in the capacity indicated. Title ----- /s/ L. David Callaway - ----------------------------------- L. David Callaway Director - 47 - EXHIBIT INDEX - 48 - - 49 - - 50 - * These items are incorporated by reference as described in Item 14(a)(3) of this report. - 51 -

355429_1993.txt

355429_1993

1993

355429

ITEM 1. BUSINESS Protective Life Corporation is an insurance holding company, whose subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Founded in 1907, Protective Life Insurance Company ("Protective Life") is the Company's principal operating subsidiary. Unless the context otherwise requires, the "Company" refers to the consolidated group of Protective Life Corporation and its subsidiaries. The Company has five marketing divisions: Agency, Group, Guaranteed Investment Contracts, Financial Institutions, and Investment Products. The Company has two additional business segments: Acquisitions and Corporate and Other. The following table sets forth revenues, income before income tax, and identifiable assets for the Company's business segments. The primary components of revenues are premiums and policy fees, net investment income, and realized investment gains or losses. Premiums and policy fees are attributable directly to each business segment. Net investment income is allocated based on directly related assets required for transacting that segment of business. Realized investment gains or losses and expenses are allocated to the business segments in a manner that most appropriately reflects the operations of that segment. Unallocated realized investment gains or losses are deemed not to be associated with any specific business segment. Assets are allocated based on policy liabilities and deferred policy acquisition costs directly attributable to each segment. AGENCY DIVISION Since 1983, the Agency Division has utilized a distribution system based on experienced independent personal producing general agents who are recruited by regional sales managers. At December 31, 1993, there were 26 regional sales managers located in Alabama, Arizona, Arkansas, California, Colorado, Florida, Georgia, Illinois, Indiana, Iowa, Louisiana, Maine, Maryland, Michigan, Minnesota, Missouri, New Jersey, North Carolina, Ohio, Oregon, Texas, and Wisconsin. During 1993, the Division had approximately 12,847 independent personal producing general agents, brokers, and other agents under contract of whom approximately 517 received first year commissions in excess of $10,000 from the Company. In 1993, the Division began distributing insurance products through securities broker-dealers. The Division also distributes insurance products through the payroll deduction market. Current marketing efforts in the Agency Division are directed toward the Company's various universal life products and products designed to compete in the term marketplace. Universal life products combine traditional life insurance protection with the ability to tailor a more flexible payment schedule to the individual's needs, provide an accumulation of cash values on which income taxes are deferred, and permit the Company to change interest rates credited on policy cash values as often as monthly to reflect current market rates. The Company currently emphasizes back-end loaded universal life policies which reward the continuing policyholder and which should maintain the persistency of its universal life business. The products designed to compete in the term marketplace are term-like policies with guaranteed level premiums for the first 15 years which provide a competitive net cost to the insured. The Division's total revenues and income before income tax have increased each year from 1989 through 1993 primarily due to a growing block of business brought about by sales and improved persistency. GROUP DIVISION The Company markets its group insurance products primarily in the southeastern and southwestern United States using the services of brokers who specialize in group products. Sales offices in Alabama, Florida, Georgia, Illinois, Missouri, North Carolina, Ohio, Oklahoma, Tennessee, and Texas are maintained to serve these brokers. The Group Division offers substantially all forms of group insurance customary in the industry, making available complete packages of life and accident and health insurance to employers. The life and accident and health insurance packages include hospital and medical coverages as well as dental and disability coverages. To address rising health care costs, the Division provides cost containment services such as utilization review and catastrophic case management. Group policies are directed primarily at employers and associations with between 25 and 1,000 employees. Two new marketing initiatives will permit direct sales to employers (by full-time Company employees) of cancer, dental, and other supplemental insurance coverages. The Division hopes to have these initiatives fully operational in 1994. Group accident and health insurance is generally considered to be cyclical. Profits rise or fall as competitive forces allow or prevent rate increases to keep pace with changes in group health medical costs. The Company is placing marketing emphasis on other health insurance products which are not as subject to medical cost inflation. These products include dental insurance policies and hospital indemnity policies which are distributed nationally through the Division's existing distribution system, as well as through joint marketing arrangements with independent marketing organizations, and through reinsurance contracts with other insurers. These products also include an individual cancer insurance policy marketed through a nationwide network of agents. It is anticipated that a significant part of the growth in the Company's health insurance premium income in the next several years will be from products like dental and individual cancer insurance which have not been as subject to medical cost inflation as traditional group health products. The Division's total revenues have increased each year from 1989 through 1993 primarily due to increased sales. Income before income tax has increased each year except in 1992 which was lower than the preceding year due to less favorable life and health claims experience. FINANCIAL INSTITUTIONS DIVISION The Financial Institutions Division specializes in marketing insurance products through commercial banks, savings and loan associations, and mortgage bankers. The Division markets an array of life and health products, the majority of which are used to secure consumer and mortgage loans made by financial institutions located primarily in the southeastern United States. The Division also markets life and health products through the consumer finance industry and through automobile dealerships. The Division markets through both employee field representatives and brokers. The Division also offers certain products through direct mail solicitation to customers of financial institutions. In July 1992, in a major expansion of the Division, the Company acquired the credit insurance business of Durham Life Insurance Company ("Durham") which more than doubled the reserves the Company then held for its existing credit insurance activities. The acquisition provided significant market share in the southeastern states not previously covered by the Company. The larger size of the Division has allowed it to lower unit costs through economies of scale. After increases in total revenues in 1989 and 1990, the Division experienced a reduction in 1991 revenues that was largely recession-related, reflecting the fact that the demand for credit life and credit health insurance is related to the level of loan demand. Total revenues significantly increased in 1992 and 1993 due to the Durham acquisition and increased sales. The Division's income before income tax has increased each year since 1989 due to a related increase in loan demand. INVESTMENT PRODUCTS DIVISION The Investment Products Division manufactures, sells, and supports annuity products. These products are sold through the Agency Division, financial institutions, and broker-dealer distribution channels. This Division was formed to respond to an increased consumer demand for savings vehicles. In April 1990, the Company began sales of modified guaranteed annuity products ("MGA products") which guarantee a compounded interest rate for a fixed term. MGA products provide the Company a greater degree of protection from changes in interest rates, because contract values are "market-value adjusted" upon surrender prior to maturity. During 1992, the Company acquired a marketing company that had previously been under contract with the Company to distribute annuities. This acquisition improved the Division's ability to distribute the Company's annuity products. In late 1992, the Division ceased sales of single premium deferred annuities in an effort to focus marketing efforts on products with less disintermediation risk such as the MGA. Also, in 1993, the Division initiated development of variable annuity products, for introduction in early 1994, to broaden the Division's product line. The Division also includes Protective Equity Services, Inc. ("PES"), a securities broker-dealer subsidiary. Through PES, licensed members of the Company's field force can sell stocks, bonds, mutual funds, and other financial instruments that may be manufactured or issued by companies other than the Company. The Company's MGA products are also sold through PES. The Division's total revenues have increased each year since 1989 as annuity account balances have increased. Income before income tax has improved each year since 1989, except for 1993. In 1993, the Division's results reflect an increase of $3.2 million of amortization of deferred policy acquisition costs. GUARANTEED INVESTMENT CONTRACTS DIVISION In November 1989, the Company began selling guaranteed investment contracts ("GICs"). The Company's GICs are contracts, generally issued to a 401(k) or other retirement savings plan, which guarantee a fixed return on deposits from the plan for a specified period and often provide flexibility for withdrawals, in keeping with the benefits provided by the plan. The Company also offers a related product which is purchased primarily as a temporary investment vehicle by the trustees of escrowed municipal bond proceeds. GICs are sold to customers through a network of specialized GIC managers, consultants, and brokers. The Company entered the GIC business in 1989 through a joint venture. The joint venture arrangement was ended in 1991. Life insurer credit concerns and a demand shift to non-traditional GIC alternatives have generally caused the GIC market to contract somewhat. Management believes that, due to its credit position, Protective Life remains well positioned in this market. The Company anticipates broadening its GIC marketing capability by introducing new products in 1994. Management believes that the introduction of these new products should enhance the Company's ability to compete in the marketplace by broadening the Division's product line. The Division's total revenues and income before income tax have significantly increased each year since 1989 as GIC account balances have increased. The rate of growth in GIC account balances will most likely significantly decrease as the number of maturing contracts increases. The assets supporting the Company's GIC and annuity businesses are generally susceptible to interest rate and asset/liability matching risks. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. ACQUISITIONS DIVISION The Company actively seeks to acquire blocks of insurance policies. These acquisitions may be accomplished through acquisitions of companies or through the assumption or reinsurance of policies. Reinsurance transactions may be made from court-administered insolvent companies or from companies otherwise divesting themselves of blocks of business. Most acquisitions do not include the Company's acquisition of an active sales force, but some do. Blocks of policies acquired through the Acquisitions Division are administered as "closed" blocks; i.e., no new policies are being sold. Therefore, the amount of insurance in force for a particular acquisition is expected to decline with time due to lapses and deaths of the insureds. The experience of the Company has been that acquired or reinsured business can be administered more efficiently by the Company than by previous management or court administrators. In addition, in some instances a supervising court may permit legal modification of the terms of reinsured policies to increase the profitability of the reinsurance (and thus encourage such transactions). More than twenty separate transactions were made between 1970 and 1987. From 1987 through 1989, the Company encountered more competition concerning acquisitions; however, it did not change its strategy concerning the margins it sought from acquisitions. Consequently, no material transactions were entered into from 1987 to 1989. The environment for acquisitions has become more favorable since 1989 and management believes that this favorable environment likely will continue into the immediate future. Insurance companies are facing heightened regulatory and market pressure to increase statutory capital and thus may seek to increase capital by selling blocks of policies. Insurance companies also appear to be selling blocks of policies in conjunction with programs to narrow strategic focus. In addition, smaller companies without strong ratings may face difficulties in marketing and thus may seek to be acquired. Several states have enacted statutes that allow policyholders to "opt out" of an assumption reinsurance transaction; this environment appears to have caused sellers to place more emphasis on the financial condition and acquisition experience of the purchaser which management believes will favorably impact the Company's competitive position. However, it appears that other companies are entering this market and therefore the Company may face increased competition in future acquisitions. Total revenues and income before income tax from the Acquisitions Division are expected to decline with time unless new acquisitions are made. Therefore, the Division's revenues and earnings may fluctuate from year-to-year depending upon the level of acquisition activity. Revenues and earnings declined in 1990 and 1992, but increased in 1991 and 1993 due to new acquisitions. In the fourth quarter of 1990, Protective Life reinsured two separate blocks of insurance. In the first quarter of 1992, Employers National Life Insurance Company, a small Texas insurance company, was purchased and merged into Protective Life. In the third quarter of 1993, Protective Life acquired Wisconsin National Life Insurance Company and coinsured a small block of universal life policies. CORPORATE AND OTHER The Corporate and Other segment consists of several small insurance lines of business, net investment income and expenses not attributable to the business segments described above (including interest on substantially all debt), the earnings of Southeast Health Plan, Inc. ("SEHP"), and the operations of several small noninsurance subsidiaries. The earnings of this segment may fluctuate from year to year. In 1988, the Company acquired convertible preferred stock of SEHP, a Birmingham-based health maintenance organization. In August 1991, the Company converted the preferred stock into 80% of the common stock of SEHP. In August 1993, the Company sold its interest in SEHP. In 1991, this segment's earnings were reduced from 1990 levels as a result of interest on debt relating to a 1990 reinsurance transaction, a write-off of certain computer equipment, and losses at SEHP. In 1992, Corporate and Other earnings were slightly higher due to SEHP having a $0.6 million profit compared to the loss in 1991, the SEHP increase being largely offset by several factors of negative effect. In 1993, the Company changed the method used to apportion net investment income within the Company. This change resulted in increased income attributable to the Agency, Investment Products, and Acquisitions Divisions of $3.0 million, $2.0 million, and $2.6 million, respectively, while decreasing income of the Corporate and Other segment. INSURANCE IN FORCE The Company's total consolidated life insurance in force at December 31, 1993 was $42.5 billion. The following table shows sales by face amount and insurance in force for the Company's business segments. The ratio of voluntary terminations of individual life insurance to mean individual life insurance in force, which is determined by dividing the amount of insurance terminated due to surrenders and lapses during the year by the mean of the insurance in force at the beginning and end of the year, adjusted for the timing of major acquisitions and assumptions was: Net terminations reflect voluntary lapses and cash surrenders, some of which may be due to the replacement of the Company's products with competitors' products. Also, a higher percentage of voluntary lapses typically occurs in the first 15 months of a policy, and accordingly, lapses will tend to increase or decrease in proportion to the change in new insurance written during the immediately preceding periods. The amount of investment products in force is measured by account balances. The following table shows guaranteed investment contract and annuity account balances. UNDERWRITING The underwriting policies of the Company's insurance subsidiaries are established by management. With respect to individual insurance, the subsidiaries use information from the application and, in some cases, inspection reports, attending physician statements, or medical examinations to determine whether a policy should be issued as applied for, rated, or rejected. Medical examinations of applicants are required for individual life insurance in excess of certain prescribed amounts (which vary based on the type of insurance) and for most ordinary insurance applied for by applicants over age 50. In the case of "simplified issue" policies, which are issued primarily through the Financial Institutions Division and the payroll deduction market, coverage is rejected if the responses to certain health questions contained in the application indicate adverse health of the applicant. For other than "simplified issue" policies, medical examinations are requested of any applicant, regardless of age and amount of requested coverage if an examination is deemed necessary to underwrite the risk. Substandard risks may be referred to reinsurers for rating and in some instances, full or partial reinsurance of the substandard risk. The Company's insurance subsidiaries require blood samples to be drawn with ordinary insurance applications for coverage at $100,000 (ages 16-50) or $150,000 (age 51 and above). Blood samples are tested for a wide range of chemical values and are screened for antibodies to the HIV virus. Applications also contain questions permitted by law regarding the HIV virus which must be answered by the proposed insureds. Group insurance underwriting policies, which are administered by experienced group underwriters, are similar to the underwriting policies of other major group insurers. The underwriting policies are designed for single employer groups. Initial premium rates are based on prior claim experience and manual premium rates with relative weights depending on the size of the group and the nature of the benefits. INVESTMENTS The Company's investment philosophy is to maintain a portfolio that is matched with respect to yield, risk, and cash flow characteristics to its liabilities. The types of assets in which the Company may invest are governed by state laws which prescribe qualified investment assets. Within the parameters of these laws, the Company invests its assets giving consideration to such factors as liquidity needs, investment quality, investment return, matching of assets and liabilities, and the composition of the investment portfolio by asset type and credit exposure. Because liquidity is important, the Company continually balances maturity against yield and quality considerations in selecting new investments. The Company's asset/liability matching practices involve monitoring of asset and liability durations for various product lines; cash flow testing under various interest rate scenarios; and rebalancing of assets and liabilities with respect to yield, risk, and cash flow characteristics. In accordance with current generally accepted accounting principles, most of the Company's fixed maturities, equity securities, and short-term investments are valued at market. Mortgage loans, investment real estate, policy loans, and other long-term investments are valued at amortized cost. The following table shows the Company's investments at December 31, 1993, valued on the basis of generally accepted accounting principles. Approximately 51% of the Company's bond portfolio is invested in mortgage- backed securities. Mortgage-backed securities are based upon residential mortgages which have been pooled into securities. Mortgage-backed securities may have greater cash flow volatility as a result of the pass-through of prepayments of principal on the underlying loans. Prepayments of principal on the underlying residential loans can be expected to accelerate with decreases in interest rates and diminish with increases in interest rates. In management's view, the overall quality of the Company's investment portfolio continues to be strong. The following table shows the approximate percentage distribution of the Company's fixed maturities by rating (utilizing Standard & Poor Corporation's rating categories) at December 31, 1993: At December 31, 1993, approximately 97.7% of the Company's bond portfolio was invested in U.S. Government-backed securities or investment grade corporate bonds and only 2.3% of its bond portfolio was rated less than investment grade by Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Corporation ("S&P"). Risks associated with investments in less than investment-grade debt obligations may be significantly higher than risks associated with investments in debt securities rated investment grade. Risk of loss upon default by the borrower is significantly greater with respect to such debt obligations than with other debt securities because these obligations may be unsecured or subordinated to other creditors. Additionally, there is often a thinly traded market for such securities and current market quotations are frequently not available for some of these securities. Issuers of less than investment-grade debt obligations usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than investment-grade issuers. The Company also invests in those bank loan participations that are the most senior debt issued in highly leveraged transactions. They are generally unrated by the credit rating agencies. In selecting bank participations for investment, the Company requires cash flows, without asset sales, to cover all interest and scheduled amortization of the bank debt by 140% and to cover total debt service by 110%. The debt is generally secured by most of the tangible assets of the issuing company. Of the $151.3 million of bank loan participations owned by the Company at December 31, 1993, $121.7 million were classified by the Company as less than investment grade. The Company also invests a significant portion of its portfolio in mortgage loans. Results for these investments have been excellent due to careful management and a focus on a specialized segment of the market. The Company generally does not lend on speculative properties and has specialized in making loans on either credit-oriented commercial properties, or credit-anchored strip shopping centers in smaller towns and cities. The following table shows a breakdown of the Company's mortgage loan portfolio by property type: The Company's mortgage lending criteria generally require that loan-to- value ratios on each mortgage remain at or under 75%. Rental payments from credit anchors (i.e., excluding rental payments from smaller local tenants) generally exceed 70% of the property's operating expenses and debt service. The average size mortgage loan in the Company's portfolio is approximately $1.4 million. The largest single loan amount is $9.3 million. Many of the Company's mortgage loans have call or interest rate reset provisions after five to seven years. However, if interest rates were to significantly increase, the Company may be unable to increase the interest rates on its existing mortgage loans commensurate with the significantly increased market rates, or call the loans. At December 31, 1993, 1.9% of the mortgage loan portfolio was nonperforming. It is the Company's policy to cease to carry accrued interest on loans that are over 90 days delinquent. For loans less than 90 days delinquent, interest is accrued unless it is determined that the accrued interest is not collectible. If a loan becomes over 90 days delinquent, it is the Company's policy to initiate foreclosure proceedings or, much less often, to adopt a workout arrangement to bring the loan current. As a general rule, the Company does not invest directly in real estate. The investment real estate held by the Company consists largely of properties obtained through foreclosures or the acquisition of other insurance companies. At foreclosure, a new appraisal is obtained, and the value of real estate acquired through foreclosure is valued at the lesser of the mortgage loan balance plus costs of foreclosure or appraised value. In the Company's experience, the appraised value of foreclosed properties often equals or exceeds the mortgage loan balance on the property plus costs of foreclosure. Also, foreclosed properties often generate a positive cash flow, enabling the Company to hold and manage the property until the property can be profitably sold. The Company has established an allowance for uncollectible amounts on investments. This allowance was $35.9 million at December 31, 1993. A combination of futures contracts and options on treasury notes are currently being used in connection with a hedging program which is designed to hedge against rising interest rates for asset/liability management of certain investments, primarily mortgage loans on real estate, and liabilities arising from interest sensitive products such as GICs and individual annuities. Realized investment gains and losses on such contracts are deferred and amortized over the life of the hedged asset. The Company also uses interest rate swap contracts to effectively convert certain investments from a variable to a fixed rate of interest. For further discussion regarding the maturity of and the concentration of risk among the Company's invested assets, see Note C to the Consolidated Financial Statements. The following table shows the investment results of the Company for the years 1989 through 1993: See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders for certain information relating to the Company's investments and liquidity. The Company is involved in financial guarantees of the debt of others. For further details, see Note G to Consolidated Financial Statements. INDEMNITY REINSURANCE As is customary in the insurance industry, the Company's insurance subsidiaries cede insurance to other insurance companies. The ceding insurance company remains contingently liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. The Company sets a limit on the amount of insurance retained on the life of any one person. In the individual lines it will not retain more than $500,000, including accidental death benefits, on any one life. Certain of the term-like plans of the Company have a retention of $50,000 per life. For group insurance, the maximum amount retained on any one life is $100,000. At December 31, 1993, the Company had insurance in force of $42.5 billion of which approximately $7.5 billion was ceded to reinsurers. RESERVES The applicable insurance laws under which the Company's insurance subsidiaries operate require that each insurance company report policy reserves as liabilities to meet future obligations on the outstanding policies. These reserves are the amounts which, with the additional premiums to be received and interest thereon compounded annually at certain assumed rates, are calculated in accordance with applicable law to be sufficient to meet the various policy and contract obligations as they mature. These laws specify that the reserves shall not be less than reserves calculated using certain named mortality tables and interest rates. The reserves carried in the Company's financial reports (presented on the basis of generally accepted accounting principles) differ from those specified by the laws of the various states and carried in the insurance subsidiaries' statutory financial statements (presented on the basis of statutory accounting principles mandated by state insurance regulation). For policy reserves other than those for universal life policies, annuity contracts, and GICs, these differences arise from the use of mortality and morbidity tables and interest rate assumptions which are deemed under generally accepted accounting principles to be more appropriate for financial reporting purposes than those required for statutory accounting purposes; from the introduction of lapse assumptions into the reserve calculation; and from the use of the net level premium reserve method on all business. Policy reserves for universal life policies, annuity contracts, and GICs are carried in the Company's financial reports at the account value of the policy or contract. FEDERAL INCOME TAX CONSEQUENCES The Company's insurance subsidiaries are taxed by the federal government in a manner similar to companies in other industries. However, certain restrictions on consolidating life insurance company income with noninsurance income are applicable to the Company; thus, the Company is not able to fully consolidate the operating results of its subsidiaries for federal income tax purposes. Under pre-1984 tax law, certain income of the Company was not taxed currently, but was accumulated in the "Policyholders' Surplus Account" for each insurance company subsidiary to be taxed only when such income was distributed to the stockholders or when certain limits on accumulated amounts were exceeded. Consistent with current tax law, amounts accumulated in the Policyholders' Surplus Account have been carried forward, although no accumulated income may be added to these accounts. As of December 31, 1993, the combined Policyholders' Surplus Accounts for the life insurance subsidiaries of the Company and the estimated tax which would become payable on these amounts if distributed to stockholders were $50.7 million and $17.7 million, respectively. The Company does not anticipate any of its life insurance subsidiaries exceeding applicable limits on amounts accumulated in these accounts and, therefore, does not expect to involuntarily pay tax on the amounts held therein. COMPETITION The Company operates in a highly competitive industry. In connection with the development and sale of its products, the Company encounters significant competition from other insurance companies, many of which have financial resources greater than those of the Company, as well as from other investment alternatives available to its customers. The operating results of companies in the insurance industry have historically been subject to significant fluctuations due to competition, economic conditions, interest rates, investment performance, maintenance of insurance ratings, and other factors. Management believes that the Company's ability to compete is dependent upon, among other things, its ability to attract and retain agents to market its insurance products, its ability to develop competitive and profitable products, and its maintenance of a high rating from rating agencies. Nontraditional sources of health care coverages, such as health maintenance organizations and preferred provider organizations, are developing rapidly in the Company's operating territory and provide competitive alternatives to the Company's group health products. Banks, by offering bank investment contracts currently guaranteed by the FDIC, provide competitive alternatives to GICs. In addition, banks and other financial institutions may be granted approval to underwrite and sell insurance products and compete directly with the Company. REGULATION Insurance companies are subject to comprehensive and detailed regulation and supervision in the states in which they transact business. The laws of the various jurisdictions establish supervisory agencies with broad administrative powers relative to granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, establishing reserve requirements, fixing maximum interest rates on life insurance policy loans and minimum rates for accumulation of surrender values, prescribing the form and content of required statutory financial statements, and regulating the type and amount of investments permitted. Insurance companies are required to file detailed annual reports with the supervisory agencies in each of the jurisdictions in which they do business and their business and accounts are subject to examination by such agencies at any time. Under the rules of the National Association of Insurance Commissioners ("NAIC"), insurance companies are examined periodically (generally every three years) by one or more of the supervisory agencies on behalf of the states in which they do business. To date, no such insurance department examinations have produced any significant adverse findings regarding any insurance company subsidiary of the Company. Recently, the insurance regulatory framework has been placed under increased scrutiny by various states, the federal government, and the NAIC. Various states have considered or enacted legislation which changes, and in many cases increases, the state's authority to regulate insurance companies. Legislation is under consideration in Congress which would result in the federal government assuming some role in the regulation of insurance companies. The NAIC, in conjunction with state regulators, has been reviewing existing insurance laws and regulations. The NAIC recently approved and recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. These initiatives include a risk-based capital requirement. A life insurance company's statutory capital is computed according to rules prescribed by the NAIC as modified by the insurance company's state of domicile. Statutory accounting rules are different from generally accepted accounting principles and are intended to reflect a more conservative view. The NAIC's risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. These risk-based capital requirements are intended to allow insurance regulators to identify inadequately capitalized insurance companies based upon the types and mixtures of risks inherent in the insurer's operations. The formula includes components for asset risk, liability risk, interest rate exposure, and other factors. Based upon the December 31, 1993 statutory financial reports of the Company's insurance subsidiaries, management believes that the Company's insurance subsidiaries are adequately capitalized under the formula. Under insurance guaranty fund laws, in most states, insurance companies doing business therein can be assessed up to prescribed limits for policyholder losses incurred by insolvent companies. The Company does not believe that any such assessments will be materially different from amounts already provided for in the financial statements. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer's own financial strength. In addition, several states, including the states in which the Company's insurance subsidiaries are domiciled, have enacted legislation or adopted regulations regarding insurance holding company systems. These laws require registration of and periodic reporting by insurance companies domiciled within the jurisdiction which control or are controlled by other corporations or persons so as to constitute an insurance holding company system. These laws also affect the acquisition of control of insurance companies as well as transactions between insurance companies and companies controlling them. Most states, including Tennessee, where Protective Life is domiciled, require administrative approval of the acquisition of control of an insurance company domiciled in the state or the acquisition of control of an insurance holding company whose insurance subsidiary is incorporated in the state. In Tennessee, the acquisition of 10% of the voting securities of a person is generally deemed to be the acquisition of control for the purpose of the insurance holding company statute and requires not only the filing of detailed information concerning the acquiring parties and the plan of acquisition, but also administrative approval prior to the acquisition. Tennessee insurance laws also impose certain restrictions on Protective Life's ability to pay dividends to the Company. Under Tennessee insurance laws, Protective Life may only pay dividends out of that part of its available surplus which is derived from realized statutory net profits. In addition, the Tennessee Commissioner of Insurance must approve (or not disapprove within 30 days of notice) payment of a dividend from Protective Life which exceeds, together with all dividends paid by Protective Life within the previous 12 months, the greater of (i) 10% of Protective Life's surplus as regards policyholders at the preceding December 31 or (ii) the net gain from operations of Protective Life for the 12 months ended on such December 31. Additional issues related to regulation of the Company and its insurance subsidiaries are discussed in "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. EMPLOYEES The Company had 990 full-time employees, including 841 in the Home Office in Birmingham, Alabama at December 31, 1993. These employees are covered by contributory major medical insurance, group life, and long-term disability insurance plans. The cost of these benefits in 1993 amounted to approximately $2.0 million for the Company. In addition, substantially all of the employees are covered by a pension plan. The Company also matches employee contributions to its 401(k) Plan. See Note K to Consolidated Financial Statements. RECENT DEVELOPMENTS The Clinton Administration has advocated changes to the current health care delivery system which will address both affordability and availability issues. The ultimate scope and effective date of any proposals are unknown at this time and are likely to be modified as they are considered for enactment by Congress. It is anticipated that these proposals may adversely affect certain products in the Company's group health insurance business. In addition to the federal initiatives, a number of states are considering legislative programs that are intended to affect the accessibility and affordability of health care. Some states have recently enacted health care reform legislation. These various state programs (which could be preempted by any federal program) may also adversely affect the Company's group health insurance business. However, in light of the small relative proportion of the Company's earnings attributable to group health insurance, management does not expect that either the federal or state proposals will have a material adverse effect on the Company's earnings. The Company has entered into a joint venture arrangement with the Lippo Group to enter the Hong Kong insurance market. Subject to regulatory approval, the Company and the Lippo Group will jointly own a recently acquired, inactive Hong Kong insurer. Management anticipates that the Hong Kong insurer will commence business in mid-1994. The Hong Kong insurer's products will be similar to those currently being offered by the Company. ITEM 2. ITEM 2. PROPERTIES The Company's Home Office building is located at 2801 Highway 280 South, Birmingham, Alabama. This building includes the original 142,000 square-foot building which was completed in 1976 and a second contiguous 220,000 square-foot building which was completed in 1985. In addition, parking is provided for approximately 1,000 vehicles. The Company leases administrative space in Birmingham, Alabama; Brentwood, Tennessee; Greenville, South Carolina; Cary, North Carolina; Indianapolis, Indiana; and Oklahoma City, Oklahoma. Substantially all of these offices are rented under leases that run for periods of three to five years. The aggregate monthly rent is approximately $32 thousand. Marketing offices are leased in 15 cities, substantially all under leases for periods of three to five years with only three leases running longer than five years. The aggregate monthly rent is approximately $31 thousand. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending 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 or of which any of the Company's properties is the subject. 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 of the Company. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Through Friday, October 1, 1993, the Company's Common Stock was traded on the over-the-counter market (NASDAQ symbol: PROT) and was quoted on the NASDAQ National Market System. On Monday, October 4, 1993, the Company's Common Stock began trading on the New York Stock Exchange (NYSE symbol: PL). The following table sets forth the highest and lowest closing prices of the Company's Common Stock, $0.50 par value, as reported by NASDAQ and the New York Stock Exchange during the periods indicated, along with the dividends paid per share of Common Stock during the same periods. At February 18, 1994, there were approximately 2,170 holders of record of Company Common Stock. The Company (or its predecessor) has paid cash dividends each year since 1926 and each quarter since 1934. The Company expects to continue to pay cash dividends, subject to the earnings and financial condition of the Company and other relevant factors. The ability of the Company to pay cash dividends is dependent in part on cash dividends received by the Company from its life insurance subsidiaries. See Item 7 - "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - LIQUIDITY AND CAPITAL RESOURCES" in the Company's 1993 Annual Report to Stockholders. Such subsidiary dividends are restricted by the various insurance laws of the states in which the subsidiaries are incorporated. See Item 1 - "BUSINESS - REGULATION". ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information regarding the Company's financial condition and results of operations is included under the caption "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" in the Company's 1993 Annual Report to Stockholders and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data for the Company and its subsidiaries, which are included under the caption "CONSOLIDATED FINANCIAL STATEMENTS" in the Company's 1993 Annual Report to Stockholders, are incorporated herein by reference. COOPERS & LYBRAND REPORT OF INDEPENDENT ACCOUNTANTS To the Directors and Stockholders Protective Life Corporation Birmingham, Alabama Our report on the consolidated financial statements of Protective Life Corporation and Subsidiaries has been incorporated by reference in this Form 10-K from page 66 of the 1993 Annual Report to Stockholders of Protective Life 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 27 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 Birmingham, Alabama February 14, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Except for the information concerning executive officers of the Company set forth below, the information called for by this Item 10 is incorporated herein by reference to the section entitled "ELECTION OF DIRECTORS AND INFORMATION ABOUT NOMINEES" in the Company's definitive proxy statement for the Annual Meeting of Stockholders, May 2, 1994, to be filed with the Securities and Exchange Commission by the Company pursuant to Regulation 14A within 120 days after the end of its 1993 fiscal year. The executive officers of the Company are as follows: Name Age Position ---- --- -------- Drayton Nabers, Jr. 53 President and Chief Executive Officer and a Director R. Stephen Briggs 44 Executive Vice President John D. Johns 41 Executive Vice President and Chief Financial Officer Ormond L. Bentley 58 Senior Vice President, Group Deborah J. Long 40 Senior Vice President and General Counsel Jim E. Massengale 51 Senior Vice President Steven A. Schultz 40 Senior Vice President, Financial Institutions Wayne E. Stuenkel 40 Senior Vice President and Chief Actuary A. S. Williams III 57 Senior Vice President, Investments and Treasurer Jerry W. DeFoor 41 Vice President and Controller, and Chief Accounting Officer All executive officers are elected annually and serve at the pleasure of the Board of Directors. None is related to any director of the Company or to any other executive officer. Mr. Nabers was President and Chief Operating Officer and a Director from August 1982 until May 1992, when he became President and Chief Executive Officer. From July 1981 to August 1982, he was Senior Vice President of the Company. Since August 1982, he has also been President of Protective Life and had been its Senior Vice President from September 1981 to August 1982. From February 1980 to September 1981, he served as Senior Vice President, Operations of Protective Life. From 1979 to February 1980, he was Senior Vice President, Operations and General Counsel of Protective Life. From February 1980 to March 1983, he served as President of Empire General Life Insurance Company, a subsidiary, and from March 1983 to December 31, 1984, he was Chairman of the Executive Committee of Empire General. He is also a director of Energen Corporation and National Bank of Commerce of Birmingham. Mr. Briggs has been Executive Vice President of the Company and of Protective Life since October 1993. From January 1993 to October 1993, he was Senior Vice President, Life Insurance and Investment Products of the Company and of Protective Life. Mr. Briggs had been Senior Vice President, Ordinary Marketing of the Company since August 1988 and of Protective Life since April 1986. From July 1983 to April 1986, he was President of First Protective Insurance Group, Inc. Mr. Johns has been Executive Vice President and Chief Financial Officer of the Company and of Protective Life since October 1993. From August 1988 to October 1993, he served as Vice President and General Counsel of Sonat, Inc. He is a director of National Bank of Commerce of Birmingham and Parisian Services, Inc. Mr. Bentley has been Senior Vice President, Group of the Company since August 1988 and of Protective Life since December 1978. Mr. Bentley has been employed by Protective Life since October 1965. Ms. Long has been Senior Vice President and General Counsel of the Company and of Protective Life since February 1, 1994. From August 2, 1993 to January 31, 1994, Ms. Long served as General Counsel of the Company and from February 1984 to January 31, 1994 she practiced law with the law firm of Maynard, Cooper & Gale, P.C. Mr. Massengale has been Senior Vice President of the Company and of Protective Life since May 1992. From May 1989 to May 1992, he was Senior Vice President, Operations and Systems of the Company and Protective Life. From January 1983 to May 1989, he served as Senior Vice President, Corporate Systems of the Company and Protective Life. Mr. Schultz has been Senior Vice President, Financial Institutions of the Company and of Protective Life since March 1993. Mr. Schultz served as Vice President, Financial Institutions of the Company from February 1993 to March 1993 and of Protective Life from February 1989 to March 1993. From June 1977 through January 1989, he was employed by and served in a number of capacities with The Minnesota Mutual Life Insurance Company, finally serving as Director, Group Sales. Mr. Stuenkel has been Senior Vice President and Chief Actuary of the Company and of Protective Life since March 1987. Mr. Stuenkel is a Fellow of the Society of Actuaries and has been employed by Protective Life since September 1978. Mr. Williams has been Senior Vice President, Investments and Treasurer of the Company since July 1981. Mr. Williams also serves as Senior Vice President, Investments and Treasurer of Protective Life. Mr. Williams has been employed by Protective Life since November 1964. Mr. DeFoor has been Vice President and Controller, and Chief Accounting Officer of the Company and Protective Life since April 1989. Mr. DeFoor is a certified public accountant and has been employed by Protective Life since August 1982. Certain of these executive officers also serve as executive officers and/or directors of various other Company subsidiaries. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Items 11 through 13 is incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders, May 2, 1994, to be filed with the Securities and Exchange Commission by the Company pursuant to Regulation 14A within 120 days after the end of its 1993 fiscal year. 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 set forth in the Company's 1993 Annual Report to Stockholders as indicated on the following table are incorporated by reference (See Exhibit 13). PAGE Report of Independent Accountants. . . . . . . . 66 Consolidated Statements of Income for the years ended December 31, 1993, 1992, and 1991 . . . . 43 Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . 44 PAGE Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . . . 46 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . . . . . . . 47 Notes to Consolidated Financial Statements. . . . 48 2. Financial Statement Schedules: The Report of Independent Accountants which covers the financial statement schedules appears on page 23 of this report. The following schedules are located in this report on the pages indicated. PAGE Schedule I - Summary of Investments - Other Than Investments in Related Parties. . . . 33 Schedule III - Condensed Financial Information of Registrant . . . . . . . . . . . . . . . . . 34 Schedule V - Supplementary Insurance Information . 38 Schedule VI - Reinsurance . . . . . . . . . . . . 39 Schedule IX - Short-Term Borrowings . . . . . . . 40 All other schedules to the consolidated financial statements required by Article 7 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits: Included as exhibits are the items listed below. The Company will furnish a copy of any of the exhibits listed upon the payment of $5.00 per exhibit to cover the cost of the Company in furnishing the exhibit. ITEM NUMBER DOCUMENT 3(a) 1985 Restated Certificate of Incorporation of the Company 3(a)(1) Certificate of Amendment of 1985 Restated Certificate of Incorporation of the Company *3(a)(2) Certificate of Designation of Junior Participating Cumulative Preferred Stock of the Company filed with the Secretary of State of Delaware on July 14, 1987 - Filed as Exhibit A to the Company's Form 8-K Report filed July 15, *3(a)(3) Certificate of Correction of Certificate of Designation of Junior Participating Cumulative Preferred Stock of the Company filed with the Secretary of State of Delaware on July 27, 1987 - Filed as Exhibit 3(a)(4) to the Company's Form 10-K Annual Report for the year ended December 31, 1987 *3(b) By-laws of the Company filed as Exhibit C to the Company's Form 10 Registration Statement filed September 4, 1981 *3(b)(1) Amended By-laws of the Company filed as Exhibit B to the Company's Form 8-K Report filed May 18, 1983 4(a) 1985 Restated Certificate of Incorporation of the Company (filed as Exhibit 3(a)) 4(a)(1) Certificate of Amendment of 1985 Restated Certificate of Incorporation of the Company (filed as Exhibit 3(a)(1)) *10(a) Management Incentive Plan filed as Exhibit 10(a) to the Company's Form 10-K Annual Report for the year ended December 31, 1984 *10(a)(1) Amendment to the Company's Management Incentive Plan renamed as the Company's Annual Incentive Plan filed as Exhibit 10(a)(1) to the Company's Form 10-Q Report filed May 14, *10(b) Performance Share Plan filed as Exhibit G to the Company's Form 10 Registration Statement filed September 4, 1981 (expired as to new grants) - -------------------------- *incorporated by reference 28 *10(b)(1) 1983 Performance Share Plan filed as Exhibit C to the Company's Form 8-K Report filed May 18, 1983 *10(b)(2) The Company's 1983 Performance Share Plan (as amended March 19, 1990) filed as Exhibit 10(b)(2) to the Company's Form 10-Q Report filed May 14, 1990 *10(b)(3) The Company's 1992 Performance Share Plan filed as Exhibit 10(b)(3) to the Company's Form 10-Q filed May 15, 1992 *10(c) Excess Benefit Plan filed as Exhibit 10(c) to the Company's Form 10-K Annual Report for the year ended December 31, 1984 *10(c)(1) Excess Benefit Plan amended and restated as of January 1, 1989 filed as Exhibit 10(c)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 *10(d) Bond Purchase Agreement filed as Exhibit 10(d) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 *10(d)(1) Escrow Agreement filed as Exhibit 10(d)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 *10(e) Indemnity Agreements filed as Exhibits to the Company's Form 10-Q Report, filed August 14, 1986 *10(f) Preferred Share Purchase Rights Plan filed as Exhibit to the Company's Form 8-A Report filed July 15, 1987, as amended July 23 and July 29, 1987 *10(i) Form of Severance Compensation Agreement filed as Exhibit 10(i) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 *10(i)(1) Form of First Amendment to Severance Compensation Agreement filed as Exhibit 10(i)(1) to the Company's Form 10-K Annual Report for the year ended December 31, 1991 *10(iii)(A)(1) The Company's Deferred Compensation Plan for Directors who are not Employees of the Company filed as Exhibit 4 to the Company's Form S-8 filed August 27, 1993 - -------------------------- *incorporated by reference 29 *10(iii)(A)(2) The Company's Deferred Compensation Plan for Officers filed as Exhibit 4 to the Company's Form S-8 filed January 13, 13 1993 Annual Report To Stockholders 21 Organization Chart of the Company and Affiliates 23 Consent of Coopers & Lybrand 24 Power of Attorney The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this Form 10-K: Exhibit Item Numbers 10(a), 10(a)(1), 10(b), 10(b)(1), 10(b)(2), 10(b)(3), 10(c), 10(c)(1), 10(i), 10(i)(1), 10(iii)(A)(1), and 10(iii)(A)(2). (b) Reports on Form 8-K: (1) Form 8-K, filed February 17, 1993 - Item 5 (2) Form 8-K, filed April 28, 1993 - Item 5 (3) Form 8-K, filed July 28, 1993 - Item 5 (4) Form 8-K, filed August 4, 1993 - Item 2 - Item 7 (5) Form 8-K, filed September 14, 1993 - Item 5 (6) Form 8-K, filed October 1, 1993 - Item 5 (7) Form 8-K, filed October 28, 1993 - Item 5 - -------------------------- *incorporated by reference 30 SIGNATURES Pursuant to the requirements of Section 13 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. PROTECTIVE LIFE CORPORATION By:/s/Drayton Nabers, Jr. -------------------------------------- Drayton Nabers, Jr. President and Chief Executive Officer 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 Company and in the capacities and on the dates indicated. SIGNATURE CAPACITY IN WHICH SIGNED DATE /s/Drayton Nabers, Jr. President and Chief Executive March 25, 1994 - ------------------------- Officer (Principal Executive DRAYTON NABERS, JR. Officer) and Director /s/John D. Johns Executive Vice President and March 25, 1994 - ------------------------- Chief Financial Officer JOHN D. JOHNS (Principal Financial Officer) /s/Jerry W. DeFoor Vice President and Controller, March 25, 1994 - ------------------------- and Chief Accounting Officer JERRY W. DEFOOR (Principal Accounting Officer) * Chairman of the Board and March 25, 1994 - ------------------------- Director WILLIAM J. RUSHTON III * Director March 25, 1994 - ------------------------- JOHN W. WOODS * Director March 25, 1994 - ------------------------- CRAWFORD T. JOHNSON III * Director March 25, 1994 - ------------------------- WILLIAM J. CABANISS, JR. * Director March 25, 1994 - ------------------------- H. G. PATTILLO * Director March 25, 1994 - ------------------------- EDWARD L. ADDISON * Director March 25, 1994 - ------------------------- JOHN J. MCMAHON, JR. * Director March 25, 1994 - ------------------------- A. W. DAHLBERG * Director March 25, 1994 - ------------------------- JOHN W. ROUSE, JR. * Director March 25, 1994 - ------------------------- ROBERT T. DAVID * Director March 25, 1994 - ------------------------- RONALD L. KUEHN, JR. * Director March 25, 1994 - ------------------------- HERBERT A. SKLENAR - -------------------- *Drayton Nabers, Jr., 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 and filed with the Securities and Exchange Commission. By: /s/Drayton Nabers, Jr. -------------------------------------- DRAYTON NABERS, JR. Attorney-in-fact SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES DECEMBER 31, 1993 (in thousands) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME PROTECTIVE LIFE CORPORATION (PARENT COMPANY) YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS PROTECTIVE LIFE CORPORATION (PARENT COMPANY) (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS PROTECTIVE LIFE CORPORATION (PARENT COMPANY) YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (in thousands) See notes to condensed financial statements. SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT PROTECTIVE LIFE CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS The Company publishes consolidated financial statements that are its primary financial statements. Therefore, these parent company condensed financial statements are not intended to be the primary financial statements of the Company, and should be read in conjunction with the consolidated financial statements and notes thereto of Protective Life Corporation and subsidiaries. NOTE 1 - DEBT At December 31, 1993, the Company had borrowed $118.0 million of its $138 million revolving line of credit. In addition, the Company has borrowed $29.0 million under an installment note. Future maturities of this note are $9.5 million in 1994, $9.5 million in 1995, and $10.0 million in 1996. NOTE 2 - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION NOTE 3 - SUBSIDIARY SURPLUS DEBENTURES Protective Life Insurance Company ("Protective Life") has issued surplus debentures to the Company in order to finance acquisitions and growth. At December 31, 1993, the balance of the surplus debentures was $48.9 million. The surplus debentures are included in receivables from subsidiaries. Protective Life must obtain the approval of the Commissioner of Insurance before it may repay any portion of the surplus debenture. NOTE 4 - SALE OF SUBSIDIARY On January 27, 1993, Protective Life contributed (in the form of a dividend) its 80% ownership interest in the common stock of Southeast Health Plan, Inc. ("SEHP"). Because SEHP was in a deficit position, the transaction was recorded as a "negative" dividend by the Company. On August 6, 1993, the Company sold its ownership interest in SEHP. The sale has been accounted for in a manner similar to an installment sale. A gain of $3.5 million is included in the Company's 1993 other income. - ---------------------------- *Eliminated in consolidation. SCHEDULE V - SUPPLEMENTARY INSURANCE INFORMATION PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (in thousands) SCHEDULE VI - REINSURANCE PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (dollars in thousands) SCHEDULE IX - SHORT-TERM BORROWINGS PROTECTIVE LIFE CORPORATION AND SUBSIDIARIES (dollars in thousands) EXHIBITS TO FORM 10-K OF PROTECTIVE LIFE CORPORATION FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 INDEX TO EXHIBITS PAGE 3(a).................................................................... 3(a)(1)................................................................. 13 ..................................................................... 21 ..................................................................... 23 ..................................................................... 24 .....................................................................

277509_1993.txt

277509_1993

1993

277509

Item 1. Business. Federal Signal Corporation, founded in 1901, was reincorporated as a Delaware Corporation in 1969. The company is a manufacturer and worldwide supplier of public safety, signaling and communications equipment, fire trucks and emergency vehicles, street sweeping, vacuum loader and catch basin cleaning vehicles, parking control equipment, custom on-premise signage, cutting tools, precision punches and related die components. Products produced and services rendered by Registrant and its subsidiaries (referred to collectively as "Registrant" herein, unless context otherwise indicates) are divided into groups (business segments) as follows: Signal, Sign, Tool and Vehicle. This classification of products and services is based upon Registrant's historical divisional structure established by management for the purposes of internal control, marketing and accounting. Developments, including acquisitions of businesses, considered significant to the company or individual segments are described under the following discussions of the applicable groups. The Financial Review sections, "Consolidated Results of Operations," "Group Operations" and "Financial Position and Cash Flow," and Note N - Segment Information contained in the annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference. On February 3, 1994, the Registrant's Board of Directors declared a 4-for-3 common stock split distributed March 1, 1994 to shareholders of record on February 14, 1994. The 554,088 post-split treasury shares held on February 14, 1994 were used to partially effect the split. Previously reported financial information has been restated to give effect to the stock split. Signal Group Signal Group products manufactured by Registrant consist of (1) a variety of visual and audible warning and signaling devices used by private industry, federal, state and local governments, building contractors, police, fire and medical fleets, utilities and civil defense and (2) parking, revenue control, and access control equipment and systems for parking facilities, commercial businesses, bridge and pier installation and residential developments. The visual and audible warning and signaling devices include emergency vehicle warning lights, electromechanical and electronic vehicle sirens and industrial signal lights, sirens, horns, bells and solid state audible signals, audio/visual emergency warning and evacuation systems, including weather and nuclear power plant warning notification systems and fire alarm system panels and devices. Parking, revenue control, and access control equipment and systems includes parking and security gates, card access readers, ticket issuing devices, coin and token units, fee computers, various forms of electronic control units and personal computer-based revenue and access control systems. Warning and signaling products, which account for the principal portion of the group's business, are marketed to both industrial and governmental users. Products are sold to industrial customers through manufacturers' representatives who sell to approximately 1,400 wholesalers. Products are also sold to governmental customers through more than 900 active independent distributors as well as through original equipment manufacturers and direct sales. International sales are made through the Registrant's independent foreign distributors or on a direct basis. Because of the large number of Registrant's products, Registrant competes with a variety of manufacturers and suppliers and encounters varying competitive conditions among its different products and encounters different classes of customers. Because of the variety of such products and customers, no meaningful estimate of either the total number of competitors or Registrant's overall competitive position can be made. Generally, competition is intense as to all of Registrant's products and, as to most such products, is based on price, including competitive bidding, on product reputation and performance, and on product servicing. Although some competitors in certain product lines are larger than Registrant, the Registrant believes it is the leading supplier of particular products. In May 1992, the Registrant acquired all of the outstanding shares of Aplicaciones Tecnologicas VAMA S.L. for cash and an earnout to be based upon future profitability of the company for a five-year period. VAMA is a leading European manufacturer of emergency vehicular signaling products located in Barcelona, Spain. The acquisition accelerates the Signal Group's strategic objective of increasing international market penetration, particularly in Europe. The backlogs of orders of Signal Group products believed to be firm at December 31, 1993 and 1992 were $9.7 million and $8.4 million, respectively. Almost all of the backlogs of orders at December 31, 1993, are reasonably expected to be filled within the current fiscal year. Sign Group The Sign Group, operating principally under the name "Federal Sign" designs, engineers, manufactures, installs and maintains illuminated and non- illuminated sign displays, for both sale and lease. Registrant additionally provides sign repair services and also enters into maintenance service contracts, usually over three-year to five-year periods, for signs it manufactures as well as for signs produced by other manufacturers. Its operations are oriented to custom designing and engineering of commercial and industrial signs or groups of signs for its customers. The sale and lease of signs and the sale of maintenance contracts are conducted primarily through Registrant's direct sale organization which operates from its twenty-two principal sales and manufacturing facilities located strategically throughout the continental U.S. Customers for sign products and services consist of local commercial businesses, as well as major national and multi-national companies. The Sign Group's markets stabilized during 1993, while the Registrant continued with aggressive, strategic restructuring programs. The group focused on reducing nonvalue-added tasks, redesigned work flow and emphasized training programs to empower employees and to improve quality and customer service. These programs, combined with a marketing effort targeted at more sophisticated, higher value-added projects, resulted in a return to profitability in 1993. A large number of Registrant's displays are leased to customers for terms of typically three to five years with both the lease and the maintenance portions of many such contracts then renewed for successive periods. Registrant is nationally a principal producer of custom-designed signs, but has numerous competitors (estimated at about 3,500 in total), most of whom are localized in their operations. Competition for sign products and services is intense and competitive factors consist largely of prices, terms, aesthetic and design considerations, and maintenance services. In some instances, smaller and more localized operations may enjoy some cost advantages which may permit lower pricing for particular displays. However, Registrant's reputation for creative design, quality manufacture and complete nationwide service together with its financial ability to maintain customer leasing programs and to undertake large project commitments in many cases offset competitors' price advantages. Total backlog at December 31, 1993, applicable to sign products and services was approximately $54.2 million compared to approximately $54.6 million at December 31, 1992. A significant part of Registrant's sign products and services backlog relates to sign maintenance contracts since such contracts are usually performed over long periods of time. At December 31, 1993, the Sign Group had a backlog of approximately $41.5 million compared to approximately $41.3 million at December 31, 1992, represented by in-service sign maintenance contracts. With the exception of the sign maintenance contracts, most of the backlog orders at December 31, 1993 are reasonably expected to be filled within the current fiscal year. Tool Group Tool Group products are produced by the Registrant's wholly-owned sub- sidiaries including: Dayton Progress Corporation, Schneider Stanznormalien GmbH, acquired in 1992, Container Tool Corp., acquired in 1991, Manchester Tool Company, Dico Corporation, acquired in 1992, Bassett Rotary Tool Company and Jamestown Punch and Tooling, Inc. Dayton Progress Corporation manufactures and purchases for resale an extensive variety of consumable die components for the metal stamping industry. These components consist of piercing punches, matched die matrixes, punch holders or retainers and many other products related to the metal stamper's needs. Registrant also produces a large variety of consumable precision metal products for customers' nonstamping needs, including special heat exchanger tools, beverage container tools, powder compacting units and molding components. In March 1992, Dayton Progress Corporation acquired for cash the assets of Schneider Stanznormalien GmbH, a German manufacturer of precision punch and die components. This acquisition gives Dayton Progress manufacturing capabilities on the European continent and provides greater access to European markets. In October 1991, Dayton Progress Corporation acquired for cash and stock all of the outstanding shares of Container Tooling Corporation. Container Tool manufactures and distributes body punch tooling used in the production of aluminum and steel beverage cans. The product complements Dayton Progress' tab-top tooling product line. In July 1989, Dayton Progress Corporation acquired for cash all of the outstanding stock of Electro Diecraft, a Canadian tool manufacturer. The name of the corporation was changed to Dayton Progress Canada, Ltd. Manchester Tool Company manufactures consumable carbide insert tooling for cutoff and deep grooving metal cutting applications. In November 1992, Manchester Tool Company acquired for cash all of the outstanding shares of Dico Corporation, a manufacturer of polycrystalline diamond and cubic boron nitride cutting tools. This product line complements Manchester Tool's carbide insert products and allows for entry into new market niches within general business areas already served. Bassett Rotary Tool Company is a manufacturer of consumable carbide cutting tools. Its products are medium to high precision in their manufacture and at times are quite complex in their configuration. The products represent a narrow band of the much broader cutting tool industry and require a high level of manufacturing skill. Jamestown Punch and Tooling, Inc. (previously known as Jamestown Perforators, Inc.) manufactures an extensive line of consumable special die components for the metal stamping and plastic molding industries in addition to a variety of precision ground high alloy parts. The markets served are located primarily east of the Mississippi River and price is an important purchasing factor in this highly competitive market. Sales are made on both a direct basis and through a limited distributor organization. Because of the nature of and market for the Registrant's products, competition is great at both domestic and international levels. Many customers have some ability to produce the product themselves, but at a cost disadvantage. Major market emphasis is placed on quality of product and level of service. Tool Group products are labor intensive with the only significant outside cost being the purchase of the tool steel, carbide and diamond raw material, as well as items necessary for manufacturing. Inventories are maintained to assure prompt service to the customer with the average order for standard tools filled in less than one week for domestic shipments and within two weeks for international shipments. Tool Group customers include metal and plastic fabricators and tool and die shops throughout the world. Because of the nature of the products, volume depends mainly on repeat orders from customers numbering in the thousands. These products are used in the manufacturing process of a broad range of items such as automobiles, appliances, construction products, electrical motors, switches and components and a wide variety of other household and industrial goods. Almost all business is done with private industry. Registrant's products are marketed in the United States, Japan and Europe principally through industrial distributors. Foreign sales and distribution offices are maintained in Weston, Ontario; Sagamihara and Tokyo, Japan; Kenilworth, England and Oberursel, Germany. Foreign manufacturing facilities are located in Weston, Ontario, Sagamihara, Japan and Oberursel, Germany. Sales to nondomestic customers are made through five wholly-owned subsidiaries: Dayton Progress Canada, Ltd., Dayton Progress International Corporation, Dayton Progress (UK) Ltd., Nippon Dayton Progress K.K. and Schneider Stanznormalien GmbH. Order backlogs of the Tool Group as of December 31, 1993 and December 31, 1992 were $7.5 million and $6.7 million, respectively. Almost all of the backlogs of orders at December 31, 1993 are expected to be filled within the current fiscal year. Vehicle Group The Vehicle Group is composed of Emergency One, Inc., Superior Emergency Vehicles, Ltd., acquired in 1991, Elgin Sweeper Company, Guzzler Manufacturing, Inc., acquired in 1993, and Ravo International, acquired in 1990. Emergency One, Inc. is the leading manufacturer of custom-designed fire trucks and rescue vehicles including four and six-wheel drive rescue trucks, tankers, pumpers, aerial ladder trucks, and airport rescue and fire fighting vehicles (each of aluminum construction for rust-free operation and energy efficiency). In December 1991, Emergency One acquired for cash all of the outstanding shares of Frontline Corporation, a manufacturer and distributor of ambulances, rescue trucks and mobile communication vehicles. The acquisition of Frontline Corporation complemented Emergency One's product line and enabled Emergency One to provide a complete product line of fire trucks, fire apparatus, emergency support and ambulance vehicles for distribution through Emergency One's domestic and international dealer network. During 1993, the company's ambulance operations were relocated to Emergency One's facilities in Ocala, Florida and the mobile communications vehicles product line was sold. The company was merged into Emergency One in January 1994. In December 1991, Emergency One acquired for cash, Superior Emergency Vehicles, Ltd., a manufacturer and distributor of a full range of fire truck bodies primarily for the Canadian market. In addition to increased manufacturing capacity, the acquisition of Superior Emergency Vehicles, Ltd. provides greater access to the Canadian market. In October 1989, Emergency One acquired for cash, American Eagle Fire Apparatus Company, Inc., a manufacturer of a full range of bodies for fire apparatus vehicles. The acquisition of American Eagle provided Emergency One with additional capacity to accommodate its rapid growth. This company was merged into Emergency One in June 1992. Elgin Sweeper Company is the leading manufacturer in the United States of self-propelled street cleaning vehicles. Utilizing three basic cleaning methods (mechanical sweeping, vacuuming and recirculating air), Elgin's products are primarily designed for large-scale cleaning of curbed streets and other paved surfaces. In March 1993, Elgin Sweeper Company acquired, principally for cash, all of the outstanding shares of Guzzler Manufacturing, Inc. Guzzler is an Alabama-based manufacturer and marketer of waste removal vehicles, using state-of-the-art vacuum technology, for worldwide industrial, environmental and municipal markets. The acquisition of Guzzler Manufacturing, Inc. complements Elgin Sweeper Company's product distribution and provides for increased exposure to the industrial and municipal marketplaces for Elgin and Guzzler, respectively. In December 1990, the Registrant, through Federal Signal Europe BV, acquired all of the outstanding shares of Van Raaij Holdings BV (which, along with its subsidiaries, is referred to herein as Ravo International), a Netherlands-based street sweeper manufacturer, for cash and an earnout to be based upon future profitability of the company for a five-year period. Ravo International is a leading European manufacturer and marketer of self- propelled street and sewer cleaning vehicles. Utilizing the vacuuming cleaning method, Ravo's products are primarily designed for cleaning of curbed streets and other paved surfaces. Both Ravo International and Elgin Sweeper Company also sell accessories and replacement parts for their sweepers. Ravo International also provides after market service and support for its products in the Netherlands. Some products and components thereof are not manufactured by Registrant but are purchased for incorporation with products of Registrant's manufacture. A majority of Vehicle Group sales are made to domestic and overseas municipalities and other governmental units, although in the street sweeper market and with the 1993 acquisition of Guzzler Manufacturing, Inc., there is an emerging trend towards commercial, industrial and private customers. Worldwide sales are principally conducted by domestic and international dealers, in most areas, with some sales being made on a direct-to-user basis. Registrant competes with several domestic and foreign manufacturers and due to the diversity of products offered, no meaningful estimate of either the number of competitors or Registrant's relative position within the market can be made, although Registrant does believe it is a major supplier within these product lines. Registrant competes with numerous foreign manufacturers principally in international markets. At December 31, 1993, the Vehicle Group backlogs were $150.3 million compared to $128.2 million at December 31, 1992. The backlogs at December 31, 1993, included approximately $3.2 million of backlog attributable to Guzzler Manufacturing, Inc., which was acquired in March 1993. A substantial majority of the orders in the backlogs at December 31, 1993 are reasonably expected to be filled within the current fiscal year. Approximately $34.3 million of the backlogs at December 31, 1993 and $30.3 million of the backlogs at December 31, 1992 represent the funded portion of a subcontract to build P-23 airport rescue and fire fighting vehicles for the U.S. Air Force, about half of which is expected to be produced and shipped after December 31, 1994. Additional Information Registrant's sources and availability of materials and components are not materially dependent upon either a single vendor or very few vendors. Registrant owns a number of patents and possesses rights under others to which it attaches importance, but does not believe that its business as a whole is materially dependent upon any such patents or rights. Registrant also owns a number of trademarks which it believes are important in connection with the identification of its products and associated goodwill with customers, but no material part of Registrant's business is dependent on such trademarks. Registrant's business is not materially dependent upon research activities relating to the development of new products or services or the improvement of existing products and services, but such activities are of importance as to some of Registrant's products. Expenditures for research and development by the Registrant were approximately $5.6 million in 1993, $5.2 million in 1992 and $5.1 million in 1991. Note N - Segment Information, presented in the annual report to shareholders for the year ended December 31, 1993, contains information concerning the Registrant's foreign sales, export sales and operations by geographic area, and is incorporated herein by reference. No material part of the business of Registrant is dependent either upon a single customer or very few customers. There are no significant seasonal aspects to Registrant's business or any material portion thereof. The Registrant is in substantial 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. These provisions have had no material adverse impact upon capital expenditures, earnings or competitive position of the Registrant and its subsidiaries. The Registrant employed 4,426 people in ongoing businesses at the close of 1993. The Registrant believes relations with its employees have been satisfactory. Item 2. Item 2. Properties. As of March 1, 1994, the Registrant utilized twenty-four principal manufacturing plants located primarily throughout North America, as well as six in Europe and one in the Far East. In addition, there were thirty-six sales and service/warehouse sites, with thirty being domestically based and six located overseas. The majority of the manufacturing plants are owned, whereas all the sales and service/warehouse sites are leased. In total, the Registrant devoted approximately 1,202,000 square feet to manufacturing and 788,000 square feet to service, warehousing and office space, as of March 1, 1994. Of the total square footage, approximately 23% is devoted to the Signal Group, 19% to the Sign Group, 13% to the Tool Group and 45% to the Vehicle Group. Not included in the manufacturing square footage is approximately 37,000 square feet of unutilized manufacturing space that resulted from the rearrangement of the Registrant's manufacturing operations, mostly in the Sign Group. This space is presently being marketed for sale or lease to nonaffiliates. Approximately 71% of the total square footage is owned by the Registrant, with the remaining 29% being leased. All of the Registrant's properties, as well as the related machinery and equipment, are considered to be well-maintained, suitable and adequate for their intended purposes. In the aggregate, these facilities are of sufficient capacity for the Registrant's current business needs. Capital expenditures for the years ended December 31, 1993, 1992, and 1991 were $10.1 million, $8.8 million, and $12.0 million, respectively. Capital expenditures in 1991 included expenditures relating to the airport rescue and fire fighting vehicle manufacturing facility at Emergency One. Registrant anticipates total capital expenditures in 1994 will not be significantly greater than 1993 amounts. Item 3. Item 3. Legal Proceedings. The Registrant is subject to various claims, other pending and possible legal actions for product liability and other damages and other matters arising out of the conduct of the Registrant's business. The Registrant believes, based on current knowledge and after consultation with counsel, that the outcome of such claims and actions will not have a material adverse effect on the Registrant's consolidated financial position or the results of operations. On May 3, 1993, a Texas federal court jury rendered a verdict of $17,745,000 against Federal Sign, a division of the company, for alleged violation of the Texas Deceptive Trade Practices Act and misrepresentations to Duravision, Inc. and Manufacturers Product Research Group of North America, Inc. in connection with a 1988 research and development project for indoor advertising signs. The company believes the court erroneously excluded important evidence and that the verdict was against the weight of the evidence. Both inside and outside counsel that initially handled the case opined at the time of the verdict that the likelihood of a substantially unfavorable result to the company on appeal was remote. Trial counsel has turned the case over to new appellate counsel and has stated they cannot currently give an opinion on the appeal because they are no longer handling the case. Appellate counsel now handling the appeal of the case has not issued an opinion on its outcome. However, if the company loses its appeal of this case, there would be a charge to earnings for this verdict, plus interest and attorney fees. The company believes that the ultimate resolution of this contingency will not have a material effect on its financial condition, and accordingly, the company has not recorded any accruals for potential losses resulting from this judgment. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders through the solicitation of proxies or otherwise during the three months ended December 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters. Federal Signal Corporation's Common Stock is listed and traded on the New York Stock Exchange under the symbol FSS. Per share data listed in Note O -Selected Quarterly Data (Unaudited) contained in the 1993 annual report to shareholders is incorporated herein by reference. As of March 1, 1994, there were 4,818 holders of record of the Registrant's common stock. Certain long-term debt agreements impose restrictions on Registrant's ability to pay cash dividends on its common stock. All of the retained earnings at December 31, 1993, were free of any restrictions. Item 6. Item 6. Selected Financial Data. Selected Financial Data contained in the 1993 annual report to shareholders is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The Financial Review sections "Consolidated Results of Operations," "Group Operations" and "Financial Position and Cash Flow" contained in the 1993 annual report to shareholders are incorporated herein by reference. Note M - Contingency, contained in the annual report to shareholders for the year ended December 31, 1993, is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and accompanying footnotes of the Registrant and the report of the independent auditors set forth in the Registrant's 1993 annual report to shareholders are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information under the caption "Election of Directors" contained in the Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 18, 1994 is incorporated herein by reference. The following is a list of the Registrant's executive officers, their ages, their business experience and their positions and offices as of March 1, 1994: Joseph J. Ross, age 48, was elected Chairman, President and Chief Executive Officer in February, 1990. Previously he served as President and Chief Executive Officer since December 1987 and as Chief Operating Officer since July 1986. Charles R. Campbell, age 54, was elected Senior Vice President and Chief Financial and Administrative Officer in July 1986. John A. DeLeonardis, age 46, was elected Vice President-Taxes in January 1992. He first joined the company as Director of Tax in November 1986. Theodore S. Fries, age 49, was elected President of Emergency One, Inc. in August 1984. Richard G. Gibb, age 50, was appointed President of the Signal Products Division in February 1985. Roger B. Parsons, age 53, was elected President of Elgin Sweeper Company in January 1983. Jesse N. Polan, age 44, was appointed President of Federal APD in February 1985. Robert W. Racic, age 45, was elected Vice President and Treasurer in April 1984. Richard L. Ritz, age 40, was elected Vice President and Controller in January 1991. He was appointed Controller effective November 1985. Richard R. Thomas, age 60, was appointed President of the Tool Group in January 1983. Kim A. Wehrenberg, age 42, was elected Vice President, General Counsel and Secretary effective October 1986. These officers hold office until the next annual meeting of the respective Boards following their election and until their successors shall have been elected and qualified. There are no family relationships among any of the foregoing executive officers. Item 11. Item 11. Executive Compensation. The information contained under the caption "Executive Compensation" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 1994 is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information contained under the caption "Security Ownership of Certain Beneficial Owners" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 1994 is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. The information contained under the caption "Executive Compensation" of Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held April 18, 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 consolidated financial statements of Federal Signal Corporation and Subsidiaries included in the 1993 annual report of the Registrant to its shareholders are filed as a part of this report and 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 Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules The following consolidated financial statement schedules of Federal Signal Corporation and Subsidiaries, for the three years ended December 31, 1993, are filed as a part of this report in response to Item 14(d): Schedule II -- Amounts receivable from related parties and underwriters, promoters and employees other than related parties Schedule VIII -- Valuation and qualifying accounts Schedule IX -- Short-term borrowings 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. 3. Exhibits 3. a. Restated Certificate of Incorporation of Registrant and Certificate of Amendment, filed as Exhibit (3)(a) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. b. By-laws of Registrant, filed as Exhibit (3)(b) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 4. a. Rights Agreement. b. The Registrant has no long-term debt agreements for which the related outstanding debt exceeds 10% of consolidated total assets as of December 31, 1993. Copies of debt instruments for which the related debt is less than 10% of consolidated total assets will be furnished to the Commission upon request. 10. a. 1988 Stock Benefit Plan, filed as Exhibit (10)(a) to Registrant's Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. b. Corporate Management Incentive Bonus Plan, filed as Exhibit (10)(b) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. c. Subsidiaries, Division and Other Designated Profit Centers Management Incentive Bonus Plan, filed as exhibit (10)(c) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. d. Supplemental Pension Plan, filed as Exhibit (10)(d) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. e. Executive Disability, Survivor and Retirement Plan, filed as Exhibit (10)(e) to Registrant's Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. f. Supplemental Savings and Investment Plan. g. Employment Agreement with Charles R. Campbell, filed as Exhibit (10)(g) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. h. Employment Agreement with Joseph J. Ross, filed as Exhibit (10)(h) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. i. Change of Control Agreement with Kim A. Wehrenberg, filed as Exhibit (10)(i) to Registrant's Form 10-K for the year ended December 31, 1989, is incorporated herein by reference. j. Director Deferred Compensation Plan, filed as Exhibit (10)(j) to Registrant's Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. k. Director Retirement Plan, filed as Exhibit (10)(k) to Registrant's Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 11. Computation of net income per common share 13. 1993 Annual Report to Shareholders of Federal Signal Corporation. Such report, except for those portions thereof which are expressly incorporated by reference in this Form 10-K, is furnished for the information of the Commission only and is not to be deemed "filed" as part of this filing. 21. Subsidiaries of the Registrant 23. Consent of Independent Auditors (b) Reports on Form 8-K No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) and (d) The response to this portion of Item 14 is being submitted as a separate section of this report. Other Matters 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. 33-12876, 33-22311, 33-38494, 33-41721 and 33-49476, dated April 14, 1987, June 26, 1988, December 28, 1990, July 15, 1991 and June 9, 1992, respectively: 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. 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. FEDERAL SIGNAL CORPORATION By: /s/ Joseph J. Ross March 25, 1994 Chairman, President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below, on March 25, 1994, by the following persons on behalf of the Registrant and in the capacities indicated. /s/ Charles R. Campbell /s/ Walter R. Peirson Senior Vice President and Chief Director Financial and Administrative Officer /s/ Richard L. Ritz /s/ J. Patrick Lannan, Jr. Vice President and Controller Director /s/ James A. Lovell, Jr. Director /s/ Thomas N. McGowen, Jr. Director

17797_1993.txt

17797_1993

1993

17797

ITEM 1. BUSINESS _________________ GENERAL _______ 1. COMPANY. Carolina Power & Light Company (Company) is a public service corporation formed under the laws of North Carolina in 1926, and is engaged in the generation, transmission, distribution and sale of electricity in portions of North Carolina and South Carolina. The Company had 8,027 employees at December 31, 1993. The principal executive offices of the Company are located at 411 Fayetteville Street, Raleigh, North Carolina 27601, telephone number: 919-546-6111. 2. SERVICE. a. The territory served, an area of approximately 30,000 square miles, includes a substantial portion of the coastal plain in North Carolina extending to the Atlantic coast between the Pamlico River and the South Carolina border, the lower Piedmont section in North Carolina, an area in northeastern South Carolina, and an area in western North Carolina in and around the City of Asheville. The estimated total population of the territory served is approximately 3.5 million. b. The Company provides electricity at retail in 219 communities, each having an estimated population of 500 or more, and at wholesale to one joint municipal power agency, 4 municipalities and 18 electric membership corporations. At December 31, 1993, the Company was furnishing electric service to approximately 1,032,000 customers. 3. SALES. During 1993, 32.6% of operating revenues was derived from residential sales, 20.5% from commercial sales, 25.7% from industrial sales, 17.2% from resale sales and 4.0% from other sources. Of such operating revenues, approximately 85% was derived from North Carolina and approximately 15% from South Carolina. For the twelve months ended December 31, 1993, average revenues per kilowatt-hour (kWh) sold to residential, commercial and industrial customers were 8.28 cents, 6.94 cents and 5.49 cents, respectively. Sales to residential customers for the past five years are listed below. Average Average Annual Annual Revenue Year kWh Use Bill per kWh ____ _______ _______ _______ 1989 12,419 $ 987.19 7.95 cents 1990 11,957 995.01 8.32 1991 12,472 1,040.70 8.34 1992 12,396 1,029.82 8.31 1993 13,167 1,090.16 8.28 4. PEAK DEMAND. a. A 60-minute system peak demand record of 10,144 megawatts (MW) was reached on January 19, 1994. At the time of this peak demand, the Company's capacity margin based on installed capacity (less unavailable capacity) and scheduled firm purchases and sales was approximately 0.22%. b. Total system peak demand for 1991 increased by 3.2%, for 1992 increased by 3.1%, and for 1993 increased by 3.8%, as compared with the preceding year. The Company currently projects a 2.3% average annual growth in system peak demand over the next ten years. The year-to-year change in actual peak demand is influenced by the specific weather conditions during those years and may not exhibit a consistent pattern. Total system load factors, expressed as the ratio of the average load supplied to the peak load demand, for the years 1991-1993 were 57.8%, 57.4% and 59.0%, respectively. The Company forecasts capacity margins of 15.2% and 13.4% over anticipated system peak load for 1994 and 1995. This forecast assumes normal weather conditions in each year consistent with long-term experience, and is based upon the rated Maximum Dependable Capacity of generating units in commercial operation and scheduled firm purchases of power. See ITEM 1, "Generating Capability" and "Interconnections With Other Systems." However, some of the generating units included in arriving at these capacity margins may be unavailable as a result of scheduled outages, environmental modifications or unplanned outages. See ITEM 1, "Environmental Matters" and "Nuclear Matters." The data contained in this paragraph includes North Carolina Eastern Municipal Power Agency's (Power Agency) load requirements and capability from its ownership interests in certain of the Company's generating facilities. See ITEM 1, "Generating Capability," paragraph 1. GENERATING CAPABILITY _____________________ 1. FACILITIES. The Company has a total system installed generating capability of 9,613 MW, with generating capacity provided primarily from the installed generating facilities listed in the table below. The remainder of the Company's generating capacity is composed of 53 coal, hydro and combustion turbine units ranging in size from a 2.5 MW hydro unit to a 78 MW coal-fired unit. Pursuant to certain agreements with Power Agency, which is comprised of former North Carolina municipal wholesale customers of the Company and Virginia Electric and Power Company (Virginia Power), Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1 (collectively, the Joint Facilities). Of the total system installed generating capability of 9,613 MW (including Power Agency's share), 55% is coal, 32% is nuclear, 2% is hydro and 11% is fired by other fuels including No. 2 oil, natural gas and propane. MAJOR INSTALLED GENERATING FACILITIES Year Maximum Plant Unit Commercial Primary Dependable Location No. Operation Fuel Capacity ________ ____ __________ _______ __________ Asheville 1 1964 Coal 198 MW (Skyland, N.C.) 2 1971 Coal 194 MW Cape Fear 5 1956 Coal 143 MW (Moncure, N.C.) 6 1958 Coal 173 MW H. F. Lee 1 1952 Coal 79 MW (Goldsboro, N.C.) 2 1951 Coal 76 MW 3 1962 Coal 252 MW H. B. Robinson 1 1960 Coal 174 MW (Hartsville, S.C.) 2 1971 Nuclear 683 MW Roxboro 1 1966 Coal 385 MW (Roxboro, N.C.) 2 1968 Coal 670 MW 3 1973 Coal 707 MW 4 1980 Coal 700 MW* L. V. Sutton 1 1954 Coal 97 MW (Wilmington, N.C.) 2 1955 Coal 106 MW 3 1972 Coal 410 MW Brunswick 1 1977 Nuclear 767 MW* (Southport, N.C.) 2 1975 Nuclear 754 MW* Mayo 1 1983 Coal 745 MW* (Roxboro, N.C.) Harris 1 1987 Nuclear 860 MW* (New Hill, N.C.) ____________ *Facilities are jointly owned by the Company and Power Agency, and the capacity shown includes Power Agency's share. 2. MAINTENANCE OF PROPERTIES. The Company maintains all of its properties in good operating condition in accordance with sound management practices. The average life expectancy for ratemaking and accounting purposes of the Company's generating facilities (excluding combustion turbine units and hydro units) is approximately 40 years from the date of commercial operation. 3. GENERATION ADDITIONS SCHEDULE. The Company's energy and load forecasts were revised in December 1993. Over the next ten years, system sales growth is forecasted to average 2.3% per year and annual growth in system peak demand is projected to average 2.3%. The Company's generation additions schedule reflects no additions until 1996, when three new combustion turbine generating units are currently scheduled to commence commercial operation. These units, having a total generating capacity of approximately 225 MW, will be located at the Company's Darlington County Electric Plant near Hartsville, South Carolina and are expected to cost an aggregate of approximately $93 million. The generation additions schedule, which is updated annually, also includes generation additions of 3,600 MW in combustion turbine generating units to be added over the period 1997 to 2007 at undesignated sites and a 500 MW baseload coal unit in 2008 at an undesignated site. 4. RELICENSING OF HYDROELECTRIC PLANT. In 1973, the Company filed an application with the Federal Power Commission, now the Federal Energy Regulatory Commission (FERC), for a new long-term license for its 105 MW Walters Hydroelectric Plant (Project No. 432-004). North Carolina Electric Membership Corporation (NCEMC), doing business as Carolina Electric Cooperatives, filed a competing application in August 1974 (Project No. 2748-000). Since the initial license expired in 1976, the Company has continued to operate the Walters Hydroelectric Plant under an annual license issued by the FERC. Loss of the license would result in significant additional costs to the Company; however, the financial impact would be dependent on future ratemaking treatment. The FERC issued orders staying the relicensing proceedings until February 1990. Thereafter, the FERC set the matter for hearing, and the North Carolina Department of Environment, Health and Natural Resources and the Tennessee Wildlife Resources Agency intervened in this proceeding. A two- phase evidentiary hearing was concluded in October 1991, but the FERC has not yet rendered its decision. On September 17, 1993, the Company and NCEMC filed a settlement agreement (Settlement Agreement) with the FERC. Under the terms of the Settlement Agreement, NCEMC will withdraw its competing request for a license for the Walters Hydroelectric Plant. The Settlement Agreement also resolves, as between the parties, issues related to NCEMC's objections to the Company's purchase power contract with Duke Power Company (Duke) and NCEMC's interest in transferring base load capacity from its ownership in Duke's Catawba Nuclear Station (Docket Nos. ER 89-106-000, EL 91-55-000 and ER 92-199-000). See ITEM 1, "Interconnections with Other Systems," paragraph 3.a. for further discussion of the purchase power contract. Also on September 17, 1993, the parties filed with the FERC a Power Coordination Agreement (PCA) and an Interchange Agreement (IA), both dated August 27, 1993. The PCA and IA set forth explicitly the future relationship between the parties and establish a framework under which they will operate. The PCA provides NCEMC the option to gradually assume responsibility for a portion of its load, subject to agreed upon limits, thereby enabling the Company to further enhance its planning for generation and transmission property. Additionally, the Company will sell electricity and provide necessary transmission and coordinating services to NCEMC subject to rates that will benefit the Company and its customers. On October 7, 1993, the FERC Staff filed comments partially opposing the settlement on technical grounds, but recommending that it be certified to the FERC. The Company filed its response to those comments with the FERC on October 18, 1993. On October 26, 1993, the Administrative Law Judge (ALJ) certified the case to the FERC for its decision. In his certification the ALJ noted that the settlement is a good one and will greatly benefit the people of North Carolina. On February 28, 1994, the Company and NCEMC agreed to extend the time for obtaining FERC approval of the PCA and the IA from February 28, 1994 to April 29, 1994. Another settlement agreement regarding various environmental issues has been signed by all the parties and was filed with the FERC for approval on February 16, 1994. On March 8, 1994, the FERC Staff filed comments supporting this settlement agreement. Approval of the settlement agreements and issuance of the license by the FERC will conclude this matter. The Company cannot predict the outcome of these matters. INTERCONNECTIONS WITH OTHER SYSTEMS ___________________________________ 1. INTERCONNECTIONS. The Company's facilities in Asheville and vicinity are integrated into the total system through the facilities of Duke via interconnection agreements that permit transfer of power to and from the Asheville area. The Company also has major interconnections with the Tennessee Valley Authority (TVA), Appalachian Power Company (APCO), Virginia Power, South Carolina Electric and Gas Company (SCE&G), South Carolina Public Service Authority (SCPSA) and Yadkin, Inc. (Yadkin). Major interconnections include 115 kV and 230 kV ties with SCE&G and SCPSA; 115 kV, 230 kV and 500 kV ties with Duke and Virginia Power; a 115 kV tie with Yadkin; a 161 kV tie with TVA; and three 138 kV ties and one 230 kV tie with APCO. See paragraph 3.b. below. 2. INTERCHANGE AGREEMENTS. a. The Company has interchange agreements with APCO, Duke, SCE&G, SCPSA, TVA, Virginia Power and Yadkin which provide for the purchase and sale of power for hourly, daily, weekly, monthly or longer periods. Purchases and sales under these agreements may be made due to changes in the in-service dates of new generating units, outages at existing units, economic considerations or for other reasons. b. The Virginia-Carolinas Subregion of the Southeastern Electric Reliability Council is made up of the Company, Duke, Nantahala Power & Light Company, SCE&G, SCPSA and Virginia Power, plus the Southeastern Power Administration and Yadkin. Electric service reliability is promoted by contractual arrangements among the members of electric reliability organizations at the area, regional and national levels, including the Southeastern Electric Reliability Council and the North American Electric Reliability Council. 3. PURCHASE POWER CONTRACTS. a. In March 1987, the Company entered into a purchase power contract with Duke, whereby Duke would provide 400 MW of firm capacity to the Company's system over the period January 1, 1992, through December 31, 1997. The contract was filed with the FERC in December 1988 (Docket No. ER89-106). NCEMC, Power Agency, Nucor Steel, the South Carolina Consumer Advocate and others moved to intervene in the proceeding, objecting to various aspects of the contract. A hearing was held in January 1990, but the FERC has not yet rendered its decision. Pursuant to an amendment of the contract, commencement of the purchase of power by the Company was delayed until July 1993 and termination was extended through June 1999. This amendment was filed with the FERC and accepted for filing, subject to refund, pursuant to an Order dated January 21, 1992. The docket was consolidated with Docket No. ER89-106 and a settlement agreement resolving issues related to the purchase power contract and other matters was filed with the FERC for approval on September 17, 1993. See ITEM 1, "Generating Capability," paragraph 4 for further discussion of the settlement agreement and other agreements between the Company and NCEMC. Pending the FERC's approval of the settlement, the Company began purchasing 400 MW of generating capacity from Duke in July 1993. The estimated minimum annual payment for power under the six-year agreement is $43 million, which represents capital-related capacity costs. Other costs associated with the agreement include fuel, energy-related operation and maintenance expenses and transmission use charges. The Company cannot predict the outcome of this matter. b. The Company has entered into an agreement, which has been approved by the FERC, with APCO and Indiana Michigan Power Company (Indiana Michigan), operating subsidiaries of American Electric Power Company, to upgrade a transmission interconnection with APCO in the Company's western service area, establish a new interconnection in the Company's eastern service area, and purchase 250 MW of generating capacity from Indiana Michigan's Rockport Unit No. 2. The transmission interconnection upgrade in the Company's western service area was completed in 1992. The purchase of generating capacity began on January 1, 1990, and will continue for a period of 20 years. The estimated minimum annual payment for power purchased under the terms of the agreement is approximately $30 million, which represents capital-related capacity costs. Other costs associated with the agreement include demand-related production expenses, fuel, energy-related operation and maintenance expenses and transmission use charges. 4. FAYETTEVILLE. The Company has an agreement with the City of Fayetteville's Public Works Commission (City) to exchange capacity and energy. The City has a 70 MW heat recovery unit and eight 27.5 MW dual fuel (gas or oil) fired combustion turbine units. The heat recovery unit and five of the combustion turbine units are being used by the City to satisfy energy requirements during periods of peak demand. The agreement makes provisions for the purchase and sale of capacity and/or energy for economic and reliability reasons to the mutual benefit of both parties. On March 10, 1994, the City and the Company entered into a new ten-year agreement under which the Company will continue to be the City's wholesale supplier of electricity. See ITEM 1, "Wholesale Rate Matters," paragraph 3.c. for further discussion of the new agreement. COMPETITION AND FRANCHISES __________________________ 1. COMPETITION. a. Generally, in municipalities and other areas where the Company provides retail electric service, no other utility directly renders such service. In recent years, however, customers interested in building their own generation facilities, competition from unregulated energy suppliers and changing government regulations have fostered the development of alternative sources of electricity for certain of the Company's wholesale and industrial customers. The Public Utility Regulatory Policies Act (PURPA) has facilitated the entry of non-utility companies into the electric generation business. Under PURPA, non-utility companies are allowed to construct "qualifying facilities" for the production of electricity in connection with industrial steam supplies and, under certain circumstances, to compel a utility to purchase the electricity generated at prices reflecting the utility's avoided cost as set by state regulatory bodies. Over the near term, the purchase of power from qualifying facilities has increased the Company's total cost of generation. b. In 1992, the Energy Policy Act of 1992 (Energy Act) was signed into law. The Energy Act addresses a wide range of energy issues, including several matters affecting bulk power competition in the electric utility industry. It creates exemptions from regulation under the Public Utility Holding Company Act of 1935 for persons or corporations that own and/or operate in the United States certain generating and interconnecting transmission facilities dedicated exclusively to wholesale sales, thereby encouraging the participation of utility affiliates, independent power producers and other non-utility participants in the development of wholesale power generation. In addition, the Energy Act confers expanded authority upon the FERC to issue orders requiring public utilities, such as the Company, to transmit power and energy to or for wholesale purchasers and sellers, and to require public utilities to enlarge or construct additional transmission capacity to provide these services. The Energy Act also requires or facilitates numerous initiatives to increase energy efficiency at federal and other facilities. Implementation of portions of this legislation through rulemaking is in progress at the FERC. The Company is unable to predict the ultimate impact the Energy Act will have on its operations. When fully implemented, the Energy Act could impact the Company's load forecasts and plans for power supply to the extent additional generation is facilitated by the Energy Act, current wholesale customers elect to purchase from other suppliers, or new opportunities are created for the Company to expand its wholesale load. The possible migration of some of the Company's load has created greater planning uncertainty and risks for the Company. The Company has been addressing these risks by negotiating long-term contracts with its customers, which allow the Company flexibility in managing its load and efficiently planning its future resource requirements. In this regard, in 1993 the Company signed a significant long-term agreement with NCEMC, which represents 17 of the Company's wholesale customers, and restructured its agreement with Power Agency. Also in 1993, the Company signed power supply agreements with the City of Camden, South Carolina and French Broad Electric Membership Corporation. In 1994, the City of Fayetteville's Public Works Commission entered into a new contract with the Company. In the industrial sector, the Company continues its efforts on a number of programs designed to retain and expand existing load and to attract new business to its service territory. 2. FRANCHISES. The Company is a regulated public utility and holds franchises to the extent necessary to operate in the municipalities and other areas it serves. CONSTRUCTION PROGRAM ____________________ 1. CAPITAL REQUIREMENTS. During 1993 the Company expended approximately $613 million for capital requirements. The Company revised its capital program in 1993 as part of its annual business planning process. Capital requirements, including anticipated construction expenditures for plant modifications, for the years 1994 through 1996 are set forth below. These estimates include Clean Air Act compliance expenditures of approximately $79 million, and generating facility addition expenditures of approximately $248 million. See ITEM 1, "Environmental Matters," paragraph 2 for further discussion of the impact of the Clean Air Act on the Company. Estimated Capital Requirements ______________________________ (In Millions) 1994 1995 1996 TOTAL ____ ____ ____ _____ Construction Expenditures $386 $476 $540 $1,402 Nuclear Fuel Expenditures 25 79 94 198 AFUDC (18) (29) (40) (87) ____ ____ ____ ______ Net expenditures (a) 393 526 594 1,513 Long-Term Debt Maturities 50 275 55 380 ____ ____ ____ ______ TOTAL $443 $801 $649 $1,893 ==== ==== ==== ====== _______________ (a) Reflects reductions of approximately $25 million, $25 million and $27 million for 1994, 1995 and 1996, respectively, in net capital requirements resulting from Power Agency's projected payment of its ownership share of capital expenditures related to the Joint Facilities. FINANCING PROGRAM _________________ 1. CAPITAL REQUIREMENTS. Based on the Company's most recent estimate of capital requirements, the Company does not expect to have external funding requirements in 1994 or 1996 due to the low level of long-term debt maturities in those years. External funding requirements, which do not include early redemptions of long-term debt or redemptions of preferred stock, are expected to approximate $300 million in 1995. These funds will be required for construction, long-term debt maturities and general corporate purposes, including the repayment of short-term debt. The Company may from time to time sell additional securities beyond the amount needed to meet capital requirements to allow for the early redemption of outstanding issues of long-term debt, the redemption of preferred stock, the reduction of short-term debt or for other corporate purposes. The amounts and timing of the sales of securities will depend upon market conditions and the specific needs of the Company. See ITEM 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for further analysis and discussion of the Company's financing plans and capital resources and liquidity. 2. SEC FILINGS. a. The Company has on file with the Securities and Exchange Commission (SEC) a shelf registration statement (File No. 33-50597), enabling the Company to issue an aggregate of $600 million principal amount of First Mortgage Bonds, $450 million of which remain available for issuance. Additionally, the Company has entered into a distribution agreement with respect to the possible future sale of an aggregate amount of $200 million principal amount of First Mortgage Bonds, designated as Secured Medium-Term Notes, Series C, $110 million of which remain available for issuance. b. The Company has on file with the SEC a shelf registration statement (File No. 33-5134) enabling the Company to issue up to $180 million of Serial Preferred Stock. 3. FINANCINGS. External financings during 1993 and early 1994 included: - The issuance on February 17, 1993, of $150 million principal amount of First Mortgage Bonds, 6 1/8% Series due February 1, 2000, for net proceeds of approximately $147.8 million. - The issuance on March 3, 1993, of $150 million principal amount of First Mortgage Bonds, 7 1/2% Series due March 1, 2023, for net proceeds of approximately $147.4 million. - The issuance on July 7, 1993, of $100 million principal amount of First Mortgage Bonds, 5 3/8% Series due July 1, 1998, for net proceeds of approximately $99.1 million. - The issuance on August 26, 1993, of $100 million principal amount of First Mortgage Bonds, 6 7/8% Series due August 15, 2023, for net proceeds of approximately $98.2 million. - During the period from September through December 1993, the Company issued an aggregate of $90 million principal amount of First Mortgage Bonds, Secured Medium-Term Notes, Series C, with interest rates ranging from 4.85% to 5.06% and maturity dates ranging from 1996 to 1998. Net proceeds from the issuances of these First Mortgage Bonds aggregated $89.4 million. - The issuance on January 19, 1994, of $150 million principal amount of First Mortgage Bonds, 5 7/8% Series due January 15, 2004, for net proceeds of approximately $148 million. The proceeds from the issuances listed above were used to reduce the outstanding balance of commercial paper and other short-term debt, to redeem outstanding long-term debt and for other general corporate purposes. 4. REDEMPTIONS/RETIREMENTS. Redemptions and retirements during 1993 included: - The redemption on March 25, 1993, of $82.549 million principal amount of First Mortgage Bonds, 8 1/2% Series due October 1, 2007, at 100.26% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on April 1, 1993, of $70 million aggregate principal amount of First Mortgage Bonds, 7 3/4% Series due October 1, 2001, at 102.30% of the principal amount of such bonds plus accrued interest to the date of redemption. - The purchase and cancellation on April 14, 1993, of $1.8 million aggregate principal amount of The Wake County Industrial Facilities and Pollution Control Financing Authority Pollution Control Revenue Bonds (Carolina Power & Light Company Project) Series 1987 due March 1, 2017, at 100.00% of the principal amount of such bonds plus accrued interest to the date of purchase, pursuant to provisions of the related trust indenture. - The redemption on April 16, 1993, of $100 million aggregate principal amount of First Mortgage Bonds, 8 7/8% Series due March 1, 2016, at 105.77% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on June 22, 1993, of $25 million aggregate principal amount of First Mortgage Bonds, 8.75% Secured Medium-Term Notes, Series A, which matured on that date. - The redemption on August 18, 1993, of $100 million principal amount of First Mortgage Bonds, 8 1/2% Series due January 1, 2017, at 104.64% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on September 1, 1993, of $100 million principal amount of First Mortgage Bonds, 9% Series, which matured on that date. - The redemption on September 16, 1993, of $30 million principal amount of First Mortgage Bonds, 4 1/2% Series due July 1, 1994, at 100% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on October 1, 1993, of $65 million principal amount of First Mortgage Bonds, 7 3/8% Series due January 1, 2001, at 101.91% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on October 1, 1993, of $100 million principal amount of First Mortgage Bonds, 7 3/4% Series due May 1, 2002, at 102.21% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on November 15, 1993, of $100 million principal amount of First Mortgage Bonds, 8 1/8 % Series, which matured on that date. 5. CREDIT FACILITIES. The Company's credit facilities presently total $208.1 million, consisting of a $115 million Revolving Credit Agreement with nine domestic money centers and major regional banks, a $70 million long-term Revolving Credit Agreement with eight foreign banks and a Revolving Credit Agreement of $23.1 million with fifteen regional banks. RETAIL RATE MATTERS ___________________ 1. GENERAL. The Company is subject to regulation in North Carolina by the North Carolina Utilities Commission (NCUC) and in South Carolina by the South Carolina Public Service Commission (SCPSC) with respect to, among other things, rates for electric energy sold at retail, retail service territory and issuances of securities. 2. CURRENT RETAIL RATES. The rates of return granted to the Company in its most recent general rate cases are as follows: 1988 North Carolina Utilities Commission Order (test year ended March 31, 1987) ______________________________________________ Capital Weighted Weighted Capital Structure Ratio Cost Rate Cost _________________ _______ _________ ________ Long-Term Debt 48.57% 8.62% 4.19% Preferred Stock 7.43 8.75 .65 Common Equity 44.00 12.75 5.61 _____ Rate of Return 10.45% ===== 1988 South Carolina Public Service Commission Order (test year ended September 30, 1987) ___________________________________________________ Capital Weighted Weighted Capital Structure Ratio Cost Rate Cost _________________ _______ _________ ________ Long-Term Debt 47.82% 8.62% 4.12% Preferred Stock 7.46 8.75 .65 Common Equity 44.72 12.75 5.71 _____ Rate of Return 10.48% ===== 3. INTEGRATED RESOURCE PLANNING. Integrated Resource Planning is a process that systematically compares all reasonably available resources, both demand-side and supply-side, in order to develop that mix of resources that allows a utility to meet customer demand in a most cost effective manner, giving due regard to system reliability and safety. The Company is required to file its IRP with the NCUC and the SCPSC once every three years. The Company filed its 1992 Integrated Resource Plan (IRP) with the NCUC on April 24, 1992, and by order dated June 29, 1993, the NCUC approved the Company's 1992 IRP. The Company filed its 1992 IRP with the SCPSC on April 30, 1992, and by order dated April 8, 1993, the SCPSC found that the Company's 1992 IRP complied with the SCPSC's integrated resource planning rules. The Company regularly reviews its IRP in light of changing conditions and evaluates the impact these changes have on its resource plans, including purchases and other resource options. 4. DEMAND SIDE MANAGEMENT. The Company's Demand Side Management (DSM) programs are an integral part of its IRP. The Company offers a variety of conservation, load management, and strategic sales programs to its residential, commercial and industrial customers. The objectives of the DSM programs are to improve system operating efficiencies, meet customer needs in a growing service area, defer the need for future generating units and delay the need for future rate increases. Currently, the Company offers time-of-use rates to all its retail customers, low interest loans to its residential customers for the installation of additional insulation and high efficiency heat pumps in existing homes, financial incentives and an energy conservation discount for all-electric homes that meet enhanced thermal integrity and appliance efficiency standards, financial incentives for Company control of residential water heaters and air conditioners in most of the major metropolitan areas served by the Company, incentives for the curtailment of large industrial loads, and energy audits for large commercial and industrial customers, as well as many other programs. Additional programs are in various stages of investigation and development. The Company had achieved a summer peak load reduction capability of 1,559 MW as of December 31, 1993, through its conservation and load management programs. The Company also has rates available for the purchase of power from cogeneration and small power production facilities, as well as standby service rates for customers using their own generation equipment. At the end of 1993, the Company had 43 cogenerators and small power producers on-line with facilities capable of generating a total of approximately 471 MW, of which 283 MW is used internally by customers and 188 MW is sold to the Company. In addition to this cogeneration and small power production, which is associated with the Company's Conservation and Load Management Programs, other cogeneration projects have been installed and used as planned generation resources. This additional capacity includes approximately 266 MW that was fully operational at the end of 1993. The Company has a Hydroelectric Generation Program designed to provide technical assistance to entrepreneurs who are reactivating abandoned hydroelectric generating sites in the Company's service territory. Presently, Hydroelectric Generation Program capability on the Company's system totals approximately 15 MW. Other proposals for generation are received and evaluated by the Company from time to time. See ITEM 1, "Competition and Franchises." 5. FUEL COST RECOVERY. In the North Carolina retail jurisdiction, the NCUC establishes base fuel costs in general rate cases and holds hearings annually to determine whether a rider should be added to base fuel rates to reflect increases or decreases in the cost of fuel and the fuel cost component of purchased power as well as changes in the fuel cost component of sales to other utilities. The NCUC considers the changes in the Company's cost of fuel during a historic test period ending March 31 of each year and corrects any past over-or under-recovery. The Company's 1994 North Carolina fuel case hearing is scheduled to begin on August 2, 1994. In the South Carolina retail jurisdiction, fuel rates are set by the SCPSC based on projected costs for a future six-month test period. At the semi-annual hearings, any past over-or under-recovery of fuel costs is taken into account in establishing the new projected rate for the subsequent six-month billing period. The Company's spring 1994 South Carolina fuel case hearing was scheduled to begin on March 15, 1994; however, on February 1, 1994, the SCPSC approved a settlement agreement that resolved all issues between all parties to the spring fuel proceeding. Pursuant to the settlement, the Company's current fuel factor of 1.425 cents/kWh will continue in effect for the six month period April 1 through September 30, 1994. Issues related to outages at Brunswick Unit No. 1 and the Robinson Nuclear Plant during the period July 1, 1993 through June 30, 1994 will be considered in the fall 1994 South Carolina fuel case hearing. See ITEM 1, "Nuclear Matters," paragraph 7.d., for considerations by the NCUC and the SCPSC regarding costs related to the Brunswick Plant outage, and for a discussion of the settlement agreements, reached in 1993, that resolved issues related to a period of the Brunswick Unit No. 1 outage, and settled the annual North Carolina and semi-annual South Carolina fuel adjustment proceedings. On December 14, 1992, the South Carolina Supreme Court rendered its decision in Nucor Steel's (Nucor) appeal (Opinion No. 23761) of the SCPSC's decision in the Company's fall 1990 South Carolina fuel case. In that fuel case the SCPSC considered the three week operator training outage experienced by the Brunswick Nuclear Plant in the spring of 1990, and also considered a refueling outage experienced by Brunswick Unit No. 2 during the test period. The South Carolina Supreme Court affirmed in part and reversed in part the SCPSC's decision. As a result of the court's decision, approximately $422,000 must be refunded to the Company's customers. As part of the settlement of the spring 1994 South Carolina fuel case, the Company agreed to reduce its fuel cost under-recovery account by this amount. Nucor's appeal of the Company's fall 1990 South Carolina fuel case also challenged the SCPSC's decision to exclude certain testimony offered by Nucor regarding a partial outage experienced by the Company's Robinson Unit No. 2 during the spring and summer of 1990. When this issue was presented to the Court of Common Pleas of Richland County, South Carolina, the court found that the SCPSC should have considered Nucor's testimony, and remanded the matter to the SCPSC. The SCPSC considered the testimony, but found it unpersuasive and reaffirmed its earlier orders on this issue. On September 8, 1993, Nucor appealed the SCPSC's decision to reaffirm its earlier orders to the Court of Common Pleas of Richland County, South Carolina. The Company cannot predict the outcome of this matter. 6. IMPACT OF ENERGY ACT. Section 111 of the Energy Act requires all state commissions to consider whether the adoption of certain standards would further the purposes of the PURPA. These standards relate to the use of integrated resource planning by electric utilities, investments in conservation and demand side management, and energy efficiency investments in power generation and supply. Both the NCUC and the SCPSC have opened dockets to consider these standards. With regard to the NCUC proceeding, direct testimony was filed by the Company on February 8, 1994. A hearing was held on March 8, 1994, but the NCUC has not yet issued its ruling. With regard to the SCPSC proceeding, the Company filed initial written comments on March 1, 1994, and reply comments are due on April 15, 1994. The SCPSC will issue its decision based upon the written comments. The Company cannot predict the outcome of these matters. WHOLESALE RATE MATTERS ______________________ 1. GENERAL. The Company is subject to regulation by the FERC with respect to rates for transmission and sale of electric energy at wholesale, the interconnection of facilities in interstate commerce (other than interconnections for use in the event of certain emergency situations), the licensing and operation of hydroelectric projects and, to the extent the FERC determines, accounting policies and practices. The Company and its wholesale customers last agreed to a general increase in wholesale rates in 1988. 2. FERC MATTERS. a. On April 12, 1991, NCEMC and one of its members, Brunswick Electric Membership Corporation, filed a Complaint and Motion for a Refund (Complaint) with the FERC, Docket No. EL91-28-000, alleging that the Company's wholesale rates and fuel clause billings were excessive and requesting that the Company provide its real-time load signal to NCEMC. All of the Company's remaining wholesale customers intervened in this proceeding. On December 6, 1991, the FERC issued an order which denied the Company's request to dismiss this Complaint, set certain matters for hearing and initiated an investigation on behalf of the intervenors (Docket No. EL91-54-000) to determine if the Company's wholesale rates are excessive. On January 10, 1992, a FERC Administrative Law Judge ordered that NCEMC's case be severed from the FERC-initiated investigation so that the proceedings could continue independently of each other. With regard to the FERC-initiated investigation, on November 12, 1992, the FERC approved the settlement agreement that was filed by the Company and all of the intervenors. With regard to NCEMC's case, the Company has settled with NCEMC on all issues, and on September 15, 1993, the FERC approved the settlement agreement between the parties. The agreement provides for the continuation of existing wholesale rate levels and resolves the wholesale fuel clause billing issue through June 30, 1993. The impact of the settlement totaled approximately $8 million, net of tax, and decreased the Company's 1993 earnings by $.05 per common share. On January 11, 1994, the Company and the intervenor that remained a party to the proceeding initiated by NCEMC filed a settlement agreement with the FERC for approval. On January 31, 1994, the FERC staff filed comments partially opposing the settlement, but recommending that it be certified to the FERC. On February 10, 1994, the Company and the intervenor filed comments supporting the settlement, and rebutting the FERC staff's contrary position. The settlement was certified to the FERC on February 17, 1994. Although the Company cannot predict the outcome of this matter, it does not believe that amounts associated with the settlement will be material to the results of operations of the Company. b. In 1989, Power Agency delivered to the Company a Notice of Intention to Arbitrate certain disputed matters related to Power Agency's use of capacity and energy from the South Carolina Public Service Authority (Santee Cooper), which matters Power Agency originally raised in a complaint before the FERC in 1988 (FERC Docket No. EL88-27-000). In June 1990, the arbitrator issued an order in favor of the Company on the most significant issues of contention between the Company and Power Agency. In addition, the arbitrator ordered the Company and Power Agency to meet for at least 120 days to negotiate a power coordination agreement relating to Power Agency's use of capacity and energy from Santee Cooper. On October 2, 1991, Power Agency filed a complaint at the FERC (Docket No. EL92-1-000) alleging that the Company had refused to agree to just and reasonable terms and conditions for power coordination agreements for Power Agency's purchase of firm capacity and energy from Santee Cooper for the period beginning January 1, 1994, and for Power Agency's use of a combustion turbine electric generating project it planned at that time to place in service on June 1, 1995. In 1993, Power Agency agreed to delay the commercial operation date of its turbine generating project for three years, until June 1, 1998. Power Agency's delay of the project was part of the agreement the Company and Power Agency entered into on April 7, 1993 to restructure portions of their contracts covering power supplies and jointly-owned interests in several of the Company's generating units. See ITEM 1, "Wholesale Rate Matters," paragraph 2.c. for further discussion of the April 7, 1993 agreement between the Company and Power Agency. On September 23, 1993, Power Agency and the Company entered into an agreement in principle that resolves all remaining issues relating to the Santee Cooper and turbine generator transactions. The parties continue to negotiate the details of a final settlement. Because the Santee Cooper transaction with Power Agency commenced on January 1, 1994, the Company and Power Agency have entered into an interim agreement covering the Santee Cooper transaction until a final agreement can be developed. The interim agreement between the parties was approved by the FERC on December 30, 1993. The Company cannot predict the outcome of these matters. c. On April 7, 1993, the Company and Power Agency entered into an agreement to restructure portions of their contracts covering power supplies and jointly-owned interests in several of the Company's generating units. Under the terms of the agreement, the Company is increasing the amount of capacity and energy purchased from Power Agency's ownership interest in the Harris Plant. Additionally, the buyback period has been extended six years through 2007. Also, pursuant to the agreement, a portion of the Harris Plant will not be recoverable through sales of supplemental power to Power Agency. As a result, the Company recorded a write-off in 1993 of approximately $14.7 million, net of tax, or $.09 per common share. Pursuant to that agreement, Power Agency also agreed to the dismissal with prejudice of the Complaint it filed against the Company on July 14, 1988 in the Superior Court of Wake County, North Carolina (Docket No. 88 CVS 6512) alleging that the Company failed to disclose alleged design, management and other problems at the Harris Plant in connection with the sale of capacity to Power Agency. The agreement also provides that Power Agency will delay the commercial operation date of its combustion turbine generating project for three years, until June 1, 1998, and will withdraw the demand of its letter dated January 20, 1993 regarding the costs incurred at the Brunswick Plant during the outage that began in 1992. See ITEM 1, "Wholesale Rate Matters," paragraph 2.b. for further discussion of the agreement. The agreement was filed with the FERC on May 19, 1993 for approval of the provisions that are subject to the FERC's jurisdiction. The Company cannot predict the outcome of this matter. 3. OTHER WHOLESALE MATTERS. a. By letter dated September 23, 1991, the City of Bennettsville, South Carolina (City) notified the Company that it was terminating service as a wholesale customer effective September 30, 1994, and that it intended to enter into a contract to purchase power at wholesale from Marlboro Electric Cooperative, Inc. On December 31, 1991, the Company filed a Declaratory Judgment Complaint in the Court of Common Pleas of Marlboro County, South Carolina (Docket No. 91-CP-34-316) seeking a determination as to the appropriate termination date and as to whether a cooperative can serve the City. On February 13, 1992, the Company filed a Motion for Summary Judgment in this proceeding. By order filed September 21, 1992, the Court of Common Pleas of Marlboro County, South Carolina denied the Company's Motion for Summary Judgment regarding the Marlboro Electric Cooperative, Inc.'s authority to serve the City and granted the Motions for Summary Judgment of Marlboro Electric Cooperative, Inc. and the City. On October 21, 1992, the Company filed a Notice of Appeal in the South Carolina Supreme Court. By order dated March 7, 1994, the South Carolina Supreme Court ruled that the City of Bennettsville can purchase power from Marlboro Electric Cooperative, Inc. beginning in 1995. The Company plans no further appeals. In 1993, the City's average peak load was approximately 16 MW. b. In March 1990, the City of Camden, South Carolina (City) notified the Company that it would terminate its purchase of wholesale power from the Company as of March 31, 1993. The Company responded that the appropriate termination date was May 1, 1995. A petition filed with the FERC by the City relating to this issue was dismissed in July 1991. On December 3, 1991, the City filed a Declaratory Judgment Complaint in the Court of Common Pleas of Kershaw County, South Carolina (Docket No. 91-CP-28-613) seeking a determination as to the proper termination date. In 1992, Motions for Summary Judgment were filed by both parties in this action. On November 9, 1992, the Court granted the Company's Motion for Summary Judgment. The City filed a Notice of Appeal to the Supreme Court of South Carolina. In 1993, both parties filed briefs in the Supreme Court of South Carolina. On January 10, 1994, the parties filed with the FERC for approval a contract amendment that will extend their contractual relationship at least through 1998. By letter dated March 9, 1994, the FERC approved the contract amendment, effective March 11, 1994. Consequently, the parties will seek a dismissal of the State court litigation. In 1993, the City's average peak load was approximately 30 MW. c. On March 10, 1994, the City of Fayetteville's Public Works Commission and the Company entered into a new power supply and coordination agreement under which the Company will continue to provide bulk power to the City. The agreement provides for the sale of a minimum of 140 to 160 MW of base load service and other services for a minimum of ten years, and at the parties' option, for up to fifteen years. The agreement also resolves all wholesale fuel clause billing issues between the City and the Company through December 31, 1993. The agreement will enable the Company to effectively and efficiently meet the growing needs of the City of Fayetteville for years to come. On March 16, 1994, the agreement was filed with the FERC for approval. The Company cannot predict the outcome of this matter. ENVIRONMENTAL MATTERS _____________________ 1. GENERAL. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes and other environmental matters, the Company is subject to regulation by various federal, state and local authorities. The Company considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations and believes it has all necessary permits to conduct such operations. Except as noted below in paragraph 2, the Company does not currently anticipate that its potential capital expenditures for environmental pollution control purposes will be material. Environmental laws and regulations, however, are constantly evolving and the character, scope and ultimate costs for compliance with such evolving laws and regulations cannot now be accurately estimated. Costs associated with compliance with pollution control laws and regulations at the Company's existing facilities, which are expected to be incurred from 1994 through 1996, are included in the estimates of capital requirements under ITEM 1, "Construction Program." 2. CLEAN AIR LEGISLATION. The 1990 amendments to the Clean Air Act (Act) require substantial reductions in sulfur dioxide and nitrogen oxides emissions from fossil-fueled electric generating plants. The Company is not required to take action to comply with the Act's Phase I requirements, which must be met by January 1, 1995. Phase II of the Act, which contains more stringent provisions, will become effective January 1, 2000. To reduce sulfur dioxide emissions, as required by Phase II, the Company will modify equipment to allow certain of the Company's plants to burn lower sulfur coal, and is planning for the installation of scrubbers. Installation of additional equipment will also be necessary to reduce nitrogen oxides emissions. The Company anticipates that it will be able to delay the installation and operation of scrubbers until 2005 by purchasing sulfur dioxide emission allowances. Each sulfur dioxide emission allowance, issued by the Environmental Protection Agency (EPA), will allow a utility to emit one ton of sulfur dioxide. In 1993, the Company purchased emission allowances under the EPA's emission allowance trading program. The Company estimates that the total capital cost to comply with the requirements of Phase II of the Act may approximate $340 million during the period 1994 through 1999, and an additional $460 million during the period 2000 through 2005. These estimates, for installation or modification of equipment, are in nominal dollars (undiscounted future amounts expected to be expended). The required modifications and additions are expected to increase operating and maintenance costs by a total of $20 million for the period 1994 through 1999, $48 million for the period 2000 through 2004, and by $42 million annually, beginning in 2005. Actual plans for compliance with the Act's requirements have not been finalized, and the amount required for capital expenditures and for increased operating and maintenance expenditures cannot be determined with certainty at this time. The financial impact of the additional expenditures will be dependent on future ratemaking treatment. The NCUC and the SCPSC are currently allowing the Company to accrue carrying charges on its investment in emission allowances. A plan for compliance with Phase II of the Act must be submitted to the EPA by January 1, 1996. The Company cannot predict the outcome of this matter. 3. SUPERFUND. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA), authorize the EPA and, indirectly, the states, to require generators and certain transporters of certain hazardous substances released from or at a site, and the owners and operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. There are presently several sites with respect to which the Company has been notified by the EPA or the State of North Carolina of its potential liability, as described below in greater detail. a. On December 2, 1986, the EPA notified the Company of its potential liability pursuant to CERCLA for the investigation and cleanup activities associated with the Maxey Flats Nuclear Disposal Site in Fleming County, Kentucky. The EPA indicated that the site was operated from 1963 to 1977 under the management of Nuclear Engineering Company (now U. S. Ecology). The EPA estimated that the Company sent 304,459 cubic feet of waste to the disposal site. In response to the EPA's notice, the Company and several other potentially responsible parties (PRPs) formed a steering committee (the Maxey Flats Steering Committee) to undertake a remedial investigation/feasibility study pursuant to CERCLA. As a result of this study, the EPA has selected a remedial action which is currently estimated to have a present value cost of between $57 million and $78 million. Subsequent analysis of waste volume sent to the site performed by the Maxey Flats Steering Committee established that the Company contributed only approximately 1% of the total waste volume. It is expected that the Company's share of remediation costs will be based on the ratio of the Company's waste volume to that of other participating PRPs. The Company is currently ranked twenty-fourth on the waste-in list. On June 30, 1992, the EPA sent the Company, along with a number of other companies, agencies and organizations, a notice demanding reimbursement of response costs of approximately $5.8 million that have been incurred at the site and seeking to initiate formal negotiations regarding performance of the remedial design and remedial action for the site. On July 20, 1992, the Company responded that it would negotiate these matters through the Maxey Flats Steering Committee. In December 1992, the EPA rejected the offer the Maxey Flats Steering Committee filed regarding the performance of the remedial design and remedial action for this site. The Maxey Flats Steering Committee submitted amended offers to the EPA in 1993. The EPA has engaged in settlement negotiations with the Maxey Flats Steering Committee. Although the Company cannot predict the outcome of these matters, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. b. On December 2, 1986, the EPA notified the Company that it is a PRP with respect to the disposal, treatment or transportation for disposal or treatment of polychlorinated biphenyls (PCBs) at the Martha C. Rose Chemicals, Inc. (Rose) facility located in Holden, Missouri. Roughly 190,000 pounds of PCB wastes (approximately .8% of the total waste volume) are alleged to have been sent to the site by the Company. By volume, the Company ranks twenty-third on the waste-in list. Site stabilization was completed by Clean Sites, Inc., the third party hired to negotiate a cleanup between the waste generators and the EPA. By letter dated November 12, 1993, the EPA approved the final remediation design for the Rose site. Final site cleanup is expected to begin in 1994. There is currently over 90% participation by the PRPs in the site cleanup. It is estimated that cleanup will cost approximately $30 million. The Company has contributed approximately $293,000 to the waste generators' group and does not expect that it will be required to contribute additional funds to complete remediation of this site. Although the Company cannot predict the outcome of this matter, it does not anticipate that the costs associated with this site will be material to the results of operations of the Company. c. In May 1989, the EPA notified the Company that it is a PRP with respect to the disposal of PCB transformers allegedly sent through Saline County Salvage to Elliot's Auto Parts Site in Benton, Arkansas. In its responses to the EPA, the Company stated its belief that no Company electrical equipment went to the site. Additionally, the Company declined to enter into an Administrative Order of Consent. In December 1992, the Elliot's Auto Parts PRP Committee requested that the Company pay a share of the estimated $2.65 million cost of cleaning up the site, and threatened to initiate litigation should the Company not contribute to the cleanup cost. The Company responded that it would be willing to participate in cleanup activities at the site if documentation was produced showing that the Company contributed any hazardous substances to the site. On January 21, 1993, the Elliot's Auto Parts PRP Committee produced documents alleging that the Company contributed hazardous substances to the site. Although the documentation provided does not clearly establish that the Company disposed of transformers at the Elliot's site, the Company is currently negotiating with the Elliot's Auto Parts PRP Committee to avoid protracted litigation. The Elliot's Auto Parts PRP Committee has completed remedial activities at the site at a cost of approximately $2.7 million and will soon submit a final report to the EPA. Although the Company cannot predict the outcome of this matter, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. d. By letter dated May 21, 1991, the EPA notified the Company that it is a PRP with respect to the disposal of hazardous substances at the Benton Salvage site in Benton, Arkansas. The Company has been unable to identify any records of shipments by the Company to that site. Until any such documentation can be produced, the Company does not intend to participate in cleanup activities at the site. The Company cannot predict the outcome of this matter. e. On April 15, 1991, the North Carolina Department of Environment, Health, and Natural Resources (DEHNR) notified the Company that it is a PRP with respect to the disposal of hazardous waste at the Seaboard Chemical Corporation (Seaboard) site in Jamestown, North Carolina. DEHNR has indicated that it is offering PRPs the opportunity to perform voluntary site cleanup. Seaboard records indicate that there are over 1,300 PRPs for the site and that the Company's contribution to waste disposal is less than 1% of the total waste disposed. On May 29, 1992, the Company entered into an Administrative Order on Consent with DEHNR, Division of Solid Waste Management, to undertake and perform a Work Plan for Surface Removal (Removal Work Plan). On July 28, 1993, DEHNR determined that the Removal Work Plan had been substantially completed. DEHNR further recommended that the Seaboard Group (a group of PRPs with respect to the Seaboard site) undertake additional remedial activities at the Seaboard site. The Seaboard Group is currently considering its response to DEHNR's recommendation. The Company estimates that to date its costs associated with completion of the Removal Work Plan total approximately $12,000. Although the Company cannot predict the outcome of this matter, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. f. On January 9, 1992, the EPA sent notice to the Company, along with a number of other companies and persons, stating that the Company is a PRP with respect to the additional remediation of hazardous wastes at the Macon-Dockery site located near Cordova, North Carolina. The Company made arrangements in the past for the transportation and sale of waste and residual oil to C&M Oil Distributors, a company that operated an oil reprocessing facility at the Macon-Dockery site for a period of several months. However, the information available to the Company indicates that no hazardous wastes from Company facilities were sent to the site. Previously, in 1987, the EPA sent notice to the Company that the EPA believed the Company was a PRP with respect to costs incurred by the EPA for initial site cleanup of the Macon-Dockery site. The Company was also a third-party defendant in a lawsuit brought in federal district court to recover the cleanup costs incurred by the EPA. That lawsuit was subsequently settled. Unless the EPA produces evidence which establishes that hazardous wastes from Company facilities were sent to the site, the Company does not intend to participate in these new cleanup activities. The Company cannot predict the outcome of this matter. 4. OTHER ENVIRONMENTAL MATTERS. a. On April 21, 1989, the North Carolina Division of Environmental Management (DEM) requested that the Company install a groundwater compliance monitoring system at the Company's Wilmington Oil Terminal located in New Hanover County, North Carolina. The request was prompted by the discovery of petroleum contamination beneath a neighboring oil transportation facility. DEM requested the installation of the monitoring system in order to determine if groundwater quality standards have been violated at the Wilmington Oil Terminal and if any such violations have contributed to the contamination underneath the neighboring facility. During the second half of 1989, six groundwater monitoring wells were installed and samples were collected and analyzed for the presence of petroleum hydrocarbons. Samples from one of the six wells indicated gasoline contamination and samples from a second well indicated No. 2 fuel oil contamination. The Company provided information on these monitoring wells to the DEM and in February 1993, DEM granted the Company permission to install a remediation system to collect and treat contaminated groundwater. This system conveys the groundwater to the neighboring facility for co-treatment of the contaminated water. Although the Company cannot predict the outcome of this matter, it believes that any remediation expense would not exceed $100,000 annually. b. Various organic materials associated with the production of manufactured gas, generally referred to as coal tar, are regulated under various federal and state laws, and a contingent liability may exist for their remediation. The production of manufactured gas was commonplace from the late 1800s until the 1950s. The Company has learned of the existence of several manufactured gas plant (MGP) sites to which the Company and certain entities which were later merged into the Company may have had some connection. In 1992, the State of North Carolina, through DEHNR's Division of Solid Waste Management (DSWM), launched an initiative to encourage former owners and operators of MGP sites to voluntarily assess those sites and to undertake remedial action where necessary. In this regard, the Company is participating in the North Carolina MGP Group (Group), a group of entities alleged to be former owners or operators of MGP sites, that was formed in response to DSWM's initiative. In December 1993, the Group and DSWM entered into a Memorandum of Understanding relative to the establishment of a uniform program and framework for addressing MGP sites for which DSWM has contended that members of the Group have potential responsibility. It is anticipated that the investigation and remediation of specific MGP sites will be addressed pursuant to one or more Administrative Orders on Consent between DSWM and individual potentially responsible parties. Additionally, a current owner of one such site formerly owned by Tidewater Power Co., which merged into the Company in 1952, made an informal claim against the Company for the cost of investigation and possible remediation, if necessary, of hazardous materials at this site. The Company and the current owner have entered into an agreement to share the cost of investigation and remediation of the site. Due to the lack of information with respect to the operation of MGP sites and the uncertainty concerning questions of liability and potential environmental harm, the extent and cost of required remedial action, if any, and the extent to which liability may be asserted against the Company or against others are not currently determinable. The Company cannot predict the outcome of these matters or the extent to which other former MGP sites may become the subject of inquiry. NUCLEAR MATTERS _______________ 1. GENERAL. Under the Atomic Energy Act of 1954 and the Energy Reorganization Act of 1974, as amended, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose nuclear safety and security requirements. In the event of non-compliance, the NRC has the authority to impose fines, set license conditions, or shut down a nuclear unit, or some combination of these, depending upon its assessment of the severity of the situation, until compliance is achieved. The electric utility industry in general has experienced challenges in a number of areas relating to the operation of nuclear plants, including substantially increased capital outlays for modifications; the effects of inflation upon the cost of operations; increased costs related to compliance with changing regulatory requirements; renewed emphasis on achieving excellence in all phases of operations; unscheduled outages; outage durations; and uncertainties regarding storage facilities for spent nuclear fuel. See paragraph 7.c. below. The Company experiences these challenges to varying degrees. Capital expenditures for modifications at the Company's nuclear units, excluding Power Agency's ownership interests, during 1994, 1995 and 1996 are expected to total approximately $108 million, $78 million and $55 million, respectively (including AFUDC). 2. SPENT FUEL AND OTHER HIGH-LEVEL RADIOACTIVE WASTE. The Nuclear Waste Policy Act of 1982 (Act) provides the framework for development by the federal government of interim storage and permanent disposal facilities for high-level radioactive waste materials. The Act promotes increased usage of interim storage of spent nuclear fuel at existing nuclear plants. The Company will continue to maximize the usage of spent fuel storage capability within its own facilities for as long as feasible. Pursuant to the Act, the Company, through a joint agreement with the U. S. Department of Energy (DOE) and the Electric Power Research Institute, has built a demonstration facility at the Robinson Plant that allows for the dry storage of 56 spent nuclear fuel assemblies. As of December 31, 1993, sufficient on-site spent nuclear fuel storage capability is available for the full-core discharge of Brunswick Unit No. 1 through 1994, Brunswick Unit No. 2 through 1996, and Robinson Unit No. 2 through 1998, assuming normal operating and refueling schedules. The Harris Plant spent fuel storage facilities, with certain modifications together with the spent fuel storage facilities at the Brunswick and Robinson Units, are sufficient to provide storage space for spent fuel generated on the Company's system through the expiration of the current operating licenses for all of the Company's nuclear generating units. Subsequent to the expiration of the licenses, as part of decommissioning of the units, dry storage may be necessary. The Company is maintaining full-core discharge capability for the Brunswick Units and Robinson Unit No. 2 by transferring spent nuclear fuel by rail to the Harris Plant. As a contingency to the shipment by rail of spent nuclear fuel, on April 27, 1989, the Company filed an application with the NRC for the issuance of a license to construct and operate an independent spent fuel storage facility for the dry storage of spent nuclear fuel at the Brunswick Plant. The Company cannot predict whether or not a license will ultimately be issued by the NRC. As required by the Act, the Company entered into a contract with the DOE under which the DOE will dispose of the Company's spent nuclear fuel. The contract includes a provision requiring the Company to pay the DOE for disposal costs. Disposal costs of fuel burned are based upon actual nuclear generation and are paid on a quarterly basis. Effective January 31, 1992, the DOE revised the method for calculating the nuclear waste disposal cost which will reduce the Company's quarterly payment. Existing overpayments, with interest, will be refunded in the form of credits over the next two fiscal years. Disposal costs, excluding waste disposal credits, are approximately $20 million annually based on the expected level of operations and the present disposal fee per kWh of nuclear generation, and are currently recovered through the Company's fuel adjustment clauses. See ITEM 1, "Retail Rate Matters," paragraph 5. Disposal fees may be reviewed annually by the DOE and adjusted, if necessary. The Company cannot predict at this time whether the DOE will be able to perform its contract and provide interim storage or permanent disposal repositories for spent fuel and/or high-level radioactive waste materials on a timely basis. 3. LOW-LEVEL RADIOACTIVE WASTE. Disposal costs for low-level radioactive waste that results from normal operation of nuclear units have increased significantly in recent years and are expected to continue to rise. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, as amended in 1985, each state is responsible for disposal of low-level waste generated in that state. States that do not have existing sites may join in regional compacts. The States of North Carolina and South Carolina are participants in the Southeast regional compact and, currently, dispose of waste at an existing disposal site in South Carolina along with other members of the compact. The North Carolina Low-Level Radioactive Waste Management Authority, which is responsible for siting and operating a new low-level radioactive waste disposal facility for the Southeast regional compact, recently selected a preferred site in Wake County, North Carolina. Although the Company does not control the future availability of low-level waste disposal facilities, the cost of waste disposal or the development process, it is actively supporting the development of new facilities and is committed to a timely and cost-effective solution to low-level waste disposal. Should shipments to the existing regional compact site cease, present projections indicate that existing on-site storage facilities at the Company's nuclear plants are sufficient to provide approximately eight months of storage capacity. The Company cannot predict the outcome of this matter. 4. DECOMMISSIONING. a. Pursuant to a NRC rule, licensees of nuclear facilities are required to submit decommissioning funding plans to the NRC for approval to provide reasonable assurance that the licensee will have the financial ability to implement its decommissioning plan for each facility. The rule requires licensees to do one of the following: prepay at least a NRC-prescribed minimum amount immediately; set up an external sinking fund for accumulation of at least that minimum amount over the operating life of the facility; or provide a surety to guarantee financial performance in the event of the licensee's financial inability to perform actual decommissioning. On July 26, 1990, the Company submitted its decommissioning funding plans to the NRC. In this regard, the Company entered into a Master Decommissioning Trust Agreement dated July 19, 1990 (Trust), with Wachovia Bank of North Carolina, N.A., as Trustee, as a vehicle to achieve such decommissioning funding. In June 1991, the Company began depositing amounts currently collected in rates into the Trust. At the currently approved jurisdictional funding levels, contributions to the Trust will be approximately $19 million on an annualized basis. Through December 31, 1993, the Company had collected through rates an aggregate of $221.6 million for decommissioning, which includes amounts funded internally and externally. b. The Company is required to increase external funding to the NRC-prescribed minimum no later than January 1, 1996. This NRC-prescribed minimum exceeds amounts currently collected in rates. In future rate filings, the Company will request rate recovery based on site-specific estimates for prompt dismantlement decommissioning. The requested rate recovery will also include funding plans that assume external funding of, at least, the NRC-prescribed minimum. The financial impact on the Company will depend on future ratemaking treatment. The NCUC and SCPSC have allowed other utilities to recover costs based on site-specific estimates for prompt dismantlement decommissioning and funding plans similar to those the Company intends to use. c. The Company's most recent site-specific estimates of decommissioning costs were developed in 1993, and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site. These estimates, in 1993 dollars, are as follows: $257.7 million for Robinson Unit No. 2; $284.3 million for the Harris Plant; $235.4 million for Brunswick Unit No. 1; and $221.4 million for Brunswick Unit No. 2. These estimates are subject to change based on a variety of factors, including, but not limited to, inflation, changes in technology applicable to nuclear decommissioning, and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to Power Agency, which holds an undivided ownership interest in certain of the Company's generating facilities. To the extent of its ownership interests, Power Agency is responsible for satisfying the NRC's financial assurance requirements for decommissioning costs. See ITEM 1, "Generating Capabilities," paragraph 1. 5. OPERATING LICENSES. Facility Operating Licenses, issued by the NRC, may be amended by the NRC to extend the expiration dates of an operating license of a nuclear facility to allow for up to 40 years of commercial operation. The current expiration dates for the Company's nuclear facilities allow for the entire 40 years of commercial operation and are set forth in the following table. Facility Operating License Facility Expiration Date ________ __________________________ Robinson Unit No. 2 July 31, 2010 Brunswick Unit No. 1 September 8, 2016 Brunswick Unit No. 2 December 27, 2014 Harris Plant October 24, 2026 6. DESIGN BASIS RECONSTITUTION EFFORTS. The Company has been in the process of reviewing the design basis documentation for Robinson Unit No. 2 since 1988 and for the Brunswick Plant since 1990. Significantly more design detail has been required by the NRC for recently constructed plants than was needed when Robinson Unit No. 2 and the Brunswick Plant were built. In order to operate effectively in the current regulatory environment, the Company must be able to provide documentary evidence of compliance with regulations and design documents. The design basis reconstitution effort involves research, compilation and verification of documents that set forth the key design requirements of the various safety systems. The Company's review of the design basis documentation for Robinson Unit No. 2 was completed in 1993, and the Brunswick Plant effort is still in progress. The baseline effort for the two Brunswick Units is scheduled for completion by the end of 1996, and is projected to have a total cost of approximately $40 million. The Company cannot predict the outcome of this matter. 7. OTHER NUCLEAR MATTERS. a. Large diameter reactor recirculation system piping in boiling water reactor (BWR) units, such as the Brunswick Units, has the potential to crack as a result of intergranular stress corrosion (IGSCC) and the NRC required an ultrasonic inspection of such piping at BWR units. As a result of these inspections, certain portions of the large diameter reactor recirculation piping were replaced at both of the Brunswick Units. Subsequently, ultrasonic testing for IGSCC was performed on Brunswick Unit No. 1 during an outage in 1991 and identified a feedwater nozzle weld which required further study. The NRC authorized restart of Unit No. 1 and, based upon additional information provided by the Company, approved full-cycle operation of Unit No. 1. The feedwater nozzle in question is being evaluated for possible replacement as part of modifications scheduled for Brunswick during the next refueling outage. b. In 1991, the NRC issued a final rule on nuclear plant maintenance that will become effective on July 10, 1996. In general terms, the new maintenance rule prescribes the establishment of performance criteria for each safety system based on the significance of that system. The rule also requires monitoring of safety system performance against the established acceptance criteria, and provides that remedial action be taken when performance falls below the established criteria. The Company has been working closely with the Nuclear Management and Resources Council and with other utilities to develop its compliance approach and to minimize the financial and operational impacts of the new rule. The Company anticipates its compliance will be on schedule and is evaluating the magnitude of the financial and operational impacts of this new rule. The Company cannot predict the outcome of this matter. c. On November 23, 1988, the NRC requested in Generic Letter 88-20 that utilities perform Individual Plant Examinations (IPEs) to determine potential vulnerabilities to severe accidents beyond the design basis accidents for which the plants are designed. These are considered to be very low probability events. The Company submitted the results of the first phase (for internally initiated events) in August 1992 for the Brunswick and Robinson Plants. Potential enhancements for the Robinson Plant are currently being evaluated, and the Company cannot predict at this time the exact magnitude of financial and operational impacts which may result from these evaluations. For the Brunswick Plant, no modifications were required to meet the guidelines of the IPE. On August 20, 1993, the Company submitted the results of the Harris Plant IPE. While some Harris Plant procedural changes were made due to the IPE results, the IPE did not reveal any significant financial or operational impacts or identify any need for plant modifications. The Company cannot predict at this time the exact magnitude of the financial and operational impact of the second phase of the IPE (for externally initiated events) to be completed for all three plants during 1994-1995. d. In April 1992, both units at the Company's Brunswick Plant were taken out of service in order for the Company to address anchor bolt deficiencies and related wall construction issues in the diesel generator building. During the outage, in addition to resolving the anchor bolt deficiencies and related diesel generator building wall construction issues, the Company conducted detailed inspections and engineering evaluations of the plant's miscellaneous steel, performed necessary corrective and preventive maintenance and made certain modifications. An intensive on-site review of Brunswick Unit No. 2 was conducted by a NRC operational readiness assessment team from March 29 through April 9, 1993. The team concluded that the depth and capability of the Brunswick staff, the organizational structure and in-place programs were adequate to support Unit No. 2 restart and operation. On April 27, 1993, the NRC issued its determination that Unit No. 2 was ready for restart. The Company promptly began a detailed startup process at Unit No. 2 to ensure a safe, controlled and deliberate return to service. The Company returned Unit No. 2 to service in May 1993. In late December 1993, Unit No. 2 set a new continuous run record for that unit of more than 219 days. In July 1993, cracks were discovered in the Brunswick Unit No. 1 reactor vessel shroud during inspections made as part of refueling activities performed during the outage. The Company conducted intensive ultrasonic testing and physical sampling inspections of the cracks. The results of this investigation provided data used to develop new stiffening braces to ensure that the shroud will continue to perform its design function. Shroud modifications were completed in late December 1993. Costs associated with the shroud repairs were not material to the results of operations of the Company. The Company commenced startup of Unit No. 1 on February 1, 1994 under a gradual power ascension startup plan. This power ascension plan was completed 27 days ahead of schedule when Unit No. 1 was returned to normal operation on February 23, 1994, after successfully completing extensive startup testing. Additional shroud inspections may be conducted during future refueling outages to identify and monitor other minor cracking in the shroud. The Company cannot predict the outcome of this matter. In July 1993, the Company also determined that the Brunswick Unit No. 2 shroud has minor crack indications which do not compromise the safety or operation of the Unit. Shroud modifications, similar to those performed on Unit No. 1, will be undertaken on Unit No. 2 during the spring 1994 refueling outage. The Company does not expect that costs associated with the shroud modifications will be material to the results of operations of the Company. On October 14, 1993, two private organizations, the National Whistleblower Center and the Coastal Alliance for a Safe Environment, and an individual filed a petition with the NRC under 10 C.F.R. Section 2.206 alleging that the Company was aware of the shroud cracks as early as 1984 and engaged in criminal activities to conceal its knowledge of the cracks. The petitioners requested that the NRC require the Company to state whether it knew about the cracks in 1984 and determine whether the Company has engaged in criminal wrongdoing. To date, the petitioners have failed to provide the Company with any evidence substantiating their claims. Additionally, the Company conducted an internal technical review of this matter which did not reveal any evidence that substantiates the petitioners' claims. The results of this technical review were submitted to the NRC in November 1993. Although the Company cannot predict the outcome of this matter, it believes the allegations contained in the petition are without merit. In December 1993, the NRC issued its latest Systematic Assessment of Licensee Performance (SALP) report for the Brunswick Plant. The report rated Brunswick's plant operations and plant support as "superior," and the Plant's maintenance and engineering as "good." The NRC, in both the report and at a public meeting, recognized significant improvements made at the plant. On July 28, 1993, the Company, the Public Staff, the Attorney General of the State of North Carolina, and Carolina Industrial Group for Fair Utility Rates II entered into an agreement that resolved as between them all issues related to the Brunswick Plant outage on or before the date of the agreement, avoided higher fuel charges to the Company's customers and settled the Company's 1993 North Carolina fuel adjustment proceeding. The Company had $31.2 million in fuel expenses for the twelve-month period ended March 31, 1993 that had not been recovered from North Carolina customers through the Company's rates. As a part of the agreement, the Company agreed to forgo recovering $25.5 million of these fuel expenses, and to recover the remaining $5.7 million through rates over a twelve-month period beginning in September 1993. That $5.7 million is subject to refund at the end of three years if the Brunswick Plant does not achieve a specified operating performance level. Additionally, the Company agreed that if the Brunswick Plant's performance for the three-year period ending March 31, 1996 does not achieve a specified operating performance level, the Company could lose up to $10 million in additional fuel expenses. By order dated September 14, 1993, the NCUC approved the agreement. The forgone fuel expense recovery of $25.5 million reduced the Company's 1993 earnings by approximately $.10 per common share. On September 7, 1993, the Company, the Staff of the SCPSC, Nucor Steel, and the Consumer Advocate for the State of South Carolina, which represents the using and consuming public in matters before the SCPSC, entered into an agreement to settle the fall 1993 SCPSC fuel proceeding. The settlement resolved all issues related to fuel costs incurred by the Brunswick Plant through June 30, 1993, avoided higher fuel charges to the Company's customers and settled the fall 1993 semi-annual South Carolina fuel adjustment proceedings. The SCPSC approved the agreement by order dated September 14, 1993. Pursuant to the terms of the settlement, the Company agreed to forgo recovery of a total of $15.6 million in fuel expenses. The forgone fuel expense recovery of $15.6 million reduced the Company's 1993 earnings by approximately $.06 per common share. The NRC, the NCUC and the SCPSC will continue to review the Company's activities at the Brunswick Plant. Except as noted, the Company cannot predict the extent to which these and other actions may impact its ability to recover costs associated with this outage. e. On November 17, 1993, during startup from a scheduled refueling outage at the Company's H. B. Robinson Plant Unit No. 2, the Company discovered problems with the fuel supplier's fabrication of certain fuel assemblies which had been loaded during the outage. A problem relating to the calibration of the power level instrumentation was also identified. The Company elected to interrupt and delay the startup process pending analysis and correction of the problems, and notified the NRC of its decision. The NRC issued a Confirmatory Action Letter, dated November 19, 1993, in which it confirmed, among other things, that the Company would conduct detailed root cause analyses of the fuel assembly and power level instrumentation issues and would take appropriate corrective actions. On November 20, 1993, an NRC Augmented Inspection Team (AIT) began its investigation of the fuel assembly and power level instrumentation issues. In investigating the fuel assembly issue, the AIT visited both the Robinson Plant and the fuel supplier's facilities. Results of the AIT's investigation were initially released in a public meeting on December 6, 1993 and the AIT's report was issued on January 5, 1994. An enforcement conference was conducted on March 14, 1994 for the purpose of discussing apparent violations identified in the AIT's report in the areas of management control of refueling and restart activities. The NRC will determine whether or not to issue violations and what, if any, resulting penalty should be imposed upon the Company. The Company cannot predict the outcome of this matter. In a separate action, on March 14, 1994, the NRC issued a Notice of Violation and Proposed Imposition of Civil Penalty in the amount of $37,500 relating to the degradation of both Robinson Unit No. 2 emergency diesel generators and failure to correct conditions which affected operation of one of the diesel generators in mid-November, 1993. The base civil penalty for this type of violation is $50,000, but the propsoed penalty was reduced to $37,500 due to the Company's comprehensive performance in analyzing the root cause of the diesel generator problem. The Company has thirty days from the date of the Notice to pay or protest the civil penalty, in whole or in part. The Company intends to pay the civil penalty. The Company cannot predict the outcome of this matter. On February 8, 1994, the NRC issued its SALP report for Robinson Unit No. 2 for the period June 1992 through December 1993. While the NRC noted that overall performance of Robinson Unit No. 2 was reasonably good, it indicated that performance declined in several areas, primarily due to the matters discussed above. The NRC rated Robinson Unit No. 2's performance as "good" in operations, engineering and plant support and "acceptable" in maintenance. In early February 1994, the Company satisfied the conditions of the NRC's confirmatory action letter, and returned Robinson Unit No. 2 to service on March 21, 1994 under a power ascension plan. f. The Company is insured against public liability for a nuclear incident up to $9.4 billion per occurrence, which is the maximum limit on public liability claims pursuant to the Price-Anderson Act. The $9.4 billion coverage includes $200 million primary coverage and $9.2 billion secondary financial protection through assessments on nuclear reactor owners. In the event that public liability claims from an insured nuclear incident exceed $200 million, the Company would be subject to a pro rata assessment, for each reactor it owns, of up to $75.5 million, plus a 5% surcharge, for each incident. Payment of such assessment would be made over time as necessary to limit the payment in any one year to no more than $10 million per reactor owned. Power Agency would be responsible for its ownership share of the assessment on jointly-owned units. FUEL ____ 1. SOURCES OF GENERATION. Total system generation (including Power Agency's share) by primary energy source, along with purchased power, for the years 1990 through 1994 is set forth below: 1990 1991 1992 1993 1994 _______________________________________________ (estimated) Fossil 47% 47% 56% 54% 47% Nuclear 41 41 27 31 40 Purchased Power 10 10 15 13 11 Hydro 2 2 2 2 2 2. COAL. The Company has intermediate and long-term agreements from which it expects to receive approximately 88% of its coal burn requirements in 1994. During 1992 and 1993, the Company obtained approximately 79% (8,185,000 tons) and 73% (7,198,000 tons), respectively, of its coal burn requirements from intermediate and long-term agreements. Over the next ten years, the Company expects to receive approximately 75% of its coal burn requirements from intermediate and long-term agreements. Existing agreements have expiration dates ranging from 1994 to 2006. During 1993, the Company maintained from 48 to 99 days' supply of coal, based on anticipated burn rate. All of the coal that the Company is currently purchasing under intermediate and long-term agreements is considered to be low sulfur coal by industry standards. Recent amendments to the Clean Air Act may result in increases in the price of low sulfur coal prior to the effective date of the first phase of the Act, with such impact to continue beyond the effective date of the second phase of the Act. See ITEM 1, "Environmental Matters," paragraph 2. The Company purchased approximately 2,250,000 tons of coal in the spot market during 1992 and 2,650,000 tons in 1993. No spot coal was purchased in 1991. The Company's contract coal purchase prices during 1993 ranged from approximately $23.19 to $39.38 per ton (F.O.B. mine). The average cost to the Company of coal delivered for the past five years is as follows: Year $/Ton Cents/Million BTU ____ _____ _________________ 1989 45.01 179 1990 45.88 183 1991 47.40 190 1992 43.25 174 1993 43.10 172 3. OIL. The Company uses No. 2 oil primarily for its combustion turbine units, which are used for emergency backup and peaking purposes. The Company burned approximately 8.4 million and 9.1 million gallons of No. 2 oil during 1992 and 1993, respectively. The Company has a No. 2 oil supply contract for its normal requirements. In the event base-load capacity is unavailable during periods of high demand, the Company may increase the use of its combustion turbine units, thereby increasing No. 2 oil consumption. The Company intends to meet any additional requirements for No. 2 oil through additional contract purchases or purchases in the spot market. There can be no assurance that adequate supplies of No. 2 oil will be available to meet the Company's requirements. To reduce the Company's vulnerability to dislocations in the oil market, seven combustion turbine units with a total generating capacity of 364 MW have been converted to burn either propane or No. 2 oil. In addition, twelve combustion turbine units with a total generating capacity of 425 MW can burn natural gas when available. Over the last five years, No. 2 oil, natural gas and propane accounted for 1.7% of the Company's total burned fuel cost. In 1993, No. 2 oil, natural gas and propane accounted for 1.5% of total burned fuel cost. The availability and cost of fuel oil could be adversely affected by energy legislation enacted by Congress, disruption of oil or gas supplies, labor unrest and the production, pricing and embargo policies of foreign countries. 4. NUCLEAR. The nuclear fuel cycle requires the mining and milling of uranium ore to provide uranium oxide concentrate (U3O8), the conversion of U3O8 to uranium hexafluoride (UF6), the enrichment of the UF6 and the fabrication of the enriched uranium into fuel assemblies. The Company has on hand or has contracted for raw materials and services for its nuclear units through the years shown below: Raw Materials and Service _______________________________________________ Unit Uranium Conversion Enrichment Fabrication ____ _______ __________ __________ ___________ Robinson No. 2 1996 1995 1994 1999 Brunswick No. 1 1996 1995 1994 1998 Brunswick No. 2 1996 1995 1994 1998 Harris Plant 1996 1995 1994 1998 These contracts are expected to supply the necessary nuclear fuel to operate Robinson Unit No. 2 through 1995, Brunswick Unit No. 1 through 1995, Brunswick Unit No. 2 through 1996, and the Harris Plant through 1996. The Company expects to meet its U3O8 requirements through the years shown above from inventory on hand and amounts received under contract. Although the Company cannot predict the future availability of uranium and nuclear fuel services, the Company does not currently expect to have difficulty obtaining U3O8 and the services necessary for its conversion, enrichment and fabrication into nuclear fuel for years later than those shown above. For a discussion of the Company's plans with respect to spent fuel storage, see ITEM 1, "Nuclear Matters," paragraph 2. 5. DOE ENRICHMENT FACILITIES DECONTAMINATION AND DECOMMISSIONING FUND. Under Title XI of the Energy Policy Act of 1992, Public Law 102-486, Congress established a decontamination and decommissioning fund for the DOE's gaseous diffusion enrichment plants. Contributions to this fund will be made by U.S. domestic utilities who have purchased enrichment services from DOE since it began sales to non-Department of Defense customers. Each utility's share of the contributions will be based on that utility's past purchases of services as a percentage of all purchases of services by U.S. utilities, with total annual contributions capped at $150 million per year, indexed to inflation, and an overall cap of $2.25 billion over 15 years, also indexed to inflation. The Company made its first payment, totaling approximately $5.2 million, to the fund on September 30, 1993. At December 31, 1993, the Company had recorded a liability of $77.7 million representing its estimated share of the contributions and expects to recover these amounts as a component of fuel cost. 6. PURCHASED POWER. In 1993 the Company purchased 6,375,907 MWh or approximately 13% of its energy requirements and had available 1,649 MW of firm purchased capacity under contract at the time of peak load. The Company also had a 100 MW firm capacity commitment to SCE&G during the peak due to a limited-term sale agreement for the summers of 1993 and 1994. See ITEM 1, "Interconnections with Other Systems," paragraph 3. The Company may acquire purchased power capacity in the future to accommodate a portion of its system load needs. OTHER MATTERS _____________ 1. SAFETY INSPECTION REPORTS. On April 3, 1990, the FERC sent a letter to the Company providing comments on its review of the Company's Fifth (1987) Independent Consultant's Safety Inspection Report (required every five years under FERC Regulation 18 CFR Part 12) for the Walters Hydroelectric Project and requesting the Company to undertake certain supplemental analyses and investigations regarding the stability of the dam under extreme and improbable loading conditions. Similar letters were sent by the FERC on May 30, 1990, with respect to the Company's Blewett and Tillery Hydroelectric Plants. With the independent consultant, the Company has begun addressing the issues raised by the FERC and is working with the FERC to complete investigations and analyses with respect to each of these matters. While both the FERC and the Company do not believe that there are any stability concerns that would be cause for any imminent safety concerns, the outcome of the analyses and investigations is currently unknown. Depending on the outcome of the analyses and the FERC's interpretations, the Company could be required to undertake efforts to enhance the stability of the dams. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. 2. MARSHALL HYDROELECTRIC PROJECT. On November 21, 1991, the FERC notified the Company that the 5 MW Marshall Hydroelectric Project is no longer exempt from 18 CFR Part 12, Subparts C and D, dam safety regulations and that the plant's regulatory jurisdiction was being transferred from the NCUC to the FERC. This change resulted from updated dambreak flood studies which identified the potential impact on new downstream development, thus indicating the need to reclassify the project from a "low" to a "high" hazard classification. In accordance with the change in regulatory jurisdiction, the Company developed an emergency action plan which meets FERC regulations and guidelines and engaged its independent consultant to perform a safety inspection. On April 6, 1992, the consultant's safety inspection report was submitted to the FERC for approval. Depending on the outcome of FERC's review of the safety inspection report, the Company could be required to undertake efforts to enhance the stability of the Marshall dam and/or powerhouse. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. [TEXT] ITEM 2. ITEM 2. PROPERTIES _______ __________ In addition to the major generating facilities listed in ITEM 1, "Generating Capability," the Company also operates the following plants: Plant Location _____ ________ 1. Walters North Carolina 2. Marshall North Carolina 3. Tillery North Carolina 4. Blewett North Carolina 5. Darlington South Carolina 6. Weatherspoon North Carolina 7. Morehead City North Carolina The Company's sixteen power plants represent a flexible mix of fossil, nuclear and hydroelectric resources, with a total generating capacity of 9,613 MW. The Company's strategic geographic location facilitates purchases and sales of power with many other electric utilities, allowing the Company to serve its customers more economically and reliably. Major industries in the Company's service area include textiles, chemicals, metals, paper, automotive components and electronic machinery and equipment. At December 31, 1993, the Company had 5,830 pole miles of transmission lines including 292 miles of 500 kV and 2,789 miles of 230 kV lines, and distribution lines of approximately 38,560 pole miles of overhead lines and approximately 7,234 miles of underground lines. Distribution and transmission substations in service had a transformer capacity of approximately 34,794 kVA in 2,263 transformers. Distribution line transformers numbered 383,314 with an aggregate 15,264,600 kVA capacity. Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1. Otherwise, the Company has good and marketable title, subject to the lien of its Mortgage and Deed of Trust, with minor exceptions, restrictions and reservations in conveyances and defects, which are of the nature ordinarily found in properties of similar character and magnitude, to its principal plants and important units, except certain rights-of-way over private property on which are located transmission and distribution lines, title to which can be perfected by condemnation proceedings. Plant Accounts (including nuclear fuel) - _______________________________________ During the period January 1, 1989 through December 31, 1993, there was added to the Company's utility plant accounts $1,827,147,000, there was retired $469,275,000 of property and there were transfers to other accounts and adjustments for a net decrease of $290,311,000 resulting in net additions during the period of $1,067,561,000 or an increase of approximately 12.6%. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ______ _________________ Legal and regulatory proceedings are included in the discussion of the Company's business in ITEM 1 and incorporated by reference herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS _______ ___________________________________________________ No matters were submitted to a vote of security holders in the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Recent Business Experience ____ ___ __________________________ Sherwood H. Smith, Jr. 59 Chairman and Chief Executive Officer, September 1992 to present; Chairman/President and Chief Executive Officer, May 1980 to September 1992. Member of the Board of Directors of the Company since 1971. William Cavanaugh III 55 President and Chief Operating Officer, September 1992 to present; Group President - Energy Supply, Entergy Corporation, July 1992; Chairman, Chief Executive Officer and Director, System Energy Resources, Inc., April 1992; Chairman and Chief Executive Officer, Entergy Operations, Inc., April 1992; Senior Vice President, System Executive - Nuclear, Entergy Corporation and Entergy Services, Inc., 1987-August 1992; Executive Vice President and Chief Nuclear Officer, Arkansas Power & Light Company and Louisiana Power & Light Company, 1990-August 1992; President and Chief Executive Officer, System Energy Resources, Inc., 1986-April 1992; President and Chief Executive Officer, Entergy Operations, Inc., 1990-April 1992. Member of Board of Directors of Arkansas Power & Light Company and Louisiana Power & Light Company, 1990-August 1992; Member of Board of Directors of System Fuels, Inc., 1992-August 1992; Member of Board of Directors of System Energy Resources, Inc., 1986-August 1992; Member of Board of Directors of Entergy Operations, Inc., 1990-August 1992; Member of Board of Directors of Entergy Services, Inc., 1987-August 1992. Before joining the Company, Mr. Cavanaugh held various senior management and executive positions during a 23-year career with Entergy Corporation, an electric utility holding company with operations in Arkansas, Louisiana and Mississippi. Member of the Board of Directors of the Company since 1993. Charles D. Barham, Jr. 63 Executive Vice President and Chief Financial Officer - Finance and Administration, November 1990 to present; Senior Vice President - Legal, Planning and Regulatory Group, July 1987; Senior Vice President and General Counsel - Legal and Regulatory Group, May 1982. Member of the Board of Directors of the Company since 1990. Lynn W. Eury 57 Executive Vice President - Power Supply, April 1989 to present; Senior Vice President - Operations Support, June 1986; Senior Vice President - Fossil Generation and Power Transmission Group, August 1983. William S. Orser 49 Executive Vice President - Nuclear Generation, April 1993 to present; Executive Vice President - Nuclear Generation, Detroit Edison Company, 1992-April 1993; Senior Vice President - Nuclear Generation, Detroit Edison Company, 1990-1992; Vice President - Nuclear Operations, Detroit Edison Company, 1988-1990. Prior to 1988, Mr. Orser held various other positions with Detroit Edison, and with Portland General Electric Company, Southern California Edison, and the U. S. Navy. James M. Davis, Jr. 57 Senior Vice President, Group Executive - Fossil Generation and Power Transmission, June 1986 to present; Senior Vice President - Operations Support Group, August 1983. Norris L. Edge 62 Senior Vice President, Group Executive - Customer and Operating Services, May 1990 to present; Vice President - Rates and Energy Services, September 1989; Vice President - Rates and Service Practices, December 1980. Richard E. Jones 56 Senior Vice President, General Counsel and Secretary, Group Executive - Legal, Rates, Communications and Public Affairs, January 1993 to present; Group Executive - Legal and Regulatory Services, November 1990 to January 1993; Vice President, General Counsel and Secretary, November 1989; Vice President and General Counsel, July 1987; Vice President, Senior Counsel and Manager - Legal Department, May 1982. Paul S. Bradshaw 56 Vice President and Controller, March 1980 to present. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS ______ ______________________________________________________ The Company's Common Stock is listed on the New York and Pacific Stock Exchanges. The high and low sales prices per share, adjusted for the two-for-one Common Stock split described below, for the periods indicated, as reported as composite transactions in The Wall Street Journal, and dividends paid are as follows: 1992 High Low Dividends Paid _________________________________________________________________ First Quarter $ 26 15/16 $ 24 9/16 $.395 Second Quarter 27 1/16 24 3/4 .395 Third Quarter 26 5/8 25 .395 Fourth Quarter 28 1/16 25 7/16 .395 1993 High Low Dividends Paid _________________________________________________________________ First Quarter $ 32 7/8 $ 27 1/16 $.410 Second Quarter 34 31 1/4 .410 Third Quarter 34 1/2 32 1/8 .410 Fourth Quarter 33 3/8 28 1/8 .410 The December 31 closing price of the Company's Common Stock was $27 3/4 in 1992 and $30 1/8 in 1993. As of February 28, 1994, the Company had 72,863 holders of record of Common Stock. In December 1992, the Board of Directors of the Company authorized a two-for-one split of the Company's Common Stock. On February 1, 1993, one additional share was issued for each share outstanding to shareholders of record on January 11, 1993. The number of common shares and average common share data for all periods reflect the two-for-one stock split. [TEXT] ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS _______ _________________________________________________ The Company's financial condition and results of operations are affected by numerous factors, including the timing and amount of rate relief, the extent of sales growth and the level of operating costs. The following discussion and analysis should be considered in conjunction with the relevant Sections of ITEM 1, "Selected Financial Data" in ITEM 6, and the Company's financial statements appearing in ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA _______ ___________________________________________ The following financial statements, supplementary data and financial statement schedules are included herein: Independent Auditors' Report Financial Statements: Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets as of December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Schedules of Capitalization as of December 31, 1993 and 1992 Notes to Financial Statements Quarterly Financial Data Financial Statement Schedules for the Years Ended December 31, 1993, 1992 and 1991: V - Utility Plant VI - Accumulated Provision for Depreciation and Amortization of Electric Utility Plant VIII - Reserves IX - Short-term Borrowings X - Supplementary Income Statement Information 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. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Carolina Power & Light Company: We have audited the accompanying balance sheets and schedules of capitalization of Carolina Power & Light Company as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of 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 financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the balance sheets and schedules of capitalization as of December 31, 1991, 1990, and 1989, and the related statements of income, retained earnings and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented herein); and we expressed unqualified opinions on those financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing at Item 6, is fairly presented in all material respects in relation to the financial statements from which it has been derived. As discussed in Note 6 to the financial statements, in 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. /s/ DELOITTE & TOUCHE Raleigh, North Carolina February 14, 1994 [TEXT] NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. System of Accounts The accounting records of the Company are maintained in accordance with uniform systems of accounts prescribed by the Federal Energy Regulatory Commission (FERC), the North Carolina Utilities Commission (NCUC) and the South Carolina Public Service Commission (SCPSC). Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. B. Electric Utility Plant The cost of additions, including replacements of units of property, and betterments is charged to utility plant. Maintenance and repairs of property, and replacements and renewals of items determined to be less than units of property, are charged to maintenance expense. The cost of units of property replaced, renewed or retired, plus removal or disposal costs, less salvage, is charged to accumulated depreciation. Electric utility plant other than nuclear fuel is subject to the lien of the Company's mortgage. As prescribed in regulatory uniform systems of accounts, an allowance for the cost of borrowed and equity funds (AFUDC) used to finance electric utility plant construction is charged to the cost of plant. Regulatory authorities consider AFUDC an appropriate charge for inclusion in the Company's utility rates to customers over the service life of the property. The equity funds portion of AFUDC is credited to other income, the borrowed funds portion is credited to interest charges and, in years prior to 1993, a deferred income tax provision was reflected as a reduction in the borrowed funds portion. The composite, net-of-tax AFUDC rate was 7.3% in 1992 and 6.3% in 1991. Due to the implementation of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," in 1993, AFUDC-borrowed funds is no longer recorded on a net-of-tax basis (see Note 6). The composite AFUDC rate in 1993, which reflects the implementation of SFAS No. 109, was 8.8%. Pursuant to the provisions of SFAS No. 109, the deferred income taxes related to AFUDC in undepreciated plant in service at January 1, 1993, were recorded to an accumulated deferred income tax liability with an offsetting adjustment to a regulatory asset. C. Depreciation and Amortization For financial reporting purposes, depreciation of utility plant other than nuclear fuel is computed on the straight-line method based on the estimated remaining useful life of the property, adjusted for estimated net salvage. Depreciation provisions, including decommissioning costs (see Note 1D), as a percent of average depreciable property other than nuclear fuel, were approximately 3.7% in each of the years 1993, 1992 and 1991. Depreciation and amortization expense also includes amortization of plant abandonment costs (see Note 7) and intangible plant, which primarily includes software development costs. Amortization of nuclear fuel costs, including disposal costs associated with obligations to the U.S. Department of Energy (DOE), is computed primarily on the unit-of-production method and charged to fuel for generation. Costs related to obligations to the DOE for the decommissioning and decontamination of enrichment facilities are also charged to fuel for generation. The disposal and the decommissioning and decontamination costs are components of fuel costs for the purpose of deferred fuel accounting (see Note 1E). D. Nuclear Decommissioning Depreciation and amortization expense includes provisions for nuclear decommissioning costs. In the Company's retail jurisdictions, provisions for nuclear decommissioning costs are approved by the NCUC and the SCPSC and are based on site-specific estimates that included the costs for removal of all radioactive and other structures at the site. Cost recovery is based on an internal modified sinking fund methodology assuming 30-year delayed dismantlement decommissioning. In the wholesale jurisdiction, the provisions for nuclear decommissioning costs are based on amounts agreed upon in applicable rate settlements. Accumulated nuclear decommissioning cost provisions included in accumulated depreciation were $221.6 million at December 31, 1993, and $186.4 million at December 31, 1992. Pursuant to regulations of the Nuclear Regulatory Commission (NRC), the Company is required to provide financial assurance that funds will be available for decommissioning. In this regard, the Company filed decommissioning plans with the NRC and, in 1991, began depositing amounts currently collected in rates in an external decommissioning trust. The Company is required to increase external funding to the NRC-prescribed minimum no later than January 1, 1996. This NRC-prescribed minimum exceeds amounts currently collected in rates. In future rate filings, the Company will request rate recovery based on site-specific estimates for prompt dismantlement decommissioning. The requested rate recovery will also include funding plans that assume external funding of, at least, the NRC-prescribed minimum. The financial impact on the Company will depend on future ratemaking treatment. The NCUC and SCPSC have allowed other utilities to recover costs based on site-specific estimates for prompt dismantlement decommissioning and funding plans similar to those the Company intends to use. The Company's most recent site-specific estimates of decommissioning costs were developed in 1993 and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site. These estimates, in 1993 dollars, are $257.7 million for Robinson Unit No. 2, $284.3 million for the Harris Plant, $235.4 million for Brunswick Unit No. 1 and $221.4 million for Brunswick Unit No. 2. These estimates are subject to change based on a variety of factors, including, but not limited to, inflation, changes in technology applicable to nuclear decommissioning, and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to North Carolina Eastern Municipal Power Agency (Power Agency), which holds an undivided ownership interest in certain of the Company's generating facilities (see Note 8). To the extent of its ownership interests, Power Agency is responsible for satisfying the NRC's financial assurance requirements for decommissioning costs. E. Other Policies Customers' meters are read and bills are rendered on a cycle basis. Revenues are recorded as services are rendered. Regulators of all three jurisdictions require deferred fuel accounting in which the Company defers the difference between fuel costs incurred and the fuel component of customer rates. Customer rates are adjusted periodically to incorporate the approved deferrals. Other property and investments are stated principally at cost, less accumulated depreciation where applicable. The Company maintains an allowance for doubtful accounts receivable, which totaled $2.3 million at December 31, 1993, and $2.1 million at December 31, 1992. Fuel inventory and inventory of materials and supplies are carried on a first-in, first-out or average cost basis. Long-term debt premiums, discounts and issuance expenses are amortized over the life of the related debt using the straight-line method. Any expenses or call premiums associated with the reacquisition of debt obligations are amortized over the remaining life of the original debt using the straight-line method. For purposes of the Statements of Cash Flows, the Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. 2. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of cash, cash equivalents and notes payable approximate fair value because of the short maturities of these instruments. The estimated fair value of long-term debt was obtained from an independent pricing service. Investments in trusts, presented in the table below, primarily includes external decommissioning trust assets and funds invested pursuant to a voluntary employee beneficiary association. The estimated fair values of the Company's trust investments were obtained from quoted market prices. These estimated fair values are as follows (in thousands). 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value Long-term debt....$2,799,761 $2,877,300 $2,958,588 $2,978,276 Investments in trusts..........$ 117,022 $ 119,277 $ 91,119 $ 91,844 There are inherent limitations in any estimation technique, and the estimates presented herein are not necessarily indicative of the amounts the Company could realize in current transactions. 3. CAPITALIZATION A. Common Stock Equity In December 1992, the Board of Directors authorized a two-for-one split of the Company's common stock. On February 1, 1993, one additional share was issued for each share outstanding to shareholders of record on January 11, 1993. The number of common shares, average common shares and per common share data for all periods reflect the two-for-one stock split. In 1989, the Company issued common stock shares to the Trustee of the Company's Stock Purchase-Savings Plan (SPSP) in conjunction with a qualified employee stock ownership plan (ESOP) loan. At December 31, 1993, the Trustee was indebted to the Company for $216.2 million. The note receivable from the Trustee is treated as a reduction in common stock equity. At December 31, 1993, the Company had 14,767,052 shares of authorized but unissued common stock reserved and available for issuance to satisfy the requirements of the Company's stock plans. The Company intends, however, to meet the requirements of these stock plans with issued and outstanding shares presently held by the Trustee of the SPSP or with open market purchases of common stock shares, as appropriate. The Company's mortgage, as supplemented, and charter contain provisions limiting the use of retained earnings for the payment of dividends under certain circumstances. At December 31, 1993, there were no significant restrictions on the use of retained earnings. B. Long-Term Debt As of December 31, 1993, long-term debt maturities for the years 1994 through 1998 were $50 million, $275 million, $55 million, $40 million and $205 million, respectively. Person County Pollution Control Revenue Refunding Bonds-Series 1992A totaling $56 million have interest rates that must be renegotiated on a weekly basis. First Mortgage Bonds-Pollution Control Series G, J and K, totaling $127 million have three-year interest rate periods that expire in 1994 and 1997. At the time, of interest rate renegotiation, holders of these bonds may require the Company to repurchase their bonds. These obligations are excluded in total from long-term debt maturities in the preceding paragraph. A portion of these bonds is classified as long-term debt in the Balance Sheets, consistent with the Company's intention to maintain the debt as long-term and to the extent that this intention is supported by a $70 million long-term revolving credit agreement (see Note 4). The amount of these obligations not covered by the long-term revolving credit agreement is included in current portion of long-term debt in the Balance Sheets. 4. REVOLVING CREDIT FACILITIES At December 31, 1993, the Company's unused and readily available revolving credit facilities totaled $208.1 million, consisting of a $115 million revolving credit agreement with nine domestic money centers and major regional banks, a $23.1 million revolving credit agreement with fifteen regional banks and a $70 million long-term revolving credit agreement with eight foreign banks. 5. POSTRETIREMENT BENEFIT PLANS The Company has a noncontributory defined benefit retirement plan (Plan) for all full-time employees and funds the Plan in amounts that comply with contribution limits imposed by law. Plan benefits reflect an employee's recent compensation, years of service and age at retirement. [TEXT] The expected long-term rate of return on plan assets used in determining the net periodic pension cost was 9% for each of the three years. In addition to pension benefits, the Company provides contributory postretirement benefits, including certain health care and life insurance benefits, for substantially all retired employees. In January 1993, the Company implemented SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires the recognition of the costs associated with these other postretirement benefits (OPEB) on an accrual basis. Previously, the cost of OPEB was generally recognized as claims were incurred and premiums were paid. These costs totaled $2.7 million in 1992 and $3.0 million in 1991. The components of the net periodic cost of OPEB for 1993 are as follows (in thousands). Actual return on plan assets....................$ (497) Variance from expected return, deferred......... 9 ---------- Expected return on plan assets.................. (488) Service cost.................................... 6,797 Interest cost on accumulated benefit obligation. 9,662 Net amortization................................ 5,966 ---------- Net cost......................................$ 21,937 ========== A reconciliation of the funded status of the OPEB plans to the amount recognized in the Balance Sheet at December 31, 1993, is presented below (in thousands). Actuarial present value of benfits for services rendered to date: Current retirees................................$ (62,727) Active employees eligible to retire............. (14,800) Active employees not eligible to retire......... (62,225) ---------- Accumulated postretirement benefit obligation. (139,752) Fair market value of plan assets, invested primarily in equity and fixed-income securities......... 7,584 ---------- Funded status.......................... (132,168) Unrecognized actuarial loss..................... 6,288 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993....... 113,345 ---------- Accrued OPEB costs recognized in the Balance Sheet ........................$ (12,535) ========== The accumulated postretirement benefit obligation (APBO) was determined using a 7.5% weighted-average discount rate. The expected long-term rate of return on plan assets used in determining the net periodic cost of OPEB (NPC) was 9%. The medical cost trend rates used in determining the APBO were assumed to be 10.7% and 9.5% in 1994 for pre-medicare and post-medicare benefits, respectively. These rates were assumed to gradually decline to 5% in 2005, and remain at that level thereafter. Assuming a one percent increase in the medical cost trend rates, the aggregate of the service and interest cost components of the NPC for 1993 would increase by $1.6 million, and the APBO as of December 31, 1993, would increase by $15.1 million. In general, OPEB costs are paid as claims are incurred and premiums are paid; however, the Company is partially funding future health care benefits for retirees in a trust created pursuant to Section 401(h) of the Internal Revenue Code of 1986. In future rate filings, the Company will request rate recovery based on the provisions of SFAS No. 106. The NCUC and the SCPSC have allowed other utilities to recover costs based on these provisions. 6. INCOME TAXES Income taxes are allocated between operating income and other income based on the source of the income that generated the tax. Investment tax credits related to operating income are amortized over the service life of the related property. On January 1, 1993, the Company implemented SFAS No. 109, which required the Company to establish additional deferred income tax assets and liabilities for certain temporary differences and to adjust deferred income tax accounts for changes in income tax rates. It also prohibits net-of-tax accounting for income statement and balance sheet items. Prior to the implementation of SFAS No. 109, deferred income taxes were not recorded for certain timing differences. At December 31, 1992, deferred income taxes were not provided for cumulative timing differences of approximately $311 million as a result of a rate moderation plan and pre-1976 flow-through. Substantially all of the adjustments required by SFAS No. 109 were recorded to deferred income tax balance sheet accounts, with offsetting adjustments to certain assets and liabilities. As a result, the cumulative effect on net income was not material. The Company's total assets and liabilities increased by approximately $450 million as a result of the implementation of SFAS No. 109. As a result of the implementation of SFAS No. 109, the Company no longer records the following income statement items on a net-of-tax basis: Harris Plant deferred costs, Harris Plant carrying costs and allowance for borrowed funds used during construction. In addition, a portion of the tax benefit of ESOP dividends is now recorded to non-operating income tax expense. The remaining portion continues to be recorded directly to retained earnings, but is no longer included in the determination of earnings per common share. Prior period financial statement amounts were not restated. [TEXT] A reconciliation of the Company's effective income tax rate to the statutory federal income tax rate follows. 1993 1992 1991 Effective income tax rate............... 35.4% 36.7% 36.3% State income taxes, net of federal income tax benefit.................... (5.1) (5.1) (5.3) Investment tax credit amortization...... 2.3 1.9 2.0 Other differences, net.................. 2.4 .5 1.0 ----- ----- ----- Statutory federal income tax rate.. 35.0% 34.0% 34.0% ===== ===== ===== At December 31, 1993, deferred income tax assets and liabilities were $260.8 million and $1.9 billion, respectively. At December 31, 1992, prior to the implementation of SFAS No. 109, deferred income tax assets and liabilities were $253.5 million and $1.3 billion, respectively. The net accumulated deferred income tax liability was comprised of the following at December 31 (in thousands). 1993 1992 Accelerated depreciation and property cost differences............... $ 1,449,796 $ 1,053,706 Deferred costs, net....................... 168,311 35,984 Miscellaneous other temporary differences, net........................ (12,443) (14,288) ---------- ---------- Net accumulated deferred income tax liability............... $ 1,605,664 $ 1,075,402 ========== ========== [TEXT] 7. DEFERRED COSTS The Company eliminated from its construction program and abandoned further efforts to complete Harris Unit Nos. 3 and 4 in December 1981, Harris Unit No. 2 in December 1983 and Mayo Unit No. 2 in March 1987. The NCUC and SCPSC each allowed the Company to recover the cost of these abandoned units over a ten-year period without a return on the unamortized balances. The amortization of Harris Unit Nos. 3 and 4 was completed in 1992. In 1988 rate orders and a 1990 NCUC Order on Remand, the Company was ordered to remove from rate base and treat as abandoned plant certain costs related to the Harris Plant. Amortization of plant abandonment costs is included in depreciation and amortization expense and totaled $100.7 million in 1993, $92.5 million in 1992 and $95.9 million in 1991. The 1993 amortization of plant abandonment costs reflects increased amortization due to the implementation of the SFAS No. 109 provision that prohibits net-of-tax accounting (see Note 6). The unamortized balances of plant abandonment costs are reported at the present value of future recoveries of these costs. The associated accretion of present value was $13.2 million in 1993, $18.2 million in 1992 and $24.6 million in 1991 and is reported in other income, net. In 1988, the Company began recovering certain Harris Plant deferred costs over ten years from the date of deferral, with carrying costs accruing on the unamortized balance. Excluding deferred purchased capacity costs (see Note 9A), the unamortized balance of Harris Plant deferred costs was $81.4 million at December 31, 1993, and $64.7 million, net of tax, at December 31, 1992. Due to the implementation of SFAS No. 109 in 1993, Harris Plant deferred costs are no longer recorded on a net-of-tax basis (see Note 6). Harris Plant deferred costs are reported net of amortization on the Statements of Income. 8. JOINT OWNERSHIP OF GENERATING FACILITIES Power Agency, which includes a majority of the Company's previous municipal wholesale customers, holds undivided ownership interests in certain generating facilities of the Company. The Company and Power Agency are entitled to shares of the generating capability and output of each unit equal to their respective ownership interests. Each also pays its ownership share of additional construction costs, fuel inventory purchases and operating expenses. The Company's share of expenses for the jointly-owned units is included in the appropriate expense category in the Statements of Income. Power Agency's payment obligation with respect to abandonment costs for Harris Unit Nos. 2, 3 and 4 and Mayo Unit No. 2 is 12.94% of such costs. The Company's share of the jointly-owned generating facilities is listed below with related information as of December 31, 1993 (dollars in millions). [TEXT] 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 on the Company's directors is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. b) Information on the Company's executive officers is set forth in Part I and incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION _______ ______________________ Information on executive compensation is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________ _______________________________________________ a) The Company knows of no person who is a beneficial owner of more than five (5%) percent of any class of the Company's voting securities except for Wachovia Bank of North Carolina, N.A., Post Office Box 3099, Winston-Salem, North Carolina 27102 which as of December 31, 1993, owned 24,380,381 shares of Common Stock (15.2% of Class) as Trustee of the Company's Stock Purchase-Savings Plan. b) Information on security ownership of the Company's management is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ________ ______________________________________________ Information on certain relationships and transactions is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. _______ ____________________________________________ a) 1. Financial Statements Filed: See ITEM 8 - Financial Statements and Supplementary Data. 2. Financial Statement Schedules Filed: See ITEM 8 - Financial Statements and Supplementary Data. 3. Exhibits Filed: Exhibit No. *3a(1) Restated Charter of Carolina Power & Light Company, dated May 22, 1980 (filed as Exhibit 2(a)(1), File No. 2-64193). Exhibit No. *3a(2) Amendment, dated May 10, 1989, to Restated Charter of the Company (filed as Exhibit 3(b), File No. 33-33431). Exhibit No. *3a(3) Amendment, dated May 27, 1992 to Restated Charter of the Company (filed as Exhibit 4(b)(2), File No. 33-55060). Exhibit No. *3a(4) By-laws of the Company as amended December 12, 1990 (filed as Exhibit 3(c), File No. 33-38298). Exhibit No. *4a(1) Resolution of Board of Directors, dated December 8, 1954, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $4.20 Series (filed as Exhibit 3(c), File No. 33-25560). Exhibit No. *4a(2) Resolution of Board of Directors, dated January 17, 1967, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $5.44 Series (filed as Exhibit 3(d), File No. 33-25560). Exhibit No. *4a(3) Statement of Classification of Shares dated January 13, 1971, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.95 Series (filed as Exhibit 3(f), File No. 33-25560). Exhibit No. *4a(4) Statement of Classification of Shares dated September 7, 1972, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.72 Series (filed as Exhibit 3(g), File No. 33-25560). Exhibit No. *4b Mortgage and Deed of Trust dated as of May 1, 1940 between the Company and The Bank of New York (formerly, Irving Trust Company) and Frederick G. Herbst (W.T. Cunningham, Successor), Trustees and the First through Fifth Supplemental Indentures thereto (Exhibit 2(b), File No. 2- 64189); and the Sixth through Sixty-second Supplemental Indentures (Exhibit 2(b)-5, File No. 2-16210; Exhibit 2(b)-6, File No. 2-16210; Exhibit 4(b)-8, File No. 2-19118; Exhibit 4(b)-2, File No. 2-22439; Exhibit 4(b)-2, File No. 2-24624; Exhibit 2(c), File No. 2-27297; Exhibit 2(c), File No. 2-30172; Exhibit 2(c), File No. 2-35694; Exhibit 2(c), File No. 2-37505; Exhibit 2(c), File No. 2-39002; Exhibit 2(c), File No. 2-41738; Exhibit 2(c), File No. 2-43439; Exhibit 2(c), File No. 2-47751; Exhibit 2(c), File No. 2-49347; Exhibit 2(c), File No. 2-53113; Exhibit 2(d), File No. 2-53113; Exhibit 2(c), File No. 2-59511; Exhibit 2(c), File No. 2-61611; Exhibit 2(d), File No. 2-64189; Exhibit 2(c), File No. 2-65514; Exhibits 2(c) and 2(d), File No. 2-66851; Exhibits 4(b)-1, 4(b)-2, and 4(b)-3, File No. 2-81299; Exhibits 4(c)-1 through 4(c)-8, File No. 2-95505; Exhibits 4(b) through 4(h), File No. 33-25560; Exhibits 4(b) and 4(c), File No. 33-33431; Exhibits 4(b) and 4(c), File No. 33-38298; Exhibits 4(h) and 4(i), File No. 33-42869; Exhibits 4(e)-(g), File No. 33-48607; Exhibits 4(e) and 4(f), File No. 33-55060; Exhibits 4(e) and 4(f), File No. 33-60014; Exhibits 4(a) and 4(b), File No. 33-38349; Exhibit 4(e), File No. 33-50597; and Item 7(c) of the Company's Current Report on Form 8-K dated January 19, 1994). Exhibit No. *10a(1) Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letter dated February 18, 1982, and amendment dated February 24, 1982 (filed as Exhibit 10(a), File No. 33-25560). Exhibit No. *10a(2) Operating and Fuel Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letters dated August 21, 1981 and December 15, 1981, and amendment dated February 24, 1982 (filed as Exhibit 10(b), File No. 33-25560). Exhibit No. *10a(3) Power Coordination Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency and amending letter dated January 29, 1982 (filed as Exhibit 10(c), File No. 33-25560). Exhibit No. *10a(4) Amendment dated December 16, 1982 to Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency (filed as Exhibit 10(d), File No. 33-25560). Exhibit No. *10a(5) Agreement Regarding New Resources and Interim Capacity between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency dated October 13, 1987 (filed as Exhibit 10(e), File No. 33-25560). Exhibit No. *10a(6) Power Coordination Agreement - 1987A between North Carolina Eastern Municipal Power Agency and Carolina Power & Light Company for Contract Power From New Resources Period 1987-1993 dated October 13, 1987 (filed as Exhibit 10(f), File No. 33-25560). +Exhibit No. *10c(1) Directors Deferred Compensation Plan effective January 1, 1982 as amended (filed as Exhibit 10(g), File No. 33-25560). +Exhibit No. *10c(2) Supplemental Executive Retirement Plan effective January 1, 1984 (filed as Exhibit 10(h), File No. 33-25560). +Exhibit No. *10c(3) Retirement Plan for Outside Directors (filed as Exhibit 10(i), File No. 33- 25560). +Exhibit No. *10c(4) Executive Deferred Compensation Plan effective May 1, 1982 as amended (filed as Exhibit 10(j), File No. 33-25560). +Exhibit No. *10c(5) Key Management Deferred Compensation Plan (filed as Exhibit 10(k), File No. 33-25560). +Exhibit No. *10c(6) Resolutions of the Board of Directors, dated March 15, 1989, amending the Key Management Deferred Compensation Plan (filed as Exhibit 10(a), File No. 33-48607). +Exhibit No. *10c(7) Resolutions of the Board of Directors dated May 8, 1991, amending the Directors Deferred Compensation Plan (filed as Exhibit 10(b), File No. 33- 48607). +Exhibit No. *10c(8) Resolutions of the Board of Directors dated May 8, 1991, amending the Executive Deferred Compensation Plan (filed as Exhibit 10(c), File No. 33- 48607). Exhibit No. 12 Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends Combined and Ratio of Earnings to Fixed Charges. Exhibit No. 23(a) Consent of Deloitte & Touche. Exhibit No. 23(b) Consent of Richard E. Jones. *Incorporated herein by reference as indicated. +Management contract or compensation plan or arrangment required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K. b) Reports on Form 8-K filed during or with respect to the last quarter of 1993 and the first quarter of 1994: Date of Report Item Reported ______________ _____________ December 1, 1993 Item 5. Other Events January 19, 1994 Item 7. Financial Statements, Pro Forma Financial Information and Exhibits 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 25th day of March, 1994. CAROLINA POWER & LIGHT COMPANY (Registrant) By: /s/ Paul S. Bradshaw 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 _________ _____ ____ /s/ Sherwood H. Smith, Jr. Principal Executive (Chairman and Chief Executive Officer and Director Officer) /s/ Charles D. Barham, Jr. Principal Financial (Executive Vice President and Officer and Director Chief Financial Officer) /s/ Paul S. Bradshaw Principal Accounting (Vice President and Controller) Officer /s/ Edwin B. Borden Director March 25, 1994 /s/ Felton J. Capel Director /s/ William Cavanaugh III Director (President and Chief Operating Officer) /s/ George H. V. Cecil Director /s/ Charles W. Coker Director /s/ Richard L. Daugherty Director /s/ William E. Graham, Jr. Director /s/ Gordon C. Hurlbert Director /s/ J. R. Bryan Jackson Director /s/ Robert L. Jones Director /s/ Estell C. Lee Director /s/ J. Tylee Wilson Director

91576_1993.txt

91576_1993

1993

91576

ITEM 1. BUSINESS OVERVIEW On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets at December 31, 1993, merged into and with Society Corporation, an Ohio corporation ("Society"), which was the surviving corporation of the merger under the name KeyCorp (See Mergers, Acquisitions and Divestitures on page 2 for a more complete description of the merger). Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the information presented in this Annual Report on Form 10-K does not give effect to the impact of the merger. Consequently, unless otherwise expressly stated, the information presented relates to Society prior to its merger with old KeyCorp. However, supplemental financial statements included on pages 65 through 94 present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. Society, a financial services holding company organized in 1958, is headquartered in Cleveland, Ohio, is incorporated in Ohio, and is registered under the Bank Holding Company Act ("BHCA") and the Home Owners' Loan Act ("HOLA"). It is principally a regional banking organization and provides a wide range of banking, fiduciary, and other financial services to corporate, institutional, and individual customers. Based on total consolidated assets of approximately $27 billion at December 31, 1993, Society ranked as the third largest bank holding company in Ohio. The first predecessor of a subsidiary of Society was organized in 1849. At December 31, 1993, Society's subsidiary banks operated 434 full-service banking offices in the States of Ohio, Indiana, Michigan, and Florida. At December 31, 1993, Society had 12,038 full-time equivalent employees. SUBSIDIARIES Banking operations in Ohio are conducted through Society National Bank, a Federally-chartered bank headquartered in Cleveland, Ohio, which is the largest bank in Ohio and one of the nation's major regional banks. At December 31, 1993, Society National Bank had total assets of $21.8 billion and operated 291 full- service banking offices. Banking operations in Indiana are conducted through Society National Bank, Indiana, a Federally-chartered bank headquartered in South Bend, Indiana. At December 31, 1993, Society National Bank, Indiana had total assets of $3.0 billion and operated 83 full-service banking offices. Banking operations in Michigan are conducted through Society Bank, Michigan, a state-chartered bank headquartered in Ann Arbor, Michigan. At December 31, 1993, Society Bank, Michigan had assets of $1.1 billion and operated 36 full-service banking offices. Banking operations in Florida are conducted through Society First Federal Savings Bank, a Federally-chartered savings bank headquartered in Fort Myers, Florida. At December 31, 1993, Society First Federal Savings Bank had assets of $1.4 billion and operated 24 full-service banking offices. In addition to the customary banking services of accepting funds for deposit and making loans, Society's subsidiary banks provide a wide range of specialized services tailored to specific markets, including investment management, personal and corporate trust services, personal financial services, cash management services, investment banking services, and international banking services. At December 31, 1993, Society had one of the nation's largest trust departments with managed assets (excluding corporate trust assets) of approximately $29.4 billion. Society's nonbanking subsidiaries provide investment advisory services, securities brokerage services, institutional and personal trust services, mortgage banking services, reinsurance of credit life and accident and health insurance on loans made by subsidiary banks, venture capital and small business investment financing services, equipment lease financing, community development financing, stock transfer agent services and other financial services. Society is a legal entity separate and distinct from its subsidiaries. The principal source of Society's income is the earnings of subsidiary banks, and the principal source of its cash flow is dividends from its subsidiary banks. Applicable state and Federal laws impose limitations on the ability of Society's banking subsidiaries to pay dividends. In addition, the subsidiary banks are subject to the limitations contained in the Federal Reserve Act regarding extensions of credit to, investments in, and certain other transactions with Society and its other subsidiaries. See "Supervision and Regulation" on page 3 for a more complete description of the regulatory restrictions to which Society and its subsidiaries are subject. The following financial data concerning Society and its subsidiaries is incorporated herein by reference as indicated below: MERGERS, ACQUISITIONS AND DIVESTITURES On March 1, 1994, old KeyCorp, a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society, which was the surviving corporation and assumed the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp common stock (based on an exchange ratio of 1.205 KeyCorp Common Shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged on a one-for-one basis for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented will be restated to include the financial results of old KeyCorp. The supplemental financial statements presented on pages 65 through 94 of this report present the financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. On October 5, 1993, Society completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. Accordingly, the results of operations of SWA have been included in the consolidated financial statements from the date of acquisition. On September 15, 1993, Society completed the sale of Ameritrust Texas Corporation ("ATC") to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the year-to-date period through the closing date, ATC had net income of $3.2 million. The $29.4 million gain on the sale ($12.2 million after tax, $.10 per Common Share) is included in noninterest income. On January 22, 1993, Society acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Accordingly, the results of operations of Society First Federal have been included in the consolidated financial statements from the date of acquisition. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. On December 4, 1992, Society and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement, Society contributed its wholly-owned subsidiary, Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. On September 30, 1992, Society acquired all the outstanding shares of First of America Bank-Monroe ("FAB-Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase, and accordingly, the results of operations of FAB-Monroe have been included in the consolidated financial statements from the date of acquisition. FAB-Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into Society. Under the terms of the merger agreement, 49,550,862 Society Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of Society for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one-for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of Society. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, Society sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) which is included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. COMPETITION The market for banking and bank-related services is highly competitive. Society and its subsidiaries compete with other providers of financial services such as other bank holding companies, commercial banks, savings and loan associations, credit unions, mutual funds, including money market mutual funds, insurance companies, and a growing list of other local, regional and national institutions which offer financial services. Mergers between financial institutions have added competitive pressure. Competition is expected to intensify as a consequence of reciprocal interstate banking laws now in effect in a substantial number of states, and the prospect of possible Federal legislation authorizing nationwide interstate banking. Society and its subsidiaries compete by offering quality products and innovative services at competitive prices. SUPERVISION AND REGULATION GENERAL As a bank holding company, Society is subject to supervision by the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). As a result of the 1993 acquisition of Society First Federal, Society is also subject to supervision by the Office of Thrift Supervision (the "OTS") as a savings and loan holding company registered under HOLA. The banking and savings association subsidiaries (collectively, "banking subsidiaries") of Society are subject to extensive supervision, examination, and regulation by applicable Federal and state banking agencies, including the Office of the Comptroller of the Currency (the "OCC") in the case of national bank subsidiaries, the Michigan Financial Institutions Bureau in the case of Society Bank, Michigan, and the OTS in the case of Society First Federal. Each of the banking subsidiaries is insured by, and therefore also subject to the regulations of, the Federal Deposit Insurance Corporation (the "FDIC"). Depository institutions such as the banking subsidiaries are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. The regulatory regime applicable to bank holding companies and their subsidiaries generally is not intended for the protection of investors and is directed toward protecting the interests of depositors, the FDIC deposit insurance funds, and the U.S. banking system as a whole. Society's nonbanking subsidiaries are also subject to supervision and examination by the Federal Reserve Board, as well as other applicable regulatory agencies. For example, Society's discount brokerage and investment advisory subsidiaries are subject to supervision and regulation by the SEC, the National Association of Securities Dealers, Inc., and state securities regulators. Society's insurance subsidiary is subject to regulation by the insurance regulatory authorities of the various states. Other nonbanking subsidiaries are subject to other laws and regulations of both the Federal government and the various states in which they are authorized to do business. The following references to certain statutes and regulations are brief summaries thereof. The references are not intended to be complete and are qualified in their entirety by reference to the statutes and regulations. In addition there are other statutes and regulations that apply to and regulate the operation of banking institutions. A change in applicable law or regulation may have a material effect on the business of Society. DIVIDEND RESTRICTIONS Various Federal and state statutory provisions limit the amount of dividends that may be paid to Society by its banking subsidiaries without regulatory approval. The approval of the OCC is required for the payment of any dividend by a national bank if the total of all dividends declared by the bank in any calendar year would exceed the total of its net profits (as defined by the OCC) for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. In addition, a national bank is not permitted to pay a dividend in an amount greater than its net profits then on hand (as defined by the OCC) after deducting its losses and bad debts. For this purpose, bad debts are defined to include, generally, loans which have matured as to which interest is overdue by six months or more, other than such loans which are well secured and in the process of collection. Society's principal banking subsidiaries -- Society National Bank and Society National Bank, Indiana are national banks. In addition, OTS regulations impose limitations upon all capital distributions by savings associations. These limitations are applicable to Society First Federal, Society's only savings association subsidiary. State banks that are not members of the Federal Reserve System ("nonmember banks") are also subject to varying restrictions on the payment of dividends under state laws. Society Bank, Michigan is Society's only state nonmember bank. Under these restrictions, as of December 31, 1993, Society's banking subsidiaries could have declared dividends of approximately $76.0 million in the aggregate, without obtaining prior regulatory approval. In addition, if, in the opinion of the applicable Federal banking agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the institution, could include the payment of dividends), the agency may require, after notice and hearing, that such institution cease and desist from such practice. In addition, the Federal Reserve Board, the OCC, the FDIC and the OTS have issued policy statements which provide that insured depository institutions and their holding companies should generally pay dividends only out of current operating earnings. HOLDING COMPANY STRUCTURE Transactions Involving Banking Subsidiaries. Transactions involving Society's banking subsidiaries are subject to Federal Reserve Act restrictions which limit the transfer of funds from such subsidiaries to Society and (with certain exceptions) to Society's nonbanking subsidiaries (together, "affiliates") in so-called "covered transactions," such as loans, extensions of credit, investments, or asset purchases. Unless an exemption applies, each such transfer by a banking subsidiary to one of its affiliates is limited in amount to 10% of that banking subsidiary's capital and surplus and, with respect to all such transfers to affiliates, in the aggregate, to 20% of that banking subsidiary's capital and surplus. Furthermore, loans and extensions of credit are required to be secured in specified amounts. "Covered transactions" also include the acceptance of securities issued by the banking subsidiary as collateral for a loan and the issuance of a guarantee, acceptance, or letter of credit for the benefit of Society or any of its affiliates. In addition, a bank holding company and its banking 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. Bank Holding Company Support of Banking Subsidiaries. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to support each such subsidiary bank. This support may be required by the Federal Reserve Board at times when Society may not have the resources to provide it or, for other reasons, would not otherwise be inclined to provide it. Any capital loans by Society to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of a subsidiary bank. In addition, the Crime Control Act of 1990 provides that in the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a Federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. A depository institution, the deposits of which are 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 (the so-called "cross guaranty" provision). "Default" is defined under the FDIC's regulations generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. CAPITAL REQUIREMENTS The minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) required by the Federal Reserve Board for bank holding companies is 8%. At least one-half of the total capital must be comprised of common equity, retained earnings, qualifying noncumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets ("Tier I capital"). The remainder may consist of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock, and a limited amount of loan and lease loss reserves ("Tier II capital"). The Federal Reserve Board has stated that banking organizations generally, and, in particular, those that actively make acquisitions, are expected to operate well above the minimum risk-based capital ratios. As of December 31, 1993, Society's Tier I and total capital to risk-adjusted assets ratios were 8.65% and 12.88%, respectively. In addition, Society is subject to minimum leverage ratio (Tier I capital to average total assets for the relevant period) guidelines. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies that meet certain specified criteria, such as having the highest supervisory rating. All other bank holding companies are required to maintain a leverage ratio which is at least 100 to 200 basis points higher (i.e., a leverage ratio of at least 4% to 5%). Neither Society, nor any of its banking subsidiaries have been advised by its appropriate Federal regulatory agency of any specific leverage ratio applicable to it. At December 31, 1993, Society's Tier I leverage ratio was 7.18%. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier I leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier I leverage ratio is the ratio of a banking organization's Tier I capital less all intangibles, to total assets less all intangibles. Each of Society's banking subsidiaries is also subject to capital requirements adopted by applicable Federal regulatory agencies which are substantially similar to those imposed by the Federal Reserve Board on bank holding companies. As of December 31, 1993, each of Society's banking subsidiaries had capital in excess of all minimum regulatory requirements. All the Federal banking agencies have proposed regulations that would add an additional capital requirement based upon the amount of an institution's exposure to interest rate risk. The OTS recently adopted its final rule adding an interest rate component to its risk-based capital rule. Under the final OTS rule, savings associations with a greater than "normal" level of interest rate risk exposure will be subject to a deduction from total capital for purposes of calculating the risk-based capital ratio. The new OTS rule was effective January 1, 1994, except for limited provisions which are effective July 1, 1994. The other Federal banking agencies have yet to adopt their final rules on the interest rate risk component of risk-based capital. The OCC, the Federal Reserve, and the FDIC have proposed amendments to their respective regulatory capital rules to include in Tier I capital the net unrealized changes in the value of securities available for sale for purposes of calculating the risk-based and leverage ratios. The proposed amendments are in response to the provisions outlined in Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which takes effect for fiscal years beginning after December 15, 1993. See Note 3, Securities, on page 46 for a more complete description of SFAS No. 115. This new accounting standard establishes, among other things, net unrealized holding gains and losses on securities available for sale as a new component of stockholders' equity. If adopted as proposed, the rules could cause the Tier I capital to be subject to greater volatility. However, neither SFAS No. 115 nor the capital proposals would have any direct impact on reported earnings. SIGNIFICANT AMENDMENTS TO THE FEDERAL DEPOSIT INSURANCE ACT In 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991, which, among other things, amended the Federal Deposit Insurance Act (the "FDIA"), and increased the FDIC's borrowing authority to resolve bank failures, mandated least-cost resolutions and prompt regulatory action with regard to undercapitalized institutions, expanded consumer protection, and mandated increased supervision of domestic depository institutions and the U.S. operations of foreign depository institutions. The amendments to the FDIA resulting from enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991 require Federal banking agencies to promulgate regulations and specify standards in numerous areas of bank operations, including interest rate exposure, asset growth, internal controls, credit underwriting, executive officer and director compensation, real estate construction financing, additional review of capital standards, interbank liabilities, and other operational and managerial standards as the agencies determine appropriate. Most of these regulations have been promulgated in final form by the appropriate Federal bank regulatory agencies, although some have only been proposed. These regulations have increased and may continue to increase the cost of and the regulatory burden associated with the banking business. Prompt Corrective Action. Effective in December 1992, the FDIC, the Federal Reserve Board, the OCC and the OTS adopted new regulations to implement the prompt corrective action provisions of the FDIA. The regulations group FDIC-insured depository institutions into five broad categories based on their capital ratios. The five categories are "well capitalized," "adequately capitalized", "undercapitalized", "significantly undercapitalized," and "critically undercapitalized." An institution is "well capitalized" if it has a total risk-based capital ratio (total capital to risk-adjusted assets) of 10% or greater, a Tier I risk-based capital ratio (Tier I capital to risk-adjusted assets) of 6% or greater and a Tier I leverage capital ratio (Tier I capital to average total assets) of 5% or greater, and it is not subject to a regulatory order, agreement or directive to meet and maintain a specific capital level for any capital measure. An institution is "adequately capitalized" if it has a total risk-based capital ratio of 8% or greater, a Tier I risk-based capital ratio of 4% or greater and (generally) a Tier I leverage capital ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution. An institution is "undercapitalized" if the relevant capital ratios are less than those specified in the definition of an "adequately capitalized" institution. An institution is "significantly undercapitalized" if it has a total risk-based capital ratio of less than 6%, a Tier I risk-based capital ratio of less than 3%, or a Tier I leverage capital ratio of less than 3%. An institution is "critically undercapitalized" if it has a ratio of tangible equity (as defined in the regulations) to total assets of 2% or less. An institution may be downgraded to, or be deemed to be in a capital category that is lower than is indicated by its actual capital position if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. The capital-based prompt corrective action provisions of the FDIA and their implementing regulations apply to FDIC insured depository institutions and are not applicable to holding companies which control such institutions. However, both the Federal Reserve Board and the OTS have indicated that, in regulating holding companies, they will take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations. Although the capital categories defined under the prompt corrective action regulations are not directly applicable to Society under existing law and regulations, based upon its ratios Society would qualify, and its subsidiary banks do qualify, as well-capitalized as of December 31, 1993. The capital category, as determined by applying the prompt corrective action provisions of the law, may not constitute an accurate representation of the overall financial condition or prospects of Society or its banking subsidiaries. The FDIA 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 institution would thereafter be undercapitalized. Undercapitalized depository institutions are also subject to restrictions on borrowing from the Federal Reserve System (effective December 19, 1993). Undercapitalized depository institutions are subject to increased monitoring by the appropriate Federal banking agency and limitations on growth, and are required to submit a capital restoration plan. The Federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company with respect to such a guarantee is limited to the lesser of: (a) an amount equal to 5% of the depository institution's total assets at the time it became undercapitalized or (b) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were 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 and requirements to reduce total assets, and are prohibited from receiving deposits from correspondent banks. "Critically undercapitalized" institutions are subject to the appointment of a receiver or conservator. FDIC Insurance. Under the risk-related insurance assessment system, adopted in final form effective beginning with the January 1, 1994 assessment period, a bank or savings association is required to pay an assessment ranging from $.23 to $.31 per $100 of deposits based on the institution's risk classification. The risk classification is based on an assignment of the institution by the FDIC to one of three capital groups and to one of three supervisory subgroups. The capital groups are "well capitalized," "adequately capitalized," and "undercapitalized." The three supervisory subgroups are Group "A" (for financially solid institutions with only a few minor weaknesses), Group "B" (for those institutions with weaknesses which, if uncorrected, could cause substantial deterioration of the institution and increase the risk to the deposit insurance fund), and Group "C" (for those institutions with a substantial probability of loss to the fund absent effective corrective action). For the period commencing on July 1, 1993 through December 31, 1993, insurance assessments on all deposits of Society's banking subsidiaries were paid at the $.23 per $100 of deposits rate. DEPOSITOR PREFERENCE STATUTE In August 1993, Federal legislation was enacted which provides that insured and uninsured deposits of, and certain claims for administrative expenses and employee compensation against, an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the "liquidation or other resolution" of such an institution by any receiver. Under this new legislation, if an insured depository institution fails, insured and uninsured depositors along with the FDIC will be placed ahead of all unsecured, nondeposit creditors in order of priority of payment. Due to its recent enactment, it is too early to determine what impact this legislation will have on the ability of financial institutions to attract junior creditors in the future or otherwise. IMPLICATIONS OF BEING A SAVINGS AND LOAN HOLDING COMPANY Society is a savings and loan holding company within the meaning of HOLA. With certain exceptions, a savings and loan holding company must obtain prior written approval from the OTS (as well as the Federal Reserve Board, or other Federal agencies whose approval may be required, depending upon the structure of the acquisition transaction) before acquiring control of a savings association or savings and loan holding company through the acquisition of stock or through a merger or some other business combination. HOLA prohibits the OTS from approving an acquisition by a savings and loan holding company which would result in the holding company's controlling savings associations in more than one state unless (a) the holding company is authorized to do so by the FDIC as an emergency acquisition, (b) the holding company controls a savings association which operated an office in the additional state or states on March 5, 1987, or (c) the statutes of the state in which the savings association to be acquired is located specifically permit a savings association chartered by such state to be acquired by an out-of-state savings association or savings and loan holding company. CONTROL ACQUISITIONS The Change in Bank Control prohibits a person or group of persons from acquiring "control" of a bank holding company unless the Federal Reserve Board has been given 60 days' prior written notice of proposed acquisition and within that time period the Federal Reserve Board has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days the period during which such a disapproval may be issued. An acquisition may be made prior to the expiration of the disapproval period if the Federal Reserve Board issues written notice of its intention not to disapprove the action. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as Society would, under the circumstances set forth in the presumption, constitute the acquisition of control. In addition, any "company" would be required to obtain the approval of the Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of the outstanding Society Common Shares, or otherwise obtaining control over Society. ITEM 2. ITEM 2. PROPERTIES The headquarters of Society and of Society National Bank are located in Society Center at 127 Public Square, Cleveland, Ohio 44114-1306. Society currently leases approximately 625,000 square feet of the complex, encompassing the first twenty-one floors and the 55th and 56th floors of the 57-story Society Tower and all ten floors of the adjacent Society for Savings Building. Society owns a four-story office building and the Summit Center Building, a 16-story office building, both located in downtown Toledo. In addition, Society has an office center located in a one-story building containing approximately 500,000 square feet on a 55 acre site in Brooklyn, Ohio which is owned in fee by a subsidiary. Society National Bank is still under lease on the former Ameritrust offices at 2017 East Ninth Street in Cleveland in accordance with obligations assumed as part of the merger. These offices under lease consist of a portion of a 29-story office building, an attached 13-story office building and an 8-story parking garage. Society Bank, Michigan owns its seven-story main office building in Ann Arbor, Michigan, which is also the headquarters of Society Bancorp of Michigan, Inc. Society National Bank, Indiana leases its 14-story headquarters building in South Bend, Indiana. At December 31, 1993, the banking subsidiaries of Society owned 247 of their branch banking offices and leased 187 offices. The lease terms for applicable branch banking offices are not individually material, with terms ranging from month-to-month to 99-year leases from inception. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the ordinary course of business, Society and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and Society's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on the consolidated financial condition of Society. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this Report, no matter was submitted to a vote of security holders of Society. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The discussion with respect to Common Shares and Shareholder Information appearing on page 32 and the dividend restrictions discussions included on page 4 and in Note 13, Commitments, Contingent Liabilities, and Other Disclosures, on page 56 are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data included on page 11 is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This section provides a narrative discussion and analysis of the consolidated financial condition and results of operations of Society Corporation and its subsidiaries (the "Corporation"). The financial data included throughout the remainder of this discussion should be read in conjunction with the consolidated financial statements and notes presented on pages 39 through 61 of this report. On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society Corporation ("Society"), an Ohio corporation, which was the surviving corporation of the merger under the name "KeyCorp". Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the financial information and narrative discussion presented herein covers Society's financial performance prior to the merger and does not give effect to the restatement to include old KeyCorp's financial results. However, the supplemental financial statements included on pages 65 through 94 of this report present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. In addition to the merger of Society and old KeyCorp, the following transactions, which were completed over the past two years and have had a significant impact on the Corporation's overall growth and geographic diversification, are described in greater detail in Note 2, Mergers, Acquisitions and Divestitures, on page 45 of this report: (i) the March 16, 1992, merger of Ameritrust Corporation ("Ameritrust") with and into Society, (ii) the September 30, 1992, acquisition by Society of all the outstanding shares of First of America Bank - Monroe ("FAB-Monroe"), (iii) the December 4, 1992, formation by Society and three other bank holding companies of a joint venture in a new corporation named Electronic Payment Services, Inc., (iv) the January 22, 1993, acquisition by Society of all the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), (v) the September 15, 1993, sale by Society of Ameritrust Texas Corporation ("ATC"), and (vi) the October 5, 1993, acquisition by Society of Schaenen Wood & Associates, Inc. ("SWA"). PERFORMANCE OVERVIEW Net income for 1993 reached a record level of $347.2 million, or $2.93 per Common Share, up from the previous record of $301.2 million, or $2.51 per Common Share, achieved in 1992 and $76.5 million, or $.61 per Common Share, in 1991. The return on average common equity for the current year rose to 17.87%, up from 17.52% and 4.24% in 1992 and 1991, respectively. The return on average total assets was 1.36% in 1993, 1.26% in 1992 and .30% in 1991. Record-level earnings were attained in 1993 despite fourth-quarter merger and integration charges of $53.9 million ($39.6 million after tax, $.33 per Common Share) recorded in connection with the merger with old KeyCorp. In 1992, earnings were also adversely impacted by similar charges of $50.0 million ($34.2 million after tax, $.29 per Common Share) recorded in the first quarter in connection with the merger with Ameritrust. In addition, 1992 earnings reflected a $20.1 million ($13.2 million after tax, $.11 per Common Share) gain on the sale of certain branch offices and loans. Excluding the impact of the above items, 1993 net income grew by $64.6 million, or 20%, relative to the previous year. On a pre-tax basis, this improvement reflected a $62.1 million, or 5%, increase in taxable-equivalent net interest income, a $28.3 million, or 6%, increase in noninterest income and a $75.1 million, or 51%, decrease in the provision for loan losses. These positive factors were offset in part by a $52.1 million, or 5%, increase in noninterest expense. Adjusting for the merger and integration charges in both years and the 1992 gain, the returns on average common equity and the returns on average total assets were 19.92% and 1.51%, respectively, in 1993, and 18.77% and 1.35%, respectively, in 1992. In 1991, net income was also impacted by merger and integration charges totaling $93.8 million ($68.2 million after tax, $.59 per Common Share) recorded during the fourth quarter in connection with the Ameritrust merger. Excluding the merger and integration charges in both 1992 and 1991 and the gain referred to above, net income in 1992 grew by $177.5 million, or 123%, relative to the previous year. On a pre-tax basis, this improvement reflected a $72.3 million, or 7%, increase in taxable-equivalent net interest income, a $26.4 million, or 6%, increase in noninterest income and a $132.7 million, or 47%, decrease in the provision for loan losses. Noninterest expense also decreased $22.7 million, after adjusting for the merger and integration charges in both years. On an adjusted basis, the 1991 return on average common equity and the return on average total assets were 8.36% and .57%, respectively. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income, which is comprised of interest and loan-related fee income less interest expense, is the principal source of earnings for Society's banking affiliates. Net interest income is affected by a number of factors including the level, pricing and maturity of earning assets and interest-bearing liabilities, interest rate fluctuations and asset quality. To facilitate comparisons in the following discussion, net interest income is presented on a taxable-equivalent basis, which increases reported interest income on tax-exempt loans and securities by an amount equivalent to the taxes which would be paid if the income were taxable at the statutory Federal income tax rate. The trends in various components of the balance sheet and their respective yields and rates which affect interest income and expense are illustrated in Figure 3. The table presented in Figure 4 provides an analysis of the effect of changes in yields/rates and average balances on net interest income in 1993 and 1992. A more in-depth discussion of changes in earning assets and funding sources is presented in the Financial Condition section beginning on page 23. Net interest income was $1.2 billion in 1993, up $62.1 million, or 5%, from the prior year. This followed an increase of $72.3 million, or 7%, in 1992 relative to the comparable 1991 period. In 1993, the growth in net interest income resulted from a higher level of average earning assets, which more than offset a slight decline in the net interest margin. The net interest margin is computed by dividing taxable equivalent net interest income by average earning assets. Average earning assets in 1993 totaled $23.2 billion which represented an increase of $1.5 billion, or 7%, from the prior year. This followed a decrease of $1.6 billion, or 7%, in 1992 relative to the previous year. Excluding the impact of the January 1993, acquisition of Society First Federal, average earning assets increased by $325.2 million in 1993 due to increases of $461.8 million in total securities and $69.2 million in loans and mortgage loans held for sale. These increases were partially offset by a $205.7 million decline in aggregate short-term investments. The increase in loans can be primarily attributed to growth in student loans held for sale, residential mortgage loans and lease financing, offset in part by lower levels of outstanding loans in the consumer and commercial portfolios. The $1.6 billion decrease in average earning assets in 1992 resulted primarily from a $1.3 billion decline in average loans, principally in the commercial and real estate construction portfolios. The decline also reflected a decrease of $375.4 million in Federal funds sold and security resale agreements. This latter decrease resulted from reduced short-term funding requirements for loans and the planned reduction of excess liquidity. The decrease in loans in 1992 can be attributed to a decline in demand due to weak economic conditions, strategic efforts to reduce certain types of lending, the anticipated run-off of certain Ameritrust credits and the second quarter sale of branch offices, including $331.8 million in loans, required in connection with the merger with Ameritrust. As shown in Figure 3, the net interest margin for the current year was 5.26% compared with 5.33% in 1992 and 4.65% in 1991. The slight decline in the 1993 net interest margin reflected the narrower interest rate spread contributed by Society First Federal and the lower proportion of interest free funds supporting earning assets in comparison with the prior year. The interest rate spread is computed as the difference between the taxable-equivalent yield on earning assets and the rate paid on interest-bearing liabilities. Excluding the impact of Society First Federal, the net interest margin increased to 5.35%. On an adjusted basis, the improvement in the margin over the past two years was principally the result of a wider spread. In 1993 and 1992 the spread increased by 16 basis points and 85 basis points, respectively, as the decrease in the rate paid on interest-bearing liabilities exceeded the decrease in the yield on earning assets. Several factors were responsible for the widened spreads, including an interest rate sensitivity position which has enabled the Corporation to benefit from the lower interest rate environment. This position was enhanced through the increased use of "portfolio" interest rate swaps and securities. The notional amount of such swaps increased to $5.2 billion at December 31, 1993, up from $4.8 billion at December 31, 1992, and $2.9 billion at December 31, 1991. Interest rate swaps contributed $131.1 million to net interest income and 56 basis points to the net interest margin in 1993. In 1992 interest rate swaps increased net interest income by $93.8 million and added 44 basis points to the net interest margin. The manner in which interest rate swaps are used in the Corporation's overall program of asset and liability management is described in the Asset and Liability Management section on page 16 of this report. Also contributing to the widened spread was a shift in deposits from time to lower rate savings deposits with higher liquidity and to noninterest-bearing deposits. The improved margin also reflected the effects of a lower level of nonperforming assets and the 1992 reduction in short-term investments (made by Ameritrust prior to the merger) which had narrower spreads. [PAGE INTENTIONALLY LEFT BLANK] ASSET AND LIABILITY MANAGEMENT The Corporation manages its exposure to economic loss from fluctuations in interest rates through an active program of asset and liability management within guidelines established by the Corporation's Asset/Liability Management Committee ("ALCO"). The ALCO has the responsibility for approving the asset/liability management policies of the Corporation, approving changes in the balance sheet that would result in deviations from guidelines in the policy, approving strategies to improve balance sheet positioning and/or earnings, and reviewing the interest rate sensitivity positions of the Corporation and each of the affiliate banks. The ALCO meets twice monthly to conduct this review and to approve strategies consistent with its policies. The primary tool utilized by management to measure and manage interest rate exposure is a simulation model. Use of the model to perform simulations of changes in interest rates over one-and two-year time horizons has enabled management to develop strategies for managing exposure to interest rate risk. In performing its simulations, management projects the impact on net interest income from pro forma 100 and 200 basis point changes in the overall level of interest rates. ALCO policy guidelines provide that a 200 basis point increase or decrease over a 12-month period should not result in more than a 2% negative impact on net interest income. Simulations as of December 31, 1993, indicated that a 200 basis point increase in interest rates over the next twelve months would have reduced net interest income by 2.2%. Conversely, a 200 basis point decrease in interest rates over the same time period would have increased net interest income by 1.4%. Accordingly, as of December 31, 1993, the simulation model indicated that the Corporation's liability-sensitivity position was outside of policy guidelines. ALCO determined that this interest rate sensitivity position was appropriate considering the pending merger with old KeyCorp. Simulations on a pro forma combined basis with old KeyCorp as of December 31, 1993, indicated that the combined corporation was positioned within the guidelines and was slightly liability sensitive. The simulation model is supplemented with a more traditional tool used in the banking industry for measuring interest rate risk known as interest rate sensitivity gap analysis. This tool measures the difference between assets and liabilities repricing or maturing within specified time periods. An asset-sensitive position indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within specified time horizons, which would generally imply a favorable impact on net interest income in periods of rising interest rates. Conversely, a liability sensitive position, where rate-sensitive liabilities exceed the amount of rate-sensitive assets repricing or maturing within applicable time frames, would generally imply a favorable impact on net interest income in periods of declining interest rates. The interest rate gap analysis table shown in Figure 5 presents the gap position (including the impact of off-balance sheet items) of the Corporation at December 31, 1993. Gap analysis has several limitations. For example, it does not take into consideration the varying degrees of interest rate sensitivity pertaining to the assets and liabilities that reprice within one year. Thus at December 31, 1993, the cumulative adjusted interest rate sensitivity gap of 4.78% within the one-year time frame indicated that the Corporation was asset-sensitive, whereas the more precise simulation model, previously described, indicated the Corporation was slightly liability-sensitive. The Corporation's core lending and deposit-gathering businesses tend to generate significantly more fixed-rate deposits than fixed-rate interest-earning assets. Left unaddressed, this tendency would place the Corporation's earnings at risk to declining interest rates as interest-earning assets would reprice faster than would interest-bearing liabilities. To reduce this risk, management has utilized its securities portfolio and, for the past several years, interest rate swaps in the management of interest rate risk. The decision to use "portfolio" interest rate swaps to manage interest rate risk versus on-balance sheet securities has depended on various factors, including funding costs, liquidity, and capital requirements. The Corporation's "portfolio" swaps totaled $5.2 billion at December 31, 1993, and consisted principally of contracts wherein the Corporation receives a fixed rate of interest, while paying at a variable rate, as summarized in Figure 6. In addition to "portfolio" swaps, the Corporation has entered into interest rate swap agreements to accommodate the needs of its customers, typically commercial loan customers. The Corporation offsets the interest rate risk of customer swaps by entering into offsetting swaps, primarily with third parties. These offsetting swaps are also included in the customer swap portfolio. Where the Corporation does not have an existing loan with the customer, the swap position of the customer and any offsetting swap with a third party are carried at their respective fair values. The $1.2 billion notional value of customer swaps in Figure 6 includes $645 million of interest rate swaps that receive a fixed rate and pay a variable rate and $569 million of interest rate swaps that receive a variable rate and pay a fixed rate. The total notional value of all interest rate swap contracts outstanding was $6.5 billion and $5.5 billion as of December 31, 1993 and 1992, respectively. Figure 7 shows the current year activity for such swaps. At December 31, 1993, the aggregate notional values of interest rate swap contracts, excluding customer swaps, maturing in each of the years 1994 through 1998 were $2.5 billion, $1.0 billion, $500 million, $200 million and $650 million, respectively. The credit risk exposure to the counterparties for each interest rate swap contract is monitored by the appropriate credit committees at both the Corporate and affiliate bank levels. Based upon detailed credit reviews of the counterparties, these credit committees establish limitations on the total credit exposure the Corporation may have with each counterparty and indicate whether collateral is required. At December 31, 1993, excluding customer swaps, the Corporation had 16 counterparties to interest rate swap contracts, of which the largest credit exposure to an individual counterparty was $16.4 million on a notional amount of $900 million. The average total notional amount of swap contracts with these 16 counterparties was $328 million with an average credit exposure of $4.1 million. NONINTEREST INCOME As shown in Figure 9, noninterest income totaled $509.8 million in 1993, up $8.3 million, or 2%, from the prior year. After excluding the $29.4 million gain on the sale of ATC, the $26.1 million in net securities gains and certain other nonrecurring items, noninterest income in 1993 was $457.6 million. This represented an increase of $14.1 million, or 3%, from the amount reported in 1992, after excluding last year's $20.1 million gain on the sale of branch offices and loans, and net securities gains totaling $9.8 million. Adjusting for the 1992 gains and the securities transactions recorded in 1991, noninterest income in 1992 rose $23.9 million, or 5%, relative to the prior year. Trust fees continued to be a major source of revenue. After excluding the gains referred to above, these fees accounted for 45% of noninterest income in both 1993 and 1992, compared to 44% in 1991. The growth during the 1992 period reflected the development of new business, expanded geographic coverage and enhanced service capability. At December 31, 1993, the Corporation, through Society Asset Management, Inc. ("SAMI") and the trust departments of its affiliate banks and trust subsidiaries, managed assets (excluding corporate trust assets) of approximately $29.4 billion. SAMI, which is a wholly-owned subsidiary of Society National Bank, is registered with the Securities and Exchange Commission ("SEC") as an investment advisor and is one of the largest money managers in the Great Lakes region. The sale of ATC in September 1993 reduced managed trust assets and trust fees by approximately $4 billion and $8.0 million, respectively. Service charges on deposit accounts decreased $1.6 million, or 2%, in 1993 following an increase of $3.7 million, or 4%, in 1992. The decrease in 1993 was due, in part, to the change in the mix of the deposit base and related pricing structure resulting from acquisitions and divestitures. Factors contributing to the improvement in 1992 were pricing strategies and other corporate-wide initiatives designed to offset higher costs associated with servicing deposit accounts. In 1993, credit card fees decreased $6.8 million, or 12%, primarily due to a decline in annual membership fees relative to the prior year. This compared to an increase of $2.5 million, or 5%, in 1992. Growth in the insurance and brokerage component of other income over the past three years was due to increased broker dealer commissions at Society Investments, Inc. (SII). SII, which is a wholly-owned subsidiary of Society National Bank, is a registered broker dealer with the SEC and the National Association of Securities Dealers. The increase in commissions at SII resulted from aggressive and strategic sales initiatives, including an expanded sales force and product line. "Miscellaneous" other income in 1993 decreased $8.0 million, or 12%, from the comparable 1992 amount. Primary factors contributing to this decrease were an $8.2 million decline in ATM fees resulting from Society's contribution of the Green Machine subsidiary to the newly formed Electronic Payment Systems joint venture which Society entered into in the fourth quarter of 1992, and $10.2 million in gains resulting from the curtailment and settlement of retirement obligations recorded in 1992 in connection with merger-related staff reductions. The impact of these factors was partially offset by a $4.5 million interest rate swap trading gain recorded in 1993. NONINTEREST EXPENSE Noninterest expense, as shown in Figure 10, totaled $1.1 billion in 1993, up $55.9 million, or 5%, from the 1992 level. In both 1993 and the prior year, noninterest expense was adversely impacted by merger and integration charges of $53.9 million and $50.0 million, respectively. In addition, the current year included several nonrecurring charges totaling $34.4 million. Significant items included in these charges were $21.6 million related to various systems conversion costs, $7.0 million of facilities-related charges and $4.0 million associated with the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Excluding the merger and integration charges and the nonrecurring items, 1993 expenses rose $17.6 million, or 2%, principally due to increases in personnel expense, marketing expense and the "Miscellaneous" category, offset in part by lower fees for professional services. The overall increase in recurring noninterest expense was due, in large part, to the acquisition of Society First Federal in January 1993. The 1991 period also included merger and integration charges of $93.8 million, as well as $6.9 million of costs associated with a branch optimization program. After adjusting for these items, 1992 noninterest expense decreased $15.8 million, or 2%, relative to the prior year, reflecting the effectiveness of cost management initiatives. Personnel expense for 1993 increased $15.0 million, or 3%, over 1992. In addition to the $9.3 million impact of the Society First Federal acquisition, this increase reflected the Corporation's January 1, 1993, adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which added $4.7 million to 1993 employee benefits expense, as well as additional costs associated with a new employee incentive program. Excluding the impact of the adoption of SFAS No. 106 and SFAS No. 112, personnel expense for 1993 increased $6.3 million or 1%. SFAS No. 106 and SFAS No. 112 are more fully described below. Personnel expense for 1992 increased $4.5 million, or less than 1%, from the prior year. The 1992 increase in the salaries component was mainly due to higher costs related to temporary contracted personnel, but was substantially offset by the decrease in benefits resulting from reduced staff levels. At December 31, 1993, the number of full-time equivalent employees was 12,038, down 3% and 11% from 1992 and 1991 levels, respectively. Merger and integration charges of $53.9 million, $50.0 million and $93.8 million were recorded in 1993, 1992, and 1991, respectively. The 1993 charges were incurred in connection with the merger with old KeyCorp, while the 1992 and 1991 amounts related to the merger with Ameritrust. The merger and integration charges directly attributable to the old KeyCorp merger included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($12.6 million); severance payments and other employee costs ($17.6 million); systems and facilities costs ($16.7 million); and other costs incident to the merger ($7.0 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the Ameritrust merger in 1992 and 1991 were similar in nature. Although no assurance can be given, it is also expected that as a result of the old KeyCorp merger, cost savings will be achieved by the combined institution at an annual rate of approximately $100 million by the end of the first quarter of 1995. These cost savings are anticipated to result from the integration of operations and from efficiencies in certain combined lines of business. Management presently expects that approximately 50% of the annual cost savings will be achieved in 1994. One measure used in the banking industry to assess the level of noninterest expense is the efficiency ratio, which is defined in Figure 10. The efficiency ratios for 1993, 1992, and 1991 were 60.41%, 61.11%, and 66.44%, respectively. The improvement in the Corporation's efficiency ratios reflects, in large part, the success achieved in reducing overhead costs through the successful integration of banking companies, coupled with the strong growth in taxable-equivalent net interest income. SFAS No. 106, previously referred to on page 20, requires that employers recognize the cost of providing postretirement benefits over the employees' active service periods to the date they attain full eligibility for such benefits. A transition obligation, defined as the unfunded accumulated postretirement benefit obligation at the date the standard is adopted, may be recognized immediately (through a charge to earnings in the year of adoption), or on a delayed basis, generally over a transition period not to exceed 20 years. The Corporation elected to recognize the transition obligation of approximately $77 million over a 20-year transition period. As previously stated, adoption of the new standard added $4.7 million to noninterest expense in the current year. As of December 31, 1993, the discount rate used in determining the actuarial present value of both pension and other postretirement benefits was reduced from 8.5% to 7.5%. In addition, the assumed rate of increase in future compensation levels (applicable only to the determination of pension benefits) was reduced from 4.5% to 4.0%. The net effect of these assumption changes on 1994 expense levels is not expected to be material. Another assumption used in the determination of the costs of other postretirement benefits is the health care cost trend rate. Because of certain cost-sharing provisions and benefit limitations in effect, increasing the rates assumed in each future year by one percentage point would not be expected to have a material impact on the costs for other postretirement benefits. The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits" during 1993. This standard requires that employers who provide benefits to former and inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of the standard increased third quarter and full year 1993 noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. INCOME TAXES The provision for income taxes for 1993 was $187.5 million, compared with $137.4 million in 1992 and $33.2 million in 1991. The increases in both 1993 and the prior year resulted from an overall increase in the level of taxable earnings. The Omnibus Budget Reconciliation Act of 1993, which was signed into law on August 10, 1993, includes a number of significant items which impacted the Corporation's Federal income tax provision. Primary among these items is a retroactive increase in the Federal statutory tax rate from 34% to 35% as of January 31, 1993. In addition, the Act places certain limitations on deductible expenses which take effect after 1993. The effective tax rate (provision for income taxes as a percentage of income before income taxes) was 35.1% in 1993, 31.3% in 1992 and 30.3% in 1991. The effective tax rate in 1993 exceeded the current Federal statutory tax rate of 35% as a higher tax-basis gain on the sale of ATC and non tax-deductible expenses, including the amortization of certain intangible assets and certain merger expenses, exceeded tax-exempt income in the current year. The non tax-deductible merger expenses incurred in 1993 were primarily due to additional costs associated with the merger with old KeyCorp. The effective tax rate in 1992 and 1991 was less than the Federal statutory tax rate of 34.0%, in effect at the time, due primarily to tax-exempt income from certain investment securities and loans. During the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." The adoption of this standard did not have a material effect on the Corporation's financial condition or results of operations. FINANCIAL CONDITION The financial condition of Society and its subsidiaries as of December 31 is presented in the comparative balance sheet on page 39. The following discussions address significant elements of financial condition including loans, securities, credit quality and experience, sources of funds, liquidity and capital adequacy. Unless otherwise indicated, amounts presented in the discussions are as of the appropriate period-end. LOANS At December 31, 1993, total loans outstanding were $17.9 billion, as compared with $16.0 billion at December 31, 1992, and $16.8 billion at December 31, 1991, as shown in Figure 11. The increase from the year-end 1992 level was due, in part, to the acquisition of Society First Federal in January 1993. Excluding the $836.6 million impact of this acquisition and adjusting for $200.0 million of student loans securitized or sold in 1993, loans increased by $1.3 billion since the prior year end. This reflected increases of $603.0 million in residential real estate loans, $578.5 million in student loans held for sale and $289.3 million in lease financing receivables. These increases were partially offset by decreases of $360.0 million in commercial mortgage and construction loans, $43.6 million in commercial loans, $41.5 million in credit card outstandings and $38.1 million in foreign loans. Commercial loans outstanding at December 31, 1993, were $4.4 billion, down slightly from the December 31, 1992 level, following a decrease of $747.6 million, or 14%, in the prior year. The declines in both years can be attributed to weaker loan demand as a consequence of the economic environment and to strategic efforts to reduce the level of exposure related to highly-leveraged transactions ("HLT"s), principally acquired in the Ameritrust Merger, where there has not been a long-standing relationship with the borrower. These transactions are defined and monitored based upon the criteria previously used by the banking regulators. In addition, the decline in 1992 reflected the run-off of certain other Ameritrust credits which management believed were incompatible with the Corporation's credit risk profile. At December 31, 1993, the Corporation had $247.5 million in HLT loans outstanding, down $157.7 million, or 39%, from the December 31, 1992, level. This followed a decline of $145.3 million, or 26%, in 1992. Loans secured by real estate totaled $7.3 billion at December 31, 1993, compared with $6.3 billion at December 31, 1992, and $6.4 billion at December 31, 1991. Loans secured by real estate consist of construction loans, one-to-four family residential loans (including home equity loans) and commercial mortgage loans. The increase from 1992 was mainly attributable to the acquisition of Society First Federal. The acquisition accounted for $811.9 million of the increase in total real estate loans and $767.2 million of the increase in the residential mortgage portfolio. Construction loans decreased to $623.2 million at December 31, 1993, from $737.6 million at December 31, 1992, and $839.4 million at December 31, 1991. After adjusting for the impact of the acquisition of Society First Federal, the decrease from year-end 1992 was $132.6 million. As portrayed in Figure 12, loans in the construction portfolio are concentrated in the Midwest, which has not experienced, to the same degree, the level of overbuilding and declines in real estate values as have certain other regions of the country. At December 31, 1993, 70% of the portfolio was secured by properties in Ohio, and 17% were in Indiana and Michigan, Society's principal banking markets. The commercial mortgage loan portfolio totaled $2.1 billion at December 31, 1993, compared with $2.3 billion at December 31, 1992, and $2.6 billion at December 31, 1991. In addition to efforts to downsize the portfolio, the slower economy also contributed to this decrease. As depicted in Figure 12, commercial mortgages are also geographically concentrated in the Midwest, with 64% of outstandings secured by properties in Ohio, and 21% in Indiana and Michigan. At December 31, 1993, 49% of the commercial mortgage loan portfolio was comprised of loans secured by owner-occupied properties. Those borrowers are engaged in business activities other than real estate, and the primary source of repayment is not solely dependent on the real estate market. The Corporation manages risk exposure in the construction and commercial mortgage portfolios through prudent underwriting criteria and by monitoring loan concentrations by geographic region and property type. One-to-four family residential mortgages (including home equity loans) were $4.6 billion at December 31, 1993, compared with $3.2 billion at December 31, 1992, and $2.9 billion at December 31, 1991. Excluding the SECURITIES In December 1992, the Corporation transferred its U.S. Treasury securities from the investment portfolio to the "available for sale" portfolio. At December 31, 1993, the book value of the securities portfolio, including securities available for sale, totaled $6.4 billion, up $784.7 million, or 14%, from December 31, 1992. The year-end 1992 amount was $816.1 million, or 17%, higher than the comparable amount for 1991. The growth from the 1992 year-end primarily resulted from an increase of $1.2 billion, or 35%, in mortgage-backed securities and an increase of $145.5 million, or 25%, in other securities. These increases were partially offset by decreases in securities issued by states and political subdivisions of $150.2 million, or 29%, and $384.1 million, or 34%, in securities available for sale. The increase during 1992 primarily resulted from purchases of U.S. Treasury securities, collateralized mortgage obligations ("CMOs") and other mortgage-backed securities. The securities portfolio comprised 26% of total earning assets at December 31, 1993, up from 25% at December 31, 1992, and up from 21% at December 31, 1991. The yield on the securities portfolio declined to 6.49% at December 31, 1993, from 7.61% at December 31, 1992. This reduction is attributable to prepayments on higher-yielding mortgage-backed securities and lower reinvestment yields resulting from the declining rate environment. The yield on the securities portfolio has not declined as rapidly as market yields due primarily to prior investment programs in which the portfolio was structured to benefit from the declining interest rate environment. The portfolio's market value exceeded its book value by $125.6 million at December 31, 1993, compared with an excess of $111.7 million at December 31, 1992, and $192.9 million at December 31, 1991. At December 31, 1993, the Corporation had $4.5 billion invested in mortgage-backed pass-through securities and collateralized mortgage obligations ("CMO") within the investment securities portfolio, compared with $3.4 billion at December 31, 1992. A mortgage-backed pass-through security depends on the underlying pool of mortgage loans to provide a cash flow "pass-through" of principal and interest. The Corporation had $2.9 billion invested in mortgage-backed pass-through securities at December 31, 1993. A CMO is a mortgage- backed security that is comprised of classes of bonds created by prioritizing the cash flows from the underlying mortgage pool in order to meet different objectives of investors. The Corporation had $1.6 billion invested in CMO securities at December 31, 1993. The CMO securities held by the Corporation are primarily shorter-maturity class bonds that were structured to have more predictable cash flows by being less sensitive to prepayments during periods of changing interest rates. At December 31, 1993, substantially all of the CMOs and mortgage-backed pass-through securities held by the Corporation were issued by Federal agencies or backed by Federal agency pass-through securities. ASSET QUALITY The measurement and management of asset quality is the responsibility of the Corporation's Credit Policy/Risk Management Group. This Group is responsible for both commercial and consumer lending credit policy, credit systems development and procedures, loan examination, providing additional controls in the early identification of problem loans, and the monitoring of major loan workouts in the subsidiary banks. The Group is also responsible for the determination of the adequacy of the allowance for loan losses for each of Society's bank subsidiaries. Each allowance is reviewed on the basis of three methodologies which, when combined, determine the allocated and unallocated portions of the allowance and provide management with a benchmark by which its adequacy is measured. The methodologies are: (1) a review of internal loan classifications; (2) an historical analysis of prior periods' charge-off experience; and (3) an evaluation of estimated worst-case losses on internally-classified credits. Management targets the maintenance of a minimum allowance equal to the indicated allocated requirement plus an unallocated portion, as appropriate, in light of current and expected economic conditions and trends, geographic and industry concentrations, and similar risk-related matters. The 1993 provision for loan losses was $72.2 million compared to $147.4 million for 1992 and $280.0 million for 1991. The 1991 amount included an additional provision of $93.9 million recorded by Ameritrust during the fourth quarter to conform its approach with that of the Corporation to determine the adequacy of the allowance. The significantly lower provisions in 1993 and 1992 reflect the continued corporate-wide improvement in asset quality trends, including significant declines in nonperforming loans. Net loans charged-off in 1993 decreased $76.4 million, or 45%, from the 1992 level, following a decrease of $43.4 million, or 20%, from 1991. The significant decrease in 1993 was due to lower net charge-offs in all loan categories with the largest improvement occurring in the consumer and real estate-mortgage portfolios. The 1992 decrease was largely due to a lower level of net charge-offs in the commercial loan portfolio and the consumer loan portfolio, partially offset by higher net charge-offs in the real estate portfolios. The majority of the charge-offs in both 1993 and 1992 reflected losses on problem credits for which reserves were established in previous periods. The allowance at December 31, 1993, was $480.6 million, or 2.69% of loans, as compared with $502.7 million, or 3.10% of loans, at December 31, 1992. The allowance as a percent of nonperforming loans was 295.20% at December 31, 1993, compared with 144.17% at December 31, 1992. Although used as a general indicator, the allowance to nonperforming loans ratio is not a primary factor in the determination of the adequacy of the allowance by management. As indicated in Figure 14, the unallocated portion of the allowance increased in 1993, reflecting the continued improvement in the overall quality of the loan portfolios. As shown in Figure 16, nonperforming assets totaled $224.4 million at December 31, 1993, down $272.5 million, or 55%, from the December 31, 1992, level. This followed a decrease of $130.1 million, or 21%, in the previous year. The significant improvement in 1993 resulted largely from a $185.9 million, or 53%, decrease in nonperforming loans and an $85.2 million, or 63.9%, decrease in other real estate owned. Other nonperforming assets, which are comprised primarily of nonperforming venture capital investments, decreased $1.4 million, or 9.4%, in 1993. The reduction in nonperforming loans was principally attributable to decreases in nonaccrual commercial (including HLTs), construction and commercial real estate loans. At the end of 1993, nonaccrual loans in these categories comprised 40%, 17% and 24%, respectively, of total nonperforming loans and totaled $131.9 million, down $173.8 million, or 57%, from the previous year-end. This reduction reflected progress made in working through the credit problems associated with the Ameritrust acquisition, principally through the efforts of the Special Assets Group ("SAG"). As indicated in Figure 17, the reduction in other real estate owned was primarily due to the selective sale of assets. At December 31, 1993, HLT loans classified as nonperforming amounted to $25.3 million, or 16% of total nonperforming loans. At December 31, 1992, nonperforming HLT loans aggregated $4.6 million, or 1% of total nonperforming loans. One individual nonperforming HLT loan represented $18.1 million or 72% of the total at December 31, 1993. The SAG was formed in conjunction with the acquisition of Ameritrust, and charged with the responsibility to manage and resolve primarily problem assets acquired in the merger. These assets totaled $865.3 million at March 31, 1992, and were comprised of commercial loans, commercial real estate loans and other real estate owned. At that date, the nonperforming portion of these assets was $432.6 million, and represented 69% of the Corporation's total nonperforming assets. As a result of the efforts of the SAG, total SAG assets declined $275.9 million, or 32%, to $589.4 million at December 31, 1992, and during 1993 declined $337.3 million, or 57%, to $252.1 million at December 31, 1993. The nonperforming portion of SAG assets at year-end totaled $68.4 million and represented 30% of the Corporation's total nonperforming assets, while comparable amounts at December 31, 1992, were $254.8 million and 51%, respectively. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This standard affects the definition and basis for measuring impaired loans and is more fully discussed in Note 5, Nonperforming Assets, on page 48. (FIG. 15) - SUMMARY OF LOAN LOSS EXPERIENCE (FIG. 17) - SUMMARY OF CHANGES IN NONACCRUAL LOANS AND OREO DEPOSITS AND OTHER SOURCES OF FUNDS Core deposits, defined as domestic deposits other than certificates of deposit of $100,000 or more, are the Corporation's primary source of funding. These deposits averaged $16.4 billion in both 1993 and 1992 and $17.5 billion in 1991. In 1993 average core deposits were significantly impacted by the January 1993 acquisition of Society First Federal. Excluding the impact of Society First Federal, core deposits declined $1.1 billion during the current year reflecting declining interest rates and other alternatives pursued by consumers. Over the past year, balances have also shifted significantly from the "Other time deposits" category, consisting primarily of fixed rate certificates of deposit, to demand and savings deposits (including NOW accounts) with higher liquidity, also principally as a result of declining interest rates. Based on the amounts shown in Figure 3, and after excluding the impact of Society First Federal, the $1.3 billion decline in the "Other time deposits" category and the $407.0 million decline in money market deposit accounts were partially offset by increases of $258.4 million in NOW accounts, $244.6 million in savings deposits and $72.9 million in demand deposits. The decline in core deposits in 1992 was primarily due to the sale of approximately $1.0 billion in deposits late in the second quarter (as part of the agreement reached with the United States Department of Justice and in accordance with the Federal Reserve Board order to divest certain branches in connection with the Ameritrust merger) and the pursuit of other alternatives by consumers in response to declining interest rates. Purchased funds, which are comprised of large certificates of deposit, foreign office deposits, and short-term borrowings, averaged $5.6 billion for 1993, up $1.1 billion, or 25%, from the prior year, following a decrease of $680.8 million, or 13%, in 1992. Average purchased funds were not materially impacted by the acquisition of Society First Federal. Based on the amounts shown in Figure 3, and after excluding the impact of Society First Federal, the 1993 increase was largely attributable to a $650.9 million increase in foreign office deposits, a $416.9 million increase in Federal funds purchased and securities sold under agreements to repurchase, and a $457.4 million increase in other short-term borrowings due to the issuance of Medium-Term Notes in the current year. These increases were partially offset by a $425.9 million decline in large certificates of deposits. LIQUIDITY Liquidity represents the availability of funding to meet the needs of depositors, borrowers, and creditors at a reasonable cost and without adverse consequences. The Corporation's ALCO actively analyzes and manages the Corporation's liquidity in coordination with similar committees at each bank subsidiary. The bank subsidiaries individually maintain sufficient liquidity in the form of short-term money market investments, anticipated prepayments on securities and through the maturity structure of their loan portfolios. Another source of liquidity are those securities classified as available for sale. In addition, the bank subsidiaries have access to various sources of non-core market funding for short-term liquidity requirements should the need arise. The effective management of balance sheet volumes, mix, and maturities enables the bank subsidiaries to maintain adequate levels of liquidity while enhancing profitability. During 1993, Society's lead bank, Society National Bank, issued $685 million in debt securities under a Medium-Term Bank Note program. These securities have maturities of less than one year and are included in other short-term borrowings. At December 31, 1993, the lead bank was authorized to issue up to an additional $2.3 billion of securities with maturities ranging from 9 months to 15 years under this program and an additional $1.0 billion under a separate, Medium-Term Deposit Note program. The proceeds from these programs are to be used for general corporate purposes in the ordinary course of business. During both the second quarter of 1993 and the fourth quarter of 1992, the lead bank issued $200 million in subordinated long-term debt to be used to supplement its capital base and to provide funds for loans and investments. During 1993, Society issued $111 million in debt securities under a separate Medium-Term Note program. These securities have maturities in excess of one year and are included in long-term debt. During 1993, Society redeemed $100 million in long-term debt securities due in 1996 at par plus accrued interest. In addition, Society redeemed 1,200,000 outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value of $60 million plus accumulated but unpaid dividends. The liquidity requirements of Society, primarily for dividends to shareholders, retirement of debt and other corporate purposes, are met principally through regular dividends from bank subsidiaries. As of December 31, 1993, $76.0 million was available in the bank subsidiaries for the payment of dividends to Society without prior regulatory approval. Excess funds are maintained in short-term investments. Society has no lines of credit with other financial institutions, but has ready access to the capital markets as a result of its favorable debt ratings. CAPITAL AND DIVIDENDS Total shareholders' equity at December 31, 1993, was $2.0 billion, up 9%, or $170.5 million, from the balance at the end of 1992. This followed an increase of $212.9 million, or 13%, in the prior year. In both years the increase was principally due to the retention of net income after dividends on Common Shares. Further information with respect to dividends is presented in the "Common Shares and Shareholder Information" section which follows and in the dividend restriction discussion included on page 56. In 1993, shareholders' equity was also impacted by the redemption of preferred stock referred to above. Capital adequacy is an important indicator of financial stability and performance. Overall, Society's capital position remains strong with a ratio of total shareholders' equity to total assets of 7.55% at December 31, 1993, up from 7.48% and 6.47% at December 31, 1992 and 1991, respectively. Banking industry regulators define minimum capital ratios for bank holding companies and their bank and savings association subsidiaries. Based on the risk-based capital rules and definitions prescribed by the banking regulators, the Corporation's Tier I and total capital to risk-adjusted assets ratios at December 31, 1993, were 8.65% and 12.88%, respectively. These compare favorably with the minimum requirements of 4.0% for Tier I and 8.0% for total capital. The Tier I leverage ratio standard prescribes a minimum ratio of 3.0%, although most banking organizations are expected to maintain ratios of at least 100 to 200 basis points above the minimum. At December 31, 1993, the Corporation's leverage ratio was 7.18%, substantially higher than the minimum requirement of 3%. Figure 19 presents the details of Society's capital position at December 31, 1993 and 1992. Effective in December 1992, Federal bank regulators adopted new regulations to implement the prompt corrective action provisions of the FDIA which group FDIC-insured institutions into five broad categories based on certain capital ratios. The five categories are "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Although these provisions are not directly applicable to Society under existing law and regulations, based upon its ratios Society would qualify, and the banks do qualify, as "well capitalized" at December 31, 1993. The Corporation's capital category, as determined by applying the prompt corrective action provisions of law, may not constitute an accurate representation of the overall financial condition or prospects of Society or its banking subsidiaries. The OCC, the Federal Reserve, and the FDIC are proposing amendments to their respective regulatory capital rules to include in Tier I capital the net unrealized changes in the value of securities available for sale for purposes of calculating the risk-based and leverage ratios. The proposed amendments are in response to the provisions outlined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which takes effect for fiscal years beginning after December 15, 1993. See Note 3, Securities, on page 46 for a more complete description of SFAS No. 115. This new accounting standard establishes, among other things, net unrealized holding gains and losses on securities available for sale as a new component of stockholders' equity. If adopted as proposed, the rules could cause the Tier I capital to be subject to greater volatility. However, neither SFAS No. 115 nor the capital proposals would have any direct impact on reported earnings. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $28 million. The regulatory agencies are also proposing to add an additional component to the risk-based capital requirements based upon the level of an institution's exposure to interest rate risk. COMMON SHARES AND SHAREHOLDER INFORMATION On September 1, 1992, Society's Common Shares commenced trading on the New York Stock Exchange under the symbol SCY. The sales price ranges of the Common Shares and per Common Share net income and dividends by quarter for each of the last two years are presented in Figure 20. Common Shares outstanding and per Common Share data have been adjusted for a two-for-one stock split declared on January 21, 1993, which was effected by means of a 100% stock dividend paid on March 22, 1993, to Common Shareholders of record on March 2, 1993. At December 31, 1993, book value per Common Share was $17.37 based on 117,377,404 shares outstanding, compared with $15.49 based on 116,725,976 shares outstanding at December 31, 1992. At year-end 1993, the closing sales price on the New York Stock Exchange was $29.75 per share. This price was 171% of year-end book value per share and had a dividend yield of 3.76%. On January 20, 1994, the quarterly dividend on Common Shares was increased by 14% to $.32 per Common Share, up from $.28 per Common Share in 1993. The new quarterly dividend rate of $.32 per Common Share will be payable on March 15, 1994, to shareholders of record on February 28, 1994. There were 36,331 holders of record of Society Common Shares at December 31, 1993. FOURTH QUARTER RESULTS As shown in Figure 20, net income for the fourth quarter of 1993 was $57.0 million, or $.49 per Common Share, compared with $86.5 million, or $.72 per Common Share, for the same period last year. The 1993 period was impacted by merger and integration charges of $53.9 million ($39.6 million after-tax, $.33 per Common Share) recorded in connection with the merger with old KeyCorp. Excluding the impact of the merger and integration charges, net income was $96.6 million, up $10.1 million or 12%, from the prior year. This reflected a $4.8 million, or 2%, increase in taxable-equivalent net interest income and an $18.0 million, or 58%, decrease in the provision for loan losses, which were partially offset by an increase of $10.3 million, or 4%, in noninterest expense. On an annualized basis, the return on average total assets for the fourth quarter of 1993 was .87% compared with 1.40% for the fourth quarter of 1992. The annualized returns on average common equity for the fourth quarters of 1993 and 1992 were 11.09% and 19.08%, respectively. Excluding the merger and integration charges, the fourth quarter 1993 annualized return on average total assets was 1.47%, while the return on average common equity was 18.80%. The improvement in taxable-equivalent net interest income in the fourth quarter of 1993, as compared to the fourth quarter of 1992, reflected a $1.4 billion or 6% increase in the level of average earning assets, offset in part by a 23 basis point decline in the net interest margin to 5.10%. The higher level of average earning assets was primarily due to the acquisition of Society First Federal in January 1993. Excluding the impact of this acquisition, average earning assets increased by $177.1 million, mainly due to an increase of $579.3 million in average loans, principally those in the residential real estate portfolio, an increase of $732.8 million in securities available for sale and an increase of $146.2 million in mortgage loans held for sale. These increases were substantially offset by decreases of $670.9 million in interest-bearing deposits with banks and $573.0 million in investment securities. The decline in the net interest margin reflected the narrowing of spreads available on the replacement of matured and prepaid securities and interest rate swaps and the narrower spread contributed by Society First Federal. The lower provision for loan losses resulted from the overall improvement in asset quality, including a $185.9 million or 53% decline in nonperforming loans from December 31, 1992, to December 31, 1993. The increase in noninterest expense, excluding merger and integration charges, was primarily due to higher personnel expense, offset in part by lower costs associated with professional services. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT The management of Society Corporation and its subsidiaries (the "Corporation") is responsible for the preparation, content and integrity of the financial statements and other statistical data and analysis compiled for this report. The financial statements and related notes have been prepared in conformity with generally accepted accounting principles and, in the judgment of management, present fairly and consistently the Corporation's financial position, results of operations, and cash flows. Management also believes that financial information elsewhere in this report is consistent with that in the financial statements. The amounts contained in the financial statements are based on management's best estimates and judgments. The Corporation maintains a system of internal controls designed to provide reasonable assurance as to the protection of assets and the integrity of the financial statements. This corporate-wide system of controls includes written policies and procedures, proper delegation of authority and organizational division of responsibility and the careful selection and training of qualified personnel. In addition, an effective internal audit function periodically tests the system of internal controls. Management believes that the system of internal controls provides reasonable assurances that financial transactions are recorded properly to permit the preparation of reliable financial statements. The Board of Directors discharges its responsibility for the Corporation's financial statements through its Audit Committee which is composed of outside directors and has responsibility for the recommendation of the independent auditors. The Audit Committee meets regularly with the independent auditors and internal auditors to review the scope of their audits and audit reports and to discuss any action to be taken. Both the independent auditors and internal auditors have direct access to the Audit Committee. Management has made an assessment of the Corporation's internal control structure and procedures over financial reporting using established and recognized criteria. On the basis of this assessment, management believes that the Corporation maintained an effective system of internal control for financial reporting as of December 31, 1993. ROBERT W. GILLESPIE Chairman of the Board and Chief Executive Officer JAMES W. WERT Vice Chairman of the Board and Chief Financial Officer REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Shareholders Society Corporation We have audited the accompanying consolidated balance sheets of Society Corporation and Subsidiaries as of December 31, 1993 and 1992, and the related 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 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, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Society 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. /s/ Ernst & Young Cleveland, Ohio January 28, 1994, except for Note 2, as to which the date is March 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Society Corporation is an Ohio-based financial services company primarily engaged in the business of commercial banking. It provides a wide range of banking, fiduciary and financial services to corporate, institutional and individual customers. The accounting policies of Society Corporation and its subsidiaries conform with generally accepted accounting principles and with general practices within the banking industry. The following is a summary of the Corporation's significant accounting policies. BASIS OF PRESENTATION The consolidated financial statements include the accounts of Society Corporation and its subsidiaries. All significant intercompany transactions have been eliminated. Certain amounts previously reported in the financial statements have been reclassified to conform with the current presentation. As discussed in Note 2, Mergers, Acquisitions and Divestitures, the financial statements give retroactive effect to the 1992 merger of Ameritrust Corporation with and into Society, accounted for as a pooling of interests. Accordingly, all financial data are presented as if both companies had been merged for all periods presented. BUSINESS COMBINATIONS Business combinations accounted for as purchases include the results of operations of the acquired businesses from the respective dates of acquisition. The assets and liabilities are recorded at fair value at the acquisition date and related purchase premiums and discounts are amortized over the remaining average lives of the respective assets or liabilities. Goodwill, representing the excess of the cost of acquisitions over the fair value of net assets acquired, is amortized on a straight-line basis, over the estimated period to be benefited, generally not exceeding 25 years. Other intangibles are amortized using either straight-line or accelerated methods, generally over periods ranging from 4 to 15 years. In transactions accounted for as poolings of interests, the assets and liabilities of the combined companies are carried forward at their historical amounts, the companies' results of operations are combined and the consolidated financial statements and notes thereto are restated as if the companies had been merged for all periods presented. On March 1, 1994, KeyCorp, ("old KeyCorp"), merged into and with Society Corporation ("Society"), which was the surviving corporation under the name KeyCorp. Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the financial statements do not give retroactive effect to the merger. However, the supplemental financial statements included on pages 65 to 94 of this report present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. Further details pertaining to this merger are presented in Note 2, Mergers, Acquisitions and Divestitures. STATEMENT OF CASH FLOWS The Corporation defines cash and cash equivalents as cash on hand and noninterest-bearing amounts due from banks as reported under the consolidated balance sheet caption, "Cash and due from banks." INVESTMENT SECURITIES Securities which the Corporation has the ability and positive intent to hold to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts using the level yield method. Gains and losses on sales of investment securities are computed using the specific identification method and are included in net securities gains. SECURITIES AVAILABLE FOR SALE AND TRADING ACCOUNT ACTIVITIES Securities available for sale are carried at the lower of aggregate cost or market value. Trading account assets include foreign exchange trading positions and are carried at market value. Gains and losses on sales of securities available for sale are computed using the specific identification method and are included in net securities gains. Market value adjustments for trading account assets (included in short-term investments) and securities available for sale are included in noninterest income. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale are carried at the lower of aggregate cost or market value. LOANS Student loans held for sale are included in total loans and are carried at the lower of aggregate cost or market value. Interest income on loans is primarily accrued based on principal amounts outstanding. Accrual of interest is discontinued, and accrued but unpaid interest on a loan is reversed and charged against current earnings, when circumstances indicate that collection is questionable. Loans are returned to accrual status when management determines that the circumstances have improved to the extent that both principal and interest are deemed collectible. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb potential losses in the loan portfolio. Management's evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and composition of the loan portfolios and their related risk characteristics, and the continual review by management of the quality of the loan portfolio. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation and amortization. Provisions for the depreciation of premises and equipment are determined using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized using the straight-line method over the terms of the leases. OTHER REAL ESTATE OWNED Other real estate owned includes real estate acquired through foreclosure or a similar conveyance of title and real estate considered to be in-substance foreclosed when specific criteria are met. Other real estate owned is carried at the lower of its recorded amount or fair value, less estimated cost of disposal. Write-downs of the assets at, or prior to, the dates of acquisition are charged to the allowance for loan losses. Subsequent write-downs, income and expenses incurred in connection with holding such assets, and gains and losses resulting from the sales of such assets, are included in other noninterest expense. INCOME TAXES The Corporation files a consolidated Federal income tax return. Effective January 1, 1992, the Corporation prospectively adopted SFAS No. 109, "Accounting for Income Taxes" which supersedes SFAS No. 96. The cumulative effect of adopting SFAS No. 109 was not material. INTEREST RATE SWAPS, FINANCIAL FUTURES AND OPTIONS The Corporation uses interest rate swaps, financial futures and options to manage the interest rate exposure of certain interest-sensitive assets and liabilities as part of the Corporation's overall strategy to manage interest rate risk. The net interest received or paid on interest rate swaps is recognized over the lives of the respective contracts as an adjustment to interest income or expense. Gains and losses resulting from the termination of interest rate swaps are deferred and amortized over the remaining lives of the related financial instruments. Gains and losses on futures and option contracts are recognized when the related hedged financial instruments are sold. COMMON SHARES Net income per Common Share is computed by dividing net income, less any dividend requirement on preferred stock, by the weighted average number of Common Shares and Common Share equivalents outstanding during the year as presented below. These amounts have been adjusted to reflect a two-for-one stock split in the form of a 100% stock dividend effective as of March 22, 1993. NOTE 2. MERGERS, ACQUISITIONS AND DIVESTITURES On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society, which was the surviving corporation under the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp (based on an exchange ratio of 1.205 shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged on a one-for-one basis for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly financial results for all prior periods presented will be restated to include the financial results of old KeyCorp. The supplemental financial statements presented on pages 65 through 94 of this report present the financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. The following table presents consolidated net interest income, net income and per Common Share reported by each of the companies and on a combined basis. On October 5, 1993, Society Asset Management, Inc., an indirect wholly-owned subsidiary of Society, completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. On September 15, 1993, Society completed the sale of Ameritrust Texas Corporation ("ATC") to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the period through the closing date, ATC had net income of $3.2 million. The $29.4 million gain on the sale ($12.2 million after tax, $.10 per Common Share) is included in noninterest income. On January 22, 1993, Society acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. On December 4, 1992, Society and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement. Society contributed its wholly-owned subsidiary Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. On September 30, 1992, Society acquired all the outstanding shares of First of America Bank - Monroe ("FAB - Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase. FAB - Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into Society. Under the terms of the merger agreement, 49,550,862 Society Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of Society for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one-for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of Society. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, Society sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with the four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. The remaining maturities of the Corporation's securities were as follows: Mortgage-backed securities are included in the above investment securities maturity schedule based on their expected average lives. Other securities consist primarily of those collateralized by credit card and automobile installment loan receivables, corporate floating-rate notes and venture capital investments. The proceeds from sales of securities were $724.6 million, $611.0 million and $435.8 million in 1993, 1992 and 1991, respectively. Gross gains and losses related to securities were $33.4 million and $7.3 million, respectively, in 1993, $10.7 million and $.9 million, respectively, in 1992 and $8.8 million and $1.4 million, respectively, in 1991. Corporate assets, primarily securities, with a book value of approximately $4.4 billion at December 31, 1993, were pledged to secure public and trust deposits and securities sold under agreements to repurchase, and for other purposes required or permitted by law. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. Debt securities that management has the positive intent and ability to hold to maturity are to be classified as "held-to-maturity securities" and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are to be classified as "trading securities" and reported at fair value, with unrealized gains and losses included in operating results. Debt and equity securities not classified as either held-to-maturity securities or trading securities are to be classified as "available for sale securities" and reported at fair value, with unrealized gains and losses excluded from operating results and reported as a separate component of shareholders' equity. Adoption of the standard is required for fiscal years beginning after December 15, 1993, with earlier application permitted. The Corporation will adopt the new standard in 1994. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $28 million, with no impact on the results of operations. With the adoption of SFAS No. 115 in 1994, the Corporation anticipates that securities with an aggregate book value of approximately $3.2 billion will be designated as available for sale. Based upon the market values of these securities at year end 1993, the reclassification of these securities is not expected to have a material effect on shareholders' equity. NOTE 4. LOANS In 1991, Ameritrust recorded an additional $93.9 million provision for loan losses to conform its approach to determining the level of the allowance for loan losses to that used by the Corporation. In the ordinary course of business, Society's banking subsidiaries have made loans at prevailing interest rates and terms to directors and executive officers of Society and its subsidiaries and their associates (as defined by the Securities and Exchange Commission). Such loans, in management's opinion, did not present more than the normal risk of collectibility or incorporate other unfavorable features. The aggregate amount of loans outstanding to qualifying related parties at January 1, 1993, was $135.0 million. During 1993, activity with respect to these loans included new loans, repayments and a net decrease (due to changes in the status of executive officers and directors) of $30.8 million, $76.5 million and $21.5 million, respectively, resulting in an aggregate balance of loans outstanding to related parties at December 31, 1993, of $67.8 million. NOTE 5. NONPERFORMING ASSETS At December 31, 1993, there were no significant commitments outstanding to lend additional funds to borrowers with nonaccrual or restructured loans. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." SFAS No. 114 prescribes a valuation methodology for impaired loans as defined by the standard. Generally, a loan is considered impaired if management believes that it is probable that all amounts due will not be collected according to the contractual terms as scheduled in the loan agreement. An impaired loan must be valued using the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the loan's underlying collateral. The Corporation expects to adopt SFAS No. 114 prospectively starting in the first quarter of 1995. It is anticipated that adoption of the new standard will not have a material effect on the Corporation's financial condition and results of operations. Depreciation and amortization expense related to premises and equipment totaled $57.1 million, $62.3 million, and $48.4 million in 1993, 1992 and 1991, respectively. At December 31, 1993, banking subsidiaries of Society were obligated under noncancellable leases for land and buildings and for other property, consisting principally of data processing equipment. Rental expense under all operating leases aggregated $53.3 million in 1993, $56.4 million in 1992, and $49.6 million in 1991. Many of the realty lease agreements contain renewal options for varying periods. In many cases, renewal terms must be negotiated at the renewal date, including annual rentals to be paid under the renewed lease. Minimum future rental payments under noncancellable leases at December 31, 1993, were as follows: 1994 -- $37.3 million; 1995 -- $30.7 million; 1996 -- $29.0 million; 1997 -- $23.8 million; 1998 -- $21.6 million; and subsequent years -- $261.3 million. NOTE 7. SHORT-TERM BORROWINGS Short-term borrowings consist primarily of Federal funds purchased and securities sold under repurchase agreements which generally represent overnight borrowing transactions. Other short-term borrowings consist of fixed rate and variable rate Medium-Term Notes with original maturities of one year or less, Treasury, tax and loan demand notes, and other borrowings with original maturities of one year or less. On November 30, 1992, Society National Bank authorized the issuance of up to $1 billion of Medium-Term Notes to be offered on a continuous basis. During 1993, $685 million in debt securities were issued under this program. These securities have original maturities of less than one year and are included in other short-term borrowings. On June 15, 1992, Society issued $200 million of 8.125% Subordinated Notes under a shelf registration. The Notes are not redeemable prior to maturity. During 1993, Society issued $110.6 million of Medium-Term Notes with maturities exceeding one year. The Notes had a weighted average annual interest rate of 5.19% at December 31, 1993, and have varying maturities through 1996. The 8.875% Notes, issued under an earlier registration, and the 11.125% Notes are not redeemable prior to maturity. In 1989, the Ameritrust Corporation Employees' Savings and Investment Plan (the "Plan") was amended to include a leveraged employee stock ownership plan ("ESOP"). To fund the ESOP, Ameritrust borrowed $71.7 million from several institutional investors through the placement of unsecured notes totaling $22.8 million (the "8.33% Notes") and $48.9 million (the "8.48% Notes"). The interest on those notes totaled $6.0 million in each of the years 1993, 1992, and 1991. The ESOP trustee used the proceeds to purchase 5,847,102 shares of Ameritrust Common Stock. These shares, as converted in the merger with Society, are held by the ESOP trustee for matching employee contributions to the Plan. The net difference between the cost of the treasury shares sold to the ESOP trustee and their market value was recorded as a reduction to retained earnings. Except for the repayment schedule, the loans to the ESOP trustee are on substantially similar terms as the borrowings from the institutional investors and, in addition, are secured by the unallocated shares held by the ESOP trustee. The ESOP trustee will repay the loans from Society using corporate contributions made by the Plan for that purpose and dividends on the Common Shares acquired with the loans. The amount of dividends on the ESOP shares used for debt service by the ESOP trustee totaled $3.9 million in 1993, $3.1 million in 1992, and $1.8 million in 1991. As contributions and dividends are received, a portion of the shares acquired with the loans will be allocated to Plan participants. Interest income recognized on loans to the ESOP trustee is netted against the interest expense incurred on the notes payable to the institutional investors. Society's receivable from the ESOP trustee, representing deferred compensation to the Corporation's employees, has been recorded as a separate reduction of shareholders' equity. Society National Bank, Society's lead bank, issued $200 million of 7.85% Subordinated Notes on November 3, 1992, and $200 million of 6.75% Subordinated Notes on June 16, 1993. The Bank issued a 10% Note in connection with the sale of branch offices and loans resulting from the merger with Ameritrust Corporation. None of these notes may be redeemed prior to maturity. Industrial revenue bonds issued by banking subsidiaries have varying maturities extending to the year 2009 and had weighted average annual interest rates of 7.14% and 7.19%, respectively, at December 31, 1993 and 1992. Other long-term debt at December 31, 1993 and 1992, consisted of capital lease obligations and various secured and unsecured obligations of corporate subsidiaries and had weighted average annual interest rates of 13.54% and 10.14%, respectively. The 8.625% Notes were redeemed at par plus accrued interest on June 30, 1993, and the 9.56% Note was assumed by the purchaser in connection with the sale of Ameritrust Texas Corporation on September 15, 1993. At December 31, 1993, the aggregate of annual maturities for all long-term debt obligations for the years 1994 through 1998 were $.5 million, $148.5 million, $147.2 million, $7.2 million, and $ 8.3 million, respectively. Long-term debt qualifying as supplemental capital for purposes of calculating Tier II Capital under Federal Reserve Board Guidelines amounted to $636.5 million and $520.9 million at December 31, 1993, and 1992, respectively. NOTE 9. SHAREHOLDERS' EQUITY PREFERRED STOCK AND COMMON SHARES In August 1989, Society's Board of Directors adopted a Shareholder Rights Plan ("Rights") under which each shareholder received one Right for each Society Common Share. Each Right represents the right to purchase a Common Share of Society at a price of $65. The Rights become exercisable 20 days after a person or group acquires 15 percent or more of the outstanding shares or commences a tender offer that could result in such an ownership interest. Until the Rights become exercisable, they will trade with the Common Shares, and any transfer of the Common Shares will also constitute a transfer of associated Rights. When the Rights become exercisable, they will begin to trade separate and apart from the Common Shares. Twenty days after the occurrence of certain "Flip-In Events," each Right will become the right to purchase a Common Share of Society for the then par value per share (now $1 per share) and the Rights held by a 15 percent or more shareholder will become void. Society may redeem these Rights at its option at $.005 per Right subject to certain limitations. Unless redeemed earlier, the Rights expire on September 12, 1999. On October 1, 1993, Society amended the Rights so that the pending merger with old KeyCorp would not activate the provisions of the Rights. On March 1, 1993, Society redeemed the 1.2 million outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value ($60 million), plus accumulated but unpaid dividends. Society effected a two-for-one stock split on March 22, 1993, by means of a 100% stock dividend. All relevant Common Share amounts, per Common Share amounts and related data in this report have been adjusted to reflect this split. In connection with the merger with old KeyCorp, at a special meeting held February 16, 1994, shareholders increased the authorized number of shares of Society to 926.4 million, of which 1.4 million are shares of 10% Cumulative Preferred Stock, Class A, par value $5 per share; 25.0 million are shares of Preferred Stock, par value $1 per share; and 900.0 million are Common Shares, par value $1 per share. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS Society maintains various incentive compensation plans which provide for its ability to grant stock options, stock appreciation rights, limited stock appreciation rights, restricted stock and performance shares to selected employees. Generally, the terms of these plans stipulate that the exercise price of options may not be less than the fair market value of Society's Common Shares at the date the options are granted. Options granted expire not later than ten years and one month from the date of grant. Several option plans have been acquired through mergers. These plans have expired or were terminated, but unexercised options granted under the plans remain outstanding. At December 31, 1993 and 1992, options for Common Shares available for future grant totaled 1,237,965 and 1,233,958, respectively. The terms of Society's plans stipulate that stock appreciation rights may only be granted in tandem with stock options. The appreciation rights have the same terms as do the options, except that, upon exercise, the holder may receive either cash or shares for the excess of the current market value of Society's Common Shares over the option's exercise price. Upon exercise of a stock appreciation right, the related option is surrendered. During 1993, all stock appreciation rights for which exercisability was limited to a period following a change in control of the Corporation were cancelled. The following table presents a summary of pertinent information with respect to Society's stock options and stock appreciation rights. STOCK OPTIONS NOTE 10. MERGER AND INTEGRATION CHARGES Merger and integration charges of $53.9 million ($39.6 million after tax, $.33 per Common Share), $50.0 million ($34.2 million after tax, $.29 per Common Share), and $93.8 million ($68.2 million after tax, $.59 per Common Share) were recorded in 1993, 1992, and 1991, respectively. The 1993 charges were incurred in connection with the merger with old KeyCorp, while the 1992 and 1991 amounts related to the merger with Ameritrust. The merger and integration charges directly attributable to the old KeyCorp merger included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($12.6 million); severance payments and other employee costs ($17.6 million); systems and facilities costs ($16.7 million); and other costs incident to the merger ($7.0 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the Ameritrust merger in 1992 and 1991 were similar in nature. Although no assurance can be given, it is also expected that, as a result of the old KeyCorp merger, cost savings will be achieved by the combined institution at an annual rate of approximately $100 million by the end of the first quarter of 1995. These cost savings are anticipated to result from the integration of operations and from efficiencies in certain combined lines of business. Management presently expects that approximately 50% of the annual cost savings will be achieved in 1994. NOTE 11. EMPLOYEE BENEFIT PLANS PENSION PLANS Society and its subsidiaries have noncontributory pension plans covering substantially all employees. Benefits paid from these plans are based on age, years of service and compensation prior to retirement or termination and are determined in accordance with defined formulas. The Corporation's policy is to fund pension expense in accordance with ERISA standards. The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of projected benefit obligations were 7.50% and 4.00%, respectively, at December 31, 1993, and 8.50% and 4.50%, respectively, at December 31, 1992. The weighted average expected long-term rate of return on pension assets used in determining net pension income was 9.50% for 1993, 9.00% for 1992 and 9.16% for 1991. In 1993, the Corporation recognized curtailment and settlement gains of $2.9 million resulting from the divestiture of ATC. Such amount was included in the net gain from that divestiture. In 1992, the Corporation recognized curtailment gains of $7.2 million resulting from merger-related staff reductions. A portion of the retirement obligations associated with these reductions were settled by lump-sum cash distributions which resulted in settlement gains of $1.4 million and $3.0 million in 1993 and 1992, respectively. Both the curtailment and settlement gains related to the merger-related staff reductions are included in other noninterest income. OTHER POSTRETIREMENT BENEFIT PLANS The Corporation provides postretirement health care and life insurance benefits to employees who retire at age 55 or later and have at least 10 years of service. Additionally, such benefits are provided to participants in the Corporation's long term disability plan. The postretirement health care plan is unfunded and contributory, with retirees' contributions adjusted annually to reflect certain cost-sharing provisions and benefit limitations. The postretirement life insurance plan is noncontributory. Life insurance benefits for participants who retired before 1993 are generally provided for through outside insurance carriers. Life insurance benefits for employees retiring in 1993 or later years are to be paid from the Corporation's pension plan and are, accordingly, included in the determination of the pension benefit obligation. Effective January 1, 1993, the Corporation adopted the provisions of SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions." This statement requires that employers recognize the cost of providing postretirement benefits over the employees' active service period to the date they attain full eligibility for such benefits. Postretirement benefits costs for 1992 and 1991, which were recorded on a cash basis, have not been restated. Net postretirement benefits expense was $11.9 million in 1993, including $4.7 million due to adoption of the new standard, $5.2 million in 1992 and $4.8 million in 1991. The following table sets forth the unfunded status of the postretirement benefit plans reconciled with the amount recognized in Society's consolidated balance sheet: The assumed 1994 health care cost trend rate for Medicare-eligible retirees was 11.0%, while that for non-Medicare-eligible retirees was 13.0%. Both rates are assumed to gradually decrease to 5.5% by the year 2009 and remain constant thereafter. Increasing the assumed health care cost trend rates by one percentage point in each future year would have an immaterial impact on postretirement benefits cost due to cost-sharing provisions and benefit limitations. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% at December 31, 1993. EMPLOYEE STOCK PURCHASE AND SAVINGS PLAN Substantially all of the Corporation's employees are covered under a stock purchase and savings plan that is qualified under Section 401(k) of the Internal Revenue Code. Under provisions of this plan, the Corporation matches 100% of the employee's pre-tax contribution, up to a maximum of 6% of eligible compensation, with an equivalent amount of Society's Common Shares. Under an annual discretionary profit sharing component, employees can receive additional matching employer contributions from the Corporation based on a formula established each year by Society's Board of Directors. Total expense associated with this plan was $24.0 million, $18.1 million and $19.7 million in 1993, 1992, and 1991, respectively. POSTEMPLOYMENT BENEFITS The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," during 1993. This standard requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of this standard increased noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. NOTE 12. INCOME TAXES During the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." The adoption of this new standard did not have a material impact on Society's consolidated financial condition or results of operations. At December 31, 1993, the net deferred tax liability totaled $146.0 million compared to $80.2 million at December 31, 1992. The gross deferred tax liability was $386.0 million at December 31, 1993, and $321.8 million at the prior year-end. In both periods, deferred taxes relating to lease financing activities comprised approximately 75% of the balance. Gross deferred tax assets were $240.0 million and $241.6 million at December 31, 1993 and 1992, respectively, and amounts related to loan loss provisions comprised approximately 70% of the balance in both periods. The current and deferred components of the provision for income taxes were as follows: Income taxes on securities transactions are provided for at the statutory income tax rate and included in the current portion of the provision. The following is a reconciliation of the provision for income taxes to the amount computed by applying the Federal statutory tax rate of 35% in 1993, and 34% in 1992 and 1991 to income before income taxes. At December 31, 1993, approximately $15.4 million of alternative minimum tax credit carryovers existed for Federal income tax purposes only. These carryovers have no fixed expiration date. NOTE 13. COMMITMENTS, CONTINGENT LIABILITIES, AND OTHER DISCLOSURES LEGAL PROCEEDINGS In the ordinary course of business, Society and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and the Corporation's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on Society's consolidated financial condition. RESTRICTIONS ON CASH, DUE FROM BANKS, SUBSIDIARY DIVIDENDS AND LENDING ACTIVITIES Under the provisions of the Federal Reserve Act, depository institutions are required to maintain certain average balances in the form of cash or noninterest-bearing balances with the Federal Reserve Bank. Average reserve balances aggregating $479.5 million in 1993 were maintained in fulfillment of these requirements. The principal source of income for the parent company is dividends from its subsidiary banks. Such dividends are subject to certain restrictions as set forth in the national and state banking laws and regulations. At December 31, 1993, undistributed earnings of $76.0 million were free of such restrictions and available for the payment of dividends to the parent company. Loans and advances from banking subsidiaries to the parent company are also limited by law and are required to be collateralized. NOTE 14. FINANCIAL INSTRUMENTS FAIR VALUE DISCLOSURES The following disclosures are made in accordance with the provisions of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," which requires the disclosure of fair value information about both on-and off-balance sheet financial instruments where it is practicable to estimate that value. Fair value is defined in SFAS No. 107 as the amount at which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. It is not the Corporation's intent to enter into such exchanges. Financial instruments, as defined in SFAS No. 107, include the categories presented on page 58 and exclude related intangible assets such as customer relationships, mortgage servicing rights and core deposit intangibles. These intangible assets, if considered an integral part of the related financial instruments, would increase their fair values. In cases where quoted market prices were not available, fair values were based on estimates using present value or other valuation methods, as described below. The use of different assumptions (e.g., discount rates and cash flow estimates) and estimation methods could have a significant effect on fair value amounts. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. Because SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements, any aggregation of the fair value amounts presented would not represent the underlying value of the Corporation. The following methods and assumptions were used in estimating the fair values of financial instruments presented in the preceding table and in the following paragraphs. For financial instruments with a remaining average life to maturity of less than six months, carrying amounts were used as an approximation of fair value. The carrying amounts reported for cash and due from banks, and short-term investments are their fair values. The carrying value of mortgage loans held for sale approximates fair value. Securities available for sale and investment securities were valued based on quoted market prices. Where quoted market prices were unavailable, fair values were based on quoted market prices of similar instruments. A discounted cash flow model was used to estimate the fair values for fixed-rate commercial, installment, construction and commercial real estate loans. Carrying amounts for variable rate loans, including loans with no stated maturity (e.g., credit card loans and home equity lines of credit), were used as a reasonable approximation of their fair values. Residential real estate loans and student loans held for sale were valued based on quoted market prices of similar loans offered or sold in recent sale or securitization transactions. Lease financing receivables, although excluded from the scope of SFAS No. 107, were included in the estimated fair value for loans at their carrying amount. The fair values of certificates of deposit and of long-term debt were estimated based on discounted cash flows. Carrying amounts reported for other deposits and short-term borrowings were used as a reasonable approximation of their fair values. Interest rate swaps were valued based on discounted cash flow models and had a fair value of $67.8 million and $78.6 million at December 31, 1993 and 1992, respectively. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation, mainly through its affiliate banks, is party to various financial instruments with off-balance sheet risk. The banks use these financial instruments in the normal course of business to meet financing needs of their customers and to effectively manage their exposure to interest rate risk. The financial instruments used include commitments to extend credit, standby letters of credit, interest rate swap agreements, forward contracts, futures and options on financial futures, and interest rate cap and floor agreements. These instruments involve, to varying degrees, credit and interest rate risks in excess of amounts recognized in Society's consolidated balance sheet. Credit risk is the possibility that a counterparty to a financial instrument will be unable to perform its contractual obligations. Interest rate risk is the possibility that, due to changes in economic conditions, the Corporation's net interest income will be adversely affected. The Corporation mitigates its exposure to credit risk through internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits, and, when deemed necessary, securing collateral. The Corporation manages its exposure to interest rate risk, in part, by using off-balance sheet instruments to offset existing interest rate risk of its assets and liabilities, and by setting variable rates of interest on contingent extensions of credit. The following is a summary of the contractual or notional amount of each significant class of off-balance sheet financial instruments outstanding. The Corporation's maximum possible accounting loss from commitments to extend credit and from standby letters of credit equals the contractual amount of these instruments. The notional amount represents the total dollar volume of transactions and is significantly greater than the amount at risk. The banks' commitments to extend credit are agreements with customers to provide financing at predetermined terms as long as the customer continues to meet specified criteria. Loan commitments serve to meet the financing needs of the banks' customers and generally carry variable rates of interest, have fixed expiration dates or other termination clauses, and may require the payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Corporation. Society evaluates each customer's creditworthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Society's mortgage banking subsidiary enters into forward sale agreements and option contracts to hedge against adverse movements in interest rates on mortgage loans held for sale. Forward sale agreements commit the subsidiary to deliver mortgage loans in future periods; option contracts allow the subsidiary to purchase mortgage loans at a specified price, in future periods. The banks enter into interest rate swap agreements primarily to manage interest rate risk and to accommodate the business needs of customers. Under a typical swap agreement, one party pays a fixed rate of interest based on a notional amount to a second party, which pays to the first party a variable rate of interest based on the same notional amount. The swaps have an average maturity of 2.4 years, with selected swaps having fixed maturity dates through 2003. The following is a summary of the notional amounts of outstanding interest rate swap agreements: The banks enter into interest rate cap and floor agreements in the management of their interest rate risk and to accommodate the business needs of customers. These financial instruments transfer interest rate risk at predetermined levels. The banks receive a fee as compensation for writing interest rate caps and floors. The risk from writing interest rate caps and floors is minimized by the banks through offsetting transactions. Financial futures contracts and options on financial futures provide for the delayed delivery or purchase of securities, interest rate instruments or foreign currency. The banks enter into forward contracts to manage their interest rate risk and in connection with customer transactions, as well as to minimize the interest rate risk exposure of mortgage banking activities. NOTE 15. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY Condensed financial information for Society Corporation (Parent Company only) is as follows: ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is set forth in the sections captioned "ELECTION OF DIRECTORS" and "EXECUTIVE OFFICERS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is set forth in the section captioned "THE BOARD OF DIRECTORS AND ITS COMMITTEES" and "COMPENSATION OF EXECUTIVE OFFICERS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held on May 19, 1994, and is incorporated herein by reference. The information set forth in the sections captioned "COMPENSATION AND ORGANIZATION AND EXECUTIVE EQUITY COMPENSATION COMMITTEE JOINT REPORT ON EXECUTIVE COMPENSATION" and "KEYCORP STOCK PRICE PERFORMANCE" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, is not incorporated by reference in this report on Form 10-K. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is set forth in the section captioned "SHARE OWNERSHIP" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is set forth in the section captioned "ELECTION OF DIRECTORS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. 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 Society Corporation and Subsidiaries, and the auditor's report thereon are included in Part II of this report:, (A)(1)(A) SUPPLEMENTAL FINANCIAL STATEMENTS On March 1, 1994, KeyCorp ("old KeyCorp") merged into and with Society Corporation, which was the surviving corporation of the merger under the name KeyCorp. Because the merger occurred subsequent to December 31, 1993, the financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K do not give effect to the restatement to include old KeyCorp's financial results. The following Supplemental Financial Statements restate the Corporation's 1993 and prior years' financial statements, giving effect to the merger with old KeyCorp. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Shareholders KeyCorp We have audited the accompanying supplemental consolidated balance sheets of KeyCorp and subsidiaries as of December 31, 1993 and 1992, and the related supplemental consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. The supplemental financial statements give retroactive effect to the merger of KeyCorp and Society Corporation on March 1, 1994, which has been accounted for as a pooling of interests as described in the notes to the supplemental financial statements. 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, the supplemental financial statements referred to above present fairly, in all material respects, the consolidated financial position of KeyCorp 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, after giving retroactive effect to the merger of KeyCorp and Society Corporation as described in the notes to the supplemental financial statements in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG Cleveland, Ohio March 1, 1994 NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES KeyCorp is a financial services holding company headquartered in Cleveland, Ohio, and is engaged primarily in the business of commercial and retail banking. It provides a wide range of banking, fiduciary, mortgage banking, insurance and other financial services to corporate, institutional and individual customers. The accounting policies of KeyCorp and its subsidiaries (the "Corporation") conform with generally accepted accounting principles and prevailing practices within the financial services industry. The following is a summary of significant accounting and reporting policies. KEYCORP-SOCIETY MERGER On March 1, 1994, KeyCorp ("old KeyCorp") merged into and with Society Corporation ("Society"), which was the surviving corporation under the name KeyCorp. The merger was accounted for by the pooling of interests method. These supplemental financial statements and notes have been restated to present the combined financial condition and results of operations of both companies as if the merger had been in effect for all periods presented. Further details pertaining to the merger are presented in Note 2, Mergers, Acquisitions and Divestitures, on page 71 of this report. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications, including adjustments to conform accounting practices, have been made to prior year amounts to agree to the current year presentation. BUSINESS COMBINATIONS In business combinations accounted for as poolings of interests, the assets, liabilities and shareholders' equity of the respective companies are carried forward at their historical amounts, the companies' results of operations are combined and the prior periods' financial statements are restated to give effect to the merger. In business combinations accounted for as purchases, the results of operations of the acquired businesses are included from the respective dates of acquisition. Net assets of the companies acquired are recorded at their cost to the Corporation at the date of acquisition and related purchase premiums and discounts are amortized over the remaining average lives of the respective assets or liabilities. STATEMENT OF CASH FLOWS Cash and due from banks are considered as cash and cash equivalents. INVESTMENT SECURITIES Securities which the Corporation has the ability and positive intent to hold to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts using the level yield method. Gains or losses from the sales of investment securities are computed using the specific identification method and included in net securities gains. SECURITIES AVAILABLE FOR SALE AND TRADING ACCOUNT ASSETS Securities available for sale are carried at the lower of aggregate cost or market value. Gains or losses from the sale of securities available for sale are computed using the specific identification method and are included in net securities gains. Market value adjustments for trading account assets (included in short-term investments) and changes in net unrealized losses on securities available for sale are included in noninterest income. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale are carried at the lower of aggregate cost, market value, or contracted sales value when fixed price commitments to sell exist. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED LOANS Loans are carried at the principal amount outstanding, net of unearned income, including deferred loan fees. Certain nonrefundable loan origination and commitment fees and the direct costs associated with originating or acquiring the loans are deferred. The net deferred amount is amortized as an adjustment to the related loan yield over the contractual lives of the related loans. Student loans held for sale are carried at the lower of aggregate cost or market value. Interest income on loans is primarily accrued based on principal amounts outstanding. The accrual of interest is discontinued when circumstances indicate that collection is questionable, or generally when payment is over 90 days past due. In such cases, interest accrued but not collected is charged against the allowance for loan losses. There after, payments received are first applied to the principal. Depending on management's assessment of the ultimate collectibility of the loan, interest income may be recognized on a cash basis. Loans are returned to accrual status when management determines that the circumstances have improved to the extent that both principal and interest are deemed collectible and there has been a sustained period of repayment performance. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb potential losses in the loan portfolio. Management's evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and composition of the loan portfolios and their related risk characteristics, and the continual review by management of the quality of the loan portfolio. INTEREST RATE SWAPS, FINANCIAL FUTURES AND OPTIONS The Corporation uses interest rate swaps, financial futures and options to manage the interest rate exposure of certain interest-sensitive assets and liabilities as part of the Corporation's overall strategy to manage interest rate risk. The net interest received or paid on interest rate swaps is recognized over the lives of the respective contracts as an adjustment to interest income or expense. Gains and losses resulting from the termination of interest rate swaps are deferred and amortized over the remaining lives of the related financial instruments. Gains and losses on futures and option contracts are recognized when the related hedged financial instruments are sold. PREMISES AND EQUIPMENT Premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation and amortization. Depreciation of premises and equipment is determined using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized using the straight-line method over the terms of the leases. OTHER REAL ESTATE OWNED Other real estate owned includes real estate acquired through foreclosure or a similar conveyance of title and real estate considered to be in-substance foreclosed when specific criteria are met. Other real estate owned is carried at the lower of its recorded amount or fair value less estimated cost of disposal. Writedowns of the assets at, or prior to, the dates of acquisition are charged to the allowance for loan losses. Subsequent writedowns, income and expenses incurred in connection with holding such assets, and gains and losses resulting from the sales of such assets, are included in other noninterest expense. INTANGIBLE ASSETS Goodwill, representing the excess of the cost of acquisitions over the fair value of net assets acquired, is amortized using the straight-line method over the estimated period to be benefited, generally not exceeding 25 years. Core deposit intangibles represent the net present value of the future economic benefits related to the use of deposits purchased. They are being amortized using an accelerated method over periods ranging from 7 to 15 years. Other intangibles are generally being amortized using the straight-line method over periods ranging from 4 to 15 years. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED PURCHASED MORTGAGE SERVICING RIGHTS Purchased mortgage servicing rights represent the cost of the right to receive future servicing income. Purchased mortgage servicing rights are amortized, as a reduction to service fee income, over the estimated life of the related loans in proportion to the recognition of estimated net servicing income. An evaluation of the carrying amount of the purchased mortgage servicing rights is performed on a disaggregated basis by discounting the expected future cash flows, taking into consideration the estimated level of prepayments based upon current industry expectations. INCOME TAXES Old KeyCorp and Society each filed consolidated Federal income tax returns for the periods presented. Effective January 1, 1992, the Corporation prospectively adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," which supersedes SFAS No. 96. The cumulative effect of adopting SFAS No. 109 was not material. EARNINGS PER SHARE Earnings per Common Share is computed by dividing net income, less preferred stock dividends, by the weighted average number of Common Shares outstanding. These amounts have been adjusted to reflect stock splits. NOTE 2. MERGERS, ACQUISITIONS AND DIVESTITURES KEYCORP-SOCIETY MERGER On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society Corporation ("Society"), a financial services holding company headquartered in Cleveland, Ohio, with approximately $27 billion in assets at year-end 1993, which was the surviving corporation and assumed the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp common stock (based on an exchange ratio of 1.205 shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the combined financial results of both companies. The following table presents net interest income, net income and net income per Common Share reported by each of the companies and on a combined basis. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED JACKSON COUNTY FEDERAL BANK On December 31, 1993, Jackson County Federal Bank of Medford, Oregon ("JCF") merged into Key Bank of Oregon, an indirect wholly-owned subsidiary of KeyCorp. A total of 1,430,813 KeyCorp Common Shares were issued to the holders of JCF common and preferred stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of JCF because the transaction was not material to KeyCorp. JCF had total assets of approximately $338 million at the date of merger. SCHAENEN WOOD & ASSOCIATES, INC. On October 5, 1993, Society Asset Management Inc., an indirect wholly-owned subsidiary of KeyCorp, completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. AMERITRUST TEXAS CORPORATION On September 15, 1993, KeyCorp completed the sale of Ameritrust Texas Corporation ("ATC"), a wholly-owned subsidiary of KeyCorp, to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the year-to-date period through the closing date, ATC had net income of $3.2 million. A $29.4 million gain was realized on the sale ($12.2 million after tax, $.10 per Common Share) and included in noninterest income. NORTHWESTERN NATIONAL BANK On July 22, 1993, Northwestern National Bank of Port Angeles, Washington ("NNB") merged into Key Bank of Washington, an indirect wholly-owned subsidiary of KeyCorp. A total of 361,607 KeyCorp Common Shares were issued to the holders of NNB common stock. The transaction was accounted for as a purchase. NNB had total assets of approximately $49 million at the date of acquisition. EMERALD CITY BANK On July 2, 1993, Key Bank of Washington, an indirect wholly-owned subsidiary of KeyCorp, assumed $7 million of deposits of the failed Emerald City Bank of Seattle, Washington in an FDIC-assisted transaction. HOME FEDERAL SAVINGS BANK On June 30, 1993, Home Federal Savings Bank of Fort Collins, Colorado ("Home Federal") merged into Key Bank of Colorado, a wholly-owned subsidiary of KeyCorp formed for the purposes of consummating the merger. A total of 590,485 KeyCorp Common Shares were issued to the holders of Home Federal common stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of Home Federal because the transaction was not material to KeyCorp. Home Federal had total assets of approximately $230 million at the date of merger. FIRST AMERICAN BANK OF NEW YORK On March 25, 1993, Key Bank of New York, an indirect wholly-owned subsidiary of KeyCorp, acquired all of the deposits and the majority of the assets of First American Bank of New York ("First American"). Key Bank of New York acquired 40 branches and other business operations with approximately $1.0 billion in deposits and approximately $600 million in loans, in addition to branch real estate and other physical assets. The transaction was accounted for as a purchase. Key Bank of New York paid a premium of $41 million on the acquired deposits. In connection with the transaction, Key Bank of New York recorded a core deposit intangible of $33 million and goodwill of $8 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NATIONAL SAVINGS BANK OF ALBANY On February 26, 1993, National Savings Bank of Albany, New York ("National") merged into Key Bank of New York, an indirect wholly-owned subsidiary of KeyCorp. A total of 2,111,638 KeyCorp Common Shares were issued to the holders of National common stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of National because the transaction was not material to KeyCorp. National had total assets of approximately $671 million at the date of merger. FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION On January 22, 1993, KeyCorp acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. PUGET SOUND BANCORP On January 15, 1993, Puget Sound Bancorp ("PSB"), a bank holding company headquartered in Tacoma, Washington, with approximately $4.7 billion in assets as of December 31, 1992, merged into Key Bancshares of Washington, Inc., a wholly-owned subsidiary of KeyCorp. A total of 31,391,544 KeyCorp Common Shares were exchanged for all of the outstanding shares of PSB common stock (based on an exchange ratio of 1.32 shares for each share of PSB). The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the combined financial results of both companies. ELECTRONIC PAYMENT SERVICES, INC. On December 4, 1992, KeyCorp and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement, the Corporation contributed its wholly-owned subsidiary, Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. FIRST OF AMERICA BANK-MONROE On September 30, 1992, KeyCorp acquired all of the outstanding shares of First of America Bank-Monroe ("FAB-Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase. FAB Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. SECURITY PACIFIC BANK BRANCHES On September 3, 1992, Key Bank of Washington ("Key Bank"), an indirect wholly-owned subsidiary of KeyCorp, acquired 48 branches and other business and private banking operations with approximately $1.3 billion in deposits and $709 million in loans in addition to branch real estate and other physical assets in the state of Washington from BankAmerica Corporation. The transaction was accounted for as a purchase. Key Bank paid a premium of $53.6 million on the acquired deposits. OLYMPIC SAVINGS BANK On July 31, 1992, Key Savings Bank ("Key Savings"), an indirect wholly-owned subsidiary of KeyCorp, acquired Olympic Savings Bank of Washington ("Olympic"). The transaction was accounted for as a purchase. Olympic had approximately $81 million in assets at the date of acquisition. VALLEY BANCORPORATION On June 4, 1992, Valley Bancorporation ("Valley") of Idaho Falls, Idaho was merged with Key Bancshares of Idaho, a wholly-owned subsidiary of KeyCorp. A total of 838,308 KeyCorp Common Shares were issued for all of the outstanding shares of Valley common stock. The transaction qualified for accounting as a pooling of NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of Valley because the transaction was not material to KeyCorp. Valley had assets of approximately $221 million at the date of merger. AMERITRUST CORPORATION On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into the Corporation. Under the terms of the merger agreement, 49,550,862 KeyCorp Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of KeyCorp for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, the Corporation sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) which is included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. PENDING ACQUISITIONS COMMERCIAL BANCORPORATION OF COLORADO On March 24, 1994, Commercial Bancorporation of Colorado ("CBC"), a bank holding company with subsidiary banks operating in the Denver, Colorado Springs, Sterling and Fort Collins areas of Colorado, merged with Key Bank of Colorado, a wholly-owned subsidiary of KeyCorp. Holders of CBC common stock received .899 KeyCorp Common Shares for each outstanding share of CBC common stock. CBC had total assets of $390 million at December 31, 1993. The transaction qualified for accounting as a pooling of interests; however, financial statements will not be restated to include the accounts and results of operations of CBC because the transaction was not material to KeyCorp. THE BANK OF GREELEY On October 5, 1993, KeyCorp agreed to acquire the Bank of Greeley, a single branch bank headquartered in Greeley, Colorado ("Greeley Bank"). Under terms of the agreement, all shares of Greeley Bank will be exchanged for approximately 240,000 KeyCorp Common Shares. Greeley Bank had total assets of approximately $61 million at December 31, 1993. 3. SECURITIES AVAILABLE FOR SALE The book values, unrealized gains and losses and approximate market values of securities available for sale were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The proceeds from sales of securities available for sale during 1993 and 1992 were $630.8 million and $661.9 million, respectively. Gross gains of $35.3 million and $9.6 million were realized on those sales in 1993 and 1992, respectively, and gross losses of $24 thousand and $7.1 million were realized on those sales in 1993 and 1992, respectively. Securities available for sale by remaining maturity were as follows: Mortgage-backed securities are included in the above maturity schedule based on their expected average lives. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. SFAS No. 115 is more fully described in Note 4, Investment Securities. 4. INVESTMENT SECURITIES The book values, unrealized gains and losses and approximate market values of investment securities were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Investment securities by remaining maturity were as follows: Mortgage-backed securities are included in the above maturity schedule based on their expected average lives. Other securities consist primarily of those collateralized by credit card and automobile installment loan receivables, corporate floating-rate notes and venture capital investments. The proceeds from sales of investment securities were $142.1 million, $662.2 million and $1.1 billion during 1993, 1992 and 1991, respectively. Gross gains and losses related to securities were $.8 million and $7.8 million, respectively, in 1993, $13.0 million and $.9 million, respectively, in 1992, and $26.2 million and $7.3 million, respectively, in 1991. At December 31, 1993, investment and available for sale securities with a book value of approximately $9.6 billion were pledged to secure public and trust deposits and securities sold under agreements to repurchase, and for certain other purposes required or permitted by law. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. Debt securities that management has the positive intent and ability to hold to maturity are to be classified as "held-to-maturity securities" and reported at amortized cost. Debt and equity securities that are bought and principally held for the purpose of selling them in the near term are to be classified as "trading securities" and reported at fair value, with unrealized gains and losses included in operating results. Debt and equity securities not classified as either held-to-maturity securities or trading securities are to be classified as "available for sale securities" and reported at fair value, with the unrealized gains and losses excluded from operating results and reported as a separate component of shareholders' equity. Adoption of SFAS No. 115 is required for fiscal years beginning after December 15, 1993, with earlier application permitted. The Corporation will adopt SFAS No. 115 in 1994. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $44 million, with no effect on the results of operations. With the adoption of SFAS No. 115 in 1994, the Corporation anticipates that securities with an aggregate book value ranging from $4.5 billion to $5.0 billion will be designated as available for sale. Based upon the market values of these securities at year-end 1993, the reclassification of these securities is not expected to have a material effect on shareholders' equity. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 5. LOANS Loans are summarized as follows: Changes in the allowance for loan losses are summarized as follows: In 1991, Ameritrust recorded an additional $93.9 million provision for loan losses to conform its approach to determining the level of the allowance to that used by the Corporation. In the ordinary course of business, KeyCorp's banking affiliates have made loans at prevailing interest rates and terms to directors and executive officers of KeyCorp and its subsidiaries and their associates (as defined by the Securities and Exchange Commission). Such loans, in management's opinion, did not present more than the normal risk of collectibility or incorporate other unfavorable features. The aggregate amount of loans outstanding to qualifying related parties at January 1, 1993, was $241.3 million. During 1993, activity with respect to these loans included new loans, repayments and a net decrease (due to changes in the status of executive officers and directors) of $149.3 million, $153.9 million and $40.3 million, respectively, resulting in an aggregate balance of loans outstanding to related parties at December 31, 1993, of $196.4 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 6. NONPERFORMING ASSETS Nonperforming assets were as follows: The effect on interest income of loans classified as nonperforming, at December 31, was as follows: At December 31, 1993, there were no significant commitments to lend additional funds to borrowers with nonaccrual or restructured loans. Changes in the allowance for OREO losses are summarized as follows: In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which takes effect for fiscal years beginning after December 15, 1994. SFAS No. 114 prescribes a valuation methodology for impaired loans as defined by the standard. Generally, a loan is considered impaired if management believes that it is probable that all amounts due will not be collected according to the contractual terms, as scheduled in the loan agreement. An impaired loan must be valued using the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the loan's underlying collateral. The Corporation expects to adopt SFAS No. 114 prospectively in the first quarter of 1995. It is anticipated that the adoption of SFAS No. 114 will not have a material effect on the Corporation's financial condition or results of operations. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 7. PREMISES AND EQUIPMENT Premises and equipment were as follows: Depreciation and amortization expense related to premises and equipment totaled $110.9 million, $104.3 million, and $84.4 million in 1993, 1992, and 1991, respectively. At December 31, 1993, KeyCorp's affiliate banks were obligated under noncancelable leases for land and buildings and for other property, consisting principally of data processing equipment. Rental expense under all operating leases totaled $123.7 million in 1993, $116.5 million in 1992 and $103.4 million in 1991. Minimum future rental payments under noncancelable leases at December 31, 1993, were as follows: 1994 -- $98.9 million; 1995 -- $89.0 million; 1996 -- $82.1 million; 1997 -- $74.2 million; 1998 -- $59.2 million; and subsequent years -- $547.5 million. 8. INTANGIBLE ASSETS AND PURCHASED MORTGAGE SERVICING RIGHTS Intangible assets, net of accumulated amortization, were as follows: The amortization expense for intangible assets was as follows: The amortization expense for purchased mortgage servicing rights totaled $56.6 million, $29.6 million and $20.4 million in 1993, 1992 and 1991, respectively. The amount of purchased mortgage servicing rights capitalized during 1993 was $77.3 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 9. SHORT-TERM BORROWINGS Short-term borrowings consist primarily of Federal funds purchased and securities sold under repurchase agreements, which generally represent overnight borrowing transactions. Other short-term borrowings consist primarily of Medium-Term Notes with original maturities of one year or less, Treasury, tax and loan demand notes and commercial paper which is issued principally in amounts of $100,000 or more with maturities of 270 days or less. On November 30, 1992, Society National Bank ("SNB"), KeyCorp's Ohio banking affiliate, authorized the issuance of up to $1 billion of Medium-Term Notes to be offered on a continuous basis. During 1993, $685 million in debt securities were issued under this program. These securities have original maturities of less than one year and are included in other short-term borrowings. The details of short-term borrowings were as follows: At December 31, 1993, the Corporation had available lines of credit for general corporate purposes aggregating $200 million, all of which were unused at December 31, 1993. Standard fees were paid for these facilities, which were cancelled subsequent to the end of the year. 10. LONG-TERM DEBT The components of long-term debt, presented net of unamortized discount where appropriate, were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Scheduled payments on long-term debt are as follows: During 1993 and 1992, KeyCorp issued $305.1 million and $77.0 million, respectively, of Medium-Term Notes with original maturities exceeding one year. In addition to general corporate purposes, the proceeds from the issuance of these notes were used to redeem and pay principal on notes and debentures; to fund the purchase of OREO from affiliate banks by NCB Properties, Inc., an OREO workout subsidiary; and to provide subordinated capital to affiliate banks. At December 31, 1993, KeyCorp's Medium-Term Notes as presented in the table had a weighted average interest rate of 6.61% and had varying maturities through 2003. On June 15, 1992, KeyCorp issued $200 million of 8.125% Subordinated Notes under a shelf registration. The Notes are not redeemable prior to maturity. The 8.875% Notes, issued under a separate registration statement, and the 11.125% Notes are not redeemable prior to maturity. On March 26, 1987, KeyCorp issued $75 million of 8.40% Subordinated Capital Notes due 1999 under an indenture dated March 1, 1987, between KeyCorp and Chemical Bank, as Trustee. The Notes are unsecured obligations of KeyCorp and will, at maturity, be exchanged for Capital Securities having a market value equal to the principal amount of the Notes. Proceeds of this issue were used primarily to fund the acquisition of Seattle Trust & Savings Bank in July 1987. On June 29, 1992, KeyCorp issued $125 million of 8.00% Subordinated Notes. Proceeds from these twelve-year notes were used to redeem without penalty all of its 11.25% Senior Notes prior to maturity. Proceeds were also employed to provide capital for Key Bank of Washington. This capital infusion was made in anticipation NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED of Key Bank of Washington's purchase of 48 former Security Pacific Bank branches from BankAmerica on September 3, 1992. In 1989, the Ameritrust Corporation Employees' Savings and Investment Plan (the "Plan") was amended to include a leveraged employee stock ownership plan ("ESOP"). To fund the ESOP, Ameritrust borrowed $71.7 million from several institutional investors through the placement of unsecured notes totaling $22.8 million (the "8.33% Notes") and $48.9 million (the "8.48% Notes"). The interest on those notes totaled $6.0 million in each of the years 1993, 1992 and 1991. The ESOP trustee used the proceeds to purchase 5.8 million shares of Ameritrust common stock. These shares, as converted in the merger with Society, are held by the ESOP trustee for matching employee contributions to the Plan. The net difference between the cost of the treasury shares sold to the ESOP trustee and their market value was recorded as a reduction to retained earnings. Except for the repayment schedule, the loans to the ESOP trustee are on substantially similar terms as the borrowings from the institutional investors and, in addition, are secured by the unallocated shares held by the ESOP trustee. The ESOP trustee will repay the loans from KeyCorp using corporate contributions made by the Plan for that purpose and dividends on the Common Shares acquired with the loans. The amount of dividends on the ESOP shares used for debt service by the ESOP trustee totaled $3.9 million in 1993, $3.1 million in 1992 and $1.8 million in 1991. As contributions and dividends are received, a portion of the shares acquired with the loans will be allocated to Plan participants. Interest income recognized on loans to the ESOP trustee is netted against the interest expense incurred on the notes payable to the institutional investors. KeyCorp's receivable from the ESOP trustees, representing deferred compensation to the Corporation's employees, has been recorded as a separate reduction of shareholders' equity. SNB issued $200 million of 7.85% Subordinated Notes on November 3, 1992, and $200 million of 6.75% Subordinated Notes on June 16, 1993. SNB also issued a 10% Note in connection with the sale of branch offices and loans resulting from the merger with Ameritrust. None of these notes may be redeemed prior to maturity. The 8.625% Notes due 1996 were redeemed at par plus accrued interest on June 30, 1993, and the 9.56% Note due 1995 was assumed by the purchaser in connection with the sale of Ameritrust Texas Corporation on September 15, 1993. On May 6, 1993, and May 27, 1993, KeyCorp redeemed prior to maturity, and without penalty, all of its floating rate subordinated notes due 1997 and all of its 7.75% debentures due through 2002, respectively. Industrial revenue bonds issued by affiliate banks have varying maturities extending to the year 2009 and had weighted average annual interest rates of 7.14% and 7.19%, respectively, at December 31, 1993 and 1992. Other long-term debt at December 31, 1993 and 1992, consisted of capital lease obligations and various secured and unsecured obligations of corporate subsidiaries and had weighted average annual interest rates of 13.54% and 10.14%, respectively. Long-term debt qualifying as supplemental capital for purposes of calculating Tier II capital under Federal Reserve Board Guidelines amounted to $993.4 million and $799.1 million at December 31, 1993, and 1992, respectively. 11. SHAREHOLDERS' EQUITY COMMON SHARES AND PREFERRED STOCK In August 1989, KeyCorp's Board of Directors adopted a Shareholder Rights Plan ("Rights") under which each shareholder received one Right for each Common Share of KeyCorp. Each Right represents the right to purchase a Common Share of KeyCorp at a price of $65. The Rights become exercisable 20 days after a person or group acquires 15% or more of the outstanding shares or commences a tender offer that could result in such an ownership interest. Until the Rights become exercisable, they will trade with the Common Shares, and any transfer of the Common Shares will also constitute a transfer of associated Rights. When the Rights become exercisable, they will begin to trade separate and apart from the Common Shares. Twenty days after the occurrence of certain "Flip-In Events," each Right will become the right to purchase a Common Share of NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED KeyCorp for the then par value per share (now $1 per share) and the Rights held by a 15% or more shareholder will become void. KeyCorp may redeem these Rights at its option at $.005 per Right subject to certain limitations. Unless redeemed earlier, the Rights expire on September 12, 1999. On October 1, 1993, KeyCorp amended the Rights so that the Merger would not activate the provisions of the Rights. At December 31, 1993, KeyCorp had 10.0 million shares of $5 par value, non-voting preferred stock authorized of which 1,280,000 shares of Series B were outstanding represented by 6.4 million Depositary Shares. Each Depositary Share represents a one-fifth interest in a share of 10% Cumulative Preferred Stock, Series B, $125 liquidation preference per share. Preferred stock is reported on the accompanying consolidated balance sheet at its stated value of $125 per share. In the Merger, each of the Series B shares were converted into one share of 10% Cumulative Preferred Stock, Class A. On August 2, 1993, KeyCorp redeemed the 479,394 outstanding shares of Series A Preferred Stock at its stated value ($24 million) plus accumulated but unpaid dividends. On March 1, 1993, KeyCorp redeemed the 1.2 million outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value ($60 million), plus accumulated but unpaid dividends. KeyCorp effected a two-for-one stock split on March 22, 1993, by means of a 100% stock dividend. All relevant Common Share amounts, per Common Share amounts and related data in this report have been adjusted to reflect this split. In connection with the Merger, at a special meeting held February 16, 1994, shareholders increased the authorized number of shares of KeyCorp to 926.4 million, of which 1.4 million are shares of 10% Cumulative Preferred Stock, Class A, par value $5 per share; 25.0 million are shares of Preferred Stock, par value $1 per share; and 900.0 million are Common Shares, par value $1 per share. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS KeyCorp maintains various incentive compensation plans which provide for its ability to grant stock options, stock appreciation rights, limited stock appreciation rights, restricted stock and performance shares to selected employees and directors. Generally, the terms of these plans stipulate that the exercise price of options may not be less than the fair market value of KeyCorp's Common Shares at the date the options are granted. Options granted expire not later than ten years and one month from the date of grant. Several option plans have been acquired through mergers. These plans have expired or were terminated, but unexercised options granted under the plans remain outstanding. At December 31, 1993 and 1992, options for Common Shares available for future grant totaled 1,237,965 and 1,233,958, respectively. The terms of KeyCorp's plans stipulate that stock appreciation rights may only be granted in tandem with stock options. The appreciation rights have the same terms as do the options, except that, upon exercise, the holder may receive either cash or shares for the excess of the current market value of KeyCorp's Common Shares over the options exercise price. Upon exercise of a stock appreciation right, the related option is surrendered. During 1993, all stock appreciation rights for which exercisability was limited to a period following a change in control of the Corporation were cancelled. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The following table presents a summary of pertinent information with respect to KeyCorp's stock options and stock appreciation rights. STOCK OPTIONS STOCK APPRECIATION RIGHTS In 1991, KeyCorp's Board of Directors approved grants to certain officers of KeyCorp and its subsidiaries under the Career Equity Program ("Program"). The Program is designed to increase equity ownership by the participants, who make an initial investment and elect to have options automatically exercised at regular intervals when share value appreciation is present. At exercise, replacement option grants are made at the current market value. Shares received under the Program are restricted as to resale during the five-year period of the Program. 12. MERGER AND INTEGRATION CHARGES Merger and integration charges of $118.7 million ($80.6 million after tax, $.33 per Common Share), $92.7 million ($66.6 million after tax, $.29 per Common Share) and $93.8 million ($68.2 million after tax, $.29 per Common Share) were recorded in 1993, 1992 and 1991, respectively. The 1993 charges were incurred in connection with the March 1, 1994, merger of old KeyCorp into and with Society, while the 1992 charges related to the mergers with PSB and Ameritrust. The 1991 charges related to the merger with Ameritrust. The merger and integration charges included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($20.5 million); severance payments and other employee costs ($49.6 million); systems and facilities costs ($35.7 million); and other costs incident to the Merger ($12.9 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for all such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the PSB and Ameritrust mergers in 1992, and the Ameritrust merger in 1991, were similar in nature. The above mergers are described in greater detail in Note 2, Mergers, Acquisitions and Divestitures, on page 71 of this report. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 13. EMPLOYEE BENEFITS PENSION PLANS KeyCorp and its subsidiaries sponsor noncontributory pension plans covering substantially all employees. Benefits paid from these plans are based on age, years of service and compensation prior to retirement and are determined in accordance with defined formulas. The Corporation's funding policy is to contribute amounts to the plans which meet the minimum funding requirements set forth in the Employee Retirement Income Security Act (ERISA) of 1974, plus such additional amounts as the Corporation determines to be appropriate. The following table sets forth the status of the unfunded plans and the amounts recognized in the consolidated balance sheets: (1)Including KeyCorp Common Shares valued at $27.8 million and $30.4 million at December 31, 1993 and 1992, respectively. The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of projected benefit obligations were 7.37% and 4.00%, respectively, at December 31, 1993, and 8.08% and 4.78%, respectively, at December 31, 1992. The weighted average expected long-term rate of return on pension assets used in determining net pension cost was 9.91% for 1993, 9.60% for 1992 and 9.69% for 1991. The Corporation also maintains several unfunded, non-qualified, supplemental executive retirement programs that provide additional defined pension benefits for certain officers. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The following table sets forth the status of the unfunded plans and the amounts recognized in the consolidated balance sheets: Net pension cost (income) for the funded and unfunded plans included the following components: In 1993, the Corporation recognized curtailment and settlement gains of $2.9 million resulting from the divestiture of ATC. Such amounts were included in the net gain from that divestiture. In 1992, the Corporation recognized curtailment gains of $7.2 million resulting from merger-related staff reductions. A portion of the retirement obligations associated with these reductions was settled by lump-sum cash distributions which resulted in settlement gains of $1.4 million and $3.0 million in 1993 and 1992, respectively. Both the curtailment and settlement gains related to the merger-related staff reductions are included in other noninterest income. OTHER POSTRETIREMENT BENEFIT PLANS The Corporation sponsors postretirement health care and life insurance plans that cover substantially all employees. The postretirement health care plans are nonfunded and contributory, with retirees' contributions adjusted annually to reflect certain cost-sharing provisions and benefit limitations. The postretirement life insurance plans are noncontributory. The Corporation has adopted a funding policy for one of its life insurance plans and annually contributes the service cost of benefits earned plus one-thirtieth of the unfunded accumulated postretirement benefit obligations. Effective January 1, 1993, the Corporation adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires that employers recognize the cost of providing postretirement benefits over the employees' active service periods to the date they attain full eligibility for such benefits. Postretirement benefits costs for 1992 and 1991, which were recorded on a cash basis, have not been restated. Net postretirement benefits cost was $16.9 million in 1993, including $8.2 million due to adoption of the new standard, $7.7 million in 1992 and $6.6 million in 1991. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Net post retirement benefits cost include the following components: The following table sets forth the plans' combined funded status reconciled with the amount shown in the consolidated balance sheet: The assumed 1994 health care cost trend rate for Medicare-eligible retirees was 11.0% while that for non-Medicare-eligible retirees was 13.0%. Both rates are assumed to gradually decrease to 5.5% by the year 2009 and remain constant thereafter. Increasing the assumed health care cost trend rates by one percentage point in each future year would have an immaterial impact on postretirement benefits cost due to cost-sharing provisions and benefit limitations. The weighted average discount rate used in determining the accumulated postretirement benefit obligations was 7.4% at December 31, 1993. EMPLOYEE STOCK PURCHASE AND SAVINGS PLANS Substantially all of the Corporation's employees are covered under stock purchase and savings plans that are qualified under Section 401(k) of the Internal Revenue Code. Under provisions of these plans, employees may contribute 1% to 15% of eligible compensation, with up to 6% being eligible for matching contributions from the Corporation in the form of KeyCorp Common Shares. Under an annual discretionary profit sharing component, employees can receive additional matching employer contributions from the Corporation based on a formula established each year by KeyCorp's Board of Directors. Total expense associated with these plans was $40.4 million, $30.4 million and $29.0 million in 1993, 1992 and 1991, respectively. POSTEMPLOYMENT BENEFITS The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," during 1993. This standard requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of this standard increased noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 14. INCOME TAXES Income taxes included in the consolidated statements of income are as follows: The reasons for the differences between income tax expense and the amount computed by applying the statutory Federal tax rate to income before taxes are as follows: The significant types of temporary differences that gave rise to net deferred income taxes include the provision for loan losses, lease income, merger and integration charges and writedown of other real estate owned. Significant components of deferred income taxes are as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Significant components of KeyCorp's deferred tax asset (liability) are as follows: 15. COMMITMENTS, CONTINGENT LIABILITIES AND OTHER DISCLOSURES LEGAL PROCEEDINGS In the ordinary course of business, KeyCorp and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and the Corporation's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on KeyCorp's consolidated financial condition. RESTRICTIONS ON CASH, DUE FROM BANKS, SUBSIDIARY DIVIDENDS AND LENDING ACTIVITIES Under the provisions of the Federal Reserve Act, depository institutions are required to maintain certain average balances in the form of cash or noninterest-bearing balances with the Federal Reserve Bank. Average reserve balances aggregating $1.1 billion in 1993 were maintained in fulfillment of these requirements. The principal source of income for the parent company is dividends from its affiliate banks. Such dividends are subject to certain restrictions as set forth in the national and state banking laws and regulations. At December 31, 1993, undistributed earnings of $535.4 million were free of such restrictions and available for the payment of dividends to the parent company. Loans and advances from banking affiliates to the parent company are also limited by law and are required to be collateralized. 16. FINANCIAL INSTRUMENTS FAIR VALUE DISCLOSURES The following disclosures are made in accordance with the provisions of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," which requires the disclosure of fair value information about both on-and off-balance sheet financial instruments where it is practicable to estimate that value. Fair value is defined in SFAS No. 107 as the amount at which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. It is not the Corporation's intent to enter into such exchanges. In accordance with the provisions of SFAS No. 107, the estimated fair values of deposits, credit card loans and residential real estate mortgage loans do not take into account the fair values of long-term relationships, which are integral parts of the related financial instruments. The disclosed estimated fair values of such instruments would increase significantly if the fair values of the long-term relationships were considered. In cases where quoted market prices were not available, fair values were estimated using present value or other valuation methods, as described below. The use of different assumptions (e.g., discount rates and cash flow estimates) and estimation methods could have a significant effect on fair value amounts. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. Because SFAS No. 107 excludes certain financial instruments and all nonfinancial NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED instruments from its disclosure requirements, any aggregation of the fair value amounts presented would not represent the underlying value of the Corporation. The following methods and assumptions were used in estimating the fair values of financial instruments presented in the preceding table and in the following paragraphs. For financial instruments with a remaining average life to maturity of less than six months, carrying amounts were used as an approximation of fair value. The carrying amounts reported for cash and due from banks, and short-term investments are their fair values. The carrying value of mortgage loans held for sale approximates fair value. Securities available for sale and investment securities were valued based on quoted market prices. Where quoted market prices were unavailable, fair values were based on quoted market prices of similar instruments. A discounted cash flow model was used to estimate the fair values for certain loans. Certain residential real estate loans and student loans held for sale were valued based on quoted market prices of similar loans offered or sold in recent securitization transactions. Lease financing receivables, although excluded from the scope of SFAS No. 107, were included in the estimated fair value for loans at their carrying amount. In circumstances in which the fair value of loans was not estimated, the carrying amount was used as a reasonable approximation of fair value. The fair values of certificates of deposit and of long-term debt were estimated based on discounted cash flows. Carrying amounts reported for other deposits and short-term borrowings were used as a reasonable approximation of their fair values. Interest rate swaps were valued based on discounted cash flow models and had a fair value of $57.2 million and $75.8 million at December 31, 1993 and 1992, respectively. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation, mainly through its affiliate banks, is party to various financial instruments with off-balance sheet risk. The banks use these financial instruments in the normal course of business to meet the financing needs of their customers and to manage effectively their exposure to interest rate risk. The financial instruments used include commitments to extend credit, standby letters of credit, interest rate swap agreements, forward contracts, futures and options on financial futures, and interest rate cap and floor agreements. These instruments involve, to varying degrees, credit and interest rate risks in excess of amounts recognized in the Corporation's consolidated balance sheet. Credit risk is the possibility that a counterparty to a financial instrument will be unable to perform its contractual obligations. Market risk is the possibility that, due to changes in economic conditions, the Corporation's net interest income will be adversely affected. The Corporation mitigates its exposure to credit risk through internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits, and, when deemed necessary, securing collateral. The Corporation manages its exposure to market risk, in part, by using NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED off-balance sheet instruments to offset existing interest rate risk of its assets and liabilities, and by setting variable rates of interest on contingent extensions of credit. The following is a summary of the contractual or notional amount of each significant class of off-balance sheet financial instruments outstanding. The Corporation's maximum possible accounting loss from commitments to extend credit and from standby letters of credit equals the contractual amount of these instruments. The notional amount represents the total dollar volume of transactions and is significantly greater than the amount at risk. KeyCorp's commitments to extend credit are agreements with customers to provide financing at predetermined terms as long as the customer continues to meet specified criteria. Loan commitments serve to meet the financing needs of the banks' customers, have fixed expiration dates or other termination clauses, and may require the payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent actual future cash requirements of the Corporation. KeyCorp evaluates each customer's creditworthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. KeyCorp's mortgage banking affiliates originate and service residential mortgage loans to be sold in the secondary market. In years prior to 1992, residential mortgages were sold with provisions for recourse by companies acquired by KeyCorp. At December 31, 1993, the amount of such loans sold with recourse was $156.1 million. KeyCorp has not and does not sell residential mortgages with provisions for recourse. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED KeyCorp's mortgage banking affiliates enter into forward sale agreements and option contracts to hedge against adverse movements in interest rates on mortgage loans held for sale. Forward sale agreements commit the affiliates to deliver mortgage loans in future periods; option contracts allow the affiliates to sell or purchase mortgage loans at a specified price, in future periods. The banks enter into interest rate swap agreements primarily to manage interest rate risk and to accommodate the business needs of customers. Under a typical swap agreement, one party pays a fixed rate of interest based on a notional amount to a second party, which pays to the first party a variable rate of interest based on the same notional amount. The swaps have an average maturity of 1.8 years, with selected swaps having fixed maturity dates through 2003. The following is a summary of the notional amounts of outstanding interest rate swap agreements: The banks enter into interest rate cap and floor agreements in the management of their interest rate risk and to accommodate the business needs of customers. These financial instruments transfer interest rate risk at predetermined levels. The banks receive a fee as compensation for writing interest rate caps and floors. The interest rate risk from writing interest rate caps and floors is minimized by the banks through offsetting transactions. Financial futures contracts and options on financial futures provide for the delayed delivery or purchase of securities, interest rate instruments or foreign currency. The banks enter into forward contracts and options to hedge their interest rate risk and in connection with customer transactions, as well as to minimize the interest rate risk exposure of mortgage banking activities. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 17. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY CONDENSED BALANCE SHEETS CONDENSED STATEMENTS OF INCOME NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED CONDENSED STATEMENTS OF CASH FLOW (A)(2) FINANCIAL STATEMENT SCHEDULES All financial statement schedules for Society Corporation and subsidiaries have been included in the consolidated financial statements or the related footnotes, or they are either inapplicable or not required. (A)(3) EXHIBITS* Society hereby agrees to furnish the Securities and Exchange Commission upon request, copies of instruments outstanding, including indentures, which define the rights of long-term debt security holders. All documents listed as Exhibits 10.1 through 10.51 constitute management contracts or compensatory plans or arrangements. - --------------- * Copies of these Exhibits have been filed with Securities and Exchange Commission. Shareholders may obtain a copy of any exhibit, upon payment of reproduction costs, by writing Mr. Jay S. Gould, Investor Relations, at 127 Public Square 01-127-0406, Cleveland, Ohio 44114-1306. ** These Exhibits are incorporated by reference from old KeyCorp's Current Report on Form 8-K dated March 9, 1992. (b) Reports on Form 8-K October 13, 1993 -- Item 5. Other Events. On October 1, 1993, Society announced the signing of a definitive agreement providing for the merger of old KeyCorp into and with Society. November 19, 1993 -- Item 7. Financial Statements, Pro Forma Financial Information, and Exhibits. Society filed certain pro forma financial information that gives effect to the proposed merger of Society and old KeyCorp, and supplemental historical financial statements of old KeyCorp and its subsidiaries. No other reports on Form 8-K were filed during the three-month period ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTIONS 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, ON THE DATE INDICATED. KEYCORP CARTER B. CHASE Executive Vice President, Secretary and General Counsel 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.

835669_1993.txt

835669_1993

1993

835669

Item 1. Business (A) General Development of Business. RYMAC Mortgage Investment Corporation (the "Company") was incorporated in the State of Maryland on July 1, 1988. The Company is primarily engaged in making investments in mortgage derivative securities and, to a lesser extent, mortgage related investments. Two wholly-owned, limited purpose finance subsidiaries of the Company, RYMAC Mortgage Investment I, Inc. ("RMI I") and RYMAC Mortgage Investment II, Inc. ("RMI II"), hold certain mortgage related investments. The Company also generates revenues from other sources, such as interest earnings on certain investments of the Company and sales of certain investments of the Company. The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). As long as the Company qualifies as a REIT, dividends paid to stockholders will be allowed as a deduction for purposes of determining income subject to federal corporate income tax. As a result, the Company will not be subject to such tax on that portion of its net income that is distributed to stockholders. (See "Federal Income Taxation of the Company and Stockholders") (B) Current Business Environment. During the period from the Company's inception in 1988 through early 1992, mortgage interest rate levels and prepayment speeds remained within levels existent from 1970 to early 1992. Historically, cash received from the Company's investments represented interest and dividend earnings and the return of investment principal (basis). However, since June of 1992, mortgage rates have been at levels lower than those existent for the prior twenty years, resulting in extraordinarily rapid and sustained levels of residential mortgage prepayments. As a direct result, the Company's investments have generated reduced interest and dividend earnings and as the duration of high levels of prepayments continued, the Company's cash flows from returns of investment principal and interest and dividend earnings have also been severely impaired and sufficient only to reduce the Company's borrowings (including margin calls), pay operating expenses and fund dividend distributions to stockholders during the second half of 1992 and all of 1993. As such, no new investments have been added to the Company's portfolio since May 1992, and there can be no assurance that new investments will be added during the 1994 calendar year. As a result, the Company's investment strategy has been modified and the Company is investigating other business alternatives to the business currently conducted by the Company. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations") (C) Narrative Description of Business. 1. Management of Operations. The Company's investment policy is controlled by its Board of Directors (the "Board of Directors"). The By-laws of the Company provide that, except in the case of a vacancy, a majority of the members of the Board of Directors and of any committee of the Board of Directors must not be employed by, or otherwise affiliated with, the Company or its former manager. Until April 1, 1992, the Company's day to day activities were managed by NVR Mortgage Management Partnership (the "Former Manager") pursuant to a management agreement (the "Management Agreement") with the Company. The Management Agreement expired on March 31, 1992, and the Board of Directors determined that the Company would thereafter operate on a self- managed basis. The Company and the Former Manager reached an agreement whereby the employees of the Former Manager's affiliate who devoted a substantial amount of time on behalf of the Former Manager to the operation of the Company became employees of the Company. (See "Management Agreement and Fees") 2. Operating Policies and Strategies. The Company has historically generated revenues primarily from investments in mortgage derivative securities ("Mortgage Derivative Securities"). The Company's investments in Mortgage Derivative Securities currently consist of (i) a class or classes of collateralized mortgage obligations ("CMOs") (as defined below) that either represents a regular class of bonds or a residual class of bonds or (ii) interests in a class or classes of mortgage-backed pass-through certificates that either represent a regular class of certificates or a residual class of certificates. These securities entitle the Company to receive a portion of the cash flow from the Mortgage Collateral (as defined below) underlying the CMOs or mortgage-backed pass-through certificates. For federal income tax purposes, a majority of the Company's Mortgage Derivative Securities represent interests in real estate mortgage investment conduits ("REMICs"). A CMO is a security issued in one or more classes ("CMO Classes") collateralized by a specific group of mortgage loans or mortgage certificates guaranteed by GNMA, FNMA or FHLMC (collectively, the "Mortgage Certificates" and together with the mortgage loans, the "Mortgage Collateral") and evidences the right of the investors to cash flows from the assets underlying such CMO. The Company also generates revenues from Mortgage Related Investments (as defined below) and has purchased for its portfolio shares of common stock of companies engaged in businesses similar to the Company's. The Company may also generate revenues from other real estate and mortgage related investments approved by its Board of Directors. In addition, or as an alternative, to the investment strategies described above, the Company, with the approval of a majority of the Unaffiliated Directors, may adopt investment strategies which, among other things, could involve the acquisition of non-real estate related assets. Such strategies, if adopted, could result in the Company being unable to qualify as a REIT under the Code. The failure to qualify as a REIT could have severe adverse tax consequences for the Company. (See "Federal Income Taxation of the Company and Stockholders") However, the adverse tax consequences may be substantially mitigated by the Company's net operating losses. In addition, the Company may purchase or otherwise reacquire, shares of its Common Stock, par value $.01 per share ("Common Stock"), if, in the opinion of the Board of Directors, such purchases can be made upon favorable terms that can be expected to result in an increase in distributions to the remaining stockholders without adversely affecting the ability of the Company to maintain its qualification as a REIT under the Code. Pursuant to a Stock Repurchase Program adopted on March 21, 1990, the Company was authorized to repurchase up to 500,000 shares of its Common Stock over a twelve-month period at market prices. The Company repurchased 209,400 shares of its Common Stock through March 20, 1992, at prices ranging from $6.75 to $7.63 per share of Common Stock, or a weighted average price per share of $7.20. In September 1992, the Company adopted a new stock Repurchase Program which authorized the repurchase of up to 500,000 additional shares of its Common Stock during the period September 1992 to September 1993. No shares were repurchased under such authoriza- tion, and the Company does not currently anticipate that it will purchase any shares of Common Stock during calendar 1994. The Company has utilized borrowings to purchase certain of the investments described above and contemplates the use of borrowings to purchase future investments. Borrowings may be used to increase income available for distribution to stockholders. There can be no assurance, however, that the Company will be able to effect such borrowings in the future or, if so effected, that the cost of such borrowings will be less than the net cash flow on the investments acquired with the proceeds of such borrowings. Also, the Company has reduced its available bank line of credit to $250,000 from $5,000,000. The amount of borrowings by the Company was approximately 62% of stockholders' equity as of December 31, 1993. (See "Capital Resources") 3. Types of Investments. (a) Mortgage Related Investments. In its first fifteen months of operations, the Company's primary vehicle for the generation of income had been its mortgage related investments, wherein the Company purchased from issuers of CMOs the right to receive the cash flow of the CMO after debt service payments on the CMO are made ("Mortgage Related Investments"). Some were purchased from affiliates of the Former Manager and others in secondary market transactions. The Company, through RMI I or RMI II, purchased from an issuer of CMOs the Mortgage Collateral and other collateral securing a CMO subject to the lien of the indenture pursuant to which such CMO was issued. The Company used this arrangement to purchase certain Mortgage Collateral from Ryan Mortgage Acceptance Corporation IV ("RYMAC IV") and from Ryland Mortgage Securities Corporation ("Ryland Mortgage"). (See "Investment Portfolio") (b) Mortgage Derivative Securities. Although Mortgage Related Investments still constitute a portion of the Company's portfolio, the Company's more recent investments consist of Mortgage Derivative Securities such as IOs, Inverse IOs, PAC and TAC IOs, POs, IOettes, Floating Rate and Inverse Floating Rate Bonds, Z Bonds, MBSs, and Residual Bonds, as defined below. 1) An IO is an interest only class. An IO entitles the holder to receive the interest portion of the cashflow from the underlying mortgage- backed security. These securities are bearish in nature and thus show improved performance as prepayment speeds slow and interest rates rise. 2) An Inverse IO is created by dividing a fixed rate bond class into floating and inverse floating rate components based upon a market interest rate index, such that, at any time the sum of the interest payments to the two classes is no greater than the coupon on the fixed rate bond. As the index rises, more interest is required in the floating rate component and therefore less is available to the inverse floating rate holder. In a rising interest rate environment, the lower coupon payments due the Inverse IO holder are to some degree offset by the IO structure of the security. With rising rates, slower prepayments will enable the Inverse IO holder to recognize a decreased coupon on an outstanding balance for a longer period. An Inverse IO does not guarantee the par face of the bond, unlike an Inverse Floating Rate Bond (see 7 below), and is usually sold with nominal principal face amount but at a premium. 3) A PAC (Planned Amortization Class) IO is an IO with a fixed coupon calculated on a nominal principal balance that is protected within a band of prepayment rates. This prepayment band offers more average life assurance than a pure IO strip. A TAC (Targeted Amortization Class) IO is similar to a PAC IO except that the band of prepayment rates is much narrower. This narrower band makes the average life of a TAC IO more sensitive to prepayment speeds than a PAC IO. 4) A PO is a principal only class. A PO entitles the holder to receive the principal portion of the underlying mortgage-backed security. These securities are sold at a discount to face and benefit when interest rates fall and prepayment rates rise. 5) An IOette represents an interest only strip from a portion of the interest component of an underlying mortgage backed security. This security is bearish in nature as it shows improved performance as prepayments slow (interest rates rise). 6) A Floating Rate Bond is a CMO bond on which the interest rate paid to bondholders fluctuates with changes in an interest rate index, such as the London Interbank Offered Rate ("LIBOR"), and is usually reset monthly. 7) An Inverse Floating Rate Bond contains a coupon that fluctuates inversely with changes in a floating rate index such as LIBOR. As the index decreases, the formula used to set the coupon on this bond results in an increased yield. Typically, this type of Mortgage Derivative Security is purchased at or near the face amount of the bond. Although the face amount of principal will always be returned, it may be faster than expected due to an increase in prepayment speeds usually associated with lower interest rates. 8) A Z, or accrual, bond is a bond class that does not receive payments of interest until certain other classes of bonds are retired. Until the Z bond begins receiving interest payments, the amount of interest due is accrued, or added, to the principal amount of the bond. 9) An MBS, or Mortgage Backed Security, is a security backed by an undivided interest in a pool of mortgages or deeds of trust. The cash flow from the mortgages or deeds of trust is used to pay principal of, and interest on, the securities. The most commonly recognized MBSs are issued through the following three governmental entities: GNMA; FNMA; and FHLMC. 10) Residual Bonds, in general, entitle the holder to receive all or a portion of the residual cash flow from an underlying CMO after payment of principal and interest on all other bond classes and other expenses related to administration of the CMO. 4. Investment Portfolio. During the year ended December 31, 1993, the Company purchased no additional investments. (See "Current Business Environment" above, and "Management's Discussion and Analysis of Financial Condition and Results of Operations") The information presented below with respect to each of the Mortgage Derivative Securities and Mortgage Related Investments held by the Company at December 31, 1993, was provided to the Company either by the issuer of the related CMO or obtained from the Bloomberg Financial System. The Company did not participate in the issuance of such CMOs and is relying on the respective CMO Issuers and Bloomberg regarding the accuracy of the information provided. The Company believes, however, that such information is accurate. In reading the information presented below, only information regarding CMO classes whose structure and balance affect the performance of the Company's investment in the related Mortgage Derivative Security or Mortgage Related Investment is shown. For investments where no information is shown for other CMO classes, the performance of the Company's investment relates solely to prepayment speeds on the underlying Mortgage Collateral. 5. Cash Flow from Investments. The Company's return on its investments has been substantially affected by a number of factors, including short-term interest rates to the extent that such rates affect certain of its investments, and the rates of prepayment of the underlying Mortgage Collateral. The rate at which principal payments occur on pools of single-family loans is influenced by a variety of economic, geographic, social and other factors. In general, however, mortgage loans are likely to be subject to higher prepayment rates if prevailing interest rates are significantly below the interest rates on the mortgage loans, as was the case during recent prior periods. Conversely, in the event that interest rates during 1994 are above the interest rate on the mortgage loans, the rate of prepayment would be expected to decrease. Other factors affecting the rate of prepayment of mortgage loans include changes in mortgagor's housing needs, job transfers, unemployment, mortgagors' net equity in the mortgaged properties, assumability of mortgage loans, servicing decisions and the cost of refinancing. The Company's Mortgage Derivative Securities each have different characteristics, thus the cash flows from any particular mortgage derivative security will vary based upon the structure of the particular Mortgage Derivative Security (see 3(b) above), the level of interest rates on mortgage loans and mortgage prepayment levels. However, the Company's portfolio of Mortgage Derivative Securities has been materially adversely affected because of such levels. The Company's cash flow from its Mortgage Related Investments is derived from three principal sources: (a) any positive difference between the interest rates of the Mortgage Collateral and the weighted average interest rates of the related CMO Classes; (b) any amounts available from prepayments on the Mortgage Collateral that are not necessary for debt service payments on such CMOs; and (c) any reinvestment income in excess of amounts required to ensure timely payments of principal and interest on such CMOs. The positive difference between rates on the Mortgage Collateral and the weighted average rates on the related CMO Classes has been negatively affected by the rapid levels of mortgage prepayments in recent periods. Rapid prepayments result in 1) a reduction of the positive difference available to the Company and 2) a shortened duration of such positive difference. Also, lower interest rates in recent periods result in reduced reinvestment rates. Excess cash flow from a particular investment will decline over time and eventually terminate. 6. Other Potential Investments. The Company's Board of Directors has adopted Investment Guidelines ("Guidelines") to provide general parameters for the Company's investments and borrowings pursuant to which the Company may make investments without case by case approval by the Board of Directors. The Guidelines list certain investments which the Company is permitted to make. Pursuant to the Guidelines, the Company may purchase Mortgage Collateral which the Company may hold or pledge to secure a CMO or to back other mortgage related securities. The Company may also acquire shares of equity securities of other CMO residual REITs. However, due to the performance of the Company's investment portfolio and the current business environment for Mortgage Related Investments in general, the Company made no additional investments during 1993. Pursuant to the investment criteria set forth in the Guidelines, the Company may, for a fee, issue commitments to sellers of Mortgage Collateral. The Company may purchase mortgage loans (i) that are eligible for securitization and guaranty by GNMA, FNMA or FHLMC or (ii) that are not eligible for such securitization and guaranty. The Company may also purchase Mortgage Collateral that could subsequently be used to secure various CMOs issued by one or more CMO Issuers, and may participate in the issuance of CMOs by forming, acquiring or entering into arrangements with CMO Issuers. The Company has not engaged in any of such activities to date. 7. Capital Resources. Prior to April 1993, the Company maintained a line of credit with a commercial bank for $5,000,000 with an expiration of March 31, 1993. During the process of documenting the line of credit renewal, the Company determined that the collateral pledged to the bank under the line of credit had substantially greater borrowing value to the Company in other financing arrangements, particularly repurchase agreements, than the value provided under the bank line of credit. Accordingly, the Company and the bank agreed to the release of the majority of the collateral pledged thereunder and the maintenance of a reduced line of credit of $250,000 with an expiration date of April 30, 1994, which availability is subject to periodic valuations of the remaining collateral. Amounts borrowed under this agreement bear interest at a rate of the prime rate plus 1.0%, and are collateralized by the pledge of the Company's ownership interests in the RYMAC IV Bonds and the Ryland Mortgage Securities Corporation Series 89-6 Bonds. The availability under the line is limited to the value of collateral pledged to the bank. At December 31, 1993, no amount was outstanding and at December 31, 1992, $575,000 was borrowed under the line bearing interest at 6.5%. The Company has supplemented its funds available for investment through repurchase agreements. The repurchase agreements entered into by the Company involve the transfer by the Company of certain of its assets to a financial institution in exchange for cash in an amount that is less than the fair market value of such assets. At the same time, the Company agrees to repurchase such assets at a future date at a price equal to the cash paid by such financial institution plus interest thereon. The extraordinarily high level of mortgage prepayments in recent periods has caused dealers to reduce substantially the financing value of investments pledged under repurchase agreements. Under such circumstances, the Company is required to reduce the amount of outstanding borrowings by cash payments under the repurchase agreement or the delivery of other unencumbered investments, thus reducing the Company's ability to purchase new investments, as has been the case since June 1992. (See "Management's Discussion and Analysis - Liquidity and Capital Resources") As of December 31, 1993 the Company had amounts outstanding under twelve repurchase agreements aggregating approximately $3,814,000 and as of March 24, 1994 approximately $3,636,000. As of December 31, 1993 and March 24, 1994, the Company has pledged substantially all of its Mortgage Derivative Securities to secure its obligations under such repurchase agreements. The Company's By-laws provide that it may not incur additional indebtedness if, after giving effect to such indebtedness, its aggregate indebtedness (other than liabilities incurred in connection with participation in the issuance of CMOs and any loans between the Company and its corporate subsidiaries), secured and unsecured, would exceed 300% of the Company's average invested assets, in each case on a consolidated basis, as calculated at the end of each calendar quarter in accordance with generally accepted accounting principles, unless such additional indebtedness is approved by a majority of the Unaffiliated Directors. The Company is currently operating under a borrowing limitation pursuant to a policy adopted by its Board of Directors that limits total borrowings to $25,000,000, an amount substantially in excess of the amount the Company would be able to borrow under the current operating condition of the Company. As of December 31, 1993 and March 24, 1994, the Company's indebtedness aggregated approximately 62% and 59%, respectively, of stockholders' equity. The Company has authorized 50,000,000 shares of Common Stock. Although Management believes that raising additional equity capital would be in the long-term best interests of the Company, the Company's present financial condition makes the prospect of raising such equity capital unlikely. In addition, the Company's Articles of Incorporation permit the Board of Directors to authorize and issue from time to time additional classes of stock without the necessity of further approval by the stockholders and with such rights and preferences as the Board of Directors of the Company may designate by resolution. Depending upon the terms set by the Board of Directors, the authorization and issuance of preferred stock or other new classes of stock could adversely affect existing stockholders. The effects on stockholders could include, for example, dilution of existing stockholders, restriction on dividends on Common Stock, restrictions on dividends for other corporate purposes and preferences to holders of a new class of stock in the distribution of assets upon liquidation. Since the filing of the Articles of Incorporation, the Board of Directors has neither authorized nor issued any additional classes of stock. 8. Investment Restrictions. Restrictions on investments by the Company in certain types of assets are imposed by the provisions of the Investment Company Act of 1940, as amended (the "Investment Company Act"). The Company believes that its current investment activities do not bring it within the definition of an investment company under the Investment Company Act because it is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The Investment Company Act specifically excepts entities primarily engaged in such activities from the definition of an investment company (the "Real Estate Exception"). Under interpretations issued by the staff of the Securities and Exchange Commission, in order to qualify for the Real Estate Exception, the Company must maintain at least 55% of its assets in mortgage loans or certain other interests in real estate. The ability of the Company to acquire Mortgage Derivative Securities may be limited by the Investment Company Act depending, among other things, upon whether the Company acquires all or only a portion of the residual interest in a CMO, the nature of the collateral underlying such CMO and the composition of the balance of the Company's assets at the time of each such acquisition. Under interpretations of the staff of the Commission, investments in mortgage-backed or other mortgage related securities (including mortgage certificates) that are securities considered to be separate from the underlying mortgage loans are not considered to be investments in mortgage loans for purposes of the 55% test unless such securities represent all the certificates issued with respect to the underlying pool of mortgages. The Company's investment policies prohibit it from making any investments that would cause the Company to be an investment company within the meaning of the Investment Company Act. The Company intends to monitor continually its operations in order to evaluate the qualification of the Company for the Real Estate Exception. Uncertainties exist as to the interpretation of the exception from the definition of an investment company under the Investment Company Act for companies primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The Company believes that, based upon its current and proposed method of operation, it falls within such exception. In connection with the review by the Commission of the registration statement for the Company's initial public offering, the Company has been advised, based on a preliminary review, that the staff of the Division of Investment Management of the Commission, while not taking a definitive position, is not in agreement with the Company's conclusion. If the Company were required to register as an investment company or to revise materially its contemplated method of operation to qualify for an exemption, it would be subject to additional limitations and restrictions on its activities. The Company is prohibited from purchasing real estate contracts of sale. The Company also may not invest in unimproved real property or mortgage loans on unimproved real property, nor may it underwrite securities of other issuers. The foregoing restrictions may not be changed without the approval of a majority of the Unaffiliated Directors. The Company may purchase or otherwise reacquire shares of its Common Stock if, in the opinion of the Board of Directors, the purchases can be made upon favorable terms that can be expected to result in an increase in distributions to the remaining stockholders. However, the Company may not make such purchases if to do so would adversely affect the ability of the Company to maintain its qualification as a REIT under the Code. (See "Federal Income Taxation of the Company and Stockholders") The operating policies and strategies of the Company are governed by the Board of Directors, which has the power to modify or alter such policies without the consent of the stockholders. Although the Company has no present intention to seek modification of its operating policies described herein, the Board of Directors may conclude that it would be advantageous for the Company to do so and may modify such operating policies accordingly. 9. Management Agreement and Fees. The Company's Management Agreement with its Former Manager expired on March 31, 1992. The Board of Directors determined that the Company would operate on a self-managed basis and, consequently, it did not enter into a new management agreement with its Former Manager. At the expiration of the Management Agreement, the Company and its Former Manager reached an agreement pursuant to which, among other things, the employees of the Former Manager's affiliate that had devoted a substantial amount of time on behalf of the Former Manager to the operation of the Company became employees of the Company. In consideration therefor, the Company agreed, among other things, to make payments to its Former Manager for each of the Company's fiscal quarters for the period April 1, 1992 through March 31, 1994, in an amount equal to 50% of the amount by which the fee that would have been paid to the Former Manager under the Management Agreement for each such quarter (based on the assets of the Company as of March 31, 1992) exceeds the audited pre-tax deductible expenses of the Company for such quarter (exclusive of certain expenses relating to any offerings by the Company of its securities). For the period April 1, 1992 through June 29, 1993, no amounts were due the Former Manager. Since both the Company and its Former Manager anticipated that for the remaining term of the agreement (ending March 31, 1994) no amounts would be owing the Former Manager, the Company and its Former Manager terminated their agreement on June 29, 1993. As such, the Company is no longer responsible for any future payments to its Former Manager. On a self-managed basis, the Company is responsible for all expenses, including resources previously provided by the Former Manager. 10. Dividend Reinvestment Plan. On December 13, 1988, the Company adopted an Automatic Dividend Reinvestment Plan (the "Plan"). The Plan is administered by American Stock Transfer & Trust Company. The Plan provides to the Company's security holders a method of investing cash dividends paid by the Company in new shares of the Company's common stock. The Plan also permits participants to make optional cash investments in additional shares of the Company's common stock. 11. Federal Income Taxation of the Company and Stockholders. THE PROVISIONS OF THE CODE ARE HIGHLY TECHNICAL AND COMPLEX. THIS SUMMARY IS NOT INTENDED AS A DETAILED DISCUSSION OF ALL APPLICABLE PROVISIONS OF THE CODE, THE RULES AND REGULATIONS PROMULGATED THEREUNDER, OR THE ADMINISTRATIVE AND JUDICIAL INTERPRETATIONS THEREOF. THE COMPANY HAS NOT OBTAINED A RULING FROM THE INTERNAL REVENUE SERVICE WITH RESPECT TO ANY TAX CONSIDERATIONS RELEVANT TO ITS ORGANIZATION OR OPERATION, OR TO AN INVESTMENT IN ITS SECURITIES. THIS SUMMARY IS NOT INTENDED TO SUBSTITUTE FOR PRUDENT TAX PLANNING, AND EACH STOCKHOLDER OF THE COMPANY IS URGED TO CONSULT ITS OWN TAX ADVISER WITH RESPECT TO THESE AND OTHER FEDERAL, STATE AND LOCAL TAX CONSEQUENCES OF THE PURCHASE, OWNERSHIP AND DISPOSITION OF SHARES OF THE COMMON STOCK OF THE COMPANY AND ANY CHANGES IN APPLICABLE LAW. General The Company operates in a manner that permits it to qualify as a REIT under the Code. As a REIT, the Company itself generally will be subject to federal income tax only on the amount of its taxable income, subject to certain modifications ("REIT Taxable Income"), that it does not distribute in the taxable year in which it is earned. In addition, the Company will be subject to a 4% excise tax to the extent it fails to satisfy certain calendar year distribution requirements. The Company expects that, with limited exceptions, it will not be subject to federal income tax at the corporate level or to federal excise tax. The Company would be subject to tax (including any applicable minimum tax) on its taxable income at regular corporate rates without any deduction for distributions to stockholders if it failed to qualify as a REIT in any taxable year. Unless entitled to relief under specific statutory provisions, the Company also would be disqualified from treatment as a REIT for the following four taxable years. The failure to qualify as a REIT for even one year could result in the Company incurring substantial indebtedness in order to pay any resulting taxes, thus reducing the amount of cash available for distribution to stockholders. For purposes of the special REIT taxation rules and the REIT qualification requirements set forth below, the assets, liabilities, income and deductions of any subsidiary, all of whose stock has been owned by the Company during the subsidiary's entire existence ("Qualified REIT Subsidiary"), will be treated as assets, liabilities, income and deductions of the Company. REIT Qualification Requirements In order to qualify as a REIT, the Company must satisfy various requirements with respect to (i) the nature of its assets ("Asset Requirements") and income ("Income Requirements"), (ii) certain organizational matters ("Organizational Requirements") and (iii) the amount of distributions to stockholders ("Distribution Requirements"). Under the Asset Requirements, at the close of each quarter during the taxable year (a) at least 75% of the assets of the Company, by value, must consist of specified real estate assets, cash or U. S. government securities and (b) as to its other assets other than securities of a Qualified REIT Subsidiary, the Company cannot own (1) securities of any one issuer which represent more than 5% of the total value of the Company's assets or (2) more than 10% of the outstanding voting securities of any one issuer. The Income Requirements provide that at least 75% of the Company's gross income must be derived from specified real estate related sources, including interest on mortgage obligations, income from REMIC interests, and gains from the sale of such obligations and interests not held primarily for sale to customers in the ordinary course of business ("Dealer Property"). Additionally, at least 95% of the Company's gross income must consist of income derived from items that qualify for the 75% income test plus other specified types of passive income, such as interest, dividends and gains from the sale or other disposition of stock and securities other than Dealer Property. If the Company fails to satisfy either of the foregoing 75% and 95% Income Requirements but (a) the Company otherwise satisfies the requirements for qualification as a REIT, (b) such failure is due to reasonable cause and not willful neglect and (c) certain other requirements are met, then the Company will continue to qualify as a REIT but will be subject to a 100% tax on the greater of the amount by which it fails to satisfy either of such tests reduced by expenses incurred in earning that amount. The Income Requirements also require that less than 30% of the Company's gross income be derived from the sale or other disposition of (a) stock or securities held for less than one year, (b) certain Dealer Property and (c) most real property (including mortgage obligations and REMIC interests) held for less than four years. In addition, the Code also generally imposes a 100% tax on gains (less associated expenses) derived from sales of Dealer Property (without an offset for any losses). The Distribution Requirements require that the Company distribute annually at least 95% of its REIT Taxable Income (and 95% of certain other income related to foreclosure property), excluding any net capital gain, to its stockholders. For this purpose, certain dividends paid by the Company after the close of a taxable year may be considered as having been paid during such taxable year, although they would be taxed to the stockholders in the year in which they were actually paid. Such dividends will also be treated as paid during the taxable year for purposes of determining whether the Company has undistributed REIT Taxable Income subject to income tax at the corporate level for the taxable year. For purposes of the 4% excise tax (described above), however, such dividends would not be treated as having been distributed in the taxable year. In addition, dividends declared in October, November or December of a calendar year, payable to stockholders of record as of a date in such a month, and actually paid during January of the following year will be considered as paid on December 31 of such calendar year for excise tax purposes as well as for other purposes under the REIT rules. Such dividends, however, will also be treated as having been paid on that December 31 for purposes of determining a stockholder's gross income. Due to the nature of the Company's income from its assets and its deductions in respect of its obligations, under certain circumstances, the Company may generate REIT Taxable Income in excess of its cash flow. For example, the maturity and pass- through rates of the Mortgage Collateral pledged to secure the CMO issuances in which the Company holds an investment are not likely to match the maturity and interest rates of the CMOs secured thereby. Similarly, the Company may recognize taxable market discount income with respect to its receipts from the sale, retirement or other disposition of the portion of the Mortgage Collateral that constitutes market discount bonds (i.e., obligations with a stated redemption price at maturity greater than the Company's tax basis therein), whereas these receipts frequently will be used to make nondeductible principal payments on CMOs. In addition, certain CMOs may be issued with original issue discount, the tax treatment of which may result in taxable income in excess of cash flow. Accordingly, the Company may be required to distribute a portion of its working capital to its stockholders or borrow funds to make required distributions in years in which the gross income of the Company on a tax basis (including "non-cash" income) exceeds its deductible expenses. In the event that the Company is unable to pay dividends equal to substantially all of its REIT Taxable Income, it may incur income tax or excise tax or may not be able to qualify as a REIT. Dividends paid for a fiscal year in excess of the Company's earnings and profits, as computed for federal income tax purposes, are reported as a return of capital to the Company's stockholders. Some of the Company's investments constitute REMIC residual interests. Certain of these residual interests produce "excess inclusion" income (see "Excess Inclusion Income" below) during the fiscal year. The Code requires that excess inclusion income be included in a taxpayer's income even though the taxpayer has losses that would otherwise offset such income. As a result, the Company could have taxable income from excess inclusions in a taxable year even though it has losses from other investments that would normally be sufficient to offset the amount of such excess inclusion income. The Company is required to distribute the taxable income representing excess inclusions to meet its 95% distribution requirement and to avoid a corporate level tax on such income. When such income is distributed to a stockholder, the stockholder will have taxable income, rather than a return of capital, equal to its share of such excess inclusion income during the fiscal year. For fiscal 1993, the Company reported that all its distributions paid in 1993, even though it experienced both a net loss and a tax loss for 1993, represented excess inclusion income. For a stockholder, excess inclusion income cannot be offset by losses, except in the case of certain excess inclusion income for certain savings and loan associations and their "qualified" subsidiaries. The most significant Organizational Requirement is that the stock of the Company must be widely held. This requires that the stock of the Company be held by a minimum of 100 persons for at least 335 days in each taxable year and that no more than 50% in value of the stock be owned, actually or constructively, by five or fewer individuals at any time during the second half of each taxable year. For this purpose, some pension funds and certain other tax-exempt entities are treated as individuals. To evidence compliance with these requirements, the Company is required to maintain records that disclose the actual ownership of its outstanding shares of Common Stock. In fulfilling its obligations to maintain records, the Company must demand written statements each year from the record holders of designated percentages of its shares of Common Stock which would, among other things, disclose the actual owners of such shares. Excess Inclusion Income All of the cash dividends distributed to the Company's stockholders in 1993 were comprised of "excess inclusion" income. Excess inclusion income is attributable to CMO issuances for which an election has been made to be treated as a REMIC for federal income tax purposes. The portion of the Company's dividends determined to be excess inclusion income is taxable to certain otherwise tax-exempt stockholders as unrelated business income. In addition, generally, excess inclusion income may not be offset by any deductions or losses, including net operating losses. 12. Restrictions on Transfer and Redemption of Shares. Two of the requirements for qualification as a REIT under the Code are that (i) during the last half of each taxable year not more than 50% of the outstanding shares may be owned directly or indirectly by five or fewer individuals and (ii) there must be at least 100 stockholders for at least 335 days in each taxable year. Those requirements apply for all taxable years after the year in which the REIT elects REIT status. In order that the Company may meet these requirements at all times, the Company's Articles of Incorporation prohibit any person or group of persons from acquiring or holding, directly or indirectly, ownership of a number of shares of Common Stock in excess of 9.8% of the outstanding shares. Shares of Common Stock owned by a person or group of persons in excess of such amounts are referred to in the Articles of Incorporation and herein as "Excess Shares". The Articles of Incorporation also provide that in the event any person acquires Excess Shares, such Excess Shares may be redeemed by the Company, at the discretion of the Board of Directors. Under the Company's Articles of Incorporation, any acquisition of shares of the Company that would result in the disqualification of the Company as a REIT under the Code is void to the fullest extent permitted by law, and the Board of Directors is authorized to refuse to recognize a transfer of shares to a person if, as a result of the transfer, that person would own Excess Shares. Additional provisions regarding restrictions on transfers and redemptions of the Company's shares are set forth in the Company's Articles of Incorporation which were filed as Exhibit 3.1 to Amendment No. 1 to the Company's Registration Statement No. 33- 22891 on Form S-11. The Articles of Incorporation also contain provisions intended to minimize the potential adverse effect on the Company of a Code provision that would impose a tax on REITs (and other pass- through entities) that hold REMIC interests if at any time during the taxable year a Disqualified Organization (as defined below) is a record holder of an interest in such entity. A "Disqualified Organization" means the United States, any state or political subdivision thereof, any foreign government, any international organization or instrumentality of the foregoing, any tax-exempt entity, other than a farmer's cooperative, not subject to the unrelated business income tax and any rural electric or telephone cooperative. If a Disqualified Organization were a stockholder of record of the Company during a year in which the Company held a REMIC interest, a tax might be imposed on the Company. The amount of tax would be equal to the product of the highest marginal corporate tax rate and the amount of REMIC excess inclusions for the taxable year allocable to the interest in the Company held by the Disqualified Organization. Accordingly, the Articles of Incorporation provide that any acquisition of shares of the Company that could or would result in the direct or indirect imposition of a penalty tax on the Company (including the tax described above) (a "Prohibited Transfer") will be void ab initio to the fullest extent permitted by applicable law, and the intended transferee of any shares that are the subject of a Prohibited Transfer may be deemed never to have had an interest therein. If the foregoing provision is determined to be void or invalid, the transferee shall be deemed, at the option of the Company, to have acted as agent of the Company in acquiring those shares and to hold those shares on behalf of the Company. In addition, any shares of the Company that are the subject of a proposed, attempted or actual Prohibited Transfer may be redeemed by the Company at the discretion of the Board of Directors. Any such redemption will be effected as provided in the preceding paragraphs with respect to Excess Shares. Furthermore, whenever it is deemed by the Board of Directors to be prudent in order to avoid a Prohibited Transfer, the Board of Directors may require a holder or proposed transferee of shares to file a statement or affidavit with the Company, stating that the holder or proposed transferee is not a Disqualified Organization; and any contract for the sale or other transfer of shares of the Company will be subject to this provision. Moreover, the Board of Directors may, in its discretion, refuse to transfer shares on the books of the Company if (i) a statement or affidavit described in the preceding sentence has not been received or (ii) the proposed transferee is a Disqualified Organization. 13. Competition. In purchasing Mortgage Derivative Securities and Mortgage Collateral, the Company competes with investment banking firms, savings and loan associations, banks, mortgage bankers, insurance companies and other lenders, other REITs, GNMA, FNMA and FHLMC and other entities, many of which have greater financial resources than the Company. As a REIT, the Company's business activities are limited by the provisions of the Code that require a REIT to meet certain tests to maintain its qualification as a REIT. Many of the Company's competitors operate through entities that may have more flexibility than the Company in conducting their business operations. 14. Employees. The Company employs four full-time employees as of March 24, 1994, and utilizes the services of consultants, as necessary. Item 2. Item 2. Properties. The Company does not own real estate or physical property. The executive offices of the Company are located in leased space at 500 Market Street, Suite 600, Steubenville, Ohio 43952 and consist of approximately 2,800 square feet. The lease covering such space can be terminated upon 60 days notice to the lessor. Item 3. Item 3. Legal Proceedings. As of December 31, 1993, there were no legal proceedings pending or threatened to which the Company or its subsidiaries were a party or to which any of their respective property was subject. 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 fourth quarter of 1993. 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 American Stock Exchange under the symbol "RM". The table below sets forth the high and low sale prices of the Company's Common Stock for each full quarterly period within the two most recent fiscal years for which such stock was traded, as reported on the American Stock Exchange Composite Tape, and certain dividend information with respect to such shares. In order to qualify as a REIT under the Code, the Company, among other things, must distribute as dividends to its stockholders an amount at least equal to (i) 95% of its REIT Taxable Income (determined before the deduction for dividends paid and excluding any net capital gain and any net income from the sale or other disposition of property held primarily for sale) plus (ii) 95% of the excess of its net income from foreclosure property over the tax imposed on such income by the Code less (iii) any excess noncash income (as determined under the Code). The actual amount and timing of dividend payments, however, is at the discretion of the Board of Directors and depends upon the financial condition of the Company in addition to the requirements of the Code. The Company's Common Stock was held by 632 stockholders of record on March 24, 1994. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations INVESTMENT PHILOSOPHY AND INVESTMENT ACTIVITIES The Company's portfolio of investments is sensitive to changes in interest rates and mortgage prepayments. The lowest interest rate levels in 20 years, beginning in early 1992 and continuing now for over two years, have resulted in unprecedented mortgage refinancings and therefore accelerated mortgage prepayments. As a result of these prepayments, earnings and cash flow from the Company's current investments have been, and continue to be, adversely impacted. For a substantial number of individual assets, earnings and cash flows have been permanently impaired and will not recover if interest rates return to higher, historical levels. In addition, the Company has been unable to sell any substantial portion of its portfolio of investments at acceptable prices, thus limiting acquisition of replacement or additional investments. During the period from the Company's inception in 1988 through early 1992, mortgage interest rate levels and prepayment speeds remained within levels existent from 1970 to early 1992. Historically, cash received from the Company's portfolio of mortgage related investments and mortgage derivative securities (collectively, "Investments") represented interest and dividend earnings and the return of investment principal (basis) and were used to 1) pay operating expenses and 2) make dividend distributions to stockholders. Cash flow amounts representing returns of principal on investments were used to 1) repay Company borrowings, including margin calls on repurchase agreements and 2) make suitable new investments for the Company's portfolio. However, since June of 1992, mortgage rates have been at levels lower than those existent for the prior twenty years, resulting in extraordinarily rapid and sustained levels of residential mortgage prepayments. As a direct result, the Company's Investments have generated reduced interest and dividend earnings and as the duration of high levels of prepayments continued, the Company's cash flows from returns of investment principal and interest and dividend earnings have also been severely impaired and sufficient only to reduce the Company's borrowings (including margin calls), pay operating expenses and fund dividend distributions to stockholders during the second half of 1992 and all of 1993. As such, no new investments have been added to the Company's portfolio since May 1992. The current prolonged period of rapid prepayments, which is anticipated to continue at least through a portion of 1994, results in 1) reduced cash flows because of the substantially diminished size of the mortgage pools underlying the Company's Investments and 2) declining market values of the Company's Investments which simultaneously reduces the financing value of these same assets. (See "Liquidity and Capital Resources") As a result, during the second half of 1992, all of 1993 and through the first several months of 1994, the Company has not purchased any new assets. In response to the Company's reduced current cash flows, the Company has been pursuing leveraged financings that either provide additional current cash flows or incremental cash flows to the Company but only at future dates. However, due to continued adverse market conditions and competing products with terms to investors more favorable than can be provided by the Company, to date leveraged financing negotiations have been unsuccessful. In addition, the Company continues to pursue other business activities that would not be sensitive to the risks of high levels of mortgage prepayments. The Company had purchased for its portfolio shares of TIS Mortgage Investment Company ("TIS"), a company engaged in a business similar to the Company's. Due to an impairment in the value of TIS, the Company elected to sell its 102,100 shares of TIS between September 15, 1993 and December 13, 1993 at an average net price of $1.804 per share versus its cost basis of $6.565 per share. FUTURE PROSPECTS If a leveraged financing providing incremental current cash flows to the Company cannot be completed within the quarterly period ending June 30, 1994, the Company intends to further reduce operating expenses while making selective new investments from its limited current cash flow. If the Company is unable to successfully institute the above mentioned plans, the Company's ability to re-establish an investment portfolio would be significantly impaired, causing the Company to evaluate actions that would include a merger or other business combination with another entity or an orderly liquidation of future excess cash receipts to stockholders. A continuation of prepayment speeds at or near current levels for more than approximately the next six months will further significantly reduce future cash flow availability. However, if prepayment speeds slow substantially within the same period, the amount of cash flow available from the current portfolio of investments would be stabilized. Although the Company's portfolio of investments continues to produce cash flows, the Company continues to incur tax losses that approximate $28 million for the two-year period ended December 31, 1993. Additionally, further tax losses from the current portfolio are likely in 1994 independent of the level of mortgage prepayments. Absent the existence of future excess inclusion income, future cash flows from the Company's current portfolio of investments will represent, to a large degree, return of investment principal (basis) to the Company and not taxable income required to be distributed as dividends to stockholders. This circumstance in conjunction with the tax loss carryforward of $28 million can be utilized to offset future taxable income generated from the contemplated investment activities (see "Investment Philosophy and Investment Activities") before the Company's earnings again become taxable and result in the requirement for dividend payments. Should the contemplated investment activities be successful, the Company would be in a tax position to use cash flows to rebuild the Company's investment portfolio prior to resuming taxable dividend payments. DIVIDEND POLICY In accordance with the Code, the Company is required to distribute at least 95% of its taxable income to its stockholders each year in order to maintain its status as a REIT. Dividends paid for a fiscal year in excess of the Company's taxable income are reported as a return of capital to the Company's stockholders, except as provided below. Some of the Company's investments constitute REMIC residual interests. Certain of these residual interests produce "excess inclusion" income during the fiscal year. The Code requires that excess inclusion income be included in a taxpayer's income even though the taxpayer has losses that would otherwise offset such income. As a result, the Company could have taxable income from excess inclusions in a taxable year even though it has losses from other investments that would normally be sufficient to offset the amount of such excess inclusion income. The Company is required to distribute the taxable income representing excess inclusions to meet its 95% distribution requirement and to avoid a corporate level tax on such income. When such income is distributed to a stockholder, the stockholder will have taxable income, rather than a return of capital, equal to its share of such excess inclusion income during the fiscal year. The Company reported for fiscal 1993 that all distributions paid in 1993 represent excess inclusion income. (See note 8 of Notes to Consolidated Financial Statements) For a stockholder, generally excess inclusion income cannot be offset by losses. The Company declared a dividend of $0.04 per share on December 17, 1993, payable on January 24, 1994 to stockholders of record at the close of business on December 31, 1993. Total dividends paid for fiscal 1993 totalled $0.04 per share, representing $0.04 per share of taxable earnings, all of which was excess inclusion income. Under the Code, a REIT must generally distribute its excess inclusion income to its stockholders even though it has losses or deductions. Accordingly, if the Company were to report future excess inclusion income, it would be required to distribute such excess inclusion income as dividends even though it has an estimated net operating loss carryforward in excess of $28 million. The net operating losses can be carried forward to offset ordinary income of the Company for fifteen years after such loss is recognized. RESULTS OF OPERATIONS 1993 TO 1992 COMPARISONS For both years ended December 31, 1993 and 1992, the Company's Balance Sheet and Statement of Revenues and Expenses reflect very substantial changes related to the unprecedented high level and extended duration of residential mortgage prepayments experienced during all of 1992 and 1993. These prepayments have resulted in the Company incurring significant losses during such periods. Statement of Revenues and Expenses For fiscal 1992 and 1993, the Company derived its income (loss) primarily from its investments in Mortgage Derivative Securities. The Company's portfolio contains several types of mortgage derivative securities. For each security that the Company purchases, it receives the right to certain designated cash flows from these securities. Due to the nature of these securities, income calculated in accordance with the Code ("Taxable Income") and income calculated in accordance with generally accepted accounting principles ("Net Income") are not always identical for any particular period, particularly when mortgage prepayment speeds are exceedingly rapid, as for 1992 and 1993, or exceedingly slow. The rapid prepayment environment of 1992 and 1993 is reflected in the substantial differences between Taxable Loss and Net Loss. Net Loss, as calculated in accordance with generally accepted accounting principles, and as presented in the accompanying consolidated financial statements, for the twelve months ended December 31, 1993, was $(25,624,000), or $(4.92) per share, as compared to $(1,868,000), or $(0.36) per share, for the twelve months ended December 31, 1992. Generally accepted accounting principles require the Company to periodically evaluate its Investments based upon current and expected future mortgage prepayment speeds and interest rates and, effective December 31, 1993, market discount rates, as well. (See note 2 to the Company's Consolidated Financial Statements) The record level of mortgage prepayments during 1992 and 1993 and market expectations of further mortgage prepayments at the end of 1993 caused the Company to revalue its Investments periodically during the year, resulting in additional valuation adjustments of $24,039,000 during 1993. Such adjustments are reflected as a reduction of interest revenues in the Company's Consolidated Statements of Revenues and Expenses. Adjustments for the year ended December 31, 1992 totalled $7,921,000. In addition, effective December 31, 1993, the Company elected to apply Financial Accounting Standard No. 115 ("FASB-115") that requires impaired investments to be carried at fair market value. Such application resulted in an additional adjustment of $1,530,000 which is reflected as a separate component on the Company's Consolidated Statements of Revenues and Expenses for 1993. The substantial increase in the Company's Net Loss from 1992 to 1993 of $23,756,000 is due to 1) substantially larger writedowns in value of Company Investments during 1993, 2) lower gains from the sale of assets in 1993 and 3) a general reduction in earnings on all of the Company's assets. Downward asset valuation adjustments in 1993 were $25,569,000, while such writedowns in 1992 were $7,921,000, an increase of $17,648,000. In 1992 the Company recorded gains on the sale of mortgage related investments and one mortgage derivative security for a total gain of $1,602,000 but in 1993 had net gains of only $352,000 related to the sale of two mortgage related investments for a gain of $838,000 and the sale of marketable equity securities (TIS) for a loss of $486,000. The difference in sales gains represents a decrease of $1,250,000 in Net Income between periods. For 1993 the Company's earning assets produced reduced levels of interest income in the amount of $5,855,000. These three decreases, when combined with expense reductions of $997,000 between 1992 and 1993, provide for a net increase in the Company's Net Loss of $23,756,000. The assumptions used to value assets at the end of each quarter take into consideration the actual mortgage prepayment speeds experienced for each asset through the end of the quarterly period, Management's evaluation of the market expectations of future prepayment speeds for the mortgages backing each asset, and effective December 31, 1993 the application of a market discount rate to future cash flows. If prepayment speeds were to continue at levels higher than market expectations, market expectations of future mortgage prepayment speeds increase beyond current anticipated levels, or the market discount rate applied was increased, further reductions in the value of the Company's Investments would be necessary. Interest revenue on Mortgage Related Investments decreased from $20,402,000 for the year ended December 31, 1992 to $9,205,000 for the year ended December 31, 1993, as a result of the substantial reduction in Mortgage Related Investments on the Company's Balance Sheet between December 31, 1992 and December 31, 1993 discussed below. Interest revenue on Mortgage Derivative Securities was $(815,000) for the year ended December 31, 1992 as compared to $(21,815,000) for the year ended December 31, 1993. The reduction in interest revenue on Mortgage Derivative Securities was attributable to a $23,270,000 writedown of this asset category for 1993 which is deducted from Mortgage Derivative Securities interest revenues. There was also a general reduction in interest earnings on that same asset category resulting from the high mortgage prepayments during the period in the amount of $5,310,000. Interest expense on Funding Notes and CMOs Payable decreased from $21,007,000 to $10,333,000 for the years ended 1992 and 1993, respectively, as a result of the offsetting balance sheet decline of Funding Notes and CMOs Payable discussed below. Operating expenses (includes "Interest on Notes Payable", "Management/ Settlement Fees" and "General and Administrative") decreased from $2,722,000 for 1992 to $1,703,000 for the comparable period in 1993. This decrease between periods of $1,019,000 was the result of reduced interest expense on Notes Payable of $668,000 as the Company repaid substantial amounts under repurchase agreements during 1993, a reduction in General and Administrative Expenses of $224,000 as the Company reduced costs in response to the deterioration of its investment portfolio, and the absence of management fees payable to its Former Manager in 1993. Balance Sheet The Company's assets declined during the twelve month period ended December 31, 1993 by $116,763,000, to a total of $81,097,000 at December 31, 1993. This decrease is attributable to the Company's Mortgage Related Investments declining during the twelve month period from $142,396,000 to $65,248,000, a decrease of $77,148,000. This reduction is primarily the result of 1) the calling, during January and September 1993, of two RYMAC IV Bond Series in order to take advantage of market premiums on the underlying Mortgage Collateral of each of these series (such calls reduced Mortgage Related Investments by approximately $16,917,000), 2) substantial prepayments on collateral underlying the Company's remaining Mortgage Related Investments and 3) to a much lesser extent, regularly scheduled principal payments on the underlying Mortgage Collateral. Such prepayments and scheduled principal payments further reduced Mortgage Related Investments by approximately $60,000,000. These asset reductions were matched by a corresponding decrease in the related liability accounts, Funding Notes Payable and CMOs Payable, from $149,215,000 to $69,934,000, or a decrease of $79,281,000, as returned principal on the underlying mortgages was used to retire outstanding obligations secured by such mortgages. Mortgage Derivative Securities decreased from $40,727,000 at December 31, 1992 to $7,161,000 at December 31, 1993, a decrease of $33,566,000, reflecting 1) the amortization and return of the cost basis of the assets held in this category of approximately $8,766,000 and 2) the writedown of carrying value of such securities which represents additional amortization in 1993 totalling $24,800,000. Funds held by trustee decreased from $3,922,000 at December 31, 1992 to $1,347,000 at December 31, 1993. This category of assets represents the receipt of monthly mortgage payments awaiting further payment (reduction) of Funding Notes and CMOs Payable at a future date. Marketable securities decreased from $332,000 at December 31, 1992 to $0 at December 31, 1993, reflecting the result of the sale of TIS during 1993. Notes Payable decreased from $14,833,000 (inclusive of $575,000 of bank line borrowings and $14,258,000 of repurchase agreements) at December 31, 1992 to $3,814,000 at December 31, 1993 consisting solely of repurchase agreements. Such $11,019,000 decrease in leverage was primarily the result of dealer margin calls under repurchase agreements. The Company declared dividends of $0.04 per share, or $208,000, for 1993 (payable in January 1994) while incurring a Net Loss of $25,624,000, or $(4.92) per share, and estimated Taxable Income of a negative $12,250,000, or $(2.35) per share. The dividend represents "excess inclusion income" for 1993 which under the Code for Real Estate Investment Trusts must be distributed as dividends even during periods where the Company has losses in excess of such excess inclusion amount. This amount, $208,000, plus the Net Loss of $25,624,000 and the reversal of $338,000 carried at December 31, 1992 as an unrealized loss but in 1993 representing a portion of the Company's Net Loss with the sale of the Company's entire holding of TIS, is reflected as an increase in Accumulated Deficit. Such amount increased from $(12,361,000) at December 31, 1992 to $(37,855,000) at December 31, 1993. 1992 TO 1991 COMPARISONS Statement of Revenues and Expenses Net Loss for the year ended December 31, 1992 was $(1,868,000) or $(0.36) per share as compared to Net Income of $7,938,000, or $1.52 per share for the year ended December 31, 1991, a decrease of $9,806,000. This significant decrease was due primarily to 1) substantially reduced gains on sales of assets in 1992 as compared to 1991 and 2) the writedown of asset valuations in 1992 to reflect the high levels of mortgage prepayment speeds in that year as compared to only minor negative adjustments in 1991. Gains on sales of assets in 1991 were $3,351,000, including $2,800,000 attributable to the sale of the Company's common stock holdings in RAC Mortgage Investment Corporation (currently known as Resource Mortgage Capital, Inc.) compared to $1,602,000 in asset sale gains in 1992, a decrease of $1,749,000. Generally accepted accounting principles which require periodic evaluation of the Company's Investments based upon current and expected future prepayment and interest rate levels caused writedowns of asset valuations totalling $7,921,000 (such writedowns are reflected as reductions to interest revenues on the Company's Statement of Revenues and Expenses) in 1992 compared to only $660,000 for 1991, a difference of $7,261,000. Reduced sales gains of $1,749,000 and asset writedown increments of $7,261,000, totalling $9,010,000 represent 92% of the decrease in Net Income from 1991 to 1992. The remaining $796,000 difference was the net result of generally reduced interest yields on the Company's portfolio of Investments in 1992 related to the extremely high level of mortgage prepayments in such year netted against a decrease in expenses (Interest on Notes Payable, General and Administrative and Management Fees) which declined from $3,344,000 in 1991 to $2,722,000 in 1992. Balance Sheet The Company's assets declined during the twelve month period ended December 31, 1992 by $196,166,000, to a total of $197,860,000 at December 31, 1992. This decrease was attributable to the Company's Mortgage Related Investments declining during the twelve month period from $332,998,000 to $142,396,000, a decrease of $190,602,000. This reduction was primarily the result of 1) the calling, during February and March 1992, of eight RYMAC IV Bond Series in order to take advantage of market premiums on the underlying Mortgage Collateral of each of these series (such calls reduced Mortgage Related Investments by approximately $71,000,000), 2) substantial prepayments on collateral underlying the Company's remaining Mortgage Related Investments and 3) to a much lesser extent, regularly scheduled principal payments on the underlying Mortgage Collateral. Such prepayments and scheduled principal payments further reduced Mortgage Related Investments by approximately $120,000,000. These asset reductions were matched by a corresponding decrease in the related liability accounts, Funding Notes Payable and CMOs Payable, from $337,366,000 to $149,215,000, or a decrease of $188,151,000, as returned principal on the underlying mortgages was used to retire outstanding obligations secured by such mortgages. Mortgage Derivative Securities decreased from $41,720,000 at December 31, 1991 to $40,727,000 at December 31, 1992, a decrease of $993,000, reflecting 1) the purchase of securities totalling approximately $15,000,000, 2) the amortization and return of the cost basis of the assets held in this category of approximately $9,100,000, and 3) the writedown of carrying value of such securities which represented additional amortization in 1992 totalling $7,580,000. Funds held by trustee decreased from $3,988,000 at December 31, 1991 to $3,922,000 at December 31, 1992. This category of assets represents the receipt of monthly mortgage payments awaiting further payment (reduction) of Funding Notes and CMOs Payable at a future date. Marketable securities increased only from $331,000 at December 31, 1991 to $332,000 at December 31, 1992, reflecting the net result of adjusting the carrying value of TIS (see "Investment Philosophy and Investment Activities") and additional purchases of TIS made in the first quarter of 1992. Notes Payable increased from $12,241,000 (inclusive of $1,330,000 of bank line borrowings and $10,911,000 of repurchase agreements) at December 31, 1991 to $14,833,000 at December 31, 1992 consisting of $575,000 in bank line borrowings and $14,258,000 in repurchase agreements. Such $2,592,000 increase in leverage was used principally to fund the purchases of new Mortgage Derivative Securities in the first half of 1992. The Company declared dividends of $0.90 per share, or $4,689,000, for 1992, while incurring a Net Loss of $1,868,000, or $(0.36) per share, and Taxable Income of a negative $16,656,000, or $(3.20) per share. Of the dividend distributions, $4,175,000 represented a return of stockholders' investment, which was reflected as a reduction to Additional paid-in capital. (See note 8 of Notes to Consolidated Financial Statements) This return of stockholders' investment reduced Additional paid-in capital from $48,160,000 at December 31, 1991 to $43,985,000 at December 31, 1992. The remaining $514,000 of dividend distributions represented excess inclusion income. This amount, $514,000 plus the Net Loss of $1,868,000, totalling $2,382,000, is reflected as an increase to Accumulated Deficit, which increased from $(9,641,000) at December 31, 1991 to $(12,023,000) at December 31, 1992. At December 31, 1992, the Balance Sheet reflected an Unrealized Loss on Marketable Equity Securities of $(338,000). This amount represented the difference between the cost basis of the Company's investment in TIS and the market value of such investment at December 31, 1992. EXPENSES AND USE OF BORROWED FUNDS Operating expenses (Interest on Notes Payable, Management/ Settlement Fees and General and Administrative) were $1,703,000 for the year ended December 31, 1993 versus $2,722,000 for the year ended December 31, 1992, a decline of $1,019,000. The components of this significant decrease in Operating expenses include: 1) significantly reduced interest costs on Notes Payable, which decreased from $965,000 in 1992 to only $297,000 for 1993, as Notes Payable on the Balance Sheet declined from $14,833,000 to $3,814,000 between December 31, 1992 and December 31, 1993 primarily due to dealer margin calls; 2) no payment of Management/Settlement Fees was made in 1993 versus $127,000 paid to the Company's Former Manager in 1992 (the Company has no further obligations to its Former Manager - see note 9 of Notes to Consolidated Financial Statements); and 3) a decrease of General and Administrative Expenses from $1,630,000 in 1992 to $1,406,000 in 1993, a decline of $224,000 as part of an expense reduction program. The Company uses the proceeds from repurchase agreements to fund a portion of its portfolio of Mortgage Derivative Securities. (See notes 3 and 7 of Notes to Consolidated Financial Statements and "Liquidity and Capital Resources") The Company's line of credit in recent periods has been used to fund day-to-day operating needs and in past periods to also temporarily fund acquisitions of new investments pending negotiation of repurchase agreements or awaiting return of invested principal. During 1993 the Company reduced its line of credit availability from $5,000,000 to $250,000 (see "Liquidity and Capital Resources") due to its ability to use available collateral more efficiently in repurchase agreement financings. During the second half of 1993 the Company had no borrowings under its $250,000 line of credit. As protection against the affects of rising interest rates on its borrowings, the Company has historically entered into interest rate cap agreements with Wall Street Dealers. At December 31, 1993 there are no outstanding cap agreements given the greatly reduced level of the Company's borrowings and the low and stable level of short-term interest rates during 1993. An interest rate cap agreement with Salomon Brothers Holding Company, Inc. expired on January 15, 1993. Under that agreement the Company had limited its interest rate exposure to 5% on borrowings of $20,000,000. The Company may enter into future interest rate cap agreements as market conditions affecting interest rates and the level of the Company's borrowings warrant. LIQUIDITY AND CAPITAL RESOURCES The Company currently maintains a line of credit with a commercial bank for $250,000 with an expiration date of April 30, 1994, which availability is subject to periodic valuations of the remaining collateral. Amounts borrowed under this agreement bear interest at a rate of the prime rate plus 1.0%, and are collateralized by the pledge of the Company's ownership interests in the RYMAC IV Bonds and the Ryland Mortgage Securities Corporation Series 89-6 Bonds. The availability under the line is limited to the value of collateral pledged to the bank. No amount is currently outstanding under such line of credit. The Company is also a party to various repurchase agreements, the proceeds of which have been used to acquire Mortgage Derivative Securities. (See notes 3 and 7 of Notes to Consolidated Financial Statements) At December 31, 1993 and December 31, 1992, the Company had outstanding under repurchase agreements $3,814,000 with maturities ranging from January 6, 1994 to April 4, 1994, and $14,258,000 with maturities ranging from January 4, 1993 to June 14, 1993, respectively. The repurchase agreements are secured by substantially all of the Company's Mortgage Derivative Securities. The repurchase agreements bear interest at rates varying from 3.30% to 5.00% at December 31, 1993 and are adjusted periodically according to current market levels. At December 31, 1993, the total amount borrowed by the Company was $3,814,000 while at December 31, 1992 the total amount borrowed was $14,833,000. Such borrowings represented 62% and 47%, respectively, of stockholders' equity at December 31, 1993 and December 31, 1992. The Company is currently subject to a limitation on the amount of total borrowings of $25,000,000 pursuant to a policy adopted by its Board of Directors in March 1992, although such amount is substantially in excess of the Company's currently available credit sources. During the period from June 8, 1992 through December 31, 1993, the Company was subject to various margin calls from the dealers with whom it had repurchase agreements. These margin calls, totalling $7,798,000 during 1992, were the result of dealer revaluations of the Mortgage Derivative Securities pledged by the Company to secure such borrowings. The extraordinarily high level of mortgage prepayments in the marketplace caused dealers to reassess the value of their collateral and call upon the Company to reduce the borrowings outstanding. Due to the continuation of high levels of mortgage prepayments during all of 1993, the Company has experienced further margin calls and normal principal repayments on its Investments resulting in further reductions of repurchase agreements by $10,444,000 during 1993. The Company has met all such repayment requirements primarily through either the use of cash flows from its portfolio of investments or the pledging of unencumbered assets. Future repayment of margin calls, if any, would be met through the use of current cash flows from the Company's portfolio of investments. Any failure to meet any such margin calls would result in the liquidation of the margined collateral. At December 31, 1993 the Company has pledged substantially all of its mortgage derivative securities to secure repurchase agreement outstandings. Nevertheless, since dealers have reduced the financing value of these mortgage derivative securities to minimum levels through margin calls, the Company believes that cash flows from the Company's current investment portfolio will be sufficient to enable the Company to meet its current and anticipated liquidity needs. DISCUSSION OF PREPAYMENTS Beginning early 1992 and through the early portion of 1994, the mortgage markets have experienced a period of unusually rapid and unprecedented prepayments. This phenomenon has been the result of residential mortgage interest rates, reaching in four different periods, their lowest levels in over twenty years. These low levels of mortgage interest rates have caused large numbers of homeowners to refinance their existing mortgages to take advantage of reduced monthly payments resulting from reduced interest costs. High levels of mortgage refinancings continued into 1994's first quarter. Mortgage rates fell rapidly in early 1992 to 20 year lows. As a result of these low rates, a record number of refinancing applications caused prepayments, on some mortgage coupons, to reach levels in March and April of 1992 which were nearly double those experienced in the last period of rapid prepayments which occurred in the fall of 1986 through the spring of 1987. Intermediate and long term interest rates then rose causing mortgage rates to rise as well. With the higher mortgage rates, refinancing activity slowed and prepayments began to slow as a result. In early July 1992, the Federal Reserve further reduced interest rates. This move by the Federal Reserve caused mortgage rates to decrease again in the August-September timeframe to levels lower than those experienced in early 1992 and resulted in prepayment levels, for some mortgage coupons, that were nearly as rapid as those encountered in the March-April period. Interest rates dropped even further in early 1993 and continued a steady decline into the September-October 1993 time period, reaching at that point a twenty-five year low. The result was a renewed escalation of refinancing applications and resultant record setting prepayment levels on mortgage-backed securities. However, during the late fourth quarter 1993 and into the first quarter 1994, increasing indications of hightened economic activity caused a substantial upward movement in interest rates, particularly longer term rates, and a slowdown in new refinancing applications. For the months of February and March 1994, statistics are beginning to reflect a slowing of prepayment speeds based upon the increased rates now applicable to new mortgage requests. Nevertheless, prepayment levels are still high compared with historical standards and continue to produce adverse affects on the Company's earnings. Due to the extended duration of high prepayment levels, the cash flows from certain of the Company's assets have been permanently impaired while cash flows from certain other assets could be preserved should the current trend toward slower prepayment speeds continue. Item 8. Item 8. Financial Statements and Supplementary Data. RYMAC MORTGAGE INVESTMENT CORPORATION AND SUBSIDIARIES Index to Consolidated Financial Statements INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of RYMAC Mortgage Investment Corporation We have audited the consolidated balance sheets of RYMAC Mortgage Investment Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These 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 RYMAC Mortgage Investment 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 years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/ KENNETH LEVENTHAL & COMPANY New York, New York March 17, 1994 RYMAC MORTGAGE INVESTMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (amounts in thousands except share data) ___________________________________________________________________________ Note 1 - The Company RYMAC Mortgage Investment Corporation ("RMIC") was incorporated in Maryland on July 1, 1988. RMIC has two wholly-owned subsidiaries, RYMAC Mortgage Investment I, Inc. ("RMI") and RYMAC Mortgage Investment II, Inc. ("RMII"). RMIC, RMI and RMII are collectively referred to hereafter as the "Company". At inception, the Company issued 5,420,000 shares of its common stock. During 1990 and 1991, the Company repurchased 209,400 shares of its common stock in accordance with a stock repurchase program at costs ranging from $6.75 to $7.63 per share. On September 21, 1992, the Board of Directors authorized the Company to repurchase up to 500,000 shares of its common stock in open market transactions over the ensuing twelve month period. No shares were repurchased under that authorization. The Company was a party to a Management Agreement (the "Management Agreement") with NVR Mortgage Management Partnership ("NVRMMP") which expired on March 31, 1992. The Company became self-managed effective April 1, 1992. (See note 9) In response to the Company's earnings difficulties and reduced cash flows from its investment portfolio, the Company is currently pursuing several financing transactions and investigating the possibility of engaging in a new complementary business. To date, no satisfactory transaction has been negotiated or new business formulated. If the Company is unable to successfully institute the above-mentioned plans, the Company's ability to re-establish an investment portfolio would be impaired, causing the Company to evaluate actions that would include a merger or other business combination with another entity or an orderly liquidation of future excess cash receipts to stockholders. ___________________________________________________________________________ Note 2 - Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of RMIC and its wholly-owned subsidiaries RMI and RMII. All intercompany balances and transactions have been eliminated in consolidation. Mortgage Related Investments Mortgage related investments are carried at their outstanding principal balance, plus or minus the applicable premium or discount. The net premium on mortgage related investments is amortized over the estimated lives of the investments using the interest method. (See note 4) On a quarterly basis, the Company makes adjustments to its mortgage related investments based upon valuation estimates. Such valuations are conducted on an asset-by-asset basis using assumptions that incorporate both market expectations as to future mortgage prepayment speeds at each valuation date and an estimate of future interest rates implied by the yield curve at each valuation date. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 2 - Summary of Significant Accounting Policies (continued) The Company compares the results of such assumptions to other relevant market data and makes appropriate adjustments if necessary. The cash flows are also evaluated for volatility under increased stress levels (higher prepayment assumptions) and additional adjustments are made for investments where cash flows rapidly deteriorate under increased stress levels. While the Company believes its prepayment assumptions are appropriate, if higher prepayment speeds had been used in the Company's assumptions, the results of the asset valuations would produce increased downward valuation adjustments. Mortgage Derivative Securities Mortgage derivative securities have been recorded at cost and are amortized over their estimated lives using the interest method. (See note 3) The Company had been applying Emerging Issues Task Force ("EITF") Issue No. 89-4 "Accounting for a Purchased Investment in a Collateralized Mortgage Obligation Instrument or in a Mortgage-Backed Interest-Only Certificate" in its quarterly valuation of its Mortgage Derivative Securities. EITF 89-4 requires a valuation adjustment when, under market based assumptions as to future mortgage prepayment speeds and interest rate levels, the nominal cash flows expected from a Mortgage Derivative Security asset are less than the current carrying value of the asset. The Financial Accounting Standards Board ("FASB") has issued Financial Accounting Standard No. 115 ("FASB-115"), "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. The Company has elected to apply FASB-115 effective December 31, 1993. FASB-115 requires that impaired investments be carried at fair market value. The EITF has tentatively concluded that an impairment to value under FASB-115 has occurred if the future cash flows, discounted at a risk free rate (the yield associated with a U.S. Treasury Security with a maturity approximating the average life of the future cash flows from the Company's portfolio of investments), are less than the investment's carrying value. After consideration of the alternative, the Company has determined to adopt FASB-115 as of December 31, 1993 instead of waiting until 1994. The application of FASB-115 required the Company to reduce the carrying value of its Mortgage Derivative Securities to their estimated fair market value at December 31, 1993. This additional writedown is shown in the Statements of Revenues and Expenses as "Cumulative Effect of Change in Accounting Principle." Fair Value Statement of Financial Accounting Standards No. 107, "Disclosure about Fair Value of Financial Instruments" ("FASB 107"), requires the Company to disclose the fair value of financial instruments for which it is practicable to estimate such value and to disclose the method(s) and assumptions used to estimate such value(s). Each of Notes 3, 4, 5 and 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 2 - Summary of Significant Accounting Policies (continued) discuss the fair value of the Company's mortgage derivative securities, mortgage related investments, funding notes payable, and CMOs payable, respectively. As described above under Mortgage Derivative Securities, those assets are valued at December 31, 1993 at fair market value as a result of the Company's application of FASB-115. For mortgage related investments, prices for similar mortgage-backed securities were obtained from Wall Street Dealers active in mortgage-backed markets. It is important to note, however, that the current market premiums on such similar mortgage-backed securities are not available to the Company unless and until the Company is able to call for early redemption the funding notes and CMOs payable that are collateralized by such mortgage related investments. The potential for early redemption (calls) is specific to each underlying collateralized obligation and the indenture covering such transaction. Although the Company was able to call for early redemption two series of bonds during 1993, the timing of additional early redemptions, if any, is not predictable. In regard to funding notes and CMOs payable, market price quotations for these underlying obligations were obtained from a dealer who actively trades such instruments. Although some of these instruments currently trade at premiums in the present financial environment, the Company's obligation thereunder is limited to the face principal amounts without any premium. In certain circumstances, however, a premium to face may be paid in order to effect a specific early redemption. Marketable Equity Securities At December 31, 1992, marketable equity securities were stated at the lower of their aggregate cost or market. At such date, the aggregate cost exceeded the aggregate market value by $338 and an allowance for unrealized losses and a separate component of stockholders' equity was recorded. During 1993, the Company sold all of its marketable equity securities for a net loss of $486. Federal Income Taxes The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). As a result, the Company generally will not be subject to federal income taxation at the corporate level to the extent it distributes annually at least 95% of its REIT taxable income, as defined in the Code, to its stockholders and satisfies certain other requirements. Accordingly, no provision has been made for income taxes in the accompanying consolidated financial statements. Net Income (Loss) Per Share Net income (loss) per share is computed based on the weighted average number of common shares outstanding during the period. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 3 - Mortgage Derivative Securities The Company's investments in mortgage derivative securities currently consist of (i) a class or classes of collateralized mortgage obligations ("CMOs") that either represents a regular class of bonds or a residual class of bonds or (ii) interests in a class or classes of mortgage-backed pass-through certificates that either represent a regular class of certificates or a residual class of certificates. For federal income tax purposes, a majority of the Company's mortgage derivative securities represent interests in real estate mortgage investment conduits ("REMICs"). CMOs are mortgage-backed bonds which bear interest at a specific predetermined rate or at a rate which varies according to a specified relationship to a specific short term interest rate index, such as the London interbank offered rate for one-month U.S. dollar deposits ("LIBOR"). Most residual bonds are structured so as to entitle the holder to receive a proportionate share of the excess (if any) of payments received from the collateral pledged to secure such bonds and the other related classes, together with the reinvestment income thereon, over amounts required to make debt service payments on such CMOs and to pay related administrative expenses. In connection with these investments, the Company acquired no other rights relating to the collateral pledged to secure its mortgage derivative securities. Most residual certificates are structured so as to entitle the Company to receive a specified percentage of the distributions generated from the pool of assets comprising the trust funds of which the certificates evidence an interest. At December 31, 1993 and 1992, the Company had investments in Mortgage Derivative Securities as set forth below: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 3 - Mortgage Derivative Securities (continued) The carrying values of the Company's investments in Mortgage Derivative Securities are net of downward valuation adjustments during 1993 of $24,800. The Company makes valuation adjustments at quarterly dates based upon assumptions as to mortgage prepayment speeds, interest rates and discount rates reflective of then current financial markets. For 1993 adjustments were made quarterly under EITF 89-4. The Company adopted FASB- 115 effective December 31, 1993, which resulted in an additional downward adjustment at December 31, 1993. (See note 2) FASB-115 incorporates a discounted cash flow valuation approach whereas EITF 89-4 was based upon future expected undiscounted cash flows. Under EITF 89-4, when current prepayment and interest rate assumptions caused the expectation that future cash flows from an asset would be less than the current carrying value, a downward adjustment was made and a zero yield applied to such asset for future quarterly accounting periods. Under FASB-115, future cash flows are discounted at a rate reflective of market yields for assets of the type held by the Company. At December 31, 1993, the Company applied a discount rate of 12% to the cash flows for its portfolio of Mortgage Derivative Securities. The additional writedown resulting from this change in accounting principle is $1,530 and is shown in the Statements of Revenues and Expenses as "Cumulative Effect of Change in Accounting Principle." If the Company had applied a higher discount rate, 20%, the resulting FASB-115 adjustment would have been increased by $900. In accordance with FASB-107, the Company computes the estimated fair value of its mortgage derivative securities by projecting anticipated future cash flows and discounting those cash flows at discount rates established in market transactions for securities having similar characteristics and backed by collateral of similar rate and term. For the December 31, 1993 estimate of fair market values, the Company used the same prepayment and interest rate assumptions as for its determination of carrying values under FASB-115. (See note 2) The PSA speeds vary depending on the collateral. The prepayment assumption model used by the Company incorporates a market methodology established by the Public Securities Association ("PSA"). Such model assumes a rate of prepayment NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 3 - Mortgage Derivative Securities (continued) each month of the unpaid principal balance of a pool of mortgage loans. 100% of PSA assumes that 0.2% per annum of the then outstanding principal balance of a pool of mortgage loans will prepay in the first month of the life of such mortgage loans and an additional 0.2% per annum in each month thereafter (for example, 0.4% per annum in the second month, 0.6% in the third month, etc.) until the 30th month. Beginning with the 30th month and in each month thereafter, 100% PSA assumes a constant prepayment rate of 6% per annum of the then outstanding principal balance of such mortgage loans. On a bi-weekly basis, Bloomberg Financial Markets ("Bloomberg") obtains PSA estimates for a wide range of mortgage coupons and ages from several dealers in mortgage derivative securities and makes them available to Bloomberg's subscribers. The prepayment speeds used by the Company in establishing the estimated fair value of its securities at December 31, 1993 are: Such PSA assumptions do not purport to be an historical description of prepayment experience or a prediction of the future rate of prepayments of any mortgage loan. All assets were modeled forward using the December 31, 1993 Bloomberg Median PSA for the life of each asset. LIBOR was assumed at 3.25% for the life of the assets and a discount rate of 12% was applied. Since PSA, interest rate and discount rate assumptions under FASB-115 and FASB-107 were identical for the Company's Mortgage Derivative Securities at December 31, 1993, fair market values and carrying values of such assets are equal. Substantially all of the Company's mortgage derivative securities have been pledged as collateral for repurchase agreements as described in note 7. ___________________________________________________________________________ Note 4 - Mortgage Related Investments The Company's mortgage related investments consist of ownership interests in certain classes of mortgage-backed securities issued by Ryan Mortgage Acceptance Corporation IV and Ryland Mortgage Securities Corporation (as described below). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 4 - Mortgage Related Investments (continued) On November 29, 1989, the Company purchased from Ryland Mortgage Securities Corporation ("RMSC") certain insured mortgage loans and other collateral owned by RMSC and pledged to secure RMSC's Mortgage Collateralized Bonds Series 1989-6 (the "RMSC Bonds"). This mortgage related investment and other collateral were purchased subject to the lien of the Indenture (the "RMSC Indenture") between RMSC and Sovran Bank, N.A., the Trustee for the RMSC Bonds (the "RMSC Trustee"), pursuant to which the RMSC Bonds were issued and subject to the rights of the RMSC Trustee and the bondholders thereunder. (See note 6) This mortgage related investment grants to the Company certain additional rights with respect to the RMSC Bonds, including rights with respect to substitution of collateral, amendments of or supplements to the RMSC Indenture, and calling of the RMSC Bonds. On September 23, 1988 the Company purchased from Ryan Mortgage Acceptance Corporation IV ("RYMAC IV"), an affiliate of NVRMMP, certain GNMA certificates and FNMA certificates and other collateral owned by RYMAC IV and pledged to secure RYMAC IV's GNMA/FNMA Collateralized Bonds, Series 1 and 2 and its Mortgage Collateralized Bonds, Series 3, 4, 7, 10, and 19 (collectively the "RYMAC IV Bonds"). (See note 5) These mortgage related investments and other collateral were purchased subject to the lien of the Indenture between RYMAC IV and the Trustee (the "RYMAC IV Indenture") pursuant to which the RYMAC IV Bonds were issued and subject to the rights of the Trustee and the bondholders thereunder. (See note 5) This series of seven purchase agreements grant to the Company certain additional rights with respect to the RYMAC IV Bonds, such as the right, if any, to substitute collateral, the right to direct the reinvestment of collateral proceeds and the right to call the related RYMAC IV Bonds. During the first and third quarters of 1993, the Company was able to conclude early redemptions of the RYMAC IV Series 1 and 2 Bonds ("Series 1" and "Series 2"), respectively. (See note 5) At December 31, 1993 and 1992 the Company owned mortgage related investments with aggregate outstanding principal balances of $64,408 and $140,881, respectively, which provide for monthly principal and interest payments. These mortgage related investments bear interest at rates ranging from 7.75% to 12.00% and have scheduled maturity dates ranging from July 1, 2001 to April 1, 2017. The RMSC collateral bears a weighted average net rate of 10.62% and a weighted average maturity of 263 months. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 4 - Mortgage Related Investments (continued) The Company held the following mortgage related investments as of December 31, 1993: The RMSC collateral consists of mortgage loans, many of which have private mortgage insurance. In addition, the collateral has limited "pool" insurance. As of February 3, 1994, the two pool insurance policies covering the RMSC collateral have remaining 90% and 96% of their available loss limits, such amount totalling $22.8 million. Based upon this information, even with the high delinquency and foreclosure levels on the RMSC collateral, the Company anticipates no reduction to its cash flow as residual interest holder. The RMSC collateral is experiencing significant delinquencies. Delinquencies decreased from approximately $13.6 million (51 loans) at December 28, 1992 to $9.8 million (35 loans) at December 27, 1993; however, the percentage of delinquencies increased from 1992 to 1993 for both the number of loans and loan balances outstanding. The percentage of delinquent loans outstanding increased from 23% to 33% while delinquent loan balances outstanding increased from 23% to 39%. A foreclosure to the holder of the residual interest represents a prepayment upon disposition of the property. Even though a loan may be delinquent, the servicer is required to advance principal and interest on the loan until it returns to a current status or its disposition through foreclosure. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 4 - Mortgage Related Investments (continued) The following is a summary of total mortgage related investments for the years ended December 31, 1993 and 1992: The sales of collateral were in connection with the redemption of the bonds of RYMAC IV, Series 1 and 2. (See note 5) In accordance with FASB-107, the Company obtained prices as of December 31, 1993 from Bloomberg for the mortgage-backed securities collateralizing the Company's mortgage related investments. Although all of the GNMA and FNMA Certificates were trading at premiums to their face values as of December 31, 1993, as described in note 2, the premiums on these GNMA and FNMA certificates are only available to the Company under limited circumstances related to early redemption of specific series of bonds. In that regard, in January and September of 1993 the Company was able to effect an early redemption of the RYMAC IV Series 1 and Series 2 Bonds respectively, and thus obtain access to the market premiums on the Series 1 and 2 collateral consisting of both GNMA and FNMA Certificates. After providing for all expenses of the early redemptions, and recovery of the remaining discounts, the Company recorded a net gain of approximately $838. Further, in March of 1994, the Company sold its ownership rights in Series 3 and 4 including the rights to excess cash flows until applicable Series call option dates, the rights to effecting the call options and the rights to the premiums, if any, existent on the underlying GNMA and FNMA certificates at future call dates. After providing for the expenses of these contractual assignments and expensing of the remaining premium on both Series, the Company expects to record a net gain of approximately $400. For the remaining RYMAC IV Bond Series 7, 10 and 19, it is not currently anticipated that either call options or the contractual assignment of the Company's rights will be available to the Company. Using similar prepayment assumptions as for its Mortgage Derivative Securities, the Company estimates the fair value of the RYMAC IV Bond Series 7, 10 and 19 to be $17,869, which equals the carrying value at December 31, 1993. For the RMSC Bonds, based upon current and historical prepayment experience, the Company anticipates access to the call option or the contractual assignment of the Company's rights prior to June 30, 1994. The Company received price indications at December 31, 1993 regarding the RMSC collateral which would provide the Company a 3% premium at the call date or a price for the assignment of its contractual rights producing a value to the Company of approximately $23,800. During 1993 the Company recorded downward adjustments on Mortgage Related Investments of $769. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 5 - Funding Notes Payable Funding notes payable represent limited recourse notes delivered to RYMAC IV as partial payment for the purchase of mortgage related investments and other collateral, and have payment terms the same as the related series of RYMAC IV Bonds. (See note 4) The funding notes payable consisted of five and seven multi-class series at December 31, 1993 and 1992, respectively, having stated maturities ranging from July 1, 2010 to May 1, 2017 and January 1, 2010 to May 1, 2017, respectively. The classes of each series of funding notes payable bear interest at fixed rates. The range of fixed rates at December 31, 1993 and 1992 were 8.250% to 11.200% and 7.375% to 13.000%, respectively. Principal and interest payments on the mortgage related investments are used to make the monthly or quarterly payments on the funding notes payable. In addition, prepayments of the underlying mortgage related investments are passed through as prepayments of the funding notes payable so that the funding notes payable may be fully paid prior to their stated maturities. During the first and third quarters of 1993, the Company called the RYMAC IV Series 1 and 2 Bonds. (See note 4) In accordance with FASB-107, the Company obtained prices for its Funding Notes Payable as of December 31, 1993, from a dealer actively trading in RYMAC IV Bonds and other bonds of this type. Such bonds were trading at par or slight discounts to their face values as of December 31, 1993. Market discounts on trades of these obligations do not affect the Company. The Company's obligations for repayment of its Funding Notes Payable are at par through receipt of principal and interest payments on its mortgage related investments. __________________________________________________________________________ Note 6 - CMOs Payable CMOs payable represent the RMSC Bonds. (See note 4) The RMSC Bonds are secured by insured mortgage loans and other collateral. (See note 4) The RMSC Bonds consist of one multi-class series having classes with stated maturities ranging from March 25, 2019 to November 25, 2020. The classes of the RMSC Bonds bear interest at fixed annual rates. The range of fixed rates at December 31, 1993 and 1992 was 9.80% to 9.85% and 9.70% to 9.85%, respectively. Principal and interest payments on the mortgage related investments are used to make the monthly payments on the CMOs payable. In addition, prepayments and proceeds from foreclosures on the underlying mortgage related investments are passed through as prepayments of the CMOs payable so that the CMOs payable may be fully paid prior to their stated maturities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 6 - CMOs Payable (continued) In accordance with FASB-107, the Company obtained prices for its CMOs Payable as of December 31, 1993, from a dealer actively trading in bonds of this type. Although RMSC Bond Classes D and E were trading at premiums to their face values as of December 31, 1993, as described in note 2, market premiums on trades of these obligations are not the responsibility of the Company. The Company's obligation for repayment of its CMOs Payable are only at par through receipt of principal and interest payments on its mortgage related investments. __________________________________________________________________________ Note 7 - Notes Payable As of December 31, 1993, the Company was a party to twelve separate repurchase agreements for borrowings of $3,814 which are collateralized by certain mortgage derivative securities. These repurchase agreements have interest rates ranging from 3.30% to 5.00% with maturities ranging from January 6, 1994 to April 4, 1994. At maturity dates, repurchase agreements are typically renewed for additional periods (usually one to twelve months). At December 31, 1993, $2,622 of such repurchase agreements was outstanding with Kidder Peabody and Company (nine separate repurchase agreements). These nine repurchase agreements were secured by the pledge of mortgage derivative securities with a carrying value of $4,820 and had an average weighted maturity of 57 days. At December 31, 1992, repurchase agreement borrowings were $14,258 under twelve separate repurchase agreements at rates ranging from 4.00% to 5.25% and maturities ranging from January 4, 1993 to June 14, 1993. If the borrowings under the repurchase agreements exceed a specified percentage of the collateral value, as determined by the lenders in their sole discretion, the lenders have the right to require either the repayment of a portion of the borrowings prior to maturity or the delivery of additional collateral. The Company maintained a line of credit with a commercial bank for $5,000 with an expiration of March 31, 1993. During the process of documenting the line of credit renewal, the Company determined that the collateral pledged to the bank under the line of credit had substantially greater borrowing value to the Company in other financing arrangements, particularly repurchase agreements, than the value provided under the bank line of credit. Accordingly, the Company and the bank agreed to the release of the majority of the collateral pledged thereunder and the maintenance of a reduced line of credit of $250 with an expiration date of April 30, 1994, which availability is subject to periodic valuations of the remaining collateral. Amounts borrowed under this agreement bear interest at a rate of the prime rate plus 1.0%, and are collateralized by the pledge of the Company's ownership interests in the RYMAC IV Bonds and the RMSC Bonds. The availability under the line is limited to the value of collateral pledged to the bank. At December 31, 1993, no amount was outstanding and at December 31, 1992, $575 was borrowed under the line bearing interest at 6.5%. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 7 - Notes Payable (continued) The following summarizes information related to the Company's short-term borrowings during 1993: Note 8 - Federal Income Taxes and Distributions As described in note 2, the Company has elected to be treated, for federal income tax purposes, as a REIT. As such, the Company is required to distribute annually, in the form of dividends to its stockholders, at least 95% of its taxable income. Because of the provisions of the Code applicable to the type of investments made by the Company, in the early years of the life of certain of the Company's initial investments (particularly investments made in connection with the Company's initial public offering, and to a lesser degree during 1989) taxable income exceeded net income. During the later years of such ownership Net Income will exceed REIT taxable income. The principal reason for such difference is that the Company reports income from its portfolio of mortgage related investments and mortgage derivative securities on the interest method for financial reporting purposes; however, for income tax purposes, the Company reports its proportionate share of the difference between interest income generated by the collateral and interest expense on the CMOs. More recent investments made by the Company and investments currently available in the market are typically structured so that taxable income and Net Income are similar during each reporting period. Over the life of a particular investment or security, taxable income and Net Income will be equal. In reporting periods where taxable income exceeds Net Income, stockholders' equity will be reduced by the amount of dividends in excess of Net Income in such period and will be increased by the excess of Net Income over dividends in future reporting periods. During 1993 and 1992, the Company incurred both taxable losses and Net Losses. During 1992, the Company made distributions totalling $4,689 of which $4,175 represented the return of stockholders' investment, representing a reduction to Additional paid-in capital. Distributions of $208 for 1993 did not affect stockholders' investment. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 8 - Federal Income Taxes and Distributions (continued) The Company estimates its taxable losses for 1992 and 1993 to aggregate approximately $28 million. Additionally, further tax losses are likely in 1994. During 1992 and 1993, the Company's investment in certain REMICs produced excess inclusion income of $514 and $213, respectively. Under the Code a REIT must generally distribute its excess inclusion income to its stockholders even though it has losses or deductions. Accordingly, if the Company were to report future excess inclusion income, it would be required to distribute such excess inclusion income as dividends even though it has an estimated net operating loss carryforward approximating $28 million. The net operating losses can be carried forward to offset ordinary income of the Company for fifteen years after such loss is recognized. The following table illustrates the reconciliation between Net Income, Accumulated Deficit and stockholders' investment, and the related per share data for the following periods: Note 9 - Related Party Transactions Pursuant to the Management Agreement which expired on March 31, 1992, NVRMMP was responsible for the day-to-day operations of the Company and performed all services and activities of the Company subject to the supervision of the Company's Board of Directors. As compensation for these services, NVRMMP received a base management fee plus incentive compensation based upon certain levels of performance. At the expiration of the Management Agreement, the Company and NVRMMP reached an agreement pursuant to which, among other things, the employees of NVRMMP's affiliate that had devoted a substantial amount of time on behalf of NVRMMP to the operation of the Company became employees of the Company. In consideration therefor, the Company agreed, among other things, to make payments to NVRMMP for each of the Company's fiscal quarters for the period April 1, 1992 through March 31, 1994, in an amount equal to 50% of the amount by which the fee that would have been paid to NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 9 - Related Party Transactions (continued) NVRMMP under the Management Agreement for each such quarter (based on the assets of the Company as of March 31, 1992) exceeds the audited pre-tax deductible expenses of the Company for such quarter (exclusive of certain expenses relating to any offerings by the Company of its securities). For the period April 1, 1992 through June 29, 1993, no amounts were due NVRMMP. Since both the Company and NVRMMP anticipated that for the remaining term of the agreement (ending March 31, 1994) no amounts would be owing NVRMMP, the Company and NVRMMP terminated their agreement on June 29, 1993. As such, the Company is no longer responsible for any future payments to NVRMMP. Pursuant to the Purchase Agreements between the Company and RYMAC IV (see note 4), $64 has been withheld from amounts released from the lien of the RYMAC IV Indenture, retained by RYMAC IV and deposited in escrow to be used for payment of expenses of the CMOs secured by certain of the mortgage related investments purchased by the Company. In addition, at December 31, 1993, the Company had incurred $43 of CMO administration fees which were paid to RYMAC IV under the terms of the Purchase Agreements. An affiliate of NVRMMP performs the servicing for the mortgage loans underlying certain of the mortgage related investments owned by the Company. ___________________________________________________________________________ Note 10 - Employee Benefits The Company's Board of Directors has established a Salary Reduction- Simplified Employee Pension Program ("SAR-SEP") for its full-time employees. A SAR-SEP is a minimal administration 408-K Plan (similar to a 401-K) for companies with fewer than 25 employees. For 1993, the Company contributed 3% of gross compensation and has established the same minimum contribution for 1994. Company contributions to the plan may vary and the Company is not required to continue the program. Employee contributions are based upon established formulas under the Employee Retirement Income Security Act ("ERISA") rules governing 408-K Plans. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (amounts in thousands except share data) ___________________________________________________________________________ Note 11 - Quarterly Financial Data (unaudited) 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 to be set forth hereunder has been omitted and will be incorporated by reference, when filed, to the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders to be held on or about May 25, 1994. Item 11. Item 11. Executive Compensation. The information required to be set forth hereunder has been omitted and will be incorporated by reference, when filed, to the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders to be held on or about May 25, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required to be set forth hereunder has been omitted and will be incorporated by reference, when filed, to the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders to be held on or about May 25, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. The information required to be set forth hereunder has been omitted and will be incorporated by reference, when filed, to the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders to be held on or about May 25, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statements, Schedules and Reports On Form 8-K. (a) Documents filed as part of this Report: 1. The following financial statements are included in Part II, Item 8 of this Form 10-K: Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Revenues and Expenses Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 2. Financial statement schedules required: None 3. The following exhibits are included as part of this Form 10-K: 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. RYMAC MORTGAGE INVESTMENT CORPORATION By: /s/ Richard R. Conte Richard R. Conte, Chief Executive 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 and on the dates indicated. [Signatures continued from previous page.]

8919_1993.txt

8919_1993

1993

8919

ITEM 1. BUSINESS (a) General Development of Business Aydin Corporation (the "Company" or "Aydin") was incorporated under the laws of the State of Delaware in September, 1967. The Company consists of seven domestic operating divisions, organized as seven profit centers each with engineering, manufacturing, marketing and accounting functions, and three foreign subsidiaries. (b) Financial Information About Industry Segments The Company operates predominantly in the electronics manufacturing industry. Therefore, no segment information is reported. (c) Narrative Description of Business The following table sets forth the percentage of the Company's total revenue contributed by each of its three classes of products (among which overlapping does occur) for each of the last three years: As stated above, the Company operates predominantly in the electronics manufacturing industry, and all information set forth below is with respect to the Company's business as a whole. The Company designs, manufactures, and sells three classes of products as set forth above and as described below: (1) Communications The Company engineers, manufactures and sells a broad range of communications equipment and turnkey systems, offering three types of microwave transmission equipment - satellite, troposcatter and line-of-sight - in both analog and digital form. The Company is planning to develop products for wireless communications. The Company also offers telemetry, airborne and ground-based data acquisition, transmission and receiving equipment, data links, VHF and UHF transceivers, T-1 and E1 ADPCM 2:1 and 4:1 transcoders and echo cancellers, and avionics equipment and systems, and thick and thin film microcircuits. Aydin's products and systems are used in military and industrial applications. (2) Computer Equipment and Systems The Company designs and manufactures several lines of high resolution color monitors, including SPECTRUM AUTOSYNC(R) versions, Ranger monitors including table tops (in sizes ranging from 14 through 21 inches), and color display processors, and associated software for process control and other industrial applications. Aydin has a line of workstations, called the Model 7402, which integrates a gateway and a high performance workstation into a single package, with a RISC processor running at 61 MIPS. Aydin also has an X-terminal available for use with the workstation. Aydin offers computer systems, display processors, rugged monitors, large screen display systems and writes software for military ground or airborne environments and air traffic control applications. In addition, Aydin supplies network access equipment for cost effective access for voice data and video to public telephone networks. The Company also manufactures precision fabricated electronics cabinets, high quality printed circuit boards including multi-layer, and miscellaneous vinyl components. With the help of its low cost subsidiary in Turkey the Company is developing more standard software products and is bidding many software programs to expand its software capability. (3) Radars, Radar Simulation and EW Aydin has developed a state-of-the-art 3-D tactical air defense radar called ASTAR-3. For EW, Aydin manufactures radar simulations systems and has capabilities in self- protection ARM decoys, both ground and airborne. Aydin is bidding opportunities combining radar and EW technologies. One major contract under which Aydin is performing is the Multiple Threat Emitter Simulator Systems (MUTES) for the U.S. Air Force. (4) Command, Control and Communications (C3)/Air Defense Systems Aydin also offers complete, turnkey air defense/C3 systems, both fixed and mobile, utilizing its own mobile air defense 3-D radar, communications equipment including radios and multiplexers, air defense consoles, and air defense software. The Company's products and systems are sold directly by Company sales personnel and manufacturers' representatives. Sales personnel for the Company are located in many cities across the United States as well as at key major military bases, with corporate marketing located in the Washington, D.C. area. With respect to exports, sales efforts are conducted by its international subsidiaries, its international sales network and manufacturers' representatives in many countries. The Company maintains standard product lines and systems sold by catalogue, although it generally does not maintain an inventory of finished goods. A significant portion of current sales is attributable to such standard products, modifications thereof, and turnkey communications systems using these products. Another portion of sales is attributable to special, made-to-order equipment based on customer's specific requirements. The Company's customers include U.S. and foreign communications and electronic and aerospace firms, electric utilities, regulated and unregulated telephone organizations, major transportation organizations, other industrial and financial concerns and process control companies, research laboratories, universities, large defense contractors, foreign governments, the U.S. Government through various agencies of the Department of Defense, and the National Aeronautics and Space Administration. A breakdown of sales for the last three years including sales to major customers who accounted for 10% or more of sales is as follows: (1) The U.S. Government and the Government of Turkey were the only customers to whom sales exceeded 10% of consolidated sales during any of the past three years. Sales to the Government of Turkey amounted to $45,134,000 in 1993, $48,738,000 in 1992 and $41,228,000 in 1991. (2) Includes foreign sales of $22,958,000 for 1993, $19,349,000 for 1992, and $17,850,000 for 1991. (3) A breakdown of total export and foreign sales by geographic area follows in section (d) below. Raw materials for the Company's business consist of manufactured components and parts. The Company's raw materials are presently available in adequate supply on the open market. The Company holds no material patents, trademarks, licenses, franchises or concessions. The Company's operations are not seasonal to any material extent. As stated above, although the Company maintains standard product lines and systems sold by catalogue, it generally does not maintain a significant level of finished goods inventory. However, the Company maintains an adequate level of raw materials inventory so that it will be able to meet initial delivery requirements of customers. The Company has had no material difficulty in obtaining goods from suppliers. The Company does not provide rights to return its products, and generally does not provide extended payment terms to customers. The backlog of unfilled orders at December 31, 1993 was $155 million as compared to $175 million at December 31, 1992. The backlog figures exclude probable production options of $58 million at the end of 1993 and $75 million at the end of 1992. Approximately 40% of the 1993 backlog is not reasonably expected to be fulfilled within the current year. The backlog includes approximately $81 million for a command, control and communications project for the Government of Turkey for which most of the work is to be done over the next two years. This contract was signed in June, 1990 and became effective in October, 1990. All contracts with the U.S. Government and some of the foreign governments are subject to cancellation at the convenience of the government. In the event a contract with the U.S. Government is so terminated, the Armed Services Procurement Regulations provide that the Company shall be reimbursed for expenses incurred and shall be entitled to reasonable profits. The greater portion of the Company's business is obtained by competitive bidding, while some is obtained through sole source negotiation. In the domestic marketplace, the Company competes with some major U.S. companies from time to time; however, some of the competition in the U.S. comes from companies which are similar in size or smaller than Aydin. In the international marketplace, Aydin competes with major European and Japanese companies in addition to U.S. firms. A number of such competitors are larger than Aydin with greater financial resources, while some are similar to or smaller than Aydin. Technical capability, reputation, price, ability to meet delivery schedules and reliability are the principal competitive factors. No single competitor offers the same range of products and systems as Aydin. Depending on the particular product itself and the requirements of the contract documents, the number of firms competing with Aydin generally ranges from one to ten. Estimated amounts spent during 1993, 1992, and 1991 on Company- sponsored research and development activities, and customer-sponsored research activities relating to the development of new products, services or techniques or the improvement of existing products, services or techniques are as follows: The Company along with others is responsible for the cost of cleanup at a site leased by the Company prior to 1984 under an order of the State of California. The cost to date for the cleanup of the California site over the past nine years has been approximately $5.4 million. Settlement has been reached with three of four insurance carriers for approximately $6.7 million which was received during 1993 and applied to the cleanup costs previously incurred and cost to go. The claim against the fourth insurance carrier is presently in litigation. A jury has ruled in Aydin's favor; however, a final decision by the court has not yet been rendered. Management believes the ultimate resolution of this entire matter will not have a materially adverse effect on the financial position or results of operations. The Company employs approximately 1,300 persons, with operations concentrated principally in the Philadelphia and San Jose areas. Employer-employee relations are considered to be satisfactory. (d) Financial Information About Foreign and Domestic Operations and Export Sales The Company had no significant foreign operations prior to 1991 although a $216 million contract from the Government of Turkey became effective in October, 1990. Approximately 40% of this contract is being performed by the Company's Turkish subsidiary. Foreign assets included in the consolidated balance sheet amounted to $16.9 million, $23.4 million, and $26.1 million at December 31, 1993, 1992, and 1991 respectively. Of these amounts, $13.7 million, $19.1 million, and $21.1 million at December 31, 1993, 1992, and 1991 respectively, are assets of the Company's Turkish subsidiary and consist mainly of U.S. dollar denominated interest-bearing time deposits received as advance payments that will be used to complete a portion of the Company's contract with the Government of Turkey. Foreign sales and pretax income for 1993 amounted to $23.0 million and $3.9 million, respectively. Foreign sales and pretax income for 1992 amounted to $19.3 million and $3.3 million respectively. Foreign sales and pretax income for 1991 amounted to $17.8 million and $3.9 million respectively. The Company's domestic operations include sales derived from customers or projects located in areas of the world outside the United States. Export and foreign sales for 1993, 1992, and 1991 by geographic area are set forth below: On a percentage basis, export and foreign sales (direct and indirect) accounted for approximately 56% of total sales in 1993, 54% in 1992, and 43% in 1991. A majority of such export and foreign sales were in the telecommunications field. Licenses are required from U.S. Government agencies for most of the Company's export products. The Company and its foreign subsidiaries may be adversely affected by certain risks generally associated with foreign contracts and operations, including ownership and control limitations, currency fluctuations, restrictions on repatriation of profits, difficulty in the enforcement of judgments, late delivery penalties, potential political or labor instability and general worldwide economic conditions. However, such factors have not had a material effect on the Company's operations to date, and management believes that the risks involved in such foreign business are no greater than the normal risks of any other portion of the Company's sales. The Company has generally been able to protect itself against foreign credit risks through contract provisions, advance payments and irrevocable letters of credit in its favor. However, it should be noted that foreign contracts are sometimes subject to foreign laws. ITEM 2. ITEM 2. PROPERTIES The Company's total plant capacity is approximately 700,000 square feet of administrative and production facilities, 540,000 of which it owns and the balance of which it leases. Three owned properties totalling 192,000 square feet are subject to mortgages and six owned properties totalling 348,000 square feet are unencumbered. All major leased properties are held under leases expiring between 1994 and 1997, most with renewal options. The principal owned properties are two administrative/production facilities in Fort Washington, Pennsylvania, and five more in the Greater Philadelphia area, and one in the San Jose area. In addition, the Company maintains its corporate headquarters in Horsham, Pennsylvania, and numerous sales offices within and outside the U.S. The administrative and production facilities occupied by the Company are well maintained and suitable for its operations, and include plant area, warehouse space, and management, engineering and clerical offices. The plants of each of the manufacturing operations generally contain machine shops, assembly areas, testing facilities and packing and shipping departments in addition to the engineering and laboratory areas. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On January 6, 1994, pursuant to the terms of settlement with the Department of Justice, the Company entered a plea of guilty to the falsification of testing data, charges to which two of its low level employees previously pled guilty to in March 1993, and the plea was accepted by the court (U.S. District Court for the Northern District of California). The Company is reinstated on its AN/GRC-222 microwave radio contract with all of its previous terms and conditions. Further, the Company withdrew its contract claims, is doing additional work for the Army at no additional cost, and paid $2 million as an added consideration. The total impact on pretax income of this settlement was approximately $14,819,000, which has been charged to the 1993 fourth quarter earnings. The additional work and the related expenditures will be spread over a period of three years or longer. 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. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, year first elected as officer or appointed as general manager, positions and recent prior experience of all current executive officers of the Company as of March 14, 1994, are as follows: AYHAN HAKIMOGLU, CHAIRMAN AND PRESIDENT (1) 66. First elected 1967. Chairman of the Board of Directors; President of the Company through February 1992, and since March 1994. JOHN F. VANDERSLICE, SENIOR VICE PRESIDENT 52. 1983. Senior Vice President of the Company. President of the Vector Division (manufactures airborne data communications products) since November 1982. Previously, he was Manager of Engineering (1969-1972), Operations Manager (1972-1973), and Vice President of Operations (1973-1982) of the Vector Division. GARY T. BOSWELL, VICE PRESIDENT 56. 1987. Vice President of the Company. President of the Computer and Monitor Division (manufactures air defense, ground data handling, computer communications equipment and systems) since September 1988. Prior to that, he was President of Monitor Systems Division (manufactures ground-based data communication products and special telecom equipment and systems) from January 1987. Prior to joining Aydin, he served from 1968 to 1986 with Texas Instruments Inc. (a designer and manufacturer of electronic products). DEMIRHAN HAKIMOGLU, VICE PRESIDENT (2) 54. 1992. Vice President of the Company. Chairman of the Board and CEO of the Company's foreign subsidiary, Aydin Yazilim A.S., since July 1990. Prior to that, served in various engineering and management positions with various divisions of the Company since 1968 (except for a two year period, 1978-1980). MATS J. OFVERBERG, VICE PRESIDENT (3) 53. 1990. Vice President of the Company and President of Aydin Corporation (West) Division from December 1990 to November 1993 and from March 14, 1994. Prior to his election as an officer, he served as Vice President of Engineering of the Company's Radar & EW Division and Executive Vice President of the Company's Aydin(West) group of divisions from February 1987. Prior to his joining Aydin, he served (1976-1987) with ESL, a subsidiary of TRW, most recently as manager of an engineering department. JOHN C. WONG, VICE PRESIDENT 52. 1993, Vice President of the Company and President of the Controls Division (manufacturer of display terminals) since March 1993. Prior to joining Aydin, he served (1985-1993) with Sun Microsystems, Inc. (manufacturer of workstations), most recently as an Engineering Director. HERBERT WELBER, CONTROLLER AND ASSISTANT TREASURER 58. 1986. Controller and Assistant Treasurer of the Company since August 1986. Previously, he was Controller and Vice President of Controls Division (manufactures display terminals) since August 1981. Each of the above officers was elected at the Annual Meeting of the Board of Directors on April 30, 1993. Dr. Ofverberg retired from the Company in November, 1993, as was re-hired as Division President and re-elected as Vice President of the Company on March 14, 1994. Officers are elected each year after the Annual Meeting of Stockholders. Each serves subject to the discretion of the Board of Directors until his successor shall be elected and qualified or until his death, disqualification, resignation or removal in the manner provided in the Company's By-Laws. There are no family relationships among any executive officers of Aydin, except for Ayhan Hakimoglu and Demirhan Hakimoglu who are brothers. - ----------------------------------------------------------------------- (1) From July 1971 to May 1972 did not serve as an officer of the Company, although he remained as a director. (2) First elected Vice President in February 1991, and resigned that position in July 1991. Re-elected Vice President in February 1992. (3) Retired November 3, 1993, and accepted re-employment effective March 14, 1994. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated by reference is the information under the heading, "Common Stock Prices" and "Stockholder and Dividend Information" on page 27 of the Annual Report. The special cash dividend declared by the Company of $0.50 per share to stockholders of record as of the close of business on March 9, 1992, was paid on March 20, 1992. Future cash dividends, if any, will depend on business conditions. There are no restrictions that prevent the Company from paying future cash dividends, except that the Company's Board of Directors had determined that no cash dividend will be declared or paid through fiscal year 1993 and for the foreseeable future, and except for maintaining compliance with certain covenants of a Credit Agreement for the funding of a standby Letter of Credit, as described more fully in Note D to the Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference is the information under the heading, "Selected Financial Data" on page 26 of the Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference is the information under the heading, "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 25 of the Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference are the Consolidated Financial Statements of Aydin Corporation and the related Notes to Consolidated Financial Statements, and Report of Independent Auditors on pages 17 to 24, inclusive, and the data under the heading, "Quarterly Financial Data" on page 26, of the Annual 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 Incorporated by reference is the information under the heading, "Election of Directors" on pages 3-5 of the Proxy Statement, the information under the heading, "Compliance With Section 16(a) of the Exchange Act" on page 10 of the Proxy Statement, and the information under the heading, "Executive Officers of the Registrant" on pages 7 and 8, Part I of this 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference is the information under the heading, "Compensation of Executive Officers", "Option Grants in Last Fiscal, "Aggregated Option Exercises and Fiscal Year-End Option Value Table", "Ten- Year Option Repricing", "Employment Contracts and Termination of Employment Arrangements", and "Compensation Committee Interlocks and Insider Participation" on pages 5-7, 9 and 10 of the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference is the information under the headings, "Beneficial Ownership of Common Stock" and "Beneficial Ownership by Management" on pages 2 and 3 of the 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 The Company files as part of this report the following documents: (a) 1. Financial Statements The following is a list of the Consolidated Financial Statements of Aydin Corporation and Subsidiaries which have been incorporated by reference from the Annual Report as set forth in Item 8 - "Financial Statements and Supplementary Data": 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 Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Auditors. 2. Schedules The following is a list of the Schedules of Aydin Corporation and Subsidiaries filed as part of this report: Schedule I - Short-term investments Schedule VIII - Valuation and qualifying accounts Schedule IX - Short-term borrowings Report of Independent Auditors All other schedules not listed above are omitted because they are inapplicable or are not required. 3. Exhibits The following is a list of Exhibits filed as part of this report: Exhibit 3(i) - Certificate of Incorporation (incorporated by reference as filed as Exhibit 3 of the 1981 Annual Report on Form 10-K and as amended and filed as Exhibit 20 on Form 10-Q for the Second Quarter ended June 26, 1982, and as amended and filed as Exhibit 4 on Form 10-Q for the First Quarter ended April 2, 1983, and as amended and filed as Exhibit 4 on Form 10-Q for the First Quarter ended March 28, 1987). Exhibit 3(ii) - By-Laws (last amended March 2, 1994) Exhibit 13 - 1993 Annual Report to Stockholders Exhibit 21 - Subsidiaries of Registrant Exhibit 23 - Consents of Independent Auditors Exhibit 99 - Report of Independent Auditors All other exhibits not listed above are omitted because they are inapplicable. (b) Reports on Form 8-K A report on Form 8-K, dated November 24, 1993, was filed by the Registrant on December 6, 1993, covering Item 5 (Other Events). AYDIN CORPORATION SCHEDULE I - SHORT-TERM INVESTMENTS FOR THE YEARS 1993, 1992, 1991 AYDIN CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS 1993, 1992, AND 1991 AYDIN CORPORATION SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS 1993, 1992, AND 1991 SIGNATURES Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Aydin Corporation Dated: March 29, 1994 By: /s/ Robert A. Clancy Robert A. Clancy 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. By: /s/ Ayhan Hakimoglu Dated: March 29, 1994 Ayhan Hakimoglu Chief Executive Officer, President and Chairman of the Board of Directors By: /s/ Herbert Welber Dated: March 29, 1994 Herbert Welber Controller and Assistant Treasurer Principal Accounting Officer By: /s/ Jay L. Landis Dated: March 29, 1994 Jay L. Landis Treasurer Principal Financial Officer By: /s/ Frederick G. Allen Dated: March 29, 1994 Frederick G. Allen Director By: /s/ Nev A. Gokcen Dated: March 29, 1994 Nev A. Gokcen Director By: /s/ Harry D. Train, II Dated: March 29, 1994 Harry D. Train, II Director AYDIN CORPORATION FORM 10-K ANNUAL REPORT EXHIBIT INDEX No. Description of Exhibit 3(i) Certificate of Incorporation (Filed as Exhibit 3 of the 1981 Annual Report on Form 10-K and as amended and filed as Exhibit 20 on Form 10-Q of the Second Quarter ended June 26, 1982, and as amended and filed as Exhibit 4 on Form 10-Q for the First Quarter ended April 2, 1983, and as amended and filed as Exhibit 4 on Form 10-Q for the First Quarter ended March 28, 1987, and incorporated herein by reference.) 3(ii) By-Laws 13 Pages 17-27, 1993 Annual Report to Security Holders 21 Subsidiaries of Registrant 23 Consent of Independent Auditors 99 Report of Independent Auditors Exhibit 3(ii) AYDIN CORPORATION BY-LAWS (Last Amended March 2, 1994) ******* ARTICLE I OFFICERS Section 1. The registered office shall be in the City of Dover, County of Kent, State of Delaware. Section 2. The corporation may also have offices at such other places both within and without the State of Delaware as the Board of Directors may from time to time determine or the business of the corporation may require. ARTICLE II MEETINGS OF STOCKHOLDERS Section 1. All meetings of the stockholders for the election of Directors shall be held in the City of Fort Washington, State of Pennsylvania, at such place as may be fixed from time to time by the Board of Directors, or at such other place either within or without the State of Delaware as shall be designed from time to time by the Board of Directors and stated in the notice of the meeting. Meetings of stockholders for any other purpose may be held at such time and place, within or without the State of Delaware, as shall be stated in the notice of the meeting or in a duly executed waiver of notice thereof. Section 2. Annual meetings of stockholders shall be held on the third Thursday of April if not a legal holiday, and if a legal holiday, then on the next secular day following at 3:00 P.M. or at such other date and time as shall be designated from time to time by the Board of Directors and stated in the notice of the meeting, at which they shall elect by a plurality vote a board of Directors, and transact such other business as may properly be brought before this meeting. Section 3. Written notice of the annual meeting stating the place, date and hour of the meeting shall be given to each stockholder entitled to vote at such meeting not less than ten nor more than fifty days before the date of the meeting. Section 4. The officer who has charge of the stock ledger of the corporation shall prepare and make, at least ten days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least 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 the time and place of the meeting during the whole time thereof, and may be inspected by any stockholder who is present. Section 5. Special meetings of the stockholders, for any purpose or purposes, unless otherwise prescribed by statute or by the certificate of incorporation, may be called by the Chairman of the Board and shall be called by the Chairman of the Board or Secretary at the request in writing of a majority of the Board of Directors, or at the request in writing of stockholders owning a majority in amount of the entire capital stock of the corporation issued and outstanding and entitled to vote. Such request shall state the purpose or purposes of the proposed meeting. Section 6. Written notice of a special meeting stating the place, date and hour of the meeting and the purpose or purposes for which the meeting is called, shall be given not less than ten nor more than fifty days before the date of the meeting, to each stockholder entitled to vote at such meeting. Section 7. Business transacted at any special meeting of stockholders shall be limited to the purposes stated in the notice. Section 8. The holders of a majority of the stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, shall constitute a quorum at all meeting of the stockholders for the transaction of business except as otherwise provided by statute or by the certificate of incorporation. If, however, such quorum shall not be present or represented at any meeting of the stockholder, the stockholders entitled to vote thereat, present in person or represented by proxy, shall have power to adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present or represented. At such adjourned meeting at which a quorum shall be present or represented any business may be transaction which might have been transacted at the meeting as originally notified. If the adjournment is for more than thirty days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting. Section 9. When a quorum is present at any meeting, the vote of the holder of a majority of the stock having voting power present in person or represented by proxy shall decide any question brought before such meeting, unless the question is one upon which by express provision of the statutes or of the certificate of incorporation, a different vote is required in which case such express provision shall govern and control the decision of such question. Section 10. Each stockholder shall at every meeting of the stockholders be entitled to one vote in person or by proxy for each share of the capital stock having voting power held by such stockholder, but no proxy shall be voted on after three years from its date, unless the proxy provides for a longer period. Section 11. Whenever the vote of stockholders at a meeting thereof is required or permitted to be taken for or in connection with any corporate action, by any provision of the statutes, the meeting and vote of stockholders may be dispensed with if all of the stockholder who would have been entitled to vote upon the action if such meeting were held shall consent in writing to such corporate action being taken; or if the certificate of incorporation authorizes the action to be taken with the written consent of the holders of less than all of the stock who would have been entitled to vote upon the action if a meeting were held, then on the written consent of the stockholders having not less than such percentage of the total number of votes as may be authorized in the certificate of incorporation; provided that in no case shall the written consent be by the holders of stock having less than the minimum percentage of the total vote required by statute for the proposed corporate action, and provided that prompt notice must be given to all stockholders of the taking of corporate action without a meeting and by less than unanimous written consent. ARTICLE III DIRECTORS Section 1. The number of Directors which shall constitute the whole Board shall be four (4). The Directors shall be elected at the annual meeting of the stockholders, except as provided in Section 2 of this Article, and each Director elected shall hold office until his successor is elected and qualified. Directors need not be stockholders. Section 2. Vacancies and newly created directorships resulting from any increase in the authorized number of Directors may be filled by a majority of the Directors then in office, though less than a quorum, or by a sole remaining director, and the Directors so chosen shall held office until the next annual election and until their successors are duly elected and shall qualify, unless sooner displaced. If their are no Directors in office, then an election of Directors may be held in the manner provided by statute. If, at the time of filling any vacancy or any newly created directorship, the Directors then in office shall constitute less than a majority of the whole board (as constituted immediately prior to any such increase), the Court of Chancery may, upon application of any stockholder or stockholders holding at least ten percent of the total number of the shares at the time outstanding having the right to vote for such Directors, summarily order an election to be held to fill any such vacancies or newly created directorships, or to replace the Directors chosen by the Directors then in office. Section 3. The business of the corporation shall be managed by its Board of Directors which may exercise all such powers of the corporation and do all such lawful acts and things as are not by statute or by the Certificate of Incorporation or by these by-laws directed or required to be exercised or done by the stockholders. MEETING OF THE BOARD OF DIRECTORS Section 4. The Board of Directors of the corporation may hold meetings, both regular and special, either within or without the State of Delaware. Section 5. The first meeting of each newly elected Board of Directors shall be held at such time and place as shall be fixed by the vote of the stockholders at the annual meeting and no notice of such meeting shall be necessary to the newly elected Directors in order legally to constitute the meeting, provided a quorum shall be present. In the event of the failure of the stockholders to fix the time or place of such first meeting of the newly elected Board of Directors, or in the event such meeting is not held at the time and place so fixed by the stockholders, the meeting may be held at such time and place as shall be specified in a notice given as hereinafter provided for special meetings of the Board of Directors, or as shall be specified in a written waiver signed by all of the Directors. Section 6. Regular meetings of the Board of Directors may be held without notice at such time and at such place as shall from time to time be determined by the Board. Section 7. Special meetings of the Board may be called by the Chairman of the Board on one day's notice to each director, either personally, by telephone, by mail or by telegram; special meetings shall be called by the Chairman of the Board or Secretary in like manner and on like notice on the written request of two directors. Section 8. At all meetings of the Board, a majority of the directors shall constitute a quorum for the transaction of business and the act of a majority of the directors present at any meeting at which there is a quorum shall be the act of the Board of Directors, except as may be otherwise specifically provided by statute or by the certificate of incorporation. If a quorum shall not be present at any meeting of the Board of Directors the directors present thereat may adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present. Section 9. Unless otherwise restricted by the certificate of incorporation or these by-laws, any action required or permitted to be taken at any meeting of the Board of Directors or of 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. COMMITTEES OF DIRECTORS Section 10. The Board of Directors may, by resolution passed by a majority of the whole board, designate one or more committees, each committee to consist of two or more of the directors of the corporation. The board 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. Any such committee, to the extent provided in the resolution, shall have and may exercise the powers of the Board of Directors in the management of the business and affairs of the corporation, and may authorize the seal of the corporation to be affixed to all papers which may require it; provided, however, that in the absence or disqualification of any member of such committee or committees, the member of members thereof present at any meeting and not disqualified from voting, whether or not he or they 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. Such committee or committees shall have such name or names as may be determined from time to time by resolution adopted by the Board of Directors. Section 11. Each committee shall keep regular minutes of its meetings and report the same to the Board of Directors when required. COMPENSATION OF DIRECTORS Section 12. The Directors may be paid their expenses, if any, of attendance at each meeting of the Board of Directors and may be paid a fixed sum for attendance at each meeting of the Board of Directors or a stated salary as Director. No such payment shall preclude any Director from serving the corporation in any other capacity and receiving compensation therefor. Members of special or standing committees may be allowed like compensation for attending committee meetings. ARTICLE IV NOTICES Section 1. Whenever, under the provisions of the statutes or of the Certificate of Incorporation or of these by-laws, notice is required to be given to any Director or stockholder, it shall not be construed to mean personal notice, but such notice may be given in writing, by mail, addressed to such Director or stockholder, at his address as it appears on the records of the corporation, with postage thereon prepaid, and such notice shall be deemed to be given at the time when the same shall be deposited in the United States mail. Notice to Directors may also be given by telegram, or by telephone. Section 2. Whenever any notice is required to be given under the provisions of the statutes or of the Certificate of Incorporation or of these by-laws, a waiver thereof in writing, signed by the person or persons entitled to said notice, whether before or after the time stated therein, shall be deemed equivalent thereto. ARTICLE V OFFICERS Section 1. The officers of the corporation shall be chosen by the Board of Directors and shall be a Chairman of the Board, a President, an Executive Vice President, a Secretary and a Treasurer. The Board of Directors may also choose additional Vice Presidents, and one or more Assistant Secretaries and Assistant Treasurers. Any number of offices may be held by the same person, unless the certificate of incorporation of these by-laws otherwise provide. Section 2. The Board of Directors at its first meeting after each annual meeting of stockholders shall choose a Chairman of the Board, a President, an Executive Vice President, a Secretary and a Treasurer, and may choose additional Vice Presidents, and one or more Assistant Secretaries and Assistant Treasurers. Section 3. The Board of Directors may appoint such other officers and agents as it shall deem necessary who shall hold their offices for such terms and shall exercise such powers and perform such duties as shall be determined from time to time by the Board. Section 4. The salaries of all officers and agents of the corporation shall be fixed by the Board of Directors. Section 5. The officers of the corporation shall hold office until their successors are chosen and qualified. Any officer elected or appointed by the Board of Directors may be removed at any time by the affirmative vote of a majority of the Board of Directors. Any vacancy occurring in any office of the corporation shall be filled by the Board of Directors. CHAIRMAN OF THE BOARD Section 6. The Chairman of the Board shall be the chief executive officer of the corporation and, subject to the control of the Board of Directors, shall have the general direction and supervision over the business and affairs of the corporation. He shall preside at all meetings of the stockholders and of the Board of Directors and shall be an ex officio member of all committees and shall see that all orders and resolutions of the Board of Directors are carried into effect. He shall participate in determining the policies to be followed by the corporation and shall perform such other duties as the Board of Directors shall from time to time request. THE PRESIDENT Section 7. The President shall undertake such duties as may be delegated to him by the Chairman of the Board and shall also have such other powers and duties as the Board of Directors may from time to time determine. In the absence of the Chairman of the Board or in the event of his inability or refusal to act, the President shall perform the duties of the Chairman of the Board, and when so acting, shall have all the powers of and be subject to all the restrictions upon the Chairman of the Board. THE VICE PRESIDENTS Section 8. In the absence of the President or in the event of his inability or refusal to act, the Executive Vice President, (or in the event of the absence or inability of or refusal to act by the Executive Vice President and in the further event there be more than one Vice President, the Vice Presidents in the order designated, or in the absence of any designation, then in the order of their election) shall perform the duties of the President, and when so acting, shall have all the powers of and be subject to all the restrictions upon the President. Such powers of and restrictions upon the President shall include the performance of the duties of the Chairman of the Board in the further event that the Chairman is absent or is unable or refuses to act. Vice Presidents shall perform such other duties and have such other powers as the Board or Directors may from time to time prescribe. THE SECRETARY AND ASSISTANT SECRETARY Section 9. The Secretary shall attend all meetings of the Board of Directors and all meetings of the stockholders and record all the proceedings of the meetings of the corporation and of the Board of Directors in a book to be kept for that purpose and shall perform like duties for the standing committees when required. He shall give, or cause to be given, notice of all meetings of the stockholders and special meetings of the Board of Directors, and shall perform such other duties as may be prescribed by the Board of Directors or Chairman of the Board, under whose supervision he shall be. He shall have custody of the corporate seal of the corporation and he, or an Assistant Secretary, shall have authority to affix the same to any instrument requiring it and when so affixed, it may be attested by his signature or by the signature of such Assistant Secretary. The Board of Directors may give general authority to any other officer to affix the seal of the corporation and to attest the affixing by his signature. Section 10. The Assistant Secretary, or if there be more than one, the Assistant Secretaries in the order determined by the Board of Directors (or if there is no such determination, then in the order of their election), shall, in the absence of the Secretary or in the event of his inability or refusal to act, perform the duties and exercise the powers of the Secretary and shall perform such other duties and have such other powers as the Board of Directors may from time to time prescribe. THE TREASURER AND ASSISTANT TREASURERS Section 11. The Treasurer shall have the custody of the corporate funds and securities and shall keep full and accurate accounts if receipts and disbursements in books belonging to the corporation and shall deposit all moneys and other valuable effects in the name and to the credit of the corporation in such depositories as may be designated by the Board of Directors. Section 12. He shall disburse the funds of the corporation as may be ordered by the Board of Directors, taking proper vouchers for such disbursements, and shall render to the Chairman of the Board and the Board of Directors, at its regular meetings, or when the Board of Directors so requires, an account of all his transactions as Treasurer and of the financial conditions of the corporation. Section 13. If required by the Board of Directors, he shall give the corporation a bond (which shall be renewed every six years) in such sum and with such surety or sureties as shall be satisfactory to the Board of Directors for the faithful performance of the duties of his office and for the restoration to the corporation, in case of his death, resignation, retirement or removal form office, of all books, papers, vouchers, money and other property of whatever kind in his possession or under his control belonging to the corporation. Section 14. The Assistant Treasurer, or if there shall be more than one, the Assistant Treasurers in the order determined by the Board of Directors (or if there be no such determination, then in the order of their election), shall, in the absence of the Treasurer or in the event of his inability or refusal to act, perform the duties and exercise the powers of the Treasurer and shall perform such other duties and have such other powers as the Board of Directors may from time to time prescribe. ARTICLE VI CERTIFICATES OF STOCK Section 1. Every holder of stock in the corporation shall be entitled to have a certificate, signed by, or in the name of the corporation by, the Chairman or Vice Chairman of the Board of Directors, the President or a Vice President and the Treasurer or an Assistant Treasurer, or the Secretary or an Assistant Secretary of the corporation, certifying the number of shares owned by him in the corporation. Section 2. Where a certificate is countersigned (1) by a transfer agent other than the corporation or its employee, or, (2) by a registrar other than the corporation or its employee, the signatures of the officers of the corporation may be facsimiles. In case any officer who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer before such certificate is issued, it may be issued by the corporation with the same effect as if he were such officer at the date of issue. LOST CERTIFICATES Section 3. The Board of Directors may direct a new certificate or certificates to be issued in place of any certificate or certificates theretofore issued by the corporation alleged to have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the person claiming the certificate of stock to be lost, stolen or destroyed. When authorizing such issue of a new certificate or certificates, the Board of Directors may, in its discretion and as a condition precedent to the issuance thereof, require the owner of such lost, stolen or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require and/or to give the corporation a bond in such sum as it may direct as indemnity against any claim that may be made against the corporation with respect to the certificate alleged to have been lost, stolen or destroyed. TRANSFERS OF STOCK Section 4. Upon surrender to the corporation or the transfer agent of the corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignment or authority to transfer, it shall be the duty of the corporation to issue a new certificate to the person entitled thereto, cancel the old certificate and record the transaction upon its books. FIXING RECORD DATE Section 5. In order that the corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or to express consent to corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board of Directors may fix, in advance, a record date, which shall not be more than sixty nor less than ten days before the date of such meeting, nor more than sixty days prior to any other action. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. REGISTERED STOCKHOLDERS Section 6. The corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and to hold liable for calls and assessments a person registered on its books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware. ARTICLE VII GENERAL PROVISIONS DIVIDENDS Section 1. Dividends upon the capital stock of the corporation, subject to the provisions of the Certificate of Incorporation, if any, may be declared by the Board of Directors at any regular or special meeting, pursuant to law. Dividends may be paid in cash, in property, or in shares of the capital stock, subject to the provisions of the Certificate of Incorporation. Section 2. Before payment of any dividend, there may be set aside out of any funds of the corporation available for dividends such sum or sums as the Directors from time to time, in their absolute discretion, think proper as a reserve or reserves to meet contingencies, or for equalizing dividends, or for repairing or maintaining any property of the corporation, or for such other purpose as the Directors shall think conducive to the interest of the corporation, and the Directors may notify or abolish any such reserve in the manner in which it was created. ANNUAL REPORT Section 3. (a) The Board of Directors shall present at each annual meeting, and at any special meeting of the stockholders when called for by vote of the stockholders, a full and clear statement of the business and condition of the corporation. (b) On or before 120 days from the close of each fiscal year, the Board of Directors shall cause to be delivered to each stockholder of record an audited statement of financial condition of the corporation as at the close of such fiscal year, together with a statement of operations, including profit and loss for such fiscal year. For the purposes of subsection (b), it will be sufficient if such report is mailed in the ordinary course of business to those shareholder of record as at the date on which the record of shareholders has been taken for the purpose of the annual meeting, pursuant to Section 5 of ARTICLE VI of these by-laws. CHECKS Section 4. All checks or demands for money and notes of the corporation shall be signed by such officer or officers or such other person or persons as the Board of Directors may from time to time designate. FISCAL YEAR Section 5. The fiscal year of the corporation shall be fixed by resolution of the Board of Directors. SEAL Section 6. The corporate seal shall have inscribed thereon the name of the corporation, the year of its organization and the words "Corporate Seal, Delaware." The seal may be used by causing it or a facsimile thereof to be impressed or affixed or reproduced or otherwise. INDEMNIFICATION Section 7. (a) Directors, Officers and Employees of the Corporation. Every person now or hereafter serving as a Director, Officer or Employee of the Corporation shall be indemnified and held harmless by the corporation from and against any and all loss, cost, liability and expense that may be imposed upon or incurred by him in connection with or resulting from any claim, action, suit, or proceeding, civil or criminal, in which he may become involved, as a party or otherwise, by reason of his being or having been a director, officer or employee of the corporation, whether or not he continues to be such at the time such loss, cost, liability or expense shall have been imposed or incurred. As used herein, the term "loss, cost, liability and expense" shall include, but shall not be limited to, counsel fees and disbursements and amounts of judgments, fines or penalties against, and amounts paid in settlement by, any such director, officer or employee; provided, however that no such director, officer or employee shall be entitled to claim such indemnity: (1) with respect to any matter as to which there shall have been a final adjudication that he has committed or allowed some act or omission, (a) otherwise than in good faith in what he considers to be the best interests of the corporation, and (b) without reasonable cause to believe that such act or omission was proper and legal; or (2) in the event of a settlement of such claim, action, suit, or proceeding unless (a) the court having jurisdiction thereof shall have approved of such settlement with knowledge of the indemnity provided herein, or (b) a written opinion of independent legal counsel, selected by or in manner determined by the Board of Directors, shall have been rendered substantially concurrently with such settlement, to the effect that it was not probable that the matter as to which indemnification is being made would have resulted in a final adjudication as specified in clause (1) above and that the said loss, cost, liability or expense may properly be borne by the corporation. A conviction or judgment (whether based on a plea of guilty or nolo contendere or its equivalent, or after trial) in a criminal action, suit or proceeding shall not be deemed an adjudication that such director, officer or employee has committed or allowed some act or omission as hereinabove provided if independent legal counsel, selected as hereinabove set forth, shall substantially concurrently with such conviction or judgement give to the corporation a written opinion that such director, officer or employee was acting in good faith in what he considered to be the best interests of the corporation or was not without reasonable cause to believe that such act or omission was proper and legal. (b) Directors, Officers and Employees of Subsidiaries. Every person (including a director, officer or employee of the corporation) who at the request of the corporation acts as a director, officer or employee of any other corporation in which the corporation owns shares of stock or of which it is a creditor shall be indemnified to the same extent and subject to the same conditions that the directors, officers, and employees of the corporation are indemnified under the preceding paragraph, except that the amount of such loss, cost, liability or expense paid to any such director, officer or employee shall be reduced by and to the extent of any amounts which may be collected by him from such other corporation. (c) Miscellaneous. The provisions of this section shall cover claims, actions, suits and proceedings, civil or criminal, whether now pending or hereafter commenced and shall be retroactive to cover acts or omissions or alleged acts or omissions which heretofore have taken place. In the event of death of any person having a right of indemnification under the provisions of this section, such right shall inure to the benefit of his heirs, executors, administrators and personal representatives. If any part of this section should be found to be invalid or ineffective in any proceeding, the validity and effect of the remaining provisions shall not be affected. (d) Indemnification Not Exclusive. The foregoing right of indemnification shall not be deemed exclusive of any other right to which those indemnified may be entitled, and the corporation may provide additional indemnity and rights to its directors, officers or employees. ARTICLE VIII AMENDMENTS Section 1. These by-laws may be altered or repealed at any regular meeting of the stockholders or of the Board of Directors or at any special meeting of the stockholders or of the Board of Directors if notice of such alteration or repeal be contained in the notice of such special meeting. Exhibit 13 AYDIN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements. AYDIN CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements. AYDIN CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements. AYDIN CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiaries, and its 99%-owned Turkish subsidiary. All significant intercompany transactions and balances are eliminated in consolidation. During 1992 $800,000 of cash was invested in the Turkish subsidiary reflecting an ownership of 71% as of December 31, 1992 from 50% earlier. During 1993, $2.8 million of cash was invested to bring the ownership to 99%. Contract Accounting: Revenue on long-term type contracts in excess of $100,000 is recorded on the percentage-of-completion method. For such contracts, a portion of the total contract price is included in sales in the proportion that costs incurred to date bear to total estimated costs at completion. The impact of periodic revisions in costs and estimated profit is reflected in the accounting period in which the facts become known. For all other contracts, revenue is recognized upon completion of the contract or upon shipment of identifiable units. The entire amount of ultimate losses estimated to be incurred upon completion of contracts is charged to income when such losses become known. Contract progress billings are based upon contract provisions for customer advance payments, contract costs incurred, and completion of specified contract objectives. Contract billings for partial shipments where product title passes to the customer are not considered progress billings. Contracts may provide for customer retainage of a portion of amounts billed until contract completion. All contract retainage at December 31, 1993 matures in 1994. Claims from customers of approximately $1.0 million for work performed outside the scope of certain contracts for which the Company anticipates recovery are included in unbilled revenue at December 31, 1993. The comparable amount at December 31, 1992 was $3.8 million. Under the contract with the Government of Turkey, the Company received total advance payments of $56 million in October 1990 which were to be applied against future billings over the next six years. The contract provides for price escalation based on U.S. and Turkish inflation rates. Inventories: Inventories are valued at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) and average cost method which approximates FIFO. Depreciation and Amortization: Depreciation is provided by the straight-line method over the estimated useful lives of the depreciable assets. Amortization of leasehold improvements under operating leases is provided over the terms of the related leases or the asset lives, if shorter. Income Taxes: The Company accounts for income taxes on the liability method in accordance with Statement of Financial Accounting Standards (FAS) No. 109 which it adopted in 1991. Previously, the Company accounted for income taxes in accordance with FAS No. 96, which it adopted in 1987. The effect of the adoption of FAS No. 109 was not material. Foreign Currency Translation: In accordance with FAS No. 52, balance sheet accounts of the Company's United Kingdom subsidiary are translated from the local currency into U.S. dollars at year-end rates while income and expenses are translated at the weighted average exchange rate for the year. The resulting translation gains or losses are shown as a separate component of stockholders' equity. The translation effects of all other non-U.S. subsidiaries are reflected in the income statement. Earnings (Loss) Per Share: Earnings (loss) per share are based on the weighted average number of common shares outstanding plus shares issuable upon the assumed exercise of dilutive common stock options. The number of shares used in earnings (loss) per share calculations was 4,959,740 for 1993, 5,043,063 for 1992, and 5,071,978 for 1991. Statement of Cash Flows: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Short-Term Investments: Short-term investments are carried at cost which approximates market. Short-term investments at December 31, 1993 consist of interest-bearing certificates of deposit and time deposits with initial terms of 3 to 12 months. The total includes $1.9 million held by the Company's Turkish subsidiary, all denominated in U.S. dollars. Cash and short term investments include $19.9 million held as collateral against outstanding letters of credit. NOTE B--INVENTORIES Inventories at December 31, 1993 and 1992 consist of: NOTE C--PROPERTY, PLANT, AND EQUIPMENT The Company's investment in property, plant, and equipment at December 31, 1993 and 1992 follows: NOTE D--SHORT- AND LONG-TERM FINANCING ARRANGEMENTS The Company has annually renewable arrangements with certain banks whereby lines of credit aggregating $70,856,000 are available for letters of credit, including $14,000,000 which, alternatively, is available for short-term cash borrowings. An additional $14,900,000 is available for short-term borrowings only. These arrangements provide for interest on borrowings at rates ranging from LIBOR-based rates (generally below prime) to the prime lending rate (6.0% at December 31, 1993) plus 1/2%. These arrangements also require informal compensating cash balances averaging (on an annual basis) $475,000 (or equivalent fees) plus an additional amount up to 5% (maximum $725,000) of outstanding borrowings, and provide for commission rates on letters of credit at 1/2% to 1 1/8%. As of December 31, 1993 and 1992 there were $21,525,000 and $22,000,000 of borrowings under these lines, respectively. At December 31, 1993, $58,000,000 of letters of credit were outstanding under these arrangements. These have been issued to foreign entities, principally to guarantee either contract performance or the return of unearned advance payments in the unlikely event that performance is not in accordance with the contracts, or to foreign suppliers to guarantee payment to them of the amount due. Of the total amount outstanding, $42.5 million pertains to the Company's contract with the Government of Turkey. This letter of credit was issued pursuant to a Credit Agreement with certain banks. The term extends to October 4, 1996 or until the letter of credit is reduced to zero, whichever occurs first. Cash or short- term investment collateral is required to be maintained equal to 1/3 of the balance outstanding in the letter of credit which amounts to $14.2 million. In addition to certain covenant requirements, the Credit Agreement contains restrictions concerning the payment of dividends and purchase of treasury stock which in the aggregate are limited to 50% of net income for the prior four fiscal quarters. An additional letter of credit of $5.7 million pertaining to the Turkish contract has been issued by a Turkish bank for the Company's Turkish subsidiary. This letter of credit is not part of the Company's line of credit. Cash or short-term investment collateral is required to be maintained by the Turkish subsidiary equal to 100% of the balance outstanding on this letter of credit. NOTE E--LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consists of the following: Interest expense on long- and short-term debt for the years 1993, 1992, and 1991 amounted to $1,310,000, $639,000, and $243,000, respectively. Interest paid for the years 1993, 1992, and 1991 amounted to $1,402,000, $409,000, and $251,000, respectively. Land and buildings having a net carrying value of $5,514,000 at December 31, 1993 have been pledged as collateral for the mortgages. Aggregate maturities of long-term debt for each of the years 1994 through 1998 are as follows: 1994--$397,000; 1995--$402,000; 1996--$407,000; 1997--$358,000; and 1998--$201,000. NOTE F -- STOCKHOLDERS' EQUITY The changes in common stock, additional paid-in capital, treasury stock, retained earnings, and foreign currency translation effects during the years 1991, 1992, and 1993 were as follows: NOTE G--STOCK OPTIONS Pursuant to stock option plans, the Company has granted certain officers, directors, and key employees options to purchase shares of its common stock. Options granted under the plans must have an option price determined by the Board of Directors, but in any event, not less than the fair market value of the stock on the date of grant except for the 1984 plan of 187,500 shares which permits the Board of Directors to set an option price up to 50% less than the fair market value of the stock on the date of grant. Generally, options become exercisable one-fourth annually beginning one year after grant, on a cumulative basis, and expire five years after grant. There is no charge to income with respect to stock options under the plans. A summary of the changes in options during 1991, 1992, and 1993 follows: These options expire on various dates beginning February 1994 and ending October 1998. The average exercise price of options outstanding at December 31, 1993 is $13.28. On January 3, 1994, the Board of Directors adopted a new incentive stock option plan to provide up to 50,000 shares for the grant of stock options to employees. The authorized number of shares was increased to 100,000 on February 25, 1994. NOTE H--TAXES ON INCOME The provision (recovery) for income taxes consists of the following: The components of deferred income tax balances follow. No valuation allowances were required. A reconciliation between the federal statutory rate and the effective income tax rate (computed by dividing income taxes by income or loss before income taxes and minority interest) is as follows: Income tax payments, net of refunds, amounted to $4,332,000 in 1991, $5,066,000 in 1992, and $2,138,000 in 1993. The Company has not provided deferred income taxes of approximately $600,000 on cumulative unremitted earnings of foreign subsidiaries, based on management's intention to permanently invest such earnings in the foreign jurisdictions. NOTE I--EXPORT SALES, MAJOR CUSTOMERS, AND FOREIGN OPERATIONS The Company operates predominantly in the electronics manufacturing industry. Export sales by geographic area are as follows: The U.S. Government and the Government of Turkey were the only customers to whom sales exceeded 10% of consolidated sales during any of the past three years. Sales to U.S. Government agencies, principally the Department of Defense, amounted to $38,600,000, $39,347,000 and $65,360,000 in 1993, 1992 and 1991, respectively. Sales to the Government of Turkey amounted to $45,134,000 in 1993, $48,738,000 in 1992 and $41,228,000 in 1991. Foreign assets included in the consolidated balance sheet amounted to $16.9 million, $23.4 million and $26.1 million at December 31, 1993, 1992 and 1991, respectively. Of these amounts, $13.7 million, $19.1 million and $21.1 million, at December 31, 1993, 1992 and 1991, respectively, are assets of the Company's Turkish subsidiary and consist mainly of U.S. dollar denominated interest-bearing time deposits that will be used to complete a portion of the Company's contract with the Government of Turkey. Foreign sales and pretax income for 1993 amounted to $23.0 million and $3.9 million, respectively. Foreign sales and pretax income for 1992 amounted to $19.3 million and $3.3 million, respectively. Foreign sales and pretax income for 1991 amounted to $17.8 million and $3.9 million, respectively. NOTE J--CONTINGENCIES The Company along with others is responsible for the cost of cleanup at a site leased by the Company prior to 1984 under an order of the State of California. The cost to date for the cleanup of the California site over the past nine years has been approximately $5.4 million. Settlement has been reached with three of four insurance carriers for approximately $6.7 million which was received during 1993 and applied to the cleanup costs previously incurred and cost to go. The claim against the fourth insurance carrier is presently in litigation. A jury has ruled in Aydin's favor, however, a final decision by the court has not yet been rendered. Management believes the ultimate resolution of this entire matter will not have a materially adverse effect on the financial position or results of operations. The IRS, as part of a field examination, has disallowed certain prior years research and development tax credits taken by the Company amounting to approximately $3.5 million plus related interest. The Company is challenging this finding with the appeals office of the IRS. Management is of the opinion that the ultimate resolution will not have a materially adverse effect on the financial position or results of operations. NOTE K - SETTLEMENT WITH THE DEPARTMENT OF JUSTICE On January 5, 1994, the Company reached settlement agreements with the U.S. Army and the Department of Justice ("DOJ") with reference to the AN/GRC-222 microwave radio contract. Under the terms of the agreement, the U.S. Army will reinstate the radio contract by withdrawing its previous termination for default issued November 30, 1993. Further, the investigation and all possible charges against the Company by the DOJ are settled. On January 6, 1994, pursuant to the terms of settlement with DOJ, the Company entered a plea of guilty to the falsification of testing data, charges to which two of its low level employees previously pled guilty to in March 1993, and the plea was accepted by the court (U.S. District Court for the Northern District of California). The Company is reinstated on its AN/GRC-222 microwave radio contract with all of its previous terms and conditions. Further, the Company withdrew its contract claims, is doing additional work for the Army at no additional cost, and paid $2 million as an added consideration. The total impact on pretax income of this settlement was approximately $14,819,000, which has been charged to the 1993 fourth quarter earnings. The additional work and the related expenditures will be spread over a period of three years or longer. REPORT OF INDEPENDENT AUDITORS Stockholders and Board of Directors Aydin Corporation We have audited the accompanying consolidated balance sheets of Aydin Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations 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 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 Aydin Corporation 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. /s/ KPMG Peat Marwick Philadelphia, Pennsylvania February 25, 1994 Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Sources of Capital Cash used by operations during 1993 was $7.0 million. The primary reasons for the cash outflow included: (1) a $7.5 million increase in unbilled revenue mainly because of costs incurred and resulting revenue recognized on the TMRC-C3 contract with the Government of Turkey in excess of billings rendered; and (2) a $7.9 million increase in accounts receivable primarily because of the commencement in 1993 of billings on the TMRC-C3 contract especially in the fourth quarter, offset partially by $4.0 million of cash received in settlement of insurance litigation related to environmental matters. Partially offsetting these cash outflows was a $3.3 million decline in inventories and $4.5 million of depreciation. Also during 1993, $2.4 million was spent for capital additions and $2.8 million was spent to increase the ownership in the Turkish subsidiary from 71% at December 31, 1992 to over 99% at December 31, 1993. Of the $24.9 million balance of cash and short-term investments at December 31, 1993, approximately $19.9 million is required to be maintained as collateral against letters of credit on the Turkish contract. Cash used by operations during 1992 was $29.6 million and short-term borrowings increased by $22.0 million primarily because of costs incurred on the TMRC-C3 contract with the Government of Turkey. An advance payment of $56.0 million was received in 1990 on this contract with further billings not scheduled to commence until early 1993. The aforementioned costs incurred and resulting revenue recognized are the reasons for the $41.4 million increase from 1991 of unbilled revenue net of advance payments (received) and contract billings in excess of recognized revenue. Accounts payable increased by $8.8 million primarily because of subcontracts placed on the TMRC-C3 contract. Also during 1992, $1.4 million was spent for capital additions and a $2.5 million cash dividend was paid. Further cash dividends are not planned for 1993. Also, the aggregate of future cash dividends and stock repurchases are limited to 50% of net income under the terms of the letters of credit agreement against the Turkish contract advance payment. Based on the present backlog and projected cash flows, the Company anticipates financing its capital needs from internal sources and from short-term borrowings in the foreseeable future. The backlog declined to approximately $155.0 million at December 31, 1993 from $175.0 million at year end 1992. At December 31, 1993 the Company had short-term borrowing arrangements of $29.0 million, of which $21.5 million had been used. These lines may be reduced if the Company has to issue letters of credit for performance guarantees in foreign countries. Results of Operations 1993 versus 1992: Net sales of $141,475,000 for 1993 decreased by $3,746,000 from 1992, a decline of 3%. Industrial sales declined to 17% of total sales from 19% last year due to continued market weakness in the Company's market niches. U.S. Government sales declined slightly and were offset by a small increase in export and foreign sales which now represent 56% of total sales versus 54% last year. The $14,819,000 1993 special settlement charge included in the cost of sales caption is the result of the Company's decision to assume responsibility and plead guilty to criminal charges of falsification of test data on a U.S. Government contract (GRC-222), actions to which two low level employees had previously pled guilty. Of this charge, $2.0 million were cash payments made after December 31, 1993. The balance represents additional work and to upgrade the GRC-222 microwave radios for the U.S. Army and Aydin's dropping of claims it had filed against the Army. Other cost of sales as a percentage of sales increased to 73.3% from 69.9% last year as a result of a more competitive U.S. Government business environment in 1993, a more favorable sales mix in 1992 and cost overruns on certain contracts in 1993. Selling, general and administrative expenses declined by $2,212,000 from 1992 because of cost reductions necessitated by the declines in sales and backlog. Net interest expense was $273,000 in 1993 compared to last year's net interest income of $1,177,000. The unfavorable swing reflects the higher level of this year's short-term borrowings and a decreased level of cash available for investment this year. The effective income tax rate decreased to 34% for 1993 from 36% last year. The primary reason for the lower 1993 income tax rate is a function of a pretax loss in the U.S. in 1993 which means that the following elements of tax reduced the effective rate: foreign income tax provisions, non-deductible costs in connection with the Department of Justice settlement, and the impact on deferred taxes of the increased U.S. statutory rate effective January 1, 1994. Partially offsetting these effects was the tax benefit from non-taxable Foreign Sales Corporation income and a higher state income tax recovery on the 1993 U.S. pretax loss than the 1992 state income tax provision. See Note H for the impact of each of these items. 1992 versus 1991: Net sales of $145,221,000 for 1992 decreased by $13,323,000 from 1991, a decline of 8%. U.S. Government sales declined to 27% of total sales from 41% last year as a result of lower U.S. Government military spending. Export and foreign sales rose to 54% of total sales from 43% last year, and industrial sales rose slightly from last year. Cost of sales as a percentage of sales improved to 69.9% from 70.2% last year as a result of a more favorable sales mix in 1992. Interest income, net of interest expense, declined by $2,471,000 from 1991 because of a lower level of short-term investments, lower interest rates, and a higher level of short-term borrowings. The income tax provision as a percentage of pretax income increased to 36% for 1992 from 27% in 1991 primarily as a result of higher foreign income tax rates during 1992 than in 1991. Minority interest was $761,000 in 1992 as compared to $1,687,000 last year. The decrease reflects lower net income of the Turkish subsidiary which resulted primarily from the aforementioned higher foreign income taxes, and also an increased investment in the ownership of the Turkish subsidiary as explained in Note A. Selected Financial Data ($000 omitted except for per share amounts) Quarterly Financial Data ($000 omitted except per share amounts) Common Stock Prices Aydin Corporation is listed on the New York Stock Exchange, symbol AYD. Audit Committee The Audit Committee of the Board of Directors is comprised of non-management directors who have no business dealings with or material equity interest in the Company. The Committee has the following powers and duties: (1) to appoint and retain or dismiss the independent auditors and the internal auditor; (2) consult with the independent auditors on a quarterly basis (a) on any disagreements with management and (b) concerning the auditors' limited review of interim financial information; (3) review the management letters issued by the independent auditors and consult with them annually as to means by which internal accounting controls can be improved; (4) receive and review quarterly reports by the independent auditors on any internal accounting control deficiencies; (5) receive quarterly reports from the internal auditors; (6) review and approve all monthly corporate and division financial statements disseminated to the stockholders or filed with the Securities and Exchange Commission; (7) consult with the chief accounting officer concerning the implementation of recommendations of the independent auditors and internal auditors; (8) review the chief executive officer's expenses; and (9) review and approve the professional services rendered by the independent auditors. Stockholder and Dividend Information Aydin has approximately 6,000 stockholders of record and individual participants in security position listings. A special cash dividend of $.50 per share to stockholders of record as of the close of business on March 16, 1992, was paid on March 31, 1992. Aydin has no present plans to pay any special cash dividends. Annual Meeting The Company's Annual Meeting of Stockholders will be held on Friday, April 29, 1994, at 3:00 p.m., in the Corporate Office at 700 Dresher Road, Horsham, Pennsylvania. Stockholders are cordially invited to attend the Annual Meeting. Form 10K A copy of Aydin Corporation's Annual Report on Form 10-K may be obtained without charge by writing to Aydin Corporation, 700 Dresher Road, P.O. Box 349, Horsham, PA 19044, Attn: Investor Relations. Exhibit 21 SUBSIDIARIES OF REGISTRANT

15393_1993.txt

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1993

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ITEM 1. Business -------- General Development of Business and Narrative Description of Business - --------------------------------------------------------------------- Business of BNA and Subsidiaries - -------------------------------- The Bureau of National Affairs, Inc. (BNA), is a leading publisher of specialized business, legislative, judicial, and regulatory information services. BNA was founded in 1929, and was incorporated in its present form as an employee owned company in 1947. BNA is independent, for profit, and is the oldest fully employee-owned company in the United States. BNA and its publishing subsidiaries, Tax Management Inc. and Pike & Fischer, Inc., are engaged in providing labor, legal, economic, tax, health care and other regulatory information to business, professional, and academic users. They prepare, publish, and market looseleaf subscription information services in print and compact disc formats, books, pamphlets, and research reports. Sales are made principally in the United States through field sales personnel who are supported by direct mail, space advertising, and telemarketing. Customers include lawyers, accountants, business executives, human resource professionals, health care administrative professionals, labor unions, trade associations, educational institutions, government agencies, and libraries in the United States and throughout the world. The BNA Electronic Media Division develops online databases and other electronic products from BNA services and other information, creates original electronic databases, and engages in research and development for electronic delivery of BNA information. These products are marketed through online database vendors such as Mead Data Central, West Publishing Company, Dialog, Cambridge Information Group, and others. BNA Software, a division of Tax Management Inc., develops, produces, and markets tax and financial planning software for use on personal computers. Sales are made to accountants, lawyers, tax and financial planners, and others. The products are marketed through direct mail, space advertising, and BNA field sales representatives. BNA International Inc. is the company's agent for sale of its domestic services in the United Kingdom, Europe, Africa, and Asia, and also engages in independent publishing activity, including adaptation of the company's domestic products for sales abroad. The McArdle Printing Co., Inc. provides printing services to mid-Atlantic area customers. It utilizes modern equipment and technology in printing information products for publishers, trade associations, professional societies, other non- profit organizations, financial institutions and governmental organizations. Approximately 65 percent of its business is derived from the BNA publishing companies. BNA Communications Inc. (BNAC) is engaged in the business of producing, publishing, and marketing programs for training in the Equal Employment Opportunity and safety and health related fields. The programs promote awareness, compliance, prevention, and training for managers and employees in industry and government, using audio visual and printed materials. Item 1 General Development of Business and Narrative Description --------------------------------------------------------- of Business (Continued) --------------------------- Review of Operations BNA's results for 1993 reflect the company's decision to bring to market as quickly as possible a new line of CD-ROM products to meet a growing demand for information in this exciting format and to protect its circulation base from aggressive new competition. The strategy carried a high price tag, but the enthusiastic response to the company's first CD-ROM offerings confirms the validity of the decision. The first CD-ROM product, TAX MANAGEMENT PORTFOLIOS PLUS, was launched late in 1992. It was followed in June of 1993 with BNA'S ENVIRONMENTAL LIBRARY ON CD-ROM. BNA'S HUMAN RESOURCES LIBRARY ON CD-ROM was introduced in September, and BNA's COMPENSATION & BENEFITS LIBRARY and TAX MANAGEMETN'S TAX PRACTICE SERIES ON CD-ROM came to market as the year drew to a close. Together these five products accounted for sales of over $10 million in 1993. The increasing importance of CD-ROM and other electronic products has made replacement of the company's aging editorial/production systems a high priority, and this, too, was begun in 1993. The present systems were designed for print. Their use to create electronic product is costly, slow, and cumbersome. A strong performance by the corporate investment portfolios, a banner year for BNA Software, the absence of ETSI losses, and a substantial reduction in the losses of other operations more than offset major expenses for new products, systems, and technology by the parent company, and consolidated net income rose to $11.3 million in 1993, a gain of 19.5 percent from comparable earnings of the previous year. Investment income increased by 40 percent to $6.2 million for the year. Realization of nearly $2 million in securities capital gains, which had resulted from declining market interest rates, was a major portion of the increase and is unlikely to be repeated in 1994. Despite higher cash outlays for capital expenditures, loan repayments, and repurchases of treasury shares, cash and investments increased by $10 million. With year-end cash and investment balances totalling $85 million, BNA's liquidity and financial reserves remain strong relative to the company's obligations. Expenses for 1993 included a charge of $4 million for post-retirement health care benefits. This charge is the result of a new accounting rule (SFAS 106) adopted in 1992. It is expected to increase with medical cost inflation and growth in employment rolls. Turnover in the ranks of management during the year demonstrated once again that the company has a depth of talent to match its financial strength. Vacant positions were filled from within and the business, including all of the sweeping new initiatives undertaken, advanced without missing a beat. The year saw a continued growth in total circulation units, although some of the CD-ROM sales resulted in cancellations of print services. It is not yet clear how much of an effect electronic alternatives will have on print circulation. The 1994 print renewal cycle should provide some enlightenment. Consolidated revenues exceeded $200 million for the first time in the company's history. Revenue gains were achieved by the parent company and by all of its publishing subsidiaries. A REVIEW OF 1993 OPERATIONS OF THE PARENT COMPANY AND EACH SUBSIDIARY FOLLOWS: THE BUREAU OF NATIONAL AFFAIRS, INC. Parent company revenues of $141 million in 1993 were 6.2 percent higher than in the previous year. Subscription service revenue was up by 6.9 percent. The Electronic Media Division also reported a year-to-year gain. Revenues were lower for the Book Division and for BNA PLUS. Much was accomplished during the year. Ten new services, including the parent company's first three CD-ROMs, were launched; two well-established older services, BNA POLICY AND PRACTICE SERIES and LABOR RELATIONS REPORTER, were extensively revised to reflect the current state of the law and to accommodate new material; substantial progress was made on the company's new business system to become operational in 1994; and work began in earnest on a new publishing system following a thorough study of the company's present and future needs and the available outside resources to meet these needs. New subscription sales of BNA and Tax Management services rose by 25 percent from the previous year to a record $29.3 million. BNA'S ENVIRONMENTAL LIBRARY ON CD-ROM, introduced in June, was the leading product of the year with sales of $3.5 million. The HUMAN RESOURCES LIBRARY ON CD-ROM, a fall launch, was second among top-sellers for the parent company, followed by LABOR RELATIONS REPORTER with its new AMERICANS WITH DISABILITIES CASES section and completely revised WAGE HOUR MANUAL. A major capital expenditure was made mid-year to equip the field sales force with laptop computers and CD-ROM drives so that representatives could effectively demonstrate the company's new line of electronic products. Sales & Marketing and Information Systems combined expertise and conducted intensive training programs throughout the country. Representatives embraced the new technology with astonishing speed and the results speak for themselves. The leading new print product of the year was HEALTH CARE POLICY REPORT, flagship of the new Health Care Services Division. The division acquitted itself well in its first full year of operations with sales of $1.6 million. It ended the year with three successful products and a fourth scheduled for launch in the first quarter of 1994. HEALTH CARE ELECTRONIC DATA REPORT was merged with its sister new product, HEALTH CARE POLICY REPORT, within a few months when initial sales fell short of pre-launch projections. The aggressive new product development program called for in the company's current strategic plan requires a close monitoring of performance and prompt action where a product fails to meet its circulation goals and shows little promise of achieving profitability in a reasonable period of time. Three services were terminated in the course of 1993 and subscribers were offered alternative, related services in their stead. A fourth service, BNA'S EASTERN EUROPE REPORT, was transferred to BNA International, where its chances for success are enhanced by a lower cost structure and more targeted foreign marketing. A fifth, BNA'S NATIONAL ENVIRONMENT WATCH, was given a new name and charter to appeal to a more promising market segment. It has become BNA'S ENVIRONMENT COMPLIANCE BULLETIN and is the company's first product with state- specific inserts produced by the editors through a desktop publishing system. Efforts to raise BNA's already high level of customer satisfaction remained a priority in an atmosphere of rapidly evolving needs and increasing competitive pressure. The Customer Satisfaction Committee appointed in 1992 worked effectively to heighten company-wide awareness of customer concerns and made significant progress on recommendations in the Customer Satisfaction Audit Report. Customer-oriented initiatives resulted in a better system for collecting and responding to subscriber comments, expanded service hours, and enhanced subscription retention efforts. The need for complete and accurate information about customers remained prominent in the design of the company's new business information system. BNA PLUS BNA PLUS, the company's highly regarded subscriber support arm, stepped up to new challenges presented by the addition of CD-ROM products to BNA's already formidable range of information services. Working in close partnership with the newly formed technical support group in the Information Systems Division, PLUS personnel helped to educate both subscribers and sales representatives as each new disk product appeared. More than 100,000 calls were handled in 1993, representing a 20 percent increase over the previous year. The three PLUS business units (documents, compilations, and custom research) produced revenues of $1.7 million in 1993. The combined revenue of the documents and compilations units, $1.4 million, increased 16.8 percent over 1992. Custom research revenue dropped from year-to-year as a result of a decision to convert custom environmental regulation monitoring to subscription services sold by the field sales force. ELECTRONIC MEDIA DIVISION The Electronic Media Division achieved record online revenues and profits in 1993. Revenues of $2.9 million were 7 percent greater than 1992, and operating profit was $509,000, an 18 percent increase. The Division also explored products for emerging media other than traditional online and CD-ROM, with the objective of preserving BNA's competitive position in the rapidly changing electronic environment. EMD ended the year with 292 products on seven online systems, including a new distributor, Legi-Slate. Electronic-only daily updating services were added to Legi-Slate, a subsidiary of the Washington Post Company, at mid-year. Two new online dailies, BNA's CORPORATE COUNSEL DAILY and BNA'S EMPLOYMENT POLICY & LAW DAILY, were introduced on Lexis, Westlaw, and Dialog. Other new electronic products launched in 1993 included: AMERICANS WITH DISABILITIES CASES on Lexis, Westlaw and the Human Resource Information Network (HRIN); HEALTH CARE PLOICY REPORT and MEDICARE REPORT on Lexis and HRIN; and HEALTH LAW REPORTER and DAILY ENVIRONMENT REPORT on Lexis. DAILY LABOR REPORT and UNITED STATES LAW WEEK were relaunched in a standardized coding format, while UNITED STATES LAW WEEK Section 4 -- Supreme Court Opinions -- was added to Lexis and Westlaw. EMD also worked very closely with Westlaw, which had keyed the 45-year electronic archive of U.S. PATENTS QUARTERLY, to bring that archive to BNA for use as a proprietary CD-ROM product. Through the newly created BNA Ventures, the management and staff of EMD participated in evaluating the array of joint venture, alliance, and acquisition opportunities created by the new electronic era. Through BNA Ventures, the best of these possibilities will be appropriately evaluated and pursued. BNA BOOKS With $4.4 million in revenues in 1993, the BNA Book Division nearly equalled its record-setting $4.5 million in 1992, a year that saw the publication of the third edition of DEVELOPING LABOR LAW. By mid-1993, cumulative sales of DEVELOPING LABOR LAW topped $1 million with 5,500 units sold. The Division reduced its operating loss to $166,000 in 1993, a 32 percent improvement from the previous year. One half of the Division's new products in 1993 were authored by BNA or former BNA employees. Four such products -- BNA'S DIRECTORY OF U.S. LABOR ORGANIZATIONS, BNA'S STATE ADMINISTRATIVE CODES AND REGISTERS DIRECTORY, BNA'S STATE AND FEDERAL COURT DIRECTORY, and CODES OF PROFESSIONAL RESPONSIBILITY -- won national recognition in LEGAL INFORMATION ALERT'S survey of the 50 most useful reference sources for law librarians. SUPREME COURT PRACTICE, 7TH EDITION, was released in 1993. The treatise, considered the "bible" in the field, has been published by BNA since 1950. ENVIRONMENTAL TAX HANDBOOK was produced with Tax Management Inc., and readily met with critical and commercial success. Also, the Division reached agreement with the ABA Section on Labor and Employment Law to incorporate sections of EMPLOYEE BENEFITS LAW into a new BNA CD-ROM product. The Division added to its successful Fact Sheet product line with new products on flexible spending accounts, COBRA, and the Americans with Disabilities Act. All fact sheets, including 1992's highly successful fact sheet on preventing sexual harassment, exceeded budget expectations. New technology continued to translate into immediate cost savings on the production side of the business. Approximately one quarter of the Division's titles employed desktop publishing technology in 1993, saving up to two-thirds of the average expense for traditional composition methods. By mid-year, it was clear, however, that the ambitious growth plan set out for the Book Division in 1989 needed to be modified. The Division managers met throughout the budgeting process and put together an entirely new plan for 1994 - -1996, which calls for more immediate profitability along with lower revenue growth expectations. Even greater use of BNA editorial talent and materials is contemplated under the new plan. The Division will take advantage of the company's new technologies to produce more spinoff book products and will seek to contribute more materials to CD-ROM efforts. Also, the Division will emphasize renewable products and regular supplementation in its new product development efforts. These strategies should hold the Division in good stead for the future. TAX MANAGEMENT INC. Tax Management had another record-breaking year with 1993 revenues of $38.2 million for services and BNA Software. Net income of $5.1 million made it the most profitable year ever, and the parent company was paid a $3.6 million dividend. Tax Management print and CD-ROM new service sales of $6 million exceeded 1992 sales by 53 percent. TAX PRACTICE SERIES ON CD-ROM, launched in September, was an immediate sales success, and TAX MANAGEMENT PORTFOLIOS PLUS, launched in the fall of 1992, continued to gain circulation. CD-ROM subscribers benefitted from the addition of the Internal Revenue Code, Treasury Regulations, and IRS publications, as well as IRS Forms and additional finding tools. Providing this public domain information, licensed from other vendors, increases the value of the CD-ROM services and compliments the unique benefits of Tax Management proprietary information. To accommodate market preferences, the portfolios are available in either CCH ACCESS or Folio versions. During the year, Tax Management published the equivalent of 50 new or revised portfolios, including major coverage of mergers and acquisitions, the foreign tax credit, and partnership transactions. Coverage of the 1993 tax act was unprecedented with TAX WEEKLY REPORT providing section-by-section explanations at each stage in the legislative process. Although the act affected more than 140 portfolios and 130 TAX PRACTICE SERIES chapters, updating was completed in record time. New marketing initiatives in advertising, mail promotion, and client relations also achieved outstanding results. The client relations and training unit built stronger subscriber allegiance through telephone interviews and training, while also generating sales leads for field follow-up that resulted in $275,000 in firm sales. Product Specialists also contributed to the on-going training of representatives and provided valuable information to marketing and editorial operations for product development and enhancement. BNA SOFTWARE 1993 was the most financially successful year in the history of BNA Software. Total revenues grew by 11.4 percent over the previous year, reaching $8.5 million, and the division's operating profit rose to $1.9 million, which was 21.8 percent of revenues. BNA Software capitalized on the uncertainty surrounding new tax legislation with the release of a special version of the BNA INCOME TAX SPREADSHEET incorporating the Clinton tax proposals. This pre-enactment release generated many new sales and a great deal of goodwill. BNA Software's rapid release of updates incorporating the new law as well as an aggressive customer retention program led to improved renewal rates and higher than expected year-end circulation. The major revenue-producing products for the software division continue to be the BNA INCOME TAX SPREADSHEET, the BNA ESTATE TAX SPREADSHEET, and the BNA FIXED ASSET MANAGEMENT SYSTEM. PIKE & FISCHER, INC. Pike & Fischer's net income rose to $776,000 in 1993, exceeding 1992 earnings by more than 24 percent. As a result, it was possible to pay the parent company a $600,000 dividend for 1993, $100,000 more than in any previous year. At $4.7 million, 1993 operating revenues were the highest in the company's 54- year history. While unfavorable economic conditions in the fertilizer industry resulted in a decline in revenues from the Green Markets product group, this shortfall was more than offset by increases in revenues from other Pike & Fischer publications and from editorial services contracts. Overall, operating revenues were 4 percent higher than in 1992. Although revenues moved up only slightly, careful cost management resulted in an 18 percent rise in operating profit. Operating profit exceeded $1 million for the first time, even though the company recorded more than $390,000 in non-cash amortization expenses, mostly related to the 1991 Green Markets purchase. Management's principal focus in 1993 was on improving the quality of existing publications. The most ambitious project begun in 1993 was a reengineering of Pike & Fischer's flagship telecommunications publication, RADIO REGULATION. The service's 32-year-old digest classification system was thoroughly re-examined and refined and more than 2,000 pages of reclassified digests were sent to subscribers. Subscribers also received the new DESK GUIDE TO COMMUNICATIONS LAW RESEARCH, a 400-page paperbound collection of the most important tables and indexes from fifteen volumes of the basic Radio service. Plans for a Third Series were formulated and are being refined in discussions with the Radio Advisory Board, which was established in the fall of 1992. Finally, work was started on adding a CD-ROM component to the service, for release in the first quarter of 1994. Other enhancements to existing products included the introduction of an electronic mail edition of the Green Markets newsletter to permit the publication to compete better in international markets, where fast, inexpensive delivery is essential. A GREEN MARKETS ELECTRONIC ARCHIVE containing the full text of all articles published in 1992 and 1993 made its debut at the end of the year. In addition, ADLAW BULLETIN, a newsletter designed to accompany Pike & Fischer's administrative law service and to be sold separately, was developed and launched. Pike & Fischer also produced its first electronic publication for both Windows and DOS, CABLE TV RULES ON DISK. BNA INTERNATIONAL INC. BNA International continued to reap the rewards of its restructuring and dramatically reduced the losses of previous years. The subsidiary company's after-tax loss dropped to $57,000 for 1993, compared to a loss of $535,000 in the prior year. BNAI service revenues grew to $2 million, partly as a result of acquiring BNA'S EASTERN EUROPE REPORT mid-year, but also from circulation gains for all BNAI services. Foreign sales of parent company products were marginally ahead of 1992. Demand for BNA's environmental and intellectual property services remained strong in most markets, and interest in tax and environment CD-ROM products began to grow as this technology became more widely available internationally. The drive to reduce costs and improve efficiency continued, and considerable savings were made in the editorial, production and marketing departments. BNAI relocated to new, less costly, and more functional offices in September, 1993. Although there were no new product introductions in 1993, a number of significant changes were made to existing BNAI services to improve their performance in 1994. Plans were developed to exploit an expanded market by replacing FOREIGN INVESTMENT IN THE U.S. with DIRECT INVESTMENT IN NORTH AMERICA, a more broadly focused service covering developments in the United States, Canada, and Mexico following adoption of the North American Free Trade Agreement (NAFTA). Also, a survey of WORLD PHARMACEUTICALS REPORT subscribers resulted in revisions to the format of that service, and both TAX PLANNING INTERNATIONAL and WORLD INTELLECTUAL PROPERTY REPORT were re-designed to increase their utility. Research was also carried out on the potential for a new service to be sold only outside the U.S. A positive response led to the decision to publish U.S. BUSINESS LAW REPORT in February, 1994. The new service will rely on existing BNA domestic products for source material and will be edited specifically for an international audience. The service will have the additional benefit of making BNA better known in the international markets. With its stronger financial position, BNAI is now actively turning its attention to growth. The year 1994 will be when the company completes its turnaround and identifies the new products that will generate increased revenues and profits from international markets in the future. The company's 1994 budget calls for a breakeven performance. BNA COMMUNICATIONS, INC. BNAC achieved the second highest revenue level in its history in 1993 despite a very difficult year in the training media industry. Revenues of $5.6 million from the sale of all video-based training products were 2.3 percent lower than the company record set in 1992. Results across product lines were mixed. Revenue from the company's human resources group of products increased by 4.7 percent while revenue from the safety product line dropped by 21.2 percent. While cost saving measures were instituted to help overcome the lower revenue, the company recorded a loss of $53,000 for 1993, compared to a profit in 1992 before the cumulative effects of accounting changes. The company strived aggressively to maintain and strengthen its dominant position in the EEO/AA and workforce diversity training arena. Revenue from this product line increased by nearly 5 percent in 1993 and has grown by 90 percent over the last five years. Two major new products, MYTHS VS. FACTS and A WINNING BALANCE, were released in this product line. Both have been embraced by the market and have solidified BNAC's leadership position in fair employment practice/diversity training. With the several new human resource products scheduled for release in the first half of 1994, there is every reason to expect continued growth. The decline in the company's safety program sales was attributable to a lack of regulatory activity, a difficult economy, and increased competition. Late in 1993, BNAC made a number of changes designed to reestablish its place in the safety training market. Among those changes are a newly created safety sales group, a segmented marketing program, including a separate SAFETY COMMUNICATOR newsletter, and the creation of a subscription-based, renewable safety product called SAFETY TRAINING SUBSCRIPTION PROGRAM. With its new product releases on schedule and the focus on the company's safety business that will result from a separate sales and marketing activity, BNAC is optimistic that 1994 will be a growth year -- just as five of the past six years have been. THE McARDLE PRINTING CO., INC. The McArdle Printing Company continued to operate in a commercial printing market that remained sluggish and highly competitive throughout 1993. However, both revenues and net earnings were slightly higher than in the preceding year. Operating revenues were $22.5 million, a gain of 1.3 percent from the previous year. Net income increased 1 percent to $682,000 and the subsidiary paid a $300,000 dividend to the Parent Company. BNA continued to be McArdle's largest customer in 1993. From the time the two were established as independent companies in 1947, the printing, binding and mailing of BNA publications has been McArdle's largest single source of revenue. Including a large increase in Tax Management printing produced at McArdle, BNA publications accounted for 65 percent of McArdle's operating revenue for the year. McArdle's top priority continues to be increasing revenues and fully utilizing the operating capacity it has established. A comprehensive and aggressive marketing program, combined with continuous training of the sales staff are leading efforts to accomplish this goal. During the latter part of 1993, McArdle instituted a Total Quality Management (TQM) program at the company. McArdle management is convinced that the implementation and maintenance of this program will increase quality, productivity, customer satisfaction, and employee satisfaction, on a continuous and lasting basis. McArdle's desktop printing operation was complemented by the recent addition of a Linotron Imagesetter and a DuPont black and white scanner. This new equipment further enhances the quality and productivity in both McArdle's communications and prepress operations. With the newly implemented TQM program and the further expansion of the communication system, desktop publishing, and prepress capabilities, McArdle is well positioned to meet BNA's present and future printing needs and to compete successfully in the commercial market by offering competitively priced, high quality, and on-time printing services. BNA WASHINGTON INC. BNA Washington's building and office renovation activity was heavier in 1993 than in the previous year. The major project was the reconfiguration and renovation of office space and base building upgrades required by safety and ADA compliances regulations at the company's Rockville, Maryland, facility. Many smaller relocation and office redesign projects were accomplished at BNA's downtown facilities. The projects were initiated to meet BNA's growth and operational restructuring activity and varied in size and scope. All in all, some 21 projects were undertaken and involved approximately 500 employees and 81,000 square feet of office space. BNAW successfully negotiated a contract with Caldor Corporation for the sale of the Silver Spring, Maryland, site of McArdle Printing Company's former plant, which was demolished during the summer. Settlement is contingent upon Caldor's obtaining appropriate building permits from Montgomery County for a department store and adjacent parking facilities. It is expected that Caldor will get the permits and that the sale will be concluded in late 1994 or early 1995. A long term strategic facility plan was initiated by BNAW in the latter part of the year. The objective of the plan is to evaluate BNA's long-term growth needs and to determine what options are available to meet these needs. The plan is scheduled to be completed by the end of June, 1994. BNAW's 1993 operating revenues included $1.8 million from outside tenants. PART I ------ Item 1. Business -------- General Development of Business and Narrative Description of Business Cont. - ---------------------------------------------------------------------------- The Bureau of National Affairs, Inc. ("BNA" or the "Company") operates primarily in the business information publishing industry. Operations consist of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments are less than 10 percent of total revenue. As a response to customer demand, advances in technology, and competition, the Company has recently increased its efforts to publish information in the CD-ROM format. CD-ROM's allow the economical addition of value-added features such as searching capabilities and additional information content. Competition in the business information industry continues to intensify and some competitors are larger and have greater resources than BNA. The Company has invested in sales aids to help its sales force demonstrate the CD-ROM products to customers. Additionally, the Company has embarked on a plan to redesign its publishing system to more effectively produce information for electronic or print delivery. This process is expected to be developed over several years. The number of employees of BNA and its subsidiaries was 1,796 at December 31, 1993. PART I ------ Item 2. Item 2. Properties ---------- BNA Washington Inc. owns and manages the buildings presently used by BNA and some of its Washington area subsidiaries. Principal operations are conducted in three adjacent buildings at 1227-1231 25th Street, NW, Washington, D.C. The office building at 1227 25th Street is being used primarily by BNA and also for commercial leasing. BNA also leases office space at 1250 23rd Street, NW, Washington, D.C. BNA's Circulation Department and BNA Communications Inc. operate in an owned facility at 9435 Key West Avenue, Rockville, Maryland. Pike & Fischer, Inc. leases office space for its operations at 4600 East-West Highway, Bethesda, Maryland. BNA International Inc. conducts its operations from leased offices at Heron House, 10 Dean Farrar Street, London, England. The McArdle Printing Co., Inc. owns its office and plant facilities at 800 Commerce Drive, Upper Marlboro, Maryland. Property at the former printing site in Silver Spring, Maryland is being held for investment. PART I ------ Item 3. Item 3. Legal Proceedings ----------------- The Company is involved in certain 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 Company's consolidated financial statements. Item 4. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- On October 6, 1993, a consent solicitation was sent to all Class A and Class B shareholders. The solicitation sought shareholders' consent to increase the authorized shares of Class B common stock by 500,000 shares, and decrease the authorized shares of Class A common stock by 500,000 shares. BNA stockholders have consented to the adoption of the amendment. As of October 29, the holders of 2,671,148 shares of Class A common stock had returned their consent forms. Of these, 2,632,673, or 79%, consented to the proposal, 31,232, or 1%, withheld consent, and 7,243, or .22%, abstained. Holders of 3,979,730 shares of Class B common stock had returned their consent forms as of October 29. Of these, 3,978,645, or 84%, consented to the proposal, 1,085, or .02%, withheld consent, and 0, or 0%, abstained. Under the laws of the State of Delaware, in which BNA is incorporated, and under BNA's Certificate of Incorporation, the affirmative consents of a majority of the 3,349,054.40 outstanding shares of Class A stock, or 1,708,018 shares, and the affirmative consents of a majority of the 4,762,546 outstanding shares of Class B stock, or 2,428,898 were required to adopt the proposed amendment. PART I ------ Item X. EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The following persons were executive officers of The Bureau of National Affairs, Inc., at December 31, 1993. Executive officers are elected annually by the Board of Directors and serve until their successors are elected. Name Age Present position and prior experience ---- --- ------------------------------------- William A. Beltz 64 President and Chief Executive Officer Elected president and editor-in-chief in 1979 and chief executive officer in 1980. Joined BNA in 1956. John P. Boylan, Jr. 54 Vice President for Administration Elected to present position in 1986. Previously was corporate manager of data processing from 1975 to 1986. Joined BNA in 1974 after employment at Fisher-Stevens, Inc. (a former BNA subsidiary) since 1962. Robert Brooks 44 Vice President and Director of Sales and Marketing. Elected to present position in 1991. Previously General Manager of BNA Software since 1984. Joined BNA in 1974. Kathleen D. Gill 47 Vice President and Executive Editor Elected to vice president and executive editor in 1993. Previously was associate editor for business and human resources services since 1987. Joined BNA in 1970. John E. Jenc 51 Treasurer Elected to present position in 1990. Joined BNA as Controller in 1981. George J. Korphage 47 Vice President and Chief Financial Officer Elected vice president in 1988 and chief financial officer in 1989. Previously was manager of financial planning and analysis since 1985. Joined BNA in 1972. John V. Schappi 64 Vice President for Human Resources Elected to present position in 1987. Previously was associate editor for labor services since 1972. Joined BNA in 1955. (Continued) Item X. EXECUTIVE OFFICERS OF THE REGISTRANT (Continued) ------------------------------------ Name Age Present position and prior experience ---- --- ------------------------------------- John D. Stewart 78 Chairman of the Board Served as Chairman of the Board since 1970. Previously was president and editor-in- chief from 1964 to 1979, and chief executive officer from 1979 to 1980. Joined BNA in 1939. Paul N. Wojcik 45 Vice President, General Counsel, and Corporate Secretary Elected vice president and general counsel in 1988 and corporate secretary in 1989. Previously was corporate counsel and assistant corporate secretary from 1984 to 1988. Joined BNA in 1972. PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related Security ------------------------------------------------------------- Holder Matters -------------- Market Information, Holders, and Dividends - ------------------------------------------ There is no established public trading market for any of BNA's three classes of stock, but the Stock Purchase and Transfer Plan provides a market in which Class A stock can be bought and sold. The Board of Directors establishes semi-annually the price at which Class A shares can be bought and sold through the Stock Purchase and Transfer Plan and declares cash dividends. In accordance with the corporation's bylaws, the price and dividends on non-voting Class B and Class C stock are the same as on Class A stock. Dividends have been paid continuously for 44 years, and they are expected to continue. As of March 1, 1994, there were 1,354 Class A shareholders, 204 Class B shareholders, and 48 Class C shareholders. The company repurchased 87,000 shares of Class B stock from retired employees or their estates in the 12 months ending March 1, 1994. Established stock price and dividends declared during 1993 and 1992 were as follows: Stock Price January 1, 1992 - March 21, 1992 $17.00 March 22, 1992 - March 27, 1993 17.50 March 28, 1993 - September 25, 1993 19.50 September 26, 1993 - December 31, 1993 20.50 Dividends Declared March 21, 1992 $ .42 September 19,1992 .42 March 27, 1993 .45 September 25, 1993 .45 The principal market for trading of voting shares of common stock of The Bureau of National Affairs, Inc., is through the Trustee of the Stock Purchase and Transfer Plan. PART II ------- Item 6. Item 6. Selected Financial Data ----------------------- PART II ------- Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- 1993 vs. 1992 - Consolidated Consolidated revenues of $201 million were up 4 percent from the prior year's $193 million. Excluding the cumulative effects of accounting changes recorded in 1992, consolidated net income for 1993 increased 19.5 percent to $11.3 million. This increase in comparable earnings was primarily the result of higher non-operating income, as operating profit showed a slight decline. Services (print and CD subscriptions and online products) accounted for all of the revenue increase as non-service revenues (software, outside printing, training media, books, and others) declined slightly. Service revenues amounted to 85.2 percent of consolidated revenues in 1993 and 84.6 percent in 1992, and increased 4.9 percent on higher prices and new print and CD product sales. Some of the CD sales replaced print products, but since CD products have more value- added features, they afford an opportunity for higher pricing than their print counterparts. Accordingly, while total service circulation increased only 1 percent, the annual subscription file dollar value, a more current measure of total subscription service business, increased 7.7 percent during 1993. The increase in service revenues was negatively affected by the absence of ETSI, the online network division which was sold in December, 1992. ETSI recorded revenues of $2,681,000 in 1992 and $2,472,000 in 1991. Non-service revenues amounted to $29.6 million, and declined .6 percent as higher software division sales were offset by lower sales for books, information-on-demand, training media, and printing sales to outside customers. Operating expenses increased 4.5 percent in 1993. The expense increase was mainly due to eleven new services developed and launched in 1993, including four in CD format, and higher systems development costs. Product development expenses increased 16.9 percent to $5.3 million, reflecting increased CD and print service development efforts. Operating expenses in 1993 include an identifiable $3.9 million for developing improved business and publishing systems. The overall expense increase was lessened by the absence of ETSI, which recorded operating expenses of $4,435,000 in 1992 and $4,813,000 in 1991. Operating profit declined 4 percent from 1992. The effect on operating profit from increased product and systems development expenses was mitigated by the absence of ETSI, which had a $1.8 million operating loss in 1992, and substantial improvements in the operating results for the international business unit and the tax planning software business. Non-operating income nearly doubled as investment income increased 40.3 percent to $6.2 million due to substantially higher gains on sales of securities and larger portfolio balances. Nearly $2 million in gains were recorded in 1993, an amount not expected to be matched in 1994. A net gain on disposal of assets in 1993 compared to a net loss in 1992 increased other net non-operating income $1.1 million. Earnings per share were $1.32 per share compared to $1.11 per share (before cumulative effects of accounting changes) in 1992. The consolidated federal, state, and local effective income tax rate was 28.5 percent in 1993 compared to 28.3 percent in 1992. A significant non-recurring item lowered the effective income tax rate in each year. In 1993, the effective rate was reduced 2 percent by the effect of the federal income tax rate change on net deferred tax assets. (Continued) In 1992, the effective rate was reduced 2.4 percent by a one-time realization of previously non-deductible expenses. The 1993 operating results reflect a substantial investment in developing and launching new products and in developing improved publishing and business systems. The Company is undertaking these efforts in response to customers' demand for information in an electronic format and to make operations more efficient. The development effort is ongoing and will negatively affect operating results, but management believes these expenditures are necessary to protect and enhance the Company's long-term value. Effective no later than 1994, the Company must account for the cost of providing continuing compensation and health care benefits for former employees in accordance with Statement of Financial Accounting Standards (SFAS) 112-- Employers' Accounting for Postemployment Benefits. The effect of adopting the new accounting standard has not been computed, but it is not expected to materially affect the financial position of the Company. 1992 vs. 1991 - Consolidated Results for 1992 were negatively impacted by the new accounting standards adopted during the fourth quarter. Consolidated net income before the cumulative effects of the accounting changes was $9.4 million, compared to $8.6 million in 1991, an increase of 9.5 percent. As discussed in Notes 5 and 8 to the consolidated financial statements, the Company adopted SFAS 106,--Employers' Accounting for Postretirement Benefits Other Than Pensions and SFAS 109-- Accounting for Income Taxes retroactive to January 1, 1992. The cumulative effect of these accounting changes was a net expense of $19.5 million. Annual operating expenses for 1992 also included an additional $4.3 million as a result of adopting SFAS 106. Consolidated net loss for 1992 was $10.1 million. Consolidated revenues of $193 million in 1992 increased 6.4 percent from $181.3 million in 1991. Service revenues amounted to 84.6 percent of total revenues in 1992 and 84.2 percent in 1991. Service revenues increased 6.9 percent in 1992 on higher prices and increased circulation. Seven new subscription services were launched in 1992 and subscription circulation increased 3 percent. Non- service revenues amounted to $29.8 million and increased 3.8 percent over 1991. Operating expenses increased 6.6 percent due to higher employment expenses (including accrued postretirement benefits and severance expenses), more published pages, a $1.1 million increase in identifiable product development costs, and $2 million in identifiable expenses for improved business and publishing systems. The consolidated operating profit for 1992 was $10.1 million, an increase of 3.6 percent over 1991. Overall favorable comparisons for non-operating items added to the year-to-year increase in income before cumulative effects of accounting changes. Investment income increased due to higher average portfolio balances during the year. Interest expense decreased due to lower interest rates and lower average outstanding debt. Other income (expense) was a higher net expense in 1992 compared to 1991 due to pre-tax losses recorded on the disposals of property, equipment, and a business unit. The consolidated federal, state, and local effective income tax rate was 28.3% in 1992 compared to 32.2% in 1991. The lower rate reflects the benefits realized for previously non-deductible expenses, and a higher level of tax- exempt investment income. (Continued) Segments The Company operates primarily in the business information publishing industry. Operations consist primarily of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments provide less than ten percent of total revenues. Deferred Tax Assets In accordance with SFAS 109, the Company has recorded $12 million of net deferred tax assets as of year-end 1993. This amount includes $17.9 million related to the accrued postretirement benefits liability. No valuation allowance has been provided for the realization of the deferred tax assets. In assessing the realizability of the deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company has a consistent history of profitability and taxable income, and management believes this trend will continue. Factors supporting this conclusion are consistent profitable operations, a quality reputation in the markets served by the Company, a high renewal rate for subscription products, a growing deferred revenue liability (representing payments and orders for future fulfillment), and the recent successful introduction of products using new CD and electronic delivery methods. In the opinion of management, it is more likely than not that the existing deferred tax assets will be realized in future years, and no valuation allowance is necessary. Financial Resources and Cash Flows The Company maintains its financial reserves in cash and investment securities which, along with its operating cash flows, are sufficient to fund ongoing cash expenditures for operations and to support employee ownership. Cash provided from operating activities amounted to $23.5 million in 1993, $34 million in 1992, and $22.4 million in 1991. Cash flow from operations declined in 1993 due to a 5.3 percent increase in expenditures and slightly lower collections. Cash flows from operations had increased substantially in 1992 due to a one-time change in the subscription billing cycle. Cash outlays for capital expenditures were $9.1 million in 1993, compared with $5.2 million in 1992, and $17.4 million in 1991. This included equipment purchases, office furnishings, and building improvements. Capital expenditures in 1991 also reflect major renovations of older office space and equipment purchases for the new printing facility, and $1.6 million for purchased publications. Capital expenditures, are expected to be $7 million in 1994. Sales of capital stock to employees provided $2.8 million of equity capital in 1993. Dividends paid to shareholders amounted to $7.7 million in 1993, $7.1 million in 1992, and $6.9 million in 1991. Other 1993 financing expenditures included $3.2 million for debt principal repayments and $2.2 million for repurchases of Class B and Class C capital stock. (Continued) For 1994, financing requirements include $4.2 million for scheduled debt repayment and $1.1 million for known repurchases of Class B and Class C stock. With $85 million in cash and investment portfolios, the financial position and liquidity of the Company remains very strong. Should additional funding become necessary in the future, the Company has substantial debt capacity based on its operating cash flows and real estate equity which could be mortgaged. Since subscription monies are collected in advance, cash flows from operations, along with existing financial reserves and proceeds from the sales of capital stock, have been sufficient in past years to meet all operational needs, new product introductions, capital expenditures, debt repayments, and, in addition, provide funds for dividend payments and the repurchase of Class B and Class C stock tendered by shareholders. PART II ------- Item 8. Item 8. Financial Statements and Supplementary Data ------------------------------------------- THE BUREAU OF NATIONAL AFFAIRS, INC. Consolidated Financial Statements December 31, 1993 and 1992 (With Independent Auditors' Report Thereon) INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders The Bureau of National Affairs, Inc.: We have audited the consolidated financial statements of The Bureau of National Affairs, Inc. as listed in the accompanying index in Part IV, Item 14(a)(1). In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying in- dex in Part IV, Item 14(a)(2). These consolidated financial statements and fi- nancial 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 The Bureau of National Affairs, Inc. 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 herein. As discussed in Note 6 to the consolidated financial statements, the Company changed its method of accounting for investments to adopt the provisions of the Financial Accounting Standards Board (SFAS) 115 - Accounting for Certain Investments in Debt and Equity Securities, at December 31, 1993. s\ KPMG Peat Marwick -------------------- Washington, D. C. February 22, 1994 THE BUREAU OF NATIONAL AFFAIRS, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (In thousands of dollars) A S S E T S ----------- 1993 1992 --------- --------- CURRENT ASSETS: Cash and cash equivalents (Note 6) $ 10,982 $ 10,553 Short-term investments (Note 6) 8,804 6,883 Accounts receivable (net of allowance for doubtful accounts of $1,376 in 1993 and $984 in 1992) 41,181 34,794 Inventories (Note 9) 6,975 7,280 Prepaid expenses 2,289 2,608 Deferred selling expenses (Note 3) 24,234 18,083 --------- --------- Total current assets 94,465 80,201 --------- --------- MARKETABLE SECURITIES (Note 6) 65,265 57,651 --------- --------- PROPERTY AND EQUIPMENT, at cost (Notes 4 and 12): Land 5,176 4,933 Buildings and improvements 47,864 48,405 Furniture, fixtures and equipment 53,832 46,768 --------- --------- 106,872 100,106 Less - accumulated depreciation 45,490 38,963 --------- --------- Net property and equipment 61,382 61,143 --------- --------- DEFERRED INCOME TAXES (NOTE 8) 16,562 15,354 --------- --------- GOODWILL (Note 10) 10,175 10,488 --------- --------- OTHER ASSETS (Note 11) 3,668 4,198 --------- --------- Total assets $ 251,517 $ 229,035 ========= ========= (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (In thousands of dollars) LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ 1993 1992 --------- --------- CURRENT LIABILITIES: Accounts payable $ 15,569 $ 14,427 Employee compensation and benefits payable 13,423 11,115 Income taxes payable 38 143 Deferred income taxes (Note 8) 4,540 1,508 Current portion of long-term debt (Note 12) 4,186 7,172 Deferred subscription revenue (Note 3) 107,834 99,523 --------- --------- Total current liabilities 145,590 133,888 POSTRETIREMENT BENEFITS, less current portion (Note 5) 49,162 43,991 LONG-TERM DEBT, less current portion (Note 12) 1,332 1,534 OTHER LIABILITIES 2,949 2,974 --------- --------- Total liabilities 199,033 182,387 --------- --------- COMMITMENTS AND CONTINGENCIES (Notes 4, 13 and 14) STOCKHOLDERS' EQUITY (Notes 6 and 14): Capital stock, common, $1.00 par value - Class A - Voting; Authorized 6,700,000 shares; issued 6,478,864 shares 6,479 6,479 Class B - Nonvoting; authorized 5,300,000 shares; issued 4,919,490 shares in 1993 and 4,594,845 shares in 1992 4,919 4,595 Class C - Nonvoting; authorized 1,000,000 shares; issued 506,336 shares 506 506 Additional paid-in capital 18,423 16,298 Retained earnings 36,933 33,372 Treasury stock, at cost - 3,351,887 shares in 1993 and 3,059,364 shares in 1992 (16,360) (14,496) Net unrealized gain (loss) on marketable securities 1,614 (67) Foreign currency translation adjustment (30) (39) --------- --------- Total stockholders' equity 52,484 46,648 --------- --------- Total liabilities and stockholders' equity $ 251,517 $ 229,035 ========= ========= See accompanying notes to consolidated financial statements. THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (1) PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of The Bureau of National Affairs, Inc. (the "Parent"), and its subsidiaries (consolidated, the "Company"). The Company operates primarily in the business information publishing industry. Operations consist primarily of the production and marketing of information products in print and electronic form, and outside printing services. Activities in other industry segments provide less than 10 percent of total revenue. The Company did not derive 10 percent or more of its revenues from any one customer or government agency or from foreign sales, nor did it have 10 percent or more of its assets in foreign locations. Material intercompany transactions and balances have been eliminated. Certain prior year balances have been reclassified to conform with current year presentation. All subsidiaries are wholly-owned and fully consolidated. The net investment under the equity method of accounting as of December 31, 1993, for each operating subsidiary was as follows (in thousands of dollars): Cumulative Cost and Increase Capital (Decrease) Net Contributions in Equity Investment --------------- ---------- ------------ BNA Communications Inc. $ 3,165 $ (1,388) $ 1,777 BNA International Inc. 1 (4,136) (4,135) BNA Washington Inc. 6,436 5,220 11,656 Pike & Fischer, Inc. 1,575 1,352 2,927 Tax Management Inc. 12,139 5,982 18,121 The McArdle Printing Co., Inc. 5,800 3,473 9,273 --------- --------- --------- Total $ 29,116 $ 10,503 $ 39,619 ========= ========= ========= (2) ACQUISITIONS AND DISPOSITIONS In December 1992, the Company sold the assets of its online human resource information business division, Executive Telecom Systems International (ETSI). The sales price was $1,340,000, and consisted of cash and the transfer of ETSI's liabilities. The sale resulted in a recorded pre-tax loss of $512,000, but an after-tax gain of $64,000. ETSI's revenues were $2,681,000 in 1992, and $2,472,000 in 1991; operating expenses were $4,435,000 in 1992, and $4,813,000 in 1991. In August 1991, the Company purchased publications from McGraw-Hill, Inc., for $1,575,000 in cash and the assumption of $602,000 in subscription fulfillment obligations. The acquisition cost was assigned to assets, (Continued) THE BUREAU OF NATIONAL AFFAIRS,INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS primarily to customer lists and a non-compete agreement, based on their respective appraised values at the date of acquisition, and to goodwill. (3) RECOGNITION OF SUBSCRIPTION REVENUES AND SELLING EXPENSES Subscription revenues and related field selling and direct promotion expenses are deferred and amortized over the subscription terms, which are primarily one year. Deferred subscription revenue is classified on the balance sheet as a current item; however the fulfillment of the Company's subscription liability will use substantially less current assets than the liability amount shown. (4) DEPRECIATION AND LEASES The Company uses straight-line and accelerated methods of depreciation based on estimated useful lives ranging from 5 to 45 years for buildings and improvements and 5 to 11 years for furniture, fixtures and equipment. Depreciation expense was $8,605,000 in 1993, $7,702,000 in 1992, and $6,846,000 in 1991. Expenditures for maintenance and repairs are expensed while major replacements and improvements are capitalized. The Company has non-cancelable operating leases for office space, data processing equipment, and vehicles. Total rent expense was $3,673,000 in 1993, $3,971,000 in 1992, and $4,056,000 in 1991 (net of sublease income of $195,000, $149,000, and $103,000, respectively). As of December 31, 1993, future minimum lease commitments under non- cancelable operating leases, net of sublease rentals, were as follows (in thousands of dollars): Rental Sublease Payments Rentals Net -------- -------- ------ 1994 3,778 (228) 3,550 1995 3,378 - 3,378 1996 2,700 - 2,700 1997 2,626 - 2,626 1998 2,606 - 2,606 Thereafter 4,946 - 4,946 -------- -------- -------- Total $20,034 $ (228) $19,806 ======== ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (5) EMPLOYEE BENEFIT PLANS The Company has noncontributory defined benefit pension plans covering employees of the Parent and certain subsidiaries. Benefits are based on years of service and average annual compensation for the highest paid five years during the last ten years of service. The plans provide for five-year cliff vesting. The Company's funding practice is to contribute amounts, which at a minimum, satisfy forty-year funding program requirements. The Company contributed $2,914,000 to the Plan in 1993 and, because of Internal Revenue Service funding limitations, none in 1992 or 1991. Pension expense is computed on an accrual basis in accordance with financial reporting standards. Components of the net pension expense, based on the actuarial study as of January 1 for each year, were as follows (in thousands of dollars): 1993 1992 1991 -------- -------- -------- Service cost - benefits earned during the period $ 2,505 $ 2,388 $ 2,550 Interest cost 4,009 3,346 3,310 Actual return on plan assets during the year (5,904) (3,825) (6,426) Net asset gain deferred for later recognition 2,255 305 3,276 Amortization of unrecognized plan assets (93) (208) (137) Special benefits for early retirement - 275 - -------- -------- -------- Net pension expense $ 2,772 $ 2,281 $ 2,573 ======== ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table sets forth the funded status of the Plan and the amounts recognized in the Company's Consolidated Balance Sheets (in thousands of dollars): December 31, ------------------- 1993 1992 -------- -------- Actuarial present value of benefit obligations: Vested benefits $ 40,283 $ 32,697 Nonvested benefits 4,778 3,187 -------- -------- Accumulated benefit obligation 45,061 35,884 Projected future compensation 18,288 13,126 -------- -------- Projected benefit obligation 63,349 49,010 Plan assets at fair value 52,906 46,761 -------- -------- Projected benefit obligation in excess of plan assets 10,443 2,249 Unrecognized net asset 3,312 3,620 Unrecognized net (loss) gain (3,843) 4,659 Unrecognized prior service cost (2,442) (2,916) -------- -------- Accrued pension liability 7,470 7,612 Less - current portion 1,562 2,914 -------- -------- Long-term portion $ 5,908 $ 4,698 ======== ======== Assumed discount rate 7.0% 8.0% Assumed rate of compensation increase 5.0% 5.0% Expected long-term rate of return on assets 8.0% 8.0% Plan assets included equity securities, fixed income securities, and temporary investments. Calculations of benefit obligations as of December 31, 1993, have been estimated by an independent actuary and are subject to revision upon completion of a detailed actuarial study. In addition, some acquired subsidiaries have defined contribution pension plans and union-sponsored multi-employer pension plans. Contributions under some of these plans are at the discretion of the Board of Directors of the respective subsidiaries. Total contributions under these plans were $721,000 in 1993, $688,000 in 1992 and $636,000 in 1991. The Company also has a cash profit sharing plan based on income before taxes, as defined, covering employees of the Parent and certain subsidiaries. Profit sharing expense was $849,000 in 1993, $1,154,000 in 1992, and $1,349,000 in 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In addition to providing pension benefits, the Company extends certain health care and life insurance benefits ("other postretirement benefits") to retired employees. Most of the Company's employees are eligible for these benefits if they retire while working for the Company. The Company's policy is to fund these benefits as claims and premiums are paid. Prior to 1992, the cost of postretirement benefits was charged to expense on a pay- as-you-go (cash) basis. Cash payments made by the Company for these benefits totaled $985,000 in 1993, $771,000 in 1992, and $666,000 in 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions, and changed its method of accounting for postretirement benefits from a cash basis to an accrual basis. The accounting change for the benefits resulted in a one-time, non-cash expense in 1992 of $21,621,000, net of taxes of $14,079,000, for the transition obligation. The transition obligation is the actuarially determined accumulated postretirement benefit obligation as of the date of adoption of SFAS 106. In addition, the pre-tax expense for postretirement benefits for 1992 was $4,313,000 higher as a result of having adopted this method of accounting. Components of the postretirement benefit expense, based on the actuarial study as of January 1 for each year, were as follows (in thousands of dollars): 1993 1992 -------- ------- Service cost-benefits earned during the period $ 1,993 $ 2,230 Interest cost 3,073 2,854 Amortization of net gain (39) - ------- ------- Postretirement benefit expense $ 5,027 $ 5,084 ======= ======= The following table sets forth the amounts recognized in the Company's Consolidated Balance Sheets (in thousands of dollars): December 31, ------------------ 1993 1992 ------- ------- Actuarial present value of benefit obligation: Retirees $12,934 $11,043 Fully eligible active plan participants 761 1,162 Other active plan participants 22,701 24,861 ------- ------- Accumulated benefit obligation 36,396 37,066 Unrecognized net gain 7,924 3,212 ------- ------- Accrued other postretirement benefits liability 44,320 40,278 Less - current portion 1,066 985 ------- ------- Long-term portion 43,254 39,293 ======= ======= Assumed discount rate 7.0% 8.0% Assumed rate of compensation increase 5.0% 5.0% (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The December 31, 1993 accumulated benefit obligation was determined using an assumed health care cost trend rate of 10.0 percent in 1994, gradually declining to 5.0 percent per year in the year 2001 and thereafter over the projected payout period of the benefits. The effect of a one percent increase in the health care cost trend rate at December 31, 1993 would have resulted in a $6,834,000 increase in the accumulated benefit obligation and a $1,141,000 increase in the 1993 postretirement benefit expense. (6) INVESTMENTS AND INVESTMENT INCOME Cash and investments were reported as follows (in thousands of dollars): December 31, -------------------- 1993 1992 ------- ------- Cash and cash equivalents $10,982 $10,553 Short-term investments 8,804 6,883 Marketable securities 65,265 57,651 -------- -------- Total $85,051 $75,087 ======== ======== Cash equivalents consist of short-term investments, with a maturity of three months or less at the time of purchase. Short-term investments consisted of other fixed-income investments, maturing in one year or less. Marketable securities consisted of equity securities and fixed-income securities maturing in more than one year. Investment income consisted of the following (in thousands of dollars): 1993 1992 1991 ------ ------ ------ Interest income $3,581 $3,344 $3,645 Dividend income 640 369 56 Gain on sales of securities 1,969 698 240 -------- -------- -------- Total $6,190 $4,411 $3,941 ======== ======== ======= Proceeds from the sales of securities in 1993 were $156,284,000 and the gross realized gains and losses on these sales were $2,179,000 and $(210,000), respectively. Net realized gains after taxes on sales of securities included in net income amounted to $1,299,000 in 1993, $461,000 in 1992, and $158,000 in 1991. The specific identification method is used in computing realized gains and losses. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) 115 - Accounting for Certain Investments in Debt and Equity Securities. SFAS 115 requires that debt and equity securities be classified into one of three categories: held-to-maturity, available- for-sale, or trading. Held-to-maturity securities are measured at amortized cost in the Consolidated Balance Sheet and would include those securities the Company had positive intent and ability to hold until maturity. Trading securities are measured at their fair values, and include securities bought and held principally for the purpose of selling them in the near term. Available-for-sale securities are also measured at their fair values, and include investments not classified as held-to-maturity or trading. All of the Company's investments portfolio have been classified as available-for- sale and are reported at their fair values (quoted market price). Retroactive application of SFAS 115 is not permitted. Investments in fixed-income and equity securities were as follows at December 31, 1993 (in thousands of dollars): Gross Gross Amortized Unrealized Unrealized Aggregate Cost Gains Losses Fair Value --------- ---------- ---------- ----------- Equity securities $ 15,305 $ 80 $ (110) $ 15,275 U.S. Government securities 2,271 - - 2,271 Municipal bonds 50,567 2,562 ( 51) 53,078 Corporate debt 3,444 1 - 3,445 ---------- ---------- ---------- ---------- Total $ 71,587 $ 2,643 $ (161) $ 74,069 ========= ========== ========== ========== The differences between amortized cost and aggregate fair value result in unrealized gains or losses. Under SFAS 115, the net unrealized gain or loss is reported, net of tax, as a separate component of Stockholders' Equity. Prior to adopting SFAS 115, only a net unrealized loss was reported therein. The aggregate unrealized gain or loss, net of tax, was a gain of $1,614,000 and a loss of $67,000 on December 31, 1993 and 1992, respectively. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Contractual maturities of the fixed-income securities as 1993 were as follows (in thousands of dollars): Amortized Cost Fair Value -------- ---------- Within one year $ 8,778 $ 8,804 One through five years 16,634 17,345 Five through ten years 13,859 14,366 Over ten years 17,011 18,279 --------- --------- Total $ 56,282 $ 58,794 ========= ========= Prior to adopting SFAS 115, the Company's equity securities were carried at the lower of cost or market and fixed-income securities were carried at amortized cost. Marketable securities consisted of the following at December 31, 1992 (in thousands of dollars): Amortized Carrying Cost Market Amount --------- --------- --------- Equity securities $ 10,775 $ 10,674 $ 10,674 Fixed-income securities 46,977 48,300 46,977 --------- --------- --------- Total $ 57,752 $ 58,974 $ 57,651 ========= ========= ========= (7) OTHER INCOME (EXPENSE), NET Other income (expense), net was comprised of the following (in thousands of dollars): 1993 1992 1991 ------- -------- -------- Gain (loss) on sales of businesses and publications $ 311 $ (374) $ - Gain (loss) on disposals of property and equipment (8) (476) (55) -------- -------- -------- Total $ 303 $ (850) $ (55) ======== ======== ======== (8) INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 109 - Accounting for Income Taxes, and changed its method of accounting for income taxes from the deferred method to the asset and liability method. Under the deferred method, deferred income taxes were recognized for income and expense items that were reported in different (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS years for financial reporting and income tax purposes using the tax rate applicable for the year of the calculation. Deferred tax assets and liabilities were not affected by changes in income tax rates under the deferred method. Under the asset and liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred assets and liabilities are measured using enacted tax rates which apply to taxable income in future years when those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities for changes in tax rates will be recognized in the period that includes the enactment date. The cumulative effect of adopting SFAS 109 amounted to a one-time, non-cash tax benefit of $2,139,000 and is reported separately in the Consolidated Statements of Income for the year ended December 31, 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS 109. As discussed in Note 5, the Company adopted SFAS 106 and recorded the transition obligation for other postretirement benefits. A deferred tax benefit of $14,079,000 was provided effective January 1, 1992, in conjunction with this accounting change. The total income tax expense (benefit) was allocated as follows (in thousands of dollars): 1993 1992 ------- ------- Income before taxes and cumulative effects of accounting changes $ 4,482 $ 3,718 Stockholders' Equity -- Change in: Unrealized gain/loss on marketable securities 902 34 Foreign currency translation adjustment 4 (36) -------- -------- Total $ 5,388 $ 3,716 ======== ======== (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The provision for income taxes, excluding those effects of accounting changes, consisted of the following (in thousands of dollars): 1993 1992 1991 ------- ------- ------- Taxes currently payable Federal $ 3,398 $ 6,198 $ 4,358 State and local 383 1,046 603 -------- -------- -------- 3,781 7,244 4,961 -------- -------- -------- Deferred tax provision Federal 571 (2,840) (768) State and local 130 (686) (101) -------- -------- -------- 701 (3,526) (869) -------- -------- -------- Total $ 4,482 $ 3,718 $ 4,092 ======== ======== ======== Reconciliation of the U.S. statutory rate to the Company's consolidated effective income tax rate was as follows: Percent of Pretax Income ------------------------------- 1993 1992 1991 ------- ------- ------- Federal statutory rate 35.0% 34.0% 34.0% Rate difference due to level of taxable income (1.0) - - State and local income taxes, net of Federal income tax benefit 2.0 1.8 2.6 Goodwill amortization and other nondeductible expenses 1.2 1.4 1.4 Tax-exempt interest exclusion (6.5) (5.9) (5.8) Adjustment to deferred taxes for enacted changes in tax rates (2.0) - - Dividends received exclusion (.9) (.7) (.1) Tax benefit from sale of business - (2.4) - Others, net .7 .1 .1 --------- --------- --------- Total 28.5% 28.3% 32.2% ========= ========= ========= (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The significant components of deferred income tax expense were as follows (in thousands of dollars): 1993 1992 -------- --------- Deferred tax expense (exclusive of the effects listed below) $ 1,011 $ (3,526) Adjustment to deferred taxes for enacted changes in tax rates (310) - --------- --------- Total $ 701 $ (3,526) ========= ========= For the year ended December 31, 1991, deferred income tax expense resulted from timing differences in the recognition of transactions for financial and tax reporting purposes as computed under the deferred method of accounting for income taxes. The tax effects of those timing differences totalled $(869,000) and were due to: inventory costs, $(177,000); depreciation, $191,000; deferred selling expense, $517,000; pension expense, $(828,000); annual leave, $(313,000); and other items, $(259,000). The tax effects of temporary differences that gave rise to the deferred tax assets and liabilities were as follows (in thousands of dollars): December 31, ------------------------- 1993 1992 -------- ---------- Deferred tax assets: Other postretirement benefits $ 17,870 $ 15,885 Pension expense 3,037 3,021 Annual leave 1,566 1,412 Inventories 1,443 1,898 Others 1,808 1,841 --------- --------- Total deferred tax assets 25,724 24,057 --------- --------- Deferred tax liabilities: Deferred selling expenses (9,778) (7,158) Depreciation (2,780) (2,971) Others (1,144) (82) --------- --------- Total deferred tax liabilities (13,702) (10,211) --------- --------- Net deferred tax assets $ 12,022 $ 13,846 ========= ========= In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS temporary differences become deductible. The Company has a consistent history of profitability and taxable income, and management believes that this trend will continue. Factors supporting this conclusion include consistent profitable operations, a quality reputation in the markets served by the Company, a high renewal rate for subscription products, a growing de- ferred revenue liability (representing payments and orders for future ful- fillment), and the recent successful introduction of products using new CD- ROM and electronic delivery methods. In the opinion of management, it is more likely than not that the existing deferred tax assets will be realized in future years, and no valuation allow- ance is necessary. (9) INVENTORIES Inventories, valued at the lower of cost (principally average cost method) or market, were as follows (in thousands of dollars): December 31, --------------------- 1993 1992 ------- -------- Materials and supplies $ 4,579 $ 3,888 Work in process 94 173 Finished goods 2,302 3,219 -------- -------- Total $ 6,975 $ 7,280 ======== ======== (10) GOODWILL Goodwill represents the excess of the cost of purchased publications and the capital stock of subsidiaries over the fair value of net assets at the dates of their respective acquisitions, net of accumulated amortization of $2,958,000 in 1993 and $2,645,000 in 1992. Goodwill acquired prior to November 1, 1970, in the amount of $634,000, is not being amortized because, in management's opinion, it has continuing value. Other goodwill is amortized on a straight-line basis, using forty years for the publishing acquisitions and ten years for the electronic infor- mation acquisitions. During 1992, unamortized goodwill of $37,000 was written off with the sale of ETSI's assets. Amortization expense was $313,000 for 1993, $334,000 for 1992, and $324,000 for 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (11) OTHER ASSETS Other assets were as follows (in thousands of dollars): December 31, -------------------- 1993 1992 ------- ------- Amortizable assets- Customer lists $ 605 $ 1,123 Film production costs 1,599 1,218 Lease commissions 533 628 Software 7 60 Editorial service agreement 48 121 Non-compete agreements 139 358 Others - 1 -------- -------- 2,931 3,509 Notes and other receivables 737 689 -------- -------- Total $ 3,668 $ 4,198 ======== ======== Film production costs are amortized using the revenue forecast method. Other amortizable assets are expensed evenly over their respective estimated lives, ranging from 3 to 10 years. Amortization expense for these assets was as follows (in thousands of dollars): 1993 1992 1991 ------ ------ ------ Customer lists $ 518 $ 665 $ 613 Film production costs 346 297 343 Lease commissions 95 71 65 Software 56 103 163 Editorial service agreement 73 73 73 Non-compete agreements 219 220 193 Others 1 7 5 ------- ------- ------- Total $1,308 $1,436 $1,455 ======= ======= ======= Accumulated amortization for customer lists, the editorial service agreement, non-compete agreements, and other intangible assets was $4,322,000 in 1993, $3,511,000 in 1992, and $3,004,000 in 1991. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (12) LONG-TERM DEBT Long-term debt was as follows (in thousands of dollars): December 31, -------------------- 1993 1992 -------- -------- Note payable, at 3-month secondary market CD rate plus 1/2% (3.66% at December 20, 1993), due in 1994, interest payable monthly $ 4,000 $ 7,000 Note payable, 8-1/4%, due in 1999; secured by real estate; principal and interest payable $26,045 monthly 1,411 1,599 Other notes payable 107 107 --------- --------- 5,518 8,706 Less - current portion 4,186 7,172 --------- --------- Long-term portion $ 1,332 $ 1,534 ========= ========= The aggregate long-term portion at December 31, 1993, is payable as follows: 1995 - $220,000; 1996 - $239,000; 1997 - $259,000; 1998 - $281,000; and 1999 - $333,000. As of December 31, 1993, property with a cost of $4,033,000 had been pledged as collateral for the real estate debt. (13) COMMITMENTS AND CONTINGENCIES The Company has ongoing service agreements with software authors and a multi- year agreement with a key employee of one of its subsidiaries. The Company's total financial commitment related to these agreements is $1,008,000 for the year 1994. The Company is involved in certain 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 consolidated fi- nancial statements. (14) STOCKHOLDERS' EQUITY Ownership and transferability of Class A, Class B, and Class C stock are substantially restricted to employees and former employees by provisions of the Parent's certificate of incorporation and bylaws. Ownership of Class A stock, which is voting, is restricted to active employees. Class B stock and Class C stock are nonvoting. No class of stock has preference over another upon declaration of dividends or liquidation. (Continued) THE BUREAU OF NATIONAL AFFAIRS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS During 1993, the Company's Certificate of Incorporation was amended to in- crease the authorized Class B stock shares by 500,000 shares and decrease the authorized Class A stock shares by 500,000 shares, so as to ensure that future retirees will have the option of exchanging their Class A stock for Class B stock upon retirement. The Company's commitment to employee ownership is supported by its policy to repurchase all Class B and Class C stock tendered by shareholders. As of December 31, 1993, Class B and Class C stock having a total market value of $1,132,000 are known or expected to be tendered during 1994. The Company, as a matter of policy, is also committed to repurchase any Class A stock ten- dered by shareholders to the Stock Purchase & Transfer Plan Trustee which the Trustee is unable to purchase with proceeds from the sale of Class A stock to employees. Treasury stock as of December 31, 1993 and 1992, respectively, consisted of: Class A, 3,289,445 and 2,980,591 shares; Class B, none and 23,786 shares; and Class C, 62,442 and 54,987 shares. Earnings per share have been computed based on the aggregate weighted average number of all outstanding shares of stock, which was 8,549,522 in 1993, 8,458,109 in 1992, and 8,334,816 in 1991. Financial statements of the Company's United Kingdom operations denominated in British pounds are translated into U.S. dollars at year-end exchange rates, and related gains and losses are reflected, net of taxes, directly in Stockholders' Equity in the accompanying Consolidated Balance Sheets. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION THE BUREAU OF NATIONAL AFFAIRS, INC. ------------------------------------ (In Thousands of Dollars) Year Ended December 31 ------------------------------ Item 1993 1992 1991 ---- ------- ------- ------- Maintenance and repairs $2,768 $2,784 $2,911 Depreciation and amortization of intangible assets, preoperating costs and similar deferrals 1,621 1,770 1,779 Taxes, other than payroll and income taxes 2,626 2,364 2,090 Royalties 3,380 3,297 2,946 Advertising costs 897 618 601 PART II ------- Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- There were no changes in or disagreements with accountants on accounting and financial disclosures during the two years ended December 31, 1993 or through the date of this Form 10-K. PART III -------- Except as set forth in this Form 10-K under Part I, Item X, "EXECUTIVE OFFICERS OF THE REGISTRANT," the information required by Items 10, 11, 12, and 13, is contained in the Company's definitive Proxy Statement (the "Proxy Statement") filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, to be filed with the SEC within 120 days of December 31, 1993. Such information is incorporated herein by reference. Item 10. Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The information required under this Item 10 is contained in the Proxy Statement under the headings "I. ELECTION OF DIRECTORS" and "BIOGRAPHICAL SKETCHES OF NOMINEES," and is incorporated herein by reference. Information related to Executive Officers is omitted from the Proxy Statement in reliance on Instruction 3 to Regulation S-K, Item 401(b), and included as Item X of Part I of this report. Item 11. Item 11. Executive Compensation ---------------------- The information required under this Item 11 is contained in the Proxy Statement under the headings "III. EXECUTIVE COMPENSATION" and "IV. EMPLOYEE BENEFIT PLANS" and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Beneficial Owners and Management ------------------------------------------------------ The information required under this Item 12 is contained in the Proxy Statement under the heading "I. ELECTION OF DIRECTORS" and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The information required under this Item 13 is contained in the Proxy Statement under the heading "III. EXECUTIVE COMPENSATION" and is incorporated herein by reference. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules, and Report on Form 8-K --------------------------------------------------------------- The following documents are filed as part of this report. (a)(1) Financial Statements: Page --------------------- ----- Report of Independent Auditors 26 Consolidated Balance Sheets as of December 31, 1993 and 1992. 28-29 Consolidated Statements of Income, Consolidated Statements of Cash Flows, and Consolidated Statements of Changes in Stockholders' Equity for each of the years ended December 31, 1993, 1992, and 1991 27,30-32 Notes to Consolidated Financial Statements 33-47 (2) Financial Statement Schedules: ------------------------------ Report of Independent Auditors as to the financial statement schedules 26 I Marketable Securities - Other Investments 48-49 V Property, Plant and Equipment 50 VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 51 VIII Valuation and Qualifying Accounts and Reserves 52 X Supplementary Income Statement Information 53 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: --------- 3.1 Certificate of Incorporation, as amended* 3.2 By laws, as amended** 11 Statement re: Computation of Per Share Earnings is contained in the 1993 Consolidated Financial Statements in the Notes to Consolidated Financial Statements, Note 14, "Stockholders' Equity," at page 46 of this Form 10-K. 22 Subsidiaries of the Registrant.* 24.1 Consent of Independent Auditors for 1993, 1992, and 1991 financial statements. 28.1 Proxy Statement for the Annual Meeting of security holders to be held on April 16, 1994.3*** 28.2 Annual Report on Form 11-K related to the Company's Deferred Stock Purchase Plan for the fiscal year ended December 31, 1993*. * Filed herewith. ** Incorporated by reference to the Company's 1988 Form 10-K, Commission File Number 2-28286, filed on March 30, 1989. The exhibit numbers indicated above correspond to the exhibit numbers in that filing. *** Previously filed with the Securities and Exchange Commission. Upon written or oral request to the Company's General Counsel, a copy of any of the above exhibits will be furnished at cost. (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. 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. THE BUREAU OF NATIONAL AFFAIRS, INC. By: s\ William A. Beltz ______________________________ William A. Beltz, President Date: 3/10/94 ______________________________ 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 dates indicated. By: s\ William A. Beltz By: s\ George J. Korphage --------------------------- ----------------------------------- William A. Beltz, George J. Korphage, President and Vice President and Chief Financial Chief Executive Officer Officer (Chief Accounting Officer) Director Director Date: 3/10/94 Date: 3/10/94 -------- -------- By: s\ Jacqueline M. Blanchard 3/10/94 By: s\ Frederick A. Schenck 3/10/94 --------------------------- ------- -------------------------- ------- Jacqueline M. Blanchard Date Frederick A. Schenck Date By: s\ Christopher R. Curtis 3/10/94 By: s\ Mary P. Swords 3/10/94 --------------------------- ------- -------------------------- ------- Christopher R. Curtis Date Mary P. Swords Date By: s\ Sandra C. Degler 3/10/94 By: s\ Daniel W. Toohey 3/10/94 --------------------------- ------- -------------------------- ------- Sandra C. Degler Date Daniel W. Toohey Date By: s\ Kathleen D. Gill 3/10/94 By: s\ Loene Trubkin 3/10/94 --------------------------- ------- -------------------------- ------- Kathleen D. Gill Date Loene Trubkin Date By: s\ John A. Jenkins 3/10/94 By: s\ Paul N. Wojcik 3/10/94 --------------------------- ------- -------------------------- ------- John A. Jenkins Date Paul N. Wojcik Date By: s\ John V. Schappi 3/10/94 --------------------------- ------- John V. Schappi Date

715969_1993.txt

715969_1993

1993

715969

ITEM 1. BUSINESS - ------- -------- (A) GENERAL ------- United Water Resources Inc. (United Water) was incorporated on February 25, 1983. United Water is a New Jersey corporation with its principal office at 200 Old Hook Road, Harrington Park, New Jersey 07640, telephone number 201-784-9434. The principal subsidiary of United Water, Hackensack Water Company (Hackensack), was incorporated by an act of the New Jersey Legislature in 1869. A number of local water companies have been merged into Hackensack since its reorganization in 1880. Spring Valley Water Company Incorporated (Spring Valley) was incorporated under the laws of New York in 1893 and is wholly owned by Hackensack. Other wholly-owned subsidiaries of United Water include Rivervale Realty Company, Inc. (Rivervale), which is engaged in real estate acquisitions and development, leasing and sales, golf course operations and consulting activities; Laboratory Resources, Inc. (Laboratory Resources), a network of private laboratories that provide a variety of laboratory testing services; and Mid-Atlantic Utilities Corporation (Mid-Atlantic), which seeks high growth areas in need of public water or sewer systems and the management necessary to maintain them and is involved with the service and installation of meters. United Water also owns 50% of the common stock of the Dundee Water Power and Land Company. Hackensack and Spring Valley, engaged solely in the water service business, provide water service to residential, commercial and industrial customers and fire protection within their franchise territories. Hackensack and Spring Valley are subject to regulation by the New Jersey Board of Regulatory Commissioners (BRC) and the New York Public Service Commission (PSC), respectively. At December 31, 1993, the distribution facility that provides water service to these utilities is comprised of approximately 2,955 miles of pipeline. United Water Resources Inc. Hackensack supplies water service to 175,044 customers in 60 New Jersey municipalities in most of Bergen County and in the northern part of Hudson County. The total population served is about 750,000 persons (1990 Census). Hackensack's principal source of water supply is the Hackensack River and its tributary streams, with a watershed of 113 square miles above the dam at Oradell, New Jersey, together with diversions into the Oradell Reservoir from an additional 55 square miles of watershed on the Saddle River, Long Swamp Brook and Sparkill Creek. The water supply of Hackensack is supplemented by ground water supplies derived from wells and by the purchase of water from the systems of Jersey City and the Passaic Valley Water Commission. Hackensack obtains stream flow benefits from Spring Valley which owns and operates an impounding reservoir, Lake DeForest, on the Hackensack River in Rockland County, New York. In addition, Hackensack has available additional water supply from the Wanaque South Project. The Wanaque South Project, which was completed in 1987, was the joint undertaking of Hackensack and the North Jersey District Water Supply Commission. Hackensack has a 50% interest in the utility plant of the project and shares project operating expenses. Spring Valley supplies water service to 59,508 customers in substantially all of Rockland County, New York, outside of the Palisades Interstate Park and the areas served by the water systems of the Villages of Nyack and Suffern. Its service area extends from Tomkins Cove on the north, south to the New Jersey state line and comprises about 121 square miles, with a population of about 250,000 persons (1990 Census). Spring Valley's principal source of supply is derived from wells and surface supplies, including Lake DeForest Reservoir and Cedar Pond Brook. United Water Resources Inc. Hackensack and Spring Valley have valid franchises authorizing them to conduct their present operations in all or substantially all of the territories in which services are rendered and to maintain their pipes in the streets and highways of these territories. Hackensack and Spring Valley have the right to secure their supplies of water from their present sources. All such franchises and rights are subject to alteration, suspension or repeal by the States of New Jersey and New York, respectively. Their properties are also subject to the exercise of the right of eminent domain as provided by law. Neither Hackensack nor Spring Valley engages in any significant operations outside its franchised territories. The business of Hackensack and Spring Valley is substantially free from direct competition with other public utilities, municipalities and other general public agencies. Both Hackensack and Spring Valley provide water that meets or surpasses the minimum standards of the Federal Safe Drinking Water Act of 1974, as amended. Rivervale is a non-regulated business engaged in real estate acquisitions and development, leasing and sales, golf course operations and consulting activities. Rivervale owns raw and income producing properties in Bergen and Essex Counties, New Jersey; and Orange, Westchester and Rockland Counties, New York. Rivervale continues to seek and receive municipal and other governmental approvals for several projects, both in New Jersey and New York. Out of its total holdings of approximately 767 acres, various approvals have been received for 198 acres of property in several parcels in northern New Jersey and Rockland County, New York. Applications are pending for projects on another 137 acres. Laboratory Resources performs a wide range of environmental analyses for consulting engineers, industry, public water suppliers, wastewater treatment facilities and governmental agencies. In 1993, Laboratory Resources received U.S. Army and Navy environmental cleanup certifications allowing them to enter into a new growing market. In December 1993, Laboratory Resources was awarded a $1 million Army base cleanup contract. Negotiations for other federal contracts are in progress. United Water Resources Inc. Mid-Atlantic owns and operates several small water and sewerage utility systems. These include water supply, sewage collection and sewage transmission companies providing service for approximately 2,752 customers in Vernon Township and Mt. Arlington, New Jersey. Mid-Atlantic is subject to regulation by the BRC. At December 31, 1993, its distribution facility is comprised of approximately 26 miles of pipeline. Through the acquisitions of several small companies, Mid-Atlantic expects to add approximately 900 additional customers early in 1994. In 1993, Metering Services Inc. sold its high technology division and retained the water meter installation division. United Water and its subsidiaries employed 706 persons as of December 31, 1993. United Water Resources Inc. (B) FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS --------------------------------------------- In September 1993, United Water and GWC Corporation (GWC), a Delaware water utility holding company, entered into a definitive agreement and plan of merger (Merger Agreement), pursuant to which GWC will merge with and into United Water. The Merger Agreement provides that 70% of each holder's GWC common stock will be converted into the right to receive 1.2 shares of United Water common stock and the remaining 30% will be converted at the election of the holder thereof into the right to receive either 1.2 shares United Water Series A Cumulative Convertible Preference Stock or an equivalent amount in cash. At December 31, 1993, United Water and GWC had 20,216,000 and 11,066,600 shares of common stock outstanding, respectively. In addition, the outstanding GWC Series A 7-5/8% Cumulative Preferred Stock would be converted into shares of United Water preferred stock with equal stated dividends and similar rights and designations. United Water Resources Inc. The Merger Agreement contains various provisions with respect to the conduct of each company's business pending consummation of the merger, such as prohibiting increases in United Water's common stock quarterly dividend above $.23 per share. Such provisions are not expected to have an adverse effect on United Water and its subsidiaries or limit the ability of United Water or its subsidiaries to operate in any material way. Discussions contained in the following pages of this Report (except where noted) pertain to United Water and its subsidiaries, and projections or estimates contained therein do not reflect the pending merger. For additional information on the merger, reference is made to United Water's Form 8-K's dated September 16, 1993 and March 10, 1994, which are filed as exhibits to this Report and incorporated herein by reference. On March 10, 1994 United Water announced that the shareholders of United Water and GWC overwhelmingly approved the companies' merger agreement at independently conducted shareholder meetings held that day. United Water Resources Inc. ITEM 2. ITEM 2. PROPERTIES ------- ---------- Hackensack owns and operates two impounding reservoirs, Oradell (3,507 million gallon (MG) capacity) and Woodcliff Lake (871 MG capacity) located in Bergen County, New Jersey and one impounding reservoir, Lake Tappan (3,853 MG capacity), partially located in Bergen County, New Jersey and partially located in Rockland County, New York. In addition, Hackensack obtains stream flow benefits from Spring Valley, which owns and operates an additional impounding reservoir, Lake DeForest (5,671 MG capacity), on the Hackensack River in Rockland County. The Wanaque South Project adds as much as 40 million gallons per day (MGD) to Hackensack's water supply. Hackensack and Spring Valley own and operate numerous wells throughout their systems. Hackensack also owns and operates a treatment and pumping plant at the Oradell Reservoir, which is comprised of raw and filtered water pumping facilities and purification works. This plant has raw and filtered water pumping capabilities in excess of 200 MGD. At Secaucus, New Jersey, Hackensack owns and operates a treatment and pumping plant for water supplied from the Jersey City aqueduct. This plant is capable of treating 18 MGD. Spring Valley has a pumping and treatment plant adjacent to Lake DeForest Reservoir, in the Town of Clarkstown, New York, with a capability of 20 MGD. A small pumping station and pressure filter plant, with a capacity of 1.5 MGD, located in the Town of Stony Point, New York, treats water from Cedar Pond Brook. Hackensack and Spring Valley own and maintain various reservoirs, standpipes, elevated tanks, transmission and distribution mains, hydrants, services and meters throughout the distribution system, including booster pump stations. In connection with the Wanaque South Project, Hackensack owns a 17-mile aqueduct from the Wanaque Reservoir to the Oradell Reservoir, along with a booster pumping station. Hackensack also owns 50% of the other elements of the Wanaque South Project, including an 11-mile aqueduct and related pump stations, and has contracted rights to yields derived from the Monksville Reservoir. United Water Resources Inc. On January 6, 1987, Spring Valley received New York State Department of Environmental Conservation (DEC) approval to build the proposed Ambrey Project, an impounding reservoir and treatment plant. However, construction of the project cannot begin until Spring Valley's water demands have reached a certain "trigger point" as determined by average daily water demands. On April 19, 1993, the Company requested the DEC's permission to adjust the Ambrey trigger mechanism to reflect current conditions and water demand characteristics. A decision on this matter is pending. Hackensack and Spring Valley own and occupy office buildings in Harrington Park and Hackensack, New Jersey; and in West Nyack, New York, respectively. Rivervale owns approximately 767 acres of land and three (3) major office buildings. Its properties are located in Bergen and Essex Counties, New Jersey; and Orange, Westchester and Rockland Counties, New York. Laboratory Resources owns and operates three (3) commercial testing laboratories in Teterboro, New Jersey; Brooklyn, Connecticut; and Bethlehem, Pennsylvania. Mid-Atlantic owns and operates public water supply, sewage collection and sewage transmission companies in Morris and Sussex Counties, New Jersey. United Water Resources Inc. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ------- ------------------ On January 12, 1990, the New Jersey Board of Public Utilities (BPU), predecessor of the Board of Regulatory Commissioners (BRC), and the New Jersey Watershed Property Review Board (WRB) approved Hackensack's transfer of approximately 290 acres of excess golf course land to Rivervale. Thereafter, two environmental advocacy groups, the Environmental Defense Fund (EDF) and Save the Watershed Action Network (SWAN), filed a consolidated appeal with New Jersey's Appellate Division contesting the approval. In June 1991, the Appellate Division remanded the matter back to the BPU and the WRB for further proceedings. Thereafter, Hackensack sought Certification to the Supreme Court of New Jersey. However, on October 30, 1991, the Supreme Court decided that it would not entertain that appeal. On February 5, 1991, the BPU denied a petition by the EDF for an enforcement order regarding development of the watershed lands, and in the alternative, a petition for reconsideration of the December 17, 1984 BPU decision approving transfer of approximately 717 acres from Hackensack to Rivervale. The February 5 Order also established a buffer zone of 500 feet for certain parcels of the property. On February 20, 1991, the EDF filed a Notice of Appeal to the New Jersey Appellate Division contesting the February 5 Order denying the reconsideration. Hackensack Water Company subsequently filed a cross appeal contesting the February 5 Order, solely as it related to the 500 foot buffer zone segment. On June 3, 1993, Hackensack and Rivervale executed a stipulation and agreement with EDF/SWAN, the Staff of the BRC and the New Jersey Department of the Public Advocate's office settling the above litigation subject to approval by the WRB and the BRC. The stipulation reinstates the transfer of the Golf Course Lands to Rivervale while providing for reacquisition by Hackensack of 355 acres transferred to Rivervale in 1984. United Water Resources Inc. Based upon decisions rendered from the WRB on July 6, 1993 and the BRC on August 5, 1993, several lawsuits were settled between Hackensack and two environmental groups related to the land transfers that occurred in 1984 and 1990. The settlement upheld the 1990 transfer from Hackensack to Rivervale of approximately 290 acres of land that are unconditionally and permanently deed restricted to golf course and country club uses. The settlement also required Hackensack to reacquire 355 acres of land which were transferred to Rivervale in 1984. This acreage was added to Hackensack's reservoir protective holdings and rate base. The transfer price of the acreage being returned to Hackensack's plant accounts was valued at $26 million, reflecting development approvals that occurred during the nine years that the land was held by Rivervale. Approximately $11 million (which includes interest) in proceeds from the 1990 golf course transfer to Rivervale was deferred for refund to water customers. To permanently reduce the rate impact of the reacquisition by Hackensack of the 355 acres, $4 million of the proceeds was applied against the utility plant accounts, resulting in a net increase in utility rate base of $22 million. The remaining $7 million of the proceeds will be applied as credits on customer bills to completely offset the impact of the rate increase of approximately 3.1%, or $3.5 million, which became effective October 12, 1993, in recognition of the increment to Hackensack's rate base. It is anticipated that the credits on customer bills will be made for approximately two years. Due to regulatory treatment, the effects of the intercompany transaction were not eliminated in consolidation. As a result of the settlement, Rivervale recognized sales proceeds of $26 million offset by costs of approximately $15.5 million associated with the land. In a separate matter, an appeal was filed with New Jersey's Intermediate Appellate Court by the Division of Rate Counsel, Department of the Public Advocate, from a 1990 BPU Order relating to the Petition of Hackensack for approval of a grant of a ground lease to Sterling Drug Capital Corporation, approving the long-term lease of certain Hackensack property for use as part of a golf course. The appeal contested those provisions of the Order directing that revenues realized from the lease be shared equally United Water Resources Inc. between Hackensack's shareholders and customers, and sought to have the lease proceeds inure to the exclusive benefit of the customers. The matter was argued before the Appellate Division and a decision was rendered on February 11, 1993, affirming the 1990 BPU Order. The Paterson Municipal Utilities Authority filed suit against the Hackensack Water Company and the North Jersey District Water Supply Commission. Summons and Complaint were served on August 8, 1990. The suit was based on alleged ownership of various water rights in the Passaic River owned by the Authority and which the Authority claimed were, or may have been, affected by diversions from the Wanaque South Project, in which Hackensack Water Company is an equal partner with the North Jersey District Water Supply Commission. The Company's Motion for Summary Judgement, dismissing the Complaint, was granted on July 23, 1992. On October 5, 1992, the Paterson Municipal Utilities Authority filed a Notice of Appeal. The Appeal is pending. The PSC, on February 20, 1985, authorized the sale and transfer of 23 acres of land from Spring Valley to Rivervale. Subsequently, the PSC initiated an administrative proceeding arising from an Order inquiring into the price for the transfer of the land. In September 1990, the PSC required Spring Valley to record a deferred credit that reduced rate base by $1.2 million to reflect the appreciated value of the property as of the date of sale of the land. In January of 1991, Spring Valley filed an appeal regarding the PSC decision; however, on February 13, 1992, the Appellate Division affirmed the action of the PSC. The effect of that decision on United Water has been recognized by an after-tax charge against income of $809,000 in 1991. The Company filed with the New York Court of Appeals a Motion for Leave to Appeal, which was denied on September 17, 1992. The Company has submitted a proposal to the PSC to make a one-time customer refund through billed credits of a portion of the deferred credit. The Company anticipates a PSC decision on its request in April 1994. On August 6, 1991, Rivervale Realty entered into a modification agreement relating to the outstanding proceeds being held in escrow from the sale of the Emerson Country Club. The modification United Water Resources Inc. provided for additional collateral to secure the purchase, the loan of the escrow monies in the amount of $13.1 million to the Buyer, and a release of the remaining portion of the escrow funds in the amount of $4.4 million to Rivervale. The release to the Buyer is secured by a note and mortgage on the Country Club and certain other properties owned by the Buyer, together with a guaranty from the Buyer's parent company, as additional security for the substitution of collateral. The Buyer failed to make its scheduled March 1992 and all subsequent payments, and as a result, the note was placed in a non-accrual status. Rivervale has begun an action in foreclosure, which the Buyer has challenged. By Superior Court Order dated February 10, 1993 Rivervale was awarded possession of the course and operated the facility during the 1993 season. On March 18, 1994 Rivervale and Bird Hills entered into a stipulation of settlement whereby Rivervale would pay Bird Hills $2 million in return for additional property acquired by Bird Hills. The stipulation also requires Bird Hills to give up all claims to the golf course parcel. The closing of the settlement is tentatively scheduled for March 30, 1994. Based upon advice from counsel, management believes Hackensack, Spring Valley and Rivervale have meritorious defenses in all of the aforementioned claims which remain pending and intends to contest them vigorously. The likelihood that the ultimate resolution will have a material effect upon the financial position or results of operations of United Water or its subsidiaries is considered to be remote. United Water Resources Inc. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------- ----------------------------------------------------------- During the fourth quarter of 1993, there were no matters submitted to a vote of security holders. United Water Resources Inc. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED ------- ----------------------------------------------------------- STOCKHOLDER MATTERS -------------------- United Water Resources' common stock is traded on the New York Stock Exchange under the symbol UWR. The high and low sales prices for United Water's common stock for 1993, 1992 and 1991 and the dividends paid on the common stock each quarter were as follows: The high and low stock prices from January 1 to February 28, 1994, were 14.750 and 13.750. The number of holders of record of United Water's common stock as of January 31, 1994 were 19,099. United Water Resources Inc. Balance Sheet Data (at end of period) - ------------------------------------- United Water Resources Inc. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ------- ----------------------------------------------------------------- AND RESULTS OF OPERATIONS ---------------------------- LIQUIDITY AND CAPITAL RESOURCES CAPITAL REQUIREMENTS United Water Resources' (United Water) existing utility subsidiaries expect to spend $89 million on construction programs over the next five years. Expenditures in 1994 and 1995 are projected to be $16.4 million and $18.1 million, respectively. These estimates are subject to continuous review and actual expenditures may vary. The construction programs include the installation of transmission and distribution facilities. The utilities plan to continue to fund their construction programs primarily through internal cash generation. Additional funding, as necessary, will be obtained through the sale of securities, available credit lines, and capital infusions by United Water from its dividend reinvestment and stock purchase plans. The amount and timing of the use of these proceeds and of future financings will depend on actual construction expenditures, the timeliness and adequacy of rate relief, the availability and cost of capital, and the ability to meet interest and fixed charge coverage requirements. In 1991, United Water implemented two enhancements to its dividend reinvestment and stock purchase plans. The first allows plan participants to make additional cash investments in United Water shares at a 5% discount from market price with no brokerage fees. The second provides our utility customers with a 5% discount on their initial investment. The amount received from all plans was: 1993-$20.5 million; 1992-$17.3 million; 1991-$9.7 million. In July 1993, Hackensack Water Company (Hackensack) redeemed $10 million of its $20 million, 9-3/4% Series First Mortgage Bonds, due 2006. Hackensack redeemed the remaining $10 million in January 1994. In 1993, Hackensack filed a petition requesting the New Jersey Board of Regulatory Commissioners' (BRC) approval to issue and sell $40 million of tax-exempt refunding bonds. United Water Resources Inc. Hackensack received BRC approval in February 1994 and plans to use the proceeds of the issue to redeem $20 million 8-3/4% bonds and $20 million 8% bonds in 1994. On March 22, 1994, Hackensack issued $20 million 5.80% 1994 Series A term bonds and $20 million 5.9% 1994 Series B term bonds, due March 1, 2024. In November 1993, Rivervale Realty Company (Rivervale) reduced its existing $9.5 million Atrium building mortgage by $1.5 million and refinanced the remaining $8.0 million with a floating rate term loan, due 2000. The interest rate will be established every 30 days and is based on London Interbank Offered Rate (LIBOR) plus a premium (4.25% at December 31, 1993). In December 1993, the New York State Environmental Facilities Corporation (EFC) issued $12 million of 5.65% tax-exempt Water Facilities Revenue Bonds (1993 Bonds) due in 2023 with optional redemption provisions on behalf of Spring Valley Water Company Incorporated (Spring Valley). The proceeds will be used to finance certain construction projects through 1995. At December 31, 1993, United Water had available $57.5 million of unused short-term bank lines of credit and $9 million in cash and temporary investments. MERGER ------ On September 15, 1993, United Water entered into a definitive agreement to merge with GWC Corporation (GWC), a company based in Wilmington, Delaware. GWC is the parent company of General Waterworks Corporation (General Waterworks), a utility holding company. Under the terms of the agreement, GWC will merge into United Water so that General Waterworks will become a wholly-owned subsidiary of United Water through an exchange of common stock, convertible preference stock, and cash for GWC common stock. The total value of the transaction is approximately $196 million. Lyonnaise des Eaux-Dumez (Lyonnaise), the majority shareholder of GWC, will receive 70% of its consideration in common stock of United Water at a ratio of 1.2 shares of United Water to 1 share of GWC United Water Resources Inc. and the remaining 30% in convertible preference stock. The minority shareholders of GWC will receive 70% of their consideration in common stock of United Water at a ratio of 1.2 shares of United Water to 1 share of GWC. They will also have a choice of taking the remaining 30% in either (i) cash equal to 1.2 times the average market price of United Water common stock on the New York Stock Exchange for 20 trading days prior to the closing, or (ii) an equivalent value of United Water convertible preference stock. The merger is expected to be tax free to the extent common shareholders of GWC receive common stock or preference stock of United Water. On November 30, 1993, the boards of directors of United Water and GWC voted to proceed with the proposed merger subject to various closing conditions. These include approvals from the shareholders of both companies and certain state regulatory agencies. A registration statement (S-4) and joint proxy statement was filed with the Securities and Exchange Commission on February 3, 1994. On March 10, 1994, special shareholder meetings of both companies were held to vote on the merger proposal, resulting in the shareholders of United Water and GWC overwhelmingly approving the companies' merger agreement. Lyonnaise, a French multi-national corporation and one of Europe's largest water purveyors, currently owns approximately 82% of GWC shares. Lyonnaise voted its shares for the merger in the same proportion as the minority shareholders of GWC. Under the terms of the agreement, Lyonnaise will own approximately 26% of the outstanding United Water shares after the merger. Lyonnaise will enter into a 12-year Governance Agreement with United Water which, subject to certain conditions, will govern the relationship of the parties. As a result of the merger, United Water will become the second largest investor-owned water utility in the country. The service territory will serve more than 2 million people in 14 states. Utility operating revenues are anticipated to double and consolidated assets are expected to exceed $1 billion. United Water Resources Inc. RATE MATTERS SPRING VALLEY In 1990 and 1989, Spring Valley deferred revenues totaling $505,000 and $1.2 million, respectively, related to reductions in pension expense and federal income tax rates pursuant to a New York Public Service Commission (PSC) order. As a result of the September 1990 rate application settlement with the PSC, Spring Valley began to refund these revenues to customers. In February 1993, Spring Valley implemented a September 1992 PSC decision which revised its tariff design and discontinued the application of federal income tax revenue credits on customer bills. Spring Valley is using unamortized revenue deferrals to recover the cost of a customer conservation program which began in the second quarter of 1993 and is anticipated to conclude in 1995. In July 1992, Spring Valley applied to the PSC for permission to increase its annual revenues by $5 million, or 14.4%, to offset the effects of continued investment in plant facilities and increases in operating expenses. On May 12, 1993, the PSC rendered its decision. The PSC Opinion No. 93-9 allowed Spring Valley an overall rate of return of 8.75% and a return on equity of 10.5%. The opinion provided for an increase in annual revenues of approximately $1.9 million, or 5.7%, which became effective on May 30, 1993. The PSC also allowed Spring Valley to recover approximately $850,000 of previously deferred expenses and required it to refund certain revenue credits of approximately $1 million immediately. This action, which resulted in a one-time increase in revenues and various expenses in the second quarter of 1993, did not have a material effect on net income. The PSC's decision also permitted Spring Valley to submit a second stage filing after February 1, 1994 to recover increases in property taxes, salaries and wages, and medical benefits that were not provided for in their previous determination. In addition, in its second stage filing, Spring Valley will seek rate recognition of its other postretirement benefits on an accrual basis. In February 1994, Spring Valley filed a request to United Water Resources Inc. increase revenues by approximately $1.6 million, or 4.4%. Spring Valley anticipates a PSC decision on its request in April 1994. The PSC's May 1993 decision also directed Spring Valley to institute a Revenue Reconciliation Clause (RRC), which requires Spring Valley to reconcile billed revenues with the pro forma revenues that were used to set rates. Any variances outside a 1% range are accrued or deferred for subsequent recovery from or refund to customers. As a result of the hot weather experienced during the summer of 1993, the RRC resulted in the deferral of $1.4 million, which will be used to recover certain deferred costs. The remaining balance will be refunded to Spring Valley customers along with previous RRC credit balances over a three-year period beginning in July 1994. In 1990, the PSC modified its earlier decision regarding the 1985 transfer of 23 acres of land from Spring Valley to Rivervale. They ordered Spring Valley to record a deferred credit that reduced rate base by $1.9 million. In 1991, Spring Valley filed an appeal with the New York State Supreme Court-Appellate Division. In February 1992, a decision was rendered on the appeal affirming the PSC order. The effect of that decision on United Water has been recognized by an after-tax charge against income of $809,000 in 1991. Spring Valley has submitted a proposal to the PSC to make a one-time customer refund through bill credits of a portion of the deferred credit. A PSC decision is anticipated in April 1994. HACKENSACK WATER Based upon decisions that were rendered by the New Jersey Watershed Property Review Board on July 6, 1993, and the BRC on August 5, 1993, several lawsuits were settled between Hackensack and two environmental groups related to the land transfers that occurred in 1984 and 1990. The settlement upheld the 1990 transfer from Hackensack to Rivervale of approximately 290 acres of land that are unconditionally and permanently deed restricted to golf course and country club United Water Resources Inc. uses. The settlement also required Hackensack to reacquire 355 acres of land which were transferred to Rivervale in 1984. This acreage was added to Hackensack's reservoir protective holdings and rate base. The transfer price of the acreage being returned to Hackensack's plant accounts was valued at $26 million, reflecting development approvals that occurred during the nine years that the land was held by Rivervale. Approximately $11 million (which includes interest) in proceeds from the 1990 golf course transfer to Rivervale was deferred for refund to Hackensack customers. To permanently reduce the rate impact of the reacquisition by Hackensack of the 355 acres, $4 million of the proceeds was applied against the utility plant accounts resulting in a net increase in utility rate base of $22 million. The remaining $7 million of the proceeds are being applied as credits on customer bills to completely offset the impact of the rate increase of approximately 3.1%, or $3.5 million, which became effective October 12, 1993, in recognition of the increment to Hackensack's rate base. It is anticipated that the credits on customer bills will be made for approximately two years. Due to regulatory treatment, the effects of the intercompany transaction were not eliminated in consolidation. REAL ESTATE ACTIVITIES The intercompany land transfer settlement discussed above had a positive impact on Rivervale's revenues. Rivervale continues to receive municipal and other governmental approvals for projects in New Jersey and New York. Various approvals have been received pertaining to 198 acres of property in several parcels in northern New Jersey and southern New York. Rivervale is pursuing joint ventures, sales, or direct development opportunities for selected properties in its portfolio. Applications are pending for projects on another 137 acres. Funding for Rivervale's real estate activities is anticipated to be obtained from internally generated funds from the sales of properties, rental income, revenues from golf course operations, consulting activities, and borrowings and advances from United Water, as required. The timing and United Water Resources Inc. magnitude of additional funding for development activities will depend upon the attainment of necessary approvals and market conditions. Rivervale currently projects spending $27 million over the next five years for capital expenditures on its existing portfolio. Expenditures in 1994 and 1995 are projected to be $4.8 million and $2.5 million, respectively. Funding for these expenditures is projected to be available from internally generated cash. RESULTS OF OPERATIONS OVERVIEW United Water's consolidated net income for 1993 of $20 million increased 27% from $15.8 million in 1992. Net income per common share for 1993 was $1.03 versus 87 cents for the same period last year, despite a 6.9% rise in the average number of common shares outstanding. This increase in consolidated net income is primarily attributable to the settlement of litigation surrounding the land transfers as well as the contribution from utility operations. REVENUES The increases (decreases) in revenues from the prior periods are attributable to the following factors: United Water Resources Inc. The rate impact of 1.2% in utility revenues in 1993 resulted from a 5.7% Spring Valley rate increase in May 1993, a 3.1% Hackensack rate increase in October 1993 and the recognition of approximately $1 million of deferred revenue credits relating to Spring Valley's rate case. The 5.6% consumption impact on utility revenues in 1993 is attributable to the 6.8% and 4.6% increase in Hackensack's and Spring Valley's consumption, respectively, due to an unusually warm and dry summer. Pursuant to the PSC Revenue Reconciliation Clause, Spring Valley deferred $1.4 million of revenues in 1993. The $23.2 million or 14.1% increase in real estate revenues was the result of a $26 million land transfer between Hackensack and Rivervale, offset by reduced revenues of land sales to third parties. Total revenues in 1992 were 1.9% above those in 1991, reflecting the contribution of approximately $4.7 million from real estate sales and $2 million from rental activities and reduced customer usage compared with 1991, when the utilities set new daily pumping records during a dry summer. United Water Resources Inc. COSTS AND EXPENSES The changes in operating expenses from the prior years were due to the following: Operation and maintenance expenses increased $25.2 million or 33.5% from 1992. This increase is primarily due to expenses related to the cost of the transferred real estate of $15.5 million, a $4.1 million valuation reserve relating to Rivervale properties, and the recognition of deferred expenses relating to the Spring Valley rate case of approximately $850,000. Higher operational expenses due to greater system demands, contracted labor costs, and higher salaries and wages also contributed to this increase. The 3.9% increase in 1992 over 1991 was primarily attributable to costs of property sold associated with real estate activities. Depreciation increased by 2.3% in 1993 and 6.1% in 1992. The higher depreciation expense in both years was primarily due to additional facilities placed in service and the application of higher utility depreciation rates resulting from Hackensack's rate settlement, which was effective in the second quarter of 1991, and the increase in Spring Valley's composite rates from 2% to 2.2% in the second quarter of 1993. General taxes increased $1.2 million, or 4%, over 1992, due principally to higher revenue based taxes of 2.1% and an increase of 8.4% in property related taxes. The decline in general taxes of $1.3 million, or 4.4%, in 1992 from 1991 is mainly attributable to the 9.4% decrease in revenue based taxes which was offset by a 13.7% increase in property related taxes. United Water Resources Inc. INTEREST AND OTHER Consolidated interest expense decreased 1% in 1993 from 1992 and 2% from 1991, due to lower interest rates on short-term borrowings, the reduction of long-term debt and an increase in short-term borrowings. In 1992, the allowance for funds used during construction decreased 32% from 1991 following the recognition of additional expenditures related to utility plant being placed in service. Other income in 1992 decreased 49% from 1991, due to a reduction in interest rates, average temporary cash investments and funds held on deposit. INCOME TAXES The effective income tax rates on income before preferred stock dividends were 36% in 1993, 31.1% in 1992 and 31.3% in 1991. In 1993, the provision for income taxes increased $4.5 million, or 56.2% over 1992, due mainly to the effect of the land transfer, higher water sales, the Spring Valley rate decision and the increase in the federal income tax rate. The rate decision resulted in the recognition of deferred IRS audit adjustments of $946,000 relating to the previously settled 1981 through 1988 IRS audit. In 1992, the provision for income taxes decreased 1% from 1991 primarily as the result of lower pre-tax earnings. An analysis of income taxes is included in Note 10 to the financial statements. EFFECTS OF INFLATION Operating income from utility operations is normally not materially affected by inflation because cost increases generally lead to proportionate increases in revenues allowed through the regulatory process. However, there is a lag in the recovery of higher expenses through the regulatory process, and therefore, high inflation could have a detrimental effect on the company until rate increases are received. United Water Resources Inc. Conversely, lower inflation and lower interest rates tend to result in reductions in the rates of return allowed by the utility commissions, as has happened over the last several years. United Water Resources Inc. ITEM 8. ITEM 8. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND ------- ---------------------------------------------------- SUPPLEMENTARY DATA ------------------- All other schedules are omitted because they are not applicable, or the required information is shown in the consolidated financial statements or notes thereto. Financial statements of one 50%-owned company have been omitted because the registrant's proportionate share of net income and total assets of the company is less than 20% of the respective consolidated amounts, and the investment in and the amount advanced to the company is less than 20% of consolidated total assets. United Water Resources Inc. REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors United Water Resources In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of United Water Resources and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes 8 and 10 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions and income taxes, effective January 1, 1993. PRICE WATERHOUSE Hackensack, New Jersey February 24, 1994 CONSOLIDATED BALANCE SHEET United Water Resources and Subsidiaries THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. STATEMENT OF CONSOLIDATED INCOME United Water Resources and Subsidiaries STATEMENT OF CONSOLIDATED COMMON EQUITY United Water Resources and Subsidiaries THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. STATEMENT OF CONSOLIDATED CASH FLOWS United Water Resources and Subsidiaries Supplemental disclosures of cash flow information: Cash paid during the year for: Interest (net of amount capitalized) $ 21,328 $ 21,388 $ 21,790 Income taxes $ 2,915 $ 5,023 $ 6,215 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. STATEMENT OF CONSOLIDATED CAPITALIZATION United Water Resources and Subsidiaries THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. United Water Resources Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The consolidated financial statements include the accounts of United Water Resources and its wholly owned subsidiaries (United Water). United Water's principal utility subsidiaries, Hackensack Water Company (Hackensack) and Spring Valley Water Company Incorporated (Spring Valley), are subject to regulation by the New Jersey Board of Regulatory Commissioners (BRC) and the New York Public Service Commission (PSC), respectively. Their accounting policies comply with the applicable uniform systems of accounts prescribed by these regulatory commissions and conform to generally accepted accounting principles as applied to rate regulated public utilities, which allows, among other things, the recognition of intercompany profit in situations where it is probable such profit will be recovered in the ratemaking process. UTILITY PLANT: Utility plant is recorded at cost, which includes direct and indirect labor and material costs associated with construction activities, related operating overheads and an allowance for funds used during construction (AFUDC). AFUDC is not current cash income; it represents the cost of borrowed funds used for construction purposes and a reasonable rate on other funds used. The amount of AFUDC related to equity funds was: 1993-$359,000; 1992-$275,000; 1991-$399,000. Utility property retired or otherwise disposed of in the normal course of business is charged to accumulated depreciation, with salvage (net of removal cost) credited thereto, and no gain or loss is recognized. The costs of property repairs, replacements and renewals of minor property items are included in maintenance expense. Utility plant includes Hackensack's 50% interest in the Wanaque South Water Supply Project, which, at original cost, totaled $51 million at December 31, 1993 and 1992. The net book value United Water Resources Inc. at December 31, 1993 was $46 million and $46.8 million at December 31, 1992. Hackensack's share of project operating expenses is included in United Water's consolidated operation and maintenance expenses. REAL ESTATE: Real estate properties are carried at the lower of cost, which includes original purchase price and direct development costs, or net realizable value. Real estate taxes and interest costs are capitalized during the development period. The amount of interest capitalized in 1993 was $2.6 million and $3 million in 1992 and 1991. Real estate operating revenues include rental income, proceeds from the disposition of real estate properties and revenues from golf course operations. Proceeds and costs related to pending real estate transactions which do not qualify as completed sales for accounting purposes have been recorded under the deposit method. At December 31, 1993 and 1992, pending proceeds of approximately $17 million have been recorded as deferred credits. UNAMORTIZED DEBT EXPENSE: Debt premium, debt discount and debt expense are amortized to income over the lives of the applicable issues. PREPAID AND DEFERRED EMPLOYEE BENEFITS: As of December 31, 1993, the prepaid employee benefits include $5.9 million of prepaid pension costs and $4.6 million of prepaid and deferred postretirement health care benefits. Most of the postretirement costs relate to employees and retirees of Hackensack and Spring Valley. Hackensack and Spring Valley have been advised by the BRC and PSC, respectively, that they are allowed to defer accrued postretirement health care costs in excess of amounts included in rates. At December 31, 1993, $3.4 million was deferred for recovery in future rates. REVENUES: Hackensack records on its books the estimated amount of accrued but unbilled revenues. Spring Valley does not accrue unbilled revenues. Spring Valley currently has $3.8 million of unamortized revenue deferrals which are available to offset other incremental deferred costs or be refunded to customers over a three-year period. Pursuant to PSC orders, Spring Valley refunded $2.3 million, $1.4 million, and $1.9 million of these revenues to customers in 1993, 1992, and 1991, respectively. Spring Valley also deferred revenues of $1.4 million, $392,000, and $1.9 million in 1993, 1992, and 1991, United Water Resources Inc. respectively. These deferrals were related to revenues in excess of amounts allowed in rates, reductions in federal income taxes and reductions in pension expenses. DEPRECIATION: Depreciation of plant and real estate properties is computed on the straight-line method based on the estimated service lives of the properties. Utility plant depreciation rates are prescribed by the regulatory commissions. The provisions for depreciation in 1993, 1992 and 1991 were equivalent to 2.2%, 2.2%, and 2.1%, respectively, of average depreciable utility plant in service. For federal income tax purposes, depreciation is computed using accelerated methods and, in general, with shorter depreciable lives as permitted under the Internal Revenue Code. INCOME TAXES: United Water files a consolidated federal income tax return. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." SFAS No. 109 requires the company to adjust its recorded deferred income tax balances to reflect an estimate of its future tax liability based on temporary differences between the financial and tax basis of assets and liabilities. This adjustment includes deferred taxes for utility temporary differences not previously recognized. It also includes the effect on the liability of changes in tax laws and rates. The adoption of SFAS No. 109 resulted in the recording of a deferred tax liability and recoverable income taxes of $20.2 million at January 1, 1993, which is reflected on the balance sheet, with no material effect on net income. The recoverable income taxes represent the probable future increase in revenues that will be received through future ratemaking proceedings for the recovery of these deferred taxes. For 1992 and 1991, the provision for income taxes represents the estimated amounts payable for the period and net deferred taxes relating to differences between income for accounting and tax purposes for certain items as discussed in Note 10. Deferred taxes were provided for timing differences between financial and income tax reporting, except where not allowed by regulation. United Water Resources Inc. Investment tax credits arising from property additions are deferred and amortized over the estimated service lives of the related properties. STATEMENT OF CASH FLOWS: United Water considers all highly liquid investments with original maturities of three months or less to be temporary cash investments. United Water Resources Inc. NOTE 2 - SHORT-TERM BORROWING AGREEMENTS: United Water has credit lines with several banks which allow for aggregate short-term borrowings of up to $73 million. Borrowings under these credit lines bear interest at a rate between the London Interbank Offered Rate (LIBOR) and the prime lending rate. There was $15.5 million outstanding on these lines at December 31, 1993, at interest rates ranging from 3.5% to 4.4%. United Water maintains balances and pays commitment fees under arrangements with certain of these banks to compensate them for services and to support these lines of credit. There are no legal restrictions placed on the withdrawal or other use of these bank balances. United Water Resources Inc. NOTE 3 - LONG-TERM DEBT: Long-term debt repayable over the next five years is: 1994-$19.8 million; 1995-$1.6 million; $1996-$1.7 million; 1997-$12.6 million and 1998-$3.6 million. Substantially all of the utility plant is subject to first mortgage liens. In July 1993, Hackensack redeemed $10 million of its $20 million, 9-3/4% Series, First Mortgage Bonds, due 2006. Hackensack redeemed the remaining $10 million in January 1994. In 1993, Hackensack filed a petition requesting BRC approval to issue and sell $40 million of tax- exempt refunding bonds. Hackensack received BRC approval in February 1994 and plans to use the proceeds of the issue to redeem $20 million 8-3/4% bonds and $20 million 8% bonds in 1994. On March 22, 1994, Hackensack issued $20 million 5.80% 1994 Series A term bonds and $20 million 5.90% 1994 Series B term bonds, due March 1, 2024. In November 1993, Rivervale reduced its existing $9.5 million Atrium building mortgage by $1.5 million and refinanced the remaining $8 million with a floating rate term loan due 2000. The interest rate will be established every 30 days and is based on LIBOR plus a premium (4.25% at December 31, 1993). In December 1993, the New York State Environmental Facilities Corporation (EFC) issued $12 million of 5.65%, tax-exempt, Water Facilities Revenue Bonds (1993 Bonds) due 2023 with optional redemption provisions on behalf of Spring Valley to finance construction programs through 1995. The bonds are insured as to the payment of interest and principal by the AMBAC Indemnity Corporation. In February 1992, Laboratory Resources obtained a $600,000 loan to finance leasehold improvements at its new facility. The loan bears interest at a floating prime (6% at December 31, 1993) with a maturity date of March 1997. Principal is payable in monthly installments. United Water Resources Inc. In May 1991, United Water obtained a $5 million loan to finance an investment in an unaffiliated New Jersey water company. The loan bears interest at floating LIBOR (4.8125% at December 31, 1993) with a maturity date of October 1994. Management expects to refinance this loan on a long- term basis. United Water Resources Inc. NOTE 4 - CONSTRUCTION EXPENDITURES: The expenditures for the utilities' construction programs over the next five years are expected to total $89 million. Construction expenditures for 1994 and 1995 are estimated to be $16.4 million and $18.1 million, respectively. Rivervale currently projects spending $27 million over the next five years for capital expenditures on its current portfolio. Expenditures in 1994 and 1995 are projected to be $4.8 million and $2.5 million, respectively. United Water Resources Inc. NOTE 5 - PREFERRED STOCK: Cumulative preferred stock of utility subsidiaries with mandatory redemption is subject to sinking fund requirements. These mandatory requirements total $260,000 in each of the years 1994 through 1997, and total $573,000 in 1998. In addition, optional sinking fund provisions can be exercised and redemptions made at specific prices for all preferred stock issues. Redemptions require payment of accrued and unpaid dividends to the date fixed for redemption. In March 1992, Hackensack issued $15 million of 7-3/8% cumulative preferred stock, with a $2.1 million annual sinking fund requirement beginning in 2001, for redemption of first mortgage bonds and to provide funds for its ongoing capital programs. Optional redemption of this new series begins in 1997. Cumulative preferred stock has been redeemed as follows: United Water Resources Inc. NOTE 6 - INCENTIVE STOCK PLANS: Under the Management Incentive Plan, the following options have been granted to key employees: These options are currently exercisable and represent the only stock options outstanding at December 31, 1993. A total of 1,140,625 shares are reserved for issuance under the plan. In May 1993, the shareholders approved the creation of dividend units to be issued in conjunction with stock options granted under the plan. One dividend unit may be attached to an unexercised option to purchase a share of common stock. This will entitle the option holder to accrue the aggregate dividends actually payable on one share of common stock while the dividend unit is in effect. The dividend units are designed to create an incentive for option holders tied to the dividend payments on the common stock. United Water recorded $47,000 in 1993 of compensation expense with respect to this plan. United Water Resources Inc. In May 1988, the shareholders approved a Restricted Stock Plan for key employees. United Water issued 7,500 shares in 1993; 16,353 shares in 1992; and 12,661 shares in 1991 in connection with the plan and such shares are earned by the recipients over a 5-year period. United Water recorded $301,000 in 1993, $241,000 in 1992 and $265,000 in 1991 of compensation expense with respect to this plan. United Water Resources Inc. NOTE 7 - SHAREHOLDER RIGHTS PLAN: In July 1989, the board of directors of United Water approved a Shareholder Rights Plan designed to protect shareholders against unfair and unequal treatment in the event of a proposed takeover. It also guards against partial tender offers and other hostile tactics to gain control of United Water without paying all shareholders a fair price. Under the plan, each share of United Water's common stock also represents one Series A Participating Preferred Stock Purchase Right (Right) until the Rights become exercisable. The Rights attach to all of United Water's common stock outstanding as of August 1, 1989, or subsequently issued, and expire on August 1, 1999. The Rights would be exercisable only if a person or group acquired 20% or more of United Water's common stock or announced a tender offer that would lead to ownership by a person or group of 20% or more of the common stock. In certain cases where an acquirer purchased more than 20% of United Water's common stock, the Rights would allow shareholders (other than the acquirer) to purchase shares of United Water's common stock at 50% of market price, diminishing the value of the acquirer's shares and diluting the acquirer's equity position in United Water. If United Water were acquired in a merger or other business combination transaction, under certain circumstances the Rights could be used to purchase shares in the acquirer at 50% of the market price. Subject to certain conditions, if a person or group acquired 20% or more of United Water's common stock, United Water's board of directors may exchange each Right held by shareholders (other than the acquirer) for one share of common stock or 1/100 of a share of Series A Participating Preferred Stock. If an acquirer successfully purchased 80% of United Water's common stock after tendering for all of the stock, the Rights would not operate. If holders of a majority of the shares of United Water's common stock approved a proposed acquisition under specified circumstances, the Rights would be redeemed at one cent each. They could also be redeemed by United Water's board of directors for one cent each at any time prior to the acquisition of 20% of the common stock by an acquirer. United Water Resources Inc. On September 15, 1993, United Water's Shareholder Rights Plan was amended in connection with United Water's execution of a merger agreement with GWC Corporation. The amendment generally excepts the majority stockholder of GWC Corporation and its affiliates and associates from triggering the Rights through the execution of the merger agreement, the performance of the transactions contemplated therein or otherwise. United Water Resources Inc. NOTE 8 - EMPLOYEE BENEFITS: POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS: In January 1993, the company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This new standard requires that employers recognize these benefits on an accrual basis rather than on a cash basis. The company sponsors one non-contributory defined benefit postretirement plan that covers hospitalization, major medical benefits, and life insurance benefits for salaried and non-salaried employees. The company is funding its postretirement health care benefits through contributions to Voluntary Employees' Beneficiary Association (VEBA) Trusts. The following sets forth the plans' funded status reconciled with the amounts recognized in the company's balance sheet as of December 31, 1993: United Water Resources Inc. Net periodic postretirement benefit cost for the year ended December 31, 1993 includes the following components: The assumed discount rate is 7.75% and the expected rate of return on plan assets is 8.25%, except for Hackensack's non-bargaining plan, which has an expected after-tax yield on assets of 5%. The associated health care cost trend rate used in measuring the postretirement benefit obligation at December 31, 1993 was 14.2%, gradually declining to 5.5% in 2002 and thereafter. Increasing the assumed health care cost trend rate by one percentage point in each year will increase the APBO as of December 31, 1993 by $3.9 million to a total of $38.9 million and the aggregate service and interest cost components of net periodic postretirement benefit cost for 1993 by $896,000 to a total of $5.5 million. Hackensack and Spring Valley have been advised by the BRC and PSC, respectively, that they are allowed to defer postretirement health care costs in excess of those currently included in rates. At December 31, 1993, $3.4 million was deferred for recovery in future rates. Most of the company's postretirement costs relate to employees and retirees of Hackensack and Spring Valley. Therefore, adoption of SFAS No. 106 has not had a material effect on consolidated net income. DEFINED BENEFIT PENSION PLAN: Most employees are covered by trusteed non-contributory defined benefit pension plans under which benefits are based upon years of service and the employee's compensation during the last five United Water Resources Inc. years of employment. United Water's policy is to fund amounts accrued for pension expense to the extent deductible for federal income tax purposes. It is expected that no funding will be made for 1993. Net periodic pension cost includes the following components at year end: The status of the funded plans at December 31, 1993 and 1992 was as follows: United Water Resources Inc. Significant actuarial assumptions used in the foregoing calculations were as follows: Certain categories of employees are covered by non-funded supplemental plans. The projected benefit obligations of these plans at December 31, 1993, totaled $5.2 million. The unfunded accumulated benefit obligation of $4.9 million has been recorded in other deferred credits and liabilities and an intangible pension asset of $1.5 million recorded in other deferred charges and assets at December 31, 1993. United Water made contributions of $552,000, $562,000 and $516,000 in 1993, 1992 and 1991, respectively, to a defined contribution savings plan. United Water Resources Inc. NOTE 9 - RATE MATTERS: SPRING VALLEY: In 1990 and 1989, Spring Valley deferred revenues totaling $505,000 and $1.2 million, respectively, related to reductions in pension expense and federal income tax rates pursuant to a PSC order. As a result of the September 1990 rate application settlement with the PSC, Spring Valley began to refund these revenues to customers. In February 1993, Spring Valley implemented a September 1992 PSC decision which revised its tariff design and discontinued the application of federal income tax revenue credits on customer bills. Spring Valley is using unamortized revenue deferrals to recover the cost of a customer conservation program which began in the second quarter of 1993 and is anticipated to conclude in 1995. In July 1992, Spring Valley applied to the PSC for permission to increase its annual revenues by $5 million, or 14.4%, to offset the effects of continued investment in plant facilities and increases in operating expenses. On May 12, 1993, the PSC rendered its decision. The PSC Opinion No. 93-9 allowed Spring Valley an overall rate of return of 8.75% and a return on equity of 10.5%. The opinion provided for an increase in annual revenues of approximately $1.9 million, or 5.7%, which became effective on May 30, 1993. The PSC also allowed Spring Valley to recover approximately $850,000 of previously deferred expenses and required it to refund certain revenue credits of approximately $1 million immediately. This action, which resulted in a one-time increase in revenues and various expenses in the second quarter of 1993, did not have a material effect on net income. The PSC's decision also permitted Spring Valley to submit a second stage filing after February 1, 1994 to recover increases in property taxes, salaries and wages, and medical benefits that were not provided for in their previous determination. In addition, in its second stage filing, Spring Valley will seek rate recognition of its other postretirement benefits. In February 1994, Spring Valley filed a request to increase revenues by United Water Resources Inc. approximately $1.6 million, or 4.4%. Spring Valley anticipates a PSC decision on its request in April 1994. The PSC's May 1993 decision also directed Spring Valley to institute a Revenue Reconciliation Clause (RRC), which requires Spring Valley to reconcile billed revenues with the pro forma revenues that were used to set rates. Any variances outside a 1% range are accrued or deferred for subsequent recovery from or refund to customers. As a result of the hot weather experienced during the summer of 1993, the RRC resulted in the deferral of $1.4 million, which will be used to recover certain deferred costs. The remaining balance will be refunded to Spring Valley customers along with previous RRC credit balances over a three-year period beginning in July 1994. In 1990, the PSC modified its earlier decision regarding the 1985 transfer of 23 acres of land from Spring Valley to Rivervale. They ordered Spring Valley to record a deferred credit that reduced rate base by $1.9 million. In 1991, Spring Valley filed an appeal with the New York State Supreme Court-Appellate Division. In February 1992, a decision was rendered on the appeal affirming the PSC order. The effect of that decision on United Water has been recognized by an after-tax charge against income of $809,000 in 1991. Spring Valley has submitted a proposal to the PSC to make a one-time customer refund through bill credits of a portion of the deferred credit. Spring Valley anticipates a PSC decision on its request in April 1994. HACKENSACK WATER: Based upon decisions rendered by the New Jersey Watershed Property Review Board on July 6, 1993, and the BRC on August 5, 1993, several lawsuits were settled between Hackensack and two environmental groups related to the land transfers that occurred in 1984 and 1990. The settlement upheld the 1990 transfer from Hackensack to Rivervale of approximately 290 acres of land that are unconditionally and permanently deed restricted to golf course and country club United Water Resources Inc. uses. The settlement also required Hackensack to reacquire 355 acres of land which were transferred to Rivervale in 1984. This acreage was added to Hackensack's reservoir protective holdings and rate base. The transfer price of the acreage being returned to Hackensack's plant accounts was valued at $26 million, reflecting development approvals that occurred during the nine years that the land was held by Rivervale. Approximately $11 million (which includes interest) in proceeds from the 1990 golf course transfer to Rivervale was deferred for refund to Hackensack customers. To permanently reduce the rate impact of the reacquisition by Hackensack of the 355 acres, $4 million of the proceeds was applied against the utility plant accounts, resulting in a net increase in utility rate base of $22 million. The remaining $7 million of the proceeds will be applied as credits on customer bills to completely offset the impact of the rate increase of approximately 3.1%, or $3.5 million, which became effective October 12, 1993, in recognition of the increment to Hackensack's rate base. It is anticipated that the credits on customer bills will be made for approximately two years. Due to regulatory treatment, the effects of the intercompany transaction were not eliminated in consolidation. United Water Resources Inc. NOTE 10 - INCOME TAXES: NEW ACCOUNTING STANDARD: In January 1993, the company implemented SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires that United Water adjust its recorded deferred income tax balances to reflect an estimate of its future tax liability based on temporary differences between the financial and tax basis of assets and liabilities. This adjustment includes deferred taxes for utility temporary differences not previously recognized. It also includes the effect on the liability of changes in tax laws and rates. The tax effect of this requirement will be considered in the ratemaking process, resulting in the recognition of recoverable income taxes. The adoption of SFAS No. 109 resulted in the recording of a deferred tax liability and recoverable income taxes of $20.2 million at January 1, 1993, which is reflected on the balance sheet, with no material effect on net income. The recoverable income taxes represent the probable future increase in revenues that will be received through future ratemaking proceedings for the recovery of these deferred taxes. The components of the total recoverable income taxes at December 31, 1993 are as follows: United Water Resources Inc. Deferred tax liabilities (assets) and deferred investment tax credits are comprised of the following at December 31, 1993: INCOME TAX PROVISION: Federal income tax returns have been settled through 1988. An appeal pertaining to a single issue from 1982 and 1985 was settled in August 1993 without a material effect on net income. Federal income tax returns for 1989, 1990 and 1991 are currently under examination by the Internal Revenue Service. Management believes that the outcome of this examination will not have a material effect upon the financial position of United Water. A reconciliation of income tax expense at the statutory federal income tax rate to the actual income tax expense for the years ended December 31, is as follows: United Water Resources Inc. Income tax expense for the three years ended December 31 consisted of the following: United Water Resources Inc. NOTE 11 - FAIR VALUE OF FINANCIAL INSTRUMENTS: The estimated fair values of United Water's financial instruments at December 31, 1993 and 1992, are as follows: The fair values of financial instruments were determined by obtaining a market valuation of each issue, taking into account current interest rates at December 31, 1993 and 1992, and redemption premiums and dates, where applicable. The carrying amount of cash and short-term investments approximates the fair value, due to the short maturity of those instruments. United Water Resources Inc. NOTE 12 - LEASES: Rivervale Realty Company owns several office buildings with a net book value totaling $45.9 million (net of accumulated depreciation of $5.3 million) which it leases to tenants under various operating leases. The following is a schedule, by year, of minimum future rentals on non- cancelable operating leases as of December 31, 1993: United Water Resources Inc. QUARTERLY FINANCIAL INFORMATION United Water Resources Inc. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ------- ----------------------------------------------------------------- AND FINANCIAL DISCLOSURE -------------------------- There were no changes or disagreements with accountants on accounting and financial disclosure in 1993. United Water Resources Inc. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT -------- -------------------------------------------------------- ITEM 11. ITEM 11. EXECUTIVE COMPENSATION -------- ----------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND -------- --------------------------------------------------------- MANAGEMENT ---------- ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS -------- -------------------------------------------------- The information called for by Items 10 (including information relating to delinquent filers under Section 16 of the Securities Exchange Act of 1934), 11, 12 and 13 is omitted because the registrant will file with the Securities and Exchange Commission, not later than 120 days after the close of the year covered by this Form 10-K, a definitive proxy statement pursuant to Regulation 14A involving the election of directors. In determining which persons may be affiliates of the registrant for the purpose of disclosing on the cover page of this Annual Report the market value of voting shares held by non-affiliates, the registrant has treated only the members of its Board of Directors as affiliates and has excluded from the calculation all shares beneficially owned by them. No determination has been made that any director or person connected with a director is an affiliate or that any other person is not an affiliate. The registrant specifically disclaims any intent to characterize any person as being or not being an affiliate. United Water Resources Inc. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON -------- ------------------------------------------------------------- FORM 8-K --------- The following documents are filed as part of this report: (a) Financial Statements and Financial Statement Schedules (see Item 8) (b) Exhibits 4(a) Restated Certificate of Incorporation (Articles of Incorporation) of United Water Resources Inc., dated July 14, 1987 (Filed as Exhibit 4(b) to Registration Statement No. 33-20067.) 4(b) Certificate of Correction to Restated Certificate of Incorporation of United Water Resources Inc., dated August 13, 1987 (Filed as Exhibit 4(c) to Registration Statement No. 33-20067). 4(c) By-laws of United Water Resources (Filed as Exhibit 4(d) to Registration Statement No. 33-41693). 4(d) Specimen of United Water Resources Common Stock (Filed as Exhibit 4(d) to Registration Statement No. 2-90540). 4(e) United Water Resources Inc. and First Interstate Bank Ltd., Rights Agent, Rights Agreement, dated as of July 12, 1989 (Filed as Exhibit 4(c) to Registration Statement No. 33- 32672). 4(f) Note Agreements, dated as of September 1, 1989, between United Water Resources Inc. and First Colony Life Insurance Company and American Mayflower Life Insurance Company. 4(g) First Mortgage of Hackensack Water Company to Hudson Trust Company dated March 1, 1946 (including all Supplemental Indentures) (Filed as Exhibit 4(a) to Registration Statement No. 2-82274). 4(h) Loan Agreement, dated as of November 15, 1986, between the New Jersey Economic Development Authority and Hackensack Water Company (Filed as Exhibit 4(g) to Form 10-K for year ended December 31, 1986). 4(i) Loan Agreement, dated as of November 15, 1987, between the New Jersey Economic Development Authority and Hackensack Water Company (Filed as Exhibit 4(g) to Form 10-K for year ended December 31, 1987). United Water Resources Inc. 4(j) Loan Agreement, dated as of December 1, 1988, between the New York State Environmental Facilities Corporation and Spring Valley Water Company (Filed as Exhibit 4(h) to Form 10-K for year ended December 31, 1988). 4(k) Loan Agreement, dated as of December 1, 1993, between the New York State Environmental Facilities Corporation and Spring Valley Water Company. 4(l) By-laws of United Water Resources dated as of March 10, 1994. 4(m) United Water Resources' Form 8-K's filed on September 16, 1993 and March 10, 1994. 13 United Water Resources' Annual Report to Shareholders for the year ended December 31, 1993. Such Annual Report, except for those portions expressly incorporated by reference, is furnished for the information of the Commission and is not deemed "filed" hereby. 21 Subsidiaries of registrant 23 Consent of Independent Accountants 28 New Indemnification Undertaking Other than the aforementioned Exhibits 4(g) and 4(h), the principal amount of debt outstanding under each instrument defining the rights of holders of long-term debt of United Water does not exceed 10% of the total assets of United Water and its subsidiaries on a consolidated basis. Upon request by the Securities and Exchange Commission, United Water agrees to file any instrument with respect to long-term debt which has not previously been filed because the total amount of securities authorized thereunder does not exceed 10% of the total assets of United Water and its subsidiaries on a consolidated basis. (c) Reports on Form 8-K filed in the fourth quarter of 1993: None 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 annual report to be signed on its behalf by the undersigned thereunto duly authorized. UNITED WATER RESOURCES INC. ----------------------------- (Registrant) March 10, 1994 By DONALD L. CORRELL --------------------- ----------------------------------- Donald L. Correll 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 --------- ----- ---- Chairman of the ROBERT A. GERBER Board of Directors March 10, 1994 -------------------------- (Robert A. Gerber) Secretary DOUGLAS W. HAWES and Director March 10, 1994 ------------------------- (Douglas W. Hawes) Vice President JOHN J. TURNER and Controller March 10, 1994 ------------------------- (John J. Turner) U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES, AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (THOUSANDS OF DOLLARS) This indebtedness was in the form of a non-interest bearing note in the principal amount of $168,500 which is secured by a first mortgage on residential property associated with Mr. Hanson's relocation to New Jersey. The note matured in 1991. Page 1 of 3 U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE V - CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) (1) Represents the purchase price of $26,000 of properties reconveyed to Hackensack from Rivervale, the book value of $14,838 in other adjustments and a ($4,000) adjustment transferred from amounts refundable to customers in additions at cost. (2) Contributions in aid of construction ($1,615) credited to plant as required by the New York Public Service Commission. (3) Spring Valley Water Company plant acquisition adjustment: $103; Mid-Atlantic Utilities amortization of plant acquisition adjustment: $51. (4) Represents $39,421 of additional construction work in progress for the year, less $38,120 transferred to plant in service. (5) Represents a valuation adjustment for certain Rivervale Realty Inc. properties ($4,111) and the book value of properties transferred to Hackensack Water from Rivervale Realty ($14,838). Page 2 of 3 U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE V - CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) (1) Contributions in aid of construction ($576) credited to plant as required by the New York Public Service Commission. (2) Amortization of Mid-Atlantic Utilities Corp. plant acquisition adjustment. (3) Represents $15,162 of additional construction work in progress for the year less $15,584 transferred to plant in service. Page 3 of 3 U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE V - CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) (1) Contributions in aid of construction ($497) credited to plant as required by the New York Public Service Commission. (2) Amortization of Mid-Atlantic Utilities Corp. plant acquisition adjustment. (3) Represents $17,268 of additional construction work in progress for the year, less $19,675 transferred to plant in service. (4) Represents proceeds from the settlement of a lawsuit. U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE VI - CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) * Spring Valley abandonment loss $(11); accumulated depreciation of acquired utility plant (Pothat Water Company) $(135). ** Pursuant to a rate order, Hackensack reversed its abandonment loss recognized in prior years. U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE VI - CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE VIII - CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS (THOUSANDS OF DOLLARS) U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE IX - CONSOLIDATED SHORT-TERM BORROWING (THOUSANDS OF DOLLARS) U N I T E D W A T E R R E S O U R C E S I N C. SCHEDULE X - CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION (THOUSANDS OF DOLLARS)

351116_1993.txt

351116_1993

1993

351116

Item 3. Legal Proceedings. - --------------------------- Although the Company may be from time to time involved in various legal proceedings of a character normally incident to the ordinary course of its businesses, the Company believes that potential liability in any such pending or threatened proceedings would not have a material adverse effect on the financial condition or results of operations of the Company. FTX maintains liability insurance to cover some, but not all, potential liabilities normally incident to the ordinary course of its businesses as well as other insurance coverages customary in its businesses, with such coverage limits as management deems prudent. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------- Not applicable. Executive Officers of the Registrant. - ------------------------------------- Listed below are the names and ages, as of March 15, 1994, of the present executive officers of FTX together with the principal positions and offices with FTX held by each. All officers of FTX serve at the pleasure of the Board of Directors of FTX. Name Age Position or Office ---- --- ------------------ James R. Moffett 55 Chairman of the Board and Chief Executive Officer Rene L. Latiolais 51 President and Chief Operating Officer George A. Mealey 60 Executive Vice President John G. Amato 50 General Counsel Richard C. Adkerson 47 Senior Vice President Richard H. Block 43 Senior Vice President Thomas J. Egan 49 Senior Vice President Charles W. Goodyear 36 Senior Vice President W. Russell King 44 Senior Vice President The individuals listed above, with the exceptions of Messrs. Adkerson, Amato, and Goodyear, have served the Company in various executive capacities for at least the last five years. Until 1989, Mr. Adkerson was a partner in Arthur Andersen & Co., an independent public accounting firm, and Mr. Goodyear was a Vice President of Kidder, Peabody & Co. Incorporated, an investment banking firm. During the past five years, and prior to that period, Mr. Amato has been engaged in the private practice of law and has served as outside counsel to the Company. PART II --------- Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder ----------------------------------------------------------------------- Matters. -------- The information set forth under the captions "Common Shares" and "Common Share Dividends", on the inside back cover of FTX's 1993 Annual Report to stockholders, is incorporated herein by reference. As of March 10, 1994, there were 26,596 record holders of FTX's common stock. Item 6. Item 6. Selected Financial Data. - --------------------------------- The information set forth under the caption "Financial Highlights" on page 1 of FTX's 1993 Annual Report to stockholders, is incorporated herein by reference. FTX's ratio of earnings to fixed charges for each of the years 1989 through 1993, inclusive, was 2.5x, 5.6x, 1.6x, 2.5x and a shortfall of $239.1 million, respectively. For this calculation, earnings are income from continuing operations before income taxes, minority interests and fixed charges. Fixed charges are interest, that portion of rent deemed representative of interest and the preferred stock dividend requirements of majority-owned subsidiaries. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ------------------------------------------------------------------------ Results of Operations. --------------------- ORE RESERVE ADDITIONS AND ONGOING EXPLORATION PROGRAM Total estimated proved and probable recoverable reserves at P.T. Freeport Indonesia Company (PT-FI), Freeport-McMoRan Copper & Gold Inc.'s (FCX) principal operating unit, have increased since December 31, 1992, by 5.9 billion pounds of copper (a 28 percent increase), 7.0 million ounces of gold (a 22 percent increase), and 32.0 million ounces of silver (a 72 percent increase), bringing PT-FI's total year-end 1993 estimated proved and probable recoverable reserves to 26.8 billion pounds of copper, 39.1 million ounces of gold, and 76.7 million ounces of silver. The increases, net of production during the year, were added primarily at the Grasberg deposit, but also include additions at the underground mine at the DOZ (Deep Ore Zone) deposit and the recently discovered Big Gossan deposit. In addition to continued delineation of the Grasberg deposit and other deposits including Big Gossan, PT-FI is proceeding with its ongoing exploration program for mineralization within the original mining area. During 1993, PT-FI initiated helicopter-supported surface drilling of the Wanagon gold/silver/copper prospect, located 1.5 miles northwest of Big Gossan and 2 miles southwest of Grasberg, where seven holes were drilled. Significant copper mineralization has been encountered below the 2,900 meter elevation. Preliminary exploration of the new contract of work area (New COW Area) has indicated numerous promising targets. Extensive stream sediment sampling within the new acreage has generated analytical results which are being evaluated. This sampling program, when coupled with regional mapping completed on the ground and from aerial photographs, has led to the outlining of over 50 exploration targets. PT-FI has also completed a fixed-wing air-magnetometer survey of the entire New COW Area. Detailed follow-up exploration of these anomalies by additional mapping and sampling and through the use of both aerial and ground magnetic surveys is now in progress. Systematic drilling of these targets has already commenced with significant mineralization being discovered at several prospects. Additional drilling is required to determine if any of these are commercially viable. Initial surface and stream sampling began on an additional 2.5 million acres, just north and west of our existing COW area, on which an affiliate has an exploration permit and a pending COW. 1993 RESULTS OF OPERATIONS COMPARED WITH 1992 1993 1992 -------- -------- (In Millions, Except Per Share Amounts) Revenues $1,610.6 $1,654.9 Operating income (loss) (93.4)(a) 251.9 Net income (loss) applicable to common stock (126.2)(b) 169.1(c) Net income (loss) per primary share (.89)(b) 1.17(c) Earnings by sources:(d) Metals $173.5 $283.6 Agricultural minerals (55.9) 18.0 Energy (39.7) (28.2) Other (37.8) (19.9) -------- -------- Segment earnings $ 40.1 $253.5 ======== ======== a. Includes a pretax charge of $196.4 million related to restructuring the administrative organization, the loss on the sale of the Freeport- McMoRan Resource Partners, Limited Partnership (FRP) producing geothermal assets, the charge to expense for the recoverability of certain assets, and adjustments to general and administrative expenses and production and delivery costs discussed below, net of the gain on the sale of a nonproducing oil and gas property and certain previously mined phosphate rock acreage (Note 4). b. Includes a $37.5 million charge ($.25 per share) related to the items discussed in Note A, net of a gain on the conversion of FCX notes (Note 5). Also includes a $20.7 million charge ($.15 per share), after taxes and minority interests, for the cumulative effect of the changes in accounting principle (Note 1). c. Includes a $134.7 million gain ($.93 per share) on the sale/conversion of FCX securities (Notes 2 and 5). d. Operating income plus other income, less provision for restructuring charges and the gain/loss on valuation and sale of assets from the Statements of Operations. After discussions with the staff of the Securities and Exchange Commission (SEC), Freeport-McMoRan Inc. (FTX or the Company) is reclassifying certain expenses and accruals previously recorded in 1993 as restructuring and valuation of assets. In response to inquiries, the Company advised the SEC staff that $27.4 million originally reported as restructuring and valuation of assets represented the cumulative effect of changes in accounting principle resulting from the adoption of the new accounting policies that the Company considered preferable, as described in Note 1 to the financial statements. The Company also informed the SEC staff of the components of other charges included in the amount originally reported as restructuring and valuation of assets. The Company concluded that the reclassification and the related supplemental disclosures more accurately reflect the nature of these charges to 1993 net income in accordance with generally accepted accounting principles. These reclassifications had no impact on net income or net income per share. FTX incurred a net loss applicable to common stock for 1993 of $126.2 million compared with income of $169.1 million for 1992. Excluding the items footnoted in the table above, 1993 earnings reflected reduced earnings from its metals and agricultural minerals business segments, generally caused by lower product realizations (see operating statistics in Note 11 to the financial statements). The reduction in general and administrative expenses reflects the initial benefits from the restructuring during the first half of 1993. Interest expense increased, as no interest was capitalized on the Main Pass sulphur operations subsequent to it becoming operational for accounting purposes in July 1993. FTX's 1993 effective tax rate for operations (excluding the net credit attributable to the nonrecurring items) rose due to the higher portion of income from FTX's metals operations in Indonesia, where the effective tax rate is higher, and from a $15.7 million loss at Rio Tinto Minera, S.A. (RTM) for which no tax benefit is recorded. Additionally, minority interests' share of net income was impacted by an increase in FCX's preferred stock dividend requirements following the issuance of additional FCX preferred stock during 1993 (Note 2). FTX recognized its proportionate share of FRP's earnings, including the recognition of a portion of the gain deferred by FTX (Note 2), during 1993 and 1992. If in future quarters FTX were to receive no distributions from FRP, the deferred gain would be fully recognized in the third quarter of 1994. Subsequent to the recognition of the balance of the deferred gain, when FRP distributions are not paid to FTX in any quarter, FTX will recognize a smaller share of any FRP net income, or a larger share of any FRP net loss, than that which would be recognized based on FTX's ownership interest in FRP. Restructuring Activities. During the second quarter of 1993, FTX undertook a restructuring of its administrative organization. This restructuring represented a major step by FTX to lower its costs of operating and administering its businesses in response to weak market prices of the commodities produced by its operating units. As part of this restructuring, FTX significantly reduced the number of employees engaged in administrative functions, changed its management information systems (MIS) environment to achieve efficiencies, reduced its needs for office space, outsourced a number of administrative functions, and implemented other actions to lower costs. As a result of this restructuring process, the level of FTX's administrative cost has been reduced substantially over what it would have been otherwise, which benefit will continue in the future. However, the restructuring process entailed incurring certain one-time costs by FTX. FTX's restructuring costs totaled $67.1 million, consisting of the following: $30.3 million for personnel related costs; $15.0 million relating to excess office space and furniture and fixtures resulting from the staff reduction; $8.2 million relating to the cost to downsize its computing and MIS structure; $4.8 million of deferred charges relating to FTX's and PT-FI's credit facilities which were substantially revised in June 1993; and $8.8 million related to costs directly associated with the formation of IMC-Agrico Company, discussed below. As of December 31, 1993, the remaining accrual for these restructuring costs was approximately $7 million. In connection with the restructuring project, FTX changed its accounting systems and undertook a detailed review of its accounting records and valuation of various assets and liabilities. As a result of this process, FTX recorded charges totaling $65.1 million, comprised of the following: (a) $26.2 million of production and delivery costs consisting of $10.4 million for revised estimates of prior year costs; $6.3 million for revised estimates of environmental liabilities; $5.0 for materials and supplies inventory obsolescence; and $4.5 million of adjustments in converting accounting systems, (b) $18.7 million of depreciation and amortization costs consisting of $11.5 million for estimated future abandonment and reclamation costs and $7.2 million for the write-down of miscellaneous properties, (c) $4.4 million of exploration expenses for the write-down of an unproved oil and gas property, and (d) $15.8 million of general and administrative expenses consisting of $9.4 million to downsize FTX's computing and MIS structure and $6.4 million for the write-off of miscellaneous assets. Metals Operations. The Company's metals segment operations are conducted through its affiliate FCX, and FCX's operating units PT-FI and RTM. FCX contributed 1993 earnings of $173.5 million on revenues of $925.9 million compared with earnings of $283.6 million on revenues of $714.3 million for 1992. Significant items impacting the segment earnings are as follows (in millions): Metals earnings - 1992 $283.6 Major increases (decreases) RTM revenues 288.4 Elimination of intercompany sales (47.7) Concentrate: Realizations: Copper (84.7) Gold 14.7 Sales volumes: Copper (5.5) Gold 30.2 Treatment charges 23.6 Adjustments to prior year concentrate sales (13.0) Other 5.6 ------ Revenue variance 211.6 Cost of sales (277.8)* Exploration expenses (21.6) General and administrative and other (22.3)* ------ (110.1) ------ Metals earnings - 1993 $173.5 ====== * Includes $10.0 million in cost of sales and $6.3 million in general and administrative expenses resulting from the restructuring project discussed above. Revenues in 1993 increased as a result of the acquisition of RTM, adding sales of copper cathodes and anodes ($204.9 million), gold bullion ($57.4 million), and other products ($26.1 million). Excluding RTM, revenues declined 4 percent when compared to 1992. Copper price realizations, taking into account PT-FI's $.90 per pound price protection program, were 12 percent lower than in 1992, but gold price realizations were up 6 percent. Although ore production averaged 62,300 metric tons of ore milled per day (MTPD) in 1993 (8 percent higher than in 1992), copper sales volumes decreased slightly from 1992 primarily because of sales from inventory in 1992. Gold sales volumes in 1993 benefited from significantly higher fourth-quarter 1993 gold grades (a 46 percent increase over fourth- quarter 1992 and a 38 percent increase over third-quarter 1993), which are not anticipated to continue in 1994, and an increase in gold recovery rates for the year which improve with higher gold grades. Revenues also benefited from a decline in treatment charges of 3.4 cents per pound from 1992, resulting from a tightening in the concentrate market as the industry's inventories were reduced for much of 1993. Additionally, lower copper prices led to lower treatment charges since these charges vary with the price of copper. Adjustments to prior year concentrate sales include changes in prices on all metals for prior year open sales as well as the related impact on treatment charges. Open copper sales at the beginning of 1993 were recorded at an average price of $1.04 per pound, but subsequently were adjusted downward as copper prices fell during the year, negatively impacting 1993 revenues. As of December 31, 1993, 213.4 million pounds of copper remained to be contractually priced during future quotational periods. As a result of PT-FI's price protection program, discussed below, these pounds are recorded at $.90 per pound. The copper price on the London Metal Exchange (LME) was $.84 per pound on February 1, 1994. In June 1993, two of PT-FI's four mill level ore passes caved, resulting in a blockage of a portion of the ore pass delivery system. The blockage's primary effect was to limit mill throughput to approximately 40,700 MTPD for approximately eight weeks. The impact of the blockage was minimized by using an ore stockpile adjacent to the mill and installing conveyors to alternative ore pass systems. The ore pass blockage has been rectified through the temporary use of alternative delivery systems and by- passes. A permanent delivery system is expected to be in service by mid- 1994. The copper recovery rate for 1993 was adversely affected because the ore milled from the stockpile contained higher than normal oxidized copper, which yields lower copper recoveries. The Company's insurance policies are expected to cover the property damage and business interruption claims relative to the blockage. PT-FI's unit site production and delivery costs, excluding $10.0 million of charges related to the restructuring project, increased slightly from 1992 primarily as a result of costs incurred in connection with the ore pass blockage and an increase in production overhead costs related to expansion activities. Unit cash production costs declined significantly to 31.1 cents per pound in 1993 from 40.7 cents per pound in 1992, benefiting from higher gold and silver credits, lower treatment charges, and reduced royalties primarily due to lower copper prices on which such royalties are based. PT-FI's depreciation rate increased from 7.4 cents per recoverable pound during 1992 to 8.3 cents in 1993, reflecting the increased cost relating to the 66,000 MTPD expansion. As a result of the reserve additions discussed earlier, PT-FI's depreciation rate is expected to decrease to 7.5 cents per recoverable payable pound for 1994, absent any other significant changes in ore reserves. In addition, FCX is amortizing costs in excess of book value ($2.4 million of amortization in 1993) relating to certain capital stock transactions with PT-FI. Amortization of these excess costs is expected to be $3.6 million per year starting in 1994. Exploration expenditures in Irian Jaya totaled $31.7 million in 1993, compared to $12.2 million in 1992 and are projected to be approximately $35 million in 1994. Exploration expenditures in Spain are expected to be approximately $6 million in 1994. FCX's general and administrative expenses increased from $68.5 million in 1992 to $81.4 million in 1993 primarily because of the increased personnel and facilities needed due to the expansion at PT-FI and the acquisition of RTM. Included in the 1993 expense is $5.0 million at RTM (since its acquisition in March 1993) and charges totaling $6.3 million resulting from the restructuring project discussed above. Further increases in general and administrative expenses are anticipated in conjunction with continuing expansion at PT-FI. Metals segment general and administrative expenses, including those of RTM, are currently expected to increase by approximately 25 percent in 1994. PT-FI's copper concentrates, which contain significant amounts of recoverable gold and silver, are sold primarily under long-term sales agreements which accounted for virtually all of PT-FI's 1993 sales. PT-FI has commitments from various parties to purchase virtually all of its estimated 1994 production. Concentrate sales agreements provide for provisional billings based on world metals prices, primarily the LME, generally at the time of loading. As is customary within the industry, sales under these long-term contracts usually "final-price" within a few months of shipment. Certain terms of the long-term contracts, including treatment charges, are negotiated annually on a portion of the tonnage to reflect current market conditions. Treatment charges have declined during 1993 as a result of the tightening in the concentrate market and are expected to remain at or below 1993 levels. RTM has commitments from most of its suppliers for 1994 treatment charge rates in excess of current spot market rates. The increased production at PT-FI has required it to market its concentrate globally. Its principal markets include Japan, Asia, Europe, and North America. PT-FI's mill throughput is currently forecast to be approximately 67,000 MTPD for 1994 as it continues to integrate new mill equipment for the expansion to 115,000 MTPD. Current estimates for 1994 production are approximately 700 million pounds of copper and 780,000 ounces of gold for PT-FI and 165,000 ounces of gold at RTM. RTM, whose smelter can be expanded, was acquired to provide low-cost smelter capacity for a portion of PT-FI's concentrate and to improve PT-FI's competitive position in marketing concentrate to other parties. During 1993, copper prices dropped to their lowest levels since 1987, reflecting lower demand caused by the continuing global recession, but recovered to a level in excess of $.80 per pound. Prices for copper, gold, and silver are influenced by many factors beyond the Company's control and can fluctuate sharply. PT-FI has a price protection program for virtually all of its estimated copper sales to be priced in 1994 at an average floor price of $.90 per pound of copper, while allowing full benefit from prices above this amount. Based on projected 1994 PT-FI copper sales of approximately 720 million pounds, a 1 cent per pound change in the average annual copper price received over $.90 per pound would have an approximately $6 million effect on pretax operating income and cash flow. Based on projected 1994 gold sales of approximately 800,000 ounces by PT- FI, a $10 per ounce change in the average annual gold price received would have an approximately $8 million effect on pretax operating income and cash flow. Agricultural Minerals Operations. FRP and IMC Fertilizer, Inc. (IMC) formed a joint venture (IMC-Agrico Company), effective July 1, 1993, for their respective phosphate fertilizer businesses, including phosphate rock and uranium. IMC-Agrico Company is governed by a policy committee having equal representation from each company and is managed by IMC. Combined annual savings of at least $95 million in production, marketing, and general and administrative costs are expected to result from this transaction, the full effect beginning by the end of the second year of operations. The operating efficiencies achievable by the joint venture should enable it to generate positive cash flow in a low-price environment, such as that experienced in 1993, and to be in a position to earn significant profits if product prices rise to historical levels. As discussed above and in Note 4 to the financial statements, significant restructuring charges were recorded in connection with this transaction. As a result of the joint venture, FRP is engaged in the phosphate rock mining, fertilizer production, and uranium oxide extraction businesses only through IMC-Agrico Company. FRP will continue to operate its sulphur and oil businesses. FRP has varying sharing ratios in IMC-Agrico Company, as discussed in Note 2 to the financial statements, which were based on the projected contributions of FRP and IMC to the cash flow of the joint venture and on an equal sharing of the anticipated savings. FRP transferred the assets it contributed to IMC-Agrico Company at their book carrying cost and proportionately consolidates its interest in IMC-Agrico Company. As a result, FRP's operating results subsequent to the formation of IMC-Agrico Company vary significantly in certain respects from those previously reported. Phosphate fertilizer realizations and unit production costs were fundamentally changed as the majority of the FRP contributed fertilizer production facilities are located on the Mississippi River, whereas the IMC contributed fertilizer production facilities are located in Florida. Fertilizer produced on the Mississippi River commands a higher sales price in the domestic market because of its proximity to markets; however, raw material transportation costs at the Florida facilities are lower for phosphate rock, partially offset by increased sulphur transportation costs. The Company's agricultural minerals segment, which includes FRP's fertilizer, phosphate rock, and sulphur businesses, reported a loss of $55.9 million on revenues of $619.3 million for 1993 compared with earnings of $18.0 million on revenues of $799.0 million for 1992. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1992 $ 18.0 Major increases (decreases) Sales volumes (67.4) Realizations (103.2) Other (9.1) ------ Revenue variance (179.7) Cost of sales 81.4* General and administrative and other 24.4* ------ (73.9) ------ Agricultural minerals earnings - 1993 $(55.9) ====== * Includes $17.5 million in cost of sales and $7.3 million in general and administrative expenses resulting from the restructuring project discussed above. Weak industrywide demand and changes attributable to FRP's participation in IMC-Agrico Company resulted in FRP's 1993 reported sales volumes for diammonium phosphate (DAP), its principal fertilizer product, declining 17 percent from that of a year-ago. The weakness in the phosphate fertilizer market prompted IMC-Agrico Company to make strategic curtailments in its phosphate fertilizer production. However, late in the year increased export purchases contributed to a rise in market prices, helping to rekindle domestic buying interests which had been unwilling to make purchase commitments. The increased demand, coupled with low industrywide production levels, caused reduced inventory levels. Late in 1993, IMC-Agrico Company increased its production levels in response to the improving markets and projected domestic and international demand for its fertilizer products. Unit production cost, excluding charges related to the restructuring project, declined from 1992 reflecting initial production efficiencies from the joint venture, reduced raw material costs for sulphur, and lower phosphate rock mining expenses, partially offset by increased natural gas costs and lower production volumes. FRP's realization for DAP was lower reflecting the near 20-year low prices realized during 1993 as well as an increase in the lower-priced Florida sales by IMC-Agrico Company. FRP believes that the outlook for 1994 is for improved prices caused by more normal market demand. Spot market prices improved from a low of nearly $100 per short ton of DAP (central Florida) in July 1993 to just over $140 per ton by year end. Industry inventories at year end were below average levels, despite a fourth quarter rebound in industry production. Export demand is expected to remain at more normal levels during the first half of 1994, with China, India, and Pakistan expected to be active purchasers. Additionally, domestic phosphate fertilizer demand is expected to benefit from increased corn acreage planted due to lower government set- asides and to increased fertilizer application rates necessitated by the widespread flooding that caused a depletion of nutrients in a number of midwestern states. FRP's proportionate share of the larger IMC-Agrico Company phosphate rock operation caused 1993 sales volumes to increase from 1992, with IMC- Agrico Company operating its most efficient facilities to minimize costs. Combined sulphur production from the Caminada and Main Pass mines increased compared with 1992; however, sales volumes declined 16 percent, primarily because of reduced purchases by IMC-Agrico Company resulting from its curtailed fertilizer production. Due to the significant decline in the market price of sulphur, FRP recorded a second-quarter 1993 noncash charge to earnings (not included in segment earnings) for the excess of capitalized cost over expected realization of its non-Main Pass sulphur assets, primarily the Caminada sulphur mine (Note 4). Due to significant improvements in Main Pass sulphur production, FRP ceased the marginally profitable Caminada operations in January 1994. The shutdown of Caminada will have no material impact on FTX's reported earnings. Although reduced global demand has forced production cutbacks worldwide, sulphur prices remain depressed. A rebound in price is not expected until demand improves. At Main Pass, sulphur production increased significantly during 1993 and achieved, on schedule, full design operating rates of 5,500 tons per day (approximately 2 million tons per year) in December 1993 and has since sustained production at or above that level. As a result of the production increases, Main Pass sulphur became operational for accounting purposes beginning July 1, 1993. Recognizing Main Pass sulphur operations in income and discontinuing associated capitalized interest did not affect cash flow, but adversely affected reported operating results. Oil and Gas Operations. During the second quarter of 1992, FTX transferred substantially all of its non-Main Pass oil and gas properties to FM Properties Inc. (FMPO), whose shares were distributed to FTX shareholders. Currently, FTX's oil and gas operations (excluding Main Pass oil operations) involve exploring for new reserves. These activities generated a 1993 loss of $38.2 million, including exploration expense of $22.3 million and $11.5 million of charges resulting from the restructuring project, compared with a 1992 loss of $32.8 million, including exploration expense of $18.3 million. In July 1993, FTX sold its interest in the recently discovered undeveloped reserves at East Cameron Blocks 331/332, offshore Louisiana in the Gulf of Mexico, for $95.3 million cash, recognizing a pretax gain of $69.1 million (not included in segment earnings). FTX had drilled seven development wells, then sold the property before setting permanent production facilities. Main Pass oil operations achieved the following: 1993 1992 --------- --------- Sales (barrels) 3,443,000 4,884,000 Average realized price $14.43 $15.91 Earnings (in millions) $(1.5) $4.6 Since completion of development drilling in mid-April 1993, oil production for the Main Pass joint venture (in which FRP owns a 58.3 percent interest) increased significantly, averaging over 20,000 barrels per day for December 1993. Production for 1994 is expected to approximate that of 1993 if water encroachment follows current trends, with the anticipated drilling of additional wells (estimated to cost FRP approximately $4 million) offsetting a production decline in existing wells. Due to the dramatic decline in oil prices at year-end, FRP recorded a $60.0 million charge to earnings (not included in segment earnings) reflecting the excess net book value of its Main Pass oil investment over the estimated future net cash flow to be received. Future price declines, increases in costs, or negative reserve revisions could result in an additional charge to future earnings. CAPITAL RESOURCES AND LIQUIDITY Cash flow from operating activities declined in 1993 to $117.3 million from $339.6 million for 1992, due to lower income from operations partially offset by working capital changes. Net cash used in investing activities was $429.0 million compared with $885.5 million for 1992. Increased metals capital expenditures were incurred associated with PT-FI's expansion whereas lower capital expenditures were incurred at Main Pass and in FRP's agricultural minerals operations, due to completion of development projects in 1992. Asset sales generated proceeds of $145.2 million during 1993, whereas 1992 included a use of $211.9 million for the purchase of an indirect interest in PT-FI. Net cash used in financing activities was $29.5 million, whereas 1992 provided net cash of $837.3 million. The 1993 period includes $561.1 million of proceeds from the FCX preferred stock offerings, whereas 1992 includes $1.3 billion of proceeds from equity security offerings. Increased distributions to minority interest holders of FCX and FRP securities as a result of the equity sales during 1993 and 1992 were offset by reduced FTX common stock purchases. Net long-term debt repayments were $159.5 million in 1993 versus net borrowings of $53.7 million in 1992. Cash flow from operations for 1992 totaled $339.6 million, up from $249.9 million in 1991, as increased income from operations was partially offset by working capital changes. Net cash used in investing activities increased to $885.5 million in 1992 compared with $408.0 million for 1991, primarily due to the purchase of the indirect PT-FI interest partially offset by lower overall capital expenditures, while 1991 included $461.5 million in proceeds from the sale of oil and gas assets. Cash flow from financing activities totaled $837.3 million in 1992 compared with $200.1 million in 1991, reflecting increased issuance of equity securities by FTX and its affiliates, receipt of proceeds from the 1991 sale of PT-FI common shares, and net long-term borrowings, partially offset by increased FTX common stock purchases and cash dividends on FTX stock and distributions to minority interests due to the additional FTX preferred stock and FRP and FCX equity securities issued during 1992. RTM's principal operations currently consist of a copper smelter. The FCX purchase proceeds will be used by RTM for working capital requirements and capital expenditures, including funding a portion of the expansion of its smelter production capacity (expected to cost approximately $50 million) from its current 150,000 metric tons of metal per year to 180,000 metric tons of metal per year by mid-1995. RTM is also studying further expansion of the smelter facilities to as much as 270,000 metric tons of metal production per year and is assessing the opportunity to expand its tankhouse operations from 135,000 metric tons per year to 215,000 metric tons per year. RTM's 1993 cash flow from operations was negative primarily due to cash requirements related to shutdown costs for RTM's gold mine. RTM has relied on short-term credit facilities and the FCX purchase proceeds to fund this shortfall. RTM is currently evaluating financing alternatives to fund its short-term needs and to provide long-term funding for expansion. RTM's future cash flow is dependent on a number of variables including fluctuations in the exchange rate between the United States dollar and the Spanish peseta, future prices and sales volumes of gold, the size and timing of the smelter and tankhouse expansions, and the supply/demand for smelter capacity and its impact on related treatment and refining charges. During 1992, FCX established the Enhanced Infrastructure Project (EIP). The full EIP (currently expected to involve aggregate cost of as much as $500 million to $600 million) includes plans for commercial, residential, educational, retail, medical, recreational, environmental and other infrastructure facilities to be constructed during the next 20 years for PT-FI operations. The EIP will develop and promote the growth of local and other third-party activities and enterprises in Irian Jaya through the creation of certain necessary support facilities. The initial phase of the EIP is under construction and is scheduled for completion in 1995. Additional expenditures for EIP assets beyond the initial phase depend on the long-term growth of PT-FI's operations and would be expected to be funded by third-party financing sources, which may include debt, equity or asset sales. As discussed in Note 9 to the financial statements, certain portions of the EIP and other existing infrastructure assets are expected to be sold in the near future to provide additional funds for the expansion to 115,000 MTPD. Through 1995, FTX's capital expenditures are expected to be greater than cash flow from operations. Upon completion of FCX's previously announced 115,000 MTPD expansion by year-end 1995, annual production is expected to approach 1.1 billion pounds of copper and 1.5 million ounces of gold. Completion of the FCX expansion, along with the additional cash flow generated through savings achieved by IMC-Agrico Company, are expected to enhance FTX's financial flexibility. Subsequently, capital expenditures will be determined by the results of FCX's exploration activities and ongoing capital maintenance programs. Estimated capital expenditures for 1994 and 1995 for the expansion to 115,000 MTPD, the initial phase of the EIP, ongoing capital maintenance expenditures, and the expansion of RTM's smelter to 180,000 metric tons of metal per year are expected to range from $850 million to $950 million and will be funded by operating cash flow, sales of existing and to-be-constructed infrastructure assets and a wide range of financing sources the Company believes are available as a result of the future cash flow from FTX's mineral reserve asset base. These sources include, but are not limited to, FTX's credit facility (Note 5) and the public and private issuances of securities. The new contract of work (New COW) contains provisions for PT-FI to conduct or cause to be conducted a feasibility study relating to the construction of a copper smelting facility in Indonesia and for the eventual construction of such a facility, if it is deemed to be economically viable by PT-FI and the Government of Indonesia. PT-FI has participated in a group assessing the feasibility of constructing a copper smelting facility in Indonesia. The New COW also provides that the Indonesian government will not nationalize the mining operations of PT-FI or expropriate assets of PT-FI. Disputes under the New COW are to be resolved by international arbitration. The 1967 Foreign Capital Investment Law, which expresses Indonesia's foreign investment policy, provides basic guarantees of remittance rights and protection against nationalization, a framework for incentives and some basic rules as to other rights and obligations of foreign investors. FTX is primarily a holding company and the principal sources of its cash flow are dividends and distributions from its ownership in FCX and FRP. FCX currently pays an annual cash dividend of 60 cents per share to FTX and to its public common shareholders. Management anticipates that this dividend will continue at this level through completion of the expansion in 1995, absent significant changes in the prices of copper and gold. FCX's Board of Directors determines its dividend payment on a quarterly basis and at its discretion may change or maintain the dividend payment. Publicly owned FRP units have cumulative rights to receive quarterly distributions of 60 cents per unit through the distribution for the quarter ending December 31, 1996 (the Preference Period) before any distributions may be made to FTX. FRP has announced that it no longer intends to supplement distributable cash with borrowings. Therefore, FRP's future distributions will be dependent on the distributions received from IMC-Agrico Company, which will primarily be determined by prices and sales volumes of its commodities and cost reductions achieved by its combined operations, and the future cash flow of FRP's oil and sulphur operations (including reclamation expenditures related to its non-Main Pass sulphur assets). On January 21, 1994, FRP declared a distribution of 60 cents per publicly held unit ($30.3 million) and 12 cents per FTX-owned unit ($6.2 million), bringing the total unpaid distribution due FTX to $239.2 million. Unpaid distributions will be recoverable from future FRP cash available for quarterly distributions as discussed in Note 2 to the financial statements. The January 1994 distribution included $30.9 million received from IMC- Agrico Company for its fourth-quarter 1993 distribution (including $9.3 million from working capital reductions) and $13.0 million in proceeds from the sale of certain previously mined phosphate rock acreage. In the past, including in 1993, the FTX Board of Directors has decided to borrow funds when the cash received from FCX, FRP, and asset sales was insufficient to pay dividends and cover FTX's other cash requirements for interest, general and administrative expenses, and oil and gas operations. These decisions reflected the Board's analyses of FTX's estimated future cash flow from the Company's large and long-lived mineral reserves, current and expected commodity price levels, its borrowing capacity, and its cash requirements in determining the dividend that the Board considers prudent. FTX's 10 7/8% Senior Subordinated Debentures potentially restrict dividend payments (Note 7); however, management has alternative courses of action that it plans to pursue to eliminate the effect of this restriction. If low commodity prices persist over an extended period, the Board can be expected to change the Company's dividend, in which event there may be a reduced dividend, a lower cash dividend supplemented by a property dividend in the form of securities in its publicly traded subsidiaries or, in an extreme case, an elimination of the dividend. If, however, the Company's cash flow from its mineral reserves increase significantly because of higher commodity prices or increased production levels, the Board is likely to raise future dividends over current levels. Management believes that operating cash flow, existing lines of credit ($425.0 million available as of February 1, 1994), selected asset sales, third-party financing, and discretion with respect to capital, exploration and development spending provides FTX with sufficient financial flexibility and capital resources to meet its anticipated cash requirements. ENVIRONMENTAL FTX has a history of commitment to environmental responsibility. Since the 1940s, long before public attention focused on the importance of maintaining environmental quality, FTX has conducted preoperational, bioassay, marine ecological, and other environmental surveys to ensure the environmental compatibility of its operations. FTX's Environmental Policy commits FTX's operations to full compliance with local, state, and federal laws and regulations, and prescribes the use of periodic environmental audits of all domestic facilities to evaluate compliance status and communicate that information to management. FTX has access to environmental specialists who have developed and implemented corporatewide environmental programs. FTX's operating units continue to study and implement methods to reduce discharges and emissions. Federal legislation (sometimes referred to as "Superfund") requires payments for cleanup of certain abandoned waste disposal sites, even though such waste disposal activities were performed in compliance with regulations applicable at the time of disposal. Under the Superfund legislation, one party may, under certain circumstances, be required to bear more than its proportional share of cleanup costs at a site where it has responsibility pursuant to the legislation, if payments cannot be obtained from other responsible parties. Other legislation mandates cleanup of certain wastes at unabandoned sites. States also have regulatory programs that can mandate waste cleanup. Liability under these laws involves inherent uncertainties. FTX has received notices from governmental agencies that it is one of many potentially responsible parties at certain sites under relevant federal and state environmental laws. Further, FTX is aware of additional sites for which it may receive such notices in the future. Some of these sites involve significant cleanup costs; however, at each of these sites other large and viable companies with equal or larger proportionate shares are among the potentially responsible parties. The ultimate settlement for such sites usually occurs several years subsequent to the receipt of notices identifying potentially responsible parties because of the many complex technical and financial issues associated with site cleanup. FTX believes that the aggregation of any costs associated with these potential liabilities will not exceed amounts accrued and expects that any costs would be incurred over a period of years. The Company maintains insurance coverage in amounts deemed prudent for certain types of damages associated with environmental liabilities which arise from unexpected and unforeseen events and has an indemnification agreement covering certain acquired sites (Note 9). FTX has made, and will continue to make, expenditures at its operations for protection of the environment. Continued government and public emphasis on environmental issues can be expected to result in increased future investments for environmental controls, which will be charged against income from future operations. Present and future environmental laws and regulations applicable to FTX's operations may require substantial capital expenditures and may affect its operations in other ways that cannot now be accurately predicted. 1992 RESULTS OF OPERATIONS COMPARED WITH 1991 1992 1991 -------- -------- (In Millions, Except Per Share Amounts) Revenues $1,654.9 $1,579.2 Operating income 251.9 223.9 Net income applicable to common stock 169.1(a) 40.1(b) Net income per primary share 1.17(a) .29(b) Earnings by sources:(c) Metals $283.6 $181.2 Agricultural minerals 18.0 78.9 Energy (28.2) (6.0) Other (19.9) (6.6) -------- -------- Segment earnings $253.5 $247.5 ======== ======== a. Includes a $134.7 million gain ($.93 per share) from the sale/issuance of FCX Class A common stock. b. Includes a $7.3 million gain ($.05 per share) from an insurance settlement (Note 9). Also includes a $55.7 million charge ($.40 per share) for the cumulative effect of the change in accounting for postretirement benefits other than pensions (Note 8). c. Operating income plus other income, less gain/loss on valuation and sale of assets from the Statements of Operations. Record metals segment earnings were partially offset by reduced agricultural minerals and energy segment earnings and an increase in general and administrative expenses caused by the significant additional effort and support required by FTX's expanding operations and increased community and philanthropic efforts. Earnings for 1992 benefited from lower interest expense reflecting reductions in average debt levels, lower interest rates, and increased capitalized interest associated with the copper mine/mill expansion and Main Pass development. Earnings for 1992 were also impacted by a greater minority interest ownership of FRP, FCX, and PT-FI, reflecting equity sales by those entities, and an increase in preferred stock dividends because of the March 1992 issuance of FTX's $4.375 Convertible Exchangeable Preferred Stock (Note 7). Net income for 1991 benefited from the reversal of deferred tax reserves no longer required. Metals Operations. FCX contributed 1992 earnings of $283.6 million compared with $181.2 million for 1991. Revenues in 1992 totaled $714.3 million compared with $467.5 million in 1991. Significant items impacting the segment earnings are as follows (in millions): Metals earnings - 1991 $181.2 Major increases (decreases) Realizations: Copper 8.8 Gold (7.4) Sales volumes: Copper 218.5 Gold 95.7 Treatment charges (73.0) Adjustments to prior year concentrate sales 12.5 Other (8.3) ------ Revenue variance 246.8 Cost of sales (114.5) Exploration expenses (5.7) General and administrative and other (24.2) ------ 102.4 ------ Metals earnings - 1992 $283.6 ====== The increase in revenues was primarily attributable to a 71 percent and 48 percent increase in gold and copper sales volumes, respectively, reflecting higher production rates due to the mine/mill expansion, higher gold grades, and the sale of all year-end 1991 inventory. Revenues were negatively impacted by a 3.6 cents per pound increase in treatment charges compared with 1991 because of tight market conditions in the smelting industry early in 1992 and increased spot market sales attributable to higher than anticipated production due to the early completion of the 57,000 MTPD expansion program. A $5.7 million upward revenue adjustment was made in 1992 compared with a $6.8 million downward revenue adjustment in 1991 for prior year concentrate sales contractually priced during the year. The amortization of the price protection programs decreased revenues by $8.9 million in 1992 and $6.2 million in 1991. Cost of sales for 1992 were $357.2 million, an increase of 47 percent from 1991 due primarily to the 48 percent increase in copper sales volumes. Unit site production and delivery costs were 47.4 cents in 1992 compared with 46.5 cents in 1991. FCX's depreciation rate declined from an average 8.7 cents per recoverable pound during 1991 to 7.4 cents in 1992 because of the significant increase in ore reserves during 1991. Agricultural Minerals Operations. Revenues and earnings for 1992 totaled $799.0 million and $18.0 million compared with $880.5 million and $78.9 million for 1991, respectively, reflecting weak market prices for phosphate fertilizers and sulphur. However, FRP's 1992 average unit production cost for phosphate fertilizers was lower than during 1991. Significant items impacting the segment earnings are as follows (in millions): Agricultural minerals earnings - 1991 $ 78.9 Major increases (decreases) Sales volumes 27.0 Realizations (107.8) Other (.7) ------ Revenue variance (81.5) Cost of sales 41.9 General and administrative and other (21.3) ------ (60.9) ------ Agricultural minerals earnings - 1992 $ 18.0 ====== Phosphate fertilizer sales volumes were slightly lower during 1992, whereas the average realization was 13 percent lower. Phosphate fertilizer realizations declined steadily throughout 1992 because of curtailed purchases by China, the largest single fertilizer importer, and supply and demand uncertainty in Europe, the former Soviet Union, and India. Also contributing to the decline in prices were lower raw material costs, most notably for sulphur, as producers in the weakening market passed along these cost savings to buyers in an attempt to preserve market share. FRP's phosphate rock and fertilizer facilities operated at or near capacity, with the 1992 phosphate fertilizer unit production cost averaging 7 percent less than during 1991 due to reduced raw material costs for sulphur and lower phosphate rock mining expenses, despite higher natural gas costs. Unit production cost also benefited during the latter part of 1992 as FRP completed a $60.0 million capital program to improve efficiency and lower costs. Sulphur production and sales volumes for 1992 declined 8 percent and 7 percent, respectively, from 1991 as the Garden Island Bay and Grand Isle mines ceased production in 1991. However, production increased at the Caminada mine, which had a significantly lower unit production cost than either Garden Island Bay or Grand Isle had prior to depletion, resulting in an average sulphur unit production cost 7 percent lower than during 1991. FRP's 1992 sulphur realization reflects the price declines which occurred since mid-1991, as world sulphur markets were burdened by the collapse of the Soviet Union as well as by a further decline in demand in Western Europe. During 1992, several Canadian sulphur marketers built inventory rather than accept depressed prices; however, others intensified their efforts to sell into the important Tampa, Florida market. Phosphate rock production and sales benefited from the capacity expansion completed in mid-1992 at one of FRP's two operated phosphate rock mines, and also reflect the output from FRP's central Florida Pebbledale property, where sales began in July 1991 under a mining agreement with IMC. Oil and Gas Operations. FTX's oil and gas operations (excluding the Main Pass oil operation) generated a loss of $32.8 million on revenues of $49.8 million in 1992 compared with a loss of $22.5 million on revenues of $180.0 million for 1991 reflecting the transfer of oil and gas properties to FMPO as well as the sale of a significant portion of its oil and gas properties in 1991. Revenues and earnings from Main Pass, which initiated oil production in late 1991, were $78.0 million and $4.6 million, respectively, on sales net to FRP of 4.9 million barrels at an average realization of $15.91 per barrel. Revenues for 1991 were $4.8 million, generating a $.6 million loss, on net sales of .4 million barrels at an average realization of $13.34 per barrel. Earnings for 1992 benefited from FRP's marketing efforts, which alleviated earlier problems related to its high-sulphur oil, and high average production rates. ____________________________ The results of operations reported and summarized above are not necessarily indicative of future operating results. Item 8. Item 8. Financial Statements and Supplementary Data. - ----------------------------------------------------- The financial statements of FTX and its consolidated subsidiaries, the notes thereto, the report of management and the report thereon of Arthur Andersen & Co., appearing on pages 33 through 56, inclusive, of FTX's 1993 Annual Report to stockholders, are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------------------------------------------------------------------------ Financial Disclosure. ---------------------- Not applicable. PART III -------- Items 10, 11, 12, and 13. Directors and Executive Officers of the Registrant, - ------------------------------------------------------------------------------ Executive Compensation, Security Ownership of Certain Beneficial Owners ----------------------------------------------------------------------- and Management, and Certain Relationships and Related Transactions. ------------------------------------------------------------------- The information set forth under the caption "Election of Directors," beginning on page 4 of the Proxy Statement dated March 31, 1994, submitted to the stockholders of FTX in connection with its 1994 Annual Meeting 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)(1), (a)(2), and (d). Financial Statements. See Index to Financial Statements appearing on page hereof. (a)(3) and (c). Exhibits. See Exhibit Index beginning on page E-1 hereof. (b). Reports on Form 8-K. No reports on Form 8-K were filed by the registrant during the fourth quarter of 1993. SIGNATURES ---------- Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 30, 1994. FREEPORT-McMoRan INC. By: /s/ James R. Moffett ------------------------------- James R. Moffett Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 30, 1994. /s/ James R. Moffett Chairman of the Board, Chief - --------------------------- Executive Officer and Director James R. Moffett (Principal Executive Officer) Richard C. Adkerson* Senior Vice President and Chief Financial Officer (Principal Financial Officer) John T. Eads* Controller-Financial Reporting (Principal Accounting Officer) Robert W. Bruce III* Director Thomas B. Coleman* Director William H. Cunningham* Director Robert A. Day* Director William B. Harrison, Jr.* Director Henry A. Kissinger* Director Bobby Lee Lackey* Director Rene L. Latiolais* Director Gabrielle K. McDonald* Director W. K. McWilliams, Jr.* Director George Putnam* Director B. M. Rankin, Jr.* Director Benno C. Schmidt* Director J. Taylor Wharton* Director Ward W. Woods, Jr.* Director *By: /s/ James R. Moffett ------------------------------ James R. Moffett Attorney-in-Fact ----------------------------- The financial statements of FTX and its consolidated subsidiaries, the notes thereto, and the report thereon of Arthur Andersen & Co., appearing on pages 33 through 56, inclusive, of FTX's 1993 Annual Report to stockholders are incorporated by reference. The financial statement schedules listed below should be read in conjunction with such financial statements contained in FTX's 1993 Annual Report to stockholders. Page ---- Report of Independent Public Accountants . . . . . . . . . . II-Amounts Receivable from Employees . . . . . . . . . . . . III-Condensed Financial Information of Registrant . . . . . V-Property, Plant and Equipment . . . . . . . . . . . . . . VI-Accumulated Depreciation and Amortization . . . . . . . . VIII-Valuation and Qualifying Accounts . . . . . . . . . . . X-Supplementary Income Statement Information . . . . . . . . Schedules other than those listed above have been omitted, since they are either not required, not applicable or the required information is included in the financial statements or notes thereto. * * * * REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- We have audited, in accordance with generally accepted auditing standards, the financial statements as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 included in Freeport-McMoRan Inc.'s annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules for the years ended December 31, 1993, 1992 and 1991 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 Orleans, Louisiana January 25, 1994 The footnotes contained in FTX's 1993 Annual Report to stockholders are an integral part of these statements. FREEPORT-McMoRan INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOW The footnotes contained in FTX's 1993 Annual Report to stockholders are an integral part of these statements. FREEPORT-McMoRan INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION for the years ended December 31, 1993, 1992, and 1991 FREEPORT-McMoRan INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 1993, 1992, and 1991 FREEPORT-MCMORAN INC. EXHIBIT INDEX ------------- Sequentially Exhibit Numbered Number Page - ------ ----------- 3.1 Composite copy of the Certificate of Incorporation of FTX, as amended. Incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q of FTX for the quarter ended June 30, 1992 (the "FTX 1992 Second Quarter Form 10-Q"). 3.2 By-Laws of FTX, as amended. Incorporated by reference to Exhibit 3.2 to the FTX 1992 Second Quarter Form 10-Q. 4.1 Certificate of Designations of the $1.875 Convertible Exchangeable Preferred Stock of FTX. Incorporated by reference to Exhibit 4.1 to the Quarterly Report on Form 10-Q of FTX for the quarter ended June 30, 1987 (the "FTX 1987 Second Quarter Form 10-Q"). 4.2 Certificate of Designations of the $4.375 Convertible Exchangeable Preferred Stock of FTX. Incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K of FTX dated March 23, 1992. 4.3 Indenture dated as of May 15, 1986 between FTX and Manufacturers Hanover Trust Company ("Manufacturers"), Trustee, relating to $150,000,000 principal amount of 10-7/8% Senior Subordinated Debentures due 2001 of FTX. Incorporated by reference to Exhibit 19.1 to the Quarterly Report on Form 10-Q of FTX for the quarter ended September 30, 1986. 4.4 Subordinated Indenture dated as of November 9, 1990 between FTX and Chemical Bank, Trustee, relating to subordinated indebtedness of FTX. Incorporated by reference to Exhibit 28.2 to the Current Report on Form 8- K of FTX dated February 7, 1991 (the "FTX February 7, 1991 Form 8-K"). 4.5 Supplemental Indenture No. 1 dated as of February 5, 1991 between FTX and Chemical Bank, Trustee, relating to $373,000,000 principal amount of 6.55% Convertible Subordinated Notes due 2001 of FTX. Incorporated by reference to Exhibit 28.3 to the FTX February 7, 1991 Form 8-K. 4.6 Supplemental Indenture No. 2 dated as of August 5, 1991 between FTX and Chemical Bank, Trustee, relating to $750,000,000 face amount of Zero Coupon Convertible Subordinated Debentures due 2006 of FTX. Incorporated by reference to Exhibit (4-a) to the Current Report on Form 8-K of FTX dated August 9, 1991. 4.7 Credit Agreement dated as of June 1, 1993 (the "FTX/FRP Credit Agreement") among FTX, FRP, the several banks which are parties thereto (the "FTX/FRP Banks") and Chemical Bank, as Agent (the "FTX/FRP Bank Agent"). Incorporated by reference to Exhibit 4.8 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1993 (the "FRP 1993 Form 10-K"). 4.8 First Amendment dated as of February 2, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. Incorporated by reference to Exhibit 4.9 to the FRP 1993 Form 10-K. 4.9 Second Amendment dated as of March 1, 1994 to the FTX/FRP Credit Agreement among FTX, FRP, the FTX/FRP Banks and the FTX/FRP Bank Agent. Incorporated by reference to Exhibit 4.10 to the FRP 1993 Form 10-K. 4.10 Amended and Restated Agreement of Limited Partnership of FRP dated as of May 29, 1987 (the "FRP Partnership Agreement") among FTX, Freeport Phosphate Rock Company and Geysers Geothermal Company, as general partners, and Freeport Minerals Company, as general partner and attorney-in-fact for the limited partners, of FRP. Incorporated by reference to Exhibit B to the Prospectus dated May 29, 1987 included in FRP's Registration Statement on Form S-1, as amended, as filed with the Commission on May 29, 1987 (Registration No. 33-13513). 4.11 Amendment to the FRP Partnership Agreement dated as of April 6, 1990 effected by FTX, as Administrative Managing General Partner of FRP. Incorporated by reference to Exhibit 19.3 to the Quarterly Report on Form 10-Q of FRP for the quarter ended March 31, 1990 (the "FRP 1990 First Quarter Form 10-Q"). 4.12 Amendment to the FRP Partnership Agreement dated as of January 27, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner of FRP. Incorporated by reference to Exhibit 3.3 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1991 (the "FRP 1991 Form 10-K"). 4.13 Amendment to the FRP Partnership Agreement dated as of October 14, 1992 between FTX, as Administrative Managing General Partner, and FMRP Inc., as Managing General Partner of FRP. Incorporated by reference to Exhibit 3.4 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1992 (the "FRP 1992 Form 10-K"). 4.14 Deposit Agreement dated as of June 27, 1986 (the "Deposit Agreement") among FRP, The Chase Manhattan Bank, N.A. ("Chase") and Freeport Minerals Company, as attorney-in-fact of those limited partners and assignees holding depositary receipts for units of limited partnership interests in FRP ("Depositary Receipts"). Incorporated by reference to Exhibit 28.4 to the Current Report on Form 8- K of FTX dated July 11, 1986. 4.15 Resignation dated December 26, 1991 of Chase as Depositary under the Deposit Agreement and appointment dated December 27, 1991 of Mellon Bank, N.A. ("Mellon") as successor Depositary, effective January 1, 1992. Incorporated by reference to Exhibit 4.5 to the FRP 1991 Form 10- K. 4.16 Service Agreement dated as of January 1, 1992 between FRP and Mellon pursuant to which Mellon will serve as Depositary under the Deposit Agreement and Custodian under the Custodial Agreement. Incorporated by reference to Exhibit 4.6 to the FRP 1991 Form 10-K. 4.17 Amendment to the Deposit Agreement dated as of November 18, 1992 between FRP and Mellon. Incorporated by reference to Exhibit 4.4 to the FRP 1992 Form 10-K. 4.18 Form of Depositary Receipt. Incorporated by reference to Exhibit 4.5 to the FRP 1992 Form 10-K. 4.19 Custodial Agreement regarding the FRP Depositary Unit Reinvestment Plan among FTX, FRP and Chase, effective as of April 1, 1987 (the "Custodial Agreement"). Incorporated by reference to Exhibit 19.1 to the FRP 1987 Second Quarter Form 10-Q. 4.20 FRP Depositary Unit Reinvestment Plan. Incorporated by reference to Exhibit 4.4 to the FRP 1991 Form 10- K. 4.21 Composite copy of the Certificate of Incorporation of FCX. Incorporated by reference to Exhibit 3.1 to the Annual Report on Form 10-K of FCX for the fiscal year ended December 31, 1993 (the "FCX 1993 Form 10-K"). 4.22 Credit Agreement dated as of June 1, 1993 (the "PT-FI Credit Agreement") among PT-FI, the several banks which are parties thereto (the "PT-FI Banks"), Morgan Guaranty Trust Company of New York ("Morgan"), as PT-FI Trustee (the "PT-FI Trustee"), and Chemical Bank, as Agent (the "PT- FI Bank Agent"). Incorporated by reference to Exhibit 4.10 to the FCX 1993 Form 10-K. 4.23 First Amendment dated as of February 2, 1994 to the PT-FI Credit Agreement among PT-FI, the PT-FI Banks, the PT- FI Trustee and the PT-FI Bank Agent. Incorporated by reference to Exhibit 4.11 to the FCX 1993 Form 10-K. 4.24 Second Amendment dated as of March 1, 1994 to the PT-FI Credit Agreement among PT-FI, the PT-FI Trustee and the PT-FI Bank Agent. Incorporated by reference to Exhibit 4.12 to the FCX 1993 Form 10-K. 4.25 Automatic Stock Purchase Plan of FTX. Incorporated by reference to Exhibit 4.28 to the Annual Report on Form 10- K of FTX for the fiscal year ended December 31, 1992 (the "FTX 1992 Form 10-K"). 10.1 Overriding Royalty Conveyance dated September 28, 1983, from McMoRan- Freeport Oil Company to McMoRan Oil & Gas Co. Incorporated by reference to Exhibit 2.2 to the Quarterly Report on Form 10-Q of FTX for the quarter ended September 30, 1983 (the "FTX 1983 Third Quarter Form 10-Q"). 10.2 Royalty Trust Indenture dated as of September 30, 1983 between FTX, as Trustor, and First City National Bank of Houston ("First City"), as Trustee. Incorporated by reference to Exhibit 2.3 to the FTX 1983 Third Quarter Form 10-Q. 10.3 First Amended and Restated Articles of General Partnership of Freeport- McMoRan Oil and Gas Royalty Partnership dated as of September 30, 1983 between McMoRan Offshore Management Co. and First City, as Trustee. Incorporated by reference to Exhibit 2.4 to the FTX 1983 Third Quarter Form 10-Q. 10.4 Contract of Work dated December 30, 1991 between The Government of the Republic of Indonesia and PT-FI. Incorporated by reference to Exhibit 10.20 to the Annual Report on Form 10-K of FCX for the fiscal year ended December 31, 1991. 10.5 Contribution Agreement dated as of April 5, 1993 between FRP and IMC (the "FRP-IMC Contribution Agreement"). Incorporated by reference to Exhibit 2.1 to the Quarterly Report on Form 10-Q of FRP for the quarter ended June 30, 1993 (the "FRP 1993 Second Quarter Form 10-Q"). 10.6 First Amendment dated as of July 1, 1993 to the FRP-IMC Contribution Agreement. Incorporated by reference to Exhibit 2.2 to the FRP 1993 Second Quarter Form 10-Q. 10.7 Amended and Restated Partnership Agreement dated as of July 1, 1993 among IMC-Agrico GP Company, Agrico, Limited Partnership and IMC-Agrico MP Inc. Incorporated by reference to Exhibit 2.3 to the FRP 1993 Second Quarter Form 10-Q. 10.8 Parent Agreement dated as of July 1, 1993 among IMC, FRP, FTX and IMC- Agrico. Incorporated by reference to Exhibit 2.4 to the FRP 1993 Second Quarter Form 10-Q. Executive Compensation Plans and Arrangements (Exhibits 10.9 through 10.40) 10.9 FTX Employee Retirement Plan as of January 1, 1986. Incorporated by reference to Exhibit 10.11 to the Annual Report on Form 10-K of Freeport-McMoRan Energy Partners, Ltd. ("FMP") for the fiscal year ended December 31, 1986. 10.10 Amendment No. 1 dated as of January 14, 1987 to the FTX Employee Retirement Plan. Incorporated by reference to Exhibit 10.10 to the FTX 1987 Form 10-K. 10.11 Amendment No. 2 dated as of May 31, 1987 to the FTX Employee Retirement Plan. Incorporated by reference to Exhibit 10.11 to the FTX 1987 Form 10-K. 10.12 Amendments to the FTX Employee Retirement Plan dated August 31, 1988, March 21, 1989 and December 29, 1989. Incorporated by reference to Exhibit 10.7 to the Annual Report on Form 10-K of FMP for the fiscal year ended December 31, 1989 (the "FMP 1989 Form 10-K"). 10.13 Amendment to the FTX Employee Retirement Plan dated March 6, 1990. Incorporated by reference to Exhibit 10.26 to the Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1989. 10.14 Amendment to the FTX Employee Retirement Plan dated December 20, 1991. Incorporated by reference to Exhibit 10.6 to the FRP 1991 Form 10-K. 10.15 Master Trust Agreement dated as of October 1, 1990 between FTX and Continental Bank, N.A., relating to the FTX Employee Retirement Plan. Incorporated by reference to Exhibit 19.2 to the Quarterly Report on Form 10-Q of FTX for the quarter ended September 30, 1990 (the "FTX 1990 Third Quarter Form 10-Q"). 10.16 Excess Benefits Plan of FTX. Incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q of FTX for the quarter ended March 31, 1988. 10.17 Amendments to the Excess Benefits Plan of FTX dated January 17, 1989, December 8, 1989, June 29, 1990 and October 17, 1990. Incorporated by reference to Exhibits 19.3, 19.4, 19.5 and 19.6, respectively, to the FTX 1990 Third Quarter Form 10-Q. 10.18 Amended and Restated FTX Employee Capital Accumulation Program dated September 14, 1990, generally effective as of January 1, 1989. Incorporated by reference to Exhibit 19.1 to the FTX 1990 Third Quarter Form 10-Q. 10.19 FTX Supplemental Executive Capital Accumulation Plan. Incorporated by reference to Exhibit 10.13 to the FTX 1987 Form 10-K. 10.20 Amendments, effective March 1, 1989 and January 1, 1990, to the FTX Supplemental Executive Capital Accumulation Plan. Incorporated by reference to Exhibit 10.20 to the FMP 1989 Form 10-K. 10.21 Amendment, effective May 1, 1991, to the FTX Supplemental Executive Capital Accumulation Plan. Incorporated by reference to Exhibit 19.1 to the FTX 1991 Third Quarter Form 10-Q. 10.22 Annual Incentive Plan of FTX, as amended. Incorporated by reference to Exhibit 10.18 to the FTX 1992 Form 10-K. 10.23 1992 Long-Term Performance Incentive Plan of FTX. Incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q of FTX for the quarter ended June 30, 1992 (the "FCX 1992 Second Quarter Form 10-Q"). 10.24 1987 Long-Term Performance Incentive Plan of FTX, as amended. Incorporated by reference to Exhibit 10.15 to the FRP 1991 Form 10-K. 10.25 FTX Variable Compensation Incentive Program, as amended. Incorporated by reference to Exhibit 19.4 to the FTX 1991 Third Quarter Form 10-Q. 10.26 Incentive Compensation Plan of FTX. Incorporated by reference to Exhibit 20.3 to the Quarterly Report on Form 10-Q of FTX for the Quarter ended June 30, 1981. 10.27 FTX Performance Incentive Awards Program, as amended. Incorporated by reference to Exhibit 19.5 to the FTX 1991 Third Quarter Form 10-Q. 10.28 FTX 1992 Stock Option Plan. Incorporated by reference to Exhibit 10.3 to the FCX 1992 Second Quarter Form 10-Q. 10.29 1982 Stock Option Plan of FTX, as amended. Incorporated by reference to Exhibit 19.6 to the FTX 1991 Third Quarter Form 10-Q. 10.30 FTX 1992 Stock Incentive Unit Plan. Incorporated by reference to Exhibit 10.2 to the FCX 1992 Second Quarter Form 10-Q. 10.31 1988 Stock Option Plan for Non- Employee Directors of FTX, as amended. Incorporated by reference to Exhibit 10.5 to the Quarterly Report on Form 10-Q of FTX for the quarter ended June 30, 1992. 10.32 FTX 1991 Plan for Deferral of Directors' Fees. Incorporated by reference to Exhibit 10.20 to the Annual Report on Form 10-K of FTX for the fiscal year ended December 31, 1991. 10.33 FTX Directors' Charitable Gift Program. Incorporated by reference to Exhibit 10.29 to the FTX 1992 Form 10-K. 10.34 FTX Matching Gifts Program. Incorporated by reference to Exhibit 10.30 to the FTX 1992 Form 10-K. 10.35 Financial Counseling and Tax Return Preparation and Certification Program of FTX. Incorporated by reference to Exhibit 10.31 to the FTX 1992 Form 10-K. 10.36 FTX Executive Universal Life Insurance Plan. Incorporated by reference to Exhibit 10.32 to the FTX 1992 Form 10-K. 10.37 Letter Agreement dated January 2, 1986 between FTX and Benno C. Schmidt. Incorporated by reference to Exhibit 10.13 to the Annual Report on Form 10-K of FTX for the fiscal year ended December 31, 1985. 10.38 Agreement for Consulting Services between FTX and B. M. Rankin, Jr., effective as of January 1, 1990. Incorporated by reference to Exhibit 19.2 to the Quarterly Report on Form 10-Q of FTX for the quarter ended March 31, 1990. 10.39 Consulting Agreement dated as of December 22, 1988, between FTX and Kissinger Associates, Inc. ("Kissinger Associates"). Incorporated by reference to Exhibit 10.35 to the FTX 1992 Form 10-K. 10.40 Letter Agreement dated May 1, 1989, between FTX and Kent Associates, Inc. (predecessor in interest to Kissinger Associates). Incorporated by reference to Exhibit 10.36 to the FTX 1992 Form 10-K. 11.1 FTX and Consolidated Subsidiaries Computation of Net Income Per Common and Common Equivalent Share. 12.1 FTX Computation of Ratio of Earnings to Fixed Charges. 13.1 Those portions of the 1993 Annual Report to stockholders of FTX which are incorporated herein by reference. 18.1 Letter from Arthur Andersen & Co. concerning changes in accounting principles. 21.1 Subsidiaries of FTX. 23.1 Consent of Arthur Andersen & Co. dated March 25, 1994. 24.1 Certified resolution of the Board of Directors of FTX authorizing this report to be signed on behalf of any officer or director pursuant to a Power of Attorney. 24.2 Powers of Attorney pursuant to which this report has been signed on behalf of certain officers and directors of FTX. 99.1 Annual Report on Form 10-K of FRP for the fiscal year ended December 31, 1993. 99.2 Annual report on Form 10-K of FCX for the fiscal year ended December 31, 1993.

86772_1993.txt

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1993

86772

ITEM 3. LEGAL PROCEEDINGS The Company, its subsidiaries and other related companies are named defendants in several lawsuits and named parties in certain governmental proceedings arising in the ordinary course of business. For a description of certain proceedings in which the Company is involved, see Items 1 and 2 ' Business and Properties -- Other Business Matters -- Environmental Regulation' and Notes 12 and 13 to the Consolidated Financial Statements. 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 position or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF SANTA FE Listed below are the names, ages (as of January 1, 1994) and positions of all executive officers of Santa Fe (excluding executive officers who are also directors of Santa Fe) and their business experience during the past five years. Unless otherwise stated, all offices were held with Santa Fe Energy Company prior to its merger with Santa Fe. Each executive officer holds office until his successor is elected or appointed or until his earlier death, resignation or removal. HUGH L BOYT, 48 Senior Vice President -- Production since March 1, 1990. From 1989 until March 1990, Mr. Boyt served as Corporate Production Manager. From 1983, when Mr. Boyt joined Santa Fe, until 1989 he served as District Production Manager -- Permian Basin. JERRY L BRIDWELL, 50 Senior Vice President -- Exploration and Land since 1986. Mr. Bridwell served in various other capacities, including Vice President -- Exploration, Central Division, since joining Santa Fe in 1974. KEITH P. HENSLER, 62 Senior Vice President -- Marketing since January, 1990. From 1980 when Mr. Hensler joined Santa Fe, until January 1990, he served as Vice President -- Marketing. Mr. Hensler is also Senior Vice President of Energy Products. RICHARD B. BONNEVILLE, 51 Vice President -- Planning and Administration since 1988. Prior to such time Mr. Bonneville served as Secretary of SFP. E. EVERETT DESCHNER, 53 Vice President -- Reservoir Engineering and Evaluation since April 1990. From 1982, when Mr. Deschner joined Santa Fe, until 1990, he served as Manager -- Engineering and Evaluation. C. ED HALL, 51 Vice President -- Public Affairs since March 1991. Prior to such time Mr. Hall served as Director -- Public Affairs since joining Santa Fe in 1984. CHARLES G. HAIN, JR., 47 Vice President -- Employee Relations since 1988. From 1981, when Mr. Hain joined Santa Fe, until 1988, Mr. Hain served as Director -- Employee Relations. DAVID L HICKS, 44 Vice President -- Law and General Counsel since March 1991. From 1988 until March 1991 Mr. Hicks was General Counsel and prior to that time was General Attorney for SFP. MICHAEL J. ROSINSKI, 48 Vice President and Chief Financial Officer since September 1992. Prior to joining Santa Fe, Mr. Rosinski was with Tenneco Inc. and its subsidiaries for 24 years. From 1988 until 1990 he served as Deputy Project Executive for the Colombian Crude Oil Pipeline Project and from 1990 until August 1992 he was Executive Director of Investor Relations. Mr. Rosinski is also a director of Hadson Corporation. JOHN R. WOMACK, 55 Vice President -- Business Development since 1987. From 1982, when Mr. Womack joined Santa Fe, until 1987, Mr. Womack served as Vice President -- Land. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Santa Fe's common stock is listed on the New York Stock Exchange and trades under the symbol SFR. The following table sets forth information as to the last sales price per share of Santa Fe's common stock as quoted on the Consolidated Tape System and cash dividends paid per share for each calendar quarter in 1992 and 1993. [CAPTION] CASH LOW HIGH DIVIDENDS [S] [C] [C] [C] 1st Quarter---------------------- 7 9 3/8 0.04 2nd Quarter---------------------- 7 7/8 9 1/4 0.04 3rd Quarter---------------------- 7 7/8 9 7/8 0.04 4th Quarter---------------------- 7 3/4 9 7/8 0.04 1st Quarter---------------------- 7 3/4 11 0.04 2nd Quarter---------------------- 9 5/8 11 7/8 0.04 3rd Quarter---------------------- 9 1/8 10 5/8 0.04 4th Quarter---------------------- 8 3/8 10 7/8 -- As discussed in Items 1 and 2, Business and Properties -- Corporate Restructuring Program, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid is in the sole discretion of Santa Fe's board of directors and will depend on dividend requirements with respect to the Company's convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of its capital and exploration expenditures, dividend restrictions in its financing agreements, its future business prospects and other matters as the Company's board of directors deems relevant. For a discussion of certain restrictions on Santa Fe's ability to pay dividends, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Financing Activities. At December 31, 1993 the Company had approximately 59,100 shareholders of record. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the year ended December 31, 1993 the Company reported a loss to common shares of $84.1 million, or $0.94 per share. The loss for the year includes a $99.3 million charge for the impairment of oil and gas properties (see ' -- Results of Operations') and a $38.6 million restructuring charge (see Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program'). The restructuring charge is comprised of losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals for certain personnel benefits and related costs of $2.2 million. At December 31, 1993 the Company's long-term debt totalled $449.7 million, a portion of which the Company intends to refinance to reduce required debt amortization in the near-term and provide additional financial flexibility in the current low oil price environment. GENERAL As an independent oil and gas producer, the Company's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of finding and producing such resources. A substantial portion of the Company's crude oil production is from long-lived fields where EOR methods are being utilized. The market price of the heavy (i.e., low gravity, high viscosity) and sour (i.e., high sulfur content) crude oils produced in these fields is lower than sweeter, light (i.e., low sulfur and low viscosity) crude oils, reflecting higher transportation and refining costs. The lower price received for the Company's domestic heavy and sour crude oil is reflected in the average sales price of the Company's domestic crude oil and liquids (excluding the effect of hedging transactions) for 1993 of $12.70 per barrel, compared to $16.94 per barrel for West Texas Intermediate crude oil (an industry posted price generally indicative of spot prices for sweeter light crude oil). In addition, the lifting costs of heavy crude oils are generally higher than the lifting costs of light crude oils. As a result of these narrower margins, even relatively modest changes in crude oil prices may significantly affect the Company's revenues, results of operations, cash flows and proved reserves. In addition, prolonged periods of high or low oil prices may have a material effect on the Company's financial position. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC, the Middle East and other producing countries. (See Items 1 and 2, "Business and Properties -- Current Markets for Oil and Gas"). The period since mid-1990 has included some of the largest fluctuations in oil prices in recent times, primarily due to the political unrest in the Middle East. The actual average sales price (unhedged) received by the Company ranged from a high of $23.92 per barrel in the fourth quarter of 1990 to a low of $9.83 per barrel for the two months ended February 28, 1994. The Company's average sales price for its 1993 oil production was $12.93 per barrel. Based on operating results of 1993, the Company estimates that a $1.00 per barrel increase or decrease in average sales prices would have resulted in a corresponding $21.6 million change in 1993 income from operations and a $16.2 million change in 1993 cash flow from operating activities. The Company also estimates that a $0.10 per Mcf increase or decrease in average sales prices would have resulted in a corresponding $5.8 million change in 1993 income from operations and a $4.4 million change in 1993 cash flow from operating activities. The foregoing estimates do not give effect to changes in any other factors, such as the effect of the Company's hedging program or depreciation and depletion, that would result from a change in oil and natural gas prices. In the third quarter of 1990 the Company initiated a hedging program with respect to its sales of crude oil and in the third quarter of 1992 a similar program was initiated with respect to the Company's sales of natural gas. See Items 1 and 2. 'Business and Properties -- Current Markets for Oil and Gas.' During 1992 and 1993, certain significant events occurred which affect the comparability of prior periods, including the merger of Adobe with and into the Company in May 1992, the formation of the Santa Fe Energy Trust in November 1992 and implementation of the corporate restructuring program adopted in October 1993. The corporate restructuring program includes (i) the concentration of capital spending in the Company's core operating areas, (ii) the disposition of non-core assets, (iii) the elimination of the $0.04 per share quarterly Common Stock dividend and (iv) the recognition of $38.6 million of restructuring charges. See Note 2 to the Consolidated Financial Statements and Items 1 and 2, 'Business and Properties -- Corporate Restructuring Program.' In addition, the Company's results of operations for 1993 include a charge of $99.3 million for the impairment of oil and gas properties. The Company's capital program will be concentrated in three domestic core areas -- the Permian Basin in Texas and New Mexico, the offshore Gulf of Mexico and the San Joaquin Valley of California -- as well as its productive areas in Argentina and Indonesia. The domestic program includes development activities in the Delaware and Cisco-Canyon formations in west Texas and southeast New Mexico, a development drilling program for the offshore Gulf of Mexico natural gas properties and relatively low risk infill drilling in the San Joaquin Valley of California. Internationally, the program includes development of the Company's Sierra Chata discovery in Argentina with gas sales expected to commence in early 1995 and the Salawati Basin Joint Venture in Indonesia. See Items 1 and 2. 'Business and Properties -- Domestic Development Activities' and '--International Development Activities.' The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson (completed in December 1993), the sale to Vintage of certain southern California and Gulf Coast oil and gas producing properties (completed in November 1993) and the sale to Bridge of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage (expected to be completed during April 1994). See Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program' for a description of the transactions with Hadson, Vintage and Bridge. In the first quarter of 1994, the Company sold the remaining 575,000 Depositary Units which it held in Santa Fe Energy Trust (the 'Trust') for $11.3 million and its interest in certain other oil and gas properties for $8.3 million. As a result of the Vintage and Bridge dispositions, the Company has sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and estimated proved reserves of approximately 16.7 MMBOE. The restructuring program also includes an evaluation of the Company's capital and cost structures to examine ways to increase flexibility and strengthen the Company's financial performance. In this respect, in 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. In May, 1992, Adobe, an oil and gas exploration and production company, was merged with and into the Company. The acquisition was accounted for as a purchase and the results of operations of the properties acquired are included in the Company's results of operations effective June 1, 1992. Pursuant to the Adobe Merger, the Company issued 5,000,000 shares of its convertible preferred stock and assumed approximately $175.0 million of long-term debt and other liabilities. Pursuant to the Adobe Merger, the Company also acquired Adobe's proved reserves and inventory of undeveloped acreage. As of December 31, 1991, Adobe's estimated proved reserves totaled approximately 53.2 MMBOE (net of 6.9 MMBOE attributable to Adobe's ownership in certain gas plants), of which approximately 58% was natural gas (approximately 66% of Adobe's estimated domestic proved reserves were natural gas). Approximately 72% of the discounted future net cash flow of Adobe's estimated domestic proved reserves was concentrated in three areas of operation -- offshore Gulf of Mexico, onshore Louisiana and in the Spraberry Trend in west Texas. In addition, Adobe's international operations consisted of certain production sharing arrangements in Indonesia, in respect of which approximately 6.0 MMBOE of estimated proved reserves had been attributed to Adobe's interest as of December 31, 1991. The location of the Adobe Properties enhanced the Company's existing domestic operations and added significant operations to the Company's international program. In November 1992, 5,725,000 Depositary Units consisting of interests in the Trust were sold in a public offering. After payment of certain costs and expenses, the Company received $70.1 million and 575,000 Depositary Units. For any calendar quarter ending on or prior to December 21, 2002, the Trust will receive additional royalty payments to the extent necessary to distribute $0.40 per Depositary Unit per quarter. The source of such payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. The aggregate amount of such payments will be limited to $20.0 million on a revolving basis. The Company was required to make an additional royalty payment of $362,000 with respect to the distribution made by the Trust for operations during the quarter ended December 31, 1993. Based upon current prices, the Company believes that a support payment will be required for the quarter ending March 31, 1994, the amount of which has not been determined. See Items 1 and 2. 'Business and Properties -- Santa Fe Energy Trust.' RESULTS OF OPERATIONS The following table sets forth, on the basis of the BOE produced by the Company during the applicable annual period, certain of the Companys costs and expenses for each of the three years ended December 31, 1993. 1993 1992 1991 Production and operating costs per BOE (a)------------------------------ $ 4.76 $ 5.02 $ 5.17 Exploration, including dry hole costs per BOE---------------------------- 0.90 0.84 0.72 Depletion, depreciation and amortization per BOE--------------- 4.44 4.79 4.09 General and administrative costs per BOE-------------------------------- 0.94 1.01 1.07 Taxes other than income per BOE (b)-------------------------------- 0.79 0.80 1.05 Interest, net, per BOE (c)----------- 0.94 1.58 1.43 (a) Excluding related production, severance and ad valorem taxes. (b) Includes production, severance and ad valorem taxes. (c) Reflects interest expense less amounts capitalized and interest income. 1993 COMPARED WITH 1992 Total revenues increased approximately 2% from $427.5 million in 1992 to $436.9 million in 1993 principally due to an increase in oil and natural gas production offset by a decline in average oil prices. Average daily oil production increased 7% from 62.5 MBbls in 1992 to 66.7 MBbls in 1993, principally due to increased domestic and Indonesian production. The average price realized per Bbl of oil during 1993 was $12.93, a decrease of 14% versus the average price of $14.96 in 1992. Natural gas production increased 31% from 126.3 MMcf per day in 1992 to 165.4 MMcf per day in 1993, primarily reflecting the effect of a full year's production from the Adobe Properties. Average natural gas prices realized increased approximately 11% from $1.70 per Mcf in 1992 to $1.89 per Mcf in 1993. Production and operating costs increased $10.4 million in 1993, primarily reflecting the effect of a full year's costs for the Adobe Properties; however, on a BOE basis such costs declined from $5.02 per barrel in 1992 to $4.76 per barrel in 1993. Exploration costs were $5.5 million higher than in 1992 primarily reflecting higher geological and geophysical costs and higher dry hole costs. Depletion, depreciation and amortization ('DD&A') increased $6.4 million in 1993 primarily reflecting a full year's expense on Adobe Properties partially offset by reduced amortization rates with respect to certain unproved properties. DD&A for 1993 includes $12.1 million with respect to the properties sold to Vintage and Bridge. On a BOE basis, DD&A decreased by $0.35 per Bbl, from $4.79 to $4.44 per Bbl. General and administrative costs increased $1.4 million principally due to a $1.8 million charge related to the adoption of Statement of Financial Standards No. 112 -- 'Employer's Accounting for Postemployment Benefits'. Taxes (other than income) increased by $3.0 million in 1993 primarily reflecting the effect of the Adobe Properties. Costs and expenses for 1993 also include $99.3 million in impairments of oil and gas properties and $38.6 million in restructuring charges. The Company estimates the impairments taken in 1993 will result in a reduction of DD&A in 1994 of approximately $20.0 million. The restructuring charges include losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals of certain personnel benefits and related costs of $2.2 million. In connection with the property dispositions effected during 1993 (See '-- Liquidity and Capital Resources'), the Company sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and combined estimated proved reserves of approximately 16.7 MMBOE. The Company's income from operations for 1993 includes $8.5 million with respect to such operations. Interest income in 1993 includes $6.8 million related to a $10 million refund received as a result of the completion of the audit of the Company's federal income tax returns for 1971 through 1980. The decrease in interest expenses during 1993 reflects a decrease in the Company's debt outstanding and a $5.7 million credit related to a revision to a tax sharing agreement with the Company's former parent. Other income and expenses of 1993 includes a $4.0 million charge related to the accrual of a contingent loss with respect to the operations of a former affiliate of Adobe. 1992 COMPARED WITH 1991 Total revenues increased approximately 13% from $379.8 million in 1991 to $427.5 million in 1992 principally due to an increase of approximately $53.2 million attributable to production from properties acquired in the Adobe Merger and an increase of approximately $10.7 million and $10.2 million in revenues from the Company's domestic and Argentine properties, respectively, offset in part by a decline of $32.0 million in crude oil hedging revenues. Oil production increased 13% from 55.5 MBbls per day in 1991 to 62.5 MBbls per day in 1992, reflecting a 3.4 MBbl per day increase in domestic oil production and a 3.6 MBbl per day increase in production in Argentina and Indonesia. The average price realized per barrel of oil during 1992 decreased to $14.96, a decrease of 7% versus the average price of $16.16 in 1991, primarily reflecting a $32.0 million decrease in hedging revenues. Natural gas production increased 33% from 95.2 MMcf per day in 1991 to 126.3 MMcf per day in 1992 as a result of properties acquired in the Adobe Merger. Average natural gas prices realized increased approximately 14% from $1.49 per Mcf in 1991 to $1.70 per Mcf in 1992. Total operating expenses of the Company increased $54.6 million from $315.4 million in 1991 to $370.0 million in 1992 primarily reflecting costs associated with the Adobe Merger. Production and operating costs in 1992 were $18.8 million higher than in 1991, primarily reflecting costs related to the Adobe Properties and increased fuel costs associated with the Company's EOR projects. On a BOE basis, production and operating costs declined from $5.17 per barrel in 1991 to $5.02 per barrel in 1992, primarily reflecting the lower cost structure of the Adobe Properties. Exploration costs were $6.8 million higher than in 1991 primarily reflecting higher geological and geophysical costs with respect to foreign projects. Depletion, depreciation and amortization costs were $39.7 million higher in 1992 due to the acquisition of the Adobe Properties and, to a lesser extent, adjustments to oil and gas reserves with respect to certain producing properties. General and administrative costs increased $3.1 million principally due to a $1.2 million charge related to certain stock awards which fully vested upon consummation of the Adobe Merger and certain other merger-related costs. Taxes (other than income) decreased by $2.9 million in 1992, as a result of lower accruals with respect to property taxes. The $13.6 million gain on the disposition of properties in 1992 primarily relates to the sale of certain royalty interest properties, in which the Company had no remaining financial basis. The increase in interest expense during 1992 reflects the increase in debt as a result of the Adobe Merger. Other income and expenses for 1992 includes a $10.9 million charge for costs incurred by Adobe in connection with the Adobe Merger and paid by Santa Fe. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has generally funded capital and exploration expenditures and working capital requirements from cash provided by operating activities. Depending upon the future levels of operating cash flows, which are significantly affected by oil and gas prices, the restrictions on additional borrowings included in certain of the Company's debt agreements, together with debt service requirements and dividends, may limit the cash available for future exploration, development and acquisition activities. Net cash provided by operating activities totaled $160.2 million in 1993, $141.5 million in 1992 and $128.4 million in 1991; net cash used in investing activities in such periods totaled $121.4 million, $15.9 million and $117.2 million, respectively. The Company's cash flow from operating activities is a function of the volumes of oil and gas produced from the Company's properties and the sales prices realized therefor. Crude oil and natural gas are depleting assets. Unless the Company replaces over the long term the oil and natural gas produced from the Company's properties, the Company's assets will be depleted over time and its ability to service and incur debt at constant or declining prices will be reduced. The Company's cash flow from operations for 1993 reflects an average sales price (unhedged) for the Company's 1993 oil production of $12.93 per barrel. For the two months ended February 28, 1994, the average sales price (unhedged) for the Company's 1994 oil production was $9.83 per barrel. If such lower oil prices prevail throughout 1994, the Company's cash flow from operating activities for 1994 will be significantly lower than that for 1993. In October 1993, the Company's Board of Directors adopted a broad corporate restructuring program that focuses on the concentration of capital spending in core areas and the disposition of non-core assets. The Company's asset disposition program adopted in connection with the 1993 restructuring program has been substantially completed by the asset sales to Hadson, Vintage and Bridge (expected to close in April 1994), the sale of the 575,000 Depositary Units in the Trust and the sale of its interest in certain other oil and gas properties. As a result of such sales, the Company sold a total of 16.7 MMBOE of proved reserves and undeveloped acreage for a total of approximately $111.0 million, and sold certain gas gathering and processing facilities for Hadson securities. As a part of the 1993 restructuring program, the Company eliminated its $0.04 per share quarterly dividend on its Common Stock and announced that it might spend up to $240 million in 1994 on an accelerated capital program. However, as a result of the depressed crude oil prices that have prevailed since November 1993, the Company, consistent with industry practice, is considering deferring some of its capital projects in order to prudently manage its cash flow available in the near term. Based on current market conditions, the Company estimates that 1994 capital expenditures may total between $100 million and $160 million, with the actual amount to be determined by the Company based upon numerous factors outside its control, including, without limitation, prevailing oil and natural gas prices and the outlook therefor. The Company is a party to several long-term and short-term credit agreements which restrict the Company's ability to take certain actions, including covenants that restrict the Company's ability to incur additional indebtedness and to pay dividends on its capital stock. For a description of such existing credit agreements, see Note 7 to the Consolidated Financial Statements. Effective March 16, 1994, the Company entered into an Amended and Restated Revolving Credit Agreement (the "Bank Facility") which consists of a five year secured revolving credit agreement maturing December 31, 1998 ("Facility A") and and a three year unsecured revolving credit facility maturing December 31, 1996 ("Facility B"). The aggregate borrowing limits under the terms of the Bank Facility are $125.0 million (up to $90.0 million under Facility A and up to $35.0 million under Facility B). Under certain circumstances, the aggregate borrowing limits under the terms of the Bank Facility may be increased to $175.0 million (up to $90.0 million under Facility A and up to $85.0 million under Facility B). Interest rates under the Bank Facility are tied to LIBOR or the bank's prime rate with the actual interest rate reflecting certain ratios based upon the Company's ability to repay its outstanding debt and the value and projected timing of production of the Company's oil and gas reserves. These and other similar ratios will also affect the Company's ability to borrow under the Bank Facility and the timing and amount of any required repayments and corresponding commitment reductions. The Bank Facility replaces the Revolving and Term Credit Agreement discussed in Note 7 to the Consolidated Financial Statements. EFFECTS OF INFLATION Inflation during the three years ended December 31, 1993 has had little effect on the Company's capital costs and results of operations. ENVIRONMENTAL MATTERS Almost all phases of the Company's oil and gas operations are subject to stringent environmental regulation by governmental authorities. Such regulation has increased the costs of planning, designing, drilling, installing, operating and abandoning oil and gas wells and other facilities. The Company has expended significant financial and managerial resources to comply with such regulations. Although the Company believes its operations and facilities are in general compliance with applicable environmental regulations, risks of substantial costs and liabilities are inherent in oil and gas operations. It is possible that other developments, such as increasingly strict environmental laws, regulations and enforcement policies or claims for damages to property, employees, other persons and the environment resulting from the Company's operations, could result in significant costs and liabilities in the future. As it has done in the past, the Company intends to fund its cost of environmental compliance from operating cash flows. See also, Items 1 and 2. 'Business and Properties -- Other Business Matters -- Environmental Regulation' and Note 12 to the Consolidated Financial Statements. DIVIDENDS Dividends on the Company's convertible preferred stock are cumulative at an annual rate of $1.40 per share. No dividends may be declared or paid with respect to the Company's common stock if any dividends with respect to the convertible preferred stock are in arrears. As described elsewhere herein, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid on the Company's common stock is in the sole discretion of the Company's Board of Directors and will depend on dividend requirements with respect to the convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of capital and exploration expenditures, dividend restrictions in financing agreements, future business prospects and other matters the Board of Directors deems relevant. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Audited Financial Statements Report of Independent Accountants------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991--------------------- 32 Consolidated Balance Sheet -- December 31, 1993 and 1992---- 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991--------------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991---------- 35 Notes to Consolidated Financial Statements---------- 36 Unaudited Financial Information Supplemental Information to the Consolidated Financial Statements-------------------- 55 Financial Statement Schedules: Schedule V --Property, Plant and Equipment------ 65 Schedule VI --Accumulated Depreciation, Depletion and Amortization of Property Plant and Equipment---------------------- 66 Schedule --Valuation and Qualifying VIII Accounts--------------------------- 67 Schedule IX --Short Term Borrowings-------------- 68 --Supplementary Income Statement Schedule X Information------------------------ 69 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 ITEM 11. EXECUTIVE COMPENSATION ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Except for the portion of Item 10 relating to Executive Officers of the Registrant which is included in Part I of this Report, the information called for by Items 10 through 13 is incorporated by reference from the Company's Notice of Annual Meeting and Proxy Statement dated March 21, 1994, which meeting involves the election of directors, in accordance with General Instruction G to the Annual Report on Form 10-K. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: PAGE 1. Financial Statements: Report of Independent Accountants--------------------------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991------------ 32 Consolidated Balance Sheet -- December 31, 1993 and 1992------------------------------------------ 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991---------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991------ 35 Notes to Consolidated Financial Statements------------ 36 2. Financial Statement Schedules: Schedule V -- Property, Plant and Equipment--------- 65 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment---------------- 66 Schedule VIII -- Valuation and Qualifying Accounts---- 67 Schedule IX -- Short Term Borrowings------------------ 68 Schedule X -- Supplementary Income Statement Information------------------------ 69 All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or the notes to financial statements. 3. Exhibits: See Index to Exhibits on page 70 for a description of the exhibits filed as a part of this report. (b) Reports on Form 8-K [CAPTION] DATE ITEM February 8, 1994 5 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Santa Fe Energy Resources, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 30 present fairly, in all material respects, the financial position of Santa Fe Energy Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Houston, Texas February 18, 1994 SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS OF DOLLARS, EXCEPT PER SHARE DATA) YEAR ENDED DECEMBER 31, 1993 1992 1991 Revenues Crude oil and liquids------------ $ 307.3 $ 333.6 $ 320.3 Natural gas---------------------- 107.8 74.8 47.9 Natural gas systems-------------- 8.2 7.3 -- Crude oil marketing and trading------------------------ 9.9 5.9 7.2 Other---------------------------- 3.7 5.9 4.4 436.9 427.5 379.8 Costs and Expenses Production and operating--------- 163.8 153.4 134.6 Oil and gas systems and pipelines---------------------- 4.2 3.2 -- Exploration, including dry hole costs-------------------------- 31.0 25.5 18.7 Depletion, depreciation and amortization------------------- 152.7 146.3 106.6 Impairment of oil and gas properties--------------------- 99.3 -- -- General and administrative------- 32.3 30.9 27.8 Taxes (other than income)-------- 27.3 24.3 27.2 Restructuring charges------------ 38.6 -- -- Loss (gain) on disposition of oil and gas properties------------- 0.7 (13.6) 0.5 549.9 370.0 315.4 Income (Loss) from Operations-------- (113.0) 57.5 64.4 Interest income------------------ 9.1 2.3 2.3 Interest expense----------------- (45.8) (55.6) (47.3) Interest capitalized------------- 4.3 4.9 7.7 Other income (expense)----------- (4.8) (10.0) 5.6 Income (Loss) Before Income Taxes---- (150.2) (0.9) 32.7 Income taxes--------------------- 73.1 (0.5) (14.2) Net Income (Loss)-------------------- (77.1) (1.4) 18.5 Preferred dividend requirement------- (7.0) (4.3) -- Earnings (Loss) Attributable to Common Shares---------------------- $ (84.1) $ (5.7) $ 18.5 Earnings (Loss) Attributable to Common Shares Per Share------------ $ (0.94) $ (0.07) $ 0.29 Weighted Average Number of Shares Outstanding (in millions)---------- 89.7 79.0 63.8 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED BALANCE SHEET (IN MILLIONS OF DOLLARS) DECEMBER 31, 1993 1992 ASSETS Current Assets Cash and cash equivalents-------- $ 4.8 $ 83.8 Accounts receivable-------------- 87.4 90.0 Income tax refund receivable----- -- 16.2 Inventories---------------------- 8.7 4.8 Assets held for sale------------- 59.5 -- Other current assets------------- 12.2 10.6 172.6 205.4 Investment in Hadson Corporation----- 56.2 -- Properties and Equipment, at cost Oil and gas (on the basis of successful efforts accounting)-------------------- 2,064.3 2,330.9 Other---------------------------- 27.3 26.8 2,091.6 2,357.7 Accumulated depletion, depreciation, amortization and impairment--------------------- (1,258.9) (1,255.9) 832.7 1,101.8 Other Assets Receivable under gas balancing arrangements------------------- 3.9 7.7 Other---------------------------- 11.5 22.3 15.4 30.0 $ 1,076.9 $ 1,337.2 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable----------------- $ 93.5 $ 90.9 Interest payable----------------- 10.2 11.0 Current portion of long-term debt--------------------------- 44.3 53.4 Other current liabilities-------- 18.1 17.1 166.1 172.4 Long-Term Debt----------------------- 405.4 492.8 Deferred Revenues-------------------- 8.6 13.0 Other Long-Term Obligations---------- 48.8 43.4 Deferred Income Taxes---------------- 44.4 119.0 Commitments and Contingencies (Note 12)-------------------------------- -- -- Convertible Preferred Stock, $0.01 par value, 5.0 million shares authorized, issued and outstanding------------------------ 80.0 80.0 Shareholders' Equity Preferred stock, $0.01 par value, 45.0 million shares authorized, none issued-------------------- -- -- Common stock, $0.01 par value, 200.0 million shares authorized--------------------- 0.9 0.9 Paid-in capital------------------ 496.9 494.3 Unamortized restricted stock awards------------------------- (0.1) (0.4) Accumulated deficit-------------- (173.8) (78.0) Foreign currency translation adjustment--------------------- (0.3) (0.2) 323.6 416.6 $ 1,076.9 $ 1,337.2 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Operating Activities: Net income (loss)---------------- $ (77.1) $ (1.4) $ 18.5 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depletion, depreciation and amortization--------------- 152.7 146.3 106.6 Impairment of oil and gas properties----------------- 99.3 -- -- Restructuring charges-------- 27.8 -- -- Deferred income taxes-------- (71.9) (6.3) 1.5 Net loss (gain) on disposition of properties----------------- 0.7 (13.6) (5.5) Exploratory dry hole costs---------------------- 8.9 4.7 3.8 Expenses related to acquisition of Adobe Resources Corporation------ -- 10.9 -- Other------------------------ 4.2 2.0 0.3 Changes in operating assets and liabilities: Decrease (increase) in accounts receivable-------- 12.4 (8.3) 23.6 Decrease (increase) in inventories---------------- (3.8) 0.3 5.6 Increase (decrease) in accounts payable----------- (2.6) 5.9 (24.9) Increase (decrease) in interest payable----------- (0.8) 0.4 0.2 Decrease in income taxes payable-------------------- (0.6) (0.4) (3.6) Net change in other assets and liabilities------------ 11.0 1.0 2.3 Net Cash Provided by Operating Activities------------------------- 160.2 141.5 128.4 Investing Activities: Capital expenditures, including exploratory dry hole costs----- (127.0) (76.8) (108.1) Acquisitions of producing properties, net of related debt--------------------------- (4.4) (14.2) (28.5) Acquisition of Adobe Resources Corporation-------------------- -- (11.9) -- Acquisition of Santa Fe Energy Partners, L.P.----------------- (28.3) -- -- Net proceeds from sales of properties--------------------- 39.9 89.1 22.1 Increase in partnership interest due to reinvestment------------ (1.6) (2.1) (2.7) Net Cash Used in Investing Activities------------------------- (121.4) (15.9) (117.2) Financing Activities: Net change in short-term debt---- -- (4.6) (4.2) Proceeds from long-term borrowings--------------------- -- 5.0 -- Principal payments on long-term borrowings--------------------- (41.5) (55.5) (16.3) Net change in revolving credit agreement---------------------- (55.0) -- -- Cash dividends paid to others---- (21.3) (14.9) (10.2) Net Cash Used in Financing Activities------------------------- (117.8) (70.0) (30.7) Net Increase (Decrease) in Cash and Cash Equivalents------------------- (79.0) 55.6 (19.5) Cash and Cash Equivalents at Beginning of Year------------------ 83.8 28.2 47.7 Cash and Cash Equivalents at End of Year------------------------------- $ 4.8 $ 83.8 $ 28.2 The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of Santa Fe Energy Resources, Inc. ('Santa Fe' or the 'Company') and its subsidiaries include the accounts of all wholly owned subsidiaries. The accounts of Santa Fe Energy Partners, L.P., (the 'Partnership') are included on a proportional basis until September 1993 when Santa Fe purchased all the Partnership's outstanding Depositary Units and undeposited LP Units other than those units held by Santa Fe and its affiliates. On September 27, 1993 the Company exercised its right under the Agreement of Limited Partnership to purchase all of the Partnership's outstanding Depositary Units and undeposited LP Units, other than those units held by the Company and its affiliates, at a redemption price of $4.9225 per unit. Consideration for the 5,749,500 outstanding units totalled $28.3 million. The acquisition of the units has been accounted for as a purchase and the results of operations of the Partnership attributable to the units acquired is included in the Company's results of operations with effect from October 1, 1993. The purchase price has been allocated primarily to oil and gas properties. References herein to the 'Company' or 'Santa Fe' relate to Santa Fe Energy Resources, Inc., individually or together with its consolidated subsidiaries; references to the 'Partnership' relate to Santa Fe Energy Partners, L.P. All significant intercompany accounts and transactions have been eliminated. Prior years' financial statements include certain reclassifications to conform to current year's presentation. OIL AND GAS OPERATIONS The Company follows the successful efforts method of accounting for its oil and gas exploration and production activities. Costs (both tangible and intangible) of productive wells and development dry holes, as well as the cost of prospective acreage, are capitalized. The costs of drilling and equipping exploratory wells which do not find proved reserves are expensed upon determination that the well does not justify commercial development. Other exploratory costs, including geological and geophysical costs and delay rentals, are charged to expense as incurred. Depletion and depreciation of proved properties are computed on an individual field basis using the unit-of-production method based upon proved oil and gas reserves attributable to the field. Certain other oil and gas properties are depreciated on a straight-line basis. Individual proved properties are reviewed periodically to determine if the carrying value of the field exceeds the estimated undiscounted future net revenues from proved oil and gas reserves attributable to the field. Based on this review and the continuing evaluation of development plans, economics and other factors, if appropriate, the Company records impairments (additional depletion and depreciation) to the extent that the carrying value exceeds the estimated undiscounted future net revenues. Such impairments totaled $99.3 million in 1993 and there were none in 1992 and 1991. The Company provides for future abandonment and site restoration costs with respect to certain of its oil and gas properties. The Company estimates that with respect to these properties such future costs total approximately $24.7 million and such amount is being accrued over the expected life of the properties. At December 31, 1993 Accumulated Depletion, Depreciation, Amortization and Impairment includes $14.6 million with respect to such costs. The value of undeveloped acreage is aggregated and the portion of such costs estimated to be nonproductive, based on historical experience, is amortized to expense over the average holding period. Additional amortization may be recognized based upon periodic assessment of prospect evaluation results. The cost of properties determined to be productive is transferred to proved SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) properties; the cost of properties determined to be nonproductive is charged to accumulated amortization. Maintenance and repairs are expensed as incurred; major renewals and improvements are capitalized. Gains and losses arising from sales of properties are included in income currently. REVENUE RECOGNITION Revenues from the sale of petroleum produced are generally recognized upon the passage of title, net of royalties and net profits interests. Crude oil revenues include the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Crude Oil Hedging Program. Crude oil revenues also include the value of crude oil consumed in operations with an equal amount charged to operating expenses. Such amounts totalled $15.4 million in 1991, $4.8 million in 1992 and $1.2 million in 1993. Revenues from natural gas production are generally recorded using the entitlement method, net of royalties and net profits interests. Sales proceeds in excess of the Company's entitlement are included in Deferred Revenues and the Company's share of sales taken by others is included in Other Assets. At December 31, 1993 the Company's deferred revenues for sales proceeds received in excess of the Company's entitlement was $6.8 million with respect to 5.2 MMcf and the asset related to the Company's share of sales taken by others was $3.9 million with respect to 2.7 MMcf. Natural gas revenues are net of the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Program. Revenues from crude oil marketing and trading represent the gross margin resulting from such activities. Revenues from such activities are net of costs of sales of $210.5 million in 1991, $247.3 million in 1992 and $225.9 million in 1993. Revenues from natural gas systems are net of the cost of natural gas purchased and resold. Such costs totalled $43.8 million in 1992 and $49.9 million in 1993. EARNINGS PER SHARE Earnings per share are based on the weighted average number of common shares outstanding during the year. ACCOUNTS RECEIVABLE Accounts Receivable relates primarily to sales of oil and gas and amounts due from joint interest partners for expenditures made by the Company on behalf of such partners. The Company reviews the financial condition of potential purchasers and partners prior to signing sales or joint interest agreements. At December 31, 1993 and 1992 the Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $6.3 million and $5.0 million, respectively. Accounts receivable totalling $0.2 million, $1.1 million and $0.1 million were written off as uncollectible in 1991, 1992 and 1993, respectively. INVENTORIES Inventories are valued at the lower of cost (average price or first-in, first-out) or market. Crude oil inventories at December 31, 1993 and 1992 were $1.1 million and $1.5 million, respectively, and materials and supplies inventories at such dates were $7.6 million and $3.3 million, respectively. ENVIRONMENTAL EXPENDITURES Environmental expenditures relating to current operations are expensed or capitalized, as appropriate, depending on whether such expenditures provide future economic benefits. Liabilities are SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized when the expenditures are considered probable and can be reasonably estimated. Measurement of liabilities is based on currently enacted laws and regulations, existing technology and undiscounted site-specific costs. Generally, such recognition coincides with the Company's commitment to a formal plan of action. INCOME TAXES The Company follows the asset and liability approach to 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, based on a scheduling of temporary differences between the tax bases of assets and liabilities and their reported amounts. Under this method of accounting for income taxes, any future changes in income tax rates will affect deferred income tax balances and financial results. (2) CORPORATE RESTRUCTURING PROGRAM In October 1993 the Company's Board of Directors endorsed a broad corporate restructuring program that focuses on the disposition of non-core assets, the concentration of capital spending in core areas, the refinancing of certain long-term debt and the elimination of the payment of its $0.04 per share quarterly dividend on common stock. In implementing the restructuring program the Company recorded a nonrecurring charge of $38.6 million in 1993 comprised of (1) losses on property dispositions of $27.8 million: (2) long-term debt repayment penalties of $8.6 million; and (3) accruals for certain personnel benefits and related costs of $2.2 million. The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson Corporation ('Hadson'), the sale to Vintage Petroleum, Inc. of certain southern California and Gulf Coast oil and gas producing properties and the sale to Bridge Oil (U.S.A.) Inc. ('Bridge') of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage. The Company also plans to dispose of other non-core oil and gas properties during 1994. In 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. SALE TO HADSON. In December 1993 the Company completed a transaction with Hadson under the terms of which the Company sold the common stock of Adobe Gas Pipeline Company ('AGPC'), a wholly-owned subsidiary which held the Company's natural gas gathering and processing assets, to Hadson in exchange for Hadson 11.25% preferred stock with a face value of $52.0 million and 40% of Hadson's common stock. In addition, the Company signed a seven-year gas sales contract under the terms of which Hadson will market substantially all of the Company's domestic natural gas production at market prices as defined by published monthly indices for relevant production locations. The Company accounted for the sale as a non-monetary transaction and the investment in Hadson has been valued at $56.2 million, the carrying value of the Company's investment in AGPC. The Company's investment in Hadson is being accounted for on the equity basis. At December 31, 1993 the Company's investment in Hadson's common stock exceeded the net book value attributable to such common shares by approximately $11.3 million. The Company's income from operations for 1993 includes $1.6 million attributable to the assets sold to Hadson. SALE TO VINTAGE. In November 1993 the Company completed the sale of certain southern California and Gulf Coast producing properties for net proceeds totalling $41.3 million in cash, $31.5 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) million of which was collected in 1993. The Company's income from operations for 1993 includes $2.7 million attributable to the assets sold to Vintage. SALE TO BRIDGE. In December 1993 the Company signed a Purchase and Sales Agreement with Bridge under the terms of which Bridge will purchase certain Mid-Continent and Rocky Mountain producing and nonproducing oil and gas properties. The sale price of $51.0 million, subject to certain adjustments, will be received by the Company either in the form of cash plus 10% of the outstanding shares of Bridge, following the contemplated public offering of that stock in the first quarter of 1994, or entirely in cash. The transaction is expected to close in the second quarter of 1994. The net book value of these assets is included in Assets Held for Sale at December 31, 1993. The Company's income from operations for 1993 includes $5.8 million attributable to the assets to be sold to Bridge. OTHER DISPOSITIONS. The Company has identified certain other oil and gas properties which it plans to dispose of in 1994. The estimated realizable value of these properties, $1.0 million, is included in Assets Held for Sale at December 31, 1993. In the first quarter of 1994 the Company sold its interest in certain other oil and gas properties for $8.3 million. (3) MERGER WITH ADOBE RESOURCES CORPORATION On May 19, 1992 Adobe Resources Corporation ('Adobe'), an oil and gas exploration and production company, was merged with and into Santa Fe (the 'Merger'). The acquisition has been accounted for as a purchase and the results of operations of the properties acquired (the 'Adobe Properties') are included in Santa Fe's results of operations effective June 1, 1992. To consummate the Merger, the Company issued 24.9 million shares of common stock valued at $205.5 million, 5.0 million shares of convertible preferred stock valued at $80.0 million, assumed long-term bank debt and other liabilities of $140.0 million and $35.0 million, respectively, and incurred $13.8 million in related costs. The Company also recorded a $19.7 million deferred tax liability with respect to the difference between the book and tax basis in the assets acquired. Certain merger-related costs incurred by Adobe and paid by Santa Fe totaling $10.9 million were charged to income in the second quarter of 1992. The Merger constituted a 'change of control' as defined in certain of the Company's employee benefit plans and employment agreements (see Notes 10 and 12). In a separate transaction in January 1992, the Company purchased three producing properties from Adobe for $14.2 million. (4) SANTA FE ENERGY TRUST In November 1992 5,725,000 Depository Units ('Trust Units'), each consisting of beneficial ownership of one unit of undivided beneficial interest in the Santa Fe Energy Trust (the 'Trust') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering. The Trust consists of certain oil and gas properties conveyed by Santa Fe. A total of $114.5 million was received from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Trust Units. A portion of the proceeds received by the Company was used to retire $30.0 million of the debt incurred in connection with the Merger and the remainder will be used for general corporate purposes including possible acquisitions. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments to the extent that it needs such payments to distribute $0.40 per SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Depository Unit per quarter. The source of such additional royalty payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. If such additional payments are made, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such additional payments. The aggregate amount of the additional royalty payments (net of any amounts recouped) will be limited to $20.0 million on a revolving basis. At December 31, 1993 the Company held 575,000 Trust Units. At December 31, 1993 Accounts Receivable includes $0.2 million due from the Trust and Accounts Payable includes $1.9 million due to the Trust. In the first quarter of 1994 the Company sold the Trust Units for $11.3 million, the Company's investment in the Trust Units, $10.4 million, is included in Assets Held for Sale at December 31, 1993. (5) ACQUISITIONS OF OIL AND GAS PROPERTIES In January 1991 the Company completed the purchase of Mission Operating Partnership, L.P.'s ('Mission') interest in certain oil and gas properties, effective from November 1, 1990, for approximately $55.0 million. The Company formed a partnership, with an institutional investor as a limited partner, to acquire and operate the properties. The investor contributed $27.5 million for a 50% interest in the partnership, which will be reduced to 15% upon the occurence of payout. Payout will occur when the investor has received distributions from the partnership totalling an amount equal to its original contribution plus a 12% rate of return on such contribution. Prior to payout, the Company will bear 100% of the capital expenditures of the partnership. Under the terms of the partnership agreement a total of $36.8 million must be expended on development of the property by the year 2000, $12.4 million of which had been expended through the end of 1993. The Company funded $16.8 million of its share of the purchase of the properties with the assumption of a term loan and paid the remainder from working capital. The Company has given the lender the equivalent of an overriding royalty interest in certain production from the properties. The royalty is payable only if such production occurs and is limited to a maximum of $3.0 million. In June 1991 the Company acquired a 10% interest in a producing field in Argentina for approximately $18.3 million and in October 1991 purchased an additional 8% interest in the field for approximately $15.7 million. The Company financed $17.8 million of the total purchase price with loans from an Argentine bank. The Company has agreed to spend approximately $16.7 million over a five-year period on development and maintenance of the field. (6) CASH FLOWS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The Merger included certain non-cash investing and financing activities not reflected in the Statement of Cash Flows as follows (in millions of dollars): Common stock issued------------------ 205.5 Convertible preferred stock issued------------------------------- 80.0 Deferred tax liability--------------- 19.7 Long-term debt----------------------- 140.0 Assets acquired, other than cash, net of liabilities assumed------------- (457.1) Cash paid---------------------------- (11.9) In 1991, the Company sold a producing property for $0.9 million in cash and a note receivable for $1.2 million. In 1991, the Partnership purchased certain surface properties for $6.2 million, SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $5.5 million of which was funded by the issuance of promissory notes and the Company also purchased producing properties for $63.1 million, $34.6 million of which was funded with debt (see Notes 5 and 7). The Company made interest payments of $45.5 million, $49.0 million and $48.0 million in 1991, 1992 and 1993, respectively. In 1991, 1992 and 1993, the Company made tax payments of $18.4 million, $4.4 million and $5.0 million, respectively, and in 1993 received refunds of $4.1 million, primarily related to the audit of prior years' returns. (7) FINANCING AND DEBT Long-term debt at December 31, 1993 and 1992 consisted of (in millions of dollars): Crude oil and liquids and natural gas accounted for more than 95% of revenues in 1991, 1992 and 1993. The following table reflects sales revenues from crude oil purchasers who accounted for more than 10% of the Company's crude oil and liquids revenues (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Texaco Trading and Transportation, Inc-------------------------------- -- 46.8 55.9 Celeron Corporation------------------ 56.8 56.3 45.6 Shell Oil Company-------------------- 86.3 -- -- None of the Company's purchasers of natural gas accounted for more than 10% of revenues in 1991, 1992 or 1993. The Company does not believe the loss of any purchaser would have a material adverse effect on its financial position since the Company believes alternative sales arrangements could be made on relatively comparable terms. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) CONVERTIBLE PREFERRED STOCK The convertible preferred stock issued in connection with the Merger is non-voting and entitled to receive cumulative cash dividends at an annual rate equivalent to $1.40 per share. The holders of the convertible preferred shares may, at their option, convert any or all such shares into 1.3913 shares of the Company's common stock. The Company may, at any time after the fifth anniversary of the effective date of the Merger and upon the occurrence of a 'Special Conversion Event', convert all outstanding shares of convertible preferred stock into common stock at the initial conversion rate of 1.3913 shares of common stock, subject to certain adjustments, plus additional shares in respect to accrued and unpaid dividends. A Special Conversion Event is deemed to have occurred when the average daily closing price for a share of the Company's common stock for 20 of 30 consecutive trading days equals or exceeds 125% of the quotient of $20.00 divided by the then applicable conversion rate (approximately $18.00 per share at a conversion rate of 1.3913). Upon the occurrence of the 'First Ownership Change' of Santa Fe, each holder of shares of convertible preferred stock shall have the right, at the holder's option, to elect to have all of such holder's shares redeemed for $20.00 per share plus accrued and unpaid interest and dividends. The First Ownership Change shall be deemed to have occurred when any person or group, together with any affiliates or associates, becomes the beneficial owner of 50% or more of the outstanding common stock of Santa Fe. (10) SHAREHOLDERS' EQUITY COMMON STOCK In 1991, 1992 and 1993 the Company issued 1.1 million previously unissued shares of common stock in connection with certain employee benefit and compensation plans. Also in 1992, the Company issued 24.9 million previously unissued shares of common stock in connection with the Merger. The Company declared dividends to common shares of $0.16 per share in 1991 and 1992 and $0.12 per share in 1993. PREFERRED STOCK The Board of Directors of the Company is empowered, without approval of the shareholders, to cause shares of preferred stock to be issued in one or more series, and to determine the number of shares in each series and the rights, preferences and limitations of each series. Among the specific matters which may be determined by the Board of Directors are: the annual rate of dividends; the redemption price, if any; the terms of a sinking or purchase fund, if any; the amount payable in the event of any voluntary liquidation, dissolution or winding up of the affairs of the Company; conversion rights, if any; and voting powers, if any. ACCUMULATED DEFICIT At December 31, 1993 Accumulated Deficit included dividends in excess of retained earnings of $89.8 million. 1990 INCENTIVE STOCK COMPENSATION PLAN The Company has adopted the Santa Fe Energy Resources 1990 Incentive Stock Compensation Plan (the 'Plan') under the terms of which the Company may grant options and awards with respect to no more than 5,000,000 shares of common stock to officers and key employees. Options granted in 1991 and prior are fully vested and expire in 2000. Options granted in 1992 have a ten year term and vest as to 33.33 percent one year after grant, as to a cumulative 66.67 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) percent two years after grant and as to the entire amount three years after grant. The options granted in 1993 have a ten year term and vest as to 50 percent 5 years after grant, as to a cumulative 75 percent 6 years after grant and as to the entire amount 7 years after grant. The options are exercisable on an accelerated basis beginning one year and ending three years after grant in certain circumstances. If the market value per share of the Company's common stock (sustained in all events for at least 60 days) exceeds $15, 25 percent of the options shall become exercisable; in the event the market value per share exceeds $20, 50 percent of the options shall become exercisable; and in the event the market value exceeds $25, 100 percent shall become exercisable. Unexercised options would be forfeited in the event of voluntary or involuntary termination. Vested options are exercisable for a period of one year following termination due to death, disability or retirement. In the event of termination by the Company for any reason there is no prorata vesting of unvested options. The following table reflects activity with respect to Non-Qualified Stock Options during 1991 through 1993: OPTION OPTIONS PRICE OUTSTANDING PER SHARE Outstanding at December 31, 1990----- 1,803,923 $14.4375 to $24.24 Grants------------------------------- 4,500 $14.625 Cancellations------------------------ (45,332) $14.4375 to $24.24 Outstanding at December 31, 1991----- 1,763,091 $14.4375 to $24.24 Grants------------------------------- 1,099,000 $ 9.5625 Cancellations------------------------ (50,163) $14.4375 to $24.24 Outstanding at December 31, 1992----- 2,811,928 $ 9.5625 to $24.24 Grants------------------------------- 800,000 $ 9.5625 Cancellations------------------------ (95,398) $ 9.5625 to $24.24 Exercises---------------------------- (6,945) $ 9.5625 Outstanding at December 31, 1993----- 3,509,585 $ 9.5625 to $24.24 At December 31, 1993 options on 780,790 shares were available for future grants. A 'Phantom Unit' is the right to receive a cash payment in an amount equal to the average trading price of the shares of common stock at the time the award becomes payable. Awards are made for a specified period and are dependent upon continued employment and the achievement of performance objectives established by the Company. In December 1990 the Company awarded 211,362 Phantom Units and in December 1991 313,262 shares of restricted stock were issued in exchange for such units. Compensation expense is recognized over the period the awards are earned based on the market price of the restricted stock on the date it was issued ($8.00 per share). During 1990 and 1991 $0.2 million and $0.8 million, respectively, were charged to expense with respect to such awards. The unamortized portion of the award at December 31, 1991 ($1.4 million) was reflected in Shareholders' Equity. The consummation of the Merger resulted in a 'change of control' as defined in the Plan and resulted in the vesting of the awards and $1.4 million in compensation expense was recognized in 1992. In 1993 the Company issued 6,432 shares of restricted stock to certain employees and 118,039 common shares in accordance with the terms of certain other employee compensation plans. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (11) PENSION AND OTHER EMPLOYEE BENEFIT PLANS PENSION PLANS Prior to the Spin-Off the Company was included in certain non-contributory pension plans of SFP. The Santa Fe Pacific Corporation Retirement Plan (the 'SFP Plan') covered substantially all of the Company's officers and salaried employees who were not covered by collective bargaining agreements. The Santa Fe Pacific Corporation Supplemental Retirement Plan was an unfunded plan which provided supplementary benefits, primarily to senior management personnel. The Company adopted, effective as of the date of the Spin-Off, a defined benefit retirement plan (the 'SFER Plan') covering substantially all salaried employees not covered by collective bargaining agreements and a nonqualified supplemental retirement plan (the 'Supplemental Plan'). The Supplemental Plan will pay benefits to participants in the SFER Plan in those instances where the SFER Plan formula produces a benefit in excess of limits established by ERISA and the Tax Reform Act of 1986. Benefits payable under the SFER Plan are based on years of service and compensation during the five highest paid years of service during the ten years immediately preceding retirement. Benefits accruing to the Company's employees under the SFP Plan have been assumed by the SFER Plan. The Company's funding policy is to contribute annually not less than the minimum required by ERISA and not more than the maximum amount deductible for income tax purposes. In the fourth quarter of 1993 the Company established a new pension plan with respect to certain persons employed in foreign locations. The following table sets forth the funded status of the SFER Plan and the Supplemental Plan at December 31, 1993 and 1992 (in millions of dollars): SFER PLAN SUPPLEMENTAL PLAN 1993 1992 1993 1992 Plan assets at fair value, primarily invested in common stocks and U.S. and corporate bonds---------------- 30.2 28.9 -- -- Actuarial present value of projected benefit obligations: Accumulated benefit obligations Vested----------------------- (30.9) (24.5) (0.6) (0.5) Nonvested-------------------- (1.5) (1.4) -- -- Effect of projected future salary increases----------- (8.3) (6.4) (0.3) (0.2) Excess of projected benefit obligation over plan assets-------- (10.5) (3.4) (0.9) (0.7) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions------------------------ 6.4 0.7 0.3 0.2 Unrecognized net (asset) obligation being recognized over plan's average remaining service life----- (1.0) (1.1) 0.2 0.3 Additional minimum liability--------- -- -- (0.3) (0.3) Accrued pension liability------------ (5.1) (3.8) (0.7) (0.5) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% 7.0% 8.25% Long-term asset yield------------ 9.5% 9.5% 9.5% 9.5% Rate of increase in future compensation------------------- 5.25% 5.25% 5.25% 5.25% SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the components of pension expense for the SFER Plan and Supplemental Plan for 1993, 1992 and 1991 (in millions of dollars): The Company also sponsors a pension plan covering certain hourly-rated employees in California (the 'Hourly Plan'). The Hourly Plan provides benefits that are based on a stated amount for each year of service. The Company annually contributes amounts which are actuarially determined to provide the Hourly Plan with sufficient assets to meet future benefit payment requirements. The following table sets forth the components of pension expense for the Hourly Plan for the years 1993, 1992 and 1991 (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Service cost--------------------- 0.2 0.2 0.2 Interest cost-------------------- 0.7 0.7 0.7 Return on plan assets------------ (0.8) (0.1) (0.5) Net amortization and deferral---- 0.4 (0.4) 0.1 0.5 0.4 0.5 The following table sets forth the funded status of the Hourly Plan at December 31, 1993 and 1992 (in millions of dollars): 1993 1992 Plan assets at fair value, primarily invested in fixed-rate securities---- 7.7 7.2 Actual present value of projected benefit obligations Accumulated benefit obligations Vested----------------------- (11.2) (9.1) Nonvested-------------------- (0.4) (0.3) Excess of projected benefit obligation over plan assets-------- (3.9) (2.2) Unrecognized net (gain) loss from past experience different from that assumed and effects of changes in assumptions------------------------ 1.5 (0.3) Unrecognized prior service cost------ 0.5 0.6 Unrecognized net obligation---------- 1.5 1.6 Additional minimum liability--------- (3.5) (2.1) Accrued pension liability-------- (3.9) (2.4) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% Expected long-term rate of return on plan assets----------------- 8.5% 8.5% At December 31, 1993 the Company's additional minimum liability exceeded the total of its unrecognized prior service cost and unrecognized net obligation by $1.5 million. Accordingly, at December 31, 1993 the Company's retained earnings have been reduced by such amount, net of related taxes of $0.6 million. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides health care and life insurance benefits for substantially all employees who retire under the provisions of a Company-sponsored retirement plan and their dependents. Participation in the plans is voluntary and requires a monthly contribution by the employee. Effective January 1, 1993 the Company adopted the provisions of SFAS No. 106 -- 'Employers' Accounting for Postretirement Benefits Other Than Pensions'. The Statement requires the accrual, during the years the employee renders service, of the expected cost of providing postretirement benefits to the employee and the employee's beneficiaries and covered dependents. The following table sets forth the plan's funded status at December 31, 1993 and January 1, 1993 (in millions of dollars): DECEMBER 31, JANUARY 1, 1993 1993 Plan assets, at fair value----------- -- -- Accumulated postretirement benefit obligation Retirees--------------------------- (3.6) (3.1) Eligible active participants------- (1.2) (0.9) Other active participants---------- (1.4) (1.2) Accumulated postretirement benefit obligation in excess of plan assets----------------------------- (6.2) (5.2) Unrecognized transition obligation------------------------- 5.0 5.2 Unrecognized net loss from past experience different from that assumed and from changes in assumptions------------------------ 0.5 -- Accrued postretirement benefit cost------------------------------- (0.7) -- Assumed discount rate---------------- 7.5% 8.25% Assumed rate of compensation increase--------------------------- 5.25% 5.25% The Company's net periodic postretirement benefit cost for 1993 includes the following components (in millions of dollars): Service costs---------------------------------------- 0.3 Interest costs--------------------------------------- 0.4 Amortization of unrecognized transition obligation----------------------------------------- 0.3 1.0 In periods prior to 1993 the cost to the Company of providing health care and life insurance benefits for qualified retired employees was recognized as expenses when claims were paid. Such amounts totalled $0.4 million in 1991 and $0.3 million in 1992. Estimated costs and liabilities have been developed assuming trend rates for growth in future health care costs beginning with 10% for 1993 graded to 6% (5.5% for post age 65) by the year 2000 and remaining constant thereafter. Increasing the assumed health care cost trend rate by one percent each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $0.9 million and the aggregate of the service cost and interest cost components of the net periodic postretirement benefit cost for 1994 by $0.2 million. SAVINGS PLAN The Company has a savings plan, which became effective November 1, 1990, available to substantially all salaried employees and intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code (the '401(k) Plan'). The Company will match employee contributions for an amount up to 4% of each employee's base salary. In addition, if at the end of each SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) fiscal year the Company's performance for such year has exceeded certain predetermined criteria, each participant will receive an additional matching contribution equal to 50% of the regular matching contribution. The Company's contributions to the 401(k) Plan, which are charged to expense, totaled $1.2 million in 1991, $1.3 million in 1992 and $1.5 million in 1993. In the fourth quarter of 1993 the Company established a new savings plan with respect to certain personnel employed in foreign locations. OTHER POSTEMPLOYMENT BENEFITS In the fourth quarter of 1993 the Company adopted SFAS No. 112 -- 'Employers' Accounting for Postemployment Benefits'. The Statement requires the accrual of the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. Such benefits include salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits, job training and counseling and continuation of benefits such as health care and life insurance coverage. The adoption of SFAS No. 112 resulted in a charge to earnings of $1.8 million in 1993. (12) COMMITMENTS AND CONTINGENCIES CRUDE OIL HEDGING PROGRAM In the third quarter of 1990, the Company initiated a hedging program designed to provide a certain minimum level of cash flow from its sales of crude oil. Settlements were included in oil revenues in the period the oil is sold. In the year ended December 31, 1990 hedges resulted in a reduction in oil revenues of $10.7 million; in 1991 hedges resulted in an increase in oil revenues of $41.7 million and in 1992 hedges resulted in an increase in oil revenues of $9.7 million. The Company had no open crude oil hedging contracts during 1993. NATURAL GAS HEDGING PROGRAM In the third quarter of 1992 the Company initiated a hedging program with respect to its sales of natural gas. The Company has used various instruments whereby monthly settlements are based on the differences between the price or range of prices specified in the instruments and the settlement price of certain natural gas futures contracts quoted on the New York Mercantile Exchange. In instances where the applicable settlement price is less than the price specified in the contract, the Company receives a settlement based on the difference; in instances where the applicable settlement price is higher than the specified prices the Company pays an amount based on the difference. The instruments utilized by the Company differ from futures contracts in that there is no contractual obligation which requires or allows for the future delivery of the product. In 1992 and 1993 hedges resulted in a reduction in natural gas revenues of $0.5 million and $8.2 million, respectively. At December 31, 1993 the Company had two open natural gas hedging contracts covering approximately 1.2 Bcf during the six month period beginning March 1994. The 'approximate break-even price' (the average of the monthly settlement prices of the applicable futures contracts which would result in no settlement being due to or from the Company) with respect to such contracts is approximately $1.82 per Mcf. In addition, certain parties hold options on contracts covering approximately 4.8 Bcf during the seven month period beginning March 1994 at an approximate break even price of $1.90 per Mcf. The Company has no other outstanding natural gas hedging instruments. INDEMNITY AGREEMENT WITH SFP At the time of the Spin-Off, the Company and SFP entered into an agreement to protect SFP from federal and state income taxes, penalties and interest that would be incurred by SFP if the Spin-off were determined to be a taxable event resulting primarily from actions taken by the Company during a one-year period that ended December 4, 1991. If the Company were required to make SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) payments pursuant to the agreement, such payments could have a material adverse effect on its financial condition; however, the Company does not believe that it took any actions during such one-year period that would have such an effect on the Spin-Off. ENVIRONMENTAL REGULATION Federal, state and local laws and regulations relating to environmental quality control affect the Company in all of its oil and gas operations. The Company has been identified as one of over 250 potentially responsible parties ('PRPs') at a superfund site in Los Angeles County, California. The site was operated by a third party as a waste disposal facility from 1948 until 1983. The Environmental Protection Agency ('EPA') is requiring the PRPs to undertake remediation of the site in several phases, which include site monitoring and leachate control, gas control and final remediation. In 1989, the EPA and a group of the PRPs entered into a consent decree covering the site monitoring and leachate control phases of remediation. The Company is a member of the group that is responsible for carrying out this first phase of work, which is expected to be completed in five to eight years. The maximum liability of the group, which is joint and several for each member of the group, for the first phase is $37.0 million, of which the Company's share is expected to be approximately $2.4 million ($1.3 million after recoveries from working interest participants in the unit at which the wastes were generated) payable over the period that the phase one work is performed. The EPA and a group of PRPs of which the Company is a member have also entered into a subsequent consent decree (which has not been finally entered by the court) with respect to the second phase of work (gas control). The liability of this group has not been capped, but is estimated to be $130.0 million. The Company's share of costs of this phase, however, is expected to be approximately of the same magnitude as that of the first phase because more parties are involved in the settlement. The Company has provided for costs with respect to the first two phases, but it cannot currently estimate the cost of any subsequent phases of work or final remediation which may be required by the EPA. In 1989, Adobe received requests from the EPA for information pursuant to Section 104(e) of CERCLA with respect to the D. L. Mud and Gulf Coast Vacuum Services superfund sites located in Abbeville, Louisiana. The EPA has issued its record of decision at the Gulf Coast Site and on February 9, 1993 the EPA issued to all PRP's at the site a settlement order pursuant to Section 122 of CERCLA. Earlier, an emergency order pursuant to Section 106 of CERLA was issued on December 11, 1992, for purposes of containment due to the Louisiana rainy season. On December 15, 1993 the Company entered into a sharing agreement with other PRP'S to participate in the final remediation of the Gulf Coast site. The Company's share of the remediation is approximately $600,000 and includes its proportionate share of those PRPs who do not have the financial resources to provide their share of the work at the site. A former site owner has already conducted remedial activities at the D. L. Mud Site under a state agency agreement. The extent, if any, of any further necessary remedial activity at the D. L. Mud Site has not been finally determined. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain key employees. The initial term of each agreement expired on December 31, 1990 and, on January 1, 1991 and beginning on each January 1 thereafter, is automatically extended for one-year periods, unless by September 30 of any year the Company gives notice that the agreement will not be extended. The term of the agreements is automatically extended for 24 months following a change of control. The consummation of the Merger constituted a change of control as defined in the agreements. In the event that following a change of control employment is terminated for reasons specified in the agreements, the employee would receive: (i) a lump sum payment equal to two years' base salary; (ii) the maximum possible bonus under the terms of the Company's incentive compensation plan; SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (iii) a lapse of restrictions on any outstanding restricted stock grants and full payout of any outstanding Phantom Units; (iv) cash payment for each outstanding stock option equal to the amount by which the fair market value of the common stock exceeds the exercise price of the option; and, (v) life, disability and health benefits for a period of up to two years. In addition, payments and benefits under certain employment agreements are subject to further limitations based on certain provisions of the Internal Revenue Code. INTEREST RATE SWAPS Prior to the Merger, Adobe had entered into two interest rate swaps with a bank with notional principal amounts of $15.0 mllion and $20.0 million. Under the terms of the $20.0 million swap, which expires in April 1994, during any quarterly period at the beginning of which a floating rate specified in the agreement is less than 7.84%, the Company must pay the bank interest for such period on the principal amount at the difference between the rates. Should the floating rate be in excess of 7.84%, the bank must pay the Company interest for such period on the principal amount at the difference between the rates. For the period from the effective date of the Merger to December 31, 1992 the amount due the bank in accordance with the terms of the $20.0 million swap totalled $0.6 million and the amount due the bank in 1993 totalled $0.9 million. For the quarterly period which ends in April 1994, the amount due the bank is based on a floating rate of 3.375%. The $15.0 million swap, which expired December 31, 1992, had terms similar to the $20.0 million swap and the amount due the bank for the period subsequent to the Merger totaled $0.5 million. OPERATING LEASES The Company has noncancellable agreements with terms ranging from one to ten years to lease office space and equipment. Minimum rental payments due under the terms of these agreements are: 1994 -- $6.1 million, 1995 -- $6.0 million, 1996 -- $5.5 million, 1997 -- $5.2 million, 1998 -- $4.4 million and $4.7 million thereafter. Rental payments made under the terms of noncancellable agreements totaled $4.0 million in 1991,$4.5 million in 1992 and $5.5 million in 1993. OTHER MATTERS The Company has several long-term contracts ranging up to fifteen years for the supply and transportation of approximately 30 million cubic feet per day of natural gas. In the aggregate, these contracts involve a minimum commitment on the part of the Company of approximately $10 million per year. There are other claims and actions, including certain other environmental matters, pending against the Company. In the opinion of management, the amounts, if any, which may be awarded in connection with any of these claims and actions could be significant to the results of operations of any period but would not be material to the Company's consolidated financial position. (13) INCOME TAXES Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 -- 'Accounting for Income Taxes'. The adoption of SFAS No. 109 had no significant impact on the Company's provision for income taxes. Through the date of the Spin-Off the taxable income or loss of the Company was included in the consolidated federal income tax return filed by SFP. The Company has filed separate consolidated federal income tax returns for periods subsequent to the Spin-Off. The consolidated federal income tax returns of SFP have been examined through 1988 and all years prior to 1981 are closed. Issues relating to the years 1981 through 1985 are being contested through various stages of administrative appeal. The Company is evaluating its position with respect to issues raised in a 1986 through 1988 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) audit. The Company believes adequate provision has been made for any adjustments which might be assessed for all open years. During 1989, the Company received a notice of deficiency for certain state franchise tax returns filed for the years 1978 through 1983 as part of the consolidated tax returns of SFP. The years subsequent to 1983 are still subject to audit. At December 31, 1993 Other Long-Term Obligations includes $20.6 million with respect to this matter. The Company intends to contest this matter. With the Merger of Adobe the Company succeeded to a net operating loss carryforward that is subject to Internal Revenue Code Section 382 limitations which annually limit taxable income that can be offset by such losses. Certain changes in the Company's shareholders may impose additional limitations as well. Losses carrying forward of $133.3 million expire beginning in 1998. At date of the Merger, Adobe had ongoing tax litigation related to a refund claim for carryback of certain net operating losses denied by the Internal Revenue Service. During 1991 Adobe successfully defended its claim in Federal District Court and prevailed again in 1992 in the United States Court of Appeals for the Fifth Circuit. The Internal Revenue Service had no further recourse to litigation and a $16.2 million refund was reflected as Income Tax Refund Receivable at December 31, 1992 and collected in 1993. Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under the following jurisdictions: 1993 1992 1991 Domestic----------------------------- (120.9) 2.7 34.8 Foreign------------------------------ (29.3) (3.6) (2.1) (150.2) (0.9) 32.7 The Company's income tax expense (benefit) for the years ended December 31, 1993, 1992 and 1991 consisted of (in millions of dollars): 1993 1992 1991 Current U.S. federal--------------------- (1.3) 3.5 11.0 State---------------------------- (1.2) 1.4 1.7 Foreign-------------------------- 1.3 1.9 -- (1.2) 6.8 12.7 Deferred U.S. federal--------------------- (65.6) (3.5) 0.2 U.S. federal tax rate change----- 2.6 -- -- State---------------------------- (8.0) (2.5) 1.3 Foreign-------------------------- (0.9) (0.3) -- (71.9) (6.3) 1.5 (73.1) 0.5 14.2 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's deferred income tax liabilities (assets) at December 31, 1993 and 1992 are composed of the following differences between financial and tax reporting (in millions of dollars): 1993 1992 Capitalized costs and write-offs----- 83.0 150.8 Differences in Partnership basis----- 15.1 29.3 State deferred liability------------- 5.8 13.4 Foreign deferred liability----------- 13.7 15.5 Gross deferred liabilities----------- 117.6 209.0 Accruals not currently deductible for tax purposes----------------------- (17.7) (28.3) Alternative minimum tax carryforwards---------------------- (8.3) (5.3) Net operating loss carryforwards----- (46.7) (56.4) Other-------------------------------- (0.5) -- Gross deferred assets---------------- (73.2) (90.0) Deferred tax liability--------------- 44.4 119.0 The Company had no deferred tax asset valuation allowance at December 31, 1993 or 1992. A reconciliation of the Company's U.S. income tax expense (benefit) computed by applying the statutory U.S. federal income tax rate to the Company's income (loss) before income taxes for the years ended December 31, 1993, 1992 and 1991 is presented in the following table (in millions of dollars): 1993 1992 1991 U.S. federal income taxes (benefit) at statutory rate------------------ (52.6) (0.3) 11.1 Increase (reduction) resulting from: State income taxes, net of federal effect--------------------------- (1.0) 1.4 2.2 Foreign income taxes in excess of U.S. rate------------------------ (0.8) 0.3 -- Nondeductible amounts-------------- (0.2) (2.4) -- Effect of increase in statutory rate on deferred taxes----------- 2.6 -- -- Federal audit refund--------------- (3.2) -- -- Amendment to tax sharing agreement with SFP------------------------- (1.2) -- -- Benefit of tax losses-------------- (11.2) -- -- Prior period adjustments----------- (5.5) -- -- Other------------------------------ -- 1.5 0.9 (73.1) 0.5 14.2 The Company increased its deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34% to 35% commencing in 1993. (14) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 'Disclosure About Fair Value of Financial Instruments' requires the disclosure, to the extent practicable, of the fair value of financial instruments which are recognized or unrecognized in the balance sheet. The fair value of the financial instruments disclosed herein is not representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences, if any, of realization or settlement. The following table reflects the financial SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) instruments for which the fair value differs from the carrying amount of such financial instrument in the Company's December 31, 1993 and 1992 balance sheets (in millions of dollars): The fair value of the Trust Units and convertible preferred stock is based on market prices. The fair value of the Company's fixed-rate long-term debt is based on current borrowing rates available for financings with similar terms and maturities. With respect to the Company's floating-rate debt, the carrying amount approximates fair value. The fair value of the interest rate swap represents the estimated cost to the Company over the remaining life of the contract. At December 31, 1993 the Company had two open natural gas hedging contracts and options outstanding on five additional contracts (see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Contracts). Based on the settlement prices of certain natural gas futures contracts as quoted on the New York Mercantile Exchange on December 30, 1993, assuming all options are exercised, the cost to the Company with respect to such contracts during 1994 would be approximately $0.6 million. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES AND RELATED FINANCIAL DATA Information with respect to the Company's oil and gas producing activities is presented in the following tables. Reserve quantities as well as certain information regarding future production and discounted cash flows were determined by independent petroleum consultants, Ryder Scott Company. OIL AND GAS RESERVES The following table sets forth the Company's net proved oil and gas reserves at December 31, 1990, 1991, 1992 and 1993 and the changes in net proved oil and gas reserves for the years ended December 31, 1991, 1992 and 1993. Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. Indonesian reserves represent an entitlement to gross reserves in accordance with a production sharing contract. These reserves include estimated quantities allocable to the Company for recovery of operating costs as well as quantities related to the Company's net equity share after recovery of costs. Accordingly, these quantities are subject to fluctuations with an inverse relationship to the price of oil. If oil prices increase, the reserve quantities attributable to the recovery of operating costs decline. Although this reduction would be offset partially by an increase in the net equity share, the overall effect would be a reduction of reserves attributable to the Company. At December 31, 1993, the quantities include 0.6 million barrels which the Company is contractually obligated to sell for $.20 per barrel. At December 31, 1993 the Company's reserves were 6.9 million barrels of crude oil and liquids and 14.5 Bcf of natural gas lower than at December 31, 1992, reflecting the sale in 1993 of properties with reserves totalling 8.7 million barrels of crude oil and liquids and 47.4 Bcf of natural gas. At December 31, 1993, 1.9 million barrels of crude oil reserves and 19.7 billion cubic feet of natural gas reserves were subject to a 90% net profits interest held by Santa Fe Energy Trust. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Company's proved oil and gas reserves at December 31, 1991, 1992 and 1993 are presented in the following table (in millions of dollars, except as noted): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) The following tables sets forth the changes in the present value of estimated future net cash flows from proved reserves during 1991, 1992 and 1993 (in millions of dollars): Estimated future cash flows represent an estimate of future net cash flows from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as general corporate overhead or interest expense. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. Income tax expense is computed based on applying the appropriate statutory tax rate to the excess of future cash inflows less future production and development costs over the current tax basis of the properties involved. While applicable investment tax credits and other permanent differences are considered in computing taxes, no recognition is given to tax benefits applicable to future exploration costs or the activities of the Company that are unrelated to oil and gas producing activities. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at year-end and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES The following table includes all costs incurred, whether capitalized or charged to expense at the time incurred (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) CAPITALIZED COSTS RELATED TO OIL AND GAS PRODUCING ACTIVITIES The following table sets forth information concerning capitalized costs at December 31, 1993 and 1992 related to the Company's oil and gas operations (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING ACTIVITIES The following table sets forth the Company's results of operations from oil and gas producing activities for the years ended December 31, 1993, 1992 and 1991 (in millions of dollars): Income taxes are computed by applying the appropriate statutory rate to the results of operations before income taxes. Applicable tax credits and allowances related to oil and gas producing activities have been taken into account in computing income tax expenses. No deduction has been made for indirect cost such as corporate overhead or interest expense. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) 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. SANTA FE ENERGY RESOURCES, INC. By /s/ MICHAEL J. ROSINSKI MICHAEL J. ROSINSKI VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) Dated: March 22, 1994 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. SIGNATURE AND TITLE JAMES L. PAYNE, Chairman of the Board, President and Chief Executive Officer and Director (PRINCIPAL EXECUTIVE OFFICER) MICHAEL J. ROSINSKI, Vice President and Chief Financial Officer (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) DIRECTORS Rod F. Dammeyer William E. Greehey Melvyn N. Klein Robert D. Krebs Allan V. Martini Michael A. Morphy Reuben F. Richards By: /s/ MICHAEL J. ROSINSKI David M. Schulte MICHAEL J. ROSINSKI Marc J. Shapiro VICE PRESIDENT AND Robert F. Vagt CHIEF FINANCIAL OFFICER Kathryn D. Wriston ATTORNEY IN FACT Dated: March 22, 1994 SANTA FE ENERGY RESOURCES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) 1993 1992 1991 Accounts receivable Balance at the beginning of period------------------------- 5.0 2.6 2.8 Charge (credit) to income---- -- -- -- Net amounts written off------ (0.1 ) (1.1 ) (.2 ) Other(a)--------------------- 1.4 3.5 -- Balance at the end of period----- 6.3 5.0 2.6 (a) Represents valuation accounts related to accounts receivable acquired in merger with Adobe Resources Corporation. SANTA FE ENERGY RESOURCES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Maintenance and repairs-------------- 27.1 25.0 22.6 Taxes (other than income) Ad valorem----------------------- 12.0 11.4 17.0 Production and severance--------- 9.5 8.2 6.8 Payroll and other---------------- 5.8 4.7 3.4 27.3 24.3 27.2 INDEX OF EXHIBITS A. EXHIBITS B. REPORTS ON FORM 8-K. DATE ITEM February 8, 1994 5 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the year ended December 31, 1993 the Company reported a loss to common shares of $84.1 million, or $0.94 per share. The loss for the year includes a $99.3 million charge for the impairment of oil and gas properties (see ' -- Results of Operations') and a $38.6 million restructuring charge (see Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program'). The restructuring charge is comprised of losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals for certain personnel benefits and related costs of $2.2 million. At December 31, 1993 the Company's long-term debt totalled $449.7 million, a portion of which the Company intends to refinance to reduce required debt amortization in the near-term and provide additional financial flexibility in the current low oil price environment. GENERAL As an independent oil and gas producer, the Company's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of finding and producing such resources. A substantial portion of the Company's crude oil production is from long-lived fields where EOR methods are being utilized. The market price of the heavy (i.e., low gravity, high viscosity) and sour (i.e., high sulfur content) crude oils produced in these fields is lower than sweeter, light (i.e., low sulfur and low viscosity) crude oils, reflecting higher transportation and refining costs. The lower price received for the Company's domestic heavy and sour crude oil is reflected in the average sales price of the Company's domestic crude oil and liquids (excluding the effect of hedging transactions) for 1993 of $12.70 per barrel, compared to $16.94 per barrel for West Texas Intermediate crude oil (an industry posted price generally indicative of spot prices for sweeter light crude oil). In addition, the lifting costs of heavy crude oils are generally higher than the lifting costs of light crude oils. As a result of these narrower margins, even relatively modest changes in crude oil prices may significantly affect the Company's revenues, results of operations, cash flows and proved reserves. In addition, prolonged periods of high or low oil prices may have a material effect on the Company's financial position. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC, the Middle East and other producing countries. (See Items 1 and 2, "Business and Properties -- Current Markets for Oil and Gas"). The period since mid-1990 has included some of the largest fluctuations in oil prices in recent times, primarily due to the political unrest in the Middle East. The actual average sales price (unhedged) received by the Company ranged from a high of $23.92 per barrel in the fourth quarter of 1990 to a low of $9.83 per barrel for the two months ended February 28, 1994. The Company's average sales price for its 1993 oil production was $12.93 per barrel. Based on operating results of 1993, the Company estimates that a $1.00 per barrel increase or decrease in average sales prices would have resulted in a corresponding $21.6 million change in 1993 income from operations and a $16.2 million change in 1993 cash flow from operating activities. The Company also estimates that a $0.10 per Mcf increase or decrease in average sales prices would have resulted in a corresponding $5.8 million change in 1993 income from operations and a $4.4 million change in 1993 cash flow from operating activities. The foregoing estimates do not give effect to changes in any other factors, such as the effect of the Company's hedging program or depreciation and depletion, that would result from a change in oil and natural gas prices. In the third quarter of 1990 the Company initiated a hedging program with respect to its sales of crude oil and in the third quarter of 1992 a similar program was initiated with respect to the Company's sales of natural gas. See Items 1 and 2. 'Business and Properties -- Current Markets for Oil and Gas.' During 1992 and 1993, certain significant events occurred which affect the comparability of prior periods, including the merger of Adobe with and into the Company in May 1992, the formation of the Santa Fe Energy Trust in November 1992 and implementation of the corporate restructuring program adopted in October 1993. The corporate restructuring program includes (i) the concentration of capital spending in the Company's core operating areas, (ii) the disposition of non-core assets, (iii) the elimination of the $0.04 per share quarterly Common Stock dividend and (iv) the recognition of $38.6 million of restructuring charges. See Note 2 to the Consolidated Financial Statements and Items 1 and 2, 'Business and Properties -- Corporate Restructuring Program.' In addition, the Company's results of operations for 1993 include a charge of $99.3 million for the impairment of oil and gas properties. The Company's capital program will be concentrated in three domestic core areas -- the Permian Basin in Texas and New Mexico, the offshore Gulf of Mexico and the San Joaquin Valley of California -- as well as its productive areas in Argentina and Indonesia. The domestic program includes development activities in the Delaware and Cisco-Canyon formations in west Texas and southeast New Mexico, a development drilling program for the offshore Gulf of Mexico natural gas properties and relatively low risk infill drilling in the San Joaquin Valley of California. Internationally, the program includes development of the Company's Sierra Chata discovery in Argentina with gas sales expected to commence in early 1995 and the Salawati Basin Joint Venture in Indonesia. See Items 1 and 2. 'Business and Properties -- Domestic Development Activities' and '--International Development Activities.' The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson (completed in December 1993), the sale to Vintage of certain southern California and Gulf Coast oil and gas producing properties (completed in November 1993) and the sale to Bridge of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage (expected to be completed during April 1994). See Items 1 and 2. 'Business and Properties -- Corporate Restructuring Program' for a description of the transactions with Hadson, Vintage and Bridge. In the first quarter of 1994, the Company sold the remaining 575,000 Depositary Units which it held in Santa Fe Energy Trust (the 'Trust') for $11.3 million and its interest in certain other oil and gas properties for $8.3 million. As a result of the Vintage and Bridge dispositions, the Company has sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and estimated proved reserves of approximately 16.7 MMBOE. The restructuring program also includes an evaluation of the Company's capital and cost structures to examine ways to increase flexibility and strengthen the Company's financial performance. In this respect, in 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. In May, 1992, Adobe, an oil and gas exploration and production company, was merged with and into the Company. The acquisition was accounted for as a purchase and the results of operations of the properties acquired are included in the Company's results of operations effective June 1, 1992. Pursuant to the Adobe Merger, the Company issued 5,000,000 shares of its convertible preferred stock and assumed approximately $175.0 million of long-term debt and other liabilities. Pursuant to the Adobe Merger, the Company also acquired Adobe's proved reserves and inventory of undeveloped acreage. As of December 31, 1991, Adobe's estimated proved reserves totaled approximately 53.2 MMBOE (net of 6.9 MMBOE attributable to Adobe's ownership in certain gas plants), of which approximately 58% was natural gas (approximately 66% of Adobe's estimated domestic proved reserves were natural gas). Approximately 72% of the discounted future net cash flow of Adobe's estimated domestic proved reserves was concentrated in three areas of operation -- offshore Gulf of Mexico, onshore Louisiana and in the Spraberry Trend in west Texas. In addition, Adobe's international operations consisted of certain production sharing arrangements in Indonesia, in respect of which approximately 6.0 MMBOE of estimated proved reserves had been attributed to Adobe's interest as of December 31, 1991. The location of the Adobe Properties enhanced the Company's existing domestic operations and added significant operations to the Company's international program. In November 1992, 5,725,000 Depositary Units consisting of interests in the Trust were sold in a public offering. After payment of certain costs and expenses, the Company received $70.1 million and 575,000 Depositary Units. For any calendar quarter ending on or prior to December 21, 2002, the Trust will receive additional royalty payments to the extent necessary to distribute $0.40 per Depositary Unit per quarter. The source of such payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. The aggregate amount of such payments will be limited to $20.0 million on a revolving basis. The Company was required to make an additional royalty payment of $362,000 with respect to the distribution made by the Trust for operations during the quarter ended December 31, 1993. Based upon current prices, the Company believes that a support payment will be required for the quarter ending March 31, 1994, the amount of which has not been determined. See Items 1 and 2. 'Business and Properties -- Santa Fe Energy Trust.' RESULTS OF OPERATIONS The following table sets forth, on the basis of the BOE produced by the Company during the applicable annual period, certain of the Companys costs and expenses for each of the three years ended December 31, 1993. 1993 1992 1991 Production and operating costs per BOE (a)------------------------------ $ 4.76 $ 5.02 $ 5.17 Exploration, including dry hole costs per BOE---------------------------- 0.90 0.84 0.72 Depletion, depreciation and amortization per BOE--------------- 4.44 4.79 4.09 General and administrative costs per BOE-------------------------------- 0.94 1.01 1.07 Taxes other than income per BOE (b)-------------------------------- 0.79 0.80 1.05 Interest, net, per BOE (c)----------- 0.94 1.58 1.43 (a) Excluding related production, severance and ad valorem taxes. (b) Includes production, severance and ad valorem taxes. (c) Reflects interest expense less amounts capitalized and interest income. 1993 COMPARED WITH 1992 Total revenues increased approximately 2% from $427.5 million in 1992 to $436.9 million in 1993 principally due to an increase in oil and natural gas production offset by a decline in average oil prices. Average daily oil production increased 7% from 62.5 MBbls in 1992 to 66.7 MBbls in 1993, principally due to increased domestic and Indonesian production. The average price realized per Bbl of oil during 1993 was $12.93, a decrease of 14% versus the average price of $14.96 in 1992. Natural gas production increased 31% from 126.3 MMcf per day in 1992 to 165.4 MMcf per day in 1993, primarily reflecting the effect of a full year's production from the Adobe Properties. Average natural gas prices realized increased approximately 11% from $1.70 per Mcf in 1992 to $1.89 per Mcf in 1993. Production and operating costs increased $10.4 million in 1993, primarily reflecting the effect of a full year's costs for the Adobe Properties; however, on a BOE basis such costs declined from $5.02 per barrel in 1992 to $4.76 per barrel in 1993. Exploration costs were $5.5 million higher than in 1992 primarily reflecting higher geological and geophysical costs and higher dry hole costs. Depletion, depreciation and amortization ('DD&A') increased $6.4 million in 1993 primarily reflecting a full year's expense on Adobe Properties partially offset by reduced amortization rates with respect to certain unproved properties. DD&A for 1993 includes $12.1 million with respect to the properties sold to Vintage and Bridge. On a BOE basis, DD&A decreased by $0.35 per Bbl, from $4.79 to $4.44 per Bbl. General and administrative costs increased $1.4 million principally due to a $1.8 million charge related to the adoption of Statement of Financial Standards No. 112 -- 'Employer's Accounting for Postemployment Benefits'. Taxes (other than income) increased by $3.0 million in 1993 primarily reflecting the effect of the Adobe Properties. Costs and expenses for 1993 also include $99.3 million in impairments of oil and gas properties and $38.6 million in restructuring charges. The Company estimates the impairments taken in 1993 will result in a reduction of DD&A in 1994 of approximately $20.0 million. The restructuring charges include losses on property dispositions of $27.8 million, long-term debt repayment penalties of $8.6 million and accruals of certain personnel benefits and related costs of $2.2 million. In connection with the property dispositions effected during 1993 (See '-- Liquidity and Capital Resources'), the Company sold properties having combined production during 1993 of 4.1 MBbls per day of oil and 21.7 MMcf per day of natural gas and combined estimated proved reserves of approximately 16.7 MMBOE. The Company's income from operations for 1993 includes $8.5 million with respect to such operations. Interest income in 1993 includes $6.8 million related to a $10 million refund received as a result of the completion of the audit of the Company's federal income tax returns for 1971 through 1980. The decrease in interest expenses during 1993 reflects a decrease in the Company's debt outstanding and a $5.7 million credit related to a revision to a tax sharing agreement with the Company's former parent. Other income and expenses of 1993 includes a $4.0 million charge related to the accrual of a contingent loss with respect to the operations of a former affiliate of Adobe. 1992 COMPARED WITH 1991 Total revenues increased approximately 13% from $379.8 million in 1991 to $427.5 million in 1992 principally due to an increase of approximately $53.2 million attributable to production from properties acquired in the Adobe Merger and an increase of approximately $10.7 million and $10.2 million in revenues from the Company's domestic and Argentine properties, respectively, offset in part by a decline of $32.0 million in crude oil hedging revenues. Oil production increased 13% from 55.5 MBbls per day in 1991 to 62.5 MBbls per day in 1992, reflecting a 3.4 MBbl per day increase in domestic oil production and a 3.6 MBbl per day increase in production in Argentina and Indonesia. The average price realized per barrel of oil during 1992 decreased to $14.96, a decrease of 7% versus the average price of $16.16 in 1991, primarily reflecting a $32.0 million decrease in hedging revenues. Natural gas production increased 33% from 95.2 MMcf per day in 1991 to 126.3 MMcf per day in 1992 as a result of properties acquired in the Adobe Merger. Average natural gas prices realized increased approximately 14% from $1.49 per Mcf in 1991 to $1.70 per Mcf in 1992. Total operating expenses of the Company increased $54.6 million from $315.4 million in 1991 to $370.0 million in 1992 primarily reflecting costs associated with the Adobe Merger. Production and operating costs in 1992 were $18.8 million higher than in 1991, primarily reflecting costs related to the Adobe Properties and increased fuel costs associated with the Company's EOR projects. On a BOE basis, production and operating costs declined from $5.17 per barrel in 1991 to $5.02 per barrel in 1992, primarily reflecting the lower cost structure of the Adobe Properties. Exploration costs were $6.8 million higher than in 1991 primarily reflecting higher geological and geophysical costs with respect to foreign projects. Depletion, depreciation and amortization costs were $39.7 million higher in 1992 due to the acquisition of the Adobe Properties and, to a lesser extent, adjustments to oil and gas reserves with respect to certain producing properties. General and administrative costs increased $3.1 million principally due to a $1.2 million charge related to certain stock awards which fully vested upon consummation of the Adobe Merger and certain other merger-related costs. Taxes (other than income) decreased by $2.9 million in 1992, as a result of lower accruals with respect to property taxes. The $13.6 million gain on the disposition of properties in 1992 primarily relates to the sale of certain royalty interest properties, in which the Company had no remaining financial basis. The increase in interest expense during 1992 reflects the increase in debt as a result of the Adobe Merger. Other income and expenses for 1992 includes a $10.9 million charge for costs incurred by Adobe in connection with the Adobe Merger and paid by Santa Fe. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has generally funded capital and exploration expenditures and working capital requirements from cash provided by operating activities. Depending upon the future levels of operating cash flows, which are significantly affected by oil and gas prices, the restrictions on additional borrowings included in certain of the Company's debt agreements, together with debt service requirements and dividends, may limit the cash available for future exploration, development and acquisition activities. Net cash provided by operating activities totaled $160.2 million in 1993, $141.5 million in 1992 and $128.4 million in 1991; net cash used in investing activities in such periods totaled $121.4 million, $15.9 million and $117.2 million, respectively. The Company's cash flow from operating activities is a function of the volumes of oil and gas produced from the Company's properties and the sales prices realized therefor. Crude oil and natural gas are depleting assets. Unless the Company replaces over the long term the oil and natural gas produced from the Company's properties, the Company's assets will be depleted over time and its ability to service and incur debt at constant or declining prices will be reduced. The Company's cash flow from operations for 1993 reflects an average sales price (unhedged) for the Company's 1993 oil production of $12.93 per barrel. For the two months ended February 28, 1994, the average sales price (unhedged) for the Company's 1994 oil production was $9.83 per barrel. If such lower oil prices prevail throughout 1994, the Company's cash flow from operating activities for 1994 will be significantly lower than that for 1993. In October 1993, the Company's Board of Directors adopted a broad corporate restructuring program that focuses on the concentration of capital spending in core areas and the disposition of non-core assets. The Company's asset disposition program adopted in connection with the 1993 restructuring program has been substantially completed by the asset sales to Hadson, Vintage and Bridge (expected to close in April 1994), the sale of the 575,000 Depositary Units in the Trust and the sale of its interest in certain other oil and gas properties. As a result of such sales, the Company sold a total of 16.7 MMBOE of proved reserves and undeveloped acreage for a total of approximately $111.0 million, and sold certain gas gathering and processing facilities for Hadson securities. As a part of the 1993 restructuring program, the Company eliminated its $0.04 per share quarterly dividend on its Common Stock and announced that it might spend up to $240 million in 1994 on an accelerated capital program. However, as a result of the depressed crude oil prices that have prevailed since November 1993, the Company, consistent with industry practice, is considering deferring some of its capital projects in order to prudently manage its cash flow available in the near term. Based on current market conditions, the Company estimates that 1994 capital expenditures may total between $100 million and $160 million, with the actual amount to be determined by the Company based upon numerous factors outside its control, including, without limitation, prevailing oil and natural gas prices and the outlook therefor. The Company is a party to several long-term and short-term credit agreements which restrict the Company's ability to take certain actions, including covenants that restrict the Company's ability to incur additional indebtedness and to pay dividends on its capital stock. For a description of such existing credit agreements, see Note 7 to the Consolidated Financial Statements. Effective March 16, 1994, the Company entered into an Amended and Restated Revolving Credit Agreement (the "Bank Facility") which consists of a five year secured revolving credit agreement maturing December 31, 1998 ("Facility A") and and a three year unsecured revolving credit facility maturing December 31, 1996 ("Facility B"). The aggregate borrowing limits under the terms of the Bank Facility are $125.0 million (up to $90.0 million under Facility A and up to $35.0 million under Facility B). Under certain circumstances, the aggregate borrowing limits under the terms of the Bank Facility may be increased to $175.0 million (up to $90.0 million under Facility A and up to $85.0 million under Facility B). Interest rates under the Bank Facility are tied to LIBOR or the bank's prime rate with the actual interest rate reflecting certain ratios based upon the Company's ability to repay its outstanding debt and the value and projected timing of production of the Company's oil and gas reserves. These and other similar ratios will also affect the Company's ability to borrow under the Bank Facility and the timing and amount of any required repayments and corresponding commitment reductions. The Bank Facility replaces the Revolving and Term Credit Agreement discussed in Note 7 to the Consolidated Financial Statements. EFFECTS OF INFLATION Inflation during the three years ended December 31, 1993 has had little effect on the Company's capital costs and results of operations. ENVIRONMENTAL MATTERS Almost all phases of the Company's oil and gas operations are subject to stringent environmental regulation by governmental authorities. Such regulation has increased the costs of planning, designing, drilling, installing, operating and abandoning oil and gas wells and other facilities. The Company has expended significant financial and managerial resources to comply with such regulations. Although the Company believes its operations and facilities are in general compliance with applicable environmental regulations, risks of substantial costs and liabilities are inherent in oil and gas operations. It is possible that other developments, such as increasingly strict environmental laws, regulations and enforcement policies or claims for damages to property, employees, other persons and the environment resulting from the Company's operations, could result in significant costs and liabilities in the future. As it has done in the past, the Company intends to fund its cost of environmental compliance from operating cash flows. See also, Items 1 and 2. 'Business and Properties -- Other Business Matters -- Environmental Regulation' and Note 12 to the Consolidated Financial Statements. DIVIDENDS Dividends on the Company's convertible preferred stock are cumulative at an annual rate of $1.40 per share. No dividends may be declared or paid with respect to the Company's common stock if any dividends with respect to the convertible preferred stock are in arrears. As described elsewhere herein, the Company has eliminated the payment of its $0.04 per share quarterly dividend on its common stock. The determination of the amount of future cash dividends, if any, to be declared and paid on the Company's common stock is in the sole discretion of the Company's Board of Directors and will depend on dividend requirements with respect to the convertible preferred stock, the Company's financial condition, earnings and funds from operations, the level of capital and exploration expenditures, dividend restrictions in financing agreements, future business prospects and other matters the Board of Directors deems relevant. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Audited Financial Statements Report of Independent Accountants------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991--------------------- 32 Consolidated Balance Sheet -- December 31, 1993 and 1992---- 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991--------------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991---------- 35 Notes to Consolidated Financial Statements---------- 36 Unaudited Financial Information Supplemental Information to the Consolidated Financial Statements-------------------- 55 Financial Statement Schedules: Schedule V --Property, Plant and Equipment------ 65 Schedule VI --Accumulated Depreciation, Depletion and Amortization of Property Plant and Equipment---------------------- 66 Schedule --Valuation and Qualifying VIII Accounts--------------------------- 67 Schedule IX --Short Term Borrowings-------------- 68 --Supplementary Income Statement Schedule X Information------------------------ 69 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Except for the portion of Item 10 relating to Executive Officers of the Registrant which is included in Part I of this Report, the information called for by Items 10 through 13 is incorporated by reference from the Company's Notice of Annual Meeting and Proxy Statement dated March 21, 1994, which meeting involves the election of directors, in accordance with General Instruction G to the Annual Report on 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 a part of this report: PAGE 1. Financial Statements: Report of Independent Accountants--------------------------------------- 31 Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991------------ 32 Consolidated Balance Sheet -- December 31, 1993 and 1992------------------------------------------ 33 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991---------------- 34 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991------ 35 Notes to Consolidated Financial Statements------------ 36 2. Financial Statement Schedules: Schedule V -- Property, Plant and Equipment--------- 65 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment---------------- 66 Schedule VIII -- Valuation and Qualifying Accounts---- 67 Schedule IX -- Short Term Borrowings------------------ 68 Schedule X -- Supplementary Income Statement Information------------------------ 69 All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or the notes to financial statements. 3. Exhibits: See Index to Exhibits on page 70 for a description of the exhibits filed as a part of this report. (b) Reports on Form 8-K [CAPTION] DATE ITEM February 8, 1994 5 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Santa Fe Energy Resources, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 30 present fairly, in all material respects, the financial position of Santa Fe Energy Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Houston, Texas February 18, 1994 SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS (IN MILLIONS OF DOLLARS, EXCEPT PER SHARE DATA) YEAR ENDED DECEMBER 31, 1993 1992 1991 Revenues Crude oil and liquids------------ $ 307.3 $ 333.6 $ 320.3 Natural gas---------------------- 107.8 74.8 47.9 Natural gas systems-------------- 8.2 7.3 -- Crude oil marketing and trading------------------------ 9.9 5.9 7.2 Other---------------------------- 3.7 5.9 4.4 436.9 427.5 379.8 Costs and Expenses Production and operating--------- 163.8 153.4 134.6 Oil and gas systems and pipelines---------------------- 4.2 3.2 -- Exploration, including dry hole costs-------------------------- 31.0 25.5 18.7 Depletion, depreciation and amortization------------------- 152.7 146.3 106.6 Impairment of oil and gas properties--------------------- 99.3 -- -- General and administrative------- 32.3 30.9 27.8 Taxes (other than income)-------- 27.3 24.3 27.2 Restructuring charges------------ 38.6 -- -- Loss (gain) on disposition of oil and gas properties------------- 0.7 (13.6) 0.5 549.9 370.0 315.4 Income (Loss) from Operations-------- (113.0) 57.5 64.4 Interest income------------------ 9.1 2.3 2.3 Interest expense----------------- (45.8) (55.6) (47.3) Interest capitalized------------- 4.3 4.9 7.7 Other income (expense)----------- (4.8) (10.0) 5.6 Income (Loss) Before Income Taxes---- (150.2) (0.9) 32.7 Income taxes--------------------- 73.1 (0.5) (14.2) Net Income (Loss)-------------------- (77.1) (1.4) 18.5 Preferred dividend requirement------- (7.0) (4.3) -- Earnings (Loss) Attributable to Common Shares---------------------- $ (84.1) $ (5.7) $ 18.5 Earnings (Loss) Attributable to Common Shares Per Share------------ $ (0.94) $ (0.07) $ 0.29 Weighted Average Number of Shares Outstanding (in millions)---------- 89.7 79.0 63.8 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED BALANCE SHEET (IN MILLIONS OF DOLLARS) DECEMBER 31, 1993 1992 ASSETS Current Assets Cash and cash equivalents-------- $ 4.8 $ 83.8 Accounts receivable-------------- 87.4 90.0 Income tax refund receivable----- -- 16.2 Inventories---------------------- 8.7 4.8 Assets held for sale------------- 59.5 -- Other current assets------------- 12.2 10.6 172.6 205.4 Investment in Hadson Corporation----- 56.2 -- Properties and Equipment, at cost Oil and gas (on the basis of successful efforts accounting)-------------------- 2,064.3 2,330.9 Other---------------------------- 27.3 26.8 2,091.6 2,357.7 Accumulated depletion, depreciation, amortization and impairment--------------------- (1,258.9) (1,255.9) 832.7 1,101.8 Other Assets Receivable under gas balancing arrangements------------------- 3.9 7.7 Other---------------------------- 11.5 22.3 15.4 30.0 $ 1,076.9 $ 1,337.2 LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable----------------- $ 93.5 $ 90.9 Interest payable----------------- 10.2 11.0 Current portion of long-term debt--------------------------- 44.3 53.4 Other current liabilities-------- 18.1 17.1 166.1 172.4 Long-Term Debt----------------------- 405.4 492.8 Deferred Revenues-------------------- 8.6 13.0 Other Long-Term Obligations---------- 48.8 43.4 Deferred Income Taxes---------------- 44.4 119.0 Commitments and Contingencies (Note 12)-------------------------------- -- -- Convertible Preferred Stock, $0.01 par value, 5.0 million shares authorized, issued and outstanding------------------------ 80.0 80.0 Shareholders' Equity Preferred stock, $0.01 par value, 45.0 million shares authorized, none issued-------------------- -- -- Common stock, $0.01 par value, 200.0 million shares authorized--------------------- 0.9 0.9 Paid-in capital------------------ 496.9 494.3 Unamortized restricted stock awards------------------------- (0.1) (0.4) Accumulated deficit-------------- (173.8) (78.0) Foreign currency translation adjustment--------------------- (0.3) (0.2) 323.6 416.6 $ 1,076.9 $ 1,337.2 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Operating Activities: Net income (loss)---------------- $ (77.1) $ (1.4) $ 18.5 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depletion, depreciation and amortization--------------- 152.7 146.3 106.6 Impairment of oil and gas properties----------------- 99.3 -- -- Restructuring charges-------- 27.8 -- -- Deferred income taxes-------- (71.9) (6.3) 1.5 Net loss (gain) on disposition of properties----------------- 0.7 (13.6) (5.5) Exploratory dry hole costs---------------------- 8.9 4.7 3.8 Expenses related to acquisition of Adobe Resources Corporation------ -- 10.9 -- Other------------------------ 4.2 2.0 0.3 Changes in operating assets and liabilities: Decrease (increase) in accounts receivable-------- 12.4 (8.3) 23.6 Decrease (increase) in inventories---------------- (3.8) 0.3 5.6 Increase (decrease) in accounts payable----------- (2.6) 5.9 (24.9) Increase (decrease) in interest payable----------- (0.8) 0.4 0.2 Decrease in income taxes payable-------------------- (0.6) (0.4) (3.6) Net change in other assets and liabilities------------ 11.0 1.0 2.3 Net Cash Provided by Operating Activities------------------------- 160.2 141.5 128.4 Investing Activities: Capital expenditures, including exploratory dry hole costs----- (127.0) (76.8) (108.1) Acquisitions of producing properties, net of related debt--------------------------- (4.4) (14.2) (28.5) Acquisition of Adobe Resources Corporation-------------------- -- (11.9) -- Acquisition of Santa Fe Energy Partners, L.P.----------------- (28.3) -- -- Net proceeds from sales of properties--------------------- 39.9 89.1 22.1 Increase in partnership interest due to reinvestment------------ (1.6) (2.1) (2.7) Net Cash Used in Investing Activities------------------------- (121.4) (15.9) (117.2) Financing Activities: Net change in short-term debt---- -- (4.6) (4.2) Proceeds from long-term borrowings--------------------- -- 5.0 -- Principal payments on long-term borrowings--------------------- (41.5) (55.5) (16.3) Net change in revolving credit agreement---------------------- (55.0) -- -- Cash dividends paid to others---- (21.3) (14.9) (10.2) Net Cash Used in Financing Activities------------------------- (117.8) (70.0) (30.7) Net Increase (Decrease) in Cash and Cash Equivalents------------------- (79.0) 55.6 (19.5) Cash and Cash Equivalents at Beginning of Year------------------ 83.8 28.2 47.7 Cash and Cash Equivalents at End of Year------------------------------- $ 4.8 $ 83.8 $ 28.2 The accompanying notes are an integral part of these financial statements. The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements of Santa Fe Energy Resources, Inc. ('Santa Fe' or the 'Company') and its subsidiaries include the accounts of all wholly owned subsidiaries. The accounts of Santa Fe Energy Partners, L.P., (the 'Partnership') are included on a proportional basis until September 1993 when Santa Fe purchased all the Partnership's outstanding Depositary Units and undeposited LP Units other than those units held by Santa Fe and its affiliates. On September 27, 1993 the Company exercised its right under the Agreement of Limited Partnership to purchase all of the Partnership's outstanding Depositary Units and undeposited LP Units, other than those units held by the Company and its affiliates, at a redemption price of $4.9225 per unit. Consideration for the 5,749,500 outstanding units totalled $28.3 million. The acquisition of the units has been accounted for as a purchase and the results of operations of the Partnership attributable to the units acquired is included in the Company's results of operations with effect from October 1, 1993. The purchase price has been allocated primarily to oil and gas properties. References herein to the 'Company' or 'Santa Fe' relate to Santa Fe Energy Resources, Inc., individually or together with its consolidated subsidiaries; references to the 'Partnership' relate to Santa Fe Energy Partners, L.P. All significant intercompany accounts and transactions have been eliminated. Prior years' financial statements include certain reclassifications to conform to current year's presentation. OIL AND GAS OPERATIONS The Company follows the successful efforts method of accounting for its oil and gas exploration and production activities. Costs (both tangible and intangible) of productive wells and development dry holes, as well as the cost of prospective acreage, are capitalized. The costs of drilling and equipping exploratory wells which do not find proved reserves are expensed upon determination that the well does not justify commercial development. Other exploratory costs, including geological and geophysical costs and delay rentals, are charged to expense as incurred. Depletion and depreciation of proved properties are computed on an individual field basis using the unit-of-production method based upon proved oil and gas reserves attributable to the field. Certain other oil and gas properties are depreciated on a straight-line basis. Individual proved properties are reviewed periodically to determine if the carrying value of the field exceeds the estimated undiscounted future net revenues from proved oil and gas reserves attributable to the field. Based on this review and the continuing evaluation of development plans, economics and other factors, if appropriate, the Company records impairments (additional depletion and depreciation) to the extent that the carrying value exceeds the estimated undiscounted future net revenues. Such impairments totaled $99.3 million in 1993 and there were none in 1992 and 1991. The Company provides for future abandonment and site restoration costs with respect to certain of its oil and gas properties. The Company estimates that with respect to these properties such future costs total approximately $24.7 million and such amount is being accrued over the expected life of the properties. At December 31, 1993 Accumulated Depletion, Depreciation, Amortization and Impairment includes $14.6 million with respect to such costs. The value of undeveloped acreage is aggregated and the portion of such costs estimated to be nonproductive, based on historical experience, is amortized to expense over the average holding period. Additional amortization may be recognized based upon periodic assessment of prospect evaluation results. The cost of properties determined to be productive is transferred to proved SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) properties; the cost of properties determined to be nonproductive is charged to accumulated amortization. Maintenance and repairs are expensed as incurred; major renewals and improvements are capitalized. Gains and losses arising from sales of properties are included in income currently. REVENUE RECOGNITION Revenues from the sale of petroleum produced are generally recognized upon the passage of title, net of royalties and net profits interests. Crude oil revenues include the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Crude Oil Hedging Program. Crude oil revenues also include the value of crude oil consumed in operations with an equal amount charged to operating expenses. Such amounts totalled $15.4 million in 1991, $4.8 million in 1992 and $1.2 million in 1993. Revenues from natural gas production are generally recorded using the entitlement method, net of royalties and net profits interests. Sales proceeds in excess of the Company's entitlement are included in Deferred Revenues and the Company's share of sales taken by others is included in Other Assets. At December 31, 1993 the Company's deferred revenues for sales proceeds received in excess of the Company's entitlement was $6.8 million with respect to 5.2 MMcf and the asset related to the Company's share of sales taken by others was $3.9 million with respect to 2.7 MMcf. Natural gas revenues are net of the effect of hedging transactions; see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Program. Revenues from crude oil marketing and trading represent the gross margin resulting from such activities. Revenues from such activities are net of costs of sales of $210.5 million in 1991, $247.3 million in 1992 and $225.9 million in 1993. Revenues from natural gas systems are net of the cost of natural gas purchased and resold. Such costs totalled $43.8 million in 1992 and $49.9 million in 1993. EARNINGS PER SHARE Earnings per share are based on the weighted average number of common shares outstanding during the year. ACCOUNTS RECEIVABLE Accounts Receivable relates primarily to sales of oil and gas and amounts due from joint interest partners for expenditures made by the Company on behalf of such partners. The Company reviews the financial condition of potential purchasers and partners prior to signing sales or joint interest agreements. At December 31, 1993 and 1992 the Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $6.3 million and $5.0 million, respectively. Accounts receivable totalling $0.2 million, $1.1 million and $0.1 million were written off as uncollectible in 1991, 1992 and 1993, respectively. INVENTORIES Inventories are valued at the lower of cost (average price or first-in, first-out) or market. Crude oil inventories at December 31, 1993 and 1992 were $1.1 million and $1.5 million, respectively, and materials and supplies inventories at such dates were $7.6 million and $3.3 million, respectively. ENVIRONMENTAL EXPENDITURES Environmental expenditures relating to current operations are expensed or capitalized, as appropriate, depending on whether such expenditures provide future economic benefits. Liabilities are SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized when the expenditures are considered probable and can be reasonably estimated. Measurement of liabilities is based on currently enacted laws and regulations, existing technology and undiscounted site-specific costs. Generally, such recognition coincides with the Company's commitment to a formal plan of action. INCOME TAXES The Company follows the asset and liability approach to 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, based on a scheduling of temporary differences between the tax bases of assets and liabilities and their reported amounts. Under this method of accounting for income taxes, any future changes in income tax rates will affect deferred income tax balances and financial results. (2) CORPORATE RESTRUCTURING PROGRAM In October 1993 the Company's Board of Directors endorsed a broad corporate restructuring program that focuses on the disposition of non-core assets, the concentration of capital spending in core areas, the refinancing of certain long-term debt and the elimination of the payment of its $0.04 per share quarterly dividend on common stock. In implementing the restructuring program the Company recorded a nonrecurring charge of $38.6 million in 1993 comprised of (1) losses on property dispositions of $27.8 million: (2) long-term debt repayment penalties of $8.6 million; and (3) accruals for certain personnel benefits and related costs of $2.2 million. The Company's non-core asset disposition program includes the sale of its natural gas gathering and processing assets to Hadson Corporation ('Hadson'), the sale to Vintage Petroleum, Inc. of certain southern California and Gulf Coast oil and gas producing properties and the sale to Bridge Oil (U.S.A.) Inc. ('Bridge') of certain Mid-Continent and Rocky Mountain oil and gas producing properties and undeveloped acreage. The Company also plans to dispose of other non-core oil and gas properties during 1994. In 1994 the Company intends to refinance a portion of its existing long-term debt and is currently evaluating a combination of debt and equity financing arrangements with which to effect the refinancing. SALE TO HADSON. In December 1993 the Company completed a transaction with Hadson under the terms of which the Company sold the common stock of Adobe Gas Pipeline Company ('AGPC'), a wholly-owned subsidiary which held the Company's natural gas gathering and processing assets, to Hadson in exchange for Hadson 11.25% preferred stock with a face value of $52.0 million and 40% of Hadson's common stock. In addition, the Company signed a seven-year gas sales contract under the terms of which Hadson will market substantially all of the Company's domestic natural gas production at market prices as defined by published monthly indices for relevant production locations. The Company accounted for the sale as a non-monetary transaction and the investment in Hadson has been valued at $56.2 million, the carrying value of the Company's investment in AGPC. The Company's investment in Hadson is being accounted for on the equity basis. At December 31, 1993 the Company's investment in Hadson's common stock exceeded the net book value attributable to such common shares by approximately $11.3 million. The Company's income from operations for 1993 includes $1.6 million attributable to the assets sold to Hadson. SALE TO VINTAGE. In November 1993 the Company completed the sale of certain southern California and Gulf Coast producing properties for net proceeds totalling $41.3 million in cash, $31.5 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) million of which was collected in 1993. The Company's income from operations for 1993 includes $2.7 million attributable to the assets sold to Vintage. SALE TO BRIDGE. In December 1993 the Company signed a Purchase and Sales Agreement with Bridge under the terms of which Bridge will purchase certain Mid-Continent and Rocky Mountain producing and nonproducing oil and gas properties. The sale price of $51.0 million, subject to certain adjustments, will be received by the Company either in the form of cash plus 10% of the outstanding shares of Bridge, following the contemplated public offering of that stock in the first quarter of 1994, or entirely in cash. The transaction is expected to close in the second quarter of 1994. The net book value of these assets is included in Assets Held for Sale at December 31, 1993. The Company's income from operations for 1993 includes $5.8 million attributable to the assets to be sold to Bridge. OTHER DISPOSITIONS. The Company has identified certain other oil and gas properties which it plans to dispose of in 1994. The estimated realizable value of these properties, $1.0 million, is included in Assets Held for Sale at December 31, 1993. In the first quarter of 1994 the Company sold its interest in certain other oil and gas properties for $8.3 million. (3) MERGER WITH ADOBE RESOURCES CORPORATION On May 19, 1992 Adobe Resources Corporation ('Adobe'), an oil and gas exploration and production company, was merged with and into Santa Fe (the 'Merger'). The acquisition has been accounted for as a purchase and the results of operations of the properties acquired (the 'Adobe Properties') are included in Santa Fe's results of operations effective June 1, 1992. To consummate the Merger, the Company issued 24.9 million shares of common stock valued at $205.5 million, 5.0 million shares of convertible preferred stock valued at $80.0 million, assumed long-term bank debt and other liabilities of $140.0 million and $35.0 million, respectively, and incurred $13.8 million in related costs. The Company also recorded a $19.7 million deferred tax liability with respect to the difference between the book and tax basis in the assets acquired. Certain merger-related costs incurred by Adobe and paid by Santa Fe totaling $10.9 million were charged to income in the second quarter of 1992. The Merger constituted a 'change of control' as defined in certain of the Company's employee benefit plans and employment agreements (see Notes 10 and 12). In a separate transaction in January 1992, the Company purchased three producing properties from Adobe for $14.2 million. (4) SANTA FE ENERGY TRUST In November 1992 5,725,000 Depository Units ('Trust Units'), each consisting of beneficial ownership of one unit of undivided beneficial interest in the Santa Fe Energy Trust (the 'Trust') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering. The Trust consists of certain oil and gas properties conveyed by Santa Fe. A total of $114.5 million was received from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Trust Units. A portion of the proceeds received by the Company was used to retire $30.0 million of the debt incurred in connection with the Merger and the remainder will be used for general corporate purposes including possible acquisitions. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments to the extent that it needs such payments to distribute $0.40 per SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Depository Unit per quarter. The source of such additional royalty payments, if needed, will be limited to the Company's remaining royalty interest in certain of the properties conveyed to the Trust. If such additional payments are made, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such additional payments. The aggregate amount of the additional royalty payments (net of any amounts recouped) will be limited to $20.0 million on a revolving basis. At December 31, 1993 the Company held 575,000 Trust Units. At December 31, 1993 Accounts Receivable includes $0.2 million due from the Trust and Accounts Payable includes $1.9 million due to the Trust. In the first quarter of 1994 the Company sold the Trust Units for $11.3 million, the Company's investment in the Trust Units, $10.4 million, is included in Assets Held for Sale at December 31, 1993. (5) ACQUISITIONS OF OIL AND GAS PROPERTIES In January 1991 the Company completed the purchase of Mission Operating Partnership, L.P.'s ('Mission') interest in certain oil and gas properties, effective from November 1, 1990, for approximately $55.0 million. The Company formed a partnership, with an institutional investor as a limited partner, to acquire and operate the properties. The investor contributed $27.5 million for a 50% interest in the partnership, which will be reduced to 15% upon the occurence of payout. Payout will occur when the investor has received distributions from the partnership totalling an amount equal to its original contribution plus a 12% rate of return on such contribution. Prior to payout, the Company will bear 100% of the capital expenditures of the partnership. Under the terms of the partnership agreement a total of $36.8 million must be expended on development of the property by the year 2000, $12.4 million of which had been expended through the end of 1993. The Company funded $16.8 million of its share of the purchase of the properties with the assumption of a term loan and paid the remainder from working capital. The Company has given the lender the equivalent of an overriding royalty interest in certain production from the properties. The royalty is payable only if such production occurs and is limited to a maximum of $3.0 million. In June 1991 the Company acquired a 10% interest in a producing field in Argentina for approximately $18.3 million and in October 1991 purchased an additional 8% interest in the field for approximately $15.7 million. The Company financed $17.8 million of the total purchase price with loans from an Argentine bank. The Company has agreed to spend approximately $16.7 million over a five-year period on development and maintenance of the field. (6) CASH FLOWS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The Merger included certain non-cash investing and financing activities not reflected in the Statement of Cash Flows as follows (in millions of dollars): Common stock issued------------------ 205.5 Convertible preferred stock issued------------------------------- 80.0 Deferred tax liability--------------- 19.7 Long-term debt----------------------- 140.0 Assets acquired, other than cash, net of liabilities assumed------------- (457.1) Cash paid---------------------------- (11.9) In 1991, the Company sold a producing property for $0.9 million in cash and a note receivable for $1.2 million. In 1991, the Partnership purchased certain surface properties for $6.2 million, SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $5.5 million of which was funded by the issuance of promissory notes and the Company also purchased producing properties for $63.1 million, $34.6 million of which was funded with debt (see Notes 5 and 7). The Company made interest payments of $45.5 million, $49.0 million and $48.0 million in 1991, 1992 and 1993, respectively. In 1991, 1992 and 1993, the Company made tax payments of $18.4 million, $4.4 million and $5.0 million, respectively, and in 1993 received refunds of $4.1 million, primarily related to the audit of prior years' returns. (7) FINANCING AND DEBT Long-term debt at December 31, 1993 and 1992 consisted of (in millions of dollars): Crude oil and liquids and natural gas accounted for more than 95% of revenues in 1991, 1992 and 1993. The following table reflects sales revenues from crude oil purchasers who accounted for more than 10% of the Company's crude oil and liquids revenues (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Texaco Trading and Transportation, Inc-------------------------------- -- 46.8 55.9 Celeron Corporation------------------ 56.8 56.3 45.6 Shell Oil Company-------------------- 86.3 -- -- None of the Company's purchasers of natural gas accounted for more than 10% of revenues in 1991, 1992 or 1993. The Company does not believe the loss of any purchaser would have a material adverse effect on its financial position since the Company believes alternative sales arrangements could be made on relatively comparable terms. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) CONVERTIBLE PREFERRED STOCK The convertible preferred stock issued in connection with the Merger is non-voting and entitled to receive cumulative cash dividends at an annual rate equivalent to $1.40 per share. The holders of the convertible preferred shares may, at their option, convert any or all such shares into 1.3913 shares of the Company's common stock. The Company may, at any time after the fifth anniversary of the effective date of the Merger and upon the occurrence of a 'Special Conversion Event', convert all outstanding shares of convertible preferred stock into common stock at the initial conversion rate of 1.3913 shares of common stock, subject to certain adjustments, plus additional shares in respect to accrued and unpaid dividends. A Special Conversion Event is deemed to have occurred when the average daily closing price for a share of the Company's common stock for 20 of 30 consecutive trading days equals or exceeds 125% of the quotient of $20.00 divided by the then applicable conversion rate (approximately $18.00 per share at a conversion rate of 1.3913). Upon the occurrence of the 'First Ownership Change' of Santa Fe, each holder of shares of convertible preferred stock shall have the right, at the holder's option, to elect to have all of such holder's shares redeemed for $20.00 per share plus accrued and unpaid interest and dividends. The First Ownership Change shall be deemed to have occurred when any person or group, together with any affiliates or associates, becomes the beneficial owner of 50% or more of the outstanding common stock of Santa Fe. (10) SHAREHOLDERS' EQUITY COMMON STOCK In 1991, 1992 and 1993 the Company issued 1.1 million previously unissued shares of common stock in connection with certain employee benefit and compensation plans. Also in 1992, the Company issued 24.9 million previously unissued shares of common stock in connection with the Merger. The Company declared dividends to common shares of $0.16 per share in 1991 and 1992 and $0.12 per share in 1993. PREFERRED STOCK The Board of Directors of the Company is empowered, without approval of the shareholders, to cause shares of preferred stock to be issued in one or more series, and to determine the number of shares in each series and the rights, preferences and limitations of each series. Among the specific matters which may be determined by the Board of Directors are: the annual rate of dividends; the redemption price, if any; the terms of a sinking or purchase fund, if any; the amount payable in the event of any voluntary liquidation, dissolution or winding up of the affairs of the Company; conversion rights, if any; and voting powers, if any. ACCUMULATED DEFICIT At December 31, 1993 Accumulated Deficit included dividends in excess of retained earnings of $89.8 million. 1990 INCENTIVE STOCK COMPENSATION PLAN The Company has adopted the Santa Fe Energy Resources 1990 Incentive Stock Compensation Plan (the 'Plan') under the terms of which the Company may grant options and awards with respect to no more than 5,000,000 shares of common stock to officers and key employees. Options granted in 1991 and prior are fully vested and expire in 2000. Options granted in 1992 have a ten year term and vest as to 33.33 percent one year after grant, as to a cumulative 66.67 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) percent two years after grant and as to the entire amount three years after grant. The options granted in 1993 have a ten year term and vest as to 50 percent 5 years after grant, as to a cumulative 75 percent 6 years after grant and as to the entire amount 7 years after grant. The options are exercisable on an accelerated basis beginning one year and ending three years after grant in certain circumstances. If the market value per share of the Company's common stock (sustained in all events for at least 60 days) exceeds $15, 25 percent of the options shall become exercisable; in the event the market value per share exceeds $20, 50 percent of the options shall become exercisable; and in the event the market value exceeds $25, 100 percent shall become exercisable. Unexercised options would be forfeited in the event of voluntary or involuntary termination. Vested options are exercisable for a period of one year following termination due to death, disability or retirement. In the event of termination by the Company for any reason there is no prorata vesting of unvested options. The following table reflects activity with respect to Non-Qualified Stock Options during 1991 through 1993: OPTION OPTIONS PRICE OUTSTANDING PER SHARE Outstanding at December 31, 1990----- 1,803,923 $14.4375 to $24.24 Grants------------------------------- 4,500 $14.625 Cancellations------------------------ (45,332) $14.4375 to $24.24 Outstanding at December 31, 1991----- 1,763,091 $14.4375 to $24.24 Grants------------------------------- 1,099,000 $ 9.5625 Cancellations------------------------ (50,163) $14.4375 to $24.24 Outstanding at December 31, 1992----- 2,811,928 $ 9.5625 to $24.24 Grants------------------------------- 800,000 $ 9.5625 Cancellations------------------------ (95,398) $ 9.5625 to $24.24 Exercises---------------------------- (6,945) $ 9.5625 Outstanding at December 31, 1993----- 3,509,585 $ 9.5625 to $24.24 At December 31, 1993 options on 780,790 shares were available for future grants. A 'Phantom Unit' is the right to receive a cash payment in an amount equal to the average trading price of the shares of common stock at the time the award becomes payable. Awards are made for a specified period and are dependent upon continued employment and the achievement of performance objectives established by the Company. In December 1990 the Company awarded 211,362 Phantom Units and in December 1991 313,262 shares of restricted stock were issued in exchange for such units. Compensation expense is recognized over the period the awards are earned based on the market price of the restricted stock on the date it was issued ($8.00 per share). During 1990 and 1991 $0.2 million and $0.8 million, respectively, were charged to expense with respect to such awards. The unamortized portion of the award at December 31, 1991 ($1.4 million) was reflected in Shareholders' Equity. The consummation of the Merger resulted in a 'change of control' as defined in the Plan and resulted in the vesting of the awards and $1.4 million in compensation expense was recognized in 1992. In 1993 the Company issued 6,432 shares of restricted stock to certain employees and 118,039 common shares in accordance with the terms of certain other employee compensation plans. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (11) PENSION AND OTHER EMPLOYEE BENEFIT PLANS PENSION PLANS Prior to the Spin-Off the Company was included in certain non-contributory pension plans of SFP. The Santa Fe Pacific Corporation Retirement Plan (the 'SFP Plan') covered substantially all of the Company's officers and salaried employees who were not covered by collective bargaining agreements. The Santa Fe Pacific Corporation Supplemental Retirement Plan was an unfunded plan which provided supplementary benefits, primarily to senior management personnel. The Company adopted, effective as of the date of the Spin-Off, a defined benefit retirement plan (the 'SFER Plan') covering substantially all salaried employees not covered by collective bargaining agreements and a nonqualified supplemental retirement plan (the 'Supplemental Plan'). The Supplemental Plan will pay benefits to participants in the SFER Plan in those instances where the SFER Plan formula produces a benefit in excess of limits established by ERISA and the Tax Reform Act of 1986. Benefits payable under the SFER Plan are based on years of service and compensation during the five highest paid years of service during the ten years immediately preceding retirement. Benefits accruing to the Company's employees under the SFP Plan have been assumed by the SFER Plan. The Company's funding policy is to contribute annually not less than the minimum required by ERISA and not more than the maximum amount deductible for income tax purposes. In the fourth quarter of 1993 the Company established a new pension plan with respect to certain persons employed in foreign locations. The following table sets forth the funded status of the SFER Plan and the Supplemental Plan at December 31, 1993 and 1992 (in millions of dollars): SFER PLAN SUPPLEMENTAL PLAN 1993 1992 1993 1992 Plan assets at fair value, primarily invested in common stocks and U.S. and corporate bonds---------------- 30.2 28.9 -- -- Actuarial present value of projected benefit obligations: Accumulated benefit obligations Vested----------------------- (30.9) (24.5) (0.6) (0.5) Nonvested-------------------- (1.5) (1.4) -- -- Effect of projected future salary increases----------- (8.3) (6.4) (0.3) (0.2) Excess of projected benefit obligation over plan assets-------- (10.5) (3.4) (0.9) (0.7) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions------------------------ 6.4 0.7 0.3 0.2 Unrecognized net (asset) obligation being recognized over plan's average remaining service life----- (1.0) (1.1) 0.2 0.3 Additional minimum liability--------- -- -- (0.3) (0.3) Accrued pension liability------------ (5.1) (3.8) (0.7) (0.5) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% 7.0% 8.25% Long-term asset yield------------ 9.5% 9.5% 9.5% 9.5% Rate of increase in future compensation------------------- 5.25% 5.25% 5.25% 5.25% SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the components of pension expense for the SFER Plan and Supplemental Plan for 1993, 1992 and 1991 (in millions of dollars): The Company also sponsors a pension plan covering certain hourly-rated employees in California (the 'Hourly Plan'). The Hourly Plan provides benefits that are based on a stated amount for each year of service. The Company annually contributes amounts which are actuarially determined to provide the Hourly Plan with sufficient assets to meet future benefit payment requirements. The following table sets forth the components of pension expense for the Hourly Plan for the years 1993, 1992 and 1991 (in millions of dollars): YEAR ENDED DECEMBER 31, 1993 1992 1991 Service cost--------------------- 0.2 0.2 0.2 Interest cost-------------------- 0.7 0.7 0.7 Return on plan assets------------ (0.8) (0.1) (0.5) Net amortization and deferral---- 0.4 (0.4) 0.1 0.5 0.4 0.5 The following table sets forth the funded status of the Hourly Plan at December 31, 1993 and 1992 (in millions of dollars): 1993 1992 Plan assets at fair value, primarily invested in fixed-rate securities---- 7.7 7.2 Actual present value of projected benefit obligations Accumulated benefit obligations Vested----------------------- (11.2) (9.1) Nonvested-------------------- (0.4) (0.3) Excess of projected benefit obligation over plan assets-------- (3.9) (2.2) Unrecognized net (gain) loss from past experience different from that assumed and effects of changes in assumptions------------------------ 1.5 (0.3) Unrecognized prior service cost------ 0.5 0.6 Unrecognized net obligation---------- 1.5 1.6 Additional minimum liability--------- (3.5) (2.1) Accrued pension liability-------- (3.9) (2.4) Major assumptions at year-end Discount rate-------------------- 7.0% 8.25% Expected long-term rate of return on plan assets----------------- 8.5% 8.5% At December 31, 1993 the Company's additional minimum liability exceeded the total of its unrecognized prior service cost and unrecognized net obligation by $1.5 million. Accordingly, at December 31, 1993 the Company's retained earnings have been reduced by such amount, net of related taxes of $0.6 million. SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides health care and life insurance benefits for substantially all employees who retire under the provisions of a Company-sponsored retirement plan and their dependents. Participation in the plans is voluntary and requires a monthly contribution by the employee. Effective January 1, 1993 the Company adopted the provisions of SFAS No. 106 -- 'Employers' Accounting for Postretirement Benefits Other Than Pensions'. The Statement requires the accrual, during the years the employee renders service, of the expected cost of providing postretirement benefits to the employee and the employee's beneficiaries and covered dependents. The following table sets forth the plan's funded status at December 31, 1993 and January 1, 1993 (in millions of dollars): DECEMBER 31, JANUARY 1, 1993 1993 Plan assets, at fair value----------- -- -- Accumulated postretirement benefit obligation Retirees--------------------------- (3.6) (3.1) Eligible active participants------- (1.2) (0.9) Other active participants---------- (1.4) (1.2) Accumulated postretirement benefit obligation in excess of plan assets----------------------------- (6.2) (5.2) Unrecognized transition obligation------------------------- 5.0 5.2 Unrecognized net loss from past experience different from that assumed and from changes in assumptions------------------------ 0.5 -- Accrued postretirement benefit cost------------------------------- (0.7) -- Assumed discount rate---------------- 7.5% 8.25% Assumed rate of compensation increase--------------------------- 5.25% 5.25% The Company's net periodic postretirement benefit cost for 1993 includes the following components (in millions of dollars): Service costs---------------------------------------- 0.3 Interest costs--------------------------------------- 0.4 Amortization of unrecognized transition obligation----------------------------------------- 0.3 1.0 In periods prior to 1993 the cost to the Company of providing health care and life insurance benefits for qualified retired employees was recognized as expenses when claims were paid. Such amounts totalled $0.4 million in 1991 and $0.3 million in 1992. Estimated costs and liabilities have been developed assuming trend rates for growth in future health care costs beginning with 10% for 1993 graded to 6% (5.5% for post age 65) by the year 2000 and remaining constant thereafter. Increasing the assumed health care cost trend rate by one percent each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $0.9 million and the aggregate of the service cost and interest cost components of the net periodic postretirement benefit cost for 1994 by $0.2 million. SAVINGS PLAN The Company has a savings plan, which became effective November 1, 1990, available to substantially all salaried employees and intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code (the '401(k) Plan'). The Company will match employee contributions for an amount up to 4% of each employee's base salary. In addition, if at the end of each SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) fiscal year the Company's performance for such year has exceeded certain predetermined criteria, each participant will receive an additional matching contribution equal to 50% of the regular matching contribution. The Company's contributions to the 401(k) Plan, which are charged to expense, totaled $1.2 million in 1991, $1.3 million in 1992 and $1.5 million in 1993. In the fourth quarter of 1993 the Company established a new savings plan with respect to certain personnel employed in foreign locations. OTHER POSTEMPLOYMENT BENEFITS In the fourth quarter of 1993 the Company adopted SFAS No. 112 -- 'Employers' Accounting for Postemployment Benefits'. The Statement requires the accrual of the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. Such benefits include salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits, job training and counseling and continuation of benefits such as health care and life insurance coverage. The adoption of SFAS No. 112 resulted in a charge to earnings of $1.8 million in 1993. (12) COMMITMENTS AND CONTINGENCIES CRUDE OIL HEDGING PROGRAM In the third quarter of 1990, the Company initiated a hedging program designed to provide a certain minimum level of cash flow from its sales of crude oil. Settlements were included in oil revenues in the period the oil is sold. In the year ended December 31, 1990 hedges resulted in a reduction in oil revenues of $10.7 million; in 1991 hedges resulted in an increase in oil revenues of $41.7 million and in 1992 hedges resulted in an increase in oil revenues of $9.7 million. The Company had no open crude oil hedging contracts during 1993. NATURAL GAS HEDGING PROGRAM In the third quarter of 1992 the Company initiated a hedging program with respect to its sales of natural gas. The Company has used various instruments whereby monthly settlements are based on the differences between the price or range of prices specified in the instruments and the settlement price of certain natural gas futures contracts quoted on the New York Mercantile Exchange. In instances where the applicable settlement price is less than the price specified in the contract, the Company receives a settlement based on the difference; in instances where the applicable settlement price is higher than the specified prices the Company pays an amount based on the difference. The instruments utilized by the Company differ from futures contracts in that there is no contractual obligation which requires or allows for the future delivery of the product. In 1992 and 1993 hedges resulted in a reduction in natural gas revenues of $0.5 million and $8.2 million, respectively. At December 31, 1993 the Company had two open natural gas hedging contracts covering approximately 1.2 Bcf during the six month period beginning March 1994. The 'approximate break-even price' (the average of the monthly settlement prices of the applicable futures contracts which would result in no settlement being due to or from the Company) with respect to such contracts is approximately $1.82 per Mcf. In addition, certain parties hold options on contracts covering approximately 4.8 Bcf during the seven month period beginning March 1994 at an approximate break even price of $1.90 per Mcf. The Company has no other outstanding natural gas hedging instruments. INDEMNITY AGREEMENT WITH SFP At the time of the Spin-Off, the Company and SFP entered into an agreement to protect SFP from federal and state income taxes, penalties and interest that would be incurred by SFP if the Spin-off were determined to be a taxable event resulting primarily from actions taken by the Company during a one-year period that ended December 4, 1991. If the Company were required to make SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) payments pursuant to the agreement, such payments could have a material adverse effect on its financial condition; however, the Company does not believe that it took any actions during such one-year period that would have such an effect on the Spin-Off. ENVIRONMENTAL REGULATION Federal, state and local laws and regulations relating to environmental quality control affect the Company in all of its oil and gas operations. The Company has been identified as one of over 250 potentially responsible parties ('PRPs') at a superfund site in Los Angeles County, California. The site was operated by a third party as a waste disposal facility from 1948 until 1983. The Environmental Protection Agency ('EPA') is requiring the PRPs to undertake remediation of the site in several phases, which include site monitoring and leachate control, gas control and final remediation. In 1989, the EPA and a group of the PRPs entered into a consent decree covering the site monitoring and leachate control phases of remediation. The Company is a member of the group that is responsible for carrying out this first phase of work, which is expected to be completed in five to eight years. The maximum liability of the group, which is joint and several for each member of the group, for the first phase is $37.0 million, of which the Company's share is expected to be approximately $2.4 million ($1.3 million after recoveries from working interest participants in the unit at which the wastes were generated) payable over the period that the phase one work is performed. The EPA and a group of PRPs of which the Company is a member have also entered into a subsequent consent decree (which has not been finally entered by the court) with respect to the second phase of work (gas control). The liability of this group has not been capped, but is estimated to be $130.0 million. The Company's share of costs of this phase, however, is expected to be approximately of the same magnitude as that of the first phase because more parties are involved in the settlement. The Company has provided for costs with respect to the first two phases, but it cannot currently estimate the cost of any subsequent phases of work or final remediation which may be required by the EPA. In 1989, Adobe received requests from the EPA for information pursuant to Section 104(e) of CERCLA with respect to the D. L. Mud and Gulf Coast Vacuum Services superfund sites located in Abbeville, Louisiana. The EPA has issued its record of decision at the Gulf Coast Site and on February 9, 1993 the EPA issued to all PRP's at the site a settlement order pursuant to Section 122 of CERCLA. Earlier, an emergency order pursuant to Section 106 of CERLA was issued on December 11, 1992, for purposes of containment due to the Louisiana rainy season. On December 15, 1993 the Company entered into a sharing agreement with other PRP'S to participate in the final remediation of the Gulf Coast site. The Company's share of the remediation is approximately $600,000 and includes its proportionate share of those PRPs who do not have the financial resources to provide their share of the work at the site. A former site owner has already conducted remedial activities at the D. L. Mud Site under a state agency agreement. The extent, if any, of any further necessary remedial activity at the D. L. Mud Site has not been finally determined. EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain key employees. The initial term of each agreement expired on December 31, 1990 and, on January 1, 1991 and beginning on each January 1 thereafter, is automatically extended for one-year periods, unless by September 30 of any year the Company gives notice that the agreement will not be extended. The term of the agreements is automatically extended for 24 months following a change of control. The consummation of the Merger constituted a change of control as defined in the agreements. In the event that following a change of control employment is terminated for reasons specified in the agreements, the employee would receive: (i) a lump sum payment equal to two years' base salary; (ii) the maximum possible bonus under the terms of the Company's incentive compensation plan; SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (iii) a lapse of restrictions on any outstanding restricted stock grants and full payout of any outstanding Phantom Units; (iv) cash payment for each outstanding stock option equal to the amount by which the fair market value of the common stock exceeds the exercise price of the option; and, (v) life, disability and health benefits for a period of up to two years. In addition, payments and benefits under certain employment agreements are subject to further limitations based on certain provisions of the Internal Revenue Code. INTEREST RATE SWAPS Prior to the Merger, Adobe had entered into two interest rate swaps with a bank with notional principal amounts of $15.0 mllion and $20.0 million. Under the terms of the $20.0 million swap, which expires in April 1994, during any quarterly period at the beginning of which a floating rate specified in the agreement is less than 7.84%, the Company must pay the bank interest for such period on the principal amount at the difference between the rates. Should the floating rate be in excess of 7.84%, the bank must pay the Company interest for such period on the principal amount at the difference between the rates. For the period from the effective date of the Merger to December 31, 1992 the amount due the bank in accordance with the terms of the $20.0 million swap totalled $0.6 million and the amount due the bank in 1993 totalled $0.9 million. For the quarterly period which ends in April 1994, the amount due the bank is based on a floating rate of 3.375%. The $15.0 million swap, which expired December 31, 1992, had terms similar to the $20.0 million swap and the amount due the bank for the period subsequent to the Merger totaled $0.5 million. OPERATING LEASES The Company has noncancellable agreements with terms ranging from one to ten years to lease office space and equipment. Minimum rental payments due under the terms of these agreements are: 1994 -- $6.1 million, 1995 -- $6.0 million, 1996 -- $5.5 million, 1997 -- $5.2 million, 1998 -- $4.4 million and $4.7 million thereafter. Rental payments made under the terms of noncancellable agreements totaled $4.0 million in 1991,$4.5 million in 1992 and $5.5 million in 1993. OTHER MATTERS The Company has several long-term contracts ranging up to fifteen years for the supply and transportation of approximately 30 million cubic feet per day of natural gas. In the aggregate, these contracts involve a minimum commitment on the part of the Company of approximately $10 million per year. There are other claims and actions, including certain other environmental matters, pending against the Company. In the opinion of management, the amounts, if any, which may be awarded in connection with any of these claims and actions could be significant to the results of operations of any period but would not be material to the Company's consolidated financial position. (13) INCOME TAXES Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109 -- 'Accounting for Income Taxes'. The adoption of SFAS No. 109 had no significant impact on the Company's provision for income taxes. Through the date of the Spin-Off the taxable income or loss of the Company was included in the consolidated federal income tax return filed by SFP. The Company has filed separate consolidated federal income tax returns for periods subsequent to the Spin-Off. The consolidated federal income tax returns of SFP have been examined through 1988 and all years prior to 1981 are closed. Issues relating to the years 1981 through 1985 are being contested through various stages of administrative appeal. The Company is evaluating its position with respect to issues raised in a 1986 through 1988 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) audit. The Company believes adequate provision has been made for any adjustments which might be assessed for all open years. During 1989, the Company received a notice of deficiency for certain state franchise tax returns filed for the years 1978 through 1983 as part of the consolidated tax returns of SFP. The years subsequent to 1983 are still subject to audit. At December 31, 1993 Other Long-Term Obligations includes $20.6 million with respect to this matter. The Company intends to contest this matter. With the Merger of Adobe the Company succeeded to a net operating loss carryforward that is subject to Internal Revenue Code Section 382 limitations which annually limit taxable income that can be offset by such losses. Certain changes in the Company's shareholders may impose additional limitations as well. Losses carrying forward of $133.3 million expire beginning in 1998. At date of the Merger, Adobe had ongoing tax litigation related to a refund claim for carryback of certain net operating losses denied by the Internal Revenue Service. During 1991 Adobe successfully defended its claim in Federal District Court and prevailed again in 1992 in the United States Court of Appeals for the Fifth Circuit. The Internal Revenue Service had no further recourse to litigation and a $16.2 million refund was reflected as Income Tax Refund Receivable at December 31, 1992 and collected in 1993. Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under the following jurisdictions: 1993 1992 1991 Domestic----------------------------- (120.9) 2.7 34.8 Foreign------------------------------ (29.3) (3.6) (2.1) (150.2) (0.9) 32.7 The Company's income tax expense (benefit) for the years ended December 31, 1993, 1992 and 1991 consisted of (in millions of dollars): 1993 1992 1991 Current U.S. federal--------------------- (1.3) 3.5 11.0 State---------------------------- (1.2) 1.4 1.7 Foreign-------------------------- 1.3 1.9 -- (1.2) 6.8 12.7 Deferred U.S. federal--------------------- (65.6) (3.5) 0.2 U.S. federal tax rate change----- 2.6 -- -- State---------------------------- (8.0) (2.5) 1.3 Foreign-------------------------- (0.9) (0.3) -- (71.9) (6.3) 1.5 (73.1) 0.5 14.2 SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's deferred income tax liabilities (assets) at December 31, 1993 and 1992 are composed of the following differences between financial and tax reporting (in millions of dollars): 1993 1992 Capitalized costs and write-offs----- 83.0 150.8 Differences in Partnership basis----- 15.1 29.3 State deferred liability------------- 5.8 13.4 Foreign deferred liability----------- 13.7 15.5 Gross deferred liabilities----------- 117.6 209.0 Accruals not currently deductible for tax purposes----------------------- (17.7) (28.3) Alternative minimum tax carryforwards---------------------- (8.3) (5.3) Net operating loss carryforwards----- (46.7) (56.4) Other-------------------------------- (0.5) -- Gross deferred assets---------------- (73.2) (90.0) Deferred tax liability--------------- 44.4 119.0 The Company had no deferred tax asset valuation allowance at December 31, 1993 or 1992. A reconciliation of the Company's U.S. income tax expense (benefit) computed by applying the statutory U.S. federal income tax rate to the Company's income (loss) before income taxes for the years ended December 31, 1993, 1992 and 1991 is presented in the following table (in millions of dollars): 1993 1992 1991 U.S. federal income taxes (benefit) at statutory rate------------------ (52.6) (0.3) 11.1 Increase (reduction) resulting from: State income taxes, net of federal effect--------------------------- (1.0) 1.4 2.2 Foreign income taxes in excess of U.S. rate------------------------ (0.8) 0.3 -- Nondeductible amounts-------------- (0.2) (2.4) -- Effect of increase in statutory rate on deferred taxes----------- 2.6 -- -- Federal audit refund--------------- (3.2) -- -- Amendment to tax sharing agreement with SFP------------------------- (1.2) -- -- Benefit of tax losses-------------- (11.2) -- -- Prior period adjustments----------- (5.5) -- -- Other------------------------------ -- 1.5 0.9 (73.1) 0.5 14.2 The Company increased its deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34% to 35% commencing in 1993. (14) FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 'Disclosure About Fair Value of Financial Instruments' requires the disclosure, to the extent practicable, of the fair value of financial instruments which are recognized or unrecognized in the balance sheet. The fair value of the financial instruments disclosed herein is not representative of the amount that could be realized or settled, nor does the fair value amount consider the tax consequences, if any, of realization or settlement. The following table reflects the financial SANTA FE ENERGY RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) instruments for which the fair value differs from the carrying amount of such financial instrument in the Company's December 31, 1993 and 1992 balance sheets (in millions of dollars): The fair value of the Trust Units and convertible preferred stock is based on market prices. The fair value of the Company's fixed-rate long-term debt is based on current borrowing rates available for financings with similar terms and maturities. With respect to the Company's floating-rate debt, the carrying amount approximates fair value. The fair value of the interest rate swap represents the estimated cost to the Company over the remaining life of the contract. At December 31, 1993 the Company had two open natural gas hedging contracts and options outstanding on five additional contracts (see Note 12 -- Commitments and Contingencies -- Natural Gas Hedging Contracts). Based on the settlement prices of certain natural gas futures contracts as quoted on the New York Mercantile Exchange on December 30, 1993, assuming all options are exercised, the cost to the Company with respect to such contracts during 1994 would be approximately $0.6 million. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES AND RELATED FINANCIAL DATA Information with respect to the Company's oil and gas producing activities is presented in the following tables. Reserve quantities as well as certain information regarding future production and discounted cash flows were determined by independent petroleum consultants, Ryder Scott Company. OIL AND GAS RESERVES The following table sets forth the Company's net proved oil and gas reserves at December 31, 1990, 1991, 1992 and 1993 and the changes in net proved oil and gas reserves for the years ended December 31, 1991, 1992 and 1993. Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. Indonesian reserves represent an entitlement to gross reserves in accordance with a production sharing contract. These reserves include estimated quantities allocable to the Company for recovery of operating costs as well as quantities related to the Company's net equity share after recovery of costs. Accordingly, these quantities are subject to fluctuations with an inverse relationship to the price of oil. If oil prices increase, the reserve quantities attributable to the recovery of operating costs decline. Although this reduction would be offset partially by an increase in the net equity share, the overall effect would be a reduction of reserves attributable to the Company. At December 31, 1993, the quantities include 0.6 million barrels which the Company is contractually obligated to sell for $.20 per barrel. At December 31, 1993 the Company's reserves were 6.9 million barrels of crude oil and liquids and 14.5 Bcf of natural gas lower than at December 31, 1992, reflecting the sale in 1993 of properties with reserves totalling 8.7 million barrels of crude oil and liquids and 47.4 Bcf of natural gas. At December 31, 1993, 1.9 million barrels of crude oil reserves and 19.7 billion cubic feet of natural gas reserves were subject to a 90% net profits interest held by Santa Fe Energy Trust. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Company's proved oil and gas reserves at December 31, 1991, 1992 and 1993 are presented in the following table (in millions of dollars, except as noted): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) The following tables sets forth the changes in the present value of estimated future net cash flows from proved reserves during 1991, 1992 and 1993 (in millions of dollars): Estimated future cash flows represent an estimate of future net cash flows from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as general corporate overhead or interest expense. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. Income tax expense is computed based on applying the appropriate statutory tax rate to the excess of future cash inflows less future production and development costs over the current tax basis of the properties involved. While applicable investment tax credits and other permanent differences are considered in computing taxes, no recognition is given to tax benefits applicable to future exploration costs or the activities of the Company that are unrelated to oil and gas producing activities. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at year-end and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES The following table includes all costs incurred, whether capitalized or charged to expense at the time incurred (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) CAPITALIZED COSTS RELATED TO OIL AND GAS PRODUCING ACTIVITIES The following table sets forth information concerning capitalized costs at December 31, 1993 and 1992 related to the Company's oil and gas operations (in millions of dollars): SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) RESULTS OF OPERATIONS FROM OIL AND GAS PRODUCING ACTIVITIES The following table sets forth the Company's results of operations from oil and gas producing activities for the years ended December 31, 1993, 1992 and 1991 (in millions of dollars): Income taxes are computed by applying the appropriate statutory rate to the results of operations before income taxes. Applicable tax credits and allowances related to oil and gas producing activities have been taken into account in computing income tax expenses. No deduction has been made for indirect cost such as corporate overhead or interest expense. SANTA FE ENERGY RESOURCES, INC. SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) -- (CONTINUED) 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. SANTA FE ENERGY RESOURCES, INC. By /s/ MICHAEL J. ROSINSKI MICHAEL J. ROSINSKI VICE PRESIDENT AND CHIEF FINANCIAL OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) Dated: March 22, 1994 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. SIGNATURE AND TITLE JAMES L. PAYNE, Chairman of the Board, President and Chief Executive Officer and Director (PRINCIPAL EXECUTIVE OFFICER) MICHAEL J. ROSINSKI, Vice President and Chief Financial Officer (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) DIRECTORS Rod F. Dammeyer William E. Greehey Melvyn N. Klein Robert D. Krebs Allan V. Martini Michael A. Morphy Reuben F. Richards By: /s/ MICHAEL J. ROSINSKI David M. Schulte MICHAEL J. ROSINSKI Marc J. Shapiro VICE PRESIDENT AND Robert F. Vagt CHIEF FINANCIAL OFFICER Kathryn D. Wriston ATTORNEY IN FACT Dated: March 22, 1994 SANTA FE ENERGY RESOURCES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) 1993 1992 1991 Accounts receivable Balance at the beginning of period------------------------- 5.0 2.6 2.8 Charge (credit) to income---- -- -- -- Net amounts written off------ (0.1 ) (1.1 ) (.2 ) Other(a)--------------------- 1.4 3.5 -- Balance at the end of period----- 6.3 5.0 2.6 (a) Represents valuation accounts related to accounts receivable acquired in merger with Adobe Resources Corporation. SANTA FE ENERGY RESOURCES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (IN MILLIONS OF DOLLARS) YEAR ENDED DECEMBER 31, 1993 1992 1991 Maintenance and repairs-------------- 27.1 25.0 22.6 Taxes (other than income) Ad valorem----------------------- 12.0 11.4 17.0 Production and severance--------- 9.5 8.2 6.8 Payroll and other---------------- 5.8 4.7 3.4 27.3 24.3 27.2 INDEX OF EXHIBITS A. EXHIBITS B. REPORTS ON FORM 8-K. DATE ITEM February 8, 1994 5

826675_1993.txt

826675_1993

1993

826675

Item 1. BUSINESS General Resource Mortgage Capital, Inc. ("the Company"), incorporated in Virginia in 1987, operates a mortgage conduit and invests in a portfolio of residential mortgage securities. The Company's primary strategy is to use its mortgage conduit operations, which involve the purchase and securitization of residential mortgage loans, to create investments for its portfolio. The Company's principal sources of income are net interest income on its investment portfolio, gains on the securitization and sale of mortgage loans and the interest spread realized while the mortgage loans are being accumulated for securitization. The Company and its wholly-owned subsidiaries elect to be taxed as a real estate investment trust. Mortgage Conduit Operations As a "mortgage conduit," the Company acts as an intermediary between the originators of mortgage loans and the permanent investors in the mortgage loans or the mortgage-related securities backed by such mortgage loans. Historically, the Company's conduit operations consisted of the purchase and securitization of single-family mortgage loans that were underwritten for mortgage pool insurance. During 1993, the Company expanded its single-family conduit operations to include the purchase of mortgage loans that were underwritten by the Company and expanded its securitization strategy to include the senior/subordinated security structure as an alternative to using pool insurance as a source of credit enhancement. The Company also operates a multi-family mortgage conduit. Single-family Mortgage Conduit The mortgage loans to be acquired through the single-family mortgage conduit are originated by various sellers that meet the Company's qualification criteria. These sellers include savings and loan associations, banks, mortgage bankers and other mortgage lenders. The Company acquires mortgage loans secured by residential properties throughout the United States. Substantially all of the mortgage loans purchased through the single- family mortgage conduit are "nonconforming" mortgage loans. Nonconforming mortgage loans will not qualify for purchase by FHLMC or FNMA or for inclusion in a loan guarantee program sponsored by GNMA. Nonconforming mortgage loans generally have outstanding principal balances in excess of the program guidelines of these agencies or are originated based upon different underwriting criteria than are required by the agencies' programs. The maximum principal balance of a conforming loan is currently $203,150 for FHLMC and FNMA. The Company focuses on the purchase of nonconforming loans because such loans are not eligible for securitization under the agencies' programs; however, such nonconforming loans may have higher risks than conforming mortgage loans due to their lower liquidity, different underwriting or qualification criteria, and higher loan balances. The average principal balance of loans acquired through the single-family mortgage conduit during 1993 was $185,665. During 1993, the Company purchased mortgage loans through the single- family mortgage conduit with an aggregate principal balance as of the respective purchase dates of $4.0 billion. These loans were purchased from approximately 150 sellers. The top five sellers accounted for approximately 25% of the total single-family mortgage loan conduit mortgage loan purchases during the year. Approximately 64% of the aggregate principal balance of mortgage loans purchased through the single-family mortgage conduit during 1993 were secured by properties in California. The Company does not anticipate any significant adverse impact on its results or its business operations due to the depressed state of the residential real estate market in California. Mortgage loans acquired by the Company in its single-family mortgage conduit are secured by first liens on single (one-to-four) family residential properties and have either fixed or adjustable interest rates. Fixed-rate mortgage loans generally have a constant interest rate over the life of the loan, generally 15 or 30 years. In addition, fixed-rate mortgage loans purchased by the Company may also have a fixed interest rate for the first 3, 5, or 7 years and thereafter interest rate adjustments at six or twelve month intervals, subject to periodic and lifetime interest rate caps. Adjustable-rate mortgage ("ARM") loans provide for the periodic adjustment to the rate of interest equal to the sum of a fixed margin and an index, subject to certain periodic and lifetime interest-rate caps. To date, all mortgage loans purchased by the Company fully amortize over their remaining terms. The Company purchases various types of ARM loans. Approximately 30% of the ARM loans the Company purchased in 1993 are convertible to a fixed interest rate at the option of the borrower at certain times and upon satisfaction of certain conditions. The Company typically sells the ARM loans in connection with their securitization and upon securitization generally becomes obligated to purchase out of the security the fixed-rate loan created upon any conversion of an ARM loan. Such conversion period commences after the ARM loan is 24 months old, and ceases after the ARM loan is 60 months old. The fixed rate of interest to which these ARM loans convert will be at a net rate 1/8% higher than the rate then offered by the Company for the purchase of comparable fixed-rate loans. The Company sets prices at least once every business day for acquiring loans through the single-family mortgage conduit. The prices posted may be for immediate delivery of the mortgage loans or for subsequent delivery (such as within 90 days). The loans' features and characteristics, such as loan-to-value ratio and insurance coverage, are set forth in a detailed Seller/Servicer Guide. Commitments will obligate the Company to purchase mortgage loans from sellers for a specific period of time at an established yield, in a specified aggregate principal amount. Following the issuance of commitments, the Company is exposed to risks of interest rate fluctuations and may enter into hedging transactions to reduce the change in value of such commitments caused by changes in interest rates. Gains and losses on these hedging transactions are deferred as an adjustment to the carrying value of the related mortgage loans until the mortgage loans are sold. These hedging transactions have been successful in reducing the decline in value of the commitments, as well as loans in inventory, when interest rates have increased, while reducing the increase in value of the commitments, as well as loans in inventory, when interest rates have decreased. During the accumulation period prior to securitization, which is typically 60 days, the Company is at risk for credit losses on the mortgage loans acquired. The mortgage loans are financed through lines of credit with warehouse lenders or through repurchase agreements with investment banks. During 1993, the Company began purchasing mortgage loans without a commitment for mortgage pool insurance in addition to purchasing mortgage loans with a commitment for mortgage pool insurance. The Company has established an underwriting department and expanded its risk management department. To the extent that the Company purchases mortgage loans without a commitment for mortgage pool insurance, the Company relies upon its own underwriting for credit review and analysis in deciding to purchase these loans. When a sufficient volume of mortgage loans is accumulated, the loans are sold directly to investment banking firms or securitized through the issuance of mortgage securities. During 1993 the Company sold $1.2 billion directly to investment banking firms as whole loans and securitized $2.3 billion through the issuance of mortgage securities. The mortgage-backed securities are structured so that substantially all of the securities are rated in one of the two highest rating categories (i.e. AA or AAA) by at least one of the nationally recognized rating agencies. In contrast to mortgage-backed securities issued by the federal agencies in which the principal and interest payments are guaranteed, securities issued by the Company do not have such a guarantee and derive their rating through adequate levels of credit enhancement. This credit enhancement can take the form of mortgage pool insurance or subordination. Each of these securitization structures is described below. Historically, the Company exclusively used mortgage pool insurance for credit enhancement and reserve funds to cover certain risks excluded under such insurance. With this structure, mortgage loans purchased through the single-family mortgage conduit have a commitment for mortgage pool insurance from a mortgage insurance company with a claims paying ability in one of the two highest rating categories. The Company relies upon the credit review and analysis of each mortgage loan, which is performed by the mortgage insurer, in deciding to purchase a mortgage loan. Credit losses covered by the pool insurance policies are borne by the pool insurers to the limits of their policies and by the security holders if losses exceed those limits. The pool insurance is issued when the loan is subsequently securitized, and the Company is at risk for credit losses on that loan prior to its securitization. After these loans are securitized, the Company has only limited exposure to losses not covered by pool insurance resulting primarily from fraud during the origination of a mortgage loan. The Company has established reserves for these potential losses. The balances of these reserves totaled $5.3 million at December 31, 1993. An alternative method of credit enhancement is used when mortgage loans are securitized using a senior/subordinated structure. The Company expects to securitize in the future most of the single-family loans purchased through the single-family mortgage conduit by the issuance of mortgage securities in a senior/subordinated structure. With the senior/subordinated structure, the credit risk is concentrated in the subordinated classes of the securities, thus allowing the senior classes of the securities to receive the higher credit ratings. To the extent losses are greater than expected, the holders of the subordinated securities will experience a lower yield (which may be negative) than expected on their investments. Although the Company did not retain any mortgage securities rated below AA during 1993, the Company may do so in the future. The securitization structure used by the Company will depend primarily on which form of credit enhancement (e.g. pool insurance or subordination) has the lower effective cost. The Company anticipates that subordination will generally have the lower cost but may require a greater capital investment by the Company to the extent any subordinated securities are retained. Each series of mortgage securities backed by single-family mortgage conduit loans is expected to be fully payable from the collateral pledged to secure the series. It is expected that the recourse of investors in the series generally will be limited to the collateral underlying the securities. Except in the case of a breach of the standard representations and warranties made by the Company when loans are securitized, the securities are non-recourse to the Company. The Company is at risk for losses on the mortgage loans while in warehouse. The Company believes that its allowances are adequate to cover any of its loss exposure on mortgage loans. Other Conduit Operations The Company originates multi-family mortgage loans secured by properties that have qualified for low income housing tax credits pursuant to Section 42 of the Internal Revenue Code. A significant amount of the equity used by the developer to build these properties was raised through the sale of the tax credits. These tax credits, which are available generally for ten years beginning when the property was placed in service, provide a substantial incentive for the borrower not to default on the mortgage loan and to maintain the property in good condition, as the borrower would lose upon foreclosure any future tax credits relating to the property and could face recapture of a portion of the tax credits already taken. During 1993, the Company originated multi-family mortgage loans with an aggregate principal balance of $91.3 million, and had commitments outstanding at December 31, 1993 to fund an additional $22.5 million in such mortgage loans. During 1993, the Company securitized $102.2 principal amount of multi-family loans. The following schedule summarizes the principal balances as of the respective funding dates for mortgage loans funded through the Company's conduit operations during the year ended December 31, 1993. (amounts in thousands) Single-family : Fixed-rate: 3-year $ 167,685 15-year 208,997 30-year 910,414 ------------- Total fixed-rate 1,287,096 Adjustable-rate: 6-month LIBOR 2,465,054 1-year Constant Maturity Treasury 250,234 ------------ Total adjustable-rate 2,715,288 ------------ Total single-family 4,002,385 Multi-family: 25-year fixed-rate 91,329 ------------- Total mortgage loans funded $ 4,093,714 ============= The Company may pursue other methods of sourcing mortgage loans for its conduit operations in the future, including the direct origination of single-family mortgage loans. The Company has recently established a business unit to pursue the direct origination of non- conforming loans, initially in the Mid-Atlantic market. Portfolio of Mortgage Investments The Company's investment strategy is to create a diversified portfolio of mortgage securities that in the aggregate generates stable income for the Company in a variety of interest rate environments and preserves the capital base of the Company. The Company creates the majority of the investments for its portfolio by retaining a portion of the mortgage securities or other assets that are generated from its business operations. By pursuing these strategies, the Company believes it can structure the portfolio to have more favorable yields in a variety of interest rate environments than if it purchased mortgage investments in the market. The majority of the Company's portfolio is comprised of investments in ARM securities. The Company increases the yield on these investments by pledging the ARM securities as collateral for repurchase agreements. The interest rates on the majority of the Company's ARM securities reset every six months, and the rates are subject to both periodic and lifetime limitations ("caps"). Generally, the repurchase agreements have terms that range from 30 to 180 days, and the interest rates are not subject to the periodic and lifetime limitations. Thus, the yield on the ARM investments could decline if the spread between the yield on the ARM security versus the interest rate on the repurchase agreement was to be reduced. To mitigate this risk, the Company (i) lengthens the term of the repurchase agreement to more closely match the reset term on the underlying ARM loans, (ii) has established a reserve to hedge against the impact on earnings when the spread is reduced, and (iii) has purchased interest rate cap agreements to reduce the risk of the lifetime interest rate limitation on the ARM securities. Another segment of the Company's portfolio consists of net investments in collateralized mortgage obligations ("CMOs"). The net margin on CMOs is derived primarily from the difference between the cash flow generated from the CMO collateral, and the amounts required for payment on the CMOs and administrative expenses. The CMOs are non-recourse to the Company. The Company's yield on its investment in CMOs is affected primarily by changes in prepayment rates; such yield will decline with an increase in prepayment rates, and the yield will increase with a decrease in prepayment rates. Fixed-rate mortgage securities consist of securities that have a fixed-rate of interest for specified periods of time. Certain fixed- rate mortgage securities have a fixed interest rate for the first 3, 5, or 7 years and thereafter interest rate adjustments at six or twelve month intervals, subject to periodic and lifetime interest rate caps. The Company's yields on these securities are primarily affected by changes in prepayment rates; such yield will decline with an increase in prepayment rates, and the yield will increase with a decrease in prepayment rates. The Company generally borrows against its fixed-rate mortgage securities. The spread between the interest rate on a repurchase agreement and the interest rate on any fixed-rate security that the Company plans to hold is generally fixed by using an interest rate swap. A portion of fixed-rate mortgage securities in the Company's portfolio may be financed by short-term repurchase agreements on a temporary basis as the Company obtains long-term financing or elects to sell the securities. As a result, the yield on these investments could decline if the spread between the yield on the fixed-rate mortgage securities and the interest rate on the repurchase agreements were to be reduced during this time period. Other mortgage securities consist of interest-only securities ("I/O"s), principal-only securities ("P/O"s) and residual interests which were either purchased or created through the Company's conduit activities. An I/O is a class of a CMO or a mortgage pass-through security that pays to the holder substantially all interest. A P/O is a class of a CMO or a mortgage pass-through security that pays to the holder substantially all principal. Residual interests represent the excess cash flows on a pool of collateral after payment of principal, interest, and expenses of the related mortgage-backed security or repurchase arrangement. Residual interests may have little or no principal amount and may not receive scheduled interest payments. The Company may borrow against its other mortgage securities for working capital purposes. The yields on these securities are affected primarily by changes in prepayment rates, and to a lesser extent, by changes in short-term interest rates. The Company continuously monitors the aggregate projected yield of its investment portfolio under various interest rate environments. While certain investments may perform very poorly in an increasing interest rate environment, certain investments may perform very well, and others may not be impacted at all. Generally, the Company adds investments to its portfolio which are designed to increase the diversification and reduce the variability of the yield produced by the portfolio in different interest rate environments. The Company may add new types of mortgage investments to its portfolio in the future. The Company may enter into transactions to protect its portfolio of mortgage investments and related debt from interest rate fluctuations. Such transactions may include the purchase or sale of interest rate futures, options on interest rate futures and interest rate caps. These transactions are designed to stabilize the portfolio yield profile in a variety of interest rate environments. The Company's portfolio of mortgage assets also includes the investment in mortgage warehouse participations. The Company provides mortgage warehouse lines of credit to established mortgage banking companies by purchasing participations in existing warehouse lines of credit from approved warehouse lenders. A mortgage warehouse line of credit provides short-term, revolving financing to a mortgage originator for mortgage loans during the time period from settlement until the mortgage loan is sold to a permanent investor. The purchases of participations are financed by equity and by the issuance of commercial paper. Federal Income Tax Considerations General The Company and its qualified REIT subsidiaries (collectively "Resource REIT") believes it has complied, and intends to comply in the future, with the requirements for qualification as a REIT under the Internal Revenue Code (the "Code"). To the extent that Resource REIT qualifies as a REIT for federal income tax purposes, it generally will not be subject to federal income tax on the amount of its income or gain that is distributed to shareholders. However, a subsidiary of the Company, which operates the single-family mortgage conduit and is included in the Company's consolidated financial statements prepared in accordance with generally accepted accounting principles ("GAAP"), is not a qualified REIT subsidiary. Consequently, all of the nonqualified REIT subsidiary's taxable income is subject to federal and state income taxes. The REIT rules generally require that a REIT invest primarily in real estate-related assets, its activities be passive rather than active, and it distribute annually to its shareholders a high percentage of its taxable income. The Company could be subject to a number of taxes if it failed to satisfy those rules or if it acquired certain types of income-producing real property through foreclosure. Although no complete assurances can be given, Resource REIT does not expect that it will be subject to material amounts of such taxes. Resource REIT's failure to satisfy certain Code requirements could cause the Company to lose its status as a REIT. If Resource REIT failed to qualify as a REIT for any taxable year, it would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the amount of after-tax earnings available for distribution to shareholders would decrease substantially. While the Board of Directors intends to cause Resource REIT to operate in a manner that will enable it to qualify as a REIT in all future taxable years, there can be no certainty that such intention will be realized because, among other things, qualification hinges on the conduct of the business of Resource REIT. Qualification of the Company as a REIT Qualification as a REIT requires that Resource REIT satisfy a variety of tests relating to its income, assets, distributions and ownership. The significant tests are summarized below. Sources of Income ----------------- To qualify as a REIT in any taxable year, Resource REIT must satisfy three distinct tests with respect to the sources of its income: the "75% income test," the "95% income test," and the "30% income test." The 75% income test requires that Resource REIT derive at least 75% of its gross income (excluding gross income from prohibited transactions) from certain real estate related sources. In order to satisfy the 95% income test, at least an additional 20% of Resource REIT's gross income for the taxable year must consist either of income that qualifies under the 75% income test or certain other types of passive income. The 30% income test, unlike the other income tests, prescribes a ceiling for certain types of income. A REIT may not derive more than 30% of its gross income from the sale or other disposition of (i) stock or securities held for less than one year, (ii) dealer property that is not foreclosure property, or (iii) certain real estate property held for less than four years. If Resource REIT fails to meet either the 75% income test or the 95% income test, or both, in a taxable year, it might nonetheless continue to qualify as a REIT, if its failure was due to reasonable cause and not willful neglect, and the nature and amounts of its items of gross income were properly disclosed to the Internal Revenue Service. However, in such a case Resource REIT would be required to pay a tax equal to 100% of any excess non-qualifying income. No analogous relief is available to REITs that fail to satisfy the 30% income test. Nature and Diversification of Assets - ------------------------------------- At the end of each calendar quarter, three asset tests must be met by Resource REIT. Under the "75% asset test," at least 75% of the value of Resource REIT's total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the "10% asset test", Resource REIT may not own more than 10% of the outstanding voting securities of any single non-governmental issuer, if such securities do not qualify under the 75% asset test. Under the "5% asset test," ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of the total assets of Resource REIT. If Resource REIT inadvertently fails to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause it to lose its REIT status, provided that (i) it satisfied all of the asset tests at the close of a preceding calendar quarter, and (ii) the discrepancy between the values of Resource REIT's assets and the standards imposed by the asset tests either did not exist immediately after the acquisition of any particular asset or was not wholly or partially caused by such an acquisition. If the condition described in clause (ii) of the preceding sentence was not satisfied, Resource REIT still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which it arose. Distributions ------------- With respect to each taxable year, in order to maintain its REIT status, Resource REIT generally must distribute to its shareholders an amount at least equal to 95% of the sum of its "REIT taxable income" (determined without regard to the deduction for dividends paid and by excluding any net capital gain) and any after-tax net income from certain types of foreclosure property minus any "excess noncash income." The Internal Revenue Code provides that distributions relating to a particular year may be made early in the following year, in certain circumstances. The Company will balance the benefit to the shareholders of making these distributions and maintaining REIT status against their impact on the liquidity of the Company. In an unlikely situation, it may benefit the shareholders if the Company retained cash to preserve liquidity and thereby lose REIT status. For federal income tax purposes, Resource REIT is required to recognize income on an accrual basis and to make distributions to its shareholders when income is recognized. Accordingly, it is possible that income could be recognized and distributions required to be made in advance of the actual receipt of such funds by Resource REIT. The nature of Resource REIT's investments is such that it expects to have sufficient cash to meet any federal income tax distribution requirements. Taxation of Distributions by the Company Assuming that Resource REIT maintains its status as a REIT, any distributions that are properly designated as "capital gain dividends'' generally will be taxed to shareholders as long-term capital gains, regardless of how long a shareholder has owned his shares. Any other distributions out of Resource REIT's current or accumulated earnings and profits will be dividends taxable as ordinary income. Shareholders will not be entitled to dividends-received deductions with respect to any dividends paid by Resource REIT. Distributions in excess of Resource REIT's current or accumulated earnings and profits will be treated as tax-free returns of capital, to the extent of the shareholder's basis in his shares, and as gain from the disposition of shares, to the extent they exceed such basis. Shareholders may not include on their own tax returns any of Resource REIT ordinary or capital losses. Distributions to shareholders attributable to "excess inclusion income'' of Resource REIT will be characterized as excess inclusion income in the hands of the shareholders. Excess inclusion income can arise from Resource REIT's holdings of residual interests in real estate mortgage investment conduits and in certain other types of mortgage-backed security structures created after 1991. Excess inclusion income constitutes unrelated business taxable income ("UBTI'') for tax-exempt entities (including employee benefit plans and individual retirement accounts), and it may not be offset by current deductions or net operating loss carryovers. In the unlikely event that the Company's excess inclusion income is greater than its taxable income, the Company's distribution would be based on the Company's excess inclusion income. In 1993 the Company's excess inclusion income was approximately 15% of its taxable income. Although Resource REIT itself would be subject to a tax on any excess inclusion income that would be allocable to a "disqualified organization'' holding its shares, Resource REIT's by-laws provide that disqualified organizations are ineligible to hold Resource REIT's shares. Dividends paid by Resource REIT to organizations that generally are exempt from federal income tax under Section 501(a) of the Code should not be taxable to them as UBTI except to the extent that (i) purchase of shares of Resource REIT was financed by "acquisition indebtedness'' or (ii) such dividends constitute excess inclusion income. Taxable Income Resource REIT uses the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with GAAP. These differences primarily arise from timing differences in the recognition of revenue and expense for tax and GAAP purposes. Additionally, Resource REIT's taxable income does not include the taxable income of its taxable affiliate, although the affiliate is included in the Company's GAAP consolidated financial statements. For the year ended December 31, 1993, Resource REIT's estimated taxable income was approximately $61.5 million. A portion of the dividends paid during 1993 was allocated to satisfy 1992 distribution requirements and a portion of the dividends paid in 1994 will be allocated to satisfy 1993 distribution requirements. All of the dividends paid during 1993 represented ordinary income for federal income tax purposes. Competition The Company competes with a number of institutions with greater financial resources in purchasing mortgage loans through its mortgage conduit operations. In addition, in purchasing mortgage assets and in issuing mortgage securities, the Company competes with investment banking firms, savings and loan associations, banks, mortgage bankers, insurance companies and other lenders, GNMA, FHLMC and FNMA and other entities purchasing mortgage assets, many of which have greater financial resources than the Company. Additionally, mortgage securities issued relative to its mortgage conduit operations will face competition from other investment opportunities available to prospective purchasers. Employees As of December 31, 1993, the Company had approximately 150 employees. Item 2. Item 2. PROPERTIES ---------- The Company's executive and administrative offices are located in Columbia, Maryland and the Company's operations offices are located in Glen Allen, Virginia, on properties leased by the Company. The executive and administrative offices are located at 10500 Little Patuxent Parkway, Suite 650, Columbia, Maryland, 21044. Item 3. Item 3. LEGAL PROCEEDINGS ----------------- In March 1993, the Company was notified by the Securities and Exchange Commission (the "Commission") that a formal order of investigation had been issued to review trading activity in the Company's stock during April and May of 1992. In this regard, the Company and certain of its officers and directors have produced documents and testified before the staff of the Commission. The Company and the subpoenaed officers and directors are complying with the requests of the Commission. Based on information available to the Company, and upon advice of counsel, management does not believe that the investigation will result in any action that will have a material adverse impact on the Company. There were no other pending legal proceedings, outside the normal course of business, to which the Company was a party or of which any of its property was subject at December 31, 1993. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- No matters were submitted to a vote of the Company's stockholders during the fourth quarter of 1993. 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 under the trading symbol RMR. The Company's common stock was held by approximately 3,900 holders of record as of January 31, 1994. In addition, depository companies held stock for approximately 25,200 beneficial owners. During the last two years, the high and low closing stock prices and cash dividends declared on common stock were as follows: Cash Dividends High Low Declared ------ ----- -------- - ---- First quarter $ 12 3/8 $ 9 3/8 $ 0.45 (1) Second quarter 17 7/8 11 7/8 0.55 Third quarter 22 3/4 17 5/8 0.65 Fourth quarter 22 3/4 19 1/2 0.75 (2) - ---- First quarter $ 29 7/8 $ 20 3/8 $ 0.85 (2) Second quarter 28 1/8 26 1/2 0.75 Third quarter 30 7/8 27 3/4 0.77 Fourth quarter 32 1/4 28 5/8 0.78 (3) - ------------------ (1) The January 1992 dividend of $0.15 was declared in December 1991 and is included in the dividends for the first quarter of 1992. (2) The $0.35 special dividend declared in December 1992 is included in the dividends for the first quarter of 1993. (3) Amount does not include the January 1994 dividend of $0.26 which was declared in December 1993. Item 6 Item 6 SELECTED FINANCIAL DATA ----------------------- (amounts in thousands except share data) Year ended December 31, 1993 1992 1991 1990 1989 - ---------------------- ---- ---- ----- ---- ----- Net margin on mortgage assets $ 45,019 $ 32,655 $ 22,923 $ 14,975 $ 5,811 ========= ======== ======= ========= ======== Gain on sale of mortgage assets, net of associated costs $ 25,985 $ 26,991 $ 10,218 $ 1,371 $ 1,007 ========= ========= ========= ========= ======= Total revenue $ 198,975 $ 177,505 $ 161,229 $ 140,038 $118,407 Total expenses 144,848 139,336 139,593 127,245 118,283 --------- -------- --------- --------- -------- Net income $ 54,127 $ 38,169 $ 21,636 $ 12,793 $ 124 ========= ========= ========= ========= ======== Net income per share $ 3.12 $ 2.73 $ 1.60 $ 0.91 $ 0.01 Average number of shares outstanding 17,364,309 13,999,047 13,531,290 14,091,783 14,450,100 Dividends declared per share $ 3.06(1)$ 2.60(2)$ 1.53(3)$ 0.74 $ 0.53 Return on average shareholders' equity 25.8% 27.7% 17.9% 10.6% 0.1% Principal balance of mortgage loans funded $ 4,093,714$ 5,334,174$ 2,491,434$605,752$ 967,291 Year ended December 31, 1993 1992 1991 1990 1989 - ---------------------- ---- ---- ----- ---- ----- Mortgage Investments: Collateral for CMOs $ 434,698$ 571,567$ 820,517$987,856$1,122,378 Adjustable-rate mortgage securities (4) 2,021,196 1,199,911 658,311 223,894 90,701 Fixed-rate mortgage securities (4) 214,128 165,206 22,062 14,741 8,547 Other mortgage securities (4) 65,625 36,461 53,176 87,825 100,630 Mortgage warehouse participations 156,688 121,624 88,312 - - Total assets 3,726,762 2,239,656 1,829,632 1,412,257 1,395,199 CMO bonds payable, net (5) 432,677 561,441 805,493 971,356 1,102,306 Repurchase agreements 2,754,166 1,315,334 637,599 235,553 99,812 Total liabilities 3,473,730 2,062,219 1,708,197 1,291,893 1,273,893 Shareholders' equity 253,032 177,437 121,435 120,364 122,016 Number of shares outstanding 19,331,932 16,507,100 13,542,137 13,529,700 14,450,100 Book value per share $ 13.09 $ 10.75 $ 8.97 $ 8.90 $ 8.44 - --------------------- (1) Includes the January 1994 dividend of $0.26 which was declared in December 1993. (2) Includes the January 1993 dividend of $0.35 which was declared in December 1992. (3) Includes the January 1992 dividend of $0.15 which was declared in December 1991. (4) Includes mortgage securities held for possible sale. (5) This debt is non-recourse to the Company. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Resource Mortgage Capital, Inc. (the "Company") operates a mortgage conduit and invests in a portfolio of residential mortgage securities. The Company's primary strategy is to use its mortgage conduit operations, which involve the purchase and securitization of residential mortgage loans, to create investments for its portfolio. The Company's principal sources of income are net interest income on its investment portfolio, gains on the securitization and sale of mortgage loans and the interest spread realized while the mortgage loans are being accumulated for securitization. In 1993, the Company's results improved primarily from an increase in the net margin on its mortgage assets. This improvement in net margin resulted from the addition of investments created by the Company's mortgage conduit operations and the rapid paydown of certain lower yielding investments owned by the Company. Results of Operations 1993 1992 1991 ---- ---- ---- (amounts in thousands except per share information) Net margin on mortgage assets $ 45,019 $ 32,655 $ 22,923 Net gain on sales 25,985 26,991 10,218 Net income 54,127 38,169 21,636 Net income per share 3.12 2.73 1.60 Dividends declared 53,835 38,197 20,706 Dividends declared per share 3.06 2.60 1.53 Principal balance of mortgage loans funded 4,093,714 5,334,174 2,491,434 1993 compared to 1992 - ---------------------- The increase in the Company's earnings during 1993 as compared to 1992 is primarily the result of (i) the increase in net margin on mortgage assets and (ii) the decrease in valuation adjustments. The increase in earnings was partially offset by (i) a decrease in the net gain on sale of mortgage assets and (ii) the increase in general and administrative expenses. Net margin on mortgage assets increased to $45.0 million for 1993 from $32.7 million for 1992. This increase resulted primarily from the overall growth of the portfolio. The Company was able to increase the size of its portfolio primarily through the use of proceeds from common stock issued during 1993. The principal amount of mortgage loans securitized or sold decreased to $3.4 billion during 1993 from $5.4 billion during the same period in 1992. As a result of the decrease in principal amount of mortgage loans securitized or sold, the Company's net gains on sales of mortgage assets decreased to $26.0 million for 1993 from $27.0 million for 1992. Although the principal amount of mortgage loans securitized decreased during 1993, the percentage gain realized on such sales or securitizations increased and generally offset the effects of such decline in volume. While the Company did not incur management fee expense in 1993 due to the termination of its prior management agreement, the Company incurred $15.2 million of general and administrative expenses for 1993. In comparison, the Company incurred management fee expense of $4.9 million and general and administrative expenses of $9.6 million during 1992. The increase in general and administrative expenses is due primarily to (i) the addition of an underwriting department in 1993 and (ii) the change to self management in June 1992. During 1993 and 1992, the Company recorded valuation adjustments to certain mortgage investments of $2.4 million and $7.3 million, respectively. These valuation adjustments were based on expectations that future prepayment speeds would result in the Company receiving less cash on certain investments than its amortized cost basis in such investments. 1992 compared to 1991 - --------------------- The increase in the Company's earnings in 1992 as compared to 1991 is primarily the result of the increase in gain on sale of mortgage assets to $27.0 million for 1992 from $10.2 million for 1991 and an improvement in net margin on mortgage assets to $32.7 million for 1992 from $22.9 million for 1991. The principal amount of mortgage loans funded increased substantially to $5.3 billion in 1992 from $2.5 billion in 1991. As a result of the increased volume of loans funded and favorable interest rates, the Company realized significant gains on securitizations and sales of $27.0 million and realized an increase in the spread between interest income earned on mortgage loans held in warehouse and the interest expense paid on warehouse borrowings. The increase in the volume of mortgage loans funded is attributable not only to general market activity arising from lower interest rates, but also to the continued success of the Company's funding of adjustable-rate mortgage loans. The increase in net margin to $32.7 million in 1992 from $22.9 million in 1991 was partially offset by valuation adjustments which were based upon projections that the Company would receive less cash on certain investments than its amortized basis in the investments due to higher than anticipated rates of mortgage prepayments. During 1992, the Company recorded valuation adjustments of $7.3 million on certain mortgage investments. Additionally, while the Company did not incur management fee expense in the third and fourth quarters of 1992 due to the termination of the management agreement with Ryland Acceptance Corporation, the manager of the Company through June 16, 1992, the Company's general and administrative expenses increased due to this transition to self-management. General and administrative expenses also include a one-time charge of $2.0 million related to the cancellation of a portion of the stock options held by Ryland Acceptance Corporation and accruals related to the Company's stock incentive plan. The following table summarizes the average balances of the Company's interest-earning assets and their average effective yields, along with the Company's average interest-bearing liabilities and the related average effective interest rates, for each of the years presented. - ------------------ (1) Average balances exclude funds held by trustees of $16,325, $26,338 and $15,198 for the years ended December 31, 1993, 1992 and 1991, respectively. (2) "Collateralized mortgage obligations: Other" expense and "Other" expense as shown on the consolidated statements of operations are excluded from the calculations of effective interest rates on interest- bearing liabilities. Portfolio Activity The Company's investment strategy is to create a diversified portfolio of mortgage securities that in the aggregate generate stable income in a variety of interest rate and prepayment rate environments and preserve the capital base of the Company. The Company has pursued its strategy of concentrating on its mortgage conduit activities in order to create investments with attractive yields and to benefit from potential gains on securitization. In many instances the Company's investment strategy involves not only the creation or acquisition of the asset, but also the related borrowing to pay for a portion of that asset. 1993 compared to 1992 - --------------------- The size of the Company's portfolio of mortgage investments at December 31, 1993 has increased as compared to December 31, 1992, through the addition of investments created through the Company's conduit operations and the purchase of mortgage investments. During 1993 the Company added approximately $728.3 million of adjustable-rate mortgage securities, $202.3 million of fixed-rate mortgage securities and $12.2 million of other mortgage securities to its portfolio through its conduit operations. During 1993, the Company retained $102.2 million principal amount of mortgage loans as collateral for CMOs. Also during 1993 the Company purchased approximately $279.5 million of adjustable-rate mortgage securities, $57.8 million of fixed-rate mortgage securities and $31.1 million of other mortgage securities for its portfolio. A portion of these securities were financed through repurchase agreements with investment banking firms. Additionally, during 1993, the Company sold $72.5 million and $184.3 million principal amount of adjustable-rate and fixed-rate mortgage securities, respectively, from its portfolio. During 1992, the Company sold $282.1 million of adjustable-rate mortgage securities, $19.1 million of other mortgage securities and $38.4 million of collateral for CMOs, net of $37.3 million of associated borrowings, from its portfolio. The Company realized net gains of $1.4 million during 1993 and $1.7 million during 1992 on the sale of mortgage securities. The net margin on the Company's portfolio of mortgage investments increased to $34.6 million for 1993 from $25.7 million for 1992. This increase resulted from the overall growth of mortgage investments. Portfolio results for 1993 and 1992 were partially offset by valuation adjustments to certain mortgage investments of $2.4 million and $7.3 million, respectively, based on expectations that future prepayment speeds would result in the Company receiving less cash on certain investments than its amortized cost basis in such investments. During 1993, the Company purchased additional LIBOR-based interest rate cap agreements to limit its exposure to the lifetime interest rate cap on its adjustable-rate mortgage securities. At December 31, 1993, the Company had purchased cap agreements with an aggregate notional amount of $1.3 billion. Pursuant to these agreements, the Company will receive additional cash flows if six month LIBOR increases above certain specified levels. The amortization of the cost of the cap agreements will reduce interest income on adjustable-rate mortgage securities over the lives of the agreements. The Company participates in mortgage warehouse lines of credit. The Company's obligations under the participations are funded primarily by sales of commercial paper. An agreement with a bond guarantor and a syndicate of commercial banks provides 100% credit and liquidity support for the commercial paper and for the Company's obligations under its participations. As of December 31, 1993, the Company had acquired $185.0 million of participations and had advanced $156.7 million pursuant to these participations. Under the Company's liquidity agreement, which terminates on April 30, 1994, participations are limited to $250 million. 1992 compared to 1991 - --------------------- The composition of the Company's portfolio of mortgage investments at December 31, 1992 has changed as compared to December 31, 1991, primarily through the addition of investments created through the single-family mortgage conduit. These changes were made in order to further stabilize the yield on the portfolio of mortgage investments in different interest rate environments. During 1992 and 1991, the Company retained $749.2 million and $611.4 million, respectively, of adjustable-rate mortgage securities that were created as the Company securitized mortgage loans purchased through the single- family mortgage conduit. These retained securities were financed through repurchase agreements with investment banking firms. Also during 1992, the Company retained $170.4 million principal amount of mortgage loans as collateral for CMOs. No loans were retained during 1991 as collateral for CMOs. Additionally, during 1992 the Company sold $282.1 million of adjustable-rate mortgage securities, $19.1 million of other mortgage securities, and $38.4 million of collateral for CMOs, net of $37.3 million of associated borrowings, from its portfolio. During 1991 the Company sold no adjustable-rate mortgage securities, $40.2 million of other mortgage securities and no collateral for CMOs. During 1992 and 1991, the Company realized net gains of $1.7 million on the sale of mortgage investments in each year. The net margin on the Company's portfolio of mortgage investments increased to $25.7 million for 1992 from $18.9 million for 1991. This increase resulted primarily from the overall growth of the portfolio and the increase in adjustable-rate mortgage securities and the decrease in CMOs as a percentage of the total portfolio. Mortgage Conduit Operations As a "mortgage conduit," the Company acts as an intermediary between the originators of mortgage loans and the permanent investors in the mortgage loans or the mortgage-related securities backed by such mortgage loans. Historically, the Company's conduit operations consisted of the purchase and securitization of single-family mortgage loans that qualified for mortgage pool insurance. During 1993, the Company expanded its single-family conduit operations to include the purchase of mortgage loans that were underwritten by the Company and expanded its securitization strategy to include the senior/subordinated security structure as an alternative to using pool insurance as a source of credit enhancement. The Company also operates other mortgage conduit activities. Single-family Mortgage Conduit Operations Through its single-family mortgage conduit, the Company purchases mortgage loans from approved sellers, primarily mortgage companies, savings and loan associations and commercial banks. When a sufficient volume of mortgage loans is accumulated, the Company sells or securitizes these mortgage loans through the issuance of CMOs or pass- through securities. During the accumulation period, the Company finances its purchases of mortgage loans through warehouse lines of credit or through repurchase agreements. The following table summarizes single-family conduit activity for 1993, 1992 and 1991. (amounts in thousands) 1993 1992 1991 Principal amount of loans purchased $4,002,385 $ 5,311,406 $ 2,491,434 Principal amount securitized or sold 3,332,200 5,374,543 2,414,189 Investments added to portfolio from the single-family conduit, net of associated borrowings 54,528 77,475 48,634 1993 Compared to 1992 - --------------------- The decrease in the purchase volume of single- family loans for 1993 as compared to 1992 reflects generally (i) the greater competition in the secondary mortgage market and (ii) the underwriting and pricing changes of the mortgage pool insurers. The Company's net gains on sale of mortgage assets decreased to $26.0 million for 1993 from $27.0 million for 1992. Although the principal amount of mortgage loans securitized decreased during 1993, the percentage gain realized on such sales or securitizations increased and generally offset the effects of such decline in volume. This higher profitability was partially offset by increased general and administrative costs related to the establishment of an internal underwriting department as the Company began to underwrite mortgage loans purchased without a commitment for mortgage pool insurance. The Company expects that its general and administrative costs will continue to increase as a greater percentage of the mortgage loans are underwritten by the Company. The Company had outstanding commitments to purchase single-family mortgage loans totaling $381.7 million and $431.1 million at December 31, 1993 and 1992, respectively. As of December 31, 1993 and December 31, 1992, the Company had $13.2 million and $11.6 million, respectively, of deferred net gains related to the securitization of certain convertible ARM loans which the Company has agreed to purchase upon their conversion to a fixed-rate of interest. The deferred income will be recognized over the remaining conversion period until the conversion option expires, which is five years after the origination of each mortgage loan. 1992 compared to 1991. The increase in the single-family mortgage conduit volume for 1992 as compared to 1991 reflects generally higher levels of mortgage activity as interest rates have declined, and increases in the purchase of ARM loans. As the single-family mortgage conduit volume has increased, the gains related to securitizations and sales increased to $27.0 million in 1992 from $10.2 million in 1991. Additionally, the spread (difference between interest income on the loans and the interest expense on associated short-term borrowings) that the Company earned on the mortgage loans during the accumulation period increased to 1.55% in 1992 from 1.17% in 1991. As of December 31, 1992 and December 31, 1991, the Company had $11.6 million and $4.5 million, respectively, of deferred net gains related to the securitization of certain convertible ARM loans which the Company has agreed to purchase upon their conversion to a fixed-rate of interest. The deferred income will be recognized over the remaining conversion period until the conversion option expires, which is five years after the origination of each mortgage loan. Other Mortgage Conduit Operations The Company originates multi-family mortgage loans secured by properties that have qualified for low income housing tax credits pursuant to Section 42 of the Internal Revenue Code. These tax credits, which are available generally for ten years beginning when the property was placed in service, provide a substantial incentive for the borrower not to default on the mortgage loan, as the borrower would lose upon foreclosure any future tax credits relating to the property and could face recapture of a portion of the tax credits already taken. During 1993, the Company funded multi-family mortgage loans with an aggregate principal balance of $91.3 million. Also during 1993 the Company securitized $102.2 million in principal amount of multi-family loans. At December 31, 1993, mortgage loans in warehouse included multi-family mortgage loans with an aggregate principal balance of $11.3 million and the Company had commitments outstanding to fund an additional $22.5 million in such mortgage loans. Due to the delay by Congress in approving the Omnibus Reconciliation Act of 1993, tax credits were not allocated to the states for re-allocation to developers until late 1993. Thus, the Company expects slower origination volume of multi-family loans during the first half of 1994, with an increase later in the year. Other Matters Upon the securitization of single-family mortgage loans using mortgage pool insurance, the Company generally retains limited exposure for special hazard losses and for losses arising from mortgagor bankruptcy claims. At December 31, 1993, the Company's total exposure for special hazard and mortgagor bankruptcy losses was $21.2 million and the Company pledged a comparable amount of mortgage securities as collateral to provide coverage for these potential losses. An estimate of possible losses is made at the time loans are securitized and securities are retained in the portfolio at a discount to compensate the Company for this risk. The estimate is based on management's judgement, and is evaluated periodically for factors such as geographic location and industry loss experience. At December 31, 1993 the discount totaled $19.7 million of which $17.2 million was included in adjustable-rate mortgage securities, net and $2.5 million was included in fixed-rate mortgage securities, net. The Company has limited exposure to losses due to fraud during the origination of a mortgage loan. The Company has established a loss allowance for such losses. An estimate for such losses is made at the time loans are sold or securitized, and the loss allowance is adjusted accordingly. This estimate is based on management's judgement and the allowance is evaluated periodically. At December 31, 1993 the allowance totaled $5.3 million and was included in other liabilities. The Company is exposed to losses to the extent that mortgage loans in warehouse are secured by properties that were damaged as a result of the January 1994 earthquake in the Los Angeles area. The Company does not expect that any losses due to this earthquake will have a material effect on its financial position or results of operations. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, which addresses the accounting and reporting for investments in debt and equity securities. This Statement is effective for fiscal years beginning after December 15, 1993 and has not yet been applied by the Company. The Company does not anticipate that its application of this Statement will have a material impact on its results of operations or its financial condition. The Company and its qualified REIT subsidiaries (collectively "Resource REIT") have elected to be treated as a real estate investment trust for federal income tax purposes, and therefore is required to distribute annually substantially all of its taxable income. Resource REIT estimates that its taxable income for 1993 was approximately $61.5 million. Taxable income differs from the financial statement net income which is determined in accordance with generally accepted accounting principles. A portion of the dividends paid in 1993 will be allocated to satisfy tax distribution requirements of the previous year. Resource REIT determines its dividend relative to its anticipated taxable income for the year. Excess inclusion income can arise from Resource REIT's holdings of residual interests in real estate mortgage investment conduits and in certain other types of mortgage-backed security structures created after 1991. In the unlikely event that the Company's excess inclusion income is greater than its taxable income, the Company's distribution would be based on the Company's excess inclusion income. In 1993 the Company's excess inclusion income was approximately 18% of its taxable income. Liquidity and Capital Resources The Company uses its cash flow from operations, issuance of CMOs or pass-through securities, other borrowings and capital resources to meet its working capital needs. The Company believes that the cash flow from its portfolio and borrowing arrangements provide sufficient liquidity for the conduct of its operations. The Company's borrowings may bear fixed or variable interest rates, may require additional collateral in the event that the value of the existing collateral declines, and may be due on demand or upon the occurrence of certain events. If borrowing costs are higher than the yields on the mortgage assets purchased with such funds, the Company's ability to acquire mortgage assets may be substantially reduced and it may experience losses. The Company borrows funds on a short-term basis to support the accumulation of mortgage loans prior to the sale of such mortgage loans or the issuance of mortgage securities. These short-term borrowings consist of the Company's warehouse lines of credit and repurchase agreements and are paid down as the Company securitizes or sells mortgage loans. The Company had a $115 million revolving warehouse line of credit to finance the purchase of mortgage loans with a consortium of commercial banks that expired on March 1, 1994. During February 1994, the Company replaced the revolving warehouse line of credit with a $150 million credit facility, which also allows the Company to borrow up to $30 million on an unsecured basis for working capital purposes. This new credit facility expires in February 1995. The Company presently has revolving committed repurchase agreements of $300 million and $100 million maturing on June 25, 1994 and September 12, 1994, respectively. The Company has arranged separate financing for the origination of multi-family mortgage loans for up to $75 million. The Company expects that these credit facilities will be renewed if necessary, at their respective expiration dates, although there can be no assurance of such renewal. At December 31, 1993 the Company had borrowed $673.7 million under these credit facilities. The lines of credit contain certain financial covenants which the Company met as of December 31, 1993. However, changes in asset levels or results of operations could result in the violation of one or more covenants in the future. The Company finances adjustable-rate mortgage securities and certain other mortgage assets through repurchase agreements. Repurchase agreements allow the Company to sell mortgage assets for cash together with a simultaneous agreement to repurchase the same mortgage assets on a specified date for an increased price, which is equal to the original sales price plus an interest component. At December 31, 1993, the Company had outstanding obligations of $2.2 billion under such repurchase agreements, of which $2.0 billion, $204.4 million and $12.1 million were secured by adjustable-rate mortgage securities, fixed-rate mortgage securities and other mortgage securities, respectively. Increases in either short-term interest rates or long-term interest rates could negatively impact the valuation of these mortgage assets and may limit the Company's borrowing ability or cause various lenders to initiate margin calls. Additionally, certain of the Company's adjustable-rate mortgage securities are AA rated classes that are subordinate to related AAA rated classes from the same series of securities. Such AA rated classes have less liquidity than securities that are not subordinated, and the value of such classes is more dependent on the credit rating of the related mortgage pool insurer. As a result of either changes in interest rates or a downgrade of a mortgage pool insurer, the Company may be required to sell certain mortgage assets in order to maintain liquidity. If required, these sales could be made at prices lower than the carrying value of the assets, which could result in losses. The Company issues asset-backed commercial paper to support its purchase of mortgage warehouse participations. An agreement with a consortium of commercial banks provides 100% liquidity support for the commercial paper and for the Company's obligation to fund on participations it has purchased. Based on such liquidity support, the Company's commercial paper has been rated in the highest category by two nationally recognized rating agencies. A substantial portion of the assets of the Company are pledged to secure indebtedness incurred by the Company. Accordingly, those assets would not be available for distribution to any general creditors or the stockholders of the Company in the event of the Company's liquidation, except to the extent that the value of such assets exceeds the amount of the indebtedness they secure. During the third quarter of 1993, the Company issued an additional 2,300,000 shares of common stock through its registration statement filed with the Securities and Exchange Commission earlier in 1993. Proceeds from this issuance were used initially to pay down short-term borrowings and to support the accumulation of mortgage loans. The REIT provisions of the Internal Revenue Code require Resource REIT to distribute to shareholders substantially all of its taxable income, thereby restricting its ability to retain earnings. The Company may issue additional common stock or other securities in the future in order to fund growth in its operations, growth in its portfolio of mortgage investments, or for other purposes. During 1993 the Company issued 524,832 additional shares of common stock through its Dividend Reinvestment Plan. Total net proceeds of $15.0 million were used for general corporate purposes. During October 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission for the issuance of up to $200 million of (i) debt securities, (ii) preferred stock, (iii) common stock, and (iv) warrants. This shelf registration statement provides for the issuance, from time to time, of one or more of the foregoing securities. Proceeds from any offerings pursuant to this shelf registration statement will be used for general corporate purposes, which may include the purchase of mortgage loans through the Company's conduit operations, investment in mortgage securities, and growth of new business lines. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- The consolidated financial statements of the Company and the related notes, together with the Independent Auditors' Report thereon are set forth on pages through of this 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 required by Item 10 as to directors and executive officers of the Company is incorporated herein by reference to the definitive proxy statement to be filed pursuant to Regulation 14A. Item 11. Item 11. EXECUTIVE COMPENSATION ---------------------- The information required by Item 11 is incorporated herein by reference to the definitive proxy statement to be filed pursuant to Regulation 14A. 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 definitive proxy statement to be filed pursuant to Regulation 14A. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ---------------------------------------------- The information required by Item 13 is incorporated herein by reference to the definitive proxy statement to be filed pursuant to Regulation 14A. 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. and 2. Financial Statements and Financial Statement Schedules The information required by this section of Item 14 is set forth in the Consolidated Financial Statements and Independent Auditors' Report beginning at page of this Form 10-K. The index to the Financial Statements and Schedules is set forth at page of this Form 10-K. 3. Exhibits Exhibit Number Exhibit - ------- ------- 3.1 Articles of Incorporation of the Registrant, as amended (A) 3.2 Amended Bylaws of the Registrant (B) 10.1 Selected Portions of the Registrant's Seller/Servicer Guide (C) 10.2 Program Servicing Agreement between the Registrant and Ryland Mortgage Company, as amended (F) 10.3 Dividend Reinvestment and Stock Purchase Plan (D) 10.4 1992 Stock Incentive Plan (E) 10.5 Executive Deferred Compensation Plan (filed herewith) 11.1 Statement of re Computation of Per Share Earnings (filed herewith) 21.1 List of subsidiaries and consolidated entities of the Company (filed herewith) 23.1 Consent of KPMG Peat Marwick (filed herewith) 99.1 Analysis of Projected Yield (filed herewith) (b) Reports on Form 8-K None - ------------------ (A) Incorporated herein by reference to the Company's Registration Statement on Form S-3 (No. 33-53494) filed October 20, 1992. (B) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, as amended. (C) Incorporated herein by reference to Saxon Mortgage Securities Corporation's Registration Statement on Form S-11 (No. 33-57204) filed January 21, 1993. (D) Incorporated herein by reference to Exhibits to Amendment No. 2 to Company's Registration Statement on Form S-3 (No. 33-52071) dated September 8, 1988. (E) Incorporated herein by reference to the Proxy Statement dated July 13, 1992 for the Special Meeting of Stockholders held August 17, 1992. (F) Incorporated herein by reference to exhibits to the registrant's Form 10-K for the year ended December 31, 1991 (No. 1-9819) dated February 18, 1992. 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. RESOURCE MORTGAGE CAPITAL, INC. (Registrant) March 21, 1994 Thomas H. Potts Thomas H. Potts President (Principal Executive Officer) March 21, 1994 Lynn K. Geurin Lynn K. Geurin Executive Vice President and Chief Financial Officer (Principal Accounting and Financial Officer) Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Capacity Date --------- --------- ------ Thomas H. Potts Director March 21, 1994 - -------------------------- Thomas H. Potts J. Sidney Davenport, IV Director March 21, 1994 - -------------------------- J. Sidney Davenport, IV Richard C. Leone Director March 21, 1994 - -------------------------- Richard C. Leone Paul S. Reid Director March 21, 1994 - -------------------------- Paul S. Reid Donald B. Vaden Director March 21, 1994 - -------------------------- Donald B. Vaden EXHIBIT INDEX Sequentially Exhibit Numbered Numbered Exhibit Page - -------- ------- ---- 10.5 Executive Deferred Compensation Plan 11.1 Statement of re Computation of per share earnings. 21.1 List of subsidiaries. 23.1 Consent of KPMG Peat Marwick. 99.1 Analysis of Projected Yield. RESOURCE MORTGAGE CAPITAL, INC. CONSOLIDATED FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT For Inclusion in Form 10-K Annual Report Filed with Securities and Exchange Commission December 31, 1993 RESOURCE MORTGAGE CAPITAL, INC. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Financial Statements: Page Independent Auditors' Report Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Operations -- For the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' 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 -- December 31, 1993, 1992 and 1991 Summary of Quarterly Results Schedules: Schedule IX - Short-Term Borrowings Schedule XII - Mortgage Loans on Real Estate All other schedules are omitted because they are not applicable or not required. INDEPENDENT AUDITORS' REPORT The Board of Directors Resource Mortgage Capital, Inc.: We have audited the consolidated financial statements of Resource Mortgage Capital, Inc. 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 Resource Mortgage Capital, 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. 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 Baltimore, Maryland February 7, 1994 CONSOLIDATED BALANCE SHEETS RESOURCE MORTGAGE CAPITAL, INC. December 31, 1993 and 1992 (amounts in thousands except share data) ASSETS 1993 1992 Mortgage investments: Collateral for CMOs $ 434,698 $ 571,567 Adjustable-rate mortgage securities, net (includes $437,811 and $203,620 held for possible sale, respectively) 2,021,196 1,199,911 Fixed-rate mortgage securities, net (includes $19,527 and $148,877 held for possible sale, respectively) 214,128 165,206 Other mortgage securities (includes $20,554 and $1,803 held for possible sale, respectively) 65,625 36,461 Mortgage warehouse participations 156,688 121,624 ------------- --------- 2,892,335 2,094,769 Mortgage loans in warehouse 777,769 123,627 Cash 1,549 1,135 Accrued interest receivable 13,466 8,422 Other assets 41,643 11,703 ----------- --------- $ 3,726,762 $ 2,239,656 ========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES Collateralized mortgage obligations, net of discounts of $12,101 and $684, respectively $ 432,677 $ 561,441 Repurchase agreements 2,754,166 1,315,334 Notes payable 87,451 32,878 Commercial paper 148,672 115,620 Accrued interest payable 14,695 8,217 Deferred income 13,214 11,644 Other liabilities 22,855 17,085 ----------- ---------- 3,473,730 2,062,219 ----------- ---------- SHAREHOLDERS' EQUITY Common stock: par value $.01 per share, 50,000,000 shares authorized 19,331,932 and 16,507,100 issued and outstanding, respectively 193 165 Additional paid-in capital 259,622 184,347 Retained earnings (deficit) (6,783) (7,075) ---------- ------- 253,032 177,437 ---------- ------- $ 3,726,762 $ 2,239,656 =========== =========== See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF OPERATIONS RESOURCE MORTGAGE CAPITAL, INC. Years ended December 31, 1993, 1992 and 1991 (amounts in thousands except share data) 1993 1992 1991 ---- ---- ---- Interest income: Collateral for CMOs $ 39,538 $ 57,694 $ 91,108 Adjustable-rate mortgage securities 76,059 49,984 28,771 Fixed-rate mortgage securities 14,033 4,595 1,904 Other mortgage securities 8,275 7,681 11,109 Mortgage warehouse participations 5,719 5,854 1,156 Mortgage loans in warehouse 28,632 24,280 16,830 --------- ---------- ---------- 172,256 150,088 150,878 ---------- ---------- ---------- Interest and CMO-related expense: Collateralized mortgage obligations: Interest 37,198 55,376 85,622 Other 2,067 3,524 4,442 Repurchase agreements 74,822 47,828 29,352 Notes payable 4,299 4,727 6,901 Commercial paper 3,465 3,786 756 Other 5,386 2,192 882 -------- ------- ------- 127,237 117,433 127,955 -------- ------- ------- Net margin on mortgage assets 45,019 32,655 22,923 Valuation adjustments on mortgage assets (2,400) (7,348) (3,021) Gain on sale of mortgage assets, net of associated costs 25,985 26,991 10,218 Other income 734 426 133 Management fees - (4,945) (5,713) General and administrative expenses (15,211) (9,610) (2,904) --------- -------- -------- Net income $ 54,127 $ 38,169 $ 21,636 ========= ========= ========= Net income per share $ 3.12 $ 2.73 $ 1.60 ========= ========= ======== Weighted average number of common shares outstanding 17,364,309 13,999,047 13,531,290 ========== ========== ========== See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY RESOURCE MORTGAGE CAPITAL, INC. Years ended December 31, 1993, 1992 and 1991 (amounts in thousands except share data) Additional Retained Number of Common paid-in earnings shares stock capital (deficit) Total Balance at December 31, 1990 13,529,700 $ 135 $ 128,206 $ (7,977) $ 120,364 Issuance of common stock 12,437 - 141 - 141 Net income - 1991 - - - 21,636 21,636 Dividends declared - $ 1.53 per share - - - (20,706) (20,706) --------- ------ -------- -------- ---------- Balance at December 31, 1991 13,542,137 135 128,347 (7,047) 121,435 Issuance of common stock 2,763,931 28 53,542 - 53,570 Options exercised 201,032 2 2,458 - 2,460 Net income - 1992 - - - 38,169 38,169 Dividends declared - $ 2.60 per share - - - (38,197) (38,197) --------- ----- ------ -------- -------- Balance at December 31, 1992 16,507,100 165 184,347 (7,075) 177,437 Issuance of common stock 2,824,832 28 75,275 - 75,303 Net income - 1993 - - - 54,127 54,127 Dividends declared - $ 3.06 per share - - - (53,835) (53,835) ---------- ------ ------ -------- -------- Balance at December 31, 1993 19,331,932 $ 193 $ 259,622 $ (6,783) $ 253,032 ========= ===== ========= ========= ========= See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS RESOURCE MORTGAGE CAPITAL, INC. Years ended December 31, 1993, 1992 and 1991 (amounts in thousands) 1993 1992 1991 ---- ---- ---- Operating activities: Net income $ 54,127 $ 38,169 $ 21,636 Adjustments to reconcile net income to net cash provided by (used for) operating activities: Amortization 6,763 4,190 4,764 Net (increase) decrease in mortgage loans in warehouse (654,437) 46,108 (82,200) Net (increase) decrease in accrued interest, other payables and other assets (18,514) 19,932 6,133 Net gain from sales of mortgage investments (1,420) (1,710) (1,739) Other 5,927 8,298 3,021 ---------- --------- --------- Net cash provided by (used for) operating activities (607,554) 114,987 (48,385) ---------- --------- -------- Investing activities: Collateral for CMOs: Purchases of mortgage loans subsequently securitized (104,650) (171,783) (73,819) Principal payments on collateral 226,198 384,222 244,997 Net change in funds held by trustees 12,909 (7,347) (7,128) ---------- --------- -------- 134,457 205,092 164,050 Proceeds from sale of CMOs, net of noncash items - 1,113 - Purchase of other mortgage investments (1,346,580) (1,004,765) (720,627) Principal payments on other mortgage investments 141,926 63,084 50,457 Proceeds from sales of other mortgage investments 263,931 302,394 195,769 Capital expenditures (675) (1,595) - ---------- ---------- -------- Net cash used for investing activities (806,941) (434,677) (310,351) ---------- ---------- --------- Financing activities: Collateralized mortgage obligations: Proceeds from issuance of securities 107,670 169,494 58,544 Principal payments on securities (235,807) (374,460) (236,534) --------- --------- --------- (128,137) (204,966) (177,990) Proceeds from short-term borrowings, net 1,526,456 502,166 557,094 Proceeds from stock offerings 75,303 55,080 141 Dividends paid (58,713) (32,219) (20,026) ---------- -------- -------- Net cash provided by financing activities 1,414,909 320,061 359,219 --------- ------- -------- Net increase in cash 414 371 483 Cash at beginning of year 1,135 764 281 --------- ------- ------- Cash at end of year $ 1,549 $ 1,135 $ 764 ========== ========== ======== See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS RESOURCE MORTGAGE CAPITAL, INC. December 31, 1993, 1992 and 1991 (amounts in thousands except share data) NOTE 1 - THE COMPANY The Company operates a mortgage conduit and invests in a portfolio of residential mortgage-related assets. The Company's primary strategy is to use its mortgage conduit operations, which involve the purchase and securitization of residential mortgage loans, to create investments for its portfolio. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation - --------------------- The consolidated financial statements include the accounts of Resource Mortgage Capital, Inc., its wholly owned subsidiaries (together, Resource Mortgage), and certain other entities (collectively, the Company). All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts for 1992 and 1991 have been reclassified to conform to the presentation for 1993. Federal income taxes - -------------------- Resource Mortgage has elected to be taxed as a real estate investment trust (REIT) under the Internal Revenue Code. As a result, Resource Mortgage generally will not be subject to federal income taxation at the corporate level to the extent that it distributes at least 95 percent of its taxable income to its shareholders and complies with certain other requirements. Accordingly, no provision has been made for income taxes for Resource Mortgage and its qualified REIT subsidiaries in the accompanying consolidated financial statements. Mortgage Assets - --------------- Collateral for CMOs, adjustable-rate mortgage securities, fixed-rate mortgage securities, certain of the other mortgage securities and mortgage warehouse participations held for investment are carried at their outstanding principal balances, net of adjustments for premiums, discounts and deferred hedging gains or losses. Mortgage loans in warehouse, adjustable-rate mortgage securities, fixed-rate mortgage securities and other mortgage securities held for sale are carried at the lower of aggregate cost or market value. Other mortgage securities are carried at the lower of amortized cost or the estimated future net cash flows to be received on a gross undiscounted basis. The amortized cost includes deferred hedging gains and losses. Income on other mortgage securities is accrued using the effective yield method based upon estimates of future net cash flows to be received over the estimated remaining life of the mortgage securities. Estimated effective yields are changed prospectively consistent with changes in current interest rates and current prepayment assumptions on the underlying mortgage collateral used by various dealers in mortgage-backed securities. Reductions in carrying value are made when the total projected cash flow is less than the Company's basis, based on either the dealers' prepayment assumptions or, if it would accelerate such adjustments, management's expectations of interest rates and future prepayment rates. Price premiums and discounts - ---------------------------- Price premiums and discounts on mortgage investments are deferred as an adjustment to the carrying value of the investment and are amortized into interest income over their contractual lives using the effective yield method adjusted for the effects of prepayments. Price premiums and discounts on CMOs are deferred as an adjustment to the carrying value of the investment and are amortized into interest expense over the lives of the CMOs using the effective yield method. CMOs are carried at their outstanding principal balance, net of any unamortized price premiums and discounts. Deferred issuance costs - ----------------------- Costs incurred in connection with the issuance of CMOs are deferred and amortized over the estimated lives of the CMOs using the interest method adjusted for the effects of prepayments. These costs are included in other assets in the consolidated balance sheets. Deferred income - --------------- The Company defers the gains related to sales of convertible adjustable-rate mortgage loans (ARMs) which the Company will repurchase if the ARM converts to a fixed-rate mortgage loan. The deferred gains are recognized over the remaining period using the straight-line method until the conversion option expires, generally five years. Net income per share - -------------------- Net income per share is computed based on the weighted average number of common shares outstanding during the periods. Hedging transactions - -------------------- The Company may enter into forward delivery contracts and into financial futures and options contracts for the purpose of reducing exposure to the effect of changes in interest rates on mortgage loans which the Company has purchased or has committed to purchase. Gains and losses on such contracts relating to mortgage loans held for investment are deferred as an adjustment of the carrying value of the related mortgage loans and amortized into interest income using the effective yield method over the expected remaining life of the mortgage loans. Gains and losses on such contracts relating to mortgage loans which are held for sale are recognized when the loans are sold. The Company may enter into financial futures and options contracts in order to reduce exposure to the effect of changes in short-term interest rates on a portion of its variable-rate debt. Gains and losses on these contracts relating to variable-rate debt are deferred as an adjustment of the carrying value of the debt and are amortized into interest expense over the period to which such contracts relate. Cash flows from hedging transactions are included with the cash flows related to the hedged item in the consolidated statements of cash flows. Interest rate cap agreements - ---------------------------- The Company may enter into interest rate cap agreements to limit the Company's risks related to certain mortgage investments should short- term interest rates rise above specified levels. The amortization of the cost of such cap agreements will reduce interest income on the related investment over the lives of the cap agreements. The remaining unamortized cost of the cap agreements is included with the related investment in the consolidated balance sheets. Fair value of financial instruments - ----------------------------------- Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, requires that the Company disclose estimated fair values for its financial instruments. Many factors which affect the determination of fair value estimates are based on management's judgments as of the respective balance sheet dates. Therefore, there can be no assurance that fair value amounts disclosed would be realized in the event of these instruments being liquidated. NOTE 3 - MORTGAGE INVESTMENTS Collateral for CMOs - ------------------- Collateral for CMOs consists of fixed-rate mortgage loans secured by first liens on single-family and multi-family residential housing and fixed-rate mortgage securities guaranteed by U.S. government agencies. All collateral for CMOs is pledged to secure repayment of the CMOs. All principal and interest on the collateral is remitted directly to a trustee and, together with any reinvestment income earned thereon, is available for payment on the CMOs. The Company's exposure to loss on collateral for CMOs is limited due to various types of insurance arrangements on the collateral for CMOs and because losses not covered by such arrangements are generally borne by the CMO bondholders. Approximately 42% of the mortgage properties underlying the whole loan CMO collateral at December 31, 1993 are located in California. The components of collateral for CMOs are summarized as follows at December 31: 1993 1992 ----- ----- Mortgage collateral $ 415,378 $ 539,381 Funds held by trustees 12,010 24,919 Accrued interest receivable 3,206 4,280 --------- --------- 430,594 568,580 Unamortized premiums and discounts, net 4,104 2,987 --------- --------- Collateral for CMOs $ 434,698 $ 571,567 ======== ========== The mortgage collateral, together with certain funds held by trustees, collateralized 34 series of CMOs at December 31, 1993. As of December 31, 1993, the net investment in CMOs (collateral for CMOs of $434,698 plus deferred issuance costs of $2,208 less CMOs of $432,677) had an estimated fair value of $14,127. As of December 31, 1992, the net investment in CMOs (collateral for CMOs of $571,567 plus deferred issuance costs of $1,352 less CMOs of $561,441) had an estimated fair value of $11,142. These estimates are determined by calculating the present value of the projected net cash flows of the instruments using appropriate discount rates. The discount rates used are based on management's estimates of market rates, and the net cash flows are projected utilizing the current interest rate environment and forecasted prepayment rates. During the years ended December 31, 1993 and 1992, the Company pledged $102,194 and $170,380, respectively, of mortgage loans as collateral for CMOs. The average effective rate of interest income for all CMO collateral was 9.1%, 9.8% and 10.0% for the years ended December 31, 1993, 1992 and 1991, respectively. Adjustable-rate mortgage securities - ----------------------------------- Adjustable-rate mortgage securities consist of mortgage certificates secured by adjustable-rate mortgages (ARMs) on single-family residential housing. During 1993 and 1992, the Company added $713,678 and $749,162, respectively, aggregate principal of adjustable-rate mortgage securities from securitizations of mortgage loans purchased through its conduit operations. These securities had pass-through rates ranging from 3.5% to 5.7% and 4.9% to 6.4% at the time of issuance in 1993 and 1992, respectively. The Company purchases LIBOR-based interest-rate cap agreements to limit its exposure to the lifetime interest-rate cap on certain of its adjustable-rate mortgage securities. Under these agreements, the Company will receive additional cash flow should six month LIBOR increase above the contract rates of the cap agreements which range from 9.0% to 11.5%. The aggregate notional amount of the cap agreements is $1,163,500 and the cap agreements expire from 1999 to 2004. The amortization of the cost of the cap agreements will reduce interest income on the adjustable-rate mortgage securities over the lives of the agreements. The Company has credit risk to the extent that the counterparties to the cap agreements do not perform their obligation under the agreements. If one of the counterparties does not perform, the Company would not receive the cash to which it would otherwise be entitled under the conditions of the agreement. The carrying value of these agreements at December 31, 1993 and 1992 was $18,875 and $13,964, respectively. The fair value of adjustable-rate mortgage securities was estimated to be $2,040,390 and $1,220,898 at December 31, 1993 and December 31, 1992, respectively. These estimates are based on market prices provided by certain dealers. The average effective rate of interest income for adjustable-rate mortgage securities was 5.0%, 5.9% and 7.9% for the years ended December 31, 1993, 1992 and 1991, respectively. Fixed-rate mortgage securities - ------------------------------ Fixed-rate mortgage securities consist of mortgage certificates secured by fixed-rate mortgages on single-family residential housing. The aggregate effective rate of interest income was 7.6%, 9.2% and 10.6% for the years ended December 31, 1993, 1992 and 1991, respectively. The fair value of fixed-rate mortgage securities was estimated to be $217,711 and $169,973 at December 31, 1993 and 1992, respectively. These estimates were based on market prices provided by certain dealers. Other mortgage securities - ------------------------- Other mortgage securities include mortgage derivative securities and mortgage residual interests. Mortgage derivative securities are classes of CMOs, mortgage pass-through certificates, or mortgage certificates that pay to the holder substantially all interest (i.e., an interest-only security), or substantially all principal (i.e., a principal-only security). Mortgage residual interests represent the right to receive the excess of (i) the cash flow from the collateral pledged to secure related mortgage-backed securities, together with any reinvestment income thereon, over (ii) the amount required for principal and interest payments on the mortgage-backed securities or repurchase arrangements, together with any related administrative expenses. At December 31, 1993 and 1992, the carrying value of the Company's mortgage derivative securities was $37,816 and $11,905 respectively. The aggregate effective yield for the mortgage derivative securities was 30.1% and 29.3% for the years ended December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, the carrying value of the Company's mortgage residual interests was $27,809 and $25,382, respectively. The aggregate effective yield for the mortgage residual interests was 11.1% and 12.3% for the years ended December 31, 1993 and 1992, respectively. The fair value of other mortgage securities was estimated to be $61,743 and $30,570 at December 31, 1993 and 1992, respectively. These estimates were based on both dealer quotes and the present value of the projected cash flows of the instruments using appropriate discount rates. The discount rates used are based on management's estimates of market rates, and the net cash flows are projected utilizing the current interest rate environment and forecasted prepayment rates. The estimated undiscounted cash flows of other mortgage securities exceeded the carrying value at December 31, 1993 and 1992. In 1993, 1992 and 1991 the Company recorded valuation adjustments of $2,400, $7,348 and $3,021, respectively, relating to certain mortgage investments. These adjustments were recorded because the expectation of future prepayment rates would result in the Company receiving less cash on those investments than its amortized basis in the investments. The average effective rate of interest income for other mortgage securities was 19.2%, 16.3% and 17.3% for the years ended December 31, 1993, 1992 and 1991, respectively. Mortgage warehouse participations - --------------------------------- The Company invests in participations in existing warehouse lines of credit from approved warehouse lenders. These revolving lines of credit provide funds to established mortgage banking companies to carry mortgage loans from the time of settlement until the loans are sold to permanent investors. These lines of credit are secured by the related mortgage loans. At December 31, 1993 and 1992, the Company had acquired $185,000 and $146,500, respectively, of participations. The amount funded under these participations at December 31, 1993 and 1992 was $156,688 and $121,624 respectively, at a weighted average interest rate of 5.1% and 5.4%, respectively. The carrying amount of the mortgage warehouse participations approximates fair value at December 31, 1993 and 1992. Mortgage investments held for possible sale - ------------------------------------------- Mortgage investments which the Company may not hold to maturity are considered investments held for possible sale. These investments are carried at the lower of cost or estimated market value determined on an aggregate basis. At December 31, 1993 and 1992, these investments had an approximate market value of $481,341 and $355,902. Mortgage investments held for possible sale may be sold by the Company depending upon market conditions and liquidity requirements. The fair value of mortgage investments held for possible sale is estimated as discussed in their respective categories above. During 1993, 1992 and 1991, the Company sold $72,473, $282,110 and $152,520 of aggregate principal of adjustable-rate mortgage securities and recognized net gains of $285, $1,506 and $3,230 on these sales, respectively. During 1993, the Company sold $184,332 of aggregate principal of fixed-rate mortgage securities and recognized a net gain of $1,135 on these sales. No fixed-rate mortgage securities were sold during 1992 or 1991. During 1992, the Company sold $38,447 of collateral for CMOs, net of $37,334 of associated borrowings for a net loss of $258. No collateral for CMOs was sold in 1993 or 1991. Additionally, during 1992 and 1991, the Company sold certain other mortgage securities with aggregate principal amounts of $19,059 and $34,683 for net gains of $462 and $1,491, respectively. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, which addresses the accounting and reporting for investments in debt and equity securities. This Statement is effective for fiscal years beginning after December 15, 1993 and has not yet been applied by the Company. The Company does not anticipate that its application of this Statement will have a material impact on its results of operations or its financial condition. Discount on mortgage securities - ------------------------------- On certain mortgage securities collateralized by mortgage loans purchased by the Company for which mortgage pool insurance is used as the primary source of credit enhancement, the Company has limited exposure to certain risks not covered by such insurance. An estimate of possible losses is made at the time loans are securitized and securities are retained in the portfolio at a discount to compensate the Company for this risk. Such discount results in a reduction in gain on sale of mortgage assets in the statement of operations. The estimate is based on management's judgment, and is evaluated periodically for factors such as geographic location and industry loss experience. At December 31, 1993 the discount totaled $19,682 of which $17,240 was included in adjustable-rate mortgage securities, net and $2,442 was included in fixed-rate mortgage securities, net. In prior periods, these amounts were included with "Reserve for excluded risks" on the consolidated balance sheets. NOTE 4 - MORTGAGE LOANS IN WAREHOUSE The Company purchases fixed-rate and adjustable-rate loans secured by first mortgages or first deeds of trust on single-family attached or detached residential properties and originates fixed-rate loans secured by first mortgages or deeds of trust on multi-family residential properties. Approximately 37% of the properties collateralizing mortgage loans in warehouse at December 31, 1993 were located in California. The Company funded mortgage loans with an aggregate principal balance of $4,093,714, $5,334,174 and $2,491,434 during 1993, 1992 and 1991, respectively. During 1993, 1992 and 1991 the Company sold mortgage loans with an aggregate principal balance of $3,332,200, $5,374,543 and $2,414,189, respectively, as collateral for mortgage securities and as whole loan pools. In connection with the issuance of these securities, the Company retained adjustable-rate mortgage securities, fixed-rate mortgage securities and other mortgage securities with aggregate principal amounts of $1,031,086, $992,514 and $643,665 in 1993, 1992 and 1991, respectively. The Company sold the remaining portion of the securities issuances. The Company recognized net gains on these securitizations and whole loan sales of $24,565, $25,280 and $8,580 net of related costs and taxes of $3,164, $7,048 and $3,828 in 1993, 1992 and 1991, respectively. As of December 31, 1993, the Company had entered into commitments to purchase single-family mortgage loans of approximately $381,654. These commitments generally had original terms of not more than 60 days. Additionally, the Company had entered into commitments to purchase multi-family mortgage loans of approximately $22,456. These had original terms of not more than two years. The Company may hedge the commitments to limit its exposure to adverse market movements. As of December 31, 1993, the Company had outstanding for hedging purposes forward delivery contracts with an aggregate gross contract amount of $361,000 and futures contracts with an aggregate gross contract amount of $3,088. At December 31, 1993, the estimated fair value of the outstanding forward delivery contracts and futures contracts approximated their carrying amounts. These estimates were determined using dealer quotes. The fair value of mortgage loans in warehouse is estimated to be $779,325 and $125,475 at December 31, 1993 and 1992, respectively. The fair value of commitments approximates the commitment price. These estimates are determined by applying an estimated weighted average price based on actual mortgage loan transactions and dealer quotes. The Company is exposed to losses to the extent that mortgage loans in warehouse are secured by properties that were damaged as a result of the January 1994 earthquake in the Los Angeles area. The Company does not expect that any losses due to this earthquake will have a material effect on its financial position or results of operations. NOTE 5 - COLLATERALIZED MORTGAGE OBLIGATIONS Each series of a CMO may consist of various classes. Payments received on the mortgage collateral and any reinvestment income thereon are used to make payments on the CMOs (see Note 3). The obligations under the CMOs are payable solely from the collateral for CMOs and are otherwise non-recourse to the Company. The maturity of each class is directly affected by the rate of principal prepayments on the related mortgage collateral. Each series is also subject to redemption according to specific terms of the respective indentures. As a result, the actual maturity of any class of a CMO series is likely to occur earlier than its stated maturity. At December 31, 1993 and 1992, the Company had outstanding, $408,483 and $532,679, respectively, of fixed-rate CMO classes with interest rates ranging from 6.5% to 11.5%. At December 31, 1993 and 1992, the Company had outstanding $7,875 and $22,926, respectively, of variable- rate CMO classes with interest rates of 3.9% and 4.0%, respectively. The variable-rates are based on LIBOR for one-month deposits. The total number of CMO series outstanding as of December 31, 1993 and 1992 was 34 and 37, respectively. Stated maturities for these series ranged from 1998 - 2024 and 1998 - 2023 at December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, accrued interest payable on CMOs was $4,218 and $6,520, respectively, which is included in collateralized mortgage obligations in the consolidated balance sheets. The average effective rate of interest expense for CMOs was 8.5%, 9.2% and 9.5% for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 6 - REPURCHASE AGREEMENTS AND NOTES PAYABLE The Company utilizes repurchase agreements to finance certain of its mortgage investments. These repurchase agreements may be secured by adjustable-rate mortgage securities, fixed-rate mortgage securities, mortgage loans, and by certain other mortgage securities. These agreements bear interest at rates indexed to LIBOR. At December 31, 1993, the repurchase agreements had the following maturities: Within 30 days $ 1,836,224 30 - 90 days 803,264 over 90 days 114,678 ----------- $ 2,754,166 =========== If the counterparty to the repurchase agreement fails to return the collateral, the ultimate realization of the security by the Company may be delayed or limited. At December 31, 1993, the Company had a $115 million line of credit to finance the purchase of mortgage loans that expired on March 1, 1994, and revolving repurchase agreements of $300 million and $100 million maturing on June 25, 1994 and September 12, 1994, respectively. During February 1994, the Company replaced the revolving warehouse line of credit with a $150 million credit facility, which also allows the Company to borrow up to $30 million on an unsecured basis for working capital purposes. This new credit facility expires in February 1995. The Company expects that these credit facilities will be renewed if necessary, at their respective expiration dates, although there can be no assurance of such renewal. The following table summarizes the Company's repurchase agreements and notes payable outstanding at December 31, 1993 and 1992: Borrowings - ---------- Amount Weighted Average Carrying Value Outstanding Annual Rate of Collateral ----------- ---------------- -------------- December 31, 1993: Repurchase agreements secured by: Mortgage loans in warehouse $ 586,275 4.36% $ 648,733 Adjustable-rate mortgage securities 1,951,441 3.67% 2,005,644 Fixed-rate mortgage securities 204,365 5.09% 209,372 Other mortgage securities 12,085 3.75% 29,105 ------------ ------ ------------ Total repurchase agreements $ 2,754,166 $ 2,892,854 =========== =========== Notes payable secured by: Mortgage loans $ 87,451 5.00% $ 129,036 =========== =========== December 31, 1992: Repurchase agreements secured by: Mortgage loans in warehouse $ 45,397 4.81% $ 55,004 Adjustable-rate mortgage securities 1,113,678 3.93% 1,162,118 Fixed-rate mortgage securities 149,222 4.23% 160,461 Other mortgage securities 7,037 4.22% 19,294 ----------- ----------- Total repurchase agreements $ 1,315,334 $ 1,396,877 Notes payable secured by: Mortgage loans $ 32,878 5.99% $ 68,623 =========== =========== The carrying value of repurchase agreements and notes payable approximates fair value at December 31, 1993. The following information relates to repurchase agreements collateralized by mortgage assets into which the Company had entered at December 31, 1993. Excess Market Value Weighted Average of Assets over Days to Maturity from Repurchase Counterparty December 31, 19 Obligation - ------------------- ------------------------ -------------------- Kidder Peabody 27 $ 33,015 Lehman Brothers 34 70,051 NOTE 7 - COMMERCIAL PAPER The Company issues commercial paper to support its investments in mortgage warehouse loans and participations. An agreement with a bond guarantor and syndicate of commercial banks provides 100% liquidity support for the commercial paper and for the Company's obligations under its participations. The liquidity agreement provides for maximum outstanding commercial paper of $250,000. The commercial paper is non-recourse to the Company except for the assets pledged. At December 31, 1993 and 1992, the Company had outstanding $148,672 and $115,620 of commercial paper, respectively, with weighted average interest rates of 3.3% and 4.1%, respectively. The remaining maturity was 3 days at December 31, 1993 and ranged from 4 to 8 days at December 31, 1992. The outstanding commercial paper, which was secured by mortgage warehouse participations and other assets with a carrying value of $156,688 and $121,624 at December 31, 1993 and 1992, respectively, approximates fair value. NOTE 8 - ALLOWANCE FOR LOSSES The Company has limited exposure to losses due to fraud during the origination of a mortgage loan. The Company has established a loss allowance for such losses. An estimate for losses is made at the time loans are sold or securitized, and the loss allowance is adjusted accordingly through a reduction in gain on sale of mortgage assets. This estimate is based on management's judgment and the allowance is evaluated periodically. The loss allowance is included in the consolidated balance sheets in "Other liabilities." This allowance was included in prior periods with "Reserve for Excluded Risks" in the consolidated balance sheets. The Company makes various representations and warranties relating to the sale or securitization of mortgage loans or other assets secured by real property. To the extent the Company were to breach any of these representations or warranties, and such breach could not be cured within the allowable time period, the Company would be required to repurchase such mortgage assets, and could incur losses. The change in the allowance during 1993 is summarized below: Balance December 31, 1992 $ 4,104 Provision 1,992 Losses charged off (809) ------- Balance December 31, 1993 $ 5,287 ======= NOTE 9 - DEFERRED INCOME At December 31, 1993 and 1992, the Company had deferred income of $13,214 and $11,644, respectively, related to the sale of convertible ARMs which the Company will repurchase at par if the ARMs convert to a fixed-rate mortgage loan. Upon conversion, the net interest rate of the mortgage loan will be 1/8% higher than the Company's then current par coupon. The deferred amounts are net of related costs and taxes of $7,815 and $7,404 at December 31, 1993 and 1992 respectively. NOTE 10 - COMMON STOCK AND RELATED MATTERS During 1993, the Company issued 2,824,832 new shares of common stock for net proceeds of $75,303. During 1993, 1992 and 1991, dividends of $53,835 or $3.06 per share, $38,197 or $2.60 per share and $20,706 or $1.53 per share, respectively, were declared and represent ordinary income for federal income tax purposes. Pursuant to the Company's 1992 Stock Incentive Plan (the "Incentive Plan"), the Compensation Committee of the Board of Directors may grant to eligible employees of the Company, its subsidiaries and affiliates for a period of ten years beginning June 17, 1992 stock options, stock appreciation rights ("SARs") and restricted stock awards. An aggregate of 675,000 shares of common stock would be available for distribution pursuant to stock options, SARs and restricted stock. The shares of common stock subject to any option or SAR that terminates without a payment being made in the form of common stock would become available for distribution pursuant to the Incentive Plan. The Compensation Committee of the Board of Directors may also grant dividend equivalent rights ("DERs") in connection with the grant of options or SARs. These SARs and related DERs generally become exercisable as to 20 percent of the granted amounts each year after the date of the grant. The following table presents a summary of the SARs outstanding at December 31, 1993. SARs Exercise Price ------ -------------- December 31, 1991 - - Granted 225,000 $ 8 3/4 - 17 7/8 SARs exercised (2,000) 8 3/4 ------- ---------------- December 31, 1992 223,000 8 3/4 - 17 7/8 Granted 45,910 29 Forfeiture (6,000) 8 3/4 SARs exercised (26,600) 8 3/4 - 17 7/8 -------- --------------- December 31, 1993 236,310 $ 8 3/4 - 29 ======= =============== The Company expensed $1,640 and $404 for SARs and DERs during 1993 and 1992, respectively. There were no stock options outstanding as of December 31, 1993. The number of SARs exercisable at December 31, 1993 and 1992 was 31,200 and 12,000, respectively. The Company is authorized to issue up to 50,000,000 shares of preferred stock. No shares of preferred stock have been issued. NOTE 11 - EMPLOYEE SAVINGS PLAN The Company provides an employee savings plan under Section 401(k) of the Internal Revenue Code. The employee savings plan allows eligible employees to defer up to 12% of their income on a pretax basis. The Company matched the employees' contribution, up to 6% of the employees' income. The Company may also make discretionary contributions based on the profitability of the Company. The total expense related to the Company's matching and discretionary contributions in 1993 and 1992 was $108 and $78, respectively. The Company does not provide post-employment or post-retirement benefits to its employees. NOTE 12 - SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS INFORMATION Year Ended December 31, 1993 1992 1991 ---- ---- ---- Supplemental disclosure of cash flow information: Cash paid for interest $ 115,608 $ 112,192 $ 120,675 ========= ========= ========= Supplemental disclosure of non-cash activities: Proceeds from sale of collateral for CMOs $ - $ 38,447 $ - Repayment of collateralized mortgage obligations - 37,334 - --------- --------- --------- Proceeds from sale of CMOs, net $ - $ 1,113 $ - ========= ========= ========= Common stock issued for exercise of stock options $ - $ 950 $ - ========= ========= ========= NOTE 13 - ANALYSIS OF NET INTEREST ON MORTGAGE ASSETS The following tables summarize the amount of change on interest income and interest expense due to changes in interest rates versus changes in volume: 1993 to 1992 Rate Volume Total - ----------------------------------- --------- -------- ------ Collateral for CMOs $ (3,529) $ (14,627) $ (18,156) Adjustable-rate mortgage securities (6,302) 32,3772 6,075 Fixed-rate mortgage securities (652) 10,090 9,438 Other mortgage securities 1,151 (557) 594 Mortgage warehouse participations (693) 558 (135) Mortgage loans in warehouse (2,151) 6,503 4,352 -------- -------- -------- Total interest income (12,176) 34,344 22,168 -------- -------- -------- Collateralized mortgage obligations (4,078) (14,100) (18,178) Repurchase agreements: Adjustable-rate mortgage securities (3,952) 23,336 19,384 Fixed-rate mortgage securities (122) 6,692 6,570 Other mortgage securities (88) (181) (269) Mortgage loans in warehouse (1,326) 2,635 1,309 Notes payable (253) (175) (428) Commercial paper (593) 272 (321) ------- ------- ------ Total interest expense (10,412) 18,479 8,067 ------- ------- ------ Net interest on mortgage assets $ (1,764) $ 15,865 $ 14,101 ========= ======== ======== 1992 to 1991 Rate Volume Total - ------------------------------------ --------- --------- ------- Collateral for CMOs $ (2,391) $ (31,023) $ (33,414) Adjustable-rate mortgage securities (5,028) 26,241 21,213 Fixed-rate mortgage securities (208) 2,899 2,691 Other mortgage securities (645) (2,783) (3,428) Mortgage warehouse participations (193) 4,891 4,698 Mortgage loans in warehouse (2,404) 9,854 7,450 -------- ---------- -------- Total interest income (10,869) 10,079 (790) -------- ---------- --------- Collateralized mortgage obligations (2,715) (27,531) (30,246) Repurchase agreements: Adjustable-rate mortgage securities (3,900) 15,571 11,671 Fixed-rate mortgage securities (146) 1,401 1,255 Other mortgage securities (424) (697) (1,121) Mortgage loans in warehouse (1,032) 7,703 6,671 Notes payable (1,777) (397) (2,174) Commercial paper (154) 3,184 3,030 ------- --------- --------- Total interest expense (10,148) (766) (10,914) ------- --------- --------- Net interest on mortgage assets $ (721) $ 10,845 $ 10,124 ======== ======== ========= Note: The change in interest income and interest expense due to changes in both volume and rate, which cannot be segregated, has been allocated proportionately to the change due to volume and the change due to rate. Summary of Quarterly Results (unaudited) (amounts in thousands except share data) Year ended December 31, 1993 First Quarter Second Quarter Third Quarter Fourth Quarter ------------- -------------- ------------- -------------- Operating results: Total revenues $ 45,051 $ 46,452 $ 52,221 $ 55,251 Net margin on mortgage assets 10,510 10,594 11,356 12,559 Net income 12,499 12,558 13,848 15,222 Net income per share 0.76 0.76 0.80 0.80 Cash dividends declared per share 0.50 0.75 0.77 1.04(1) Mortgage loans funded 863,585 847,509 1,192,022 1,190,598 Year ended December 31, 1992 - ------------------ Operating results: Total revenues $ 44,194 $ 47,389 $ 44,499 $ 41,423 Net margin on mortgage assets 5,976 8,413 8,186 10,080 Net income 7,054 8,882 10,824 11,409 Net income per share 0.52 0.66 0.77 0.78 Cash dividends declared per share 0.30 0.55 0.65 1.10(2) Mortgage loans funded 895,057 1,793,624 1,490,239 1,155,254 - ------------------ (1) Includes a dividend of $0.26 which was declared in December 1993 and paid in January 1994. (2) Includes a dividend of $0.35 which was declared in December 1992 and paid in January 1993. RESOURCE MORTGAGE CAPITAL, INC. SCHEDULE IX - SHORT-TERM BORROWINGS For the Years Ended December 31, 1993, 1992 and 1991 (in thousands) Maximum Average Weighted Category of Weighted Amount Amount Average Aggregate Balance Average Outstanding Outstanding Interest Rate Short-Term at End Interest During the During the During the Borrowings of Period Rate Period Period (1) Period (2) - ------------------------------------------------------------------------ - ---- Notes payable to banks 87,451 5.00% 129,733 80,220 5.36% Repurchase agreements 2,754,166 3.92% 2,754,166 1,931,034 3.87% Commercial Paper 148,672(3) 3.45% 148,672 106,464 3.25% - ---- Notes payable to banks $ 32,878 5.99% $ 147,601 $ 83,398 5.67% Repurchase agreements 1,315,334 4.00% 1,507,767 1,057,943 4.52% Commercial Paper 115,620(3) 4.07% 132,325 100,057 3.78% - ---- Notes payable to banks $ 147,601 5.86% $ 147,601 $ 88,761 7.77% Repurchase agreements 637,599 5.61% 637,599 454,073 6.46% Commercial Paper 82,981(3) 5.97% 82,981 14,016 5.39% - ------------------ (1) Calculation of average amount outstanding during the period based upon the daily weighted average principal amount of borrowings. (2) Calculation of weighted average interest rate during the period based upon the total interest incurred (including the effects of hedging transactions) divided by the daily weighted average principal balance of borrowings. (3) Net of discount. RESOURCE MORTGAGE CAPITAL, INC. SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE December 31, 1993 (amounts in thousands except number of loans) Carrying Principal Amount Number Final Amount of of Loans Subject of Interest Maturity Mortgage to Delinquent Description Loans Rate Date Loans Principal or Interest - ------------------------------------------------------------------------ Outstanding principal balance of Mortgage Loans $ 0 - $ 50 135 3.80% - 8.38% Varies $ 5,955 - 51 - 100 1,068 3.25% - 11.38% Varies 82,791 252 101 - 150 1,080 3.13% - 10.63% Varies 135,705 660 151 - 200 718 3.25% - 9.00% Varies 124,358 162 201 - 250 660 3.38% - 11.38% Varies 149,526 451 251 - 300 333 3.25% - 11.50% Varies 89,847 1,086 301 - 350 152 3.50% - 8.84% Varies 49,515 318 351 - 400 122 3.63% - 8.75% Varies 45,728 - 401 - 450 67 3.63% - 8.25% Varies 28,304 - 451 - 500 42 4.00% - 8.25% Varies 20,000 - Over $ 500 59 3.75% - 9.35% Varies 46,040 - ----- ------ ---------- ------------ 4,436 $ 777,769 $ 2,929 All mortgage loans in warehouse are conventional mortgage loans secured by single-family or multi-family dwellings with initial maturities of 15 to 30 years. Of the carrying amount, $348,673 or 45% are fixed-rate and $429,096 or 55% are adjustable-rate mortgage loans in warehouse. The Company believes that its mortgage pool insurance and allowance are adequate to cover any exposure on delinquent mortgage loans in warehouse. A summary of activity of mortgage loans for the years ended December 31, 1993, 1992 and 1991 is as follows: Balance at December 31, 1990 $ 87,079 Mortgage loans purchased 2,498,149 Collection of principal (3,041) Mortgage loans sold (2,412,561) Balance at December 31, 1991 169,626 Mortgage loans purchased 5,342,167 Collection of principal (2,388) Mortgage loans sold (5,385,778) ------------- Balance at December 31, 1992 123,627 Mortgage loans purchased 4,132,101 Collection of principal (5,516) Mortgage loans sold (3,472,443) Balance at December 31, 1993 $ 777,769 The geographic distribution of the Company's mortgage loans in warehouse at December 31, 1993 is as follows: State Number of Loans Principal Amount - ----- --------------- ---------------- Alabama 4 $ 1,042 Arizona 60 12,104 Arkansas 1 180 California 1,868 384,367 Colorado 94 15,544 Connecticut 8 1,808 Delaware 16 2,443 District of Columbia 31 7,975 Florida 663 72,241 Georgia 40 5,876 Hawaii 4 1,204 Idaho 18 1,362 Illinois 49 8,000 Indiana 16 2,447 Louisiana 1 238 Maryland 340 67,920 Massachusetts 7 905 Michigan 8 1,235 Minnesota 20 1,977 Missouri 1 52 Nevada 36 6,757 New Hampshire 1 97 New Jersey 97 15,527 New Mexico 10 1,484 New York 116 21,843 North Carolina 50 7,630 Ohio 22 4,500 Oklahoma 7 698 Oregon 138 15,231 Pennsylvania 33 4,786 Rhode Island 2 777 South Carolina 50 8,314 Tennessee 2 218 Texas 113 18,792 Utah 10 1,404 Virginia 308 57,636 Washington 188 23,489 Wisconsin 2 1,137 Wyoming 2 560 Discount (2,049) ---- --------- Total 4,436 $ 777,769 Exhibit 10.5 RESOURCE MORTGAGE CAPITAL, INC. EXECUTIVE DEFERRED COMPENSATION PLAN Effective July 1, 1993 RESOURCE MORTGAGE CAPITAL, INC. EXECUTIVE DEFERRED COMPENSATION PLAN ------------------ Page ---- ARTICLE I PURPOSE AND EFFECTIVE DATE 1 1.1 Purpose 1 1.2 Effective Date 1 ARTICLE II DEFINITIONS 2 2.1 Definitions 2 ARTICLE III ELIGIBILITY 5 3.1 Eligibility 5 ARTICLE IV DEFERRED COMPENSATION 6 4.1 Voluntary Deferrals 6 4.2 Company Matching Deferrals 6 4.3 Company Discretionary Deferrals 6 4.4 Vesting 6 ARTICLE V ACCOUNTING FOR DEFERRED COMPENSATION 8 5.1 Accounts 8 5.2 Deferred Compensation 8 5.3 Value Adjustments 8 ARTICLE VI PAYMENT OF DEFERRED COMPENSATION 9 6.1 Payment Upon Termination of Employment 9 6.2 Payment Upon Death 9 6.3 Value Adjustments Regarding Installment Form of Distribution 10 6.4 Incapacity of Recipient 10 ARTICLE VII FUNDING 11 ARTICLE VIII ADMINISTRATION 12 8.1 Administration 12 8.2 Determinations 12 ARTICLE IX CLAIMS PROCEDURE 13 9.1 Claim for Benefits 13 9.2 Notice of Denial 13 9.3 Right to Reconsideration 13 9.4 Review of Documents 14 9.5 Decision by the Compensation Committee 14 9.6 Notice by the Compensation Committee 14 ARTICLE X AMENDMENT, DISCONTINUANCE, AND TERMINATION 15 ARTICLE XI MISCELLANEOUS 16 11.1 Non-Guarantee of Employment 16 11.2 Rights of Participants to Benefits 16 11.3 No Assignment 16 11.4 Withholding 16 11.5 Account Statements 16 11.6 Masculine, Feminine, Singular and Plural 16 11.7 Governing Law 16 11.8 Titles 16 11.9 Other Plans 16 11.10 Binding Plan 16 RESOURCE MORTGAGE CAPITAL, INC. EXECUTIVE DEFERRED COMPENSATION PLAN ARTICLE I PURPOSE AND EFFECTIVE DATE 1.1 Purpose. The Plan is intended to provide deferred compensation for a select group of management or highly compensated employees of the Company. The Plan is an unfunded plan that is not intended to be (i) subject to Parts 2, 3 or 4 of Title I, Subtitle B of the Employee Retirement Income Security Act of 1974, or (ii) qualified under Section 401(a) of the Internal Revenue Code. 1.2 Effective Date. The effective date for this Plan shall be July 1, 1993. ARTICLE II DEFINITIONS 2.1 Definitions. ------------- As used herein, the following terms shall have the following meanings: (a) Account. ----------The bookkeeping reserve account established and maintained for each Participant pursuant to Section 5.1 for purposes of determining the amount payable to the Participant pursuant to Article VI. (b) Beneficiary. ------------- The person or persons designated by a Participant to receive Plan benefits in the event of the Participant's death, such designation to be made in writing on a form satisfactory to the Committee and effective when received by the Committee thereby revoking any and all prior designations. If the Participant has not designated a Beneficiary, or if the Beneficiary does not survive the Participant, the aggregate amount then credited to the Participant's Account shall be paid in a single sum to the Participant's estate. (c) Board. ------- The Board of Directors of the Company. (d) Code. ------ The Internal Revenue Code of 1986, as amended. (e) Committee. ---------- The compensation committee of the Board authorized by the Board to administer the Plan, or designees of such compensation committee. As used herein, in the event that there is not a compensation committee of the Board from time to time, the Board or its designees shall constitute the Committee. (f) Company. ---------- Resource Mortgage Capital, Inc. and any successor thereto. (g) Compensation. ------------- With respect to any Plan Year, the total remuneration payable during the Plan Year to the Participant from the Employer for personal services rendered, including base salary, commissions, overtime, bonuses and other extra compensation. Notwithstanding the foregoing, Compensation shall not include (A) contributions, credits or benefits paid or accrued under this Plan or any other qualified or nonqualified retirement plan, deferred compensation plan, stock-related plan, welfare benefit plan or fringe benefit plan of the Employer, (B) compensation resulting from grant, exercise or cancellation of stock options or stock awards or disposition of the underlying stock, (C) compensation resulting from the grant or exercise of stock appreciation rights or dividend equivalent rights, and from any other stock-based compensation arrangements of the Employer, (D) amounts payable as a tax "gross-up" bonus with respect to Voluntary Deferrals hereunder, or (E) direct reimbursement for expenses. In all cases, however, notwithstanding any exclusions specified above, Compensation shall include any amount which would otherwise be deemed Compensation but for the fact that it is deferred pursuant to a Payroll Deduction Agreement or a salary reduction agreement under any plan described in Section 401(k), 402(h) or 125 of the Code. (h) Deferred Compensation. ---------------------- The amount of a Participant's Employer Matching Deferrals and Employer Discretionary Deferrals. (i) Disability. ------------ The inability to engage in any substantial, gainful activity by reason of any medically determined physical or mental impairment that can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than twelve months. (j) Employer. --------- The Company, its successors and assigns, any subsidiary or affiliated organization authorized by the Board to participate in this Plan with respect to its employees and any organization into which an Employer may be merged or consolidated or to which all or substantially all of its assets may be transferred. (k) Employer Discretionary Deferrals. ----------------------------------- Amounts credited to a Participant's Account at the discretion of the Committee, as specified in Section 4.3. (l) Employer Matching Deferrals. ----------------------------- Matching amounts credited to a Participant's Account with respect to Voluntary Deferrals, as specified in Section 4.2. (m) Normal Retirement Age. ----------------------- The attainment of age sixty-five. (n) Participant. ------------ An employee who is eligible to participate pursuant to Article III and who has made an election pursuant to Section 4.1. (o) Payroll Deduction Agreement. ---------------------------- Written payroll deduction agreement entered into between the Participant and the Employer pursuant to Article IV. (p) Plan. ------ The Resource Mortgage Capital, Inc. Executive Deferred Compensation Plan, as amended from time to time. (q) Plan Year. ------------ The one-year period commencing on January 1 and ending on the succeeding December 31; provided, however, that the period commencing on July 1, 1993, and ending on December 31, 1993, shall be a short Plan Year. (r) Valuation Date. ---------------- The last business day of March, June, September and December of each Plan Year, or such additional days as the Committee may deem necessary or appropriate. (s) Value Adjustments. ------------------- Amounts of interest credited to a Participant's Account pursuant to Section 5.3. (t) Voluntary Deferrals. --------------------- Part or all of a Participant's after-tax Compensation which, through payroll deduction, is directed to be applied pursuant to Section 4.1. (u) Year of Service. ----------------- Year of vesting service that the Participant would accrue if he were a participant in the Resource Mortgage Capital, Inc. 401(k) Plan, as the term "vesting service" is defined therein. ARTICLE III ELIGIBILITY 3.1 Eligibility. Eligibility to participate in the Plan will be limited to a select group of management or highly compensated employees of the Employer who are designated by the Committee to participate in the Plan. The Committee shall have sole and absolute discretion as to the management or highly compensated employees designated as eligible to participate in the Plan and the date on which such participation shall commence. ARTICLE IV DEFERRED COMPENSATION 4.1 Voluntary Deferrals. --------------------- An employee who satisfies the requirements of Section 3.1 may elect to forgo receipt of all or any portion of the amount of his after-tax Compensation for a Plan Year, subject to any maximum limitation determined by the Committee in its sole discretion, pursuant to a Payroll Deduction Agreement entered into between the Employer and the employee, which forgone amount shall be applied by the Employer to the payment of premiums on an insurance policy on the life of the employee and owned by the employee or the employee's designee. Neither the Employer nor the Plan shall have any rights, title or interest in said Voluntary Deferrals or said insurance policy. 4.2 Employer Matching Deferrals. ------------------------------ For each Plan Year for which a Participant elects to make Voluntary Deferrals, the Employer shall credit to the Participant's Account an amount equal to 100 percent of the Participant's Voluntary Deferrals; provided, however, that only those Voluntary Deferrals as are made at a rate not in excess of six percent of the Participant's Compensation shall be taken into account for such Participant. 4.3 Employer Discretionary Deferrals. ---------------------------------- For each Plan Year for which an employee is eligible to participate in the Plan pursuant to the provisions of Section 3.1 and such employee is employed with the Employer on the last day of such Plan Year, the Employer may, in the sole and absolute discretion of the Committee, credit an amount to be determined by the Committee to the Account of such employee. Notwithstanding the foregoing, otherwise eligible employees who terminate employment with the Employer during such Plan Year on account of retirement, death or Disability shall be entitled to have their Accounts credited with Employer Discretionary Deferrals hereunder, regardless of the fact that such employees are not employed by the Employer on the last day of the Plan Year. Any such Employer Discretionary Deferrals shall be credited to the Accounts of those eligible employees in the same ratio as each such employee's Compensation for the Plan Year bears to the total Compensation of all such eligible employees for the Plan Year. 4.4 Vesting. --------- (a) Unless his participation in the Plan shall have terminated prior thereto, upon a Participant's death, Disability or attainment of Normal Retirement Age, a Participant shall be fully vested in and have a nonforfeitable right to the aggregate amount credited to his Account. (b) Upon termination of his employment with the Employer prior to his death, Disability or attainment of Normal Retirement Age, a Participant shall be vested in and have a nonforfeitable right to a percentage of the amount credited to his Account determined in accordance with the following schedule: Years of Service Vested Percentage ---------------- ----------------- Less than 2 0% 2 25% 3 50% 4 75% 5 or more 100% ARTICLE V ACCOUNTING FOR DEFERRED COMPENSATION 5.1 Accounts. ----------- The Employer shall establish an Account on behalf of each Participant which shall be credited or debited with Deferred Compensation as provided in Section 5.2, Value Adjustments as provided in Section 5.3 and Payment of Deferred Compensation pursuant to Article VI. Each such Account may consist of an Employer Matching Deferrals subaccount, an Employer Discretionary Deferrals subaccount, and such other subaccounts as are necessary or desirable to the Employer for the convenient administration of the Plan. The Accounts and subaccounts shall be bookkeeping reserve accounts only and shall not require segregation of any funds of the Employer or provide any Participant with any rights to any assets of the Employer, except as a general creditor thereof. A Participant shall have no right to receive payment of any amount credited to his Account except as expressly provided in Article VI of this Plan. 5.2 Deferred Compensation. ----------------------- A Participant's Account shall be credited with Employer Matching Deferrals, if any, as of each Valuation Date based upon Voluntary Deferrals attributable to such Participant since the immediately preceding Valuation Date; provided, however, that such Employer Matching Deferrals to be credited as of the September 30, 1993, Valuation Date shall be based upon the aggregate Voluntary Deferrals attributable to such Participant for the period commencing January 1, 1993, and ending September 30, 1993. A Participant's Account shall be credited with Employer Discretionary Deferrals, if any, with respect to a Plan Year as of the last day of such Plan Year. 5.3 Value Adjustments. ------------------- As of each Valuation Date, the Account of each Participant shall be credited with interest at a per annum rate determined from time to time by the Committee in its sole and absolute discretion, based upon the balance of such Participant's Account as of the first day of the calendar quarter in which such Valuation Date falls. ARTICLE VI PAYMENT OF DEFERRED COMPENSATION 6.1 Payment Upon Termination of Employment. Upon a Participant's termination of employment for any reason other than death, the vested portion, if any, of his Account shall be paid to the Participant as follows: (a) to the extent that the vested portion of such Participant's Account does not exceed $500,000, as valued as of the Valuation Date coincident with or next preceding such date of termination, the Participant may elect within thirty days following such termination of employment, subject to approval by the Committee in its sole and absolute discretion, to receive payment in either a single sum sixty days following the Participant's termination of employment or in substantially non-increasing annual installments, commencing as of the Valuation Date that next follows the sixtieth day after the Participant's termination of employment, over a period of years not in excess of five years; and (b) to the extent that the vested portion of such Participant's Account exceeds $500,000, the Committee in its sole and absolute discretion shall determine the manner in which payment shall be made of such vested portion that exceeds $500,000, provided that the entire vested portion of such Participant's Account is distributed within five years from the date of the Participant's termination of employment. Notwithstanding the foregoing, however, if one or more Valuation Dates have occurred between the date of the Participant's termination of employment and the actual date of distribution, then the Participant's Account shall be valued as of the Valuation Date immediately preceding such distribution. 6.2 Payment Upon Death. Upon a Participant's death prior to his having received full payment of all vested amounts credited to his Account, the aggregate vested amount credited to the Participant's Account, if any, shall be paid to the Participant's Beneficiary as follows: (a) to the extent that the vested portion of such Participant's Account does not exceed $500,000, as valued as of the Valuation Date coincident with or next preceding the date of the Participant's death, the Participant's Beneficiary may elect within thirty days following the date of the Participant's death, subject to approval by the Committee in its sole and absolute discretion, to receive payment in either a single sum sixty days following the Participant's date of death or in substantially non-increasing annual installments, commencing as of the Valuation Date that next follows the sixtieth day after the Participant's date of death, over a period of years not in excess of five years; and (b) to the extent that the vested portion of such Participant's Account exceeds $500,000, the Committee in its sole and absolute discretion shall determine the manner in which payment shall be made of such vested portion that exceeds $500,000, provided that the entire vested portion of such Participant's Account is distributed within five years from the date of the Participant's death. Notwithstanding the foregoing, however, if one or more Valuation Dates have occurred between the date of the Participant's death and the actual date of distribution, then the Participant's Account shall be valued as of the Valuation Date immediately preceding such distribution. 6.3 Value Adjustments Regarding Installment Form of Distribution. Insofar as any portion of the Participant's Account is not distributed in a single sum within sixty days following the earlier of the Participant's termination of employment or death, the Participant's Account shall be credited with interest as of each Valuation Date occurring after such sixty-day period, based upon the balance of the Participant's Account as of the first day of the calendar quarter in which such Valuation Date falls, at a per annum rate equal to one percent plus the constant maturity yield on five-year U. S. Treasury Notes for the first month of the calendar quarter in which such Valuation Date falls as reported in the "Federal Reserve Statistical Release", or at a per annum rate based upon such other index as the Committee may determine from time to time. Interest credited pursuant to this Section 6.3 shall be in lieu of crediting Value Adjustments pursuant to Section 5.3 as of any Valuation Date occurring subsequent to sixty days following the Participant's termination of employment or death. 6.4 Incapacity of Recipient. If any person entitled to a distribution under the Plan is deemed by the Committee to be incapable of personally receiving and giving a valid receipt for such payment, then, unless and until claim therefor shall have been made by a duly appointed guardian or other legal representative of such person, the Committee may provide for such payment or any part thereof to be made to any other person or institution then contributing toward or providing for the care and maintenance of such person. Any such payment shall be a payment for the account of such person and a complete discharge of any liability of the Employer and the Plan therefor. ARTICLE VII FUNDING 7.1 The obligation of the Employer to pay benefits under this Plan shall be interpreted solely as an unfunded, contractual obligation to pay only those amounts credited to the Participant's Account pursuant to Article V in the manner and under the conditions prescribed in Article VI. Any assets set aside, including any assets transferred to a rabbi trust or purchased by the Employer with respect to amounts payable under the Plan, shall be subject to the claims of the Employer's general creditors, and no person other than the Employer shall, by virtue of the provisions of the Plan, have any interest in such assets. Nothing contained in this Plan shall constitute a guaranty by the Employer or any other person or entity that the assets of the Employer will be sufficient to pay the benefit hereunder. ARTICLE VIII ADMINISTRATION 8.1 Administration. The Plan shall be administered by the Committee, whether or not the members thereof or their designees are employees of the Employer or are Participants. The Committee shall have authority to act to the full extent of its absolute discretion to: (a) interpret the Plan; (b) resolve and determine all disputes or questions arising under the Plan, including the power to determine the rights of Participants and Beneficiaries, and their respective benefits, and to remedy any ambiguities, inconsistencies or omissions in the Plan; (c) create and revise rules and procedures for the administration of the Plan and prescribe such forms as may be required for Participants to make elections under, and otherwise participate in, the Plan; and (d) take any other actions and make any other determinations as it may deem necessary and proper for the administration of the Plan. Any expenses incurred in the administration of the Plan will be paid by the Employer. 8.2 Determinations. All decisions and determinations by the Committee shall be final and binding upon all Participants and Beneficiaries. ARTICLE IX CLAIMS PROCEDURE 9.1 Claim for Benefits. Each person eligible for a benefit under the Plan shall apply for such benefit by filing a claim with the Committee on a form or forms prescribed by the Committee. If no form or forms have been prescribed, a claim for benefits shall be made in writing to the Committee setting forth the basis for the claim. Each person making a claim for benefits shall furnish the Committee with such documents, evidence, data, or information in support of such claim as the Committee considers necessary or desirable. 9.2 Notice of Denial. If a claim for benefits under this Plan is denied, either in whole or in part, the Committee shall advise the claimant in writing of the amount of his benefit, if any, and the specific reasons for the denial. The Committee shall also furnish the claimant at that time with a written notice containing: (a) a specific reference to pertinent Plan provisions; (b) a description of any additional material or information necessary for the claimant to perfect his claim, if possible, and an explanation of why such material or information is needed; and (c) an explanation of the Plan's claim review procedure. The written notice of claim denial shall be provided to the claimant within a reasonable period of time, but not more than 90 days after receipt of the claim by the Committee, unless special circumstances require an extension of time for processing the claim, in which case the Committee shall provide a written notice of such extension to the claimant before the expiration of the initial 90-day period. In no event shall such extension exceed 90 days from the end of such initial period. 9.3 Right to Reconsideration. Within 60 days of receipt of the information described in Section 9.2 above, the claimant shall, if he desires further review, file a written request for reconsideration with the Committee. Such reconsideration shall be conducted by the members of the compensation committee of the Board (the "Compensation Committee"), or by the members of the Board if there is no Compensation Committee in existence when the request for reconsideration is filed. 9.4 Review of Documents. So long as the claimant's request for review is pending (including the 60-day period described in Section 9.3 above), the claimant or his duly authorized representative may review pertinent Plan documents (and any pertinent related documents) and may submit issues and comments in writing to the Compensation Committee. 9.5 Decision by the Compensation Committee. A final and binding decision shall be made by the Compensation Committee or the Board, as applicable, within 60 days of the filing by the claimant of his request for reconsideration; provided, however, that if the Compensation Committee or the Board, as applicable, in its discretion, feels that a hearing with the claimant or his representative present is necessary or desirable, this period shall be extended an additional 60 days. 9.6 Notice by the Compensation Committee. The Compensation Committee's decision or the Board's, as applicable, shall be conveyed to the claimant in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, with specific references to the pertinent Plan provisions on which the decision is based. ARTICLE X AMENDMENT, DISCONTINUANCE, AND TERMINATION The Committee reserves the right to modify, amend, discontinue or terminate the Plan or any provision thereof at any time and from time to time, including specifically the right to make any such amendments or modifications effective retroactively; provided, however, that no modification, amendment, discontinuance or termination shall adversely affect the rights of Participants to amounts credited to the Accounts maintained on their behalf before such modification, amendment, discontinuance or termination. Notice of every such modification, amendment, discontinuance or termination shall be given in writing to each Participant. In the case of termination of the Plan, any amounts credited to the Account of a Participant may, in the sole discretion of the Committee, be distributed in full to such Participant as soon as reasonably practicable following such termination, or, in the alternative, may be distributed at such later date and in such manner pursuant to Article VI hereof as the Committee may determine, but in no event later than when distributions would otherwise commence pursuant to Article VI hereof if the Plan were not so terminated. ARTICLE XI MISCELLANEOUS 11.1 Non-Guarantee of Employment. Participation in the Plan does not give any person any right to be retained in the service of the Employer. The right and power of the Employer to terminate any employee is expressly reserved. 11.2 Rights of Participants to Benefits. All rights of a Participant under the Plan to amounts credited to his Account are mere unsecured contractual rights of the Participant against the Employer. 11.3 No Assignment. No amounts credited to Accounts, rights or benefits under the Plan shall be subject in any way to voluntary or involuntary alienation, sale, transfer, assignment, pledge, attachment, garnishment, execution, or encumbrance, and any attempt to accomplish the same shall be void. 11.4 Withholding. The Employer shall have the right to deduct from any payment made hereunder any taxes required by law to be withheld from a Participant with respect to such payment. 11.5 Account Statements. Periodically (as determined by the Employer), each Participant shall receive a statement indicating the amounts credited to and payable from the Participant's Account. 11.6 Masculine, Feminine, Singular and Plural. The masculine shall be read in the feminine, the singular in the plural, and vice versa, whenever the context shall so require. 11.7 Governing Law. Except to the extent preempted by applicable Federal laws, the Plan shall be construed according to the laws of the Commonwealth of Virginia, other than its conflict of laws principles. 11.8 Titles. The titles to Articles and Sections in this Plan are placed herein for convenience of reference only, and the Plan is not to be construed by reference thereto. 11.9 Other Plans. Nothing in this Plan shall be construed to affect the rights of a Participant, his beneficiaries, or his estate to receive any retirement or death benefit under any tax-qualified or nonqualified pension plan, deferred compensation agreement, insurance agreement, tax-deferred annuity or other retirement plan of the Employer. 11.10 Binding Plan. This Plan shall be binding upon and inure to the benefit of the Employer, its successors and assigns and each Participant and his heirs, executors, administrators and legal representatives. Each Employer shall be primarily responsible for payment of benefits hereunder to the Participants it employs and the Beneficiaries of such Participants. In the event an Employer fails to pay such benefits for any reason, the Company shall be jointly and severally liable for the payment of such benefits. This Plan was approved and ratified by the Board of Directors of the Company on the day of , 199 , and is hereby executed on behalf of the Company this day of , 199 . WITNESS: RESOURCE MORTGAGE CAPITAL, INC. - -------------------------- By:----------------------------- Corporate Secretary Title:----------------------------- [SEAL] APPENDIX A RESOURCE MORTGAGE CAPITAL, INC. EXECUTIVE DEFERRED COMPENSATION PLAN BENEFICIARY DESIGNATION I, the undersigned Participant, hereby designate the following primary beneficiary or beneficiaries and contingent beneficiary or beneficiaries of any benefits payable pursuant to the Resource Mortgage Capital, Inc. Executive Deferred Compensation Plan (the "Plan") on account of or after my death. PRIMARY BENEFICIARY OR BENEFICIARIES - ------------------------------------------------------------------------ Name Address Percentage - ------------------------------------------------------------------------ Name Address Percentage - ------------------------------------------------------------------------ Name Address Percentage In the event any of the primary beneficiaries designated above predeceases me or dies before receiving all payments to be made under the Plan, the amount otherwise payable to such primary beneficiary shall be paid to the remaining primary beneficiary or beneficiaries proportionately based upon the percentages specified above (disregarding the percentage of the deceased primary beneficiary). In the event no primary beneficiary shall be living at the time any payment is made pursuant to the Plan on account of my death, such payment and all remaining payments shall be made to the following contingent beneficiaries. CONTINGENT BENEFICIARY OR BENEFICIARIES - ------------------------------------------------------------------------ Name Address Percentage - ------------------------------------------------------------------------ Name Address Percentage - ------------------------------------------------------------------------ Name Address Percentage In the further event that none of the persons named above shall be living at the time of any payment made pursuant to the Plan on account of my death, such payment and all remaining payments shall be made to my estate. This Beneficiary Designation, when properly executed by the Participant and the Employer, replaces and supersedes all prior Beneficiary Designations made with respect to the Plan. WITNESS: PARTICIPANT - --------------------------------- ------------------------------- [Print Participant's Full Name] Date: --------------------------- ------------------------------- [Participant's Signature] ATTEST: RESOURCE MORTGAGE CAPITAL, INC. [Signature of Authorized Officer] - --------------------------------- ------------------------------- Date:---------------------------- Its: --------------------------- [Title of Authorized Officer] Exhibit 11.1 RESOURCE MORTGAGE CAPITAL, INC. STATEMENT RE COMPUTATION OF PER SHARE EARNINGS Computation of Full Diluted Earnings Per Share (amounts in thousands except share data) Years ended December 31, 1993 1992 1991 ---- ---- ----- Net income $ 54,127 $ 38,169 $ 21,636 Shares: Weighted average number of common shares outstanding 17,364,309 13,999,047 13,531,290 Assuming exercise of options reduced by the number of shares which could have been purchased with the proceeds from the exercise of the options - - 72,429 --------- ----------- ------- Weighted average of number of shares outstanding and adjusted 17,364,309 13,999,047 13,603,719 ========== =========== ========== Net income per share assuming full dilution $ 3.12 $ 2.73 $ 1.59 ========== =========== ========== This calculation is submitted in accordance with Regulation S-K item 601 (b) (11). In 1991 it is not a required disclosure pursuant to Accounting Interpretations of APB Opinion No. 15 because the dilution is less than 3%. Exhibit 21.1 RESOURCE MORTGAGE CAPITAL, INC. LIST OF SUBSIDIARIES AND CONSOLIDATED ENTITIES At December 31, 1993, the consolidated subsidiaries of Resource Mortgage Capital, Inc. were as follows: Company Parent State of Incorporation Resource Finance Co. One Resource Mortgage Capital, Inc. Virginia N.D. Holding Co. Resource Finance Co. One Virginia Resource Finance Co. Two Resource Finance Co. One Virginia SHF Corp. Resource Finance Co. One Virginia Saxon Mortgage Capital Corporation Resource Mortgage Capital, Inc. Virginia Multi-Family Capital Resources, Inc. Resource Mortgage Capital, Inc. Virginia Multi-Family Capital Access One, Inc. Multi-Family Capital Resources, Inc. Virginia Camden Home Mortgage Corporation Resource Mortgage Capital, Inc. Virginia TC Acquisiton, Inc. Resource Mortgage Capital, Inc. Virginia At December 31, 1993, the other entities consolidated with Resource Mortgage Capital, Inc. were as follows: Saxon Mortgage Funding Corporation SMFC Holding, Inc. Virginia Saxon Mortgage Management Corporation SMFC Holding, Inc. Virginia SMFC Holding, Inc. N/A Delaware Saxon Mortgage Securities Corporation Saxon Mortgage Funding Corporation Virginia Exhibit 23.1 Accountants' Consent -------------------- The Board of Directors Resource Mortgage Capital, Inc.: We consent to incorporation by reference in the registration statements (No. 33-50705 and 33-52071) on Form S-3 of Resource Mortgage Capital, Inc. of our report dated February 7, 1994, relating to the consolidated balance sheet of Resource Mortgage Capital, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 Form 10-K of Resource Mortgage Capital, Inc. KPMG PEAT MARWICK Baltimore, Maryland March 21, 1994 Exhibit 99.1 ANALYSIS OF PROJECTED YIELD This presentation contains an analysis of the projected yield on the Company's mortgage investments as of December 31, 1993, under the specific assumptions set forth herein. This presentation does not seek to predict, nor should it be interpreted as a prediction of, the actual present or future yield on such investments since the actual interest rates and prepayment rates in the future will be different than those assumed in any of the projected scenarios. Capitalized terms used herein and not defined herein shall have the respective meanings assigned to them in the Glossary. Resource Mortgage invests a portion of its equity in a portfolio of mortgage investments. These investments include mortgage loans and mortgage securities subject to collateralized mortgage obligations (CMOs), adjustable-rate mortgage securities, fixed-rate mortgage securities, other mortgage securities and participations in mortgage warehouse lines of credit. The Company has pursued its investment strategy of concentrating on its mortgage conduit activities in order to create investments for its portfolio with attractive yields and also to benefit from potential securitization income. Through its single-family mortgage conduit activities the Company purchases mortgage loans from approved mortgage companies, savings and loan associations and commercial banks; in its multi-family conduit activities, the Company originates the loans directly. When a sufficient volume of loans is accumulated, the Company securitizes these mortgage loans through the issuance of mortgage-backed securities. The mortgage-backed securities are structured so that substantially all of the securities are rated in one of the two highest categories (i.e. AA or AAA) by at least one of the nationally recognized rating agencies. The yield on the Company's investment portfolio is influenced primarily by (i) prepayment rates on the underlying mortgage loans, (ii) the level of short-term interest rates and (iii) the relationship between short-term financing rates and adjustable-rate mortgage yields. The following analysis provides a projection of the yield of the Company's investment portfolio in variety of interest rate and prepayment rate environments. The Company's investment strategy is to create a diversified portfolio of mortgage securities that in the aggregate generate stable income in a variety of interest rate and prepayment rate environments. For purposes of this analysis only, certain of the Company's assets and liabilities have been excluded, and certain liability balances have been reduced to better reflect the Company's net investment in its investment portfolio. Summary of Mortgage Investments For purposes of calculating the projected yield, the Company calculates its net investment in its mortgage investments as of December 31, 1993 and December 31, 1992 and can be summarized as follows (amounts in thousands): December 31, December 31, 1993 1992 ----------- ------------ Collateral for CMOs, net of CMO liabilities $ 8,403 $ 11,582 ---------- ---------- Adjustable-rate mortgage securities, net (1) 132,401 100,661 --------- ---------- Fixed-rate mortgage securities, net (1) 14,520 18,842 --------- ---------- Other mortgage securities: Mortgage residual interests 22,900 25,082 Mortgage derivative securities 37,494 10,856 -------- ------- Other mortgage securities subtotal 60,394 35,938 Mortgage warehouse participations, net of related liabilities 9,393 8,941 -------- ------- Net investment $ 225,111 $ 175,964 ========= ========== (1) Net of repurchase borrowings and discounts recorded by the Company to compensate for certain risks on mortgage securities collateralized by mortgage loans purchased by the Company for which mortgage pool insurance is used as the primary source of credit enhancement. At December 31, 1993 the discount totaled $17.2 million on adjustable-rate mortgage securities and $2.4 million on fixed-rate mortgage securities. The following tables list the Company's various investments (and related information) as of December 31, 1993 that were used in the calculation of the projected yield. Collateral Pledged to Secure CMOs (Dollars in thousands) Type of Weighted Mortgage Average Net Series Collateral Coupon Rate (1) Investment (2) MCA 1, Series 1, Class D Loans(3) 8.97% $ 1,100 RAC Four, Series 77 Loans 9.55 1,750 RMSC Series 89-1A Loans 11.25 36(89-1A&B) RMSC Series 89-1B Loans 11.12 RMSC Series 89-3A Loans 11.14 143(89-3A&B) RMSC Series 89-3B Loans 11.21 RMSC Series 89-4A Loans 10.60 314(89-4A&B) RMSC Series 89-4B Loans 10.59 RMSC Series 89-5 Loans 10.60 33 RMSC Series 91-2 Loans 9.81 1,135 RMSC Series 92-12 Loans 8.10 1,555 RAC Four, 26 Misc. Series Various 9.90 2,337 ------ Total $ 8,403 ======= - ------------------------ (1) Based on the weighted average coupons of the underlying mortgage loans or mortgage certificates when the CMOs were issued and the current principal balances of such mortgage collateral. This information is presented as of December 31, 1993. (2) Equal to the outstanding principal balance of the mortgage collateral plus unamortized discounts, premiums, accrued interest receivable and deferred issuance costs, and net of bond principal, discounts, premiums and accrued interest payable as of December 31, 1993. (3) Multi-family loans. Adjustable-Rate Mortgage Securities (Dollars in thousands) Remaining Principal Interest Net Description (1) Balance (2) Rate (3) Investment (4) FNMA Pools, various $ 383,717 3.46-5.21%(A) $ 22,090 FNMA and FHLMC Pools, various 106,848 3.95-5.66 (B) 7,423 FNMA and FHLMC Pools, various 6,525 3.95-5.66 (C) 367 LIBOR ARM Trust 1991-19, Class B 40,018 5.60 (A) 2,298 LIBOR ARM Trust 1992-1, Class B 40,350 5.46 (A) 2,223 LIBOR ARM Trust 1992-4, Class B 59,940 5.51 (A) 3,408 LIBOR ARM Trust 1992-6, Class B 70,109 5.61 (A) 3,993 LIBOR ARM Trust 1992-8, Class B 105,208 5.54 (A) 6,019 LIBOR ARM Trust 1992-10, Class B 32,945 5.41 (A) 1,884 RMSC, AHF 1989-1 Trust, Class A-2 7,051 5.81 (B) 399 RMSC, Series 1991-5 55,476 5.71 (A) 3,174 RMSC, Series 1991-7, Class B 48,003 5.85 (A) 2,768 RMSC, Series 1991-11 76,217 5.68 (A) 4,339 RMSC, Series 1991-12, Class B 45,983 5.59 (A) 2,639 RMSC, Series 1991-15, Class B 39,972 5.67 (A) 2,293 RMSC, Series 1991-16, Class B 57,109 5.79 (A) 3,276 RMSC, Series 1991-17, Class B 39,523 5.62 (A) 2,269 RMSC, Series 1992-5 85,726 5.71 (A) 4,911 RTC M-1, A-4 415 6.97 (C) 23 RTC M-6, A-1, A-2 41,090 5.53, 5.62 (C) 2,375 SMSC, Series 1992-1, Class B 5,000 5.46 (A) 285 SMSC, Series 1992-4, Class B 55,900 5.46 (A) 3,157 SMSC, Series 1992-6, Class B 60,193 5.40 (A) 3,416 SMSC, Series 1993-1, Class B-1, B-2 9,963 5.49, 5.46 (A) 570 SMSC, Series 1993-3, Class A-2, B-2 118,194 5.55 (A) 6,753 SMSC, Series 1993-5, Class A-2, B-2 70,356 5.28 (A) 4,049 SMSC, Series 1993-6, Class B 17,684 4.62 (A) 1,014 SMSC, Series 1993-7, Class B 31,580 4.08 (A) 1,807 SMSC, Series 1993-9, Class A-2, B-2 98,745 3.99 (A) 5,688 SMSC, Series 1993-11 149,164 3.56 (A) 8,616 LIBOR Cap Agreements (5) 18,875 -------- Total $ 132,401 ========= (A) Index - Six-month LIBOR (B) Index - 1-yr CMT (C) Index - COFI (1) All the "Class B" adjustable-rate mortgage securities were created from the Company's mortgage conduit operations, and represent a AA rated class that is subordinated to AAA rated class(es) within the security offering. (2) As of December 31, 1993. (3) Pass-through rate as of December 31, 1993. (4) Equal to the outstanding principal balance of the adjustable-rate mortgage securities, plus any unamortized premiums and net of any unamortized discounts, less repurchase borrowings, if any, calculated at 94% of such amount. (5) The Company has purchased various LIBOR cap agreements in regard to the adjustable-rate mortgage securities. Pursuant to the cap agreements, the Company will receive additional cash flows should six- month LIBOR increase above certain levels as specified below. Notional Amount Cap Rate --------------- -------- Cap agreements expiring in 2004 $ 100,000 9.00% Cap agreements expiring between 2001 and 2002 230,500 11.50% Cap agreements expiring between 2001 and 2002 108,000 10.50% Cap agreements expiring between 2000 and 2003 490,000 9.50% Cap agreements expiring in 1999 235,000 10.00% ------------ $ 1,163,500 =========== Fixed-rate Mortgage Securities (Dollars in thousands) Remaining Principal Interest Net Description Balance (1) Rate Investment (2) - ----------- ---------- --------- -------------- Citibank, Series 1990-B, Class B-5 $ 1,175 9.60% $ 721 RMSC, various series 13,029 8.19 822 RMSC, various series 4,233 9.92 259 RMSC, Series 91-2, Class 2-B 11,672 10.00 1,513 SMSC, Series 1993-3, Class A-1, B-1 88,848 6.76 5,510 SMSC, Series 1993-5, Class A-1, B-1 55,755 6.53 3,448 SMSC, Series 1993-9, Class A-1, B-1 34,851 6.09 2,154 LIBOR Cap Agreements(3) 93 --------- Total $14,520 ======== (1) As of December 31, 1993. (2) Equal to the outstanding principal balance of the securities, plus any unamortized premiums and net of any unamortized discounts at December 31, 1993. (3) Equal to the outstanding principal balance of the securities, plus any unamortized premiums and net of any unamortized discounts, less the associated repurchase agreement borrowings at December 31, 1993. (4) The Company has purchased various LIBOR cap agreements in regard to the repurchase borrowings on SMSC Series 1993-3, Series 1993-5 and Series 1993-9. Pursuant to the cap agreements, the Company will receive additional cash flows should six-month LIBOR increase above certain levels ranging from 6.58%-6.75%. The aggregate notional amount of these cap agreements was $16 million at December 31, 1993. Other Mortgage Securities (Dollars in thousands) Other Mortgage Securities are comprised of mortgage residual interests and mortgage derivative securities as set forth below. Mortgage residual interests: Type of Weighted Mortgage Percent Average Net Net Series Collateral Owned Coupon Rate (1) Investment (2) FNMA REMIC Trust 1988-22 FNMA 40.00% 9.50% $ 1,691 LIBOR ARM Trust 1991-19 Loans 100.00 5.60 298 LIBOR ARM Trust 1992-1 Loans 100.00 5.46 345 LIBOR ARM Trust 1992-4 Loans 100.00 5.51 382 ML Trust XI FHLMC 49.00 8.50 780 RAC Four, Series 39 FHLMC 49.90 10.20 535 RAC Four, Series 62 GNMA 30.00 10.00 498 RAC Four, Series 73 GNMA 55.00 11.50 5,323 RAC Four, Series 74 GNMA 23.60 10.50 1,953 RAC Four, Series 75 GNMA 36.00 9.50 1,526 RAC Four, 22 Misc. Series Various Various 11.54 435 RMSC, Series 1991-7 Loans 100.00 6.01 448 RMSC, Series 1991-12 Loans 100.00 6.59 21 RMSC, Series 1991-15 Loans 100.00 6.67 108 RMSC, Series 1991-16 Loans 100.00 6.79 16 RMSC, Series 1991-17 Loans 100.00 5.62 101 Shearson Lehman, Series K FNMA 50.00 10.00 314 LCPI Various 100.00 9.00 7,948 LIBOR Cap Agreements (3) 178 ------- Total $ 22,900 ======== - ------------------- (1) Based on the weighted average coupons of the underlying mortgage loans or mortgage certificates when the mortgage securities were issued and the current principal balances of such mortgage collateral. This information is presented as of December 31, 1993. (2) Equal to the amortized cost of the mortgage residual interests as of December 31, 1993. (3) The Company has purchased LIBOR cap agreements through June 1994 in regard to portions of the exposure to higher short-term interest rates of certain of the mortgage residual interests. These cap agreements reduce the Company's risk should one-month LIBOR exceed 8.50%. The aggregate notional amount of these cap agreements was $150 million at December 31, 1993. Other Mortgage Securities (continued) Mortgage derivative securities: Weighted Type of Average Type of Mortgage Net Coupon Net Description Securities (1) Collateral Rate (2) Investment (3) - ------------ ------------- ---------- ---------- ------------- Chemical, Series 1988-4 I/O Loans 9.82% $ 109 FNMA Trust 1 I/O FNMA 9.00 5,539 FNMA Trust 29 I/O GNMA 9.50 9,454 FNMA Trust 151 I/O FNMA 10.00 1,835 Interest-only strips, various I/O Loans Various 10,295 LIBOR ARM Trust 1992-8, Class I I/O Loans 5.54 826 LIBOR ARM Trust 1992-9, Class I I/O Loans 5.46 594 LIBOR ARM Trust 1992-10, Class I I/O Loans 5.41 500 Principal-only strips, various P/O Loans Various 3,806 RMSC, Series 89-6, 6F I/O Loans 10.62 308 RMSC, Series 1989-7A, A-2 I/O Loans 10.33 75 RMSC, Series 1989-7B, B-2 I/O Loans 10.39 161 RMSC, Series 1991-14, Class 14-P P/O Loans 9.77 149 RMSC, Series 1991-16, Class I I/O Loans 5.79 268 RMSC, Series 1991-20, Class P P/O Loans 8.96 412 RMSC, Series 1992-2, Class P P/O Loans 8.47 48 RMSC, Series 1992-18, Class P P/O Loans 8.18 154 RMSC, Series 1992-18, Class X I/O Loans 8.18 1,326 SMSC, Series 1992-1, Class I I/O Loans 5.46 509 SMSC, Series 1992-2, Class I I/O Loans 5.53 558 SMSC, Series 1992-3, Class I I/O Loans 5.56 266 SMSC, Series 1992-4, Class I I/O Loans 5.46 302 ------ Total $ 37,494 ========= - ------------------- (1) I/O means an interest-only security; P/O means a principal-only security. (2) Based on the weighted average coupons of the underlying mortgage loans or mortgage certificates when the mortgage securities were issued and the current principal balances of such mortgage collateral. This information is presented as of December 31, 1993. (3) Equal to the amortized cost of the mortgage derivative securities as of December 31, 1993. The Company owned 100% of each such security, except for the FNMA Trusts. Mortgage Warehouse Participations (Dollars in thousands) Description Weighted Average Coupon (1) Net Investment (2) - ------------ -------------------------- ------------------ Various Participations 5.2% $ 9,393 - ------------------ (1) Based upon the weighted average rate on each participation as of December 31, 1993. (2) Equal to equity invested in mortgage warehouse participations as of December 31, 1993. YIELD ON MORTGAGE INVESTMENTS This presentation contains an analysis of the yield sensitivity to different short-term interest rates and prepayment rates of the Company's Mortgage Investments (as described in the previous section) as of January 1, 1994. The Company utilizes this analysis in making decisions as to the cash flow characteristics of investments that the Company desires to create or acquire for its investment portfolio. The Company's investment strategy is to create a diversified portfolio of mortgage securities that in the aggregate generates stable income in a variety of interest rate and prepayment rate environments and preserves the capital base of the Company. Capitalized terms used herein and not defined within this section are defined in the glossary on page 15 of this Exhibit. This presentation does not reflect all of the Company's assets and liabilities (or income and expenses of such excluded assets or liabilities) nor any of the general and administrative expenses of the Company. This presentation also does not purport to reflect the liquidation or ongoing value of the Company's business or assets. The yield information presented herein is provided solely for analytical purposes. This presentation does not seek to predict, nor should it be interpreted as a prediction of, the actual present or future yield on such investments. The table below sets forth the estimated cash yields calculated on a semi-annual equivalent basis as of December 31, 1993 of the projected net cash flows on the Company's existing investment portfolio as set forth in "Mortgage Investments" above, based upon the current balances of the assets as of January 1, 1994, and upon assumptions set forth below on pages 10 through 14 for each of the respective cases. The most important of these assumptions are the prepayment rates applicable to each mortgage investment and the level of short-term interest rates. MORTGAGE INVESTMENTS YIELD SENSITIVITY ANALYSIS ------------------------------------------------ PRE-TAX YIELD ON INVESTMENT (%) Short-Term Interest Rate Assumption Case ---------------------------------------- Prepayment Assumption Case Case I Case II Case III Case IV Case V Case VI Case VII - ----- ------ ------- -------- ------- ------ ------- -------- Case A 24.9% 23.3% 23.0% 21.6% 19.0% 16.1% 12.9% Case B 26.2 24.6 24.3 23.0 20.4 17.6 14.6 Case C 27.6 26.0* 25.6 24.4 21.9 19.3 16.4 Case D 28.7 27.0 26.6 25.4 23.2 20.8 18.1 Case E 29.7 28.1 27.6 26.4 24.4 22.2 19.6 Case F 30.8 29.2 28.7 27.5 25.6 23.5 21.0 Case G 31.9 30.3 29.8 28.6 26.8 24.8 22.3 The case most representative of short-term interest rates and prepayment rates as of January 1, 1994, is case C-II, represented by the "*." This "base case" is not in the center of the table due to the relatively low levels of short term interest rates and relatively high projected prepayment speeds as of December 31, 1993. The yields for each case expressed above are level yields relative to the Company's aggregate net investment of $225.1 million in the various listed mortgage investments as shown beginning on page 2. In addition to the foregoing, the projected yields assume that the Company is able to reinvest principal received on its investments at the same yield as the yield in each case; consequently, these yields do not purport to reflect the return when such reinvestment is not available. Such yields do not give effect to the operating expenses of the Company. These yields are also exclusive of the yields on mortgage assets of the Company not listed in "Mortgage Investments" above. In particular, the listed mortgage investments do not include (i) mortgage loans in warehouse, and (ii) certain adjustable-rate and fixed-rate mortgage securities. These securities are excluded in an amount equal to the discount which compensates the Company for certain risks on mortgage securities collateralized by mortgage loans for which mortgage pool insurance is used as the primary source of credit enhancement. There is no assurance that any particular yield actually will be obtained. Prepayment speeds may exceed those shown in the tables on pages 11 and 12 and/or short-term interest rates may exceed those shown in the table on page 13. If this happens, the portfolio yields may differ significantly from those shown below. Also, the table shows changes in short-term interest rates and prepayment rates occurring on a gradual basis over one year. If these factors change more rapidly, the portfolio yields may be significantly affected. The Company also calculates the MacCauley duration of the aggregate cash flows on its mortgage investments. The duration is 2.4 years in Case C-II, the base case, and ranges from a high of 4.4 years in Case G- VII to a low of 2.2 years in Case A-I. The assumptions that are set forth below detail certain information with respect to the mortgage investments as of December 31, 1993, or other dates as specified. Factors Affecting Return The return on the Company's portfolio of investments will be affected by a number of factors. These include the rate of prepayments of the mortgage loans directly or indirectly securing the mortgage investments and the characteristics of the net cash flows available. Prepayments on mortgage loans commonly are measured by a prepayment standard or model. Two models are used herein. One such model which is used primarily for fixed-rate mortgage loans (the "PSA" prepayment assumption model) is based on an assumed rate of prepayment each month of the unpaid principal amount of a pool of new mortgage loans expressed on an annual basis. A prepayment assumption of 100 percent of the PSA assumes that each mortgage loan (regardless of interest rate, principal amount, original term to maturity or geographic location) prepays at an annual compounded rate of 0.2% of its outstanding principal balance in the first month after origination. The prepayment rate increases by an additional 0.2% per annum in each month thereafter until the thirtieth month after origination. In the thirtieth month and each month thereafter each mortgage loan prepays at a constant prepayment rate of 6% per annum. The other model used herein is the Constant Prepayment Rate ("CPR"), which is used primarily to model prepayments on adjustable-rate mortgage loans. CPR represents an assumed rate of prepayment each month relative to the then outstanding principal balance of a pool of mortgage loans. A prepayment assumption of 18% CPR assumes a rate of prepayment of the then outstanding principal balance of such mortgage loans in each month equal to 18% per annum. The Prepayment Assumption Model and CPR do not purport to be either an historical description of the prepayment experience of any pool of mortgage loans or a prediction of the anticipated rate of prepayment of any pool of mortgage loans, including mortgage loans underlying the mortgage investments. The actual prepayment rate of the mortgage loans will likely differ from the assumed prepayment rates. The rate of principal payments on a single-family pool of mortgage loans is influenced by a variety of economic, geographic, social and other factors. In general, however, mortgage loans are likely to be subject to relatively higher prepayment rates if prevailing long-term interest rates fall significantly below the interest rates on the mortgage loans. Conversely, the rate of prepayments would be expected to decrease if long-term interest rates rise above the interest rate on the mortgage loans. Other factors affecting prepayment of mortgage loans include changes in mortgagors' housing needs, job transfers, unemployment, mortgagors' net equity in the mortgaged properties, assumability of mortgage loans and servicing decisions. The terms of the multi-family mortgage loans that collateralize the multi-family investments prohibit the prepayment of principal during the lock-out period, a period generally equal to fifteen years after origination of the loan. Subsequent to the lock-out period, prepayments will be subject to a prepayment premium based on 1% of the remaining principal balance of the multi-family mortgage loan. The net cash flows on the Company's CMOs will be derived principally from the difference between (i) the cash flow from the collateral pledged to secure the CMO together with reinvestment income, and (ii) the amount required for payment on the CMOs together with related administrative expenses. Certain of the Company's other mortgage securities have similar net cash flow characteristics (collectively, net cash flow investments). Distributions of net cash flows on such net cash flow investments represent both income relative to the investment and a return of the principal invested. Assumptions Employed in Projecting the Net Cash Flows In calculating the "Mortgage Investments Yield Sensitivity Analysis" above, the projected net cash flows on the Company's mortgage investments were calculated on the basis of the following: (1) Prepayments on the mortgage loans underlying the mortgage investments (other than adjustable-rate mortgage securities) were projected to be received in proportion to the PSA model described in this report. Prepayments on the adjustable-rate mortgage securities were projected to be received in proportion to the CPR model described in this report. The tables below show the prepayment rate projections, expressed as a percentage of the PSA or CPR, on the mortgage loans underlying the mortgage investments in which the Company has an interest under the assumed Case A, Case B, Case C, Case D, Case E, Case F and Case G scenarios. Neither the prepayment projections used in this report nor any other prepayment model or projection purports to be a historical description of prepayment experience or a prediction of the anticipated rate of prepayment of any pool of mortgage loans. It is unlikely that actual prepayments on the mortgage collateral will conform to any of the projected prepayment rates shown in the table below. Prepayment rate projections for certain of the Company's smaller investments are not listed in the tables below. The prepayment rate for each type of mortgage loan is projected to begin at the prepayment rate used in Case C in the table below. For cases other than Case C, the applicable rate increases or decreases ratably over a one-year period to the prepayment rate set forth for the applicable case. The prepayment rates set forth in Case C are the average of the published estimates of projected prepayment rates of a number of major Wall Street firms, excluding the highest and lowest estimates, as published on Bloomberg on January 1, 1994. Cases A through B and Cases D through G represent the average of the prepayment estimates from two investment banking firms multiplied by the ratio of Case C and the average of the comparable prepayment estimates of the two investment banking firms. PREPAYMENT ASSUMPTION TABLE FIXED-RATE MORTGAGE LOANS OR CERTIFICATES Pass Through Percentage of PSA ------------------------------------------------ Mortgage Certificates Rate (%)Case A Case B Case C* Case D Case E Case F Case G GNMA Certif. 9.50 715 635 455 355 245 215 190 10.00 640 590 445 365 270 225 200 10.50 575 530 400 350 285 215 190 11.50 475 440 350 320 290 255 205 FNMA Certif. 9.00 810 725 540 410 290 250 230 9.50 830 740 545 465 335 275 250 10.00 795 720 530 465 360 285 255 FHLMC Certif. 8.50 700 635 475 315 235 210 200 10.00 770 705 530 470 370 305 225 10.25 735 680 510 460 380 305 230 10.50 700 655 495 445 390 310 230 Fixed-rate Mortgage Loans: MCA 1, Series 1 340 335 330 325 320 315 310 RAC Four, Series 77 735 680 510 460 380 305 230 RMSC, Series 1989-1A and 89-1B 635 595 435 405 365 300 250 RMSC, Series 1989-3A, and 89-3B 635 595 435 405 365 300 250 RMSC, Series 1989-4A and 89-4B 715 660 495 445 380 290 220 RMSC, Series 89-5 715 660 495 445 380 290 220 RMSC, Series 89-6 715 660 495 445 380 290 220 RMSC, Series 91-2** 435 370 300 235 170 100 70 RMSC, Series 92-12 700 635 475 315 235 210 200 * Case C is the case most representative of projected prepayment speeds as of January 1, 1994. This is representative of the yield on a FNMA 30-year pass-through security of 6.75%. (Case A represents a FNMA pass-through yield of 4.75%, Case B 5.75%, Case D 7.75%, Case E 8.75%, Case F 9.75% and Case G 10.75%). ** The mortgage loans underlying the security become adjustable-rate in 1996-1998. CONSTANT PREPAYMENT RATES (CPR) TABLE (%) ADJUSTABLE-RATE MORTGAGE LOANS OR CERTIFICATES Case A Case B Case C*Case D Case E Case F Case G FNMA Pools, Various 36 32 28 26 22 18 14 FHLMC Pools, Various 26 22 18 14 10 6 2 LIBOR ARM Trust 1991-19 26 22 18 14 10 6 2 LIBOR ARM Trust 1992-1 26 22 18 14 10 6 2 LIBOR ARM Trust 1992-4 26 22 18 14 10 6 2 LIBOR ARM Trust 1992-6 26 22 18 14 10 6 2 LIBOR ARM Trust 1992-8 26 22 18 14 10 6 2 LIBOR ARM Trust 1992-10 26 22 18 14 10 6 2 RMSC, AHF 1989-1 40 36 32 28 26 22 18 RMSC, Series 1991-5 26 22 18 14 10 6 2 RMSC, Series 1991-7 26 22 18 14 10 6 2 RMSC, Series 1991-11 26 22 18 14 10 6 2 RMSC, Series 1991-12 26 22 18 14 10 6 2 RMSC, Series 1991-15 26 22 18 14 10 6 2 RMSC, Series 1991-16 26 22 18 14 10 6 2 RMSC, Series 1991-17 26 22 18 14 10 6 2 RMSC, Series 1992-5 26 22 18 14 10 6 2 RTC M-1 15 13 10 7 5 5 5 RTC M-6 17 15 10 7 5 5 5 SMSC, Series 1992-4 26 22 18 14 10 6 2 SMSC, Series 1992-6 26 22 18 14 10 6 2 SMSC, Series 1993-1 26 22 18 14 10 6 2 SMSC, Series 1993-3**26 22 18 14 10 6 2 SMSC, Series 1993-5**26 22 18 14 10 6 2 SMSC, Series 1993-6 26 22 18 14 10 6 2 SMSC, Series 1993-7 26 22 18 14 10 6 2 SMSC, Series 1993-9**26 22 18 14 10 6 2 SMSC, Series 1993-11 26 22 18 14 10 6 2 - ------------------ * Case C is the case most representative of projected prepayment speeds as of January 1, 1994. ** The mortgage loans underlying these securities become adjustable-rate in 1995-1996. (2) Principal and interest payments on the mortgage collateral was assumed to be received monthly with interest payments received in arrears. (3) The LIBOR, commercial paper, COFI, 1 Yr-CMT, and reinvestment income rates are assumed to be as set forth in the table set forth below. The applicable rate is assumed to begin at the rate set forth in Case II in the table below. For cases other than Case II, the applicable rate increases or decreases ratably over a one-year period to the rate set forth for the applicable case. The rates set forth in Case II are representative of the rates as of January 1, 1994. Case I and Cases III through VII indicate rates decreasing or increasing, respectively, from the rates of Case II in equal steps each month over one year, to the rate indicated and continuing thereafter at that rate. According to the scheduled resets and subject to the periodic and lifetime caps, if applicable, the interest rates on the Company's adjustable-rate mortgage securities, in each case, reset at the defined margin relative to their respective indices. SHORT TERM INTEREST RATE ASSUMPTIONS Case I Case II* Case III Case IV Case V Case VI Case VII LIBOR One-month 2.250% 3.250% 4.250% 5.250% 6.250% 7.250% 8.250% Three-month 2.375 3.375 4.375 5.375 6.375 7.375 8.375 Six-month 2.563 3.563 4.563 5.563 6.563 7.563 8.563 COFI 3.122 3.822 4.522 5.222 5.922 6.622 7.322 1 Yr-CMT 2.630 3.630 4.630 5.630 6.630 7.630 8.630 Reinvestment Rates 1.813 2.813 3.813 4.813 5.813 6.813 7.813 - ------------------- * Case II is the case most representative of short-term interest rates as of January 1, 1994. (4) Principal and interest payments on each mortgage investment were assumed to be made in accordance with the terms for each such mortgage investment. (5) It was assumed that no optional redemptions are exercised on any of the mortgage investments. (6) Administrative fees for each series of mortgage securities have been calculated using the assumptions set forth in the prospectus relating to each such series. The administrative fee generally is based upon a fixed percentage of the principal amount of such mortgage securities outstanding. (7) For the purposes of calculating the net cash flows on the adjustable-rate mortgage securities that are subject to repurchase borrowings, it was assumed that the repurchase borrowings were equal to 94% of the Company's cost basis in such adjustable-rate mortgage securities, and that such ratio would remain constant. Actual repurchase borrowings were greater on December 31, 1993 than the amount used for modeling. If the ratio that the Company was able to borrow were to decrease to a level below the 94% for adjustable-rate mortgage securities used in modeling due to either increases in short-term interest rates or other market conditions, the yield to the Company would be lower in each case. (8) For purposes of calculating the net cash flows on the fixed-rate mortgage securities that are subject to repurchase borrowings, it was assumed that the repurchase borrowings were equal to 93.5% of the Company's basis in such fixed-rate mortgage securities, and that such ratio would remain constant. Actual repurchase borrowings were greater on December 31, 1993 than the amount used for modeling. If the ratio that the Company was able to borrow were to decrease to a level below the 93.5% for fixed-rate mortgage securities used in modeling due to either increases in short-term interest rates or other market conditions, the yield to the Company would be lower in each case. (9) In modeling the mortgage warehouse participations, it was assumed that each participation had a remaining average life of one year and the spread between the weighted average coupon, associated costs and the commercial paper rate remained constant. (10) No losses are projected on any mortgage loans owned by the Company or underlying any adjustable-rate mortgage security or other mortgage security that would not be covered by external sources of insurance or the Company's allowance for losses. Any losses not covered by such insurance or allowance would lower the yield in each case to the Company. (11) While the cost of the LIBOR cap agreements has been added to the Company's investment in its portfolio, the projections do not include any benefit from them, as such caps are above the range of the short- term interest rate assumptions set forth on page 13. (12) In modeling certain of the Company's smaller mortgage investments, the cash flows of the investments were modeled by substituting for the actual assets and liabilities a small number of representative assets or liabilities, the characteristics of which summarize the actual mortgage loans or mortgage securities and the related liabilities that comprise the investment. GLOSSARY AHF - American Home Funding. Adjustable-rate mortgage loan (ARM) - A mortgage loan that features adjustments of the loan interest rate at predetermined times based on an agreed margin to an established index. An ARM is usually subject to periodic and lifetime interest-rate and/or payment-rate caps. Adjustable-rate mortgage securities - Mortgage certificates that represent the pass-through of principal and interest on adjustable-rate mortgage loans. Bloomberg - Bloomberg Business Services, Inc. information systems. Chemical - Chemical Acceptance Corporation. Citibank - Citibank, N.A., REMIC mortgage pass-through certificates. COFI - Eleventh District Cost of Funds Index. Collateralized Mortgage Obligations (CMOs) - Debt obligations (bonds) that are collateralized by mortgage loans or mortgage certificates. CMOs are structured so that principal and interest payments received on the collateral are sufficient to make principal and interest payments on the bonds. The bonds may be issued in one or more classes with specified interest rates and maturities which are designed for the investment objectives of different bond purchasers. Company - Resource Mortgage Capital, Inc. FHLMC - Federal Home Loan Mortgage Corporation. Fixed-rate mortgage loan - A mortgage loan which features a fixed interest rate that does not change during the life of the loan, or does not change for at least one year from the date of the analysis. FNMA - Federal National Mortgage Association. FNMA Yield - FNMA 30-year mortgage certificate yield. GAAP - Generally accepted accounting principles. GNMA - Government National Mortgage Association. LIBOR - The London Inter-Bank Offered Rate for overseas deposits of U.S. dollars. The LIBOR index generally follows the patterns of the short-term interest rate environment in the U.S. market. Long-term interest rates - The interest rates applicable to debt securities with an average life of 10 years or more. MCA 1 - Multi-family Capital Access One, Inc., a subsidiary of the Company ML - Merrill Lynch Mortgage certificates - Certificates which represent participation in pools of mortgage loans. The principal and interest payments on the mortgage loans are passed through to the certificate holders. GNMA, FNMA, or FHLMC may issue and guarantee the payment of principal and interest on mortgage certificates issued by them. Mortgage certificates may also be privately issued. Mortgage derivative securities - Mortgage securities that generally have a market price that is substantially below or in excess of the principal balance of the underlying mortgage loans or mortgage certificates (e.g., a principal-only or interest-only security). Mortgage loans - Mortgage loans secured by first liens on single-family residential properties. Mortgage residual interests - An investment which entitles the Company to receive any excess cash flow on a pool of mortgage loans or mortgage certificates after payment of principal, interest and fees on the related mortgage securities. Mortgage warehouse participations - A participation in a line of credit to a mortgage originator that is secured by recently originated mortgage loans that are in the process of being sold to permanent investors. N/A - Not available. 1 Yr-CMT - One-year constant maturity treasury index. Other mortgage securities - Mortgage derivative securities and mortgage residual interests. Prepayment rates - Represent a measure as to how quickly the number of mortgage loans in a pool are prepaid-in-full. RAC Four - Ryland Acceptance Corporation Four. REMIC - A real estate mortgage investment conduit pursuant to the Internal Revenue Code of 1986, as amended. RMSC - Ryland Mortgage Securities Corporation. RTC - Resolution Trust Corporation SMART - Structured Mortgage Asset Residential Trust. SMSC - Saxon Mortgage Securities Corporation, an affiliate of the Company. Short-term interest rates - Short-term interest rates are the interest rates applicable to debt securities with an average life of six months or less.

869739_1993.txt

869739_1993

1993

869739

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

20947_1993.txt

20947_1993

1993

20947

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

820081_1993.txt

820081_1993

1993

820081

ITEM 1 BUSINESS. GENERAL Cambrex Corporation (the Company or Cambrex), a Delaware corporation, began business in December 1981 through its predecessor, and now wholly-owned subsidiary, CasChem, Inc. (CasChem). The Company manufactures and markets a broad line of specialty chemicals and commodity chemical intermediates and also manufactures chemicals to customer specifications. There are five product categories: health and pharmaceuticals; agricultural intermediates and additives; specialty and fine chemicals; performance chemicals; and coatings. Important objectives of the Company are to expand its operations through internal growth and to make strategic acquisitions of product lines, technology and companies that have substantial positions in niche markets, where customizing a Cambrex core technology to meet specific customer needs is a prime ingredient for success. The Company's plans for internal growth include: - developing new applications for technologies in which the Company has expertise; - expanding product offerings to increase use of existing equipment and resources; and - expanding domestic and international markets for existing products. On January 31, 1994, Cambrex purchased substantially all of the assets of Hexcel Corporation's fine chemicals business located in Middlesbrough, England, for approximately $9,500,000. This business, now known as Seal Sands Chemicals, Ltd., manufactures chemical intermediates used in the pharmaceutical, photographic, water treatment, health care, and plastics industries. On March 12, 1993, the Company purchased substantially all of the assets of Viscosity Oil's fiber optic gel business for $5,886,000. On March 31, 1992, the Company acquired substantially all of the assets of the fine chemicals business of Hexcel Fine Chemicals, located in Zeeland, Michigan, for $20,251,000 and the assumption of certain liabilities consisting primarily of a variable rate Industrial Development Revenue Bond in the principal amount of $4,150,000, and a capital lease maturing in 1997 with a net present value of $8,214,000. The business, now known as Zeeland Chemicals, Inc. (Zeeland), manufactures synthetic organic chemicals for the pharmaceutical, food additive, photographic, agricultural, personal care, and plastics industries. On July 1, 1991, the Company purchased substantially all of the assets of the chemicals business of Solvay Animal Health, Inc., located in Charles City, Iowa, for $12,299,000. The business, now known as Salsbury Chemicals, Inc. (Salsbury), manufactures custom and fine chemicals, as well as pharmaceutical intermediates, generic pharmaceuticals, animal feed additives, and photographic and polymer chemicals. PRODUCTS The following table sets forth for the periods indicated information concerning gross revenues from the Company's five product categories: - --------------- (1) In 1992, certain customers within specific product categories were changed to conform to classifications which the Company feels will better reflect the end use of its products. The 1991 revenues have been reclassified to conform to the 1992 presentation. (2) Revenues from Zeeland, acquired in March of 1992, are included from the date of acquisition. The Company expanded its health and pharmaceuticals, and specialty and fine chemicals product lines through this acquisition. (3) Revenues from Salsbury, acquired in July of 1991, are included from the date of acquisition. The Company expanded its health and pharmaceuticals, agricultural, and specialty and fine chemicals product lines through this acquisition. Health and Pharmaceuticals. This category consists of four principal product groups: (1) specialty compounds utilized in the formulation of cosmetics and toiletries, (2) intermediates converted into the active ingredients in a variety of food additives and over-the-counter medications, (3) bulk pharmaceuticals utilized as the active ingredients in over-the-counter and prescribed medications, and (4) Vitamin B3 and its chemical precursors. Such health and pharmaceutical products are sold to a diverse group of more than 500 customers. During 1993, sales of health and pharmaceuticals decreased $3,617,000 (6%) from 1992. The full year effect of the acquisition of Zeeland Chemicals in March 1992 added $3,200,000 to this sales category. The decrease in this category's performance was due to lower shipments of a bulk pharmaceutical, and to reduced shipments of niacinamide (Vitamin B3) intermediates. Sales in the health and pharmaceuticals category are expected to recover in 1994. Sales of cosmetic and toiletry related compounds represented $22,700,000, or 41%, of this category's 1993 revenues and were $200,000 higher than 1992. An increase of $1,200,000 in sales is due to products associated with the Zeeland acquisition. Sales of castor oil based personal care products totaled $8,900,000 in 1993 and were $700,000 lower than the prior year. Sales of pyridine based products totaled $6,200,000 in 1993 and were $300,000 lower than the prior year due to reduced demand in the Asia-Pacific region and competitive pressure in China. Sales are expected to remain at present levels in 1994. Sales of pharmaceutical intermediates represented $14,600,000, or 26%, of this category's 1993 revenues and were $300,000 higher than 1992. The increase is due to a variety of products associated with the Zeeland acquisition and an increase in x-ray contrast preparations. This increase was partially offset by decreases in pyridine based intermediates used in the pharmaceutical industry in Europe that were due to depressed economic conditions. The overall market for x-ray contrast drugs continues to grow as less toxic compounds are developed. Sales of bulk pharmaceuticals represented $9,700,000, or 18%, of this category's 1993 revenues and were $2,700,000 lower than 1992. The decrease was due to the unusually high 1992 sales caused by a disruption in the supply chain that resulted in distributors building excessive inventories. Sales were below normal levels in 1993 due to this inventory correction. Sales are expected to return to normal levels in 1994. Sales of Vitamin B3 and its chemical precursors represented $8,500,000, or 15%, of this category's 1993 revenues and were $1,400,000 lower than 1992. The Company's strategy to convert more of the intermediate into niacinamide (Vitamin B3) produced increased sales of USP grade B3 offset by reduced sales of the intermediate. Overall sales were lower because of currency restrictions in China and depressed economic conditions in Europe. Agricultural Intermediates. This category includes two principal product groups: (1) intermediates for use in the manufacture of herbicides and insecticides, and (2) animal feed additives. The Company's agricultural intermediates and additives are sold to approximately 15 customers. Two customers accounted for 24% and 15% of 1993 revenues in this category. Total sales in this category increased $2,033,000, or 4%, in 1993. The improvement was due to increased sales of feed additives to the poultry industry and to higher shipments of a pyridine compound to a major herbicide producer. This category was decreased by lost sales from a contract for a herbicide intermediate that ended in the fourth quarter 1992, and a decrease in pyridine derivative export sales. In 1994, the feed additive markets are expected to increase and the herbicide markets will remain at 1993 levels. The sales of products used in the manufacture of herbicides and insecticides amounted to $22,800,000, or 45%, of this category's 1993 revenues and were down 12% from 1992. Sales of pyridine, the largest item in this group, were at the same level as 1992. The largest pyridine customer is Zeneca, Inc. who uses it in the manufacture of herbicides. The Company produces another major pyridine compound and is the exclusive supplier of this product to Dow Elanco who uses it in production of a herbicide. Sales of this compound increased 88% in 1993 due to Dow resuming normal ordering patterns after reducing their inventories in 1992. Sales of other pyridine derivatives in this category decreased 80% from 1992 due to high inventory positions in the Asia-Pacific region and reduced use of a wheat fungicide in Europe. This level of sales activity will continue in 1994. The sales of animal feed additive products was $28,400,000, or 55%, of this category's 1993 revenues, up 23% from 1992. Sales of organo-arsenical feed additives increased 33% over the prior year due to a competitor stopping production, increased dosages by poultry producers, and increased poultry production in the U.S. These products improve weight gain, feed efficiency and antibiotic performance in poultry feed. Specialty and Fine Chemicals. This category principally consists of four product groups: (1) photographic chemicals, (2) specialty additives used for lubricants and surfactant intermediates, (3) organic intermediates, and (4) catalysts. The Company's manufacturing plants have available reactor capacity which enables Cambrex to seek additional opportunities to manufacture internally developed and customer-specific compounds. Such specialty and fine chemical products are sold to a diverse group of more than 1,000 customers. During 1993, sales of specialty and fine chemical products increased $11,218,000, a 30% rise from 1992. That increase included $6,000,000 related to the Zeeland Chemicals acquisition of March 1992. Increases in this category were in specialty additives, organic intermediates, specialty catalysts and custom manufactured products. The most significant improvement in sales was due to the expansion in the production facilities of a polymer used in instamatic film. Sales of photographic chemical products represented $13,700,000, or 28%, of this category's 1993 revenues and were $5,500,000 higher than 1992. The increase is due to a substantial increase in production capacity of a photochemical used as a polymer in instamatic film. Sales of specialty additive products represented $13,300,000, or 28%, of this category's 1993 revenues and were $3,500,000 higher than 1992. This increase is primarily attributable to sales of a chemical used in a fire retardant fiber and for cooling tower water treatments, and to sales of a product used as a cross linker for strengthening plastic. Sales of both these products are expected to continue to increase in 1994. Sales of organic intermediate products represented $10,800,000, or 22%, of this category's 1993 revenues and were $1,800,000 higher than 1992. This increase is attributable to a wide variety of products used as chemical intermediates. Sales of catalyst chemical products represented $9,800,000, or 20%, of this category's 1993 revenues and were $1,400,000 higher than 1992. The increase is primarily attributable to a variety of products associated with the Zeeland acquisition. Performance Chemicals. The Company's urethane elastomers are used in the telecommunications and electronics industries as encapsulants for wiring connections, biomedical devices to seal filter elements, and adhesives for artificial turf and industrial uses. This category also includes fiber optic cable gels. The key increase in this business was due to the acquisition of a complimentary fiber optic gel business in March 1993. The principal competitors in the telecommunications and electronics markets include two companies that have substantially greater resources than the Company. Competitors in the other end-use markets for performance products are numerous and varied. The Company competes in these markets on the basis of its patent and proprietary positions, technical expertise, and customer service. Performance chemicals are sold to approximately 550 customers with one customer accounting for 12% of this category's 1993 revenues. Total sales of performance products increased $10,439,000, or 51%, from 1992 levels. This increase was due to increases in sales of fiber optic cable gels and encapsulants to the telecommunications industry. The acquisition of a complimentary fiber optic gel business in March 1993 contributed $8,900,000 in increased revenues. The encapsulant sales were up 8% over 1992 due to penetration into international markets. Performance chemical sales will continue to increase in 1994 as fiber optic gel products grow with increased use of fiber optic cables. Coatings. The Company manufactures and sells products that are used as intermediates or performance-enhancing additives in the manufacture of paints and other coatings. The Company's coatings products compete based on a variety of factors including price, performance and technical support, depending on the particular market involved. These products are sold to approximately 300 customers. One customer accounted for 7% of 1993 revenues in this category. Sales of coatings products declined $1,643,000, or 9%, from 1992. The major part of the decline, $1,600,000, was attributable to a tolling agreement for biocides products that ended in May 1993. Although overall revenues in the coatings category are not expected to increase, 1994 results will depend on the economic trends in both the housing and automotive markets. RAW MATERIALS The Company uses significant amounts of castor oil in the manufacture of a number of its products and, under advantageous market conditions, sells it in bulk quantities as simple castor oil derivatives. The Company believes it is one of the largest purchasers of castor oil in the United States and, currently, the only buyer which has the ability to take delivery and store a large quantity of castor oil (up to 23 million pounds) on site. Castor oil, which is not produced in the United States, is an agricultural product whose market price is affected by natural factors relating to the castor bean crop from which the oil is produced. Castor oil is produced commercially in a few foreign countries with Brazil, India and China being the largest producers. The Company obtains its castor oil from several suppliers and negotiates castor oil purchases directly with principals of those organizations or their selling agents. The Company has been able to obtain adequate supplies of castor oil at acceptable prices in the past and expects to be able to do so in the future. Pyridine is produced by the Company using an efficient, cost-competitive process through the high temperature reaction of acetaldehyde, formalin and ammonia. Acetaldehyde's feedstock is ethylene, which is produced from natural gas liquids or crude oil. Ethylene is readily available although its price is often affected by the price of crude oil. Acetaldehyde is readily available from two suppliers in the United States and several international sources at competitive prices. Formalin's feedstock is methanol, which is also used by the petro-chemical industry in the manufacture of methyl-tert-butyl-ether (MTBE). The production of and demand for MTBE is expected to increase rapidly over the next few years in connection with its use as a gasoline additive. Although that is not expected to have an effect upon the availability of formalin, it may have an unfavorable effect upon its pricing. Ammonia has been widely available in the past and the Company believes that it will continue to be so in the future. The Company uses a wide array of other raw materials, in addition to those previously described, in the conduct of its business, all of which are in adequate supply and most of which are available from multiple suppliers. RESEARCH AND DEVELOPMENT The Company's research and development program is designed to increase the Company's competitiveness through improving its manufacturing technology and developing new product applications for that technology. The goal is to improve the Company's manufacturing processes to reduce costs, improve quality and increase capacity and to identify market opportunities which are large enough to warrant a significant and sustained technical effort, but not so large that success would result in direct competition from organizations with far greater resources than those possessed by the Company. Research and development activities are carried on at most of the Company's manufacturing facilities. Fifty employees are involved directly in research and development activities. The Company spent approximately $5,800,000, $4,000,000 and $3,300,000 in 1993, 1992 and 1991, respectively, on research and development. PATENTS AND TRADEMARKS The Company has patent protection in many of its product areas, especially in telecommunications encapsulants, biomedical sealants, coatings additives, pyridine process technology and its emerging hydrogel business. The Company also has know-how in many of its manufacturing processes and techniques not generally known to other chemical companies, particularly urethanes, castor oil derivatives, pyridine, alkenyl succinic anhydrides, organo-mercuric compounds, aromatic nitration, sulfonation, resolution of drugs in intermediates, and high pressure reactions. The Company currently owns approximately 45 United States patents which have varying durations and which cover selected items in each of the Company's major product areas. The Company also owns the foreign equivalent of many of its United States patents. In addition, the Company has applied for patents for various concepts and is in the process of preparing patent applications for other concepts. Although some of the Company's patents will expire over the next five years, the expirations are not expected to have a materially adverse effect on the Company. The Company has trademarks registered in the United States and a number of foreign countries for use in connection with the Company's products and business. The Company believes that many of its trademarks are generally recognized in its industry, particularly the cosmetic product related Wickenol(R) and Waxenol(R) trademarks. ENVIRONMENTAL AND SAFETY REGULATIONS AND PROCEEDINGS General: Production of certain of the Company's chemicals involves the use, storage and transportation of toxic and hazardous materials. The Company's operations are subject to extensive federal, state and local laws and regulations relating to the storage, handling, emission, transportation and discharge of materials into the environment and the maintenance of safe conditions in the work place. The Company maintains environmental and industrial safety and health compliance programs at its plants, and believes that its manufacturing operations are in general compliance with all applicable safety, health and environmental laws. The Company's acquisitions of Cosan Chemical Corporation (Cosan), Nepera, Inc. (Nepera), Heico Chemicals, Inc. (Heico), The Humphrey Chemical Company, Inc. (Humphrey), Salsbury Chemicals, Inc. (Salsbury), Zeeland Chemicals, Inc. (Zeeland) and Seal Sands Chemicals, Ltd. (Seal Sands) were made subject to known environmental conditions. Also, risks of substantial costs and liabilities are inherent in certain plant operations and certain products produced at the Company's plants, as they are with other companies engaged in the chemical business, and there can be no assurance that significant costs and liabilities will not be incurred. Additionally, prevailing legislation tends to hold chemical companies primarily responsible for the proper disposal of their chemical wastes even after transferral to third party waste disposal facilities. Moreover, other future developments, such as increasingly strict environmental, safety and health laws and regulations, and enforcement policies thereunder, could result in substantial costs and liabilities to the Company and could subject the Company's handling, manufacture, use, reuse, or disposal of substances or pollutants at its plants to more rigorous scrutiny than at present. Although the Company has no direct operations and conducts its business through subsidiaries, certain legal principles that provide the basis for the assertion against a parent company of liability for the actions of its subsidiaries may support the direct assertion against the Company of environmental liabilities of its subsidiaries. Known environmental matters which may result in liabilities to the Company are summarized in Note #18 to the Cambrex Corporation and Subsidiaries Consolidated Financial Statements. Present and Future Environmental Expenditures: The Company's policy is to comply with all legal requirements of applicable environmental, health and safety laws and regulations, and believes it is in general compliance with such requirements and has adequate professional staff and systems in place to remain in compliance. In some cases, compliance can only be achieved by capital expenditures, and the Company made capital expenditures of approximately $1,700,000 in 1993, $1,300,000 in 1992, and $3,300,000 in 1991 for environmental projects and has budgeted $5,100,000 in 1994 for such projects. The Company anticipates that capital requirements will increase in subsequent years as a result of the Clean Air Act Amendments and other pending environmental laws. Additionally, as the environmental proceedings in which the Company is involved progress from the remedial investigation and feasibility study stage to implementation of remedial measures, related expenditures will probably increase. The Company considers costs for environmental compliance to be a normal cost of doing business, and includes such costs in pricing decisions. EMPLOYEES At December 31, 1993 the Company had 791 employees (414 of whom were salaried and 377 of whom were hourly) employed as follows: All hourly plant employees at the Bayonne, New Jersey facility are represented by Local 8-406 of the Oil, Chemical and Atomic Workers International Union under a contract expiring September 17, 1994; the hourly plant employees at the Carlstadt, New Jersey plant are represented by the Amalgamated Industrial Union of East Orange, New Jersey under a contract expiring November 30, 1994; and the hourly plant employees at the Harriman, New York facility are represented by Local 810 of the International Brotherhood of Teamsters under a contract expiring June 30, 1995. The Company believes its labor relations are satisfactory. EXPORT SALES The Company exports numerous products to various areas, principally Western Europe, Asia and Latin America. Export sales in 1993, 1992 and 1991 amounted to $37,300,000, $44,500,000 and $37,400,000, respectively. ITEM 2 ITEM 2 PROPERTIES. The Company's manufacturing facilities are located on an eight acre tract in Bayonne, New Jersey, a three acre tract in Carlstadt, New Jersey, a twenty-nine acre tract in Harriman, New York, a twelve acre tract in Delaware Water Gap, Pennsylvania, a four acre tract in North Haven, Connecticut, a fifty-seven acre tract in Charles City, Iowa, and a fourteen acre tract in Zeeland, Michigan. In addition, the Company owns thirty-one acres of undeveloped land adjacent to the North Haven facility, 103 acres of undeveloped land adjacent to the Harriman facility, and sixty-six acres of undeveloped land adjacent to the Zeeland facility. The Company believes its facilities to be in good condition, well maintained and adequate for its current needs. Set forth below is information relating to the places of manufacture of the Company's products: ITEM 3 ITEM 3 LEGAL PROCEEDINGS. See "Environmental and Safety Regulations and Proceedings" under Item 1 hereof with respect to various proceedings involving the Company in connection with environmental matters. There are no other material legal proceedings affecting the Company. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None The following table lists the executive officers of the Company and the chief operating officers of the Company's operating subsidiaries: - --------------- (1) Unless otherwise indicated, positions shown are with the Company. The Company's executive officers are elected by the Board of Directors and serve at the Board's discretion. Mr. Baldwin, who was elected Chairman of the Board in July 1991, has been Chief Executive Officer and a director of the Company since it began business in December 1981. Mr. Mack was appointed President and Chief Operating Officer and a director of the Company in February 1990. For five years prior thereto he was Vice President in charge of the performance chemicals businesses worldwide of Olin Corporation, a manufacturer of chemical products, metal products, and ammunition and defense-related products. Mr. Tracey joined the Company in November 1990 as Vice President and Chief Financial Officer. For three years prior to joining Cambrex, he was Vice President -- Finance and Chief Financial Officer for Joyce International Inc., a manufacturer of office products. From 1986 to 1987, he was Vice President -- Finance and Chief Financial Officer for Robotic Vision Systems, Inc., a manufacturer of industrial automation systems. Prior to 1986, Mr. Tracey was a principal in the firm of Sirius Management Consultants. Mr. Thauer was appointed Vice President, Legal & Environment in December 1992, and General Counsel and Corporate Secretary in August 1989. Prior to joining Cambrex, he was Counsel to the business and finance group of the firm of Crummy, Del Deo, Dolan, Griffinger and Vecchione since 1987. From 1971 to 1987, Mr. Thauer has held various positions with Avon Products, Inc. including U. S. Legal Department Head and Corporate Assistant Secretary. Mr. Klosk joined the Company in October 1992 as Vice President, Administration. Prior to joining Cambrex, he was Vice President, Administration and Corporate Secretary for the Genlyte Group, Inc., a lighting fixture manufacturer, since February 1988. From 1985 to January 1988, he was Vice President, Administration for Lightolier, Inc., a subsidiary of the Genlyte Group, Inc. Dr. Rein was appointed Senior Vice President in April 1993. He joined the Company in June 1991 as President of Cambrex Fine Chemicals Group. For more than five years prior thereto, he was Director of Commercial Planning for W. R. Grace & Company. Mr. Eilender, who was employed by the Company's Cosan Chemical Corporation subsidiary when it was acquired by the Company in October 1985, joined the Company as a result of the acquisition. For more than three years prior to October 1985 he held various executive positions with Cosan including Vice President, Research and Development and Executive Vice President. He was President of Cosan from October 1986 until July 1989 at which time he was appointed to the additional position of President of CasChem, Inc. Mr. Noack joined the Company in December 1991 as President and Chief Operating Officer of Nepera, Inc. For more than five years prior thereto he held various positions with Hexcel Corporation, a leading producer of technologically advanced structural products and resins and chemical products, including General Manager of the Chemical Products Division. Mr. Smith was appointed Vice President, General Manager of Salsbury Chemicals, Inc. upon the Company's acquisition of the Salsbury facility. Prior to the acquisition, Mr. Smith had many years of service with Solvay Animal Health, Inc. starting in 1968 as Chemical Engineer through his appointment as Director, Chemical Operations in 1982. Mr. Thornton joined the Company as General Manager of Zeeland Chemicals, Inc. in April 1992. In his previous association with Hexcel Corporation, Zeeland, he held the positions of Sales/Marketing Manager and Plant Manager. Mr. Thornton also has extensive manufacturing management associations with M&T Chemicals, Inc. and Hercules, Inc. Mr. Behrend joined the Company in 1988 as Manager, Business Analysis. In July 1991, he was promoted to Director, Operations of Fine Chemicals Group with overall responsibility for Fine Chemical plant operations at Heico, Humphrey and Salsbury. In June 1993, Mr. Behrend was appointed to his current position as General Manager of Heico and Humphrey. Prior to joining Cambrex, Mr. Behrend was associated with Colgate Palmolive in Traffic Management and has also been a Portfolio Specialist, handling municipal and government securities. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) Since November 15, 1990, the Company's Common Stock, $.10 par value, has been traded on the American Stock Exchange (AMEX) under the symbol CBM. The Common Stock previously had been quoted on the National Association of Securities Dealers Automated Quotation (NASDAQ) National Market System. The following table sets forth the high and low market prices of the Common Stock for the indicated periods as reported by AMEX: (b) As of March 14, 1994, the Company estimates that there were approximately 1,800 beneficial holders of the outstanding Common Stock of the Company. (c) Since the fourth quarter of 1989, Cambrex has paid a regular $.05 per share quarterly dividend on the Common Stock. ITEM 6 ITEM 6 SELECTED FINANCIAL DATA. The following selected consolidated financial data of the Company for each of the years in the seven-year period ended December 31, 1993 are derived from audited financial statements. The consolidated financial statements of the Company as of December 31, 1993 and December 31, 1992 and for each of the years in the three year period ended December 31, 1993 and the accountants' reports thereon are included elsewhere in this annual report. The data presented below should be read in conjunction with the financial statements of the Company and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. - --------------- (1) Includes the results of a business acquired from March 31, 1992, the date of acquisition, through December 31, 1992. (2) Includes the results of a business acquired from July 1, 1991, the date of acquisition, through December 31, 1991. (3) Includes the results of two businesses from their respective dates of acquisition, June 5, 1989 and July 18, 1989, through December 31, 1989. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain items from the Selected Financial Data as a percentage of net revenues. The Company's product mix has changed substantially over the periods indicated, principally as a result of acquisitions. The following tables show the contributions to gross revenues of the Company's five product groups. In 1992, certain customers within specific product categories were changed to conform to classifications which the Company feels will better reflect the end use of its products. The 1991 revenues have been reclassified to conform to the 1992 presentation. 1993 COMPARED TO 1992 Net revenues in 1993 increased $17,751,000 (9.9%) over 1992 as a result of including a full year of Zeeland sales, the increased performance chemicals business due to the acquisition of a fiber optic gel business, and increased feed additive sales. The health and pharmaceuticals business declined in 1993. Health and Pharmaceuticals' revenues decreased $3,617,000 (6.1%) from 1992. The full year effect of the acquisition of Zeeland in March 1992 added $3,215,000 to this sales category. This category's performance was affected by decreases in the shipments of bulk pharmaceuticals from unusually high levels in 1992, and from reduced shipments of niacinamide (Vitamin B3) intermediates to the Asia-Pacific region due to economic problems and increased competition. Revenues from Agricultural Intermediates and Additives increased by $2,033,000 (4.1%) over 1992. The increase was due to higher sales of organo-arsenical feed additives to the poultry industry and to increased shipments of a pyridine compound to a major herbicide producer. This category was negatively affected by the end of a contract for a herbicide intermediate in the fourth quarter 1992, and a decrease in export sales of pyridine derivatives. Sales from Specialty and Fine Chemicals' increased by $11,218,000 (29.8%). This increase included the effect of Zeeland for a full year of $5,957,000. Increases in this category included photographic chemicals, specialty additives, organic intermediates, specialty catalysts and custom manufactured products. The most significant improvement in this category was due to the expansion in production capabilities of a polymer used in instamatic film. Performance Chemicals' sales increased $10,439,000 (51.1%) from 1992 due to increases in fiber optic cable gels and encapsulants to the telecommunications industry. The acquisition of a complimentary fiber optic gel business in March 1993 contributed $8,900,000 in increased revenues. The encapsulant sales were 8% above 1992 primarily due to penetration of international markets. Coatings revenues decreased $1,643,000 (8.9%) from 1992 primarily due to a tolling agreement for paint additives and corrosion inhibitors that ended in May 1993. Sales of castor oil derivatives were at the same level as 1992. Export and international sales decreased by $7,200,000, or 16.2%. Exports were 18.3% of gross revenues in 1993 versus 24.1% in 1992 due to lower export sales caused by poor economic conditions in Europe and payment problems in the Asia-Pacific region. Total gross profit of $51,778,000 increased by $5,742,000, or 12.5%, from 1992. The gross profit as a percent of net revenues improved from 25.7% in 1992 to 26.3% in 1993. The increased gross profit was due to an improvement in sales mix and the continued effort to improve manufacturing costs and production processes. Selling, general and administrative expenses as a percentage of net revenues was 14.9% in 1993, down from 15.7% in 1992. The 1993 expense of $29,286,000 was $1,085,000 (3.8%) above 1992, due to the full year effect of the Zeeland acquisition and the costs of establishing a sales office in Hong Kong. Bonus payments to employees declined by 40% to $1,700,000 in 1993 based on a formula using year-to-year changes in net income and return on investment achieved. Periodically, the Company conducts a comprehensive review of its environmental and litigation issues, prepares estimates of the range of potential costs of each issue wherever possible, and adjusts the accruals for environmental contingencies as circumstances warrant. An environmental provision of $1,029,000 was recorded in 1993 attributable to activity in a number of pending environmental matters. The current year provision was less than the $1,747,000 which was recorded in 1992. A discussion of those matters is included in the footnotes to the financial statements. Research and development expenses of $5,843,000 were 3.0% of net revenues in 1993, and represented a 44.4% increase over 1992. The increase of $1,797,000 in 1993 was largely due to the commitment to develop new products and processes to ensure future growth in profitability. This commitment will continue in the future. The operating profit in 1993 increased 20.7% to $16,649,000 from $13,789,000 in 1992. The increased operating profits were due to increased sales and gross margin, partially offset by the increases in research and development spending. Net interest expense of $2,771,000 in 1993 reflected an increase of $334,000 from 1992. The increase was due to higher borrowings in order to finance acquisition activity and the capital program. Other expense in 1993 was $466,000 compared with other expense of $1,054,000 in 1992. The decrease was due to a 1992 provision of $553,000 for the write-off of a receivable. The provision for income taxes for 1993 was based on an effective rate of 35.6% versus 39.5% in 1992. The rate decreased due to the realization of the benefit of tax planning strategies. The Company's net income increased 38.7% to $8,641,000 compared with a net income of $6,230,000 in 1992. 1992 COMPARED TO 1991 Net revenues in 1992 increased $34,952,000 (24.2%) as a result of the acquisition of Zeeland in March 1992, increased revenues from the Salsbury 1991 acquisition included for a full year, and price increases. The increased revenues were partially offset by declines in coatings business volume. Health and Pharmaceuticals' revenues increased $20,783,000 (54.1%) over 1991. The acquisition of Zeeland added $11,264,000 to this sales category with sales of intermediates for cough and cold preparations and pharmaceuticals, a reagent in the manufacture of antibiotics for respiratory infections, and a food additive for soft drinks. The full year effect of Salsbury added $9,404,000 to sales. Revenues from Agricultural Intermediates and Additives increased by $13,222,000 (36.8%) over 1991. The Salsbury acquisition, which occurred in July 1991, contributed $7,605,000 of the increased sales. Another factor in the increased sales was the renewal of a contract (which had been terminated in 1990) for the manufacture of a herbicide intermediate by our facility in Delaware Water Gap, Pennsylvania. This contract was completed in November 1992. The sales of feed grade Vitamin B3 also increased both in terms of volume and in price. Sales from Specialty and Fine Chemicals' increased by $9,738,000 (34.9%) mainly due to the Zeeland acquisition which contributed $11,482,000 to this total. The major Zeeland products include products for the photographic industry, catalysts, organic intermediates and specialty additives. Performance Chemicals' sales decreased $583,000 (2.8%) from prior year. Sales of encapsulant products declined approximately 3% from 1991 reflecting a continued decline in the use of copper cables in the telecommunications sector, but rebuilding after Hurricane Andrew in Florida and Louisiana helped to reduce the decline. Pricing of encapsulants, however, was slightly better than in 1991. Coatings revenues decreased $8,577,000 (31.6%) from 1991 due to the withdrawal of rheological additive products and mercury biocides in 1991. Castor oil based products sold in this category increased due to sales to the construction and automotive industries. Export and international sales increased by $7,110,000, or 19.0%. Exports were 24.1% of gross revenues in 1992 versus 24.9% in 1991 due to lower export percentages from Zeeland and Salsbury than the overall Cambrex average. The increased export activity was attributable to Zeeland, which exported $4,500,000 in 1992 (mostly to Europe), and higher pyridine derivative sales to the Far East and Europe. Total gross profit of $46,036,000 increased by $19,710,000, or 74.9%, from the 1991 level. The gross profit as a percent of net revenues improved from 18.2% in 1991 to 25.7% in 1992. The improved gross profit was due to the increased sales of higher margin products, lower cost of major raw materials, and a $4,000,000 charge in 1991 for obsolete and off-specification inventories and the related waste disposal costs for products manufactured at the Bayonne, New Jersey facility. Selling, general and administrative expenses as a percentage of net revenues was 15.7% in 1992, consistent with 1991. The 1992 expense of $28,201,000 was $5,458,000 above 1991, due to the addition of Salsbury and Zeeland, and the cost of bonus payments to management and to other employees in 1992 of $2,800,000. Periodically, the Company conducts a comprehensive review of its environmental and litigation issues, prepares estimates of the range of potential costs of each issue, where it can be estimated, and adjusts the accruals for environmental contingencies as circumstances warrant. An environmental provision of $1,747,000 was recorded in 1992 attributable to activity in a number of pending environmental matters. A discussion of those matters is included in the footnotes to the financial statements. The current year provision compares favorably with that of the prior year which included a $2,538,000 provision related to estimated remediation costs for a particular site. Research and development expenses of $4,046,000 were 2.3% of net revenues in 1992, and represent the same percentage as 1991. The increase of $767,000 in 1992 was largely due to the Zeeland acquisition and a full year of operations at Salsbury. Spending by all our other businesses was comparable to 1991 levels. Operating profit in 1992 was $13,789,000 compared to $304,000 in 1991. The increased operating profit was due to the improved gross profit, partially offset by higher selling, general and administrative expenses and research and development expenses. Net interest expense of $2,437,000 in 1992 reflected a decrease by $94,000 from 1991. The lower average interest rate, based on better terms in the credit agreement negotiated in February 1992 and lower market rates, offset higher average loan balances in 1992, relating to acquisition activities. Other expense in 1992 was $1,054,000 compared with other income of $2,279,000 in 1991. The key item in 1992 was a $553,000 provision for the potential write-off of an other receivable related to a product previously manufactured by Cambrex for a specific customer in prior years. The 1991 other income consisted primarily of $2,758,000 which represented the elimination of the remaining balance of a $3,400,000 accrual previously established in connection with the sale of certain product lines in 1990. In 1992, the Company reported net income of $6,230,000 compared with a net income of $31,000 in 1991. 1991 COMPARED TO 1990 Net revenues in 1991 increased $10,872,000 (8.1%) attributable to the acquisition of Salsbury Chemicals, Inc. (Salsbury) in July 1991. Excluding the acquisition, net revenues were unchanged from 1990's level, with increased selling prices offsetting declines in volume. Health and Pharmaceuticals' revenues increased by $9,240,000 (31.7%) over 1990. Excluding the contribution of Salsbury, revenues increased 12.9% attributable to higher sales volumes of 3-cyanopyridine for the production of Vitamin B3 and increased sales of castor oil based intermediates to the cosmetics market. During the year, increased production capacity for the conversion of 3-cyanopyridine to niacinamide (Vitamin B3) were brought on line. Revenues from Agricultural Intermediates and Additives increased by $2,791,000 (8.4%) over 1990, primarily due to the inclusion of Salsbury. Without the benefit of Salsbury, gross revenues decreased by 5.1%. The decrease was due to reduced revenues from a herbicide intermediate at the Company's Delaware Water Gap, Pennsylvania facility due to the completion of a contract, and to reduced 2-cyanopyridine for a herbicide due to excess customer inventory. Specialty and Fine Chemicals' revenues increased by $4,732,000, or 20.4%, mainly as a result of the acquisition. Otherwise, sales of these products increased by 0.8% from last year. Declines in sales volumes of castor oil products, affected by the higher cost of castor oil, were offset by increased sales volumes of pyridine products. In Performance Chemicals, domestic sales of encapsulant products declined approximately 20% from 1990 reflecting continued decline in market size, major customers' reducing inventories and a period of lowered construction budgets. Increases in sales of fiber optic gel and biomedical products, which have been introduced in recent years, maintained sales in this category at 1990's level. Revenues from Coatings decreased by $4,905,000 (15.3%) from 1990 due to poor economic conditions in the housing and automotive markets and the Company's decision to de-emphasize low margin, cyclical products that constitute much of this group. Coatings revenues were negatively impacted by the sale of the Company's organic biocides business to Huls America Inc., (Huls) in February 1990, the withdrawal of phenyl-mercuric acetate (PMA), a biocidal agent for paints, and the expiration of a major contract on November 30, 1991 for the manufacture of rheological additives products. Revenues under this contract accounted for approximately 5% of total gross revenues in 1991 and the prior fiscal year. Export and international sales increased by 41.2%. Exports were 24.9% of gross revenues in 1991 versus 19.2% in 1990. Higher sales volumes of 3-cyanopyridine and piperidine to the Far East were responsible for the increase. Total gross profit of $26,326,000 declined by $2,404,000, or 8.4%, from the 1990 level. Gross profit benefited from the lower cost of a key raw material, acetaldehyde, as well as increased revenues as discussed above; however, offsetting the benefits were the reduced margins on castor oil products due to higher cost. In 1991, the Company included in its cost of sales an expense of $4,000,000 for certain obsolete and off-specification inventories and related waste disposal costs for products manufactured at its Bayonne, New Jersey facility. In an effort to reduce the number of products it manufactures and markets, the Company obsoleted certain slower moving and excess inventories. The Company also reevaluated its off-specification inventory and determined that although the material could be reprocessed, the cost of reworking it was not justified. Selling, general and administrative expenses as a percentage of net revenues increased from 15.6% in 1990 to 15.7% in 1991. Reductions achieved through strict cost controls, including personnel reductions and the benefits of restructuring, were offset by increased environmental expenses. Environmental expenses relating to administrative and judicial proceedings as well as site remediation of $3,190,000 were 2.2% of revenues in 1991. There were no comparable expenses in the prior year. Such expenses in 1991 were comprised primarily of a $2,538,000 provision related to the Company's estimated share of the cost of remediation of a site in Hamptonburgh, New York. A discussion of this matter is included in the footnotes to the financial statements. Research and development expenses of $3,279,000 were 2.3% of net revenues in 1991, a decrease of 6.2% attributable to personnel reductions effected during the year. The Company continues to maintain its commitment to allocate significant resources to product and process development. In 1991, operating profit was $304,000 as compared to an operating loss of $5,021,000 in 1990. In 1990, a one-time, pretax restructuring charge of $9,427,000 was recorded. The restructuring charge included the write-down of certain tangible and intangible assets and inventories and a reserve for personnel severance costs relating to the discontinuance of non-performing products and product lines. Net interest expense of $2,532,000 in 1991 increased by $417,000 largely as a result of bank borrowings to finance the acquisition of Salsbury in July 1991. Other income in 1991 was $2,279,000 compared with other expense of $186,000 in 1990. In 1990, coincident with the sale of certain technology and product lines to Huls, the Company set up a provision against the proceeds from the sale to provide a reserve for costs that were deemed probable to be incurred as a direct result of the sale. During the fourth quarter of 1991, management determined that no additional costs would be incurred and, therefore, reversed the remaining balance of $2,758,000 to other income. In 1991, the Company reported net income of $31,000 compared with a net loss of $5,075,000 in 1990. LIQUIDITY AND CAPITAL RESOURCES Net cash flow from operations was $16,390,000 in 1993 compared to $24,022,000 in 1992 and $13,811,000 in 1991. The reduced cash flow in 1993 as compared to 1992 was due to changes in inventory levels and accrued liabilities. The inventory levels of various finished goods increased in 1993 due to lower sales orders in the fourth quarter. Increases in accounts payable and accrued liabilities in 1993 were not as substantial as the levels of increase from 1991 to 1992. Management decided to increase accruals significantly in 1992 to reflect various potential liabilities based on business decisions made in the fourth quarter of the year. Such accruals were not necessary at the end of 1993, and many of the circumstances requiring the accruals in 1992 were resolved. Capital expenditures were $15,535,000 in 1993, $9,133,000 in 1992, and $7,044,000 in 1991. The Company continued to upgrade all of the production facilities to meet marketing and regulatory requirements. Construction of support facilities, including office, warehouse and maintenance areas, were completed at the Salsbury plant in the first quarter and an expansion of one of the production facilities at the Zeeland plant was started in the fourth quarter of 1993. Depreciation of fixed assets was $10,735,000 in 1993, $9,349,000 in 1992, and $6,870,000 in 1991. An additional $5,886,000 was used to acquire the assets and technology of Viscosity Oil's fiber optic gel business. On September 15, 1993, the remaining holders of convertible 9% notes totalling $3,990,000 opted to convert to 257,397 shares of common stock at the conversion price of $15.50 per share. No gain or loss resulted from this transaction. On November 16, 1993, the Company bought out a lease assumed as a part of the purchase of the assets of Zeeland Chemicals in March 1992. This debt, with an interest rate of 10.2%, was replaced with the London Interbank Offering Rate (LIBOR) borrowings through the existing Revolving Bank Credit line at the rate of 4 3/8% as of December 31, 1993. On May 10, 1993 the Company amended the Revolving Credit and Term Loan Agreement (Credit Agreement) with NBD Bank, N.A., National Westminster NJ and United Jersey Bank. The new Credit Agreement provides for an additional revolving credit facility of $10,000,000, bringing the aggregate principal amount to $65,000,000, of which $28,311,000 was unused at year end. Management is of the opinion that these amounts are adequate for meeting the Company's capital requirements. The Credit Agreement permits the Company to choose between various interest rate options and to specify the portion of the borrowing to be covered by specific interest rate options. Under the Credit Agreement, the interest rate options available approximate (1) LIBOR plus no more than 1 1/2% or (2) the U.S. Prime Rate. During 1993, the Company paid cash dividends of $0.20 per share. ENVIRONMENTAL The Company maintains environmental and industrial safety and health compliance programs at its plants, and believes that its manufacturing operations are in general compliance with all applicable safety, health and environmental laws. Through the activities of its predecessors and third parties in connection with the handling and disposal of hazardous and other wastes, the Company may become liable, irrespective of fault, for certain site remediation costs under federal and state environmental statutes. Descriptions of such environmentally related contingencies are presented in Note #18 to the financial statements and incorporated herein by reference. The resolution of such matters often spans several years and frequently involves regulatory oversight and/or adjudication. Additionally, many remediation requirements are not fixed and are likely to be affected by future technological, site and regulatory developments. Consequently, the ultimate extent of liabilities with respect to such matters as well as the timing of related cash disbursements cannot be determined with certainty. However, management is of the opinion that while the ultimate liability resulting from these matters may have a material effect upon the results of operations in any given year, they will not have a material adverse effect upon the Company's liquidity or financial position. IMPACT OF RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standard No. 106 "Employers' Accounting for Post Retirement Benefits Other than Pensions" (SFAS 106) requires the recognition of postretirement benefits, including health care benefits, on an accrual basis. The Company adopted SFAS 106 effective January 1, 1993 and amortizes the transition obligation of $1,853,000 over twenty years. The net effect upon 1993 pretax operating results, including the amortization of the transition obligation, resulted in a cost of $301,000. The Company has recently reviewed its health care benefit plans for retirees and does not anticipate significant increases in the annual expense related to SFAS 106. Statement of Financial Accounting Standard No. 109 "Accounting for Income Taxes" (SFAS 109) requires the use of current statutory rates in the determination of deferred tax assets and liabilities. The Company adopted SFAS 109 effective January 1, 1993. The net effect upon 1993 income was immaterial. However, under SFAS 109, future changes in the statutory tax rate could have an impact upon net income of future periods. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following consolidated financial statements and selected quarterly financial data of the Company are filed under this item: The financial statements and schedules are filed pursuant to Item 14 of this report. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Cambrex Corporation: We have audited the accompanying consolidated balance sheets of Cambrex Corporation and Subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, stockholders' equity and cash flows and the consolidated financial statement schedules for the years then ended, as listed in Item 14(a) 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 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Cambrex Corporation and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. In addition, 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. As discussed in Notes 9 and 14 to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes and changed its method of accounting for postretirement benefits other than pensions. COOPERS & LYBRAND Parsippany, New Jersey January 19, 1994, except for Note 3, the date of which is January 31, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Cambrex Corporation: We have audited the accompanying consolidated income statement, statements of stockholders' equity and cash flows of Cambrex Corporation and Subsidiaries for the year ended December 31, 1991, as listed in Item 14(a) of this Form 10-K. In connection with our audit of the consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14(a) 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 audit. We conducted our audit 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 audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flow of Cambrex Corporation and Subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK New York, New York January 28, 1992 CAMBREX CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to consolidated financial statements. CAMBREX CORPORATION AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS (IN THOUSANDS, EXCEPT PER-SHARE DATA) See accompanying notes to consolidated financial statements. CAMBREX CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER-SHARE DATA) See accompanying notes to consolidated financial statements. CAMBREX CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) (1) THE COMPANY Cambrex Corporation supplies a broad line of pharmaceutical related products, specialty chemicals, fine chemicals and commodity chemical intermediates to a diverse customer base for use in a wide variety of applications. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Cash Equivalents Temporary cash investments with a maturity of less than three months are considered cash equivalents. Financial Instruments Financial instruments consist principally of accounts receivable. Concentration of credit risk exists inasmuch as the Company sells its products to customers primarily in the chemical and pharmaceutical industries. However, receivables are spread among many customers and are geographically dispersed. No customer represents more than 10% of sales nor receivables. Inventories Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market. Property, Plant and Equipment Property, plant and equipment is stated at cost, net of accumulated depreciation. Plant and equipment are depreciated on a straight-line basis over the estimated useful lives for each applicable asset group as follows: Intangible Assets Intangible assets are recorded at cost and amortized on a straight-line basis as follows: Income Taxes The Company files a consolidated Federal income tax return which includes all domestic subsidiaries. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Deferred taxes are recorded based upon differences between the financial statement and tax bases of assets and liabilities, and available tax credit carryforwards. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." Prior to that date, income taxes were accounted for in accordance with the provisions of Accounting Principles Board Opinion No. 11. Earnings Per Common Share The calculation of primary earnings per common share is based on the weighted average number of common shares and common share equivalents outstanding during the applicable period. Fully diluted earnings per share assumes conversion of the outstanding convertible subordinated notes and the elimination of the related interest expense, net of tax. (3) ACQUISITIONS AND DIVESTITURES (a) On January 31, 1994, the Company purchased substantially all of the assets of Hexcel Corporation's fine chemicals business located in Middlesbrough, England for approximately $9,500. On March 12, 1993, the Company purchased substantially all of the assets of Viscosity Oil's fiber optic gel business for $5,886. These transactions were accounted for as purchases and were financed with the Company's credit agreement. No goodwill resulted from these transactions. (b) On March 31, 1992, the Company purchased substantially all of the assets of the fine chemicals business of Hexcel Fine Chemicals, now known as Zeeland Chemicals, Inc. (Zeeland), for $20,251, and the assumption of certain liabilities consisting of a variable rate Industrial Development Revenue Bond in the principal amount of $4,150, and the remaining payments of a capital lease obligation with a net present value of $8,214. The transaction was accounted for as a purchase and was financed with the Company's credit agreement. No goodwill resulted from this transaction. On July 1, 1991, the Company purchased substantially all of the assets of the chemicals business of Solvay Animal Health, Inc., now known as Salsbury Chemicals, Inc. (Salsbury), for $12,299. The transaction was accounted for as a purchase and was financed by borrowings against the Company's credit agreement. No goodwill resulted from this transaction. Unaudited pro forma results as if both the Zeeland acquisition and the Salsbury acquisition had occurred at January 1 of each of 1992 and 1991 are presented below. The pro forma financial information is not necessarily indicative of results of operations that would have occurred had the combinations been in effect at the beginning of the periods nor of future results of operations of the combined companies. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Assets acquired and liabilities assumed are as follows: The proforma information has not been adjusted for the effect of the fiber optic gel business, acquired in March of 1993, as such amounts cannot be reasonably separated from existing operations and are deemed to be immaterial. (4) FUTURE IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENT Statement of Financial Accounting Standard No. 112 "Employers' Accounting for Postemployment Benefits" (SFAS 112) requires the recognition on an accrual basis of all types of postemployment benefits provided to former or inactive employees subsequent to employment but before retirement. The Company currently provides limited benefits in this regard. The Company plans to adopt SFAS 112 effective January 1, 1994. The net effect upon 1994 pretax operating results is expected to be minimal. (5) INVENTORIES Inventories consist of the following: CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) (6) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following: Depreciation expense amounted to $10,735, $9,349 and $6,870 for the years ended December 31, 1993, 1992 and 1991, respectively. (7) INTANGIBLE ASSETS Components of intangible assets are as follows: (8) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES The components of accounts payable and accrued liabilities are as follows: (9) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standard No. 109 (SFAS 109), the effect of which was not material. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) In summary, SFAS 109 requires the determination of deferred tax assets and liabilities by applying applicable tax rates to the difference between the financial statement and tax bases of assets and liabilities. Additionally, it requires separate balance sheet disclosure of deferred tax assets and liabilities and has different recognition criteria for certain deferred tax assets than Accounting Principles Board Opinion No. 11 (APB 11), the standard under which the Company's financial statements were previously prepared. As permitted under SFAS 109, prior year financial statements have not been restated. The provision for income taxes consists of the following expenses (benefits): The significant components of the deferred tax expense (benefit) are presented in the schedule below. For 1993, the components of the deferred tax expense (benefit) were computed in accordance with the provisions of SFAS 109. For 1992 and 1991, the components of the deferred income tax expense (benefit) were computed in accordance with the provisions of APB 11. The provision for income taxes differs from the statutory Federal income tax rate of 34% as follows: CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) The components of deferred tax assets and liabilities as of December 31, 1993 relate to temporary differences and carryforwards as follows: Deferred tax assets: Deferred tax liabilities: The alternative minimum tax credits totaling $2,084 are available to offset future Federal income taxes on an indefinite carryforward basis. The research and development credit carryforwards totaling $493 expire between the years 2001 and 2005. (10) LONG-TERM DEBT Long-term debt consists of the following: The Company estimates the fair market value of its debt instruments to approximate book value, based on the variable interest rates described in this Note. (a) On May 10, 1993, the Company amended the Revolving Credit and Term Loan Agreement (Credit Agreement) with NBD Bank, N.A., National Westminster NJ and United Jersey Bank to increase the commitment by $10,000 bringing the aggregate principal amount to $65,000. The new Credit Agreement provides for a term loan in the aggregate principal amount of $20,000, payable in quarterly payments of $1,000 beginning in 1994, and a revolving credit facility in the aggregate principal amount of $45,000 which has a termination date of March 27, 1995. It permits the Company to choose between various interest rate options and to specify the portion of the borrowing to be covered by specific interest rate options. Under the Revolving Credit Agreement, the interest rate options available to the CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Company are: (1) U.S. prime rate or (2) the London Interbank Offering Rate (LIBOR) plus 1 1/4%. The Term Loan will have the same options plus 1/4%. Additionally, the Company pays an annual commitment fee of between 25/100 of 1% and 15/100 of 1% on the unused portion of the revolving credit facilities. This facility contains various restrictive covenants which, among other matters, require the Company to maintain minimum consolidated net worth levels, as defined, and certain financial ratios. If these covenants are not met, the loan is collateralized by the assets of the Company. The Company met all bank covenants for all four quarters of 1993. (b) Pursuant to a note and stock purchase agreement entered into in June 1985, the Company issued $4,941 of convertible subordinated notes due and payable in four equal annual installments commencing on June 30, 1994. Interest was payable semiannually, at the rate of 9% per annum. The notes, at the holders' option, were convertible to Common Stock at a conversion price of $15.50 per share, subject to market price and anti-dilution provisions. On September 15, 1993, all existing notes were converted to common stock at the price of $15.50 per share. No gain or loss resulted from this transaction. (c) On November 16, 1993, the Company bought out the capital lease obligation which was assumed as part of the acquisition of Zeeland Chemicals, Inc. for $7,672. This capital lease obligation required quarterly payments of $343 through June 1997 and a balloon payment of $4,555 in July 1997. Such payments were discounted at 10.2% so that the net present value of the obligation as of the date of acquisition equaled the fair market value of the related assets. The debt was replaced with LIBOR borrowings against the Revolving Credit Agreement, at a rate of 4 3/8% as of December 31, 1993. No gain or loss resulted from this transaction. (d) A variable rate Industrial Development Revenue Bond in the principal amount of $4,150 due March 1, 2008 was assumed as part of the purchase of the assets of Zeeland Chemicals, Inc. The interest is payable quarterly while the interest rate is reset monthly by Morgan Stanley based on the current market rate for long-term bonds. During 1993, the interest rate approximated 3%. (e) Aggregate maturities of long-term debt are as follows: (11) STOCKHOLDERS' EQUITY The Company has two classes of common shares designated Common Stock and Nonvoting Common Stock. Authorized shares of Common Stock were 20,000,000 at December 31, 1993 and 1992. Authorized shares of Nonvoting Common Stock were 730,746 at December 31, 1993 and 1992. At December 31, 1993, authorized shares of Common Stock were reserved for issuance as follows: Nonvoting Common Stock has equal rights with Common Stock, with the exception of voting power. Nonvoting Common Stock is convertible, share for share, into Common Stock, subject to any legal CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) requirements applicable to holders restricting the extent to which they may own voting stock. In 1991, all 113,182 outstanding shares were converted. In 1990, Cambrex purchased 1,000,000 shares of its Common Stock as part of a previously announced stock buy back program. These shares were purchased in the open market at an average purchase price of $12.12 per share. All of the acquired shares are held as Common Stock in treasury, less shares issued to the Cambrex Savings Plan. The Company held 819,049 and 895,494 shares of treasury stock at December 31, 1993 and 1992, respectively. In 1987, the Company authorized 5,000,000 shares of Series Preferred Stock, par value $0.10, issuable in series and with rights, powers and preferences as may be fixed by the Board of Directors. At December 31, 1993 and 1992, there was no preferred stock outstanding. (12) STOCK OPTIONS On October 24, 1983, the Company's stockholders approved the 1983 Incentive Stock Option Plan ("1983 Plan"), which provides for the grant of options intended to qualify as incentive stock options to management and other key employees of Cambrex. On September 1, 1987 the Company's stockholders approved the 1987 Stock Option Plan ("1987 Plan"), which provides for the granting to key employees both non-qualified stock options and incentive stock options. On May 7, 1990, the Company's stockholders approved the 1989 Senior Executive Stock Option Plan ("1989 Plan"), which provides for the grant of options intended to qualify as additional incentives to the Company's Senior Executive Officers. On May 1, 1992, the Company's stockholders approved the 1992 Stock Option Plan ("1992 Plan"), which provides for the granting to key employees both non-qualified stock options and incentive stock options. As of December 31, 1993, 233,900 options had been exercised. Shares of Common Stock subject to outstanding options under the Plans were as follows: On July 26, 1990, the Board of Directors approved a management proposal to provide current stock option holders under the 1983 and 1987 Plans the opportunity to exchange their existing stock options for new five year stock options at the rate of two existing option shares for each new option share at a new option price of $7.375 per share. The options received in the exchange became exercisable on January 26, 1991. The Company established the 1987 Long-Term Incentive Plan (the "Long-Term Plan"), which provides for the granting of long-term award opportunities to employees. Under the Long-Term Plan, key employees may receive cash, Common Stock, or a combination of cash and Common Stock, measured by the difference between the market value of the stock on the vesting date and the grant date, and the value of cash dividends which would have been paid on the stock covered by the grant. Units granted under this plan become vested three years from the date of issuance. In 1991, 30,000 units were granted. In 1992, the units were exchanged for cash and new options in the 1992 Plan. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Information regarding the Company's stock option plans is summarized below: (13) RETIREMENT PLANS As of January 1, 1992, Cambrex maintains three defined benefit pension plans which cover substantially all employees as follows: (1) The CasChem Hourly Pension Plan (the "CasChem Plan") which covers the union employees of the Bayonne, New Jersey and Carlstadt, New Jersey plants, (2) The Nepera Hourly Pension Plan (the "Nepera Plan") which now covers the union employees at the Harriman, New York plant, and (3) The Cambrex Salaried Pension Plan (the "Cambrex Plan") which covers all other employees. Benefits for the salaried plan are based on salary and years of service, while hourly plans are based on negotiated benefits and years of service. The Company's policy is to fund pension costs currently to the extent deductible for income tax purposes. Pension plan assets consist primarily of equity and fixed income securities. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) In accordance with the requirements of Statement of Financial Accounting Standard No. 87 "Employers' Accounting for Pensions" (SFAS 87), the overfunded and underfunded plans are presented separately. The funded status of these plans as of December 31, 1993 and 1992 is as follows: Assumptions used to develop the 1993 and 1992 net periodic pension expense and the December 31, 1993 and 1992 actuarial present value of projected benefit obligations: - --------------- * Contractually negotiated with union at 4.0% and 3.5% in 1993 and 1992, respectively. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Net pension costs included in operating results amounted to $713, $450 and $418 in 1993, 1992 and 1991, respectively, and were comprised of the following: Included in the net periodic pension cost is the amortization of prior service cost over a period of twelve to nineteen years and the amortization of the SFAS 87 transition obligation over a period of ten to twenty years. Cambrex also makes available to all employees a savings plan as permitted under Sections 401(k) and 401(a) of the Internal Revenue Code. Employee contributions are matched in part by Cambrex. In July 1991, to promote wider holding of its stock among employees, the Company began issuing, from its treasury, Company stock to replace the matching cash contribution in the savings plan. The cost of this plan amounted to $1,436, $1,145 and $682 in 1993, 1992 and 1991, respectively. (14) OTHER POSTRETIREMENT BENEFITS Cambrex provides postretirement health and life insurance benefits (postretirement benefits) to all eligible retired employees. Employees who retire at or after age 55 with ten years of service are eligible to participate in the postretirement benefit plans. The Company's responsibility for such premiums for each plan participant is based upon years of service subject to an annual maximum of one thousand dollars. Such plans are self-insured and are not funded. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standard No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106). SFAS 106 requires such benefits to be accounted for on an accrual basis. Previously, such costs were expensed as claims were incurred. In connection with the adoption of SFAS 106, the Company has elected to amortize the transition obligation of $1,853 over twenty years. The net effect upon 1993 pretax operating results, including the amortization of the transition obligation, resulted in a cost of $301. The Company has recently reviewed its health care benefit plans for retirees and does not anticipate significant increases in the annual expense related to SFAS 106. The periodic postretirement benefit cost includes the following components: CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) Accumulated postretirement benefit obligation: The discount rate used to determine the accumulated postretirement benefit obligation was 7.5%. The assumed health care cost trend rate used to determine the accumulated postretirement benefit obligation was initially 16%, declining ratably to 6% in 2002 and thereafter. A one-percentage-point increase in the assumed health care cost trend rate would have no effect upon the accumulated postretirement benefit obligation. The cost of all health and life insurance benefits is recognized as incurred and was approximately $3,797, $3,258 and $3,106 in 1993, 1992 and 1991, respectively. The cost of providing these benefits for the 181, 186 and 162 retirees in 1993, 1992 and 1991, respectively, is not separable from the cost of providing benefits for the 791, 746 and 583 active employees. (15) OTHER INCOME AND EXPENSE Other expense in 1992 consisted primarily of a $553 provision for the potential write-off of an other receivable related to a product manufactured by Cambrex for a specific customer in prior years. The receivable and corresponding reserve were written-off in 1993; $250 of other income was recorded as a result of payment received from the customer. There were no individually significant components in other expense in 1993. Other income in 1991 consisted primarily of $2,758 which represented the elimination of the remaining balance of a $3,400 accrual previously established in connection with the sale of certain product lines in the first quarter of 1990. That accrual represented anticipated costs associated with the transaction. During 1991, it was determined that no additional costs would be incurred in connection with that matter and, therefore, the elimination of the remaining accrual was reflected in the 1991 income statement. (16) FOREIGN OPERATIONS AND EXPORT SALES In 1987, the Company organized Cambrex Ltd., a wholly owned subsidiary, to act as parent company for two foreign subsidiaries, CasChem, Ltd. and Nepera, Ltd., which were also established in 1987. These companies are incorporated in the United Kingdom and conduct certain European sales and marketing activities of Cambrex. Export sales in 1993, 1992 and 1991 amounted to $37,296, $44,536 and $37,425, respectively. No country, in any of the given years, represents more than 10% of total revenues. (17) COMMITMENTS In conjunction with the acquisition of Zeeland Chemicals, Inc., the Company assumed the remaining payments of a capital lease obligation for equipment, which required quarterly payments through and a balloon payment in 1997. The related capitalized asset of $8,214 is being depreciated over ten years, and accumulated CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) depreciation amounted to $1,410 at December 31, 1993. In November of 1993, the Company paid $7,672 to buy out the lease obligation. The Company currently has no significant capital lease obligations. The Company has operating leases expiring on various dates through the year 2013. The leases are primarily for office and laboratory equipment and vehicles. At December 31, 1993, future minimum commitments under operating lease arrangements were as follows: Total operating lease expense was $872, $1,097 and $947 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company has three letters of credit outstanding aggregating $578 as of December 31, 1993. The letters of credit were issued in connection with various administrative or environmental activities. During 1993, the Company was no longer required to maintain the $1,500 letter of credit held in 1992 for the New Jersey Department of Environmental Protection and Energy in connection with environmental cleanup at the Cosan site. This requirement was fulfilled through a corporate guarantee of Cosan's Environmental Conservation and Recovery Act (ECRA) obligations. (18) CONTINGENCIES Contingencies exist for Cambrex and certain of its subsidiaries because of legal and administrative proceedings arising out of the normal course of business. Such contingencies include environmental proceedings directly and indirectly against the Company or its subsidiaries as well as matters internally identified by the Company. The resolution of such matters often spans several years and frequently involves regulatory oversight and/or adjudication. Additionally, many remediation requirements are not fixed and are likely to be affected by future technological, site, and regulatory developments. Consequently, the ultimate extent of liabilities with respect to such matters as well as the timing of cash disbursements cannot be determined with certainty. However, management is of the opinion that while the ultimate liability resulting from these matters may have a material effect upon the results of operations in any given year, they will not have a material adverse effect upon the Company's financial position. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) The following table exclusively addresses matters wherein the related liabilities are considered estimable. It summarizes the estimated range of the Company's share of costs associated with such matters, the related accruals, and activity associated with those accruals. Such ranges and accruals have not been reduced for recoveries, if any, under insurance policies or from third parties due to the numerous uncertainties associated with such claims. The changes in the estimated ranges from 1992 to 1993 represent revisions to estimates and the addition of matters that were quantified for the first time during 1993. The related accruals represent management's assessment of the aggregate liability associated with estimable matters. - --------------- * Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standard #109, "Accounting for Income Taxes." At that date and in accordance with the provisions of that Statement, a deferred tax asset of $1,320 previously netted against this accrual was reclassified to non-current assets. During 1991, income statement charges for additions to the accrual for environmental contingencies aggregated $3,190. Significant matters wherein the related liability or range of liability is estimable, are summarized as follows: (a) Nepera, Inc. (Nepera) was named in 1987 as a Potentially Responsible Party (PRP) along with certain prior owners of the Maybrook Site in Hamptonburgh, New York by the United States Environmental Protection Agency (EPA) in connection with the disposition, under appropriate permits, of wastewater at that site prior to Cambrex's acquisition of Nepera in 1986. The Hamptonburgh site is on the EPA's National Priorities List for remedial work and clean-up. However, to date the EPA has entrusted the management of the remediation effort to the New York State Department of Environmental Conservation (DEC). Although the periods of ownership of the site and the extent of its use for wastewater disposal are well established, the PRP's have not been able to agree upon an allocation method for future remediation costs. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) During 1991, the DEC, through the use of a computer model, developed an estimated cost to remediate the Hamptonburgh site and proposed an allocation method which considered the number of years each named party owned the site and the number of years each party used the site for wastewater disposal. Under that proposal, Nepera's suggested liability aggregated $2,600 and an expense was recorded in the same amount. During 1992, the Company received a draft Remedial Investigation/Feasibility Study (RI/FS) report which enumerated several remediation alternatives and submitted the Remedial Investigation portion to the DEC for review. Consequently, although this RI/FS has not been approved by the DEC, the Company utilized it to revise the estimated liability for this matter included in the accrual for environmental contingencies. This estimate considers the probability of cost sharing with prior owners of the site. During 1993, the DEC requested the performance of additional site investigation prior to reviewing the Feasibility Study portion of the report. The Company prepared a plan for such additional site investigation and submitted it for review. (b) Nepera was named in 1987 as a responsible party along with certain prior owners of Nepera's Harriman, New York production facility by the DEC in connection with contamination at that site. The Company believes that any remediation to be conducted at that site is primarily related to contamination attributable to material handling and disposal practices, including drum burial at the site, which occurred prior to Cambrex's acquisition of Nepera in 1986. During 1991, the Company, with the agreement of the DEC, began an interim remedial measure which involves the pumping and treatment of groundwater to mitigate the possibility of contamination progressing beyond the Harriman site boundaries. This interim remedial measure continued throughout 1993. During 1992, the Company received a draft RI/FS report which enumerated several remediation alternatives and submitted the Remedial Investigation portion to the DEC for review. Consequently, although this RI/FS has not been approved by the DEC, the Company utilized it to develop an estimated liability for this matter and included it in the accrual for environmental contingencies. This estimate considers the probability of cost sharing with prior owners of the site. During 1993, the Company has not received from the DEC any commentary on the Remedial Investigation portion of the report. (c) CasChem, Inc. (CasChem) was subject to an investigation in 1990 by agents of the EPA and the Federal Bureau of Investigation pursuant to a search warrant indicating an interest in the handling, storage, and disposal of hazardous wastes. Various records were taken and a number of materials were sampled. During 1992, the United States Attorney's Office (USAO) contacted the Company and indicated that it believes there were violations of the Resource Conservation and Recovery Act at the site. During 1993, the Company was served with a subpoena requiring submission of additional documents relating to the site's activities. Discussions with the USAO to resolve this matter are ongoing. (d) Cosan, Inc. (Cosan) entered into an Administrative Consent Order in 1985 with the New Jersey Department of Environmental Protection and Energy (NJDEPE) under New Jersey's Environmental Conservation and Recovery Act (ECRA) in order to consummate the sale of the controlling interest in Cosan to the Company. Through that action, Cosan became required to determine whether its facility located in Carlstadt, New Jersey was contaminated by hazardous materials and, if appropriate, effect a cleanup. During 1992, based upon the results of an evaluation of the site, the Company proposed the installation of a groundwater recovery system to remove contaminates from the soil. Presently, the Company is awaiting the NJDEPE's approval of that proposal. CAMBREX CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) (e) As more fully described in Note #3, in 1992 the Company acquired substantially all of the assets of the fine chemicals business of Hexcel Fine Chemicals, now known as Zeeland Chemicals, Inc. In connection with that transaction, the Company established an accrual of $3,300 for environmental conditions existing as of the date of the acquisition. (f) Cosan received notice in 1990 of a proposed NJDEPE administrative fine of $2,308 relating to allegedly exceeding permit levels for discharges into a local sewerage treatment plant during the 1980's. The Company contested the proposed fine stating that the Company was installing a modern treatment plant to meet effluent limits in a new permit and that the Company fully advised the NJDEPE of all activities at the time. During 1993, the Company agreed to a settlement consisting of a payment of $650. Such settlement did not constitute any admission of fact or acknowledgement of any fault or liability on the part of the Company. The payment was charged to the accrual for contingent liabilities. Those matters wherein the related liability is not estimable and no amounts are included in the accrual for environmental contingencies are summarized as follows: (a) Nepera has been named as a PRP along with approximately 130 other companies by the EPA in connection with the SCP Corporation (SCP) site in Carlstadt, New Jersey. The SCP site is on the EPA's National Priorities List for remedial work and cleanup. SCP disposed of process wastewater and minor amounts of other material for Nepera during the 1970's. The EPA has directed an Interim Remedial Measure for this site consisting of the construction of slurry walls and a pump and treat facility. Presently, there are no reliable remediation cost estimates for this site nor has a proportionate allocation of responsibility been established. However, the Company's alleged responsibility may be relatively large in relation to other parties. The Company is contesting the proposed basis for the allocation of responsibility for this site, and believes it has grounds to, and will, oppose any efforts to charge it with excessive responsibility. Therefore, the ultimate extent of liability, if any, with respect to this matter cannot be estimated at this time. (b) Cosan was named in 1992 as a defendant in a suit filed by the owners of a manufacturing site in Clifton, New Jersey that had been owned and operated by Cosan from 1968 to 1979. Through this action, the plaintiffs allege Cosan contributed to the contamination at the site and seek to compel the Company to contribute toward present and future costs of remediation of the site under ECRA. However, the magnitude of those costs and Cosan's alleged responsibilities have not been specified. Presently, the matter is in discovery. The Company is party to a number of other proceedings. Management is of the opinion that the ultimate liability resulting from those proceedings will not have a material adverse effect upon the Company's results of operations nor its financial position. CAMBREX CORPORATION SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA) - --------------- (1) Earnings per share calculations for each of the quarters are based on the weighted average number of shares outstanding for each period, as such, the sum of the quarters may not necessarily equal the earnings per share amount for the year. ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The registrant changed the accounting firm engaged as the principal accountant to audit the registrant's financial statements. The former accountant, KPMG Peat Marwick was dismissed by the registrant on March 19, 1992. The principal accountant's report on the financial statements for the period up to December 31, 1991 did not contain any adverse opinion or disclaimer of opinion and was not qualified or modified in any manner. The decision to change accountants was approved by the Board of Directors of the registrant, in accordance with the recommendation of the Audit Committee. During the periods up to December 31, 1991 and any subsequent interim period preceding the dismissal of the former accountant there were no disagreements with the former accountant on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which would have caused the former accountant to make reference to the subject matter of the disagreement in connection with its report. The registrant engaged Coopers and Lybrand as the principal accountant on March 19, 1992. PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION. ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information called for by Part III is hereby incorporated by reference to the information set forth under the captions "Principal Stockholders," "Board of Directors," "Election of Directors," and "Executive Compensation" in the Registrant's definitive proxy statement for the 1994 Annual Meeting of Stockholders, which meeting involves the election of directors, which definitive proxy statement is being filed with the Securities and Exchange Commission pursuant to Regulation 14A. In addition, information concerning the registrant's executive officers has been included in Part I above under the caption "Executive Officers of the Registrant." 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 Company are filed as part of this report: (a) 2.(i) The following schedules to the consolidated financial statements of the Company as filed herein and the Report of Independent Certified Public Accountants on Schedules are filed as part of this report. All other schedules are omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements of the Company or the notes thereto. (ii) Separate financial statements of Cosan Canada, Ltd., which is 42.5% owned by the Company, have been omitted as neither the assets nor income from continuing operations before taxes of Cosan Canada, Ltd. exceeds 20 percent of the Company's related consolidated totals. (a) 3. The exhibits filed in this report are listed in the Exhibit Index on page 50. The registrant agrees, upon request of the Securities and Exchange Commission, to file as an exhibit each instrument defining the rights of holders of long-term debt of the registrant and its consolidated subsidiaries which has not been filed for the reason that the total amount of securities authorized thereunder does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K The registrant did not file any reports on Form 8-K during the last quarter of the year ended December 31, 1993. SCHEDULE V CAMBREX CORPORATION PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) - --------------- (1) Amounts included in 1993, 1992 and 1991 represent the cost of tangible assets acquired in business combinations accounted for as purchases. Other changes to machinery and equipment in 1992 include equipment of $8,214 acquired through the assumption of a capital lease obligation. SCHEDULE VI CAMBREX CORPORATION ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) - --------------- (1) 1991 changes represent depreciation expense which was applied against an accrual for probable costs. SCHEDULE VIII CAMBREX CORPORATION VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE X CAMBREX CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) 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. CAMBREX CORPORATION By /s/ CYRIL C. BALDWIN, JR. Cryil C. Baldwin, Jr. Chairman of the Board and Chief Executive Officer Date: 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. CAMBREX CORPORATION ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1992 EXHIBIT INDEX - --------------- (A) Incorporated by reference to the indicated Exhibit to registrant's Registration Statement on Form S-1 (Registration No. 33-16419). (B) Incorporated by reference to the indicated Exhibit to registrant's Annual Report on Form 10-K for 1987. (C) Incorporated by reference to registrant's Registration Statement on Form S-8 (Registration No. 33-21374) and Amendment No. 1. (D) Incorporated by reference to registrant's Annual Report on Form 10-K dated June 5, 1989. (E) Incorporated by reference to the indicated Exhibit to registrant's Annual Report on Form 10-K for 1989. (F) Incorporated by reference to the indicated Exhibit to registrant's Registration Statement on Form S-8 (Registration No. 33-37791). (G) Incorporated by reference to registrant's Annual Report on Form 10-K for 1990. (H) Incorporated by reference to registrant's Current Report on Form 8-K dated July 1, 1991. (I) Incorporated by reference to the registrant's Annual Report on Form 10-K for 1991. (J) Incorporated by reference to the registrant's Current Report on Form 8-K dated March 19, 1992 and Amendments No. 1 and No. 2 to its Current Report. (K) Incorporated by reference to the registrant's Current Report on Form 8-K dated April 10, 1992 and Amendment No. 1 to its Current Report. (L) Filed herewith.

763657_1993.txt

763657_1993

1993

763657

Item 1. Regulation and Legislation. Generally, the franchising authority can decide not to renew a franchise only if it finds that the cable operator has not substantially complied with the material terms of the franchise, has not provided reasonable service in light of the community's needs, does not have the financial, legal and technical ability to provide the services being proposed for the future, or has not presented a reasonable proposal for future service. A final decision of non-renewal by the franchising authority is appealable in court. The General Partner and its affiliates recently have experienced lengthy negotiations with some franchising authorities for the granting of franchise renewals and transfers. Some of the issues involved in recent renewal negotiations include rate reregulation, customer service standards, cable plant upgrade or replacement and shorter terms of franchise agreements. The inability of a Partnership to renew a franchise, or lengthy negotiations or litigation involving the renewal process could have an adverse impact on the business of a Partnership. The inability of a Partnership to transfer a franchise could have an adverse impact on the ability of a Partnership to accomplish its investment objectives. COMPETITION. The Systems face competition from a variety of alternative entertainment media, such as: Multichannel Multipoint Distribution Service ("MMDS"), which is often called a "wireless cable service" and is a microwave service authorized to transmit television signals and other communications on a complement of channels, which when combined with instructional fixed television and other channels, is able to provide a complement of television signals potentially competitive with cable television systems; Satellite Master Antenna Television System ("SMATV"), commonly called a "private" cable television system, which is a system wherein one central antenna is used to receive signals and deliver them to, for example, an apartment complex; and Television Receive-Only Earth Stations ("TVRO"), which are satellite receiving antenna dishes that are used by "backyard users" to receive satellite delivered programming directly in their homes. Programming services sell their programming directly to owners of TVROs as well as through third parties. The competition from MMDS and TVRO potentially diminishes the pool of subscribers to the Systems because persons who subscribe to MMDS services or who own backyard satellite dishes are not likely to subscribe to all of the Systems' cable television services. In the near future, the Systems will also face competition from direct satellite to home transmission ("DBS"). DBS can provide to individuals on a wide-scale basis premium channel services and specialized programming through the use of high-powered DBS satellites that transmit such programming to a rooftop or side-mounted antenna. There are currently no DBS operators in the areas served by the Systems. DBS systems' ability to compete with the cable television industry will depend on, among other factors, the ability to obtain access to programming and the availability of reception equipment at reasonable prices. The first DBS satellite was recently launched, and it is anticipated that DBS services will become available throughout the United States during 1994. The Systems also face competition from video cassette rental outlets and movie theaters in the Systems' service areas. The General Partner believes the preponderance of video cassette recorder ("VCR") ownership in the Systems' service areas may be a positive rather than a negative factor because households that have VCRs are attracted to non-commercial programming delivered by the Systems, such as movies and sporting events on cable television, that they can tape at their convenience. Cable television franchises are not exclusive, so that more than one cable television system may be built in the same area (known as an "overbuild"), with potential loss of revenues to the operator of the original cable television system. Other than as described below, the Systems currently face no direct competition from other cable television operators. Although the Partnerships have not yet encountered competition from a telephone company entering into the cable television business, the Partnerships' Systems could potentially face competition from telephone companies doing so. Bell Atlantic, a regional Bell operating company ("RBOC"), has announced its intention, if permitted by the courts, to build a cable television system in Alexandria, Virginia, and has won a lawsuit to obtain such authority. The case is on appeal. The General Partner currently owns and manages the cable television system in Alexandria, Virginia. Another RBOC, Ameritech, has also indicated its intention to build and operate a cable television system in Naperville, Illinois, a location where the General Partner manages a system on behalf of one of its managed limited partnerships. Other RBOCs have indicated their intention to enter the cable television market, and have filed lawsuits similar to the one being pursued by Bell Atlantic and Ameritech. Widespread competition through overbuilds by RBOCs could have a negative impact on companies like the General Partner that are already established cable television system operators. COMPETITION FOR SUBSCRIBERS IN THE PARTNERSHIPS' SYSTEMS. Following is a summary of competition from MMDS, SMATV and TVRO operators in the Partnerships' franchise areas. Albuquerque System Two SMATV operators serve approximately 3,190 units in trailer parks and apartments. Augusta System Two SMATV operators serve two apartment complexes; one TVRO dealer principally operates in areas which are not serviced by cable. Ft. Myers System One MMDS operator provides negligible competition; five SMATV operators provide service to motels and an occasional apartment complex; and twelve TVRO dealers serve a customer base that is confined primarily to rural areas. Northern Illinois System The General Partner is not aware of any MMDS or TVRO satellite dish dealers in the system's service area. There are a limited number of SMATV operators in the system's service area, but they do not provide significant competition. Palmdale/Lancaster System No MMDS operators; numerous SMATV operators provide some competition in several apartment complexes, hotels, motels, trailer parks and two hospitals. There are numerous TVRO dealers in the service area. Approximately 2% of the homes in the service area have TVRO systems. Tampa System One MMDS operator provides minimal competition; ten SMATV operators provide moderate competition; thirty TVRO dealers provide minimal competition. REGULATION AND LEGISLATION. The cable television industry is regulated through a combination of the Federal Communications Commission ("FCC"), some state governments, and most local governments. In addition, the Copyright Act of 1976 imposes copyright liability on all cable television systems. Cable television operations are subject to local regulation insofar as systems operate under franchises granted by local authorities. Cable Television Consumer Protection and Competition Act of 1992. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act"), which became effective on December 4, 1992. This legislation effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services and ordered an interim freeze on these rates effective on April 15, 1993. The rate freeze recently was extended by the FCC until the earlier of May 15, 1994, or the date on which a cable system's basic service rate is regulated by a franchising authority. The FCC's rate regulations became effective on September 1, 1993. On February 22, 1994, the FCC announced a revision of its rate regulations which it believes will generally result in a further reduction of rates for basic and non-basic services. The 1992 Cable Act encourages competition with existing cable systems by allowing municipalities, which are otherwise legally qualified, to own and operate their own cable systems without having to obtain a franchise; prevents franchising authorities from granting exclusive franchises; or unreasonably refusing to award additional franchises covering an existing cable system's service area. The 1992 Cable Act also makes several procedural changes to the process under which a cable operator seeks to enforce renewal rights which could make it easier in some cases for a franchising authority to deny renewal. The 1992 Cable Act prohibits the common ownership of cable systems and co-located MMDS or SMATV systems, and absent certain exceptions, the sale or transfer of ownership of a cable system within 36 months after its acquisition or initial construction. The 1992 Cable Act also precludes video programmers affiliated with cable companies from favoring cable operators over competitors and requires such programmers to sell their programs to other multichannel video distributors. This provision may limit the ability of cable program suppliers to offer exclusive programming arrangements with cable companies and could affect the volume discounts that program suppliers currently offer to the General Partner in its capacity as a multiple system operator. The 1992 Cable Act has eliminated the latitude of operators to set rates for commercially leased access channels and requires that leased access rates be set according to a formula determined by the FCC. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable television system carry its signal, or to require the cable television system to negotiate with the station for "retransmission consent." A cable television system is generally required to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial broadcast television stations, and non-commercial television stations are also given mandatory carriage rights, although such stations are not given the option to negotiate retransmission consent for the carriage of their signals by cable television systems. Additionally, cable television systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable television systems. See Item 1. Cable Television Services. There have been several lawsuits filed by cable television operators and programmers in Federal court challenging various aspects of the 1992 Cable Act, including provisions relating to mandatory broadcast signal carriage, retransmission consent, access to cable programming, rate regulation, commercial leased channels and public access channels. On April 8, 1993, a three-judge Federal district court panel issued a decision upholding the constitutional validity of the mandatory signal carriage requirements of the 1992 Cable Act. That decision has been appealed directly to the United States Supreme Court. Appeals have been filed in the Federal appellate court challenging the validity of the FCC's retransmission consent rules. Ownership and Market Structure. The FCC rules and federal law generally prohibit the direct or indirect common ownership, operation, control or interest in a cable television system, on the one hand, and a local television broadcast station whose television signal reaches any portion of the community served by the cable television system, on the other hand. The FCC recently lifted its ban on the cross-ownership of cable television systems by broadcast networks. The FCC revised its regulations to permit broadcast networks to acquire cable television systems serving up to 10% of the homes passed in the nation, and up to 50% of the homes passed in a local market. Neither the Partnerships nor the General Partner has any direct or indirect ownership, operation, control or interest in a television broadcast station, or a telephone company, and they are thus presently unaffected by the cross-ownership rules. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") and FCC regulations generally prohibit the common operation of a cable television system and a telephone company within the same service area. Until recently, a provision of a Federal court antitrust consent decree also prohibited the regional Bell operating companies ("RBOCs") from engaging in cable television operations. This prohibition was recently removed when the court retaining jurisdiction over the consent decree ruled that the RBOCs could provide information services over their facilities. This decision permits the RBOCs to acquire or construct cable television systems outside of their own service areas. The 1984 Cable Act prohibited local exchange carriers, including the RBOCs, from providing video programming directly to subscribers within their local exchange telephone service areas, except in rural areas or by specific waiver of FCC rules. This statutory provision has recently been challenged on constitutional grounds by Bell Atlantic, one of the RBOCs. The court held that the 1984 Cable Act cross-ownership provision is unconstitutional, and it issued an order enjoining the United States Justice Department from enforcing the cross-ownership ban. The National Cable Television Association, an industry group of which the General Partner is a member, has appealed this landmark decision, and the case could ultimately be reviewed by the United States Supreme Court. This federal cross-ownership rule is particularly important to the cable industry since these telephone companies already own certain facilities needed for cable television operation, such as poles, ducts and associated rights-of-way. The FCC has conducted a comprehensive proceeding examining whether and under what circumstances telephone companies should be allowed to provide cable television services, including video programming, to their customers. The FCC has concluded that under the 1984 Cable Act interexchange carriers (such as AT&T, which provide long distance services) are not subject to the restrictions which bar the provision of cable television service by local exchange carriers. In addition, the FCC concluded that neither a local exchange carrier providing a video dialtone service nor its programming suppliers leasing the dialtone service are required to obtain a cable television franchise. This determination has been appealed. If video dialtone services become widespread in the future, cable television systems could be placed at a competitive disadvantage because 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. The FCC has tentatively concluded that construction and operation of technologically advanced, integrated broadband networks by carriers for the purpose of providing video programming and other services would constitute good cause for waiver of the cable/telephone cross-ownership prohibitions. 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, and as a result of this decision, the FCC may be required to follow a stricter policy in granting such waivers in the future. As part of the same proceeding, the FCC recommended that Congress amend the 1984 Cable Act to allow Local Exchange Carriers ("LECs") to provide their own video programming services over their facilities. The FCC recently decided to loosen ownership and affiliation restrictions currently applicable to telephone companies, and has proposed to increase the numerical limit on the population of areas qualifying as "rural" and in which LECs can provide cable service without a FCC waiver. Legislation is pending in Congress which would permit the LECs to provide cable television service within their own operating areas conditioned on establishing separate video programming affiliates. The legislation would generally prohibit, however, telephone companies from acquiring cable systems within their own operating areas. The legislation would also enable cable television companies and others, subject to regulatory safeguards, to offer telephone services by eliminating state and local barriers to entry. ITEM 2. ITEM 2. PROPERTIES The cable television systems owned at December 31, 1993 by the Partnerships are described below. The following tables set forth (i) the monthly basic plus service rates charged to subscribers, (ii) the number of basic subscribers and pay units, (iii) the number of homes passed by cable plant, (iv) the miles of cable plant and (v) the range of franchise expiration dates for the cable television systems owned and operated by the Partnerships. The monthly basic plus service rates set forth herein represent, with respect to systems with multiple headends, the basic plus service rate charged to the majority of the subscribers within the system. While the charge for basic plus service may have increased in some cases as a result of the FCC's rate regulations, overall revenues to the Partnerships may have decreased due to the elimination of charges for additional outlets and certain equipment. In cable television systems, basic subscribers can subscribe to more than one pay TV service. Thus, the total number of pay services subscribed to by basic subscribers are called pay units. Figures for numbers of subscribers, miles of cable plant and homes passed are compiled from the General Partner's records and may be subject to adjustments. As of December 31, 1993, the number of homes passed and the miles of cable plant were 21,869 and 300, respectively. Franchise expiration dates range from March 1996 to June 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 16,751 and 262, respectively. Franchise expiration date is August 1994. The renewal of this franchise is currently being negotiated. As of December 31, 1993, the number of homes passed and the miles of cable plant were 9,182 and 81, respectively. Franchise expiration date is November 1995. As of December 31, 1993, the number of homes passed and the miles of cable plant were 64,507 and 664, respectively. Franchise expiration dates range from December 1999 to January 2002. As of December 31, 1993, the number of homes passed and the miles of cable plant were 100,100 and 1,602, respectively. Franchise expiration dates range from December 1998 to October 2003. As of December 31, 1993, the number of homes passed and the miles of cable plant were 85,768 and 937, respectively. Franchise expiration dates range from September 1994 to October 2005. Any franchises expiring in 1994 are in the process of franchise renewal negotiations. As of December 31, 1993, the number of homes passed and the miles of cable plant were 200,500 and 2,202, respectively. Franchise expiration dates range from January 1999 to August 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 127,800 and 1,093, respectively. The Tampa franchise expires in December 1997. The City of Tampa has notified the Venture of its belief that the Venture is not in compliance with certain provisions of the franchise agreement. Specifically, the City has claimed that the Venture is not in compliance with local origination programming requirements, institutional network requirements, and other facilities, equipment and service obligations under the franchise. The Venture has responded to the claim with a detailed demonstration that many of the City's claims are erroneous and that the remaining unmet obligations should be modified. The City of Tampa and the Venture have reached an agreement in principle with respect to the settlement of the franchise dispute. A definitive settlement agreement is in the process of being negotiated. PROGRAMMING SERVICES Programming services provided by the Systems include local affiliates of the national broadcast networks, local independent broadcast channels, the traditional satellite services (e.g., American Movie Classics (AMC), Arts & Entertainment (ARTS), Black Entertainment Network (BET), C-SPAN, The Discovery Channel (DISC), Lifetime (LIFE), Entertainment Sports Network (ESPN), Home Shopping Network (HSN), Mind Extension University (MEU), Music Television (MTV), Nickelodeon (NICK), Turner Network Television (TNT), The Nashville Network (TNN), Video Hits One (VH-1), and superstations WOR, WGN and TBS. The Partnerships' Systems also provide a selection, which varies by system, of premium channel programming (e.g., Bravo (BRVO), Cinemax (CMAX), The Disney Channel (DISN), Encore (ENC), Home Box Office (HBO), Showtime (SHOW) and The Movie Channel (TMC)). ITEM 3. ITEM 3. LEGAL PROCEEDINGS On July 15, 1992, the General Partner received a Civil Investigative Demand (the "CID") from the Department of Justice ("DOJ") in connection with an investigation to determine whether there is or has been a violation of Section 2 of the Sherman Act as a consequence of the General Partner's alleged refusal to carry a television broadcast station on cable television systems. The interrogatories and document requests included in the CID request information relating to systems owned or managed by the General Partner in Los Angeles County, and elsewhere, including the Palmdale/Lancaster System owned by the Venture. Specific reference is made in the CID to KHIZ, Channel 64. The General Partner has responded to a variety of requests for information and documents from the DOJ but has had no communication from the DOJ since March 1992. 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 While the Partnerships are all publicly held, there is no public market for the limited partnership interests and it is not expected that a market will develop in the future. As of March 1, 1994, the approximate number of equity security holders was: Item 6. Item 6. Selected Financial Data ** The above financial information represents the consolidated operations of Cable TV Fund 12-BCD Venture, in which Cable TV Fund 12-D has an approximate 76 percent equity interest. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CABLE TV FUND 12-A Results of Operations 1993 Compared to 1992 - Revenues of Fund 12-A increased $2,270,698, or approximately 9 percent, from $26,693,028 in 1992 to $28,963,726 in 1993. During 1993, Fund 12-A added approximately 1,923 basic subscribers, an increase of 3 percent. This increase in basic subscribers accounted for approximately 28 percent of the increase in revenues. An increase in advertising revenues accounted for approximately 24 percent of the increase in revenues. Basic service rate adjustments implemented in all of Fund 12-A's systems accounted for approximately 17 percent of the increase in revenues. The increase in revenues would have been greater but for the reduction in basic rates due to new basic rate regulations issued by the FCC in May 1993 with which Fund 12-A complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other individual factor was significant to the increase in revenues. Operating, general and administrative expense increased $991,718, or approximately 6 percent, from $15,492,913 in 1992 to $16,484,631 in 1993. Operating, general and administrative expense represented 57 percent of revenue in 1993 compared to 58 percent in 1992. Programming fees, advertising and plant related costs primarily accounted for the increase. These increases were offset, in part, by a decrease in copyright fees. There were no other individual factors that contributed significantly to the increase. Management fees and allocated overhead from the General Partner increased $285,162, or approximately 9 percent, from $3,156,916 in 1992 to $3,442,078 in 1993. This increase was due to the increase in revenues, upon which such fees and allocations are based, and an increase in expenses allocated from the General Partner. Depreciation and amortization expense increased $311,388, or approximately 4 percent, from $7,528,805 in 1992 to $7,840,193 in 1993. This increase was due to additions in Fund 12- A's asset base. Operating income increased $682,430 to $1,196,824 in 1993 compared to $514,394 in 1992. This was due to the fact that revenue growth exceeded the increases in operating, general and administrative expense, management fees and allocated overhead from the General Partner and depreciation and amortization expense. Operating income before depreciation and amortization increased $993,818, or approximately 12 percent, from $8,043,199 in 1992 to $9,037,017 in 1993. The increase was due to the fact that revenue growth exceeded the increases in operating, general and administrative expense, management fees and allocated overhead from the General Partner. Interest expense decreased $302,642, or approximately 16 percent, from $1,864,954 in 1992 to $1,562,312 in 1993. This decrease was due primarily to lower effective interest rates and lower outstanding balances on interest bearing obligations. Other expense decreased $188,649 from $232,887 in 1992 to $44,238 in 1993. Such expense was primarily due to allocated depreciation from affiliated entities. Net loss decreased $1,173,721, or approximately 74 percent, from $1,583,447 in 1992 to $409,726 in 1993. This decrease is due to the factors discussed above. Fund 12-A's losses are expected to continue in the future. 1992 Compared to 1991 - Revenues of Fund 12-A increased $2,370,428, or approximately 10 percent, from $24,322,600 in 1991 to $26,693,028 in 1992. Basic service rate adjustments implemented in all of Fund 12-A's systems accounted for approximately 43 percent of the increase in revenues. During 1992, Fund 12-A added approximately 2,220 basic subscribers, an increase of 4 percent. This increase in basic subscribers accounted for approximately 39 percent of the increase. In addition, Fund 12-A added approximately 6,316 pay units which accounted for approximately 14 percent of the increase in revenues. Operating, general and administrative expense increased $1,650,299, or approximately 12 percent, from $13,842,614 in 1991 to $15,492,913 in 1992. Operating, general and administrative expense represented 58 percent of revenue in 1992 compared to 57 percent in 1991. Programming fees accounted for approximately 29 percent of the increase in expense and was due, in part, to the increases in the subscriber base. Personnel related expense accounted for approximately 32 percent of the increase. There were no other individual factors that contributed significantly to the increase. Management fees and allocated overhead from the General Partner increased $456,198, or approximately 17 percent, from $2,700,718 in 1991 to $3,156,916 in 1992. This increase was due to the increase in revenues, upon which such fees and allocations are based, and an increase in expenses allocated from the General Partner. Depreciation and amortization expense decreased $1,513,475, or approximately 17 percent, from $9,042,280 in 1991 to $7,528,805 in 1992. This decrease is due to the maturation of Fund 12-A's asset base. Fund 12-A recorded operating income of $514,394 in 1992 compared to an operating loss of $1,263,012 in 1991. This was due to the fact that revenue growth exceeded the increases in operating, general and administrative expense and management fees and allocated overhead from the General Partner, as well as the decrease in depreciation and amortization expense. Operating income before depreciation and amortization increased $263,931, or approximately 3 percent, from $7,779,268 in 1991 to $8,043,199 in 1992. The increase was due to the fact that revenue growth exceeded the increases in operating, general and administrative expense and management fees and allocated overhead from the General Partner. Interest expense decreased $785,801, or approximately 30 percent, from $2,650,755 in 1991 to $1,864,954 in 1992. This decrease is due primarily to lower effective interest rates on interest bearing obligations. Other expense increased $247,812 from income of $14,925 in 1991 to expense of $232,887 in 1992 due primarily to the allocated depreciation from related entities that provide advertising sales, warehouse and converter repair services to Fund 12-A. Net loss decreased $2,315,395, or approximately 59 percent, from $3,898,842 in 1991 to $1,583,447 in 1992. These decreases in net losses are due to the factors discussed above. Financial Condition Capital expenditures totalled approximately $3,639,000 in 1993. Approximately 37 percent of these expenditures related to rebuild projects in all of Fund 12-A's systems. Approximately 31 percent of these expenditures related to plant extensions in all of Fund 12-A's systems. The remaining expenditures were used for various enhancements in all of Fund 12-A's systems. Funding for these expenditures was provided by cash generated from operations. Fund 12-A anticipates capital expenditures of approximately $5,189,000 in 1994. Plant extensions in all of Fund 12-A's systems are expected to account for approximately 34 percent of these expenditures, and service drops to homes are anticipated to account for approximately 20 percent. The remainder of the anticipated expenditures is for various enhancements in all of Fund 12- A's systems. The actual level of capital expenditures will depend, in part, upon the General Partner's determination as to the proper scope and timing of such expenditures in light of the FCC's announcement of a further rulemaking regarding the 1992 Cable Act on February 22, 1994 and Fund 12-A's liquidity position. Funding for these expenditures is expected to be provided by cash on hand and cash generated from operations. During March 1990, the General Partner renegotiated Fund 12-A's $35,000,000 credit facility, extending the revolving credit period to June 30, 1992, at which time the then-outstanding balance of $34,000,000 converted to a term loan. The term loan is payable in 20 consecutive quarterly installments that commenced on September 30, 1992. Payments in 1993 totaled $3,000,000. At December 31, 1993, $29,500,000 was outstanding under this term loan. Payments due in 1994 total $4,500,000. Fund 12-A intends to fund these payments with cash on hand and cash generated from operations. The General Partner is currently negotiating to reduce amortization payments in order to provide liquidity for capital expenditures. Generally, interest payable on amounts borrowed under the term loan is at Fund 12-A's option of prime plus 1/2 percent or a fixed rate defined as the CD rate plus 1-1/4 percent or the Euro-Rate plus 1-1/4 percent. On January 12, 1993, Fund 12-A entered into an interest rate cap agreement covering outstanding debt obligations of $15,000,000. The agreement protects Fund 12-A from interest rates that exceed 7 percent for three years from the date of the agreement. Subject to the regulatory matters discussed below and assuming successful renegotiation of Fund 12-A's credit facility, of which there can be no assurance, the General Partner believes that Fund 12-A has sufficient sources of capital from cash on hand and cash generated from operations to meet its presently anticipated needs. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which Fund 12-A complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on the General Partner's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, Fund 12-A reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in Fund 12-A's revenue of approximately $1,800,000, or approximately 6 percent, and a decrease in operating income before depreciation and amortization of approximately $1,600,000, or approximately 12 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on Fund 12-A's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing directed at non- subscribers. To the extent such reductions are not mitigated, the values of Fund 12-A's cable television systems, which are calculated based on cash flow, could be adversely impacted. In addition, such reductions could adversely effect the General Partner's ability to renegotiate Fund 12-A's credit facility. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television systems owned by Fund 12-A, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. CABLE TV FUND 12-BCD VENTURE Results of Operations 1993 Compared to 1992 Revenues of Cable TV Fund 12-BCD Venture (the "Venture") increased $5,564,003, or approximately 7 percent, from $83,567,527 in 1992 to $89,131,530 in 1993. Between December 31, 1992 and 1993, the Venture added 7,498 basic subscribers, an increase of approximately 4 percent. This increase in basic subscribers accounted for approximately 32 percent of the increase in revenues. Basic service rate adjustments were responsible for approximately 38 percent of the increase in revenues. Advertising sales revenue accounted for approximately 12 percent of the increase in revenues. Increases in pay per view revenue accounted for approximately 14 percent of the increase. The increase in revenues would have been greater but for the reduction in basic rates due to new basic rate regulation issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other single factor significantly affected the increase in revenues. Operating, general and administrative expenses in the Venture's systems increased $3,941,804, or approximately 8 percent, from $48,132,180 in 1992 to $52,073,984 in 1993. Operating, general and administrative expense represented 58 percent of revenue in 1993 and in 1992. The increase in operating, general and administrative expense was due to increases in subscriber related costs, programming fees and marketing related costs. No other single factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from Jones Intercable, Inc. increased $746,870, or approximately 8 percent, from $9,758,490 in 1992 to $10,505,360 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses. Depreciation and amortization expense decreased $1,113,583, or approximately 4 percent, from $26,764,820 in 1992 to $25,651,237 in 1993. The decrease is due to the maturation of the Venture's asset base. The Venture recorded operating income of $900,949 for 1993 compared to an operating loss of $1,087,963 for 1992. This change is the result of increases in revenue and the decreases in depreciation and amortization expenses exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable Inc. Operating income before depreciation and amortization increased $875,329, or approximately 3 percent, from $25,676,857 in 1992 to $26,552,186 in 1993. This increase is due to the increase in revenues exceeding the increase in operating, general, and administrative expenses and administrative fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $33,744, or less than 1 percent, from $12,022,874 in 1992 to $11,989,130 in 1993 due to lower interest rates on interest bearing obligations, which were offset, in part, by higher balances on such obligations. The Venture recorded other expense of $556,309 in 1993 compared to other expense of $2,708,833 in 1992. The 1992 expense primarily represented the Sunbelt litigation settlement as discussed in Note 6 of notes to financial statements of the Venture. The settlement was accrued by the Venture in 1992 and paid by the Venture in March 1993. Net loss decreased $3,299,949, or approximately 22 percent, from $14,884,365 in 1992 to $11,584,416 in 1993 due to the factors discussed above. These losses are expected to continue in the future. 1992 Compared to 1991 Revenues of the Venture increased $5,518,022, or approximately 7 percent, from $78,049,505 in 1991 to $83,567,527 in 1992. Between December 31, 1991 and 1992, the Venture added 3,670 basic subscribers, an increase of approximately 2 percent. This increase in basic subscribers accounted for approximately 17 percent of the increase in revenues. Basic service rate adjustments were responsible for approximately 46 percent of the increase in revenues. Advertising sales revenue accounted for approximately 14 percent of the increase in revenues. Increases in equipment rental revenue accounted for approximately 13 percent of the increase. No other single factor significantly affected the increase in revenues. Operating, general and administrative expenses in the Venture's systems increased $4,487,834, or approximately 10 percent, from $43,644,346 in 1991 to $48,132,180 in 1992. Operating, general and administrative expense represented 58 percent of revenue in 1992 compared to 56 percent in 1991. The increase in operating, general and administrative expense was due to increases in personnel related costs, programming fees and property taxes, which were partially offset by decreases in marketing related costs and copyright fees. No other single factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from Jones Intercable, Inc. increased $1,215,796, or approximately 14 percent, from $8,542,694 in 1991 to $9,758,490 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $4,028,233, or approximately 13 percent, from $30,793,053 in 1991 to $26,764,820 in 1992. The decrease is due to the maturation of the Venture's asset base. Operating loss decreased $3,842,625, or approximately 78 percent, from $4,930,588 in 1991 to $1,087,963 in 1992 as a result of the increase in revenues and the decreases in depreciation and amortization exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $898,899, or approximately 7 percent, from $12,921,773 in 1991 to $12,022,874 in 1992 due primarily to lower interest rates on interest bearing obligations, despite higher balances on such obligations. The Venture recorded other expense of $2,708,833 in 1992 compared to other income of $23,761 in 1991. This increase was due to the Sunbelt litigation settlement as discussed above. This settlement was paid by the Venture in March 1993. Net loss decreased $2,944,235, or approximately 17 percent, from $17,828,600 in 1991 to $14,884,365 in 1992 due primarily to the reductions in operating loss and interest expense which were offset, in part, by the litigation settlement discussed above. These losses are the result of the factors discussed above and are expected to continue in the future. Financial Condition Capital expenditures for the Venture totaled approximately $18,711,600 during 1993. Service drops to homes accounted for approximately 29 percent of the capital expenditures. Approximately 18 percent of these capital expenditures related to plant extensions in all of the Venture's systems. The completion of a rebuild of the Venture's Palmdale, California system accounted for approximately 17 percent of capital expenditures. Approximately 12 percent of capital expenditures was for fiber upgrades. The remaining expenditures related to various system enhancements. These capital expenditures were funded primarily from cash generated from operations and borrowings under the Venture's credit facility. Expected capital expenditures for 1994 are approximately $25,914,000. The upgrade of the Albuquerque, New Mexico system is expected to account for approximately 31 percent. Plant extensions in all of the Venture's systems are expected to account for approximately 15 percent. Service drops to homes are anticipated to account for approximately 23 percent. The remainder of the expenditures are for various system enhancements in all of the Venture's systems. Funding for these expenditures is expected to be provided by cash on hand, cash generated from operations and borrowings from the Venture's credit facility. Subject to the regulatory matters discussed below and assuming successful renegotiation of its credit facility, the Venture has sufficient sources of capital available in its ability to generate cash from operations and to borrow under its credit facility to meet its presently anticipated needs. During the first quarter of 1992, the Venture renegotiated its debt arrangements, which increased the maximum amount of debt available to $183,000,000. Such new debt arrangements consist of $93,000,000 of Senior Notes placed with a group of institutional lenders and a renegotiated $90,000,000 revolving credit agreement with a group of commercial bank lenders. The Venture used the funds from the Senior Notes to repay approximately $88,000,000 of the $155,000,000 outstanding on its previous credit facility and to repay advances from Intercable. The Venture used borrowings under its new credit facility to repay the remaining balance on its previous credit facility. The Senior Notes have a fixed interest rate of 8.64 percent and a final maturity date of March 31, 2000. The Senior Notes call for interest only payments for the first four years, with interest and accelerating amortization of principal payments for the next four years. Interest is payable semi-annually. The Senior Notes carry a "make-whole" premium, which is a prepayment penalty, if they are prepaid prior to maturity. The make-whole premium protects the lenders in the event that the funds are reinvested at a rate below 8.64 percent, and is calculated per the note agreement. The Venture's current revolving credit facility has a maximum amount available of $90,000,000. As of December 31, 1993, $73,800,000 was outstanding under the Venture's revolving credit agreement, leaving the Venture with $16,200,000 of available borrowing capacity until March 31, 1994. The revolving credit period will expire on March 31, 1994, at which time the principal balance converts to a term loan payable in quarterly installments with a final maturity date of March 31, 2000. The General Partner is negotiating to to extend the revolving credit period for one year. Interest is at the Venture's option of LIBOR plus 1.25 percent to 1.75 percent, the CD rate plus 1.375 percent to 1.875 percent or the Base Rate plus 0 percent to .50 percent. An annual commitment fee of .5 percent is required on the unused portion of the facility until it converts to a term loan. Both lending facilities are equal in standing with the other, and both are equally secured by the assets of the Venture. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which the Venture complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on Intercable's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, the Venture reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in the Venture's revenue of approximately $4,500,000, or approximately 5 percent, and a decrease in operating income before depreciation and amortization of approximately $4,300,000, or approximately 10 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on the Venture's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c)marketing efforts directed at non- subscribers. To the extent such reductions are not mitigated, the values of the Venture's cable television systems, which are calculated based on cash flow, could be adversely impacted. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television system owned by the Venture, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions, without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. Item 8. Item 8. Financial Statements CABLE TV FUND 12 FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 AND 1992 INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 12-A: We have audited the accompanying balance sheets of CABLE TV FUND 12-A (a Colorado limited partnership) as of December 31, 1993 and 1992, and the related statements of operations, partners' capital (deficit) 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 General Partner'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 Cable TV Fund 12-A 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 schedules listed in the index of 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. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11, 1994. CABLE TV FUND 12-A (A Limited Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-A (A Limited Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-A (A Limited Partnership) STATEMENTS OF OPERATIONS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-A (A Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-A (A Limited Partnership) STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-A (A Limited Partnership) NOTES TO FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business Cable TV Fund 12-A ("Fund 12-A"), a Colorado limited partnership, was formed on January 2, 1985, under a public program sponsored by Jones Intercable, Inc. Fund 12-A was formed to acquire, construct, develop and operate cable television systems. Jones Intercable, Inc., a publicly held Colorado corporation, is the "General Partner" and manages Fund 12-A. The General Partner and its subsidiaries also own and operate cable television systems. In addition, the General Partner manages cable television systems for other limited partnerships for which it is general partner and, also, for affiliated entities. Contributed Capital The capitalization of Fund 12-A is set forth in the accompanying statements of partners' capital (deficit). No limited partner is obligated to make any additional contributions to partnership capital. The General Partner purchased its interest in Fund 12-A by contributing $1,000 to partnership capital. All profits and losses of Fund 12-A are allocated 99 percent to the limited partners and 1 percent to the General Partner, except for income or gain from the sale or disposition of cable television properties, which will be allocated to the partners based upon the formula set forth in the Partnership Agreement, and interest income earned prior to the first acquisition by Fund 12-A of a cable television system, which was allocated 100 percent to the limited partners. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Fund 12-A's tax returns are also prepared on the accrual basis. Property, Plant and Equipment Depreciation of property, plant and equipment is provided primarily using the straight-line method over the following estimated service lives: Replacements, renewals and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises and subscriber lists are being amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. Reclassification Certain prior year amounts have been reclassified to conform to the 1993 presentation. (3) TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES Brokerage Fees An affiliate of the General Partner performed brokerage services for Fund 12-A. For brokering the acquisition of cable television systems for Fund 12-A, The Jones Group, Ltd. is paid a fee equal to 4.5 percent of the purchase prices. The Jones Group, Ltd. brokered the acquisition of a SMATV system for Fund 12-A in 1991 and earned a fee of $37,000, or 4 percent of the acquisition price. No brokerage fees were paid by Fund 12-A in 1992 and 1993. Management Fees, Distribution Ratios and Reimbursement The General Partner manages Fund 12-A and receives a fee for its services equal to 5 percent of the gross revenues of Fund 12-A, excluding revenues from the sale of cable television systems or franchises. Management fees for the years ended December 31, 1993, 1992 and 1991 were $1,448,186, $1,334,651 and $1,216,130, respectively. Any distributions made from cash flow (defined as cash receipts derived from routine operations, less debt principal and interest payments and cash expenses) are allocated 99 percent to the limited partners and 1 percent to the General Partner. Any distributions other than from cash flow, such as from the sale or refinancing of a system or upon dissolution of the partnership, will be made as follows: first, to the limited partners in an amount which, together with all prior distributions, will equal the amount initially contributed to the partnership capital by the limited partners; the balance, 75 percent to the limited partners and 25 percent to the General Partner. Fund 12-A reimburses the General Partner for certain allocated overhead and administrative expenses. These expenses consist primarily of salaries and benefits paid to corporate personnel, rent, data processing services and other facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to Fund 12-A. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each partnership managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the partnership. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the general partner are also allocated a proportionate share of these expenses. The General Partner believes that the methodology used in allocating overhead and administrative expenses is reasonable. Reimbursements by Fund 12-A to the General Partner for allocated overhead and administrative expenses were $1,993,892, $1,822,265 and $1,484,588 in 1993, 1992 and 1991, respectively. Fund 12-A was charged interest during 1993 an average interest rate of 10.61 percent on the amounts due the General Partner, which approximated the General Partner's weighted average cost of borrowing. Total interest charged Fund 12-A by the General Partner was $1,029, $-0- and $1,071 in 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Partnership receives programming from Superaudio and The Mind Extension University, affiliates of the General Partner. Payments to Superaudio totaled $45,495, $44,605 and $39,588 in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totaled $26,411, $25,559 and $24,313 in 1993, 1992 and 1991, respectively. (4) DEBT Fund 12-A's credit facility's revolving credit period expired on June 30, 1992. The credit facility has been converted to a term loan payable in 20 consecutive quarterly installments. Fund 12-A repaid $3,000,000 of the outstanding balance during 1993. Principal payments required in 1994 are $4,500,000. Generally, interest is at Fund 12-A's option of prime plus 1/2 percent or a fixed rate defined as the CD Rate plus 1-1/4 percent or the Euro-Rate plus 1-1/4 percent. The effective interest rates on outstanding obligations as of December 31, 1993 and 1992 were 4.83 percent and 5.13 percent, respectively. On January 12, 1993, Fund 12-A entered into an interest rate cap agreement covering outstanding debt obligations of $15,000,000. Fund 12-A paid an initial fee of $150,000. The agreement protects Fund 12-A for interest rates that exceed 7 percent for three years from the date of the agreement and will be charged to interest expense over the life of the agreement using the straight-line method. Installments due on all debt principal for each of the five years in the period ending December 31, 1998, respectively, are: $4,567,359, $6,067,359, $7,567,359, $11,522,453, and $-0-. At December 31, 1993, substantially all of Fund 12- A's property, plant and equipment secured the above indebtedness. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners. The Federal and state income tax returns of Fund 12-A are prepared and filed by the General Partner. Fund 12-A's tax returns, the qualification of the partnership as such for tax purposes, and the amount of distributable partnership income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to Fund 12-A's recorded income or loss, the tax liability of the general and limited partners would likely be changed accordingly. Taxable loss reported to the partners is different from that reported in the statements of operations due to the difference in depreciation recognized under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable loss and the net loss reported in the statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television systems owned by Fund 12-A, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. Fund 12-A rents office and other facilities under various long-term operating lease arrangements. Rent paid under such lease arrangements totaled $74,142, $81,669 and $35,060, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments for each of the five years in the period ending December 31, 1998, and thereafter are as follows: (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective years is presented below: CABLE TV FUND 12-A SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 CABLE TV FUND 12-A SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 12-BCD Venture: We have audited the accompanying balance sheets of CABLE TV FUND 12-BCD VENTURE (a Colorado general partnership) as of December 31, 1993 and 1992, and the related statements of operations, 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 General Partners' 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 Cable TV Fund 12-BCD Venture 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 schedules listed in the index of 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. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11, 1994. CABLE TV FUND 12-BCD VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-BCD VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF OPERATIONS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF PARTNERS' CAPITAL The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) NOTES TO FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business On March 17, 1986, Cable TV Funds 12-B, 12-C and 12-D (the "Venture Partners") formed Cable TV Fund 12-BCD Venture (the "Venture"). The Venture was formed for the purpose of acquiring certain cable television systems serving Tampa, Florida; Albuquerque, New Mexico; and Palmdale, California. Jones Intercable, Inc. ("Intercable"), the "General Partner" of each of the Venture Partners, manages the Venture. Intercable and its subsidiaries also own and operate cable television systems. In addition, Intercable manages cable television systems for other limited partnerships for which it is general partner and, also, for affiliated entities. Contributed Capital The capitalization of the Venture is set forth in the accompanying statements of partners' capital. All Venture distributions, including those made from cash flow, from the sale or refinancing of Partnership property and on dissolution of the Venture, shall be made to the Venture Partners in proportion to their approximate respective interests in the Partnership as follows: Cable TV Fund 12-B 9% Cable TV Fund 12-C 15% Cable TV Fund 12-D 76% --- 100% === Venture Acquisitions and Sales The Venture owns and operates the cable television systems serving certain areas in and around Albuquerque, New Mexico; Palmdale, California; and Tampa, Florida. On September 20, 1991, the Venture entered into a purchase and sale agreement with an unaffiliated party to sell the cable television system serving the area in and around California City, California for $2,620,000. Closing on this transaction occurred on April 1, 1992. The proceeds were used to repay a portion of the amounts outstanding under the Venture's credit facility. The Venture's acquisitions were accounted for as purchases with the individual purchase prices allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of the net tangible assets acquired; second, to the value of subscriber lists; third, to franchise costs; and fourth, to cost in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of Intercable and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. The Venture's tax returns are also prepared on the accrual basis. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Distribution systems 5 - 15 years Buildings 20 years Equipment and tools 3 - 5 years Premium television service equipment 5 years Earth receive stations 5 - 15 years Vehicles 3 years Other property, plant and equipment 5 years Replacements, renewals and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises and subscriber lists and cost in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Franchise costs 3 years Subscriber lists 1 year Cost in excess of interests in net assets purchased 32 years Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH JONES INTERCABLE, INC. AND AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services for the Venture in connection with Venture acquisitions and sales. For brokering two acquisitions in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $13,120, or 4 percent of the transaction prices, during 1992. Additionally, The Jones Group, Ltd. received $65,500, or 2.5 percent of the transaction price, during 1992 for brokering a sale in the Palmdale System. For brokering the acquisitions of two SMATV systems in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $55,400, or 4 percent of the original purchase prices, during 1991. There were no brokerage fees paid during the year ended December 31, 1993. Management Fees and Reimbursements Intercable manages the Venture and receives a fee for its services equal to 5 percent of the gross revenues of the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to Intercable for the years ended December 31, 1993, 1992 and 1991 were $4,456,577, $4,178,376 and $3,902,475, respectively. The Venture reimburses Intercable for certain allocated overhead and administrative expenses. These expenses represent the salaries and related benefits paid to corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each entity managed. Remaining overhead costs are allocated based on total revenues and/or the cost of assets managed for the entity. Systems owned by Intercable and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. Intercable believes that the methodology used in allocating overhead and administrative expenses is reasonable. Overhead and administrative expenses allocated to the Venture by Intercable during the years ended December 31, 1993, 1992 and 1991 were $6,048,783, $5,580,114 and $4,640,219, respectively. The Venture was charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due Intercable, which approximated Intercable's cost of borrowing. Total interest charged the Venture by Intercable was $15,477, $126,073 and $171,942 during 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Venture receives programming from Superaudio and The Mind Extension University, affiliates of Intercable. Payments to Superaudio totaled $134,179, $132,091 and $120,851 in 1993, 1992, and 1991, respectively. Payments to The Mind Extension University totaled $79,002, $76,676 and $72,218 in 1993, 1992 and 1991, respectively. (4) DEBT During the first quarter of 1992, the Venture renegotiated its debt arrangements, which increased the maximum amount of debt available to $183,000,000. The Venture's debt arrangements consist of $93,000,000 of Senior Notes placed with a group of institutional lenders and a $90,000,000 revolving credit agreement with a group of commercial bank lenders. The Senior Notes have a fixed interest rate of 8.64 percent and a final maturity date of March 31, 2000. The Senior Notes call for only interest payments for the first four years, with interest and accelerating amortization of principal payments for the next four years. Interest is payable semi-annually. The Senior Notes carry a "make-whole" premium, which is a prepayment penalty, if they are prepaid prior to maturity. The make-whole premium protects the lenders in the event that the funds are reinvested at a rate below 8.64 percent, and is calculated per the note agreement. The Venture's current revolving credit facility has a maximum amount available of $90,000,000. As of December 31, 1993, $73,800,000 was outstanding under the current revolving credit agreement, leaving the Venture with $16,200,000 of available borrowing capacity until March 31, 1994. The revolving credit period is scheduled to expire on March 31, 1994, at which time the principal balance will convert to a term loan payable in quarterly installments with a final maturity date of March 31, 2000. The General Partner is negotiating to extend the revolving credit period for one year. Interest is at the Venture's option of LIBOR plus 1.25 percent to 1.75 percent, the CD rate plus 1.375 percent to 1.875 percent or the Base Rate plus 0 percent to .50 percent. An annual commitment fee of .5 percent is required on the unused portion of the facility. The effective interest rates on amounts outstanding on the Venture's revolving credit facility as of December 31, 1993 and 1992 were 4.08 percent and 5.29 percent, respectively. Both lending facilities are equal in standing with the other, and both are equally secured by the assets of the Venture. During 1992, the Venture incurred costs associated with renegotiating its debt arrangements. These fees were capitalized and are being amortized over the life of the debt agreements. During 1988, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of an additional $25,000,000. The Venture paid a fee of $957,500. The agreement protects the Venture from interest rates that exceed 10 percent for five years from the date of the agreement. The fee was charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: $2,262,209, $4,697,609, $7,945,609, $30,201,870, $36,681,000 and $85,910,400, respectively. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners of Cable TV Funds 12-B, 12-C and 12-D. The Venture's tax returns, the qualification of the Venture as such for tax purposes, and the amount of distributable income or loss, are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to the Venture's qualification as such, or in changes with respect to the Venture's recorded loss, the tax liability of the Venture's general partners would likely be changed accordingly. Taxable losses reported to the partners is different from that reported in the statements of operations due to the difference in depreciation allowed under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable income or losses and the net losses reported in the statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re- packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television systems owned by the Venture, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions, without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. In February 1993, the General Partner entered into a settlement agreement related to litigation brought by Sunbelt Television, Inc. against the Venture in the amount of $2,850,000. As of December 31, 1992, the Venture had accrued $2,850,000, which was reflected as an increase in other expense in the 1992 statement of operations. The settlement was paid by the Venture in March 1993. Offices and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totaled $454,229, $450,295 and $345,994, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for the five years in the period ending December 31, 1998 and thereafter are as follows: (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective years is presented below: CABLE TV FUND 12-BCD VENTURE SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. CABLE TV FUND 12-BCD VENTURE SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL STATEMENTS None PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnerships themselves have no officers or directors. Certain information concerning directors and executive officers of the General Partner is set forth below. Mr. Glenn R. Jones has served as Chairman of the Board of Directors and Chief Executive Officer of the General Partner since its formation in 1970, and he was President from June 1984 until April 1988. Mr. Jones was elected a member of the Executive Committee of the Board of Directors in April 1985. He is also Chairman of the Board of Directors and Chief Executive Officer of Jones Spacelink, Ltd., a publicly held cable television company that is a subsidiary of Jones International, Ltd. and the parent of the General Partner. Mr. Jones is the sole shareholder, President and Chairman of the Board of Directors of Jones International, Ltd. He is also Chairman of the Board of Directors of the subsidiaries of the General Partner and of certain other affiliates of the General Partner. Mr. Jones has been involved in the cable television business in various capacities since 1961, is a past and member of the Board of Directors of the National Cable Television Association and is a former member of its Executive Committee. Mr. Jones is a past director and member of the Executive Committee of C-Span. Mr. Jones has been the recipient of several awards including the Grand Tam Award in 1989, the highest award from the Cable Television Administration and Marketing Society, the Chairman's Award from the Investment Partnership Association, which is an association of sponsors of public syndications; the cable television industry's Public Affairs Association President's Award in 1990; the Donald G. McGannon award for the advancement of minorities and women in cable; the STAR Award from American Women in Radio and Television, Inc., for exhibition of a commitment to the issues and concerns of women in television and radio; and the Women in Cable Accolade in 1990 in recognition of support of this organization. Mr. Jones is also a founding member of the James Madison Council of the Library of Congress, is on the Board of Governors of the American Society of Training and Development and is a director of the National Alliance of Business. Mr. James B. O'Brien, the General Partner's President, joined the General Partner in January 1982 as System Manager, Brighton, Colorado, and was later promoted to the position of General Manager, Gaston County, North Carolina. Prior to being elected President and a Director of the General Partner in December 1989, Mr. O'Brien served as a Division Manager, Director of Operations Planning/Assistant to the CEO, Fund Vice President and Group Vice President/Operations. As President, he is responsible for the day-to-day operations of the cable television systems managed and owned by the General Partner. Mr. O'Brien is also President and a Director of Jones Cable Group, Ltd., Jones Global Funds, Inc., and Jones Global Management, Inc., all affiliates of the General Partner. Mr. O'Brien is a board member of Cable Labs, Inc., the research arm of the cable television industry. He also serves as a director of the Cable Television Administration and Marketing Association and as a director of the Walter Kaitz Foundation. Ms. Ruth E. Warren joined the General Partner in August 1980 and served in various capacities, including system manager and Fund Vice President, since then. Ms. Warren was elected Group Vice President/Operations of the General Partner in September 1990. Ms. Warren also serves as Vice President/Operations of Jones Spacelink, Ltd. Mr. Kevin P. Coyle joined The Jones Group, Ltd. in July 1981 as Vice President/Financial Services. In September 1985, he was appointed Senior Vice President/Financial Services. He was elected Treasurer of the General Partner in August 1987, Vice President/Treasurer in April 1988 and Group Vice President/Finance in October 1990. Mr. Christopher J. Bowick joined the General Partner in September 1991 as Group Vice President/Technology and Chief Technical Officer. Previous to joining the General Partner, Mr. Bowick worked for Scientific Atlanta's Transmission Systems Business Division in various technical management capacities since 1981, and as Vice President of Engineering since 1989. Mr. Timothy J. Burke joined the General Partner in August 1982 as corporate tax manager, was elected Vice President/Taxation in November 1986 and Group Vice President/Taxation/Administration in October 1990. He is also a member of the Board of Directors of Jones Spacelink, Ltd. Mr. Raymond L. Vigil joined the General Partner in April 1993 as Group Vice President/Human Resources and was elected a Director of the General Partner in November 1993. Previous to joining the General Partner, Mr. Vigil served as Executive Director of Learning with USWest from September 1989 to April 1993. Prior to that, Mr. Vigil worked in various human resources posts over a 14-year term with the IBM Corporation. Mr. James J. Krejci joined Jones International, Ltd. in March 1985 as Group Vice President. He was elected Group Vice President and Director of the General Partner in August 1987. He is also an officer of Jones Futurex, Inc., a subsidiary of Jones Spacelink, Ltd. engaged in manufacturing and marketing data encryption devices, Jones Information Management, Inc., a subsidiary of Jones International, Ltd. providing computer data and billing processing facilities and Jones Lightwave, Ltd., a company owned by Jones International, Ltd. and Mr. Jones, and several of its subsidiaries engaged in the provision of telecommunications services. Prior to joining Jones International, Ltd., Mr. Krejci was employed by Becton Dickinson and Company, a medical products manufacturing firm. Ms. Elizabeth M. Steele joined the General Partner in August 1987 as Vice President/General Counsel and Secretary. Ms. Steele also is an officer of Jones Spacelink, Ltd. From August 1980 until joining the General Partner, Ms. Steele was an associate and then a partner at the Denver law firm of Davis, Graham & Stubbs, which serves as counsel to the General Partner. Mr. Michael J. Bartolementi joined the General Partner in September 1984 as an accounting manager and was promoted to Assistant Controller in September 1985. He was named Controller in November 1990. Mr. George J. Feltovich was elected a Director of the General Partner in March 1993. Mr. Feltovich has been a private investor since 1978. Prior to 1978, Mr. Feltovich served as an administrative and legal consultant to various private and governmental housing programs. Mr. Feltovich was admitted to practice law in California, Pennsylvania and the District of Columbia and is a member of the California Bar Association. Mr. Patrick J. Lombardi has been a Director of the General Partner since February 1984 and has served as a member of the Audit Committee of the Board of Directors since February 1985. In September 1985, Mr. Lombardi was appointed Vice President of The Jones Group, Ltd., and in June 1989 was elected President of Jones Global Group, Inc., both affiliates of the General Partner. Mr. Lombardi is President and a director of Jones Financial Group, Ltd., an affiliate of the General Partner, and Group Vice President/Finance and a director of Jones International, Ltd. Mr. Howard O. Thrall was elected a Director of the General Partner in December 1988 and serves as a member of the Audit Committee and the special Stock Option Committee, which was established in August of 1992. From 1984 until August 1993, Mr. Thrall was associated with Douglas Aircraft Company, an aircraft manufacturing firm, most recently as Regional Vice President Marketing. In September 1993, Mr. Thrall joined World Airways, Inc. as Vice President of Sales, Asian Region. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Partnerships have no employees; however, various personnel are required to operate the cable television systems owned by the Partnerships. Such personnel are employed by the General Partner and, pursuant to the terms of the limited partnership agreements of the Partnerships, the cost of such employment is charged by the General Partner to the Partnerships as a direct reimbursement item. See Item 13. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGERS No person or entity owns more than 5 percent of the limited partnership interests in any of the Partnerships. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The General Partner and its affiliates engage in certain transactions with the Partnerships as contemplated by the limited partnership agreements of the Partnerships and as disclosed in the prospectus for the Partnerships. The General Partner believes that the terms of such transactions, which are set forth in the Partnerships' limited partnership agreements, are generally as favorable as could be obtained by the Partnerships from unaffiliated parties. This determination has been made by the General Partner in good faith, but none of the terms were or will be negotiated at arm's-length and there can be no assurance that the terms of such transactions have been or will be as favorable as those that could have been obtained by the Partnerships from unaffiliated parties. The General Partner charges the Partnerships for management fees, and the Partnerships reimburse the General Partner for certain allocated overhead and administrative expenses in accordance with the terms of the limited partnership agreements of the Partnerships. These expenses consist primarily of salaries and benefits paid to corporate personnel, rent, data processing services and other facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Partnerships. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each Partnership managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the Partnerships. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the general partner are also allocated a proportionate share of these expenses. The General Partner also advances funds and charges interest on the balance payable from the Partnerships. The interest rate charged the Partnerships approximates the General Partner's weighted average cost of borrowing. Affiliates of the General Partner have received amounts from the Partnerships for performing brokerage services. The Systems receive stereo audio programming from Superaudio, a joint venture owned 50% by an affiliate of the General Partner and 50% by an unaffiliated party, for a fee based upon the number of subscribers receiving the programming. These systems also receive educational video programming from Mind Extension University, Inc., an affiliate of the General Partner, for a fee based upon the number of subscribers receiving the programming. The charges to the Partnerships for related transactions are as follows for the periods indicated: The activities of Fund 12-C and Fund 12-D are limited to their equity ownership in the Venture. See the following related party disclosure for the Venture. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)1. See index to financial statements at page 23 for list of financial statements and exhibits thereto filed as a part of this report. 2. Fund 12-A: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Fund 12-B: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Fund 12-D: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 12-BCD Venture Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 3. The following exhibits are filed herewith. 4.1 Limited Partnership Agreements for Cable TV Funds 12-A, 12-B and 12-C. (1) 4.2 Limited Partnership Agreement of Cable TV Fund 12-D. (3) 4.3 Joint Venture Agreement of Cable TV Fund 12-BCD Venture dated as of March 17, 1986, among Cable TV Fund 12-B, Ltd., Cable TV Fund 12-C, Ltd. and Cable TV Fund 12-D, Ltd. (3) 10.1.1 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Edwards Air Force Base, California (Fund 12-BCD). (2) 10.1.2 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Lancaster, California (Fund 12-BCD). (2) 10.1.3 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Unincorporated portions of Los Angeles County, California (Fund 12-BCD). (2) 10.1.3.1 Copy of Los Angeles County Code regarding cable tv system franchises (Fund 12- BCD). (8) 10.1.3.2 Copy of Ordinance 90-0118F dated 10/29/90 granting a cable television franchise to Fund 12-BCD (Fund 12-BCD). (8) 10.1.4 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Green Valley/Elizabeth Lake/Leona Valley unincorporated areas of Los Angeles County, California (Fund 12-BCD). (3) 10.1.4.1 Ordinance 88-0166F dated 10/4/88 amending the franchise described in 10.1.5 (Fund 12-BCD). (8) 10.1.5 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Palmdale, California (Fund 12-BCD). (8) 10.1.6 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Fort Myers, Florida (Fund 12-A). (1) 10.1.7 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Lee County, Florida (Fund 12-A). (1) 10.1.7.1 Renewal of Permit dated 3/4/92 (Fund 12-A). (8) 10.1.8 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Tampa, Florida (Fund 12-BCD). (1) 10.1.8.1 Resolution No. 1153 dated 10/2/86 authorizing consent to transfer of the franchise and amendment to the franchise agreement (Fund 12-BCD). (8) 10.1.8.2 Amendment to franchise agreement dated 10/6/86 (Fund 12-BCD). (8) 10.1.8.3 Franchise transfer, acceptance and consent to transfer dated 10/6/86 (Fund 12- BCD). (8) 10.1.9 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Augusta, Georgia (Fund 12-B). (1) 10.1.10 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Blythe, Georgia (Fund 12-B). (3) 10.1.11 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Burke, Georgia (Fund 12-B). (5) 10.1.12 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Columbia County, Georgia (Fund 12-B). (8) 10.1.13 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Hephzibah, Georgia (Fund 12-B). (1) 10.1.14 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Richmond County, Georgia (Fund 12-B). (1) 10.1.15 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated portions of Cook County, Illinois (Fund 12-A). (3) 10.1.16 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Grayslake, Illinois (Fund 12-A). (1) 10.1.17 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Lake County, Illinois (Fund 12-A). (1) 10.1.18 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Libertyville, Illinois (Fund 12- A). (1) 10.1.19 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Mundelein, Illinois (Fund 12-A). (1) 10.1.20 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Orland Park, Illinois (Fund 12-A). (1) 10.1.21 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Park Forest, Illinois (Fund 12-A). (1) 10.1.22 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Wauconda, Illinois (Fund 12-A). (1) 10.1.23 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Albuquerque, New Mexico (Fund 12- BCD). (2) 10.1.24 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Bernalillo, New Mexico (Fund 12- BCD). (2) 10.1.25 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Town of Bernalillo, New Mexico (Fund 12-BCD). (2) 10.1.25.1 Resolution No. 12-14-87 dated 12/14/87 authorizing the assignment of the franchise to Fund 12-BCD. (8) 10.1.26 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Bosque Farms, New Mexico (Fund 12- BCD). (2) 10.1.27 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Corrales, New Mexico (Fund 12- BCD). (2) 10.1.28 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Kirtland Air Force Base, New Mexico (Fund 12- BCD). (8) 10.1.29 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Los Ranchos, New Mexico (Fund 12-BCD). (2) 10.1.30 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Sandoval, New Mexico (Fund 12-BCD). (2) 10.1.31 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Valencia, New Mexico (Fund 12-BCD). (2) 10.1.31.1 Resolution No. 88-23 dated 2/14/88 authorizing assignment of the franchise to Fund 12-BCD. (8) 10.2.1 Credit Agreement, dated as of July 15, 1992, between Cable TV Fund 12-A, Ltd. and Mellon Bank, N.A, for itself and as agent for various lenders. (8) 10.2.2 Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (1) 10.2.2.1 Amendment No. 1 dated as of August 14, 1986, to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.2 Amendment No. 2 dated March 31, 1988 to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.3 Amendment No. 3 dated March 29, 1989 to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.4 Amendment No. 4 dated November 29, 1991 to Loan and Security Agreement dated November 1991 between Cable TV Fund 12-B, Ltd. and Corestates Bank, N.A. (formerly The Philadelphia National Bank), individually and as agent for various lenders. (6) 10.2.3 Note Purchase Agreement dated as of March 31, 1992 among Fund 12-BCD Venture and various note purchasers. (8) 10.3.1 Purchase and Sale Agreement dated as of March 29, 1988 by and between Cable TV Fund 12-BCD Venture as Buyer and Video Company as Seller. (4) 10.3.2 Purchase and Sale Agreement dated 9/20/91 and amendments thereto between Cable TV Fund 12-BCD Venture as Seller and Falcon Classic Cable Income Properties, L.P. (Fund 12-BCD). (7) __________ (1) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1985 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (2) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1986 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (3) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1987 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (4) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1988 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (5) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (6) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (7) Incorporated by reference from the Forms 8-K of Fund 12-B, Fund 12-C and Fund 12- D dated 4/6/92 (Commission File Nos. 0-13193, 0-13964 and 0-14206, respectively). (8) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (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. CABLE TV FUND 12-A, LTD. CABLE TV FUND 12-B, LTD. CABLE TV FUND 12-C, LTD. CABLE TV FUND 12-D, LTD. Colorado limited partnerships By: Jones Intercable, Inc., their general partner By: /s/ GLENN R. JONES Glenn R. Jones Chairman of the Board and Chief Dated: March 25, 1994 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.

63506_1993.txt

63506_1993

1993

63506

Item 1. Business. The business of Mayflower Group, Inc. ("Group") is conducted entirely through its two operating subsidiaries, Mayflower Contract Services, Inc. ("Contract Services"), and Mayflower Transit, Inc. ("Transit") and their respective subsidiaries (Group, with its respective subsidiaries, being referred to collectively herein as "the Company or "the Registrant"). Group, formerly known as MG Holdings, Inc., was formed in 1986 for the purpose of acquiring another company whose name was Mayflower Group, Inc. ("Old Mayflower"), a holding company that owned 100% of the stock of three operating subsidiaries: Mayflower Contract Services, Inc. ("Contract Services"), Mayflower Transit, Inc. ("Transit"), and Mayflower Consumer Products, Inc. ("Consumer Products"). The acquisition was completed in December 1986 in a two-step merger: a cash tender offer for all the 7.9 million outstanding common shares of Old Mayflower at $31.50 per share followed by a merger of Old Mayflower into a wholly-owned subsidiary of Group. To finance the acquisition, Group raised approximately $330 million of debt financing, including a $110 million senior secured credit facility and $160 million through private placement of 12 5/8% Senior Subordinated Debentures ("Debentures") with Warrants to purchase common stock of Group. The remaining debt financing consisted of a secured bank loan to a subsidiary of Contract Services. Group sold Consumer Products in 1987 and eventually refinanced the senior secured credit facility with secured credit facilities at Contract Services and Transit. Group is a holding company that relies upon the cash flow of its two operating subsidiaries to satisfy its obligations, which through December 1990 consisted primarily of interest payments on the Debentures. Following Group's financial reorganization, discussed below, it had no significant obligations remaining. From 1987 through 1991, operating results and cash flow generated by Group and its operating subsidiaries were not sufficient to pay significant amounts of principal on Group's senior debt or allow Group to remain in compliance with all financial covenants contained in the secured credit facilities. As a result, beginning after December 1990, Contract Services and Transit were prohibited by terms of the secured credit facilities from making any further cash dividend payments to Group for the purposes of servicing interest payments on its Debentures. Consequently, the two scheduled semiannual interest payments on the Debentures of $10.1 million each were not made in 1991 resulting in a default under provisions of the related indenture. After various restructuring proposals were considered, Group's Debenture holders, along with Group's common stock and warrant holders, overwhelmingly approved a Prepackaged Plan of Reorganization ("Plan of Reorganization") in early 1992. The Plan of Reorganization was confirmed by the court and became effective March 1992. Under the Plan of Reorganization, the holders of the Debentures received shares of newly issued common stock equal to approximately 94% of the common stock of Group. The existing holders of the common stock and warrants of Group received shares of newly issued common stock equal to approximately 5% of the common stock of Group. Two other creditors received approximately 1% of the common stock as payment in lieu of cash for services in connection with the Plan of Reorganization. The Plan of Reorganization did not affect Contract Services or Transit. Contract Services Contract Services was created through the acquisition of R.W. Harmon & Sons, Inc. by Old Mayflower in October 1984. Since that date, Contract Services has purchased 17 additional passenger transportation companies. Contract Services provides service in 28 states. Contract Services derives revenues from two distinct lines of business: student transportation and public transportation. Student Transportation. Student transportation represents the largest source of revenue for Contract Services. Revenues from this segment were approximately $166.4 million in 1993, which represents approximately 71% of Contract Services' total revenues. Contract Services renders daily transportation services to more than 200 school districts in 20 states. While the nature and scope of services to school districts vary, the most typical arrangement encompasses a multi-year contract under which Contract Services operates owned or leased school buses driven by its own drivers. Services rendered to school districts include traditional daily home-to-school transportation for students, as well as after-hours or mid-day activity charters. Contracts are typically priced in terms of a per-day charge for base services and a per-hour charter rate for extracurricular transportation. In most instances, billings are rendered monthly and remittances are collected immediately. Public Transportation. The Federal Transit Administration (formerly the Urban Mass Transit Administration), the Department of Transportation, and certain legislation have, in recent years, established additional rules and guidelines governing participants in federally assisted transportation programs. These rules encourage private enterprise participation, prohibit discrimination and require programs to provide transit service to disabled individuals. Contract Services has capitalized on these trends by establishing public transportation operations in several major metropolitan markets beginning in 1988. In 1993, revenues from this segment were approximately $69.5 million, which represents approximately 29% of Contract Services' total revenues. In this segment, Contract Services provides year-round local demand-responsive service and fixed route transit service for transportation authorities in ten major metropolitan markets. As in its student transportation segment, these contracts are performed through use of Contract Services-provided and/or managed vehicles. Marketing. Traditionally, government agencies and municipalities have performed the bulk of student and public transportation services. While there has been a gradual trend toward privatizing such municipal/ government services, only about 30% of student transportation is provided by private sector companies today, and the figure in the public and para transit industries is considerably lower. In this market, the competitive challenge for Contract Services lies in persuading its potential public sector customers to convert to a private vendor. Contract Services believes that the key to success in both the student and public transportation markets is demonstrated expertise. Contract Services competes on the basis of quality, efficiency and price. In both markets, Contract Services has determined that a reputation as a safe provider is essential. Complementing safety, a company must demonstrate sensitivity in the school market and expertise in the transit market. These attributes may induce a customer to renew or extend contracts, foregoing the bid process. Most transit authorities award contracts via an overall evaluation process that gives weight to operating qualifications as well as price. Contract Services has operating or sales management assigned to certain geographical areas that are responsible for maintaining contact with active and prospective customers and for prospecting conversion leads, as well as staying alert to public bid opportunities in adjacent geographic markets. Competition. The private, public and student transportation industries are highly fragmented and regionalized. Contract Services believes it is the nation's largest provider of paratransit services and has one of the three largest market shares of any private contractor in the United States student transportation industry. Safety Program. Contract Services operates formal safety programs centering on employee selection and training, and bus maintenance. A prospective driver's record is screened for past criminal and motor vehicle violations through a search of public records (where such searches are permitted). The prospective driver must also pass certain tests that screen for traits that may affect the driver's performance. In addition, Contract Services has conducted pre-employment and random drug and alcohol tests since 1989. Contract Services has a formal training program for its drivers that involves at least ten hours of one-on-one, behind the wheel instruction with a certified trainer. The driver also receives at least ten hours of classroom training, covering student discipline on the bus, safety rules and other bus procedures. On an ongoing basis, drivers attend at least nine hours per year of meetings to view films and review safety procedures. Field safety supervisors periodically perform road observations to assure drivers are complying with traffic laws and safety procedures. Motor vehicle and criminal records are also monitored on an ongoing basis for violations and accidents. Environmental Laws. Compliance by Contract Services with federal, state and local environmental protection laws has not in the past had, and is not expected to have in the future, a material effect upon its capital expenditures, liquidity, earnings or competitive position. Insurance. Contract Services' insurance program consists of three principal types of coverage: auto liability (for third party personal injury or property damage claims), general liability and workers' compensation. Workers' compensation is regulated by the individual states in which Contract Services operates. With the rising cost of liability insurance in the mid-1980's, Contract Services moved to an "economic" self-insurance program in 1987 whereby Contract Services retains financial exposure for the first $2.0 million of each claim. Though Contract Services does not purchase insurance coverage for this exposure, Contract Services purchases a "fronted" policy from an insurance carrier. The insurance carrier's liability under this arrangement is to make any claim payments that are not made by Contract Services. Contract Services indemnifies the insurance company for any losses and collateralizes this indemnification obligation with letters of credit. The amounts of letter of credit collateralization are calculated based upon expected losses for a given policy year. Because of the nature of this liability, it takes several years to settle fully all claims for a given policy period. As of December 31, 1993, Contract Services had $28.1 million in letters of credit outstanding under its primary credit facility as collateral for its insurance related obligations. Contract Services also maintains excess liability insurance policies providing in total up to an additional $42 million in limits. Fuel Costs. The impact of additional fuel taxes, which became effective in October 1993 following the enactment of the 1993 Omnibus Budget Reconciliation Act will not be significant as Contract Services' student transportation system is exempt from federal fuel taxes. Also Contract Services limits the effects of significant increases in fuel prices by including fuel escalator clauses in many of its contracts, a "fuel cap" which provides price protection against such increases, and arrangements with certain vendors to fix fuel costs within a predetermined range. Employees. Contract Services employs approximately 11,000 people, approximately 9,000 of whom are employed as drivers and driver aides. Most drivers are part-time employees, 60% working fewer than 1,000 hours per year. Approximately 20% of Contract Services' drivers belong to collective bargaining units. These unions represent employees in major metropolitan markets or in school districts where drivers and mechanics were formerly employed by the school corporation. Relations with employees are satisfactory. Transit Transit is involved in a number of transportation service businesses. It provides household goods moving services and transportation services for goods that require special handling, such as electronic products and trade show exhibits. It also provides warehousing services such as storage and distribution, freight forwarding for domestic and international shipments, and flatbed hauling of containerized shipments. In these operations, Transit uses its network of approximately 550 independent agents in the United States and Canada as well as more than 800 independent owner-operators who are skilled in providing transportation services. Transit also currently owns and operates 25 moving and storage agencies located throughout the United States. Other Transit operations sell and finance transportation equipment to Transit's agents and owner-operators, and sell and underwrite commercial lines of insurance coverage. Transit operates through two lines of business: domestic household goods moving services and special transportation services. Domestic Household Goods Moving Services -- Household Goods. The Household Goods division ("Household Goods") is the largest single operating division of Transit, generating line haul revenue in 1993 equal to 42% of Transit's total revenue. Total revenue generated by Household Goods in 1993, including both line haul and accessorial revenue, accounted for approximately 60% of Transit's total revenue. -- The Household Goods division serves individual residential customers, governmental entities and national accounts. The national account business, which consists of providing household goods moving services to corporations transferring their employees, is generally the most profitable segment of the business, due to the larger shipment sizes and the accessorial services such as packing and storage that are normally provided in connection with these moves. Transit's agent/owner-operator system is used to transport household goods shipments. See "Agent/ Owner- Operator System." -- Moving and Storage Division ("M&S"). This division consists of 25 agencies owned and operated by Transit. These agents function and provide the same services as the independent agents included in the Transit agent/ owner-operator system. See "Agent/ Owner-Operator System." Special Transportation Services -- Electronic and Trade Show ("E&TS"). This division, which generated line haul revenue in 1993 equal to approximately 19% of Transit's total revenue, is engaged primarily in the transportation of electronic products and trade show exhibits for corporate customers. These items typically require special handling and other services. The E&TS division began commercial operations in the early 1970's and has experienced significant growth since then. Operating revenues have increased from $71.9 million in 1991 to $92.7 million in 1993. Transit's agent/owner- operator system is used to transport E&TS shipments. -- International ("International"). This division operates four business segments: commercialhousehold goods, its largest business segment; a motor van/ sea van operation that provides trailer service between the continental United States and Alaska or Hawaii; international commodities and tradeshows; and a consolidating service for household goods being shipped to foreign locations. While Transit has provided international services for over 25 years, it has seen its most significant growth in the past few years. In 1993, this division generated $29.7 million in revenues, or 6.7% of Transit's total revenue. -- Other Transportation Operations ("Other"). Several smaller subsidiaries and divisions of Transit engage in sales of products and services to serve the needs of Transit's owner- operators and agents, including: (i) sales of tractors, trailers and other equipment, and the administration of the financing of such equipment by independent lending institutions for Transit owner-operators and agents; (ii) the operation of a full service road equipment maintenance facility to service vehicles for agents, owner-operators and nonaffiliated customers as well as Transit's own fleet; (iii) the operation of a full service insurance agency and captive insurance company that sell and underwrite property, casualty and other insurance coverages, primarily to agents and owner-operators; and (iv) sales of moving supplies, equipment and uniforms to agents and owner-operators. Revenues and Expenses. Transit derives its revenues primarily from three sources. Line haul revenues consist of revenues obtained from transporting goods. These revenues are generally based upon the weight of the shipment, distance traveled, type of goods transported and points of origin and destination. The Household Goods and E&TS divisions generate substantially all of Transit's line haul revenues. Accessorial revenues are fees received for other services such as packing, unpacking, storage and other related services. The majority of accessorial revenues are related to household goods line haul activities. The balance of Transit's revenues are generated by the M&S, International and Other divisions. Transit's expenses consist primarily of commissions paid to agents and owner-operators for their services. Sales and origin commissions are paid to agents for obtaining orders and providing support services at point of origin. Hauler commissions are paid primarily to agents and owner-operators for hauling the goods from the point of origin to their destination. The total of these line haul related expenses is historically between 82% and 83% of line haul revenues. Additional operating expenses not related to the services of the agent and owner-operator systems are also incurred in connection with Transit's line haul activities and the activities of other divisions within Transit. Overhead expenses incurred by Transit include overhead costs directly related to Transit operations. Customers. The Household Goods market is made up of three basic customer groups: individual residential customers, national account customers and various agencies of the United States Government. Individual residential customers arrange and pay for their own moves and are required to pay for shipping services upon delivery. National account customers are generally corporate customers, or their representatives, which are billed for moves they arrange for employees. United States Government moves are arranged by various departments of the United States Government, including the Military Traffic Management Command, which coordinates the movement of household goods for military personnel of all branches of the service. Most individual shippers choose a mover from Yellow Pages advertising and discuss their move, services and prices with a local agent. National account business is generally solicited by agent sales personnel and, to a lesser extent, by sales personnel employed by Transit. United States Government business is generally awarded on a shared basis among qualified carriers meeting the lowest rate for the particular installation. The E&TS business is solicited by agents and, to a lesser extent, by the employees of Transit. This business is formed almost entirely by national account customers, which include major computer and other high technology companies, hospitals and trade show exhibitors. Transit provides marketing support for its agents through field sales representatives, advertising, incentive programs and promotional materials and services. Agent/ Owner-Operator System. Transit has approximately 550 agents in the United States and Canada, of which 25 are owned by Transit, with the remainder being independent business entities. Agents operate full service moving and storage businesses in their geographic areas. They solicit business, pack, unpack and store goods and provide labor to assist haulers in loading and unloading goods. Agents also provide tractor/ trailer units and drivers for the transportation of household goods and E&TS products. In a typical interstate move of household goods or E&TS products, the agent at the point of origin provides packing and preparation services. From its Indianapolis headquarters, Transit arranges and coordinates the transportation of the goods, which about half of the time are hauled by one of Transit's agents with the balance by independent owner-operators. The agent at the destination of the shipment provides unpacking and other support services. In addition to arranging for and coordinating the interstate transportation of goods, pursuant to orders booked by its agents, Transit provides national advertising and other marketing support, administers the settlement of damage claims, provides certain data processing services to agents and collects and distributes the revenues among Transit, its agents and its owner- operators. All United States agents enter agreements with Transit that generally provide that the agent will represent Transit exclusively. Agents are compensated according to commission schedules for services rendered. Agents receive substantially all the revenue from the packing, unpacking and storage services, a portion of the line haul revenue for booking and origination services and a majority of the line haul revenue if the agent provides the equipment and driver for hauling the goods. Some agents have their own interstate operating authority (which is generally limited to states surrounding their locations). Transit's operations outside the United States and Canada are conducted through approximately 125 independent representatives whose arrangements with Transit permit them to represent other carriers. For the year ended December 31, 1993, orders booked by agents owned by Transit accounted for approximately 11% of Transit's revenues. No other agent or group of agents under common control accounted for as much as 5% of such revenues. Approximately 30% of Transit's revenues were generated by the 20 largest agents or group of agents under common control, excluding the agents owned by Transit. Approximately 35% of Transit's agents have been with Transit for 25 years or more; approximately 50% have been agents of Transit for 15 years or more. Transit does not employ drivers except for local, intrastate and, during the peak season, interstate hauling services in agencies owned by Transit. Transit typically uses approximately 800 independent owner-operators to haul and, generally with the assistance of local agents, to load and unload shipments. During the peak summer season, however, Transit may use up to 1,200 owner-operators. Each owner-operator is engaged pursuant to an agreement with Transit that requires the owner-operator to furnish a tractor and to pay maintenance, insurance, fuel and other expenses incurred in hauling goods. Transit trains the owner-operators and, for the majority of owner-operators, provides a trailer. Owner-operators in the Household Goods division are generally compensated by Transit through a base commission which has traditionally averaged 56% of the line haul revenues. While the majority of owner-operators in the E&TS division are also compensated through a base commission that has averaged 56% of line haul revenues, an increasing portion of these owner-operators are being compensated on a mileage basis. As discussed above, Transit's independent owner-operators and independent agent drivers agree to pay for fuel costs incurred in providing their services. Higher fuel costs hurt the profitability of Transit's independent owner-operators, and result in higher costs for Transit associated with driver turnover. The impact of the additional taxes on fuel prices, which became effective in October 1993 following the enactment of the 1993 Omnibus Budget Reconciliation Act, is not expected to be significant to Transit. Further, Transit does not expect changes in fuel prices will materially affect its financial condition or its results of operations in the foreseeable future. Employees. Transit employs approximately 1,400 full time employees, approximately 500 of whom are salaried employees and the remainder of whom are hourly employees. Transit has not experienced any material strikes or work stoppages during the past five years and believes that its relations with employees are satisfactory. Insurance. Transit's insurance program consists of three principal types of coverage: auto liability (for third party personal injury or property damage claims), general liability and workers' compensation. Auto liability coverage is regulated by the Interstate Commerce Commission ("ICC") and workers' compensation is regulated by the individual states in which Transit operates. In order to comply with ICC regulations, evidence of insurance must be provided to the ICC. With the rising cost of liability insurance in the mid-1980's, Transit moved to an "economic" self-insurance program in 1987 whereby Transit retains financial exposure for the first $2.0 million of each claim. Though Transit does not purchase insurance coverage for this exposure, due to ICC regulations the ICC must be provided evidence of insurance. This is accomplished by Transit purchasing a "fronted" policy from an insurance carrier. The insurance carrier's liability under this arrangement is to make any claim payments that are not made by Transit. Transit indemnifies the insurance company for any losses and collateralizes this indemnification obligation with letters of credit. The amounts of letter of credit collateralization are calculated based upon expected losses for a given policy year. Because of the nature of this liability, it takes several years to settle fully all claims for a given policy period. As of December 31, 1993, Transit had $26.2 million in letters of credit outstanding under its primary credit facility as collateral for its insurance related obligations. Transit management has received approval from the ICC to self-insure the first $1.0 million of each auto liability claim effective April 1, 1994, eliminating the need for Transit to purchase a "fronted" policy from an insurance carrier for these claims. The Company will benefit by reducing its fronting costs and its letter of credit requirements in the future, as the ICC only requires a $1.0 million letter of credit related to this self-insurance liability. Transit also maintains excess liability insurance policies providing in total up to an additional $42 million in limits. Competition. Transit is in direct competition in the United States with approximately 2,000 motor common carriers having ICC authority for the interstate transportation of household goods and E&TS products. Based upon financial data filed with the ICC, Transit is the fourth largest mover in the United States in terms of intercity revenues. According to reports filed with the ICC, 1993 intercity revenues aggregated approximately $2.5 billion for the 20 largest motor carriers of which Transit accounted for 11.1% and the six largest carriers, including Transit accounted for 82.0% of this amount. Carriers compete on the basis of the number and location of agents, perceived quality of service, price and carrier name recognition. Transit's name recognition and its reputation for quality service, together with Transit's agency network, are important factors in its competitive position. As a result of reduced government regulation, increased price competition, principally in the form of binding estimates and discounts, has become more significant. Rates, Pricing and Regulation. Since 1980, a significant reduction in statutory and administrative restrictions on entry into surface transportation and the moving industry has increased competition. Traditionally, in Transit's industry, pricing has been based upon tariffs approved by the ICC for each class of goods hauled by an interstate carrier. These tariffs are a function of the weight of the shipment, the distance the shipment is moved and accessorial services rendered. Most moves are now priced below tariffs through individual discount programs filed by each carrier with the ICC, binding estimates negotiated between Transit and, primarily, individual residential customers or on the basis of a contract entered between Transit and a corporate customer. Household goods carriers participate in rate bureaus through which competitors jointly establish and publish tariffs and rates. Transit is currently a member of the Household Goods Carriers' Committee of the American Movers Conference, along with approximately 2,000 other common carriers of household goods, including the ten largest carriers in the industry. The Interstate Commerce Act permits certain collective ratemaking activities through a rate bureau by exempting such ratemaking from the antitrust laws. Certain members of Congress have proposed legislation that could result in complete deregulation of rates and tariff filings, repeal of antitrust immunity for collective ratemaking, total elimination of the ICC over a period of time and transfer of authority over motor carriers of property (as to unfair competition and trade practice matters) to other governmental agencies. Although trade association and industry leaders do not believe that such legislation will be enacted, they have provided comments to Congress in opposition to the legislation. Transit is unable to assess the likelihood of passage by Congress of such legislation. Environmental Laws. Compliance by Transit with federal, state and local environmental protection laws has not in the past had, and is not expected to have in the future, a material effect upon its capital expenditures, liquidity, earnings or competitive position. Operating Authority. Transit operates nationwide as an interstate common carrier pursuant to a Certificate of Public Convenience and Necessity granted by the ICC. This Certificate authorizes Transit to transport various classes of goods and products. Transit also operates as a contract carrier, pursuant to contract authority granted by the ICC. Transit is required to comply with ICC regulations and the failure to do so could subject it to civil or criminal penalties, the suspension or revocation of its operating authority or both. The suspension of operating authority could have a material adverse impact upon Transit's operations depending primarily upon the duration of the suspension and the class or classes of goods or products affected. In addition, the Department of Transportation regulates the hours of service of Transit's drivers and other safety aspects of operations. A failure by Transit with these regulations could subject it to civil or criminal liabilities. The agencies owned by Transit also hold intrastate operating authority that subjects them to the jurisdiction of various state regulatory commissions. Transit believes that a material suspension or revocation of these certificates of operating authority would not have a material adverse effect upon Transit's operations. Trademarks. Transit has registered trademarks on a number of variations of the Mayflower name and corporate logo in the United States and approximately 25 foreign countries. Depending on the jurisdiction of registration, trademarks are generally protected 10 to 20 years (if they are in continuous use during that period) and are renewable. These trademarks are material to Transit in the marketing of its services because of the name recognition possessed by Transit in the transportation services industry. Executive Officers of the Registrant. The following persons comprise the Executive Officers of the Registrant. All of the Executive Officers have been employed by the Registrant or its subsidiaries in one of the capacities indicated below for more than five (5) years. Each officer serves a term of one year expiring at the Annual Meeting of the Board of Directors. Name Age Position Michael L. Smith 45 Chairman, President and Chief Executive Officer Patrick F. Carr 42 Senior Vice President, Chief Financial Officer and Treasurer Robert H. Irvin 42 Senior Vice President, Secretary and General Counsel Michael L. Smith: Mr. Smith was originally employed at Old Mayflower in 1974. He has been a Director of the Registrant since October 1986, President of the Registrant since April 1989, Chief Executive Officer of the Registrant since January 1990, and Chairman of the Board of the Registrant since April 1992. He was Chief Operating Officer of the Registrant between April 1989 and January 1990. Mr. Smith was Executive Vice President of the Registrant from January 1987 to April 1989. He has been Chief Executive Officer of Transit since June 1989 and a director of Transit since October 1986. He was President of Transit from June 1989 to April 1991. He has been Chairman of the Board and Chief Executive Officer of the subsidiaries of Transit since June 1989. He has been Chairman of the Board and Chief Executive Officer of Contract Services since January 1987 and has been a director of Contract Services since October 1986. He was President of Contract Services and the subsidiaries of Contract Services from January 1987 through December 1992. Mr. Smith also serves as a Director of First Indiana Corporation, Somerset Group, Inc. and Acordia, Inc. Patrick F. Carr: Mr. Carr has been Senior Vice President and Chief Financial Officer of the Registrant since January 1987. He has been President of Transit and its subsidiaries since April 1991 and has been a director of Transit since January 1987. Between January 1989 and January 1990, Mr. Carr was Executive Vice President of Transit and Executive Vice President of the subsidiaries of Transit. From January 1987 to January 1989, he was the Treasurer of Transit. He has been an officer of Contract Services since 1987 and was a director of Contract Services from 1987 to 1993. Robert H. Irvin: Mr. Irvin has been Secretary of the Registrant since September 1986 and Senior Vice President and General Counsel since January 1987. He has been a director and an officer of Transit since 1987. From 1987 to 1993, he was a director of Contract Services. He has been an officer of Contract Services since 1987. Item 2. Item 2. Properties. The Company itself owns no property other than the stock of Contract Services and Transit. All properties are owned by Contract Services and Transit. Contract Services Properties Contract Services is headquartered in Overland Park, Kansas, a suburb of Kansas City, Missouri. The Company moved to these premises in December 1987 and occupies approximately 18,000 square feet under a multi-year lease. Contract Services owns twelve operating terminals and leases approximately 130 others. Contract Services' strategy is to lease facilities on terms that approximate the length of the service contracts at each locale. These properties typically include two to five acres of parking space with a small office facility for driver training and dispatch and a two to three bay maintenance facility. In some instances, Contract Services will secure its operating terminals from its client and negotiates its occupancy costs as a part of its service contract. The average age of Contract Services' fleet is approximately 6 years. The 8,447 vehicles operated by Contract Services are primarily diesel and gas powered, although some units are propane powered. The operating fleet includes 1,345 customer owned vehicles. Nearly all vehicles owned by Contract Services are encumbered by liens in favor of the Company's lenders, under its financing agreements. Contract Services' equipment is maintained under a comprehensive preventive maintenance program emphasizing avoidance of on-the-road failures while minimizing per mile maintenance and tire costs. Fleet maintenance standards are established by a corporate department located in its Overland Park headquarters facility. This department supervises the purchasing of equipment and establishes standards for preventive maintenance in addition to monitoring levels of repair parts inventories throughout the Contract Services system. Contract Services has obtained a substantial portion of the additions to its fleet through operating leases. As of December 31, 1993, Contract Services was a party to operating leases with eight equipment finance entities. The Company has guaranteed the performance of Contract Services' obligations under a portion of these operating leases. Transit Properties Transit owns a 190-acre tract northwest of Indianapolis, Indiana upon which the Company's headquarters building is located. Located on the same tract is Transit's driver training facility, a building used for the preparation and maintenance of trailers, a storage building, and a warehouse and office facility used by an agent wholly owned by Transit. This entire tract is mortgaged to Mellon Bank, N.A. ("Mellon") as part of the security for a $5.0 million loan to Transit. Transit also owns a total of approximately 182,000 square feet of office and warehouse space in Indianapolis, Indiana and Alexandria, Virginia that is used in its local moving and storage operations. All these properties owned by Transit are also mortgaged to Mellon. In addition, Transit owns another 40,000 square feet which are not encumbered and leases approximately 1.3 million additional square feet at various other locations. At December 31, 1993, Transit and its Moving & Storage subsidiaries owned approximately 1,600 trailers, with an average age of 11 years, which are used primarily by owner-operators in hauling goods with the owner-operator's tractor. Transit also owned approximately 240 tractors, straight trucks and other vehicles at December 31, 1993. The majority of the tractors and trailers owned by Transit are subject to a security interest granted to the Company's lenders under its financing agreements. Agents also provide equipment for Transit's use under long-term and short-term contract hauling arrangements. Approximately 400 of Transit's fleet of tractor-trailer units are maintained pursuant to long-term contract hauling arrangements, while approximately 1,700 additional units are available on a short-term basis, some of which are added to the fleet during the peak season. Item 3. Item 3. Legal Proceedings Litigation On October 24, 1989, two alleged shareholders of Old Mayflower filed suit in the federal district court against certain directors of Old Mayflower and the Company. The plaintiffs in this lawsuit are also the plaintiffs in a suit filed in Indiana state court on October 29, 1986. These complaints allege that the directors breached their fiduciary obligations to the shareholders of Old Mayflower by entering into a leveraged buy-out transaction at a grossly inadequate price. The suits purport to be class actions on behalf of all the shareholders. In addition to seeking injunctive relief, the plaintiffs are asking for compensatory and punitive damages. The defendants in these suits believe the plaintiffs' claims to be without merit; however, because of the costs associated with defending these actions, the Company has joined in an agreement to settle both lawsuits. The settlement agreement must be approved by the federal and state courts. If approved, the maximum amount of the settlement will be approximately $2.1 million in cash and notes. Attorneys for the settlement class will receive approximately $725,000 in cash for fees and litigation expenses. The Company's insurance carrier will contribute $617,000 toward the cash payment with the balance to be paid by the Company. The remainder of the settlement amount, not more than approximately $1.4 million, will be paid in the form of unsecured subordinated notes of the Company to members of the settlement class that properly complete and submit proofs of claim. The settlement notes (a) will mature in ten years, (b) will be unsecured and subordinated to certain indebtedness of the Company, (c) will pay interest semi-annually, (d) will require no payment of principal until maturity, and (e) will not be registered with the Securities and Exchange Commission. The subsidiaries become involved from time to time in various actions that are incidental to the ordinary course of their business, including property damage and personal injury claims. Based upon information currently available to it, the Registrant believes that its reserves and insurance coverage with respect to all such actions are adequate to cover liabilities reasonably anticipated at the date of this filing. (See Note 4 to Consolidated Financial Statements.) The Registrant becomes involved from time to time in actions arising from the operations of its subsidiaries. The Registrant routinely seeks to be dismissed from such actions on the grounds that it is not a proper party defendant. 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 of the Registrant, through the solicitation of proxies or otherwise. [The remainder of this page was intentionally left blank.] PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Registrant's Common Stock was registered effective August 22, 1992, under Section 12 of the Securities Exchange Act of 1934. The Common Stock of the Registrant was listed on the Nasdaq National Market on December 1, 1992. Prior to that date there was no established public trading market for these securities. As of December 31, 1993, the Registrant had 276 shareholders of record. The high and low sales prices for the Registrant's Common Stock during the portion of the fourth calendar quarter of 1992 following the date on which the Registrant's Common Stock began trading on the Nasdaq National Market were $10.50 and $7.50, respectively, as reported by Nasdaq. The high and low sales prices reported by for the Registrant's Common Stock reported by the Nasdaq National Market during each calendar quarter of 1993 were as follows: Quarter High Low 1 12 1/4 9 2 11 1/2 8 1/4 3 13 9 1/2 4 12 1/4 10 3/4 There were 278 holders of record of the Registrant's Common Stock on March 7, 1994. The high and low sales prices reported by the Nasdaq National Market on that date were $11 3/4 and $11 1/4. The Registrant has not paid cash dividends in its two most recent fiscal years. The senior bank credit agreement entered into by the Registrant and its operating subsidiaries prohibits the payment of dividends on its Common Stock. (For a discussion of the Registrant's credit facilities, see Note 7 to Consolidated Financial Statements.) Therefore, the Registrant does not anticipate paying cash dividends on its Common Stock in the foreseeable future. [The remainder of this page was intentionally left blank.] CONSOLIDATED BALANCE SHEETS MAYFLOWER GROUP, INC. Intangible assets are amortized by the straight-line basis over periods ranging from 5 to 35 years. D. Federal Income Taxes Effective April 1, 1992, the Company adopted Financial Accounting Standards Board Statement No. 109 "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires a significantly different approach to the financial accounting and reporting of income taxes than had been previously used and, in accordance with SFAS 109, the Company has chosen not to restate prior year financial statements. Refer to Note 9 for further discussion of SFAS 109. Prior to April 1, 1992, the Company computed income taxes in accordance with Accounting Principles Board Opinion No. 11. E. Post-retirement Benefits Other Than Pensions Effective April 1, 1992, the Company adopted Financial Accounting Standards Board Statement No. 106 "Employers' Accounting for Post-retirement Benefits Other Than Pensions" ("SFAS 106"). SFAS 106 requires the Company to accrue for the expected cost of Post-retirement benefits during the years an employee renders service rather than the previous practice of expensing such costs as incurred. Refer to Note 10 for further discussion of SFAS 106. F. Reserve for Self-insured Claims The Company is self-insured for certain risks and is covered by insurance policies for other risks. The Company maintains reserves for losses and premium adjustments using case basis evaluations and other analyses. Reserve and premium adjustment estimates are continually reviewed and adjustments are reflected in current operations. The Company recognizes the noncurrent nature of the self insured claims reserves by classifying a portion of these reserves as a noncurrent liability. See Note 4 for discussion of adjustment to self-insured claims reserves recorded in 1993. G. Recognition of Operating Revenues Revenues and related direct expenses for Contract Services, which is primarily involved in student transportation, are recognized over the period during which the service is rendered, which generally corresponds with the traditional nine month school year. Transit, which is primarily involved in the shipment of household goods and electronic and trade show products, recognizes revenue and associated transportation costs when the order has been unloaded at the destination. Transit's equipment financing subsidiary sells transportation equipment to certain of its owner-operators and agents. Beginning in 1993, revenues associated with these installment sales are recorded net of the related cost of goods sold as an operating expense, with the related gain on the sale being recognized on the installment basis. Revenues and operating expenses for 1992 and 1991 have been reclassified to conform with this presentation. H. Cash Equivalents The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amount reported on the balance sheet for cash approximates fair value. I. Inventories Inventories are stated at the lower of cost or market as determined for each specific unit. J. Property and Equipment Property and equipment is stated on a cost basis. Depreciation is provided primarily by the straight-line method at annual rates considered adequate to amortize the costs over the estimated useful lives of the assets. The lives used in computing depreciation during the periods were: Building and improvements 3 to 40 years Revenue equipment 3 to 10 years Other operating equipment and improvements 2 to 10 years The portion of fleet operating buses used in the operations of Contract Services and classified as property and equipment, is based upon the Company's requirements for fleet buses to fulfill existing contract requirements, including an estimate of reserve buses necessary to ensure continuity of service based on historical maintenance records and experience. The remaining buses are classified as equipment and inventory held for resale. K. Reclassification Certain amounts within the 1992 and 1991 Consolidated Financial Statements have been reclassified to conform with the 1993 presentation. Note 2- Corporate Reorganization Plan of Reorganization Group was formed in 1986 for the purpose of acquiring another company whose name was Mayflower Group, Inc. ("Old Mayflower"), a holding company that owned 100% of the stock of three operating subsidiaries: Contract Services, Transit, and Mayflower Consumer Products, Inc. ("Consumer Products"). The acquisition was completed in December 1986 in a two-step merger (the "Merger"): a cash tender offer for all of the 7.9 million outstanding common shares of Old Mayflower at $31.50 per share followed by a merger of Old Mayflower into a wholly-owned subsidiary of Group. To finance the acquisition, Group raised approximately $330 million of debt financing, including a $110 million senior secured credit facility and $160 million through private placement of 12 5/8% Senior Subordinated Debentures ("Debentures") with Warrants to purchase common stock of Group. The remaining debt financing consisted of a secured bank loan to a subsidiary of Contract Services. Group sold Consumer Products in 1987 and eventually refinanced the senior secured credit facility with secured credit facilities at Transit and Contract Services. Group is a holding company that relies upon the cash flow of its two operating subsidiaries to satisfy its obligations, which through December 1990 consisted primarily of interest payments on the Debentures. Following Group's financial reorganization, discussed below, it had no significant obligations remaining. From 1987 through 1991, operating results and cash flow generated by Group and its operating subsidiaries were not sufficient to pay significant amounts of principal on Group's senior debt or allow Group to remain in compliance with all financial covenants contained in the secured credit facilities. As a result, beginning after December 1990, Contract Services and Transit were prohibited by terms of the secured credit facilities from making any further cash dividend payments to Group for the purposes of servicing interest payments on its Debentures. Consequently, the two scheduled semiannual interest payments on the Debentures of $10.1 million each were not made in 1991 resulting in a default under the provisions of the related indenture. After various restructuring proposals were considered in early 1992, Group's Debenture holders, along with Group's common stock and warrant holders, overwhelmingly approved a Prepackaged Plan of Reorganization ("Plan of Reorganization"). The Plan of Reorganization was confirmed by the court and became effective in March 1992. Under the Plan of Reorganization, the holders of the Debentures received shares of newly issued common stock equal to approximately 94% of the common stock of Group. The existing holders of the common stock and warrants of Group received shares of newly issued common stock equal to approximately 5% of the common stock of Group. Two other creditors received approximately 1% of the common stock as payment in lieu of cash for services in connection with the Plan of Reorganization. The Plan did not affect Contract Services or Transit. Basis of Presentation Group emerged from the Plan of Reorganization on March 24, 1992, successfully completing Group's financial reorganization. Because the results of operations from March 25, 1992 to March 31, 1992 were not significant, the Company has used March 31, 1992 as the effective date of the Reorganization for accounting purposes. Accordingly, the Consolidated Statements of Operations and Cash Flows for the year ended December 31, 1992 reflect the results of operations of the Company prior to reorganization for the three months ended March 31, 1992 and the operations of the Company after reorganization for the nine months ended December 31, 1992. The Consolidated Balance Sheet at December 31, 1992 reflects the financial position of the Company subsequent to reorganization. The Consolidated Statements of Operations and Cash Flows for the year ended December 31, 1991 reflects the financial position and results of operations of the Company prior to reorganization. See discussion of pro forma financial information contained in Note 3. Accounting Treatment Using Fresh Start Reporting The Company accounted for the Reorganization using Fresh Start Reporting, in accordance with Statement of Position (SOP) 90-7 (Financial Reporting by Entities in Reorganization under the Bankruptcy Code) issued by the AICPA. Accordingly, all assets and liabilities were adjusted to reflect their estimated reorganization value, which approximated Group's book value less liabilities at the date of reorganization. This resulted in reorganization value in excess of amounts allocated to assets of $16.7 million, which is comparable to the amount of goodwill existing prior to reorganization. The reorganization value of Group, less liabilities, was determined to be approximately $86 million at March 31, 1992. This value was determined to fall within an acceptable range developed by considering several factors and relying upon various valuation methods including discounted values of estimated future cash flows, earnings multiples as appropriate in the two industries in which Transit and Contract Services operate, and other recent financial transactions. Forecasts used in earnings and cash flow estimates assumed revenue and cost patterns similar to historical levels in recent years. The most significant of the reorganization adjustments reduced Long-Term Debt by $155.1 million and Accrued Interest by $23.6 million, and increased Shareholders' Investment by $173.8 million, including the elimination of a retained deficit totaling $118.3 million prior to the Reorganization. The conversion of the Debentures to common stock resulted in an extraordinary gain totaling $93.1 million. In accordance with SOP 90-7, the Consolidated Statement of Operations for the year ended December 31, 1992 includes $1.7 million of interest expense related to the Debentures, representing the amount accrued in 1992 and shown as part of a claim on the petition filed with the court. Note 3- Pro Forma Financial Information (Unaudited) During 1992 and 1991, certain events occurred that result in the Consolidated Financial Statements not being comparable between the respective fiscal periods. As presented below, the pro forma net income excludes credits and charges relating to a) the corporate reorganization in March 1992 as discussed in Note 2 (which resulted in the exchange of common stock for subordinated debentures significantly increasing the equity and decreasing the debt of the Company) and b) the write-down of Transit's intangible assets of $69.0 million in December 1991 as discussed in Note 6. It also includes a) additional expense relative to the adoption of SFAS 109 and SFAS 106 (actual adoption date was April 1, 1992), and b) additional expense relative to the adoption of shorter lives of intangible assets and excess reorganization value to reflect the prevailing useful lives of similar assets (actual adoption date was October 1, 1992) as if these events and their related adjustments had occurred as of December 31, 1990. The effects of these pro forma adjustments result in the following pro forma operating profit, net income, and earnings per share for the years ended December 31, 1992 and 1991: Pro forma earnings per share is based on the number of shares issued and outstanding as a result of the Plan of Reorganization. The pro forma financial information should be read in conjunction with the related historical financial statements, and is not necessarily indicative of results of operations that would have occurred had the events giving rise to the pro forma adjustments actually taken place earlier. Note 4 - Self-Insured Claims Adjustment As discussed in Note 1F, the Company is self-insured for certain risks and, accordingly, maintains reserves for losses and premium adjustments which are determined using case basis evaluations and other analyses. Based on a review by management during the fourth quarter of 1993 of the calculations underlying the reserve for self-insured claims, the Company has determined that the portion of the reserve attributable to claims incurred by Contract Services prior to 1991 was $4.9 million below an appropriate level. As a result, the Company recognized $4.9 million, or $3.0 million net of tax, in additional self-insured claims expense, which had the effect of reducing earnings per share in 1993 by $.23. Management believes that the annual expense related to risks incurred under the self-insurance program since January 1, 1991, excluding this adjustment, has been sufficient to provide for anticipated losses, and that the magnitude of this expense is such that this adjustment represents a one-time nonrecurring increase to its reserve for self-insured claims. Note 5- Extraordinary Items In May 1993, the Company refinanced its primary debt facilities which were scheduled to mature in 1994 (Note 7). Such refinancing resulted in the write-off of $549,000 of deferred debt costs, net of tax, which has been accounted for as an extraordinary loss. In 1992, the Company recognized an extraordinary gain totaling $93.1 million, resulting from the conversion of the Company's debentures to common stock in conjunction with its Plan of Reorganization (Note 2). Note 6- Revaluation of Intangible Assets The revaluation of intangible assets in 1991 represents a non-cash charge to operations that does not relate directly to normal ongoing business activity and, in the opinion of management, is nonrecurring. In 1986, the Merger (Note 2) was accounted for as a purchase and, accordingly, the assets and liabilities were adjusted to their estimated fair values based upon independent appraisals and business conditions at that time. During the final analysis and evaluation of various restructuring proposals, which were completed in 1991, the Company determined that the recorded value of Transit's goodwill and intangible assets were stated in excess of current market value. Accordingly, during 1991, goodwill and intangible assets were adjusted to reflect a write down of $37.8 million and $31.2 million, respectively. Note 7- Financing Agreements Long-term debt consists of the following: Maturities on long-term debt during each of the next five years ending December 31, are as follows (in thousands): 1994 $ 2,276 1995 2,521 1996 2,521 1997 16,807 1998 15,126 Thereafter 58,432 -------- $ 97,683 ======== New Financing Agreements Effective May 27, 1993, the Company consummated three separate agreements for refinancing certain of its debt facilities which were scheduled to expire in 1993 and 1994. The first agreement was for an $80 million term loan from a group of lenders, the proceeds of which were used both to refinance existing obligations to secured lenders of Contract Services and Transit, and for working capital purposes. The term loan has two separate facilities. The first facility is for $65 million and has a ten-year maturity with interest only payments required in the initial three years. Amortization of principal begins in year four with equal annual installments through April 2003. Interest on this facility is to be paid quarterly, and is fixed at 9.5% per annum. The second facility is for $15 million and has a seven-year maturity with repayment of principal occurring in eight equal quarterly installments during years six and seven through April 2000. Interest on this facility is to be paid quarterly, and is computed using LIBOR plus 2.8% per annum, which was 6.3% at December 31, 1993. The second financing agreement was for a $25 million loan facility to be used by Contract Services to finance the acquisition of new school buses over a period of approximately two years. At December 31, 1993, $11.7 million was outstanding under this loan facility. Periodic fundings under this agreement convert to five-year term notes when the amount outstanding exceeds $5 million, with no term note maturing later than September, 1999. The term notes bear interest at the prime rate plus 1.5% per annum, which was 7.5% at December 31, 1993. Alternatively, the Company may elect to fix the interest rate at the time each funding converts to a term note. The notes will be collateralized by a lien on the purchased school buses. Through the third agreement, a group of banks provide the Company with a $70 million revolving credit facility. The facility, which has a maturity date of June 1995, will be used for letters of credit and seasonal working capital purposes. At December 31, 1993, the Company has letters of credit totaling $54.3 million, and no borrowings were outstanding under its line of credit. Interest is to be paid monthly, and is computed using the prime rate plus 1.5% per annum. The facility does not require compensating balances but does require the payment of a commitment fee at an annual rate of .375% of the unused portion of the facility and a fee of 2% per annum of the amount of letters of credit outstanding. The first and third financing facilities discussed above are collateralized by substantially all of the assets of Transit and Contract Services and guaranteed by the Company. Effective December 31, 1993, the Company entered into two new agreements to sell $13.9 million of installment notes receivable of Transit's equipment sales and financing subsidiary to the same creditors which had previously financed such notes receivable. The Company recognized no gain or loss on the sale of the notes receivable and proceeds were used to fully repay amounts outstanding under the related notes payable. Financial Covenants and Restrictions Under terms of the financing agreements with senior lenders, the ability of Contract Services and Transit to transfer cash to Group is limited to required income tax payments and $1.5 million annually for on-going cash expenses. The financing agreements also contain various restrictive financial covenants that, among other things, prohibit cash dividend payments, restrict property and equipment additions, restrict certain additional indebtedness, and require the maintenance of certain financial ratios. Other Interest paid during 1993, 1992 and 1991 totaled $8.3 million, $9.9 million, and $9.6 million, respectively. The carrying value of the Company's borrowings does not significantly differ from its fair value. The fair value of the Company's long- term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Note 8- Common Stock Stock Option Plan In 1992, the Company established two Stock Option Plans ("Option Plans"). The Option Plans provide for the issuance of 530,000 shares of common stock, no par value, to directors of the Company and officers and key employees of the Company and its subsidiaries. Options granted under the Option Plans become exercisable in 33.3% increments on the first, second and third anniversaries of the date of grant and must be exercised within ten years from the date of grant. As of December 31, 1993, 336,500 options are outstanding including options to acquire 159,500 shares of common stock at an exercise price of $6.875 per share and options to acquire 177,000 shares of common stock at an exercise price of $9.00 per share. In 1993, options to acquire 53,167 shares of the common stock at $6.875 per share became exercisable. No options have lapsed or were exercised in 1993 or 1992. Restricted Stock Plan In 1993, the Company adopted a restricted stock plan whereby key employees were granted restricted shares of the Company's stock. Shares were granted in the name of the employee, who has all rights of a shareholder, subject to certain restrictions or forfeitures. Restrictions on the grants expire on the third anniversary of the date of the grant. During 1993, 17,000 shares were granted. As of December 31, 1993, there were 8,000 shares available for grant. The market value of shares granted under the plan has been recorded as unearned compensation and is presented as a reduction in the value of common stock. Compensation expense will be charged to general and administrative expense over the respective three-year vesting period. Such compensation expense was $14,000 in 1993. Note 9- Federal Income Taxes Effective April 1, 1992, the Company changed its method of accounting for income taxes from the deferred to the liability method required by SFAS 109. As provided by SFAS 109, financial statements have not been restated. The cumulative effect of adopting SFAS 109 as of April 1, 1992 was to decrease shareholders' investment by $8.9 million. For the nine months ended December 31, 1992, application of the new accounting method decreased income before federal income taxes and federal income tax expense by approximately $2.1 million. Federal income taxes paid totaled $4.5 million, $4.2 million, and $.4 million in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company has net operating loss carryforwards of $4.8 million and alternative minimum tax credit carryforwards of $3.2 million for federal income tax purposes. The net operating loss carryforwards expire in years 2003 and 2006, while the alternative minimum tax credit carryforwards have an indefinite carryforward period. Because management believes these carryforwards will be used prior to expiration, no valuation allowance has been recorded. Transit has a capital loss carryforward of $2.6 million. The capital loss carryforward will expire in 1994. Because of the uncertainty of the ability to generate sufficient capital gains against which to utilize the capital loss, this carryforward has been fully provided for in the valuation allowance. Due to the Company's change in ownership resulting from its Plan of Reorganization (Note 2) the annual aggregate utilization of the net operating loss carryforward and the capital loss tax carryforward will be limited to approximately $6.0 million annually. 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 federal income tax purposes. Significant components of the Company's noncurrent and current deferred taxes as of December 31, 1993 are as follows (in thousands): For 1991, the Company did not provide for any deferred income taxes on timing differences in the recognition of revenues and expenses for tax and financial statement purposes, due to the absence of taxable income after consideration of net operating loss carryforwards. For 1993, 1992, and 1991, effective rates that differed from the U.S. federal statutory rates were used in recording federal tax expense. The primary reasons for these differences are as follows. For 1993, the Company recorded additional income tax expense to reflect the cumulative effect on the net deferred income tax liability of tax rate increases, as required by SFAS No. 109, primarily as a result of the enactment in August 1993 of Omnibus Budget Reconciliation Act. Also in 1993, the Company recorded additional income tax expense to eliminate a federal income tax receivable from prior years which was determined to be unrealizable. In 1993, 1992 and 1991, a difference in rates was created as a result of the nondeductibility of amortization of intangible assets. These intangible assets were created at the time of Group's formation in 1986 and were also generated by the excess reorganization value resulting from the Plan of Reorganization for 1992. The following table summarizes the differences between the statuary federal income tax rate and the effective tax rate provided in the Consolidated Statements of Operations. Federal income taxes currently payable are remitted to Group in the form of dividends from Transit and Contract Services based upon the separate liability of each segment, but limited to the consolidated liability. The benefit of consolidation, if any, upon the current liability is shared ratably between Transit and Contract Services. Note 10- Pension Plans and Other Post-retirement Benefits Pension Plans Transit sponsors a noncontributory defined benefit pension plan that covers full-time Transit employees. Benefits are based on years of service and compensation during the five highest consecutive years of earnings before retirement. The Company's policy is to fund actuarially determined amounts adequate to meet future benefit payment requirements. At December 31, 1993, plan assets consisted of U.S. government and corporate bonds, listed stocks, and cash equivalents. Net pension cost for the Company's defined benefit pension plan included the following components: The funded status and amount recognized in the Consolidated Balance Sheets at December 31, 1993 and 1992 were as follows (in thousands): The discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% and 8.5% at December 31, 1993 and 1992, respectively. The rate of future compensation increases used was 5% and 6% at December 31, 1993 and 1992, respectively. The weighted average expected long-term rate of return on plan assets in 1993, 1992, and 1991 was 9.0%. Contract Services sponsors a defined contribution profit sharing plan covering substantially all full-time employees. Contributions to this plan are made by Contract Services based upon a discretionary contribution formula. Contract Services expensed $170,000 and $350,000 in connection with this plan in 1993 and 1992, respectively. No amount was expensed in 1991. Other Postretirement Benefit Plans Effective April 1, 1992, the Company adopted SFAS 106. In accordance with SOP 90-7, the cumulative effect of the accounting change was recognized as a $3.0 million reduction in shareholders' investment ($.24 per share). In prior years, the Company had recognized the expense related to these benefits as they were paid. As the effect on net income of adopting SFAS 106 was not significant, postretirement benefit cost for prior periods has not been restated. The Company's contributory defined benefit postretirement plans make available health and life insurance benefits to the majority of the Company's retirees and their eligible dependents. The postretirement plans are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles and co-insurance. Eligibility for these benefits is based upon retirement from the Company as well as those retirees having met certain age and vesting service requirements. The Company provides contributions to the plan as necessary to fund the plan's current benefits and expenses. Net postretirement benefit expense for the Company included the following components for the year ended December 31, 1993 and the nine months ended December 31, 1992 (in thousands): The funded status and amounts recognized in the Consolidated Balance Sheets for the Company's defined benefit postretirement plans at December 31, 1993 and 1992, were as follows (in thousands): For measurement purposes, the weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% in 1993 and 8.5% in 1992. The Company's health care cost trend rate is 11% for 1994 and is assumed to gradually decrease to approximately 8% by the year 2000 and remain approximately at that level thereafter. If these trend rates were to be increased by one percent each year, the December 31, 1993, accumulated postretirement benefit obligation would increase by $1.1 million and the aggregate of the service and interest cost components of 1993 annual expenses would increase by $166,000. Note 11- Commitments and Contingencies During 1993, the Company agreed to a settlement of two class action lawsuits which had been filed against it in 1986 and 1989 on behalf of the shareholders of Old Mayflower. The complaints had alleged that the directors of Old Mayflower had breached their fiduciary obligation by entering into the Merger, discussed in Note 2. The Company and other defendants in these suits believe the plaintiffs' claims to be without merit. Because of the costs associated with defending these actions, however, the Company agreed to settle the two lawsuits. The settlement is subject to approval by the courts. The maximum amount of the settlement will be $1.5 million, net of approximately $600,000 contributed by the Company's insurance carrier. The Company will pay approximately $100,000 in cash, and the remainder, not to exceed $1.4 million, in the form of unsecured subordinated notes which mature in ten years. Contract Services and Transit become involved from time to time in various actions that are incidental to the ordinary course of their businesses, including property damage and personal injury claims. Management believes that the disposition of these matters will not have a material adverse effect on the financial position of the Company. The Company has guaranteed aggregate rental and certain residual values under various leasing arrangements entered into by the Company's subsidiaries. It also has guaranteed the collection of certain installment notes receivable, which were sold by Transit's equipment sales and financing subsidiary. The contingent liability resulting from these guarantees totaled approximately $44.9 million at December 31, 1993. The Company has a right to property and equipment which serves as collateral against these contingent obligations that, the Company believes, would substantially offset any potential obligation. The Company's operating subsidiaries lease certain transportation equipment and warehouse facilities, as well as data processing and other office equipment. Generally, these leases require the Company's operating subsidiaries to pay maintenance and insurance costs. There are no significant capital leases. Total rent expense was $25.8 million, $23.9 million, and $22.7 million for 1993, 1992, and 1991, respectively. Future minimum lease payments on noncancellable operating leases are as follows (in thousands): 1994 $ 22,076 1995 18,562 1996 14,088 1997 5,961 1998 2,074 Thereafter 1,753 ---------- $ 64,514 ========== At December 31, 1993, the Company has committed to approximately $19.4 million in capital purchases during 1994. This includes $15.0 million, or 159 units, for school and transit buses by Contract Services and $4.4 million for 175 trailers by Transit. Note 12- Segments of Business Contract Services engages in passenger transportation service businesses, primarily contract public school busing and, to a lesser extent, municipal transit and paratransit contracting. Transit primarily operates as a common carrier and a contract carrier under ICC authority, engaging in the shipment and storage of household goods, electronic, trade show, and other commercial products for individual and corporate customers. Other operations sell and finance transportation equipment to Transit's agents and owner-operators, and sell and underwrite commercial lines of insurance coverage. Operating profit represents operating revenue less operating expenses. In computing operating profit, interest expense, purchase fee on receivables sold, gains on the sale of property and equipment (other than sales of new and used buses) and federal income taxes have not been included. Corporate assets primarily include deferred debt costs, prepaid federal income taxes and cash. Both Contract Services and Transit operate throughout the United States with no significant geographic emphasis. No single customer accounts for 10% or more of the consolidated operating revenues, and export sales to foreign unaffiliated customers are immaterial to consolidated operating revenues. Note 13- Related Party Transactions Four directors of the Company, prior to its reorganization, were associated with firms that are shareholders of the Company and which provided financial services in relation to the Merger and Plan of Reorganization. The Company incurred fees of $871,000 during 1991 related to services provided by those firms. No fees were incurred in 1993 and 1992. (b) Reports on Form 8-K: The Registrant filed no reports on Form 8-K in 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. MAYFLOWER GROUP, INC. By: /s/ Michael L. Smith Michael L. Smith, Chairman, 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 this 30th day of March, 1994. Signature Title 1. Principal Executive Officer /s/ Michael L. Smith Chairman, President, Chief Executive Officer and Director 2. Principal Financial Officer /s/ Patrick F. Carr Senior Vice President, Chief Financial Officer and Treasurer 3. Principal Accounting Officer /s/ Ronald W. Martin Vice President and Chief Accounting Officer 4. Non-employee Directors /s/ Roderick M. Hills Director /s/ Perry J. Lewis Director /s/ Lary R. Scott Director /s/ Sheldon M. Stone Director S-1 S-4

25232_1993.txt

25232_1993

1993

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ITEM 1. BUSINESS CORPORATE PROFILE Cousins Properties Incorporated (the "Registrant" or "Cousins") is a Georgia corporation, which since 1987 has elected to be taxed as a real estate investment trust ("REIT"). Cousins Real Estate Corporation ("CREC"), a taxable entity consolidated with the Registrant, owns, develops, leases, and manages a portion of the Company's real estate portfolio. Cousins/New Market Development Company, Inc. ("CNM") is a subsidiary of CREC which develops retail shopping centers. The Registrant, together with CREC, CNM and CREC's other consolidated entities, is hereafter referred to as the ("Company"). Cousins is an Atlanta-based, fully integrated equity real estate investment trust. The Company has extensive experience in the real estate industry, including the acquisition, financing, development, management and leasing of properties. Cousins has been a public company since 1962, and its common stock trades on the New York Stock Exchange. The Company owns a portfolio of well located, high-quality retail and office developments and holds several tracts of strategically located undeveloped land. The Company's holdings are concentrated in the southeastern United States, primarily in the Atlanta area. The strategies employed to achieve the Company's investment goals include the acquisition of quality income producing properties at attractive prices; the development of properties which are substantially precommitted to quality tenants; maintaining high levels of occupancy within owned properties and the selective sale of assets. The Company also seeks to be opportunistic and take advantage of normal real estate business cycles. BRIEF DESCRIPTION OF COMPANY INVESTMENTS Presently, the Company owns, directly and indirectly, equity interests of at least 50% in eight high-quality commercial office buildings, primarily in the Atlanta, Georgia area, with aggregate rentable space of approximately 3.7 million square feet (4.2 million gross square feet). The Company also owns a 9.8% interest in and manages a 1.2 million square foot building in Atlanta, Georgia. The Company believes that its portfolio of commercial office buildings is currently the largest (measured by leasable area) in the southeastern United States held by any publicly-traded REIT. The weighted average leased percentage of the eight 50% or more owned buildings was approximately 87% as of March 15, 1993. The leases at these major office properties expire as follows: (a) Includes 130,847 square feet and 63,688 square feet of leases which expire in 1995 and 1998, respectively, only if significant cancellation penalties are paid. Otherwise, the leases expire 5 years later than shown in the above table. All of the Company's major office tenant leases in these buildings provide for pass through of operating expenses, and base rents which escalate over time. The Company also owns the land under and leasehold mortgage note on a 188,000 square foot office building used as a training facility which has a book value of $18 million. The training facility, which was developed by Cousins, is located in Wildwood Office Park, and is 100% leased to International Business Machines Corporation ("IBM") through November 1998. Under terms of this note and land lease, the Company is expected to receive substantially all of the building's cash flows (see Note 3 of "Notes to Consolidated Financial Statements"). On March 10, 1994, the Company purchased two mortgage notes for $28 million from the Resolution Trust Corporation which are secured by a 250,000 square foot office building in Washington, D.C. The terms of these two notes have some of the characteristics of an equity investment, and should provide a comparable return on investment (see Note 11 of "Notes to Consolidated Financial Statements"). In the retail area, which is the primary focus of the Company's current development activity, the Company's holdings include a 50% interest in a regional mall (currently being expanded), a 100% interest in two retail power centers, and an 82.3% interest in a third retail power center (two of which power centers were under construction at December 31, 1993). All of the Company's retail power centers are significantly preleased to anchor tenants with lease terms of 15 years or more, pass through of operating expenses, and base rents which escalates over time. The Company's other real estate holdings include equity interests in approximately 600 acres of strategically located land held for investment and future development, and $40 million of mortgage notes receivable guaranteed by the AT&T Master Pension Trust which mature on June 21, 1994. The $40 million of mortgage notes were consideration received from the sale of several retail mall properties in 1984. The Company's joint venture partners include IBM and affiliates of The Coca-Cola Company ("Coca-Cola"), NationsBank Corporation ("NationsBank"), Corporate Property Investors, Odyssey Partners, L.P., Temple-Inland Inc., Dutch Institutional Holding Company ("DIHC"), and American General Corporation The success of the Company's operations is dependent upon such unpredictable factors as the availability of satisfactory financing; general and local economic conditions; the activity of others developing competitive projects; and zoning, environmental impact, and other government regulations. Refer to Item 2 ITEM 2. PROPERTIES TABLE OF MAJOR PROPERTIES The following tables set forth certain information relating to office and retail properties, stand alone retail lease sites, and land held for investment and future development in which the Company has a 50% or greater ownership interest. All information presented is as of December 31, 1993, except percentage leased which is as of March 15, 1994. Dollars are stated in thousands. (1) Cost as shown in the accompanying table includes deferred leasing and financing costs and other related assets. For each of the following projects: 2300 and 2500 Windy Ridge Parkway, 3200 Windy Hill Road, Wildwood Stand Alone Retail Lease Sites and North Point Market, the cost shown is what the cost would be if the venture's land cost were adjusted downward to the Company's lower basis in the land it contributed to the venture. (2) Adjusted cash flows from operating activities represents cash flows from operating activities excluding changes in other operating assets and liabilities. (3) Floating rates range between .75% and 1% over Federal Funds rate; Federal Funds rate averaged 2.96% for the month of December 1993. (4) Actual tenant or venture partner is affiliate of entity shown. (5) Includes $322,000 of deferred rent from a tenant who had occupied 8% of the building, but whose lease expired December 31, 1993. This space is currently being marketed to prospective tenants. (6) The System Works, Inc. lease began in January 1994 and is expected to generate cash flows from operating activities of approximately $400,000 on an annualized basis. The lease contains options to expand to 100% of the building over the next several years. This building was unoccupied during 1993. (7) The joint venture's indebtedness was fully repaid with the proceeds of the October 1993 common stock offering and with matching funds contributed by the Company's venture partner. (8) This anchor tenant owns its own space. (9) Computer Associates, Equifax, and The Systems Works, Inc. have the right to terminate their leases in 1995, 1995 and 1998, respectively, upon payment of significant cancellation penalties. (10) Maturity extendible to December 31, 2008. Rate becomes floating after November 30, 2001. (11) Summit Green and a portion of the Haywood Mall parking lot are subject to long-term ground leases. (12) Perimeter Expo became operational for financial reporting purposes on December 1, 1993. Thus, cash flows from operating activities before debt service reported for Perimeter Expo represent one month of operations. Cash flows from operating activities before debt service are expected to be approximately $2.8 million on an annualized basis when the center becomes fully operational. (13) Project was under construction as of December 31, 1993. Lease expiration dates are based upon estimated commencement dates. Final project size may vary from that shown based on how much of the unleased space is actually constructed. (14) Approximately 10 acres of these sites were generating cash flows from operating activities at December 31, 1993, of which 4 acres became operational in the second half of 1993. Three of the remaining four acres are leased to a tenant whose rental commencement date begins no later than June 1, 1994, at which time cash flows from operating activities before debt service from the 13 leased acres will be approximately $1.0 million on an annualized basis. The remaining acre is currently being marketed to prospective tenants. (15) North Point Market includes approximately 8 acres being developed as stand alone retail sites which are being ground leased to tenants. (16) Presidential Market excludes approximately 6 acres being developed as stand alone retail sites held for sale or lease to tenants, which costs are included in Land Held for Investment and Future Development. (17) Rentals have commenced on only six acres of the GA Highway 400 Property, and those rentals commenced during the fourth quarter of 1993. To date leases have been signed for approximately 5 additional acres, with the lease commencements for these 5 acres ranging from the second to the third quarter of 1994. Leases on the 11 leased acres will generate cash flows from operating activities before debt service of over $550,000 per year. The remaining acres are currently being marketed to prospective tenants. LAND HELD FOR INVESTMENT AND FUTURE DEVELOPMENT (1) Based upon management's estimates. (2) For the portion of the Wildwood Office Park land and Midtown Atlanta land owned by joint ventures, the cost shown is what the cost would be if the venture's land cost were adjusted downward to the Company's lower basis in the land it contributed to the venture. For the 50%-owned Wildwood Office Park land, the adjusted cost excludes building predevelopment costs of $1,317,000. (3) The Georgia Highway 400 property is located both east and west of Georgia Highway 400. Currently, only the land which is located east of Georgia Highway 400 is being developed. This land surrounds North Point Mall, a 1.3 million square foot regional mall on a 100 acre site which the Company sold in 1988 to a joint venture of Homart Development Co. and JMB/Federated Realty Associates, Ltd. (4) This note bears interest at 8.5% and amortizes in equal monthly installments through October 1997. There is a 15% penalty for prepayment of this loan. (5) Joint venture partner is an affiliate of the entity shown. (6) Temco Associates has an option through March 2006, with no carrying costs, to acquire approximately 35,000 acres in Paulding County, Georgia (northwest of Atlanta, Georgia), of which approximately 13,000 acres would be a fee simple interest and approximately 22,000 acres would be a timber rights interest only. The option may be exercised in whole or in part over the option period. Temco Associates has also engaged in certain sales of land as to which it simultaneously exercised its purchase option. During 1993, approximately 1,100 acres of the option related to the fee simple interest was exercised and simultaneously sold for gross profits of $305,000. (7) The Company has entered into a contract for sale of the Peachtree Road property for $4.8 million net proceeds to the Company. The buyer has deposited a $700,000 non-refundable deposit under the contract, and is scheduled to close the sale by the second quarter of 1994. If the sale closes as contemplated, the Company will recognize a gain of $3.1 million on the transaction. MAJOR OFFICE AND RETAIL PROPERTIES General. This section describes the major operating properties in which the Company has an interest either directly or indirectly through joint venture arrangements. A "negative investment" in a joint venture results from distributions of capital to the Company, if any, exceeding the sum of (i) the Company's contributions of capital and (ii) reported earnings (losses) of the joint venture allocated to the Company. "Investment" in a joint venture means the book value of the Company's investment in the joint venture. Wildwood Office Park. Wildwood Office Park, a Class A commercial development in suburban Atlanta, was master planned by I.M. Pei. Located in Atlanta's northwest commercial district, just north of the Interstate 285/Interstate 75 intersection, the property features convenient access to all of Atlanta's major office, commercial and residential districts. The Wildwood complex overlooks the Chattahoochee River and borders 1,200 acres of national forest, thus providing an urban office facility in a forest setting. Developments in Wildwood Office Park include the 3200 Windy Hill Road Building (681,000 rentable square feet), the 2300 Windy Ridge Parkway Building (634,000 rentable square feet) and the 2500 Windy Ridge Parkway Building (313,000 rentable square feet). At December 31, 1993, these three buildings were 93%, 95% and 83% leased, respectively. IBM has been a major tenant in these three buildings, leasing approximately 813,000 square feet, or approximately 50% of the rentable square feet. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Additional Prospective Information." Wildwood Office Park also contains 13 acres leased to two banking facilities and four restaurants (one of which is currently under construction); an additional one acre retail site currently being marketed to prospective users, and a child care facility. The 3200 Windy Hill Road Building was financed primarily with equity, and at December 31, 1993 had $9.7 million outstanding debt related to it. The 2300 Windy Ridge Parkway Building and the 2500 Windy Ridge Parkway Building were financed primarily with debt and, at December 31, 1993, had $82 million and $31.5 million of outstanding debt related to them, respectively. The developments described above are located on land controlled by Wildwood Associates, a joint venture between the Company and IBM formed in 1985. The Company and IBM each have a 50% interest in Wildwood Associates. Wildwood Associates also controls approximately 53 acres in Wildwood Office Park held for future development, which is composed of a 6 acre site with a restaurant and approximately 58,000 square feet of office space which was purchased in 1986 for future development, and 47 acres of other land to be developed (see "Land Held for Investment - Wildwood Office Park"). At December 31, 1993, the Company's investment in Wildwood Associates and a related partnership (see "Summit Green") was approximately $4,867,000, which included the cost of the land the Company is committed to contribute to Wildwood Associates. In addition, the Company has severally guaranteed one-half of a $50,000,000 bank line of credit to Wildwood Associates related to the 3200 Windy Hill Road Building, under which, as noted above, $9.7 million was drawn at December 31, 1993. Wildwood Office Park also contains the 3301 Windy Ridge Parkway Building, a 106,000 rentable square foot office building located on approximately 5 acres which is wholly owned by the Company. Commencing January 1994, a single tenant leased approximately 60% of this building. The lease has options permitting the tenant to expand its occupancy to the remainder of the building over the next several years. In addition, the 3100 Windy Hill Road Building, a 188,000 rentable square foot corporate training facility occupies a 13-acre parcel of land which is wholly owned by the Company. The training facility improvements were sold in 1983 to a limited partnership of private investors, at which time the Company received a leasehold mortgage note. The training facility land was simultaneously leased to the partnership for thirty years, along with certain equipment for varying periods. The training facility was 100% leased by the partnership to IBM through November 1993. In January 1993, the IBM lease was extended through November 30, 1998. Concurrently with the IBM extension, the mortgage note and related leases were also modified (see Note 3 of "Notes to Consolidated Financial Statements"). NationsBank Plaza. NationsBank Plaza is a Class A, 55-story, 1.3 million rentable square foot office tower designed by Kevin Roche and is located on approximately 3.7 acres of land between the midtown and downtown districts of Atlanta, Georgia. The building, which was completed in 1992, was approximately 80% leased at December 31, 1993. An affiliate of NationsBank, the fourth largest bank in the United States, leases 46% of the rentable square feet. NationsBank Plaza was developed by CSC Associates, L.P. ("CSC"), a joint venture formed by the Company and C&S Premises, Inc., an affiliate of NationsBank. The Company and C&S Premises, Inc. each have a 50% interest in CSC. In October 1993, the partnership fully repaid all of its debt with equity contributions of $86.7 million made by each partner. At December 31, 1993, the Company's investment in CSC was approximately $106,759,000. The Company has guaranteed one-half of a $20,000,000 bank line of credit under which there was no outstanding balance at December 31, 1993. CSC's net income or loss and cash distributions are allocated to the partners based on their percentage interests (50% each), subject to a preference to Cousins. The Cousins preference is $2.5 million (giving Cousins an additional $1.25 million over what it would otherwise receive), and accrues to Cousins, with interest at 9% to the extent unpaid, over the period February 1, 1992 through January 31, 1995. Following repayment of the partnership's debt in October 1993, Cousins began recognizing its accrued preference currently in income, which resulted in Cousins recognizing $874,000 in income over what it would have otherwise recognized in the year ended December 31, 1993. The partners have agreed that until cumulative retained earnings (before considering distributions) exceed zero, which should occur in 1994, distributions will be based on their percentage interests. Thereafter, Cousins will be distributed its preference, to the extent earned, with amounts above the preference amount distributed based on the partners' percentage interests. First Union Tower. First Union Tower is a Class A office building containing approximately 317,000 rentable square feet. The property is located on approximately one acre of land in downtown Greensboro, North Carolina. First Union Tower opened in the first quarter of 1990 and at December 31, 1993 was approximately 81% leased. First Union Tower is owned by North Greene Associates Limited Partnership ("North Greene Associates"), which was formed in 1987 as a joint venture of the Company and Weaver Downtown Limited Partnership. The Company has an 85% ownership interest in North Greene Associates, and accounts for it as a consolidated entity. At December 31, 1993, the Company had a demand loan outstanding to the partnership of $28,051,000. The Company's demand loan to the partnership was used to pay down to $3,500,000 the outstanding balance of a first mortgage bank line of credit on this property. The Company has guaranteed 27.3% of the bank line of credit. One Ninety One Peachtree Tower. One Ninety One Peachtree Tower is a 50-story, Class A office tower located in downtown Atlanta, Georgia that was completed in December 1990. One Ninety One Peachtree Tower, which contains 1.2 million rentable square feet, was designed by John Burgee Architects, with Phillip Johnson as design consultant. One Ninety One Peachtree Tower was developed on approximately 2 acres of land, of which approximately 1.5 acres is owned and approximately one-half acre under the parking facility is leased for a 99-year term expiring in 2088 with a 99-year renewal option. One Ninety One Peachtree Tower was approximately 90% leased at December 31, 1993. C-H Associates, Ltd. ("C-H Associates"), a partnership formed in 1988 between CREC (49%), Hines Peachtree Associates Limited Partnership (49%) and Peachtree Palace Hotel, Ltd. (2%), owns a 20% interest in the partnership that owns One Ninety One Peachtree Tower. C-H Associates' 20% ownership of One Ninety One Peachtree Tower results in an effective 9.8% ownership interest by CREC in the One Ninety One Peachtree Tower project. The balance of the One Ninety One Peachtree Tower project is owned by DIHC Peachtree Associates, an affiliate of DIHC. Through C-H Associates, CREC received 50% of the development fees from the One Ninety One Peachtree Tower project. In addition, CREC owns a 50% interest in two general partnerships which receive fees from leasing and managing the One Ninety One Peachtree Tower project. The One Ninety One Peachtree Tower project was funded substantially by debtuntil March 1993, at which time DIHC Peachtree Associates contributed equity in the amount of $145,000,000. Subsequent to the equity contribution, C-H Associates is entitled to a priority distribution of $250,000 per year (of which the Company is entitled to receive $112,500) for seven years beginning in 1993. The equity contributed by DIHC Peachtree Associates is entitled to a preferred return at a rate increasing over the first 14 years from 5.5% to 11.5% (payable after the Company's priority return). Thereafter, the partners will share in any distributions in accordance with their percentage interests. At December 31, 1993, the Company had a negative investment of $90,000 in the One Ninety One Peachtree Tower project. Ten Peachtree Place. Ten Peachtree Place is a 20-story, 259,000 rentable square foot Class A office building located in midtown Atlanta, Georgia. Completed in 1991, this structure was designed by Michael Graves and is currently 100% leased to Coca-Cola. Approximately four acres of adjacent land, currently used for surface parking, are available for future development. Ten Peachtree Place is owned by Ten Peachtree Place Associates, a general partnership between the Company (50%) and a wholly owned subsidiary of Coca-Cola (50%). Ten Peachtree Place Associates acquired the property in 1991 for a nominal cash investment, subject to a ten-year purchase money note. This 8% purchase money note had an outstanding balance of $22.3 million at December 31, 1993. If the purchase money note is paid in accordance with its terms, it will amortize to approximately $15.3 million ($59 per rentable square foot) over the ten-year term of the Coca-Cola lease, at which time Coca-Cola is entitled to receive the preferred return described below and the property may be sold, re-leased, or returned to the lender under the purchase money note for $1.00 without penalty or any further liability to the Company for the indebtedness. At December 31, 1993, the Company had a negative investment in Ten Peachtree Place Associates of $66,000. The Company anticipates that Ten Peachtree Place Associates will generate approximately $400,000 per year of cash flows from operating activities net of note principal amortization during the ten-year lease. The partnership agreement generally provides that each of the partners is entitled to receive 50% of cash flows from operating activities net of note principal amortization (excluding any sale proceeds) for ten years, after which time the Company is entitled to 15% of cash flows (including any sale proceeds) and its partner is entitled to receive 85% of cash flows (including any sale proceeds), until the two partners have received a combined distribution of $15.3 million, after which time each partner is entitled to receive 50% of cash flows (including any sale proceeds). Summit Green. Summit Green, a 21-acre office park located in Greensboro, North Carolina, is owned by Wildwood Associates (the partnership with IBM) and a related partnership. The park contains a 135,000 rentable square foot mid-rise office building which was 100% leased at March 15, 1994. The Summit Green land is leased from an unrelated third party for a 99-year term expiring in 2084. Space exists for two additional office buildings, but the Company has no plans to commence additional development without prior leasing commitments. Haywood Mall. Haywood Mall, a 942,000 square foot enclosed regional shopping center located 5 miles southeast of downtown Greenville, South Carolina, was developed by the Company and opened in 1980. Haywood Mall Associates, a joint venture formed in 1979 by the Company and Bellwether Properties of South Carolina, L.P., an affiliate of Corporate Properties Investors, owns approximately 270,000 rentable square feet of shop space in the mall. The balance of the mall, approximately 672,000 square feet, is owned by four major department stores (Sears, Roebuck & Co., J.C. Penney, Rich's and Belk). The portion of Haywood Mall owned by Haywood Mall Associates was developed on approximately 19 acres of land, of which approximately 16 acres is owned and approximately 3 acres (of parking area) is leased under a ground lease expiring in 2067. The portion of Haywood Mall owned by the joint venture was approximately 98% leased to approximately 107 tenants as of December 31, 1993 and has been at least 90% leased since 1986. The Company has a 50% interest in Haywood Mall Associates. The Company originally had only a nominal cash investment, but funded an aggregate of $2.8 million in 1988 through 1990 as its 50% share of capital improvements made to the mall, including a new food court area. At December 31, 1993 the Company's investment was $323,000. Haywood Mall Associates has announced an expansion of the mall to be completed by mid-1995. The expansion will include the addition of approximately 70,000 square feet of new mall shops owned by the venture, a Dillard's department store, and an expansion of the Belk-Simpson department store. The venture intends to fund the expansion, as well as the prepayment of an existing 9.37% first mortgage in May 1994, with equity contributions of approximately $22 million from each venturer. Perimeter Expo Associates, L.P. In June 1993, Perimeter Expo Associates, L.P. (90% owned by Cousins and 10% owned by CNM) purchased the land for and began construction of this retail power center adjacent to Perimeter Mall in Atlanta, Georgia. Perimeter Expo features a new concept called The Home Depot Expo, which was separately developed by The Home Depot as an upscale interior design center. Perimeter Expo contains approximately 295,000 square feet, of which approximately 178,000 square feet are owned by the Company and the balance of the center, 117,000 square feet, owned by The Home Depot. The center opened in November 1993 and became operational for financial reporting purposes on December 1, 1993. North Point Market Associates, L.P. In September 1993, the Georgia Highway 400 land owned through Spring/Haynes Associates (see Note 5 of "Notes to Consolidated Financial Statements") was distributed to its partners, with each partner concurrently recontributing certain acres of the land to a new venture, North Point Market Associates, L.P. (owned 82.3% by Cousins and 17.7% by an affiliate of Coca-Cola). Additionally, Cousins contributed certain acres of its wholly owned Georgia Highway 400 land to the new venture. The venture is constructing North Point Market, a retail power center adjacent to North Point Mall, which will have 314,000 square feet in Phase I. The center also includes six outparcels that are being ground leased to freestanding users. Phase I will open in the spring of 1994. Presidential Market. In October 1993, construction commenced on Presidential Market, an approximately 310,000 square foot retail power center, located in northeast suburban Atlanta. The Company will own approximately 194,000 square feet of the center (depending upon how much of the unleased space is actually constructed), with the remaining 116,000 square feet being separately developed as a Target which is owned by Dayton Hudson Corporation. The center is scheduled to open in the fall of 1994. Georgia Highway 400 Stand Alone Retail Sites. In September 1993, the Company transferred to Operating Properties the carrying value of 32 acres of the land the Company owns at the intersection of Georgia Highway 400 and Haynes Bridge Road in suburban Atlanta, Georgia surrounding North Point Mall. This land is being ground leased in 1 to 2 acre sites to freestanding users. The remaining 308 developable acres is discussed below in Land Held for Investment and Future Development. LAND HELD FOR INVESTMENT AND FUTURE DEVELOPMENT The following describes significant land holdings owned directly by the Company or indirectly through joint venture arrangements. The Company intends to convert its land holdings to income-producing usage or to sell portions of land holdings as opportunities present themselves over time. Wildwood Office Park. Wildwood Office Park consists of approximately 289 acres of land in suburban Atlanta, Georgia which is zoned for office, institutional, and commercial use. Approximately 104 acres in the park are owned by, or committed to be contributed to, Wildwood Associates, including approximately 53 acres of land held for future development. See "Major Operating Properties - Wildwood Office Park." The Company owns 100% of the balance of the developable land of which approximately 151 acres are available for future development. Utilities are available at the site, and over 7 million additional gross square feet of office and commercial space are planned for the park. The Company has no plans to commence additional office development without prior leasing commitments. Georgia Highway 400 Property. In addition to the stand alone retail sites discussed above, the Company owns 100% of approximately 308 developable acres and 82.3% of 14 developable acres at the intersection of Georgia Highway 400 and Haynes Bridge Road in suburban Atlanta, Georgia. The Company previously sold 100 acres of its holdings in 1988 to a joint venture of Homart Development Co. and JMB/Federated Realty Associates, Ltd. This joint venture constructed North Point Mall, a 1.3 million square foot regional mall which opened in October 1993. The Company believes the construction of North Point Mall has significantly enhanced the value of its Georgia Highway 400 land. Of the Company's land, approximately 92 acres of the land located on the east side of Georgia Highway 400 are zoned for mixed-use development including retail and office space. Approximately 230 acres of the land are located on the west side of Georgia Highway 400 and are zoned for office, institutional and light industrial use. Spring/Haynes Associates. This general partnership was formed in 1985 between the Company and a wholly owned subsidiary of Coca-Cola, each as 50% general partners, to jointly own and develop real estate. The Company contributed 40 acres of undeveloped land at Georgia Highway 400 and Haynes Bridge Road in north central suburban Atlanta, Georgia. Coca-Cola contributed 11 acres of property in midtown Atlanta. In September 1993, the undeveloped land at Georgia Highway 400 was distributed to the partners who concurrently recontributed certain areas of the land into North Point Market Associates, L.P., a consolidated partnership formed between the partners. The Company's remaining investment in Spring/Haynes Associates is $1,571,000 at December 31, 1993. Hickory Hollow. Hickory Hollow Associates is a partnership formed in 1975 between the Company and American General Realty Investment Corporation, an affiliate of American General Corporation (an insurance company). CREC has a 50% interest in Hickory Hollow Associates. Hickory Hollow Associates owns approximately 19 acres of land held for sale near Hickory Hollow Mall, an enclosed regional shopping center approximately 12 miles southeast of downtown Nashville, Tennessee which was developed by the Company. The venture sold 2 acres of this land in 1993 for a gross profit of $375,000. The venture's holdings originally included the shopping center and approximately 236 adjacent acres, with all but the remaining acres sold in prior years. The Company's investment in Hickory Hollow Associates at December 31, 1993 was $104,000. Additional Land Holdings. The Company owns approximately 9 acres on Peachtree Road in the Buckhead area of Atlanta, Georgia zoned for multifamily use and approximately 2 acres on Peachtree Street in the Pershing Point area of Atlanta, Georgia zoned for office and commercial use. In addition, the Company owns approximately 38 acres in west Cobb County, Georgia which is zoned for retail, commercial and office development uses. The Company has entered into a contract for sale of the Peachtree Road property for $4.8 million net proceeds to the Company. The buyer has deposited a $700,000 non-refundable deposit under the contract, and is scheduled to close the sale by the second quarter of 1994. If the sale closes as contemplated, the Company will recognize a gain of $3.1 million on the transaction. Temco Associates. Temco Associates was formed in March 1991 as a partnership between CREC (50%) and a subsidiary of Temple-Inland Inc. (50%). Temco Associates has an option through March 2006, with no carrying costs, to acquire approximately 35,000 acres in Paulding County, Georgia (northwest of Atlanta, Georgia), of which approximately 13,000 acres would be a fee simple interest and approximately 22,000 acres would be a timber rights interest only. The option may be exercised in whole or in part over the option period. The Temco Associates property has the potential for future residential and industrial development. Temco Associates has also engaged in certain sales of land as to which it simultaneously exercised its purchase option. During 1993, approximately 1,100 acres of the option related to the fee simple interest was exercised and simultaneously sold for gross profits of $305,000. OTHER REAL PROPERTY INVESTMENTS Omni Norfolk Hotel. Norfolk Hotel Associates ("NHA") is a general partnership formed in 1978 between the Company and an affiliate of Odyssey Partners, L.P. (an investment partnership), each as 50% partners, which held a mortgage note on and owned the land under the 442-room Omni International Hotel in downtown Norfolk, Virginia. In January 1992, NHA terminated the land lease and became the owner of the hotel and a long-term parking agreement with an adjacent building owner. The partnership is currently receiving cash payments of approximately $400,000 per year (subject to annual increases) under the parking agreement. In April 1993, the partnership sold the hotel, but retained its interest in the parking agreement. The Company's share of the gain on this transaction was approximately $.5 million and is included in Income From Joint Ventures in the Consolidated Statements of Income. The partnership received a mortgage note for a portion of the sales proceeds. At December 31, 1993, the Company had an investment of $830,000 in NHA. The Company has also guaranteed a $4.85 million line of credit to NHA under which $1,000 had been drawn at December 31, 1993, and its partner has guaranteed an equal line of credit under which $4.625 million had been drawn at December 31, 1993. Additionally, NHA has a $4.75 million line of credit, payable upon demand to the Company under which $4.624 million had been drawn at December 31, 1993. The line bears interest at the daily Federal funds rate plus 75 basis points with payments of interest only until the maturity date of November 1, 1994. This line of credit is being used by the Company for temporary investment of excess cash. NHA used the cash to temporarily pay down the bank line of credit which the Company guarantees. Dusseldorf Joint Venture. In 1992, Cousins entered into a joint venture agreement for the development of a 133,000 rentable square foot office building in Dnsseldorf, Germany which is 34% preleased to IBM. Cousins' venture partners are IBM and Multi Development Corporation International B.V. ("Multi"), a Dutch real estate development company. In December 1993, the building was presold to an affiliate of Deutsche Bank. CREC and Multi will jointly develop the building, with CREC receiving fees of approximately $1.3 million ratably over the development period of January 1994 through June 1995. In addition, the Company will recognize 30% of the venture's profit or 50% of the venture's loss. Due to the Company's continuing involvement in the project (see Notes 4 and 5 of "Notes to Consolidated Financial Statements"), all fees and profits are being deferred until the project's completion and leaseup. Kennesaw Crossings. The Company owns Kennesaw Crossings, a shopping center in suburban Atlanta, Georgia. Kennesaw Crossings is a 116,000 square foot shopping center constructed in 1974 located on 14 acres of land leased from an unrelated party through 2068. The Company's net carrying value in Kennesaw Crossings as of December 31, 1993 was $1.3 million. Air Rights and Other Property Near the CNN Center. The Company owns a leasehold interest in the air rights over the approximately 365,000 square foot CNN Center parking facility in Atlanta, Georgia, adjoining the world headquarters of Turner Broadcasting System, Inc. and Cable News Network. The air rights are developable for additional parking or office use. The Company's net carrying value of this property is $0. The Company also owns 0.8 acres of additional land proximate to the CNN Center which is currently being used for surface parking and has a net carrying value of $398,000. Residential Lots Under Development. In October 1993, CREC purchased 38 acres in northwest suburban Atlanta, Georgia which is being developed as residential lots. In January 1994, an additional 81 acres in northeast suburban Atlanta, Georgia was purchased for residential lot development. ITEM 3. ITEM 3. LEGAL PROCEEDINGS No material legal proceedings are presently pending by or against 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 during the fourth quarter of the Registrant's fiscal year ended December 31, 1993. ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT The Executive Officers of the Registrant as of the date hereof are as follows: Relationships: There are no family relationships among the Executive Officers or Directors. Term of Office: The term of office for all officers expires at the annual directors' meeting, but the Board has the power to remove any officer at any time. Business Experience: Mr. Cousins has been the Chief Executive Officer of the Company since its inception. Mr. Patel has been Senior Executive Vice President of the Company since March 1991. He joined the Company in December 1982 and was Executive Vice President from March 1983 through February 1991. Mr. Berry has been Senior Vice President since joining the Company in September 1990. Prior to that he was Commissioner of the State of Georgia's Department of Industry, Trade and Tourism from 1983 to 1990. Mr. Charlesworth joined the Company in October 1992 and became Senior Vice President, Secretary, and General Counsel in November 1992. Prior to that he worked for certain affiliates of Thomas G. Cousins as Chief Financial Officer and Legal Counsel. Mr. DuPree joined the Company in October 1992 and became Senior Vice President in April 1993. Prior to that he was President of New Market Companies, Inc. and affiliates since 1984. Mr. Murphy has been Senior Vice President since joining the Company in December 1987. Mr. Overton has been Senior Vice President since joining the Company in September 1989. Prior to that he was employed by Hardin Construction Group, Inc. from 1972 to 1989, where he served as President from 1985 to 1989. Mr. Smith has been Senior Vice President since joining the Company in September 1993. Prior to that he was employed as the Chief Operating Officer and Senior Vice President of The John Akridge Company, an office development company headquartered in Washington, D.C. since 1978. Mr. Tartikoff has been Senior Vice President and Chief Financial Officer of the Company since February 1986. Mr. Wood has been a Senior Vice President of the Company since September 1992 and a Senior Vice President of Cousins Real Estate Corporation since January 1990. From January 1987 to November 1992, he was principally employed as President of Cousins Management, Inc. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The information concerning the market prices for the Registrant's common stock and related stockholder matters appearing under the caption "Market and Dividend Information" on page 38 of the Registrant's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information appearing under the caption "Five Year Summary of Selected Financial Data" on page 34 of the Registrant's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations which appears on pages 35 through 37 of the Registrant's 1993 Annual Report to Stockholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Notes to Consolidated Financial Statements of the Registrant and Report of Independent Public Accountants which appear on pages 19 through 34 of the Registrant's 1993 Annual Report to Stockholders are incorporated herein by reference. The information appearing under the caption "Selected Quarterly Financial Information (Unaudited)" on page 33 of the Registrant's 1993 Annual Report to Stockholders is incorporated herein by reference. Other financial statements and financial statement schedules required under Regulation S-X are filed pursuant to Item 14 of Part IV of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning the Directors and Executive Officers of the Registrant that is required by this Item 10, except that which is presented in Item X in Part I above, is included under the captions "Directors and Executive Officers of the Company" on pages 2 through 6 of the Proxy Statement dated March 29, 1994 relating to the 1994 Annual Meeting of the Registrant's Stockholders, and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the captions "Executive Compensation" on pages 6 through 12 of the Proxy Statement dated March 29, 1994 relating to the 1994 Annual Meeting of the Registrant's Stockholders is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information concerning security ownership of certain beneficial owners and management required by this Item 12 is included under the captions "Directors and Executive Officers of the Company" on pages 2 through 6 and "Principal Stockholders" on pages 15 through 16 of the Proxy Statement dated March 29, 1994 relating to the 1994 Annual Meeting of the Registrant's Stockholders, and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information concerning certain transactions required by this Item 13 is included under the caption "Certain Transactions" on pages 13 through 14 of the Proxy Statement dated March 29, 1994 relating to the 1994 Annual Meeting of the Registrant's 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 A. The following Consolidated Financial Statements of the Registrant, together with the applicable Report of Independent Public Accountants, are contained on pages 19 through 34 of the Registrant's 1993 Annual Report to Stockholders and are incorporated herein by reference: B. The following Report of Independent Auditors is incorporated as Exhibit 28 herein: Report of Independent Auditors on Haywood Mall Associates C. The following Combined Financial Statements, together with the applicable Report of Independent Public Accountants, of Wildwood Associates and Green Valley Associates II, joint ventures of the Registrant meeting the criteria for significant subsidiaries under the rules and regulations of the Securities and Exchange Commission, are filed as a part of this report. ITEM 14. CONTINUED D. The following Financial Statements, together with the applicable Report of Independent Auditors, of CSC Associates, L.P., a joint venture of the Registrant meeting the criteria for a significant subsidiary under the rules and regulations of the Securities and Exchange Commission, are filed as a part of this report. 2. Financial Statement Schedules The following financial statement schedules, together with the applicable report of independent public accountants are filed as a part of this report. ITEM 14. CONTINUED NOTE: 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. Item 14. Continued 3. Exhibits 3(a)(i) Articles of Incorporation of Registrant, as restated as of April 29, 1993, filed as Exhibit 4(a) to the Registrant's Form S-3 dated September 28, 1993, and incorporated herein by reference. 3(b) By-laws of Registrant, as amended and restated as of November 30, 1989, as further amended by Stockholders on April 30, 1990, and as further amended by the Stockholders on April 29, 1993, filed as Exhibit 4(b) to the Registrant's Form S-3 dated September 28, 1993, and incorporated herein by reference. 4(a) Dividend Reinvestment Plan as effective January 27, 1993, filed in the Registrant's Form S-3 dated March 31, 1993, and incorporated herein by reference. 10(a)(i) Cousins Properties Incorporated 1989 Stock Option Plan, filed as Exhibit A to the Registrant's Proxy Statement dated March 31, 1989 relating to the 1989 Annual Meeting of Registrant's Stockholders, and incorporated herein by reference. 10(a)(ii) Cousins Real Estate Corporation Stock Appreciation Right Plan, amended and restated as of March 15, 1993, filed as Exhibit to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10(a)(iii) Cousins Properties Incorporated Stock Appreciation Right Plan, dated as of March 15, 1993, filed as Exhibit 10(a)(iii) to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10(b)(i) Cousins Properties Incorporated Profit Sharing Plan as effective as of January 1, 1991, filed as Exhibit 10(b)(i) to the Registrant's Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10(b)(ii) Amendment Number One to the Cousins Properties Incorporated Profit Sharing Plan, effective as of January 3, 1993, filed as Exhibit 10(b)(ii) to the Registrant's Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. 10(b)(iii) Cousins Properties Incorporated Profit-Sharing Trust Agreement as effective as of January 1, 1991, filed as Exhibit 10(b)(ii) to the Registrant's Form 10-K for the year ended December 31, 1991, and incorporated herein by reference. 10(d) Land lease (Kennesaw) dated December 17, 1969, and an amendment thereto dated December 15, 1977, filed as Exhibit l0(d) to the Registrant's Form 10-K for the year ended December 31, 1980, and incorporated herein by reference. ITEM 14. CONTINUED 10(f) Cousins Properties Incorporated 1987 Restricted Stock Plan for Outside Directors, filed as Exhibit A to the Registrant's Proxy Statement dated March 27, 1987 relating to the 1987 Annual Meeting of Registrant's Stockholders, and incorporated herein by reference. 11 Schedule showing computations of weighted average number of shares of common stock outstanding as used to compute primary and fully diluted income per share for each of the five years ended December 31, 1993. 13 Annual Report to Stockholders for the year ended December 31, 1993. 22 Subsidiaries of the Registrant. 24(a) Consent of Independent Public Accountants (Arthur Andersen & Co.). 24(b) Consent of Independent Auditors (Ernst & Young). 28 Report of Independent Auditors on Haywood Mall Associates. (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. Cousins Properties Incorporated (Registrant) Dated: March 24, 1994 BY: ------------------- Peter A. Tartikoff Senior Vice President - Finance 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. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To the Stockholders of Cousins Properties Incorporated: We have audited in accordance with generally accepted auditing standards, the financial statements included in the Cousins Properties Incorporated annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated March 10, 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, Part (a)2.A. 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. Atlanta, Georgia March 10, 1994 SCHEDULE X COUSINS PROPERTIES INCORPORATED SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) (1) Includes amortization of deferred leasing costs, marketing expenses, financing costs, predevelopment rights, goodwill, and organization expenses SCHEDULE XI (Page 1 of 3) COUSINS PROPERTIES INCORPORATED AND CONSOLIDATED ENTITIES REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ in thousands) SCHEDULE XI (Page 2 of 3) COUSINS PROPERTIES INCORPORATED AND CONSOLIDATED ENTITIES REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ in thousands) SCHEDULE XI (Page 3 of 3) COUSINS PROPERTIES INCORPORATED AND CONSOLIDATED ENTITIES REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ in thousands) NOTES: (a) Reconciliations of total real estate carrying value and accumulated depreciation for the three years ended December 31, 1993 are as follows: (b) Initial cost was previously adjusted to reflect the following write-downs to state the properties at the then realizable value: (c) Other for the North Fulton Property includes $11,134 of transfers to Projects Under Construction and another category within Land Held for Investment and Future Development. SCHEDULE XII (Page 1 of 2) COUSINS PROPERTIES INCORPORATED AND CONSOLIDATED ENTITIES MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 ($ in thousands) SCHEDULE XII (Page 2 of 2) COUSINS PROPERTIES INCORPORATED AND CONSOLIDATED ENTITIES MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 ($ in thousands) NOTE: (a) Reconciliation of total carrying amounts of mortgage loans for the three years ended December 31, 1993 are as follows: REPORT OF INDEPENDENT PUBLIC ACCOUNTANT To the Partners of Wildwood Associates and Green Valley Associates II: We have audited the accompanying combined balance sheets of WILDWOOD ASSOCIATES (a Georgia general partnership) and GREEN VALLEY ASSOCIATES II (a North Carolina general partnership) as of December 31, 1992 and 1993, and the related combined statements of income, partners' capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the management of the partnerships. 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 Wildwood Associates and Green Valley Associates II as of 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. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14 are 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. Atlanta, Georgia March 10, 1994 WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II COMBINED BALANCE SHEETS DECEMBER 31, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these combined balance sheets. WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II COMBINED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these combined statements. WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II COMBINED STATEMENTS OF PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these combined statements. WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II COMBINED STATEMENTS OF CASH FLOWS (Note 9) FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these combined statements. WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1991, 1992 AND 1993 1. SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The Combined Financial Statements include the accounts of Wildwood Associates ("WWA") and Green Valley Associates II ("GVA II"), both of which are general partnerships. Cousins Properties Incorporated (together with its other consolidated entities hereinafter referred to as "Cousins") and International Business Machines Corporation ("IBM") each have a 50% general partnership interest in both partnerships. The financial statements of the partnerships have been combined because of the common ownership. The combined entities are hereinafter referred to as the "Partnerships." All transactions between WWA and GVA II have been eliminated in the Combined Financial Statements. COST OF PROPERTY CONTRIBUTED BY COUSINS: The cost of property contributed or committed to be contributed by Cousins was recorded by WWA based upon the procedure described in Note 3. Such cost was, in the opinion of the partners, at or below estimated fair market value at the time of such contribution or commitment, but was in excess of Cousins' historical cost basis. COST CAPITALIZATION: All costs related to planning, development and construction of buildings, and expenses of buildings prior to the date they become operational for financial statement purposes, are capitalized. Interest and real estate taxes are also capitalized to property under development. DEPRECIATION AND AMORTIZATION: Buildings are depreciated over 25 to 40 years. Furniture, fixtures, and equipment are depreciated over 5 years. Leasehold improvements and tenant improvements are amortized over the life of the leases or useful life of the assets, whichever is shorter. Deferred expenses - which include organizational costs, certain marketing and leasing costs, and loan acquisition costs - are amortized over the period of estimated benefit. The straight-line method is used for all depreciation and amortization. ALLOWANCE FOR POSSIBLE LOSSES: The allowance for possible losses provides for potential writeoffs of certain tenant related assets on WWA's books. The allowance reflects management's evaluation of the credit exposure to WWA based on a specific review of existing tenants and the impact of current economic conditions on those tenants. ALLOCATION OF OPERATING EXPENSES: In accordance with certain lease agreements, certain management and maintenance costs incurred by WWA are allocated to individual buildings or tenants, including buildings not owned by WWA. INCOME TAXES: No provision has been made for federal or state income taxes because each partner's proportionate share of income or loss from the Partnerships is passed through to be included on each partner's separate tax return. CASH AND CASH EQUIVALENTS: Cash and Cash Equivalents includes all cash and highly liquid money market instruments. Highly liquid money market instruments include securities and repurchase agreements with original maturities of three months or less, money market mutual funds, and securities on which the interest rate is adjusted to market rate at least every three months. RENTAL INCOME: In accordance with Statement of Financial Accounting Standards No. 13 ("SFAS No. 13"), income on leases which include scheduled increases in rental rates over the lease term is recognized on a straight-line basis. 2. FORMATION AND PURPOSE OF THE PARTNERSHIPS WWA and GVA II were formed under the terms of partnership agreements effective May 30, 1985 and March 31, 1988, respectively. The purpose of the Partnerships is, among other things, to develop and operate the Summit Green project located in Greensboro, North Carolina, and selected property within Wildwood Office Park ("Wildwood"), located in Cobb County, Georgia. Summit Green is a project consisting of one office building and a parts distribution center totaling approximately 144,000 gross square feet ("GSF") which was completed in 1986, and land for two additional office buildings not yet constructed. The two additional buildings are planned to total approximately 240,000 GSF. The 21 acres in the project are leased from a third party by WWA (see Note 8). GVA II subleases the undeveloped portion of this land from WWA. Wildwood is an office park containing a total of approximately 289 acres, of which approximately 73 acres are owned by WWA, and an estimated 31 acres are committed to be contributed to WWA by Cousins (see Note 3). Cousins owns the balance of the developable acreage in the park. At December 31, 1993, WWA's income producing real estate assets in Wildwood consisted of: one office building of 338,000 GSF which became operational January 1, 1986, one office building of 684,000 GSF which became operational December 1, 1987 and one office building of 757,000 GSF which became operational April 1, 1991 (including land under such buildings totaling approximately 35 acres); land parcels totaling approximately 13 acres leased to two banking facilities and four restaurants (one of which is currently under construction); a 2 acre site on which a child care facility is constructed, and a 1 acre restaurant site. In addition, WWA's assets include 53 acres of land held for future development, which is composed of a 6 acre site with a restaurant and approximately 58,000 square feet of office space which was purchased in 1986 for future development (classified with income producing properties in the ac- companying financial statements), and 47 acres of other land to be developed (including additional land committed to be contributed by Cousins) (see Note 3). 3. CONTRIBUTIONS TO THE PARTNERSHIPS IBM and Cousins have each contributed or committed to contribute $62,857,000 in cash or properties to the Partnerships. The value of property contributed was agreed to by the partners at the time of formation of WWA. The status of contributions at December 31, 1993, was as follows ($ in thousands): WWA has elected not to take title to the remaining land committed to be contributed by Cousins until such land is needed for development. However, Cousins' capital account was previously credited with the amount originally required to bring it equal to IBM's, and a like amount, plus preacquisition costs paid by WWA, and condemnation proceeds net of condemnation restoration costs, were set up as an asset entitled "Land Committed To Be Contributed." This asset account subsequently has been reduced as land actually has been contributed, or as land yet to be contributed became associated with a particular building. At December 31,1993, Cousins was committed to contribute land on which an additional 1,473,691 GSF are developable, provided that regardless of planned use or density, 38,333 GSF shall be the minimum GSF attributed to each developable acre contributed. Cousins has also agreed to contribute infrastructure land in Wildwood, as defined, at no cost to WWA, in order to provide the necessary land for development of roads and utilities. The ultimate acreage remaining to be contributed by Cousins will depend upon the actual density achieved, but would be approximately 31 acres if the density were similar to that achieved on land contributed to date. 4. OTHER PROVISIONS OF THE PARTNERSHIP AGREEMENTS Net income or loss and net cash flow, as defined, shall be allocated to the partners based on their percentage interests (50% each, subject to adjustment as provided in the partnership agreements). In the event of dissolution of the Partnerships, the assets will be distributed as follows: - First, to repay all debts to third parties, including any secured loans with the partners. - Second, to each partner until each capital account is reduced to zero. - The balance to each partner in accordance with its percentage interest. WWA pays all real estate taxes on property owned by Cousins which is subject to future contribution. Such real estate taxes were $208,000, $194,000, and $190,000, in 1991, 1992 and 1993, respectively, all of which were expensed. 5. FEES TO RELATED PARTIES The Partnerships engaged Cousins to develop and lease the Partnerships' property, and Cousins Management, Inc. ("CMI"), to manage the Partnerships' property. As of November 20, 1992, Cousins acquired the assets of CMI and assumed its management functions. Fees to Cousins and CMI incurred by the Partnerships during 1991, 1992 and 1993 were as follows ($ in thousands): 6. RENTAL REVENUES WWA leases property to the partners, as well as to unrelated third parties. The leases with partners are at rates comparable to those quoted to third parties. The leases typically contain escalation provisions and provisions requiring tenants to pay a pro rata share of operating expenses. The leases typically include renewal options and all are classified and accounted for as operating leases. At December 31, 1993, future minimum rentals to be received under existing non-cancelable leases, including tenants' current pro rata share of operating expenses are as follows ($ in thousands): In the years ended December 31, 1991, 1992 and 1993, income recognized on a straightline basis exceeded income which would have accrued in accordance with the lease terms by $2,527,000, $3,278,000, and $570,000, respectively. At December 31, 1992 and 1993, receivables which related to the cumulative excess of revenues recognized in accordance with SFAS No. 13 over revenues which accrued in accordance with the actual lease agreements totaled $13,452,000 and $14,022,000, respectively. Of the 1993 amount, 61% was related to leases with IBM. 7. NOTES PAYABLE At December 31, 1992 and 1993, notes payable consisted of the following ($ in thousands): The 2300 Windy Ridge Parkway Building note is secured by the building and two additional leased commercial properties in Wildwood, which properties had a net carrying value of approximately $64,600,000 and $62,300,000 at December 31, 1992 and 1993, respectively. The note is also secured by a bank letter of credit under which $362,000 could be drawn by the lender at December 31, 1993. The note is payable interest only through August 10, 1994, after which it amortizes in equal monthly installments of $665,108 based on a 30 year amortization schedule, and matures August 10, 1999. The 2500 Windy Ridge Parkway Building note is secured by the building, which had a net carrying value of approximately $22,000,000 and $21,300,000 at December 31, 1992 and 1993, respectively. The note amortizes in equal monthly installments of $268,499 based on a 30 year amortization schedule, and matures June 28, 1996. The Summit Green Building note is secured by a leasehold mortgage on the building, which had a net carrying value of approximately $8,300,000 and $7,900,000 at December 31, 1992 and 1993, respectively. The note amortizes in equal monthly installments of $95,517 based on a 30 year amortization schedule, and matures April 1, 1998. The note related to the 3200 Windy Hill Road building is an unsecured line of credit under which up to $50,000,000 may be drawn. As amended and restated as of August 1, 1990, the line of credit matures September 1, 1994, but will automatically be renewed from year to year unless the lender provides a notice of non-renewal at least three months in advance of the annual renewal date. The line generally prohibits new borrowings other than those under the line, or the pledging of any assets not pledged as of August 1, 1990. The line bears a floating interest rate equal to the daily federal funds rate plus 3/4%, and there are no fees or compensating balance arrangements required under the line. Cousins and IBM have each severally guaranteed one-half of the line of credit. The Partnerships capitalize interest expense to property under development as required by Statement of Financial Accounting Standards No. 34. In the years ended December 31, 1991 and 1993, the Partnerships capitalized interest totaling $1,443,000 and $108,000, respectively. No interest was capitalized during the year ended December 31, 1992. The estimated fair value of the Partnership's $133 million and $134 million of notes payable at December 31, 1992 and 1993, respectively, is $139 million and $144 million, respectively, calculated by discounting future cash flows under the notes payable at estimated rates at which similar notes would be made currently. 8. GROUND LEASE All of the land in the Summit Green development is subject to a non-subordinated ground lease expiring October 31, 2084. Lease payments commenced December 1, 1986, and are payable in monthly installments at an annual rate of approximately $322,000 per year for the first ten years. The lease rate escalates at ten year intervals commencing December 1, 1996, based on the cumulative increase in the Consumer Price Index ("Index") over the prior ten year period (subject to a 5% annual cap on the increase in such Index in any one year); or, at lessor's option, at the end of any ten year interval the property shall be appraised, and the lessee shall elect to either purchase the land for the appraised value, or pay annually during the succeeding ten year period 10% of the appraised fair market value of the land. 9. COMBINED STATEMENTS OF CASH FLOWS-SUPPLEMENTAL INFORMATION Interest (net of amounts capitalized) was as follows ($ in thousands): Significant non-cash financing and investing activities included the following: In 1992, land parcels with an aggregate value of $4,583,000 were transferred from Land Committed To Be Contributed to Land and Property Predevelopment Costs. In 1993, a land parcel with a value of $926,000 was transferred from Land Committed To Be Contributed to Land and Property Predevelopment Costs. In September 1993, restaurant site parcels under construction with an aggregate value of $6,700,000 were transferred from Land and Property Predevelopment Costs to Income Producing Properties. See Notes 2 and 3. SCHEDULE VIII WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) NOTES: (a) The allowance for possible losses provides for potential writeoffs of certain tenant related assets on Wildwood Associates' books. (b) Additions charged to other accounts are recoveries. (c) Deductions are writeoffs of tenant improvements, deferred lease costs, and receivables. SCHEDULE IX WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) NOTES: (a) The average borrowings were determined based on the daily amounts outstanding. (b) The weighted average interest rate during the year was computed by dividing the actual applicable interest expense for the year by the average borrowings outstanding. SCHEDULE X WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) (1) Includes amortization of deferred leasing costs, marketing expenses, financing costs, and organization expenses. SCHEDULE XI WILDWOOD ASSOCIATES AND GREEN VALLEY ASSOCIATES II REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ in thousands) REPORT OF INDEPENDENT AUDITORS TO THE PARTNERS OF CSC ASSOCIATES, L.P. (A LIMITED PARTNERSHIP) We have audited the accompanying balance sheets of CSC Associates, L.P. (the Partnership) as of December 31, 1992 and 1993, and the related statements of operations, partners' capital, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules of CSC Associates, L.P. 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 statement 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 opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CSC Associates, L.P. at December 31, 1992 and 1993, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, 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 Atlanta, Georgia February 4, 1994 CSC ASSOCIATES, L.P. BALANCE SHEETS DECEMBER 31, 1992 AND 1993 ($ in thousands) ASSETS The accompanying notes are an integral part of these balance sheets. CSC ASSOCIATES, L.P. STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these statements. CSC ASSOCIATES, L.P. STATEMENTS OF PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) The accompanying notes are an integral part of these statements. CSC ASSOCIATES, L.P. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) (Note 6) The accompanying notes are an integral part of these statements. CSC ASSOCIATES, L.P. NOTES TO FINANCIAL STATEMENTS DECEMBER 31 1991, 1992 AND 1993 1. FORMATION OF THE PARTNERSHIP AND TERMS OF THE PARTNERSHIP AGREEMENT CSC Associates, L.P. ("CSC," or the "Partnership") was formed under the terms of a Partnership Agreement effective September 29, 1989. C&S Premises, Inc. ("Premises"), a wholly owned subsidiary of C&S/Sovran Corporation (the "Holding Corporation"), and Cousins Properties Incorporated ("CPI"), each own a 1% general partnership and a 49% limited partnership interest in the Partnership. The Holding Corporation became a wholly owned subsidiary of NationsBank Corporation on December 31, 1991. The Partnership was formed for the purpose of developing and owning a 1.4 million gross square foot office tower in downtown Atlanta, Georgia (the "Building"), which is the Atlanta headquarters of NationsBank Corporation. The Partnership Agreement and related documents (the "Agreements") contain among other provisions, the following: a. CPI is the Managing Partner. b. CPI is obligated to contribute a total of $18.2 million cash to the Partnership, all of which has been contributed. Premises is obligated to contribute land parcels to the Partnership having an aggregate agreed upon value of $18.2 million, all of which has been contributed, which property value, in the opinion of the partners, is equal to the estimated fair market value of the land at the time of formation of the Partnership. In October 1993, the partners each contributed an additional $86.7 million. c. No interest is earned on partnership capital. d. Net income or loss and cash distributions are allocated to the partners based on their percentage interests (50% each), subject to a preference to CPI. The CPI preference is $2.5 million, and accrues to CPI, with interest at 9% to the extent unpaid, over the period February 1, 1992 through January 31, 1995. The partners have agreed that until cumulative retained earnings (before considering distributions), exceed zero, distributions will be based on their percentage interests. Thereafter, CPI will be allocated its preference, to the extent earned, with amounts above the preference amount allocated based on the partners' percentage interests. 2. SIGNIFICANT ACCOUNTING POLICIES CAPITALIZATION POLICIES All costs related to planning, development and construction of the Building, and expenditures for the Building prior to the date it became operational for financial statement purposes, have been capitalized. Interest expense, amortization of financing costs, and real estate taxes were also capitalized while the Building was under development. The accompanying financial statements reflect revenues and expenses subsequent to February 1, 1992, the date the first lease in the building commenced. For financial reporting purposes, the Building was considered operational on June 1, 1992. Capitalized operations in the accompanying statement of operations represent revenues of $4,849,000 and expenses of $6,241,000 which were capitalized for the period February 1, 1992 through May 31, 1992. DEPRECIATION AND AMORTIZATION Depreciation of the Building commenced the date the Building became operational for financial statement purposes and the Building is being depreciated over 40 years. Leasehold and tenant improvements are amortized over the life of the leases or useful life of the assets, whichever is shorter. Furniture, fixtures, and equipment are depreciated over 5 years. Deferred expenses which include organizational costs, certain marketing and leasing costs, and loan acquisition costs are amortized over the period of estimated benefit. The straight line method is used for all depreciation and amortization. INCOME TAXES No provision has been made for federal or state income taxes because each partner's proportionate share of income or loss from the Partnership will be passed through to be included on each partner's separate tax return. RENTAL INCOME In accordance with Statement of Financial Accounting Standards No. 13 ("SFAS No. 13"), income on leases which include increases in rental rates over the lease term is recognized on a straight-line basis. PRESENTATION Certain 1992 amounts have been reclassified to conform with the 1993 presentation. 3. LEASES The Partnership has leased office space to the Holding Corporation, as well as to unrelated third parties. The lease with the Holding Corporation is at rates comparable to those quoted to third parties. The leases contain escalation provisions and provisions requiring tenants to pay a pro rata share of operating expenses. The leases typically include renewal options and all are classified and accounted for as operating leases. At December 31, 1993, future minimum rentals to be received under existing non-cancelable leases, including tenants' current pro rata share of operating expenses, are as follows ($ in thousands): In the years ended December 31, 1992 and 1993, income recognized on a straight-line basis exceeded income which would have accrued in accordance with the lease terms by $2,047,000 and $3,333,000, respectively. At December 31, 1992 and 1993, receivables which related to the cumulative excess of revenues recognized in accordance with SFAS No. 13 over revenues which accrued in accordance with the actual lease agreements totaled $2,047,000 and $5,380,000, respectively. Of that amount, 28% was related to leases with the Holding Corporation. 4. NOTES PAYABLE At December 31, 1992, notes payable consisted solely of the amount borrowed under a Construction Loan Agreement with six banks under which a maximum of $210 million could have been drawn. On October 29, 1993, using capital contributions made by each partner, the Partnership paid off this note payable, which had an outstanding balance of $168 million. Approximately $723,000 of deferred loan costs were written off due to the early extinguishment of this note payable and is classified as an Extraordinary Item in the accompanying Statements of Operations. The Construction Loan was payable interest only monthly and had a floating interest rate equal to LIBOR plus the Applicable Spread Rate. The Applicable Spread Rate was .85% through May 29, 1992, and .70% through December 31, 1992. The Applicable Spread Rate was reduced to .65% effective January 1, 1993 and .60% effective February 1, 1993 to maturity. The Partnership entered into an interest rate swap agreement with an affiliate of Premises which effectively fixed LIBOR at 8.45% through September 1993. The face amount of the swap increased over time in amounts corresponding to the projected increases in the Construction Loan balance. The Partnership has an unsecured $20 million line of credit provided by an affiliate of Premises. Interest on the line is paid at a floating rate (3.8% weighted average rate in December 1993), and interest only is payable through July 31, 1994, at which time the entire outstanding balance is due. There were no borrowings under the line at December 31, 1993. For the years ended December 31, 1991 and 1992, the Partnership capitalized interest expense totaling $5,749,000, and $4,591,000, respectively, including $3,853,000 capitalized as part of capitalized operations in 1992. 5. RELATED PARTIES The Partnership has engaged an affiliate of CPI, Cousins Real Estate Corporation ("CREC"), to develop and lease the Building and has engaged Cousins Management, Inc. ("CMI") to manage the Building. In November 1992, CPI purchased the assets of CMI and assumed all responsibilities under the management agreement. During 1991, 1992 and 1993, fees to CREC, CMI, and CPI incurred by the Partnership were as follows ($ in thousands): 6. STATEMENTS OF CASH FLOWS - SIGNIFICANT NON-CASH TRANSACTIONS In February 1992, the office building under construction with a book value of $167,511,000 was transferred to Buildings and Improvements. In 1991 and 1993, there were no significant non-cash transactions. Interest paid net of amounts capitalized was $8,007,000 and $13,387,000 in 1992 and 1993, respectively. SCHEDULE IX CSC ASSOCIATES, L.P. SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 ($ in thousands) NOTES: (a) The average borrowings were determined based on the daily amounts outstanding. (b) The weighted average interest rate during the year was computed by dividing the actual applicable interest expense for the year by the average borrowings outstanding. SCHEDULE X CSC ASSOCIATES, L.P. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1992 and 1993 (1) ($ in thousands) (1) All expenses were capitalized into the Building prior to June 1, 1992, the date it became operational for financial reporting purposes. (2) This item was less than 1% of revenues in the year indicated. (3) Includes amortization of deferred leasing costs, marketing expenses, financing costs, and organization expenses. CSC ASSOCIATES, L.P. REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ in thousands)

201499_1993.txt

201499_1993

1993

201499

Item 1. BUSINESS. THE COMPANY Commercial Credit Company (the "Company") is a financial services holding company engaged, through its subsidiaries, principally in two business segments: (i) Consumer Finance; and (ii) Insurance Services. The Company is a wholly owned subsidiary of The Travelers Inc. ("The Travelers"), formerly known as Primerica Corporation. The Travelers is a financial services holding company engaged, through its subsidiaries, principally in four business segments: (i) Investment Services; (ii) Consumer Services (through the Company); (iii) Life Insurance Services; and (iv) Property & Casualty Insurance Services. The periodic reports of The Travelers provide additional business and financial information concerning that company and its consolidated subsidiaries. In December 1992, The Travelers acquired approximately 27% of the common stock of The Travelers Corporation ("old Travelers"), a Connecticut corporation that was one of the largest multiline financial services companies in the United States. As a part of the transaction, the Company sold to old Travelers 50% of the Company's equity in Commercial Insurance Resources, Inc. (the parent of Gulf Insurance Company, the Company's property and casualty insurance subsidiary) in exchange for approximately 5.5% of old Travelers' common stock, and one of the Company's subsidiaries purchased additional shares directly from old Travelers. This acquisition was accounted for as a purchase with an effective accounting date of December 31, 1992. On December 31, 1993, old Travelers was merged into The Travelers and each outstanding share of common stock of old Travelers owned by the Company was converted into 0.80423 of a share of common stock of The Travelers. See "Insurance Services" and Note 4 of Notes to Consolidated Financial Statements. The principal executive offices of the Company are located at 300 St. Paul Place, Baltimore, Maryland 21202; telephone number 410-332-3000. CONSUMER FINANCE SERVICES The Company's Consumer Finance Services segment includes consumer lending services conducted primarily under the name "Commercial Credit," as well as credit-related insurance and credit card services. Consumer Finance As of December 31, 1993, the Company maintained 768 loan offices in 42 states, and it plans to open approximately 60 additional loan offices in 1994. The Company owns two state- chartered banks headquartered in Newark, Delaware, which generally limit their activities to offering credit card services nationwide. Total consumer finance receivables of this segment at December 31, 1993, 1992 and 1991 were approximately $6.3 billion, $5.8 billion and $5.8 billion, respectively. For an analysis of consumer finance receivables, net of unearned finance charges ("Consumer Finance Receivables"), see Note 5 of Notes to Consolidated Financial Statements. Loans to consumers by the Consumer Finance Services unit include secured and unsecured personal loans, real estate-secured loans and consumer goods financing. Credit card loans are discussed below. The Company's loan offices are located throughout the United States. They are generally located in small to medium-sized communities in suburban or rural areas, and are managed by individuals who generally have considerable consumer lending experience. The primary market for the Company's consumer loans consists of households with an annual income of $15,000 to $54,000. The number of loan customers (excluding credit card customers) was approximately 1,142,000 at December 31, 1993, as compared to approximately 1,058,000 at December 31, 1992 and approximately 1,078,000 at December 31, 1991. A loan program of the Company solicits applications for second mortgage loans through the sales force of the Primerica Financial Services group of companies, which are subsidiaries of The Travelers. The average amount of cash advanced per personal loan made was approximately $3,800 in each of 1993, 1992 and 1991. The average amount of cash advanced per real estate-secured loan made was approximately $28,800 in 1993 and approximately $26,000 in each of 1992 and 1991. The average annual yield for loans in 1993 was 15.83%, as compared to 16.31% in 1992 and 16.69% in 1991. The average annual yield for personal loans in 1993 was 20.11%, as compared to 19.99% in 1992 and 19.97% in 1991, and for real estate-secured loans it was 13.14% in 1993, as compared to 14.05% in 1992 and 14.48% in 1991. The 1993 average yield for real estate-secured loans was affected by the successful introduction of a variable rate product. The Company's average net interest margin for loans was 8.44% in 1993, 8.66% in 1992 and 8.63% in 1991. Prior to 1992, both delinquencies and charge-offs had increased, reflecting the recessionary economic environment. The Company took steps to combat this trend, by tightening the credit criteria used for making new loans and placing a greater emphasis on collection policies and practices. As a result of these measures and recent economic trends, delinquency rates generally have continued to improve throughout 1993. See "Delinquent Receivables and Loss Experience," below. In addition, aggregate quarterly loss charge-off rates have generally declined since the first quarter of 1992. Delinquent Receivables and Loss Experience The management of the consumer finance business attempts to prevent customer delinquency through careful evaluation of each borrower's application and credit history at the time the loan is made or acquired, and attempts to control losses through appropriate collection activity. An account is considered delinquent for financial reporting purposes when a payment is more than 60 days past due, based on the original or extended terms of the contract. Due to the nature of the finance business, some customer delinquency and loss is unavoidable. The delinquency and loss experience on real estate-secured loans is generally more favorable than on personal loans. The following table shows the ratio of receivables delinquent for 60 days or more on a contractual basis (i.e., more than 60 days past due) to gross receivables outstanding: Ratio of Receivables Delinquent 60 Days or More to Gross Receivables Outstanding (1) Real Estate- Personal Secured Credit Sales Total Loans Loans Cards Finance Consumer ----- ----- ------ ------- -------- As of December 31, ------------------ 1993 2.62% 2.15% 1.03% 1.54% 2.21%(2) 1992 3.02% 2.31% 1.87% 1.48% 2.55% 1991 3.51% 2.19% 2.57% 2.00% 2.80% __________________________ (1) The receivable balance used for these ratios is before the deduction of unearned finance charges and excludes accrued interest receivable. Receivables delinquent 60 days or more include, for all periods presented, accounts in the process of foreclosure. (2) Includes the reacquisition in the fourth quarter of 1993 of the remainder of a portfolio of loans collateralized by manufactured housing units. The following table shows the ratio of net charge-offs to average Consumer Finance Receivables. For all periods presented, the ratios shown below give effect to all deferred origination costs. Ratio of Net Charge-Offs to Average Consumer Finance Receivables Real Estate- Personal Secured Credit Sales Total Loans Loans Cards Finance Consumer ----- ----- ------ ------- -------- Year Ending December 31, ------------ 1993 4.08% 0.84% 2.56% 1.78% 2.36%(1) 1992 5.09% 0.74% 4.01% 2.05% 2.84% 1991 5.03% 0.69% 3.05% 2.52% 2.72% ______________________________ (1) Includes the reacquisition in the fourth quarter of 1993 of the remainder of a portfolio of loans collateralized by manufactured housing units. The following table sets forth information regarding the ratio of allowance for losses to Consumer Finance Receivables. Ratio of Allowance For Losses to Consumer Finance Receivables As of December 31, ------------------ 1993 2.64% 1992 2.91% 1991 2.86% Credit-Related Insurance American Health and Life Insurance Company ("AHL"), a subsidiary of the Company, underwrites or arranges for credit- related insurance, which is offered to customers of the consumer finance business. AHL has an A+ (superior) rating from the A.M. Best Company, whose ratings may be revised or withdrawn at any time. Credit life insurance covers the declining balance of unpaid indebtedness. Credit disability insurance provides monthly benefits during periods of covered disability. Credit property insurance covers the loss of property given as security for loans. Other insurance products offered or arranged for by AHL include accidental death and dismemberment, auto single interest, nonfiling, involuntary unemployment insurance and mortgage impairment insurance. Most of AHL's products are single premium, which premiums are earned over the related contract period. The following table sets forth gross written insurance premiums, net of refunds, by AHL for consumer finance customers: Consumer Finance Insurance Premiums Written (in millions) Year Ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Credit life . . . . . . . . $ 33.5 $ 33.1 $ 40.7 Credit disability . . . . . 47.1 44.7 49.9 ------ ------ ------- Total . . . . . . . . . . $ 80.6 $ 77.8 $ 90.6 ====== ======= ======= See Note 7 of Notes to Consolidated Financial Statement for information regarding reinsurance activities. Credit Card Services Primerica Bank, a subsidiary of the Company, is a state- chartered bank located in Newark, Delaware, which provides credit card services, including upper market gold credit card services, to individuals and to affinity groups (such as nationwide professional associations and fraternal organizations). Primerica Bank USA, another state-chartered bank subsidiary of the Company, was formed in September 1989. Primerica Bank USA is not subject to certain regulatory restrictions relating to growth and cross-marketing activities to which Primerica Bank is subject. See "Regulation" below. These banks generally limit their activities to credit card operations. The following table sets forth aggregate information regarding credit cards issued by Primerica Bank and Primerica Bank USA: Credit Cardholders and Total Outstandings (outstandings in millions of dollars) As of and for the year ended December 31, ----------------------------------------- 1993 1992 1991 ---- ---- ---- Approximate total credit cardholders 534,000 423,000 370,000 Approximate gold credit cardholders 478,000 371,000 305,000 Total outstandings $697.1 $538.2 $472.9 Average annual yield 11.66% 12.12% 13.50% The primary market for the banks' credit cards consists of households with annual incomes of $40,000 and above. The Delaware credit card banks offer deposit-taking services (which as to Primerica Bank USA are limited to deposits of at least $100,000 per account). At December 31, 1993, deposits at the Delaware offices were $51.7 million, as compared to $22.4 million at December 31, 1992 and $23.8 million at December 31, 1991. At December 31, 1993, all of such deposits were federally insured. The increase in deposits resulted from a balance transfer promotion conducted by Primerica Bank during 1993. Competition The consumer finance business competes with banks, savings and loan associations, credit unions, credit card issuers and other consumer finance companies. Additionally, substantial national financial services networks have been formed by major brokerage firms, insurance companies, retailers and bank holding companies. Some competitors have substantial local market positions; others are part of large, diversified organizations. Deregulation of banking institutions has greatly expanded the consumer lending products permitted to be offered by these institutions, and because of their long-standing insured deposit base, many of them are able to offer financial services on very competitive terms. The Company believes that it is able to compete effectively with such institutions. In particular, the Company believes that the diversity and features of the products it offers, personal service and cultivation of repeat and referral business support and strengthen its competitive position in its Consumer Finance Services businesses. Regulation Most consumer finance activities are subject to extensive federal and state regulation. Personal loan, real estate-secured loan and sales finance laws generally require licensing of the lender, limitations on the amount, duration and charges for various categories of loans, adequate disclosure of certain contract terms and limitations on certain collection practices and creditor remedies. Federal consumer credit statutes primarily require disclosure of credit terms in consumer finance transactions. The Company's banking operations, which must undergo periodic examination, are subject to additional regulations relating to capitalization, leverage, reporting, dividends and permitted asset and liability products. The Company's credit card banks are also covered by the Competitive Equality Banking Act of 1987 (the "Banking Act"), which, among other things, prevents the Company from acquiring or forming most types of new banks or savings and loan institutions and, with respect to Primerica Bank, restricts cross-marketing of products by or of certain affiliates. The Company's banks are also subject to the Community Reinvestment Act, which requires a bank to provide equal credit opportunity to all persons in such bank's delineated community. The Company believes that it complies in all material respects with applicable regulations. The Real Estate Settlement Procedures Act of 1974 ("RESPA") has been extended to cover real estate-secured loans that are subordinated to other mortgage loans. Generally, RESPA requires disclosure of certain information to customers and regulates the receipt or payment of fees or charges for services performed. INSURANCE SERVICES The Company's Insurance Services business includes property and casualty insurance and specialty lines of insurance. The Company's insurance activities relating to its consumer finance business are discussed above under "Consumer Finance Services." The Company's property and casualty insurance operations are conducted principally through Gulf Insurance Company and its subsidiaries ("Gulf"). Gulf operates through regional offices for traditional lines of property and casualty insurance and specialty lines of business. Gulf has an A+ (superior) rating from the A.M. Best Company, whose ratings may be revised or withdrawn at any time. In connection with The Travelers' 1992 acquisition of old Travelers' common stock, the Company sold to old Travelers 1,000 newly issued shares of Commercial Insurance Resource, Inc. ("CIRI"), the parent of Gulf, in exchange for approximately 5.5% of old Travelers' then outstanding common stock. As a result, during 1993 CIRI and its subsidiaries were 50%-owned by each of the Company and a subsidiary of old Travelers. In 1993, CIRI was treated as a consolidated subsidiary of the Company, and the 50% ownership interest of old Travelers was reflected as minority interest. Regional and Specialty Lines Gulf obtains its regional property and casualty insurance business primarily through independent insurance agencies that represent it on a non-exclusive basis. During 1993, approximately 19% of Gulf's regional business represented personal lines of insurance, approximately 29% represented workers' compensation insurance and approximately 52% represented other commercial lines of business, including commercial automobile liability and physical damage and commercial multiple peril insurance. At the end of 1993, Gulf discontinued writing personal lines of insurance and transferred a major part of that business to a subsidiary of The Travelers, although Gulf does retain some run-off business. Approximately 73% of Gulf's regional business, as represented by direct written premiums during 1993, is in Texas, Georgia, Florida and Missouri. Product offerings in Gulf's specialty lines include directors' and officers' liability and various forms of nonprofessional errors and omissions, fidelity bonds, commercial umbrella coverages and contingent liability coverages; coverages relating to the entertainment industry; and standard commercial property and casualty products for specific niche markets. These specialty lines are produced mainly through commercial insurance brokers and several wholesale brokers, and underwriting managers for specific industry programs. In the aggregate these specialty lines comprised approximately 53%, 47% and 42% of Gulf's earned premiums in 1993, 1992 and 1991, respectively. Reserves are subject to ongoing review as additional experience and other data become available. Increases or decreases to reserves for loss and loss adjustment expenses may be made, which would be reflected in operating results for the period in which such adjustments, if any, are made. Gulf attempts to limit its risks through careful underwriting and the reinsurance of portions of certain policies with unaffiliated reinsurers. Reinsurance is subject to collectibility in all cases and to aggregate loss limits in certain cases. In Gulf's regional business, losses on any single claim are limited by reinsurance to $500,000 per occurrence and reinsurance arrangements limit Gulf's maximum loss from any single property catastrophic occurrence to $4.0 million, and it participates for 5% of any excess, up to a maximum excess participation of $36 million. For its specialty lines coverages, Gulf's maximum risk is limited through reinsurance to approximately $2.73 million per policy or, under certain policies, per occurrence. See Note 7 of Notes to Consolidated Financial Statements. Also included in this area is account insurance provided by Gulf to Smith Barney Shearson Inc., a subsidiary of The Travelers, in excess of that provided by the Securities Investor Protection Corporation ("SIPC"). This insurance provides certain excess coverage for losses due to forced liquidation of broker- dealers, which losses would be recoverable by securities customers from SIPC but for SIPC's $500,000 limitation on liability per customer. The following table sets forth information concerning property and casualty operations of Gulf and its subsidiaries: Gulf Insurance Company and Subsidiaries (in millions of dollars) Year Ended December 31, ----------------------------- 1993 1992 1991 ---- ---- ---- Net premiums written . . $ 264.9 $ 250.1 $ 232.2 Premiums earned: Regional business . . . $ 121.9 $ 128.4 $ 128.7 Specialty business . . 135.4 112.1 93.0 ------- ------- ------- Total premiums earned $ 257.3 $ 240.5 $ 221.7 Total Loss and Expense Reserve $ 244.7 $ 223.1 $ 216.8 Loss ratio (1) . . . . . 72.1% 70.3% 75.1% Expense ratio (2) . . . . 23.8% 27.3% 26.8% Combined ratio (3) . . . 95.9% 97.6% 101.9% ____________________________ (1) Ratio of losses and loss expenses incurred to premiums earned, determined in accordance with statutory insurance accounting principles. (2) Ratio of underwriting expenses incurred to net premiums written, determined in accordance with statutory insurance accounting principles. (3) Total of loss ratio and expense ratio. Investments The investment holdings of the insurance companies at December 31, 1993 were composed primarily of fixed income securities. At December 31, 1993, approximately 97% in total dollar amount of the fixed income securities portfolios of the Company's insurance subsidiaries had investment grade ratings. The remaining investments are principally issues of utilities and private placement securities that are not subject to investment rating. The weighted average maturity of the fixed income holdings at December 31, 1993 was approximately 9.6 years. State insurance laws prescribe the types, quality and diversity of permissible investments for insurance companies. Competition The property and casualty insurance industry includes many insurance companies of varying size. Companies may be small local firms, large regional firms or large national firms, as well as self-insurance programs or captive insurers. Market competition, regulated by state insurance departments, works to set the price charged for insurance products and the level of service provided. Growth is driven by a company's ability to provide insurance and services at a price that is reasonable and acceptable to the customer. In addition, the marketplace is affected by available capacity of the insurance industry as measured by policyholders' surplus. Surplus expands and contracts primarily in conjunction with profit levels generated by the industry, which is generally referred to as the underwriting cycle. Growth in premium and service business is also measured by a company's ability to retain existing customers and to attract new customers. Local or regional companies are effective competitors in personal lines business because of their expense structure or because they specialize in providing coverage to particular risk groups. Personal automobile and homeowners insurance is marketed mainly through one of two distribution systems: independent agents or direct writing. Direct writing companies operate either by mail or through exclusive agents or sales representatives. Due in part to the expense advantage that direct writers typically have relative to agency companies, the direct writers have been able to gradually expand their market share. Gulf's insurance sales force is primarily composed of independent commissioned agents and brokers. Regulation The Company's insurance subsidiaries are subject to considerable regulation and supervision by insurance departments or other authorities in each state or other jurisdiction in which they transact business. The laws of the various jurisdictions establish supervisory and regulatory agencies with broad administrative powers. The purpose of such regulation and supervision is primarily to provide safeguards for policyholders, rather than to protect the interests of the insurers' stockholders. Typically, state regulation extends to such matters as licensing companies, regulating the type, amount and quality of permitted investments, licensing agents, regulating aspects of a company's relationship with its agents, requiring triennial financial examinations, market conduct surveys and the filing of reports on financial condition, recording complaints, restricting expenses, commissions and new business issued, restricting use of some underwriting criteria, regulating rates, forms and advertising, specifying what might constitute unfair practices, fixing maximum interest rates on policy loans and establishing minimum reserve requirements and minimum policy surrender values. Such powers also extend to premium rate regulation, which varies from open competition to limited review upon implementation, to requirements for prior approval for rate changes. State regulation may also cover regulating capital and surplus and actuarial reserve maintenance, setting solvency standards, mandating loss ratios for certain kinds of insurance, limiting the grounds for cancellation or nonrenewal of policies and regulating solicitation and replacement practices. State laws also regulate transactions and dividends between an insurance company and its parent or affiliates, and require prior approval or notification of any change in control of an insurance subsidiary. In addition, under insurance holding company legislation, most states regulate affiliated groups with respect to intercorporate transfers of assets, service arrangements and dividend payments from insurance subsidiaries. The insurance industry generally is exempt from federal antitrust laws because of the application of the McCarran- Ferguson Act. In recent years, legislation has been introduced to modify or repeal the McCarran-Ferguson Act. The effect of any such modification or repeal cannot currently be determined. Virtually all states mandate participation in insurance guaranty associations and/or insolvency funds, which assess insurance companies in order to fund claims of policyholders of insolvent insurance companies. Under these arrangements, insurers are assessed their proportionate share (based on premiums written for the relevant lines of insurance in that state each year) of the estimated loss and loss expense of insolvent insurers. Similarly, as a condition to writing a line of property and casualty business, many states mandate participation in "fair plans" and/or "assigned risk pools" that underwrite insurance for individuals and businesses that are otherwise unable to obtain insurance. Participation is based on the amount of premiums written in past years by the participating company in an individual state for the classes of insurance involved. These plans or pools traditionally have been unprofitable, although the effect of their performance has been partially mitigated in certain lines of insurance by the states' allowance of increases in rates for business voluntarily written by plan or pool participants in such states. For workers' compensation plans or pools the effect may be further mitigated by the method of participation selected by insurance companies. In addition to state insurance laws, the Company's insurance subsidiaries are also subject to general business and corporation laws, state securities laws, consumer protection laws, fair credit reporting acts and other laws. Many jurisdictions require prior regulatory approval of rate and rating plan changes and some impose restrictions on the cancellation or nonrenewal of risks and the termination of agency contracts, or have regulations that preclude immediate withdrawal from certain lines of business. Certain lines of business, such as commercial automobile and workers' compensation, experience rate inadequacies in many jurisdictions. Automobile insurance is also subject to varying regulatory requirements as to mandated coverages and availability, such as no-fault benefits, assigned risk pools, reinsurance facilities and joint underwriting associations. The added expense associated with involuntary pools in this and other areas has adversely affected profitability. In December 1992, the Florida legislature created the Residential Property and Casualty Joint Underwriting Association ("RPCJUA") to provide residential property and casualty insurance to individuals who cannot obtain coverage in the voluntary market. Property-casualty insurance companies in Florida, including Gulf, will be required to share the risk in the RPCJUA. In November 1993, the Florida legislature created a Florida Hurricane Catastrophe Fund to provide reimbursement to insurers for a portion of their future catastrophic hurricane losses. This Hurricane Catastrophe Fund will be funded in part by assessments on insurance companies. The National Association of Insurance Commissioners (the "NAIC") adopted risk-based capital ("RBC") requirements for property-casualty companies in December 1993, effective with reporting for 1994. The RBC requirements are to be used as early warning tools by the NAIC and states to identify companies that merit further regulatory action. CORPORATE AND OTHER OPERATIONS The Corporate and Other segment consists of corporate staff and treasury operations, a hotel mortgage investment and certain corporate income and expenses that have not been allocated to the operating subsidiaries. During 1993, this segment also included the Company's share of equity income of old Travelers. See Notes 3 and 4 of Notes to Consolidated Financial Statements. Investment in The Travelers In December 1988, in connection with an acquisition by The Travelers, the Company's parent company, the Company made an investment of approximately $500 million in an entire issue of preferred stock of Primerica Holdings, Inc. ("Primerica Holdings"), then a wholly owned subsidiary of The Travelers. Since then $400 million of such preferred stock has been repurchased from the Company. In December 1992 Primerica Holdings was merged into The Travelers and the Company's investment in the preferred stock was converted into preferred stock of The Travelers, with the same terms. The preferred stock is entitled to a cumulative quarterly dividend at an annual rate of 85% of the daily average of the 30-day commercial paper rate multiplied by the stock's $45,000 per share liquidation value. Additionally, the preferred stock has customary provisions regarding preferences upon liquidation, is redeemable without premium at the issuer's option at any time, and is subject to repurchase at the holder's request at its liquidation value plus accrued dividends if not redeemed on or prior to September 15, 1998. See Note 13 of Notes to Consolidated Financial Statements. GENERAL BUSINESS FACTORS In the judgment of the Company, no material part of the business of the Company and its subsidiaries is dependent upon a single customer or group of customers, the loss of any one of which would have a materially adverse effect on the Company, and no one customer or group of affiliated customers accounts for as much as 10% of the Company's consolidated revenues. At December 31, 1993, the Company had approximately 5,000 full-time employees. The Company also employs part-time employees. OTHER INFORMATION Source of Funds For a discussion of the Company's sources of funds and maturities of the long-term debt of the Company's subsidiaries, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources," and Note 6 of Notes to Consolidated Financial Statements. The following table sets forth information concerning annual weighted average interest rates on the Company's borrowed funds: Annual Weighted Average Interest Rates Years ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- Savings accounts, certificates and deposits................ 4.4% 5.4% 6.8% Short-term borrowings (1)..... 3.2% 3.8% 6.1% Long-term borrowings (2)...... 8.0% 8.4% 8.9% Total borrowings.............. 6.3% 6.6% 7.6% Bank prime rate .............. 6.0% 6.3% 8.5% ____________________ (1) Includes all commercial paper and short-term bank loans; does not include cost of maintaining bank credit lines. (2) Includes current maturities of long-term debt and amortization of long-term debt expenses. Taxation For a discussion of tax matters affecting the Company and its operations, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Notes 1 and 8 of Notes to Consolidated Financial Statements. Financial Information about Industry Segments For financial information regarding industry segments of the Company, see Note 3 of Notes to Consolidated Financial Statements. Item 2. Item 2. PROPERTIES. The Company is engaged in the business of providing services that are generally not dependent upon their physical plant. In 1989, a subsidiary of the Company completed the sale of the Company's headquarters office building in Baltimore, Maryland, and the lease back of a portion of the space therein, which is used by the Company as its executive offices. Offices and other properties used by the Company's subsidiaries are located throughout the United States. One subsidiary owns and uses office space in Tel Aviv, Israel. Most office locations and other properties are leased on terms and for durations that are reflective of commercial standards in the communities where such offices and other properties are located. A few offices are owned, none of which is material to the Company's financial condition or operations. The Company believes its properties are adequate and suitable for its business as presently conducted and are adequately maintained. For further information concerning leases, see Note 12 of Notes to Consolidated Financial Statements. Item 3. Item 3. LEGAL PROCEEDINGS. For information concerning Gallagher, et. al. v. American Health and Life Insurance Company, et. al., a purported class action relating to annuity policies that were transferred by the defendants to an insurance company that is now insolvent, see the description that appears in the second paragraph of page 2 of the Company's filing on Form 8-K dated July 28, 1992, which description is incorporated by reference herein. A copy of the pertinent paragraph of such filing is included as an exhibit to this Form 10-K. Because the nature of the businesses of the Company and its subsidiaries involves the collection of numerous accounts, the validity of liens, accident and other damage or loss claims under many types of insurance, and the construction and interpretation of contracts, the Company and its subsidiaries are plaintiffs and defendants in numerous legal proceedings. Neither the Company nor any of its subsidiaries is a party to, nor is its property the subject of, any legal proceeding that departs from litigation normally incident to the kinds of business conducted by the Company or its subsidiaries which, in the opinion of the Company's management, would be expected to have a material adverse impact on the consolidated financial condition of the Company and its subsidiaries. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Pursuant to General Instruction J of Form 10-K, the information required by Item 4 is omitted. PART II ------- Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the outstanding common stock of the Company is owned by CCC Holdings, Inc., which is a wholly owned subsidiary of The Travelers. Item 6. Item 6. SELECTED FINANCIAL DATA. COMMERCIAL CREDIT COMPANY and SUBSIDIARIES FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA (In millions of dollars) -------------------------------------------- (1) Included in 1992 results are after-tax gains of $7.1 from the sale of stock of subsidiaries and affiliates and $22.7 from the sale of the common stock investment in Musicland Stores Corporation. (2) See Note 1 of Notes to Consolidated Financial Statement for information regarding changes in accounting principles in 1992 and 1993. (3) Assets and liabilities for 1992 have been reclassified to conform with the 1993 presentation for the adoption, effective January 1, 1993, of Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Results of Operations Year Ended December 31, --------------------------- ($ in millions) 1993 1992 1991 ----------------------------------------------------------------------- Revenues $1,580.3 $1,523.5 $1,459.1 ======== ======== ======== Income before cumulative effect of changes in accounting principles $ 291.8 $ 281.2 $ 203.2 ======== ======== ======== Net income $ 286.0 $ 263.1 $ 203.2 ======== ======== ======== Results of Operations Commercial Credit Company's (the Company) earnings in 1993 reflect a substantial increase in the contribution of Consumer Finance Services, which continued to post record results. Income before the cumulative effect of changes in accounting principles for 1993 includes: - Reported investment portfolio gains of $33.3 million; Income before the cumulative effect of changes in accounting principles for 1992 includes: - Reported investment portfolio gains of $10.3 million; - a gain of $22.7 million from the sale of the common stock investment in Musicland Stores Corporation (Musicland); - a gain of $11.1 million from the exchange of 50% of Commercial Insurance Resources, Inc. (CIRI), the parent of Gulf Insurance Company (Gulf), for The Travelers Corporation (old Travelers) common stock; - a net loss of $4.0 million from the divestment of securities of the Company's affiliate, Inter-Regional Financial Group, Inc. (IFG) Included in net income for 1993 is an after-tax charge of $3.4 million resulting from the adoption of Statement of Financial Accounting Standards No. 112 (FAS 112), "Employers' Accounting for Postemployment Benefits," and an after-tax charge of $2.4 million resulting from the adoption of Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." Included in net income for 1992 is an after-tax charge of $18.1 million resulting from the adoption of Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes." Excluding these items, earnings for 1993 increased by $17.4 million or 7% over the 1992 period reflecting improved performance at Consumer Finance Services and the 1993 contribution to earnings of an equity investment in old Travelers, partially offset by the 1993 minority interest in Gulf and higher corporate expenses. The most significant factor in 1992's and 1991's earnings growth over 1991 and 1990, respectively, were increases in the contributions of Consumer Finance Services. The following discussion presents in more detail each segment's performance. Consumer Finance Services Year Ended December 31, ------------------------------------------------------- 1993 1992 1991 ------------------------------------------------------- Net Net Net ($ in millions) Revenues income Revenues income Revenues income ------------------------------------------------------------------------- Consumer Finance Services (1) $1,190.6 $230.8 $1,154.8 $196.6 $1,147.1 $173.8 ========================================================================= (1) Net income includes $22.7 and $4.3 of reported investment portfolio gains in 1993 and 1992, respectively. Consumer Finance earnings before reported investment portfolio gains increased 8% in 1993 over the prior year. The increase primarily reflects a significant decline in loan losses and a 3% increase in average receivables outstanding. The increase in net income and revenues in 1992 compared to 1991 reflects an increase in average receivables outstanding (offset by slightly lower yields), improved operating efficiencies and some benefit from lower funding costs. Year-end receivables increased in 1993 by $554 million to end the year at $6.342 billion. The 1993 increase occurred across-the-board in real estate loans, personal loans and credit cards and also reflects the reacquisition of the remainder of a portfolio of loans collateralized by manufactured housing units amounting to $135 million at year end. While average receivables increased in 1992, year-end receivables declined reflecting an increase in early payoffs of real estate loans outstandings. This was partially offset by an increase in credit card outstandings. Seventy-three branch offices were added during 1993, bringing the total to 768 at year end. Consumer Finance borrows from the Company's corporate treasury operation which raises funds externally. For fixed rate loan products Consumer Finance is charged agreed-upon rates that have generally been set within a narrow range and have approximated 8% over the last three years. For variable rate loan products Consumer Finance is charged prime-based rates. The Company's actual cost of funds may be higher or lower than rates charged to Consumer Finance, with the difference reflected in Corporate and Other. The average yield on receivables outstanding decreased to 15.83% in 1993 from 16.31% in the prior year and 16.69% in 1991, due to lower yields on fixed rate second mortgages and the adjustable rate real estate-secured loan product introduced at the end of 1992. Lower yields on loans outstanding, partially offset by decreased cost of funds to Consumer Finance on variable rate loans, have resulted in a decline in net interest margins to 8.44% in 1993 from 8.66% in 1992. The allowance for losses as a percentage of net receivables was reduced to 2.64% at year-end 1993 from 2.91% at year-end 1992 due to the improved credit quality of the loan portfolio. The increase in the allowance in 1992 from 2.86% at year-end 1991 reflected the impact of the recessionary economic environment. As of, and for, the Year Ended December 31, ----------------------- 1993 1992 1991 ----------------------- Allowance for losses as % of net consumer finance 2.64% 2.91% 2.86% receivables at year end Charge-off rate for the year 2.36% 2.84% 2.72% 60 + days past due on a contractual basis as % of gross consumer finance 2.21% 2.55% 2.80% receivables at year end Accounts 60+ days past due include accounts in the process of foreclosure for all periods presented. The Company's wholly owned subsidiary, American Health and Life Insurance Company (AHL), provides credit life and health insurance to Consumer Finance customers. Premiums earned were $84.8 million in 1993, $86.1 million in 1992 and $82.5 million in 1991. Outlook - Consumer Finance is affected by the interest rate environment and general economic conditions. In a rising interest rate environment, real estate loan liquidations may decline compared to the last two years, when potential customers refinanced their first mortgages instead of turning to the second mortgage-market or proceeds from the refinancing of first mortgages were used to pay off existing second mortgages. Lower loan liquidations would benefit the level of receivables outstanding. In addition, a rising interest rate environment could also reduce the downward pressure experienced during the last several years on the interest rates charged on new real estate-secured receivables, as well as credit cards, which are substantially based on the prime rate. However, significantly higher rates could result in an increase in the interest rates charged to Consumer Finance on the funds it borrows from the Company to reflect the Company's overall higher cost of funds. These impacts could be at least partially offset by the benefits of a strengthening U.S. economy, which typically would include an increase in consumer borrowing demand. Asset Quality - Consumer Finance assets totaled approximately $7 billion at December 31, 1993, of which $6 billion, or 86%, represented the net consumer finance receivables (after accrued interest and the allowance for credit losses). These receivables were predominantly residential real estate-secured loans and personal loans. Receivable quality depends on the likelihood of repayment. The Company seeks to reduce its risks by focusing on individual lending, making a greater number of smaller-sized loans than would be practical in commercial markets, and maintaining disciplined control over the underwriting process. The Company has a geographically diverse portfolio as described in Note 5 of Notes to Consolidated Financial Statements. The Company believes that its loss reserves on the consumer finance receivables are appropriate given current circumstances. Of the remaining Consumer Finance assets, approximately $631 million were investments of AHL and its affiliates, including $352 million of fixed-income securities and $204 million of short-term investments. Insurance Services Year Ended December 31, ----------------------------------------------------- 1993 1992 1991 ----------------------------------------------------- Net Net Net ($ in millions) Revenues income Revenues income Revenues income - ------------------------------------------------------------------------------ Gulf property and casualty (1) $314.5 $ 44.9 $322.2 $57.9 $257.0 $21.6 Minority Interest - Gulf -- (22.5) -- -- -- -- Other 5.6 (0.2) 5.0 (0.5) 9.7 1.4 - ------------------------------------------------------------------------------ Total Insurance Services $320.1 $ 22.2 $327.2 $57.4 $266.7 $23.0 ============================================================================== (1) Net income includes $15.2 and $6.0 of reported investment portfolio gains in 1993 and 1992, respectively and $22.7 from the sale of Musicland common stock in 1992. Earnings from Gulf increased slightly compared to 1992, before old Travelers' 50% minority interest, reported net investment portfolio gains of $15.2 million and $6.0 million in 1993 and 1992, respectively, and a $22.7 million gain in 1992 from the sale of Musicland. Gulf's results reflect ongoing growth in its high-margin specialty businesses offset by relatively high local storm losses in the regional business in 1993. Notwithstanding a $2 million after-tax provision for losses from Hurricane Andrew in the third quarter of 1992, Gulf's 1992 earnings improved over 1991, also as a result of the growth of the specialty business. Gulf's 1993 combined ratio improved to 95.9%, from 97.6% in 1992 and 101.9% in 1991. However, for the fourth quarter of 1993 the combined ratio increased to 97.8%, principally as a result of higher storm-related claims. Gulf writes both traditional and specialty insurance lines. Gulf's traditional lines - largely written in Texas, Georgia, Florida and Missouri - include automobile liability and physical damage, workers' compensation, other liability, fire and related homeowners' insurance and multiple peril insurance. Gulf's specialty lines include directors' and officers', errors and omissions, fidelity bonds and contingent liability coverages, as well as coverages relating to the entertainment industry and other specialty markets. Outlook Changes in the general interest rate environment affect the return received by the insurance subsidiaries on newly invested and reinvested funds. While a rising interest rate environment enhances the returns available, it reduces the market value of existing fixed maturity investments and the availability of gains on disposition. As required by various state laws and regulations, the Company's insurance subsidiaries are required to participate in state- administered guarantee associations established for the benefit of the policyholders of insolvent insurance companies. Management believes that payments to such associations will not have a material impact on financial condition or results of operations. Asset Quality - The investment portfolio of the Insurance Services segment totaled approximately $519 million, representing 57% of total Insurance Services' assets of approximately $907 million. Because the primary purpose of the portfolio is to fund future policyholder benefits and claims payments, and in order to provide for economies of scale and tight control, it is managed centrally, employing a conservative investment philosophy. Approximately $433 million of the portfolio is invested in long-term fixed-income securities, of which 97.0% had investment grade ratings. At December 31, 1993, the weighted average maturity of these fixed-income holdings was approximately 9.6 years. Corporate and Other Year Ended December 31, --------------------------------------------------------- 1993 1992 1991 --------------------------------------------------------- Net Net Net ($ in millions) Revenues income Revenues income Revenues income ---------------------------------------------------------------------------- Corporate and Other $ 3.9 $20.1 $6.4 Equity in income of old Travelers in 1993 34.9 -- -- Net gain on sales of stock of subsidiary and affiliate -- 7.1 -- ---------------------------------------------------------------------------- Total Corporate and Other $69.6 $38.8 $41.5 $27.2 $45.3 $6.4 ============================================================================ Corporate and Other reflects lower income from miscellaneous investments, somewhat higher corporate expenses and lower net interest income reflecting an increase in the proportion of variable rate loans in the Consumer Finance receivables portfolio. These factors were partially offset by lower interest rates on debt in 1993. Lower interest rates in 1992 contributed to the improvement over 1991. The equity in income of old Travelers includes $3.0 million from the Company's share of old Travelers' realized portfolio gains. The 1992 net gain on sale of stock of an affiliate represents a gain of $11.1 million from the exchange of 50% of CIRI, the parent of Gulf, for old Travelers common stock and an after-tax loss of $4.0 million relating to the sale of Inter-Regional Financial Group, Inc. common stock. On December 31, 1993, The Travelers Inc. (the Parent), the parent of Commercial Credit Company, acquired the approximately 73% it did not already own of The Travelers Corporation (old Travelers), by means of a merger of old Travelers into the Parent. As a result of the merger, the Company's investment in the common stock of old Travelers, which through that date had been carried on the equity basis of accounting, was exchanged for 7.2 million shares of common stock of the Parent at a ratio of 0.80423 of a share of the Parent common stock for each share of old Travelers common stock. At December 31, 1993 the investment was reflected at a carrying amount of $211.3 million. On March 31, 1994, 6.3 million of the Company's shares of the Parent's common stock will be exchanged for a variable rate preferred stock of the Parent, which is redeemable at the option of the holder at certain times and callable by the Parent at certain times. The preferred stock will have a value equal to the market value of the common shares at the time the exchange was agreed upon. The balance of such shares, which are held by an insurance subsidiary, will be exchanged upon receipt of regulatory approval. Liquidity and Capital Resources The Company issues commercial paper directly to investors and maintains unused credit availability under committed revolving credit agreements at least equal to the amount of commercial paper outstanding. As of December 31, 1993, the Company has unused credit availability of $2.295 billion. The Company may borrow under its revolving credit facilities at various interest rate options and compensates the banks for the facilities through commitment fees. During 1993, the Company completed the following debt offerings and, as of February 28, 1994, had $850 million available for debt offerings under its shelf registration statement: - 5.70% Notes due March 1, 1998 ...... $100 million - 6 1/8 Notes due March 1, 2000 ...... $100 million - 6.00% Notes due April 15, 2000 ..... $150 million - 5 1/2% Notes due May 15, 1998 ...... $100 million - 6.00% Notes due June 15, 2000 ...... $100 million - 5 3/4% Notes due July 15, 2000 ..... $200 million - 5.9% Notes due September 1, 2003 ... $200 million The Company is limited by covenants in its revolving credit agreements as to the amount of dividends and advances that may be made to the Parent or its affiliated companies. At December 31, 1993, the Company would have been able to remit $149.8 million to the Parent under its most restrictive covenants or regulatory requirements. Recent Accounting Standards FAS 114 Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," describes how impaired loans should be measured when determining the amount of a loan loss accrual. The Statement also amends existing guidance on the measurement of restructured loans in a troubled debt restructuring involving a modification of terms. The Company has not yet determined the impact, if any, this statement will have on its financial statements. The Statement has an effective date of January 1, 1995. FAS 115 Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses accounting and reporting for investments in equity securities that have a readily determinable fair value and for all debt securities. Those investments are to be classified in one of three categories. Debt securities that the Company has the positive intent and ability to hold to maturity are to be classified as "held for investment" and are to be reported at amortized cost. Securities that are bought and held principally for the purpose of selling them in the near term are classified as "trading securities" and are to be reported at fair value, with unrealized gains and losses included in earnings. Securities that are neither to be held to maturity nor to be sold in the near term are classified as "available for sale" and are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a net amount in a separate component of stockholders' equity. At December 31, 1993 the market value of fixed maturities exceeded the cost by $32.9 million. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Index to Consolidated Financial Statements and Schedules on page hereof. There is also incorporated by reference herein in response to this Item the Company's Consolidated Financial Statements and the notes thereto and the material under the caption "Quarterly Financial Data (Unaudited)" set forth in the Consolidated Financial Statements. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III -------- Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Pursuant to General Instruction J of Form 10-K, the information required by Item 10 is omitted. Item 11. Item 11. EXECUTIVE COMPENSATION. Pursuant to General Instruction J of Form 10-K, the information required by Item 11 is omitted. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Pursuant to General Instruction J of Form 10-K, the information required by Item 12 is omitted. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Pursuant to General Instruction J of Form 10-K, the information required by Item 13 is omitted. PART IV ------- Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as a part of the report: (1) Financial Statements. See Index to Consolidated Financial Statements and Schedules on page hereof. (2) Financial Statement Schedules. See Index to Consolidated Financial Statements and Schedules on page hereof. (3) Exhibits: See Exhibit Index. (b) Reports on Form 8-K: On October 21, 1993, the Company filed a Current Report on Form 8-K dated October 18, 1993, reporting under Item 5 thereof the results of its operations for the three months and nine months ended September 30, 1993, and certain other selected financial data. No other reports on Form 8-K have been filed by the Company during the last quarter of the period covered by this report. EXHIBIT INDEX ------------- Exhibit Filing Number Description of Exhibit Method ------- ---------------------- ------ 3.01 Restated Certificate of Incorporation of Commercial Credit Company (the "Company"), included in Certificate of Merger of CCC Merger Company into the Company; Certificate of Ownership and Merger merging CCCH Acquisition Corporation into the Company; and Certificate of Ownership and Merger merging RDI Service Corporation into the Company, incorporated by reference to Exhibit 3.01 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-6594). 3.02 By-laws of the Company, as amended May 14, 1990, incorporated by reference to Exhibit 3.02.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-6594). 4.01.1 Indenture, dated as of December 1, 1986 (the "Indenture"), between the Company and Citibank, N.A., relating to the Company's debt securities, incorporated by reference to Exhibit 4.01 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988 (File No. 1-6594). 4.01.2 First Supplemental Indenture, dated as of June 13, 1990, to the Indenture, incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated June 13, 1990 (File No. 1-6594). The total amount of securities authorized pursuant to any other instrument defining rights of holders of long-term debt of the Company does not exceed 10% of the total assets of the Company and its consolidated subsidiaries. The Company will furnish copies of any such instrument to the Commission upon request. Exhibit Filing Number Description of Exhibit Method ------- ---------------------- ------ 10.01 $1,500,000,000 Three Year Credit Agreement Electronic dated as of February 24, 1994 among the Company, the Banks party thereto and Morgan Guaranty Trust Company of New York, as Agent. 12.01 Computation of Ratio of Earnings to Fixed Electronic Charges. 21.01 Pursuant to General Instruction J of Form 10-K, the list of subsidiaries of the Company is omitted. 23.01 Consent of KPMG Peat Marwick, Independent Electronic Certified Public Accountants. 99.01 The second paragraph of page 2 of the Electronic Company's Current Report on Form 8-K dated July 28, 1992 (File No. 1-6594). Copies of any of the exhibits referred to above will be furnished at a cost of $.25 per page to security holders who make written request therefor to Patricia A. Rouzer, Corporate Communications and Investor Relations, Commercial Credit Company, 300 St. Paul Place, Baltimore, Maryland 21202. 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. COMMERCIAL CREDIT COMPANY (Registrant) By: /s/ Robert S. Willumstad . . . . . . . . . . . . . . Robert B. Willumstad, Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated on the 30th day of March, 1994. Signature Title --------- ----- /s/ Robert B. Willumstad . . . . . . . . . . . . . . Chairman of the Board, Chief Robert B. Willumstad Executive Officer (Principal Executive Officer) and Director /s/ William R. Hofmann . . . . . . . . . . . . . . Vice President and Chief William R. Hofmann Financial Officer (Principal Financial Officer) /s/ Irwin R. Ettinger . . . . . . . . . . . . . . Senior Vice President, Chief Irwin R. Ettinger Accounting Officer (Principal Accounting Officer) and Director /s/ James Dimon . . . . . . . . . . . . . . Director James Dimon /s/ Jerome T. Fadden . . . . . . . . . . . . . . Director Jerome T. Fadden /s/ Robert I. Lipp . . . . . . . . . . . . . . Director Robert I. Lipp COMMERCIAL CREDIT COMPANY and SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES* Page Herein ------ Independent Auditors' Report Consolidated Statement of Income for the year ended December 31, 1993, 1992 and 1991 Consolidated Statement of Financial Position at December 31, 1993 and 1992 Consolidated Statement of Changes in Stockholder's Equity for the year ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for the year ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements - Schedules: Schedule I - Marketable Securities - Other Investments Schedule III - Condensed Financial Information of Registrant (Parent Company only) - Schedule IX - Short-Term Borrowings Schedule X - Supplementary Income Statement Information *Schedules not listed are omitted as not applicable or not required by Regulation S-X. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholder Commercial Credit Company: We have audited the consolidated financial statements of Commercial Credit 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 Commercial Credit 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 1 to the consolidated financial statements, the Company changed its methods of accounting for postretirement benefits other than pensions and accounting for postemployment benefits in 1993, and its method of accounting for income taxes in 1992. /s/ KPMG Peat Marwick Baltimore, Maryland January 24, 1994 COMMERCIAL CREDIT COMPANY and SUBSIDIARIES Consolidated Statement of Income (In millions of dollars) Year Ended December 31, 1993 1992 1991 ------------------------------------------------------------------- Revenues Finance related interest and other charges $ 953.5 $ 952.7 $ 958.3 Insurance premiums 342.1 326.7 304.2 Interest and dividends 69.2 79.5 85.9 Equity in income of old Travelers 38.0 - - Other income 177.5 164.6 110.7 ------------------------------------------------------------------- Total revenues 1,580.3 1,523.5 1,459.1 ------------------------------------------------------------------- Expenses Interest 363.7 369.7 434.9 Policyholder benefits and claims 216.2 210.4 200.9 Insurance underwriting, acquisition and operating 87.0 85.2 77.0 Non-insurance compensation and benefits 164.1 153.5 152.5 Provision for credit losses 133.9 165.3 165.1 Other operating 147.5 122.6 125.8 ------------------------------------------------------------------- Total expenses 1,112.4 1,106.7 1,156.2 ------------------------------------------------------------------- Gain on sale of stock of subsidiary and affiliate -- 12.0 -- ------------------------------------------------------------------- Income before income taxes, minority interest and cumulative effect of changes in accounting principles 467.9 428.8 302.9 Provision for income taxes 153.6 147.6 99.7 ------------------------------------------------------------------- Income before minority interest and cumulative effect of changes in accounting principles 314.3 281.2 203.2 Minority interest, net of income taxes (22.5) -- -- Cumulative effect of changes in accounting principles, net of income taxes (5.8) (18.1) -- ------------------------------------------------------------------- Net income $ 286.0 $ 263.1 $ 203.2 =================================================================== See Notes to Consolidated Financial Statements COMMERCIAL CREDIT COMPANY and SUBSIDIARIES Consolidated Statement of Financial Position (In millions of dollars, except per share amounts) December 31, 1993 1992 ------------------------------------------------------------------------- Assets Cash and cash equivalents $ 25.6 $22.0 Investments: Fixed maturities: Available for sale (market $784.1 and $765.1) 752.5 727.8 Held for investment (market $35.0 and $36.7) 33.7 35.0 Equity securities (market $368.5 and $82.8) 300.0 82.8 Mortgage loans 205.1 188.9 Short-term and other 246.7 115.3 -------------------------------------------------------------------------- Total investments 1,538.0 1,149.8 -------------------------------------------------------------------------- Consumer finance receivables 6,383.1 5,823.5 Allowance for losses (167.5) (168.6) -------------------------------------------------------------------------- Net consumer finance receivables 6,215.6 5,654.9 Other receivables 560.9 363.6 Deferred policy acquisition costs 26.7 26.7 Cost of acquired businesses in excess of net assets 105.8 106.5 Investment in old Travelers - 170.0 Other assets 421.1 545.5 -------------------------------------------------------------------------- Total assets $8,893.7 $8,039.0 ========================================================================== Liabilities Certificates of deposit $ 56.7 $ 22.4 Short-term borrowings 2,206.1 2,486.6 Long-term debt 3,969.8 3,241.9 -------------------------------------------------------------------------- Total debt 6,232.6 5,750.9 Insurance policy and claims reserves 894.7 765.6 Accounts payable and other liabilities 655.7 487.2 -------------------------------------------------------------------------- Total liabilities 7,783.0 7,003.7 -------------------------------------------------------------------------- Stockholder's equity Common stock ($.01 par value; authorized shares: 1,000; share issued: 1) - - Additional paid-in-capital 94.7 105.9 Retained earnings 1,002.6 926.6 Other 13.4 2.8 -------------------------------------------------------------------------- Total stockholder's equity 1,110.7 1,035.3 -------------------------------------------------------------------------- Total liabilities and stockholder's equity $8,893.7 $8,039.0 ========================================================================== See Notes to Consolidated Financial Statements COMMERCIAL CREDIT COMPANY and SUBSIDIARIES Consolidated Statement of Changes in Stockholder's Equity (In millions of dollars, except per share amounts) Year ended December 31, 1993 1992 1991 --------------------------------------------------------------------- Common stock-$.01 par value, 1,000 shares with 1 share issued Balance, beginning of year - - - Balance, end of year - - - --------------------------------------------------------------------- Additional Paid-In Capital Balance, beginning of year $ 105.9 $ 105.9 $ 105.4 Capital contribution 1.2 - 0.5 Adjustments relating to exchange of investment in old Travelers, net (12.4) - - --------------------------------------------------------------------- Balance, end of year 94.7 105.9 105.9 --------------------------------------------------------------------- Retained Earnings Balance, beginning of year 926.6 943.5 845.1 Net income 286.0 263.1 203.2 Dividends (210.0) (280.0) (104.8) --------------------------------------------------------------------- Balance, end of year 1,002.6 926.6 943.5 --------------------------------------------------------------------- Other Balance, beginning of year 2.8 0.7 1.3 Net appreciation (depreciation) of equity 10.8 2.3 (0.5) securities Translation adjustments (0.2) (0.2) (0.1) --------------------------------------------------------------------- Balance, end of year 13.4 2.8 0.7 --------------------------------------------------------------------- Total stockholder's equity $1,110.7 $1,035.3 $1,050.1 ===================================================================== See Notes to Consolidated Financial Statements COMMERCIAL CREDIT COMPANY and SUBSIDIARIES Consolidated Statement of Cash Flows (In millions of dollars) Notes to Consolidated Financial Statements (continued) The amortized cost and estimated market value at December 31, 1993 by contractual maturity are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or pre-payment penalties. Estimated Amortized Market Cost Value -------- --------- Due in one year or less $ 30.3 $ 32.3 Due after one year through five years 83.9 86.9 Due after five years through ten years 132.2 170.3 Due after ten years 306.9 297.4 ----- ----- 553.3 586.9 Mortgage-backed securities 232.9 232.2 ----- ----- $786.2 $819.1 ===== ===== Realized gains and losses on fixed maturities for the year ended December 31 were as follows: 1993 1992 1991 ---- ---- ---- Realized gains Pre-tax $67.3 $22.2 $5.2 ---- ---- --- After-tax 43.7 14.7 3.4 ---- ---- --- Realized losses Pre-tax $0.2 $0.2 $0.7 --- --- --- After-tax 0.1 0.1 0.5 --- --- --- On December 31, 1993, the Parent acquired the approximately 73% it did not already own of old Travelers, by means of a merger of old Travelers into the Parent. As a result of the merger, the Company's investment in the common stock of old Travelers, which through that date had been carried on the equity basis of accounting, was exchanged for 7.2 million shares of common stock of the Parent at a ratio of 0.80423 of a share of the Parent common stock for each share of old Travelers common stock. At December 31, 1993 the investment was reflected at a carrying amount of $211.3. On March 31, 1994, 6.3 million of the Company's shares of the Parent's common stock will be exchanged for a variable rate preferred stock of the Parent, which is redeemable at the option of the holder at certain times and callable by the Parent at certain times. The preferred stock will have a value equal to the market value of the common shares at the time the exchange was agreed upon. The balance of such shares, which are held by an insurance subsidiary, will be exchanged upon receipt of regulatory approval. Notes to Consolidated Financial Statements (continued) 5. Consumer Finance Receivables ---------------------------- Consumer finance receivables, net of unearned finance charges of $613.0 and $535.3 at December 31, 1993 and 1992, respectively, consisted of the following: 1993 1992 -------- -------- Real estate-secured loans $2,705.8 $2,607.7 Personal loans 2,495.2 2,378.8 Credit cards 697.1 538.2 Sales finance and other 443.7 263.0 -------- -------- Consumer finance receivables 6,341.8 5,787.7 Accrued interest receivable 41.3 35.8 Allowance for credit losses (167.5) (168.6) -------- -------- Net consumer finance receivables $6,215.6 $5,654.9 ======== ======== An analysis of the allowance for credit losses on consumer finance receivables at December 31, was as follows: 1993 1992 1991 -------- -------- --------- Balance, January 1 $ 168.6 $ 166.8 $ 135.5 Provision for credit losses 133.9 165.3 165.1 Amounts written off (163.1) (184.8) (174.8) Recovery of amounts previously written off 22.7 21.3 20.6 Allowance on receivables purchased 5.4 - 20.4 ------- -------- -------- Balance, December 31 $ 167.5 $ 168.6 $ 166.8 ======= ======== ======== Net outstandings $6,341.8 $5,787.7 $5,825.1 ======= ======== ======== Ratio of allowance for credit losses to net outstandings 2.64% 2.91% 2.86% ======= ======= ======== Contractual maturities of receivables before deducting unearned finance charges and excluding accrued interest were as follows: Receivables Outstanding Due December 31, Due Due Due Due After 1993 1994 1995 1996 1997 1997 ----------- ------- -------- ------ ------ ------- Real estate-secured loans $2,769.9 $ 175.6 $ 180.9 $193.1 $198.0 $2,022.3 Personal loans 2,952.5 954.1 822.1 608.1 331.0 237.2 Credit cards 695.0 114.4 95.6 79.8 66.7 338.5 Sales finance and other 537.4 217.9 121.0 63.6 37.0 97.9 -------- -------- -------- ------ ------ -------- Total $6,954.8 $1,462.0 $1,219.6 $944.6 $632.7 $2,695.9 ======== ======== ======== ====== ====== ======== Percentage 100% 21% 18% 14% 9% 38% ===== ===== ===== ===== ===== ===== Contractual terms average 12 years on real estate-secured loans and 4 years on other personal loans. Experience has shown that a substantial amount of the receivables will be renewed or repaid prior to contractual maturity dates. Accordingly, the foregoing tabulation should not be regarded as a forecast of future cash collections. Notes to Consolidated Financial Statements (continued) The Company has a geographically diverse consumer finance loan portfolio. At December 31, the distribution by state was as follows: 1993 1992 -------- ------ Ohio 13% 14% North Carolina 10% 9% South Carolina 7% 6% Maryland 6% 7% Pennsylvania 6% 6% California 5% 6% Texas 5% 5% All other states* 48% 47% ---- ---- Total 100% 100% ==== ==== * None of the remaining states individually accounts for more than 4% of total consumer finance receivables. The estimated fair value of the consumer finance receivables portfolio depends on the methodology selected to value such portfolio (i.e., entry value versus exit value). Entry value is determined by comparing the portfolio yields to the yield at which new loans are being originated. Under the entry value methodology, the estimated fair value of the receivables portfolio at December 31, 1993 is approximately $40 to $55 above the recorded carrying values. Exit value represents a valuation of the portfolio based upon sales of comparable portfolios which takes into account the value of customer relationships and the current level of funding costs. Under the exit value methodology, the estimated fair value of the receivables portfolio at December 31, 1993 is approximately $550 to $650 above the recorded carrying value. 6. Debt ---- Short-term borrowings consisted of the following at December 31: 1993 1992 ---- ---- Commercial paper $2,206.1 $2,386.6 Medium-term floating rate notes -. 100.0 -------- -------- $2,206.1 $2,486.6 ======== ======== The Company issues commercial paper directly to investors and maintains unused credit availability under its bank lines of credit at least equal to the amount of its outstanding commercial paper. The Company may borrow under its revolving credit facilities at various interest rate options and compensates the banks for the facilities through commitment fees. The Company and its Parent have agreements with certain banks whereby the Parent, with the consent of the Company, may assign certain revolving credit amounts (swing facilities) to the Company for specific periods of time. At December 31, 1993, the Company had committed and available revolving credit facilities of $2,295.0, which was increased to $2,495.0 in January 1994 through additional amounts assigned under the swing facilities. Also in February 1994, a $1,825.0 revolving credit facility, which, would have matured in August 1994, was replaced with two new facilities totaling $2,000.0. With these new facilities, the Company has revolving credit facilities totaling $2,670.0, of which $250.0 expires in 1994, $920.0 expires in 1995 and $1,500.0 expires in 1997. Notes to Consolidated Financial Statements (continued) The carrying value of short-term borrowings approximates fair value. Long-term debt, including its current portion, and final maturity dates were as follows at December 31: 1993 1992 ---- ---- 8.29% to 12.85% Medium-Term Notes due 1994-1995 $ 54.8 $ 76.9 9 1/8% Notes due 1993 - 100.0 9.15% Notes due 1993 - 100.0 8% Notes due 1994 100.0 100.0 12.7% Notes due 1994 15.0 15.0 6.95% Notes due 1994 200.0 200.0 8.45% Notes due 1994 100.0 100.0 9 7/8% Notes due 1995 150.0 150.0 9.2% Notes due 1995 100.0 100.0 6.25% Notes due 1995 100.0 100.0 7.7% Notes due 1995 150.0 150.0 8.1% Notes due 1995 150.0 150.0 8 3/8% Notes due 1995 150.0 150.0 6.375% Notes due 1996 200.0 200.0 7.375% Notes due 1996 150.0 150.0 8% Notes due 1996 100.0 100.0 6.75% Notes due 1997 200.0 200.0 8 1/8% Notes due 1997 150.0 150.0 5.70% Notes due 1998 100.0 - 5 1/2% Notes due 1998 100.0 - 8 1/2% Notes due 1998 100.0 100.0 6.70% Notes due 1999 150.0 150.0 10% Notes due 1999 100.0 100.0 9.6% Notes due 1999 100.0 100.0 6.00% Notes due 2000 100.0 - 5 3/4% Notes due 2000 200.0 - 6 1/8% Notes due 2000 100.0 - 6.00% Notes due 2000 150.0 - 5.9% Notes due 2003 200.0 - 10% Notes due 2008 150.0 150.0 10% Debentures due 2009 100.0 100.0 8.7% Debentures due 2009 150.0 150.0 8.7% Debentures due 2010 100.0 100.0 ------- ------- $3,969.8 $3,241.9 ======= ======= Notes to Consolidated Financial Statements (continued) Payments due on debt, excluding amortization of the net discount to fair values, are as follows: 1994 $459.8 1995 $810.0 1996 $450.0 1997 $350.0 1998 $300.0 The fair value of the Company's long-term debt is estimated based on the quoted market price for the same or similar issues or on current rates offered to the Company for debt of the same remaining maturities. At December 31, 1993 these fair values were approximately $4,234. 7. Reinsurance ----------- The Company's insurance subsidiaries cede portions of certain insurance business in order to limit losses, to reduce exposure on large risks and to provide additional capacity for future growth. This is accomplished through various plans of reinsurance, primarily coinsurance, modified coinsurance and yearly renewable term. Reinsurance ceded arrangements do not discharge the insurance subsidiaries or the Company as the primary insurer. Reinsurance amounts included in the Condensed Consolidated Statement of Income were as follows: Ceded to Gross Other Net Amount Companies Amount ------ --------- ------ Year ended December 31, 1993 ---------------------------- Premiums Credit life insurance $ 53.0 $ (12.9) $ 40.1 Credit accident and health insurance 86.9 (42.2) 44.7 Property and casualty insurance 433.8 (176.5) 257.3 ------ ------- ------ $573.7 $(231.6) $342.1 ====== ======= ====== Claims $318.0 $(101.8) $216.2 ====== ======= ====== Year ended December 31, 1992 ---------------------------- Premiums Credit life insurance $ 52.2 $ (10.8) $ 41.4 Credit accident and health insurance 75.0 (30.2) 44.8 Property and casualty insurance 390.2 (149.7) 240.5 ------ ------- ----- $517.4 $(190.7) $326.7 ====== ======== ====== Claims $284.8 $ (74.4) $210.4 ====== ======== ====== Year ended December 31, 1991 ---------------------------- Premiums Credit life insurance $ 58.5 $ (18.1) $ 40.4 Credit accident and health insurance 69.8 (27.6) 42.2 Property and casualty insurance 376.3 (154.7) 221.6 ------ -------- ----- $504.6 $(200.4) $304.2 ====== ======== ====== Claims $290.0 $ (89.1) $200.9 ====== ======== ====== Notes to Consolidated Financial Statements (continued) 8. Income Taxes ------------ For the years ended December 31, 1993 and 1992, income taxes have been provided in accordance with the provisions of FAS 109, which has been adopted effective January 1, 1992. The provision for income taxes (before minority interest) for the year ended December 31 was as follows: 1993 1992 1991 ----- ------ ------ Current: Federal $128.7 $113.6 $62.6 Foreign 2.5 2.0 1.6 State 7.1 6.0 5.1 ----- ----- ---- 138.3 121.6 69.3 ----- ----- ---- Deferred: Federal 18.0 27.2 31.8 Foreign (2.2) (1.8) (1.4) State (0.5) 0.6 -. ----- ----- ---- 15.3 26.0 30.4 ----- ----- ---- Total $153.6 $147.6 $99.7 ===== ===== ==== Deferred income taxes at December 31 related to the following: 1993 1992 -------- -------- Deferred tax assets: Bad debt reserves $ 62.8 $ 68.5 Policy reserves 24.0 23.9 Basis difference on old Travelers stock - 17.8 Other deferred tax assets 24.7 24.7 ----- ----- 111.5 134.9 ----- ----- Deferred tax liabilities: Deferred gains - (26.9) Israeli leasing transactions (9.3) (13.9) Fixed asset depreciation (11.7) (9.3) Deferred policy acquisition costs (7.8) (6.2) Other deferred tax liabilities (28.1) (36.4) ------ ------ (56.9) (92.7) ------ ------ Total $54.6 $42.2 ==== ==== The Company and its wholly owned domestic non-life insurance subsidiaries join with the Parent in filing a consolidated federal income tax return. Under a tax sharing agreement with the Parent, the Company is entitled to a current tax benefit if it incurs losses which are utilized in the Parent's consolidated return. The Parent's consolidated tax return group has reported large amounts of taxable income in recent years and can, more likely than not, expect to have significant taxable income in the future thereby enabling utilization of the Company's deferred tax asset. Notes to Consolidated Financial Statements (continued) The provision for deferred income taxes for the year ended December 31, 1991 related to the following: Bad debt reserves $ 4.2 Divested businesses and assets 19.9 Israeli leasing transactions (1.4) Net costs to originate loans 4.6 Other, net 3.1 ---- Total $30.4 ==== The reconciliation of the federal statutory income tax rate to the Company's effective income tax rate for the year ended December 31 was as follows: 1993 1992 1991 ---- ---- ---- Federal statutory rate 35.0% 34.0% 34.0% Dividends from affiliate - The Travelers Inc. (0.3) (0.6) (2.0) Equity in income of old Travelers (1.6) -- -- Other, net (0.3) 1.0 0.9 ----- ---- ---- Effective income tax rate 32.8% 34.4% 32.9% ==== ==== ==== 9. Stockholder's Equity -------------------- Certain long-term loan credit agreements restrict the payment of dividends with such restrictions based on cumulative net earnings, as defined. Additionally, a minimum net worth restriction, as defined, contained in such agreements, imposes an additional constraint on dividends. At December 31, 1993 the Company would be able to remit $149.8 in dividends to its parent under the most restrictive debt covenants. The Company's share of the combined insurance subsidiaries' statutory stockholder's equity at December 31, 1993 and 1992 was $231.5 and $318.3, respectively, and is subject to certain restrictions imposed by state insurance departments as to the transfer of funds and payment of dividends. The combined insurance subsidiaries' net income determined in accordance with statutory accounting practices and after minority interest in 1993, for the years ended December 31, 1993, 1992 and 1991 was $64.4, $107.4 and $52.7, respectively. 10. Employee Benefit Plans ---------------------- The Company along with affiliated companies, participates in a noncontributory defined benefit pension plan sponsored by the Parent (the Plan) covering the majority of U.S. employees. Notes to Consolidated Financial Statements (continued) Benefits are based on an account balance formula. Under this formula, each employee's accrued benefit can be expressed as an account that is credited with amounts based upon the employee's pay, length of service and a specified interest rate, all subject to a minimum benefit level. The Plan is funded in accordance with the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. Pension cost allocated to the Company from the Plan was $2.1, $1.3 and $0.2 in 1993, 1992 and 1991, respectively. Certain non-U.S. employees of the Company are covered by noncontributory defined benefit plans. These plans are funded based upon local laws. Pension cost related to these plans was not material. The Company also has an unfunded noncontributory supplemental retirement plan that covers certain executives and key employees. Pension cost related to the plan was $1.2, $0.8 and $0.6 in 1993, 1992 and 1991, respectively. 11. Postretirement and Postemployment Benefits ------------------------------------------ The Company provides postretirement life insurance benefits to certain eligible retirees. As required by FAS 106, the Company changed its method of accounting for these benefits effective January 1, 1993, to accrue the Company's share of the costs of the benefits over the service period rendered by an employee. Previously these benefits were charged to expense when paid. The Company elected to recognize immediately the liability for postretirement benefits as the cumulative effect of a change in accounting principle. This change resulted in a noncash after-tax charge to net income of $2.4 in 1993. The Company generally funds the postretirement benefits when due. Payments and ongoing net periodic postretirement benefit cost were not material in 1993. In accordance with the Company's early adoption of FAS 112, the Company changed its method of accounting for postemployment benefits effective January 1, 1993, to accrue the cost of postemployment benefits over the service period rendered by an employee. Previously these benefits were charged to expense when paid. For the Company these benefits are principally disability-related benefits and severance. Adoption of FAS 112 resulted in the recognition of a noncash after-tax charge to net income of $3.4 in 1993 for the cumulative effect of a change in accounting principle. The Company continues to fund benefits on a "pay-as-you-go" basis. Payments and annual expense for providing postemployment benefits in 1993 were not material. 12. Lease Commitments and Other Financial Instruments ------------------------------------------------- Rentals Rental expense (principally for offices and computer equipment) was $33.7, $35.0 and $34.4 for the years ended December 31, 1993, 1992 and 1991, respectively. Notes to Consolidated Financial Statements (continued) At December 31, 1993, future minimum annual rentals under noncancellable operating leases were as follows: 1994 $18.1 1995 14.5 1996 12.2 1997 7.1 1998 4.1 Thereafter 5.7 ----- $61.7 ==== Credit Cards The Company provides credit card services through its subsidiaries, Primerica Bank and Primerica Bank USA. These services are provided to individuals and to affinity groups nationwide. At December 31, 1993 and 1992 total credit lines available to credit cardholders were $3,916.1 and $3,056.2, of which $697.1 and $538.2 were utilized, respectively. 13. Related Party Transactions -------------------------- Included in other assets is an investment in redeemable preferred stock of the Parent amounting to $100 and $200 at December 31, 1993 and 1992, respectively. The Company recorded $4.0, $8.0 and $17.8 for the years ended December 31, 1993, 1992 and 1991, respectively, of dividend income from the Parent on this investment of which $100.0 and $100.0 was repurchased in 1993 and 1992, respectively. To facilitate cash management the Company has entered into an agreement with the Parent under which the Company or the Parent may borrow from the other party at any time an amount up to the greater of $50.0 or 1% of the Company's consolidated assets. The agreement may be terminated by either party at any time. The interest rate to be charged on borrowings outstanding will be equivalent to an appropriate market rate. 14. Contingencies ------------- In the ordinary course of business the Company and/or its subsidiaries are defendants or co-defendants in various litigation matters. Although there can be no assurances, the Company believes, based on information currently available, that the ultimate resolution of these legal proceedings would not be likely to have, but may have, a material adverse effect on the results of operations. Notes to Consolidated Financial Statements (continued) 15. Quarterly Financial Data (unaudited) (1) Previously reported quarterly results for the first quarter of 1993 have been restated to reflect the Statement of Financial Accounting Standards (FAS 112) "Accounting For Postemployment Benefits," with retroactive application to January 1, 1993. This had the effect of reducing first quarter 1993 net income by $3.4. SCHEDULE I COMMERCIAL CREDIT COMPANY and SUBSIDIARIES Marketable Securities - Other Investments December 31, 1993 (In millions of dollars) Column A Column B Column C Column D -------- -------- -------- -------- Amount at Which Shown Market in the Type of Investment Cost Value Balance Sheet ------------------ ---- ----- ------------- Fixed maturities Bonds United States Government and government agencies and authorities (1) $ 507.4 $519.4 $ 507.4 States, municipalities and political sub-divisions 177.8 190.3 177.8 Foreign governments 0.3 0.3 0.3 Public utilities 13.1 14.5 13.1 All other corporate bonds 76.1 82.9 76.1 Redeemable preferred stock 11.5 11.7 11.5 ------- ----- ------- Total fixed maturities $ 786.2 $819.1 $ 786.2 ------- ----- ------- Equity securities Common stocks $ 237.2 $324.4 $ 255.9 Non-redeemable preferred stocks 40.1 44.1 44.1 ------- ----- ------- Total equity securities 277.3 $368.5 300.0 ------- ------ ------- Mortgage loans on real estate 205.1 205.1 Short-term investments 233.0 233.0 Other investments 13.8 13.7 ------- ------- Total investments $1,515.4 $1,538.0 ======= ======= (1) includes mortgage-backed security obligations of U.S. Government agencies. SCHEDULE III COMMERCIAL CREDIT COMPANY (Parent Company Only) Condensed Financial Information of Registrant (In millions of dollars) Condensed Statement of Income Year Ended December 31, 1993 1992 1991 ----------------------------------------------------------------- Income Equity in income of old Travelers $ 38.0 $ - $ - Gain on sales of stock of subsidiary and affiliate - 12.0 - Other income 383.2 423.5 451.5 ----------------------------------------------------------------- Total 421.2 435.5 451.5 ----------------------------------------------------------------- Expenses Interest 364.2 368.9 427.8 Other 22.2 13.0 11.7 ----------------------------------------------------------------- Total 386.4 381.9 439.5 ----------------------------------------------------------------- Pre-tax income 34.8 53.6 12.0 Income tax benefit (expense) (3.3) (18.5) 0.2 ----------------------------------------------------------------- Net income before equity in net income of subsidiaries 31.5 35.1 12.2 Equity in net income of subsidiaries 260.3 246.1 191.0 Cumulative effect of changes in accounting principles (including $5.8 and $18.1, respectively, applicable to subsidiaries) (5.8) (18.1) - ----------------------------------------------------------------- Net income $286.0 $263.1 $203.2 ================================================================ The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto. SCHEDULE III COMMERCIAL CREDIT COMPANY (Parent Company Only) Condensed Financial Information of Registrant (In millions of dollars except per share amounts) Condensed Statement of Financial Position December 31, 1993 1992 -------------------------------------------------------------------------- Assets Equity securities $ 178.4 $ - Investment in old Travelers - 150.0 Investment in mortgage loans 194.4 178.8 Notes and accounts receivable from subsidiaries- eliminated in consolidation 6,035.6 5,304.7 Investment in subsidiaries at cost plus equity in net earnings-eliminated in consolidation 832.0 954.6 Investment in redeemable preferred stock of the Parent 100.0 200.0 Other 128.1 118.4 -------------------------------------------------------------------------- Total assets $7,468.5 $6,906.5 ========================================================================== Liabilities Short-term borrowings $2,206.1 $2,486.5 Long-term debt 3,969.8 3,241.9 Accrued expenses and other liabilities 181.9 142.8 -------------------------------------------------------------------------- Total liabilities 6,357.8 5,871.2 -------------------------------------------------------------------------- Stockholder's equity Common stock ($.01 par value; authorized shares: 1,000; share issued: 1) - - Additional paid-in capital 94.7 105.9 Retained earnings 1,002.6 926.6 Other 13.4 2.8 -------------------------------------------------------------------------- Total stockholder's equity 1,110.7 1,035.3 -------------------------------------------------------------------------- Total liabilities and stockholder's equity $7,468.5 $6,906.5 ========================================================================== The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto. SCHEDULE III COMMERCIAL CREDIT COMPANY (Parent Company Only) Condensed Financial Information of Registrant (In millions of dollars) Condensed Statement of Cash Flows The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto. Schedule IX SCHEDULE X COMMERCIAL CREDIT COMPANY and SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In millions of dollars) Column A Column B ------------------------------ ---------------------- Charged to costs and expenses Year ended December 31, ----------------------- Item 1993 1992 1991 ---- ---- ---- ---- Taxes, other than payroll and $22.7 $20.9 $19.1 income taxes ===== ===== ===== Advertising costs $26.2 $19.7 $22.0 ===== ===== ===== EXHIBIT INDEX ------------- Exhibit Filing Number Description of Exhibit Method ------- ---------------------- ------ 3.01 Restated Certificate of Incorporation of Commercial Credit Company (the "Company"), included in Certificate of Merger of CCC Merger Company into the Company; Certificate of Ownership and Merger merging CCCH Acquisition Corporation into the Company; and Certificate of Ownership and Merger merging RDI Service Corporation into the Company, incorporated by reference to Exhibit 3.01 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-6594). 3.02 By-laws of the Company, as amended May 14, 1990, incorporated by reference to Exhibit 3.02.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-6594). 4.01.1 Indenture, dated as of December 1, 1986 (the "Indenture"), between the Company and Citibank, N.A., relating to the Company's debt securities, incorporated by reference to Exhibit 4.01 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988 (File No. 1-6594). 4.01.2 First Supplemental Indenture, dated as of June 13, 1990, to the Indenture, incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated June 13, 1990 (File No. 1-6594). The total amount of securities authorized pursuant to any other instrument defining rights of holders of long-term debt of the Company does not exceed 10% of the total assets of the Company and its consolidated subsidiaries. The Company will furnish copies of any such instrument to the Commission upon request. Exhibit Filing Number Description of Exhibit Method ------- ---------------------- ------ 10.01 $1,500,000,000 Three Year Credit Agreement Electronic dated as of February 24, 1994 among the Company, the Banks party thereto and Morgan Guaranty Trust Company of New York, as Agent. 12.01 Computation of Ratio of Earnings to Fixed Electronic Charges. 21.01 Pursuant to General Instruction J of Form 10-K, the list of subsidiaries of the Company is omitted. 23.01 Consent of KPMG Peat Marwick, Independent Electronic Certified Public Accountants. 99.01 The second paragraph of page 2 of the Electronic Company's Current Report on Form 8-K dated July 28, 1992 (File No. 1-6594). Copies of any of the exhibits referred to above will be furnished at a cost of $.25 per page to security holders who make written request therefor to Patricia A. Rouzer, Corporate Communications and Investor Relations, Commercial Credit Company, 300 St. Paul Place, Baltimore, Maryland 21202.

41499_1993.txt

41499_1993

1993

41499

ITEM 1. DESCRIPTION OF BUSINESS GENERAL The Gillette Company was incorporated under the laws of the State of Delaware in 1917 as the successor of a Massachusetts corporation incorporated in 1912 which corporation was the successor of a Maine corporation organized in 1901 by King C. Gillette, inventor of the safety razor. A description of the Company and its businesses appears in the 1993 Annual Report on the inside of the front cover and at pages 3 through 5 under the caption "Letter to Stockholders" and at page 42 under the caption "Principal Divisions and Subsidiaries," the texts of which are incorporated by reference. See also Item 7, Management's Discussion. BUSINESS SEGMENTS The approximate percentages of consolidated net sales and segment profit from operations during the last five years for each of the Company's business segments appear in the 1993 Annual Report at page 39 under the caption, "Business Segments," and are incorporated by reference. "Financial Information by Business Segment," and "Segment and Area Commentary" containing information on net sales, profit from operations, identifiable assets, capital expenditures and depreciation for each of the last three years, appear in the 1993 Annual Report at page 37 and are incorporated by reference. The Company's businesses range across several industry segments, including blades and razors, toiletries and cosmetics, stationery products, electric shavers, small household appliances, hair care appliances, oral care appliances and oral care products. Descriptions of those businesses appear in the 1993 Annual Report at pages 6 through 15, the text of which is incorporated by reference. DISTRIBUTION In the Company's major markets, traditional Gillette product lines are sold to wholesalers, chain stores and large retailers and are resold to consumers primarily through food, drug, discount, stationery, tobacco and department stores. Jafra skin care products are sold directly to consumers by independent consultants, primarily at classes in the home. Waterman and Parker products are sold to wholesalers and retailers and are resold to consumers through fine jewelry, fine stationery and department stores, pen specialists and other retail outlets. Braun products are sold to wholesalers and retailers and are resold to consumers mainly through department, discount, catalogue and specialty stores. In many small Gillette International and Braun markets, products are distributed through local distributors and sales agents. Oral-B products are marketed directly to dental professionals for distribution to patients and also are sold to wholesalers, chain stores and large retailers for resale to consumers through food, drug and discount stores. PATENTS Certain of the Company's patents and licenses in the blade and razor segment are of substantial value and importance when considered in the aggregate. Additionally, the Company holds significant patents in the toiletries and cosmetics, writing instruments and Braun business segments. No patent or license held by the Company is considered to be of material importance when judged from the standpoint of the Company's total business. Gillette has licensed many of its blade and razor patents to other manufacturers. In all these categories, Gillette competitors also have significant patent positions. The patents and licenses held by the Company are of varying remaining durations. TRADEMARKS In general, the Company's principal trademarks have been registered in the United States and throughout the world where the Company's products are sold. Gillette products are marketed outside the United States under various trademarks, many of which are the same as those used in the United States. The trademark Gillette is of principal importance to the Company. In addition, a number of other trademarks owned by the Company and its subsidiaries have significant importance within their business segments. The Company's rights in these trademarks endure for as long as they are used or registered. COMPETITION The blades and razors segment is marked by competition in product performance, innovation and price, as well as by competition in marketing, advertising and promotion to retail outlets and to consumers. The Company's major competitors worldwide are Warner-Lambert Company, with its Schick and Wilkinson Sword (in North America and Europe) product lines, and Societe Bic S.A., a French company. Additional competition in the United States is provided by the American Safety Razor Company, Inc. under its own brands and a number of private label brands. The toiletries and cosmetic segment is highly competitive in terms of price, product innovation and market positioning, with frequent introduction of new brands and marketing concepts, especially for products sold through retail outlets, and with product life cycles typically shorter than in the other business segments of the Company. Competition in the stationery products segment, particularly in the writing instruments market, is marked by a high degree of competition from domestic and foreign suppliers and low entry barriers, and is focused on a wide variety of factors including product performance, design and price, with price an especially important factor in the commercial sector. Competition in the electric shaver, small household, hair care and oral care appliances segments is based primarily on product performance, innovation and price, with numerous competitors in the small household and hair care appliances segments. Competition in the oral care product segment is focused on product performance, price and dental profession endorsement. EMPLOYEES At year-end, Gillette employed 33,400 persons, three-quarters of them outside the United States. RESEARCH AND DEVELOPMENT In 1993, research and development expenditures were $133.1 million, compared with $123.8 million in 1992 and $108.9 million in 1991. RAW MATERIALS The raw materials used by Gillette in the manufacture of products are purchased from a number of outside suppliers, and substantially all such materials are readily available. OPERATIONS BY GEOGRAPHIC AREA The following table indicates the geographic sources of consolidated net sales and profit from operations of the Company for the last three years: "Financial Information by Geographic Area" and "Segment and Area Commentary" containing information on net sales, profit from operations and identifiable assets for each of the last three years appear in the 1993 Annual Report under the same captions at page 37 and are incorporated by reference. ITEM 2. ITEM 2. DESCRIPTION OF PROPERTY The Company owns and leases manufacturing facilities and other important properties in the United States and abroad consisting of approximately 14,041,000 square feet of floor space, of which 76%, or about 10,690,000 square feet, is devoted to the Company's principal manufacturing operations. Additional premises, such as sales and administrative offices, research laboratories, and warehouse, distribution and other manufacturing facilities account for about 24% of Gillette's principal property holdings, or about 3,370,000 square feet. Gillette's executive offices are located in the Prudential Center, Boston, Massachusetts, where the Company holds a long-term lease covering approximately 300,000 square feet. Approximately 84% of these U.S. manufacturing facilities and the land they occupy are owned by Gillette. The Santa Monica property is leased in its entirety and 308,000 square feet of the St. Paul facility is located on leased land. Foreign manufacturing subsidiaries of Gillette, excluding Braun and Oral-B, operate plants with an aggregate of approximately 4.7 million square feet of floor space, about 87% of which is on land owned by Gillette. Many of the international facilities are engaged in the manufacture of products from two or more of the Company's major business segments. Approximately 85% of these facilities and 94% of the land they occupy are owned by Braun. Oral-B's executive offices are in leased space in Redwood City, California. In addition to its Iowa City plant, it owns or leases approximately 200,000 square feet of manufacturing facilities in four countries outside the United States. Miscellaneous manufacturing operations in North Chicago, Illinois and other locations account for approximately 80,000 square feet. The above facilities are in good repair, adequately meet the Company's needs and operate at reasonable levels of production capacity. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is subject to legal proceedings and claims arising out of its business, which cover a wide range of matters, including antitrust and trade regulation, product liability, contracts, environmental issues, patent and trademark matters and taxes. Management, after review and consultation with counsel considers that any liability from all of these legal proceedings and claims would not materially affect the consolidated financial position or results of operations of the Company. The previously reported class action titled In re Gillette Securities Litigation filed in the Federal District Court in Boston has been settled subject to the final approval of the court. The previously reported derivative action titled Albert B. Evans v. Colman M. Mockler, Jr., et al. filed in the same court has been dismissed with prejudice. The previously reported environmental suits filed in the Federal District Court in Boston titled United States v. Charles George Trucking Company, Inc., et al. and Commonwealth of Massachusetts v. Charles George Trucking Company, Inc., et al. have been settled and consent decrees have been entered. Certain parties have appealed the settlements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ------------------------ The Executive Officers hold office until the first meeting of the Board of Directors following the annual meeting of the stockholders and until their successors are respectively elected or appointed and qualified, unless a shorter period shall have been specified by the terms of their election or appointment, or until their earlier resignation, removal or death. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The information required by this item appears in the 1993 Annual Report on the inside back cover and at page 39 under the caption, "Quarterly Financial Information," and is incorporated by reference. As of March 1, 1994, the record date for the 1994 Annual Meeting, there were 29,067 Gillette stockholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item appears in the 1993 Annual Report at pages 40 and 41 under the caption, "Historical Financial Summary," and is incorporated 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 in the 1993 Annual Report at pages 23 through 25 under the caption, "Management's Discussion," and is incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information required by this item with respect to the Directors of the Company appears in the 1994 Proxy Statement at pages 1 through 4, at page 7 under the caption "Certain Transactions with Directors and Officers" and at page 24 under the caption "Compliance with Section 16(a) of the Exchange Act," the texts of which are incorporated by reference. The information required for Executive Officers of the Company appears at the end of Part I of this report at page 5. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item appears in the 1994 Proxy Statement at page 8 under the caption "Compensation of Directors" and at pages 11 through 17 under the captions "Compensation of Chief Executive Officer" and "Executive Compensation" and is incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item concerning the security ownership of certain beneficial owners and management appears in the 1994 Proxy Statement at pages 6 through 7 under the caption, "Stock Ownership of Certain Beneficial Owners and Management," and is incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appears in the 1994 Proxy Statement at page 7 under the caption "Certain Transactions with Directors and Officers" and at page 8 under the caption "Compensation of Directors" and is incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K A. FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS Schedules other than those listed above are omitted because they are either not required or not applicable. B. REPORTS ON FORM 8-K There were no reports on Form 8-K filed by the Company during the last quarter of the period covered by this report. OTHER MATTERS 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 the following Registration Statements of the registrant on Form S-8 (1) No. 33-27916, filed April 10, 1989, and amended thereafter, which incorporates by reference therein Registration Statements on Form S-8 Nos. 2-90276, 2-63951 and 1-50710, and all amendments thereto, all relating to shares issuable and deliverable under The Gillette Company 1971 Stock Option Plan and 1974 Stock Purchase Plan and on Form S-7 No. 2-41016 relating to shares issuable and deliverable under The Gillette Company 1971 Stock Option Plan; (2) No. 33-9495, filed October 20, 1986, and all amendments thereto, relating to shares and plan interests in The Gillette Company Employees' Savings Plan; (3) No. 2-93230, filed September 12, 1984, and all amendments thereto, relating to shares and plan interests in the Oral-B Laboratories Savings Plan; (4) No. 33-56218, filed December 23, 1992, relating to shares and plan interests in The Gillette Company Employees' Savings Plan; and (5) No. 33-52465, filed March 1, 1994, and all amendments thereto, relating to shares issuable and deliverable under The Gillette Company Global Employee Stock Ownership Plan. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant, 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 a claim for indemnification against such liabilities (other than the payments 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. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors of The Gillette Company: Under date of January 27, 1994, we reported on the consolidated balance sheet of The Gillette Company and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income and earnings reinvested in the business and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed on page 7 of this report. 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 Boston, Massachusetts January 27, 1994 THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- (A) -- Transfers between accounts. (B) -- Foreign currency exchange fluctuations from beginning of year to end of year. (C) -- Acquisitions. THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------------- Note -- Depreciation is computed primarily on a straight-line basis over the estimated useful lives of assets which are as follows: THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES * Acquisition balances THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- NOTE: Short-term borrowings, excluding commercial paper, represent primarily foreign currency debt. The maximum and average amounts outstanding during the year are based on quarter-end total outstanding balances and are representative of the year. Average interest rates on short-term borrowings in all three years have been materially impacted by high interest rates in the hyperinflationary economies. Borrowings in these economies have been significantly reduced compared with 1991. THE GILLETTE COMPANY AND SUBSIDIARY COMPANIES - --------------- * Restated to reflect reported years on a comparable basis. 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 GILLETTE COMPANY (Registrant) By THOMAS F. SKELLY ------------------------------- Thomas F. Skelly Senior Vice President and Chief Financial Officer Date: March 22, 1994 By THOMAS F. SKELLY -------------------------- Thomas F. Skelly as Attorney-In-Fact

66901_1993.txt

66901_1993

1993

66901

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

86103_1993.txt

86103_1993

1993

86103

Item 1. BUSINESS Background SafeCard Services, Incorporated ("SafeCard") has been in the business of selling subscriptions by mail and telephone for continuity services that it operates or administers. Continuity services are services provided pursuant to subscriptions which typically continue annually or periodically unless cancelled by the subscriber. SafeCard is a Delaware corporation organized in 1969. During 1992, the Company* relocated its headquarters and operational facility from Ft. Lauderdale, Florida to Cheyenne, Wyoming. The Company's executive offices are located at 3001 E. Pershing Blvd., Cheyenne, Wyoming, 82001, and its telephone number is (307) 771-2700. (See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note E of Notes to Consolidated Financial Statements under Item 8. Financial Statements and Supplementary Data). Subscriptions are primarily sold to credit cardholders through arrangements with credit card issuers, including banks and financial services companies, major oil companies, retail department stores and others. Subscriber acquisition material printed for the Company that describes its services and how to subscribe is inserted in the credit card issuer's monthly billing statements or mailed by the Company directly to credit cardholders. Credit cardholders are also asked to subscribe by means of telephone calls. Subscription fees are generally billed to subscribers' credit card accounts and remitted to the Company by the credit card issuer. The Company's principal service is credit card loss notification ("Hot- Line"), whereby the Company gives prompt notice to credit card issuers upon being informed that a subscriber's credit cards have been lost or stolen (plus a variety of ancillary service features). Other continuity services offered by the Company include those related to fee-based credit cards, reminder services, a personal credit information service, a discount travel service and a legal plan. Certain of the Company's services include incidental insurance coverage underwritten by its insurance subsidiary. In 1993, the Company also began placing greater emphasis on the development of new products and services. For information regarding the Company's revenue, earnings and financial condition, see Item 6. Selected Financial Data, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data. In December 1993, the Board of Directors elected Paul G. Kahn as Chairman of the Board and Chief Executive Officer. Under Mr. Kahn's leadership, the Company's strategy is to broaden its scope so as to become an entrepreneurial, market-driven consumer services company. While expansion of the business and the development of new areas of business may not contribute significantly to revenues in 1994, the Company may incur certain expenses in 1994 in developing these new areas of business. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. References herein to the years 1993, 1992 and 1991 refer to the Company's fiscal years ended October 31. *Unless otherwise noted or where the context otherwise requires, the term "Company" refers to SafeCard Services, Incorporated, including its 100%-owned subsidiaries, SafeCard Services Insurance Company, SafeCard Travel Services, Inc., SafeCard Marketing, Inc. and one inactive subsidiary. Services Provided Hot-Line Credit Card Loss Notification Service Hot-Line is the Company's original service and has been its major source of revenue and earnings. A subscriber's credit cards may be registered with the Company's operations center where the data is maintained. If a subscriber notifies the Company of the loss or theft of his/her credit cards, the Company retrieves (or, if cards have not previously been registered, obtains) the necessary information, and then promptly notifies the credit card issuers of the loss, simultaneously requesting replacement. A variety of ancillary services are typically also made available to subscribers. In 1993, the Company increased the price of certain annual membership fees from $12 to $15. The Company also sells multi-year subscriptions, generally for three year periods at prices historically ranging from $36-$39, which provide for payment in advance of the full subscription price. The Company increased the price of certain multi-year membership fees from $36 - $39, to $45 in 1993. The Company sometimes offers to subscribers an initial trial period at either no fee or a nominal fee. In most states Hot-Line includes liability insurance against fraudulent use of credit cards, issuance of fraud-deterrent stickers to be affixed to credit cards, notification to card issuers of a subscriber's address change, and in some instances, issuance of an emergency medical card containing a microfilm history of certain medical data provided by the subscriber. The Company will also typically wire a $100 to $1500 cash advance or send an airplane ticket to subscribers under certain conditions. Such advances and the cost of such tickets are typically repayable in thirty days. Other services available to subscribers include a nationwide toll-free message service (similar to an answering service) and a lost key return service. During 1993, 1992 and 1991, Hot-Line provided 73%, 73% and 72%, respectively, of the Company's subscription revenue. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Fee-Based Credit Card Services The Company, through arrangements with credit card issuers, markets fee- based credit cards, generally to the issuer's existing no fee cardholders. For an annual fee of $15 to $25, cardholders who subscribe to the fee-based credit cards typically receive a new credit card, issued by the credit card issuer, and various services such as credit card registration, discounts on travel, insurance and other services provided or obtained by the Company. The card issuer is responsible for the collection of all charges made to the credit card and may also provide other services to the cardholder. During 1993, 1992 and 1991, Fee Card programs provided 13%, 12% and 12%, respectively, of the Company's subscription revenue. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Reminder Services The date reminder services ("Reminder Services") provide subscribers, by mail, a monthly computer-generated reminder listing personal dates and events registered by the subscriber in addition to standard holidays. Subscribers add dates and events as desired, either by mail or by calling the Company's toll-free, 24 hour-a-day operations center. The Reminder Services include either a large plastic-laminated wall calendar, and/or a personal Desk Appointment Book, and/or a Pocket Appointment Book. During 1993, 1992 and 1991, Reminder Services provided less than 10% of the Company's subscription revenue. CreditLine Services CreditLine is a personal credit information service. Subscribers receive a comprehensive personal credit report biography either annually or upon request and other services such as a date reminder service and a social security update service. The subscriber's credit information is obtained from national credit bureaus and reorganized into a user-friendly format. The annual fees are typically $29. The Company also sometimes markets CreditLine in conjunction with other services at higher prices. The credit reporting business is subject to existing regulation, as well as future regulation, if any. During 1993, 1992 and 1991, CreditLine Services provided less than 10% of the Company's subscription revenue. The Company began marketing CreditLine in 1989. The Company markets CreditLine pursuant to an agreement ("the CreditLine Agreement") with CreditLine Corporation, a corporation owned by Peter and Steven J. Halmos, the Company's co-founders and their families. Billings, costs and any resulting profits or losses, are shared 50% by the Company and 50% by CreditLine Corporation. In June 1993, the Company was notified by CreditLine Corporation that the license agreement under which the Company markets certain credit information products and services known as CreditLine would not be renewed effective November 1, 1993. However, the Company believes it has certain continuing marketing rights under the license agreement. In addition, the CreditLine Agreement is the subject of litigation between Peter Halmos and related entities and the Company. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Item 8. Financial Statements and Supplementary Data. New Services Under Development In 1993, the Company began placing greater emphasis on the development of new products and services and is currently test marketing three new services with various credit card issuer clients. Results to date are too preliminary to determine the viability of these services. New products and services which are test marketed are frequently not successful. Other Services The Company offers a discount travel service, either separately or in conjunction with other programs. Although the Company is no longer actively marketing its prepaid legal and home protection services, it does provide these services to existing subscribers who renew their subscriptions. In past years, the Company marketed certain reference services ("Reference Services") which included either the Guiness Book of World Records, The World Almanac and Book of Facts or The J.K. Lasser Tax Guide. While the Company is not marketing these programs at the present time, the Company continues to provide services to existing subscribers who renew their subscriptions. During 1993, 1992 and 1991, these other services collectively provided less than 10% of the Company's subscription revenue. Subscriber Acquisition The Company sells subscriptions for its services primarily through arrangements with credit card issuers, to consumers who use credit cards. The Company's subscriber acquisition strategy includes direct mail (generally "Solo Mailings" and "Billing Inserts") and telephone sales. The Company's subscriber acquisition campaigns are typically based on internally-developed strategies, research, formats, copy and graphics and often include multiple solicitations within an overall strategy. The Company's Solo Mailings are generally those created and mailed directly by the Company to holders of credit cards from listings supplied to the Company by the issuers of such credit cards. The printing is typically done by others under contract with SafeCard. While Solo Mailings vary in type and content, they generally include a descriptive brochure, a letter and other subscriber acquisition materials, as well as a postage-paid return subscription form. Each Solo Mailing typically must be approved by the credit card issuer and generally contains materials (i.e., letter, envelope, etc.) bearing the credit card issuer's name and logo. Billing Inserts are generally created by the Company and printed by others under contract and are inserted in the monthly billing statements of credit card issuers. Billing Inserts have the advantage of low cost (because postage is generally paid by credit card issuers). Each Billing Insert mailing typically must be approved by the credit card issuer. Due to the comparatively low cost of Billing Inserts and the limitation on the number of inserts which may be placed in any single billing statement, there is intense competition for insert space. The current average cost of Solo Mailings is approximately $230 per thousand pieces of mail, as compared with about $30 per thousand pieces for Billing Inserts. While Solo Mailings are more costly, primarily due to the fact that the Company pays the postage, Solo Mailings typically generate a higher response rate. In addition, Solo Mailings may be sent to all cardholders of a card issuer, whereas Billing Inserts are mailed only to cardholders who are receiving a statement in the month of insertion. A U.S. postal rate increase is anticipated in 1995. Since postage represents the largest component of direct mail cost, this will have a direct impact on the Company. The Company also sells subscriptions (primarily Hot-Line) by telephone. Although the cost of telephone sales is typically higher, as compared to Solo Mailing and Billing Inserts, the response rates are generally higher and the initial subscription period for telephone sales is often for more than one year, with payment to the Company in advance. Mailings result in both single year and multi year subscribers, with a larger percentage being single year. During 1993, 1992 and 1991, approximately 54%, 58% and 50%, respectively of all subscriptions for Hot-Line were acquired through telephone sales. See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Subscriber acquisition costs are the Company's largest expense category. Subscriber fees are the primary source of revenue. The relationship of these costs to subscription revenues is dependent on a variety of factors including prices, net response rates (gross enrollments less cancellations), marketing costs and renewal rates. These factors are affected by economic conditions, interest rates, other factors affecting the number of credit cards in use, demographic trends, consumers' propensity to buy, the degree of market penetration and the effectiveness of subscriber acquisition concepts, copy and marketing strategies, and other factors. In addition, cardholders of certain credit card issuer clients respond more favorably than others to similar promotions. In 1993, subscriber acquisition and service costs, as a percentage of subscription revenue, increased by approximately 2% over the prior year (primarily due to a decline in certain net response rates, primarily in telemarketing). See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Relationships with Credit Card Issuers The Company acquires its subscribers primarily through contractual arrangements with credit card issuers (including banks and financial services companies, major oil companies, retail department stores and others) for the mail and telephone sales of its services to the issuers' credit card customers. The Company also provides, to a limited extent, on a wholesale basis, its services to large membership groups which are affiliated with credit card issuers, such as oil company travel clubs. New marketing with particular credit card issuers varies from year to year based on both the Company's and the credit card issuer's strategies as well as contractual requirements. The Company has written agreements with a few large credit card issuers which account for a large percentage of its subscription revenue. Termination of any of these contracts would adversely affect the Company. Contracts with Citicorp (South Dakota), N.A. and related entities contributed 34%, 37% and 41% of the Company's consolidated subscription revenue in 1993, 1992 and 1991, respectively. The Company has had contracts with Citicorp since 1981. The principal Citicorp contract, which had an initial term through June 1993, was amended on March 31, 1992 to extend the contract to December 31, 1997 and again on September 1, 1993 to extend the contract to December 31, 1999. Citicorp has a right to terminate the contract in the event of the sale of a majority of the shares of the Company to specified credit card issuers, to banks and their corporate affiliates, and to entities that do not have equity of at least $25 million. Contracts with Sears, Roebuck and Co. contributed approximately 10% of the Company's subscription revenue during 1993 (and less than 10% in 1992 and 1991). The agreement, which contains a provision for cancellation without cause upon 90 days notice, is subject to renewal annually. Contracts with Shell Oil Company accounted for approximately 10% of the Company's consolidated subscription revenue in 1991 (and less than 10% in 1993 and 1992). The Shell Oil Company contracts have varying initial terms but automatically renew on an annual basis unless terminated by either party. Credit card issuers from time to time may adopt a change in business strategy which may affect the Company. For example, in October 1993, Shell Oil Company and a major bank announced the joint marketing of a co-branded card. In addition, certain consolidations of credit card issuers and market share shifts have occured and may continue to occur. To date, the Company has not noted any material impact as a result of these changes in business strategy. The Company's many contracts with credit card issuers generally (though not always) have a one-year or two-year initial term, provide for automatic annual renewal thereafter unless cancelled by either party, and are subject to the fulfillment of certain contractual obligations. These contracts generally provide for the mail and/or telephone sales of subscriptions to the issuer's credit card customers, for the billing (to the subscriber's credit card account) and collection of subscription fees by the card issuers and for payment to the card issuers of commissions or fees. In certain cases, the Company enters into profit-sharing arrangements with credit card issuers, in which the Company pays compensation to credit card issuers based on profitability (as defined in the agreement with the credit card issuer). Authorization for each mailing and/or telephone sales campaign typically must be obtained by the Company from the card issuer, although some contracts contain minimum marketing volume requirements. The Company's ability to obtain such authorization is critical and is dependent on many factors, including the business strategies of the credit card issuer clients; the volume, profitability and efficiency of subscriber acquisitions; quality and efficiency of the Company's subscriber servicing; and competition for the limited subscriber acquisition volume which may be allowed by any one issuer. Additional important factors in the maintenance of these contracts are the Company's knowledge of the differing operational requirements of each credit card issuer, including compatible data processing software, innovative subscriber acquisition strategies, operational efficiency and financial stability. The Company generally does not have proprietary or other rights to the issuers' credit card customer lists should a credit card issuer terminate its contract with the Company. In that event, with the majority of issuers, the Company would continue to provide services to, and receive its revenue from, existing subscribers after termination. The Company's right to continue to bill existing subscribers after termination of client contract generally continues as long as there is an active credit card or until such subscribers cancel their subscriptions or for certain contractually specified periods of time. Competition Competition in securing contracts with credit card issuers for sales of subscriptions to the issuers' cardholders -- i.e., the third party endorsed segment of the credit card industry -- is intense. Among the factors affecting the outcome of such competition are the quality and reliability of the services to be offered, subscriber acquisition strategy and expertise (which is highly dependent upon creative talents), operational capability, reputation, financial stability of the company supplying the services, the confidence of credit card issuers in management of the company and the compensation or fee paid to the credit card issuer. Additionally, the Company must maintain security over credit card and credit data of which it has custody. The Company believes it has greater than 50% of the market share (within the United States) for credit card registration. Competitors in the credit card registration business include Credit Card Sentinel, CUC International, American Express and others. Fee-based credit cards are sometimes directly marketed and/or serviced by certain credit card issuers. Certain national credit bureaus, as well as CUC International, offer or have offered personal credit information services in competition with CreditLine. CreditLine is dependant upon the purchase of consumer credit data from such credit bureaus and there is no other comparable source for such data. In addition, some of the new products and services which the Company may be exploring, developing or testing, are currently marketed by competitors. The Company's competition is not limited to companies offering similar products and services. Since the Company competes for "advertising space" of various credit card issuers, it competes with companies who market other products and services through credit card issuers. Certain of the Company's competitors may have greater resources and/or other competitive advantages. The Company's competition is not confined to any particular region of the country. The Company has a non-compete with Steven J. Halmos, the Company's co- founder, which expires in the year 2000. See Note I of Notes to Consolidated Financial Statements under Item 8. Financial Statements and Supplementary Data. Employees As of December 31, 1993, the Company employed 435 persons, including 12 part-time employees, as compared to 372 employees (including 27 part-time employees) as of December 31, 1992. Other Information Printing of subscriber acquisition materials is generally contracted to commercial printers. The Company copyrights most of this material and registers its trademarks. Telephone sales are made using the services of independent contractors with the Company developing and dictating sales strategies, methods and controls. These strategies, methods and controls are subject to approval by the credit card issuers. Currently the Company has contracted with several independent telemarketing contractors, with one such contractor accounting for what may be considered a material portion of the volume, to execute its telephone sales using scripts and procedures provided by the Company. There are other independent telephone sales contractors who could provide similar services for the Company. Certain copyrights and trademarks of the Company, such as the name "Hot- Line", may be material to its business. The earliest expiration date of any such copyright is 2002. Various trademarks of the Company are registered under applicable federal law. These trademarks, which expire periodically, are subject to renewal, and the Company presently intends to renew all such trademarks. The agreement pursuant to which the Company markets CreditLine provides that logos, trademarks, tradenames, service marks and copyrights do not belong to the Company. This agreement is subject to litigation. In June 1993, the Company was notified by CreditLine Corporation, that the license agreement under which the Company markets certain credit information products and services would not be renewed on November 1, 1993. See Note K of Notes to Consolidated Financial Statements under Item 8. Financial Statements and Supplementary Data and Item 13. Certain Relationships and Related Transactions. Due to the nature of the Company's business, the Company views security as a significant function, a breach of which could have a material adverse impact on the Company. As such, the Company places a great deal of emphasis on security of its assets and information. No security systems/procedures are foolproof. In fact, many aspects of the Company's activities involve some degree of security risk. The Company's business is not generally seasonal in nature, except that the Company avoids subscriber acquisition campaigns prior to and during certain holiday periods, i.e., Thanksgiving, Christmas and Independence Day. The Company's cash receipts and disbursements are also related to the timing of advertising campaigns. All raw materials, primarily paper, plastic and printer's ink, are readily available. Subscribers to the Company's services are entitled to receive the benefits of their subscriptions immediately; consequently, the Company has no backlog. Management believes there are no material adverse effects upon the Company from current federal, state and local laws and regulations with respect to the discharge of materials into the environment. The Company's operations for mail and telephone sales are conducted on a nationwide basis and the Company does not derive its revenue from any particular geographic area of the United States. During the period 1991 through 1993, the Company did not conduct any significant operations, nor derive any material portion of its sales or revenue, from subscribers in foreign countries. Item 2. Item 2. PROPERTIES During 1992, the Company relocated its headquarters and operational facility from Ft. Lauderdale, Florida to Cheyenne, Wyoming where it occupies an approximately 115,000 square foot building on approximately 17 acres. Item 3. Item 3. LEGAL PROCEEDINGS The Company is defending or prosecuting three complex litigations against Peter Halmos, former Chairman of the Board and Executive Management Consultant to the Company, and parties related to him. See Note K of Notes to Consolidated Financial Statements under Item 8. Financial Statements and Supplementary Data. The Company is involved in certain other claims and litigation, which are not currently considered material. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS NONE PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information called for by this item is incorporated by reference to the "Market Prices and Distributions" section of the 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA The information called for by this item is incorporated by reference to the "Five Year Financial Summary" section of the 1993 Annual Report. 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 by reference to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the 1993 Annual Report. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this item and listed below is incorporated by reference to the 1993 Annual Report. Index to Financial Statements and Supplementary Data Description Report of Independent Accountants Consolidated Balance Sheets as of October 31, 1993 and 1992 Consolidated Statements of Earnings - Three Years Ended October 31, 1993 Consolidated Statements of Changes in Stockholders' Equity - Three Years Ended October 31, 1993 Consolidated Statements of Cash Flows - Three Years ended October 31, 1993 Notes to Consolidated Financial Statements Individual unconsolidated financial statements of SafeCard Services, Inc. have been omitted since consolidated financial statements have been presented. SafeCard is primarily an operating company, and its subsidiaries are not material. Schedules other than those listed in Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by this item with regard to Directors and Executive Officers who are also Directors is incorporated by reference to the Company's definitive proxy statement which is to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Company's annual meeting of shareholders. Other Executive officer information is as follows: Name of Individual Position Age John Bochak Senior Vice President 42 Joanne J. Seehousen Executive Vice President 46 Agneta K. Breslin Executive Vice President 46 and Assistant Secretary David Gallimore Executive Vice President 33 Lynn C. Torrent Chief Financial Officer 29 John Bochak has been associated with SafeCard since 1978. He became Executive Vice President, Data Processing in 1981, Executive Vice President, Operations in 1987 and Senior Vice President, Operations in 1992. Joanne J. Seehousen has been associated with SafeCard since 1978. She has been an Executive Vice President, Sales since 1980. Agneta K. Breslin has been associated with SafeCard since 1981. She became Vice President in 1983 and Executive Vice President in 1987 and Assistant Secretary in October 1990. David Gallimore has been associated with SafeCard since 1981. He became Assistant Vice President of Operations in 1987 and in 1989 moved into a sales role. In 1993, Mr. Gallimore became an Executive Vice President of Marketing. Lynn C. Torrent became Chief Financial Officer in 1992. She joined SafeCard as an Assistant Controller in 1989 and became Controller in 1990. She was previously with the international accounting firm of Arthur Anderson & Company. Item 11. Item 11. EXECUTIVE COMPENSATION The information called for by this item is incorporated by reference to the Company's definitive proxy statement which is to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Company's annual meeting of shareholders. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this item is incorporated by reference to the Company's definitive proxy statement which is to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Company's annual meeting of shareholders. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this item and listed below is incorporated by reference to the 1993 Annual Report. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Certain of the agreements listed below, including, but not limited to, the Property Lease identified as Exhibit 10(j), are the subject of litigation with Peter Halmos and parties related to him. (a)1. Financial Statements The Financial Statements are in the Index thereto set forth in Item 8. Financial Statements and Supplementary Data. (a)2. Financial Statement Schedules Page Report of Independent Accountants 19 Schedule I 20-22 Schedule VIII 23 (a)3. Exhibits 3(a) SafeCard Services, Incorporated's Certificate of Incorporation, incorporated by reference to Exhibit 3(a) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1992. 3(b) SafeCard Services, Incorporated's Certificate of Amendment of Certificate of Incorporation, as filed with the Secretary of State of Delaware, Division of Corporations on August 20, 1987, incorporated by reference to Exhibit 3(g) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1987. 3(c) SafeCard Services Insurance Company's Certificate of Incorporation, incorporated by reference to Exhibit 3(e) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1987. 3(d) SafeCard Services Insurance Company's By-Laws, incorporated by reference to Exhibit 3(f) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1987. 3(e) SafeCard Services, Incorporated By-Laws as amended through September 13, 1993, incorporated by reference to Exhibit 10(c) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(a) Description of 1979 Stock Option Plan, incorporated by reference to Exhibit 10(b) to the Company's Registration Statement on Form S-1, No. 2-72966, as filed with the Securities and Exchange Commission on June 26, 1981. 10(b) Form of Non-Qualified Stock Option Agreement dated August 30, 1989 between the Company and each of William T. Bacon and Richard W. Nixon, incorporated by reference to Exhibit 10(a) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1989. 10(c) Form of 1987 Non-Qualified Stock Option Agreement dated August 30, 1989 between the Company and each of various employees of the Company, incorporated by reference to Exhibit 10(b) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1989. 10(d) Form of Non-Qualified Stock Option Agreement dated August 30, 1989 between the Company and each of six officers of the Company, incorporated by reference to Exhibit 10(c) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1989. 10(e) Form of Non-Qualified Stock Option Agreement dated August 30, 1989 between the Company and each of Peter Halmos and Steven J. Halmos, incorporated by reference to Exhibit 10(d) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1989. 10(f) Form of 1989 Stock Option Plan Amended Non-Qualified Stock Option Agreement between the Company and each of various employees of the Company, effective November 9, 1990, incorporated by reference to Exhibit 10(f) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1990. 10(g) Form of Non-Qualified Stock Option Agreement, effective as of November 29, 1989, between the Company and Steven J. Halmos, incorporated by reference to Exhibit 10(c) to the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1990. 10(h) Form of Termination Agreements dated August 31, 1989 between the Company and each of six officers of the Company, incorporated by reference to Exhibit 10(f) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1989. 10(i) Form of letter amending Termination Agreements between the Company and each of six officers of the Company, incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1990. 10(j) Property Lease, dated March 1, 1985, between the Company and a partnership consisting of Peter Halmos and Steven J. Halmos, incorporated by reference to Exhibit 10(c) to the Company's Annual Report on Form 10-K, for its fiscal year ended October 31, 1986. 10(k) Agreement with Citicorp (South Dakota), N.A., effective January 1, 1989, incorporated by reference to the Company's Form 8 Amendment No. 3, dated November 10, 1989, to its Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1989. 10(l) Agreement with Peter Halmos, dated November 1, 1988, regarding a marketing license for credit information services, incorporated by reference to Exhibit 10(e) of the Company's Annual Report on Form 10-K, for its fiscal year ended October 31, 1988. 10(m) First Amendment to Agreement, dated January 25, 1991, regarding marketing license for credit information services, incorporated by reference to Exhibit 10(m) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1990. 10(n) Form of Non-Qualified Stock Option Agreement dated October 16, 1991 between the Company and an outside director, incorporated by reference to Exhibit 10(n) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(o) Form of Non-Qualified 1991 Employee Stock Option Plan dated October 16, 1991 between the Company and twenty key employees, incorporated by reference to Exhibit 10(o) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(p) Public Relations Consulting Agreement dated October 1, 1991 between the Dilenschneider Group, Inc. and the Company, incorporated by reference to Exhibit 10(p) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(q) Letter Agreement dated January 27, 1992, between CreditLine Corporation and the Company, incorporated by reference to Exhibit 10(q) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(r) Confirmation Agreement between Peter Halmos, High Plains Capital Corporation, CreditLine Corporation and the Company dated January 27, 1992, incorporated by reference to Exhibit 10(r) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(s) Board of Directors' Resolution dated December 6, 1991 establishing a non-employee director retirement plan, incorporated by reference to Exhibit 10(s) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(t) SafeCard Services, Incorporated Employee Relocation Incentive Package, incorporated by reference to Exhibit 10(a) to the Company' Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1992. 10(u) Second Amendment to Agreement with Citicorp (South Dakota), N.A. dated March 31, 1992 incorporated by reference to Exhibit 10(b) to the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1992. 10(v) Letter Agreement dated May 28, 1992 between SafeCard Services, Incorporated and Gerald R. Cahill incorporated by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1992. 10(w) Letter Agreement dated October 26, 1992 between SafeCard Services, Incorporated and WM Stalcup incorporated by reference to Exhibit 10(w) to the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1992. 10(x) Indemnification Agreements for the Company's Directors and certain of the Company's executive officers dated October 2, 1992 incorporated by reference to Exhibit 10(x) to the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1992. 10(y) Memorandum of Understanding between SafeCard Services, Incorporated and Steven J. Halmos dated December 19, 1992, incorporated by reference to Exhibit 1 of the Company's report on form 8-K as filed with the Securities and Exchange Commission on December 19, 1992. 10(z) Amended Complaint filed February 24, 1993 in Peter Halmos v. SafeCard Services, Incorporated, Civil Case No. 93-04354 (Circuit Court for the 17th Judicial Circuit in and for Broward County) incorporated by reference to Exhibit 10(c) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1993. 10(aa) Answer and Affirmative Defenses, Counterclaims and Third Party Complaint, and Demand for Jury Trail of SafeCard Services, Incorporated filed May 26, 1993 in Peter Halmos v. SafeCard Services, Incorporated, Civil Case No. 93-04354 (Circuit Court for the 17th Judicial Circuit in and for Broward County, Florida) incorporated by reference to Exhibit 10(d) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1993. 10(ab) Complaint filed May 26, 1993 in Peter Halmos, et al. v. SafeCard Services, Incorporated, et al., Case No. 93-CH-4807 (Circuit Court of Cook County, Illinois, County Department, Chancery Division) incorporated by reference to Exhibit 10(e) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1993. 10(ac) Agreements between SafeCard Services, Incorporated and Steven J. Halmos as follows: * Standstill, Voting and Right of First Refusal Agreement dated April 1, 1993 between SafeCard Services, Incorporated and Steven J. Halmos. * The first Amended and Restated Memorandum of Understanding dated April 1, 1993 between SafeCard Services, Incorporated and Steven J. Halmos. * Side Letter Agreement dated April 1, 1993 between SafeCard Services, Incorporated and Steven J. Halmos referred to in Paragraph 10.1.1 of the First Amended and Restated Memorandum of Understanding. incorporated by reference to Exhibit 1 of the Company's report on Form 8-K as filed with the Securities and Exchange Commission on April 1, 1993. 10(ad) Complaint filed August 11, 1993 in SafeCard Services, Incorporated v. Peter A. Halmos, et al., Doc. 134, No. 192 (District Court, First Judicial District, Laramie County, Wyoming) incorporated by reference to Exhibit 10(a) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(ae) Second Amended Complaint filed July 27, 1993 in Halmos Trading & Investment Co., a Florida general partnership, by and through Peter Halmos, as managing general partner v. SafeCard Services, Incorporated, et al., Case No. 93-04354 (06) (Circuit Court, 17th Judicial Circuit, Broward County, Florida, Civil Division) incorporated by reference to Exhibit 10(b) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(af) Investor Relations Consulting Agreement dated June 21, 1993, effective January 1, 1993 between the Dilenschneider Group, Inc. and the Company incorporated by reference to Exhibit 10(d) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(ag) Investor Relations Consulting Agreement dated June 21, 1993, effective January 1, 1993 between Eugene Miller and the Company incorporated by reference to Exhibit 10(e) of the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(ah) Third Amendment to the Agreement with Citibank (South Dakota), N.A., dated August 30, 1993. 10(ai) Indemnification Agreements for two of the Company's Directors dated February 11, 1993 and September 1, 1993. 10(aj) Forms of Non-Qualified Stock Option Agreements dated February 11, 1993 and September 1, 1993 between the Company and two outside directors. 10(ak) 1994 Long Term Stock-Based Incentive Plan, incorporated by reference to the Company's definitive proxy statement. 10(al) Counterclaim filed January 14, 1994 by Peter Halmos in Halmos Trading & Investment Co., a Florida general partnership, by and through Peter Halmos, as managing general partner v. SafeCard Services, Incorporated, et al., Case No. 93-04354 (06) (Circuit Court, 17th Judicial Circuit, Broward County, Florida, Civil Division) incorporated by reference to Exhibit 1 of the Company's Current Report on Form 8-K filed on January 14, 1994. 10(am) Amended complaint filed December 1, 1993 in Peter Halmos, et al. v. SafeCard Services, Inc., et al., Case No. 93-CH-4807 (circuit Court of Cook County, Illinois, County Department, Chancery Division. 10(an) Employment Agreement, effective as of December 1, 1993, between the Company and Paul G. Kahn incorporated by reference to Exhibit 1 of the Company's Current Report on Form 8-K filed on December 6, 1993. 10(ao) Investor relations letter agreement dated January 6, 1994, effective January 1, 1994 between the Company and the Dilenschneider Group, Inc. 10(ap) Investor relations letter agreement dated December 20, 1993, effective January 1, 1994 between the Company and Eugene Miller. 10(aq) Letter Agreement dated May 28, 1992 between SafeCard Services, Incorporated and Lynn C. Torrent. 10(ar) Letter Agreement dated December 4, 1992 between SafeCard Services, Incorporated and David Gallimore. 11(a) Computation of Primary Earnings Per Share. 11(b) Computation of Fully Diluted Earnings Per Share. 13 SafeCard Services, Incorporated 1993 Annual Report. 15 Consent of Independent Accountants to incorporation by reference of their report in Prospectuses constituting part of Registration Statements on Forms S-3 and S-8. 22 Subsidiaries of the Registrant. (b) Reports on Form 8-K NONE REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of SafeCard Services, Incorporated Our audits of the consolidated financial statements referred to in our report dated December 10, 1993 appearing in the SafeCard Services, Incorporated 1993 Annual Report to Shareholders (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 Denver, Colorado December 10, 1993 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. SAFECARD SERVICES, INCORPORATED By: /s/ Paul G. Kahn ------------------------------ Paul G. Kahn Chief Executive Officer January 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Signature Title - ---- --------- ----- January 28, 1994 /s/ Paul G. Kahn Chief Executive Officer, ---------------- Chairman of the Board Paul G. Kahn and Director January 28, 1994 /s/ William T. Bacon, Jr. Director -------------------------- William T. Bacon, Jr. January 28, 1994 /s/ Robert L. Dilenschneider Director ---------------------------- Robert L. Dilenschneider January 28, 1994 /s/ Eugene Miller Director ----------------- Eugene Miller January 28, 1994 /s/ Marshall Burman Director -------------------- Marshall Burman January 28, 1994 /s/ WM Stalcup, Jr. President and -------------------- Director WM Stalcup, Jr. January 28, 1994 /s/ Gerald R. Cahill Chief Operating Officer -------------------- and Director Gerald R. Cahill January 28, 1994 /s/ Lynn C. Torrent Chief Financial Officer ------------------- (Principal Financial and Lynn C. Torrent Accounting Officer) Exhibit Index Exhibit Page Numbers 3(a) SafeCard Services, Incorporated Incorporated by reference to Certificate of Incorporation. Exhibit 3(a) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1992. 3(b) SafeCard Services, Incorporated Incorporated by reference to Certificate of Amendment of Exhibit 3(g) of the Company's Certificate of Incorporation, as Annual Report on Form 10-K for filed with the Secretary of State its fiscal year ended October of Delaware, Division of Corporations 31, 1987. on August 20, 1987. 3(c) SafeCard Services Insurance Incorporated by reference to Company's Certificate of Exhibit 3(e) of the Company's Incorporation. Annual Report on Form 10-K for its fiscal year ended October 31, 1987. 3(d) SafeCard Services Insurance Incorporated by reference to Company's By-Laws. Exhibit 3(f) of the Company's Annual Report on Form 10-K for its fiscal year ended October 31, 1987. 3(e) SafeCard Services, Incorporated Incorporated by reference to By-Laws as amended through Exhibit 10(c) of the Company's September 13, 1993. Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1993. 10(a) Description of 1979 Incorporated by reference to Stock Option Plan. Exhibit 10(b) to the Company's Registration Statement on Form S-1, No. 2-72966, as filed with the Securities and Exchange Commission on June 26, 1981. 10(b) Form of Non-Qualified Stock Option Incorporated by reference to Agreement dated August 30, 1989 Exhibit 10(a) of the Company's between the Company and each of Quarterly Report on Form 10-Q William T. Bacon and Richard W. Nixon. for its fiscal quarter ended July 31, 1989. 10(c) Form of 1987 Non-Qualified Stock Incorporated by reference to Option Agreement dated August 30, Exhibit 10(b) of the Company's 1989 between the Company and each Quarterly Report on Form 10-Q of Peter Halmos and Steven J. Halmos. of its fiscal quarter ended July 31, 1989. 10(d) Form of Non-Qualified Stock Option Incorporated by reference to Agreement dated August 30, 1989 Exhibit 10(c) of the Company's between the Company and each of Report on Form 10-Q of its six officers. fiscal quarter ended July 31, 1989. Exhibit Index Exhibit Page Numbers 10(e) Form of Non-Qualified Stock Option Incorporated by reference to Agreement dated August 30, 1989 Exhibit 10(d) of the Company's between the Company and each of Quarterly Report on Form 10-Q Peter Halmos and Steven J. Halmos. for its fiscal quarter ended July 31, 1989. 10(f) Form of 1989 Stock Option Plan Incorporated by reference to Amended Non-Qualified Stock Option Exhibit 10(f) of the Company's Agreement between the Company and Annual Report on Form 10-K for each of various employees of the its fiscal year ended October Company, effective November 9, 1990. 31, 1990. 10(g) Form of Non-Qualified Stock Option Incorporated by reference to Agreement, effective as of November Exhibit 10(c) to the Company's 29, 1989, between the Company and Quarterly Report on Form 10-Q Steven J. Halmos. for its fiscal quarter ended April 30, 1990. 10(h) Form of Termination Agreements dated Incorporated by reference to August 31, 1989 between the Company Exhibit 10(f) of the Company's and each of six officers of the Annual Report on Form 10-K for Company. its fiscal year ended October 31, 1989. 10(i) Form of letter amending Termination Incorporated by reference to Agreements between the Company and Exhibit 10(b) to the Company's each of six officers of the Company. Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1990. 10(j) Property Lease, dated March 1, 1985, Incorporated by reference to between the Company and a partnership Exhibit 10(c) to the Company's consisting of Peter Halmos and Steven Annual Report on Form 10-K for J. Halmos. its fiscal year ended October 31, 1986. 10(k) Agreement with Citicorp (South Incorporated by reference to Dakota), N.A., effective January 1, the Company's Form 8 Amendment 1989. No. 3, dated November 10, 1989, to its Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1989. 10(l) Agreement with Peter Halmos, dated Incorporated by reference to November 1, 1988, regarding a marketing Exhibit 10(e) to the Company's for credit information services. Annual license Report on Form 10-K for its fiscal year ended October 31, 1988. 10(m) First Amendment to Agreement, dated Incorporated by reference to January 25, 1991, regarding marketing Exhibit 10(m) of the Company's license for credit information Annual Report on Form 10-K for services. its fiscal year ended October 31, 1990. Exhibit Index Exhibit Page Numbers 10(n) Form on Non-Qualified Stock Option Incorporated by reference to Agreement dated October 16, 1991 Exhibit 10(n) of the Company's between the Company and an outside Annual Report on Form 10-K director. for its fiscal year ended October 31, 1991. 10(o) Form of Non-Qualified Stock Option Incorporated by reference to Plan dated October 16, 1992 between Exhibit 10(o) of the Company's the Company and twenty key employees. Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(p) Public Relations Consulting Agreement Incorporated by reference to dated October 1, 1992 between The Exhibit 10(p) of the Company's Dilenschneider Group, Inc. and Annual Report on Form 10-K for the Company. its fiscal year ended october 31, 1991. 10(q) Letter Agreement dated January 27, Incorporated by reference to 1992, between CreditLine Corporation Exhibit 10(q) of the Company's and the Company. Annual Report on Form 10-K for its fiscal year ended October 31, 1991. 10(r) Confirmation Agreement between Peter Incorporated by reference to Halmos, High Plains Capital Exhibit 10(r) of the Company's Corporation, CreditLine Corporation Annual Report on Form 10-K for and the Company dated January 27, 1992. its fiscal year ended October 31, 1992. 10(s) Board of Directors' Resolution dated Incorporated by reference to December 6, 1991 establishing non- Exhibit 10(s) of the Company's employee director retirement plan. Annual Report on Form 10-K for its fiscal year ended October 31, 1991. Exhibit Index Exhibit Page Numbers 10(t) SafeCard Services, Incorporated Incorporated by reference to Employee Relocation Incentive Packages. Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for its fiscal quarter ended April 30, 1992. 10(u) Second Amendment to Agreement with Incorporated by reference to Citicorp (South Dakota), N.A. Exhibit 10(b) to the Company's dated March 31, 1992. Quarterly Report on Form 10-Q for its fiscal quarter ended April 30,1992. 10(v) Letter Agreement dated May 28, 1992 Incorporated by reference to between SafeCard Services, Exhibit 10(a) to the Company's Incorporated and Gerald R. Cahill. Quarterly Report on Form 10-Q for its fiscal quarter ended July 31, 1992. 10(w) Letter Agreement dated October 26, Incorporated by reference to 1992 between SafeCard Services, Exhibit 10(w) to the Company's Incorporated and WM Stalcup. Annual Report on Form 10-K for its fiscal year ended October 31, 1992. 10(x) Indemnification Agreements for the Incorporated by reference to Company's Directors and certain of Exhibit 10(x) to the Company's the Company's executive officers Annual Report on Form 10-K for dated October 2, 1992. its fiscal year ended October 31, 1992. 10(y) Memorandum of Understanding between Incorporated by reference to SafeCard Services, Incorporated and Exhibit 1 of the Company's Steven J. Halmos dated December 19, report on form 8-K as filed 1992. with the Securities and Exchange Commission on December 19, 1992. 10(z) Amended Complaint filed February 24, Incorporated by reference to 1993 in Peter Halmos v. SafeCard Exhibit 10(c) of the Company's Services, Incorporated, Civil Case Quarterly Report on Form 10-Q No. 93-04354 (Circuit Court for the for its fiscal quarter ended 17th Judicial Circuit in and for April 30, 1993. Broward County). 10(aa) Answer and Affirmative Defenses, Incorporated by reference to Counterclaims and Demand for Exhibit 10(d) of the Company's Jury Trial of SafeCard Services, Quarterly Report on Form 10-Q Incorporated May 26, 1993 in Peter for its fiscal quarter ended Halmos v. SafeCard Services, April 30, 1993. Incorporated, Civil Case No. 93- 04354 (Circuit Court for the 17th Judicial Circuit in and for Broward County, Florida). Exhibit Index Exhibit Page Numbers 10(ab) Complaint filed May 26, 1993 in Incorporated by reference to Peter Halmos et al. v. SafeCard Exhibit 10(e) of the Company's Services, Incorporated, et al., Quarterly Report on Form 10-Q Case No. 93-CH-4807 (Circuit Court for its fiscal quarter ended of Cook County, Illinois, County April 30, 1993. Department, Chancery Division). 10(ac) Agreements between SafeCard Services, Incorporated by reference to Incorporated and Steven J. Halmos. Exhibit 1 of the Company's report on Form 8-K as filed with the Securities and Exchange Commission on April 1, 1993. 10(ad) Complaint filed August 11, 1993 in Incorporated by reference to SafeCard Services, Incorporated v. Exhibit 10(a) of the Company's Peter A. Halmos et al., Doc. 134, Report on Form 10-Q for its No. 192 (District Court, First fiscal quarter ended July 31, Judicial District, Laramie County, 1993. Wyoming). 10(ae) Second Amended Complaint filed July Incorporated by reference to 27, 1993 Halmos Trading & Investment Exhibit 10(b) of the Company's Co., a Florida general partnership, Quarterly Report on Form 10-Q by and through Peter Halmos, as for its fiscal quarter ended managing general partner v. SafeCard July 31, 1993. Services, Incorporated, et al., Case No. 93-04354(06) (Circuit Court, 17th Judicial District, Laramie County, Wyoming). 10(af) Investor Relations Consulting Agreement Incorporated by reference to dated June 21, 1993, effective January Exhibit 10(d) of the Company's 1, 1993 between The Dilenschneider Quarterly Report on Form 10-Q Group Inc. and the Company. for its fiscal quarter ended July 31, 1993. 10(ag) Investor Relations Consulting Agreement Incorporated by reference to dated June 21, 1993, effective January Exhibit 10(e) of the Company's 1, 1993 between Eugene Miller and the Quarterly Report on Form 10-Q Company. for its fiscal quarter ended July 31, 1993. 10(ah) Third Amendment to the Agreement with 33 - 36 Citibank (South Dakota), N.A. dated August 30, 1993. 10(ai) Indemnification Agreements for two of 37 - 54 the Company's Directors dated February 11, 1993 and September 1, 1993. 10(aj) Forms of Non-Qualified Stock Option 55 - 67 Agreements dated February 11, 1993 and September 1, 1993 between the Company and two outside directors. 10(ak) 1994 Long Term Stock-Based Incorporated by reference to Incentive Plan. the Company's 1993 definitive proxy statement. Exhibit Index Exhibit Page Numbers 10(al) Counterclaim filed January 14, 1994 Incorporated by reference to by Peter Halmos in Halmos Trading & Exhibit 1 of the Company's Investment Co., a Florida general Current Report on Form 8-K partnership, by and through Peter filed on January 14, 1994. Halmos, as managing general partner v. SafeCard Services Incorporated, et al., Case No. 93-04354 (06) (Circuit Court, 17th Judicial Circuit, Broward County, Florida Civil Division). 10(am) Amended Complaint filed December 1, 1993 68 - 125 in Peter Halmos, et al. v. SafeCard Services, Incorporated, et al., Case No. 93-CH-4807 (Circuit Court of Cook County, Illinois, County Department, Chancery Division. 10(an) Employment Agreement, effective as of Incorporated by reference to December 1, 1993, between the Company Exhibit 1 of the Company's and Paul G. Kahn. Current Report on Form 8-K filed on December 6, 1993. 10(ao) Investor relations letter agreement dated 126 January 6, 1994, effective January 1, 1994 between the Company and the Dilenschneider Group, Inc. 10(ap) Investor relations letter agreement dated 127 December 20, 1993, effective January 1, 1994 between the Company and Eugene Miller. 10(aq) Letter Agreement dated May 28, 1992 between 128 SafeCard Services, Incorporated and Lynn C. Torrent. 10(ar) Letter Agreement dated December 4, 1992 129 between SafeCard Services, Incorporated and David Gallimore. 11(a) Computation of Primary Earnings Per Share. 130 11(b) Computation of Fully Diluted Earnings Per Share. 131 13 SafeCard Services, Incorporated 132 - 157 1993 Annual Report. 15 Consent of Independent Accountants to incorporate 158 by reference their report in Prospectuses constituting part of the Registration Statements on Forms S-3 and S-8. 22 Subsidiaries of the Registrant. 159 EXHIBITS PAGE LEFT BLANK

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ITEM 3. LEGAL PROCEEDINGS THE COMPANY On March 23, 1979, in the case of Van Vranken, et al. v. Atlantic Richfield, two California service station dealers purporting to represent a class of all resellers of gasoline, aviation fuels, butane and propane sued the Company in the United States District Court for the Northern District of California (Case No. C-79-0627-SW) for allegedly willfully violating the Department of Energy's ("DOE") 1973-1981 price regulations by unlawfully inflating its costs of crude oil eligible for recovery. On March 25, 1986, the District Court certified the plaintiffs as representatives of the class for purchases made between May 1, 1976 and January 28, 1981. On July 23, 1992, a jury found for the Company on the class' original claim, and for the class on three subsequent claims in the amount of $22.8 million, plus prejudgment interest. On October 22, 1992, the trial court ordered a formula for interest resulting in a total judgment of approximately $63 million. On September 30, 1993, the United States Court of Appeals for the Federal Circuit affirmed, without opinion, the trial court's judgment. The Company has sought reconsideration. On June 7, 1989, the City of New York, the New York City Housing Authority and the New York City Health and Hospitals Corporation brought suit in the Supreme Court of the State of New York for the County of New York (Case No. 14365/89) against six alleged former lead pigment manufacturers or their successors (including ARCO as successor to International Smelting and Refining Company ("IS&R"), a former subsidiary of The Anaconda Company), and the Lead Industries Association ("LIA"), a trade association. Plaintiffs seek to recover damages in excess of $50 million including (i) past and future costs of abating lead-based paint from housing owned by New York City and the New York City Housing Authority; (ii) other costs associated with dealing with the presence of lead-based paint in that housing and privately owned housing; and (iii) any amounts paid by the City or the Housing Authority to tenants because of injuries caused by the ingestion of lead-based paint. Plaintiffs also seek punitive damages and attorney fees. On January 7, 1991, defendant Eagle- Picher, one of the lead pigment manufacturers, filed for Chapter 11 bankruptcy protection in the Southern District of Ohio, for reasons unrelated to this litigation. As a result of the filing, all proceedings against Eagle-Picher have been stayed in this litigation. On December 23, 1991, the Court dismissed plaintiffs' claims of negligent product design, negligent failure to warn, and strict liability as time-barred under the applicable statute of limitation. The Court also ruled, however, that the plaintiffs' fraud and restitution claims were adequately pled and that more facts were needed to determine if the fraud claim was also time-barred. Interlocutory appeals were taken, and this decision was affirmed. On March 12, 1992, ARCO filed its answer to the complaint and its counterclaims against the City of New York and the New York City Housing Authority. On April 8, 1993, pursuant to stipulation by the parties, the trial court entered an order dismissing with prejudice plaintiffs' claims for indemnification arising from third-party personal injury claims resolved before March 15, 1993, and dismissing without prejudice claims for indemnification brought after that date. On September 3, 1993, plaintiffs filed an amended complaint adding American Cyanamid Company and Fuller-O'Brien Corporation as defendants. On August 25, 1992, ARCO (as successor to IS&R) was added as a defendant to a purported class action suit pending in the Court of Common Pleas in Cuyahoga County (Cleveland), Ohio, Jackson, et al. v. The Glidden Company, et al. (Case No. 236835), that seeks on behalf of the three named plaintiffs, and all other persons similarly situated in the state of Ohio, money damages for injuries allegedly suffered from exposure to lead paint, punitive damages, and an order requiring defendants to remove and abate all lead paint applied to any building in Ohio. The suit names as defendants, in addition to ARCO, the LIA and 16 companies alleged to have participated in the manufacture and sale of lead pigments and paints and includes causes of action for strict product liability, negligence, breach of warranty, fraud, nuisance, restitution, negligent infliction of emotional distress, and enterprise, market share and alternative liability. On July 29, 1993, the Court entered an order granting defendants' motion to dismiss the complaint on the grounds that Ohio law does not recognize market share, enterprise or alternative liability causes of action in this case. On August 27, 1993, plaintiffs filed their notice of appeal. In addition, the Company is a defendant in several lawsuits, brought by individuals that allege injury from exposure to lead paint. These cases, in the aggregate, are not material to the financial condition of the Company. On July 5, 1990, an explosion and fire occurred at ARCO Chemical's Channelview, Texas plant. The incident resulted in the death of 17 people and in significant damage to the waste water treatment section of the plant, with some damage to the adjacent area providing utilities to the plant. Various lawsuits have been filed and claims made against ARCO Chemical for wrongful death, personal injury and property damage in connection with this incident, most of which have been resolved. ENVIRONMENTAL PROCEEDINGS As discussed under the caption "Environmental Matters," ARCO is currently participating in environmental assessments and cleanups at numerous operating and non-operating sites under Superfund and comparable state laws, RCRA and other state and local laws and regulations, and pursuant to third party indemnification requests, and is the subject of material legal proceedings relating to certain of these sites. See "Environmental Matters--Material Environmental Litigation." Set forth below is a description, in accordance with SEC rules, of certain fines and penalties imposed by governmental agencies in respect of environmental rules and regulations. In September 1991, the California Department of Toxic Substances Control filed an administrative complaint against ARCO Products Company seeking a civil penalty of $137,500 for failure to comply with certain hazardous waste regulations. The alleged violations stem from sandblasting and related actions by subcontractors while performing work at the Los Angeles Refinery. In December 1991, an administrative law hearing was held on these alleged violations. The Administrative Law Judge proposed a reduced penalty of $62,000, and the matter has been settled on that basis. ARCO Chemical has discovered that certain organic waste material is situated in the soil and ground water at portions of its Monaca, Pennsylvania (Beaver Valley) plant. ARCO Chemical has commenced a feasibility study to determine the technology required to remedy the conditions at the plant. Concurrently, ARCO Chemical is working with the Pennsylvania Department of Environmental Resources ("DER") to design a plan to remedy the conditions at the plant. ARCO Chemical has signed an agreement with Beazer East, Inc., the successor to Koppers Inc. (the previous owner of the Beaver Valley plant), whereby Beazer East, Inc. has agreed to pay for approximately 50 percent of the cost of the remediation. ARCO Chemical has agreed to pay to the Pennsylvania DER a fine in the amount of $300,000 in settlement for contamination of the ground water at the plant. In August 1993, the City Prosecuting Attorney of Long Beach, California, filed a complaint against ARCO Terminal Services Corporation ("ATSC"), an ARCO subsidiary, alleging that ATSC illegally disposed of hazardous waste. A second complaint was filed against ATSC and Four Corners Pipe Line Company ("FCPL"), another ARCO subsidiary, alleging that ATSC and FCPL illegally disposed of hazardous waste. The allegations made in each complaint are not related. In December 1993, pursuant to the provisions of judicially approved Orders for Civil Compromise, the complaints were dismissed. Liability was not admitted with regard to any of the allegations raised in the complaints, but payments in the amount of $150,000 and $100,000 have been placed into escrow accounts to fund environmental training and the acquisition of various materials and equipment to be used for environmental purposes. In addition to the matters reported herein, from time to time, certain of the Company's operating divisions and subsidiaries receive 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. Such alleged violations may become the subject of enforcement actions or other legal proceedings and may involve monetary sanctions of $100,000 or more (exclusive of interest and costs). OTHER LITIGATION The Company and its subsidiaries are defendants in numerous suits in which they are not covered by insurance which involve smaller amounts than the matters described above. Although the legal responsibility and financial impact in respect to such litigation cannot be ascertained, it is not anticipated that these suits will result in the payment by the Company or its subsidiaries of monetary damages which in the aggregate would be material in relation to the net assets of the Company and its subsidiaries. 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 February 28, 1994. - -------- (a) Division names used in the descriptions of business experience of executive officers of the Company are the names which were in effect at the time such officers held such positions. In some instances, divisions have been combined or reorganized and, accordingly, activities thereof are presently conducted under different division names. (b) 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 following description of the Company's capital stock is included in order to facilitate incorporation by reference of such description in filings by the Company under the federal securities laws. Certain statements under this heading are summaries of provisions of the Certificate of Incorporation of ARCO, as adopted upon the reincorporation of the Company into a Delaware corporation on May 7, 1985, and do not purport to be complete. A copy of the Certificate of Incorporation, as amended through May 3, 1993, is filed as an exhibit hereto. The summaries make use of certain terms defined in the Certificate of Incorporation and are qualified in their entirety by reference thereto. The term "$3.00 Preference Stock" refers to the Company's $3.00 Cumulative Convertible Preference Stock, par value $1 per share. The term "$2.80 Preference Stock" refers to the Company's $2.80 Cumulative Convertible Preference Stock, par value $1 per share. The term "Preferred Stock" refers to the Company's Preferred Stock, par value $.01 per share; this new class of Preferred Stock was authorized by stockholders on May 3, 1993. The term "Common Stock" refers to the Company's Common Stock, par value $2.50 per share. The following is a summary of the capital stock of ARCO as of December 31, 1993. - -------- * Excludes treasury stock. New Class of Preferred Stock. Under the Certificate of Incorporation, as amended following approval by stockholders on May 3, 1993, the Board is authorized to issue, at any time or from time to time, one or more series of Preferred Stock at its discretion. In addition, the Board has the power to determine all designations, powers, preferences and the rights of such stock and any qualifications, limitations and restrictions, including but not limited to: (i) the designation of series and numbers of shares; (ii) the dividend rights, if any; (iii) the rights upon liquidation or distribution of the assets of the Company, if any; (iv) the conversion or exchange rights, if any; (v) the redemption provisions, if any; and (vi) the voting rights, if any. So long as the Preference Stocks are outstanding, and only for that period of time, the rights of the Preferred Stock are subordinate to the rights of the holders of Preference Stocks. Dividend Rights. Holders of $3.00 Preference Stock and holders of $2.80 Preference Stock are entitled to receive cumulative dividends at the annual rate of $3.00 per share and $2.80 per share, respectively, payable quarterly, before cash dividends are paid on the Preferred Stock, if any, and the Common Stock. Shares of $3.00 Preference Stock and shares of $2.80 Preference Stock rank on a parity as to dividends. After provision for payment in full of cumulative dividends on the outstanding $3.00 Preference and $2.80 Preference Stocks, and the payment in full of cumulative dividends on the outstanding Preferred Stock, if any, dividends may be paid on the Common Stock as the Board of Directors may deem advisable, within the limits and from the sources permitted by law. Conversion Rights. Each share of $3.00 Preference Stock is convertible, at the option of the holder, into six and eight-tenths (6.8) shares of Common Stock of the Company at any time, and each share of $2.80 Preference Stock is convertible, at the option of the holder, into two and four-tenths (2.4) shares of Common Stock of the Company at any time. These conversion rates are subject to adjustment as set forth in the Certificate of Incorporation. Shares of Preferred Stock would be convertible, if at all, on such terms as were designated by the Board of Directors. Voting Rights. The holders of $3.00 Preference Stock are entitled to eight votes per share; holders of $2.80 Preference Stock are entitled to two votes per share; and holders of Common Stock are entitled to one vote per share. Holders of $3.00 Preference and $2.80 Preference Stocks are entitled to vote cumulatively for directors; holders of Common Stock have no cumulative voting rights. The $3.00 Preference, $2.80 Preference and Common Stocks vote together as one class, except as provided by law and except as to certain matters which require a vote by the holders of $3.00 Preference Stock or by the holders of $2.80 Preference Stock as a separate class as set forth below. The Certificate of Incorporation provides that if the Company shall be in default with respect to dividends on the $3.00 Preference Stock in an amount equal to six quarterly dividends, the number of directors of the Company shall be increased by two at the first annual meeting thereafter, and at such meeting and at each subsequent annual meeting until all dividends on the $3.00 Preference Stock shall have been paid in full, the holders of the $3.00 Preference Stock shall have the right, voting as a class, to elect such two additional directors. The Certificate of Incorporation contains identical provisions with respect to the $2.80 Preference Stock. The Certificate of Incorporation provides that the Company shall not, without the assent of the holders of two-thirds of the then outstanding shares of $3.00 Preference Stock, (a) change any of the terms of the $3.00 Preference Stock in any material respect adverse to the holders, or (b) authorize any prior ranking stock; and that the Company shall not, without the assent of the holders of a majority of the then outstanding shares of $3.00 Preference Stock, (1) authorize any additional $3.00 Preference Stock or stock on a parity with it; (2) sell, lease or convey all or substantially all of the property or business of the Company; or (3) become a party to a merger or consolidation unless the surviving or resulting corporation will have immediately after such merger or consolidation no stock either authorized or outstanding (except such stock of the Company as may have been authorized or outstanding immediately before such merger or consolidation of such stock of the surviving or resulting corporation as may be issued upon conversion thereof or in exchange therefor) ranking as to dividends or assets prior to or on a parity with the $3.00 Preference Stock or the stock of the surviving or resulting corporation issued upon conversion thereof or in exchange therefor. The Certificate of Incorporation contains identical provisions with respect to the $2.80 Preference Stock. The holders of Preferred Stock, if any, would have such voting rights, if any, as were designated by the Board. Redemption Provisions. The $3.00 Preference Stock is redeemable at the option of the Company as a whole or in part at any time on at least thirty days' notice at $82 per share plus accrued dividends to the redemption date. The $2.80 Preference Stock is redeemable at the option of the Company as a whole or in part at any time on at least thirty days' notice at $70 per share plus accrued dividends to the redemption date. The holders of Preferred Stock, if any, would have such redemption provisions, if any, as were designated by the Board. Liquidation Rights. In the event of liquidation of the Company, the holders of $3.00 Preference Stock and holders of $2.80 Preference Stock will be entitled to receive, before any payment to holders of Common Stock, $80 per share and $70 per share, respectively, together in each case with accrued and unpaid dividends. Shares of $3.00 Preference Stock and shares of $2.80 Preference Stock will rank on a parity as to assets of the Company upon its liquidation. Subject to the rights of creditors and the holders of $3.00 Preference Stock and $2.80 Preference Stock, the holders of Common Stock are entitled pro rata to the assets of the Company upon its liquidation. The holders of Preferred Stock, if any, would have such liquidation rights, if any, as were designated by the Board. Preemptive Rights. No holders of shares of capital stock of the Company have or will have any preemptive rights to acquire any securities of the Company. Liability to Assessment. The shares of Common Stock are fully paid and non- assessable. Prohibition of Greenmail. Article VII of the Certificate of Incorporation provides in general that any direct or indirect purchase by the Company of any of its voting stock (or rights to acquire voting stock) known to be beneficially owned by any person or group which holds more than 3 percent of a class of its voting stock and which has owned the securities being purchased for less than two years must be approved by the affirmative vote of at least 66 2/3 percent of the votes entitled to be cast by the holders of the voting stock. Such approval shall not be required with respect to any purchase by the Company of such securities made (i) at or below fair market value (based on average New York Stock Exchange closing prices over the preceding 90 days) or (ii) as part of a Company tender offer or exchange offer made on the same terms to all holders of such securities and complying with the Securities Exchange Act of 1934 or (iii) in a Public Transaction (as defined). Rights to Purchase Common Stock. On May 27, 1986, the Board of Directors of the Company declared a dividend distribution of one Right for each outstanding share of Common Stock to the stockholders of record on June 9, 1986 (the "Record Date"). Each Right entitles the registered holder to purchase from the Company one share of Common Stock at a price of $200 per share (the "Purchase Price"), subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement (the "Rights Agreement") between the Company and Morgan Guaranty Trust Company of New York, as Rights Agent (the "Rights Agent"). The Rights were issued on the Record Date. Thereafter, as long as the Rights are attached to the Common Stock, the Company will issue one Right with each share of Common Stock that shall become outstanding so that all such shares will have attached Rights. The Rights are attached to all Common Stock certificates representing outstanding Common Stock, and no separate certificates evidencing Rights ("Right Certificates") have been distributed. Until the earlier to occur of (i) 10 days following a public announcement that a person or group of affiliated or associated persons acquired, or obtained the right to acquire, beneficial ownership of 20 percent or more of the outstanding shares of Common Stock (an "Acquiring Person") or (ii) 10 days following the earlier of the commencement of, or the announcement of an intention to make, a tender offer or exchange offer the consummation of which would result in the beneficial ownership by a person or group of 30 percent or more of the outstanding shares of Common Stock (the earlier of such dates described in (i) and (ii) above being called the "Distribution Date"), the Rights are evidenced by such Common Stock certificate with a copy of the Summary of Rights attached thereto. The date of announcement of the existence of an Acquiring Person referred to in clause (i) above is hereinafter referred to as the "Shares Acquisition Date." The Rights Agreement provides that, until the Distribution Date, the Rights will be transferred with and only with the Common Stock. Until the Distribution Date (or earlier redemption or expiration of the Rights), Common Stock certificates issued after the Record Date upon transfer or issuance of Common Stock contain a notation incorporating the Rights Agreement by reference. Until the Distribution Date (or earlier redemption or expiration of the Rights), the surrender for transfer of any certificates evidencing Common Stock outstanding as of the Record Date, even without a copy of the Summary of Rights attached thereto, will also constitute the transfer of the Rights associated with the Common Stock represented by such certificate. As soon as practicable following the Distribution Date, Right Certificates will be mailed to holders of record of the Common Stock as of the close of business on the Distribution Date and such separate Right Certificates alone will evidence the Rights. The Rights are not exercisable until the Distribution Date. The Rights will expire on June 9,1996, unless earlier redeemed by the Company as described below. The Purchase Price payable, and the number of shares of Common Stock or other securities or property issuable, upon exercise of the Rights are subject to adjustment from time to time to prevent dilution (i) in the event of a stock dividend on, or a subdivision, combination or reclassification of the Common Stock, (ii) upon the grant to holders of the Common Stock of certain rights or warrants to subscribe for Common Stock or convertible securities at less than the current market price of the Common Stock or (iii) upon the distribution to holders of the Common Stock of evidences of indebtedness or assets (excluding regular periodic cash dividends out of earnings or retained earnings at a rate not in excess of 125 percent of the rate of the last cash dividend theretofore paid or dividends payable in Common Stock) or of subscription rights or warrants (other than those referred to above). In the event that the Company were to be acquired in a merger or other business combination transaction, or more than 50 percent of its assets or earning power were sold, proper provision would be made so that each holder of a Right would thereafter have the right to receive, upon the exercise thereof at the then current exercise price of the Right, that number of shares of common stock of the acquiring company which at the time of such transaction would have a market value of two times the exercise price of the Right. In the event that the Company were to be the surviving corporation in a merger with an Acquiring Person and its Common Stock were not changed or exchanged, or in the event that an Acquiring Person were to engage in one of a number of self- dealing transactions or certain other events occur while there is an Acquiring Person (e.g., a reverse stock split), as specified in the Rights Agreement, proper provision would be made so that each holder of a Right (except as provided below) would thereafter have the right to receive upon exercise that number of shares of Common Stock of the Company having a market value of two times the exercise price of the Right. Upon the occurrence of any of the events described in the preceding sentence, any Rights that are or were at any time on or after the earlier of (a) the Shares Acquisition Date and (b) the Distribution Date beneficially owned by an Acquiring Person will immediately become null and void, and no holder of such Rights will have any right with regard to such Rights from and after such occurrence. With certain exceptions, no adjustment in the Purchase Price will be required until cumulative adjustments require an adjustment of at least 1 percent in such Purchase Price. No fractional shares will be issued and in lieu thereof, an adjustment in cash will be made based on the market price of the Common Stock on the last trading date prior to the date of exercise. At any time prior to the time that a person or group of affiliated or associated persons has acquired beneficial ownership of 20 percent or more of the outstanding Common Stock, the Company may redeem the Rights in whole, but not in part, at a price of $0.10 per Right (the "Redemption Price"). Immediately upon the action of the Board of Directors of the Company electing to redeem the Rights, the Company will make announcement thereof, and upon such election, the right to exercise the Rights will terminate and the only right of the holders of Rights will be to receive the Redemption Price. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. While the distribution of the Rights was not, and the issuance of Rights thereafter is not, taxable to plan participants or the Company, stockholders may recognize taxable income if the Rights become exercisable. The terms of the Rights may be amended by the Board of Directors of the Company and the Rights Agent, provided that the amendment does not adversely affect the interests of the holders of Rights. The Rights have certain antitakeover effects. The Rights will cause substantial dilution to a person or group that attempts to acquire the Company on terms not approved by its Board of Directors, except pursuant to an offer conditioned on a substantial number of Rights being acquired. The Rights should not interfere with any merger or other business combination approved by the Board of Directors at a time when the Rights are redeemable. A copy of the Rights Agreement is filed as an exhibit hereto. This summary description of the Rights is qualified in its entirety by reference thereto. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Prices in the foregoing table are from the New York Stock Exchange composite tape. On February 28, 1994 the high price per share was $101 3/8 and the low price per share was $100 5/8. As of December 31, 1993, the approximate number of holders of record of Common Stock of ARCO was 120,000. The principal markets in which ARCO's Common Stock is traded are listed on the cover page. The quarterly dividend rate for Common Stock was increased to $1.375 per share in January 1991. On January 24, 1994, a dividend of $1.375 per share was declared on Common Stock, payable on March 15, 1994 to stockholders of record on February 18, 1994. Future cash dividends will depend on earnings, financial conditions and other factors; however, the Company presently expects that dividends will continue to be paid. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected financial information for ARCO: - -------- (1) See Note 2 of Notes to Consolidated Financial Statements regarding unusual items on page 42. (2) Includes after-tax gain of $634 million from sale of majority interest in Lyondell. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW OF 1993 RESULTS In 1993, ARCO's net income was $269 million, or $1.66 per share. Operating results were lower compared to 1992. Operations in 1993 benefited from improved margins and higher gasoline sales volumes in ARCO's West Coast refining and marketing operations, higher coal sales volumes and higher natural gas prices. These benefits were more than offset by lower crude oil prices and volumes, lower natural gas volumes, higher exploration and selling, general and administrative expenses and lower after-tax earnings from transportation operations. The 1993 results included net charges of $545 million after tax related to reorganization of ARCO's Lower 48 oil and gas operations, the impact of the federal corporate tax rate increase on deferred taxes, litigation issues, reserves for future environmental remediation and a loss on the sale of Brazilian marketing subsidiaries partially offset by gains from Lower 48 property sales. The charges associated with the fourth quarter reorganization of ARCO's Lower 48 oil and gas operations were $450 million after tax. Included in those charges were unusual items of $659 million before tax, $404 million after tax, primarily related to writedowns for sale or other disposition of oil and gas properties and excess office space, in addition to workforce reductions. The incremental cash cost associated with these charges is approximately $60 million after tax. OVERVIEW OF 1992 RESULTS In 1992, ARCO's net income was $801 million, or $4.96 per share. The improvement in operating results compared to 1991 reflected improved margins and higher sales volumes in refining and marketing operations, lower lease operating costs, higher sales volumes and margins in chemical operations and higher natural gas prices, partially offset by lower natural gas sales volumes. In addition, income from equity earnings, interest income and interest expense were lower in 1992. The 1992 results included approximately $140 million after tax in net benefits primarily related to unusual items, partially offset by provisions for future environmental costs. Unusual items were $271 million before tax, $211 million after tax, and were comprised of a settlement on assets nationalized by Iran and recognition of a previously deferred portion of the gain from the 1989 sale of a majority interest in Lyondell Petrochemical Company (Lyondell), partially offset by a charge related to the withdrawal by ARCO Chemical Company (ARCO Chemical) from a South Korean joint venture. The 1992 results also included a net after-tax charge of $392 million, or $2.43 per share, for the cumulative effect of adopting two new accounting standards related to non-pension postretirement benefits and income taxes. OVERVIEW OF 1991 RESULTS In 1991, ARCO's net income was $709 million, or $4.39 per share. Results included net charges for unusual items of $503 million before tax, $312 million after tax, primarily related to personnel reductions, anticipated loss on property sales and property writedowns. RESULTS OF CONSOLIDATED OPERATIONS REVENUES Sales and other operating revenues were $18.5 billion in 1993, $18.7 billion in 1992 and $18.2 billion in 1991. The decrease in revenues in 1993, compared to 1992, resulted from lower crude oil prices and volumes, lower natural gas volumes, decreased crude oil trading volumes and lower refined and chemical products prices, partially offset by increased natural gas marketing volumes and higher refined and chemical products sales volumes and natural gas prices. The increase in revenues in 1992, compared to 1991, resulted from higher crude oil trading volumes, refined product prices and sales volumes, chemical product sales volumes and natural gas prices, partially offset by lower crude oil prices and natural gas volumes. Income from equity investments was $40 million in 1993, $22 million in 1992 and $119 million in 1991. The increase in income from equity investments in 1993, compared to 1992, primarily reflected reduced losses from ARCO Chemical's equity affiliates. The lower income in 1992, compared to 1991, primarily resulted from a decline in earnings from Lyondell. Other revenues were $492 million in 1993, compared to $376 million in 1992 and $385 million in 1991. The increase in 1993 reflected higher gains on asset sales. EXPENSES Trade purchases were $7.2 billion in 1993, $7.3 billion in 1992 and $7.0 billion in 1991. The 1993 trade purchases decrease compared to 1992 reflected lower crude oil trading prices and volumes and lower purchased volumes of finished refined products and chemical feedstocks, partially offset by higher natural gas marketing volumes and prices. The trade purchases increase in 1992, compared to 1991, related primarily to higher crude oil trading volumes, partially offset by lower crude oil prices. Operating expenses were $3.3 billion in 1993, $3.2 billion in 1992 and $3.1 billion in 1991. In 1993, operating expenses were higher than in 1992 as a result of litigation-related accruals, higher compensation and contract personnel costs associated with downstream and coal operations and higher maintenance costs, including turnarounds at three chemical plants, partially offset by lower operating costs in oil and gas operations. In 1992, lower operating costs in oil and gas were offset by higher operating costs in chemical operations. Exploration expenses were $667 million in 1993, $567 million in 1992 and $593 million in 1991. The increase in 1993, compared to 1992, reflected higher dry hole costs in Alaska and increased activity overseas, partially offset by decreased activity in the Lower 48. Selling, general and administrative expenses were $1.8 billion in 1993, $1.7 billion in 1992, and $1.8 billion in 1991. Increased expenses in 1993, compared to 1992, primarily resulted from higher compensation expense and higher delivery and advertising costs. The decrease in expenses in 1992, compared to 1991, primarily reflected lower insurance and pension costs. Taxes other than excise and income taxes were $1.1 billion in 1993, $1.2 billion in 1992, and $1.1 billion in 1991. The decrease in 1993 primarily resulted from lower production taxes related to lower crude oil prices and volumes. The increase in 1992 primarily resulted from an increase in the Brazilian value- added tax rate. Excise taxes were $1.3 billion in 1993, $1.2 billion in 1992 and $1.1 billion in 1991. The increase in 1993, compared to 1992, primarily resulted from the fourth quarter 1993 federal excise tax rate increase, the full-year effect in 1993 of increased state excise tax rates in 1992 and higher refined products sales volumes. The increase in 1992, compared to 1991, resulted from higher refined product sales volumes and increases in state excise tax rates in certain states in the fourth quarter of 1992. Depreciation, depletion and amortization was $1.7 billion in 1993, $1.8 billion in 1992 and $1.7 billion in 1991. The decrease in 1993, compared to 1992, resulted from the sale of Lower 48 oil and gas properties, partially offset by a $73 million accrual for the plugging and abandonment of onshore wells. The increase in 1992, compared to 1991, included the startup of the new ARCO Chemical propylene oxide/styrene monomer plant in Channelview, Texas and assets placed in service at the Corporation's two West Coast refineries. Interest expense was $715 million in 1993, $762 million in 1992 and $892 million in 1991. A decline in the weighted average interest rate on outstanding long- term debt in 1993 and 1992 is the primary cause of the lower interest expense compared to 1991. The Corporation's effective tax rate was 51.6% in 1993, compared to 35.6% in 1992 and 36.2% in 1991. The higher effective tax rate in 1993 reflected increased taxes on foreign income and the effect of the 1993 federal tax rate increase on deferred taxes. RESULTS OF SEGMENT OPERATIONS OIL AND GAS ARCO's worldwide oil and gas exploration and production operations earned $45 million after tax in 1993, versus $816 million after tax in 1992. The effect of lower crude oil prices and volumes and natural gas volumes and higher dry hole expense, partially offset by higher natural gas prices and lower depletion and lease operating costs, resulted in the lower earnings for 1993. The 1993 results included net charges of approximately $390 million after tax comprised of the previously discussed charges associated with the Lower 48 reorganization, the federal tax rate increase and other charges, partially offset by gains on property sales. Annual future cost savings associated with the Lower 48 reorganization are estimated to be approximately $100 million after tax. The 1992 results included a net benefit of $138 million after tax consisting of gains from the Iranian settlement, and gains from Lower 48 property sales, partially offset by charges associated with the downsizing of Lower 48 operations. ARCO's oil and gas exploration and production operations earned $816 million after tax in 1992, up from $549 million after tax in 1991. The 1992 results reflected the effect of lower operating and exploration costs and higher natural gas prices, offset by lower natural gas sales volumes, compared to 1991. The 1991 results included approximately $170 million after tax in net charges related to personnel reductions and the anticipated loss on divestiture of properties in the Lower 48, partially offset by a benefit from the reduction in U.K. corporation tax rates. The Corporation's domestic composite average price for crude oil was $11.67 per barrel in 1993, $12.92 per barrel in 1992 and $12.93 per barrel in 1991. Average domestic natural gas prices were $1.93 per thousand cubic feet in 1993, $1.65 per thousand cubic feet in 1992 and $1.54 per thousand cubic feet in 1991. Worldwide petroleum liquids production averaged 684,400 barrels per day in 1993, 738,200 barrels per day in 1992 and 744,200 barrels per day in 1991. Volumes decreased in 1993 as a result of Lower 48 property divestitures and natural field declines, partially offset by increased overseas production. Natural field decline in Alaska was partially offset by the September 1993 startup of the first phase of the second gas handling expansion facility (GHX-2) at Prudhoe Bay and new volumes which came on-stream from the Greater Point McIntyre area in October 1993. Worldwide production in 1992, compared to 1991, benefited from increased international volumes, although this was offset by natural field declines and Lower 48 property divestitures. ARCO's share of production from its largest Alaskan field, Prudhoe Bay, was 250,800 barrels of petroleum liquids per day in 1993, compared to 270,500 barrels per day in 1992 and 281,700 barrels per day in 1991. The decline in 1993 and 1992, compared to 1991, primarily reflected natural field decline. ARCO's share of petroleum liquids production from the Kuparuk River field was 151,500 barrels per day in 1993 compared to 150,800 barrels per day in 1992 and 140,300 barrels per day in 1991. The increase in 1992, compared to 1991, reflected the completion as of July 1, 1992 of a 24-month production payback of 9,000 barrels per day and improved field operations. Lower 48 petroleum liquids production was 186,000 barrels per day in 1993, 221,600 barrels per day in 1992 and 227,900 barrels per day in 1991. Domestic natural gas production totaled 911 million cubic feet per day in 1993, 1.2 billion cubic feet per day in 1992 and 1.4 billion cubic feet per day in 1991. The decreases in 1993 and 1992 production were primarily associated with the sale of Lower 48 properties and natural field declines. Foreign petroleum liquids production averaged 79,700 barrels per day in 1993, 77,700 barrels per day in 1992 and 75,700 barrels per day in 1991. Foreign natural gas production increased to 321 million cubic feet per day in 1993 as a result of the first full year of production from the Pickerill field in the United Kingdom North Sea and new production from the Orwell and Murdoch fields in the U.K. North Sea and from the offshore Northwest Java Sea field in Indonesia, all of which began production in late 1993. The decrease in 1992 natural gas production to 240 million cubic feet per day from 261 million cubic feet per day in 1991, reflected primarily natural field decline in the United Kingdom. COAL After-tax earnings from coal operations were $107 million in 1993, $83 million in 1992 and $33 million in 1991. The improvement in 1993 earnings reflected record sales volumes as a result of strong electric utility demand and reduced East Coast supply as a result of a mine workers strike. Australian mines also set production volumes and sales records for 1993. 1993 results included a benefit of approximately $10 million after tax associated with a change in the accrued estimated loss on the sale of the Coal Resources of Queensland (CRQ) mine, which was completed in January 1993. Included in the 1991 earnings were approximately $50 million in net after-tax charges primarily associated with a writedown of the CRQ mine, partially offset by gains from the sale of Venezuelan and other assets. Total worldwide coal shipments in 1993 were 47.7 million tons compared to 39.8 million tons in 1992 and 41.6 million tons in 1991. REFINING AND MARKETING After-tax earnings for refining and marketing operations were $307 million in 1993, $346 million in 1992 and $266 million in 1991. Earnings were lower in 1993, compared to 1992, because operating results were offset by a net charge of approximately $80 million after tax, comprised primarily of litigation-related accruals, the loss associated with the sale of the Brazilian marketing subsidiaries and the effect of the federal tax rate increase on deferred taxes. The improved earnings in 1992, compared to 1991, were the result of higher margins and sales volumes in the West Coast marketing area. The 1992 results included a charge of approximately $40 million after tax primarily for environmental costs related to previously divested operations. The 1991 earnings included approximately $10 million of net after-tax charges for personnel reductions, future environmental remediation primarily associated with previously divested properties and certain legal exposures, partially offset by benefits associated with accounting and tax adjustments related to Brazilian operations. West Coast petroleum products sales totaled 481,500 barrels per day in 1993, 479,500 barrels per day in 1992 and 466,400 barrels per day in 1991. The higher level of sales in 1993, compared to 1992, resulted from increased demand. The higher level of sales in 1992, compared to 1991, resulted from increased market share. The marketing operations supplemented ARCO's production with third-party purchases in order to meet increased sales. TRANSPORTATION After-tax earnings for the transportation operations were $189 million in 1993, $239 million in 1992 and $212 million in 1991. The 1993 earnings were lower, compared to 1992, as a result of a lower Trans Alaska Pipeline System (TAPS) tariff, lower volumes and the effect of the federal tax rate increase on deferred taxes. In 1992, improved results from Lower 48 terminal and pipeline operations offset a decline in earnings from TAPS. The 1991 earnings included after-tax charges of approximately $30 million for personnel reduction costs and for settlement of the Kuparuk Pipeline tariff rate litigation. INTERMEDIATE CHEMICALS AND SPECIALTY PRODUCTS After-tax earnings for the intermediate chemicals and specialty products segment were $239 million in 1993, $210 million in 1992 and $192 million in 1991. The segment consists of ARCO Chemical, an 83.3 percent owned subsidiary of the Corporation. ARCO Chemical's reported net income in 1993 included a $10 million after-tax loss on early debt extinguishment and benefited from a lower effective income tax rate. The 1992 results included $56 million before tax for a charge resulting from ARCO Chemical's withdrawal from the YUKONG ARCO Chemical Ltd., joint venture in South Korea. In 1993, increased sales volumes in ARCO Chemical's core products worldwide were offset by higher fixed costs associated with a new plant and maintenance expense resulting from turnarounds at three plants. Additional offsets included lower methyl tertiary butyl ether (MTBE) margins, primarily in Europe and lower overall propylene oxide (PO) and derivative margins as a result of lower margins for new products and continued weakness in the European economy. The 1992 earnings improved, compared to 1991, as a result of higher sales volumes and margins. Sales volumes for all major product groups, including PO derivatives and MTBE, were higher in 1992 than 1991. PO margins were higher in 1992, primarily in Europe, reflecting a weaker dollar. MTBE sales volumes were higher in 1992, primarily in the U.S., as a result of higher demand from domestic gasoline refiners. MTBE margins were higher on average in 1992 in both the U.S. and Europe as a result of lower raw material costs. ARCO Chemical's reported 1991 results included a $153 million before tax benefit from business interruption insurance related to a plant accident and to feedstock contamination at another plant in 1990. Also included in 1991 results were net pretax charges totaling $20 million reflecting personnel reductions and future environmental remediation costs, partially offset by a benefit related to a change in estimated accident charges. LYONDELL PETROCHEMICAL COMPANY ARCO's 49.9 percent equity share of Lyondell's net income was $13 million for 1993, $8 million for 1992 and $111 million for 1991. Lyondell's results in 1993 improved as a result of higher margins attained through the processing of greater volumes of Venezuelan crude oil. Lyondell's 1992 earnings, compared to 1991, were lower as a result of lower olefins margins and volumes and reduced refining margins in the Gulf Coast. UNALLOCATED EXPENSES AND OTHER Unallocated expenses and other was a net after-tax expense of $140 million in 1993 and $60 million in 1991 compared to a net after-tax benefit of $25 million in 1992. The increase in unallocated expenses in 1993, compared to 1992, reflected the absence of a $111 million after-tax gain recognized in 1992, increased employee-related expenses, higher charges for future environmental remediation, and lower net investment income. In 1992, unallocated expenses and other included the recognition of a $111 million after-tax gain representing a previously deferred portion of the gain from the 1989 sale of a majority interest in Lyondell, partially offset by corporate staff expense and charges for future environmental remediation. The 1991 unallocated expenses and other included after-tax charges of $34 million for future environmental remediation and higher insurance costs. RECENT DEVELOPMENTS On January 28, 1994, Vastar Resources, Inc. (Vastar), a wholly owned subsidiary of ARCO, filed a registration statement on Form S-1 with the Securities and Exchange Commission for the proposed sale of up to 17,250,000 shares of common stock to the public. ARCO intends to retain 80,000,001 shares, or 82.3 percent of Vastar's common stock. On December 7, 1993, Vastar borrowed $1.25 billion under a revolving credit agreement with a group of banks at an initial interest rate of 3.9 percent. The revolving line of credit is available until November 30, 1996. FINANCIAL POSITION AND LIQUIDITY Cash flows from operating activities were $2.8 billion in 1993, $3.1 billion in 1992 and $3.0 billion in 1991. The net cash used in investing activities was $2.2 billion in 1993 and primarily included expenditures for additions to fixed assets (including dry hole costs) of $2.1 billion, proceeds from asset sales of $582 million and a net increase in short-term investments of $789 million. The net cash used in financing activities was $431 million in 1993 and primarily included repayments of long-term debt of $886 million, proceeds of $1.3 billion from the issuance of long-term debt and dividend payments of $879 million. Cash and cash equivalents and short-term investments totaled $3.7 billion at year-end 1993 and short-term borrowings were $1.5 billion. Working capital was $1.1 billion higher at the end of 1993, reflecting an increase in short-term investments and a decrease in long-term debt due within one year. At December 31, 1993, the Corporation had unused committed bank credit facilities totaling $3.2 billion. In addition, ARCO Chemical had unused bank credit facilities totaling $300 million. The Corporation's 1994 capital spending program includes $1.9 billion for additions to fixed assets. Future capital expenditures remain subject to business conditions affecting the industry, particularly changes in price and demand for crude oil, natural gas and petroleum products. Changes in the tax laws, the imposition of and changes in federal and state clean air and clean fuel requirements, and other changes in environmental rules and regulations may also affect future capital expenditures. It is expected that future cash requirements for capital expenditures, dividends and debt repayments will come from cash generated from operating activities, existing cash balances, and any asset sales and future financings. ENVIRONMENTAL MATTERS During 1993, the Corporation charged to income $172 million before tax for environmental remediation costs and made related payments of $206 million. At December 31, 1993, the environmental remediation reserve totaled $648 million. The amount reserved represents an estimate of the undiscounted costs which the Corporation will incur to remediate sites with known contamination. In view of the uncertainties associated with estimating these costs, such as uncertainties with respect to the appropriate method for remediating contaminated sites, the extent of contamination at various sites, and the Corporation's ultimate share of costs at various sites, actual future costs could exceed the amount accrued by as much as $1 billion. Although the contingencies associated with environmental matters could result in significant expenses or judgments that, if aggregated and assumed to occur within a single fiscal year, would be material to the Corporation's results of operations, the likelihood of such occurrence is considered remote. On the basis of management's best assessment of the ultimate amount and timing of these events, such expenses or judgments are not expected to have a material adverse effect on the Corporation's consolidated financial position, stockholders' equity, liquidity or capital resources. In addition to the provision for environmental remediation costs, $788 million has been accrued for the estimated cost, net of salvage value, of dismantling facilities as required by contract, regulation or law, and the estimated costs of restoration and reclamation of land associated with such facilities. For further discussion of environmental matters see Note 12 of Notes to Consolidated Financial Statements. EFFECTS OF INFLATION While the annual rate of inflation remained moderate during the three-year period ended December 31, 1993, the Corporation continued to experience certain inflationary effects. The Corporation will achieve some benefits by using current, inflated dollars to satisfy its debt obligations and other monetary liabilities, because the Corporation's monetary assets are less than its monetary liabilities at December 31, 1993. Based on the age of the Corporation's property, plant and equipment, it is estimated that the replacement cost of those assets is greater than the historical cost reflected in the Corporation's financial statements. Accordingly, the Corporation's depreciation, depletion and amortization expense for the three years ended December 31, 1993, would be greater if the expense were stated on a current-cost basis. To the extent that the Corporation uses the last-in, first-out (LIFO) inventory accounting method, the replacement cost of inventory is greater than the historical cost reflected on the Corporation's balance sheet, while the costs of products sold reflected in the Corporation's income statement approximate current cost. ITEM 8. ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Schedules other than those listed above have been omitted since they are either not required, are not applicable, or the required information is shown in the financial statements or related notes. Financial statements with respect to unconsolidated subsidiaries and 50 percent owned companies are omitted per Rule 3-09(a) of Regulation S-X. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Atlantic Richfield Company We have audited the accompanying consolidated balance sheets of Atlantic Richfield Company 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 and the related financial statement schedules listed in the index on page 37 of this Form 10- K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Atlantic Richfield 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 3 to the consolidated financial statements, the Company changed its method of accounting for income taxes, postretirement benefits other than pensions and postemployment benefits in 1992. COOPERS & LYBRAND Los Angeles, California February 11, 1994 CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS ARCO See Notes on pages 42 through 53. CONSOLIDATED BALANCE SHEET ARCO The Corporation follows the successful efforts method of accounting for oil and gas producing activities. See Notes on pages 42 through 53. CONSOLIDATED STATEMENT OF CASH FLOWS ARCO (a) Includes noncash unusual items of $659 and ($149) in 1993 and 1992, respectively. (b) Includes noncash unusual items of $476. See Notes on pages 42 through 53. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 Accounting Policies ARCO's accounting policies conform to generally accepted accounting principles, including the "successful efforts" method of accounting for oil and gas producing activities. Principles of Consolidation The consolidated financial statements include the accounts of all subsidiaries, ventures and partnerships in which a controlling interest is held, including ARCO Chemical Company (ACC), of which ARCO owned 83.3 percent of the outstanding shares at December 31, 1993. ARCO also consolidates its interests in undivided interest pipeline companies and in oil and gas and coal mining joint ventures. ARCO uses the equity method of accounting for companies where its ownership is between 20 and 50 percent and for other ventures and partnerships in which less than a controlling interest is held. Cash Equivalents; Short-Term Investments Cash equivalents consist of highly liquid investments, such as time deposits, certificates of deposit and marketable securities other than equity securities, maturing within three months of purchase. Short-term investments consist of similar investments maturing in more than three months of purchase. Cash equivalents and short-term investments are stated at cost, which approximates market value. Oil and Gas Unproved Property Costs Unproved property costs are capitalized and amortized on a composite basis, considering past success experience and average property life. In general, costs of properties surrendered or otherwise disposed of are charged to accumulated amortization. Costs of successful properties are transferred to developed properties. Fixed Assets Fixed assets are recorded at cost and are written off on either a unit-of- production method or a straight-line method based on the expected lives of individual assets or groups of assets. Upon disposal of assets depreciated on an individual basis, residual cost less salvage is included in current income. Upon disposal of assets depreciated on a group basis, unless unusual in nature or amount, residual cost less salvage is charged against accumulated depreciation. Dismantlement, Restoration and Reclamation Costs The estimated costs, net of salvage value, of dismantling facilities or projects with limited lives or facilities that are required to be dismantled by contract, regulation or law, and the estimated costs of restoration and reclamation associated with oil and gas and mining operations are accrued during production and classified as a long-term liability. Such costs are taken into account in determining the cost of production in all operations, except oil and gas production, in which case such costs are considered in determining depreciation, depletion and amortization. Environmental Remediation Environmental remediation costs are accrued as operating expenses based on the estimated timing and extent of remedial actions required by applicable governmental authorities, experience gained from similar sites on which remediation has been completed, and the amount of ARCO's liability in consideration of the proportional liability and financial wherewithal of other responsible parties. Estimated liabilities are not discounted to present value. Reclassifications Certain previously reported amounts have been restated to conform to classifications adopted in 1993. NOTE 2 Unusual Items In the fourth quarter of 1993, ARCO announced a reorganization of its Lower 48 oil and gas operations. ARCO provided as unusual items a pretax charge of $659 million, $404 million after tax, primarily related to the writedown for sale or other disposition of oil and gas properties and excess office space, in addition to workforce reductions. In the fourth quarter of 1992, ARCO recognized a pretax benefit of $149 million from the settlement with Iran related to Corporation assets that had been nationalized in the late 1970s. In the second quarter of 1992, ARCO recognized a pretax benefit of $178 million related to a portion of the gain from the 1989 sale of a majority interest in Lyondell Petrochemical Company (Lyondell) which was previously deferred as the amount equal to ARCO's guarantee of notes associated with certain of Lyondell's manufacturing facilities. When Lyondell repaid the notes in 1992, ARCO was released from its guarantee and accordingly recognized the gain. In the second quarter of 1992, ARCO also recognized a pretax charge of $56 million resulting from ACC's withdrawal from the YUKONG ARCO Chemical Ltd. joint venture in Korea. The net benefit related to 1992 unusual items was $211 million after tax. In 1991, ARCO announced a reorganization of its oil and gas operations in the Lower 48 states and a companywide workforce reduction. An estimated pretax charge of $281 million was provided as unusual items for the cost of these programs. ARCO also provided as unusual items a pretax charge of approximately $222 million for the anticipated loss on the sale of certain Lower 48 oil and gas properties and the writedown of certain coal assets. The net provision related to the above items was $312 million after tax. NOTE 3 Accounting Changes Effective January 1, 1992, ARCO implemented on the immediate recognition basis Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual of the actuarially determined costs of postretirement benefits during the years that the employee renders the necessary service. ARCO's previous policy was to expense these costs when incurred. The cumulative effect of adopting SFAS No. 106 as of January 1, 1992, resulted in a charge of $435 million, or $2.70 per share, to 1992 earnings, net of income tax effects of approximately $262 million. Effective January 1, 1992, ARCO adopted SFAS No. 109, "Accounting for Income Taxes." The cumulative effect of the change on 1992 net income was a benefit of $43 million, or $0.27 per share. The effect of adopting SFAS Nos. 106 and 109 on 1992 net income, excluding the cumulative effect, was not material. Effective January 1, 1992, ARCO also adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The standard requires companies to accrue the cost of postemployment 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. NOTE 4 Segment Information ARCO operates primarily in the Resources and Products segments. The Resources segment includes oil and gas operations, which comprise the exploration, development and production of petroleum, including petroleum liquids (crude oil, condensate and natural gas liquids) and natural gas; the purchase and sale of petroleum liquids and natural gas; and the mining and sale of coal. The Products segment includes the refining and transportation of petroleum and petroleum products; the marketing of petroleum products; and the manufacture and sale of intermediate chemicals and specialty products, including propylene oxide and derivatives, tertiary butyl alcohol, methyl tertiary butyl ether and styrene monomer. Segment information for the years ended December 31, 1993, 1992 and 1991 was as follows: Intersegment sales were made at prices approximating current market values. The amounts for intersegment sales included in sales and other operating revenues were as follows: (a) Net of minority interest of $(36), $(32), and $(31) in 1993, 1992 and 1991, respectively. (a) Excludes undeveloped leasehold amortization of $98, $110, and $113, respectively, included in exploration expense. Foreign operations are conducted principally in the following geographic regions: Oil and gas--United Kingdom, Indonesia and Dubai; Coal--Australia; Intermediate chemicals and specialty products---Europe and Asia Pacific; Refining and marketing--Brazil (marketing only). The Brazilian operations were sold in December 1993. (a) Includes gain from settlement on assets nationalized by Iran (Note 2). (b) Includes losses of equity affiliates, principally Asian joint ventures, of $(2), $(18), and $(22), in 1993, 1992 and 1991, respectively. (c) Operations sold in December 1993. NOTE 5 Inventories Inventories are recorded when purchased, produced or manufactured and are stated at the lower of cost or market. In 1993, approximately 88 percent of inventories excluding materials and supplies were determined by the last-in, first-out (LIFO) method. Materials and supplies and other non-LIFO inventories are determined predominantly on an average cost basis. Total inventories at December 31, 1993 and 1992 comprised the following categories: The excess of the current cost of inventories over book value was approximately $228 million and $285 million at December 31, 1993 and 1992, respectively. NOTE 6 Taxes Taxes other than excise and income taxes for the years ended December 31, 1993, 1992 and 1991 comprised the following: The components of the provision for taxes on income for the years ended December 31, 1993, 1992 and 1991 were as follows: The deferred tax benefit in 1993 and 1991 primarily resulted from book accruals associated with the reorganizations and workforce reductions. The major components of the net deferred tax liability as of December 31, 1993 and 1992, and January 1, 1992 were as follows: ARCO has foreign loss carryforwards of $227 million which begin expiring in 1994. The domestic and foreign components of income before income taxes, minority interest and cumulative effect of changes in accounting principles, and a reconciliation of income tax expense with tax at the effective federal statutory rate for the years ended December 31, 1993, 1992 and 1991 were as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 Long-Term Debt Long-term debt at December 31, 1993 and 1992 comprised the following: Maturities and sinking fund obligations for the five years subsequent to December 31, 1993 are as follows (millions of dollars): 1994--$165; 1995--$632; 1996--$1,434; 1997--$269; 1998--$182. No material amounts of long-term debt are collateralized by Corporation assets. Vastar Resources, Inc. (Vastar), a wholly owned subsidiary of ARCO, entered into a $1.25 billion unsecured, variable rate, revolving-term credit agreement. In December 1993, Vastar borrowed $1.25 billion principal amount at an initial interest rate of 3.9 percent. The agreement contains restrictions which, among other things, require Vastar to maintain certain financial ratios and restrict encumbrance of assets. NOTE 8 Bank Credit Facilities and Compensating Balances In 1993, ARCO and certain wholly owned subsidiaries had committed bank credit facilities of approximately $3.2 billion, including a credit facility negotiated on behalf of a subsidiary that is denominated in pounds sterling. At December 31, 1993, there were no borrowings under these committed facilities. ACC maintains two credit facilities under which it may borrow up to $300 million which are not guaranteed by ARCO. At December 31, 1993, there were no borrowings against the ACC credit facilities. The facilities replace a previous facility that effectively expired in December 1993. Notes payable on the balance sheet consist primarily of commercial paper issued to a variety of financial investors and institutions and any amounts outstanding under ARCO or ACC credit facilities. ARCO has no requirements for compensating balances. ARCO does maintain balances for some of its banking services and products. Such balances are solely at ARCO's discretion, so that on any given date, none of ARCO's cash is restricted. At December 31, 1993, ARCO had letters of credit outstanding totalling $305 million. NOTE 9 Interest Expense Interest expense for the years ended December 31, 1993, 1992 and 1991 was comprised of the following: NOTE 10 Foreign Currency Transaction Gains Foreign exchange transactions, which relate primarily to Brazilian operations, resulted in net gains of $22 million, $1 million and $41 million in 1993, 1992 and 1991, respectively. NOTE 11 Fixed Assets Property, plant and equipment, and related accumulated depreciation, depletion and amortization at December 31, 1993 and 1992 were as follows: Expenses for maintenance and repairs for 1993, 1992 and 1991 were $509 million, $513 million and $523 million, respectively. NOTE 12 Other Commitments and Contingencies ARCO has commitments, including those related to the acquisition, construction and development of facilities, all made in the normal course of business. At December 31, 1993 and 1992, there were contingent liabilities primarily with respect to guarantees of securities of other issuers of approximately $111 million and $100 million, respectively, of which approximately $41 million and $45 million, respectively, were indemnified. Following the March 1989 EXXON VALDEZ oil spill, Alyeska Pipeline Service Company (Alyeska) and Alyeska's owner companies were the subject of numerous lawsuits by the State of Alaska, the United States and private plaintiffs. ARCO Transportation Alaska, Inc. (ATA) owns approximately 21 percent of Alyeska. In July 1993, it was announced that Alyeska and its owner companies had agreed to pay $98 million in settlement of all but a handful of the lawsuits by private plaintiffs of which $20.9 million was ATA's share. At the October 1993 approval hearing on the settlement, the settlement was tentatively approved; however, there remain certain issues concerning claims that Exxon might assert against Alyeska and its owner companies that must be resolved before the settlement becomes final. ARCO and former producers of lead pigments have been named as defendants in cases filed by a municipal housing authority, a purported class and several individuals seeking damages and injunctive relief as a consequence of the presence of lead-based paint in certain housing units. ARCO and its subsidiary, Atlantic Richfield Hanford Company (ARHCO), and several other companies have been named as defendants in lawsuits filed on behalf of individual persons and a number of purported classes. These lawsuits arise out of radioactive and non-radioactive toxic and hazardous substances allegedly generated at the Hanford Nuclear Reservation in Richland, Washington (HNR). The claims against ARCO and ARHCO arise out of the performance by ARHCO of a contract with the Atomic Energy Commission to provide chemical processing, waste management and support services at HNR from 1967 to 1977. ARCO and ARHCO believe that, should either or both ultimately be held liable, they will be entitled to indemnification by the federal government as provided under the Price-Anderson Act, and pursuant to the terms of the contract between ARHCO and the Atomic Energy Commission. ARCO is also the subject of or party to a number of pending or threatened legal actions for which the legal responsibility and financial impact cannot presently be ascertained. Although any ultimate liability arising from any of these suits, or from any of the proceedings described above, if aggregated and assumed to occur in a single fiscal year, would be material to ARCO's results of operations, the likelihood of such occurrence is considered remote. On the basis of management's best assessment of the ultimate amount and timing of these events, such expenses or judgments are not expected to have a material adverse effect on ARCO's consolidated financial position, stockholders' equity, liquidity or capital resources. ARCO is subject to other loss contingencies pursuant to federal, state and local environmental laws and regulations. These include possible obligations to remove or mitigate the effects on the environment of the disposal or release of certain chemical, mineral and petroleum substances at various sites, including the restoration of natural resources located at these sites and damages for loss of use and non-use values. ARCO is currently participating in environmental assessments and cleanups under these laws at federal Superfund and state-managed sites, as well as other clean-up sites, including service stations, refineries, terminals, chemical facilities, third-party landfills, former nuclear processing facilities, and sites associated with discontinued operations. ARCO may in the future be involved in additional environmental assessments and cleanups, including the restoration of natural resources and damages for loss of use and non-use values. The amount of such future costs is indeterminable due to such factors as the unknown nature and extent of contamination at many sites, the unknown timing, extent and method of the remedial actions which may be required and the determination of ARCO's liability in proportion to other responsible parties. ARCO continues to estimate the amount of these costs in periodically establishing reserves based on progress made in determining the magnitude of remediation costs, experience gained from sites on which remediation has been completed, the timing and extent of remedial actions required by the applicable governmental authorities and an evaluation of the amount of ARCO's liability considered in light of the liability and financial wherewithal of the other responsible parties. At December 31, 1993, the reserve balance is $648 million. As the scope of ARCO's obligations becomes more clearly defined, there may be changes in these estimated costs, which might result in future charges against ARCO's earnings. ARCO's reserve covers federal Superfund and state-managed sites as well as other clean-up sites, including service stations, refineries, terminals, chemical facilities, third-party landfills, former nuclear processing facilities and sites associated with discontinued operations. ARCO has been named a potentially responsible party (PRP) for 123 sites. The number of PRP sites in and of itself does not represent a relevant measure of liability, because the nature and extent of environmental concerns varies from site to site and ARCO's share of responsibility varies from sole responsibility to very little responsibility. ARCO reviews all of the PRP sites, along with other sites as to which no claims have been asserted, in estimating the amount of the reserve. ARCO's future costs at these sites could exceed the reserve by as much as $1 billion. Approximately half of the reserve related to sites associated with ARCO's discontinued operations, primarily mining activities in the states of Montana and Colorado. Another significant component related to currently and formerly owned chemical, nuclear processing, and refining and marketing facilities, and other sites which received wastes from these facilities. The remainder related to other sites with reserves ranging from $1 million to $10 million per site. No one site represents more than 15 percent of the total reserve. Substantially all amounts accrued in the reserve are expected to be paid out over the next five to six years. Claims for recovery of remediation costs already incurred and to be incurred in the future have been filed against various insurance companies and other third parties. None of these claims has been resolved. Due to the uncertainty as to ultimate recovery from these parties, ARCO has neither recorded any asset nor reduced any liability in anticipation of such recovery. Environmental loss contingencies also include claims for personal injuries allegedly caused by exposure to toxic materials manufactured or used by ARCO. Although these contingencies could result in significant expenses or judgments that, if aggregated and assumed to occur within a single fiscal year, would be material to ARCO's results of operations, the likelihood of such occurrence is considered remote. On the basis of management's best assessment of the ultimate amount and timing of these events, such expenses or judgments are not expected to have a material adverse effect on ARCO's consolidated financial position, stockholders' equity, liquidity or capital resources. The operations and consolidated financial position of ARCO continue to be affected from time to time in varying degrees by domestic and foreign political developments as well as legislation, regulations and litigation pertaining to restrictions on production, imports and exports, tax increases, environmental regulations, cancellation of contract rights and expropriation of property. Both the likelihood of such occurrences and their overall effect on ARCO vary greatly and are not predictable. These uncertainties are part of a number of items that ARCO has taken and will continue to take into account in periodically establishing reserves. NOTE 13 Retirement Plans ARCO and its subsidiaries have defined benefit pension plans to provide pension benefits to substantially all employees. The benefits are based on years of service and the employee's compensation, primarily during the last three years of service. ARCO's funding policy is to make annual contributions as required by applicable regulations. ARCO charges pension costs as accrued, based on an actuarial valuation for each plan, and funds the plans through contributions to trust funds that are kept apart from Corporation funds. The following table sets forth the plans' funded status and amounts recognized in the balance sheet at December 31, 1993 and 1992: Pension costs related to ARCO-sponsored plans, on a pretax basis, including amortization of unfunded projected benefit obligations for the years ended December 31, 1993, 1992 and 1991 were as follows: In addition to the pension (benefit) cost above, in 1993 and 1991 ARCO recorded $61 million and $103 million, respectively, before tax as additional pension expense in connection with the workforce reductions in those years. ARCO's assumptions used as of December 31, 1993, 1992 and 1991 in determining the pension cost and pension liability shown above were as follows: NOTE 14 Other Postretirement Benefits ARCO and its subsidiaries sponsor defined postretirement benefit plans to provide other postretirement benefits to substantially all employees who retire with ARCO having rendered the required years of service, along with their spouses and eligible dependents. Health care benefits are provided primarily through comprehensive indemnity plans. Currently, ARCO pays approximately 80 percent of the cost of such plans, but has the right to modify the cost-sharing provisions at any time. Life insurance benefits are based primarily on the employee's final compensation and are also partially paid for by retiree contributions, which vary based upon coverage chosen by the retiree. ARCO's current policy is to fund the cost of postretirement health care and life insurance plans on a pay-as-you-go basis. Pursuant to Section 401(h) of the Internal Revenue Code of 1986, excess pension assets totalling $21 million were transferred from the pension plans to health care benefit accounts within the pension plans for reimbursement of 1992 retiree health care benefits. The following table sets forth the plans' combined postretirement benefit liability as of December 31, 1993 and 1992: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ARCO charges postretirement benefit costs as accrued, based on actuarial calculations for each plan. Net annual postretirement benefit costs as of December 31, 1993 and 1992 included the following components: In addition to the cost above, ARCO recorded $9 million as additional postretirement benefit expense in connection with the workforce reduction in 1993. For the year ended December 31, 1991, ARCO recognized postretirement costs as incurred. Accordingly, the amount recognized as expense in prior years is not comparable. The significant assumptions used in determining postretirement benefit cost and the accumulated postretirement benefit obligation were as follows: The weighted average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care trend rate) for the health plans is 10 percent for 1993 to 1996, 8 percent for 1997 to 2001, and 6 percent thereafter. The effect of a one-percentage-point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately 10.5 percent, and the aggregate of the service and interest cost components of net annual postretirement benefit cost by approximately 11 percent. NOTE 15 Stockholders' Equity Detail of ARCO's capital stock as of December 31, 1993 and 1992 was as follows: The changes in preference stocks outstanding were due solely to conversions. The $3.00 cumulative convertible preference stock is convertible into 6.8 shares of common stock. The $2.80 cumulative convertible preference stock is convertible into 2.4 shares of common stock. The common stock is subordinate to the preference stocks for dividends and assets. The $3.00 and $2.80 preference stocks may be redeemed at the option of ARCO for $82 and $70 per share, respectively. ARCO has authorized 75,000,000 shares of preferred stock, $.01 par, of which none were issued or outstanding at December 31, 1993. By stockholder approval, all of the Series B, 3.75 percent cumulative preferred stock, $100 par, of which none were issued and outstanding, was cancelled effective May 3, 1993. By Board authorization, effective December 31, 1991, ARCO canceled 7 million shares of common stock held in treasury. As a result of this cancellation, common stock decreased by $17 million, capital in excess of par value of stock decreased by $30 million, and retained earnings decreased by $684 million in 1991. The balance in ARCO's common stock at December 31, 1993, 1992 and 1991 was $402 million. Detail of changes in treasury stock in 1993, 1992 and 1991 was as follows: The net decrease in capital in excess of par value of stock in 1993, 1992 and 1991 of $15 million, $12 million and $52 million, respectively, was due primarily to the conversion of preference stock to common stock and the cancellation of treasury stock in 1991. ARCO's Certificate of Incorporation contains a provision restricting dividend payments; however, at December 31, 1993, retained earnings were free from such restriction. At December 31, 1993, shares of ARCO's authorized and unissued common stock were reserved as follows: Under ARCO's incentive compensation plans, awards of ARCO's common stock may be made to officers, outside directors and key employees. NOTE 16 Earned per Share Earned per share is based on the average number of common shares outstanding during each period including common stock equivalents that consist of certain outstanding options and all outstanding convertible securities. The average shares used in the calculation of earned per share for the years ended December 31, 1993, 1992 and 1991 were 162.4 million, 161.5 million and 161.7 million, respectively. NOTE 17 Stock Options Options to purchase shares of ARCO's common stock have been granted to executives, outside directors and key employees. These options become exercisable in varying installments and expire ten years after the date of grant. Transactions during 1993, 1992 and 1991 were as follows: NOTE 18 Supplemental Cash Flow Information The following is supplemental cash flow information for the years ended December 31, 1993, 1992 and 1991: NOTE 19 Lease Commitments Commitments under capital financial leases are capitalized with the obligation recorded at the present value of future rental payments. The related assets are amortized on a straight-line basis. At December 31, 1993, future minimum rental payments due under leases were as follows: Minimum future rental income under noncancelable subleases at December 31, 1993 amounted to $98 million. Operating lease net rental expense for the years ended December 31, 1993, 1992 and 1991 was as follows: No restrictions on dividends or on additional debt or lease financing exist under ARCO's lease commitments. Under certain conditions, options and obligations exist to purchase certain leased properties. NOTE 20 Lyondell Petrochemical Company Lyondell Petrochemical Company (Lyondell) is engaged in the manufacture, refining and marketing of basic commodity chemicals, including ethylene, propylene, methanol and aromatics, and petroleum products. At December 31, 1993, ARCO owned 49.9 percent of Lyondell common stock outstanding; ARCO accounts for this investment on the equity method. The market value of ARCO's shares of Lyondell common stock, based on the closing quoted market price at December 31, 1993, was $848 million. Summarized financial information for Lyondell was as follows: (a) Includes $278, $329 and $526 of sales to ARCO in 1993, 1992 and 1991, respectively, which approximated 4%, 5% and 8% of ARCO's purchases in those years. (b) ARCO's investment in Lyondell comprises 49.9% of Lyondell's stockholders' deficit plus $72 of dividends received in excess of basis of investment. NOTE 21 Financial Instruments; Fair Value and Off-Balance-Sheet Risk The following methods and assumptions were used to estimate the fair value of each class of financial instruments: The carrying amount of cash equivalents, short-term investments and notes payable approximates fair value because of the short maturity of those instruments. The fair value of other investments and long-term receivables was estimated primarily based on quoted market prices for those or similar investments. At December 31, 1993 and 1992, the fair value of other investments and long-term receivables approximated carrying value. The fair value of ARCO's long-term debt was estimated based on the quoted market prices for the same or similar issues or on the current rates offered to ARCO for debt of the same remaining maturities. At December 31, 1993 and 1992, the fair value of long-term debt, including long-term debt due within one year, was $8,307 million and $7,570 million, respectively. The fair value of foreign currency forward contracts and derivatives was estimated by obtaining quotes from brokers. Fair value of these instruments at December 31, 1993 and 1992, approximated carrying value. At December 31, 1993 and 1992, ARCO had foreign currency forward contracts and foreign cross-currency contracts outstanding, which mature at various dates, to reduce exposure to foreign currency exchange risk. The aggregate contract value of instruments used to buy U.S. dollars in exchange for Australian dollars was approximately $483 million and $367 million at December 31, 1993 and 1992, respectively. The aggregate contract value of instruments used to sell European currencies and Japanese yen in exchange for Deutsche marks, U.S. dollars and functional currencies of ARCO's European operations was approximately $24 million and $65 million at December 31, 1993 and 1992, respectively. Additionally, ARCO had outstanding foreign currency swaps which mature at various dates through 1994, to sell approximately 187 million French francs for $35 million at both December 31, 1993 and 1992. At December 31, 1993 and 1992, approximately $355 million and $405 million, respectively, of the long-term debt was denominated in foreign currencies. To reduce the exposure to foreign currency fluctuations, ARCO entered into a swap agreement on an 18 billion yen debt issue due in 1996 which fixes the principal balance at $102 million with an effective rate of 8.14 percent. At December 31, 1993, ARCO had outstanding interest rate swaps on two loans totalling 300 million Dutch guilders due in 1997 (one loan for 150 million Dutch guilders in 1992). This effectively changed both loans' floating interest rates to fixed rates of 5.70 percent and 6.71 percent (9.69 percent in 1992). The counterparties to these transactions are major international financial institutions; ARCO does not anticipate nonperformance by the counterparties. NOTE 22 Unaudited Quarterly Results (a) See Note 2. (b) The impact of cumulative effect of changes in accounting principles resulted in a net after-tax charge of ($392) million, or ($2.43) per share. (c) Includes $100 million benefit from reduced taxes resulting from adjustments for capital transactions and revisions of previously accrued taxes. SUPPLEMENTAL INFORMATION (UNAUDITED) Oil and Gas Producing Activities The Securities and Exchange Commission (SEC) defines proved oil and gas reserves as those estimated quantities of crude oil, 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 existing economic and operating conditions. Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. ARCO reports reserve estimates to various federal government agencies and commissions. These estimates may cover various regions of crude oil and natural gas classifications within the United States and may be subject to mandated definitions. There have been no reports of total ARCO reserve estimates furnished to federal government agencies or commissions which vary from those reported to the SEC since the beginning of the last fiscal year. Estimated quantities of ARCO's proved oil and gas reserves were as follows: The changes in proved reserves for the years ended December 31, 1991, 1992 and 1993 were as follows: Significant changes to proved oil and gas reserves during 1993 were due to the addition of reserves from the Sirasun gas discovery in Indonesia, the Mustang Island gas discovery offshore Gulf of Mexico and the sale of Lower 48 oil and gas properties. Estimates of petroleum reserves have been made by ARCO engineers. These estimates include reserves in which ARCO holds an economic interest under production-sharing and other types of operating agreements with foreign governments. These estimates do not include probable or possible reserves. Natural gas liquids comprise 12 percent of petroleum liquid proved reserves. The sale of natural gas from the North Slope of Alaska, which is not used in providing fuel in North Slope operations or sold to others on the North Slope, is dependent upon construction of a natural gas transportation system or another marketing alternative. Such gas is not included in ARCO's reserves. There are currently several projects under consideration, including the Alaska Natural Gas Transportation System and the Trans Alaska Gas System. However, there are a number of regulatory, financial, legal and marketing questions regarding the projects that remain unresolved. ARCO has studied various options for marketing North Slope gas over the past few years. However, ARCO Alaska believes that market conditions are not likely to permit implementation of any large gas sales project within the foreseeable future. The aggregate amounts of capitalized costs relating to oil and gas producing activities and the related accumulated depreciation, depletion and amortization as of December 31, 1993, 1992 and 1991 were as follows: Costs, both capitalized and expensed, incurred in oil and gas producing activities during the three years ended December 31, 1993, 1992 and 1991 were as follows: Results of operations from oil and gas producing activities (including operating overhead) for the three years ended December 31, 1993, 1992 and 1991 were as follows: The difference between the above results of operations for 1993, 1992 and 1991 and the amounts reported for after-tax oil and gas segment earnings in Note 4 of Notes to Consolidated Financial Statements is primarily marketing-related activities and the exclusion of gains on property sales and unusual items related to the Lower 48 reorganization. Information for 1992 and 1991 has been restated to conform to 1993 formats, primarily the reclassification of allocated overhead from production and exploration costs to other operating expenses and the removal of certain unusual items previously included. The standardized measure of discounted estimated future net cash flows related to proved oil and gas reserves at December 31, 1993, 1992 and 1991 was as follows: Primary changes in the standardized measure of discounted estimated future net cash flows for the years ended December 31, 1993, 1992 and 1991 were as follows: Estimated future cash inflows are computed by applying year-end prices of oil and gas to year-end quantities of proved reserves. Future price changes are considered only to the extent provided by contractual arrangements. Estimated future development and production costs are determined by estimating the expenditures to be incurred in developing and producing the proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions. Estimated future income tax expense is calculated by applying year-end statutory tax rates (adjusted for permanent differences and tax credits) to estimated future pretax net cash flows related to proved oil and gas reserves, less the tax basis of the properties involved. These estimates are furnished and calculated in accordance with requirements of the Financial Accounting Standards Board and the SEC. Because of unpredictable variances in expenses and capital forecasts, crude oil and natural gas price changes, largely influenced and controlled by U.S. and foreign governmental actions, and the fact that the bases for such estimates vary significantly, management believes the usefulness of these projections is limited. Estimates of future net cash flows presented do not represent management's assessment of future profitability or future cash flow to ARCO. Management's investment and operating decisions are based on reserve estimates that include proved reserves prescribed by the SEC as well as probable reserves, and on different price and cost assumptions from those used here. It should be recognized that applying current costs and prices and a 10 percent standard discount rate does not convey absolute value. The discounted amounts arrived at are only one measure of the value of proved reserves. Regarding the information on estimated reserve quantities and discounted future net cash flows, ARCO has no long-term supply contracts to purchase from foreign governments or any interest in equity affiliates involved in oil and gas producing activities. Coal Operations Supplemental operating statistics for the coal operations of ARCO for the three years ended December 31, 1993, 1992 and 1991 were as follows: The significant change to reserves in 1992 was due to the acquisition of the West Black Thunder lease acreage. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding executive officers of the Company is included in Part I. For the other information called for by Items 10, 11, 12 and 13, reference is made to the Registrant's definitive proxy statement for its Annual Meeting of Stockholders, to be held on May 2, 1994, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1993, and which is incorporated herein by reference, except for the material included under the captions "Report of Compensation Committee" and "Performance Graph." 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 AND 2. Financial Statements and Financial Statement Schedules: These documents are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules. 3. Exhibits: 3.1 Certificate of Incorporation of Atlantic Richfield Company as amended through May 3,1993 filed herewith; proposed amendment to Certificate of Incorporation is included in Appendix A of Registrant's Proxy Statement dated March 14, 1994 (the "1994 Proxy Statement") filed with the Securities and Exchange Com- mission (the "Commission") under File No. 1-1196 and incorpo- rated herein by reference. 3.2 By-Laws of Atlantic Richfield Company as amended through Janu- ary 23, 1989 filed herewith. 4.1 Rights Agreement dated as of May 27, 1986 between the Company and Morgan Guaranty Trust Company of New York, as Rights Agent, filed as Exhibit 2.1 to the Company's Form 8-A filed with the Commission under File No. 1-1196 on June 3, 1986, and incorporated herein by reference. 4.2 Indenture dated as of May 15, 1985 between the Company and The Chase Manhattan Bank, N.A., filed as Exhibit 4.4 to the Company's Quarterly Report on Form 10-Q for the six months ended June 30, 1985, File No. 1-1196, and incorporated herein by reference. 4.3 Indenture, dated as of January 1, 1992, between the Company and The Bank of New York, filed as an exhibit, bearing the same number, to the Company's Registration Statement on Form S-3 (No. 33-44925), filed with the Commission on January 6, 1992, and incorporated herein by reference. 4.4 Instruments defining the rights of holders of long-term debt which is not registered under the Securities Exchange Act of 1934 are not filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the consolidated total assets of the Company. The Company agrees to furnish a copy of any such instrument to the Commis- sion upon request. 10.1(a) Atlantic Richfield Company Supplementary Executive Retirement Plan, as adopted by the Board of Directors of the Company on March 26, 1990, and effective on October 1, 1990, filed as Ex- hibit 10.2 to the Company's Form 10-K Report for the year 1990, File No. 1-1196, and incorporated herein by reference. 10.1(b) Amendment No. 1 to Atlantic Richfield Company Supplementary Executive Retirement Plan effective March 22, 1993, filed as Exhibit 10 to the Company's Form 10-Q Report for the quarterly period ended June 30, 1993, File No. 1-1196, and incorporated herein by reference. 10.2(a) Atlantic Richfield Company Executive Deferral Plan, as adopted by the Board of Directors of the Company on March 26, 1990 and effective on October 1, 1990, filed as Exhibit 10.3 to the Company's Form 10-K Report for the year 1990, File No. 1-1196, and incorporated herein by reference. 10.2(b) Amendment No. 1 to Atlantic Richfield Company Executive Defer- ral Plan effective July 27, 1992, filed as an exhibit, bearing the same number, to the Company's Form 10-K Report for the year 1992, File No. 1-1196, and incorporated herein by reference. 10.3 Atlantic Richfield Executive Medical Insurance Plan-Summary Plan Description, as in effect January 1, 1994, filed herewith. 10.4(a) Atlantic Richfield Company Executive Supplementary Savings Plan II, as amended, restated and effective on July 1, 1988, filed as Exhibit 10.6 to the Company's Form 10-K Report for the year 1988, File No. 1-1196, and incorporated herein by reference. 10.4(b) Amendment No. 1 to Atlantic Richfield Company Executive Sup- plementary Savings Plan II as amended and effective on January 1, 1989, filed as Exhibit 10.6(b) to the Company's Form 10-K Report for the year 1989, File No. 1-1196, and incorporated herein by reference. 10.5 Atlantic Richfield Company Policy on Financial Counseling and Individual Income Tax Service, as revised effective January 1, 1991, filed as Exhibit 10.6 to the Company's Form 10-K Report for the year 1990, File No. 1-1196, and incorporated herein by reference. 10.6 Annual Incentive Plan, as adopted by the Board of Directors of the Company on November 26, 1984, and effective on that date, as amended through January 1, 1991, filed as Exhibit 10.7 to the Company's Form 10-K Report for the year 1990, File No. 1-1196, and incorporated herein by reference; proposed amendment to the Annual Incentive Plan is included in Appendix B of Reg-istrant's 1994 Proxy Statement filed with the Commission under File No. 1-1196 and incorporated herein by reference. 10.7 Atlantic Richfield Company's 1985 Executive Long-Term Incen- tive Plan, as adopted by the Board of Directors of the Company on May 28, 1985, and effective on that date, as amended through February 24, 1992, filed as Exhibit 10.8 to the Company's Form 10-K Report for the year 1991, File No. 1-1196, and incorporated herein by reference, and as amended on Febru- ary 22, 1993 and effective on that date, filed as an exhibit bearing the same number, to the Company's 10-K Report for the year 1992, File No. 1-1196, and incorporated herein by reference. 10.8 Atlantic Richfield Company Executive Life Insurance Plan--Sum- mary Plan Description, as in effect January 1, 1994, filed herewith. 10.9 Atlantic Richfield Company Executive Long-Term Disability Plan--Summary Plan Description, as in effect January 1, 1994, filed herewith. 10.10 Form of Indemnity Agreement adopted by the Board of Directors on January 26, 1987 and executed in February 1987 by the Com- pany and each of its directors and officers, included in Ex- hibit A to the 1987 Proxy Statement (filed with the Commission under File No. 1-1196) and incorporated herein by reference. 10.11 Exchange Agreement between Tosco Corporation and Atlantic Richfield Company dated October 2, 1986, as amended by letter dated November 5, 1986, filed as Exhibit 10.14, to the Company's Form 10-K Report for the year 1986, File No. 1-1196, and incorporated herein by reference. 10.12 Retirement Plan for Outside Directors effective October 1, 1990, as amended March 31, 1993, filed as Exhibit 10 to the Company's Form 10-Q Report for the quarterly period ended March 31, 1993, File No. 1-1196, and incorporated herein by reference. 10.13(a) Stock Option Plan for Outside Directors effective December 17, 1990, filed as Exhibit 10.14 to the Company's Form 10-K Report for the year 1990, File No. 1-1196, and incorporated herein by reference. 10.13(b) Amendment No. 1 to Stock Option Plan for Outside Directors effective June 22, 1992, filed as an exhibit, bearing the same number, to the Company's Form 10-K Report for the year 1992, File No. 1-1196, and incorporated herein by reference. 10.14 Special Incentive Plan, as adopted by the Board of Directors of the Company on February 28, 1994, and effective on that date, is included in Appendix C of Registrant's Proxy State- ment filed with the Commission under File No. 1-1196 and in- corporated herein by reference. 22 Subsidiaries of the Registrant. 23 Consent of Coopers & Lybrand. Copies of exhibits will be furnished upon prepayment of 25 cents per page. Requests should be addressed to the Corporate Secretary. (b) REPORTS ON FORM 8-K: No Current Reports on Form 8-K were filed during the quarter ended December 31, 1993, and thereafter through March 1, 1994. CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the following registration statements of Atlantic Richfield Company, Registration Statement on Form S-8 (No. 33-43830), Registration Statement on Form S-8 (No. 33-21558), Post- Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33- 21160), Post-Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33-23639), Post-Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33-21162), Post-Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33-21553), Post-Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33-23640), and Post-Effective Amendment No. 4 to Registration Statement on Form S-8 (No. 33-21552) of our report dated February 11, 1994, on our audits of the consolidated financial statements and financial statement schedules of Atlantic Richfield Company as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which report is included in this Annual Report on Form 10-K. COOPERS & LYBRAND Los Angeles, California March 1, 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. ATLANTIC RICHFIELD COMPANY /s/ Lodwrick M. Cook By ___________________________________ Lodwrick M. Cook Chairman of the Board and Chief Executive Officer FEBRUARY 28, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE /s/ Lodwrick M. Cook Chairman of the February 28, 1994 - ------------------------------------- Board, Chief Lodwrick M. Cook Principal executive Executive Officer officer and Director /s/ Mike R. Bowlin President, Chief February 28, 1994 - ------------------------------------- Operating Officer Mike R. Bowlin and Director /s/ Ronald J. Arnault Executive Vice February 28, 1994 - ------------------------------------- President, Chief Ronald J. Arnault Principal Financial Officer financial officer and Director /s/ James A. Middleton Executive Vice February 28, 1994 - ------------------------------------- President and James A. Middleton Director /s/ William E. Wade, Jr. Executive Vice February 28, 1994 - ------------------------------------- President and William E. Wade, Jr. Director SIGNATURE TITLE DATE /s/ Frank D. Boren Director February 28, 1994 - ------------------------------------- Frank D. Boren /s/ Richard H. Deihl Director February 28, 1994 - ------------------------------------- Richard H. Deihl /s/ John Gavin Director February 28, 1994 - ------------------------------------- John Gavin /s/ Hanna H. Gray Director February 28, 1994 - ------------------------------------- Hanna H. Gray /s/ Philip M. Hawley Director February 28, 1994 - ------------------------------------- Philip M. Hawley /s/ William F. Kieschnick Director February 28, 1994 - ------------------------------------- William F. Kieschnick /s/ Kent Kresa Director February 28, 1994 - ------------------------------------- Kent Kresa /s/ David T. McLaughlin Director February 28, 1994 - ------------------------------------- David T. McLaughlin /s/ John B. Slaughter Director February 28, 1994 - ------------------------------------- John B. Slaughter /s/ Hicks B. Waldron Director February 28, 1994 - ------------------------------------- Hicks B. Waldron /s/ Henry Wendt Director February 28, 1994 - ------------------------------------- Henry Wendt /s/ Allan L. Comstock Vice President and February 28, 1994 - ------------------------------------- Controller Allan L. Comstock Principal accounting officer SCHEDULE V ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS OF DOLLARS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (See footnotes on following page.) SCHEDULE V (CONTINUED) ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS OF DOLLARS) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - -------- (a) Primarily the sale of various oil and gas properties. (b) Primarily dry hole costs charged to income. (c) Primarily an equity translation adjustment at December 31, 1992 and dry hole costs charged to income. (d) Primarily the reclassification of assets associated with the ARCO exploration and production technology division and dry hole costs charged to income. (e) Primarily the Union Carbide Chemicals and Plastics Company, Inc. assets transferred from deferred charges upon finalization of purchase. (f) Primarily the reclassification of assets associated with the ARCO exploration and production technology division. The methods used in computing the annual provision for depreciation, depletion and amortization of property, plant and equipment are presented in Note 1 of Notes to Consolidated Financial Statements herein. SCHEDULE VI ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS OF DOLLARS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (See footnotes on following page.) SCHEDULE VI (CONTINUED) ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS OF DOLLARS) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - -------- (a) Primarily the sale of various oil and gas properties. (b) Primarily the writedown of various oil and gas properties and the Company's office building and parking structure in Dallas, Texas. (c) Primarily the reclassification of assets associated with the ARCO exploration and production technology division. SCHEDULE VIII ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS (IN MILLIONS OF DOLLARS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (See footnotes on following page.) SCHEDULE VIII (CONTINUED) ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS (IN MILLIONS OF DOLLARS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Write-off for uncollectible accounts, net of recoveries. (b) Primarily a reclassification of pension liability. SCHEDULE IX ATLANTIC RICHFIELD COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS (DOLLARS IN MILLIONS) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- - -------- (a) The average amount outstanding equals the sum of the amounts outstanding at each month-end divided by twelve. (b) The weighted average interest rate equals the sum of each outstanding amount times its rate for each day in the period, divided by the total number of days in the period times the average amount outstanding during the period.

788784_1993.txt

788784_1993

1993

788784

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

103730_1993.txt

103730_1993

1993

103730

Item 1. DESCRIPTION OF BUSINESS - - - -------------------------------- General Vishay Intertechnology, Inc. (together with its consolidated subsidiaries, "Vishay" or the "Company") is a leading international manufacturer and supplier of passive electronic components, particularly resistors and tantalum and film capacitors. Resistors, the most common component in electronic circuits, are used to adjust and regulate levels of voltage and current. Capacitors perform energy storage, frequency control, timing and filtering functions in almost all types of electronic equipment. The Company's products are used in a broad variety of electronic applications, including those in the computer, telecommunications, military/aerospace, instrument, industrial, automotive, office equipment and entertainment industries. Through a series of acquisitions over the last eight years, the Company has grown from a small manufacturer of precision resistors and strain gages to one of the world's largest manufac- turers and suppliers of a broad line of passive electronic compo- nents. The Company's acquisition strategy has focused on acquiring manufacturers of those types of quality products in which the Company has strong marketing organizations and technical expertise but who have encountered operating, financial or management difficulties. In connection with each acquisition, the Company has implemented programs to realize synergies between its existing businesses and the acquired business. These programs have focused on reducing selling, general and administrative expenses and maximizing production efficiencies, including the integration of redundant sales offices and administrative functions and the transfer of some production operations to regions where the Company can take advantage of lower labor costs and available tax and other incentives. The Company's first major acquisition was the purchase in 1985 of a 50% interest in Dale Electronics, Inc. ("Dale"), a United States producer of precision and commercial resistors, magnetic components and plasma displays. In 1987, the Company established a major presence in Germany with the acquisition of Draloric Electronic GmbH ("Draloric"), strengthening the Company's metal film resistor and specialty resistor businesses. In 1988, the Company acquired the remaining 50% interest in Dale as well as all of the outstanding shares of Sfernice, S.A., a French manufacturer of resistors, potentiometers and printed circuit boards. Subse- quently, Vishay acquired several small United States inductor manufacturers and one French inductor manufacturer. In 1992, the Company acquired the worldwide tantalum capacitor and United States thick film resistor network businesses of American Annuity Group, Inc., formerly Sprague Technologies, Inc. ("STI"). In January 1993, Vishay exercised its option to purchase 81% of the outstanding share capital of Roederstein Spezialfabriken fur Bauelemente der Elektronik und Kondensatoren der Starkstromtechnik GmbH ("Roederstein"). Vishay acquired its initial 19% interest in Roederstein in February 1992. Roederstein's principal products include film, aluminum electrolytic and tantalum capacitors as well as resistors. It also manufactures single layer ceramic capacitors, heavy current capacitors and triplers. Most recently, on July 2, 1993, Vishay acquired the assets of the tantalum capacitor business of Philips Electronics North America Corporation, a subsidiary of Philips Electronics N.V., for approximately $11 million. The Company currently operates as five separate business units: (i) Vishay Electronic Components, U.S., which is comprised of Dale, a manufacturer and supplier of resistors, the Vishay Resistive Systems Unit, which primarily manufactures high performance foil resistors and thin film resistor networks, and Sprague, which consists of the tantalum capacitor and thick film resistor network manufacturing businesses acquired from STI; (ii) Draloric/Roederstein, German-based manufacturers and suppliers of resistors and capacitors in Europe; (iii) Sfernice, S.A., a resistor producer in France; (iv) Measurements Group, Inc., which produces resistive sensors and other stress measuring devices in the United States; and (v) Vishay Components (UK) Ltd., a manufacturer and supplier of the Company's products in the United Kingdom. Vishay was incorporated in Delaware in 1962 and maintains its principal executive offices at 63 Lincoln Highway, Malvern, Pennsylvania 19355-2120. The telephone number is (610) 644-1300. Products Vishay designs, manufactures and markets electronic components that cover a wide range of products and technologies. The products primarily consist of fixed resistors, tantalum and film capacitors, and, to a lesser extent, inductors, specialty ceramic capacitors, transformers, potentiometers, plasma displays and thermistors. Resistors are basic components used in all forms of electronic circuitry to adjust and regulate levels of voltage and current. They vary widely in precision and cost, and are manufactured in numerous materials and forms. Resistive components may be either fixed or variable, the distinction being whether the resistance is adjustable (variable) or not (fixed). Resistors can also be used as measuring devices, such as Vishay's resistive sensors. Resistive sensors, or strain gages, are used in electronic measurement and experimental stress analysis systems, as well as in transducers, for measuring loads (scales), acceleration and fluid pressure. Fixed resistive components can be broadly categorized as discrete components or networks. A discrete component is designed to perform a single function and is incorporated by the customer in the circuitry of a system which requires that particular function. A network, on the other hand, is a microcircuit (consisting of a number of resistors placed on a ceramic base), which is designed to perform a number of standard functions. Vishay manufactures discrete resistors and networks both of which are principally sold in the precision or higher quality segments of the resistor market (i.e., fixed precision wirewound, metal film and foil resistors and network resistors). The Company's resistive products primarily consist of fixed resistors (foil and thin film resistors, wire-wound resistors, metal film resistors, oxide film resistors, thermistors, thick film resistor chips, networks (microcircuits) and resistive sensors); variable resistors (trimmers and potentiometers); magnetic components (inductors and transformers) and printed circuit boards. Vishay produces resistors for virtually every segment of the resistive product market, from resistors used in the highest quality precision instruments for which the performance of the resistors is the most important requirement, to resistors for which price is the most important factor. Capacitors perform energy storage, frequency control, timing and filtering functions in most types of electronic equip- ment. The more important applications for capacitors are (i) electronic filtering for linear and switching power supplies, (ii) decoupling and bypass of electronic signals or integrated circuits and circuit boards, and (iii) frequency control, timing and conditioning of electronic signals for a broad range of applica- tions. The Company's capacitor products primarily consist of solid tantalum chip capacitors, solid tantalum leaded capacitors, wet/foil tantalum capacitors and film capacitors. The tantalum capacitor is the smallest and most stable type of capacitor for its range of capacitance. Markets The Company's products are sold primarily to other manufacturers and, to a much lesser extent, to United States and foreign government agencies. Its products are used in, among other things, the circuitry of measuring instruments, industrial equip- ment, automotive applications including engine controls and fuel injection systems, process control systems, computer-related products, telecommunications, military and aerospace applications, medical instruments and scales. Approximately 41% of the Company's net sales for the year ended December 31, 1993 was attributable to sales to customers in the United States while the remainder was attributable to sales primarily in Europe. In the United States, products are marketed primarily through independent manufacturers' representatives (who are compensated solely on a commission basis), the Company's own sales personnel and independent distributors. The Company has regional sales personnel in several locations to provide technical and sales support for independent manufacturers' representatives throughout the United States, Mexico and Canada. In addition, the Company uses independent distributors to resell its products. Internationally, products are sold to customers in Germany, the United Kingdom, France, Israel, Japan, Singapore, South Korea and other European and Pacific Rim countries through Company sales offices, independent manufacturers' representatives and distributors. The Company endeavors to have its products incorporated into the design of electronic equipment at the research and proto- type stages. Vishay employs its own staff of application and field engineers who work with its customers, independent manufacturers' representatives and distributors to solve technical problems and develop products to meet specific needs. One of the fastest growing markets for passive electronic components is for surface mounted devices. These devices adhere to the surface of a circuit board rather than being secured by leads that pass through holes to the back side of the board. Surface mounting provides certain advantages over through-hole mounting, including the ability to place more components on a circuit board. The Company believes it has taken advantage of the growth of the surface mount market and is an industry leader in designing and marketing surface mount devices. The Company offers a wide range of these devices, including both thick and thin film resistor chips and networks, capacitors, inductors, oscillators, transformers and potentiometers, as well as a number of component packaging styles to facilitate automated product assembly by its customers. Sales of the Company's products to manufacturers in defense-related industries have continued to decline over the past year, primarily as a result of reduced governmental procurements of defense-related products. The Company has qualified certain products under various military specifications, approved and monitored by the United States Defense Electronic Supply Center ("DESC"), and under certain European military specifications. Classification levels have been established by DESC based upon the rate of failure of products to meet specifications (the "Classifi- cation Level"). In order to maintain the Classification Level of a product, tests must be continuously performed, and the results of these tests must be reported to DESC. If the product fails to meet the requirements for the applicable Classification Level, the product's classification may be reduced to a less stringent level. In that event, the Company's product may not qualify for use as a component in other products required to meet a more stringent Classification Level, although the Company's product may still be sold for use in other products requiring a less stringent classifi- cation. After completion of additional retesting, however, the product may again be classified at its original level. Sales of the product may be adversely affected pending the completion of any such additional retesting and the resumption of the original Classification Level. Various United States manufacturing facili- ties from time to time experience a product Classification Level modification. During the time that such level is modified for any specific product, net sales and earnings derived from such product may be adversely affected. The Company is undertaking to have the quality systems at all of its major manufacturing facilities approved under the established ISO 9000 international quality control standard. ISO 9000 is a comprehensive set of quality program standards developed by the International Standards Organization. Several of the Company's manufacturing operations have already received ISO 9000 approval and others are actively pursuing such approval. Vishay's largest customers vary from year to year, and no customer has long-term commitments to purchase products of the Company. No customer accounted for more than 10% of the Company's sales for the year ended December 31, 1993. Research and Development The Company maintains separate research and development staffs and promotes separate programs at a number of its production facilities to develop new products and new applications of existing products, and to improve product and manufacturing techniques. This decentralized system encourages individual product development and, from time to time, developments at one manufacturing facility will have applications at another facility. Most of the Company's products and manufacturing processes have been invented, designed and developed by Company engineers and scientists. Company research and development costs were approximately $7.1 million for 1993, $7.1 million for 1992 and $7.0 million for 1991. The Company spends additional amounts for the development of machinery and equipment for new processes and for cost reduction measures. See "Competition". Sources of Supplies Although most materials incorporated in the Company's products are available from a number of sources, certain materials (particularly tantalum) are available only from a limited number of suppliers. In order to protect itself from manufacturing disruptions due to potential supply shortages, the Company maintains a supply of certain critical materials, the nondelivery of which could have a materially adverse effect on the Company. Tantalum metal is the principal material used in the manufacture of tantalum capacitor products. Tantalum is purchased in powder form, primarily under annual contracts with domestic suppliers, at prices that are subject to periodic adjustment. The Company is a major consumer of the world's annual tantalum production. Tantalum, and other required raw materials have generally been available in sufficient quantities, but have been subject to wide price variations. Disruptions in the supply of, or substantial increases in the price of, tantalum metal could have a materially adverse effect on the Company. Inventory and Backlog Although Vishay manufactures standardized products, a substantial portion of its products are produced to meet specific customer specifications. The Company does, however, maintain an inventory of resistors and other components. Backlog of outstand- ing orders for the Company's products was $198.4 million, $134.3 million and $104.5 million, at December 31, 1993, 1992 and 1991, respectively. The increase in backlog at December 31, 1993 and 1992, as compared with prior periods, is attributable to the acquisitions of Roederstein and Sprague, respectively. The current backlog is expected to be filled during the next 12 months. Most of the orders in the Company's backlog may be cancelled by its customers, in whole or in part, although sometimes subject to penalty. To date, however, cancellations have not represented a material portion of the backlog. Competition The Company faces strong competition in its various product lines from both domestic and foreign manufacturers that produce products using technologies similar to those of the Company. Certain of the Company's products compete on the basis of its marketing and distribution network, which provides a high level of customer service, such as design assistance, order expediting and prompt delivery. In addition, the Company's competitive position depends on its product quality, know-how, proprietary data, marketing and service capabilities, business reputation and price. A number of the Company's customers are contractors or subcontractors on various United States and foreign government contracts. Under certain United States Government contracts, retroactive adjustments can be made to contract prices affecting the profit margin on such contracts. The Company believes that its profits are not excessive and, accordingly, no provision has been made for any such adjustment. In several areas the Company strengthens its market position by conducting seminars and educational programs for customers and for potential customers. Although the Company has numerous United States and foreign patents covering certain of its products and manufacturing processes, and acquired various patents with the acquisition of the STI tantalum capacitor and network lines, no particular patent is considered material to the business of the Company. Manufacturing Operations The Company conducts manufacturing operations in three principal geographic regions: the United States, Europe and Israel. At December 31, 1993, approximately 40% of the Company's identifiable assets were located in the United States, approximately 50% were located in Europe, approximately 9% were located in Israel and 1% in other regions. In the United States, the Company's main manufacturing facilities are located in Nebraska, South Dakota, North Carolina, Pennsylvania and Maine. In Europe, the Company's main manufacturing facilities are located in Selb and Landshut, Germany and Nice and Tours, France. In Israel, manufacturing facilities are located in Holon and Dimona. The Company also maintains manufacturing facilities in Juarez, Mexico and Toronto, Canada. For the year ended December 31, 1993, sales of products manufactured in Israel accounted for approximately 8% of the Company's net sales. The Company conducts manufacturing operations in Israel in order to take advantage of the relatively low wage rates in Israel and several incentive programs instituted by the Government of Israel, including certain tax abatements. These programs have contributed substantially to the growth and profitability of the Company. The Company may be materially and adversely affected if these incentive programs were no longer available to the Company or if hostilities were to occur in the Middle East that materially interfere with the Company's operations in Israel. Due to a shift in manufacturing emphasis, resulting from the growing market for surface mount devices, over-capacity at a number of the Company's manufacturing facilities and the relocation of some production to regions with lower labor costs, portions of the Company's work force and certain facilities may not be fully utilized in the future. As a result, the Company may incur significant costs in connection with work force reductions and the closing of additional manufacturing facilities. Environment The Company's manufacturing operations are subject to various federal, state and local laws restricting discharge of materials into the environment. The Company is not involved in any pending or threatened proceedings which would require curtailment of its operations at this time. However, the Company is involved in various legal actions concerning state government enforcement proceedings and various dump site clean-ups. These actions may result in fines and/or clean-up expenses. The Company believes that any fine and/or clean-up expense, if imposed, would not be material. The Company continually expends funds to ensure that its facilities comply with applicable environmental regulations. The Company has nearly completed its undertaking to comply with new environmental regulations, relating to the elimination of chlorofluorocarbons (CFCs) and ozone depleting substances (ODS), and other anticipated compliances with the Clean Air Act amendments of 1990. The Company anticipates that it will undertake capital expenditures of approximately $1,000,000 in fiscal 1994 for general environmental enhancement programs. Employees As of December 31, 1993, the Company employed approximately 14,200 full time employees of whom approximately 8,600 were located outside the United States. The Company hires few employees on a part time basis. While many of the Company's foreign employees are members of trade unions, none of the Company's employees located in the United States are represented by unions except for approximately 172 employees at the North Adams, Massachusetts facility acquired from STI, who are represented by three unions. The Company is currently negotiating the collective bargaining agreements of such domestic employees with each of these unions. The Company believes that its relationship with its employees is excellent. Item 2. Item 2. PROPERTIES - - - ------- ---------- The Company maintains 53 manufacturing facilities. The principal locations of such facilities, along with available space including administrative offices, are: Approx. Available Owned Locations Space (Square Feet) - - - --------------- ------------------- United States ------------- Malvern and Bradford, PA 223,000 Columbus and Norfolk, NE 336,000 Wendell and Statesville, NC 193,000 Sanford, ME 212,000 Foreign ------- Germany (11 locations) 1,375,000 France (11 locations) 606,000 Israel (2 locations) 400,000 Portugal 100,000 Vishay owns an additional 239,000 square feet of manufac- turing facilities located in Colorado, Maryland, South Dakota and Florida. Available leased facilities in the United States include 420,000 square feet of space located in New York, California, New Jersey, South Dakota, Texas, Massachusetts and New Hampshire. Foreign leased facilities consist of 206,000 square feet in Mexico, 151,000 square feet in France, 130,000 square feet in England, 109,000 square feet in Canada and 98,000 square feet in Germany. The Company also has facilities in Japan, Austria, Switzerland, and the Czech Republic. In September 1993, Vishay entered into negotiations to build an additional manufacturing facility in Israel. The facility, which will be approximately 200,000 square feet, will be located near Haifa. Management believes it has sufficient manufacturing space for its current business. Item 3. Item 3. LEGAL PROCEEDINGS - - - ------- ----------------- The Company, from time to time, is involved in routine litigation incidental to its business. Management believes that such matters, either individually or in the aggregate, should not have a materially adverse effect on the Company's business or financial condition. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - - ------- --------------------------------------------------- During the fourth quarter of the fiscal year covered by this report, no matter was submitted to a vote of security holders of the Company. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT - - - -------- ------------------------------------ The following table sets forth certain information regarding the executive officers of the Company as of March 25, 1994. Name Age Positions Held - - - ---- --- -------------- Felix Zandman* 65 Chairman of the Board, President, Chief Executive Officer and Director Robert A. Freece* 53 Vice President, Treasurer, Chief Financial Officer and Director Henry V. Landau 47 Vice President; President -- Measurements Group, Inc. Moshe Shamir 70 Vice President; President -- Vishay Israel Limited William J. Spires 52 Vice President and Secretary Donald G. Alfson 48 Vice President, Director; President -- Vishay Electronic Components, U.S. and Asia and President -- Dale Electronics, Inc. Gerald Paul 45 Vice President, Director; President -- Vishay Electronic Components, Europe and Managing Director -- Draloric Electronic GmbH. * Member of the Executive Committee of the Board of Directors. Felix Zandman, a founder of the Company, has been President, Chief Executive Officer and a Director of the Company since its inception. Dr. Zandman has been Chairman of the Board since March 1989. Robert A. Freece has been Vice President, Treasurer, Chief Financial Officer and a Director of the Company since 1972. Henry V. Landau has been a Vice President of the Company since 1983. Mr. Landau has been the President and Chief Executive Officer of Measurements Group, Inc., a subsidiary of the Company, since July 1984. Mr. Landau was an Executive Vice President of Measurements Group, Inc. from 1981 to 1984 and has been employed by the Company since 1972. Moshe Shamir has been the President of Vishay Israel Limited since its inception in 1969. Mr. Shamir has been a Vice President of the Company since 1972. Mr. Shamir is also a member of the Board of Directors of Teva Pharmaceuticals Industries, Ltd. and Chairman of the Executive Committee thereof. William J. Spires has been a Vice President and Secretary of the Company since 1981. Mr. Spires has been Vice President - Industrial Relations since 1980 and has been employed by the Company since 1970. Donald G. Alfson has been a Vice President since May 1993, a Director of the Company since May 1992 and the President of Vishay Electronic Components U.S. and Asia, and President of Dale Electronics, Inc. since April 1992. Mr. Alfson has been employed by the Company since 1972. Gerald Paul has been a Vice President and a Director of the Company since May 1993 and President of Vishay Electronic Components, Europe since January 1994. Dr. Paul has been Managing Director of Draloric Electronic GmbH since January 1991. Dr. Paul has been employed by the Company since February 1978. PART II ------- Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY - - - ------- HOLDER MATTERS --------------------------------------------------------- The Company's Common Stock is listed on the New York Stock Exchange under the symbol VSH. The following table sets forth the high and low sale prices for the Company's Common Stock as reported on the New York Stock Exchange Composite Tape for the quarterly periods within the 1993 and 1992 fiscal years indicated. Stock prices have been restated to reflect stock dividends. The Company does not currently pay cash dividends on its capital stock. Its policy is to retain earnings to support the growth of the Company's business and the Company does not intend to change this policy at the present time. In addition, the Company is restricted from paying cash dividends under the terms of the Company's revolving credit and term loan agreement (see Note 6 to the consolidated financial statements). Holders of record of the Company's Common Stock totalled approximately 1,441 at March 25, 1994. COMMON STOCK MARKET PRICES Calendar 1993 Calendar 1992 High Low High Low ------ ------ ------ ------ First Quarter $35.48 $27.38 $21.31 $14.74 Second Quarter 36.25 25.48 24.29 18.59 Third Quarter 37.75 31.63 26.67 22.03 Fourth Quarter 35.38 28.75 35.48 25.36 On October 1, 1990, the Company commenced a stock repur- chase program pursuant to which the Company was authorized to purchase up to $5 million worth of its Common Stock. The purchases of Common Stock by the Company under the repurchase program are made in open-market transactions, subject to the availability of stock in accordance with the rules of the Securities and Exchange Commission and at the discretion of management. As of December 31, 1990 the Company had repurchased 36,600 shares at an approximate cost of $459,000. No repurchases were made in 1991, 1992 or 1993. In addition at March 25, 1994, the Company had outstanding 3,590,232 shares of Class B Common Stock, par value $.10 per share (the "Class B Stock"), each of which entitles the holder to ten votes. The Class B Stock generally is not transferable and there is no market for those shares. The Class B Stock is convertible, at the option of the holder, into Common Stock on a share for share basis. Substantially all such Class B Stock is beneficially owned by Dr. Felix Zandman, Mr. Moshe Shamir and a revocable trust for the benefit of Mr. Alfred P. Slaner. Dr. Felix Zandman is an executive officer and director of the Company, and Mr. Shamir is a director. Mr. Slaner and his wife, Luella B. Slaner, are Trustees of the Slaner Trust, and accordingly, Mrs. Slaner, a Vishay director, may also be deemed beneficially to own such shares. Item 6. Item 6. SELECTED FINANCIAL DATA - - - ------- ----------------------- The following table sets forth selected consolidated financial information of the Company for the fiscal years ended December 31, 1993, 1992, 1991, 1990 and 1989. This table should be read in conjunction with the Consolidated Financial Statements of the Company and the related notes thereto included elsewhere in this Form 10-K. - - - --------------- (1) Includes the results from January 1, 1993 of the Roederstein acquisition. (2) Includes the results from January 1, 1992 of the businesses acquired from STI. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - - - ------- CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------- Introduction and Background The Company's sales and net income have increased significantly in the past several years primarily as a result of its acquisitions. Following each acquisition, the Company implemented programs to take advantage of distribution and operating synergies among its businesses. This implementation is reflected in an increase in the Company's sales and in the decline in selling, general and administrative expenses as a percentage of the Company's sales. Since mid-1990, sales of most of the Company's products have been adversely affected by the worldwide slowdown in the electronic components industry. In addition, sales to defense-related industries have declined since the first quarter of 1991. These trends are continuing. Year ended December 31, 1993 compared to Year ended December 31, 1992 Results of Operations - - - --------------------- Net sales for the year ended December 31, 1993 increased by $192,046,000 over the comparable period of the prior year. The increase resulted from the acquisition of Roederstein, effective January 1, 1993. Net sales of Roederstein were $212,124,000 for the year ended December 31, 1993. Net sales, exclusive of Roederstein, decreased by $20,078,000, compared to the same period of the prior year. This decrease in net sales is attributable to the strengthening of the U.S. dollar against foreign currencies, which resulted in a decrease in reported Vishay sales of $15,671,000 for the year ended December 31, 1993, and recessionary pressures in Europe. Costs of products sold for the year ended December 31, 1993 were 77.5% of net sales as compared to 76.5% for the comparable period of the prior year. The reason for this increase is that the costs of products sold for Roederstein (prior to the full implementation of synergistic cost reductions) are approx- imately 80% of net sales, while Vishay's business, exclusive of Roederstein, has been operating in the 76% to 78% range. In 1993, grants of $3,424,000 received from the government of Israel, which were utilized to offset start-up costs of new facilities, were recognized as a reduction of costs of products sold. Selling, general, and administrative expenses for the year ended December 31, 1993 were 13.9% of net sales as compared to 15.3% for the comparable period of the prior year. The current year's lower rates reflect the effect of the acquisition of Roederstein and the ongoing cost savings programs implemented with the acquisition of certain businesses of STI during 1992. Restructuring charges of $6,659,000 for the year ended December 31, 1993 consist primarily of severance costs related to the Company's decision to downsize its European operations, primarily in France, as a result of the European business climate. Income from unusual items of $7,221,000 for the year ended December 31, 1993 represents proceeds received for business interruption insurance claims principally related to operations in Dimona, Israel. Interest costs increased by $1,514,000 for the year ended December 31, 1993 as a result of increased debt incurred for the acquisition of Roederstein. Other income for the year ended December 31, 1993 decreased by $4,410,000 over the comparable period of the prior year because other income for the year ended December 31, 1992 included consulting fees of $2,307,000 from Roederstein. These fees to Vishay were for time and expenses of Vishay personnel utilized by Roederstein in its attempt to restructure itself. Also, other income for the year ended December 31, 1992 included fees of approximately $3,325,000 from STI under one-year sales and distribution agreements. Foreign currency losses for the year ended December 31, 1993 were $1,382,000, as compared to foreign currency losses of $1,594,000 for the year ended December 31, 1992. The effective tax rate of 16.2% for the year ended December 31, 1993 reflects the non-taxability of certain insurance recoveries. The 1993 rate was also affected by increased manufacturing in Israel, where the Company's average income tax rate was approximately 4% in 1993. The effective tax rate for the year ended December 31, 1993, exclusive of the effect of the non- taxable insurance proceeds, was 18.6%. The effective tax rate for the year ended December 31, 1992 was 19.8%. Accounting Changes - - - ------------------ Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes". The cumulative effect of adopting Statement 109 as of January 1, 1993 was to increase net income by $1,427,000. Application of the new income tax rules also decreased pretax earnings by $2,870,000 for the year ended December 31, 1993 because of increased depreciation expense as a result of Statement 109's requirement to report assets acquired in prior business combinations at their pretax amounts. The Company also adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", effective January 1, 1993. The Company has elected to recognize the transition obligation on a prospective basis over a twenty-year period. In 1993, the new standard resulted in additional annual net periodic postretirement benefit costs of $1,200,000 before taxes, and $792,000 after taxes, or $0.04 per share. Prior-year financial statements have not been restated to apply the new standard. Year ended December 31, 1992 compared to Year ended December 31, 1991 Net sales for the year ended December 31, 1992 increased $221,943,000 over the comparable period of the prior year. The increase was the result of the inclusion of the businesses acquired from STI effective as of January 1, 1992. Net sales of the acquired businesses were $230,492,000 for the year ended December 31, 1992. For the year ended December 31, 1992, net sales, exclusive of the acquired businesses, decreased by $8,549,000 compared to the same period of the prior year when recessionary pressures affecting sales were not as great. The weakening of the U.S. dollar against foreign currencies resulted in an increase in reported Vishay sales of $10,418,000 for the year ended December 31, 1992. Costs of products sold for the year ended December 31, 1992 were 76.5% of net sales as compared to 71.9% for the comparable period of the prior year. The reason for this increase is that the costs of products sold for the newly purchased businesses from STI (prior to any synergistic cost reductions) are 80% of net sales, while Vishay's resistor businesses traditionally operate at levels of 70% to 75%. Selling, general, and administrative expenses for the year ended December 31, 1992 were 15.3% of net sales compared to 17.2% for the comparable period of the prior year. The 15.3% rate reflects the effect of the businesses acquired from STI. The rate applicable to the businesses acquired from STI (approximately 11%) includes the effects of initial cost saving programs installed subsequent to the acquisition. For the year ended December 31, 1992, selling, general and administrative expenses of the Vishay resistor business (approximately 17%) were comparable to the levels experienced in the prior year. Interest costs increased by $3,903,000 for the year ended December 31, 1992 as a result of the increased debt incurred for the purchase of the businesses from STI. Other income for the year ended December 31, 1992 includes consulting fees of $2,307,000 from Roederstein. Other income for the year ended December 31, 1992 also includes fees of approxi- mately $3,325,000 from STI under one-year sales and distribution agreements expiring February 14, 1993, which were entered into in connection with the acquisition of the businesses from STI. The effective tax rate was 19.8% for the year ended December 31, 1992. The effective rate is comparable to the rate of 23.3% for 1991. The 1992 rate was in part affected by increased manufacturing in Israel where the Company's average income tax rate was 7% for 1992. Year ended December 31, 1991 compared to Year ended December 31, 1990 Net sales decreased by $3,313,000 or approximately 1% to $442,283,000 for the year ended December 31, 1991 from $445,596,000 for the year ended December 31, 1990. Sales increased in the United States by 2.7% as a result of acquisitions, which partially offset the effect of the worldwide recession. Sales in Western Europe declined 4.9% compared to the year ended December 31, 1990 as a result of the recession and the strengthening of the dollar against foreign currencies. Price increases did not materially affect sales. Costs of products sold increased to $318,166,000 or 71.9% of sales for the year ended December 31, 1991 from $312,925,000 or 70.2% of sales for the year ended December 31, 1990. The increase in costs of products sold as a percentage of sales reflects increased production costs of relatively flat sales in addition to certain manufacturing inefficiencies during the latter part of 1991. Selling, general, and administrative expenses decreased to $75,973,000 or 17.2% of sales for the year ended December 31, 1991 from $77,740,000 or 17.4% of sales for the year ended December 31, 1990 primarily because of the continuation of cost reduction programs introduced during 1990. Expenses of approximately $3,700,000 for layoff costs at the Company's European subsidiaries were incurred during the latter half of 1991. This correction to the work force was made to strengthen the subsidiaries' ability to attain earnings goals and to respond to the current recession. Interest expense decreased by $4,219,000 to $15,207,000 for the year ended December 31, 1991 from $19,426,000 for the year ended December 31, 1990 primarily as a result of payments made on long-term debt and lower interest rates. Other expenses for the year ended December 31, 1991 were $289,000 compared to income of $2,344,000 for the year ended December 31, 1990, primarily due to decreases in investment grants from Israel and interest income. Investment grants and interest income for the year ended December 31, 1991 were $106,000 and $797,000, respectively, compared to $980,000 and $2,257,000, respectively, for the year ended December 31, 1990. The effective tax rate for the year ended December 31, 1991 was 23.3% versus 31.5% for the year ended December 31, 1990. The decrease in the effective tax rate resulted from a reduced tax rate for certain Israeli operations and an increase in the propor- tion of earnings taxable in Israel. The lower rate was primarily due to tax advantages of doing business in Israel where the Company's effective average tax rate was approximately 10% at that time. Financial Condition Cash flows from operations were $50,114,000 for the year ended December 31, 1993 compared to $54,357,000 for the prior year and were used primarily to finance capital expenditures. Purchases of property and equipment were $76,813,000 for the year ended December 31, 1993 compared to $49,801,000 for the prior year primarily due to additions of manufacturing equipment for surface mount products and expansion of manufacturing facilities in Israel. The Company's financial condition at December 31, 1993 is strong with the Company's current ratio of 2.1 to 1. The Company's ratio of long-term debt to stockholders' equity was .7 to 1 at December 31, 1993 as compared to .4 to 1 at December 31, 1992. The increase in this ratio resulted from additional borrowings in connection with the acquisition of Roederstein. In connection with the Roederstein acquisition, Vishay entered into a DM 104,316,000 term loan agreement with its lending banks in January 1993. In addition, an Israeli subsidiary of Vishay borrowed $20 million pursuant to an unsecured credit agreement. The funds from the credit facilities were used in connection with the Roederstein acquisition and the refinancing of Roederstein's debt. Vishay and the Banks also amended certain terms of the outstanding $170,000,000 Revolving Credit and Term Loan Agreement dated as of January 10, 1992 among Vishay and the Banks and the Amended and Restated DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement dated as of January 10, 1992 among Vishay, Draloric and the lending banks in order to, among other things, allow Vishay to draw upon its revolving credit facilities to refinance a portion of Roederstein's debt. See Note 6 to the Company's Consolidated Financial Statements elsewhere herein for additional information with respect to Vishay's loan agreements, long-term debt and available short- term credit lines. Management believes that available sources of credit, together with cash expected to be generated from operations, will be sufficient to satisfy the Company's anticipated financing needs for working capital and capital expenditures during the next twelve months. Inflation Normally, inflation has not had a significant impact on the Company's operations. The Company's products are not generally sold on long-term contracts. Consequently, selling prices, to the extent permitted by competition, can be adjusted to reflect cost increases caused by inflation. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - - - ------- ------------------------------------------- The following Consolidated Financial Statements of the Company and its subsidiaries, together with the report of independent auditors thereon, are presented under Item 14 of this report: Report of Independent Auditors Consolidated Balance Sheets -- December 31, 1993 and 1992. Consolidated Statements of Operations -- 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 Stockholders' Equity -- for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements -- December 31, 1993. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON - - - ------- ACCOUNTING AND FINANCIAL DISCLOSURE ------------------------------------------------ None. PART III -------- Information with respect to Items 10, 11, 12 and 13 on Form 10-K is set forth in the Company's definitive proxy statement, which will be filed within 120 days of December 31, 1993, the Company's most recent fiscal year. Such information is incor- porated herein by reference, except that information with respect to Executive Officers of Registrant is set forth in Part I, Item 4A hereof under the caption, "Executive Officers of the Registrant". PART IV ------- Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON - - - -------- FORM 8-K ------------------------------------------------------ (a) (1) All Consolidated Financial Statements of the Company and its subsidiaries for the year ended December 31, 1993 are filed herewith. See Item 8 of this Report for a list of such financial statements. (2) Financial Statement Schedules for Vishay, set forth immediately following this Item 14 are as follows: Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and therefore have been omitted. (3) Exhibits -- See response to paragraph (c) below. (b) Reports on Form 8-K None (c) Exhibits: 2.1 Purchase and Sale Agreement, dated as of November 14, 1991, among Sprague Technologies, Inc., Sprague Electric Company and Vishay Intertechnology, Inc. Incorporated by reference to Exhibit 1 to the Current Report on Form 8-K dated November 14, 1991. 3.1 Certificate of Incorporation of Registrant, as amended and Certificate of Amendment of Restated Certificate of Incorporation of Registrant dated May 18, 1993. 3.2 Amended and Restated Bylaws of Registrant. Incorporated by reference to Exhibit 3.2 to Registration Statement No. 33-13833 of Registrant on Form S-2 under the Securities Act of 1933 (the "Form S-2") and Amendment No. 1 to Amended and Restated Bylaws of Registrant. 10.1 Performance-Based Compensation Plan for Chief Executive Officer of Registrant. 10.2 Second Amendment dated as of January 29, 1993 to Amended and Restated Vishay Intertechnology, Inc. $170,000,000 Revolving Credit and Term Loan Agreement by and among Comerica Bank, NationsBank of North Carolina, N.A., Signet Bank Maryland, CoreStates Bank, N.A., Bank Hapoalim, B.M., Meridian Bank, Bank Leumi le-Israel, B.M., Berliner Handels-und Frankfurter Bank and ABN AMRO Bank N.V. (collectively, the "Banks"), Comerica Bank, as agent for the Banks (the "Agent"), and Vishay Intertechnology, Inc. ("Vishay"), dated as of January 10, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated January 29, 1993. 10.3 Second Amendment dated as of January 29, 1993 to Amended and Restated Draloric Electronic GmbH DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement by and among the Banks, the Agent and Draloric Electronic GmbH ("Draloric"), dated as of January 10, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated January 29, 1993. 10.4 Roederstein DM 104,315,990.20 Term Loan Agreement dated as of January 29, 1993 by and among the Banks, the Agent, Draloric and Vishay. Incorporated by reference to Exhibit (10.3) to the Current Report on Form 8-K, dated January 29, 1993. 10.5 Agreement between First International Bank of Israel and Vishay Israel Ltd. dated January 28, 1993. Incorporated by reference to Exhibit (10.4) to the Current Report on Form 8-K, dated January 29, 1993. 10.6 Amended and Restated Vishay Intertechnology, Inc. $170,000,000 Revolving, Credit and Term Loan Agreement by and among Manufacturers Bank, N.A., NationsBank of North Carolina, N.A., Signet Bank Maryland, CoreStates Bank, N.A., Bank Hapoalim, B.M., Meridian Bank and Bank Leumi le-Israel, B.M. (collectively, the "Prior Banks"), the Agent and Vishay, dated as of January 10, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated January 10, 1992. 10.7 Amended and Restated Draloric Electronic, GmbH DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement by and among the Prior Banks, the Agent and Draloric, dated as of January 10, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated January 10, 1992. 10.8 Amended and Restated Guaranty by Vishay to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.5) to the Current Report on Form 8-K, dated January 29, 1993. 10.9 Amended and Restated Guaranty by Dale Holdings, Inc., Dale Electronics, Inc., Bradford Electronics, Inc., and Measurements Group, Inc. to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.6) to the Current Report on Form 8-K, dated January 29, 1993. 10.10 Amended and Restated Permitted Borrowers Guaranty by Vilna Equities Holding B.V., Visra Electronics Financing, B.V., Draloric, E-Sil Components, Ltd., Vishay Components (U.K.) Limited, Sfernice, S.A., Ultronix, Inc., Techno Components Corporation and Ohmtek, Inc. to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.7) to the Current Report on Form 8-K, dated January 29, 1993. 10.11 Guaranty by Vishay Sprague, Inc., Sprague North Adams, Sprague Sanford and Roederstein Electronics, Inc. to the Banks, dated January 29, 1993. Incorporated by reference to Exhibit (10.8) to the Current Report on Form 8-K, dated January 29, 1993. 10.12 Guaranty Agreement, dated as of November 29, 1989 between the Company and Societe Generale, New York Branch. Incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for December 31, 1989. 10.13 Option Agreement for the Assets of the Resista Division of Roederstein by and among Vishay, Mr. Jorg Roederstein, Roederstein Spezialfabriken fur Bauelemente der Elektronik und Kondensatoren der Starkstromtechnik GmbH ("Roederstein") and Mr. Till Roederstein, dated February 18, 1992. Incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K, dated February 18, 1992. 10.14 Purchase and Transfer Agreement concerning Shares by and among, Mrs. Ute Roederstein, Mrs. Cornelia Bodinka, nee Roederstein, Ms. Claudia Roederstein, Mr. Jorg Roederstein, Mr. Till Roederstein and Vishay dated February 18, 1992. Incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K, dated February 18, 1992. 10.15 Notarial Offer for a Purchase and Transfer Agreement concerning Shares by Mr. Till Roederstein and Vishay Intertechnology, Inc. dated February 18, 1992. Incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K, dated February 18, 1992. 10.16 Fiscal Agency Agreement, dated July 28, 1988, between the Company and Citibank, N.A. Incorporated by reference to Exhibit (10(i)) to the Current Report on Form 8-K, dated August 30, 1988. 10.17 Management Fee Agreement between Dale Holdings, Inc. and the Company, dated May 14, 1986. Incorporated by reference to Exhibit 10.15 to the Form S-2. 10.18 Employment Agreement, dated as of March 15, 1985, between the Company and Dr. Felix Zandman. Incorporated by reference to Exhibit 10.12 to the Form S-2. 10.19 1986 Employee Stock Plan of the Company. Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8 (No. 33-7850). 10.20 1986 Employee Stock Plan of Dale Electronics, Inc. Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8 (No. 33-7851). 10.21 Money Purchase Plan Agreement of Measurements Group, Inc. Incorporated by reference to Exhibit 10(a)(6) to Amendment No. 1 to the Company's Registration Statement on Form S-7 (No. 2-69970). 10.22 Distributor Agreement between Nytron Inductors and VSD, Inc. dated as of January 1, 1991. Incorporated by reference to the Company's Annual Report on Form 10-K for December 31, 1990. 10.23 Distribution Sales Agreement between Sprague Electric Company and Vishay Intertechnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated February 14, 1992. 10.24 Sales Representation Agreement between Sprague Electric Company and Vishay Intertechnology, Inc. dated February 14, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated February 14, 1992. 10.25 Agreement for Transfer of Computer Software License Administration Services Agreement between Sprague Electric Company and Vishay Intertechnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.3) to the Current Report on Form 8-K, dated February 14, 1992. 10.26 Lease of Concord Facility, dated February 14, 1992. Incorporated by reference to Exhibit (10.4) to the Current Report on Form 8-K, dated February 14, 1992. 10.27 Sublease of Hudson Facility, dated February 14, 1992. Incorporated by reference to Exhibit (10.5) to the Current Report on Form 8-K, dated February 14, 1992. 10.28 Lease of El Paso Property, dated February 14, 1992. Incorporated by reference to Exhibit (10.6) to the Current Report on Form 8-K, dated February 14, 1992. 10.29 Non-Competition Agreement among Sprague Technologies, Inc., Sprague Electric Company and Vishay Inter- echnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.7) to the Current Report on Form 8-K, dated February 14, 1992. 10.30 Agreement between Sprague Technologies, Inc. and Vishay Israel, Ltd., dated February 14, 1992. Incorporated by reference to Exhibit (10.8) to the Current Report on Form 8-K, dated February 14, 1992. 11. Statement regarding Computation of Per Share Earnings. 22. Subsidiaries of the Registrant. 23. Consent of Independent Auditors. Report of Independent Auditors Board of Directors and Stockholders Vishay Intertechnology, Inc. We have audited the accompanying consolidated balance sheets of Vishay Intertechnology, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and stockholders equity 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 Companys 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 Vishay Intertechnology, 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 discussed in the Notes to Consolidated Financial Statements, in 1993 the Company changed its methods of accounting for income taxes (Note 5) and postretirement benefits other than pensions (Note 10). /s/ ERNST & YOUNG Philadelphia, Pennsylvania February 10, 1994 except for Note 6, as to which the date is March 25, 1994 Vishay Intertechnology, Inc. Consolidated Balance Sheets (In thousands, except per share and share amounts) December 31 1993 1992 -------------------------- Assets Current assets: Cash and cash equivalents $ 10,931 $ 15,977 Accounts receivable, less allowances of $5,150 and $3,885 125,284 102,757 Inventories: Finished goods 85,783 50,874 Raw materials and work in process 138,872 99,901 Prepaid expenses and other current assets 33,365 18,192 -------------------------- Total current assets 394,235 287,701 Property and equipment--at cost: Land 33,791 12,917 Buildings and improvements 136,432 87,623 Machinery and equipment 398,885 288,527 -------------------------- 569,108 389,067 Less allowances for depreciation (149,004) (117,448) -------------------------- 420,104 271,619 Goodwill 118,286 74,872 Other assets 15,481 27,451 -------------------------- $948,106 $661,643 ========================== December 31 1993 1992 -------------------------- Liabilities and stockholders' equity Current liabilities: Notes payable to banks $ 22,695 $ 18,966 Trade accounts payable 48,404 42,727 Payroll and related expenses 28,942 23,124 Other accrued expenses 54,112 25,984 Income taxes 3,740 - Current portion of long-term debt 30,536 31,573 -------------------------- Total current liabilities 188,429 142,374 Long-term debt--less current portion 266,999 139,540 Deferred income taxes 26,080 9,786 Other liabilities 24,081 1,021 Accrued pension costs 66,014 22,297 Stockholders' equity: Preferred Stock, par value $1.00 a share: Authorized--1,000,000 shares; none issued Common Stock, par value $.10 a share: Authorized--35,000,000 shares; 17,639,081 and 16,795,234 shares outstanding after deducting 47,441 and 47,432 shares in treasury 1,763 1,679 Class B convertible Common Stock, par value $.10 a share: Authorized-- 15,000,000 shares; 3,590,232 and 3,419,385 shares outstanding after deducting 125,965 and 119,967 shares in treasury 359 342 Capital in excess of par value 288,980 253,446 Retained earnings 105,849 97,156 Foreign currency translation adjustment (13,109) (5,864) Unearned compensation (60) (134) Pension adjustment (7,279) - -------------------------- 376,503 346,625 -------------------------- $948,106 $661,643 ========================== See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Operations (In thousands, except per share and share amounts) Year ended December 31 1993 1992 1991 ------------------------------------------ Net sales $856,272 $664,226 $442,283 Costs of products sold 663,239 508,018 318,166 ------------------------------------------ Gross profit 193,033 156,208 124,117 Selling, general, and administrative expenses 118,906 101,327 75,973 Restructuring expense 6,659 - 3,700 Unusual items (7,221) - - ------------------------------------------ 74,689 54,881 44,444 Other income (expense): Interest expense (20,624) (19,110) (15,207) Amortization of goodwill (3,294) (2,380) (1,695) Other 123 4,533 (289) ------------------------------------------ (23,795) (16,957) (17,191) ------------------------------------------ Earnings before income taxes and cumulative effect of accounting change 50,894 37,924 27,253 Income taxes 8,246 7,511 6,363 ------------------------------------------ Earnings before cumulative effect of accounting change 42,648 30,413 20,890 Cumulative effect of accounting change for income taxes 1,427 - - ------------------------------------------ Net earnings $44,075 $30,413 $20,890 ========================================== Earnings per share: Before cumulative effect of accounting change $2.01 $1.71 $1.25 Accounting change for income taxes 0.07 - - ------------------------------------------ Net earnings $2.08 $1.71 $1.25 ========================================== Weighted average shares outstanding 21,228,000 19,366,000 16,649,000 ========================================== See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Cash Flows (In thousands) See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Stockholders' Equity (In thousands, except share amounts) See accompanying notes. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements December 31, 1993 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements of Vishay Intertechnology, Inc. include the accounts of the Company and its subsidiaries, after elimination of all significant intercompany transactions, accounts, and profits. Inventories Inventories are stated at the lower of cost, determined by the first-in, first-out method, or market. Depreciation Depreciation is computed principally by the straight-line method based upon the estimated useful lives of the assets. Depreciation of capital lease assets is included in total depreciation expense. Depreciation expense was $43,493,000, $30,995,000, and $23,706,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Goodwill Goodwill, representing the excess of purchase price over net assets of businesses acquired, is being amortized on a straight-line basis over 40 years. Accumulated amortization amounted to $10,945,000 and $7,679,000 at December 31, 1993 and 1992, respectively. Cash Equivalents For purposes of the Statement of Cash Flows, the Company considers demand deposits and all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. Research and Development Expenses The amount charged to expense aggregated $7,097,000, $7,149,000, and $6,967,000 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company spends additional amounts for the development of machinery and equipment for new processes and for cost reduction measures. Grants Grants received from governments by certain foreign subsidiaries are recognized as income when conditions for receipt are met. In 1993, grants of $3,424,000 received from the government of Israel, which were utilized to offset startup costs of new facilities, were recognized as a reduction of costs of products sold. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) Earnings Per Share Earnings per share is based on the weighted average number of common shares and dilutive common equivalent shares (from the assumed conversion of convertible subordinated debentures) outstanding during the period. In October 1992, the convertible subordinated debentures were converted into 2,536,783 shares of Common Stock. For the year ended December 31, 1992, where assumed conversion of the debentures has a dilutive effect, net earnings used in the computations are adjusted for interest expense, net of income taxes, on the convertible subordinated debentures. Earnings per share amounts for all periods presented reflect 5% stock dividends paid on June 11, 1993, June 16, 1992, and June 11, 1991. Earnings per share for the years ended December 31, 1993 and 1992 reflect the weighted effect of the issuance of 1,800,000 shares of Common Stock on December 24, 1992. Accounting Changes In 1993, the Company changed its methods of accounting for income taxes (Note 5) and postretirement benefits other than pensions (Note 10). Reclassifications Certain prior-year amounts have been reclassified to conform with the current presentation. 2. Acquisitions During January 1993, Vishay exercised its option to purchase the remaining 81% of the outstanding share capital of Roederstein GmbH, a passive electronic components manufacturer with headquarters in Germany for 4,050,000 Deutsche Marks ("DM") ($2,502,000) pursuant to an option agreement dated February 18, 1992. Vishay had acquired its initial 19% interest in Roederstein on February 18, 1992 for DM 950,000 ($577,000). In connection with the acquisition, Vishay refinanced all of Roederstein's existing bank debt of DM 160,381,000 ($99,062,000). Funds to refinance Roederstein's debt were provided by a DM 104,316,000 term loan with a group of banks, $20,000,000 borrowed under an unsecured credit agreement, and borrowings under an existing line of credit. Effective January 1, 1992, the Company acquired the worldwide tantalum capacitor and U.S. thick film resistor network businesses of Sprague Technologies, Inc. Under the terms of the purchase agreement, Vishay paid $127,000,000 cash, transferred to Sprague real property with a fair value of $4,771,000, and assumed certain liabilities relating to the businesses. Vishay also entered into certain ancillary agreements with the seller, including one-year sales and distribution agreements under which Vishay received fees of $3,325,000 during 1992, which are included in other income. The purchase price was funded primarily from a $125,000,000 term loan facility. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 2. Acquisitions (continued) The acquisitions have been accounted for under the purchase method of accounting. The operating results of Roederstein and Sprague have been included in the Company's consolidated results of operations from January 1, 1993 and January 1, 1992, respectively. Excess of cost over the fair value of net assets acquired (Roederstein--$45,210,000; Sprague--$19,534,000) is being amortized on a straight-line basis over forty years. Had the Roederstein and Sprague acquisitions been made at the beginning of the year prior to their acquisition, the Company's pro forma unaudited results would have been (in thousands, except per share amounts): Year ended December 31 1992 1991 ------------------------- Net sales $913,398 $679,183 Net earnings (loss) (22,992) 20,591 Earnings (loss) per share $(1.19) $1.24 The unaudited pro forma results are not necessarily indicative of the results that would have been attained had the acquisitions occurred at the beginning of the periods presented or of results which may occur in the future. Pro forma net earnings for 1992 reflect $31,860,000 of restructuring costs incurred by Roederstein for work force reductions. During 1992, Vishay provided Roederstein with management and sales support, short-term working capital advances, and assistance in renegotiating Roederstein's bank debt. Vishay also assisted Roederstein in developing a cost-savings program involving reductions in the Roederstein work force, including the closing of an unprofitable division. Vishay recognized consulting fees, which are included in other income, from Roederstein of $2,307,000 for the year ended December 31, 1992 for its assistance to Roederstein. As of December 31, 1992, Vishay had investments in Roederstein of $3,229,000, advances to Roederstein, included in other assets, of $16,918,000, accounts receivable and other current receivables from Roederstein of $5,166,000, and accounts payable to Roederstein of $1,158,000. The Company made several minor acquisitions in 1993 and 1991, all of which were accounted for under the purchase method. The results of operations of these businesses have been included in the consolidated results of the Company from the dates of acquisition. 3. Restructuring Expense and Unusual Items Restructuring expenses of $6,659,000 for 1993 related to the downsizing of some of the Company's European operations. Income from unusual items of $7,221,000 for 1993 represents insurance recoveries the Company has received for business interruption insurance claims. The Company incurred restructuring costs of $3,700,000 in 1991 relating primarily to costs associated with layoffs in France. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 4. Foreign Subsidiaries The following amounts relating to foreign subsidiaries are included in the consolidated financial statements (in thousands): 5. Income Taxes Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 as of January 1, 1993 was to increase net earnings by $1,427,000, or $.07 per share. For the year ended December 31, 1993, application of the new income tax rules decreased pretax income by $2,870,000 because of increased depreciation expense as a result of Statement 109's requirement to report assets acquired in prior business combinations at their pretax amounts. At December 31, 1993, the Company has net operating loss carryforwards for tax purposes of approximately $96,300,000 in Germany (no expiration date), $3,100,000 in France (expire December 31, 1998), and $1,800,000 in Portugal (expire December 31, 1997). Approximately $70,800,000 of the carryforward in Germany, and the full $1,800,000 in Portugal, resulted from the Company's acquisition of Roederstein. For financial reporting purposes, a valuation allowance of $34,862,000 has been recognized to offset deferred tax assets related to German net operating loss carryforwards. If tax benefits are recognized in the future through reductions of the valuation allowance, such amounts will reduce goodwill of acquired companies. The valuation allowance decreased from January 1, 1993 by $6,584,000 primarily due to a decrease in German tax rates which had the effect of reducing the deferred tax asset for German net operating loss carryforwards. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. 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 are as follows (in thousands): Deferred tax liabilities: Tax over book depreciation $57,401 Other--net 2,685 --------- Total deferred tax liabilities 60,086 --------- Deferred tax assets: Pension and other retiree obligations 20,179 Net operating loss carryforwards 38,773 Restructuring reserves 7,354 Other accruals and reserves 12,300 --------- Total deferred tax assets 78,606 Valuation allowance for deferred tax assets (34,862) --------- Net deferred tax assets 43,744 --------- Net deferred tax liabilities $16,342 ========= For financial reporting purposes, earnings before income taxes and cumulative effect of accounting change includes the following components (in thousands): Year ended December 31 1993 1992 1991 ---------------------------------- Pretax income: Domestic $13,136 $10,252 $8,519 Foreign 37,758 27,672 18,734 ---------------------------------- $50,894 $37,924 $27,253 ================================== Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. Income Taxes (continued) Significant components of income taxes attributable to continuing operations are as follows (in thousands): Liability Method Deferred Method -------------------------------- Year ended December 31 1993 1992 1991 -------------------------------- Current: U.S. Federal $3,032 $1,639 $3,558 Foreign 2,706 2,521 1,706 State 332 502 675 -------------------------------- 6,070 4,662 5,939 Deferred: U.S. Federal 1,960 1,760 103 Foreign 36 832 312 State 180 257 9 -------------------------------- 2,176 2,849 424 -------------------------------- $8,246 $7,511 $6,363 ================================ For the year ended December 31, 1992, deferred income taxes resulted from accelerated methods of depreciation used for tax purposes ($2,494,000) and restructuring reserves ($2,012,000). These amounts were partially offset by differences relating to inventory valuation methods ($900,000) and other items ($757,000). For the year ended December 31, 1991, deferred taxes resulted principally from use of accelerated methods of depreciation for tax purposes. A reconciliation of income tax at the U.S. federal statutory income tax rate to actual income tax expense is as follows (in thousands): Liability Method Deferred Method -------------------------------- Year ended December 31 1993 1992 1991 -------------------------------- Tax at statutory rate $17,304 $12,894 $9,266 State income taxes, net of federal tax 396 501 452 Effect of foreign income tax rates (10,532) (5,649) (5,166) Effect of purchase accounting adjustments 717 939 1,291 Other 361 (1,174) 520 -------------------------------- $8,246 $7,511 $6,363 ================================ Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. Income Taxes (continued) At December 31, 1993, no provision has been made for U.S. income taxes on approximately $169,678,000 of foreign earnings which are expected to be reinvested indefinitely. Income taxes paid were $6,933,000, $5,729,000 and $8,418,000 for the years ended December 31, 1993, 1992, and 1991, respectively. 6. Long-Term Debt Long-term debt consisted of the following (in thousands): December 31 1993 1992 ------------------------ Revolving Credit Loan $51,500 $7,500 Term Loan 102,500 117,500 Deutsche Mark Revolving Credit Loan 23,035 10,500 Deutsche Mark Term Loan 10,948 23,486 Deutsche Mark Term Loan II 60,073 - Unsecured Credit Agreements 38,638 - Industrial Development Revenue Bonds 578 2,581 French Industrial Bonds 3,147 1,952 Other Debt and Capital Lease Obligations 7,116 7,594 ------------------------ 297,535 171,113 Less current portion 30,536 31,573 ------------------------ $266,999 $139,540 ======================== As of December 31, 1993, five facilities were available under the Company's amended and restated Revolving Credit and Term Loan and Deutsche Mark Revolving Credit and Term Loan agreements with a group of banks; a multicurrency revolving credit loan (interest 4.25% at December 31, 1993), a U.S. term loan (interest 4.44% at December 31, 1993), a Deutsche Mark revolving credit loan (interest 7.50% at December 31, 1993), a Deutsche Mark term loan (interest 7.69% at December 31, 1993), and an additional Deutsche Mark term loan (interest 8.25% at December 31, 1993). During March 1994, the Company's bank group agreed to amend the Revolving Credit and Term Loan and Deutsche Mark Revolving Credit and Term Loan agreements in effect at December 31, 1993. The terms of the five facilities, as agreed in March 1994, are summarized below. The first facility is a $90,000,000 multicurrency revolving credit facility which is available to the Company on a revolving basis until December 31, 1996, at which time the Company may elect a term out option, with quarterly payments due beginning March 31, 1997 through December 31, 2000. Interest is payable at prime or at other interest rate options. The Company is required to pay a commitment fee equal to 3/8% per annum on the average unused line. The second facility is a $102,500,000 term loan, with interest payable at prime plus 1/8% or at other interest rate options. Principal payments are due as follows: 1994 -- $5,000,000; 1995--$10,000,000; 1996--$10,000,000; Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 6. Long-Term Debt (continued) 1997--$15,000,000; 1998--$20,000,000; 1999--$20,000,000; 2000--$22,500,000. Additional principal payments may be required based on excess cash flow as defined in the agreement. The loan agreements also provide a German subsidiary of the Company with three Deutsche Mark ("DM") facilities. The first DM facility is a DM 40,000,000 ($23,035,000) revolving credit facility which is available until December 31, 1996, at which time the Company may elect a term out option, with quarterly payments due beginning March 31, 1997 through December 31, 2000. Interest is based on DM market rates plus 15/16%. The Company is required to pay a commitment fee equal to 3/8% per annum on the average unused line. The second DM facility is a DM 19,012,000 ($10,948,000) term loan. Principal of DM 4,753,000 ($2,737,000) and interest at DM market rates plus 1-1/8% is due quarterly with final payment on December 31, 1994. The third DM facility is a DM 104,316,000 ($60,073,000) term loan. Interest is based on DM market rates plus 1-11/16%. Principal payments of DM 18,700,000, 34,100,000, 37,000,000, and 14,516,000 ($10,769,000, $19,637,000, $21,307,000, and $8,360,000) are due on or before December 31, 1994, 1995, 1996, and 1997, respectively. Additional principal payments may be required based on excess cash flow as defined in the agreement. Under the loan agreements, the Company is restricted from paying cash dividends and must comply with other covenants, including the maintenance of specific ratios. The Company is in compliance with the restrictions and limitations under the terms of loan agreements, as amended. All of the Company's U.S. assets and the stock of certain foreign subsidiaries are pledged as collateral under loan agreements. Borrowings under a $20,000,000 unsecured credit agreement with First International Bank of Israel are at LIBOR plus 1-1/8% (4.25% at December 31, 1993). Principal payments of $5,000,000, $6,666,666, and $8,333,334 are due on or before December 31, 1997, 1998, and 1999, respectively. Other unsecured borrowings are at various interest rates ranging from 3.9% to 7.2%. The industrial development revenue bonds are at various interest rates ranging from 8% to 12% and mature at various dates from 1996 through 1999. The French industrial bonds are payable in French francs and bear interest at rates ranging from zero to 10% and require periodic payments through 2004. Aggregate annual maturities of long-term debt, as revised to reflect the agreement reached with the Company's bank group in March 1994 and excluding payments which may be required based on excess cash flow, are as follows: 1994--$30,536,000; 1995--$32,132,000; 1996--$41,729,000; 1997--$50,393,000; 1998--$48,305,000; thereafter--$94,440,000. The Company has short-term credit lines with various banks aggregating $64,667,000, of which $29,030,000 was unused at December 31, 1993. Interest paid was $20,587,000, $16,496,000, and $12,775,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 7. Stockholders' Equity The Company's Class B Stock carries ten votes per share while the Common Stock carries one vote per share. Class B shares are transferable only to certain permitted transferees while the Common Stock is freely transferable. Class B shares are convertible on a one-for-one basis at any time to Common Stock. Unearned compensation relating to Common Stock issued under employee stock plans is being amortized over a 36-month period. 132,153 shares are available for issuance under stock plans at December 31, 1993. 8. Other Income Other income (expense) consists of the following (in thousands): Year ended December 31 1993 1992 1991 --------------------------------------- Foreign exchange gains (losses) $(1,382) $(1,594) $41 Investment income 722 1,565 797 Sales and distribution fees from Sprague Technologies, Inc. - 3,325 - Roederstein consulting fees - 2,307 - Other 783 (1,070) (1,127) --------------------------------------- $123 $4,533 $(289) ======================================= 9. Employee Retirement Plans Two U.S. subsidiaries of Vishay, Dale Electronics, Inc. and Sprague North Adams, Inc., which was acquired effective January 1, 1992, maintain defined benefit pension plans (the "Plans"). Substantially all full-time employees of Dale and hourly employees of Sprague's North Adams facility are eligible to participate. The benefits under the Dale Plan are based on the employees' compensation during all years of participation. The benefits under the Sprague Plan are based on number of years of credited service. The Plans are tax qualified subject to the minimum funding requirements of ERISA. Employees participating in the Dale Plan are required to contribute an amount based on annual earnings. The Company's funding policy is to contribute annually amounts that satisfy the funding standard account requirements of ERISA. The assets of the Dale Plan are invested primarily in guaranteed investment contracts issued by an insurance company and mutual funds. The assets of the Sprague Plan are invested primarily in fixed income securities and common stock. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) Net pension cost for the Plans included the following components (in thousands): The expected long-term rate of return on assets was 9.5%. The following table sets forth the funded status of the Plans and amounts recognized in the Company's financial statements (in thousands): The following assumptions have been used in the actuarial determinations of the Plans: 1993 1992 -------------------- Discount rate 7.5% 8.0%-8.5% Rate of increase in compensation levels 4.5% 4.5% Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) The Company's U.S. subsidiary, Measurements Group, Inc., maintains a defined contribution pension plan covering substantially all full-time employees. Contributions are made based on participants' compensation. Costs for this plan were $530,000, $512,000, and $485,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In addition, many of the Company's U.S. employees are eligible to participate in 401(k) Savings Plans, some of which provide for Company matching under various formulas. The Company's matching expense for the plans was $1,996,000, $1,894,000, and $1,170,000 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company provides pension and similar benefits to employees of certain foreign subsidiaries consistent with local practices. German subsidiaries of the Company (including Roederstein, which was acquired in January 1993) have noncontributory defined benefit pension plans covering management and employees. Pension benefits are based on years of service. Net pension cost for the German Plans included the following components (in thousands): The following table sets forth the funded status of the German Plans and amounts recognized in the Company's financial statements (in thousands): Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) The following assumptions have been used in the actuarial determinations of the German Plans: December 31 1993 1992 ------------------------ Discount rate 7.0% 6.0% Rate of increase in compensation levels 3.0% 4.0% 10. Postretirement Medical Benefits The Company pays limited health care premiums for certain eligible retired U.S. employees. Prior to 1993, the cost of these benefits, which was not significant, was charged to expense when the benefits were paid. Effective January 1, 1993, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Under this new standard, the Company recognizes the cost of postretirement benefits over the active service period of its employees. The Company elected to recognize the transition obligation, which represents the previously unrecognized prior service cost, on a prospective basis over a twenty-year period. In 1993, the new standard resulted in additional annual net periodic postretirement benefit cost of $1,200,000 before taxes and $792,000 after taxes, or $0.04 per share. Prior-year financial statements have not been restated to apply the new standard. Net postretirement benefit cost for the year ended December 31, 1993 included the following components (in thousands): Service cost $ 351 Interest cost 713 Net amortization and deferral 424 ------- Net postretirement benefit cost $ 1,488 ======= The cost information does not include the effects of Plan amendments made at the end of 1993, which are expected to reduce future costs. Cash payments for these benefits were $288,000 for 1993. The Company continues to fund postretirement medical benefits on a pay-as-you-go basis. The status of the plan and amounts recognized in the Company's consolidated balance sheet as of December 31, 1993 were as follows (in thousands): Accumulated postretirement benefit obligation: Retirees $(2,234) Actives eligible to retire (956) Other actives (3,028) ------------ Total (6,218) Unrecognized loss 955 Unrecognized transition obligation 4,063 ------------ Accrued postretirement benefit liability $(1,200) ============ The accumulated postretirement benefit obligation reflects Plan amendments made at the end of 1993 which capped employer contributions for each participant at the 1993 dollar amounts. The discount rate used in the calculation was 7.5%. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 11. Leases Total rental expense under operating leases was $7,528,000, $9,577,000, and $4,435,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Future minimum lease payments for operating leases with initial or remaining noncancelable lease terms in excess of one year are as follows: 1994-- $5,694,000; 1995--$4,226,000; 1996--$3,582,000; 1997--$2,947,000; 1998-- $2,602,000; thereafter--$7,492,000 12. Financial Instruments Financial instruments with potential credit risk consist principally of accounts receivable. Concentrations of credit risk with respect to receivables are limited due to the Company's large number of customers and their dispersion across many countries and industries. At December 31, 1993 and 1992, the Company had no significant concentrations of credit risk. The amounts reported in the balance sheet for cash and cash equivalents and for short-term and long-term debt approximate fair value. 13. Segment and Geographic Information Vishay operates in one line of business--the manufacture of electronic components. Information about the Company's operations in different geographic areas is as follows (in thousands): Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 13. Segment and Geographic Information (continued) * Includes export sales of $78,793, $63,606, and $34,282 for the years ended December 31, 1993, 1992, and 1991, respectively. Sales between geographic areas are priced to result in operating profit which approximates that earned on sales to unaffiliated customers. Operating profit is total revenue less operating expenses. In computing operating profit, general corporate expenses, interest expense, and income taxes were not deducted. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 14. Summary of Quarterly Financial Information (Unaudited) Quarterly financial information for the years ended December 31, 1993 and 1992 is as follows: (1) Included in net earnngs for the first quarter of 1993 is a one-time tax benefit of $1,427 or $.07 per share resulting from the adoption of FASB Statement No. 109, "Accounting for Income Taxes". (2) Adjusted to give retroactive effect to 5% stock dividends in June 1993 and June 1992. Fourth quarter 1992 earnings reflect the difference between the Company's actual effective income tax rate of 19.8% and the estimated effective rate of 23.1% used through the third quarter. Vishay Intertechnology, Inc. Schedule V -- Property, Plant, and Equipment (In thousands) (1) $18,406 recorded for the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". Statement 109 requires assets acquired in prior business combinations to be reported at their pretax amounts. Offset principally by foreign currency translation adjustments. (2) $93,022 of the additions and $5,798 of the retirements relate to the Sprague acquisition. (3) $109,961 of the additions relate to the Roederstein acquisition. (4) Principally foreign currency translation adjustments. Vishay Intertechnology, Inc. Schedule VI -- Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment (In thousands) (1) Principally foreign currency translation adjustments. (2) $1,026 of the retirements relates to the Sprague acquisition. Vishay Intertechnology, Inc. Schedule IX Short-Term Borrowings (In thousands, except percentages) (1) Notes payable to bank represent borrowings under lines of credit borrowing arrangements which have no termination date but are reviewed annually for renewal. (2) The average amount outstanding during the period was based on quarter ending balances. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. Vishay Intertechnology, Inc. Schedule X -- Supplementary Income Statement Information (In thousands) COL. A COL. B - - - ----------------------------------------------------------------------------- ITEM Charged to Costs and Expenses - - - ----------------------------------------------------------------------------- Year ended December 31, 1993 1992 1991 ---------------------------------- Maintenance and repairs $23,177 $18,344 $12,131 Amounts for depreciation and amortization of intangible assets, taxes, other than payroll and income taxes, royalties, and advertising costs are not presented as such amounts are less than 1% of total sales and revenues. SIGNATURES Pursuant to the requirement 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. VISHAY INTERTECHNOLOGY, INC. March 30, 1994 /s/Felix Zandman ------------------------------------- Date Felix Zandman, Chairman of the Board, President, Chief Executive Officer & Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated below. /s/Robert A. Freece /s/Felix Zandman - - - -------------------------- ------------------------------ Robert A. Freece Felix Zandman, Chairman Director, Vice President, of the Board, Director, Treasurer and Chief President and Chief Financial Officer Executive Officer (Principal Financial and (Principal Executive Officer) Accounting Officer) /s/Luella B. Slaner /s/Avi D. Eden - - - -------------------------- ------------------------------ Luella B. Slaner, Director Avi D. Eden, Director /s/Edward B. Shils /s/Guy Brana - - - -------------------------- ------------------------------ Edward B. Shils, Director Guy Brana, Director /s/Donald Alfson /s/Jean-Claude Tine - - - -------------------------- ------------------------------ Donald Alfson, Director, Jean-Claude Tine, Director Vice President, President of Vishay Electronic Components, U.S. and Asia, and President of Dale Electronics, Inc. /s/Gerald Paul /s/Mark I. Solomon - - - -------------------------- ------------------------------ Gerald Paul, Director, Mark I. Solomon, Director Vice President, President of Vishay Electronic Components, Europe, and Managing Director of Draloric Electronic GmbH March 30, 1994 Date

97210_1993.txt

97210_1993

1993

97210

ITEM 1: BUSINESS Teradyne, Inc. is a manufacturer of electronic test systems and backplane connection systems used in the electronics and telecommunications industries. For financial information concerning these two industry segments, see "Note L: Industry Segment and Geographic Information" in Notes to Consolidated Financial Statements. Unless the context indicates otherwise, the term "Company" as used herein includes Teradyne, Inc. and all its subsidiaries. ELECTRONIC TEST SYSTEMS The Company designs, manufactures, markets, and services electronic test systems and related software used by component manufacturers in the design and testing of their products and by electronic equipment manufacturers for the incoming inspection of components and for the design and testing of circuit boards and other assemblies. Manufacturers use such systems and software to increase product performance, to improve product quality, to shorten time to market, to enhance manufacturability, to conserve labor costs, and to increase production yields. The Company's electronic systems are also used by telephone operating companies for the testing and maintenance of their subscriber telephone lines and related equipment. Electronic systems produced by the Company include: (i) test systems for a wide variety of semiconductors, including digital and analog integrated circuits, (ii) test systems for circuit boards and other assemblies, and (iii) test systems for telephone lines and networks. The Company's test systems are all controlled by computers, and programming and operating software is supplied both as an integral part of the product and as a separately priced enhancement. The Company's systems are extremely complex and require extensive support both by the customer and by the Company. Prices for the Company's systems range from less than $100,000 to $5 million or more. BACKPLANE CONNECTION SYSTEMS The Company also manufactures backplane connection systems, principally for the computer, telecom-munications, and military/aerospace industries. A backplane is a panel that supports the circuit boards in an electronic assembly and carries the wiring that connects the boards to each other and to other elements of a system. The Company produces both printed-circuit and metal backplanes, along with mating circuit-board connectors. Backplanes are custom-configured to meet specific customer requirements. The Company has begun to evolve the manufacture of backplane connection systems to the manufacture of fully integrated electronic assemblies that include backplane, card cage, cabling, and related design and production services. MARKETING AND SALES MARKETS The Company sells its products across most sectors of the electronics industry and to companies in other industries that use electronic devices in high volume. The Company believes that it could suffer the loss of one or even a few major customers without serious long-term adverse effects. Sales to Motorola, Inc. were $69.3 million in 1993, which were greater than 10% of the Company's net sales in 1993. No other customer accounted for more than 10% of net sales in 1993. Direct sales to United States Government agencies accounted for approximately 2% of net sales in 1993 and 1992, and 1% in 1991. In addition, sales are made, within each of the Company's segments, to customers who are government contractors. Approximately 33% of all backplane connection systems sales and less than 10% of all electronic test systems sales fell into this category during 1993. The Company's overseas customers are located primarily in Europe, Asia Pacific, and Japan. Sales to overseas customers consist principally of electronic test systems, and these sales occur either through foreign sales subsidiaries or through direct exports. Substantially all of the Company's manufacturing activities are conducted in the United States. Sales to overseas customers accounted for 41% of net sales in 1993, 42% in 1992, and 47% in 1991. Identifiable assets of the Company's foreign subsidiaries, consisting principally of accounts receivable and other operating assets, approximated $65.0 million at December 31, 1993, $86.0 million at December 31, 1992, and $82.0 million at December 31, 1991. Of these identifiable assets at December 31, 1993, $39.0 million were in Europe, $23.0 million were in Japan, and $3.0 million were in Asia Pacific. Since sales to overseas customers have little correlation with the location of manufacture, it is not meaningful to present operating profit by geographic area. The Company is subject to the inherent risks involved in international trade, such as political instability, restrictive trade policies, controls on funds transfer, and foreign currency fluctuations. The Company attempts to reduce the effects of currency fluctuations by hedging part of its exposed position and by conducting some of its foreign transactions in U.S. dollars or dollar equivalents. DISTRIBUTION The Company sells its electronic systems primarily through a direct sales force. Backplane connection systems are sold by direct sales personnel as well as by manufacturers' representatives. The Company has sales and service offices throughout North America, Europe, Asia Pacific, and Japan. COMPETITION Competition is intense in each of the business areas that the Company operates. In each market there are several significant competitors (three to five). Many of these competitors have greater resources than the Company. Competition is principally based on technical performance, equipment and service reliability, reputation and accessibility to the vendor, and price. While relative positions vary from year to year, the Company believes that it operates with a significant market share position in each of its businesses. BACKLOG On December 31, 1993, the Company's backlog of unfilled orders for electronic test systems and backplane connection systems was approximately $238.9 million and $49.1 million, respectively, compared with $183.0 million and $34.8 million, respectively, on December 31, 1992. Of the backlog at December 31, 1993, approximately 75% of the electronic test systems backlog, and substantially all of the backplane connection systems backlog is expected to be delivered in 1994, although the Company's past experience indicates that a portion of orders included in the backlog may be cancelled. There are no seasonal or unusual factors related to the backlog. RAW MATERIALS The Company's products require a wide variety of electronic and mechanical components. In the past, the Company has experienced occasional delays in obtaining timely delivery of certain items. Additionally, the Company could experience a temporary adverse impact if any of its sole source suppliers ceased to deliver products. Management believes, however, that alternate sources could be developed. PATENTS AND LICENSES The development of products by the Company, both hardware and software, is largely based on proprietary information. The various copyrights, trademarks, and patents owned by the Company, together with patent applications pending, are generally not significant in relation to the Company's overall business. However, protection of such proprietary information, through methods such as patents, software license agreements with customers and employee agreements, is important for certain of the Company's products. The Company does not hesitate to assert its rights to intellectual property when, in its view, these rights are infringed upon. Also from time to time, claims have been asserted that certain of its products and technologies infringe the patent rights of third parties. In the opinion of management, none of these claims are expected to have a material effect on the consolidated financial or competitive position of the Company. EMPLOYEES As of December 31, 1993, the Company employed approximately 4,000 persons. Since the inception of the Company's business, there have been no work stoppages or other labor disturbances. The Company has no collective bargaining contracts. ENGINEERING AND DEVELOPMENT ACTIVITIES The highly technical nature of the Company's products requires a large and continuing engineering and development effort. Engineering and development expenditures for new and improved products were approximately $62.4 million in 1993, and $62.0 million in 1992 and 1991. These expenditures amounted to approximately 11% of net sales in 1993, and 12% in 1992 and 1991. ENVIRONMENTAL AFFAIRS The Company's manufacturing facilities are subject to numerous laws and regulations designed to protect the environment, particularly from plant wastes and emissions. These include laws such as the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Hazardous and Solid Waste Amendments of 1984 and Resource Conservation and Recovery Act of 1976. In the opinion of management, compliance with these laws and regulations has not had and will not have a material effect upon the capital expenditures, earnings and competitive position of the Company. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth the names of all executive officers of the Company and certain other information relating to their positions held with the Company and other business experience. Executive officers of the Company do not have a specific term of office but rather serve at the discretion of the Board of Directors. The Company owns the majority of its manufacturing and office facilities. The Company believes its present and planned facilities and equipment are adequate to service its current and immediately foreseeable business needs. Approximately 120,000 square feet of the Agoura Hills property listed above is currently unoccupied. The Company is subleasing an additional 85,000 square feet of space in Walnut Creek through the expiration of the lease in June 1996. ITEM 3: ITEM 3: LEGAL PROCEEDINGS The Company is not a party to any litigation that, in the opinion of management, could reasonably be expected 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. Not Applicable. PART II ITEM 5: ITEM 5: MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The following table shows the market range for the Company's Common Stock based on reported sales prices on the New York Stock Exchange. The number of record holders of the Company's Common Stock at February 25, 1994 was 3,225. The Company has never paid cash dividends because it has been its policy to use earnings to finance expansion and growth. While payment of future dividends will rest within the discretion of the Board of Directors and will depend, among other things, upon the Company's earnings, capital requirements and financial condition, the Company presently expects to retain all of its earnings for use in the business. ITEM 6: ITEM 6: SELECTED FINANCIAL DATA ITEM 7: ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SELECTED RELATIONSHIPS WITHIN THE CONSOLIDATED STATEMENTS OF INCOME RESULTS OF OPERATIONS: 1993 Compared to 1992 Sales increased 5% in 1993, to $554.7 million. The increase in sales was primarily due to a 13% increase in sales of semiconductor test systems and, to a lesser extent, a 7% increase in sales of backplane connection systems. Sales of semiconductor test systems increased as semiconductor manufacturers added capacity in response to rising demand for their products. Sales of circuit-board test systems and telecommunications systems declined 7% and 18%, respectively, in 1993 compared to 1992. Incoming orders increased 19% in 1993 to $625.0 million over 1992 with increased orders occurring in each of the Company's major groups. The Company's backlog grew during 1993 to $288.0 million. Income before taxes increased by $25.3 million from 1992 to 1993 on a sales increase of $25.2 million as the Company continued to control the growth in its operating expenses. In addition, costs in 1993 were lower in the Company's circuit-board test operations following actions taken by the Company in 1992 to consolidate those operations. These lower costs helped to offset the impact of the reduced sales of circuit-board test systems. Cost of sales decreased from 59% of sales in 1992 to 57% in 1993. While sales increased in 1993, the fixed and semi-variable components of cost of sales decreased as a result of the Company's cost reduction programs. The changes in engineering and development expenses and selling and administrative expenses were each less than 1% in 1993, compared to 1992. These expenses have essentially remained at their current level since 1991, as the Company has controlled the growth of its fixed costs. Interest income increased 44% in 1993 as a result of a $76.2 million increase in the Company's cash and cash equivalents balance during the year. Interest expense decreased 12% in 1993 primarily as a result of the Company's retirement of its 9.25% outstanding convertible subordinated debentures in the fourth quarter. The Company's effective tax rate increased from 13.5% in 1992 to 30% in 1993. The Company had been able to utilize net operating loss carryforwards to lower its United States taxable income for financial reporting purposes in 1992, while in 1993 those carryforwards were no longer available. However, the Company's tax rate in 1993 was below the United States statutory rate of 35%, as a result of the utilization of tax credit carryforwards and foreign net operating loss carryforwards. There continue to be tax credit carryforwards and foreign net operating loss carryforward amounts which will lower the Company's prospective tax rate if utilized. The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" at the beginning of 1993. The effect of this change in accounting principle was not material to the Company's consolidated financial position. See "Note K: Income Taxes" in Notes to Consolidated Financial Statements. In connection with the retirement of the Company's outstanding 9.25% convertible subordinated debentures, the Company incurred, in the fourth quarter of 1993, an extraordinary charge of $0.7 million, net of income taxes, for the costs of the redemption premium of 3.7% and the write off of unamortized debt issuance costs. 1992 Compared to 1991 Sales increased 4% in 1992, to $529.6 million. The sales increase was primarily due to a 13% increase in sales of semiconductor test systems over 1991 and, to a lesser extent, a 7% increase in sales of connection systems. Offsetting the increased sales were reduced sales of circuit-board test systems and telecommunications systems which were down 12% and 5%, respectively. The Company believes that the over-all market for semiconductor test systems declined in 1992 and that, the increase in sales represents market-share growth. The decline in sales of circuit-board test systems was primarily due to a decrease in demand from U.S. government defense contractors. During the year, the Company decided to concentrate its efforts in Electronic Design Automation (EDA) on software products for test generation and design verification. This decision led to the closing of the EDA operation in Santa Clara, California and the consolidation of the EDA operation in Boston, Massachusetts with the circuit-board test division. The Company also decided to move the circuit-board assembly operation in Walnut Creek, California to the central circuit-board assembly operation in Boston. Cost of sales increased as a percent of sales from 58% to 59%. This increase was due to the fact that, while the Company reduced its overhead associated with circuit-board test systems and telecommunications systems, it did not reduce such expenses proportionately with the reduction in sales of these two product lines. Engineering and development expenses were essentially unchanged in 1992, while the amount of selling and administrative expenses increased less than 1% as the Company controlled the growth of these expenses. Interest income increased 78% in 1992 to $2.5 million due to an increase in the Company's cash and cash equivalents balance beginning in the second half of 1991. Cash had grown by $63.8 million from June 29, 1991 to December 31, 1992. Interest expense decreased 21% in 1992 due to a reduction in the average level of debt outstanding during the year and lower average short-term interest rates. The Company's effective tax rate increased from 10% in 1991 to 13.5% in 1992. At the end of 1992, the Company had utilized all of its available U.S. Federal net operating loss carryforwards for financial reporting purposes. LIQUIDITY AND CAPITAL RESOURCES The Company's cash balance increased by $76.2 million in 1993, following an increase of $32.0 million in 1992. Cash flow generated from operations was $91.8 million in 1993 and $40.7 million in 1992. Additional cash of $33.6 million in 1993 and $15.7 million in 1992 was generated from the sale of stock to employees under the Company's stock option and stock purchase plans. In 1992, cash of $3.2 million was also raised from a bank note to finance future construction of a plant in Kumamoto, Japan. Cash was used to fund additions to property, plant and equipment of $32.2 million in 1993 and $28.2 million in 1992. The Company also used $14.7 million of its cash to retire outstanding debt and $2.3 million to purchase stock from its shareholders pursuant to the Company's open market stock repurchase program. The debt retirement included $10.8 million for the repurchase of the outstanding convertible debentures and a cash payment of $3.2 million for the exercise of a purchase option on the Company's headquarters building in Boston, Massachusetts. The Company believes its cash and cash equivalents balance of $143.6 million, together with other sources of funds, including cash flow generated from operations and available borrowing capacity of $80.0 million under its line of credit agreement, will be sufficient to meet future working capital and capital expenditure requirements. Inflation has not had a significant long-term impact on earnings. If there were inflation, the Company's efforts to cover cost increases with price increases would be frustrated in the short term by its relatively high backlog. ITEM 8: ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION REPORT OF INDEPENDENT ACCOUNTANTS To the Directors and Shareholders of TERADYNE, INC.: We have audited the consolidated financial statements and financial statement schedules of Teradyne, Inc. and Subsidiaries listed below. 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 Teradyne, 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. 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 Boston, Massachusetts January 24, 1994 TERADYNE, INC. The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. ACCOUNTING POLICIES: Basis of Presentation The consolidated financial statements include the accounts of Teradyne, Inc. and its subsidiaries, all of which are wholly owned (referred to collectively in these notes as the "Company"). All significant intercompany balances and transactions have been eliminated. Certain prior years' amounts have been reclassified to conform to the current year presentation. Inventories Inventories are stated at the lower of cost (first-in, first-out basis) or market (net realizable value). Property, Plant and Equipment Property, plant and equipment are stated at cost. Leasehold improvements and major renewals are capitalized and included in property, plant and equipment accounts while expenditures for maintenance and repairs and minor renewals are charged to expense. When assets are retired, the assets and related allowances for depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in operations. The Company provides for depreciation of its property principally on the straight-line method by charges to expense which are sufficient to write off the cost of the assets over their estimated useful lives. Revenue Recognition Revenue is recorded when products are shipped or, in instances where products are configured to customer requirements, upon the successful completion of test procedures. Service revenue is recognized ratably over applicable contract periods or as services are performed. In certain situations, revenue is recorded using the percentage of completion method based upon the completion of measurable milestones, with changes to total estimated costs and anticipated losses, if any, recognized in the period in which determined. Engineering and Development Costs The Company's products are highly technical in nature and require a large and continuing engineering and development effort. All engineering and development costs are expensed as incurred. Income Taxes Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." This statement superseded the previous accounting standard for income taxes, SFAS 96, which the Company adopted January 1, 1991. The adoption of SFAS 109 had no material effect on the results of operations. Under SFAS 109, 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. The measurement of deferred tax assets is reduced by a valuation allowance if, based upon weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. In general, the Company's practice is to provide U.S. federal taxes on undistributed earnings of the Company's foreign sales and service subsidiaries. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. ACCOUNTING POLICIES -- (CONTINUED) Translation of Foreign Currencies Assets and liabilities of foreign subsidiaries which are denominated in foreign currencies have been remeasured into U.S. dollars at rates of exchange in effect at the end of the fiscal year except fixed assets which have been remeasured using historical exchange rates. Revenue and expense accounts have been remeasured using an average of exchange rates in effect during the year. Net realized and unrealized gains and losses resulting from foreign currency remeasurement are included in operations. Financial Instruments and Related Disclosures Financial instruments consist primarily of investments in cash, cash equivalents and accounts receivables and obligations under accounts payable and debt instruments. Fair value of financial instruments have been determined through information obtained from market sources and management estimates. At December 31, 1993, the fair value of the Company's financial instruments approximates the carrying value. The Company enters into foreign exchange contracts to hedge assets, liabilities, and transactions denominated in foreign currencies on a continuing basis for periods consistent with its committed exposures. The foreign exchange contracts are used to reduce the Company's risk associated with exchange rate movements, as gains and losses on these contracts are intended to offset foreign exchange gains and losses on the assets, liabilities, and transactions being hedged. As of December 31, 1993, the Company had $51.9 million of foreign exchange contracts outstanding, $40.0 million of which were in German marks, $11.0 million in various other European currencies, and $0.9 million in Japanese yen. The German mark contracts have maturities of one to three years. The Company's other foreign exchange contracts generally have maturities which do not exceed six months. All of the foreign exchange contracts require the Company to exchange foreign currencies for U.S. dollars at maturity, at rates agreed to at inception of the contracts. Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash equivalents and trade receivables. The Company places its cash equivalents in high grade financial instruments and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of diverse and geographically dispersed customers. Net Income Per Common Share Net income per common share is based upon the weighted average number of common and common equivalent shares (when dilutive) outstanding each year. Common equivalent shares result from the assumed exercise of outstanding stock options, the proceeds of which are then assumed to have been used to repurchase outstanding common stock at the average market price during the year. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS B. CASH AND CASH EQUIVALENTS Cash equivalents consist of short-term investments in money market instruments with an original maturity of three months or less. These amounts are carried at cost plus accrued interest, which approximates market value. Of the $143.6 million cash and cash equivalents balance at December 31, 1993, cash equivalents amounted to $125.3 million, which included $112.5 million of U.S. Treasury bills. Of the $67.4 million cash and cash equivalents balance at December 31, 1992, cash equivalents amounted to $58.8 million, which included $50.8 million of U.S. Treasury bills. C. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consisted of the following (in thousands): The total maturities of long-term debt for each of the next five years are $0.5 million. Revolving Credit Agreement The Company has $80.0 million of revolving credit available through January 31, 1996 under a domestic line of credit agreement with its banks. Under the terms of the agreement, any amounts outstanding at December 31, 1996 are converted into a one year term note. As of December 31, 1993, no amounts were outstanding under this agreement. The terms of this line of credit also include restrictive covenants regarding the working capital, tangible net worth and leverage. Interest rates on borrowings are either at the stated prime rate or based upon Eurocurrency or certificate of deposit interest rates. Additional domestic and foreign borrowings up to $30.0 million are permitted outside the agreement provided that the liabilities of the Company, exclusive of deferred income taxes and subordinated debt, shall not exceed 100% of the Company's tangible net worth. Mortgage Note Payable The Company has received a loan of $4.5 million from the Boston Redevelopment Authority in the form of a 3% mortgage loan maturing March 31, 2013. This loan is collateralized by a mortgage on the Company's property at 321 Harrison Avenue which may, at the Company's option, become subordinated to another mortgage up to a maximum of $5.0 million. For the first 4 1/2 years of the note, interest was accrued but not paid ("Accrued Interest"). Beginning September 30, 1987, semi-annual interest payments are being paid on principal and Accrued Interest. The principal and Accrued Interest are payable in full at maturity. Industrial Revenue Bonds At December 31, 1993, the Company has outstanding industrial revenue bonds, in the amount of $1.3 million, maturing in 1998 and 1999. These bonds are payable in quarterly installments, including interest at the higher of 75% of the stated prime rate or 7 1/2%. The bonds are collateralized by mortgage interests on certain properties owned by the Company. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS C. LONG-TERM DEBT -- (CONTINUED) Capitalized Lease Obligations On December 31, 1993, the Company exercised its lease option to purchase the property located at 321 Harrison Avenue, Boston, Massachusetts for $3.2 million. Other Long-term Debts At December 31, 1993, other long-term debt consists principally of a Japanese yen-denominated note in the amount of $3.6 million at an interest rate of 4.8%, secured by land in Kumamoto, Japan, with interest only payable until March 31, 1995, and principal and interest payable in monthly installments from April 29, 1995 to March 30, 2007. D. CONVERTIBLE SUBORDINATED DEBENTURES At December 31, 1992, the Company had outstanding $15.4 million of 9.25% convertible subordinated debentures due March 15, 2012. These debentures were convertible into shares of the Company's common stock any time prior to maturity at a conversion price of $23.50 per share. The amount shown on the Consolidated Balance Sheets at December 31, 1992 was net of $1.0 million unamortized debt issue costs. During 1993, $5.0 million principle amount of debentures were converted into 210,585 shares of common stock resulting in an increase of $4.7 million of shareholders' equity (net of the related $0.3 million unamortized debt issue costs). On November 19, 1993, the Company exercised its option to repurchase the remaining $10.4 million outstanding debentures. The Company used $10.8 million of available cash from operations to repurchase the debentures at a premium of 103.7% of the principal amount. The premium amount and the writeoff of the remaining unamortized debt issue cost resulted in a charge of $1.0 million. This charge, net of the related taxes of $0.3 million, is reflected as an extraordinary loss in the Consolidated Statements of Income. E. COMMITMENTS Rental expense for the years ended December 31, 1993, 1992, and 1991 was $11.2 million, $12.6 million, and $13.0 million, respectively. Minimum annual rentals under all noncancellable leases are: 1994 -- $6.8 million; 1995 -- $5.5 million; 1996 -- $2.6 million; 1997 -- $1.1 million; 1998 -- $0.9 million; and $6.3 million thereafter, totalling $23.2 million. Offsetting the future lease payments, the Company's income from noncancellable subleases totals $1.2 million. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS F. PENSION PLANS The Company has defined benefit pension plans covering substantially all domestic employees and employees of certain international subsidiaries. Benefits under these plans are based on the employee's years of service and compensation. The Company's funding policy is to make contributions to the plans in accordance with local laws and to the extent that such contributions are tax deductible. The assets of the plans consist primarily of equity and fixed income securities. In 1993, the Company established a supplemental defined benefit pension plan in the United States to provide retirement benefits in excess of levels allowed by ERISA. In 1992, the Company established a defined benefit pension plan covering its employees in Japan. The Company's foreign plans were not included in the table below in 1991 because they were not significant in the aggregate. Net pension expense for the domestic plans was $2.4 million in 1993, $1.8 million in 1992, and $1.5 million in 1991. The components of net pension expense are summarized as follows (in thousands): The following table sets forth the plans' funded status at December 31 (in thousands): The Company has recorded an additional minimum pension liability for underfunded plans of $7.5 million at December 31, 1993, representing the excess of unfunded accumulated benefit obligations over previously recorded pension cost liabilities. A corresponding amount has been recognized as an intangible asset to the extent of related unrecognized prior service cost of $5.2 million, with the remaining amount of $1.5 million, net of taxes of $0.8 million, recorded as a charge to stockholders' equity. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS G. STOCK OPTION PLANS Under its stock option plans, the Company has granted options to certain directors, officers and employees entitling them to purchase common stock at 100% of market value at the date of grant. There have been no charges to income in connection with these options other than incidental expenses related to the issuance of shares. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS H. SAVINGS PLAN The Company sponsors a Savings Plan covering substantially all domestic employees. Under this plan, employees may contribute up to 12% of their compensation (subject to Internal Revenue Service limitations). The Company annually matches employee contributions of up to 6% of such compensation at rates ranging from 50% to 100%. The Company's contributions vest after two years, although contributions for those employees with five years of service vest immediately. The trustees of the Savings Plan have been granted an option to purchase 900,000 shares of the Company's common stock, exercisable at $9.50 per share (the fair market value of the Company's common stock at the date of the grant) in five cumulative annual installments beginning in 1990. The trustees exercised 335,000, 200,000, and 100,000 shares respectively in 1993, 1992, and 1991. Under the terms of the Plan, any gains realized from the sale of option shares are first allocated to participants' accounts to fund up to one-half of the minimum Company contribution, with any excess applied to additional funding. Under this plan, the amounts charged to operations were $2.0 million in 1993 and 1992, and $1.8 million in 1991. I. EMPLOYEE STOCK PURCHASE PLAN Under the 1979 Stock Purchase Plan, employees are entitled to purchase shares of common stock through payroll deductions of up to 10% of their compensation. The price paid for the common stock is equal to 85% of the lower of the fair market value of the Company's common stock on either the first or last business day of the year. In January 1994, the Company issued 375,124 shares of common stock to employees who participated in the plan during 1993 at a price of $12.82 per share. Currently there are 405,869 shares reserved for issuance. There have been no charges to income in connection with this plan other than incidental expenses related to the issuance of shares. J. STOCKHOLDER RIGHTS PLAN The Company's Board of Directors adopted a Stockholder Rights Plan on March 14, 1990. Under the Plan, the Company distributed to stockholders a dividend of one Common Stock Purchase Right for each outstanding share of Common Stock. Initially, the Purchase Rights enable a stockholder to purchase one share of Teradyne Common Stock for $40.00. Upon certain events, such as the initiation of a tender offer for more than 30% of the Company's Common Stock, the Purchase Rights allow stockholders to purchase $80.00 worth of Common Stock (or other securities or consideration as determined by Continuing Directors of the Company) for $40.00. Generally, at any time until 10 days following the announcement that a person has acquired 20% of the outstanding shares of the Company, the Company may redeem the Purchase Rights for $0.01 per share. The Plan will expire March 26, 2000, unless earlier redeemed by the Company. K. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." As permitted by SFAS 109, the Company has elected not to restate its financial statements for any periods prior to 1993. The effect on operations for 1993 was immaterial. However, upon adoption of SFAS 109 the Company increased Additional Paid-in Capital by $5.7 million relating to the tax benefits to be derived from the utilization of U.S. net operating loss carryforward amounts resulting from tax deductions pertaining to the issuance of the Company's stock to employees under its benefit plans. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS K. INCOME TAXES -- (CONTINUED) The components of income before income taxes and extraordinary item and the provision (credit) for income taxes as shown in the Consolidated Statements of Income are as follows (in thousands): Under 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 assets (liabilities) as of December 31, 1993 are as follows (in thousands): TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS K. INCOME TAXES -- (CONTINUED) The valuation allowance applies to U.S. federal and foreign tax credit carryforwards, and net operating losses carryforwards in certain foreign jurisdictions that may expire before the Company can utilize them. For U.S. federal and foreign tax return purposes, the Company has approximately $8.4 million and $10.7 million, respectively of net operating loss carryforwards, of which $5.2 million expire in the years 1995 through 1998, $8.4 million expire in the year 2005, and $5.5 million may be carried forward indefinitely. The Company also has available U.S. federal and foreign tax credits carryforwards of approximately $4.1 million, of which $2.4 million expire in the years 2000 through 2002, $0.5 million in the year 2008, and the remainder indefinitely. The components of the provision (benefit) for deferred income taxes for the years ended December 31, 1992 and 1991 are as follows (in thousands): Below is a reconciliation of the effective tax rates for the three years indicated: TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS L. INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION The Company operates in principally two industry segments, which are the design, manufacturing and marketing of electronic test systems and backplane connection systems. Corporate assets consist principally of cash and cash equivalents, deferred tax assets and certain other assets. The Company's sales to unaffiliated customers for the three years ended December 31 were made to customers in the following geographic areas: See "Item 1: Business -- Marketing and Sales" elsewhere in this report for information on the Company's export activities, identifiable assets of foreign subsidiaries, and major customers. SUPPLEMENTARY INFORMATION (UNAUDITED) Quarterly financial information for 1993 and 1992 (in thousands of dollars, except per share amounts): ITEM 9: ITEM 9: DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10: ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. (Also see "Item I -- Executive Officers of the Company" elsewhere in this report.) ITEM 11: ITEM 11: EXECUTIVE COMPENSATION. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. ITEM 12: ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. ITEM 13: ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. 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 are included in Item 8: Balance Sheets as of December 31, 1993 and 1992 Statements of Income 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 Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 (A)2. FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules are included in Item 14(d): Schedule V -- Property Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property Schedule IX -- Short-term Borrowings Schedule X -- Supplementary Income Statement Information Schedules other than those listed above have been omitted since they are either not required or the information is otherwise included. (A)3. LISTING OF EXHIBITS Executive Compensation Plans and Arrangements 1. 1987 Non-Employee Director Stock Option Plan (filed as Exhibit 3.10(iii) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992). 2. Teradyne, Inc. Supplemental Executive Retirement Plan (filed as Exhibit 3.10(iv) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992). (B) REPORTS ON FORM 8-K There have been no 8-K filings during the three months ended December 31, 1993. (C) EXHIBITS The Company hereby files as part of this Form 10-K the exhibits listed in Item 14 (a) 3 as set forth above. SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED THIS DAY OF MARCH, 1994. TERADYNE, INC. By: /s/ OWEN W. ROBBINS ------------------------------------ OWEN W. ROBBINS, 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. S-1 S-2 S-3

854094_1993.txt

854094_1993

1993

854094

Item 1. Business. Central Newspapers, Inc. (the "Company") is engaged, through its subsidiaries, in newspaper publishing primarily in the metropolitan areas of Phoenix, Arizona and Indianapolis, Indiana. The Company is an Indiana corporation organized in 1934. Through its wholly-owned subsidiary, Phoenix Newspapers, Inc., the Company publishes The Arizona Republic (mornings and Sunday), The Phoenix Gazette (evenings) and the Arizona Business Gazette (weekly). Through its 71.2%-owned subsidiary, Indianapolis Newspapers, Inc., the Company publishes The Indianapolis Star (mornings and Sunday) and The Indianapolis News (evenings). The Company also publishes several daily newspapers serving smaller communities in Indiana. The Company is a partner (13.5% interest) in Ponderay Newsprint Company, a general partnership that owns and operates a newsprint mill in the state of Washington. The Company has published its newspapers in its two primary markets for more than forty-four years. The Company has managed its newspapers with the objective of long-term growth and believes that this philosophy has contributed to the stability of the Company's operations. The Company's ability to establish and maintain its daily newspapers as the only major newspapers in their respective markets has promoted its growth and is of primary importance in attracting and maintaining advertising, the principal source of revenue for the Company. Each of the Company's newspapers has substantial autonomy over editorial policy. PHOENIX NEWSPAPERS, INC. Phoenix Newspapers, Inc. ("PNI") was formed in 1946 by a group of investors, including the Company, to purchase The Arizona Republic and The Phoenix Gazette. The Company originally owned a 30% interest in PNI and has owned 100% of the common stock of PNI since 1977. The newspapers published by PNI are The Arizona Republic (mornings and Sunday), The Phoenix Gazette (evenings) and the Arizona Business Gazette (weekly). Circulation As of December 26, 1993, approximately 82% of the daily and 68% of the Sunday circulation of The Arizona Republic and 88% of the daily circulation of The Phoenix Gazette were home delivered. Single copy sales account for approximately 32% of Sunday newspaper sales and approximately 17% of combined daily newspaper sales. The Arizona Business Gazette contains business news and legal notices relating to the Phoenix metropolitan area. The average paid circulation of the Arizona Business Gazette was 9,686; 8,379; and 9,599 for 1991, 1992 and 1993. The circulation levels of The Arizona Republic and The Phoenix Gazette are seasonal due to the large number of part-year residents of the Phoenix area. Historically, circulation for The Arizona Republic and The Phoenix Gazette achieves its highest levels in February and decreases during the late spring and summer months. During 1993 the seasonal variation in combined daily circulation and Sunday circulation was approximately 89,000 and 95,000. The following table shows the average paid circulation for The Arizona Republic and The Phoenix Gazette for the last three fiscal years. The figures for 1991 and 1992 are based upon annual reports issued by the Audit Bureau of Circulations ("ABC"), an independent agency which audits the circulation of daily and Sunday newspapers and include circulation outside the Phoenix metropolitan statistical area ("MSA"). The figures for 1993 are based upon the records of the Company because, as of the date of this report, the ABC annual report for 1993 has not been released. Net circulation revenue for the last three fiscal years is based upon the records of the Company. 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 The Arizona Republic (Sunday) 557,399 560,850 576,576 The Arizona Republic (Daily) 358,269 360,148 366,787 The Phoenix Gazette (Daily) 87,355 86,126 81,497 Net Circulation Revenue (in thousands) $61,930 $70,621 $74,368 The home delivered price for The Arizona Republic (seven days) in the Phoenix MSA is $3.05 per week including a $.55 per week increase during November 1991. The home delivered price for The Phoenix Gazette (six days) is $1.50 per week. During January 1993 the single copy price of the morning paper increased by $.15 to $.50. The single copy price of the afternoon paper is $.35. The single copy price of the Sunday paper is $1.50 including a $.25 increase in January 1991. A weekend package comprising the Sunday paper and the Friday and Saturday edition of either the morning or evening paper is offered at $2.00 per week which reflects a $.50 per week increase effective November 1991. Advertising The newspapers generate revenue from two primary types of advertisements, "run of paper," which are printed in the body of the newspaper, and "pre-printed," which are furnished by the advertiser and inserted into the newspaper. PNI derives the majority of its advertising revenue from run of paper advertisements. However, like other major newspapers, The Arizona Republic and The Phoenix Gazette have experienced an increase in the use by advertisers of pre-printed advertisements in recent years. Because pre-printed advertisements are furnished by the advertisers and can be distributed by alternate means, revenues and profits from pre-printed advertisements are generally lower than would be derived if an advertiser had chosen to use run of paper advertisements. To encourage use of run of paper advertisements, PNI structures its advertising rates to provide more favorable rates to high volume and frequent run of paper advertisers. PNI also structures its advertising format to accommodate the numerous communities that comprise the Phoenix metropolitan area. The Arizona Republic and The Phoenix Gazette publish a common "Community" section that is inserted in up to twelve zoned editions on certain days of the week. Zoned editions, which include news stories and advertisements targeted to specific communities or geographic areas, provide an important means of competing with news coverage of local newspapers and thereby promote circulation. Other part run sections are also provided to accommodate the needs of advertisers for more targeted distribution. The combined run of paper advertising linage for The Arizona Republic, The Phoenix Gazette and the Arizona Business Gazette for the past three fiscal years and the combined advertising revenues of the newspapers for such periods are set forth in the following table: 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 Advertising Linage--Run of Paper (in thousands of six- column inches): Full run 3,463 3,371 3,562 Part run 1,763 2,024 2,239 Weekly 410 324 278 Net Advertising Revenue (in thousands) $203,887 $203,267 $218,092 Distribution PNI distributes The Arizona Republic and The Phoenix Gazette primarily by home delivery through a network of independent contractors that deliver newspapers pursuant to agreements with PNI. PNI has implemented a centralized billing system which removes the responsibility for billing and collection from the independent contractors. Newspapers are distributed to the independent contractor network by an outside company which has been under contract with PNI for over thirty-nine years. Production The Arizona Republic and The Phoenix Gazette have separate editorial/news staffs but share the same production facilities and equipment. The editing and composing functions are performed primarily at PNI's facility in downtown Phoenix. To increase efficiency and reduce work force requirements, the editing and composing functions have been computerized. Electronic pagination allows entire pages of the newspaper to be formatted at a computer terminal instead of by manual assembly. Composed pages are electronically transmitted from PNI's downtown facility to its two satellite production facilities. PNI has two satellite production facilities, one located in Deer Valley which is north of downtown Phoenix and one in Mesa, Arizona. Construction of the Deer Valley facility began in 1990 and was completed in 1992. This facility includes four new offset presses and related production equipment as well as circulation, advertising and editorial offices. Production began during the first quarter of 1992 with full operation commencing in the third quarter of 1992. The Mesa facility began operation in 1982 and has been expanded and upgraded since that date. It has three offset presses and related production equipment. Because of the growth expected in the Phoenix area, PNI owns an additional site in western Maricopa County for a future satellite production facility. INDIANAPOLIS NEWSPAPERS, INC. Indianapolis Newspapers, Inc. ("INI") was formed by the Company in 1948. The Company owns all of the issued and outstanding Class B Common Stock and 4.1% of the Class A Common Stock of INI, representing 71.2% of the voting power and equity of INI. The remaining issued and outstanding Class A Common Stock of INI, which represents the remaining 28.8% of the voting power and equity of INI, is held either directly or through trusts by members of the family which previously owned The Indianapolis News. The holders of the Class A Common Stock are entitled to elect a minority of INI's Board of Directors. The primary newspapers published by INI are The Indianapolis Star (mornings and Sunday) and The Indianapolis News (evenings). Circulation As of December 26, 1993, approximately 80% of the daily and 81% of the Sunday circulation of The Indianapolis Star and 83% of the daily circulation of The Indianapolis News were home delivered. Single copy sales account for approximately 18% of Sunday newspaper sales and 17% of combined daily newspaper sales. The following table shows the average paid circulation for The Indianapolis Star and The Indianapolis News for the last three fiscal years. The figures for 1991 and 1992 are based upon annual reports issued by ABC, and include circulation outside the Indianapolis MSA. The figures for 1993 are based upon records of the Company because, as of the date of this report, the ABC annual report for 1993 has not been released. Net circulation revenue for the last three fiscal years is based upon the records of the Company. 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 The Indianapolis Star (Sunday) 414,080 413,630 411,261 The Indianapolis Star (Daily) 230,179 229,842 231,123 The Indianapolis News (Daily) 100,123 96,540 93,245 Net Circulation Revenue (in thousands) $36,050 $36,979 $38,523 The home delivered price for The Indianapolis Star (seven days) in the Indianapolis MSA is $3.00 per week which includes a $.25 price increase during May 1993. The home delivered price for The Indianapolis News (six days) is $1.50 per week. The single copy price is $.35 for each daily paper. The single copy price of the Sunday newspaper is $1.50 which includes a $.25 price increase during September 1991. Advertising Newspapers generate revenue from two primary types of advertisements, "run of paper," which are printed in the body of the newspaper, and "pre-printed," which are furnished by the advertiser and inserted into the newspaper. INI derives the majority of its advertising revenue from run of paper advertisements. Like the Company's Phoenix newspapers, The Indianapolis Star and The Indianapolis News have experienced an increase in the use by advertisers of pre-printed advertisements in recent years. To encourage use of run of paper advertisements, INI structures its advertising rates to provide more favorable rates to high volume and frequent run of paper advertisers. The combined run of paper advertising linage for The Indianapolis Star and The Indianapolis News for the past three fiscal years and the combined advertising revenue of the newspapers for such periods are set forth in the following table: 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 Advertising Linage--Run of Paper (in thousands of six- column inches): Full run 2,432 2,425 2,458 Part run 33 22 62 Net Advertising Revenue (in thousands) $102,364 $106,056 $114,004 Distribution INI distributes The Indianapolis Star and The Indianapolis News primarily by home delivery through a network of approximately 3,200 carriers. Generally, a carrier is an independent contractor who purchases newspapers from INI and resells them to his or her customers. Production The Indianapolis Star and The Indianapolis News have separate editorial/news staffs but share the same production and distribution facilities. All editorial, production and distribution functions are handled from INI's facility in downtown Indianapolis. INI's production facility is equipped with six offset presses, after the conversion of four letterpress presses and the installation of two new offset presses during 1988 - 1992 at a cost of $57.7 million. SMALLER NEWSPAPERS The Company also publishes several smaller newspapers. Through Muncie Newspapers, Inc., which is 88%-owned by INI and 12%-owned by the Company, the Company publishes The Muncie Star (mornings and Sunday) and The Muncie Evening Press (evenings). These two daily newspapers serve the Muncie, Indiana area, which has a population of approximately 119,000. As of December 26, 1993, the average paid circulation of The Muncie Star was 29,405 daily, and 36,873 Sunday and the average paid circulation of The Muncie Evening Press was 13,174 daily. The Company publishes the Vincennes Sun-Commercial, a daily newspaper which serves the city of Vincennes, Indiana, with a population of approximately 19,800. As of December 26, 1993, the average paid circulation of the Vincennes Sun-Commercial was 13,857 daily (five days) and 15,842 Sunday. During January 1993, the Company formed Topics Newspapers, Inc. as a wholly owned subsidiary to purchase the net assets of two daily newspapers, one weekly newspaper and twelve controlled circulation newspapers that serve the fastest growing area of metropolitan Indianapolis. As of December 26, 1993, the average paid circulation of The Daily Ledger was 9,273 (six days) and the combined weekly circulation was 85,285. The revenues received by the Company from these smaller publications represented approximately 4% of the total revenues of the Company in each of its last three fiscal years. RAW MATERIALS - PONDERAY NEWSPRINT COMPANY The Company consumed approximately 148,700 metric tons of newsprint in fiscal 1993 and estimates that consumption will increase slightly in fiscal year 1994. The Company currently obtains its newsprint from a number of suppliers, both foreign and domestic, under long-term contracts, standard in the industry, which offer dependable sources of newsprint at current market rates. To provide the Company with an additional source of newsprint for a portion of its needs, the Company formed Central Newsprint Company, Inc. and Bradley Paper Company (the "Newsprint Subsidiaries"), both of which are wholly-owned subsidiaries of the Company. The Newsprint Subsidiaries, together with four other newspaper publishing companies and a Canadian newsprint manufacturer, are partners in Ponderay Newsprint Company ("Ponderay"), a general partnership formed to own and operate a newsprint mill in Usk, Washington. The mill began operations in December 1989. PNI has committed to purchase annually the lesser of 13.5% of Ponderay's newsprint production or 28,400 metric tons on a "take if tendered" basis until the debt of Ponderay is repaid. COMPETITION The Company faces competition for advertising revenue from television, radio and direct mail programs, as well as competition for advertising and circulation from suburban neighborhood and national newspapers and other publications. Competition for advertising is based upon circulation levels, readership demographics, price and advertiser results. Competition for circulation is generally based upon the content, journalistic quality and price of the newspaper. In Indianapolis, the Company's newspapers do not receive significant direct competition from suburban newspapers. In Phoenix, several suburban newspapers owned by major media corporations operate in cities that are part of the Phoenix metropolitan area and compete with The Arizona Republic and The Phoenix Gazette for advertising and circulation. EMPLOYEES - LABOR As of January 31, 1994, the Company had approximately 5,000 employees (including 1,280 part-time employees), 42% of whom were covered by collective bargaining agreements. The Company has never had a significant strike or work stoppage at its operations and considers its labor relationships with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT As of February 28, 1994, the executive officers of the Company and their ages are as follows: Name Age Positions Malcolm W. Applegate 58 Director; President and General Manager of INI Eugene S. Pulliam 79 Director and Executive Vice President; President of PNI; Publisher of The Indianapolis Star and The Indianapolis News Frank E. Russell 73 Director; President and Chief Executive Officer Louis A. Weil III 52 Director; Executive Vice President of PNI; Publisher of The Arizona Republic and The Phoenix Gazette Wayne D. Wallace 47 Treasurer Malcolm W. Applegate has been President since May 1993 and General Manager since July 1990 of Indianapolis Newspapers, Inc. From 1985 until assuming his current position with Indianapolis Newspapers, Inc., Mr. Applegate was publisher of the Lansing (Michigan) State Journal. He has been a director of the Company since 1991. Eugene S. Pulliam has been the Publisher of The Indianapolis Star and The Indianapolis News since 1975 and President of Phoenix Newspapers, Inc. since 1979. He has been a director of the Company since 1954. Frank E. Russell has been President of the Company since 1979. He has been a director of the Company since 1974. Louis A. Weil, III has been Publisher of The Arizona Republic and The Phoenix Gazette and Executive Vice President of Phoenix Newspapers, Inc. since July 1991. Mr. Weil served as Publisher of Time from May 1989 to July 1991, and President and Publisher of The Detroit News from May 1987 to May 1989. Mr. Weil serves as a member of the Board of Directors of Global Government Plus Fund, Inc. as well as eleven investment companies within the Prudential family of mutual funds. He has been a director of the Company since 1991. Wayne D. Wallace has been Treasurer of the Company since October of 1989. Previously, he had been Assistant Treasurer of the Company since 1983. Each executive officer will serve as such until his successor is chosen and qualified. No family relationships exist among the Company's executive officers. Item 2. Item 2. Properties. The corporate headquarters of the Company are located at 135 North Pennsylvania Street, Indianapolis, Indiana. The general character, location and approximate size of the principal physical properties owned by the Company at the end of fiscal year 1993 are set forth below. In addition to those listed, the Company owns employee recreational facilities and other real estate aggregating approximately 130 acres. Approximate Area in Square Feet Printing plants, business and editorial offices and warehouse space Owned Leased Phoenix, Arizona 765,613 16,828 Mesa, Arizona 151,451 --- Indianapolis, Indiana 464,952 168,890 Muncie, Indiana 67,658 --- Vincennes, Indiana 14,000 --- Noblesville, Indiana 7,500 5,412 Carmel, Indiana 13,460 --- The Company believes that its current facilities and planned building projects are adequate to meet the needs of its newspapers. Item 3. Item 3. Legal Proceedings. The Company becomes involved from time to time in various claims and lawsuits incidental in the ordinary course of its business, including such matters as libel and invasion of privacy actions and is involved from time to time in various governmental and administrative proceedings. Management believes that the outcome of any pending claims or proceedings will not have a significant adverse effect on the Company and its subsidiaries, taken as a whole. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of shareholders during the quarter ended December 26, 1993 through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Markets for Registrant's Common Equity and Related Stockholder Matters. The information set forth under the caption "Shareholder Information" on page 31 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6. Item 6. Selected Financial Data. The information set forth under the caption "Selected Ten-Year Financial Data" on page 29 of the Company's 1993 Annual Report To Shareholders is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. The information set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" beginning on page 11 of the Company's 1993 Annual Report To Shareholders is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The Company's Consolidated Financial Statements and Notes thereto, together with the report thereon of Geo. S. Olive & Co. dated February 18, 1994, appearing on pages 14 through 28 of the Company's 1993 Annual Report To Shareholders, and the information contained under the heading "Quarterly Financial Information (unaudited)" on page 30 of such Annual Report are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated herein by reference is the information set forth under the captions "Election of Directors," on page 4 and "Committees of the Board of Directors and Compensation of Directors" on page 5 and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on page 12 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. See Part I, Item 1 of this report for information regarding the executive officers of the Company. Item 11. Item 11. Executive Compensation. Incorporated herein by reference is the information set forth under the captions "Compensation of Executive Officers" on page 6 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by reference is the information set forth under the captions "Voting Securities And Principal Holders Thereof" on page 1 and "Security Ownership of Management" on page 3 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. Item 13. Item 13. Certain Relationships and Related Transactions. Incorporated herein by reference is the information set forth under the captions "Transactions With Certain Related Persons" and "Compensation Committee Interlocks and Insider Participation" on page 12 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) List of Documents Included In This Report. 1. Financial Statements. The following financial statements are incorporated into this report by reference to the Company's 1993 Annual Report To Shareholders: (i) Independent Auditor's Report (ii) Consolidated Statement of Income for each of the three fiscal years in the period ended December 26, 1993 (iii) Consolidated Statement of Financial Position at December 26, 1993 and December 27, 1992 (iv) Consolidated Statement of Shareholders' Equity for each of the three fiscal years in the period ended December 26, 1993 (v) Consolidated Statement of Cash Flows for each of the three fiscal years in the period ended December 26, 1993 (vi) Notes to Consolidated Financial Statements 2. Supplementary Data and Financial Statement Schedules. (i) Incorporated herein by reference is the information set forth under the caption "Quarterly Financial Information (Unaudited)" appearing on page 30 of the Company's 1993 Annual Report To Shareholders (ii) The following financial statement schedules and report with respect thereto are filed as a part of this Report: Page in this filing Independent Auditor's Report on Financial Statement Schedules 18 Schedule V Property, Plant and Equipment 19 Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment 20 Schedule VIII Valuation Accounts 21 Schedule X Supplementary Income Statement Information 22 Schedules other than those referred to above have been omitted because they are not required or because the information is included elsewhere in the Consolidated Financial Statements of the Company. 3. Exhibits Required by Securities and Exchange Commission Regulation S-K. (i) The following exhibits are filed as a part of this report: Exhibit Number Description of Document 13 Portions of the 1993 Annual Report To Shareholders of Central Newspapers, Inc. incorporated by reference into the 1993 Annual Report on Form 10-K 21 Subsidiaries of the Registrant 23 Consent of Geo. S. Olive & Co. (ii) The following exhibits are incorporated herein by reference to documents previously filed with the Securities and Exchange Commission as indicated. Exhibit Number Description of Document 3.1 Amended and Restated Articles of Incorporation of Central Newspapers, Inc. (Filed August 10, 1989 with Form S- 1 Registration Statement, No. 33-30436) 3.2 Amended and Restated Code of By-Laws of Central Newspapers, Inc. (Filed with Form 10-K for year ended December 29, 1991) 4.1 Form of Certificate for Class A Common Stock (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33- 30436) 4.2 Indenture between Indianapolis Newspapers, Inc. and the Indiana Trust Company, as trustee, dated as of December 1, 1948 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) 10.1 Indenture creating the Eugene C. Pulliam Trust, dated as of December 9, 1965, as amended (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33- 30436) 10.2 Newsprint Purchase Agreement between Ponderay Newsprint Company and Phoenix Newspapers, Inc., dated as of November 18, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) *10.3 Amended and Restated Central Newspapers, Inc. Stock Option Plan (Filed with Form 10-K for year ended December 27, 1992) *10.4 The Phoenix Newspapers, Inc. Nonqualified Supplemental Retirement Plan (Filed with Form 10-K for year ended December 30, 1990) 10.5 Ponderay Newsprint Company Partnership Agreement between Lake Superior Forest Products Inc. and Central Newsprint Company, Inc. dated as of September 12, 1985 (Filed August 10, 1989 with Form S- 1 Registration Statement, No. 33-30436) 10.6 Amendment to Ponderay Newsprint Company Partnership Agreement between Lake Superior Forest Products Inc., Central Newsprint Company, Inc., Bradley Paper Company, Copley Northwest, Inc., Puller Paper Company, Newsprint Ventures, Inc., Wingate Paper Company, Tribune Newsprint Company and Nimitz Paper Company, dated as of June 30, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) 10.7 Guarantee by Central Newspapers, Inc. dated as November 18, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) *10.8 Termination Benefits Agreement dated as of as of August 1, 1991 between Phoenix Newspapers, Inc. and Louis A. Weil, III (Filed with Form 10-K for year ended December 27, 1992) *10.9 Phoenix Newspapers, Inc. Management by Objectives Program (Filed with Form 10-K for year ended December 27, 1992) *10.10 Form of Split-Dollar Life Insurance Agreement for Executive Officers between the Registrant and Malcolm W. Applegate, Wayne D. Wallace and Louis A. Weil, III (Filed with Form 10-K for year ended December 27, 1992) *10.11 Form of Split-Dollar Life Insurance Agreement for Outside Directors between the Registrant and Kent E. Agness, William A. Franke and Dan Quayle (Filed with Form 10-K for year ended December 27, 1992) *10.12 Form of Death Benefit Only Insurance Plan Agreement between the Registrant and Frank E. Russell, Eugene S. Pulliam and James C. Quayle (Filed with Form 10- K for year ended December 27, 1992) * Represents a contract, plan or arrangement providing for executive officer or director benefits. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Indianapolis, state of Indiana, on this 16th day of March, 1994. CENTRAL NEWSPAPERS, INC. By: /s/ Frank E. Russell -------------------------------- Frank E. Russell, President and Chief Executive 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 indicated on this 16th day of March, 1994. Signature Title (1) Principal Executive Officer President, Chief /s/ Frank E. Russell Executive Officer --------------------------- and a Director Frank E. Russell (2) Principal Financial and Accounting Officer /s/ Wayne D. Wallace Treasurer --------------------------- Wayne D. Wallace (3) A majority of the Board of Directors /s/ Kent E. Agness Director -------------------------- Kent E. Agness /s/ Malcolm W. Applegate Director -------------------------- Malcolm W. Applegate /s/ William A. Franke Director -------------------------- William A. Franke /s/ Eugene S. Pulliam Director -------------------------- Eugene S. Pulliam /s/ Dan Quayle Director -------------------------- Dan Quayle /s/ James C. Quayle Director -------------------------- James C. Quayle /s/ Louis A. Weil, III Director -------------------------- Louis A. Weil, III INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENT SCHEDULES Board of Directors and Shareholders Central Newspapers, Inc. We have audited the consolidated statement of financial position of Central Newspapers, Inc. and Subsidiaries as of December 26, 1993 and December 27, 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 26, 1993, and have issued our report dated February 18, 1994. Such financial statements and reports are included in the 1993 Annual Report To Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules listed under Item 14 (a)(2)(ii). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these schedules based on our audits. In our opinion, such financial statement schedules are fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ Geo. S. Olive & Co. - ------------------------- GEO. S. OLIVE & CO. Indianapolis, Indiana February 18, 1994 Schedule X CENTRAL NEWSPAPERS,INC. AND SUBSIDIARIES Supplementary Income Statement Information Column A Column B Amounts Charged to Costs and Expenses Fiscal Years Ended 52 Weeks 52 Weeks 52 Weeks December 29 December 27 December 26 Description 1991 1992 1993 Maintenance $ 3,834,721 $ 4,689,386 $ 5,128,116 Advertising Costs $ 4,725,153 $ 6,166,394 $ 5,913,739 Sales Taxes $ 3,669,552 $ 4,363,303 $ 5,193,813 Property Taxes $ 3,233,614 $ 5,889,001 $ 6,682,564

78890_1993.txt

78890_1993

1993

78890

Item 3: Legal Proceedings For a description of the Evergreen Case, see Items 1 and 2: "Pittston Minerals Group -- Description of Businesses -- Coal Operations -- Evergreen Case." Item 4: Item 4: Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following is a list as of March 15, 1994, of the names and ages of the executive and other officers of Pittston and the names and ages of certain officers of its subsidiaries, indicating the principal positions and offices held by each. There is no family relationship between any of the officers named. Name Age Positions and Offices Held Held Since Executive Officers Joseph C. Farrell 58 Chairman, President and Chief 1991 Executive Officer David L. Marshall 55 Vice Chairman of the Board 1990 Garold R. Spindler 46 Senior Vice President 1990 James B. Hartough 46 Vice President - Corporate Finance 1988 and Treasurer Frank T. Lennon 52 Vice President - Human Resources 1985 and Administration Gary R. Rogliano 42 Vice President - Controllership 1991 and Taxes Other Officers Karl K. Kindig 42 Vice President - Corporate Development 1991 Jack D. McDaniel 64 Vice President 1979 Michael E. Odom 42 Vice President - Special Projects 1991 Austin F. Reed 42 Vice President, General Counsel and 1994 Secretary Arthur E. Wheatley 51 Vice President and Director of Risk 1986 Management Subsidiary Officers Michael T. Dan 43 President and Chief Executive Officer 1993 of Brink's, Incorporated Peter A. Michel 51 President and Chief Executive Officer 1988 of Brink's Home Security, Inc. Garold R. Spindler 46 President and Chief Executive Officer 1990 of Pittston Coal Company Executive and other officers of Pittston are elected annually and serve at the pleasure of its Board of Directors. Mr. Farrell was elected to his present position effective October 1, 1991. From July 1990 through September 1991, he served as President and Chief Operating Officer of Pittston, and from 1984 to 1990, he served as Executive Vice President of Pittston. Mr. Marshall was elected Vice Chairman and Chief Financial Officer in July 1990 and resigned as Chief Financial Officer in February 1994. He remains as Vice Chairman of the Board and a director of Pittston. From 1984 to 1990, he served as Executive Vice President and Chief Financial Officer of Pittston. Mr. Marshall served as Chairman of Burlington Air Express Inc. from 1985 to February 1994. Mr. Spindler was elected President and Chief Executive Officer of Pittston Coal Company in October 1990. From 1986 to 1990 he served as President of Pyxis Resources Company, a subsidiary of Pittston. He was elected a Vice President of Pittston in 1986 and a Senior Vice President in July 1990. Mr. Kindig was elected Vice President - Corporate Development in October 1991. From 1990 to 1991 he served as Vice President and General Counsel of Pittston Coal Management Company, and from 1986 to 1990 he served as Counsel to Coal Operations. Mr. Odom was elected to his present position in October 1991. He served Pittston Coal Group, Inc. as President and Chief Executive Officer from 1989 to 1991 and as Executive Vice President - Operations from 1986 to 1989. Mr. Reed has served as Vice President and Secretary since September 1993 and was elected General Counsel in March 1994. Since 1989 he has served as General Counsel to Brink's, Incorporated and Burlington Air Express Inc. Mr. Rogliano was elected to his present position in October 1991. From 1986 to 1991, he served as Vice President and Director of Taxes of Pittston. Messrs. Hartough, Lennon, McDaniel and Wheatley have served in their present positions for more than the past five years. Mr. Dan was elected President and Chief Executive Officer of Brink's, Incorporated in July 1993. From August 1992 to July 1993 he served as President of North American operations of Brink's, Incorporated and as Executive Vice President of Brink's, Incorporated from 1985 to 1992. Mr. Michel was elected President and Chief Executive Officer of Brink's Home Security, Inc. in April 1988. From 1985 to 1987 he served as President and Chief Executive Officer of Penn Central Technical Security Company. PART II Item 5: Item 5: Market for Registrant's Common Equity and Related Shareholder Matters MARKET PRICES OF PITTSTON COMMON STOCK On July 26, 1993, the outstanding shares of the Company's common stock were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on a basis of one-fifth of one share of Minerals Stock for each share of the Company's common stock. The common stock prices represent the actual historical high and low market prices. When issued trading for Services Stock and Minerals Stock commenced on July 6, 1993. Services Stock and Minerals Stock are traded on the New York Stock Exchange under the ticker symbols "PZS" and "PZM", respectively. As of March 1, 1994, there were approximately 7,300 and 6,100 shareholders of record of Services Stock and Minerals Stock, respectively. Item 6: Item 6: Selected Financial Data THE PITTSTON COMPANY AND SUBSIDIARIES SELECTED FINANCIAL DATA (a) For purposes of computing net income (loss) per common share and book value per share for Pittston Services Group ("Services Group") and Pittston Minerals Group ("Minerals Group") for the periods prior to July 1, 1993, the number of shares of Pittston Services Group Common Stock ("Services Stock") are assumed to be the same as the total corresponding number of shares of The Pittston Company's (the "Company") common stock. The number of shares of Pittston Minerals Group Common Stock ("Minerals Stock") are assumed to equal one-fifth of the number of shares of the Company's common stock (Note 9). The initial dividends on the Services Stock and Minerals Stock were paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993, have been attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and Minerals Stock. (b) As of January 1, 1992, Brink's Home Security, Inc. elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase income (loss) before extraordinary credit and cumulative effect of accounting changes and net income of the Company and the Services Group by $2,435,000 or $.07 per share of Services Stock in 1993 and by $2,596,000 or $.07 per share of Services Stock in 1992. (c) Calculated based on the number of shares outstanding at end of the period excluding shares outstanding under the Company's Employee Benefits Trust (Note 9). PITTSTON SERVICES GROUP SELECTED FINANCIAL DATA The following Selected Financial Data reflects the results of operations and financial position of the businesses which comprise Pittston Services Group ("Services Group") and should be read in connection with the Services Group's financial statements. The financial information of the Services Group and Pittston Minerals Group ("Minerals Group") supplements the consolidated financial information of The Pittston Company and Subsidiaries (the "Company") and, taken together, includes all accounts which comprise the corresponding consolidated financial information of the Company. (a) For purposes of computing net income per common share and book value per share for the Service Group for the periods prior to July 1, 1993, the number of shares of Pittston Services Group Common Stock ("Services Stock") are assumed to be the same as the total corresponding number of shares of the Company's common stock. The initial dividend on Services Stock was paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993, have been attributed to the Services Group in relation to the initial dividend paid on the Services Stock. Book value per share is calculated based on the number of shares outstanding at the end of the period excluding 3,853,778 and 3,951,033 shares outstanding under the Company's Employee Benefits Trust at December 31, 1993 and 1992, respectively. Shares outstanding under the Company's Employee Benefits Trust are evaluated for inclusion in the evaluation of net income per share and have no dilutive effect (Note 1). (b) As of January 1, 1992, Brink's Home Security, Inc. ("BHS") elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase income before extraordinary credit and cumulative effect of accounting changes and net income of the Services Group by $2,435,000 or $.07 per share of Services Stock in 1993 and by $2,596,000 or $.07 per share of Services Stock in 1992. PITTSTON MINERALS GROUP SELECTED FINANCIAL DATA The following Selected Financial Data reflects the results of operations and financial position of the businesses which comprise Pittston Minerals Group ("Minerals Group") and should be read in connection with the Minerals Group's financial statements. The financial information of Minerals Group and Pittston Services Group ("Services Group") supplements the consolidated financial information of The Pittston Company and Subsidiaries (the "Company") and, taken together, includes all accounts which comprise the corresponding consolidated financial information of the Company. -2- (a) For purposes of computing net income per common share and book value per share for the Minerals Group for the periods prior to July 1, 1993, the number of shares of Pittston Minerals Group Common Stock ("Minerals Stock") are assumed to equal one-fifth of the number of shares of the Company's common stock. The initial dividend on Minerals Stock was paid on September 1, 1993. Dividends paid by the Company prior to September 1, 1993 have been attributed to the Minerals Group in relation to the initial dividend paid on the Minerals Stock. Book value per share is calculated based on the number of shares outstanding at the end of the period excluding 770,301 and 790,207 shares outstanding under the Company's Employee Benefits Trust at December 31, 1993 and 1992, respectively. Shares outstanding under the Company's Employee Benefits Trust are evaluated for inclusion in the calculation of net income per share and have no dilutive effect (Note 1). Item 7: Item 7: Management's Discussion and Analysis of Results of Operations and Financial Condition THE PITTSTON COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS Net income for 1993 was $14.1 million compared with $49.1 million for 1992. Operating profit totalled $26.1 million for 1993 compared with $89.5 million for 1992. Net income and operating profit for 1993 included restructuring and other charges of $48.9 million and $78.6 million, respectively, impacting Coal and Mineral Ventures operations. Consequently, these operations each reported operating losses for 1993, while each of The Pittston Company's (the "Company") services businesses, which include the operations of Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS"), reported improved operating earnings compared with 1992. Net income and operating profit for 1992 were positively impacted by a pension credit of $7.0 million and $11.1 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards ("SFAS") No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of the Company's employees since the date of adoption which expired at the end of 1992. In 1991, the Company had a net loss of $151.9 million and an operating loss of $33.9 million. The operating loss in 1991 included restructuring charges in the Coal segment of $115.2 million. Excluding the 1991 restructuring charges, operating profit in the Coal segment increased $5.8 million in 1992 compared with 1991. The combined operating profit of the Company's services businesses increased $3.3 million for the same period, with increased results for home security operations partially offset by decreased results for air freight operations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1992 by $2.6 million. The net loss for 1991 was due to the coal restructuring charges and to the net effect of two accounting changes adopted in 1991. The Company adopted the provisions of SFAS No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of SFAS No. 109 increased net income by $10.1 million in 1991, while the cumulative effect of SFAS No. 106 decreased net income by $133.1 million in 1991. BURLINGTON Operating profit of Burlington increased $22.9 million to $38.0 million in 1993 from $15.1 million in 1992. Worldwide revenues increased $97.8 million or 11% to $998.1 million in 1993 from $900.3 million in 1992. The increase in revenues primarily reflects volume increases only partially offset by lower average yields (revenues per pound). Total weight shipped worldwide for 1993 increased 14% to 1,020.4 million pounds from 893.0 million pounds in 1992. Operating expenses increased $76.2 million in 1993, while selling, general and administrative expenses decreased $.5 million in 1993 compared with the prior year. Selling, general and administrative expenses in 1992 were adversely affected by charges for costs related to organizational downsizing in both domestic and foreign operations. Higher operating expenses resulting from the increased volume of business in 1993 were, however, favorably impacted by increased efficiency in private fleet operations achieved as a result of a fleet upgrade to DC8-71 aircraft replacing B707 aircraft, accomplished by lease transactions at year-end 1992 and in early 1993. Two additional DC8-71's were added to the fleet during the fourth quarter of 1993, replacing less fuel efficient DC8-63 freighters. These aircraft meet Stage III noise regulations and provide the company with a significant increase in its lift capacity. During the 1993 fourth quarter Burlington also completed a 30% expansion of its airfreight hub in Toledo, Ohio. This expansion assists in achieving continuing efficiency gains, including higher average weight shipped per container. The increase in operating profit for 1993 compared with 1992 is attributable to increased Americas' operating profit of $22.0 million and increased foreign operating profit of $.9 million. The increase in Americas' operating profit was largely due to increased domestic and export volume and lower transportation costs per pound, partially offset by decreased average yields. Intra-Americas' volume increases resulted from strong electronics industry shipments as well as increased shipments from the health care industry, retail businesses and local accounts. While average yields decreased in 1993 compared with 1992 reflecting a highly competitive pricing environment, market improvement was evident during the last quarter of the year as load factors reached record levels throughout the industry. Burlington's operating profit decreased $4.7 million to $15.1 million in 1992 from $19.8 million in 1991 even though worldwide revenues increased $69.4 million or 8%. The increase in revenues reflected significant company-wide volume increases occurring principally during the latter part of 1992, offset by weaker average yields. The 1992 volume gains reflected recovering economic conditions. Yield declines resulted from a change in customer mix, due to a loss of high-yielding business with volume gains in lower-yielding accounts, and a change in product mix to an increased proportion of second-day business. The decline in operating profit, resulting from increased operating expenses which exceeded increased revenues is principally attributable to decreased Americas' operating profit of $8.3 million, which was only partially offset by increased foreign operating profit of $3.6 million. Americas' operating profit was adversely affected by decreased yields in 1992, only partially offset by volume gains. Operating profit of foreign subsidiaries increased $3.6 million in the aggregate to $12.5 million from $8.9 million in 1991 as improved results in the Far East more than offset declines in Europe. Operating profit in the Far East benefitted from volume increases despite pressures on yields. Operating profit in Europe was adversely impacted by the weakening in foreign currencies in relation to the U.S. dollar. However, margins in local currencies were maintained due to strong volumes, despite lower yields. In 1991, although operating expenses were adversely affected by $2.8 million of costs related to the move of Burlington's freight sorting hub from Fort Wayne, Indiana to Toledo Express Airport in Ohio, station costs and corporate support group costs were positively impacted by productivity gains. BRINK'S Operating profit of Brink's totalled $35.0 million in 1993 compared with $30.4 million in 1992. Worldwide operating revenues increased 9% or $37.9 million to $481.9 million with increased operating expenses and selling, general and administrative expenses of $31.7 million. Revenues increased for North American operations largely as a result of new business, but were partially offset by weak securities volumes for U.S. air courier operations. Operating expenses increased largely as a result of new business expansion, while selling, general and administrative expenses increased only slightly compared with the prior year. Other operating income decreased $1.5 million in 1993 almost entirely due to a $1.2 million decrease in equity earnings of foreign affiliates. Improved operating results from North American ground operations, air courier operations and international subsidiaries in 1993 compared with 1992 were partially offset by decreased equity earnings of foreign affiliates. North American ground operations had a 25% or $3.6 million operating profit improvement in 1993 compared with 1992 with increases in ATM, armored car and coin wrapping results, partially offset by a decrease in currency processing results. Air courier results increased $.5 million in 1993 largely due to high volume of precious metals exports, foreign currency shipments and new money shipments, which more than offset lower diamond and jewelry margins and the continued decline in the domestic securities business. Operating results for international subsidiaries increased $1.2 million compared with 1992, while equity earnings of foreign affiliates, included in operating profit decreased $1.2 million to $6.9 million in 1993 from $8.1 million in 1992. The increased results for international subsidiaries were largely attributable to earnings reported for operations in Brazil, partially offset by decreased results from a U.K. subsidiary. Operations in Brazil reported a $1.4 million operating profit in 1993 compared with a $.3 million operating loss in 1992. Although results were positive during 1993, operational and inflationary problems caused by the Brazilian economy make it uncertain as to whether this favorable trend in earnings will continue. Results in the U.K. were affected by competitive price pressures and recessionary pressures and were impacted by the cost of a labor settlement which will reduce future labor rates. In 1993, equity earnings of foreign affiliates were negatively impacted by substantially lower earnings of a 20% owned affiliate in Mexico. Operations in Mexico have been affected by a recessionary economy, new competitive pressures, losses from new business ventures and severance costs incurred in streamlining the work force. In 1992, Brink's operating profit increased $.4 million to $30.4 million from $30.0 million in 1991. Worldwide operating revenues increased 7% or $28.7 million to $444.0 million with increased operating expenses and selling, general and administrative expenses of $27.3 million and decreased other operating income of $1.0 million. Revenues increased for domestic operations as a result of new business, expansion of service with existing customers and increased specials work as a result of Hurricane Andrew. U.S. revenue increases were partially offset by decreases from Canada as a result of competitive pricing pressures as well as recessionary pressures. Operating costs increased as a result of providing new and expanded service for domestic customers, rising foreign labor costs and costs incurred for expansion in foreign markets. These operating cost increases were partially offset by benefits gained from domestic operating efficiencies. Increased operating results from foreign and North American ground operations of $2.2 million and $.3 million, respectively, were offset by a $2.1 million reduction in air courier profits. Operating profit of North American ground operations in 1992 increased 2% to $14.3 million from $14.0 million in 1991. Canadian operations continued to be adversely impacted by the weak economy and significant competitive pressures. The slight increase in North American operating profits was attributable to increases in armored car and coin wrapping results, almost entirely offset by decreases in ATM and currency processing results. Operating profit of domestic and international air courier operations in the aggregate declined by 44% to $2.7 million in 1992 from $4.8 million in 1991, as increases in international diamond and jewelry business were more than offset by reduced Canadian profits. Foreign subsidiaries had operating profit of $7.2 million in 1992 compared with $3.7 million in the prior year as increased results in Brazil, Israel and Chile more than offset an earnings decline in the United Kingdom. Although the operating loss for Brazil decreased $3.3 million in 1992 compared with 1991, operations in Brazil, while nearly breaking even, continued to be adversely impacted by cost and pricing pressures caused by a hyperinflationary economy. Operations in Israel benefitted from a growing share of local diamond shipments. Operations in the United Kingdom were affected by competitive price pressures as well as recessionary pressures. Equity earnings of foreign affiliates included in operating profit increased by $.5 million in 1992 to $8.1 million primarily due to higher operating results reported by an affiliate in France. Results from Brink's Mexican affiliate were strong, although 1992 results fell short of prior year earnings. While results for both subsidiaries and equity affiliates increased over the prior year, overhead expenses increased $2.0 million principally for costs related to tighter management oversight and expansion in European markets. BHS Operating profit of BHS aggregated $26.4 million in 1993 compared with $16.5 million in 1992 and $8.9 million in 1991. The $9.9 million increase in operating profit in 1993 compared with 1992 reflects increased monitoring margin of $11.6 million, partially offset by increased installation expenses of $.9 million and increased overhead costs of $.8 million. The $7.6 million increase in operating profits in 1992 compared with 1991 reflects increased monitoring margin of $7.8 million and reduced installation expenses of $2.5 million, partially offset by increased overhead costs of $2.7 million. The increased monitoring margin in 1993 as in 1992 was largely attributable to an expanding subscriber base which resulted in improved economies of scale and other cost efficiencies achieved in servicing BHS's subscribers. Monitoring margin in 1993 also benefitted from higher per subscriber revenues. At year-end 1993, BHS had approximately 259,600 subscribers, 44% more than the year-end 1991 subscriber base. New subscribers totalled 59,700 in 1993 and 51,300 in 1992. As a result, BHS's average subscriber base increased by 20% in 1993 and in 1992 when compared with each year prior. The increased installation expenses in 1993 compared with 1992 largely resulted from the increase in new installations. The reduced installation expenses in 1992 reflect a change in the capitalization rate for home security installations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs included as capitalized installation costs, which added $4.1 million and $4.3 million to operating profit in 1993 and 1992, respectively. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2.6 million and $2.3 million in 1993 and 1992, respectively) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1.5 million and $2.0 million in 1993 and 1992, respectively). The increase in the capitalization rate, while adding to current period profitability comparisons, defers recognition of expenses over the estimated useful life of the installed asset. The additional subscriber installation costs which are currently capitalized were expensed in prior years for subscribers in those years. Because capitalized subscriber installation costs for periods prior to January 1, 1992 were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in those periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and in 1992 was immaterial. While the amounts of the costs incurred which are capitalized vary based on current market and operating conditions, the types of such costs which are currently included in BHS's capitalization rate will not change. The change in the capitalization rate has no additional effect on current or future cash flows or liquidity. COAL Coal operations had a $48.2 million operating loss in 1993 compared with an operating profit of $36.9 million in 1992. Operating results in 1993 included a $70.7 million charge for closing costs for mines which were closed at the end of 1993 and scheduled closures of mines in early 1994, including employee benefit costs and certain other noncash charges, together with the estimated liability in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the United Mine Workers of America ("UMWA"). Excluding this charge, coal operating results decreased $14.4 million in 1993 compared with 1992. Operating income in 1993 was negatively impacted by $10.0 million in expenses relating to retiree health benefits required by federal legislation enacted in October 1992 and a $1.8 million charge to settle litigation related to the moisture content of tonnage used to compute royalty payments to the UMWA pension and benefit funds during the period ended February 1, 1988. Coal operating profit also included other operating income of $9.8 million in 1993 compared with $9.0 million in the year-earlier period primarily for third party royalties and sales of properties and equipment. Average margin (realization less current production costs of coal sold) in 1993 of $3.30 per ton decreased 6% or $.20 per ton for the current year, as a 4% or $1.29 per ton decrease in average realization was only partially offset by a 4% or $1.09 per ton decrease in average current production costs of coal sold. The decrease in average realization in 1993 reflected lower export pricing and a downward price revision on a key domestic utility contract. The decrease in average current production costs of coal sold in 1993 was mainly due to a higher proportion of production sourced from company surface mine operations. Sales volume of 22.0 million tons in 1993 was 6% higher than sales volume in the year earlier. Production totalled 17.1 million tons in 1993, which was slightly lower than production in 1992. In 1993, 54% of total production was derived from deep mines and 46% was derived from surface mines compared with 65% and 35% of deep and surface mine production, respectively, in 1992. The strike by the UMWA against certain coal producers in the eastern United States, which lasted throughout a significant portion of 1993, has been settled. None of the operations of the Company's coal subsidiaries were involved in the strike. As a result of the strike, the supply of metallurgical coal was appreciably reduced. However, Australian producers increased production to absorb the shortfall. The strike had little impact on coal operating profits during 1993 since a large proportion of production is under contract. Coal operations benefitted from improved spot prices for domestic steam coal on relatively small amounts of uncommitted tonnage available for this market. Steam coal prices, which had strengthened during the strike, however, have weakened since the strike has been settled. Competition in the export metallurgical coal market is expected to be strong for the contract year beginning April 1994. While the Company has not yet reached agreements with its principal metallurgical export coal customers for such contract year, certain Australian, Canadian and U.S. producers of metallurgical coal have recently agreed to price reductions of as much as U.S. $4.00 per metric ton for the upcoming contract year, further exacerbating the deteriorating conditions in the metallurgical coal market which have been evident for over a decade. These recent price settlements may require the Company to further reduce production and sales to the metallurgical coal market. Given these recent developments, and in light of the Company's long-standing strategy to reduce its exposure in the metallurgical coal market, the Company is actively reviewing the carrying value of its production assets to determine whether they are economically viable and whether the Company should accelerate the continuing implementation of this strategy. During early 1994, coal production was sharply impacted by severe weather conditions which affected much of the United States. These weather conditions also restricted trucking of coal to plants and terminals and impaired shipments from river terminals due to frozen harbors. On January 14, 1994, Coal operations completed the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. This acquisition is expected to add approximately 8.5 million tons of low sulphur steam coal sales and production and provide substantial additional reserves of surface minable low sulphur coal. The contracts acquired, some of which contain terms in excess of five years, will provide a broader base of domestic utility customers and reduce exposure in the export metallurgical market, where contract prices are renegotiated annually. The Company's principal labor agreement with the UMWA expires on June 30, 1994. In 1992, operating profit for coal was $36.9 million compared with an operating loss of $84.1 million in 1991. Operating results in 1991 included $115.2 million of restructuring charges primarily related to costs associated with mine shutdowns. Production was augmented in 1992 with the addition of a new surface mine in eastern Kentucky, the on-time start-up of the $11 million new Moss 3 preparation plant in September and success of the highwall mining systems utilized at the Heartland surface mine in West Virginia. Excluding the 1991 restructuring charges, operating results for the Coal segment increased $5.8 million in 1992 compared with 1991. Operating results in 1991 included gains of $5.8 million from the disposal of excess coal reserves. There were no comparable disposals in 1992. Operating profit in 1992 benefitted from a 2.9 million (16%) increase in tonnage sold largely due to shipments to utilities under coal sales contracts acquired in March 1992 and under a contract being supplied by the Company's Heartland mine which began operations in the fourth quarter of 1991. Average margin per ton improved nearly 2% in 1992 compared with 1991, due to a 3% or $.85 per ton decrease in average current production costs of coal sold per ton only partially offset by lower per ton realization. The decrease in average current production costs of coal sold per ton reflects the increase in tonnage sold, increased productivity and a change in production mix. In 1992, 65% of total production was derived from deep mines, and 35% of production was derived from surface mines compared with 76% and 24% of deep and surface mine production, respectively, in 1991. Operating profit in 1992 also benefitted from a $2.4 million reduction in federal and state black lung expenses due to favorable claims experience. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9.1 million and $11.0 million, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10 to $11 million range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. In February 1990, the Pittston Coal Group companies and the UMWA entered into a successor collective bargaining agreement that resolved a labor dispute and related strike of Pittston Coal Group operations by UMWA-represented employees that began on April 5, 1989. As part of the agreement, the Pittston Coal Group companies agreed to make a $10 million lump sum payment to the 1950 Benefit Trust Fund and to renew participation in the 1974 Pension and Benefit Trust Funds at specified contribution rates. These aspects of the agreement were subject to formal approval by the trustees of the funds. The trustees did not accept the terms of the agreement and, therefore, payments are being made to escrow accounts for the benefit of union employees. In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case. In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act, there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. MINERAL VENTURES Mineral Ventures was formed in 1989 to develop opportunities in minerals other than coal. Mineral Ventures operations reported an operating loss of $8.3 million for 1993. This loss includes a $7.9 million charge related to the write-down of the company's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Excluding the $7.9 million charge, Mineral Ventures operations incurred a $.4 million operating loss. Operating results for 1993 reflected production from the Stawell gold mine. In December 1992, Mineral Ventures acquired its ownership in the Stawell property through its participation in a joint venture with Mining Project Investors Pty Ltd., (in which Mineral Ventures holds a 34% interest). The Stawell gold mine, which is in western Victoria, Australia, currently has proved reserves for approximately four years of production and a current annual output of approximately 70,000 ounces. The joint venture also has exploration rights in the highly prospective district around the mine. Mineral Ventures has a 67% net equity interest in the Stawell mine and its adjacent exploration acreage. In 1993, the Stawell mine produced 73,765 ounces of gold with Mineral Ventures' share of the operating profit amounting to $4.9 million. The contribution to operating profit from the Stawell mine was offset by administrative overhead in addition to exploration expenditures related chiefly to other potential gold mining projects. Operating losses, which primarily related to expenses for project review and exploration, totalled $3.4 million in 1992 and $3.5 million in 1991. FOREIGN OPERATIONS A portion of the Company's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Company are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. The Company's international activity is not concentrated in any single currency, which limits the risks of foreign rate fluctuations. In addition, foreign currency rate fluctuations may adversely affect transactions which are denominated in currencies other than the functional currency. The Company routinely enters into such transactions in the normal course of its business. Although the diversity of its foreign operations limits the risks associated with such transactions, the Company uses foreign exchange forward contracts to hedge the risks associated with certain transactions denominated in currencies other than the functional currency. Realized and unrealized gains and losses on these contracts are deferred and recognized as part of the specific transaction hedged. At December 31, 1993, the Company held foreign exchange forward contracts of approximately $4.6 million. In addition, cumulative translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains or losses for the period. Brink's subsidiaries in Brazil and Israel operate in such highly inflationary economies. Additionally, the Company is subject to other risks customarily associated with doing business in foreign countries, including economic conditions, controls on repatriation of earnings and capital, nationalization, expropriation and other forms of restrictive action by local governments. The future effects, if any, of such risks on the Company cannot be predicted. OTHER OPERATING INCOME Other operating income increased $.9 million to $20.0 million in 1993 from $19.1 million in 1992 and decreased $11.1 million in 1992 from $30.2 million in 1991. Other operating income principally includes the Company's share of net income of unconsolidated foreign affiliates, which are substantially attributable to equity affiliates of Brink's, and royalty income from coal and natural gas properties. Equity earnings of foreign affiliates totalled $7.5 million, $8.0 million and $7.7 million in 1993, 1992 and 1991, respectively. In 1991, other operating income also included gains aggregating $5.8 million from the disposal of certain excess coal reserves. CORPORATE AND OTHER EXPENSES General corporate expenses were comparable for 1993, 1992 and 1991 and aggregated $16.7 million, $17.1 million and $16.1 million, respectively, in those years. Other income (expense), net was a net expense of $4.6 million in 1993, a net expense of $4.0 million in 1992 and net income of $9.8 million in 1991. The net amounts in 1992 and 1991 included gains of $2.3 million and $11.1 million, respectively, from the sales of investments in leveraged leases. INTEREST EXPENSE Interest expense totalled $10.2 million, $11.1 million and $15.9 million for 1993, 1992 and 1991, respectively. The $1.1 million decrease for 1993 compared with 1992 was largely a result of lower interest rates worldwide. The $4.8 million decrease in interest expense for 1992 compared with 1991 was principally due to lower average interest rates during 1992. TAXES AND EXTRAORDINARY CREDITS In 1993, the provision for income taxes is less than the statutory federal income tax rate of 35% due to the tax benefits of percentage depletion, favorable adjustments to the Company's deferred tax assets as a result of the increase in the statutory U.S. federal income tax rate and a reduction in the valuation allowance for deferred tax assets primarily in foreign jurisdictions. These benefits were partially offset by state income taxes and goodwill amortization. In 1992, the provision for income taxes exceeded the statutory federal income tax rate of 34% primarily due to provisions for state income taxes, goodwill amortization and the increase in the valuation allowance for deferred tax assets. In 1991, the credit for income taxes was less than the amount that would have been recognized using the statutory federal income tax rate of 34% since provisions for state income taxes, taxes on foreign earnings and goodwill amortization were in excess of the tax benefit from percentage depletion. Based on the Company's historical and expected taxable earnings, management believes it is more likely than not that the Company will realize the benefit of the existing deferred tax asset at December 31, 1993. FINANCIAL CONDITION CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operating activities for 1993 totalled $119.9 million compared with $124.8 million in 1992. Cash required to support the Company's investing and financing activities was less than cash generated from operations and, as a result, there were net repayments of debt in 1993 of $30.2 million and cash and cash equivalents increased $2.1 million during 1993. Net income, noncash charges and changes in operating assets and liabilities in 1993 were significantly affected by after-tax restructuring and other charges of $48.9 million which had no effect in 1993 on cash generated by operations. Of the total amount of the 1993 charges, $10.8 million was for noncash write-downs of assets and the remainder represents liabilities, of which $7.0 million are expected to be paid in 1994. The Company intends to fund any cash requirements during 1994 with anticipated cash flows from operations, with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. CAPITAL EXPENDITURES Cash capital expenditures totalled $97.8 million in 1993. An additional $64.0 million was financed through capital and operating leases. Approximately 40% of the gross capital expenditures in 1993 were incurred in the Coal segment. Of that amount, greater than 40% of the expenditures was for business expansion, and the remainder was for replacement and maintenance of current ongoing business operations. Expenditures made by Mineral Ventures approximated 2% of the Company's total capital expenditures and were primarily costs incurred for project development. Capital expenditures made by both Burlington and Brink's during 1993 were primarily for replacement and maintenance of current ongoing business operations and comprised approximately 21% and 19%, respectively, of the Company's total. Expenditures incurred by BHS during 1993 were 18% of total expenditures and were primarily for customer installations, representing the expansion in the subscriber base. OTHER INVESTING ACTIVITIES All other investing activities in 1993 provided cash of $11.8 million. In 1993, the Company sold assets of a coal subsidiary, from which cash, net of any expenses related to the transaction, totalled $9.7 million. Disposal of property, plant and equipment also provided $4.6 million in cash in 1993. In January 1994, the Company paid $157 million in cash for the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. (the "Addington Acquisition"). The purchase price of the acquisition was financed through the issuance of $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, and additional debt under existing revolving credit facilities. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Company intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, there was $2.1 million in borrowings outstanding under these agreements. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Net cash repayments of outstanding debt totalled $30.2 million in 1993 with total debt outstanding amounting to $75.8 million at year-end. The availability of funds for the repayment of debt in 1993 was largely due to $22.3 million of cash generated from operating activities in excess of the net requirement for investing activities and payment of cash dividends. Proceeds from exercise of stock options provided additional cash of $14.8 million in 1993. Subsequent to December 31, 1993, the Company financed the Addington Acquisition in part with debt under revolving credit facilities. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility. CONTINGENT LIABILITIES In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one- fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group"), respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the approval of the Services Stock Proposal, capitalization of the Company has been affected by the share activity related to each of the classes of common stock. As of December 31, 1993, debt as a percent of total capitalization (total debt and shareholders' equity) was 18%, decreasing from 23% at December 31, 1992 largely due to decreased revolving credit debt at the end of 1993. In July 1993, the Company's Board of Directors (the "Board") authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. Under the new share repurchase program through December 31, 1993, 19,000 shares of Minerals Stock was repurchased at a total cost of $.4 million. There were no repurchases of Services Stock during 1993. In January 1994, the Company issued $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of the Addington Acquisition. DIVIDENDS The Board intends to declare and pay dividends on Services Stock and Minerals Stock based on the earnings, financial condition, cash flow and business requirements of the Services Group and the Minerals Group, respectively. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses by one Group could affect the Company's ability to pay dividends in respect of stock relating to the other Group. Dividends on Minerals Stock are also limited by the Available Minerals Dividend Amount as defined in the Company's Articles of Incorporation. At December 31, 1993, the Available Minerals Dividend Amount was at least $10.1 million. After giving effect to the issuance of the convertible preferred stock, the pro forma Available Minerals Dividend Amount would have been at least $85.6 million. On an equivalent basis, in 1993 the Company paid dividends of 62.04 cents per share of Minerals Stock and 19.09 cents per share of Services Stock compared with 49.24 cents per share of Minerals Stock and 15.15 cents per share of Services Stock in 1992. In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the Addington Acquisition. Commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Company's Board of Directors. Such stock bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Company is required to implement a new accounting standard for postemployment benefits - SFAS No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Company has determined that the cumulative effect of adopting SFAS No. 112 is immaterial. The Company is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Company has determined that the cumulative effect of adopting SFAS No. 115 is immaterial. PITTSTON SERVICES GROUP MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The financial statements of the Pittston Services Group (the "Services Group") include the balance sheets, results of operations and cash flows of Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS"), and a portion of The Pittston Company's (the "Company") corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment. The Services Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The accounting policies applicable to the preparation of the Services Group's financial statements may be modified or rescinded at the sole discretion of the Company's Board of Directors (the "Board") without the approval of the shareholders, although there is no intention to do so. The Company will provide to holders of Pittston Services Group Common Stock ("Services Stock") separate financial statements, financial reviews, descriptions of business and other relevant information for the Services Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Pittston Minerals Group (the "Minerals Group") and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Services Group's financial statements. The following discussion is a summary of the key factors management considers necessary in reviewing the Services Group's results of operations, liquidity and capital resources. This discussion should be read in conjunction with the financial statements and related notes of the Company. RESULTS OF OPERATIONS Net income for the Services Group for 1993 was $47.1 million compared with $27.3 million for 1992. Operating profit for 1993 was $89.9 million compared with $57.4 million in the prior year. Each of the segments in the Services Group contributed to the increase in operating profit for the current year compared with the prior year. Net income and operating profit in 1992 were positively impacted by a pension credit of $2.5 million and $4.0 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of employees since the date of adoption, which expired at the end of 1992. Revenues for 1993 increased $153.9 million compared with 1992, of which $97.7 million was from Burlington, $37.9 million was from Brink's and $18.3 million was from BHS. Operating expenses and selling, general and administrative expenses for 1993 increased $116.7 million, of which $75.7 million was from Burlington, $31.7 million was from Brink's, $8.3 million was from BHS and $1.0 million was due to an increase in the allocation of corporate expenses. In 1992, net income increased $6.1 million to $27.3 million from $21.2 million in 1991. Operating profit for 1992 was $57.4 million compared with operating profit of $54.7 million in 1991. The $2.7 million increase in operating profit is attributable to an increase in results for BHS partially offset by decreased results for Burlington. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installation to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1992 by $2.6 million. Combined revenues for 1992 increased by $112.9 million, of which $69.4 million was attributable to Burlington, $28.7 million was attributable to Brink's and $14.8 million was attributable to BHS. Operating expenses and selling, general and administrative expenses for 1992 increased $109.6 million, of which $74.6 million was attributable to Burlington, $27.3 million was attributable to Brink's, $7.2 million was attributable to BHS and $.5 million was attributable to an increase in the allocation of corporate expenses. BURLINGTON Operating profit of Burlington increased $22.9 million to $38.0 million in 1993 from $15.1 million in 1992. Worldwide revenues increased $97.8 million or 11% to $998.1 million in 1993 from $900.3 million in 1992. The increase in revenues primarily reflects volume increases only partially offset by lower average yields (revenues per pound). Total weight shipped worldwide for 1993 increased 14% to 1,020.4 million pounds from 893.0 million pounds in 1992. Operating expenses increased $76.2 million in 1993, while selling, general and administrative expenses decreased $.5 million in 1993 compared with the prior year. Selling, general and administrative expenses in 1992 were adversely affected by charges for costs related to organizational downsizing in both domestic and foreign operations. Higher operating expenses resulting from the increased volume of business in 1993 were, however, favorably impacted by increased efficiency in private fleet operations achieved as a result of a fleet upgrade to DC8-71 aircraft replacing B707 aircraft, accomplished by lease transactions at year-end 1992 and in early 1993. Two additional DC8-71's were added to the fleet during the fourth quarter of 1993, replacing less fuel efficient DC8-63 freighters. These aircraft meet Stage III noise regulations and provide the company with a significant increase in its lift capacity. During the 1993 fourth quarter Burlington also completed a 30% expansion of its airfreight hub in Toledo, Ohio. This expansion assists in achieving continuing efficiency gains, including higher average weight shipped per container. The increase in operating profit for 1993 compared with 1992 is attributable to increased Americas' operating profit of $22.0 million and increased foreign operating profit of $.9 million. The increase in Americas' operating profit was largely due to increased domestic and export volume and lower transportation costs per pound, partially offset by decreased average yields. Intra-Americas' volume increases resulted from strong electronics industry shipments as well as increased shipments from the health care industry, retail businesses and local accounts. While average yields decreased in 1993 compared with 1992 reflecting a highly competitive pricing environment, market improvement was evident during the last quarter of the year as load factors reached record levels throughout the industry. Burlington's operating profit decreased $4.7 million to $15.1 million in 1992 from $19.8 million in 1991 even though worldwide revenues increased $69.4 million or 8%. The increase in revenues reflected significant company-wide volume increases occurring principally during the latter part of 1992, offset by weaker average yields. The 1992 volume gains reflected recovering economic conditions. Yield declines resulted from a change in customer mix, due to a loss of high-yielding business with volume gains in lower-yielding accounts, and a change in product mix to an increased proportion of second-day business. The decline in operating profit, resulting from increased operating expenses which exceeded increased revenues is principally attributable to decreased Americas' operating profit of $8.3 million, which was only partially offset by increased foreign operating profit of $3.6 million. Americas' operating profit was adversely affected by decreased yields in 1992, only partially offset by volume gains. Operating profit of foreign subsidiaries increased $3.6 million in the aggregate to $12.5 million from $8.9 million in 1991 as improved results in the Far East more than offset declines in Europe. Operating profit in the Far East benefitted from volume increases despite pressures on yields. Operating profit in Europe was adversely impacted by the weakening in foreign currencies in relation to the U.S. dollar. However, margins in local currencies were maintained due to strong volumes, despite lower yields. In 1991, although operating expenses were adversely affected by $2.8 million of costs related to the move of Burlington's freight sorting hub from Fort Wayne, Indiana to Toledo Express Airport in Ohio, station costs and corporate support group costs were positively impacted by productivity gains. BRINK'S Operating profit of Brink's totalled $35.0 million in 1993 compared with $30.4 million in 1992. Worldwide operating revenues increased 9% or $37.9 million to $481.9 million with increased operating expenses and selling, general and administrative expenses of $31.7 million. Revenues increased for North American operations largely as a result of new business, but were partially offset by weak securities volumes for U.S. air courier operations. Operating expenses increased largely as a result of new business expansion, while selling, general and administrative expenses increased only slightly compared with the prior year. Other operating income decreased $1.5 million in 1993 almost entirely due to a $1.2 million decrease in equity earnings of foreign affiliates. Improved operating results from North American ground operations, air courier operations and international subsidiaries in 1993 compared with 1992 were partially offset by decreased equity earnings of foreign affiliates. North American ground operations had a 25% or $3.6 million operating profit improvement in 1993 compared with 1992 with increases in ATM, armored car and coin wrapping results, partially offset by a decrease in currency processing results. Air courier results increased $.5 million in 1993 largely due to high volume of precious metals exports, foreign currency shipments and new money shipments, which more than offset lower diamond and jewelry margins and the continued decline in the domestic securities business. Operating results for international subsidiaries increased $1.2 million compared with 1992, while equity earnings of foreign affiliates, included in operating profit decreased $1.2 million to $6.9 million in 1993 from $8.1 million in 1992. The increased results for international subsidiaries were largely attributable to earnings reported for operations in Brazil, partially offset by decreased results from a U.K. subsidiary. Operations in Brazil reported a $1.4 million operating profit in 1993 compared with a $.3 million operating loss in 1992. Although results were positive during 1993, operational and inflationary problems caused by the Brazilian economy make it uncertain as to whether this favorable trend in earnings will continue. Results in the U.K. were affected by competitive price pressures and recessionary pressures and were impacted by the cost of a labor settlement which will reduce future labor rates. In 1993, equity earnings of foreign affiliates were negatively impacted by substantially lower earnings of a 20% owned affiliate in Mexico. Operations in Mexico have been affected by a recessionary economy, new competitive pressures, losses from new business ventures and severance costs incurred in streamlining the work force. In 1992, Brink's operating profit increased $.4 million to $30.4 million from $30.0 million in 1991. Worldwide operating revenues increased 7% or $28.7 million to $444.0 million with increased operating expenses and selling, general and administrative expenses of $27.3 million and decreased other operating income of $1.0 million. Revenues increased for domestic operations as a result of new business, expansion of service with existing customers and increased specials work as a result of Hurricane Andrew. U.S. revenue increases were partially offset by decreases from Canada as a result of competitive pricing pressures as well as recessionary pressures. Operating costs increased as a result of providing new and expanded service for domestic customers, rising foreign labor costs and costs incurred for expansion in foreign markets. These operating cost increases were partially offset by benefits gained from domestic operating efficiencies. Increased operating results from foreign and North American ground operations of $2.2 million and $.3 million, respectively, were offset by a $2.1 million reduction in air courier profits. Operating profit of North American ground operations in 1992 increased 2% to $14.3 million from $14.0 million in 1991. Canadian operations continued to be adversely impacted by the weak economy and significant competitive pressures. The slight increase in North American operating profits was attributable to increases in armored car and coin wrapping results, almost entirely offset by decreases in ATM and currency processing results. Operating profit of domestic and international air courier operations in the aggregate declined by 44% to $2.7 million in 1992 from $4.8 million in 1991, as increases in international diamond and jewelry business were more than offset by reduced Canadian profits. Foreign subsidiaries had operating profit of $7.2 million in 1992 compared with $3.7 million in the prior year as increased results in Brazil, Israel and Chile more than offset an earnings decline in the United Kingdom. Although the operating loss for Brazil decreased $3.3 million in 1992 compared with 1991, operations in Brazil, while nearly breaking even, continued to be adversely impacted by cost and pricing pressures caused by a hyperinflationary economy. Operations in Israel benefitted from a growing share of local diamond shipments. Operations in the United Kingdom were affected by competitive price pressures as well as recessionary pressures. Equity earnings of foreign affiliates included in operating profit increased by $.5 million in 1992 to $8.1 million primarily due to higher operating results reported by an affiliate in France. Results from Brink's Mexican affiliate were strong, although 1992 results fell short of prior year earnings. While results for both subsidiaries and equity affiliates increased over the prior year, overhead expenses increased $2.0 million principally for costs related to tighter management oversight and expansion in European markets. BHS Operating profit of BHS aggregated $26.4 million in 1993 compared with $16.5 million in 1992 and $8.9 million in 1991. The $9.9 million increase in operating profit in 1993 compared with 1992 reflects increased monitoring margin of $11.6 million, partially offset by increased installation expenses of $.9 million and increased overhead costs of $.8 million. The $7.6 million increase in operating profits in 1992 compared with 1991 reflects increased monitoring margin of $7.8 million and reduced installation expenses of $2.5 million, partially offset by increased overhead costs of $2.7 million. The increased monitoring margin in 1993 as in 1992 was largely attributable to an expanding subscriber base which resulted in improved economies of scale and other cost efficiencies achieved in servicing BHS's subscribers. Monitoring margin in 1993 also benefitted from higher per subscriber revenues. At year-end 1993, BHS had approximately 259,600 subscribers, 44% more than the year-end 1991 subscriber base. New subscribers totalled 59,700 in 1993 and 51,300 in 1992. As a result, BHS's average subscriber base increased by 20% in 1993 and in 1992 when compared with each year prior. The increased installation expenses in 1993 compared with 1992 largely resulted from the increase in new installations. The reduced installation expenses in 1992 reflect a change in the capitalization rate for home security installations. As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs included as capitalized installation costs, which added $4.1 million and $4.3 million to operating profit in 1993 and 1992, respectively. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2.6 million and $2.3 million in 1993 and 1992, respectively) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1.5 million and $2.0 million in 1993 and 1992, respectively). The increase in the capitalization rate, while adding to current period profitability comparisons, defers recognition of expenses over the estimated useful life of the installed asset. The additional subscriber installation costs which are currently capitalized were expensed in prior years for subscribers in those years. Because capitalized subscriber installation costs for periods prior to January 1, 1992 were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in those periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and in 1992 was immaterial. While the amounts of the costs incurred which are capitalized vary based on current market and operating conditions, the types of such costs which are currently included in BHS's capitalization rate will not change. The change in the capitalization rate has no additional effect on current or future cash flows or liquidity. FOREIGN OPERATIONS A significant portion of the Services Group's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Services Group are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. The Services Group's international activity is not concentrated in any single currency, which limits the risks of foreign rate fluctuation. In addition, foreign currency rate fluctuations may adversely affect transactions which are denominated in currencies other than the functional currency. The Services Group routinely enters into such transactions in the normal course of its business. Although the diversity of its foreign operations limits the risks associated with such transactions, the Company, on behalf of the Services Group, uses foreign exchange forward contracts to hedge the risk associated with certain transactions denominated in currencies other than the functional currency. Realized and unrealized gains and losses on these contracts are deferred and recognized as part of the specific transaction hedged. At December 31, 1993, the Company held, on behalf of the Services Group, foreign exchange forward contracts of approximately $4.6 million. In addition, cumulative translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains or losses for the period. Brink's subsidiaries in Brazil and Israel operate in such highly inflationary economies. Additionally, the Services Group is subject to other risks customarily associated with doing business in foreign countries, including economic conditions, controls on repatriation of earnings and capital, nationalization, expropriation and other forms of restrictive action by local governments. The future effects, if any, of such risks on the Services Group cannot be predicted. CORPORATE EXPENSES A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Services Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Services Group operated on a stand alone basis. These allocations were $9.5 million, $8.6 million and $8.0 million in 1993, 1992 and 1991, respectively. OTHER OPERATING INCOME Other operating income decreased $.6 million to $9.7 million in 1993 from $10.3 million in 1992 and decreased $.5 million in 1992 from $10.8 million in 1991. Other operating income consists primarily of equity earnings of foreign affiliates. These earnings, which are primarily attributable to equity affiliates of Brink's, amounted to $7.0 million, $8.2 million and $7.7 million 1993, 1992 and 1991, respectively. OTHER INCOME (EXPENSE), NET Other income (expense), net improved by $1.9 million to a net expense of $4.1 million in 1993 from a net expense of $6.0 million in 1992. In 1992, other income (expense), net decreased by $4.6 million to a net expense of $6.0 million from a net expense of $1.4 million a year earlier. In 1992, other income (expense), net included losses on asset sales. Other changes for the comparable periods are largely due to fluctuations in foreign translation losses. INTEREST EXPENSE Interest expense for 1993 increased $1.2 million to $8.8 million from $7.6 million in 1992 and in 1992 interest expense decreased $6.4 million from $14.0 million a year earlier. The decrease in 1992 compared to 1991 was principally due to lower average interest rates during the year. TAXES AND EXTRAORDINARY CREDITS In 1993 and 1992, the provision for income taxes exceeded the statutory federal income tax rate of 35% in 1993 and 34% in 1992 primarily because of provisions for state income taxes and goodwill amortization. In 1991, the provision for income taxes exceeded the statutory federal income tax rate of 34% primarily because of provisions for state income taxes, taxes on foreign earnings and goodwill amortization. FINANCIAL CONDITION A portion of the Company's corporate assets and liabilities has been attributed to the Services Group based upon utilization of the shared services from which assets and liabilities are generated, which management believes to be equitable and a reasonable estimate of the assets and liabilities which would be generated if the Services Group operated on a stand alone basis. Corporate assets which were allocated to the Services Group consisted primarily of pension assets and deferred income taxes and amounted to $33.5 million and $36.0 million at December 31, 1993 and 1992, respectively. CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operations totalled $91.4 million in 1993, an $11.9 million increase compared with $79.4 million generated by operations in 1992. The net increase in 1993 compared with 1992 consisted of a $19.8 million increase in net income and a $10.5 million increase attributable to a change in noncash charges and credits, partially offset by $18.4 million in additional requirements to fund operating assets and liabilities. Cash generated from operations of the Services Group exceeded cash requirements for investing and financing activities and, as a result, cash and cash equivalents increased $1.9 million during 1993 to a year-end total of $30.3 million. CAPITAL EXPENDITURES Cash capital expenditures totalled $76.0 million in 1993. An additional $18.5 million was financed through capital and operating leases. A substantial portion of the Services Group's total cash capital expenditures was attributable to BHS customer installations representing the expansion in the subscriber base. Of the total cash capital expenditures, $26.4 million or 35% related to these costs. Capital expenditures made by both Burlington and Brink's during 1993 were primarily for replacement and maintenance of current ongoing business operations. Cash capital expenditures for 1993 were funded by cash flow from operating activities, with any shortfalls financed through the Company by borrowings under its revolving credit agreements or short-term borrowing arrangements, which were thereby attributed to the Services Group. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Services Group intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements or borrowings from the Minerals Group. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, there was $2.1 million in borrowings outstanding under these agreements which was attributed to the Services Group. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Total debt outstanding for the Services Group amounted to $88.8 million at year-end 1993, including $13.3 million payable to the Minerals Group. During 1993, cash generated from operations exceeded requirements for investing activities and as a result, net debt repayments totalled $17.0 million. CONTINGENT LIABILITIES Under the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act"), the Company and its majority-owned subsidiaries at July 20, 1992, including the Services Group are jointly and severally liable with the Minerals Group for the costs of health care coverage provided for by that Act. For a description of the Health Benefit Act and a calculation of certain of such costs, see Note 13 to the Company's consolidated financial statements. At this time, the Company expects the Minerals Group to generate sufficient cash flow to discharge its obligations under the Act. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Pittston Mineral Group Common Stock ("Minerals Stock), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the approval of the Services Stock Proposal, capitalization of the Services Group has been affected by all share activity related to Services Stock. In July 1993, the Board authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. There were no repurchases of Services Stock during 1993 under the new share repurchase program. DIVIDENDS The Board intends to declare and pay dividends on Services Stock based on the earnings, financial condition, cash flow and business requirements of the Services Group. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses by the Minerals Group could affect the Company's ability to pay dividends in respect of stock relating to the Services Group. On an equivalent basis, in 1993 the Company paid dividends of 19.09 cents per share of Services Stock compared with 15.15 cents per share of Services Stock in 1992. In January 1994, the Company issued 161,000 shares or $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of a coal acquisition. While the issuance of the preferred stock had no effect on the capitalization of the Services Group, commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, out of all funds of the Company legally available therefor, when, as and if declared by the Board. Such stock also bears a liquidation preference of $500 per share plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Services Group is required to implement a new accounting standard for postemployment benefits - Statement of Financial Accounting Standards ("SFAS") No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Services Group has determined that the cumulative effect of adopting SFAS No. 112 is immaterial. The Company is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Services Group has determined that the cumulative effect of adopting SFAS No. 115 is immaterial. PITTSTON MINERALS GROUP MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The financial statements of the Pittston Minerals Group (the "Minerals Group") include the balance sheets, results of operations and cash flows of the Coal and Mineral Ventures operations of The Pittston Company (the "Company"), and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment. The Minerals Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The accounting policies applicable to the preparation of the Minerals Group's financial statements may be modified or rescinded at the sole discretion of the Company's Board of Directors (the "Board") without the approval of the shareholders, although there is no intention to do so. The Company will provide to holders of the Pittston Minerals Group Common Stock ("Minerals Stock") separate financial statements, financial reviews, descriptions of business and other relevant information for the Minerals Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Pittston Services Group (the "Services Group") for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Minerals Group's financial statements. The following discussion is a summary of the key factors management considers necessary in reviewing the Minerals Group's results of operations, liquidity and capital resources. This discussion should be read in conjunction with the financial statements and related notes of the Company. RESULTS OF OPERATIONS In 1993, the Minerals Group had a net loss of $33.0 million compared with net income of $21.8 million for 1992. In 1993, the Minerals Group had an operating loss of $63.8 million compared with an operating profit of $32.1 million for 1992. Net income and operating profit for 1993 included restructuring and other charges totalling $48.9 million and $78.6 million, respectively. The charges impacted both Coal and Mineral Ventures operations, and consequently, these operations each reported operating losses for 1993. Net income and operating profit for 1992 were positively impacted by a pension credit of $4.4 million and $7.0 million, respectively, relating to the amortization of the unrecognized initial net pension asset at the date of adoption of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", which was recognized over the estimated remaining average service life of the Company's employees since the date of adoption which expired at the end of 1992. Net income for 1992 was $21.8 million compared with a net loss of $173.0 million for 1991. Operating profit for 1992 was $32.1 million compared with an operating loss of $88.6 million in 1991. The operating loss in 1991 included restructuring charges for Coal operations of $115.2 million. Excluding the 1991 restructuring charges, operating profit increased $5.5 million in 1992 compared with 1991. The net loss for 1991 was due to the coal restructuring charges and to the net effect of two accounting changes adopted in 1991. The Minerals Group adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of SFAS No. 109 increased net income by $6.4 million in 1991, while the cumulative effect of SFAS No. 106 decreased net income by $129.7 million in 1991. COAL Coal operations had a $48.2 million operating loss in 1993 compared with an operating profit of $36.9 million in 1992. Operating results in 1993 included a $70.7 million charge for closing costs for mines which were closed at the end of 1993 and scheduled closures of mines in early 1994, including employee benefit costs and certain other noncash charges, together with the estimated liability in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the United Mine Workers of America ("UMWA"). Excluding this charge, coal operating results decreased $14.4 million in 1993 compared with 1992. Operating income in 1993 was negatively impacted by $10.0 million in expenses relating to retiree health benefits required by federal legislation enacted in October 1992 and a $1.8 million charge to settle litigation related to the moisture content of tonnage used to compute royalty payments to the UMWA pension and benefit funds during the period ended February 1, 1988. Coal operating profit also included other operating income of $9.8 million in 1993 compared with $9.0 million in the year-earlier period primarily for third party royalties and sales of properties and equipment. Average margin (realization less current production costs of coal sold) in 1993 of $3.30 per ton decreased 6% or $.20 per ton for the current year, as a 4% or $1.29 per ton decrease in average realization was only partially offset by a 4% or $1.09 per ton decrease in average current production costs of coal sold. The decrease in average realization in 1993 reflected lower export pricing and a downward price revision on a key domestic utility contract. The decrease in average current production costs of coal sold in 1993 was mainly due to a higher proportion of production sourced from company surface mine operations. Sales volume of 22.0 million tons in 1993 was 6% higher than sales volume in the year earlier. Production totalled 17.1 million tons in 1993, which was slightly lower than production in 1992. In 1993, 54% of total production was derived from deep mines and 46% was derived from surface mines compared with 65% and 35% of deep and surface mine production, respectively, in 1992. The strike by the UMWA against certain coal producers in the eastern United States, which lasted throughout a significant portion of 1993, has been settled. None of the operations of the Company's coal subsidiaries were involved in the strike. As a result of the strike, the supply of metallurgical coal was appreciably reduced. However, Australian producers increased production to absorb the shortfall. The strike had little impact on coal operating profits during 1993 since a large proportion of production is under contract. Coal operations benefitted from improved spot prices for domestic steam coal on relatively small amounts of uncommitted tonnage available for this market. Steam coal prices, which had strengthened during the strike, however, have weakened since the strike has been settled. Competition in the export metallurgical coal market is expected to be strong for the contract year beginning April 1994. While the Minerals Group has not yet reached agreements with its principal metallurgical export coal customers for such contract year, certain Australian, Canadian and U.S. producers of metallurgical coal have recently agreed to price reductions of as much as U.S. $4.00 per metric ton for the upcoming contract year, further exacerbating the deteriorating conditions in the metallurgical coal market which have been evident for over a decade. These recent price settlements may require the Minerals Group to further reduce production and sales to the metallurgical coal market. Given these recent developments and in light of the Company's long-standing strategy to reduce its exposure in the metallurgical coal market, the Minerals Group is actively reviewing the carrying value of its production assets to determine whether they are economically viable and whether the Minerals Group should accelerate the continuing implementation of this strategy. During early 1994, coal production was sharply impacted by severe weather conditions which affected much of the United States. These weather conditions also restricted trucking of coal to plants and terminals and impaired shipments from river terminals due to frozen harbors. On January 14, 1994, Coal operations completed the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. This acquisition is expected to add approximately 8.5 million tons of low sulphur steam coal sales and production and provide substantial additional reserves of surface minable low sulphur coal. The contracts acquired, some of which contain terms in excess of five years, will provide a broader base of domestic utility customers and reduce exposure in the export metallurgical market, where contract prices are renegotiated annually. The Company's principal labor agreement with the UMWA expires on June 30, 1994. In 1992, operating profit for coal was $36.9 million compared with an operating loss of $84.1 million in 1991. Operating results in 1991 included $115.2 million of restructuring charges primarily related to costs associated with mine shutdowns. Production was augmented in 1992 with the addition of a new surface mine in eastern Kentucky, the on-time start-up of the $11 million new Moss 3 preparation plant in September and success of the highwall mining systems utilized at the Heartland surface mine in West Virginia. Excluding the 1991 restructuring charges, operating results for the Coal segment increased $5.8 million in 1992 compared with 1991. Operating results in 1991 included gains of $5.8 million from the disposal of excess coal reserves. There were no comparable disposals in 1992. Operating profit in 1992 benefitted from a 2.9 million (16%) increase in tonnage sold largely due to shipments to utilities under coal sales contracts acquired in March 1992 and under a contract being supplied by the Company's Heartland mine which began operations in the fourth quarter of 1991. Average margin per ton improved nearly 2% in 1992 compared with 1991, due to a 3% or $.85 per ton decrease in average current production costs of coal sold per ton only partially offset by lower per ton realization. The decrease in average current production costs of coal sold per ton reflects the increase in tonnage sold, increased productivity and a change in production mix. In 1992, 65% of total production was derived from deep mines, and 35% of production was derived from surface mines compared with 76% and 24% of deep and surface mine production respectively, in 1991. Operating profit in 1992 also benefitted from a $2.4 million reduction in federal and state black lung expenses due to favorable claims experience. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9.1 million and $11.0 million, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10 to $11 million range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. In February 1990, the Pittston Coal Group companies and the UMWA entered into a successor collective bargaining agreement that resolved a labor dispute and related strike of Pittston Coal Group operations by UMWA-represented employees that began on April 5, 1989. As part of the agreement, the Pittston Coal Group companies agreed to make a $10 million lump sum payment to the 1950 Benefit Trust Fund and to renew participation in the 1974 Pension and Benefit Trust Funds at specified contribution rates. These aspects of the agreement were subject to formal approval by the trustees of the funds. The trustees did not accept the terms of the agreement and, therefore, payments are being made to escrow accounts for the benefit of union employees. In 1988, the trustees of certain pension and benefit funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case. In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act, there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. MINERAL VENTURES Mineral Ventures was formed in 1989 to develop opportunities in minerals other than coal. Mineral Ventures operations reported an operating loss of $8.3 million for 1993. This loss includes a $7.9 million charge related to the write-down of the Minerals Group's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Excluding the $7.9 million charge, Mineral Ventures operations incurred a $.4 million operating loss. Operating results for 1993 reflected production from the Stawell gold mine. In December 1992, Mineral Ventures acquired its ownership in the Stawell property through its participation in a joint venture with Mining Project Investors Pty Ltd., (in which Mineral Ventures holds a 34% interest). The Stawell gold mine, which is in western Victoria, Australia, currently has proved reserves for approximately four years of production and a current annual output of approximately 70,000 ounces. The joint venture also has exploration rights in the highly prospective district around the mine. Mineral Ventures has a 67% net equity interest in the Stawell mine and its adjacent exploration acreage. In 1993, the Stawell mine produced 73,765 ounces of gold with Mineral Ventures' share of the operating profit amounting to $4.9 million. The contribution to operating profit from the Stawell mine was offset by administrative overhead in addition to exploration expenditures related chiefly to other potential gold mining projects. Operating losses, which primarily related to expenses for project review and exploration, totalled $3.4 million in 1992 and $3.5 million in 1991. CORPORATE EXPENSES A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Minerals Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Minerals Group operated on a stand alone basis. These allocations were $7.2 million, $8.6 million and $8.1 million in 1993, 1992 and 1991, respectively. OTHER OPERATING INCOME Other operating income for the Minerals Group primarily consists of royalty income from coal and natural gas properties and gains and losses attributable to sales of property and equipment. Other operating income increased $1.5 million to $10.3 million in 1993 from $8.8 million in 1992 and decreased $10.6 million in 1992 from $19.4 million in 1991. In 1991, other operating income included gains aggregating $5.8 million from the disposal of certain excess coal reserves. There were no comparable disposals in 1993 or 1992. OTHER INCOME (LOSS), NET Other income (loss), net was a net loss of $.5 million in 1993 and net income in 1992 and 1991 of $1.9 million and $11.1 million, respectively. The net amounts in 1992 and 1991 included gains of $2.3 million and $11.1 million, respectively, from the sales of investments in leveraged leases. INTEREST EXPENSE Interest expense in 1993 decreased $2.2 million from $3.5 million in 1992 and increased $1.5 million in 1992 from $2.0 million in 1991. The decrease in 1993 was attributable to lower outstanding debt during the year, partially offset by interest assessed in 1993 on settlement of coal litigation related to the moisture content of tonnage used to compute royalty payments to UMWA pension and benefit funds. Interest expense in 1993, 1992 and 1991 included a portion of the Company's interest expense related to borrowings from the Company's revolving credit lines which was attributed to the Minerals Group. The amount of interest expense attributed to the Minerals Group for 1993, 1992 and 1991 was $.4 million, $2.8 million and $1.4 million, respectively. TAXES AND EXTRAORDINARY CREDITS In 1993, the credit for income taxes is higher than the amount that would have been recognized using the statutory federal income tax rate of 35% due to the tax benefits of percentage depletion, favorable adjustments to deferred tax assets as a result of the increase in the statutory U.S. federal income tax rate and a reduction in the valuation allowance for deferred tax assets primarily in foreign jurisdictions. In 1992, the provision for income taxes was less than the statutory federal income tax rate of 34% and in 1991 the credit for income taxes was higher than the amount that would have been recognized using the federal statutory income tax rate of 34% because of the tax benefit from percentage depletion. The Minerals Group's net deferred federal tax assets are based upon their expected utilization in the Company's consolidated federal income tax return and the benefit that would accrue to the Minerals Group under the Company's tax allocation policy. FINANCIAL CONDITION A portion of the Company's corporate assets and liabilities has been attributed to the Minerals Group based upon utilization of the shared services from which assets and liabilities are generated, which management believes to be equitable and a reasonable estimate of the assets and liabilities which would be generated if the Minerals Group operated on a stand alone basis. Corporate assets which were allocated to the Minerals Group consisted primarily of pension assets and deferred income taxes and amounted to $90.1 million and $54.3 million at December 31, 1993 and 1992, respectively. CASH FLOW PROVIDED BY OPERATING ACTIVITIES Cash provided by operations totalled $28.4 million in 1993, a $17.0 million decrease compared with $45.4 million generated by operations in 1992. The net decrease in 1993 compared with 1992 consisted of a $54.8 million decrease attributable to the change in net income and a $19.9 million decrease attributable to a change in net noncash charges and credits, partially offset by a $57.7 million decrease attributable to changes in operating assets and liabilities. Net income, noncash charges and changes in operating assets and liabilities in 1993 were significantly affected by after-tax restructuring and other charges for Minerals Group of $48.9 million which had no effect in 1993 on cash generated by operations. Of the total amount of the 1993 charges, $10.8 million was for noncash write-downs of assets and the remainder represents liabilities, of which $7.0 million are expected to be paid in 1994. The Minerals Group intends to fund any cash requirements during 1994 with anticipated cash flows from operations, with shortfalls, if any, financed through borrowings under the Company's revolving credit agreements or short-term borrowing arrangements or borrowings from the Services Group. Cash required to support the Minerals Group's investing activities was less than cash generated from operations and, as a result, after financing its stock activities, the Minerals Group made an additional cash loan to the Services Group of $13.3 million during 1993. CAPITAL EXPENDITURES Cash capital expenditures totalled $21.7 million for the 1993. An additional $45.5 million was financed in 1993 through operating leases which were predominately for surface mining equipment. Approximately 96% of the gross capital expenditures in 1993 were incurred in the Coal segment. Of that amount, greater than 40% of the expenditures was for business expansion, and the remainder was for replacement and maintenance of current ongoing business operations. Gross expenditures made by Mineral Ventures operations approximated 4% of the Minerals Group's total capital expenditures and were primarily costs incurred for project development. Cash capital expenditures for 1993 were funded by cash flow from operating activities, with any shortfalls financed through the Company by borrowings under its revolving credit agreements or short-term borrowing arrangements, which were thereby attributed to the Minerals Group. OTHER INVESTING ACTIVITIES All other investing activities in 1993 provided net cash of $12.0 million, which was largely attributable to proceeds from the sale of the assets of a coal subsidiary. Cash, net of any expenses related to the transaction, totaled $9.7 million. In January 1994, the Minerals Group paid $157 million in cash for the acquisition of substantially all the coal mining operations and coal sales contracts of Addington Resources, Inc. (the "Addington Acquisition"). The purchase price of the acquisition was financed through the issuance of $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, and additional debt under existing revolving credit facilities. FINANCING Gross capital expenditures in 1994 are not currently expected to increase significantly over 1993 levels. The Minerals Group intends to fund such expenditures through cash flow from operating activities or through operating leases if the latter are financially attractive. Any shortfalls will be financed through the Company's revolving credit agreements or short-term borrowing arrangements. As of December 31, 1993, revolving credit agreements provided for commitments of up to $250.0 million. At December 31, 1993, no portion of the borrowings outstanding under those agreements, which amounted to $2.1 million, was attributed to the Minerals Group, as cash generated from operations was sufficient for Minerals' investing and financing activities. In March 1994, the Company entered into a $350.0 million revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250.0 million of revolving credit agreements. The New Facility includes a $100.0 million five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250.0 million until March 1999. DEBT Total debt outstanding for the Minerals Group amounted to $.3 million. At December 31, 1993, none of the Company's long-term debt was attributed to the Minerals Group. Subsequent to December 31, 1993, the Addington Acquisition was financed in part with debt under the Company's revolving credit facilities, which was attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility. CONTINGENT LIABILITIES In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. CAPITALIZATION On July 26, 1993, the Company's shareholders approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, which resulted in the reclassification of the Company's common stock. The outstanding shares of common stock of the Company were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The redesignation of the Company's common stock as Services Stock and the distribution of Minerals Stock as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock and Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. The change in the capital structure of the Company had no effect on the Company's total capital, except as to expenses incurred in the execution of the Services Stock Proposal. Since the creation of Minerals Stock upon approval of the Services Stock Proposal, capitalization of the Minerals Group has been affected by all share activity related to Minerals Stock. In July 1993, the Board authorized a new share repurchase program under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. This program replaced the previous program under which 1,500,000 shares of common stock of the Company remained authorized for repurchase. During 1993 under the previous program 75,000 shares of the Company's common stock were repurchased at a total cost of $1.1 million. Under the new share repurchase program through December 31, 1993, 19,000 shares of Minerals Stock were repurchased at a total cost of $.4 million. In January 1994, the Company issued $80.5 million of a new series of convertible preferred stock, which is convertible into Minerals Stock, to finance a portion of the Addington Acquisition. DIVIDENDS The Board intends to declare and pay dividends on Minerals Stock based on the earnings, financial condition, cash flow and business requirements of the Minerals Group. Since the Company remains subject to Virginia law limitations on dividends and to dividend restrictions in its public debt and bank credit agreements, losses incurred by the Services Group could affect the Company's ability to pay dividends in respect of stock relating to the Minerals Group. Dividends on Minerals Stock are also limited by the Available Minerals Dividend Amount as defined in the Company's Articles of Incorporation. At December 31, 1993, the Available Minerals Dividend Amount was at least $10.1 million. After giving effect to the issuance of the convertible preferred stock, the pro forma Available Minerals Dividend Amount would have been at least $85.6 million. On an equivalent basis, in 1993 the Company paid dividends on 62.04 cents per share of Minerals Stock compared with 49.24 cents per share of Minerals Stock in 1992. In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the Addington Acquisition. Commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears from the date of original issue out of all funds of the Company legally available therefor, when, as and if declared by the Board. Such stock bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. PENDING ACCOUNTING CHANGES The Minerals Group is required to implement a new accounting standard for postemployment benefits - SFAS No. 112 - in 1994. SFAS No. 112 requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Minerals Group has determined the effect of adopting SFAS No. 112 is immaterial. The Minerals Group is required to implement a new accounting standard for investments in debt and equity securities - SFAS No. 115 - in 1994. SFAS No. 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Minerals Group does not have investments in debt or equity securities and therefore the provisions of SFAS No. 115 do not apply. Item 8: Item 8: Financial Statements and Supplementary Data THE PITTSTON COMPANY AND SUBSIDIARIES STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the consolidated financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The Company's consolidated financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Company's consolidated financial statements. The Company's Board of Directors pursues its oversight role with respect to the Company's consolidated financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Company's consolidated financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying consolidated balance sheets of The Pittston Company and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' 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 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 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 Pittston 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. As discussed in Notes 4 and 16 to the consolidated financial statements, the Company changed its method of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 6, 13 and 16 to the consolidated financial statements, the Company changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG PEAT MARWICK KPMG Peat Marwick Stamford, Connecticut January 24, 1994 THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In thousands, except share amounts) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to consolidated financial statements. THE PITTSTON COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: On July 26, 1993, the shareholders of The Pittston Company (the "Company") approved the Services Stock Proposal, as described in Note 9, resulting in the reclassification of the Company's common stock into shares of Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis. In addition, a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock") was distributed on a basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock. The Pittston Services Group (the "Services Group") consists of the Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS") operations of the Company. The Pittston Minerals Group (the "Minerals Group") consists of the Coal and Mineral Ventures operations of the Company. The approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. The Company prepares separate financial statements for the Minerals and Services Groups in addition to consolidated financial information of the Company. Due to the reclassification of the Company's common stock, all stock and per share data in the accompanying financial statements for 1992 and 1991 have been restated from amounts previously reported. The primary impacts of this restatement are as follows: o Net income per common share has been restated in the Consolidated Statements of Operations to reflect the two classes of stock, Services Stock and Minerals Stock, as if they were outstanding for all periods presented. For the purposes of computing net income per common share of Services Stock and Minerals Stock, the number of shares of Services Stock are assumed to be the same as the total corresponding number of shares of the Company's common stock. The number of shares of Minerals Stock are assumed to be one-fifth of the shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock prior to the effective date of the Services Stock Proposal have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. Accordingly, the Consolidated Statements of Shareholders' Equity have been restated to reflect these changes. For 1993, all stock activity (including dividends) prior to the Services Stock Proposal has been attributed to the Services Group and the Minerals Group based on the methods described above. PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial statements reflect the accounts of the Company and its majority-owned subsidiaries. The Company's interests in 20% to 50% owned companies are carried on the equity method. Undistributed earnings of such companies included in consolidated retained earnings approximated $39,104,000 at December 31, 1993. All material intercompany items and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments primarily include funds set aside by management for certain obligations and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the first-in, first-out or average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Depletion of bituminous coal lands is provided on the basis of tonnage mined in relation to the estimated total of recoverable tonnage in the ground. Mine development costs, primarily included in bituminous coal lands, are capitalized and amortized over the estimated useful life of the mine. These costs include expenses incurred for site preparation and development as well as operating deficits incurred at the mines during the development stage. A mine is considered under development until all planned production units have been placed in operation. Subscriber installation costs for home security systems provided by BHS are capitalized and amortized over the estimated life of the assets and are included in machinery and equipment. The basic equipment that is installed, remains the property of BHS and is capitalized at cost. Other capitalized costs, which arise solely as a direct result of the installation process and bring the revenue producing asset to its intended use, include costs of setting up customers on the monitoring network, labor costs and costs incurred for installation scheduling and testing. When a customer is identified for disconnect, the remaining net book value of the basic equipment is fully depreciated. INTANGIBLES: The excess of cost over fair value of net assets of companies acquired is amortized on a straight-line basis over the estimated periods benefitted. INCOME TAXES: In 1991, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. PNEUMOCONIOSIS (BLACK LUNG) EXPENSE: The Company acts as self-insurer with respect to black lung benefits. Provision is made for estimated benefits in accordance with annual actuarial reports prepared by outside actuaries. The excess of the present value of expected future benefits over the accumulated book reserves is recognized over the amortization period as a level percentage of payroll. Cumulative actuarial gains or losses are calculated periodically and amortized on a straight-line basis. Assumptions used in the calculation of the actuarial present value of black lung benefits are based on actual retirement experience of the Company's coal employees, black lung claims incidence for active miners, actual dependent information, industry turnover rates, actual medical and legal cost experience and current inflation rates. As of December 31, 1993 and 1992, the accrued value of estimated future black lung benefits discounted at 6% was approximately $61,067,000 and $61,095,000, respectively, and are included in workers' compensation and other claims. Based on acruarial data, the Company charged to earnings $438,000 in 1993, $1,029,000 in 1992 and $3,113,000 in 1991. In addition, the Company accrued additional expenses for black lung benefits related to federal and state assessments, legal and administration expenses and other self insurance costs. These amounted to $2,887,000 in 1993, $2,073,000 in 1992 and $2,435,000 in 1991. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Company. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign subsidiaries have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been recorded as a separate component of shareholders' equity. Translation adjustments relating to subsidiaries in countries with highly inflationary economies are included in net income, along with all transaction gains and losses for the period. A portion of the Company's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Company are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. However, the Company's international activity is not concentrated in any single currency, which limits the risks of foreign currency rate fluctuations. FINANCIAL INSTRUMENTS: The Company uses foreign currency forward contracts to hedge risk of changes in foreign currency rates associated with certain transactions denominated in various currencies. Realized and unrealized gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the specific transaction hedged. The Company also utilizes other financial instruments to protect against adverse price movements in gold, which the Company produces, and crude oil and its derivative products, which the Company consumes. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the transaction hedged. The Company is required to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), in 1994. SFAS 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Company has determined that the cumulative effect of adopting SFAS 115 is immaterial. REVENUE RECOGNITION: Coal - Coal sales are generally recognized when coal is loaded onto transportation vehicles before shipment to customers. For domestic sales, this occurs when coal is loaded onto railcars at mine locations. For export sales, this occurs when coal is loaded onto marine vessels at terminal facilities. Mineral Ventures - Gold sales are recognized when products are shipped to a refinery. Settlement adjustments arising from final determination of weights and assays are reflected in sales when received. Burlington - Revenues related to transportation services are recognized, together with related transportation costs, on the date shipments physically depart from facilities en route to destination locations. Brink's - Revenues from contract carrier armored car, automatic teller machine, air courier, coin wrapping, and currency and deposit processing services are recognized when services are performed. BHS - Monitoring revenues are recognized when earned and amounts paid in advance are deferred and recognized as income over the applicable monitoring period, which is generally one year or less. Revenues from the sale of equipment, excluding equipment which is part of the standard package security system, are recognized, together with related costs, upon completion of the installation. Connection fee revenues are recognized to the extent of direct selling costs incurred and expensed. Connection fee revenues in excess of direct selling costs are deferred and recognized as income on a straight-line basis over ten years. NET INCOME PER COMMON SHARE: Net income per common share for Services Stock and Minerals Stock is computed by dividing the net income for each Group by the weighted average number of shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The assumed conversion of the 9.20% convertible subordinated debentures is not included since its effect is antidilutive. The shares of Services Stock and Minerals Stock held in The Pittston Company Employee Benefits Trust (Note 9) are evaluated for inclusion in the calculation of net income per share under the treasury stock method and have no dilutive effect. 2. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents and short-term investments and trade receivables. The Company places its cash and cash equivalents and short-term investments with high credit qualified financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across many different industries and geographic areas. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Company's long-term debt obligations, which is based upon quoted market prices and rates currently available to the Company for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Company enters into various off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to such instruments may be unable to perform is minimized by limiting the counterparties to major international banks. The Company does not expect any losses due to such counterparty default. Foreign currency forward contracts - The Company enters into foreign currency forward contracts with a duration of 30 to 45 days as a hedge against accounts payable denominated in various currencies. These contracts do not subject the Company to risk due to exchange rate movements because gains and losses on these contracts offset losses and gains on the payables being hedged. At December 31, 1993, the total contract value of foreign currency forward contracts outstanding was $4,600,000. As of such date, the carrying amounts of the foreign currency forward contracts approximate fair value. Forward sales contracts - In order to protect itself against downward movements in gold prices, the Company hedges a portion of its recoverable proved and probable reserves primarily through forward sales contracts. At December 31, 1993, 72,000 ounces of gold, representing approximately 50% of the Company's recoverable proved and probable reserves, were sold forward under forward sales contracts at an average price of $350 per ounce. Because only a portion of its future production is currently sold forward, the Company can take advantage of increases, if any, in the spot price of gold. At December 31, 1993, the aggregate carrying value of the Company's forward sales contracts exceeded their fair value by approximately $2,900,000. Other contracts - The Company has hedged a significant portion of its jet fuel requirements for the period January 1, 1994 through March 31, 1995, through swap contracts which were intended to fix the Company's per gallon fuel costs below 1993 levels. At December 31, 1993, the contract value of the jet fuel swaps, aggregating 50.1 million gallons, was $25,492,000. In addition, a call option was purchased for 12.6 million gallons of crude oil for the first half of 1994. Each of these transactions are settled monthly based upon the average of the high and low prices during each period. The fair value of these fuel hedge transactions may fluctuate over the course of the contract period due to changes in the supply and demand for oil and refined products. Thus, the economic gain or loss, if any, upon settlement of the contracts may differ from the fair value of the contracts at an interim date. At December 31, 1993, the aggregate carrying value of the swap contracts and the call option exceeded their fair value by approximately $1,700,000. 3. ACCOUNTS RECEIVABLE - TRADE In 1991, the Company entered into agreements with two financial institutions whereby it had the right to sell certain coal receivables, with recourse, to those institutions. One agreement expired on June 30, 1992. The other agreement, which expires September 27, 1994, limits the maximum amount of outstanding receivables that could be owned by the financial institution to $20,000,000. The Company sold total coal receivables of approximately $16,143,000 in 1993, $23,959,000 in 1992 and $2,776,000 in 1991 under these agreements. In 1985, the Company entered into an agreement whereby it had the right to sell certain coal receivables, with limited recourse, to a financial institution from time to time until December 31, 1991. During 1992, the Company continued to sell certain coal receivables to the financial institution under essentially the same terms and conditions as the expired agreement. The Company sold total coal receivables of approximately $41,272,000 in 1992 and $10,706,000 in 1991 under this agreement, which has since been terminated. As of December 31, 1993, there were no receivables sold which remained to be collected. As of December 31, 1992, receivables sold totalling $11,987,000 remained to be collected. 4. PROPERTY, PLANT AND EQUIPMENT Capitalized mine development costs totalled $2,181,000 in 1993, $18,487,000 in 1992 and $12,167,000 in 1991. During the three years ended December 31, 1993, changes in capitalized subscriber installation costs for home security systems were as follows: As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security system installations. This change in accounting principle is preferable because it more accurately reflects subscriber installation costs. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2,567,000 in 1993 and $2,327,000 in 1992) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1,484,000 in 1993 and $1,994,000 in 1992). The effect of this change in accounting principle was to increase operating profit of the consolidated group and the BHS segment in 1993 and 1992 by $4,051,000 and $4,321,000, respectively, and net income of the Services Group by $.07 per share in each year. Prior to January 1, 1992, the records needed to identify such costs were not available. Thus, it was impossible to accurately calculate the effect on retained earnings as of January 1, 1992 or the pro forma effects of retroactive application on the year ended December 31, 1991 for the change in accounting principle. However, the Company believes the effect on retained earnings as of January 1, 1992 was immaterial. Because capitalized subscriber installation costs for prior periods were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in prior periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Company believes the effect on net income in 1993 and 1992 was immaterial. New subscriber installations for which costs were capitalized totalled 56,700 in 1993, 48,600 in 1992 and 41,000 in 1991. Additional subscribers who purchased the installed equipment and for which no costs were capitalized totalled 1,600 in 1993 and 700 in each of 1992 and 1991. In 1993 and 1992, BHS also added 1,300 and 2,000 subscribers, respectively, as a result of converting previously installed competitors' systems to BHS monitoring. The acquisition of monitoring contracts added 6,400 subscribers in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $63,953,000 in 1993, $57,291,000 in 1992 and $53,059,000 in 1991. 5. INTANGIBLES Intangibles consist entirely of the excess of cost over fair value of net assets of companies acquired and are net of accumulated amortization of $65,738,000 at December 31, 1993 and $58,739,000 at December 31, 1992. The estimated useful life of intangibles is generally forty years. Amortization of intangibles aggregated $7,126,000 in 1993, $7,184,000 in 1992 and $7,021,000 in 1991. 6. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Company adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. As of January 1, 1991, the Company recorded a tax credit of approximately $10,061,000, of which $3,665,000 or $.10 per share was attributed to the Services Group and $6,396,000 or $.86 per share was attributed to the Minerals Group, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the consolidated statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993, 1992 and 1991, cash payments for income taxes, net of refunds received, were $30,237,000, $6,129,000 and $15,285,000, respectively. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholders' equity. The components of the net deferred tax asset as of December 31, 1993 and December 31, 1992 were as follows: The valuation allowance relates to deferred tax assets in certain foreign and state jurisdictions. Based on the Company's historical and expected taxable earnings, management believes it is more likely than not that the Company will realize the benefit of the existing deferred tax asset at December 31, 1993. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income (loss) before income taxes. It is the policy of the Company to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992 the unrecognized deferred tax liability for temporary differences of approximately $43,640,000 and $36,200,000, respectively, related to investments in foreign subsidiaries and affiliates that are essentially permanent in nature and not expected to reverse in the foreseeable future was approximately $15,274,000 and $12,308,000, respectively. The Company and its domestic subsidiaries file a consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Service through the year 1981. As of December 31, 1993, the Company had $30,774,000 of alternative minimum tax credits available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefit of net operating loss carryforwards as at December 31, 1993 was $8,299,000 and relate to various state and foreign taxing jurisdictions. The expiration periods primarily range from 5-15 years. 7. LONG-TERM DEBT Consists of the following: For the four years through December 31, 1998, minimum repayments of long-term debt outstanding are as follows: At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. The Dutch guilder loan to Brink's, a wholly owned indirect subsidiary of the Company, bears interest based on a Euroguilder rate, or if converted to a U.S. dollar loan, bears interest based on prime, Eurodollar or money market rates. In January 1992, a portion of the guilder loan was converted into a U.S. dollar loan. In March 1993, a pound sterling loan to Brink's was converted into a U.S. dollar term loan due 1995 to 1997. Interest was previously based on the Eurosterling rate and is currently based on the Eurodollar rate. The Canadian dollar loan to a wholly owned indirect subsidiary of the Company was paid in June 1993. Under the terms of the loans, Brink's has agreed to various restrictions relating to net worth, disposition of assets and incurrence of additional debt. The 4% subordinated debentures due July 1, 1997 are exchangeable only for cash, at the rate of $157.80 per $1,000 debentures. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices equal to 100% of principal amount. The 9.20% convertible subordinated debentures due July 1, 2004 are convertible into shares of Services Stock and Minerals Stock at the rate of two shares of Services Stock and two-fifths of a share of Minerals Stock for each $100 principal amount, subject to adjustment pursuant to antidilution provisions. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices which decline from 102.76% of principal amount before July 1, 1994, to 100% of principal amount after June 30, 1999. Various international subsidiaries maintain lines of credit and overdraft facilities aggregating approximately $58,000,000 with a number of banks on either a secured or unsecured basis. Under the terms of some of its debt instruments, the Company has agreed to various restrictions relating to the payment of dividends, the repurchase of capital stock, maintenance of consolidated working capital and net worth, and the amount of additional funded debt which may be incurred. Allowable restricted payments for dividends and stock repurchases aggregated $107,365,000 at December 31, 1993. At December 31, 1993, the Company had outstanding unsecured letters of credit totalling $72,274,000, primarily supporting the Company's obligations under its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $10,207,000, $11,553,000 and $15,955,000, respectively. 8. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 9), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 9, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of a share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, a total of 987,605 shares of Services Stock and 240,814 shares of Minerals Stock were exercisable. In addition, there were 2,578,770 shares of Services Stock and 640,298 shares of Minerals Stock reserved for issuance under the plans, including 199,966 shares of Services Stock and 16,800 shares of Minerals Stock reserved for future grant. 9. CAPITAL STOCK On July 26, 1993 (the "Effective Date"), the shareholders of the Company approved the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulting in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Services Stock on a share-for-share basis and a second class of common stock, designated as Minerals Stock, was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock are designed to provide shareholders with separate securities reflecting the performance of the Minerals Group and the Services Group, respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share, subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market value of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. Prior to the approval of the Services Stock Proposal, the Company had a share repurchase program whereby the Company could acquire up to 8.2 million shares of its common stock from time to time in the open market or in private transactions, as conditions warrant. Through July 26, 1993, the Company had acquired 6,776,000 shares under the program at an aggregate cost of $88,616,000, of which 75,000 shares were acquired during 1993 at a total cost of $1,105,000. This program was replaced with a new share repurchase program authorized by the Board of Directors in July 1993, under which up to 1,250,000 shares of Services Stock and 250,000 shares of Minerals Stock may be repurchased. Through December 31, 1993, a total of 19,000 shares of Minerals Stock were repurchased under the new program at a total cost of $407,000; no shares of Services Stock were repurchased in 1993 under the new program. The program to acquire shares in the open market remains in effect in 1994. The Company has authority to issue up to 2,000,000 shares of preferred stock, par value $10 per share. In January 1994, the Company issued 161,000 shares of its $31.25 Series C Cumulative Convertible Preferred Stock, par value $10 per share (the "Convertible Preferred Stock") (Note 20). The Convertible Preferred Stock pays an annual cumulative dividend of $31.25 per share payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Board of Directors of the Company, and bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. Each share of the Convertible Preferred Stock is convertible at the option of the holder at any time after March 11, 1994, unless previously redeemed or, under certain circumstances, called for redemption, into shares of Minerals Stock at a conversion price of $32.175 per share of Minerals Stock, subject to adjustment in certain circumstances. Except under certain circumstances, the Convertible Preferred Stock is not redeemable prior to February 1, 1997. On and after such date, the Company may at its option, redeem the Convertible Preferred Stock, in whole or in part, for cash initially at a price of $521.875 per share, and thereafter at prices declining ratably annually on each February 1 to an amount equal to $500.00 per share on and after February 1, 2004, plus in each case an amount equal to accrued and unpaid dividends on the date of redemption. Except under certain circumstances or as prescribed by Virginia law, shares of the Convertible Preferred Stock are nonvoting. Other than the Convertible Preferred Stock no shares of preferred stock are presently issued or outstanding. The Company's 9.20% convertible subordinated debentures (Note 7) are convertible into 556,216 shares of Services Stock and 111,243 shares of Minerals Stock. Under a Shareholder Rights Plan adopted by the Company's Board of Directors in 1987 and amended in December 1988, rights to purchase a new Series A Participating Cumulative Preferred Stock (the "Series A Preferred Stock") of the Company were distributed as a dividend at the rate of one right for each share of the Company's common stock. Pursuant to the Services Stock Proposal, the Shareholders Rights Plan was amended and restated to reflect the change in the capital structure of the Company. Each existing right was amended to become a Pittston Services Group right (a "Services Right"). Holders of Minerals Stock received one Pittston Minerals Group right (a "Minerals Right") for each outstanding share of Minerals Stock. Each Services Right, if and when it becomes exercisable, will entitle the holder to purchase one-thousandth of a share of Series A Preferred Stock at a purchase price of $40, subject to adjustment. Each Minerals Right, if and when it becomes exercisable, will entitle the holder to purchase one-thousandth of a share of Series B Participating Cumulative Preferred Stock (the "Series B Preferred Stock") at a purchase price of $40, subject to adjustment. Each fractional share of Series A Preferred Stock and Series B Preferred Stock will be entitled to participate in dividends and to vote on an equivalent basis with one whole share of Services Stock and Minerals Stock, respectively. Each right will not be exercisable until ten days after a third party acquires 20% or more of the total voting rights of all outstanding Services Stock and Minerals Stock or ten days after commencement of a tender offer or exchange offer by a third party for 30% or more of the total voting rights of all outstanding Services Stock and Minerals Stock. If after the rights become exercisable, the Company is acquired in a merger or other business combination, each right will entitle the holder to purchase, for the purchase price, common stock of the surviving or acquiring company having a market value of twice the purchase price. In the event a third party acquires 30% or more of all outstanding Services Stock and Minerals Stock or engages in one or more "self dealing" transactions with the Company, the rights will entitle each holder to purchase, at the purchase price, that number of fractional shares of Series A Preferred Stock and Series B Preferred Stock equivalent to the number of shares of common stock which at the time of the triggering event would have a market value of twice the purchase price. The rights may be redeemed by the Company at a price of $.01 per right and expire on September 25, 1997. The Company's Articles of Incorporation limits dividends on Minerals Stock to the lesser of (i) all funds of the Company legally available therefor (as prescribed by Virginia law) and (ii) the Available Minerals Dividend Amount (as defined in the Articles of Incorporation). At December 31, 1993, the Available Minerals Dividend Amount was at least $10,054,000. After giving effect to the issuance of the Convertible Preferred Stock, the pro forma Available Minerals Dividend Amount would have been at least $85,622,000. Dividends on Minerals Stock are also restricted by covenants in the Company's public indentures and bank credit agreements (Note 7). In December 1992, the Company formed The Pittston Company Employee Benefits Trust (the "Trust") to hold shares of its common stock to fund obligations under certain employee benefit programs. Upon formation of the Trust, the Company sold for a promissory note of the Trust, four million new shares of its common stock to the Trust at a price equal to the fair value of the stock on the date of sale. Upon approval of the Services Stock Proposal, 3,871,826 shares in the Trust were redesignated as Services Stock and 774,365 shares of Minerals Stock were distributed to the Trust. At December 31, 1993, 3,853,778 shares of Services Stock and 770,301 shares of Minerals Stock remained in the Trust, valued at market. These shares will be voted by the trustee in the same proportion as those voted by the Company's employees participating in the Company's Savings Investment Plan. The fair market value of the shares are included in common stocks and capital in excess of par and, in total, as a reduction to common shareholders' equity in the Company's consolidated balance sheet. 10. ACQUISITIONS During 1993, the Company acquired one small business and made installment and contingency payments related to other acquisitions made in prior years. The total consideration paid was $1,435,000. During 1992, the Company acquired several businesses for an aggregate purchase price of $47,800,000 including debt and installment payments to be made of $2,864,000. The fair value of assets acquired was $50,858,000 and liabilities assumed was $3,058,000. In addition, the Company made cash payments of $7,624,000 in the aggregate for an equity investment and contingency payments for acquisitions made in prior years. During 1991, the Company acquired one small business and made contingency payments related to other acquisitions made in prior years. The total consideration paid was $1,914,000. All acquisitions have been accounted for as purchases. In 1993, 1992 and 1991, the purchase price was essentially equal to the fair value of assets acquired. The results of operations of the acquired companies have been included in the Company's results of operations from their date of acquisition. 11. JOINT VENTURE The Company, through a wholly owned indirect subsidiary, entered into a partnership agreement in 1982 with four other coal companies to construct and operate coal port facilities in Newport News, Virginia, in the Port of Hampton Roads (the "Facilities"). The Facilities commenced operations in 1984, and now have an annual throughput capacity of 22 million tons, with a ground storage capacity of approximately 2 million tons. The Company initially had an indirect 25% interest in the partnership, DTA. Initial financing of the Facilities was accomplished through the issuance of $135,000,000 principal amount of revenue bonds by the Peninsula Ports Authority of Virginia (the "Authority"), which is a political subdivision of the Commonwealth of Virginia. In 1987, the original revenue bonds were refinanced by the issuance of $132,800,000 of coal terminal revenue refunding bonds of which two series of these bonds in the aggregate principal amount of $33,200,000 were attributable to the Company. In 1990, the Company acquired an additional indirect 7 1/2% interest in the DTA partnership, increasing its ownership to 32 1/2%. With the increase in ownership, $9,960,000 of the remaining four additional series of the revenue refunding bonds of $99,600,000 became attributable to the Company. In November 1992, all bonds attributable to the Company were refinanced with the issuance of a new series of coal terminal revenue refunding bonds in the aggregate principal amount of $43,160,000. The new series of bonds bear a fixed interest rate of 7 3/8%. The Authority owns the Facilities and leases them to DTA for the life of the bonds, which mature on June 1, 2020. DTA may purchase the Facilities for $1 at the end of the lease term. The obligations of the partners are several, and not joint. Under loan agreements with the Authority, DTA is obligated to make payments sufficient to provide for the timely payment of the principal of and interest on the bonds of the new series. Under a throughput and handling agreement, the Company has agreed to make payments to DTA that in the aggregate will provide DTA with sufficient funds to make the payments due under the loan agreements and to pay the Company's share of the operating costs of the Facilities. The Company has also unconditionally guaranteed the payment of the principal of and premium, if any, and the interest on the new series of bonds. Payments for operating costs aggregated $7,949,000 in 1993, $6,819,000 in 1992 and $6,885,000 in 1991. The Company has the right to use 32 1/2% of the throughput and storage capacity of the Facilities subject to user rights of third parties which pay the Company a fee. The Company pays throughput and storage charges based on actual usage at per ton rates determined by DTA. 12. LEASES The Company and its subsidiaries lease aircraft, facilities, vehicles, computers and coal mining and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $6,451,000. Included in future minimum lease payments are rentals for aircraft and the Toledo, Ohio hub operated as part of a controlled airlift project by a wholly owned direct subsidiary of the Company. The Toledo, Ohio hub lease commenced in 1991, for a twenty-two year period. Certain costs of the project are being amortized over the terms of the respective leases. The unamortized expense as of December 31, 1993 and 1992 aggregated $1,525,000 and $2,825,000, respectively. A wholly-owned subsidiary of the Company entered into two transactions covering various leases which provide for the replacement of eight B707 aircraft with seven DC8-71 aircraft and completed an evaluation of other fleet related costs. One transaction, representing four aircraft, is reflected in the 1993 financial statements, while the other transaction, covering the remaining three aircraft, was reflected in the 1992 financial statements. The net effect of these transactions did not have a material impact on operating profit for either year. Rent expense amounted to $91,439,000 in 1993, $84,365,000 in 1992 and $78,758,000 in 1991 and is net of sublease rentals of $862,000, $1,488,000 and $2,218,000, respectively. The Company incurred capital lease obligations of $1,601,000 in 1993, $2,316,000 in 1992 and $5,530,000 in 1991. As of December 31, 1993, the Company's obligations under capital leases were not significant. 13. EMPLOYEE BENEFIT PLANS The Company and its subsidiaries maintain several noncontributory defined benefit pension plans covering substantially all nonunion employees who meet certain minimum requirements. Benefits of most of the plans are based on salary and years of service. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension credit for 1993, 1992 and 1991 for all plans is as follows: The funded status and prepaid pension expense at December 31, 1993 and 1992 are as follows: The assumptions used in determining the net pension credit for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986 (January 1, 1989 for certain foreign pension plans), the date of adoption of Statement of Financial Accounting Standards No. 87, has been amortized over the estimated remaining average service life of the employees. As of December 31, 1993, approximately 71% of plan assets were invested in equity securities and 29% in fixed income securities. Under the 1990 collective bargaining agreement with the United Mine Workers of America ("UMWA"), the Company has made payments, based on hours worked, into an escrow account established for the benefit of union employees (Note 18). The Company's coal operations recognized pension expense of $1,799,000 in 1993, $2,457,000 in 1992 and $2,273,000 in 1991 under the terms of the agreement. The total amount accrued at December 31, 1993 and 1992 under these escrow agreements was $21,064,000 and $20,184,000, respectively, and is included in miscellaneous accrued liabilities. The Company and its subsidiaries also provide certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States and Canada. Effective January 1, 1991, the Company adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Company recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $201,810,000, with a net earnings effect of $133,078,000, of which $3,354,000 or $.09 per share was attributed to the Services Group and $129,724,000 or $17.40 per share was attributed to the Minerals Group. The latter amounts have been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: Interest costs on the accumulated postretirement benefit obligation were based upon a rate of 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The assumed health care cost trend rate used in 1993 was 10% for pre-65 retirees, grading down to 5% in the year 2000. For post-65 retirees, the assumed trend rate in 1993 was 8%, grading down to 5% in the year 2000. The assumed medicare cost trend rate used in 1993 was 7%, grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $3,309,000 increase in the aggregate service and interest components of expense for the year 1993, and a $35,528,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Company also sponsors a Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched at rates of 50% to 100% up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $5,381,000 in 1993, $5,391,000 in 1992 and $4,742,000 in 1991. In 1992, 71,000 shares were issued to the plan valued at $902,000 to fund a portion of the matching contribution. The Company sponsors several other defined contribution benefit plans based on hours worked, tons produced or other measurable factors. Contributions under all of these plans aggregated $918,000 in 1993 and 1992 and $917,000 in 1991. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9,100,000 and $11,000,000, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10,000,000 to $11,000,000 range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. The Company is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112") in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Company has determined that the cumulative effect of adopting SFAS 112 is immaterial. 14. RESTRUCTURING AND OTHER CHARGES Operating results include restructuring and other charges of $78,633,000 in 1993 and $115,214,000 in 1991 which have been recognized in the statements of operations. The 1993 charges relate to mine closing costs including employee benefit costs and certain other noncash charges, together with the estimated liabilities in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA (Note 18). These charges impacted Coal and Mineral Ventures operating profit in the amount of $70,713,000 and $7,920,000, respectively. The charge in the Coal segment in 1993 consists of closing costs for mines which were closed at the end of 1993 and for scheduled closures of mines in early 1994, including employee severance and other benefit costs and estimated liabilities regarding the Evergreen Case. The charge in the Mineral Ventures segment in 1993 related to the write-down of the company's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Of the total amount of 1993 charges, $10,846,000 was for noncash write-downs of assets and the remainder represents liabilities, of which $7,015,000 are expected to be paid in 1994. The Company intends to fund any cash requirements during 1994 and thereafter with anticipated cash flows from operating activities with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. The 1991 charge impacted Coal segment operations and primarily related to costs associated with coal mine shutdowns. Of the total charge, $14,415,000 was for noncash asset write-downs. 15. OTHER INCOME AND EXPENSE Other operating income includes the Company's share of net income of unconsolidated affiliated companies which are carried on the equity method. The following table presents summarized financial information of the companies accounted for by the equity method. Amounts presented include the accounts of the following equity affiliates: The following table presents summarized financial information of these companies. Other operating income also includes gains aggregating $5,846,000 in 1991 from the disposal of certain excess coal reserves, which increased the Minerals Group's net income by $.51 per share. In addition, other operating income primarily includes royalty income generated from coal and natural gas properties owned by the Company. Other income (expense), net includes gains aggregating $2,341,000 in 1992 and $11,102,000 in 1991 from the sales of investments in leveraged leases, which increased the Minerals Group's net income by $.37 per share in 1992 and $1.11 per share in 1991. 16. ACCOUNTING CHANGES As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1993 by $2,435,000 and in 1992 by $2,596,000 (Note 4). During 1991, the Company adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 17. SEGMENT INFORMATION Net sales and operating revenues by geographic area are as follows: Segment operating profit (loss) by geographic area is as follows: Identifiable assets by geographic area are as follows: Segment operating profit (loss) includes restructuring and other charges aggregating $78,633,000 in 1993, of which $70,713,000 is included in United States and $7,920,000 is included in other foreign, and $115,214,000 in 1991, all of which is included in United States (Note 14). Industry segment information is as follows: * Includes equity in net income of unconsolidated foreign affiliates of $6,895,000 in 1993, $8,133,000 in 1992 and $7,629,000 in 1991. ** As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase operating profit in 1993 by $4,051,000 and in 1992 by $4,321,000 (Note 4). *** Operating profit (loss) of the Coal segment includes restructuring and other charges of $70,713,000 in 1993 and $115,214,000 in 1991 (Note 14). Operating loss of the Mineral Ventures segment includes restructuring and other charges of $7,920,000 in 1993 (Note 14). 18. LITIGATION In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegation that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case (Note 14). In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act (Note 13), there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 19. COMMITMENTS At December 31, 1993, the Company had contractual commitments to purchase coal which is primarily used to blend with Company mined coal. Based on the contract provisions these commitments are currently estimated to aggregate approximately $195,790,000 and expire from 1994 through 1998 as follows: The 1994 amount includes a commitment of $23,250,000, relating to a purchase contract with Addington Resources, Inc. ("Addington"). This contract was part of the coal mining operations of Addington acquired in 1994 (Note 20). A new commitment totalling $127,920,000 over approximately four years was entered into with the operations of Addington which were not part of the acquisition. Purchases under the contracts were $81,069,000 in 1993, $74,331,000 in 1992 and $58,155,000 in 1991. 20. SUBSEQUENT EVENT In January 1994, a wholly owned indirect subsidiary of the Company completed the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington for $157 million, subject to certain purchase price adjustments. The acquisition will be accounted for as a purchase; accordingly, the purchase price has been allocated to the underlying assets and liabilities based on their respective estimated fair values at the date of acquisition. Such allocation has been based on preliminary estimates which may be revised at a later date. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was approximately $77 million. The acquisition was financed by the issuance of $80.5 million of a new series of the Company's preferred stock convertible into Minerals Stock (Note 9), and additional debt under existing credit facilities. This financing has been attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 7). The following table presents, on a pro forma basis, a condensed consolidated balance sheet of the Company at December 31, 1993, giving effect to the acquisition as if it had occurred on that date. The acquisition will be included in the Company's consolidated statements of operations beginning in 1994. The following pro forma results, however, assume that the acquisition and related financing had occurred at the beginning of 1993. The unaudited pro forma data below are not necessarily indicative of results that would have occurred if the transaction were in effect for the year ended December 31, 1993, nor are they indicative of the future results of operations of the Company. 21. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. Net loss in the fourth quarter of 1993 includes restructuring and other charges of $78,633,000 (Note 14). Net income in the fourth quarter of 1992 includes gains of $2,341,000 from the sale of leveraged leases (Note 15). PITTSTON SERVICES GROUP STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The accompanying financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Services Group's financial statements. The Company's Board of Directors pursues its oversight role with respect to the Services Group's financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Services Group's financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying balance sheets of Pittston Services Group (as described in Note 1) as of December 31, 1993 and 1992 and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of The Pittston 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 of Pittston Services Group present fairly, in all material respects, the financial position of Pittston Services Group 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. As more fully discussed in Note 1, the financial statements of Pittston Services Group should be read in connection with the audited consolidated financial statements of The Pittston Company and subsidiaries. As discussed in Notes 4 and 14 to the financial statements, Pittston Services Group changed its method of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 7, 12 and 14 to the financial statements, Pittston Services Group changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG Peat Marwick Stamford, Connecticut January 24, 1994 PITTSTON SERVICES GROUP BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to financial statements. PITTSTON SERVICES GROUP STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to financial statements. PITTSTON SERVICES GROUP STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to financial statements. PITTSTON SERVICES GROUP NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The approval on July 26, 1993 (the "Effective Date"), by the shareholders of The Pittston Company (the "Company") of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulted in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group") respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either Group. Accordingly, all stock and per share data prior to the reclassification have been restated to reflect the reclassification. The primary impacts of this restatement are as follows: o Net income per common share has been included in the Statements of Operations. For the purpose of computing net income per common share of Services Stock, the number of shares of Services Stock prior to the Effective Date are assumed to be the same as the total number of shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise, of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market values of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. In conjunction with the Services Stock Proposal, a new share repurchase program was approved whereby the Company could acquire up to 1,250,000 shares of Services Stock from time to time in the open market or in private transactions, as conditions warrant. No shares of Services Stock were repurchased in 1993 under the new program. The program to acquire shares remains in effect in 1994. The financial statements of the Services Group include the balance sheets, results of operations and cash flows of the Burlington Air Express Inc. ("Burlington"), Brink's, Incorporated ("Brink's") and Brink's Home Security, Inc. ("BHS") operations of the Company, and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment (Note 2). The Services Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The Company provides holders of Services Stock separate financial statements, financial reviews, descriptions of business and other relevant information for the Services Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Services Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Services Group's financial statements. PRINCIPLES OF COMBINATION: The accompanying financial statements reflect the combined accounts of the businesses comprising the Services Group and their majority-owned subsidiaries. The Services Group interests in 20% to 50% owned companies are carried on the equity method. Undistributed earnings of such companies approximated $38,857,000 at December 31, 1993. All material intercompany items and transactions have been eliminated in combination. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments are those with original maturities in excess of three months and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the first-in, first-out or average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense, and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Subscriber installation costs for home security systems provided by BHS are capitalized and amortized over the estimated life of the assets and are included in machinery and equipment. The basic equipment that is installed, remains the property of BHS and is capitalized at cost. Other capitalized costs, which arise solely as a direct result of the installation process and bring the revenue producing asset to its intended use, include costs of setting up customers on the monitoring network, labor costs and costs incurred for installation scheduling and testing. When a customer is identified for disconnection, the remaining net book value of the basic equipment is fully depreciated. INTANGIBLES: The excess of cost over fair value of net assets of companies acquired is amortized on a straight-line basis over the estimated periods benefitted. INCOME TAXES: In 1991, the Services Group adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. See Note 2 for allocation of the Company's U.S. federal income taxes to the Services Group. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Services Group adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Services Group. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign operations have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been included as a separate component of shareholder's equity. Translation adjustments relating to operations in countries with highly inflationary economies are included in net income, along with all transaction gains and losses for the period. A significant portion of the Services Group's financial results is derived from activities in several foreign countries, each with a local currency other than the U.S. dollar. Because the financial results of the Services Group are reported in U.S. dollars, they are affected by the changes in the value of the various foreign currencies in relation to the U.S. dollar. However, the Services Group's international activity is not concentrated in any single currency, which limits the risks of foreign currency rate fluctuations. FINANCIAL INSTRUMENTS: The Services Group uses foreign currency forward contracts to hedge risk of changes in foreign currency rates associated with certain transactions denominated in various currencies. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized as part of the specific transaction hedged. The Services Group also utilizes swap contracts and call options to protect against price increases in jet fuel and crude oil. Gains and losses on such financial instruments, designated and effective as hedges, are recognized as part of the specific transaction hedged. The Services Group is required to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), in 1994. SFAS 115 requires classification of debt and equity securities and recognition of changes in the fair value of the securities based on the purpose for which the securities are held. The Services Group has determined that the cumulative effect of adopting SFAS 115 is immaterial. REVENUE RECOGNITION: Burlington - Revenues related to transportation services are recognized, together with related transportation costs, on the date shipments physically depart from facilities en route to destination locations. Brink's - Revenues from contract carrier armored car, automatic teller machine, air courier, coin wrapping and currency and deposit processing services are recognized when services are performed. BHS - Monitoring revenues are recognized when earned and amounts paid in advance are deferred and recognized as income over the applicable monitoring period, which is generally one year or less. Revenues from the sale of equipment, excluding equipment which is part of the standard package security system, are recognized, together with related costs, upon completion of the installation. Connection fee revenues are recognized to the extent of direct selling costs incurred and expensed. Connection fee revenues in excess of direct selling costs are deferred and recognized as income on a straight-line basis over ten years. NET INCOME PER COMMON SHARE: Net income per Services Group common share is computed by dividing the net income by the weighted average number of Services Group common shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The potential dilution from the assumed conversion of the 9.20% convertible subordinated debentures is not included since its effect is antidilutive. The shares of Services Stock held in The Pittston Company Employee Benefits Trust are evaluated for inclusion in the calculation of net income per share under the treasury stock method and have no dilutive effect. 2. RELATED PARTY TRANSACTIONS The following policies may be modified or rescinded by action of the Company's Board of Directors (the "Board"), or the Board may adopt additional policies, without approval of the shareholders of the Company, although the Board has no present intention to do so. The Company allocated certain corporate general and administrative expenses, net interest expense and related assets and liabilities in accordance with the policies described below. Corporate assets and liabilities are primarily cash, deferred pension assets, income taxes and accrued liabilities. FINANCIAL: As a matter of policy, the Company manages most financial activities of the Services Group and Minerals Group on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance and repurchase of common stock and the payment of dividends. In preparing these financial statements for the three-year period ended December 31, 1993, transactions primarily related to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs have been attributed to the Services Group based upon its cash flows for the periods presented after giving consideration to the debt and equity structure of the Company. At December 31, 1993, the Company attributed all of its long-term debt to the Services Group based upon the specific purpose for which the debt was incurred and the cash flow requirements of the Services Group. See Note 8 for details and amounts of long-term debt. The portion of the Company's interest expense allocated to the Services Group for 1993, 1992 and 1991 was $5,206,000, $3,003,000 and $4,269,000, respectively. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Services Group operated on a stand alone basis. To the extent borrowings are deemed to occur between the Services Group and the Minerals Group, intercompany accounts have been established bearing interest at the rate in effect from time to time under the Company's unsecured credit lines or, if no such credit lines exist, at the prime rate charged by Chemical Bank from time to time. At December 31, 1993, the Services Group owed the Minerals Group $13,266,000 as the result of borrowings. SHARED SERVICES: A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Services Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Services Group operated on a stand alone basis. These allocations were $9,514,000, $8,556,000 and $8,011,000 in 1993, 1992 and 1991, respectively. PENSION: The Services Group's pension cost related to its participation in the Company's noncontributory defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets and calculated in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("SFAS 87"). Pension plan assets have been allocated to the Services Group based on the percentage of its projected benefit obligation to the plan's total projected benefit obligation. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Services Group operated on a stand alone basis. INCOME TAXES: The Services Group is included in the consolidated U.S. federal income tax return filed by the Company. The Company's consolidated provision and actual cash payments for U.S. federal income taxes are allocated between the Services Group and Minerals Group in accordance with the Company's tax allocation policy and reflected in the financial statements for each Group. In general, the consolidated tax provision and related tax payments or refunds are allocated between the Groups, for financial statement purposes, based principally upon the financial income, taxable income, credits and other amounts directly related to the respective Group. Tax benefits that cannot be used by the Group generating such attributes, but can be utilized on a consolidated basis, are allocated to the Group that generated such benefits and an intercompany account is established for the benefit of the Group generating the attributes. At December 31, 1993 and 1992, the Services Group owed the Minerals Group $20,541,000 and $5,079,000, respectively, for such tax benefits, of which $14,709,000 and $2,918,000, respectively, was not expected to be paid within one year from such dates in accordance with the policy. As a result, the allocated Group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the Groups had filed separate tax returns. 3. SHAREHOLDER'S EQUITY The following analyzes shareholder's equity of the Services Group for the periods presented: Included in shareholder's equity is the cumulative foreign currency translation adjustment of $17,295,000, $13,191,000 and $8,886,000 at December 31, 1993, 1992 and 1991, respectively. 4. PROPERTY, PLANT AND EQUIPMENT During the three years ended December 31, 1993, changes in capitalized subscriber installation costs for home security systems were as follows: As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security system installations. This change in accounting principle is preferable because it more accurately reflects subscriber installation costs. The additional costs not previously capitalized consisted of costs for installation labor and related benefits for supervisory, installation scheduling, equipment testing and other support personnel (in the amount of $2,567,000 in 1993 and $2,327,000 in 1992) and costs incurred in maintaining facilities and vehicles dedicated to the installation process (in the amount of $1,484,000 in 1993 and $1,994,000 in 1992). The effect of this change in accounting principle was to increase operating profit of the Services Group and the BHS segment in 1993 and 1992 by $4,051,000 and $4,321,000, respectively, and net income of the Services Group by $.07 per share in each year. Prior to January 1, 1992, the records needed to identify such costs were not available. Thus, it was impossible to accurately calculate the effect on retained earnings as of January 1, 1992 or the pro forma effects of retroactive application on the year ended December 31, 1991 for the change in accounting principle. However, the Services Group believes the effect on retained earnings as of January 1, 1992 was immaterial. Because capitalized subscriber installation costs for prior periods were not adjusted for the change in accounting principle, installation costs for subscribers in those years will continue to be depreciated based on the lesser amounts capitalized in prior periods. Consequently, depreciation of capitalized subscriber installation costs in the current year and until such capitalized costs prior to January 1, 1992 are fully depreciated will be less than if such prior periods' capitalized costs had been adjusted for the change in accounting. However, the Services Group believes the effect on net income in 1993 and 1992 was immaterial. New subscriber installations for which costs were capitalized totalled 56,700 in 1993, 48,600 in 1992 and 41,000 in 1991. Additional subscribers who purchased the installed equipment and for which no costs were capitalized totalled 1,600 in 1993 and 700 in each of 1992 and 1991. In 1993 and 1992, BHS also added 1,300 and 2,000 subscribers, respectively, as a result of converting previously installed competitors' systems to BHS monitoring. The acquisition of monitoring contracts added 6,400 subscribers in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $40,708,000 in 1993, $38,023,000 in 1992 and $37,060,000 in 1991. 5. INTANGIBLES Intangibles consist entirely of the excess of cost over fair value of net assets of companies acquired and are net of accumulated amortization of $65,574,000 at December 31, 1993 and $58,618,000 at December 31, 1992. The estimated useful life of intangibles is generally forty years. Amortization of intangibles aggregated $7,083,000 in 1993, $7,141,000 in 1992 and $6,978,000 in 1991. 6. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Services Group to concentrations of credit risk consist principally of cash and cash equivalents, short-term cash investments and trade receivables. The Services Group's cash and cash equivalents and short-term investments are placed with high credit qualified financial institutions. Also, by policy, the amount of credit exposure to any one financial institution is limited. Concentration of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Services Group's customer base, and their dispersion across many different industries and geographic areas. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Services Group's long-term debt obligations, which is based upon quoted market prices and rates currently available to the Services Group for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Services Group utilizes various off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to such instruments may be unable to perform is minimized by limiting the counterparties to major international banks. The Services Group does not expect any losses due to such counterparty default. Foreign currency forward contracts - The Company enters into foreign currency forward contracts with a duration of 30 to 45 days as a hedge against accounts payable denominated in various currencies. These contracts do not subject the Company to risk due to exchange rate movements because gains and losses on these contracts offset losses and gains on the payables being hedged. At December 31, 1993, the total contract value of foreign currency forward contracts outstanding was $4,600,000. As of such date, the carrying amounts of the foreign currency forward contracts approximate fair value. Other contracts - The Services Group has hedged a significant portion of its jet fuel requirements for the period January 1, 1994 through March 31, 1995, through swap contracts which were intended to fix the Company's per gallon fuel costs below 1993 levels. At December 31, 1993, the contract value of the jet fuel swaps, aggregating 50.1 million gallons, was $25,492,000. In addition, a call option was purchased for 12.6 million gallons of crude oil for the first half of 1994. Each of these transactions are settled monthly based upon the average of the high and low prices during each period. The fair value of these fuel hedge transactions may fluctuate over the course of the contract period due to changes in the supply and demand for oil and refined products. Thus, the economic gain or loss, if any, upon settlement of the contracts may differ from the fair value of the contracts at an interim date. At December 31, 1993, the aggregate carrying value of the swap contract and the call option exceeded their fair value by approximately $1,700,000. 7. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Services Group adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. As of January 1, 1991, the Services Group recorded a tax credit of approximately $3,665,000 or $.10 per share, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993, 1992 and 1991, cash payments for income taxes, net of refunds received, were $27,776,000, $13,091,000 and $10,990,000, respectively. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholder's equity. The components of the net deferred tax liability as of December 31, 1993 and December 31, 1992 were as follows: The valuation allowance relates to deferred tax assets in certain foreign jurisdictions. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income before income taxes. It is the policy of the Services Group to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992 the unrecognized deferred tax liability for temporary differences of approximately $43,640,000 and $36,200,000, respectively, related to investments in foreign subsidiaries and affiliates that are essentially permanent in nature and not expected to reverse in the foreseeable future was approximately $15,274,000 and $12,308,000, respectively. The Services Group is included in the Company's consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Services through the year 1981. As of December 31, 1993, the Services Group had $8,695,000 of alternative minimum tax credits allocated to it under the Company's tax allocation policy. Such credits are available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefits of net operating loss carryforwards of the Services Group as at December 31, 1993 were $6,617,000 and relate to various state and foreign taxing jurisdictions. The expiration periods primarily range from 5 to 15 years. 8. LONG-TERM DEBT All outstanding debt under the Company's revolving credit agreements and the Company's subordinated obligations have been attributed to the Services Group. Total long-term debt of the Services Group consists of the following: For the four years through December 31, 1998, minimum repayments of long-term debt outstanding are as follows: The Dutch guilder loan bears interest based on Euroguilder rate, or if converted to a U.S. dollar loan, bears interest based on prime, Eurodollar or money market rates. In January 1992, a portion of the guilder loan was converted into a U.S. dollar loan. In March 1993, a pound sterling loan was converted into a U.S. dollar term loan due 1995 to 1997. Interest was previously based on the Eurosterling rate and is currently based on the Eurodollar rate. The Canadian dollar loan was paid in June 1993. Under the terms of the loans, Brink's has agreed to various restrictions relating to net worth, disposition of assets and incurrance of additional debt. At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. The 4% subordinated debentures due July 1, 1997, are exchangeable for cash, at the rate of $157.80 per $1,000 debentures. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices equal to 100% of principal amount. The 9.20% convertible subordinated debentures due July 1, 2004 are convertible into shares of Services Stock and Minerals Stock at the rate of two shares of Services Stock and two-fifths of a share of Minerals Stock for each $100 principal amount of debenture, subject to adjustment pursuant to antidilution provisions. The debentures are redeemable at the Company's option, in whole or in part, at any time prior to maturity, at redemption prices which decline from 102.76% of principal amount before July 1, 1994, to 100% of principal amount after June 30, 1999. Various international operations maintain lines of credit and overdraft facilities aggregating approximately $58,000,000 with a number of banks on either a secured or unsecured basis. Under the terms of some of its debt instruments, the Company has agreed to various restrictions relating to the payment of dividends, the repurchase of capital stock, maintenance of consolidated working capital and net worth, and the amount of additional funded debt which may be incurred. See the Company's consolidated financial statements and related footnotes. At December 31, 1993, the Company's portion of outstanding unsecured letters of credit allocated to the Services Group was $31,163,000, primarily supporting the Services Group's obligations under aircraft leases and its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $8,081,000, $8,916,000 and $13,080,000, respectively. 9. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 1), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 1, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of a share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, a total of 987,605 shares of Services Stock shares were exercisable. In addition, there were 2,578,770 shares of Services Stock reserved for issuance under the plans, including 199,966 shares of Services Stock reserved for future grant. 10. ACQUISITIONS During 1993, the Services Group acquired one small business and made a contingency payment related to an acquisition consummated in a prior year. The total consideration paid was $736,000. During 1992, the Services Group acquired a business for an aggregate purchase price of $2,658,000, including debt of $1,144,000. The fair value of assets acquired was $2,690,000 and liabilities assumed was $32,000. In addition, cash payments of $226,000 were made for contingency payments for acquisitions made in prior years. During 1991, the Services Group acquired one small business and made contingency payments related to other acquisitions consummated in prior years. The total consideration paid was $1,179,000. All acquisitions have been accounted for as purchases. In 1993, 1992 and 1991, the purchase price was essentially equal to the fair value of assets acquired. The results of operations of the acquired companies have been included in the Services Group's results of operations from their date of acquisition. 11. LEASES The Services Group's businesses lease aircraft, facilities, vehicles, computers and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $6,364,000. Rent expense amounted to $66,585,000 in 1993, $58,795,000 in 1992 and $52,577,000 in 1991 and is net of sublease rentals of $793,000, $1,419,000 and $2,149,000, respectively. Included in future minimum lease payments are rentals for aircraft and the Toledo, Ohio hub operated as part of a controlled airlift project. The Toledo, Ohio hub lease commenced in 1991 for a twenty-two year period. Certain costs of the project are being amortized over the terms of the respective leases. The unamortized expense as of December 31, 1993 and 1992, aggregated $1,525,000 and $2,825,000, respectively. Burlington entered into two transactions covering various leases which provide for the replacement of eight B707 aircraft with seven DC8-71 aircraft and completed an evaluation of other fleet related costs. One transaction, representing four aircraft, is reflected in the 1993 financial statements, while the other transactions, covering three aircraft, is reflected in the 1992 financial statements. The net effect of these transactions did not have a material impact on operating profit for either year. The Services Group incurred capital lease obligations of $1,601,000 in 1993, $2,316,000 in 1992 and $5,530,000 in 1991. As of December 31, 1993, the Services Group's obligations under capital leases were not significant. 12. EMPLOYEE BENEFIT PLANS The Services Group's businesses participate in the Company's noncontributory defined benefit pension plan covering substantially all nonunion employees who meet certain minimum requirements in addition to sponsoring certain other defined benefit plans. Benefits of most of the plans are based on salary and years of service. The Services Group's pension cost relating to its participation in the Company's defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension expense (credit) for 1993, 1992 and 1991 for all plans is as follows: The funded status and prepaid pension expense at December 31, 1993 and 1992, are as follows: The assumptions used in determining the net pension expense (credit) for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986 (January 1, 1989, for certain foreign pension plans), the date of adoption of SFAS 87, has been amortized over the estimated remaining average service life of the employees. As of December 31, 1993, approximately 69% of plan assets were invested in equity securities and 31% in fixed income securities. The Services Group also provide certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States and Canada. Effective January 1, 1991, the Services Group adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Services Group recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $5,450,000, with a net income effect of $3,354,000 or $.09 per share. The latter amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: Interest costs on the accumulated postretirement benefit obligation were based on a rate of 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The postretirement benefit obligation for U.S. salaried employees does not provide for changes in health care costs since the employer's contribution to the plan is a fixed monthly amount. The assumed health care cost trend rate used in 1993 for employees under a foreign plan was 10% grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $12,000 increase in the aggregate service and interest components of expense for the year 1993, and a $108,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Services Group also participates in the Company's Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched at rates of 50% to 100% up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $3,360,000 in 1993, $3,332,000 in 1992 and $2,878,000 in 1991. The Services Group sponsors several other defined contribution benefit plans based on hours worked or other measurable factors. Contributions under all of these plans aggregated $443,000 in 1993, $498,000 in 1992 and $280,000 in 1991. The Services Group is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"), in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Services Group has determined that the cumulative effect of adopting SFAS 112 is immaterial. 13. OTHER OPERATING INCOME Other operating income includes the Services Group's share of net income in unconsolidated affiliated companies which are carried on the equity method. Summarized financial information for these equity method companies is shown below. Amounts presented include the accounts of the following equity affiliates: The following table presents summarized financial information of these companies. 14. ACCOUNTING CHANGES As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase net income in 1993 and 1992 by $2,435,000 and $2,596,000, respectively (Note 4). During 1991, the Services Group adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 15. SEGMENT INFORMATION Operating revenues by geographic area are as follows: The following is derived from the business segment information in the Company's consolidated financial statements as it relates to the Services Group. See Note 2, Related Party Transactions, for a description of the Company's policy for corporate allocations. The Services Group's portion of the Company's operating profit is as follows: The Services Group portion of the Company's assets at year end is as follows: Industry segment information is as follows: * Includes equity in net income of unconsolidated foreign affiliates of $6,895,000 in 1993, $8,133,000 in 1992 and $7,629,000 in 1991. ** As of January 1, 1992, BHS elected to capitalize categories of costs not previously capitalized for home security installations to more accurately reflect subscriber installation costs. The effect of this change in accounting principle was to increase operating profit in 1993 by $4,051,000 and in 1992 by $4,321,000 (Note 4). 16. CONTINGENT LIABILITIES Under the Coal Industry Retiree Health Benefit Act of 1992 (the "Act"), the Company and its majority-owned subsidiaries at July 20, 1992, including the Services Group included in these financial statements, are jointly and severally liable with the Minerals Group for the costs of health care coverage provided for by that Act. For a description of the Act and a calculation of certain of such costs, see Note 13 to the Company's consolidated financial statements. At this time, the Company expects the Minerals Group to generate sufficient cash flow to discharge its obligations under the Act. In April 1990, the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. 18. SUBSEQUENT EVENTS In January 1994, 161,000 shares of convertible preferred stock (convertible into Minerals Stock) were issued to finance a portion of the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington Resources, Inc. While the issuance of the preferred stock had no effect on the capitalization of the Services Group, commencing March 1, 1994, annual cumulative dividends of $31.25 per share of convertible preferred stock are payable quarterly, in cash, in arrears, from the date of original issue out of all funds of the Company legally available therefor, when, as and if declared by the Company's Board. A portion of the acquisition was also financed with additional debt under existing credit facilities. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 8). The acquisition and related financing will be attributed to the Minerals Group. PITTSTON MINERALS GROUP STATEMENT OF MANAGEMENT RESPONSIBILITY The management of The Pittston Company (the "Company") is responsible for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. Management has also prepared the other information in the annual report and is responsible for its accuracy. In meeting our responsibility for the integrity of the financial statements, we maintain a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with management's authorization and that the accounting records provide a reliable basis for the preparation of the financial statements. Qualified personnel throughout the organization maintain and monitor these internal controls on an ongoing basis. In addition, the Company maintains an internal audit department that systematically reviews and reports on the adequacy and effectiveness of the controls, with management follow-up as appropriate. Management has also established a formal Business Code of Ethics which is distributed throughout the Company. We acknowledge our responsibility to establish and preserve an environment in which all employees properly understand the fundamental importance of high ethical standards in the conduct of our business. The accompanying financial statements have been audited by KPMG Peat Marwick, independent auditors. During the audit they review and make appropriate tests of accounting records and internal controls to the extent they consider necessary to express an opinion on the Minerals Group's financial statements. The Company's Board of Directors pursues its oversight role with respect to the Minerals Group's financial statements through the Audit and Ethics Committee, which is composed solely of outside directors. The Committee meets periodically with the independent auditors, internal auditors and management to review the Company's control system and to ensure compliance with applicable laws and the Company's Business Code of Ethics. We believe that the policies and procedures described above are appropriate and effective and do enable us to meet our responsibility for the integrity of the Minerals Group's financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY We have audited the accompanying balance sheets of Pittston Minerals Group (as described in Note 1) as of December 31, 1993 and 1992 and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of The Pittston 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 of Pittston Minerals Group present fairly, in all material respects, the financial position of Pittston Minerals Group 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. As more fully discussed in Note 1, the financial statements of Pittston Minerals Group should be read in connection with the audited consolidated financial statements of The Pittston Company and subsidiaries. As discussed in Notes 7, 13 and 16 to the financial statements, Pittston Minerals Group changed its methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG Peat Marwick Stamford, Connecticut January 24, 1994 PITTSTON MINERALS GROUP BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes to financial statements. PITTSTON MINERALS GROUP STATEMENTS OF OPERATIONS Years Ended December 31, 1993, 1992 and 1991 (In thousands, except per share amounts) See accompanying notes to financial statements. PITTSTON MINERALS GROUP STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 (In thousands) See accompanying notes to financial statements. PITTSTON MINERALS GROUP NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION: The approval on July 26, 1993 (the "Effective Date"), by the shareholders of The Pittston Company (the "Company") of the Services Stock Proposal, as described in the Company's proxy statement dated June 24, 1993, resulted in the reclassification of the Company's common stock. The outstanding shares of Company common stock were redesignated as Pittston Services Group Common Stock ("Services Stock") on a share-for-share basis and a second class of common stock, designated as Pittston Minerals Group Common Stock ("Minerals Stock"), was distributed on the basis of one-fifth of one share of Minerals Stock for each share of the Company's previous common stock held by shareholders of record on July 26, 1993. Minerals Stock and Services Stock provide shareholders with separate securities reflecting the performance of the Pittston Minerals Group (the "Minerals Group") and the Pittston Services Group (the "Services Group") respectively, without diminishing the benefits of remaining a single corporation or precluding future transactions affecting either group. Accordingly, all stock and per share data prior to the reclassification have been restated to reflect the reclassification. The primary impacts of this restatement are as follows: o Net income per common share has been included in the Statements of Operations. For the purpose of computing net income per common share of Minerals Stock, the number of shares of Minerals Stock are assumed to be one-fifth of the total number of shares of the Company's common stock. o All financial impacts of purchases and issuances of the Company's common stock prior to the Effective Date have been attributed to each Group in relation of their respective common equity to the Company's common stock. Dividends paid by the Company were attributed to the Services and Minerals Groups in relation to the initial dividends paid on the Services Stock and the Minerals Stock. The Company, at any time, has the right to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. In addition, upon the sale, transfer, assignment or other disposition, whether by merger, consolidation, sale or contribution of assets or stock or otherwise, of all or substantially all of the properties and assets of the Minerals Group to any person, entity or group (with certain exceptions), the Company is required to exchange each outstanding share of Minerals Stock for shares of Services Stock having a fair market value equal to 115% of the fair market value of one share of Minerals Stock. Shares of Services Stock are not subject to either optional or mandatory exchange. Holders of Services Stock have one vote per share. Holders of Minerals Stock have one vote per share subject to adjustment on January 1, 1996, and on each January 1 every two years thereafter based upon the relative fair market values of one share of Minerals Stock and one share of Services Stock on each such date. Accordingly, beginning on January 1, 1996, each share of Minerals Stock may have more than, less than or continue to have exactly one vote. Holders of Services Stock and Minerals Stock vote together as a single voting group on all matters as to which all common shareholders are entitled to vote. In addition, as prescribed by Virginia law, certain amendments to the Company's Restated Articles of Incorporation affecting, among other things, the designation, rights, preferences or limitations of one class of common stock, or any merger or statutory share exchange, must be approved by the holders of such class of common stock, voting as a separate voting group, and, in certain circumstances, may also have to be approved by the holders of the other class of common stock, voting as a separate voting group. In the event of a dissolution, liquidation or winding up of the Company, the holders of Services Stock and Minerals Stock will receive the funds remaining for distribution, if any, to the common shareholders on a per share basis in proportion to the total number of shares of Services Stock and Minerals Stock, respectively, then outstanding to the total number of shares of both classes of common stock then outstanding. The Company's Articles of Incorporation limits dividends on Minerals Stock to the lesser of (i) all funds of the Company legally available therefore (as prescribed by Virginia law) and (ii) the Available Minerals Dividend Amount (as defined in the Articles of Incorporation). At December 31, 1993, the Available Minerals Dividend Amount was at least $10,054,000. After giving effect to the issuance of the Convertible Preferred Stock (Note 20), the pro forma Available Minerals Dividend Amount would have been at least $85,622,000. Dividends on Minerals Stock are also restricted by covenants in the Company's public indentures and bank credit agreements. In conjunction with the Services Stock Proposal, a new share repurchase program was approved whereby the Company could acquire up to 250,000 shares of Minerals Stock from time to time in the open market or in private transactions, as conditions warrant. Through December 31, 1993, 19,000 shares of Minerals Stock were repurchased under the new program at a total cost of $407,000. The program to acquire shares remains in effect in 1994. The financial statements of the Minerals Group include the balance sheets, results of operations and cash flows of the Coal and Mineral Ventures operations of the Company, and a portion of the Company's corporate assets and liabilities and related transactions which are not separately identified with operations of a specific segment (Note 2). The Minerals Group's financial statements are prepared using the amounts included in the Company's consolidated financial statements. Corporate allocations reflected in these financial statements are determined based upon methods which management believes to be an equitable allocation of such expenses and credits. The Company provides holders of Minerals Stock separate financial statements, financial reviews, descriptions of business and other relevant information for the Minerals Group in addition to consolidated financial information of the Company. Notwithstanding the attribution of assets and liabilities (including contingent liabilities) between the Minerals Group and the Services Group for the purpose of preparing their financial statements, this attribution and the change in the capital structure of the Company as a result of the approval of the Services Stock Proposal did not result in any transfer of assets and liabilities of the Company or any of its subsidiaries. Holders of Minerals Stock are shareholders of the Company, which continues to be responsible for all its liabilities. Therefore, financial developments affecting the Minerals Group or the Services Group that affect the Company's financial condition could affect the results of operations and financial condition of both Groups. Accordingly, the Company's consolidated financial statements must be read in connection with the Minerals Group's financial statements. PRINCIPLES OF COMBINATION: The accompanying financial statements reflect the accounts of the businesses comprising the Minerals Group. All material intercompany items and transactions have been eliminated in combination. Certain prior year amounts have been reclassified to conform to the current year's financial statement presentation. CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand, demand deposits and investments with original maturities of three months or less. SHORT-TERM INVESTMENTS: Short-term investments primarily include funds set aside by management for certain obligations and are carried at cost which approximates market. INVENTORIES: Inventories are stated at cost (determined under the average cost method) or market, whichever is lower. PROPERTY, PLANT AND EQUIPMENT: Expenditures for maintenance and repairs are charged to expense, and the costs of renewals and betterments are capitalized. Depreciation is provided principally on the straight-line method at varying rates depending upon estimated useful lives. Depletion of bituminous coal lands is provided on the basis of tonnage mined in relation to the estimated total of recoverable tonnage in the ground. Mine development costs, primarily included in bituminous coal lands, are capitalized and amortized over the estimated useful life of the mine. These costs include expenses incurred for site preparation and development as well as operating deficits incurred at the mines during the development stage. A mine is considered under development until all planned production units have been placed in operation. INCOME TAXES: In 1991, the Minerals Group adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. See Note 2 for allocation of the Company's U.S. federal income taxes to the Minerals Group. PNEUMOCONIOSIS (BLACK LUNG) EXPENSE: The Minerals Group acts as self-insurer with respect to black lung benefits. Provision is made for estimated benefits in accordance with annual actuarial reports prepared by outside actuaries. The excess of the present value of expected future benefits over the accumulated book reserves is recognized over the amortization period as a level percentage of payroll. Cumulative actuarial gains or losses are calculated periodically and amortized on a straight-line basis. Assumptions used in the calculation of the actuarial present value of black lung benefits are based on actual retirement experience of the Company's coal employees, black lung claims incidence for active miners, actual dependent information, industry turnover rates, actual medical and legal cost experience and current inflation rates. As of December 31, 1993 and 1992, the accrued value of estimated future black lung benefits discounted at 6% was approximately $61,067,000 and $61,095,000, respectively and are included in workers' compensation and other claims. Based on actuarial data, the amount charged to earnings was $438,000 in 1993, $1,029,000 in 1992 and $3,113,000 in 1991. In addition, the Company accrued additional expenses for black lung benefits related to federal and state assessments, legal and administrative expenses and other self insurance. These amounted to $2,887,000 in 1993, $2,073,000 in 1992 and $2,435,000 in 1991. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: In 1991, the Minerals Group adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"), which requires employers to accrue the cost of such retirement benefits during the employees' service with the Minerals Group. FOREIGN CURRENCY TRANSLATION: Assets and liabilities of foreign operations have been translated at current exchange rates, and related revenues and expenses have been translated at average rates of exchange in effect during the year. Resulting cumulative translation adjustments have been included as a separate component of shareholder's equity. FINANCIAL INSTRUMENTS: The Minerals Group hedges against downward movements in gold prices principally through the use of forward sales contracts. Gains and losses on these contracts, designated and effective as hedges, are deferred and recognized upon delivery of gold against these contracts. REVENUE RECOGNITION: Coal sales are generally recognized when coal is loaded onto transportation vehicles before shipment to customers. For domestic sales, this occurs when coal is loaded onto railcars at mine locations. For export sales, this occurs when coal is loaded onto marine vessels at terminal facilities. Gold sales are recognized when products are shipped to a refinery. Settlement adjustments arising from final determination of weights and assays are reflected in sales when received. NET INCOME PER COMMON SHARE: Net income per Pittston Minerals Group common share is computed by dividing the net income by the weighted average number of Pittston Minerals Group common shares outstanding during the period. The potential dilution from the exercise of stock options is not material. The shares of Minerals Stock held in The Pittston Company Employee Benefits Trust are evaluated for inclusion in the calculation of net income per Pittston Minerals Group common share under the treasury stock method and have no dilutive effect. 2. RELATED PARTY TRANSACTIONS The following policies may be modified or rescinded by action of the Company's Board of Directors (the "Board"), or the Board may adopt additional policies, without approval of the shareholders of the Company, although the Board has no present intention to do so. The Company allocated certain corporate general and administrative expenses, net interest expense and related assets and liabilities in accordance with the policies described below. Corporate assets and liabilities are primarily cash, deferred pension assets, income taxes and accrued liabilities. FINANCIAL: As a matter of policy, the Company manages most financial activities of the Minerals Group and the Services Group on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance, repayment and repurchase of short-term and long-term debt; the issuance and repurchase of common stock and the payment of dividends. In preparing these financial statements for the three-year period ended December 31, 1993, transactions primarily related to invested cash, short-term and long-term debt (including convertible debt), related net interest and other financial costs have been attributed to the Minerals Group based upon its cash flows for the periods presented after giving consideration to the debt and equity structure of the Company. The portion of the Company's interest expense allocated to the Minerals Group for 1993, 1992 and 1991 was $359,000, $2,800,000 and $1,400,000, respectively. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Minerals Group operated on a stand alone basis. To the extent borrowings are deemed to occur between the Services Group and the Minerals Group, intercompany accounts have been established bearing interest at the rate in effect from time to time under the Company's unsecured credit lines or, if no such credit lines exist, at the prime rate charged by Chemical Bank from time to time. At December 31, 1993, the amount owed the Minerals Group by the Services Group as a result of borrowings totaled $13,266,000. SHARED SERVICES: A portion of the Company's corporate general and administrative expenses and other shared services has been allocated to the Minerals Group based upon utilization and other methods and criteria which management believes to be equitable and a reasonable estimate of such expenses as if the Minerals Group operated on a stand alone basis. These allocations were $7,218,000, $8,554,000 and $8,096,000 in 1993, 1992 and 1991, respectively. PENSION: The Minerals Group's pension cost related to its participation in the Company's noncontributory defined benefit pension plan is actuarially determined based on its respective employees and an allocable share of the pension plan assets and calculated in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("SFAS 87"). Pension plan assets have been allocated to the Minerals Group based on the percentage of its projected benefit obligation to the plan's total projected benefit obligation. Management believes such method of allocation to be equitable and a reasonable estimate of such costs as if the Minerals Group operated on a stand alone basis. INCOME TAXES: The Minerals Group is included in the consolidated U.S. federal income tax return filed by the Company. The Company's consolidated provision and actual cash payments for U.S. federal income taxes are allocated between the Minerals Group and Services Group in accordance with the Company's tax allocation policy and reflected in the financial statements for each Group. In general, the consolidated tax provision and related tax payments or refunds are allocated between the Groups, for financial statement purposes, based principally upon the financial income, taxable income, credits and other amounts directly related to the respective Group. Tax benefits that cannot be used by the Group generating such attributes, but can be utilized on a consolidated basis, are allocated to the Group that generated such benefits and an intercompany account is established for the benefit of the Group generating the attributes. At December 31, 1993 and 1992, the Minerals Group was owed $20,541,000 and $5,079,000, respectively, from the Services Group for such tax benefits, of which $14,709,000 and $2,918,000, respectively, was not expected to be received within one year from such dates in accordance with the policy. As a result, the allocated Group amounts of taxes payable or refundable are not necessarily comparable to those that would have resulted if the Groups had filed separate tax returns. 3. SHAREHOLDER'S EQUITY The following analyzes shareholder's equity of the Minerals Group for the periods presented: Included in shareholder's equity is the cumulative foreign currency translation adjustment of $1,086,000, $871,000 and $271,000 at December 31, 1993, 1992 and 1991, respectively. 4. PROPERTY, PLANT AND EQUIPMENT Mine development costs which were capitalized totalled $2,181,000 in 1993, $18,487,000 in 1992 and $12,167,000 in 1991. The estimated useful lives for property, plant and equipment are as follows: Depreciation of property, plant and equipment aggregated $23,245,000 in 1993, $19,268,000 in 1992 and $15,999,000 in 1991. 5. ACCOUNTS RECEIVABLE - TRADE In 1991, the Company, on behalf of the Minerals Group, entered into agreements with two financial institutions whereby it had the right to sell certain coal receivables, with recourse, to those institutions. One agreement expired on June 30, 1992. The other agreement, which expires September 27, 1994, limits the maximum amount of outstanding receivables that could be owned by the financial institution to $20,000,000. The Minerals Group sold total coal receivables of approximately $16,143,000 in 1993, $23,959,000 in 1992 and $2,776,000 in 1991 under these agreements. In 1985, the Company, on behalf of the Minerals Group, entered into an agreement whereby it had the right to sell certain coal receivables, with limited recourse, to a financial institution from time to time until December 31, 1991. During 1992, the Minerals Group continued to sell certain coal receivables to the financial institution under essentially the same terms and conditions as the expired agreement. The Minerals Group sold total coal receivables of approximately $41,272,000 in 1992 and $10,706,000 in 1991 under this agreement, which has since been terminated. As of December 31, 1993, there were no receivables sold which remained to be collected. As of December 31, 1992, receivables sold totalling $11,987,000 remained to be collected. 6. FINANCIAL INSTRUMENTS Financial instruments which potentially subject the Minerals Group to concentrations of credit risk consist principally of cash and cash equivalents, short-term investments and trade receivables. The Minerals Group's cash and cash equivalents and short-term investments are placed with high credit qualified financial institutions. Also, by policy, the amount of credit exposure to any one financial institution is limited. The Minerals Group makes substantial sales to relatively few large customers. Credit limits, ongoing credit evaluation and account monitoring procedures are utilized to minimize the risk of loss from nonperformance on trade receivables. The following details the fair values of financial instruments for which it is practicable to estimate the value: CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The carrying amounts approximate fair value because of the short maturity of these instruments. DEBT The aggregate fair value of the Minerals Group's long term debt obligations, which is based upon quoted market prices and rates currently available to the Company for debt with similar terms and maturities, approximates the carrying amount. OFF-BALANCE SHEET INSTRUMENTS The Minerals Group utilizes off-balance sheet financial instruments, as discussed below, to hedge its foreign currency and other market exposures. Accordingly, the fair value of these instruments have been considered in determining the fair values of the assets and liabilities being hedged. The risk that counterparties to these contracts may be unable to perform is minimized by limiting the counterparties to major international banks. The Company does not expect any losses due to such counterparty default. In order to protect itself against downward movements in gold prices, the Minerals Group hedges a portion of its recoverable proved and probable reserves primarily through forward sales contracts. At December 31, 1993, 72,000 ounces of gold, representing approximately 50% of the Minerals Group's recoverable proved and probable reserves, were sold forward under forward sales contracts at an average price of $350 per ounce. Because only a portion of its future production is currently sold forward, the Minerals Group can take advantage of increases, if any, in the spot price of gold. At December 31, 1993, the aggregate carrying value of the Minerals Group's forward sales contracts exceeded their fair value by approximately $2,900,000. 7. INCOME TAXES The provision (credit) for income taxes consists of the following: Effective January 1, 1991, the Minerals Group adopted SFAS 109, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial 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. As of January 1, 1991, the Minerals Group recorded a tax credit of approximately $6,396,000, or $.86 per share, which amount represents the net decrease to the deferred tax liability as of that date. Such amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years ended December 31, 1993 and 1991, cash payments for income taxes, net of refunds received, were $2,461,000 and $4,295,000, respectively. For the year ended December 31, 1992, there was a net cash tax refund of $6,962,000. The significant components of the deferred tax expense (benefit) were as follows: The tax benefit for compensation expense related to the exercise of certain employee stock options for tax purposes in excess of compensation expense for financial reporting purposes is recognized as an adjustment to shareholder's equity. The components of the net deferred tax asset as of December 31, 1993, and December 31, 1992, were as follows: The recording of net deferred federal tax assets is based upon their expected utilization in the Company's consolidated federal income tax return and the benefit that would accrue to the Minerals Group under the Company's tax allocation policy. The valuation allowance relates to deferred tax assets in certain foreign and state jurisdictions. The following table accounts for the difference between the actual tax provision and the amounts obtained by applying the statutory U.S. federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the income (loss) before income taxes. It is the policy of the Minerals Group to accrue deferred income taxes on temporary differences related to the financial statement carrying amounts and tax bases of investments in foreign subsidiaries and affiliates which are expected to reverse in the foreseeable future. As of December 31, 1993 and December 31, 1992, there was no unrecognized deferred tax liability for temporary differences related to investments in foreign subsidiaries and affiliates. The Minerals Group is included in the Company's consolidated U.S. federal income tax return. Such returns have been audited and settled with the Internal Revenue Service through the year 1981. As of December 31, 1993, the Minerals Group had $22,079,000 of alternative minimum tax credits allocated to it under the Company's tax allocation policy. Such credits are available to offset future U.S. federal income taxes and, under current tax law, the carryforward period for such credits is unlimited. The tax benefit of net operating loss carryforwards for the Minerals Group as at December 31, 1993 was $1,682,000 primarily related to foreign operations which have an unlimited carryforward period. 8. LONG-TERM DEBT At December 31, 1993, $309,000 of debt outstanding was directly incurred by the Minerals Group. At December 31, 1993 and 1992, none of the Company's long-term debt was attributed to the Minerals Group. Any borrowings by the Company for the benefit of the Minerals Group are directly attributed to it. See the Company's consolidated financial statements and related footnotes for additional discussions of the Company's long-term debt and various financial covenants related to debt agreements. At December 31, 1993, the Company had separate revolving credit agreements with several banks under which it is permitted to borrow, repay and reborrow up to an aggregate of $250,000,000. Interest is payable at rates based on prime, certificate of deposit, Eurodollar, money market or Federal Funds rates. The agreements, which have various expiration dates beginning in December 1994 and continuing through December 1997, include provisions under which borrowings are converted to term loans with various repayment dates. In March 1994, the Company entered into a $350,000,000 syndicated revolving credit agreement with a syndicate of banks (the "New Facility"), replacing the Company's previously existing $250,000,000 of revolving credit agreements. The New Facility includes a $100,000,000 five-year term loan, which matures in March 1999. The New Facility also permits additional borrowings, repayments and reborrowings of up to an aggregate of $250,000,000 until March 1999. Interest on borrowings under the New Facility is payable at rates based on prime, certificate of deposit, Eurodollar or money market rates. At December 31, 1993, the Company's portion of outstanding unsecured letters of credit allocated to the Minerals Group was $41,111,000, primarily supporting its obligations under its various self-insurance programs. Cash payments made for interest for the years ended December 31, 1993, 1992 and 1991 were $2,126,000, $2,637,000 and $2,875,000, respectively. 9. STOCK OPTIONS The Company grants options under its 1988 Stock Option Plan (the "1988 Plan") to executives and key employees and under its Non-Employee Directors' Stock Option Plan (the "Non-Employee Plan") to outside directors to purchase common stock at a price not less than 100% of quoted market value at date of grant. The 1988 Plan provides for the grant of "incentive stock options", which terminate not later than ten years from the date of grant, and "nonqualified stock options", which terminate not later than ten years and two days from the date of grant. As part of the Services Stock Proposal (Note 1), the 1988 Plan was amended to permit option grants to be made to optionees with respect to either Services Stock or Minerals Stock, or both. The Non-Employee Plan authorizes initial and automatic grants of "nonqualified stock options" which terminate on the tenth anniversary of grant. Pursuant to the Non-Employee Plan, also amended for the Services Stock Proposal, each non-employee director of the Company elected after July 26, 1993, shall receive an initial grant of an option to purchase 10,000 shares of Services Stock and an option to purchase 2,000 shares of Minerals Stock. On July 1 of each subsequent year, each non-employee director will automatically be granted an option to purchase 1,000 shares of Services Stock and an option to purchase 200 shares of Minerals Stock. The first of such automatic grants was made on August 1, 1993. The Company's 1979 Stock Option Plan (the "1979 Plan") and 1985 Stock Option Plan (the "1985 Plan") terminated in 1985 and 1988, respectively, except as to options theretofore granted. At the Effective Date, as defined in Note 1, a total of 2,228,225 shares of common stock were subject to options outstanding under the 1988 Plan, the Non-Employee Plan, the 1979 Plan and the 1985 Plan. Pursuant to antidilution provisions in the option agreements covering such options, the Company has converted these options into options for shares of Services Stock or Minerals Stock, or both, depending primarily on the employment status and responsibilities of the particular optionee. In the case of optionees having Company-wide responsibilities, each outstanding option has been converted into an option for Services Stock and an option for Minerals Stock, in the same ratio as the distribution on the Effective Date of Minerals Stock to shareholders of the Company, viz., one share to one-fifth of the share, with any resultant fractional share of Minerals Stock rounded downward to the nearest whole number of shares. In the case of other optionees, each outstanding option has been converted into a new option for only Services Stock or Minerals Stock, as the case may be, following the Effective Date. As a result, 2,167,247 shares of Services Stock and 507,698 shares of Minerals Stock were subject to options outstanding as of the Effective Date. The table below summarizes the activity in all plans. At December 31, 1993, total of 240,814 shares of Minerals Stock were exercisable. In addition, there were 640,298 shares of Minerals Stock reserved for issuance under the plans, including 16,800 shares of Minerals Stock reserved for future grant. 10. ACQUISITIONS During 1993, the Minerals Group made installment and contingency payments related to acquisitions consummated in prior years. Total consideration paid was $699,000. During 1992, the Minerals Group acquired two businesses for an aggregate purchase price of $45,142,000, including installment payments to be made of $1,720,000. Of the total purchase price, $42,734,000 was for the purchase of a company whose principal assets include two long-term coal supply contracts. The fair value of assets acquired was $48,168,000 and liabilities assumed was $3,026,000. The acquisitions have been accounted for as purchases and the purchase price was essentially equal to the fair value of net assets acquired. In addition, the Minerals Group made cash payments of $7,398,000 for an equity investment. During 1991, the Minerals Group made a contingency payment of $735,000 related to an acquisition consummated in a prior year. The results of operations of the acquired companies have been included in the Minerals Group's results of operations from their date of acquisition. 11. JOINT VENTURE The Minerals Group, through a wholly owned indirect subsidiary of the Company, entered into a partnership agreement in 1982 with four other coal companies to construct and operate coal port facilities in Newport News, Virginia, in the Port of Hampton Roads (the "Facilities"). The Facilities commenced operations in 1984, and now have an annual throughput capacity of 22 million tons, with a ground storage capacity of approximately 2 million tons. The Minerals Group initially had an indirect 25% interest in the partnership, Dominion Terminal Associates ("DTA"). Initial financing of the Facilities was accomplished through the issuance of $135,000,000 principal amount of revenue bonds by the Peninsula Ports Authority of Virginia (the "Authority"), which is a political subdivision of the Commonwealth of Virginia. In 1987, the original revenue bonds were refinanced by the issuance of $132,800,000 of coal terminal revenue refunding bonds of which two series of these bonds in the aggregate principal amount of $33,200,000 were attributable to the Minerals Group. In 1990, the Minerals Group acquired an additional indirect 7 1/2% interest in DTA for cash of $3,055,000 plus the assumption of bond indebtedness, increasing its ownership to 32 1/2%. With the increase in ownership, $9,960,000 of the remaining four additional series of the revenue refunding bonds of $99,600,000 became attributable to the Minerals Group. In November 1992, all bonds attributable to the Minerals Group were refinanced with the issuance of a new series of coal terminal revenue refunding bonds in the aggregate principal amount of $43,160,000. The new series of bonds bear a fixed interest rate of 7 3/8%. The Authority owns the Facilities and leases them to DTA for the life of the bonds, which mature on June 1, 2020. DTA may purchase the facilities for $1 at the end of the lease term. The obligations of the partners are several, and not joint. Under loan agreements with the Authority, DTA is obligated to make payments sufficient to provide for the timely payment of the principal of and interest on the bonds of the new series. Under a throughput and handling agreement, the Minerals Group has agreed to make payments to DTA that in the aggregate will provide DTA with sufficient funds to make the payments due under the loan agreements and to pay the Minerals Group's share of the operating costs of the Facilities. The Company has also unconditionally guaranteed the payment of the principal of and premium, if any, and the interest on the new series of bonds. Payments for operating costs aggregated $7,949,000 in 1993, $6,819,000 in 1992 and $6,885,000 in 1991. The Minerals Group has the right to use 32 1/2% of the throughput and storage capacity of the Facilities subject to user rights of third parties which pay the Minerals Group a fee. The Minerals Group pays throughput and storage charges based on actual usage at per ton rates determined by DTA. 12. LEASES The Minerals Group's businesses lease coal mining and other equipment under long-term operating leases with varying terms, and most of the leases contain renewal and/or purchase options. As of December 31, 1993, aggregate future minimum lease payments under noncancellable operating leases were as follows: The above amounts are net of aggregate future minimum noncancellable sublease rentals of $87,000. Almost all of the above amounts related to equipment are guaranteed by the Company. Rent expense amounted to $24,854,000 in 1993, $25,570,000 in 1992 and $26,181,000 in 1991 and is net of sublease rentals of $69,000 in each year. 13. EMPLOYEE BENEFIT PLANS The Minerals Group's businesses participate in the Company's noncontributory defined benefit pension plan covering substantially all nonunion employees who meet certain minimum requirements. Benefits under the plan are based on salary and years of service. The Minerals Group's pension cost is actuarially determined based on its employees and an allocable share of the pension plan assets. The Company's policy is to fund the actuarially determined amounts necessary to provide assets sufficient to meet the benefits to be paid to plan participants in accordance with applicable regulations. The net pension credit for 1993, 1992 and 1991 for the Minerals Group is as follows: The Minerals Group's allocated funded status and deferred pension assets at December 31, 1993 and 1992 are as follows: The assumptions used in determining the net pension credit for the Company's major pension plan for 1993, 1992 and 1991 were as follows: For the valuation of pension obligations and the calculation of the funded status, the discount rate was 7.5% in 1993 and 9.0% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all years presented. The rate of increase in compensation levels used was 4% in 1993 and 5% in 1992 and 1991. The unrecognized initial net asset at January 1, 1986, the date of adoption of SFAS 87, has been amortized over the estimated remaining average service life of the employees, which period ended at December 31, 1992. As of December 31, 1993, approximately 73% of plan assets were invested in equity securities and 27% in fixed income securities. Under the 1990 collective bargaining agreement with the United Mine Workers of America ("UMWA"), the Minerals Group has made payments, based on hours worked, into escrow accounts established for the benefit of union employees (Note 18). The Minerals Group's coal operations recognized pension expense of $1,799,000 in 1993, $2,457,000 in 1992 and $2,273,000 in 1991 under the terms of the agreement. The total amount accrued at December 31, 1993 and 1992 under these escrow agreements was $21,064,000 and $20,184,000, respectively, and is included in miscellaneous accrued liabilities. The Minerals Group also provides certain postretirement health care and life insurance benefits for eligible active and retired employees in the United States. Effective January 1, 1991, the Minerals Group adopted SFAS 106, which requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. As of January 1, 1991, the Minerals Group recognized the full amount of its estimated accumulated postretirement benefit obligation on that date, which represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1991 earnings was $196,360,000 with a net earnings effect of $129,724,000 or $17.40 per share. The latter amount has been reflected in the statement of operations as the cumulative effect of an accounting change. For the years 1993, 1992 and 1991, the components of periodic expense for these postretirement benefits were as follows: The interest costs on the accumulated postretirement benefit obligation was 9% for all years presented. At December 31, 1993 and 1992, the actuarial and recorded liabilities for these postretirement benefits, none of which have been funded, were as follows: The accumulated postretirement benefit obligation was determined using the unit credit method and an assumed discount rate of 7.5% in 1993 and 9.0% in 1992. The assumed health care cost trend rate used in 1993 was 10% for pre-65 retirees, grading down to 5% in the year 2000. For post-65 retirees, the assumed trend rate in 1993 was 8%, grading down to 5% in the year 2000. The assumed medicare cost trend rate used in 1993 was 7%, grading down to 5% in the year 2000. A one percent increase each year in the health care cost trend rate used would have resulted in a $3,297,000 increase in the aggregate service and interest components of expense for the year 1993, and a $35,421,000 increase in the accumulated postretirement benefit obligation at December 31, 1993. The Minerals Group also participates in the Company's Savings-Investment Plan to assist eligible employees in providing for retirement or other future financial needs. Employee contributions are matched up to 5% of compensation (subject to certain limitations imposed by the Internal Revenue Code of 1986, as amended). Contribution expense under the plan aggregated $2,021,000 in 1993, $2,059,000 in 1992 and $1,864,000 in 1991. The Minerals Group sponsors two other defined contribution plans and contributions under these plans aggregated $475,000 in 1993, $420,000 in 1992 and $637,000 in 1991. In October 1992, the Coal Industry Retiree Health Benefit Act of 1992 (the "Health Benefit Act") was enacted as part of the Energy Policy Act of 1992. The Health Benefit Act established new rules for the payment of future health care benefits for thousands of retired union mine workers and their dependents. Part of the burden for these payments has been shifted by the Health Benefit Act from certain coal producers, which had a contractual obligation to fund such payments, to producers such as the Company which have collective bargaining agreements with the UMWA that do not require such payments and to numerous other companies which are no longer in the coal business. The Health Benefit Act established a trust fund to which "signatory operators" and "related persons," including the Company and certain of its coal subsidiaries (the "Pittston Companies") would be obligated to pay annual premiums for assigned beneficiaries, together with a pro rata share for certain beneficiaries who never worked for such employers ("unassigned beneficiaries"), in amounts to be determined by the Secretary of Health and Human Services on the basis set forth in the Health Benefit Act. In October 1993, the Pittston Companies received notices from the Social Security Administration (the "SSA") with regard to their assigned beneficiaries for which they are responsible under the Health Benefit Act; the Pittston Companies also received a calculation of their liability for the first two years. For 1993 and 1994, this liability (on a pretax basis) is approximately $9,100,000 and $11,000,000, respectively. The Company believes that the annual liability under the Health Benefit Act for the Pittston Companies' assigned beneficiaries will continue in the $10,000,000 to $11,000,000 range for the next ten years and should begin to decline thereafter as the number of such assigned beneficiaries decreases. Based on the number of beneficiaries actually assigned by the SSA, the Company estimates the aggregate pretax liability relating to the Pittston Companies' assigned beneficiaries at approximately $265-$275 million, which when discounted at 8% provides a present value estimate of approximately $100-$110 million. The ultimate obligation that will be incurred by the Company could be significantly affected by, among other things, increased medical costs, decreased number of beneficiaries, governmental funding arrangements and such federal health benefit legislation of general application as may be enacted. In addition, the Health Benefit Act requires the Pittston Companies to fund, pro rata according to the total number of assigned beneficiaries, a portion of the health benefits for unassigned beneficiaries. At this time, the funding for such health benefits is being provided from another source and for this and other reasons the Pittston Companies' ultimate obligation for the unassigned beneficiaries cannot be determined. The Company accounts for its obligations under the Health Benefit Act as a participant in a multi-employer plan and recognizes the annual cost on a pay-as-you-go basis. The Minerals Group is required to implement a new accounting standard for postemployment benefits, Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112") in 1994. This standard requires employers who provide benefits to former employees after employment but before retirement to accrue such costs as the benefits accumulate or vest. The Minerals Group has determined that the cumulative effect of adopting SFAS 112 is immaterial. 14. RESTRUCTURING AND OTHER CHARGES Operating results include restructuring and other charges of $78,633,000 in 1993 and $115,214,000 in 1991 which have been recognized in the statements of operations. The 1993 charges relate to mine closing costs including employee benefit costs and certain other noncash charges, together with the estimated liabilities in connection with previously reported litigation (the so-called "Evergreen Case") brought against the Company and a number of its coal subsidiaries by the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA (Note 18). These charges impacted Coal and Mineral Ventures operating profit in the amount of $70,713,000 and $7,920,000, respectively. The charge in the Coal segment in 1993 consists of closing costs for mines which were closed at the end of 1993 and for scheduled closures of mines in early 1994, including employee severance and other benefit costs and estimated liabilities regarding the Evergreen Case. The charge in the Mineral Ventures segment in 1993 related to the write-down of the Minerals Group's investment in the Uley graphite mine in Australia. Although reserve drilling of the Uley property indicates substantial graphite deposits, processing difficulties, depressed graphite prices which have remained significantly below the level prevailing at the start of the project and an analysis of various technical and marketing conditions affecting the project resulted in the determination that the assets have been impaired and that loss recognition was appropriate. Of the total amount of 1993 charges, $10,846,000 was for noncash write-downs of assets and the remainder represents liabilities, of which $7,015,000 are expected to be paid in 1994. The Minerals Group intends to fund any cash requirements during 1994 and thereafter with anticipated cash flows from operating activities with shortfalls, if any, financed through borrowings under revolving credit agreements or short-term borrowing arrangements. The 1991 charge impacted Coal segment operations and primarily related to costs associated with coal mine shutdowns. Of the total charge, $14,415,000 was for noncash asset write-downs. 15. OTHER INCOME AND EXPENSE Other operating income includes gains aggregating $5,846,000 in 1991 from the disposal of certain excess coal reserves which increased net income by $.51 per share. In addition, other operating income primarily includes coal royalty income generated from coal and natural gas properties owned by the Minerals Group. Other income includes gains aggregating $2,341,000 in 1992 and $11,102,000 in 1991 from the sale of investments in leveraged leases which increased net income by $.37 per share in 1992 and $1.11 per share in 1991. 16. ACCOUNTING CHANGES During 1991, the Minerals Group adopted two changes in accounting principles in connection with the issuance of two accounting standards by the Financial Accounting Standards Board. The effect of these changes on the statement of operations as of January 1, 1991, the date of adoption, has been recognized as the cumulative effect of accounting changes as follows: 17. SEGMENT INFORMATION Net sales by geographic area are as follows: The following is derived from the business segment information in the Company's consolidated financial statements as it relates to the Minerals Group. See Note 2, Related Party Transactions, for a description of the Company's policy for corporate allocations. The Minerals Group's portion of the Company's operating profit is as follows: * Operating profit (loss) includes restructuring and other charges aggregating $78,633,000 in 1993, of which $70,713,000 is included in the United States and $7,920,000 is included in Australia, and $115,214,000 in 1991, all of which is included in the United States (Note 14). The Minerals Group's portion of the Company's assets at year end is as follows: Industry segment information is as follows: * Operating profit (loss) of the Coal segment includes restructuring and other charges of $70,713,000 in 1993 and $115,214,000 in 1991 (Note 14). Operating loss of the Mineral Ventures segment includes restructuring and other charges of $7,920,000 in 1993 (Note 14). In 1993, 1992 and 1991, net sales to one customer of the Coal segment amounted to $106,253,000, $86,319,000 and $51,823,000, respectively. 18. LITIGATION In 1988, the trustees of certain pension and benefit trust funds established under collective bargaining agreements with the UMWA brought an action (the so-called "Evergreen Case") against the Company and a number of its coal subsidiaries in the United States District Court for the District of Columbia, claiming that the defendants are obligated to contribute to such trust funds in accordance with the provisions of the 1988 National Bituminous Coal Wage Agreement, to which neither the Company nor any of its subsidiaries is a signatory. In January 1992, the Court issued an order granting summary judgment in favor of the trustees on the issue of liability, which was thereafter affirmed by the Court of Appeals. In June 1993 the United States Supreme Court denied a petition for a writ of certiorari. The case has been remanded to District Court, and damage and other issues remain to be decided. In September 1993, the Company filed a motion seeking relief from the District Court's grant of summary judgment based on, among other things, the Company's allegations that plaintiffs improperly withheld evidence that directly refutes plaintiffs' representations to the District Court and the Court of Appeals in this case. In December 1993, that motion was denied. In furtherance of its ongoing effort to identify other available legal options for seeking relief from what it believes to be an erroneous finding of liability in the Evergreen Case, the Company has filed suit against the Bituminous Coal Operators Association and others to hold them responsible for any damages sustained by the Company as a result of the Evergreen Case. Although the Company is continuing that effort, the Company, following the District Court's ruling in December 1993, recognized the potential liability that may result from an adverse judgment in the Evergreen Case (Note 14). In any event, any final judgment in the Evergreen Case will be subject to appeal. As a result of the Health Benefit Act (Note 13), there is no continuing liability in this case in respect of health benefit funding after February 1, 1993. In April 1990 the Company entered into a settlement agreement to resolve certain environmental claims against the Company arising from hydrocarbon contamination at a petroleum terminal facility ("Tankport") in Jersey City, New Jersey, which operations were sold in 1983. Under the settlement agreement, the Company is obligated to pay 80% of the remediation costs. Based on data available to the Company and its environmental consultants, the Company estimates its portion of the cleanup costs on an undiscounted basis using existing technologies to be between $4.5 million and $13.5 million over a period of three to five years. Management is unable to determine that any amount within that range is a better estimate due to a variety of uncertainties, which include the extent of the contamination at the site, the permitted technologies for remediation and the regulatory standards by which the cleanup will be measured by the New Jersey Department of Environmental Protection and Energy. The Company commenced insurance coverage litigation in 1990, in the United States District Court for the District of New Jersey, seeking a declaratory judgment that all amounts payable by the Company pursuant to the Tankport obligation were reimbursable under comprehensive general liability and pollution liability policies maintained by the Company. Although the underwriters have disputed this claim, management and its legal counsel believe that recovery is probable of realization in the full amount of the claim. This conclusion is based upon, among other things, the nature of the pollution policies which were broadly designed to cover such contingent liabilities, the favorable state of the law in the State of New Jersey (whose laws have been found to control the interpretation of the policies), and numerous other factual considerations which support the Company's analysis of the insurance contracts and rebut many of the underwriters' defenses. Accordingly, since management and its legal counsel believe that recovery is probable of realization in the full amount of the claim, there is no net liability in regard to the Tankport obligation. 19. COMMITMENTS At December 31, 1993, the Minerals Group had contractual commitments to purchase coal which is primarily used to blend with company mined coal. Based on the contract provisions these commitments are currently estimated to aggregate approximately $195,790,000 and expire from 1994 through 1998 as follows: The 1994 amount includes a commitment of $23,250,000 relating to a purchase contract with Addington Resources, Inc. ("Addington"). This contract was part of the coal mining operations of Addington acquired in 1994 (Note 20). A new commitment totaling $127,920,000 over approximately four years was entered into with operations of Addington which were not part of the acquisition. Purchases under the contracts were $81,069,000 in 1993, $74,331,000 in 1992, $58,155,000 in 1991. 20. SUBSEQUENT EVENT In January 1994, a wholly owned indirect subsidiary of the Company completed the acquisition of substantially all of the coal mining operations and coal sales contracts of Addington for $157 million, subject to certain purchase price adjustments. The acquisition will be accounted for as a purchase; accordingly, the purchase price has been allocated to the underlying assets and liabilities based on their respective estimated fair values at the date of acquisition. Such allocation has been based on preliminary estimates which may be revised at a later date. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was approximately $77 million. The acquisition was financed by the issuance of $80.5 million of a new series of the Company's preferred stock convertible into Minerals Stock, described below, and additional debt under existing credit facilities. This financing will be attributed to the Minerals Group. In March 1994, the additional debt incurred for this acquisition was refinanced with a five-year term loan under the New Facility (Note 8). In January 1994, the Company issued 161,000 shares of its $31.25 Series C Cumulative Convertible Preferred Stock, par value $10 per share (the "Convertible Preferred Stock"). The Convertible Preferred Stock pays an annual cumulative dividend of $31.25 per share payable quarterly, in cash, in arrears, out of all funds of the Company legally available therefor, when, as and if declared by the Board and bears a liquidation preference of $500 per share, plus an amount equal to accrued and unpaid dividends thereon. Each share of the Convertible Preferred Stock is convertible at the option of the holder at any time after March 11, 1994, unless previously redeemed or, under certain circumstances, called for redemption, into shares of Minerals Stock at a conversion price of $32.175 per share of Minerals Stock, subject to adjustment in certain circumstances. Except under certain circumstances, the Convertible Preferred Stock is not redeemable prior to February 1, 1997. On and after such date, the Company may at its option, redeem the Convertible Preferred Stock, in whole or in part, for cash initially at a price of $521.875 per share, and thereafter at prices declining ratably annually on each February 1 to an amount equal to $500.00 per share on and after February 1, 2004, plus in each case an amount equal to accrued and unpaid dividends on a date of redemption. Except under certain circumstances or as prescribed by Virginia law, shares of the Convertible Preferred Stock are nonvoting. The following table presents, on a pro forma basis, a condensed consolidated balance sheet of the Minerals Group at December 31, 1993, giving effect to the acquisition as if it had occurred on that date. The acquisition will be included in the Minerals Group's statements of operations beginning in 1994. The following pro forma results, however, assume that the acquisition had occurred at the beginning of 1993. The unaudited pro forma data below are not necessarily indicative of results that would have occurred if the transaction were in effect for the year ended December 31, 1993, nor are they indicative of the future results of operations of the Minerals Group. 21. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Tabulated below are certain data for each quarter of 1993 and 1992. Net income (loss) includes fourth quarter 1993 restructuring and other charges of $78,633,000 (Note 14). Net income in the fourth quarter of 1992 includes gains of $2,341,000 from the sale of leveraged leases (Note 15). 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 required by this Item regarding directors is incorporated by reference to Pittston's definitive proxy statement to be filed pursuant to Regulation 14A within 120 days after December 31, 1993. The information regarding executive officers is included in this report following Item 4, under the caption "Executive Officers of the Registrant." Item 11: Item 11: Executive Compensation Item 12: Item 12: Security Ownership of Certain Beneficial Owners and Management Item 13: Item 13: Certain Relationships and Related Transactions The information required by Items 11 through 13 is incorporated by reference to Pittston's definitive proxy statement to be filed pursuant to Regulation 14A within 120 days after December 31, 1993. PART IV Item 14: Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. All financial statements - see index to financial statements and schedules 2. Financial statement schedules - see index to financial statements and schedules 3. Exhibits - see exhibit index (b) Reports on Form 8-K were filed as follows: 1. Report filed December 13, 1993, with respect to amendment of the Company's bylaws. 2. Report filed December 20, 1993, with respect to the Company's announcement of the acquisition of Addington Resources, Inc. 3. Report filed December 22, 1993, with respect to the Company's acquisition of Addington Resources, Inc. Undertaking For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8 Nos. 2-64258, 33-2039, 33-21393, 33-23333 and 33-69040: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 30, 1994. The Pittston Company (Registrant) By J. C. Farrell (J. C. Farrell, Chairman of the Board, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated, on March 30, 1994. Signatures Title R. G. Ackerman* Director M. J. Anton* Director J. R. Barker* Director J. L. Broadhead* Director W. F. Craig* Director J. C. Farrell Director and Chairman of (J. C. Farrell) the Board, President and Chief Executive Officer (principal executive officer) C. F. Haywood* Director E. G. Jordan* Director D. L. Marshall* Director and Vice Chairman of the Board G. R. Rogliano Vice President -Controllership (G. R. Rogliano) and Taxes (principal accounting officer) R. H. Spilman* Director R. G. Stone, Jr.* Director A. H. Zimmerman* Director *By J. C. Farrell (J. C. Farrell, Attorney-in-Fact) The Registrant does not have any designated principal financial officer. Index to Financial Statements and Schedules THE PITTSTON COMPANY AND SUBSIDIARIES Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements PITTSTON SERVICES GROUP Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements PITTSTON MINERALS GROUP Statement of Management Responsibility Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Financial Statement Schedules: Independent Auditors' Report on Financial Statement Schedules THE PITTSTON COMPANY AND SUBSIDIARIES V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Income Statement Information PITTSTON SERVICES GROUP VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Income Statement Information PITTSTON MINERALS GROUP V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment X - Supplementary Income Statement Information Schedules other than those listed above are omitted because they are not applicable or not required, or the information is included elsewhere in the financial statements. INDEPENDENT AUDITORS' REPORT THE BOARD OF DIRECTORS AND SHAREHOLDERS THE PITTSTON COMPANY Under date of January 24, 1994, we reported on the consolidated balance sheets of The Pittston Company and subsidiaries (the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, the balance sheets of Pittston Services Group as of December 31, 1993 and 1992, and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993, and the balance sheets of Pittston Minerals Group as of December 31, 1993 and 1992, and the related statements of operations and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report on Form 10-K of The Pittston Company. In connection with our audits of the aforementioned financial statements, we also audited the related financial statement schedules 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, the Company's financial statement schedules, when considered in relation to the basic consolidated financial statements of the Company taken as a whole, and the Groups' financial statement schedules, when considered in relation to the respective basic financial statements of Pittston Services Group and Pittston Minerals Group taken as a whole, present fairly, in all material respects, the information set forth therein. Our reports for Pittston Services Group and Pittston Minerals Group contain an explanatory paragraph that states that the financial statements of Pittston Services Group and Pittston Minerals Group should be read in connection with the audited consolidated financial statements of the Company. As discussed in Notes 4 and 16 to the consolidated financial statements of the Company, and Note 4 and 14 to the financial statements of Pittston Services Group, the Company and Pittston Services Group changed their methods of accounting for capitalizing subscriber installation costs in 1992. As discussed in Notes 6, 13 and 16 to the consolidated financial statements of the Company, Notes 7, 12 and 14 to the financial statements of Pittston Services Group, and Notes 7, 13 and 16 to the financial statements of Pittston Minerals Group, the Company, Pittston Services Group and Pittston Minerals Group changed their methods of accounting for income taxes and accounting for postretirement benefits other than pensions in 1991. /s/ KPMG Peat Marwick KPMG PEAT MARWICK Stamford, Connecticut January 24, 1994 THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (a) Amount represents the reserves received as partial payment from the sale of assets of a coal subsidiary. THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Notes: (A) Amounts recovered (B) Amounts reclassified from other accounts (C) Accounts written off THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (1) Represents weighted average interest rate at end of period. (2) Represents maximum amount outstanding at any month-end. (3) The average amount outstanding during the period was computed by dividing the total of the daily outstanding principal balances by 365. (4) The weighted average interest rate during the period was computed by dividing interest expense by avereage short-term debt outstanding. Borrowings and interest rates relate to foreign operations for all years. THE PITTSTON COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) ======== ======= ======= PITTSTON SERVICES GROUP SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Notes: (A) Amounts recovered (B) Amounts reclassified from other accounts (C) Accounts written off PITTSTON SERVICES GROUP SCHEDULE IX - SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) (1) Represents weighted average interest rate at end of period. (2) Represents maximum amount outstanding at any month-end. (3) The average amount outstanding during the period was computed by dividing the total of the daily outstanding principal balances by 365. (4) The weighted average interest rate during the period was computed by dividing interest expense by avereage short-term debt outstanding. Borrowings and interest rates relate to foreign operations for all years. PITTSTON SERVICES GROUP SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) PITTSTON MINERALS GROUP SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) (a) Amount represents the reserves received as partial payment from the sale of assets of a coal subsidiary. PITTSTON MINERALS GROUP SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) PITTSTON MINERALS GROUP SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In thousands of dollars) Exhibit Index Exhibit Number Description Each Exhibit listed below that is followed by a reference to a previously filed document is hereby incorporated by reference to such document. 3(a) The Registrant's Restated Articles of Incorporation. Exhibit 3(a) to the Registrant's report on Form 8-K dated January 14, 1994. 3(b) The Registrant's Bylaws, as amended. Exhibit 3(b) to the Registrant's report on Form 8-K dated December 3, 1993. 4(a) (i) Rights Agreement (the "Rights Agreement") dated as of September 11, 1987, between the Registrant and Chemical Bank, as successor Rights Agent. Exhibit 1 to the Registrant's Registration Statement on Form 8-A filed September 15, 1987 (the "Form 8-A"). (ii) Amendment No. 1 dated as of December 12, 1988, to the Rights Agreement. Exhibit 4 to Amendment No. 2 on Form 8 to the Form 8-A filed February 15, 1989. (iii) Amendment No. 2 dated as of October 16, 1989, to the Rights Agreement. Exhibit 4(c)(iii) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 (the "1989 Form 10-K"). (iv) Form of Right Certificate. Exhibit 3 to the Form 8-A. Instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries have been omitted because the amount of debt under any such instrument does not exceed 10% of the total assets of the Registrant and its consolidated subsidiaries. The Registrant agrees to furnish a copy of any such instrument to the Commission upon request. 10(a)* The Registrant's 1979 Stock Option Plan, as amended. Exhibit 10(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 Form 10-K"). 10(b)* The Registrant's 1985 Stock Option Plan, as amended. Exhibit 10(b) to the 1992 Form 10-K. 10(c)* The Registrant's Key Employees Incentive Plan, as amended. Exhibit 10(c) to the Regi- strant's Annual Report on Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K"). 10(d)* The Registrant's Pension Equalization Plan, as amended. Exhibit 10(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 (the "1990 Form 10-K"). 10(e)* The Registrant's Executive Salary Continuation Plan. Exhibit 10(e) to the 1991 Form 10-K. 10(f)* The Registrant's 1988 Stock Option Plan, as amended. 10(g)* The Registrant's Non-Employee Directors' Stock Option Plan. 10(h)* (i) Employment Agreement dated as of May 1, 1993, between the Registrant and J. C. Farrell. Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (ii) Amendment No. 1 to Employment Agreement dated as of May 1, 1993, between the Registrant and J. C. Farrell. 10(i)* (i) Employment agreement dated September 1, 1992, between the Registrant and D. L. Marshall. Exhibit 10(h) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. (ii) Supplemental retirement benefit agreement dated July 12, 1991 between the Registrant and D. L. Marshall. Exhibit 10(i)(iii) to the 1991 Form 10-K. 10(j)* Supplemental retirement benefit agreement dated as of October 1, 1989, between the Registrant and R. D. Duke. Exhibit 10(b) to the Second Quarter 1990 Form 10-Q. 10(k)* (i) Form of change in control employment agreement between the Registrant and Messrs. Farrell and Marshall. Exhibit 10(j) to the 1987 Form 10-K. (ii) Form of change in control employment agreement between the Registrant and two of its officers. Exhibit 10(l)(ii) to the 1989 Form 10-K. (iii) Form of change in control employment agreement between the Registrant (or a subsidiary) and seven of the Registrant's officers. Exhibit 10(l)(iii) to the 1989 Form 10-K. (iv) Form of letter agreement amending change in control employment agreements between the Registrant (or a subsidiary) and seven of the Registrant's officers. 10(l)* Form of Indemnification Agreement entered into by the Registrant with its directors and officers. Exhibit 10(l) to the 1991 Form 10-K. 10(m)* Registrant's Retirement Plan for Non-Employee Directors. Exhibit 10(n) to the 1989 Form 10-K. 10(n)* Registrant's Amended and Restated Plan for Deferral of Directors' Fees. Exhibit 10(o) to the 1989 Form 10-K. 10(o) (i) Participation Agreement (the "Participation Agreement") dated as of December 19, 1985, among Burlington Air Express Inc. (formerly, Burlington Northern Air Freight Inc. and Burlington Air Express USA Inc.) ("Burlington"), the loan participants named therein (the "Loan Participants"), Manufacturers Hanover Leasing Corporation, as Owner Participant (the "Owner Participant"), The Connecticut National Bank, as Indenture Trustee (the "Indenture Trustee") and Meridian Trust Company, as Owner Trustee (the "Owner Trustee"). Exhibit 10(p)(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 (the "1988 Form 10-K"). (ii) Trust Agreement (the "Trust Agreement") dated as of December 19, 1985, between the Owner Participant and the Owner Trustee. Exhibit 10(p)(ii) to the 1988 Form 10-K. (iii) Trust Indenture and Mortgage (the "Trust Indenture and Mortgage") dated December 19, 1985, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee (the "Mortgagee"). Exhibit 10(p)(iii) to the 1988 Form 10-K. (iv) Lease Agreement (the "Lease Agreement") dated as of December 19, 1985, between the Owner Trustee, as Lessor, and Burlington, as Lessee. Exhibit 10(p)(iv) to the 1988 Form 10-K. (v) Tax Indemnity Agreement (the "Tax Indemnity Agreement") dated as of December 19, 1985, between the Owner Participant and Burlington, including Amendment No. 1 dated March 10, 1986. Exhibit 10(p)(v) to the 1988 Form 10-K. (vi) Guaranty (the "Guaranty") dated as of December 19, 1985, by the Registrant. Exhibit 10(p)(vi) to the 1988 Form 10-K. (vii) Trust Agreement and Mortgage Supplement Nos. 1 through 4, dated December 23 and 30, 1985 and March 10 and May 8, 1986, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee, including Amendment No. 1 dated as of October 1, 1986 to Trust Agreement and Mortgage Supplement Nos. 3 and 4. Exhibit 10(p)(vii) to the 1988 Form 10-K. (viii) Lease Supplements Nos. 1 through 4 dated December 23 and 30, 1985 and March 10 and May 8, 1986, between the Owner Trustee, as Lessor, and Burlington, as Lessee, including Amendment No. 1 dated as of October 1, 1986 to Lease Supplements Nos. 3 and 4. Exhibit 10(p)(viii) to the 1988 Form 10-K. (ix) Letter agreement dated March 10, 1986, among the Owner Participant, the Mortgagee, the Owner Trustee, the Loan Participants, Burlington and the Registrant, amending the Lease Agreement, the Trust Indenture and Mortgage and the Participation Agreement. Exhibit 10(p)(ix) to the 1988 Form 10-K. (x) Letter agreement dated as of May 8, 1986, among the Owner Participant, the Mortgagee, the Owner Trustee, the Loan Participants, Burlington and the Registrant, amending the Participation Agreement. Exhibit 10(p)(x) to the 1988 Form 10-K. (xi) Letter agreement dated as of May 25, 1988, between the Owner Trustee, as Lessor, and Burlington, as Lessee, amending the Lease Agreement. Exhibit 10(p)(xi) to the 1988 Form 10-K. (xii) Partial Termination of Lease, dated September 18, 1992, between the Owner Trustee, as Lessor, and Burlington, as Lessee, amending the Lease Agreement. Exhibit 10 (o) (xii) to the 1992 Form 10-K. (xiii) Partial Termination of Trust Indenture and Mortgage, dated September 18, 1992, between the Indenture Trustee, as Mortgagee, and the Owner Trustee, as Mortgagor, amending the Trust Indenture and Mortgage. Exhibit 10 (o) (xiii) to the 1992 Form 10-K. (xiv) Trust Agreement and Mortgage Supplement No. 5, dated September 18, 1992, between the Owner Trustee, as Mortgagor, and the Indenture Trustee, as Mortgagee. Exhibit 10 (o) (xiv) to the 1992 Form 10-K. (xv) Lease Supplement No. 5, dated September 18, 1992, between the Owner Trustee, as Lessor, and Burlington, as Lessee. Exhibit 10 (o) (xv) to the 1992 Form 10-K. (xvi) Lease Supplement No. 6, dated January 20, 1993, between the Owner Trustee, as Lessor, and Burlington, as Lessor, amend- ing the Lease Agreement. Exhibit 10 (o) (xvi) to the 1992 Form 10-K. 10(p) (i) Lease dated as of April 1, 1989 between Toledo-Lucas County Port Authority (the "Authority"), as Lessor, and Burlington, as Lessee. Exhibit 10(i) to the Registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1989 (the "Second Quarter 1989 Form 10-Q"). (ii) Lease Guaranty Agreement dated as of April 1, 1989 between Burlington (formerly, Burlington Air Express Management Inc.), as Guarantor, and the Authority. Exhibit 10(ii) to the Second Quarter 1989 Form 10-Q. (iii) Trust Indenture dated as of April 1, 1989 between the Authority and Society Bank & Trust (formerly, Trustcorp Bank, Ohio) (the "Trustee"), as Trustee. Exhibit 10(iii) to the Second Quarter 1989 Form 10-Q. (iv) Assignment of Basic Rent and Rights Under a Lease and Lease Guaranty dated as of April 1, 1989 from the Authority to the Trustee. Exhibit 10(iv) to the Second Quarter 1989 Form 10-Q. (v) Open-End First Leasehold Mortgage and Security Agreement dated as of April 1, 1989 from the Authority to the Trustee. Exhibit 10(v) to the Second Quarter 1989 Form 10-Q. (vi) First Supplement to Lease dated as of January 1, 1990, between the Authority and Burlington, as Lessee. Exhibit 10 to the Registrant's quarterly report on Form 10-Q for the quarter ended March 31, 1990. (vii) Revised and Amended Second Supplement to Lease dated as of September 1, 1990, between the Authority and Burlington. Exhibit 10(i) to the Registrant's quarterly report on Form 10-Q for the quarter ended September 30, 1990 (the "Third Quarter 1990 Form 10-Q"). (viii) Amendment Agreement dated as of September 1, 1990, among City of Toledo, Ohio, the Authority, Burlington and the Trustee. Exhibit 10(ii) to the Third Quarter 1990 Form 10-K. (ix) Assumption and Non-Merger Agreement dated as of September 1, 1990, among Burlington, the Authority and the Trustee. Exhibit 10(iii) to the Third Quarter 1990 Form 10-Q. 10(q) Stock Purchase Agreement dated as of September 24 1993, between the Pittston Acquisition Company and Addington Holding Company, Inc. Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 11 Computation of Earnings Per Common Share. 21 Subsidiaries of the Registrant. 23 Consent of independent auditors. 24 Powers of attorney. 99* Amendment to the Registrant's Pension- Retirement Plan relating to preservation of assets of the Pension-Retirement Plan upon a change in control. Exhibit 99 to the 1992 Form 10-K. _____________________ *Management contract or compensatory plan or arrangement.

105598_1993.txt

105598_1993

1993

105598

745287_1993.txt

745287_1993

1993

745287

ITEM 1. BUSINESS GENERAL The Registrant is a leading independent manufacturer of precision ductile and gray iron castings, with production facilities in North America and Germany. The Registrant's castings are used primarily in automobiles and light trucks, as well as in heavy trucks, construction and farm equipment, air conditioning and refrigeration equipment and internal combustion engines. The Registrant specializes in safety-related parts critical to vehicle control that meet its customers' exacting metallurgical, dimensional and quality control standards. Products manufactured for the automotive, light truck and heavy truck industries include brake parts, steering components, differential cases, camshafts and crankshafts. The Registrant provides castings used by over 20 automobile manufacturers throughout the world, including Ford, Chrysler, General Motors, Volkswagen, BMW and Mercedes-Benz. As used herein, the term "Registrant" refers collectively to Intermet Corporation and its subsidiaries, and their respective predecessors, except where otherwise indicated by context. RECENT DEVELOPMENTS On August 30, 1993 the Registrant announced plans to permanently close its Lower Basin foundry in Lynchburg, Virginia. The Lower Basin foundry had been operating well below its capacity of 70,000 tons in recent years. The foundry stopped pouring iron in December 1993 and is expected to close completely in 1994. The foundry employed approximately 660 people at the time the closing was announced. Primarily as a result of the decision to close this foundry, the Registrant recorded a restructuring charge of $24 million in the third quarter of 1994. The Board of Directors of the Registrant suspended the regular quarterly dividend in October 1993 pending an improvement in the Registrant's operating performance. PRODUCTS, MARKETS AND SALES The Registrant specializes in safety-related parts critical to vehicle control, including brake parts and steering system components, as well as differential cases, camshafts and crankshafts. The Registrant produces housings, wheels, brake parts and brackets for the construction and earthmoving equipment industries. Products for other industries include compressor parts for refrigeration and air conditioning units, cylinder heads, manifolds, valves and gears. The Registrant is seeking to expand its products to include aluminum castings. The Registrant has had a longstanding quality assurance program and is committed to maintaining its reputation for high quality products and timely delivery. For example, the Archer Creek, Radford Shell, New River and Columbus foundries and the PBM machining facility hold Ford's Q-1 quality award. The Archer Creek, Radford Shell and Ironton foundries and the Columbus machining facility hold Chrysler's Pentastar award. Radford Shell also holds the Caterpillar Certified Supplier award. The Registrant markets its products exclusively through its own sales and customer service staff, except in Europe where it also uses independent sales representatives. The Registrant currently maintains sales offices in Michigan, Ohio, Virginia and Germany. The Registrant produces principally to customer order and does not maintain any significant inventory of finished goods not on order. The Registrant provides extensive production and technical training to its sales staff. This technical background enables the sales staff to act as an effective liaison between customers and the Registrant's production personnel and permits the Registrant to offer customer assistance at the design stage of major casting programs. The Registrant also employs quality assurance representatives and engineers who work with customers' manufacturing personnel to detect and avoid potential problems and to develop new product opportunities for the Registrant. In addition to working with customer purchasing personnel, the Registrant's sales engineers confer with design engineers and other technical staff. During 1991, 1992 and 1993, direct sales to Ford accounted for 20%, 20% and 23%, respectively, direct sales to Chrysler accounted for 23%, 22% and 23%, respectively, and direct sales to General Motors Corporation accounted for 6%, 10% and 10%, respectively, of the Registrant's consolidated net sales. The loss of any of these customers or a substantial reduction in their purchases from the Registrant would have a material adverse effect on the Registrant. The Registrant's six largest customers accounted for approximately 71%, 73% and 76% of the Registrant's consolidated net sales during 1991, 1992 and 1993, respectively. The following table sets forth information regarding sales by the Registrant to customers in these markets during 1991, 1992 and 1993. In 1993 reported sales included 381,000 tons of casting shipments. The Registrant's foundries operated at 82% of average annual capacity during 1993. MANUFACTURING, MACHINING AND DESIGN The Registrant produces both ductile and gray iron castings. Gray iron, the oldest and most widely used cast iron, is readily cast into intricate shapes that are easily machinable and wear resistant. Ductile iron, which is produced by removing sulphur from the molten iron and adding magnesium and other alloys, has greater strength and elasticity than gray iron, and its use as a higher strength substitute for gray iron and a lower-cost substitute for steel has grown steadily. For the years ended December 31, 1991, 1992 and 1993, sales of ductile iron castings represented 82%, 85% and 87%, respectively, of the Registrant's total sales of castings, the balance being gray iron. The Registrant's castings range in size from small pieces weighing less than one pound to castings weighing up to 100 pounds. The manufacturing process involves melting steel scrap and pig iron in cupola or electric furnaces, adding various alloys and pouring the molten metal into molds made primarily of sand. The molten metal solidifies and cools in the molds, and the molds are broken and removed. Customers usually specify the properties their castings are to embody, such as hardness and strength, and the Registrant determines how best to meet those specifications. Constant testing and monitoring of the manufacturing process is necessary to maintain the quality and performance consistency of the castings. Electronic testing and monitoring equipment, including x-ray, cobalt x-ray, ultrasonic and magnetic-particle testing equipment, is used extensively in grading scrap metal, analyzing molten metal and testing castings. The Registrant also uses its testing equipment and procedures to provide particular tests requested by a customer for its castings. Many castings require machining (which may include drilling, threading or cutting operations) before they can be put to their ultimate use. Most customers machine their own castings or have them machined by third parties. The Registrant operates facilities in Columbus, Georgia and Chesterfield, Michigan, where it machines castings produced by it or by others. The Registrant also contracts with other companies to machine castings it produces before shipment to customers. The Registrant's design and engineering teams assist the customer, when requested, in the initial stages of product creation and modification. Among other computer-aided design techniques, the Registrant uses three-dimensional solid modeling software in conjunction with rapid prototype equipment. This equipment greatly enhances the Registrant's design flexibility and, depending on the complexity of the product, can reduce the time required to produce sample castings for customers by several weeks. RESEARCH AND DEVELOPMENT The Registrant conducts process and product development programs, principally at its separate research and development foundry located adjacent to the Archer Creek facility in Lynchburg, Virginia, and to a lesser extent at the laboratories in its other facilities. Current research and testing projects encompass both new manufacturing processes and product development. The research foundry has a self-contained melting and molding facility with complete metallurgical, physical and chemical testing capabilities. The work on new manufacturing processes is focused on ways to lower costs and improve quality. Product development work includes projects to enhance existing iron castings, such as austempering, which enhances the strength and elasticity of iron, as well as projects to develop new products, such as the conversion of forgings to castings. COMPETITION The Registrant competes with many other foundries, both in the United States and Europe. Some of these foundries are owned by major users of iron castings, and a number of foundry operators have, or are subsidiaries of companies which have, greater financial resources than the Registrant. For example, the three largest domestic automobile manufacturers, which are among the Registrant's largest customers, operate their own foundries. However, they also purchase a significant amount of castings from the Registrant and others, and there is a trend toward increased outsourcing by the domestic original equipment manufacturers. Castings produced by the Registrant also compete to some degree with malleable iron castings, other metal castings and steel forgings. The machining industry is highly fragmented and competitive. As in the foundry industry, large purchasers of machined components often have significant in-house capabilities to perform their own machining work. The Registrant competes primarily on the basis of product quality, engineering, service and price. The Registrant emphasizes its ability to produce complex, precision-engineered products in order to compete for value-added castings that generally provide a higher profit margin. RAW MATERIALS The primary raw material used by the Registrant to manufacture iron castings is steel scrap. The Registrant is not dependent on any single supplier of scrap. The Registrant has no long-term contractual commitments with any scrap supplier and does not anticipate any difficulties in obtaining scrap because of the large number of suppliers and because of the Registrant's position as a major purchaser. The cost of steel scrap is subject to fluctuations, but the Registrant has implemented arrangements with most of its customers for adjusting its castings prices to reflect those fluctuations. The Registrant has contractual arrangements, which expire at various times through 1998, for the purchase of various materials, other than steel scrap, used in or during the manufacturing process. While these contracts and the Registrant's overall level of purchases provide some protection against price increases, in most cases the Registrant does not have specific arrangements in place to adjust its casting prices for fluctuations in the prices of alloys and other materials. CYCLICALITY AND SEASONALITY Most of the Registrant's products are generally not affected by year-to-year automotive style changes. However, the inherent cyclicality of the automotive industry has affected the Registrant's sales and earnings during periods of slow economic growth or recession. For example, North American automotive production in 1991 was at its lowest level in almost ten years, but by 1993 had risen more than 20% over the 1991 level. On the other hand, much of Europe was in a recession during 1993, and automotive production fell significantly from the previous year. The Registrant's third and fourth quarter sales are usually lower than first and second quarter sales due to plant closings by automakers for vacations and model changeovers. BACKLOG Most of the Registrant's business involves supplying all or a stated portion of the customer's annual requirements, generally flexible in amount, for a particular casting against blanket purchase orders. The lead time and cost of commencing production of a particular casting tend to inhibit transfers of production from one foundry to another. Customers typically issue firm releases and shipping schedules on a monthly basis. The Registrant's backlog at any given time therefore consists only of the orders which have been released for shipment. The backlog at December 31, 1993 was approximately $50 million, compared to approximately $44 million at December 31, 1992. EMPLOYEES At February 6, 1994, the Registrant employed 4,151 persons, including 3,686 in the United States. Of the persons employed in the United States, 2,885 were hourly manufacturing personnel, and the remainder were clerical, sales and management personnel. The Registrant employed 465 persons in Germany, 384 of whom were hourly manufacturing personnel. Most of the manufacturing personnel are represented by unions under collective bargaining agreements expiring at various times through 1997. Three domestic bargaining agreements covering approximately 989 hourly employees expire in 1994. The Registrant entered into a replacement agreement for one facility, covering 363 employees, in February 1994, and expects to enter into replacement agreements for the other expiring agreements, as well. The Registrant from time to time adjusts the size of its work force to meet fluctuations in production demands at various facilities. During the past ten years the Registrant has not experienced any strike or work stoppage, other than a five-week strike by the 69 covered employees at the Hibbing, Minnesota plant during 1992. The Registrant believes that its relationship with its employees is satisfactory. ENVIRONMENTAL MATTERS The Registrant's operations are subject to various federal, state and local laws and regulations relating to the protection of the environment. These regulations, which are implemented principally by the EPA and corresponding state agencies, govern the management of solid and hazardous waste, the discharge of pollutants into the air and into surface and underground waters, and the manufacture and disposal of chemical substances. The Registrant believes that current operations of its facilities are in substantial compliance with applicable environmental laws, regulations and government orders. In February 1992 the Registrant's Board of Directors established an Environmental Compliance Committee to oversee the Registrant's environmental program. The Registrant has completed internal environmental reviews of all of its facilities and intends to remedy all non-complying situations. In addition, the Registrant has increased its environmental compliance staff and has expanded its training programs to emphasize environmental matters. The Registrant is currently in the process of attempting to resolve certain environmental matters with various governmental agencies and third parties. In addition to the administrative complaint filed by the EPA and the issue raised by the Ohio Attorney General's Office described in "Item 3 -- Legal Proceedings", these matters include the closure of five former hazardous waste treatment units at the Archer Creek and Radford Shell facilities, the remediation of soil and groundwater contamination at the Lower Basin foundries, and certain other soil remediation and clean-up projects. The Registrant believes that expenses to be incurred in resolving these matters will not materially exceed reserves established for such purposes or cause the Registrant to exceed its level of anticipated capital expenditures. However, it is not possible to accurately predict such costs. The recent amendments to the federal Clean Air Act are expected to have a major impact on the compliance costs of many U.S. companies, including foundries of the type owned by the Registrant. Until regulations implementing those amendments are adopted by the federal and state governments, it is not possible to estimate such costs. Over the years, the Registrant has landfilled wastes, such as baghouse dust and foundry sand, on or near its foundry properties. The Registrant believes its landfills and its other waste management units comply with all existing regulations. However, it is not possible to predict whether, or to what extent, future federal, state or local regulations will require the Registrant to incur additional costs to monitor, close, remediate or otherwise manage those units in ways not currently contemplated. FOREIGN OPERATIONS Information as to revenues, operating profits and identifiable assets for its foreign operations for 1993, 1992 and 1991 is contained in Note 11 of the consolidated financial statements included in the Registrant's 1993 Annual Report to Shareholders included as Exhibit 13 to this Report and is incorporated herein by reference. EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers are elected by the Board of Directors annually at its meeting immediately following the Annual Meeting of Shareholders, and hold office until the next Annual Meeting unless they sooner resign or are removed from office by the Board of Directors. The executive officers of the Registrant as of February 10, 1994 and their ages and principal positions with the Registrant as of that date are as follows: Mr. Mathews has occupied the positions of Chairman and Chief Executive Officer of the Registrant since its organization. He became President of the Registrant in 1991. Mr. Tarr has served as a director of the Registrant since 1984, Vice Chairman of the Board of the Registrant since 1992, President of Intermet International, Inc. since 1991, and a consultant to the Registrant from late 1989 through 1990. He was employed as Dean and professor of the Johnson Graduate School of Management at Cornell University from 1984 through 1989 and remained as professor through June 1990. Mr. Bodnar was Vice President - Foundry Sales of the Registrant from 1987 to 1991, when he became President of Intermet Foundries, Inc. Mr. Bodnar joined Lynchburg Foundry Company in 1951, and he has held management positions in Intermet Foundries, Inc. and the Registrant since 1984. Mr. Trezek has served as Executive Vice President of the Registrant since February 10, 1994. From 1991 to 1993 he was President of Knight Facilities Management, a division of Lester B. Knight. He was director of training and retraining resources at Delta College from 1988 to 1991. From 1987 to 1988 he served as an instructor of management courses at Saginaw Valley State University and Delta College. Prior to that time he held various management positions with the Central Foundry Division of General Motors Corporation. Mr. Ernst became Treasurer in 1984 and Secretary of the Registrant in 1986. He was named Vice President - Finance and Chief Financial Officer in 1991. Mr. Rydel has served as Vice President - Human Resources of the Registrant since 1991. He served as Director of Compensation and Benefits of the Registrant from 1986 until 1990, when he became Director of Human Resources of the Registrant. Mr. Bouxsein became Controller of the Registrant in 1991. From 1987 until 1991 he was Corporate Director - Financial Reporting of the Registrant. Mr. Marsh became Vice President of the Registrant in August 1993. From 1969 through 1993, Mr. Marsh was employed by Simpson Industries, Inc., most recently as Group Vice President, Transmission and Chassis Group. ITEM 2. ITEM 2. PROPERTIES The Registrant currently owns or operates or has an ownership interest in 10 ductile and gray iron foundries, one aluminum test foundry and one research foundry. Most castings can be produced at more than one of the Registrant's foundries. The following provides information about the location and capacity of the iron foundries, all of which are wholly-owned by the Registrant: The Registrant continually reviews the operation of its foundries and may from time to time close one or more foundries on a permanent or temporary basis due to its production needs and general business and economic conditions. The Pennsylvania foundry is currently idled, and the Lower Basin foundries will be closed in 1994. The aluminum test foundry is located in Lewisport, Kentucky and is jointly owned by the Registrant and Comalco Aluminum, Ltd. The research foundry is located in Virginia and is wholly-owned by the Registrant. The Registrant owns or leases several machining and design facilities. The Registrant owns a 100,000 square foot machining facility in Columbus, Georgia. The Registrant also has a machining operation housed in a leased facility containing approximately 200,000 square feet in Chesterfield, Michigan. InterMotive Technologies, Inc., a subsidiary providing engineering and design services, operates from a 38,000 square foot leased facility in Van Buren Township, Michigan. In addition, the Registrant owns or leases certain executive, sales, and other management offices, located in Georgia, Michigan, Ohio and Virginia. The Registrant believes that all of its facilities are well maintained. The only property of the Registrant which secures long-term indebtedness is the German foundry, which secures indebtedness with an aggregate outstanding principal balance at December 31, 1993 of $4,802,000. See Note 6 to the consolidated financial statements of the Registrant included in the Registrant's 1993 Annual Report to Shareholders included as Exhibit 13 to this Report for additional information on secured debt. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Except as set forth below, the Registrant is not aware of any material pending or threatened legal proceedings to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. On August 5, 1991 Lynchburg Foundry Company ("Lynchburg"), a wholly-owned subsidiary of the Registrant, was served with a complaint (the "Complaint") dated July 31, 1991 by the United States Environmental Protection Agency (the "EPA"). The Complaint alleges certain violations by Lynchburg of the Resource Conservation and Recovery Act ("RCRA"), the most significant of which relates to the treatment of certain hazardous waste at two of Lynchburg's foundry sites. The EPA initially proposed a civil penalty of $1,514,000, which Lynchburg appealed. Lynchburg and the EPA have reached an agreement in principle calling for a penalty of $330,000. The Registrant has made certain provisions in its consolidated financial statements for the penalty and remediation costs. Management does not expect this matter to have a material adverse effect on the Registrant's results of operations or financial position. The Registrant has entered into negotiations with the Office of the Ohio Attorney General with respect to certain past violations by the Registrant's Ironton, Ohio foundry of Ohio water pollution laws and regulations. In a letter dated March 15, 1994, the Attorney General's Office advised the Registrant that the Registrant could avoid litigation with respect to such violations by entering into a consent order. The Registrant will fully respond to the Attorney General's letter by mid April 1994 and expects to enter into a consent order providing for monetary penalties. Management does not expect this matter to have a material adverse effect on the Registrant's operations or 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 of the Registrant during the fourth quarter of the fiscal year covered by this Report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION AND DIVIDENDS The information contained in Note 12 to the consolidated financial statements of the Registrant included in the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, furnished to the Commission as Exhibit 13 to this Report, is hereby incorporated herein by reference. The Registrant's Common Stock, $0.10 par value, is traded in the over-the-counter market under the Nasdaq symbol "INMT." As of March 1, 1994, there were approximately 881 holders of record of the Registrant's Common Stock. The Board of Directors of the Registrant suspended payment of the regular quarterly dividend in October 1993 pending improvement in the Registrant's operating performance. Even if payment of dividends resumes, the payment is subject to the discretion of the Board of Directors and will depend upon the results of operations and financial condition of the Registrant and other factors the Board of Directors deems relevant. The Registrant is also subject to restrictions on the payment of dividends under certain loan agreements. As of December 31, 1993, all of the Registrant's retained earnings were restricted and unavailable for the payment of dividends under those agreements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data included in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, under the headings "Statement of Operations Data," "Share Data" and "Balance Sheet Data," are hereby incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information included under the heading "Discussion of Financial Information" in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, is hereby incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and related notes of the Registrant and the report of the independent auditors thereon included in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, are hereby incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Within the 24-month period prior to the date of the Registrant's financial statements for the fiscal year ended December 31, 1993, the Registrant did not change auditors and had no disagreement with its auditors on any matter of accounting principles or practices or financial statement disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the heading "INFORMATION ABOUT NOMINEES FOR DIRECTORS" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. Pursuant to Instruction 3 to Paragraph (b) of Item 401 of Regulation S-K, information relating to the executive officers of the Registrant is included in Item 1 of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information contained under the heading "EXECUTIVE COMPENSATION" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained under the heading "VOTING SECURITIES AND PRINCIPAL HOLDERS" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. For purposes of determining the aggregate market value of the Registrant's voting stock held by nonaffiliates, shares held by all current directors and executive officers of the Registrant have been excluded. The exclusion of such shares is not intended to, and shall not, constitute a determination as to which persons or entities may be "affiliates" of the Registrant as defined by the Securities and Exchange Commission. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained under the headings "CERTAIN TRANSACTIONS" and the second paragraph of "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements and notes thereto of the Registrant and its subsidiaries contained in the Registrant's 1993 Annual Report to Shareholders are incorporated by reference in Item 8 of this Report: Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' 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 Report of Independent Auditors 2. Financial Statement Schedules The following consolidated financial statement schedules for the Registrant are filed as Item 14(d) hereof, beginning on page. Consent of Independent Auditors Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information 3. Exhibits The following exhibits are required to be filed with this Report by Item 601 of Regulation S-K: (b) No current reports on Form 8-K were filed during the fourth quarter of the Registrant's 1993 fiscal year. (c) The Registrant hereby files as exhibits to this Report the exhibits set forth in Item 14(a)3 hereof. (d) The Registrant hereby files as financial statement schedules to this Report the financial statement schedules set forth in Item 14(a)2 hereof. INDEX TO FINANCIAL STATEMENT SCHEDULES Consent of Independent Auditors We consent to the incorporation by reference in this Annual Report (Form 10-K) of Intermet Corporation of our report dated February 9, 1994, included in the 1993 Annual Report to Shareholders of Intermet Corporation. Our audits also included the financial statement schedules on Intermet Corporation listed in Item 14(a). These schedules are the responsiblity 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 Nos. 33-58354 and 33-58352) pertaining to the Intermet Corporation Directors Stock Option Plan and the Intermet Corporation Key Individual Stock Option Plan of our report dated February 9, 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 Intermet Corporation. /s/ Ernst and Young Atlanta, Georgia March 29, 1994 Intermet Corporation (Consolidated) Schedule II Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Intermet Corporation (Consolidated) Schedule V Property, Plant and Equipment (Including Foreign Industrial Development Grants, Net of Amortization) Intermet Corporation (Consolidated) Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment Intermet Corporation (Consolidated) Schedule VIII Valuation and Qualifying Accounts Intermet Corporation (Consolidated) Schedule X Supplementary Income Statement Information SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERMET CORPORATION -------------------- (Registrant) By: /s/ George W. Mathews, Jr. -------------------------- George W. Mathews, Jr., Chairman of the Board of Directors, Chief Executive Officer and President Date: March 28, 1994 POWER OF ATTORNEY AND SIGNATURES Know all men by these presents, that each person whose signature appears below constitutes and appoints George W. Mathews, Jr. and John D. Ernst, or either of them, as attorney-in-fact, either with power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may 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 as of March 28, 1994 by the following persons on behalf of the Registrant in the capacities indicated. Signature Capacity - --------- -------- /s/ George W. Mathews, Jr. Chairman of the Board of - --------------------------- Directors, Chief Executive George W. Mathews, Jr. Officer and President (Principal Executive Officer) /s/ Vernon R. Alden Director - ----------------------------- Vernon R. Alden Director - ----------------------------- J. Frank Broyles /s/ John P. Crecine Director - ----------------------------- John P. Crecine Director - ----------------------------- Anton Dorfmueller, Jr. /s/ John B. Ellis Director - -------------------------------- John B. Ellis /s/ Wilfred E. Gross, Jr. Director - ------------------------------ Wilfred E. Gross, Jr. Director - ---------------------------- A. Wayne Hardy /s/ Harold C. McKenzie, Jr. Director - --------------------------- Harold C. McKenzie, Jr. /s/ J. Mason Reynolds Director - ----------------------------- J. Mason Reynolds /s/ Curtis W. Tarr Director - ------------------------------ Curtis W. Tarr /s/ John D. Ernst Vice President - Finance, - ------------------------------ Chief Financial Officer, John D. Ernst Secretary and Treasurer (Principal Financial Officer) /s/ Peter C. Bouxsein Controller (Principal - ------------------------------ Accounting Officer) Peter C. Bouxsein EXHIBIT INDEX

18647_1993.txt

18647_1993

1993

18647

Item 1 - BUSINESS Generally Registrant ("Company") is a gas and electric corporation formed, on December 31, 1926, as a consolidation of several operating utilities which had been accumulated under one management during the previous 26 years. The Company generates, purchases and distributes electricity and purchases and distributes gas. The Company, in the opinion of its general counsel, has, with minor exceptions, valid franchises, unlimited in duration, to serve a territory extending about 85 miles along the Hudson River and about 25 to 40 miles east and west from such River. The southern end of the territory is about 25 miles north of New York City, and the northern end is about 10 miles south of the City of Albany. The territory, comprising approximately 2,600 square miles, has a population estimated at 639,000. Electric service is available throughout the territory, and natural gas service is provided in and about the cities of Poughkeepsie, Beacon, Newburgh and Kingston and in certain outlying and intervening territory. The number of Company employees at December 31, 1993 was 1,370. The Company's territory reflects a diversified economy, including manufacturing industries, research firms, farms, governmental agencies, public and private institutions, resorts, and wholesale and retail trade operations. Total revenues and operating income before income taxes (expressed as percentages), derived from electric and gas operations for each of the last three years, were as follows: Percent of Percent of Operating Total Revenues Income before Income Taxes Electric Gas Electric Gas 1993 82% 18% 89% 11% 1992 82% 18% 87% 13% 1991 86% 14% 93% 7% Electric Sales to IBM: The Company's largest customer is International Business Machines Corporation ("IBM"), which accounted for approximately 14% of the Company's total electric revenues for the year ended December 31, 1993. Published reports indicate that IBM reduced its employment by 45,000 worldwide to 256,000 in 1993 from 301,000 in 1992. Such reports also indicate that IBM has reduced its employment in the Company's service territory by up to 8,400 employees in 1993. IBM, in February 1994, announced a further reduction of approximately 1,500 employees in 1994 in the Company's service territory. Such reductions would bring the total number employed in the Company's service territory to approximately 11,600, as compared to the peak level of IBM employment in excess of 30,000 in 1985. During 1993, IBM phased out its semiconductor manufacturing operations at its East Fishkill, New York facility, which is in the Company's service territory. This downsizing of IBM has resulted in a decline of electric sales to IBM by 20% in 1993. The Company cannot assess at this time the effect, if any, of such IBM employment reductions on the Company's future results of operations. Additional information concerning revenues and operating profits, and information concerning identifiable assets for the electric and gas segments, which are the significant industry segments of the Company, are set forth in Note 10 to the Company's Consolidated Financial Statements for the fiscal year ended December 31, 1993 (which Statements, including the Notes thereto, are hereinafter called "Company's 1993 Financial Statements"), appearing on pages 69 through 71 of the Company's 1993 Financial Statements (which Statements, together with Registrant's "Management's Discussion and Analysis of Financial Condition and Results of Operations" are included as Exhibit 13 hereto and hereinafter called "Exhibit 13"), which Note 10 is incorporated herein by reference. Construction Program and Financing The Company is engaged in a construction program which is presently estimated to involve total cash expenditures during the period 1994 through 1998 of approximately $364 million. The Company's principal construction projects consist of those designed to improve the reliability, efficiency and environmental compatibility of the Company's generating facilities and those required to expand, reinforce and replace the Company's transmission, substation, distribution and common facilities. For estimates of construction expenditures, internal funds, mandatory redemption of long-term securities, and working capital requirements for the five-year period 1994-1998, see the subcaption "Construction Program" of "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing on pages 6 through 8 of Exhibit 13 hereto, which subcaption is incorporated herein by reference. For a discussion of the Company's capital structure, financing program, short-term borrowing arrangements and sale of accounts receivable, see Notes 4 through 6 and Note 8 to the Company's 1993 Financial Statements, and the subcaptions "Capital Structure," "Financing Program" and "Short-term Debt and Sale of Receivables," appearing in "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing, in the case of said Notes, on pages 52 through 56, and 61 of Exhibit 13 hereof and, in the case of said subcaptions, on pages 8 and 9 of Exhibit 13 hereof, which Notes and subcaptions are incorporated herein by reference. The Company's Certificate of Incorporation and its various debt instruments do not contain any limitations upon the issuance of authorized, but unissued, Preferred Stock and Common Stock or of unsecured short-term debt. The Company's various debt instruments include limitations as to the amount of additional funded indebtedness which the Company can issue. The Company believes such limitations will not impair its ability to issue any or all of the debt described under said caption "Financing Program" incorporated herein by reference. The Company has authority from the State of New York Public Service Commission ("PSC") to issue, at any time through December 31, 1997, unsecured short-term debt for capital purposes in an aggregate principal amount not to exceed at any time $52 million. Rates Generally: The electric and gas rates of the Company applicable to service supplied to retail customers within the State of New York generally are regulated by the PSC. Transmission rates and rates for electricity sold for resale in interstate commerce are regulated by the Federal Energy Regulatory Commission ("FERC"). During 1993, the average price per kWh paid by the Company's residential electric customers was 11.2 cents, representing an increase of approximately 1.8% over the 11 cents average price during 1992. The rise in average price during 1993 was due primarily to the annualized effect of the increase in the Company's base electric rates effective April 15, 1992. Rate Proceedings - Electric and Gas: For information with respect to the PSC's Opinion and Order Determining Revenue Requirement and Rate Design, issued and effective February 11, 1994, incorporating the PSC's Order Adopting Revenue Requirement and Rate Design, issued and effective December 16, 1993, which authorizes the Company to increase its base rates for electric service and denies the Company's request to increase rates for base gas service, see subcaptions "Rate Proceeding - Electric" and "Rate Proceeding - Gas," in "Management's Discussion and Analysis of Financial Condition and Results of Operations," on pages 9 and 10 of Exhibit 13 hereto, which subcaptions are incorporated herein by reference. Cost Adjustment Clauses: The Company's tariff for retail electric service includes a fuel cost adjustment clause pursuant to which electric rates are adjusted to reflect changes in the costs of fuels used in electric generation and of certain purchased power from the level of such costs included in the Company's base rates for electricity. The Company's tariff for gas service includes a gas cost adjustment clause pursuant to which gas rates are adjusted to reflect changes in the price of natural gas purchased from pipeline and/or third party suppliers and certain costs of manufactured gas from the level of such costs included in base rates for gas. For more information with respect to such clauses, see the discussions under the subcaptions "Deferred Electric Fuel Costs" and "Deferred Gas Costs" in Note 1 to the Company's 1993 Financial Statements appearing on pages 44 and 45 of Exhibit 13 hereto, which subcaptions are incorporated herein by reference. Take-or-Pay Gas Liability: For a discussion of the PSC proceeding commenced in 1988 to determine, among other things, whether recovery of some or all of take-or-pay costs should be denied New York gas distribution companies, see the subcaption "Take-or-Pay Gas Costs" in Note 9 to the Company's 1993 Financial Statements appearing on page 65 of Exhibit 13 hereto, which subcaption is incorporated herein by reference. Other Rate Matters: From time to time legislation is introduced in the New York State Legislature which, if enacted, would affect the rate structures and ability to recover costs of service of all electric and/or gas utilities operating in New York State. The PSC from time to time has initiated various proceedings and taken action relating to the rate structures and operations of electric and/or gas utilities which could or will require Company action and the expenditure of funds. Fuel Supply and Cost The Company's two primary fossil fuel-fired electric generating stations are the Roseton Plant (described in Item 2 Item 2 - PROPERTIES Electric General: The net capability of the Company's electric generating plants as of December 31, 1993, the net output of each plant for the year ended December 31, 1993, and the year each plant was placed in service or rehabilitated are as set forth below: Electric Net Capability 1993 Unit Generating Year Placed (MW)* Net Output Plant Type of Fuel In Service Summer Winter (MWh) Danskammer Residual Oil, Natural 1951-1967 496.5 507.0 1,990,979 Plant Gas and Coal Roseton Plant Residual Oil 1974 422.1 426.0 1,072,734 (35% share) and Natural Gas Neversink Water 1953 23.5 23.0 64,028 Hydro Station Dashville Water 1920 3.0 3.9 11,880 Hydro Station Sturgeon Pool Water 1924 14.6 15.3 53,863 Hydro Station High Falls Water 1986 1.2 2.7 5,342 Hydro Station Coxsackie Kerosene or 1969 20.0 24.0 5,609 Gas Turbine Natural Gas So. Cairo Kerosene 1970 18.0 24.0 820 Gas Turbine Nine Mile 2 Nuclear 1988 94.0 95.0 645,036 Plant (9% share) ------- ------ --------- Total 1,092.9 1,120.9 3,850,291 * Reflects Company ownership of generation resources and, therefore, does not include firm purchases or sales. The Company entered into a contract with New York State Electric and Gas Corporation, with a term of May 24, 1993 through April 29, 1995, for the purchase of energy and capacity of up to 300 MW. During 1993, the Company purchased 920,000 MWh of energy under this contract. The Company has a contract with PASNY which entitles the Company to 49 MW net capability from the Blenheim-Gilboa Pumped Storage Hydroelectric Plant through 2002. Since 1975, the Company has purchased capacity in relatively small amounts from the Fitzpatrick Nuclear Plant of PASNY, pursuant to a contract which may be terminated by either party on 12 months' notice. Under such contract, the maximum capacity which can be purchased during specific periods is 6 MW. See Item 1, subcaption "Regulation - Alternative Electric Power Generation," with respect to alternative electric power generation interconnected with the Company's system. The Company owns 89 substations having an aggregate transformer capacity of 4.3 million KVA. The transmission system consists of 584 pole miles of line and the distribution system of 7,224 pole miles of overhead lines and 783 trench miles of underground lines. Load and Capacity: The Company's maximum one-hour demand within its own territory, for the year ended December 31, 1993, occurred on July 15, 1993 and amounted to 860 MW. The Company's maximum one-hour demand within its own territory, for that part of the 1993-1994 winter capability period through March 15, 1994, occurred on January 26, 1994 and amounted to 845 MW. Based on current projections of peak one-hour demands for the three-year period comprising the 1994 summer capability period through the winter capability period of 1996-1997, the Company estimates that it will have capacity available to satisfy its projected peak demands plus the estimated reserve generating capacity requirements which it is required to maintain as a member of the New York Power Pool ("NYPP"), described below. The following table sets forth the amounts of any excess capacity by summer and winter capability periods for such three-year period: Excess of Capacity over Forecasted Peak + Available Peak Plus NYPP Capability Peak Reserve Capacity Reserve Requirements Period (MW) (MW)* (MW) (MW) Percent 1994 Summer 840 991 1,092.9 101.9 9.3 1994-95 Winter 760 991 1,152.9 161.9 14.0 1995 Summer 820 968 1,122.9 154.9 13.8 1995-96 Winter 765 968 1,182.9 214.9 18.2 1996 Summer 820 968 1,152.9 184.9 16.0 1996-97 Winter 770 968 1,212.9 251.9 20.8 * Summer period peak plus reserve requirements carry over to the following winter period. The foregoing table reflects the following: (1) reduction in capacity requirements as a result of the Company's Energy Efficiency Programs described above in Item 1 under the subcaption "Regulation - Energy Efficiency Programs," (2) the decreases in IBM related electric sales and revenues (as described above in Item 1 under the subcaption "Rates - Rate Proceedings - Electric and Gas") and (3) effective with the 1994-1995 Winter - Capability Period, the capacity represented by the interests in the Roseton Plant proposed to be purchased by the Company from Niagara Mohawk Power Corporation ("Niagara Mohawk") under the "Amendment" (as described below under the subcaption "Roseton Plant"). The Company is a member of the NYPP consisting of the major investor-owned electric utility companies in the State and PASNY. The members of the NYPP, by agreement, provide for coordinated operation of their bulk power electric systems with a view to the use of the most economical source of electricity, for the maintenance of a reserve margin equal to at least 18% of each member's forecasted peak load and for the sale and interchange of electric generating capability and energy among such members. The members of the NYPP also provide for the cooperative development of long-range plans for the expansion on an integrated basis of the bulk power supply system for New York State, compatible with environmental standards, and appropriately related to interstate and international capacity and reliability considerations. Roseton Plant: The Roseton Plant is located in the Company's franchise area at Roseton, New York, and is owned by the Company, Con Edison and Niagara Mohawk as tenants-in-common. The Roseton Plant, placed in commercial operation in 1974, has a generating capacity of 1,200 MW consisting of two 600 MW generating units, both of which are capable of being fired either by residual oil or natural gas (see subcaption below entitled "Gas - Sufficiency of Supply and Future Gas Supply"). The Company is acting as agent for the owners with respect to operation of the Roseton Plant. Generally, the owners share the costs and expenses of the operation of such Plant in accordance with their respective ownership interests. In March 1993, Unit No. 2 of the Roseton Plant went out of service because of extensive damage to that Unit and related facilities caused by fire. No injury to personnel was involved. Some non-hazardous mineral oil spillage also occurred into a tributary of the Hudson River. No customer service interruptions occurred. Appropriate governmental agencies, including the PSC, the U.S. Coast Guard and the NYSDEC were contacted. Unit No. 1 of the Roseton Plant was taken out of service due to less extensive damage to that Unit. Unit No. 1 was returned to service in May 1993 and Unit No. 2 was returned to service in December 1993. Total restoration costs are approximately $32 million, most of which will be recovered through insurance. Pursuant to an agreement among the cotenant owners of the Roseton Plant, dated October 1, 1968, and thereafter amended ("Roseton Plant Agreement"), Con Edison owns 40% of such Plant, Niagara Mohawk owns 25% of such Plant and the Company owns 35% of such Plant, all as tenants-in-common. The Company, under the Roseton Plant Agreement, has an option to purchase the interests of Con Edison and Niagara Mohawk in the Roseton Plant in December 2004 at a purchase price based upon fair value within specified limits of amortized costs. The exercise of such option by the Company is subject to approval by the PSC and may be subject to the statutory standards and/or competitive bidding requirements described in Item 1 above under the caption "Regulation - Least- Cost Generation Supply." In order to satisfy then anticipated requirements for additional generating capacity starting in the mid-1990s, in 1987 the Company and Niagara Mohawk entered into an agreement ("Amendment") which revises the option of the Company to purchase the interest of Niagara Mohawk in the Roseton Plant under the Roseton Plant Agreement. The Company's option to buy Con Edison's interest in the Roseton Plant is not affected by the Amendment. The Amendment is subject to PSC approval, and in the event such approval is not obtained, the Amendment is cancelled and the parties return to their same positions under the Roseton Plant Agreement. Pursuant to the Amendment, Niagara Mohawk will sell to the Company a 2.5% interest in the Roseton Plant on December 31, 1994 and on each succeeding December 31, through and including December 31, 2003, which will constitute all of Niagara Mohawk's interest in the Roseton Plant. In exchange, Niagara Mohawk will have the option to repurchase from the Company up to a 25% interest in the Roseton Plant in December 2004. The prices for the purchases will be based on the depreciated book cost of the Roseton Plant assuming straight-line amortization to provide for a fully amortized facility as of December 31, 2009. Pursuant to the Amendment, the Company has the option to repurchase Niagara Mohawk's remaining interest in the Roseton Plant when such Plant reaches the end of its assumed physical life as agreed upon by the parties to the Amendment. In July 1988, the PSC established a proceeding to consider a joint petition filed by the Company and Niagara Mohawk requesting the PSC to approve the transfers of interests in the Roseton Plant contemplated by the Amendment. In May 1989, the Company and the PSC Staff reached a Stipulation Agreement indicating that, giving consideration to expected demand-side management activities, the proposed transfers of interest of the Roseton Plant under the Amendment were one alternative which would meet the Company's future needs for power. The PSC has not yet acted on such petition. The Company continues to consider other alternatives to the Amendment. The 345 Kv transmission lines and related facilities to connect the Roseton Plant with other points in the system of the Company and with the systems of Con Edison and Niagara Mohawk to the north and west of such Plant are 100%-owned by the Company. The share of each of the parties in the output of the Roseton Plant is transmitted over these lines pursuant to a certain transmission agreement relating to such Plant, which provides, among other things, for compensation to the Company for such use by the other parties. In addition, the Company has contract rights which entitle the Company to the lesser of 300 MW or one quarter of the capacity in a 345 Kv transmission line owned by PASNY which connects the Roseton Plant with a Con Edison substation to the east of such Plant in East Fishkill, New York. In exchange for these rights, the Company agreed to provide PASNY capacity in the 345 Kv transmission lines the Company owns from the Roseton Plant, to the extent it can do so after satisfying its obligations to Con Edison and Niagara Mohawk. Nine Mile 2 Plant: General: Unit No. 2 of the Nine Mile Point Nuclear Station ("Nine Mile 2 Plant" or "Plant") is located in Oswego County, New York, and is operated by Niagara Mohawk. The Nine Mile 2 Plant is owned as tenants-in-common by the Company (9% interest), Niagara Mohawk (41% interest), New York State Electric & Gas Corporation (18% interest), Long Island Lighting Company (18% interest) and Rochester Gas and Electric Corporation (14% interest). The output of the Nine Mile 2 Plant, which has a nominally rated net capability of 1,080 MW, is shared, and the operating expenses of and capital additions to the Plant are allocated to the cotenants, in the same proportions as the cotenants' respective ownership interests. An Operating Agreement for the operation of the Plant was entered into by the Nine Mile 2 Plant cotenants effective January 1, 1993, and the PSC approved said Operating Agreement on February 24, 1994. Under that Agreement, Niagara Mohawk operates the Nine Mile 2 Plant, but all five owners shared certain policy, budget and managerial oversight functions. The fixed term of such Operating Agreement is 24 months from its effective date and, unless terminated on the expiration of such 24 month period, continues, subject to termination on six months' notice. In August 1989, the non-operating cotenants of the Nine Mile 2 Plant entered into an agreement for consulting services with Management, Analytical & Technical Services, Inc. ("MATS") concerning the monitoring and assessment of the operation of the Plant, including the provision of technical advice, with the objective of improving the operation of the Plant. Pursuant to such agreement, MATS is acting as the on-site representative of the non-operating cotenants. Operational Matters: NRC and INPO Monitoring: On September 28, 1993, the Nuclear Regulatory Commission ("NRC") issued its latest systematic assessment of licensee performance ("SALP") review of the Nine Mile Point Nuclear Station for the period May 24, 1992 to August 14, 1993 ("1992/93 SALP Report"). The Nine Mile Point Nuclear Station is comprised of Units No. 1 and No. 2, Unit No. 1 being located adjacent to the Nine Mile 2 Plant and owned and operated solely by Niagara Mohawk and Unit No. 2 being the Nine Mile 2 Plant. The 1992/93 SALP Report, conducted under the revised SALP process that was implemented by the NRC on July 19, 1993, rates licensee performance in four functional areas: Operations, Maintenance, Engineering and Plant Support. Overall, the NRC indicated that it continues to see improved performance at the Nine Mile Point Nuclear Station. According to the NRC, Niagara Mohawk's management demonstrated a proactive and proper safety perspective and excellent oversight, control and involvement in and support of activities at such Station. Due to the change in the NRC's revised SALP process, direct comparisons to previous SALP reports are not available in all areas. Operations was rated Category 2 ("good"), which was the same rating as on the prior SALP Report (covering the period April 1991 through May 23, 1992). Maintenance was rated Category 2 ("good"), up from Category 2 "with a declining trend" in said prior SALP Report. Engineering was rated Category 1 ("excellent"), up from Category 2 in said prior SALP Report. Plant Support was rated Category 2 ("good"). Plant Support is a new functional area covering all activities related to plant support functions, including Radiological Controls, Emergency Preparedness, Security, Chemistry, Fire Protection and House Keeping Controls. The Institute of Nuclear Power Operations ("INPO"), an industry sponsored oversight group, conducted evaluations of the Nine Mile Point Nuclear Station during the weeks of May 17 and 24, 1993. Niagara Mohawk informed the Company that the INPO Report was generally favorable, however, there were some areas in need of improvement. Niagara Mohawk reports that it has responded to INPO with its intent to correct any problem areas. INPO evaluations are conducted at twelve (12) to eighteen (18) month intervals. Radioactive Waste: For a discussion of the low-level and high-level radioactive waste management programs at the Nine Mile 2 Plant, see the caption "Radioactive Waste" in Note 2 to the Company's 1993 Financial Statements appearing on pages 46 and 47 of Exhibit 13 hereto, which caption is incorporated herein by reference. Refueling Outage: A scheduled refueling outage for the Nine Mile 2 Plant commenced on October 2, 1993. Such refueling outage was completed on November 29, 1993 and full plant output was achieved on December 3, 1993. Gas General: The Company's gas system consists of 156 miles of transmission pipelines and 923 miles of distribution pipelines. Current Gas Supply: During 1993, natural gas was available to firm gas customers at a price competitive with that of alternative fuels. As compared to 1992, in 1993, firm retail gas sales, normalized for weather, increased by 1% and the average number of firm gas customers increased by 1.9%. Sales to interruptible customers decreased 37.4% in 1993 as compared to 1992. For information on the Company's gas suppliers and gas storage capability, see the caption "Natural Gas Supply" in Note 9 to the Company's 1993 Financial Statements appearing on pages 63 and 64 of Exhibit 13, which caption is incorporated herein by reference. For the year ended December 31, 1993, the total amount of gas purchased from all sources was 18,293,178 Mcf., which includes 1,940,214 Mcf. purchased directly for use as a boiler fuel at the Roseton Plant. The Company owns two propane-air mixing facilities for emergency and peak shaving purposes located in Poughkeepsie and in Newburgh, New York. Each facility is capable of supplying 8,000 Mcf. per day with propane storage capability adequate to provide maximum facility sendout for up to three consecutive days. Sufficiency of Supply and Future Gas Supply: The peak daily demand for natural gas by the Company's customers for the year ended December 31, 1993 occurred on February 6, 1993, and amounted to 100,774 Mcf. The Company's peak-day gas capability in 1993 was 116,865 Mcf. The peak daily demand for natural gas by the Company's customers for that part of the 1993-1994 heating season through March 15, 1994, occurred on January 27, 1994 and amounted to 113,033 Mcf. Other: In late 1985, FERC instituted a rule which permits non-discriminatory access to the pipeline facilities of interstate gas pipeline transmission companies subject to the jurisdiction of FERC under the Natural Gas Act. This rule allows access to such pipelines by the pipeline transmission company's customers enabling them to transport gas purchased directly from third parties and spot sources through such pipelines. Such access, moreover, also permits industrial customers of gas distribution utilities to connect directly with the pipeline transmission company and to contract directly with the pipeline transmission companies to transport gas, thereby by-passing the distribution utility. In 1985, the PSC issued its Opinion and Order requiring New York State distribution gas utilities to transport customer-owned gas through its facilities upon request of a customer. Except in the Towns of Carmel, Pleasant Valley, New Baltimore, Coxsackie, Athens, Milan, Clinton, LaGrange and Unionvale, currently, no interstate pipeline transmission companies are located in areas where the Company provides retail gas service. For a discussion of FERC Order 636, issued in 1992, and thereafter amended, which requires pipeline gas suppliers to unbundle natural gas sales service from transportation and storage service, see the caption "Natural Gas Supply" in Note 9 to the Company's 1993 Financial Statements appearing on pages 63 and 64 of Exhibit 13 hereto, which caption is incorporated herein by reference. The Company is a member of the New York Gas Group ("NYGAS"), a voluntary association of utilities providing gas service in New York State. The purpose of NYGAS is to achieve, by cooperative action among gas distributors, greater efficiency in meeting present demands for gas service in New York State and to develop state-wide gas sufficiency to support future economic growth throughout the State. Other Matters The Danskammer Plant and the Roseton Plant and all of the other principal generating plants and important property units of the Company are held by it in fee simple, except (1) certain rights-of-way, and (2) a portion of the property used in connection with the hydroelectric plants of the Company consisting of flowage or other riparian rights. The Company's present interests in the Roseton Plant and the Nine Mile 2 Plant are owned as undivided interests as a tenant-in-common with the other utility owners thereof. Certain of the properties of the Company are subject to rights-of-way and easements which do not interfere with the Company's operations. In the case of certain distribution lines, the Company owns only a part interest in the poles upon which its wires are installed, the remaining interest being owned by telephone companies. Certain electric transmission facilities owned by others are used by the Company pursuant to long-term contractual arrangements. All of the physical properties of the Company (other than property, such as material and supplies, excluded in the Company's Mortgage) and its franchises are subject to the lien of the Company's Mortgage under which all of its Mortgage Bonds are outstanding. Such properties are from time to time subject to liens for current taxes and assessments which it is the Company's practice to pay regularly as and when due. The Company's properties have been well maintained and are in good operating condition. During the three-year period ended December 31, 1993, the Company made gross property additions of $186.7 million and property retirements and adjustments of $35.8 million, resulting in a net increase (including Construction Work in Progress) in utility plant of $150.9 million, or 12.5% Item 3 Item 3 - LEGAL PROCEEDINGS Asbestos Litigation The Company, as of March 1, 1994, is a defendant or third-party defendant in 189 asbestos lawsuits commenced in New York state and federal courts. Since 1987, and as of March 1, 1994, the Company, along with many other parties, has been a defendant or third-party defendant in a total of 439 such asbestos lawsuits (including the 189 cases which are currently pending). The plaintiffs in these lawsuits typically allege that they were injured by exposure to airborne asbestos fibers while working at a Company job site, either as an employee of an independent contractor or as an employee of the Company, when asbestos-containing products were being installed, maintained, renovated or removed. Typically, each plaintiff seeks $10,000,000 in compensatory damages, plus punitive damages, from all defendants. Of the 439 cases that have been brought against the Company, only 189 remain pending against the Company, as of March 1, 1994, as a result of the following developments: (1) the Company negotiated voluntary dismissals in 22 cases and won summary judgment dismissals in 9 cases; (2) 114 third-party claims were extinguished with respect to the Company when the third-party plaintiff, Owens-Corning Fiberglass ("OCF") settled the cases with the plaintiffs; and (3) the Company settled 105 cases for an amount that in the aggregate is not material to the Company's financial condition. Four of the pending cases were commenced against the Company and numerous other defendants in the United States District Court for the Southern District of New York by complaints dated March 26, 1991, June 13, 1991 and February 19, 1992. All four federal court plaintiffs allege to have been injured by exposure to asbestos fibers while working as an employee of an independent contractor at a Company facility. In two of the cases, the Company was joined as a third-party defendant by OCF. The third-party complaint alleges that the Company is responsible to OCF for the amount of any recovery obtained by the plaintiffs against OCF in each lawsuit. The two remaining federal court plaintiffs each seek $10,500,000 in compensatory damages, plus punitive damages. One hundred eighty-five (185) cases are pending against the Company in New York State Supreme Court, County of New York. These cases were commenced against the Company and numerous other defendants by complaints dated March 6, 1990, August 12, 1991, October 21, 1991, December 12, 1991, January 3, 1992, May 11, 1992, May 21, 1992, July 10, 1992, August 24, 1992, October 5, 1992, October 6, 1992, October 27, 1992, December 21, 1992, December 22, 1992, January 3, 1993, February 23, 1993, March 5, 1993, May 28, 1993, July 1, 1993, August 2, 1993, November 1, 1993, November 26, 1993, December 1, 1993, January 6, 1994, January 12, 1994, January 24, 1994 and January 25, 1994. All of these cases involve persons who were allegedly exposed to asbestos fibers while working as employees of independent contractors at Company facilities. One hundred seventy-seven (177) of these plaintiffs seek $10,000,000 in compensatory damages, plus punitive damages. Seven (7) plaintiffs seek $10,500,000 in compensatory damages, plus punitive damages. One (1) plaintiff seeks $27,000,000 in compensatory damages, plus punitive damages. In summary, as of March 1, 1994, the Company is a defendant or third-party defendant in 189 asbestos lawsuits. Although the Company is presently unable to assess the validity of these 189 lawsuits, based on information known to the Company at this time, including its experience in settling asbestos cases and in obtaining dismissals of asbestos cases, the Company believes that the costs to be incurred in connection with these lawsuits will not have a material adverse effect on the Company's financial position. However, if the Company were ultimately held liable under these lawsuits and insurance coverage were not available, the cost thereof could have a material adverse effect (a reasonable estimate of which cannot be made at this time) on the financial condition of the Company if the Company could not recover all or a substantial portion thereof through rates. Environmental Litigation In December 1980, several utilities, including the Company, three environmental groups and the NYSDEC, among others, entered into an agreement ("Settlement Agreement") which relates to compliance with environmental matters concerning the operations of certain electric generating stations located along the Hudson River, including the Roseton Plant. The Settlement Agreement expired on May 9, 1991. Effective May 9, 1991, such utilities and the NYSDEC entered into an interim agreement which relates to certain environmental aspects of the operation of such plants, pending future developments. In September, 1991, Natural Resources Defense Council, Inc., the Hudson River Fisherman's Association and Scenic Hudson, Inc. commenced an action in the Supreme Court of the State of New York, County of Albany, against the NYSDEC, Con Edison, PASNY, Orange and Rockland Utilities, Inc. and the Company. This lawsuit challenged, as arbitrary and capricious, an abuse of discretion and a violation of lawful procedure, the determination of the NYSDEC to enter into said interim agreement, alleging, among other things, that it would result in less stringent regulatory standards than set forth in the SPDES permits applicable to, among others, the Roseton Plant, without regard to the applicable SPDES permit modification procedures. The lawsuit also sought a declaratory judgment that the existing SPDES permits (which expired October 1, 1992) include all covenants contained in the expired Settlement Agreement which restrict operations at said plants, including the Roseton Plant. On March 23, 1992, the Court approved an agreed-upon Consent Order which resolved this action. Such Consent Order provides for certain operating restrictions at the Roseton Plant relating to the use of river water for plant cooling purposes, which have not imposed, and are not expected to impose, material additional costs on the Company. Such Consent Order remains in effect until September 1, 1994 (originally due to expire on September 1, 1993, but extended for one year by agreement by the parties thereto, as approved by the Court on August 5, 1993), or until renewal SPDES permits for said plants, including the Roseton Plant, are finally effective, whichever first occurs. For a description of the pending NYSDEC proceeding involving renewal of the SPDES permit for the Roseton Plant (which expired on October 1, 1992), see Item 1 above under the subcaption "Environmental Quality - Water." IBM Litigation By complaint, dated July 28, 1988, the International Business Machines Corporation ("IBM") commenced a lawsuit in the Supreme Court of the State of New York, County of Dutchess, against the Company and other unnamed defendants. IBM is the largest electric customer of the Company (see in Item 1 above, subcaption entitled "Generally"). In such complaint IBM alleges that negligence, gross negligence and breach of contract on the part of the defendants resulted in a power outage and electrical loss on August 2, 1985, whereby IBM sustained damages in the amount of $470,740. The Company filed its answer, denying liability and cross complaint on September 26, 1988. Currently, discovery is underway. The Company denies liability in this matter; if, however, it were held to be so liable, the amount of such damages would not have a material adverse effect on the financial condition of the Company. Catskill Incident In November 1992, an explosion in a dwelling in the Company's gas service territory in Catskill, New York resulted in personal injuries, including the death of an occupant, and property damage. The National Transportation Safety Board ("NTSB"), the Office of Pipeline Safety ("OPS," a part of the Research and Special Program Administration of the U.S. Department of Transportation) and the PSC investigated this incident. On January 27, 1993, the Staff of the PSC issued a report which attributed the cause of this incident to the Company's alleged violations of the PSC's gas safety regulations and the Company's operating procedures. Based upon such report, the PSC approved the commencement of a penalty proceeding against the Company. The PSC Staff, based on its interpretation of the New York Public Service Law, sought a penalty of up to approximately $8.25 million. The Company and the staff of the PSC reached an Agreement in connection with the PSC's threatened penalty proceeding arising out of such explosion, which Agreement expires on December 31, 1998. The Agreement provides that the Company will not pay any penalties or fines in connection with the Catskill incident. Under the terms of such Agreement, which was approved by the PSC, by Order issued and effective January 7, 1994, the Company has established a Quality Control Program to assure the safe and efficient operation of the Company's Gas System. The Company also will establish, under the Agreement, an expanded training program, create four training centers and implement an expanded program to evaluate and replace cast iron and steel pipeline facilities. Shareholders will contribute the following amounts under the Agreement: an aggregate of $500,000 in 1994 toward the cost of the pipeline replacement program and the cost of the creation of the training centers; in each of 1995 and 1996, $500,000 toward the cost of such pipeline replacement program; and in 1997 from $0 to $500,000 toward the cost of such pipeline replacement program, depending on the Company's completion of certain tasks by specified dates. As a result of an investigation of the Catskill incident conducted by the OPS pursuant to the Natural Gas Pipeline Safety Act, the OPS issued a Notice of Proposed Violation and Proposed Civil Penalty in December 1992. By Final Order, issued December 2, 1993, the OPS found that the Company failed to submit a telephonic report of the Catskill incident to the DOT at the earliest practicable moment following discovery of such incident as required by applicable regulations. The Company did notify the DOT of the Catskill incident by telephone approximately nine hours and forty-five minutes after such incident. The OPS assessed the Company a civil penalty of $5,000, which the Company elected not to appeal. The NTSB in its investigation of the Catskill incident, by letter dated August 23, 1993, determined that the probable cause of such incident was the Company's failure to follow its procedures and the PSC's code for the immediate replacement of exposed cast iron pipe. The NTSB also recommended that the Company undertake a certain program to ensure continuity of supervisory responsibility for the timely and effective verification of the safety integrity of exposed cast iron pipe and to identify and replace in a timely manner cast iron piping systems that may threaten public safety. By letter, dated October 22, 1993, the Company responded that it would undertake such a program. Two lawsuits have been commenced against the Company alleging personal injuries and wrongful death arising out of such incident as follows: By complaint, dated February 2, 1994, Carl Fatzinger, as executor of the estate of Mildred Fatzinger, and Virginia Fatzinger commenced an action in the Supreme Court of the State of New York, Greene County, against the Company and two other defendants. The complaint alleges that Mildred and Virginia Fatzinger were residents of the dwelling in which said explosion occurred and that, as a result of said explosion, Mildred Fatzinger was killed, Virginia Fatzinger received serious personal injuries, and the Fatzingers suffered extensive damage to their property. The complaint seeks an unspecified amount of compensatory and punitive damages against the Company based on theories of negligence, absolute liability and gross negligence. By complaint, dated October 18, 1993 and filed in the Supreme Court of the State of New York, Greene County, Frank Reyes commenced an action against the Company for unspecified personal injuries and property damage alleged to have been caused by said explosion. Mr. Reyes was a nearby resident at the time of said explosion. The complaint seeks $2,000,000 in compensatory damages and $2,000,000 in punitive damages from the Company, based on theories of negligence and gross negligence, respectively. The Company is investigating these claims and presently has insufficient information on which to predict their outcome. The Company believes that it has adequate insurance to cover any compensatory damages that might be awarded. The Company's insurance, however, does not extend to punitive damages. If punitive damages were ultimately awarded in either or both of these lawsuits, such award(s) could have a material adverse effect on the financial condition of the Company if the Company could not recover all or a substantial portion thereof through rates. At this time the Company can make no prediction as to any other litigation which may arise out of the Catskill incident. Income Tax Assessments: Reference is made to the subcaption "Tax Matters - Assessments" in Note 9 to the Company's 1993 Financial Statements, on page 67 of Exhibit 13, for a discussion of the examination by the Internal Revenue Service ("IRS") of the Company's federal income tax returns for 1987 and 1988, which subcaption is incorporated herein by reference. On or about March 7, 1994, the Company received letters from the IRS, arising out of this examination, proposing net increases in the Company's federal tax liability of approximately $16 million. Such letters do not represent a notice of deficiency from the IRS, and the Company has received no notice of deficiency regard- ing these taxable years from the IRS. According to such letters, the Company has the option of: (i) responding within 30 days from the date of the letters to agree or disagree with the proposed adjustments and request a conference with the Regional Office of Appeals of the IRS, or (ii) seeking relief in the United States Tax Court. The Company intends to respond (in either a 30-day period or, pending the granting by the IRS of an extension, a 60- day period) to these letters, challenge the proposed adjustments, and request a conference with said Office of Appeals. The Company can make no prediction at this time as to the ultimate resolution of these proposed adjustments. However, the Company believes that a significant portion of any final assessments would be recovered in rates. And, the Company believes that the amount of any final assessments, not recovered in rates, would not have a material adverse effect on the financial condition 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 during the fourth quarter of the Company's fiscal year covered by this Report. PART II Item 5 Item 5 - MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information set forth under the subcaption "Common Stock Dividends and Price Ranges" in Management's Discussion and Analysis of Financial Condition and Results of Operations, on page 29 of Exhibit 13 hereto, is incorporated herein by reference. Pursuant to applicable statutes and its Certificate of Incorporation, the Company may pay dividends on shares of Preferred and Common Stock only out of surplus. The Company has an Automatic Dividend Reinvestment and Stock Purchase Plan which permits holders of the Company's Common Stock who elect to participate in such Plan to reinvest dividends and also permits participants to make additional cash investments in the Company's Common Stock. Shares can be acquired directly from the Company or on the open market at the election of the Company. For a complete description of said Plan, reference is made to the Prospectus, dated January 5, 1993, which is part of the Company's Registration Statement on Form S-3 (Registration No. 33-56760), relating to 3,550,000 shares of Common Stock registered under the Securities Act of 1933 ("1933 Act") for issuance under said Plan. The Company's Customer Stock Purchase Plan provides the Company's residential customers and members of their families residing with them who are residents of New York State with a method of purchasing shares of the Company's Common Stock directly from the Company. Shares can be acquired directly from the Company or on the open market at the election of the Company. For a complete description of said Plan, reference is made to the Prospectus, dated January 5, 1993, which is part of the Company's Registration Statement on Form S-3 (Registration No. 33-55764), relating to 780,000 shares of Common Stock registered under the 1933 Act for issuance under said Plan. The Company also maintains for its employees an Employee Stock Purchase Plan, which provides for the purchase of the Company's Common Stock on the open market. Item 6 Item 6 - SELECTED FINANCIAL DATA The information required hereunder is incorporated herein by reference to the material on pages 4 and 5 of Exhibit 13 hereto. Item 7 Item 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required hereunder is incorporated herein by reference to the material appearing on pages 6 through 29 of Exhibit 13 hereto. Item 8 Item 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) Financial Statements The Company's 1993 Financial Statements, together with the report thereon of Price Waterhouse, dated January 28, 1994, appearing on pages 30 through 72 of Exhibit 13 hereto, are incorporated by reference in this Annual Report on Form 10-K. The Financial Statement Schedules incorporated by reference as part of this Annual Report on Form 10-K should be read in conjunction with the Company's 1993 Financial Statements. Financial Statement Schedules not included with this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the Company's 1993 Financial Statements. The Company's 1993 Financial Statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated. The Company's subsidiaries are wholly-owned landholding, cogeneration and energy management companies. Due to immateriality, the net income of the Company's subsidiaries is reflected in the Company's Consolidated Statement of Income as Other Non-operating Income - net; such Consolidated Statement of Income is contained on pages 36 and 37 of Exhibit 13 hereto. (b) Supplementary Financial Information The supplementary financial information specified by Item 302 of Regulation S-K is found under the caption "Selected Quarterly Financial Data (Unaudited)," of the Company's 1993 Financial Statements on page 73 of Exhibit 13 hereto, which caption is incorporated herein by reference pursuant to Item 8 (a) above. (c) Other Financial Statements and Schedules Other financial statements and schedules required under Regulation S-X are filed pursuant to Item 14 of this Report. Item 9 Item 9 - DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10 Item 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information with respect to the Directors of the Company required hereunder is incorporated by reference to the caption "Election of Directors" in the Company's definitive proxy statement, dated February 25, 1994, to be used in connection with its Annual Meeting of Shareholders to be held on April 5, 1994, which proxy statement has previously been submitted to the Securities and Exchange Commission pursuant to that Commission's Regulation S-T. The information with respect to the executive officers of the Company required hereunder is incorporated by reference to Item 1 of this Report, under the caption "Executive Officers of the Company." Item 11 Item 11 - EXECUTIVE COMPENSATION The information required hereunder is incorporated by reference to the caption "Executive Compensation" in the Company's definitive proxy statement, dated February 25, 1994, to be used in connection with its Annual Meeting of Shareholders to be held on April 5, 1994. Item 12 Item 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required hereunder is incorporated by reference to the caption "Security Ownership" in the Company's definitive proxy statement, dated February 25, 1994, to be used in connection with its Annual Meeting of Shareholders to be held on April 5, 1994. Item 13 Item 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no relationships or transactions of the type required to be described by this Item. 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 See subpart 1 of Index to Financial Statements on page of this Report. 2. Financial Statement Schedules See subpart 2 of Index to Financial Statements on page of this Report. 3. Exhibits Incorporated herein by reference to the Exhibit Index beginning on page E-1 of this Report. Such Exhibits include the following management contracts or compensatory plans or arrangements required to be filed as an Exhibit pursuant to Item 14(c) hereof: Description in the Exhibit List and Exhibit Nos. for this Report Directors' Deferred Compensation Plan, effective October 1, 1980. (Exhibit (10)(iii)(1)) Trust Agreement between Registrant and Dutchess Bank & Trust Company, as trustee, dated as of January 1, 1984, pursuant to Registrant's Savings Incentive Plan. (Exhibit (10)(iii)(2)) First Amendment, dated December 31, 1990, to Trust Agreement between Registrant and The Bank of New York, as successor trustee, dated as of January 1, 1984, pursuant to Registrant's Savings Incentive Plan. (Exhibit (10)(iii)(3)) Savings Incentive Plan of Registrant, as restated as of January 1, 1987, together with Amendments thereto dated September 23, 1988 and March 17, 1989, December 31, 1990, January 14, 1991, October 25, 1991, December 11, 1992, July 23, 1993, September 24, 1993, December 17, 1993 and March 3, 1994. (Exhibits (10)(iii)(4, 5, 6, 7, 9, 12, 13, 14 and 16)) Executive Deferred Compensation Plan of the Company, effective March 1, 1992 together with Amendment thereto dated December 17, 1993. (Exhibits (10)(iii)(8 and 15)) Retirement Benefit Restoration Plan of the Company, effective May 1, 1993, together with Amendment thereto dated July 23, 1993. (Exhibits (10)(iii) (10 and 11)) Executive Incentive Compensation Plan of the Company, effective January 1, 1993. (Exhibit (10)(iii)(17)) (b) Reports on Form 8-K During the period October 1, 1993, to the date hereof, the following Reports on Form 8-K were filed by the Company: Report, dated October 8, 1993, reporting the issuance on September 22, 1993, of the Recommended Decision of the PSC Administrative Law Judge in the PSC proceeding relating to the Company's request for increased gas and electric rates filed with the PSC on November 12, 1992. Report, dated January 5, 1994, reporting (i) the issuance by the PSC, on December 16, 1993, of an Order authorizing an increase in the Company's electric base rates and denying the Company's request for increased base gas rates, all with respect to the Company's request for increased gas and electric rates filed with the PSC on November 12, 1992, and (ii) the return to full service on December 20, 1993 of Unit No. 2 of the Company's Roseton Electric Generating Station after repair of damage to such Unit suffered on March 18, 1993. Report, dated January 24, 1994, reporting (i) the issuance of an Order of the PSC approving an agreement between the Company and the Staff of the PSC relating to the PSC's threatened penalty proceeding arising out of a November 1992 explosion in a dwelling in the Company's gas service territory in Catskill, New York, (ii) the $5,000 fine assessed by the Office of Pipeline Safety due to this explosion incident and (iii) the Company's response to the recommendation of the National Transportation Safety Board with respect to this explosion incident. (c) Exhibits Required by Item 601 of Regulation S-K Incorporated herein by reference to subpart (a)-3 of Item 14, above. (d) Financial Statement Schedules required by Regulation S-X which are excluded from the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993 Incorporated herein by reference to subpart 2 of Index to Financial Statements on page of this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. CENTRAL HUDSON GAS & ELECTRIC CORPORATION By (John E. Mack, III, Chairman of the Board 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 the Company and in the capacities and on the date indicated. Signature Title Date (a) Principal Executive Officer or Officers: (John E. Mack, III) Chairman of the Board and Chief Executive Officer March 25, 1994 (b) Principal Financial Officer and Principal Accounting Officer: (John F. Drain) Vice President - Finance and March 28, 1994 Controller (c) Directors: (L. Wallace Cross) Director March 25, 1994 SIGNATURES - (Continued) Signature Title Date (Jack Effron) Director March 25, 1994 (Richard H. Eyman) Director March 25, 1994 (Frances D. Fergusson) Director March 25, 1994 (Heinz K. Fridrich) Director March 25, 1994 (Edward F. X. Gallagher) Director March 25, 1994 (Paul J. Ganci) Director March 25, 1994 (Charles LaForge) Director March 25, 1994 (John E. Mack, III) Director March 25, 1994 (Howard C. St. John) Director March 25, 1994 (Edward P. Swyer) Director March 25, 1994 CENTRAL HUDSON GAS & ELECTRIC CORPORATION Page(s) in Exhibit 13 of this Report* 1. Financial Statements Report of Independent Accountants 30 Consolidated Statement of Retained 31 Earnings for the three years ended December 31, 1993 Consolidated Balance Sheet at 32-35 December 31, 1993 and 1992 Consolidated Statement of Income for 36-37 the three years ended December 31, 1993 Consolidated Statement of Cash Flows for 38-39 the three years ended December 31, 1993 Notes to Consolidated Financial Statements 40-72 Selected Quarterly Financial Data (unaudited) 73 Page(s) in Form 10-K Report of Independent Accountants on Financial Statement Schedules Consent of Independent Accountants 2. The Financial Statement Schedules for the Years 1991, 1992 and 1993 Schedule V - Utility Plant - Schedule VI - Accumulated Depreciation - and Amortization of Utility Plant Schedule VIII - Reserves - Schedule IX - Short-Term Borrowings - Schedule X - Supplementary Income - Statement Information *Incorporated by reference to the indicated pages of Exhibit 13 to this Report. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Central Hudson Gas & Electric Corporation Our audits of the consolidated financial statements referred to in our report dated January 28, 1994 appearing on page 30 of Exhibit 13 of this Annual Report on Form 10-K, (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 on page of this Annual Report on Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE New York, New York January 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in (i) the Prospectus constituting part of the Registration Statement, on Form S-3 (Registration No. 33-56760), relating to Central Hudson Gas & Electric Corporation's Automatic Dividend Reinvestment and Stock Purchase Plan, (ii) the Prospectus constituting part of the Registration Statement, on Form S-3 (Registration No. 33-55764), relating to Central Hudson Gas & Electric Corporation's Customer Stock Purchase Plan and (iii) the Prospectus constituting part of the Registration Statement on Form S-3 (Registration No. 33- 46624), relating to certain debt securities of Central Hudson Gas & Electric Corporation, of our report dated January 28, 1994 appearing on page 30 of Exhibit 13 to this Annual Report on Form 10-K. We also consent to the incorporation by reference therein of our report on the Financial Statement Schedules, which appears above. PRICE WATERHOUSE New York, New York March 25, 1994

67727_1993.txt

67727_1993

1993

67727

ITEM 1. BUSINESS GENERAL - INDUSTRY SEGMENTS: The Montana Power Company (the Company) and its subsidiaries conduct a number of diversified, but related businesses. The Company's principal business, which is conducted through its Utility Division, includes regulated utility operations involving the generation, purchase, transmission and distribution of electricity and the production, purchase, transportation and distribution of natural gas. The Company, through its wholly-owned subsidiary, Entech, Inc. (Entech), engages in nonutility operations principally involving the mining and sale of coal and exploration for, and the development, production, processing and sale of oil and natural gas. The Company, through its Independent Power Group (IPG) manages long-term power sales, invests in cogeneration projects, and provides energy-related support services, including the operation and maintenance of power plants. See Item 8, Note 10 to the Consolidated Financial Statements for further information. A group of officers and employees of the Company constitute the Office of the Corporation. The Office of the Corporation provides strategic direction and policy, approves the allocation of capital and provides financial, legal and other services to all of the operating units. The Company was incorporated in 1961 under the laws of the State of Montana, where its principal business is conducted, as the successor to a New Jersey corporation incorporated in 1912. UTILITY DIVISION: SERVICE AREA AND SALES: The Utility Division's service area comprises 107,600 square miles or approximately 73% of Montana. Its estimated 1993 population was 723,000 or 90% of the total population of the State. Dominant factors in Montana's diversified economy are agriculture and livestock, which constitute Montana's largest industry, tourism and year-round recreation, coal and metals mining, oil and gas production, and the forest products industry which embraces the production of pulp and paper, plywood and lumber. Electric service is provided to 186 communities, the rural areas surrounding them and Yellowstone National Park, and natural gas service is provided to 105 communities. Firm electric power is sold at wholesale to two rural electric cooperatives. Natural gas is sold at wholesale or transported to distribution companies in Great Falls, Cut Bank, Shelby, Kevin, Sweetgrass and Sunburst, Montana. The Company's residential and commercial business is substantially free from direct competition with other utilities. The Utility Division is subject to, in certain circumstances, increased competition with self-generation for large industrial loads and with other energy suppliers for large wholesale loads. Because of the absence of competing transmission pipelines in its natural gas service territory, the Utility Division is less subject to bypass by its large industrial and wholesale natural gas customers with respect to wholesale or transportation service. Weather is a factor which can significantly affect electric and natural gas revenues. The Company's sales generally increase as a result of colder weather with customer demand peaking during the winter months. REGULATION AND RATES: The Company's public utility business in Montana is subject to the jurisdiction of the Public Service Commission of Montana (PSC). The PSC has jurisdiction over the issuance of securities by the Company. The Federal Energy Regulatory Commission (FERC) also has jurisdiction over the Company, under the Federal Power Act, as a licensee of hydroelectric projects and as a public utility engaged in interstate commerce. The importation of natural gas from Canada requires approval by the Alberta Energy Resources Conservation Board, the National Energy Board of Canada and the United States Department of Energy. On June 21, 1993, the Company filed and has since updated general rate increase requests of $30,900,000 annually for electricity and $9,600,000 annually for natural gas based upon a 12.25% return on common equity. Lower interest costs from refinancings will reduce the combined amounts by approximately $3,000,000. A 1% change in the return allowed on common equity would result in a change of approximately $7,000,000 in annual electric revenues and a change of approximately $1,800,000 in annual natural gas revenues. This rate case was filed pursuant to the optional filing rules adopted by the PSC in February 1992. The optional rules improve the matching of test year expenses and costs with the time rates are in effect. The optional rules, as interpreted by the Company, increase the revenue request by $5,700,000 for the electric utility and $1,000,000 for the gas utility. Effective October 18, 1993, the PSC approved interim annual increases of $8,800,000 in electric revenues and $4,000,000 for natural gas revenues. A final decision on the Company's requests is expected in late April. In August 1993, the Company filed an Allocated Cost of Service/Rate Design Application with the PSC which reevaluates the costs and rates for providing electric service to retail customers. Although the Company's total revenue requirement would remain the same, the amount of revenue collected from each customer class would change. Under the Company's proposal, the share of total revenue collected from the residential and commercial customer classes would increase by 1% and 8%, respectively, while the share of total revenue collected from the industrial class would decrease by 10%. A final decision in this docket is expected in May 1994. The PSC, in 1991, approved the unbundling of natural gas services, authorized open access on the Company's transmission and distribution system, and approved a three-year transition period for customer conversions. On September 1, 1993, natural gas rates for core residential, commercial and other full service customers were increased $2,954,000 for the last of three annual increases to recover costs that had previously been allocated to noncore customers. This rate change did not affect the Company's earnings. ELECTRIC OPERATIONS: The maximum demand on the Company's resources in 1993 was 1,445,000 kW on January 11, 1993. Total firm capability of the Company's electric system for 1993 was 1,601,000 kW. Of this capability, 1,186,000 kW was provided by the Company's generating facilities, and 415,000 kW was provided by firm long-term power purchases and exchange arrangements. The Company's 1993 reserve margin, as a percentage of maximum demand, was 11%. Planned increases in peak capability are expected to be met with a combination of resources including upgrades to hydroelectric and thermal facilities and both short and long-term purchase contracts. New electric capacity will be required in the late 1990s to meet load growth and the expiration of two power purchase contracts totalling approximately 150 megawatts. Pursuant to a Request for Proposal, a variety of projects, including some proposed by the Company are being evaluated under least cost planning process. To date, the bid resources that have been acquired include the extension to 2003 of an existing 50,000 kW exchange contract with the Idaho Power Company, the purchase of a 15 year 98,000 kW winter season power purchase starting in November 1996 from Basin Electric Power Cooperative, and construction has commenced on a 41,000 kW upgrade to MPC's hydroelectric facility at Thompson Falls. In addition, the Company is continuing to decrease energy and peak demand by investing in demand-side management programs. ITEM 1. BUSINESS (Continued) During the year ended December 31, 1993, the sources of the Utility Division electric generation were: hydro, 32%; coal, 40%; and purchased power, 28%. Improved stream flows in 1993 provided 27% more low-cost hydroelectric generation than in 1992. Extended plant outages at the Colstrip plants mostly offset the increased hydrogeneration. The cost of coal burned has been as follows: Year Ended December 31 1993 1992 1991 Average cost per million Btu's. . . . . . $ 0.65 $ 0.65 $ 0.66 Average cost per ton (delivered). . . . . 11.16 11.30 11.39 NATURAL GAS OPERATIONS: Natural gas supply requirements in 1993 totaled 22,617 Mmcf, of which 14,680 Mmcf were from Montana and 7,937 Mmcf from Canada. The Company produced 42% of the Montana natural gas. Its Canadian subsidiaries produced 71% of the Canadian natural gas. The Company implemented open access gas transportation on November 1, 1991. As of that date, fifteen large industrial customers and one utility customer of the Gas Utility were allowed to acquire a portion of their gas supply requirements directly from gas suppliers. The Gas Utility transports these gas supplies for these customers. As of September 1993, these customers were able to acquire 100% of their gas supplies directly from other suppliers. The total volumes of natural gas transported during 1993 were 17,900 Mmcf. As a result, the Gas Utility's gas supply requirements declined through 1993 as noncore customers increasingly acquired their own supplies directly. Total 1994 natural gas requirements, estimated to be 21,046 Mmcf, are anticipated to be supplied from existing reserves and purchase contracts. Approximately 14,433 Mmcf of these requirements are expected to be obtained in the United States and 6,613 Mmcf from Canada. The Company expects to produce 40% of the Montana natural gas. Its Canadian subsidiaries are expected to produce 64% of the Canadian natural gas. The 1994 transportation volumes are anticipated to be 23,500 Mmcf. Exportation of natural gas from Canada is controlled by the Canadian provincial and federal governments. The Company has a long-term export license which entitles it to export up to 10,000 Mmcf, after losses, annually through October 2006. ENTECH: GENERAL: Entech conducts its businesses through various subsidiaries, all of which, with immaterial exceptions, are wholly-owned. It also owns a passive investment in a gold mine in Brazil. Its coal and lignite business is conducted through several subsidiaries. Western Energy Company (Western) holds leases and rights on coal properties in Montana and Wyoming and operates the Rosebud Mine. Western's subsidiary, Western SynCoal Company (SynCoal), and a subsidiary of Northern States Power, each own 50 percent of a patented coal enhancement process and 50 percent of the Rosebud SynCoal Partnership. The Partnership owns and operates a coal enchancement process demonstration plant at the Rosebud Mine. Northwestern Resources Company (Northwestern) holds leases on coal and lignite properties in Texas and Wyoming and operates the Jewett Mine. Basin Resources, Inc. (Basin) operates the Golden Eagle Mine, and North Central Energy Company (North Central) owns and holds leases on coal properties in Colorado. Horizon Coal Services, Inc. (Horizon) markets coal and lignite, and holds leases and rights on lignite properties in Montana, Texas and Alabama. Approximately 93 percent of total annual coal and lignite production is sold under long-term contracts. Entech's oil and natural gas business is conducted in the United States through North American Resources Company and in Canada through both Altana Exploration Company and Roan Resources, Ltd. Entech's other businesses are conducted by various subsidiaries, none of which is a significant subsidiary. COAL OPERATIONS: Western's Rosebud Mine is at Colstrip, Montana, in the northern Powder River Basin, where coal is surface-mined and, after crushing, sold without further preparation, principally for use by electric utilities in steam-electric generating plants. Western's principal customers from this mine are the owners of the four mine-mouth Colstrip units and the Company's Corette Plant located at Billings, Montana. These customers purchased approximately 70 percent of the 1993 production. Most of the remainder of Rosebud coal is sold to customers located in Michigan, Minnesota, North Dakota and Wisconsin. During 1993, Western mined and sold 12,190,651 tons, of which 3,629,994 tons were sold to the Company. Western's Colstrip production is estimated to be 13,000,000 tons in 1994 and 12,000,000 tons in 1995. Western has experienced competition from southern Powder River Basin producers, primarily those in Wyoming, for its Midwestern coal sales, which represent approximately 26% of total sales. While Western has a per-ton rail rate advantage to some of the upper Midwest markets, Wyoming producers generally experience lower stripping ratios, royalty amount and production taxes. In addition, Western produces coal containing higher, noncompliance levels of sulfur than southern Powder River Basin Mines. Northwestern's Jewett Mine is located in central Texas about midway between Dallas and Houston. Northwestern supplies lignite under a long-term contract to the two electric generating units, located adjacent to the mine, that are owned by Houston Lighting and Power Company. Total deliveries during 1993 were 7,907,585 tons. The estimated production for 1994 and 1995 is 7,900,000 and 7,700,000 tons, respectively. Basin's underground Golden Eagle Mine is located in southern Colorado near Trinidad. The coal is processed through an on-site wash plant to reduce the ash content. Total deliveries from the mine, which has a capacity to produce 2,200,000 tons, were 596,700 tons during 1993. Basin has entered into a long-term contract to supply up to 1,200,000 tons annually starting July 1994. Basin has several short-term contracts to supply industrial and utility customers. Basin is also selling coal for test burns by potential customers. Estimated production for 1994 and 1995 is 1,600,000 and 2,000,000 tons, respectively. Entech anticipates an increase in demand for Basin's compliance coal due to the provisions of the Clean Air Act Amendments of 1990. OIL AND GAS OPERATIONS: Entech's producing oil and natural gas properties are principally located in the states of Wyoming, Colorado, Kansas, Oklahoma and Montana, and the Province of Alberta, Canada. An Entech Oil Division subsidiary has entered into agreements to supply 174 Bcf of natural gas to four cogeneration facilities over periods of 11 to 15 years. Entech has sufficient proven, developed and undeveloped reserves, and controls related sales of production sufficient to supply all of the natural gas required by those agreements. For information on another subsidiary's participation in an investment in these cogeneration projects, See Item 1 "Independent Power Group." Natural gas production in both the United States and Canada is currently sold pursuant to short-term, spot market and long-term contracts. In Canada, approximately 28 Bcf of the Company's natural gas reserves are dedicated to long-term contracts expiring at various times through 2005. Through its subsidiary Entech Altamont, Inc., Entech owns a minority interest in a joint venture to construct the proposed Altamont pipeline. Altamont has received FERC approval to construct a 620 mile pipeline running from the Alberta-Montana border to the Opal area in southwest Wyoming. The decision to proceed with the construction of this pipeline will depend upon obtaining the necessary regulatory approval and shipper commitments. INDEPENDENT POWER GROUP: GENERAL: The Independent Power Group (IPG) manages sales of the Company's 210 megawatt share of Colstrip Unit 4 generation to the Los Angeles Department of Water and Power and to Puget Sound Power and Light Company under contracts which are coextensive with the Company's leasehold interest in the Unit. The IPG also manages the Company's investment in five operating, natural gas fired, cogeneration projects located in Texas, New York and the United Kingdom, one cogeneration project under construction in Washington, and three projects under development in Washington, Texas and China. The Company's subsidiary, North American Energy Services Company (North American), which is included in the IPG, provides energy-related support services including the operation and maintenance of power plants for private power generating companies and provides maintenance services for power plants owned and operated by electric utilities. ENVIRONMENT: The information required in this section is contained in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" under "Environmental Issues." EMPLOYEES: At December 31, 1993, the Company and its subsidiaries employed 4,089 persons of which 2,364 were utility and Office of the Corporation employees (including 613 employees at the jointly owned Colstrip Units 1-4), 400 Independent Power Group employees and 1,325 Entech employees. FOREIGN AND DOMESTIC OPERATIONS: See Item 2, "Utility Natural Gas Properties," for information on the Company's Canadian and domestic utility natural gas properties. See Item 2, "Entech Oil and Natural Gas Properties" for information on Entech's Canadian and domestic oil and natural gas properties. EXECUTIVE OFFICERS: In 1992, D. T. Berube, 60, was elected Chairman of the Board and Chief Executive Officer. He served as President and Chief Operating Officer, Entech, Inc., 1988-1991. In 1991, J. P. Pederson, 51, was elected Vice President and Chief Financial Officer. He served as Controller - Utility Division 1984-1990 and Vice President Corporate Finance 1990-1991. In 1993, P. K. Merrell, 41, was elected Vice President and Secretary. She served as Staff Attorney 1981-1992, Assistant Secretary 1991-1992, and Secretary 1992-1993. In 1991, M. E. Zimmerman, 45, was elected Vice President and General Counsel. He served as Staff Attorney 1986-1989 and General Counsel from 1989- 1991. In 1990, R. P. Gannon, 49, was elected President and Chief Operating Officer - Utility Division. He served as Vice President and General Counsel 1984-1989. In 1993, A. K. Neill, 56, was elected Executive Vice President - Generation and Transmission. He had previously served as Executive Vice President - Utility Services since 1987. In 1993, J. D. Haffey, 48, was elected Vice President - Administration and Regulatory Affairs. He had previously served as Vice President - Regulatory Affairs for the Utility Division since 1987. In 1993, D. A. Johnson, 48, was elected Vice President - Utility Services. He had previously served as Vice President - Gas Supply and Transportation for the Utility Division since 1984. In 1993, C. D. Regan, 57, was elected Vice President - Natural Gas Supply and Transportation. He had previously served as Vice President - Energy Services for the Utility Division since 1986. In 1988, G. A. Thorson, 59, was elected Vice President - Colstrip Project Division for the Utility Division. In 1993, W. C. Verbael, 56, was elected Vice President - Accounting, Finance and Information Systems. He had previously served as Vice President - Accounting and Finance for the Utility Division since 1984. In 1993, P. J. Cole, 36, was elected Treasurer for the Utility Division. He served as Manager, Corporate Financial Planning and Analysis 1986-1992, and Assistant Treasurer 1992-1993. In 1990, J. S. Miller, 50, was elected Controller for the Utility Division. He served as Assistant Controller 1985-1990. In 1992, J. J. Murphy, 55, was elected President and Chief Operating Officer - Entech, Inc. He served as President and Chief Operating Officer, Western Energy and Northwestern Resources Co., 1988-1991, and Vice President, Mining Division, Entech, Inc., 1988-1991. In 1985, E. M. Senechal, 44, was elected Vice President and Treasurer - Entech, Inc. In 1992, R. F. Cromer, 48, was elected President and Chief Operating Officer - Continental Energy Services, Inc. He served as Vice President and General Manager, Continental Energy Services 1989-1992. ITEM 2. ITEM 2. PROPERTIES UTILITY DIVISION: ELECTRIC PROPERTIES: The Company's Utility Division electric system extends through the western two-thirds of Montana. Generating capability is provided by four coal-fired thermal generation units, with total net capability available to the Company of 697,000 kW, and 12 hydroelectric projects, with total planned net capability of 489,000 kW. The thermal units are (1) Colstrip Unit 3, which has a net capability of 727,000 kW, of which the Company owns 218,000 kW, (2) Colstrip Units 1 and 2, with a combined net capability of 638,000 kW, of which the Company owns 319,000 kW, and (3) the 160,000 kW Corette Plant. All of the Company's coal requirements are supplied by Western Energy Company under long-term contracts. Reliability of service is enhanced by the location of hydroelectric generation on two separate watersheds with different precipitation characteristics and by the availability of thermal generation. In addition to the Company's hydroelectric and thermal resources, it currently receives power through 21 power contracts totaling 415,000 kW of firm winter peak capacity. These existing contracts vary in type, size, seller and ending dates. The Company has one energy contract ending in 1995 for the delivery of power to MPC during the off-peak hours. Hydroelectric projects are licensed by the FERC under licenses which expire on varying dates from 1994 to 2035. The Company is in the process of relicensing its nine dams located on the Missouri and Madison rivers. See Item 8, "Note 2 to the Consolidated Financial Statements." The Company's electric system forms an integral part of the Northwest Power Pool consisting of the major electric suppliers in the United States, Pacific Northwest and British Columbia, and parts of Alberta, Canada. The Company also is a party to the Pacific Northwest Coordination Agreement which integrates electric and hydroelectric operations of the 18 parties associated with generating facilities in the Columbia River Basin; is a member of the Western Systems Coordinating Council, organized by 62 member systems and 4 affiliates in the 14 western states, British Columbia, Alberta and Mexico to assure reliability of operations and service to their customers; is one of 51 members of the Western Systems Power Pool, organized to enhance the economics of power production and reliability of service among the western states power systems; and is a party to the Intercompany Pool Agreement for the coordination of load, resource and transmission planning, operations and reserve requirements among eight utilities in Washington, Oregon, Idaho, Montana, Wyoming, Nevada and Utah. The Company participates in an interconnection agreement with The Washington Water Power Company, Idaho Power Company, and PacifiCorp, providing for the sharing of transmission capacity of certain lines on their respective interconnected systems. The Company also operates, in coordination with its own transmission lines and facilities, the transmission lines and facilities which are jointly owned by the utility owners of the four Colstrip generating units. The Company and the Western Area Power Administration have transmission interconnection and agreements which provide for the mutual use of excess capacity of certain lines on each party's system for the transmission of power east of the Continental Divide in Montana and for the firm use of certain of the Company's transmission lines to deliver government power. At December 31, 1993, the Company owned and operated 7,074 miles of transmission lines and 14,880 miles of distribution lines. NATURAL GAS PROPERTIES: The Company produces natural gas from fields in Montana and Wyoming and through its subsidiary, Canadian-Montana Gas Company, from fields in southeastern Alberta, Canada. Natural gas is also purchased from independent producers in Montana and Alberta. All of the Company's utility natural gas customers are served from its transmission system which extends through the western two-thirds of Montana. The Company operates four natural gas storage fields on the system which enable the Company to store natural gas in excess of system load requirements during the summer and to deliver natural gas during winter periods of peak demand. At December 31, 1993, the Company and its subsidiaries owned and operated 1,912 miles of natural gas transmission lines and 2,890 miles of distribution mains. All natural gas volumes are at a pressure base of 14.73 psia at 60 degrees Fahrenheit, except for those volumes used to compute the average revenues by customer classification. For information pertaining to the Company's net recoverable utility natural gas reserves, see Item 8, "Supplementary Information." In addition to Company-owned reserves, the Company, at December 31, 1993, controlled under purchase contracts, 65,305 Mmcf of proven reserves in the United States and 37,824 Mmcf in Canada. No significant change has occurred and no event has taken place since December 31, 1993, that would materially affect the magnitude of the Company's reserve estimates. Utility natural gas reserve estimates have not been filed with any other federal or any foreign governmental agency during the past twelve months. Certain lease and well data, with respect only to owned wells, are filed with the Internal Revenue Service for tax purposes. Total produced, royalty and purchased natural gas volumes in Mmcf during the last three years were as follows: The following table presents information as of December 31, 1993, concerning Company-owned utility natural gas wells and the owned or leased acreages in which they are located. United States Canada Gross productive wells. . . . . . . . . . 591 167 Net productive wells. . . . . . . . . . . 485 156 Gross wells with multiple completions . . 17 10 Net wells with multiple completions . . . 11.8 9.5 Gross producing acres . . . . . . . . . . 452,194 203,672 Net producing acres . . . . . . . . . . . 292,820 180,438 Gross undeveloped acres . . . . . . . . . 76,761 54,240 Net undeveloped acres . . . . . . . . . . 58,292 52,640 These acreages are located primarily in Montana and Alberta, Canada. The Company anticipates that during 1994 total exploration and development expenditures (expense and capital) will be approximately $1,857,000 in the United States and approximately $960,000 in Canada. The following table presents information on utility natural gas exploratory and development wells drilled during 1993, 1992 and 1991. United States Canada 1993 1992 1991 1993 1992 1991 Net productive exploratory wells. . . . . . . . . . . . - - - - - - Net dry exploratory wells. . . - - - - - - Net productive development wells. . . . . . . . . . . . 12.25 6.38 8.31 3.00 - - Net dry development wells. . . 2.00 3.00 1.00 1.00 - - The following table presents average revenues received per Mcf by customer classification for natural gas from all sources for the years 1993, 1992 and 1991. Revenues per Mcf are computed based on volumes at varying pressure bases as billed. Year Ended December 31 Customer Classification 1993 1992 1991 Residential. . . . . . . . . . . . . . . $ 4.35 $ 4.22 $ 3.98 Commercial . . . . . . . . . . . . . . . 4.20 3.91 3.67 Industrial . . . . . . . . . . . . . . . 4.02 3.76 3.19 Other gas utilities. . . . . . . . . . . 3.38 3.33 3.25 The following table presents the average production cost per Mcf for produced utility natural gas, in U. S. dollars, for the three years 1993, 1992 and 1991. United States Canada 1991. . . . . . $ 1.18 $ 0.52 1992. . . . . . 1.30 0.78 1993. . . . . . 1.44 0.60 Production cost per unit fluctuated over the three-year period primarily as a result of expensing fixed costs over varying levels of production resulting from fluctuations in weather sensitive sales. ENTECH: COAL PROPERTIES: Western leases and produces coal in Montana and Wyoming. Northwestern leases and produces lignite from properties in Texas and leases coal properties in Wyoming. Basin produces coal, and North Central owns and leases coal, in Colorado. Horizon leases lignite properties in Montana, Texas and Alabama. Western SynCoal owns a 50% partnership interest in a coal enhancement demonstration plant at Colstrip, Montana. Western has coal mining leases covering approximately 561,000,000 proved and probable, and recoverable, tons of surface-mineable coal reserves averaging less than 1.25 pounds of sulfur per million Btu (low-sulfur) at Colstrip. Approximately 280,000,000 tons of these reserves are committed to present contracts, including requirements of the Colstrip Units. Western also has coal mining leases covering approximately 6,000,000 proved and probable, and recoverable, tons of surface-mineable coal reserves averaging less than 0.6 pounds of sulfur per million Btu (compliance quality) in Wyoming. Northwestern has lignite mining leases in central Texas at the Jewett Mine covering approximately 186,000,000 proved and probable, and recoverable, tons of surface-mineable lignite. Northwestern has contracted to supply the entire capacity of the Jewett Mine to Houston Lighting and Power Company, which owns two electric generating units located adjacent to the mine. In 1990, Northwestern acquired surface rights and coal leases which contain approximately 628,000,000 proved and probable, and recoverable, tons of compliance quality surface-mineable coal reserves in the southern Powder River coal region located at Rocky Butte, Wyoming. In January 1993, Northwestern acquired an adjacent federal lease which contains approximately 56,000,000 proved and probable, and recoverable tons of compliance quality coal reserves. Northwestern's application with the Department of Interior to combine these leases into one logical mining unit, which was granted in December 1993, requires the property to be developed by 2003. However, a challenge to the 1993 federal lease is pending. If this challenge should be successful, the logical mining unit approved in December 1993 would be nullified and Northwestern would lose the rights to the federal coal leases containing approximately 599,000,000 proved and probable, and recoverable tons of reserves as described above. North Central owns and leases lands containing approximately 90,000,000 tons of proved and probable, and recoverable, compliance quality underground-mineable coal reserves near Trinidad, Colorado. Approximately 18,000,000 tons of these reserves are dedicated to a long-term contract. Horizon has undeveloped mining leases covering lands in three different states. Properties in eastern Montana contain approximately 31,000,000 proved and probable, and recoverable, tons of low-sulfur surface-mineable lignite. Those in southeastern Alabama contain approximately 97,000,000 proved and probable, and recoverable, tons of surface-mineable lignite (averaging greater than 1.25 pounds of sulfur per million Btu). Those in central Texas contain approximately 177,000,000 proved and probable, and recoverable, tons of surface-mineable lignite. OIL AND NATURAL GAS PROPERTIES: No significant change has occurred and no event has taken place since December 31, 1993, which would materially affect the estimated quantities of proved reserves. For information pertaining to net recoverable Entech oil and natural gas reserves, see Item 8, "Supplementary Information to the Consolidated Financial Statements." All Entech oil and natural gas volumes are at a pressure base of 14.73 psia at 60 degrees Fahrenheit. Entech oil and natural gas reserve estimates have not been filed with any other federal or any foreign government agency during the past twelve months. Certain lease information and well data, only with respect to owned wells, is filed with the Internal Revenue Service for tax purposes. The following table presents information on produced oil and natural gas average sales prices and production costs in U.S. dollars for 1993, 1992 and 1991. Natural gas production was converted to barrel of oil equivalents based on a ratio of six Mcf to one barrel of oil. Entech's oil, natural gas and natural gas liquids production was sold under both short and long-term contracts at posted prices or under forward market arrangements. From 1992 to 1993, Entech's average sale prices changed due to fluctuations in market prices and currency exchange rates. In the U.S., Entech's average production cost changed reflecting higher production taxes per barrel of oil equivalent due to higher revenues received. In Canada, average production cost decreased because of lower well operating expenses. Information on Entech natural gas and oil wells and the owned or leased acreages in which they are located, as of December 31, 1993, is presented below. United States Canada Gross productive natural gas wells 400 194 Net productive natural gas wells 205.52 123.71 Gross productive oil wells 250 251 Net productive oil wells 151.86 115.71 Gross producing acres 143,891 192,410 Net producing acres 59,708 95,197 Gross undeveloped acres 235,360 210,405 Net undeveloped acres 112,547 118,731 The wells located in Canada include multiple completions of 12 gross productive natural gas wells and 10.56 net productive gas wells. The foregoing acreages are located in the United States and Canada primarily in the Rocky Mountain states and Alberta. It is anticipated that during 1994 total exploration, acquisition and development expenditures (expense and capital) will be approximately $23,000,000 in the United States and approximately $14,600,000 in Canada. The following table presents information on Entech oil and natural gas exploratory and development wells drilled during 1993, 1992 and 1991. For information on properties acquired, see Item 8, "Supplementary Information - Oil and Natural Gas Producing Activities." INDEPENDENT POWER GROUP: The IPG manages the sale of power from the Company's 210 MW Colstrip 4 leased interest and associated common and transmission facilities. The IPG also has general and limited partnership interests in or is providing development funding to the following nonutility generation projects: Projects in Operation Projects Under Development ITEM 3. ITEM 3. LEGAL PROCEEDINGS Refer to 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 None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Common Stock Information The Common Stock of the Company is listed on the New York and Pacific Stock Exchanges. The following table presents the high and low sale prices of the common stock of the Company as well as dividends declared for the years 1993 and 1992. The number of common shareholders on December 31, 1993, was 38,883. Dividends Declared per 1993 High Low Share 1st quarter $ 27.875 $ 25.125 $ 0.395 2nd quarter 27.750 25.500 0.395 3rd quarter 28.125 26.375 0.395 4th quarter 27.500 24.500 0.400 Dividends Declared per 1992 High Low Share 1st quarter $ 28.000 $ 24.000 $ 0.385 2nd quarter 26.375 23.625 0.385 3rd quarter 26.625 24.875 0.385 4th quarter 26.625 24.500 0.395 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Income Statement Items (000) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations: The following discussion presents significant events or trends which have had an effect on the operations of the Company during the years 1991 through 1993. Also presented are factors which are expected to have an impact on operating results in the future. This discussion should be read in conjunction with the Consolidated Statement of Income. Net Income Per Share of Common Stock: The Company's consolidated net income increased to $107,211,000 in 1993 compared to $107,065,000 and $105,715,000 in 1992 and 1991, respectively. The following table shows the sources of consolidated net income on a per share basis. 1993 1992 1991 Utility Operations $ 1.07 $ 0.97 $ 0.98 Entech 0.91 0.98 0.98 Independent Power Group -- 0.07 0.07 $ 1.98 $ 2.02 $ 2.03 Colder weather and increased hydroelectric generation combined to increase the earnings of the Utility Division for 1993. The Utility increase offset reduced earnings of Entech and the Independent Power Group (IPG). Entech earnings decreased primarily due to reduced coal sales resulting from an extended outage at a Colstrip generating unit. The IPG earnings decrease resulted primarily from a decrease in cogeneration project development revenues. Consolidated net income for 1992 benefited from the higher earnings of Entech's Oil Division, lower interest rates and the gain resulting from the sale of securities held for investment. Net income for the year was also boosted by increased wholesale sales of electricity. The warm, dry weather experienced in the Company's service territory during the first half of 1992 caused power supply costs to increase and natural gas sales to decline. Strong natural gas sales during the fourth quarter resulting from colder weather and record operating performance by the Utility's coal-fired plants throughout the year partially offset the adverse effect of weather early in the year. Losses incurred at a coal mine acquired in June 1991 adversely impacted consolidated net income during 1992. Utility Operations: The following table shows changes from the prior year, in millions of dollars, in principal categories of utility revenues and the related percentage changes in volumes sold and prices received: 1993 1992 Electric General business - revenue $ 9 $ 9 - volume 3% - - price/kWh - 2% Other utilities - revenue $ 14 $ 8 - volume 11% 3% - price/kWh 8% 9% Natural Gas General business - revenue $ 14 $ (9) - volume 11% (17%) - price/Mcf 6% 9% Other utilities - revenue $ (5) $ (4) - volume (53%) (35%) - price/Mcf 1% 2% Transportation* - revenue $ 2 $ 3 - volume 19% NM** - price/Mcf 35% (16%) *Service commenced November 1, 1991. **Not Meaningful Weather can significantly affect electric and natural gas revenues, and should be considered when determining trends. The Company's sales usually increase as a result of colder weather, especially in the winter months. As measured by heating degree days, the weather in 1993 in the Company's service territory was 17% colder than 1992 and 8% colder than normal. The weather in 1992 was 2% warmer than in 1991 and 8% warmer than normal. 1993 Compared to 1992 Operating Revenues: Electric revenues from general business customers increased due to a 3% increase in volumes sold. Weather, which was 17% colder than 1992, and a 2% increase in the number of customers combined to increase revenues $8,600,000. Electric revenues from sales to other utilities increased revenues $14,300,000. Volumes increased 11% and unit prices increased 8%, providing additional revenues of $7,000,000 and $7,300,000, respectively. The increases occurred primarily during the first and fourth quarters as a result of improved regional market conditions during those periods. In spite of reduced steam generation resulting from outages at a Colstrip generating unit, volumes sold increased due to a 27% increase in hydroelectric generation for the year and increased power purchases. Under a transportation tariff effective November 1, 1991, natural gas customers who consume more than 60,000 Mcfs annually (noncore customers) may purchase natural gas from other suppliers and transport that gas on the Company's transportation and distribution system for a fee. One noncore customer was no longer required to purchase any natural gas from the Company. The remaining customers were required to purchase two-thirds of their gas supplies from the Company until September 1, 1992, and thereafter, one-third until September 1, 1993, at which time they became free to purchase all of their gas from other sources. The resulting decline in natural gas sales revenue has been offset by revenues from transportation fees, lower purchase gas costs and increased revenues from higher rates charged to core general business customers. Natural gas revenues from general business customers increased $14,500,000. A 19% increase in volumes sold to residential and commercial customers, primarily a result of 17% colder weather and a 4% increase in the number of customers, increased revenues $13,900,000. Rate increases resulting from the transportation phase-in mentioned previously and an interim rate order effective October 18, 1993, increased revenues $4,100,000. These increases were partially offset by a $3,500,000 decrease resulting from a 54% reduction in volumes sold to industrial, government and municipal customers who switched to transportation. Natural gas revenues from sales to other utilities also decreased $4,600,000 due to a 53% decrease in volumes resulting from switches to transportation service. Operating Expenses and Taxes: The following table shows the Company's sources of electricity and power supply expenses (Operation, Fuel for electric generation, and Maintenance) for 1993 and 1992. The Company's hydroelectric output increased as a result of improved streamflows, offsetting a decline in generation from the Company's coal-fired plants. Purchased power volumes were increased to meet higher sales to general business and wholesale customers. Increases in purchased power costs were partially offset by a $2,900,000 decrease in the amortization of previously deferred costs. Fuel for electric generation decreased $4,900,000 as a result of outages at a Colstrip generating unit. The decrease in fuel was partially offset by a $3,000,000 increase in maintenance of steam plants resulting from scheduled maintenance and unscheduled repairs due to the previously mentioned outages. Operations expense not associated with power supply costs increased $9,600,000 primarily due to a $5,000,000 increase in labor costs, a $2,400,000 increase in transmission costs and expenses of $1,600,000 related to property damage to homes at Colstrip. Purchased gas increased $1,900,000 primarily as a result of increased deferred amortizations which are offset by similar increases in natural gas revenues through gas cost tracking procedures, and do not affect net income. The $4,100,000 increase in taxes - other than income taxes is principally due to increased property taxes resulting from property additions and higher mill levies. Interest Charges: The $1,700,000 decrease in interest on long-term debt is primarily a result of lower interest rates due to refinancings. 1992 Compared to 1991 Operating Revenues: Electric revenues from general business customers improved $9,100,000. A 2% increase in unit prices, primarily the result of a $16,700,000 annual rate increase effective July 1991, contributed approximately $7,700,000. The remaining $1,400,000 increase resulted from a slight increase in volumes sold. Electric revenues from sales to other utilities increased $8,300,000 due to a 9% increase in price and a 3% increase in volumes sold. Price increases were caused by reduced hydroelectric generation throughout the Pacific Northwest, the result of drought conditions that reduced streamflows. Volumes available for sale increased, in spite of reduced hydroelectric generation at Company facilities, as a result of a 10% increase in generation at the Utility's coal-fired plants and purchases. Natural gas revenues from general business customers decreased $8,900,000, the result of decreased sales volumes. Specifically, sales volumes to industrial, government and municipal customers decreased 55%, principally as the result of the switch of customers to the gas transportation tariff, reducing revenues $10,300,000. In addition, volumes sold to residential and commercial customers decreased 5%, reducing revenues $3,700,000. Increased consumption resulting from a 3% increase in customers was more than offset by reduced volumes caused by warmer weather. Revenue decreases resulting from lower sales volumes were partially offset by rate adjustments, which contributed approximately $5,000,000. These adjustments consist of $5,900,000 and $2,800,000 annual increases, effective November 1991 and September 1992, respectively, to recover costs that had previously been allocated to non-core customers, partially offset by a $1,900,000 annual decrease, effective November 1991, resulting from a gas cost tracking procedure that annually balances costs collected from customers with the cost of supplying gas. These rate adjustments do not affect earnings. Natural gas revenues from other utilities declined $4,400,000 due to a 35% decrease in sales volumes. This decline is largely a result of an eligible customer switching to the gas transportation tariff. Operating Expenses and Taxes: The following table shows the Company's sources of electricity and power supply expenses (Operation, Fuel for electric generation, and Maintenance) for 1992 and 1991. The Company's 1992 hydroelectric generation was reduced as a result of the drought conditions experienced in the Pacific Northwest. Increased power purchases from other utilities and qualifying facilities offset the hydro reduction and provided energy for sales to other utilities. In addition, power purchase costs increased $3,500,000 as a result of the amortization of costs related to certain 1991 qualifying facility purchases which were deferred in accordance with regulatory decisions. Fuel for electric generation was up $2,800,000, largely a result of increased generation by the Corette Plant in 1992. This plant was out-of-service from May through August 1991 for maintenance and rehabilitation work. Maintenance expenses decreased $2,100,000, primarily a result of the aforementioned work at the Corette Plant in 1991. Purchased gas expense decreased $8,100,000. The assignment of gas purchase contracts to the customers who switched to gas transportation decreased expense approximately $5,600,000. The remainder of the decrease is largely the result of lower sales due to warmer weather. Since purchased gas expense decreases are offset by similar changes in natural gas revenues through gas cost tracking procedures, net income is not affected. The $3,400,000 increase in taxes - other than income taxes is principally due to increased property taxes resulting from property additions and higher mill levies. Other Income and Expense: Income taxes applicable to other income decreased $2,100,000, the result of the recalculation, in 1992, of taxes accrued in 1991. Interest Charges: The $2,900,000 decrease in total interest expense is principally the result of lower interest rates on long and short-term debt. Entech Operations: The following table shows year-to-year changes for the previous two years, in millions of dollars, in the various classifications of revenues of Entech's businesses with the related percentage changes in volumes sold and prices received: 1993 1992 Coal -revenue $ (8) $ 5 -volume (7%) - -price/ton 1% 1% Oil -revenue $ (5) $ 11 -volume (10%) 61% -price/bbl (6%) (10%) Natural Gas -revenue $ 9 $ 5 -volume 16% 24% -price/Mcf 20% (3%) Natural Gas Marketing -revenue $ 23 $ 13 Other Operations -revenue $ (6) $ 1 1993 Compared to 1992 Revenues: Coal revenues at the Rosebud Mine decreased $21,000,000 due to lower volumes sold to the Colstrip units as a result of unscheduled outages and from fewer spot sales to Midwestern customers. This revenue decrease was partially offset by an increase of $5,800,000 from a combination of brokered coal revenues and fees related to operating the SynCoal demonstration plant. At the Jewett Mine, coal revenues increased by $11,400,000 due to higher volumes sold to the mine-mouth power plants, offset by an $8,000,000 decrease from lower reimbursable mining expenses. Higher volumes sold to supply coal for test burns and spot market sales resulted in increased revenues of $4,000,000 at the Golden Eagle Mine. In July 1994, the Golden Eagle Mine will begin delivering up to 1,200,000 tons of coal per year to a new customer under a long-term contract. Entech's coal business faces increasing competition for Midwestern customers resulting from surplus coal capacity in the southern Powder River Basin. In 1993, the Rosebud Mine sold approximately 2,000,000 tons of coal under contracts with two Midwestern customers. One of the contracts with a Midwestern customer, totaling approximately 1,000,000 tons per year, has a price reopener at the end of 1994. The other contract, which includes take- or-pay provisions, also totaling approximately 1,000,000 tons, will expire at the end of 1995. It is uncertain whether either of these contracts will be retained. Both customers are expected to purchase the same number of tons during 1994 as they purchased in 1993, and take-or-pay revenues are expected to be at the same levels as in 1993. Oil revenues decreased $5,400,000 primarily from lower volumes sold as a result of natural declining production and from lower market prices received in both Canada and the U.S. Natural gas revenues increased $9,200,000 principally from higher market prices received and higher volumes sold as a result of development drilling in both Canada and the U.S. The increase in natural gas marketing revenues reflects escalated prices received under three cogeneration supply contracts and higher volumes sold. Revenues from Entech's other operations decreased $6,200,000 as a net result of the sale of the waste management operations in May 1993 offset by higher telecommunications revenues resulting from expansion of services into three Northwestern states and increased contractual services provided to common carriers. Costs and Expenses: Cost of sales increased approximately $21,500,000. This amount is comprised of several items. Natural gas for resale increased $23,100,000 and costs from increased production of natural gas increased $1,400,000. In addition, $1,900,000 of the increase resulted from telecommunications services. These amounts were offset by a $4,500,000 decrease as a result of the sale of the waste management operations. Taxes other than income taxes decreased as a result of lower coal revenues at the Rosebud Mine. The decrease in depreciation and depletion results primarily from lower coal production at the Rosebud Mine. Selling, general and administrative expense increased $1,600,000 from the implementation of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and from a non-recurring workers' compensation refund of $800,000 received in 1992. Interest income and other-net increased approximately $700,000 from the net effect of several events. Profits from asset sales increased $2,200,000 and an increase of $3,000,000 was realized because of a 1992 payment to settle a lawsuit. These increases were offset by a $3,300,000 decrease in joint ventures income and $1,100,000 less income received from the Brazilian subsidiary in 1993. 1992 Compared to 1991 Revenues: Coal revenues at the Rosebud Mine improved $8,300,000 principally due to higher volumes sold because of improved operating performance by the Colstrip units and the Company's Corette Plant. Coal revenues decreased at the Jewett Mine $6,900,000 reflecting lower tonnages sold as a result of scheduled and unscheduled power plant maintenance offset by a $4,300,000 increase due to higher reimbursable mining expenses. Coal revenues decreased $600,000 at the Golden Eagle Mine. The mine was temporarily closed in April 1992 because its primary customer discontinued buying coal. The mine resumed limited operations in mid-October 1992 to supply coal for test burn orders. Markets for coal from this mine are being sought. The Coal Division faces increasing price competition for Midwestern customers caused by surplus coal capacity. In 1992, the Rosebud Mine sold approximately 14,700,000 tons of coal. One Rosebud Mine long-term contract with a Midwestern customer, totaling approximately 1,000,000 tons per year, has a price reopener in 1994. Renegotiation of this contract has not yet begun. Another Rosebud Mine long-term contract with another Midwestern customer, totaling approximately 1,000,000 tons per year, will expire in 1995. It is uncertain whether this contract will be renewed. Oil revenues increased $11,000,000 from higher volumes sold as the result of development drilling and a 1991 Canadian property acquisition. Natural gas revenues increased $5,000,000 primarily from higher volumes sold resulting from development drilling and the property acquisition. The increased natural gas revenues from higher volumes sold were partially offset by lower Canadian natural gas prices. Natural gas marketing revenues increased $13,000,000 from higher volumes sold and escalated prices received under three cogeneration supply contracts. In 1992, the Entech Oil Division entered into forward sales and swap transactions to reduce the effect of fluctuations in oil prices on its profitability and cash flow. Prospectively, the Division has hedged 700,000 barrels, which represent approximately 40% of its 1993 U.S. and Canadian oil production, with various financial instruments. This strategy provides price protection should the Nymex-based price fall below $17.94 per barrel. The difference between market value and hedged contract prices is recognized in income when the hedged production is sold. Revenues from Entech's other operations increased approximately $1,000,000 resulting from a $4,400,000 increase in telecommunications operations and a $1,500,000 increase in waste management operations. These increases were partially offset by a $3,000,000 decrease from real estate sales and a $2,200,000 decrease from automated system control contracts. Real estate sales are not expected to make a material contribution to revenues in future periods due to reduced real estate inventory. Costs and Expenses: Cost of sales increased approximately $28,000,000. This amount is comprised of $10,000,000 of increased cost of purchasing natural gas for resale, $7,000,000 of increase coal production costs due to increased volumes and higher maintenance costs at Colstrip, $5,000,000 of increased costs reflecting a full year operation of the Golden Eagle Mine, which was acquired mid-1991, and $6,000,000 of increased oil and gas production costs associated with greater volumes produced. Taxes - other than incomes taxes increased due to the settlement of a state production tax audit and due to higher revenues at Colstrip. The majority of these taxes were passed through to customers under coal contract provisions. The increase in depreciation and depletion results from increased oil and gas production offset by reduced depletion rates due to the Canadian acquisition. Increased interest expense resulted from higher levels of debt outstanding during the period. Interest income and other-net decreased $1,600,000 because of a $3,000,000 payment attributable to a lawsuit settlement and $1,000,000 less income received from the Brazilian subsidiary in 1992. These decreases were offset by $2,400,000 increased profits from asset sales. Income tax expense decreased principally due to lower pretax income and additional tax credits. Independent Power Group Operations: 1993 Compared to 1992 IPG revenues increased $33,700,000. The acquisition of a company that provides energy-related support services in November 1992 resulted in increased revenues of $39,300,000. The increase was partially offset by a $6,000,000 reduction in cogeneration project development fees. Revenues from electricity sold under long-term contracts remained at 1992 levels. IPG expenses increased $37,500,000 primarily as a result of a $38,900,000 increase resulting from the acquisition mentioned above. Expenses also increased $3,000,000 due to increases in purchased power costs resulting from outages at a Colstrip generating unit, $1,000,000 due to the accrual of Colstrip housing damage claims and $3,800,000 resulting from a change in the amount of amortization of the loss on long-term sales. The increases were offset by a $3,500,000 reduction in fuel expense resulting from the plant outages, a $3,000,000 decrease in cogeneration development expenses and a $2,700,000 decrease in income tax expense. 1992 Compared to 1991 IPG revenues improved $16,800,000. The acquisition of a company that provides energy-related support services in November 1992 resulted in increased revenues of $8,200,000. Revenues from electricity sales increased $4,600,000, caused by higher prices on electricity sold under long-term contracts. Successful cogeneration project development activities resulted in additional revenues of $3,900,000. IPG expenses increased $16,400,000. The acquisition and cogeneration project development activities mentioned above resulted in additional expenses of $8,200,000 and $4,600,000, respectively. Expenses increased an additional $3,600,000 as a result of more scheduled maintenance at a Colstrip generating unit and higher transmission expenses. Liquidity and Capital Resources: Net cash provided by operating activities was $182,437,000 in 1993 compared to $211,081,000 in 1992 and $193,704,000 in 1991. Cash from operating activities less dividends paid provided 53% of capital expenditures in 1993, down from 80% in 1992 and 61% in 1991. The Company's long-term debt as a percentage of capitalization was 36%, 39% and 41% in 1993, 1992 and 1991, respectively. The Company also has entered into long-term lease arrangements and other long-term contracts for sales and purchases that are not reflected on its balance sheet and impact its liquidity. See Item 8, "Note 3 to the Consolidated Financial Statements" for additional information. In addition, $90,460,000 of long-term debt will mature during the years 1994-1998. See Item 8, "Note 7 to the Consolidated Financial Statements" for details on maturities of long-term debt. For the years 1994-1998, the Company estimates that approximately 51% of its utility construction program, 100% of Entech capital expenditures and 44% of IPG investments will be financed from funds generated internally and that the balance, as well as maturing long-term debt, will be financed through the incurrence of short and long-term debt and the sales of equity securities, the timing and amounts of which will depend upon future market conditions. The Company has adequate sources of external capital to meet its financing needs. Dividends on common and preferred stock increased to $87,054,000 in 1993 from $83,209,000 in 1992 and $78,114,000 in 1991. The Company paid dividends of $1.58 per share of outstanding common stock during 1993, up 2.6% from 1992. The dividend paid January 31, 1994 was increased by the Company's Board of Directors to 40 cents per share, an increase of 0.5 cents per share from the previous quarter. This 1.3% increase raises the common stock dividend to an indicated rate of $1.60 per share on an annual basis. The Company and Entech have Revolving Credit and Term Loan Agreements in the amount of $60,000,000 and $75,000,000, respectively. These businesses also have short-term borrowing facilities with commercial banks that provide both committed and uncommitted lines of credit, and the ability to sell commercial paper. See Item 8, "Notes 7 and 8 to the Consolidated Financial Statements." During the first quarter of 1993, the Company sold $50,000,000 of First Mortgage Bonds and $43,000,000 of Medium-Term Notes, which are secured by First Mortgage Bonds, with interest rates from 7% to 8.11%. The proceeds were used to reduce interest expense by refinancing long-term debt maturities and redeeming, prior to maturity, $60,000,000 of the 8 5/8% series of First Mortgage Bonds, due 2004. In 1993, the Company sold $90,205,000 of Pollution Control Revenue Bonds, 6 1/8% series due 2023. The proceeds of this issue were used to redeem, prior to maturity, $90,205,000 of Pollution Control Revenue Bonds, which includes $18,545,000 of the 5.75% series due 2003, $7,000,000 of the 6.3% series due 2007, $39,660,000 of the Adjustable Rate Series due 2014 and $25,000,000 of the Variable Rate Series due 2014. The Company also sold $80,000,000 of Pollution Control Revenue Bonds, 5.9% series due 2023, the proceeds of which were used to redeem, prior to maturity, $80,000,000 of Pollution Control Revenue Bonds which included $40,000,000 of the 10% series due 2004 and $40,000,000 of the 10 1/8% series due 2014. See Item No. 8, "Note 7 to the Consolidated Financial Statements." In November 1993, the Company sold $50,000,000 of the $6.875 series of perpetual Preferred Stock, stated value and liquidation value $100. The net proceeds from the sale were used to repay short-term debt. The stock is redeemable at the option of the Company, in whole or in part, at any time on or after November 1, 2003. On January 19, 1994, the Company sold $5,000,000 of Secured Medium-Term Notes, 7.25% series due 2024, the proceeds of which were used to repay short- term debt. The Company also intends to sell additional Secured Medium-Term Notes within the first half of 1994 for the purpose of retiring Commercial Paper. The Company's Mortgage and Deed of Trust contains certain restrictions upon the issuance of additional First Mortgage Bonds. At December 31, 1993, after taking into account the sale of $98,000,000 of First Mortgage Bonds and Secured Medium-Term Notes discussed above, the unfunded net property additions and retired bonds test, which is the most restrictive test, would have permitted the issuance of approximately $488,000,000 additional First Mortgage Bonds. There are no restrictions upon issuance of short-term debt or preferred stock in the Company's Restated Articles of Incorporation, its Mortgage and Deed of Trust or its Sinking Fund Debenture Agreement. SEC Ratio of Earnings to Fixed Charges: For the twelve months ended December 31, 1993, the Company's ratio of earnings to fixed charges was 2.86 times. Fixed charges include interest, the implicit interest of Unit 4 rentals and one-third of all other rental payments. Inflation: Capital intensive businesses, such as the Company's electric and natural gas operations, are significantly affected by long-term inflation. Neither depreciation charges against earnings nor the ratemaking process reflect the replacement cost of utility plant. However, based on past practices of regulators, these businesses will be allowed to recover and earn on the actual cost of investment in the replacement or upgrade of plant. Although prices for natural gas may fluctuate, earnings are not impacted because a gas cost tracking procedure annually balances gas costs collected from customers with the costs of supplying gas. Entech's long-term coal contracts and the IPG's long-term operation, maintenance and power sales contracts provide for the adjustment of prices either through indices, fixed rate escalations and/or direct pass-through of costs. The Company believes that the effects of inflation, at currently anticipated levels, will not significantly affect results of operations. Postemployment Benefits: The Financial Accounting Standards Board released SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in 1992. SFAS No. 112 is not expected to have a significant effect upon results of operations. See Item 8, "Note 9 to the Consolidated Financial Statements" for additional information. Environmental Issues: The Company's businesses are subject to, and in substantial compliance with, existing federal and state environmental regulations. The Company is committed to careful management and actions which will permit it to continue to do its part to protect and maintain the environment. The Clean Air Act Amendments of 1990 should impose no major effects on the Company's electric generation facilities. The Company's coal-fired generating plants meet the 1995 Phase I requirements of the Act. Low-sulfur coal and state-of-the-art scrubbers already result in sulfur dioxide emissions from the Colstrip units well below the new requirements. Either fuel switching or the use of allowances, or both, would permit the Corette Plant to meet the Phase II requirements of the Act in 2000. Despite the expectation that the Corette Plant may be operated to comply with the Act, air quality problems in the Billings, Montana area may result in the imposition of additional emissions restrictions that would require the evaluation of other options. Modifications will be required at three units in the late 1990's to meet the nitrogen oxide emission standards of the Act. However, Phase I rules implementing the Act have not been published. Nor does the Company know what requirements may result from Phase II Rules, which also are yet to be published. Consequently, the capital costs associated with the modifications to meet the nitrogen oxide standards of the Act have not yet been determined. However, capital improvements that may be required are expected to be recovered through rates and therefore, the costs are not expected to have a material impact on earnings. In 1988, the United States Environmental Protection Agency advised the Company that it, along with certain upstream industries, is a potentially responsible party (PRP) for the release of certain toxic substances which have come to rest behind the dam at the Company's Milltown Hydroelectric Plant. Because of federal legislation specifically relating to Milltown, the Company believes it has no responsibility for any of the alleged releases. If the Company should have some responsibility, it would have to share, together with other responsible parties, the costs related to the handling of these toxic substances. While these costs have not been determined, the Company believes that any portion which it might bear would not have a significant impact upon its earnings. The Company, along with others, has been named a PRP with respect to the Silver Bow Creek/Butte Area Superfund Site. The alleged contamination is soil and groundwater contamination, for the most part, associated with decades of copper mining in the area. The PRPs have cooperated to summarize the data that currently exists, to evaluate the useability of this existing data and to determine additional data needs. Studies to determine the extent of the alleged contamination, and a proposal for removal or remediation of the alleged contamination are not complete. Regarding this superfund site, the Company has focused on its property ownership and alleged contamination that may be attributed to that ownership. It has spent approximately $450,000 to investigate its property within the site, collect data, evaluate studies and monitor its property. Costs to clean up this contamination, including sums spent in the studies mentioned above, are not expected to exceed $1,000,000. Other contamination at the Company's property within the site involves heavy metals and substances which may be attributed to mining and activities of others within the greater area of the site. Neither the Company nor, to the best of the Company's knowledge, any PRP or state or federal agency has estimated the total cost of the potential clean-up of mining-related contamination of either its property or other property within the site because the extent of the contamination has not been established. The Company intends to deny any responsibility for costs associated with this contamination. The Company also is a PRP at a second site of soil contamination in Montana, alleged to have resulted from the salvage of electric transformers by a third party or parties who obtained the transformers from the Company. The state agency with jurisdiction over this site has recently determined that the contamination is contained within the site, that temporary measures taken by the Company to contain the contamination are effective, and that contamination has not affected surface water. Costs incurred by the Company are approximately $500,000. Additional costs are not expected to exceed $350,000. The Company is a PRP at two sites in the State of Washington where electric transformers were sent for salvage. At one of the sites, the Company believes it will qualify as a de minimis settlor. At the second site, pursuant to the terms of a Consent Decree, the Company is obligated to pay approximately $350,000. The Company has accrued the estimated minimum costs associated with these matters. The Company does not expect these costs to materially impact the results of its operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA AND SUPPLEMENTAL DATA Page Management's Responsibility for Financial Statements 40 Report of Independent Accountants 41 Consolidated Financial Statements: Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 42 Consolidated Balance Sheets as of December 31, 1993 and 1992 43-44 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 45 Consolidated Statements of Common Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 46 Notes to Consolidated Financial Statements 47-74 Supplemental Financial Information (Unaudited) 75-83 Financial Statement Schedules for the Years Ended December 31, 1993, 1992 and 1991: Schedule V - Property, Plant and Equipment 89-94 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 95-96 Schedule VIII - Valuation and Qualifying Accounts and Reserves 97 Schedule IX - Short-term Borrowings 98 Schedule X - Supplementary Income Statement Information 99 Financial statement schedules not included in this Form 10-K Annual Report have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or notes thereto. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS The management of The Montana Power Company is responsible for the preparation and integrity of the consolidated financial statements of the Corporation. These financial statements have been prepared in accordance with generally accepted accounting principles which are consistently applied, and appropriate in the circumstances. In preparing the financial statements, management makes appropriate estimates and judgements based upon available information. Management also prepared the other financial information in the annual report and is responsible for its accuracy and consistency with the financial statements. Management maintains systems of internal accounting control which are adequate to provide reasonable assurance that the financial statements are accurate, in all material respects. The concept of reasonable assurance recognizes that there are inherent limitations in all systems of internal control in that the costs of such systems should not exceed the benefits to be derived. Management believes the Company's systems provide this appropriate balance. The Company maintains an internal audit function that independently assesses the effectiveness of the systems and recommends possible improvements. Price Waterhouse, the Company's independent public accountants, also considered the systems in connection with its audit. Management has considered the internal auditors' and Price Waterhouse's recommendations concerning the systems and has taken cost-effective actions to respond appropriately to these recommendations. The Board of Directors, acting through an Audit Committee composed entirely of directors who are not employees of the Company, is responsible for determining that management fulfills its responsibilities in the preparation of the financial statements. The Audit Committee recommends, and the Board of Directors appoints, the independent public accountants. The independent accountants and internal auditors are assured of full and free access to the Audit Committee and meet with it to discuss their audit work, the Company's internal controls, financial reporting and other matters. The Committee is also responsible for determining that there is adherence to the Company's Code of Business Conduct (Code). The Code addresses, among other things, potential conflicts of interests and compliance with laws, including those relating to financial disclosure and the confidentiality of proprietary information. The financial statements have been examined by Price Waterhouse, which is responsible for conducting its examination in accordance with generally accepted auditing standards. Report of Independent Accountants To the Board of Directors and Shareholders of The Montana Power Company In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Montana Power 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 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 9 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits other than pensions. PRICE WATERHOUSE Portland, Oregon February 10, 1994 CONSOLIDATED STATEMENT OF INCOME The Montana Power Company and Subsidiaries The accompanying notes are an integral part of these statements. CONSOLIDATED BALANCE SHEET The Montana Power Company and Subsidiaries ASSETS CONSOLIDATED STATEMENT OF CASH FLOWS The Montana Power Company and Subsidiaries CONSOLIDATED STATEMENT OF COMMON SHAREHOLDERS' EQUITY The Montana Power Company and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - Summary of significant accounting policies: The Company's accounting policies conform to generally accepted accounting principles. With respect to utility operations, such policies are in accordance with the accounting requirements and ratemaking practices of the regulatory authorities having jurisdiction. Principles of consolidation: The Consolidated Financial Statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. The Independent Power Group (IPG) includes the Company's Colstrip Unit 4 operations. The Utility and the IPG purchase coal from Western Energy Company, and sell and purchase electricity to and from each other. In addition, the Utility sells electricity and natural gas to the Entech businesses located within the Utility's service area. Entech sells natural gas to the Utility and to independent power projects in which the IPG has an ownership interest. Finally, a subsidiary of the IPG provides maintenance services to the Utility's power plants, and operation and maintenance services to the independent power projects mentioned above. Intercompany sales and purchases between the Utility, Entech, and the IPG are included in the Consolidated Statement of Income as revenues and expenses. See Note 10 for details. All other significant intercompany items have been eliminated. Plant and property: Additions to and replacement of plant and property are recorded at original cost, which includes material, labor, overhead and contracted services. Cost includes interest capitalized and, with respect to utility plant, also includes an allowance for funds used during construction. Gas in underground storage is included in natural gas utility plant. Maintenance and repairs of plant and property, and replacements and renewals of items determined to be smaller than established units of plant, are charged to operating expenses. The cost of units of utility plant retired or otherwise disposed of, adjusted for removal costs and salvage, is charged to the accumulated provision for depreciation and depletion, and the cost of related replacements and renewals is added to utility plant. Gain or loss is recognized upon the sale or other disposition of Entech property, Independent Power Group property and Utility land. Provisions for depreciation and depletion are recorded at amounts substantially equivalent to calculations made on straight-line and unit-of-production methods by application of various rates based on useful lives of properties determined from engineering studies. The provisions for utility depreciation and depletion approximated 2.7% for 1993, 1992, and 1991 of the depreciable and depletable utility plant at the beginning of the year. The Company and its subsidiaries have adopted two methods of accounting for oil and gas exploration and development costs. Entech's Oil Division uses the successful efforts method. The regulated natural gas utility capitalizes all costs associated with the successful development of a natural gas well and expenses those costs incurred on an unsuccessful well. The Company is a joint-owner of Colstrip Units 1, 2, and 3 and of transmission facilities serving these Units. At December 31, 1993, the Company's joint ownership percentage and investment in these Units and transmission facilities were: *This is an approximate ownership percentage. The ownership percentages are generally based on capacity rights on the various segments of the transmission system. The Company also owns $35,216,000 and $32,953,000 of the Colstrip Unit 4 share of common production plant and transmission plant that had related accumulated depreciation of $10,377,000 and $5,258,000, respectively. Each joint-owner provides its own financing. The Company's share of direct expenses associated with the operation and maintenance of these joint facilities is included in the corresponding operating expenses in the Consolidated Statement of Income. Utility revenue and expense recognition: Operating revenues are recorded on the basis of service rendered. In 1985, the Public Service Commission of Montana (PSC) and the Federal Energy Regulatory Commission (FERC) approved annual electric rate increases in the amounts of $80,400,000 and $7,500,000, respectively, to be collected in accordance with rate-moderation plans. During 1992 and 1991, cash collected under these plans exceeded revenues recorded by $12,462,000 and $23,133,000, respectively. As of October 1992, all deferred revenues under the plans had been collected. Costs of service are recognized on the accrual basis and charged to expense currently except for natural gas costs deferred pursuant to PSC- approved deferred gas accounting procedures and other costs deferred pursuant to regulatory decisions which are discussed in the following paragraph of this note. Costs deferred to future operating periods: As a result of the adoption of SFAS No. 109 in 1992, the Company must recognize a deferred tax liability for certain temporary differences that were not previously required to be provided. A corresponding asset of $142,123,000 and $137,700,000 has been recorded at December 31, 1993 and 1992, respectively and is classified as a cost deferred to future operating periods. See the Income Taxes section of this note for further information on the effects of the adoption of SFAS No. 109. Cash and cash equivalents: For the purposes of these financial statements, the Company considers all liquid investments with original maturities of three months or less to be cash equivalents. Allowance for funds used during construction: The Company capitalizes, as a part of the cost of utility plant, an allowance for the cost of equity and borrowed funds required to finance construction work in progress. The rate used to compute the allowance is determined in accordance with a formula established by the FERC and was an average of 6.5% for 1993, 7.3% for 1992, and 8.4% for 1991. The Company capitalized an allowance for borrowed funds used during construction of $1,372,000, $1,255,000, and $1,181,000 for 1993, 1992, and 1991, respectively. Income taxes: The Company and its U.S. subsidiaries file a consolidated U.S. income tax return. Consolidated U.S. income taxes are allocated to Utility, Entech, and IPG operations as if separate U.S. income tax returns were filed. The difference, if any, between such amounts and the consolidated U.S. income tax expense is included in utility operations - income taxes applicable to other income. 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. In 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which required a change to the asset and liability method of accounting for income taxes. Under this method, deferred tax assets or liabilities are computed using the tax rates that are expected to be in effect when the temporary differences reverse. For regulated companies, the changes in tax rates applied to accumulated deferred income taxes may not be immediately recognized because of regulatory practices. For non-regulated companies, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The Company elected to report the cumulative effect of the change in the method of accounting for income taxes as of January 1, 1987. The cumulative effect of the accounting change was $5,900,000 and was recorded as a reduction in Common Shareholders' Equity. Prior to the adoption of SFAS No. 109, deferred income taxes were not provided for certain Utility Operations' temporary differences pursuant to regulatory practices. Now the Company must recognize a deferred tax liability for these temporary differences in the amount of $142,123,000 and $137,700,000 as of December 31, 1993, and 1992, respectively. Because of regulatory precedent and the Company's intent to request rate recovery of these amounts in the future, a corresponding asset has been recorded and is classified as a cost deferred to future operating periods. Net income per share of common stock: Net income per share of common stock is computed for each year based upon the weighted average number of common shares outstanding. The effect of options outstanding under the Company's Long-Term Incentive Plan is not significant (see Note 5). Financial instruments: All of the Company's significant financial instruments were recognized in the Consolidated Balance Sheet as of December 31, 1993. The value reflected in the Consolidated Balance Sheet (carrying value) approximates fair value for the Company's financial assets and current liabilities. Descriptions of the methods and assumptions used to reach this conclusion are as follows: Miscellaneous special funds, cash and temporary cash investments, and current liabilities: These financial instruments have short maturities, or are invested in financial instruments with short maturities. Investment in cogeneration projects and other investments: The carrying value equals cash surrender value, or approximates the present value of future cash flows, discounted using a market rate of return. The fair value of the Company's long-term debt, based on quoted market prices for the same or similar issues or by discounting future cash flows using interest rates that could be obtained currently, exceeds carrying value by approximately 6.7%. This is because the average interest rate of the Company's debt exceeds the rate which could be obtained currently. The Company refinances the debt that is callable when associated benefits exceed costs, and when the Company believes it is an opportunistic time to do so. Reclassifications: Certain reclassifications have been made to the prior year amounts to make them comparable to the 1993 presentation. These changes had no impact on previously reported results of operations or shareholders' equity. NOTE 2 - Contingencies: The Company's hydroelectric projects are operated under licenses issued by the FERC, which expire on varying dates from 1994 to 2035. When a license expires, it may be reissued to the Company, issued to a new licensee or the facility may be taken over by the United States. In either of the last two events, the Company would be entitled to compensation equivalent to its net investment in the project plus severance damages. In determining net investment in the project, the licenses provide that there may be deducted the amount contained in an appropriated retained earnings account, which shall be accumulated from a portion of the amount earned in excess of a specified reasonable rate of return after 20 years of operation under the license. At December 31, 1993, the amount of these appropriated retained earnings relating to the Company's hydroelectric projects as computed by the Company is estimated to be $6,238,000. The Board of Directors has appropriated retained earnings in the same amount for this purpose, thereby restricting their availability for dividend purposes. Under a joint 50-year license with the Confederated Salish and Kootenai Tribes (Tribes), the Company will own and operate the Kerr Hydroelectric project until September 2015. The Tribes may take over the project anytime between 2015 and 2025 on one year's written notice in return for payment equal to the Company's remaining net investment. The Company pays the Tribes an annual rental fee that is adjusted yearly to reflect changes in the Consumer Price Index. In 1990, the Company filed with the FERC a plan to mitigate damages to and manage fish and wildlife habitat impacted by the operation of the Kerr Hydroelectric Project. The Management and Mitigation Plan (Plan) was prepared pursuant to the joint license issued by the FERC to the Company and the Tribes. It consists of a one-time payment by the Company of $15,418,000 and annual payments of $965,000 allocated between the Tribes and various groups. The annual payments would be adjusted annually on the basis of the Consumer Price Index. Additionally, the Secretary of Interior may impose certain conditions pertaining to fish and wildlife. While the Company cannot predict when or in what form the Plan finally will be approved, it expects that the cost of mitigation measures will be recovered through rates and, therefore, will not have a materially adverse effect on the Company's financial condition or results of operations. In November 1992, the Company filed with FERC its application to relicense nine Madison and Missouri River hydroelectric facilities with electric generating capacity totaling 292 megawatts. The application, in preparation since 1989, proposes an additional 74 megawatts of generation. The total capital investment of relicensing, including physical improvements, environmental protection, mitigation and enhancement measures, is estimated at $167,600,000. Additional costs for operational changes, as well as annual payments for environmental protection, mitigation and enhancement, are estimated to be about $5,400,000 per year. The Company expects that the relicensing costs will be recovered through rates and, therefore, will not have a materially adverse effect on the Company's financial condition or results of operations. The owners of homes in two residential developments in Colstrip, Montana, which were built for the Colstrip Units 3 and 4 Project have made claims against the Company and the other owners of the Colstrip Units 3 and 4 for property damages to their homes allegedly caused by soil-related subsidence. The Company has settled all of these claims. The other Colstrip 3 and 4 owners have denied responsibility for a substantial part of the settlement costs on the ground that the Company exceeded its authority in settling the claims. The amount in controversy is not expected to exceed $5,000,000. The Company is pursuing resolution and it is uncertain whether it will ultimately pay more than its proportionate share of the settlement costs. Other property owners in Colstrip also have made claims against the Company and the other Colstrip Units' owners for property damages allegedly resulting from soil-related subsidence. The Company has not determined the magnitude of such alleged damages or the responsibility, if any, of the Colstrip owners. While the resolution of these claims is uncertain, the Company believes they will not have a materially adverse effect on the Company's financial condition or results of operations. A Rosebud Mine coal supply agreement provides for periodic price redetermination over the life of the contract. The first date under the contract that a price redetermination could have occurred was August 1,1991. Negotiations to redetermine the coal price have been unsuccessful and an arbitration proceeding has been scheduled to commence in October, 1994. Through December 31, 1993, 6,923,000 tons, of which 3,466,000 tons were delivered to the Company, have been delivered and are subject to a redetermined price. The price change, if any, from this arbitration is not expected to have a materially adverse effect on the Company's results of operations. NOTE 3 - Commitments: The Company purchases approximately 600 million kWh annually under an Exchange Agreement with the Washington Public Power Supply System and the Bonneville Power Administration which expires in 1996. The rate is 4.6 cents per kWh in the contract year which began in July 1993 and will increase each subsequent contract year to approximately 4.8 cents per kWh in the final contract year beginning July 1995. In 1993, the Company entered into a contract to purchase 98 megawatts of seasonal capacity from Basin Electric Power Cooperative beginning in 1996. The rate, including the capacity charge, will be approximately 3.3 cents per kWh in the contract year beginning in November 1996 and will increase each subsequent year to approximately 7.1 cents per kWh in the final contract year which begins in November 2009. The Company also has long-term purchase contracts with certain independent power producers and natural gas producers. The purchased power contracts, including the Basin Electric contract discussed above, provide for capacity payments subject to a facility meeting certain operating standards, and payments based on energy received. The purchased gas contracts provide for take-or-pay payments. The Entech Oil Division has various natural gas transportation contracts with terms that expire beginning in 1998. Total payments under these contracts for the prior three years were as follows: Thousands of Dollars Years Electric Natural Gas Entech 1991. . . . . . . $ 15,553 $ 18,422 $ 713 1992. . . . . . . 18,143 12,496 1,938 1993. . . . . . . 18,434 11,633 2,260 The present value of future minimum payments, at an assumed discount rate of 8%, under the above agreements are estimated as follows: Thousands of Dollars Years Electric Natural Gas Entech 1994. . . . . . . $ 3,882 $ 12,164 $ 2,976 1995. . . . . . . 4,280 9,560 2,199 1996. . . . . . . 7,576 7,321 2,021 1997. . . . . . . 10,328 6,026 1,664 1998. . . . . . . 10,296 3,308 1,521 Remainder. . . .. 150,085 8,064 8,658 Total . . . . . $ 186,447 $ 46,443 $ 19,039 In 1993, the Company entered into contracts for the construction of a second powerhouse at the Thompson Falls Hydroelectric Plant. In 1993, expenditures for the project were $9,000,000, while the total costs for the next three years are expected to be $51,000,000. An Entech Coal Division coal lease purchase agreement requires minimum annual payments beginning in 1991 of $1,125,000 escalated quarterly by the Gross National Product implicit price deflator. These payments will continue until the equivalent of $18,750,000, in 1986 dollars, has been paid. At December 31, 1993, the remaining payments under this agreement were $14,349,000. A similar agreement requires minimum annual payments of $1,000,000 through 1995. Under current mine plans, the payments made through December 1993 should be recovered. In 1990, a patented coal enhancement process developed by the Entech Coal Division was selected for funding under the U.S. Department of Energy (DOE) Clean Coal Technology Program. The Entech Coal Division and a subsidiary of Northern States Power are partners in a five-year, $69,000,000 coal enhancement demonstration plant at Colstrip, Montana. DOE is funding 50% and the partners share equally in the remaining 50% of the cost of the project. The Division's remaining commitment at December 31, 1993, was $5,100,000. The Entech Oil Division has agreed to supply 174 Bcf of natural gas to four cogeneration facilities over 15 years. The Oil Division has sufficient proven, developed and undeveloped reserves, and controls related sales of production sufficient to supply all of the remaining natural gas required by these agreements. The Entech Oil Division owns a 50% interest in a natural gas marketing company. Entech has agreed to guarantee the performance by the marketing company of $4,300,000 in transportation and purchase contracts. The guaranteed amounts outstanding were $3,400,000 at December 31, 1993. Rental expense for the prior three years was as follows: 1993 1992 1991 Thousands of Dollars Colstrip Unit 4. . . . $ 32,226 $ 32,226 $ 32,226 Kerr project . . . . . 11,837 11,486 11,027 Other. . . . . . . . . 11,917 11,985 13,452 $ 55,980 $ 55,697 $ 56,705 In addition, operating expenses include delay rentals paid by the Company to retain mineral rights before development of leased acreage. Delay rentals were $1,021,000, $999,000, and $1,000,000 in 1993, 1992, and 1991, respectively. Leases: The Company classifies leases as operating or capitalized leases. Capitalized leases are not material and are included in other long-term debt. On December 30, 1985, the Company sold its 30% share of Colstrip Unit 4 and is leasing back this share under a net lease. The transaction has been accounted for as an operating lease with semiannual lease payments of approximately $16,113,000 over the remaining term of the 25-year lease. At December 31, 1993, the Company's future minimum operating lease payments are as follows: Thousands of Year Dollars 1994. . . . . . . . . . . . . . . $ 34,833 1995. . . . . . . . . . . . . . . 34,492 1996. . . . . . . . . . . . . . . 34,362 1997. . . . . . . . . . . . . . . 34,216 1998. . . . . . . . . . . . . . . 34,301 Remainder . . . . . . . . . . . . 393,459 Total . . . . . . . . . . . . $ 565,663 NOTE 4 - Income tax expense: Income before income taxes for the years ended December 31, 1993, 1992 and 1991 was as follows: 1993 1992 1991 Thousands of Dollars Utility Operations: United States..................... $ 94,247 $ 77,752 $ 75,872 Canada............................ 2,340 1,395 5,073 96,587 79,147 80,945 Other Income and Expense: United States..................... 230 1,497 1,061 Canada............................ 609 (314) 46 839 1,183 1,107 Entech Operations: United States..................... 58,611 61,409 71,640 Canada............................ 5,842 4,966 (2,665) 64,453 66,375 68,975 Independent Power Group Operations: United States.................... (548) 5,999 5,082 $ 161,331 $ 152,704 $ 156,109 Income tax expense as shown in the Consolidated Statement of Income consists of the following components: 1993 1992 1991 Thousands of Dollars Utility Operations: Current United States..................... $ 23,519 $ 24,563 $ 24,104 Canada............................ 1,121 879 2,044 State............................. 4,903 4,999 5,370 Deferred United States..................... 6,902 (1,593) (2,507) Canada............................ 80 (191) (262) State............................. 980 (641) (941) 37,505 28,016 27,808 Other Income and Expense: Current United States..................... (2,281) 1,139 655 State............................. (302) 141 181 Deferred United States..................... 2,410 (1,865) 694 State............................. 32 (204) (252) (141) (789) 1,278 Entech Operations: Current United States..................... 14,090 14,703 18,180 Canada............................ 2,114 2,283 814 State............................. 2,098 3,442 1,905 Deferred United States..................... (1,619) (3,093) (1,322) Canada............................ 294 (9) 10 State............................. 286 (1,148) 5 17,263 16,178 19,592 Independent Power Group Operations: Current United States..................... (4,289) (2,153) (6,286) State............................. (3,177) (275) (1,178) Deferred United States..................... 5,971 3,905 7,645 State............................. 988 757 1,535 (507) 2,234 1,716 $ 54,120 $ 45,639 $ 50,394 Deferred tax liabilities (assets) are comprised of the following at December 31: 1993 1992 Thousands of Dollars Plant Related......................... $ 372,236 $ 353,900 Investment in nonutility generation projects............................ 16,370 13,904 Other................................. 16,260 11,622 Gross deferred tax liabilities........ 404,866 379,426 Coal reclamation...................... (37,321) (33,005) Amortization of gain on sale/ leaseback........................... (18,090) (19,295) Investment Tax Credit Amortization.... (32,801) (33,958) Other................................. (14,937) (13,409) Gross deferred tax assets............. (103,149) (99,667) Net deferred tax liabilities (assets). 301,717 279,759 Current deferred tax assets........... 8,063 8,339 Total noncurrent deferred tax liabilities(assets)............... $ 309,780 $ 288,098 The change in net deferred liabilities differs from current year deferred tax expense as a result of the following: Thousands of Dollars Increase (decrease) in total noncurrent deferred tax liabilities (assets).............................. $ 21,682 Costs deferred to future operating periods.......... (4,991) Other............................................... (367) Deferred Tax Expense.............................. $ 16,324 The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax income as a result of the following differences: 1993 1992 1991 Thousands of Dollars Computed "expected" income tax expense.. $ 56,466 $ 51,919 $ 53,077 Adjustments for tax effects of: Statutory depletion in coal mining operations............ (3,775) (5,920) (5,972) General business and nonconventional fuel tax credits.................. (4,496) (3,723) (2,201) State income tax, net................ 4,704 3,332 4,890 Reversal of excess of U.S. utility income tax depreciation over financial accounting depreciation on utility plant additions......................... 2,281 1,987 2,535 Other................................ (1,060) (1,956) (1,935) Actual income tax expense............... $ 54,120 $ 45,639 $ 50,394 During 1993, the federal income tax rate increased from 34% to 35%. The following table summarizes the increased income taxes that resulted. Thousands of Dollars Utility Operations . . . . . . . . . . . . $ 1,072 Entech Operations. . . . . . . . . . . . . 867 Independent Power Group Operations . . . . 749 $ 2,688 NOTE 5 - Common stock: At December 31, 1993 and 1992, the Company had 120,000,000 shares of authorized common stock. The Company has a Shareholder Protection Rights Plan which provides one preferred share purchase right (Right) on each outstanding common share of the Company. Each Right entitles the registered holder, upon the occurrence of certain events, to purchase from the Company one one-hundredth of a share of Participating Preferred Shares, A Series, without par value. If it should become exercisable, each Right would have economic terms similar to one share of common stock of the Company. The Rights trade with the underlying shares and will, except under certain circumstances described in the Plan, expire on June 6, 1999, unless earlier redeemed or exchanged by the Company. The Company's Dividend Reinvestment and Stock Purchase Plan allows owners of common and preferred stock, as well as Montana utility customers, to reinvest the dividends paid on their common and preferred stock to purchase shares of common stock. Participants in the plan may also elect to invest by purchasing up to $15,000 per quarter of common stock. The Company has a Deferred Savings and Employee Stock Ownership Plan (Plan) that covers all regular eligible employees. The Company, on behalf of the employee, contributes a percentage of the amount contributed to the Plan by the employee. In 1990, the Company borrowed $40,000,000 at an interest rate of 9.2% to be repaid in equal annual installments over 15 years. The proceeds of the loan were lent on similar terms to the Plan Trustee, which purchased 1,922,297 shares of Company common stock. The loan, which is reflected as long-term debt, is offset by a similar amount in common shareholders' equity as unallocated stock. Company contributions plus the dividends on the shares held under the Plan are used to meet principal and interest payments on the loan. Shares acquired with loan proceeds are allocated to Plan participants. As principal payments on the loans are made, long-term debt and the offset in common shareholders' equity are both reduced. At December 31, 1993, 482,387 shares had been allocated to the participants' accounts. Expense for the Plan is recognized using the Shares Allocated Method, and consists of the following for the three years ended December 31, 1993: 1993 1992 1991 Thousands of Dollars Principal allocated.................... $ 2,663 $ 2,683 $ 2,672 Interest incurred...................... 3,275 3,448 3,557 Dividends.............................. (3,028) (2,965) (2,843) Additional contribution................ 2,310 1,765 1,290 Total Expense..................... $ 5,220 $ 4,931 $ 4,676 The Company's amount of Plan costs funded, which currently is less than the aforementioned expense amounts, is included in utility rates. Accordingly, the difference of $758,000, $694,000 and $892,000 for the years ending December 31, 1993, 1992 and 1991, respectively, were recorded as a reduction of Plan expense. Under the Long-Term Incentive Plan, options have been issued to Company employees. Options issued to Utility employees are not reflected in balance sheet accounts until exercised, at which time (i) authorized, but unissued shares are issued to the employee, (ii) the capital stock account is credited with the proceeds, and (iii) no charges or credits to income are made. Options issued to Entech and IPG employees are not reflected in balance sheet accounts. Rather, upon exercise, outstanding shares are purchased at current market prices and compensation expense is charged with the excess of the market price over the option price. Option activity is summarized below. Number Option Price Of Shares Per Share Outstanding December 31, 1990 436,642 $11.4375 - 20.0625 Granted 372,600 22.125 - 26.50 Exercised (128,930) 11.4375 - 22.125 Cancelled (22,865) 14.25 - 22.125 Outstanding December 31, 1991 657,447 $11.4375 - 26.50 Granted - Exercised (116,905) 11.4375 - 22.125 Cancelled (4,457) 11.4375 - 22.125 Outstanding December 31, 1992 536,085 $14.25 - 26.50 Granted - Exercised (118,243) 14.25 - 26.50 Cancelled (5,532) 14.25 - 26.50 Outstanding December 31, 1993 412,310 $14.25 - 26.50 Options Exercisable at December 31, 1993 412,310 Options were granted at not less than the closing price on the New York Stock Exchange on the date granted, and generally become exercisable after two years. Options granted prior to January 1, 1987 must be exercised in the order granted. All options expire ten years from the date of grant. NOTE 6 - Preferred stock: The number of authorized shares of preferred stock is 5,000,000. No dividends may be declared or paid on common stock while cumulative dividends have not either been declared and set apart or paid on any of the preferred stock. In November 1993, the Company sold $50,000,000 of the $6.875 series of Preferred Stock, stated value and liquidation value $100. The net proceeds from the sale were used to repay short-term debt. The stock is redeemable at the option of the Company, in whole or in part, at any time on or after November 1, 2003. Preferred stock, as shown in the Consolidated Balance Sheet, is in four series as detailed in the following table: Shares Amount Issued and Thousands of Series Outstanding Dollars $6.875 500,000 $ 50,000 6.00 159,589 15,959 4.20 60,000 6,025 2.15 1,200,000 30,000 1,919,589 $ 101,984 The stated value and liquidation price of preferred shares is $100 for the $6.875 series, the $6.00 series and the $4.20 series and $25 for the $2.15 series, plus accumulated dividends. The preferred stock is redeemable at the option of the Company upon the written consent or affirmative vote of the holders of a majority of the common shares on thirty days notice at $110 per share for the $6.00 series, $103 per share for the $4.20 series and $25.25 per share for the $2.15 series, plus accumulated dividends. The $6.875 series is redeemable in whole or in part, at anytime on or after November 1, 2003 for a price beginning at $103.438 per share with annual decrements through the year 2013, after which the redemption price is $100 per share. NOTE 7 - Long-term debt: Long-term debt consists of the following: December 31 1993 1992 Thousands of Dollars First Mortgage Bonds: 7.7% series, due 1999...................... $ 55,000 $ 55,000 7 1/2% series, due 2001.................... 25,000 25,000 8 5/8% series, due 2004.................... 60,000 7% series, due 2005........................ 50,000 8 1/4% series, due 2007.................... 55,000 55,000 8.95% series, due 2022..................... 50,000 50,000 Secured Medium-Term Notes.................. 43,000 Pollution Control Revenue Bonds: County of Rosebud, Montana 5 3/4% series, due 2003.................... 18,545 6.3% series, due 2007...................... 7,000 City of Forsyth, Montana 10% series, due 2004....................... 40,000 10 1/8% series, due 2014................... 40,000 Variable rate series, due 2014............. 39,660 Adjustable rate series, due 2014........... 25,000 6 1/8% series, due 2023.................... 90,205 5.9% series, due 2023...................... 80,000 Sinking Fund Debentures: 7 1/2%, due 1998........................... 17,500 18,000 Revolving Credit Agreements: Entech..................................... 12,000 ESOP Notes Payable, due 2004................... 33,850 35,596 Medium-Term Notes, Series A.................... 67,250 100,000 Long-Term Commercial Paper..................... 20,000 20,000 Other.......................................... 15,144 20,917 Unamortized Discount and Premium.......... (3,880) (3,157) 598,069 618,561 Less: Portion due within one year............. 26,199 37,382 $ 571,870 $ 581,179 First Mortgage Bonds: The Company's Mortgage and Deed of Trust imposes a first mortgage lien on all physical properties owned, exclusive of subsidiary company assets, and certain property and assets specifically excepted. The obligations collateralized are First Mortgage Bonds, including those First Mortgage Bonds securing Pollution Control Revenue Bonds, in the aggregate principal amount of $448,200,000 at December 31, 1993. In February 1993, the Company sold $50,000,000 of First Mortgage Bonds, 7% series due 2005, and $13,000,000 of Secured Medium-Term Notes, 7.25% series due 2008. The proceeds of these sales were used to redeem $60,000,000 of First Mortgage Bonds, 8 5/8% series due 2004. Secured Medium-Term Notes: These notes constitute a series of First Mortgage Bonds. On January 26, 1993, the Company sold $22,000,000 of Medium-Term Notes, $15,000,000 of the 8.11% series due 2023 and $7,000,000 of the 7.23% series due 2003. Another $8,000,000 of the 7.23% series due 2003 was sold on January 28, 1993. The proceeds of these issues were used to repay Long-Term Commercial Paper and other long-term bank debt outstanding. In February 1993, the Company sold $13,000,000 of Secured Medium-Term Notes, 7.25% series due 2008. As previously mentioned, the proceeds of this sale were used to redeem $60,000,000 of First Mortgage Bonds, 8 5/8% series due 2004. On January 19, 1994, the Company sold $5,000,000 of Secured Medium-Term Notes, 7.25% series due 2024, the proceeds of which were used to repay short- term debt incurred to complete the refinancing of the 10% and 10 1/8% series Pollution Control Revenue Bonds. Pollution Control Revenue Bonds: In June 1993, the City of Forsyth, Rosebud County, Montana, sold $90,205,000 of its 6 1/8% Pollution Control Revenue Refunding Bonds due 2023, the principal of, and interest on, which the Company is obligated to pay. The proceeds from the sale of these Bonds were loaned to the Company and used to redeem, prior to maturity, $18,545,000 of Rosebud County's 5 3/4% Pollution Control Revenue Bonds due 2003, $7,000,000 of the County's 6.3% Pollution Control Revenue Bonds due 2007, $39,660,000 of the City of Forsyth's Variable Rate Pollution Control Revenue Bonds due 2014 and $25,000,000 of the City's Adjustable Rate Pollution Control Revenue Bonds due 2014, the principal of, and interest on, all of which the Company was obligated to pay. On December 30, 1993, the City of Forsyth, Rosebud County, Montana, sold $80,000,000 of its 5.9% Pollution Control Revenue Refunding Bonds due 2023, the principal of, and interest on, which the Company is obligated to pay. The proceeds from the sale of these Bonds were loaned to the Company and used to redeem, prior to maturity, $40,000,000 of the City of Forsyth's 10% Pollution Control Revenue Bonds due 2004, $40,000,000 of the City's 10 1/8% Pollution Control Revenue Bonds due 2014, the principal of, and interest on, all of which the Company was obligated to pay. Although not redeemed until January 1, 1994, the 10% and 10 1/8% series were considered to be retired on December 30, 1993 for financial reporting purposes, since the Company had placed funds on deposit with the trustee at year end to cover all costs associated with the redemption of these bonds. Accordingly, the funds held by the trustee and the bonds do not appear on the December 31, 1993 Consolidated Balance Sheet. Revolving Credit Agreements: The Company has a Revolving Credit and Term Loan Agreement that allows it to borrow up to $60,000,000, all of which was unused at December 31, 1993. Under the agreement, borrowings outstanding at October 31, 1995, must be repaid in eight quarterly installments beginning in January 1996. Entech has a Revolving Credit and Term Loan Agreement with a group of banks that allows it to borrow up to $75,000,000, all of which was unused at December 31, 1993. Under the agreement, borrowings outstanding at September 30, 1994 must be repaid in eight quarterly installments beginning in December 1994. Fixed or variable interest rate options are available under the facilities, with commitment fees on the unused portions. On December 31, 1992, Entech had outstanding $12,000,000 under these agreements, at a 4% interest rate. ESOP Notes Payable: In 1990, the Company borrowed $40,000,000 at an interest rate of 9.2% in a 15-year loan to be repaid in equal annual installments. The proceeds of the loan were used to purchase shares of the Company's stock to pre-fund a portion of the Company's matching requirements under the Deferred Savings and Employee Stock Ownership Plan. See Note 5 for further information. Medium-Term Notes, Series A: At December 31, 1993 and 1992, the Company had outstanding $67,250,000 and $100,000,000 principal amount of Medium-Term Notes, respectively, maturing from eleven months to 29 years with interest rates varying between 8.57% and 8.90%. On January 15, 1993, $13,000,000 of Medium-Term Notes, 8.65% series due 1993, matured. The Company retired these notes with the proceeds of short- term borrowing. On December 20, 1993, $19,750,000 of Medium-Term Notes, 8.8% series due 1993, matured. The Company retired these notes with the proceeds of long-term commercial paper. During the period 1994 through 1998, the Company is required to make the following maturity and sinking fund payments on long-term debt: 1994 1995 1996 1997 1998 Thousands of Dollars 7 1/2% Sinking Fund Debentures............... $ 500 $ 500 $ 500 $ 500 $ 15,500 ESOP Notes Payable......... 1,907 2,082 2,274 2,483 2,712 Medium-Term Notes.......... 19,000 10,000 8,750 7,500 2,500 Other...................... 4,792 4,475 4,092 201 192 $ 26,199 $ 17,057 $ 15,616 $ 10,684 $ 20,904 NOTE 8 - Short-term borrowing: The Company is currently authorized by the PSC to incur short-term debt not to exceed $150,000,000. The Company and Entech have short-term borrowing facilities with commercial banks that provide both committed, as well as uncommitted, lines of credit, and the ability to sell commercial paper. Bank borrowings either bear interest at the lender's floating base rate and may be repaid at any time, or have fixed rates of interest and maturities. Commercial paper has fixed rates of interest and maturities. At December 31, 1993, the Company had lines of credit consisting of $75,000,000 committed and $65,400,000 uncommitted, and Entech had lines of credit consisting of $15,000,000 committed and $20,000,000 uncommitted. There is a commitment fee on the unused portion of some of these facilities which is not significant. The Company has the ability, subject to the previously mentioned PSC limitation, to issue up to $135,000,000 of commercial paper based on the total of its unused committed lines of credit and its revolving credit agreement and Entech has a $50,000,000 commercial paper facility. At December 31, 1993 and 1992, the Company's and Entech's short-term borrowing included the following: 1993 1992 Thousands of Dollars Notes payable to banks MPC.......................... $ 43,900 $ 34,300 Entech....................... 8,000 13,000 Commercial paper MPC.......................... 16,000 Entech....................... 16,965 $ 68,865 $ 63,300 NOTE 9 - Retirement plans: The Company maintains trusteed, noncontributory retirement plans covering substantially all employees. Retirement benefits are based on salary, years of service and social security integration levels. In 1993, pension costs funded were less than SFAS No. 87 pension expense by $1,887,000 and the difference was recorded as a reduction of unearned revenue. The amount of utility pension costs funded are included in rates. In 1992 and 1991, pension costs funded exceeded SFAS No. 87 pension expense by $969,000 and $48,000, respectively and the differences were recorded as unearned revenue. At December 31, 1993, the cumulative amount by which pension costs funded exceed SFAS No. 87 pension expense is $1,362,000. The assets of the plans consist primarily of corporate stocks, corporate bonds and U.S. Government securities. The Company also has an unfunded, nonqualified benefit plan for senior management executives and directors that provides for defined benefit payments upon retirement over the life of the participant or to their beneficiary for a minimum fifteen-year period. Life insurance payable to the Company is carried on plan participants as an investment. Utility nonqualified benefit plan expense is not included in rates. Net pension and benefit expense includes the following components: 1993 1992 1991 Thousands of Dollars Service cost benefits earned during the period.......................... $ 6,746 $ 5,287 $ 4,875 Interest cost on projected benefit obligation.......................... 12,077 9,978 9,230 Actual return market value of assets.. (18,701) (12,688) (20,509) Net amortization and deferral......... 10,891 4,642 14,548 Total net periodic pension and benefit expense................... $ 11,013 $ 7,219 $ 8,144 The funded status of the pension and benefit plans is as follows: In addition to providing pension benefits, the Company and its subsidiaries provide certain health care and life insurance benefits for eligible retired employees. Until 1993, the cost of retiree health care and life insurance benefits was recognized as expense on a pay-as-you-go (cash) basis. The cost of these benefits in 1993, 1992 and 1991 was $1,387,000, $1,267,000 and $1,187,000, respectively. The Company adopted Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106) effective January 1, 1993. SFAS No. 106 requires accrual of the expected cost of these postretirement benefits during the employees' years of service rather than when the costs are paid. The Company's accumulated postretirement benefit obligation at January 1, 1994 is estimated to be $34,400,000, with $24,600,000 and $9,800,000 related to utility and non-utility operations, respectively. The utility and non-utility amounts are being amortized through charges to earnings over 20 and 24-year periods, respectively. The incremental increase in 1993 consolidated expenses due to SFAS No. 106 adoption was $1,600,000, all of which related to the non-utility operations. In accordance with an Accounting Order issued by the PSC on November 10, 1992, the Company has recorded as a deferred expense in 1993 the increased costs of $2,100,000 which resulted from adopting SFAS No. 106 for the Utility Division. The Company requested recovery of utility SFAS No. 106 costs from ratepayers in its rate filing on June 21, 1993 and a final rate order is expected by the end of April 1994. The Company believes that the costs will be allowed in rates based on previous PSC rate decisions addressing this issue. The cost of SFAS No. 106 adoption for the year ended December 31, 1993, a portion of which has been capitalized, includes the following components: December 31 Thousands of Dollars Service cost on benefits earned during the year. . . . . . . . . . . . $ 1,356 Interest cost on projected benefit obligation . . . . . . . . . . . . . . 2,296 Amortization of transition obligation . . 1,492 Total postretirement benefit cost . . . . $ 5,144 The funded status of the postretirement benefit plans is as follows: December 31 Thousands of Dollars Accumulated benefit obligation: Fully eligible active employees . . . . . . $ 1,920 Other active employees. . . . . . . . . . . 20,195 Retirees. . . . . . . . . . . . . . . . . . 12,298 Accumulated benefit obligation. . . . . . . 34,413 Plan assets at fair value . . . . . . . . . . 0 Plan assets less than projected benefit obligation. . . . . . . . . . . . . (34,413) Unrecognized net transition obligation. . . . 27,519 Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions. . . . . . . . . . . . . . . 3,113 Prepaid (Accrued) benefits expense. . . . . . $ (3,781) The assumed 1993 health care cost trend rates used to measure the expected cost of benefits covered by the plans are 9% and 12% for the utility and non-utility operations, respectively. Both trend rates decrease through 2003 to an ultimate rate of 5.75%. The trend rates are for pre-65 benefits since most of the plans provide a fixed dollar annual benefit for retirees over age 65. One Entech subsidiary's plan used a trend rate of 9% decreasing through 2003 to an ultimate rate of 5.75% for post-65 benefits. The effect of a 1% increase in each future year's assumed health care cost trend rates increases the service and interest cost from $3,700,000 to $4,100,000 and the accumulated postretirement benefit obligation from $34,400,000 to $37,500,000. In November 1992, the FASB released Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," (SFAS No. 112) effective for fiscal years beginning after December 15, 1993. The Company adopted SFAS No. 112 with respect to disability related benefits up to age 65 effective January 1, 1994. This statement requires the accrual of a liability or loss contingency for the estimated obligation for postemployment benefits. At December 31, 1993, the Company's postemployment benefit liability is estimated to be $10,600,000, with $9,300,000 and $1,300,000 relating to regulated utility and nonregulated operations, respectively. The utility had recorded a liability and recovered through rates by year-end approximately $2,400,000 for disability-related benefits. The incremental increase in 1994 consolidated expenses due to SFAS No. 112 adoption is estimated to be $1,300,000, all of which relates to non-utility operations. Effective January 1, 1994, the Company is no longer self-insured for a significant portion of the disability-related benefits relating to the Utility Division. The Company will record as a deferred expense in 1994 the additional postemployment benefit liability of $6,900,000 that was incurred by the utility but not recognized while self-insured. The Company will charge a significant portion of this amount to income and will recover it through rates within 10 years. NOTE 10 - Information on industry segments: The Company's principal business includes regulated utility operations involving the generation, purchase, transmission and distribution of electricity and the production, purchase, transportation and distribution of natural gas. The Company, through Entech, engages in nonutility operations principally involving the mining and sale of coal and exploration for, and the development, production, processing and sale of oil and natural gas. The Company, through its Independent Power Group (IPG), manages long-term power sales, invests in cogeneration projects, and provides energy-related support services, including the operation and maintenance of power plants. Substantially all of the natural gas produced by the Company's Canadian utility operations has been sold to the Company's United States utility operations. Operating income before income taxes for utility segments represents operating revenues less total operating expenses and taxes other than income taxes. Operating income for Entech segments represents total revenues less all costs and expenses except interest, interest income and other-net, and income taxes. Depreciation and depletion includes a provision for abandonment of nonproducing leases, amortization of other deferred charges and certain depreciation amounts included in operation expense in the Consolidated Statement of Income. Immaterial intersegment sales are not disclosed. Identifiable assets of each industry segment are those assets used in the Company's operations in such industry segments. Corporate assets are principally miscellaneous special funds, cash and temporary cash investments, other investments and unallocable property. The assets of the Company's Canadian operations were $80,304,000, $83,790,000 and $84,433,000 at December 31, 1993, 1992 and 1991, respectively. Operations Information Operations Information Operations Information Assets and Expenditures SUPPLEMENTARY INFORMATION OIL AND NATURAL GAS PRODUCING ACTIVITIES SUPPLEMENTARY INFORMATION Oil and Natural Gas Producing Activities (Cont.) As determined by utility engineers, natural gas reserves were revised during 1993, 1992 and 1991 due to a change in projected performance or a change in the Company's ownership interest in specific fields. In 1993, Entech's U.S. oil and natural gas reserves increased as a result of the drilling of 55 development wells and 10 exploratory wells in Colorado, North Dakota, Wyoming, Oklahoma and Kansas. Natural gas liquid reserves increased due to the startup of the Fort Lupton, Colorado, gas processing plant in September 1993. Lower oil market prices contributed to downward revisions in U.S. reserves. The Canadian companies participated in 26 development and 13 exploratory wells. Significant gas reserves were added from discoveries in the exploratory wells. Additions in oil reserves were the result of two successful secondary recovery schemes completed in the Manyberries area during 1993. Revisions due to price and performance resulted in a net increase in natural gas liquid reserves and a net decrease in oil reserves. In 1992, the drilling of 43 development wells and one exploratory well in Colorado, Wyoming, and Oklahoma, resulted in additions to Entech's oil and gas reserves in the United States. Price changes also added to the reserves of existing properties. The Canadian companies participated in 59 development and two exploratory wells, resulting in the addition of significant oil and gas reserves. Revisions due to price and improved performance provided a net increase in oil and gas reserves. Natural gas liquid reserves decreased due to a downward revision in unit working interest in the recently developed Shell Caroline area. In 1991, additions to Entech's United States oil and gas reserves resulted from the drilling of 32 development wells and two successful exploratory wells, principally in Colorado, Oklahoma and Wyoming. Acquisitions of new oil and gas properties added reserves in Colorado, North Dakota and Wyoming. Price changes and unsuccessful drilling activities resulted in downward revisions to existing reserves. Additions to oil and gas reserves in Canada resulted from the drilling of 14 development wells in Alberta and one exploratory well in British Columbia. Acquisition of a new oil and gas property, development drilling and favorable production performance in Alberta reflect upward revisions in reserves. Natural gas reserves and associated liquids were revised downward as a result of revised estimates of performance in 26 mature Alberta fields and market price declines. The following table presents information for 1993, 1992 and 1991 on the capitalized costs relating to utility natural gas producing activities, costs incurred in utility natural gas property acquisition, exploration and development activities and certain utility natural gas production costs reflected in results of operations. As a regulated public utility, the Company is authorized to earn a rate of return on its utility natural gas plant rate base. The Company's cost of acquiring utility natural gas reserves and the net cost of natural gas in underground storage are included in the natural gas plant which is a part of the utility rate base. Due to the commingling of produced natural gas with purchased and royalty natural gas for sale to utility customers and application of the ratemaking process to the utility natural gas producing activities, the Company is unable to identify revenues resulting solely from utility natural gas producing activities. Accordingly, the information on revenues, income taxes, results of operations and estimated future net cash flows and changes therein relating to proved utility natural gas reserves are not presented for the Company's utility natural gas producing activities. The following table presents information for 1993, 1992 and 1991 on the capitalized costs relating to Entech oil and natural gas producing activities, costs incurred in Entech oil and natural gas property acquisition, exploration and development activities and results of Entech operations for oil and natural gas producing activities: SUPPLEMENTARY INFORMATION Oil and Natural Gas Producing Activities (Cont.) Estimated future cash inflows are computed by applying year-end prices and contract prices, when appropriate, of oil and natural gas to year-end quantities of proved reserves. Estimated future development and production costs are determined by estimating the expenditures to be incurred in developing and producing the proved oil and natural gas reserves at the end of the year, based on year-end costs. Estimated future income tax expenses are calculated by applying year-end statutory tax rates to estimated future pretax net cash flows related to proved oil and natural gas reserves, less the tax basis of the properties involved. The future income tax expenses give effect to permanent differences, tax credits and deferred taxes relating to proved oil and natural gas reserves. These estimates are furnished and calculated in accordance with requirements of the Financial Accounting Standards Board and the Securities and Exchange Commission (SEC). Management believes the usefulness of these projections is limited because of the unpredictable variances in expenses, capital forecasts and crude oil and natural gas prices. Estimates of future net cash flows presented do not represent management's assessment of future profitability or future cash flow to the Company. Management's investment and operating decisions are based upon reserve estimates that include proved reserves prescribed by the SEC as well as probable reserves, and upon different price and cost assumptions from those used here. Standardized Measure of Discounted Future Net Cash Flows and Changes Therein Relating to Proved Oil and Natural Gas Reserves Extensions, discoveries, and improved recovery, less related costs, represent the present value of current year reserve additions valued at year-end prices less actual unit production costs for the current year. For the years 1993 and 1992, the amount described as other is primarily the result of changes in the timing of production. Quarterly Financial Data Operating revenues, operating income and net income in thousands of dollars and net income per common share for the four quarters of 1993 and 1992 are shown in the tables below. Due to the seasonal nature of the utility business, the annual amounts are not generated evenly by quarter during the year. ITEM 9. ITEM 9. DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS See Item 1. Business - "Executive Officers." Information on Directors is incorporated by reference from the Company's Notice of 1994 Annual Meeting of Shareholders and Proxy Statement, pages 2-5. Information on Section 16(a) compliance is incorporated by reference from the Company's Notice of 1994 Annual Meeting of Shareholders and Proxy Statement, page 20. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from Notice of 1994 Annual Meeting of Shareholders and Proxy Statement, pages 9-12. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from Notice of 1994 Annual Meeting of Shareholders and Proxy Statement, pages 5-7. 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) Please refer to Item 8, "Financial Statements and Supplementary Data" for a complete listing of all consolidated financial statements and financial statement schedules. (b) The Company filed the following reports on Form 8-K: Date Subject None ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. 3. Exhibits Incorporation by Reference Previous Previous Exhibit Filing Designation 3(a) Restated Articles of Incorporation 33-42882 4(a) 3(a)(1) Restated Articles of Incorporation 3(a)(2) Amendments to the Restated Articles of Incorporation 3(b) By-laws, as amended 33-42882 4(b) 4(a) Mortgage and Deed Trust 2-5927 7(e) 4(b) First Supplemental Indenture 2-10834 4(e) 4(c) Second Supplemental Indenture 2-14237 4(d) 4(d) Third Supplemental Indenture 2-27121 2(a)-5 4(e) Fourth Supplemental Indenture 2-36246 2(a)-6 4(f) Fifth Supplemental Indenture 2-39536 2(a)-7 4(g) Sixth Supplemental Indenture 2-49884 2(a)-8(a) 4(h) Seventh Supplemental Indenture 2-52268 2(a)-9 4(i) Eighth Supplemental Indenture 2-53940 2(a)-10 4(j) Ninth Supplemental Indenture 2-55036 2(a)-11 4(k) Tenth Supplemental Indenture 2-63264 2(a)-12 4(l) Eleventh Supplemental Indenture 2-86500 2(a)-13 4(m) Twelfth Supplemental Indenture 33-42882 4(c) 4(n) Thirteenth Supplemental Indenture 33-55816 4(a)-14 4(o) Fourteenth Supplemental Indenture 33-64576 4(c) 4(p) Fifteenth Supplemental Indenture 33-64576 4(d) 4(q) Sixteenth Supplemental Indenture 33-50235 99(a) 4(r) Seventeenth Supplemental Indenture Instruments defining the rights of holders of long-term debt which are not required to be filed with the Commission will be furnished to the Commission upon request. Incorporation by Reference Previous Previous Exhibit Filing Designation 4(m) Rights Agreement dated as of 33-42882 4(d) June 6, 1989, between The Montana Power Company and First Chicago Trust Company of New York, as Rights Agent 10(a)(i) Benefit Restoration Plan for 33-42882 10(a)(i) Senior Management Executives and Board of Directors 10(a)(ii) Deferred Compensation Plan for 33-42882 10(a)(ii) Non-Employee Directors Incorporation by Reference Previous Previous Exhibit Filing Designation 10(a)(iii) Long-Term Incentive Stock 1-4566 10(a)(iii) Ownership Plan 1992 Form 10-K 10(a)(iv) The Montana Power Company 33-28096 4(c) Employee Stock Ownership Plan (Revised) 10(a)(v) Termination Compensation 1-4566 10(a)(v) Agreements with Senior 1992 Management Executives Form 10-K 10(c) Participation Agreements among 33-42882 10(c) United States Trust Company of New York, Burnham Leasing Corporation, and SGE (New York) Associates, Certain Institutions, The Montana Power Company and Bankers Trust Company 12 Statement re computation of ratio of earnings to Fixed Charges 21 Subsidiaries of the registrant THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) Year Ended December 31, 1993 Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) Year Ended December 31, 1992 Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING INTANGIBLES) Year Ended December 31, 1991 Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (a) Thousands of Dollars THE MONTANA POWER COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Thousands of Dollars 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 MONTANA POWER COMPANY By /s/ Daniel T. Berube Daniel T. Berube (Chairman of the Board) Date March 22, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Daniel T. Berube Principal Executive Daniel T. Berube Officer and Director March 22, 1994 (Chief Executive Officer) /s/ J. P. Pederson Principal Financial J. P. Pederson and Accounting Officer March 22, 1994 (Vice President and Chief and Director Financial Officer) /s/ J. J. Burke Director March 22, 1994 J. J. Burke /s/ Alan F. Cain Director March 22, 1994 Alan F. Cain /s/ R. D. Corette Director March 22, 1994 R. D. Corette /s/Kay Foster Director March 22, 1994 Kay Foster /s/ Robert P. Gannon Director March 22, 1994 Robert P. Gannon /s/ Beverly D. Harris Director March 22, 1994 Beverly D. Harris /s/ Chase T. Hibbard Director March 22, 1994 Chase T. Hibbard /s/ Daniel P. Lambros Director March 22, 1994 Daniel P. Lambros /s/ Carl Lehrkind, III Director March 22, 1994 Carl Lehrkind, III /s/ James P. Lucas Director March 22, 1994 James P. Lucas /s/ Arthur K. Neill Director March 22, 1994 Arthur K. Neill /s/ George H. Selover Director March 22, 1994 George H. Selover /s/ N. E. Vosburg Director March 22, 1994 N. E. Vosburg Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 No. 33-64922, to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 No. 33-43655, to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 No. 33-64576, to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 No. 33-24952, to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 No. 33-28096, to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 No. 33-32275 and to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 No. 33-55816 of our report dated February 10, 1994 appearing on page 41 of The Montana Power Company's Annual Report on Form 10-K for the year ended December 31, 1993. PRICE WATERHOUSE Portland, Oregon March 28, 1994 EXHIBIT INDEX Exhibit 3(a)(1) Restated Articles of Incorporation Exhibit 3(a)(2) Amendments to the Restated Articles of Incorporation Exhibit 4(r) Seventeenth Supplemental Indenture Exhibit 12 Statement re computation of ratio of earnings to Fixed Charges Exhibit 21 Subsidiaries of the registrant

12400_1993.txt

12400_1993

1993

12400

ITEM 1. BUSINESS GENERAL The Company was incorporated under the laws of South Dakota in 1941 under the name Black Hills Power and Light Company. In 1986 the Company changed its name to Black Hills Corporation and now operates its investor-owned electric public utility operations under the assumed name of Black Hills Power and Light Company. In addition the Company has diversified into coal mining through Wyodak Resources and into oil and gas production through Western Production. Black Hills Power is engaged in the generation, purchase, transmission, distribution and sale of electric power and energy to approximately 53,330 customers in 11 counties in western South Dakota, northeastern Wyoming and southeastern Montana. The territory served by Black Hills Power includes 20 incorporated communities and various unincorporated and rural areas with a population estimated at 165,000. The largest community served is Rapid City, South Dakota, with a population, including environs, estimated at 75,000. Rapid City is the major retail, wholesale and health care center for a 250-mile radius. Principal industries in the territory served are tourism (including small stake casino gambling at Deadwood), cattle and sheep raising, farming, milling, meat packing, lumbering, the production of cement, the mining of bentonite, stone, gravel, silica sand, gold, silver, coal and other minerals, the manufacture of electronic products, wood products and gold jewelry, and the production and refining of oil. Black Hills Power serves a substantial portion of the electric needs of the Black Hills tourist region which includes the National Shrine of Democracy, Mount Rushmore National Memorial and the Crazy Horse Memorial, a large granite mountain carving under construction as a memorial to native Americans and one of their leaders. Tourism has been and is expected to continue to be enhanced significantly by the establishment of small stakes casino gambling at Deadwood, South Dakota, which is a part of Black Hills Power's service territory. Although only a small portion of EAFB is served by Black Hills Power, EAFB forms a significant economic base for the territory served. Wyodak Resources, incorporated under the laws of Delaware in 1956, is engaged in the mining and sale of sub-bituminous coal. The coal mining operation is located approximately five miles east of Gillette, Wyoming. In 1986, Wyodak Resources acquired all of the outstanding capital stock of Western Production, an oil and gas exploration, producing and operating company incorporated under the laws of Wyoming. Western Production is an oil producing and operating company with interests located in the Rocky Mountain Region and Texas. Western Production also has a partial interest in a natural gas processing plant. Information as to the continuing lines of business of the Company for the calendar years 1991-1993 is as follows: Reference is made to the Consolidated Statements of Income and Note 11 of "Notes to Consolidated Financial Statements" appended hereto. ELECTRIC POWER SALES AND SERVICE TERRITORY ELECTRIC POWER SALES--RETAIL. Even though Black Hills' service area again experienced milder than normal summer weather, Black Hills Power's firm kilowatt hour sales increased in 1993 by 3.5 percent over 1992. The increase in energy sales is largely due to an increase in the number of customers and their use of electricity. Firm energy sales are forecast to increase over the next ten years at an annual compound growth rate of approximately 2.5 percent. During the next ten years the peak system demand is forecast to increase at an annual compound growth rate of 2.6 percent. These forecasts are from studies conducted by Black Hills Power with the help of outside consultants whereby the service territory of Black Hills Power is carefully examined and analyzed to estimate changes in the needs for electrical energy and demand over a 20-year period. These forecasts are only estimates, and the actual changes in electric sales may be substantially different. In the past Black Hills Power's forecasts have tracked actual sales within a band of reasonable performance. Electric sales are materially affected by weather. Like 1992, Black Hills Power's electric service territory again experienced a cool summer in 1993, resulting in degree days that were 59 percent lower than normal for the 1993 summer months. Consequently, energy sales and peak demand were substantially less during the cooling season than they would have been in a normal weather year. RETAIL ELECTRIC SERVICE TERRITORY. Black Hills Power's service territory is currently protected by assigned service area and franchises that generally grant to Black Hills Power the exclusive right to sell all electric power consumed therein, subject to providing adequate service. See--COMPETITION IN ELECTRIC UTILITY BUSINESS--COMPETITION IN SERVICE AT RETAIL under this Item 1. At the end of 1993, Black Hills served electric energy to 53,330 customers in a population island that includes the major population centers of the Black Hills area in western South Dakota and northeastern Wyoming and a small oil field in southeastern Montana. (See--GENERAL under this Item 1 for a general description of the service territory.) Black Hills Power's electric service territory is experiencing modest business and population growth. In 1993 the value of commercial building permits in Rapid City increased by 91 percent, and residential building permits increased 10.5 percent. South Dakota's unemployment rate in 1993 averaged 3.4 percent. Personal income in South Dakota increased 7.3 percent in 1993 and visitor spending in South Dakota increased by 14 percent. The Company believes that this growth in its electric service territory will continue; however, the Company can give no assurances. One of the major employers in the Rapid City area is the United States Defense Department's EAFB. EAFB is a military air force base near Rapid City, South Dakota. Its current mission is to serve as the training, operation and maintenance base for the Air Force's B-1 bombers. There are now stationed at EAFB 30 B-1 bombers, out of the Defense Department's total of 96 B-1s, of which 80 are operational. Black Hills Power does not provide electric service to EAFB. However, currently EAFB employs approximately 5,200 military and 600 civilian personnel. In addition to these direct employees, additional nongovernmental employees residing in Rapid City and the surrounding area depend upon the continual operation of EAFB. Many of the persons with these jobs reside in the service territory of Black Hills Power. Many businesses in Black Hills Power's service territory are at least partially dependent upon the operations at EAFB. The exact economic impact from a closing of EAFB on Black Hills Power's electric sales cannot be estimated. While the impact would be felt, there are other businesses that would not be affected and are experiencing growth for other reasons in Black Hills Power's electric service territory. While the future of EAFB is not certain, management believes that the mission of EAFB assures that the base will continue. Emphasis on reducing the budget deficit and the deemphasis of military spending are expected to result in additional military base closings. The independent commission that recommends base closings is expected to make its recommendations in 1995 for the next base closings. If the United States Congress or the Administration does not interfere with those recommendations, those bases as recommended for closing are expected to be subsequently closed. There are many criteria used by the independent commission in making its decision, but three of the most important considerations are the strategic importance of the mission of the base, civilian encroachments interfering with the safe operation of the base, and the amount and timing of the savings or payback to the government resulting from such closings. EAFB personnel have been complaining about certain civilian business and housing encroachments to the flight line of the base. The City of Box Elder and the State of South Dakota are expected to take corrective action to satisfy those complaints, but no assurances can be given that the encroachments will be eliminated. Box Elder has already placed a moratorium on new buildings in the encroachment zone. Because of the large number of employees at EAFB and the cost of maintaining EAFB, a large savings would result to the Department of Defense from the closing. The Company believes, however, that the strategic mission of the base (the training, maintenance and operation of the B-1 bombers) and the open, low-populated area in western South Dakota and eastern Wyoming that is available for practicing bombing runs along with strong community support of the base should result in no EAFB closing. This may depend, however, upon the continual support by the Department of Defense and Congress of the B-1 bomber program. Due to cost overruns and failures of some tactical ancillary equipment along with debates on the need for long-range bombing capability in light of the end of the cold war have caused the B-1 bomber program to be somewhat controversial. This controversy has led to a decision to run the B-1 through extensive tests during 1994. EAFB has announced that those tests will be conducted at EAFB. Currently the Clinton Administration's budget provides for the Air Force to maintain an active, operational B-1 bomber fleet of 50. A fleet of 50 is believed to require the B-1s to be operated from two bases. The current Air Force plan is to base its operational B-1s only at EAFB and Dyess Air Force Base, Texas. The EAFB receives strong support from the Black Hills communities and the State of South Dakota and is the only major military establishment of the Department of Defense located in South Dakota. For all of these reasons, the Company believes that the EAFB will survive the next round of base closings, but the Company can give no assurances. Two other major industries in Black Hills' service territory suffering some stress are the lumbering industry and gold mining industry. The lumbering industry has already suffered substantial cutbacks due to government cutbacks in timber harvesting. Some impact has already occurred. The gold mining industry, including Homestake Mining Company (representing 11.8 percent of Black Hills' total firm KWH sales in 1993 and 8.2 percent of firm electric sales revenue) depends largely upon the price of gold and continuing to find economically minable ore reserves. Homestake has gradually over the years reduced the number of employees, and this impact has substantially occurred. Homestake recently abandoned a deep exploration program 6,000 feet underground to a location north of its present mine to locate another ore body that would have economically justified the construction of another shaft and the extension of the underground mine for several years. However, Homestake did recently report the discovery of some additional deep reserves at its present underground mining location below the 7,000-foot level. Unless a substantial reduction in the current price of gold occurs, the Company believes that the gold mining industry will be stable in the Black Hills area for at least the next ten years; however, the life of mines cannot be predicted, and no assurances can be given. The new industry of low stakes casino gambling at Deadwood (located in Black Hills Power's service territory) continues to experience modest growth despite the South Dakota voters' rejection of raising the $5 betting limit to $100. The Black Hills area continues to attract new small businesses and retirees who are attracted by a quality place to live. ELECTRIC SALES--WHOLESALE. At this time the only firm wholesale customer of Black Hills Power is the municipal electric system at Gillette, Wyoming. Service is rendered under a long- term contract expiring July 1, 2012 wherein Black Hills Power undertakes the obligation to serve the City of Gillette 60 percent of its highest demand and that associated energy as if the demand served by Black Hills Power was always Gillette's first demand. The agreement also allows Gillette to obtain the benefits of a 4,000 kilowatt average firm power purchase agreement from WAPA. Gillette's highest demand to date is 38.78 megawatts, making Black Hills' current base load obligation to serve 23 megawatts. The most recent average yearly capacity factor of this 23 megawatt demand has been approximately 80 percent. Revenue from sales to Gillette represented 8 percent of revenue from total sales in 1993. Black Hills Power is further obligated to serve the next increment of 10 megawatts of Gillette's demand above 33 megawatts if Gillette is unable to obtain other sources. Subject to certain emergency conditions, once Black Hills Power serves a full increment of another 10 megawatts, that increment is added to Black Hills Power's firm obligation to serve. When Gillette serves 10 megawatts, that increment is added to Gillette's firm obligation to serve. At this time Gillette has obtained resources to serve its load above the 60 percent of base load obligation of Black Hills Power. However, Gillette's resources come from short-term contracts, so Black Hills Power is required to stand by to serve a 10 megawatt increment of capacity to Gillette. Other than this firm sale to the City of Gillette, Black Hills Power has made only minimal energy sales to other utilities. FUTURE WHOLESALE OPPORTUNITIES. Black Hills Power has not had sufficient surplus resources in the past to effectively engage in the wholesale electric market. Therefore, to date Black Hills Power has not developed any wholesale markets other than the Gillette sale. If utility retail sales do not increase as expected, the addition of Neil Simpson Unit #2 may result in surplus power and energy. In that event, Black Hills Power would explore all possible avenues to sell that surplus power. Due to the inability to serve firm power to the east of Black Hills Power's service territory without high-cost AC-DC-AC converter stations because of the incompatibility of the east and west transmission systems, Black Hills Power's opportunities for wholesale sales are restricted to the western system. Black Hills Power maintains two firm interconnections to the western system, one with WAPA's western transmission system at Stegall, Nebraska and one with Pacific Power's transmission system at the Wyodak Plant. These two interconnections give Black Hills Power the potential ability to sell power wholesale to any utility entity in the western part of the United States if transmission charges are paid. See--COMPETITION IN ELECTRIC UTILITY BUSINESS - --TRANSMISSION ACCESS under this Item 1. Whether physical transmission limitations exist that would restrict such sales by Black Hills Power is unknown for any particular sale, but Black Hills Power believes that the western transmission system is adequate at this time to accommodate the relatively small sale of wholesale power required for Black Hills Power to sell any surplus resulting from Neil Simpson Unit #2. The revenue received from such a sale would depend on transmission costs, the type of sale Black Hills Power would make (i.e., firm long-term or short-term, capacity sale with minimum energy or base load sale with maximum energy, unit power from Neil Simpson Unit #2 only or system power with reserves), and the competitive market at the time such sale is made. The needs of Black Hills to serve its present retail and wholesale commitments and the regulatory treatment of Neil Simpson Unit #2 will govern the type of power and energy sale Black Hills Power would be able to make. All of these conditions are unknown at this time, but Black Hills Power will be carefully studying these conditions as the operating date for Neil Simpson Unit #2 approaches. ELECTRIC POWER SUPPLY GENERAL. In 1993 Black Hills Power retired three 5 megawatt low-pressure units at the Kirk Station. Obsolescence and high costs of operation made these units no longer economical to operate and maintain. Black Hills Power owns generation with a nameplate rating totalling 283.21 megawatts. See--UTILITY PROPERTIES under Item 2. ITEM 2. PROPERTIES UTILITY PROPERTIES The following table provides information on the generating plants of Black Hills Power. During 1993, 99 percent of the fuel used in electric generation, measured in Btus (British thermal units), was coal. Black Hills Power owns transmission lines and distribution systems in and adjoining the communities served consisting of 445 miles of 230 kV, 4 miles of 115 kV, 532 miles of 69 kV, 8 miles of 47 kV and numerous distribution lines of less voltage. Black Hills Power owns a service center in Rapid City, several district office buildings at various locations within its service area, and an eight-story home office building at Rapid City, South Dakota housing its home office on four floors, with the balance of the building rented to three tenants. MINING PROPERTIES Wyodak Resources is engaged in mining and processing sub- bituminous coal near Gillette in Campbell County, Wyoming. The coal averages 8,000 Btus per pound. Mining rights to the coal are based upon coal owned and five federal leases. The estimated tons of recoverable coal from each source as of December 31, 1993 are set forth in the following table: ESTIMATED TONS OF RECOVERABLE COAL (IN THOUSANDS) Fee coal 1,381 Federal lease dated May 1, 1959 19,763 Federal lease dated April 1, 1961 7,703 Federal lease dated October 1, 1965 117,534 Federal lease dated September 28, 1983 20,355 Federal lease dated March 1, 1983 22,604 189,340 Coal reserves are estimated at 189,340,000 tons of which approximately 32,250,000 tons are committed to be sold to the Wyodak Plant, approximately 10,000,000 tons to Black Hills Power's other plants, and 20,000,000 tons for Neil Simpson Unit #2. Purchase options are granted on 52,000,000 tons of which options for 50,000,000 tons can be exercised only if Wyodak Resources has not committed the coal reserves to other buyers prior to such exercise. Because the coal purchase price that will be paid if the options are exercised would be substantially higher than prices being paid under new coal contracts, it is unlikely that the options will be exercised. In 1989 an oil and gas developer established two oil- producing wells on the north portion of the lease dated October 1, 1965. The oil was leased to the developer by the owner of the oil rights, the State of Wyoming, and the coal is leased by Wyodak Resources from the owner of the coal rights, the federal government through its BLM. The oil is produced from a formation at a depth of approximately 9,000 feet while the coal is mined by the open pit method at a depth of 200 to 300 feet. Therefore, it is impossible to mine coal in the vicinity of the oil wells and maintain and operate the oil wells at the same time. The law is uncertain as to who would have priority under these circumstances. To date this conflict would affect approximately 15,000,000 tons of coal. At this time Wyodak Resources does not plan any mining operations at the site of the oil wells for at least 15 years, but the life of oil wells may extend for many years beyond 15. To mitigate its potential damages, Wyodak Resources has negotiated an option to purchase the oil wells at fair market value if a mining conflict should occur. Each federal lease grants Wyodak Resources the right to mine all of the coal in the land described therein, but the government has the right at the end of 20 years from the date of the lease to readjust royalty payments and other terms and conditions. All of the federal leases provide for a royalty of 12.5 percent of the selling price of the coal. Each federal lease requires diligent development to produce at least one percent of all recoverable reserves within either 10 years from the respective dates of the 1983 leases or 10 years from the date of adjustment of the other leases. Each lease further requires a continuing obligation to mine, thereafter, at an average annual rate of at least one percent of the recoverable reserves. All of the federal leases and its remaining fee coal constitute one logical mining unit and is treated as one lease for the purpose of determining diligent development and continuing operation requirements. All coal is to be mined within 40 years from 1992, the date of the logical mining unit. Even if federal coal leases are not mined out in 40 years, the federal coal is likely to be available for further lease after the 40 years. Wyodak Resources' current coal agreements require production which should be sufficient to satisfy the diligent development and continual operation requirements of present law. Wyodak Resources will require additional coal sales in order to mine all of its federal coal within the 40 year requirement. The law, which requires that an owner of land that is primarily devoted to agriculture must approve a reclamation plan before the state will approve a permit for open pit mining, affects approximately 3,100,000 tons of the recoverable coal included in the federal lease dated October 1, 1965. Wyodak Resources has excluded these tons of coal from its mine plan and will not mine such coal until a surface consent has been negotiated or the right to mine has been settled by litigation. Approximately 32,250,000 tons of the Federal Coal Lease dated October 1, 1965, has been mortgaged as security for the performance of its obligations under the coal supply agreement for the Wyodak Plant. In 1992, Pacific Power, the Company and Wyodak Resources entered into an agreement providing for the construction of new coal handling facilities. The new coal handling facilities consist of an in-pit system (consisting of in-pit movable crushers and a conveyor to a secondary crusher transfer point), an out-of-pit system (consisting of the secondary crusher), new truck load-out facilities, a conveyor to deliver coal to Neil Simpson Unit #1 and a conveyor to deliver coal to the Wyodak Plant and eventually to Neil Simpson Unit #2. The total construction costs of these facilities is expected to be $24,500,000, of which Pacific Power will pay $19,000,000 and Wyodak Resources $5,500,000. The reason for the large amount being paid by Pacific Power is that under the PacifiCorp Settlement, Pacific Power was obligated to pay up to $15,000,000, plus an amount to adjust for inflation since 1987, for new coal handling facilities which were required to extend the mining of coal to another pit, the Peerless area, situated west of the Wyodak Plant. Under the agreement among PacifiCorp, the Company and Wyodak Resources, Wyodak Resources will operate the in-pit system, the conveyor to Neil Simpson Unit #1 and the truck load-out system, and PacifiCorp will operate the secondary crusher transfer building and the conveyor to the Wyodak Plant. The agreement provides for the use of the new coal handling facilities to deliver coal to the Wyodak Plant, Neil Simpson Unit #1, Neil Simpson Unit #2, the truck load-out and, if there is sufficient capacity, to additional power plants to be constructed at the site. The agreement provided for Black Hills Power to own certain undivided interests of these facilities, but Black Hills Power and Wyodak Resources have entered into an agreement providing for the transfer of all interests of Black Hills Power in these facilities to Wyodak Resources. This transfer is consistent with the agreement of Wyodak Resources to deliver Black Hills Power completely processed coal. OIL AND GAS PROPERTIES Western Production operates 347 wells as of December 31, 1993. The vast majority of these wells are in the Finn Shurley Field, located in Weston and Niobrara Counties, Wyoming. Twelve of the wells Western Production operates are located in Adams and Weld Counties, Colorado, two are located in Washakie County, Wyoming and two are located in Fall River County, South Dakota. Western Production does not operate but owns a working interest in 39 producing properties located in Wyoming, Kansas, Colorado, Montana, North Dakota and Texas. The majority of wells operated by Western Production were drilled between 1977 and 1984, prior to its acquisition by Wyodak Resources. They were drilled under drilling programs wherein working interests were sold to various investors. Approximately 232 investors own working interests in wells operated by Western Production. Western Production owns a 44.7 percent interest in a natural gas processing plant also located at the Finn Shurley Field. The gas plant is operated by Western Gas Resources, Inc. of Denver, Colorado, which owns a 50 percent interest therein and processes all the gas produced from the Finn Shurley Field and the Boggy Creek Field. The following table summarizes Western Production's estimated quantities of proved developed and undeveloped oil and natural gas reserves at December 31, 1993 and 1992, and a reconciliation of the changes between these dates using constant product prices for the respective years. These estimates are based on reserve reports by Ralph E. Davis Associates, Inc. (an independent engineering company selected by the Company). Such reserve estimates are based upon a number of variable factors and assumptions which may cause these estimates to differ from actual results. Western Production has approximately 99,000 gross and 65,000 net acres of oil and gas leases, out of which 25,000 gross and 15,000 net acres are producing and 74,000 gross and 50,000 net acres are undeveloped. Approximately 23 percent of the undeveloped acres are held by production thereby not requiring annual delay rental payments. No representations are made that reserves can be attributed to any undeveloped oil and gas leases. Undeveloped leasehold that are not held by production have varying provisions but generally terminate if oil and gas is not produced within the primary term of the lease. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in minor routine administrative proceedings and litigation incidental to the businesses, none of which, in the opinion of management, will have a material effect on the consolidated financial statements 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 during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE COMPANY The following is a list of all executive officers of the Company. There are no family relationships among them. Officers are normally elected annually. Daniel P. Landguth, born May 9, 1946, Chairman, President, and Chief Executive Officer of Black Hills Corporation Mr. Landguth was elected to his present position in January 1991. He had served as President of Black Hills Corporation since October 1989, President and Chief Operating Officer of Black Hills Power since June 1987, and Senior Vice President and Chief Operating Officer since 1985. Dale E. Clement, born August 1, 1933, Senior Vice President - Finance Mr. Clement was elected to his present position in September 1989. He had served on the Board of Directors since 1979. Prior to joining the Company he was Dean and Professor of Finance at the University of South Dakota, School of Business. Joseph E. Rovere, born July 7, 1929, Vice President - Public Affairs/District Administration Mr. Rovere was elected to his present position in October 1982. Roxann R. Basham, born August 6, 1961, Secretary and Treasurer Mrs. Basham was elected to her present position January 1, 1993. She had served as Assistant Secretary/Treasurer since May 1991 and as Financial Analyst since February 1985. Gary R. Fish, born August 1, 1958, Controller Mr. Fish was elected to his present position in August 1988. Everett E. Hoyt, born August 8, 1939, President and Chief Operating Officer of Black Hills Power Mr. Hoyt was elected to his present position in October 1989. Prior to joining the Company he was Senior Vice President - Legal, Corporate Secretary, and Assistant Treasurer of Northwestern Public Service Company. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by Item 5 is provided in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on page 32 appended hereto and market price information is shown in Note 13 of "Notes to Consolidated Financial Statements" on page 29 of the Annual Report to Shareholders of the Company for the year ended December 31, 1993, appended hereto. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by Item 6 is provided under an identical caption in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on page 29 appended hereto. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information required by Item 7 is provided under a similar caption in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on pages 12 through 18 appended hereto. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by Item 8 is provided under proper captions in the Annual Report to Shareholders of the Company for the year ended December 31, 1993, on pages 20 through 29 appended hereto. Selected quarterly financial data is shown in Note 13 of "Notes to Consolidated Financial Statements" on page 29 of the Annual Report to Shareholders of the Company for the year ended December 31, 1993, appended hereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change of accountants or disagreements on any matter of accounting principles or practices or financial statement disclosure have occurred. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Company is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. For information regarding the executive officers of the Company refer to Part I, Item 4. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding management remuneration and transactions is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding the security ownership of certain beneficial owners and management is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions is incorporated herein by reference to the Proxy Statement for the Annual Shareholders' Meeting to be held May 24, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Index to Consolidated Financial Statements Page Reference* Report of Independent Public Accountants. . . . .19 Consolidated Statements of Income and Retained Earnings for the three years ended December 31, 1993. . . . . . . . . . . . .20 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. . . . .21 Consolidated Balance Sheets at December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . . . .22 Consolidated Statements of Capitalization at December 31, 1993 and 1992 . . . . . . . . . . .23 Notes to Consolidated Financial Statements. . 24-29 2. Schedules ** V Property, Plant, and Equipment for the three years ended December 31, 1993 VI Accumulated Depreciation and Depletion of Property, Plant, and Equipment for the three years ended December 31, 1993 IX Short-Term Borrowings for the three years ended December 31, 1993 * Page References are to the incorporated portion of the Annual Report to Shareholders of the Company for the year ended December 31, 1993. ** All other schedules have been omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements incorporated by reference in the Form 10-K. 3. Exhibits *3(a) Bylaws dated December 10, 1991 (Exhibit 3(a) to Form 10-K for 1991). *3(b) Restated Articles of Incorporation dated July 28, 1986 (Exhibit 3(b) to Form 10-K for 1986). Articles of Amendment to Restated Articles of Incorporation dated May 21, 1987, (Exhibit 3(b) to Form 8-K for May 1987, File No. 0-0164). Articles of Amendment to Restated Articles of Incorporation dated May 16, 1989 (Exhibit 3(b) to Form 10-K for 1989). Articles of Amendment to Restated Articles of Incorporation dated May 28, 1992 (Exhibit 3(b) to Form 10-K for 1992). Articles of Correction to Amendment to Restated Articles of Incorporation, dated September 13, 1993 (Exhibit 4.03 to Form S-3 dated September 22, 1993, Registration No. 33- 69234). *4(a) Reference is made to Article Fourth (7) of the Restated Articles of Incorporation of the Company and the Articles of Amendment to Restated Articles of Incorporation (Exhibit 3(b) hereto). *4(b) Indemnification Agreement and Company and Directors' and Officers' indemnification insurance (Exhibit 4(b) to Form 10-K for 1987). *4(c) Indenture of Mortgage and Deed of Trust, dated September 1, 1941, and as amended by supplemental indentures (Exhibit B to Form 8-K, File No. 2-4832); (Exhibit 7-B, File No. 2-6576); (Exhibit 7-C, File No. 2-7695); (Exhibit 7-D, File No. 2-8157); (Exhibit A to Form 10-K for fiscal year 1950, File No. 2-4832); (Exhibit 4-I, File No. 2-9433); (Exhibit 4-H, File No. 2-13140); (Exhibit 4-I, File No. 2-14829); (Exhibits 4-J and 4-K, File No. 2-16756); (Exhibits 4-L, 4-M, and 4-N, File No. 2-21024); (Exhibits 2(q), 2(r), 2(s), 2(t), 2(u), and 2(v) to Form S-7, File No. 2-57661); (Exhibit (b) to Form 8-K for February 1977, File No. 2-4832); (Exhibit II-1 to Form 10-Q for quarter ended April 30, 1977, File No. 2-21024); (Exhibit II-1 to Form 10-Q for quarter ended July 31, 1977, File No. 2-21024); (Exhibit 4(b) to Form S-3, File No. 2-81643); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1986, File No. 0-0164); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1987, File No. 0-0164); (Exhibit II-6a to Form 10-Q for quarter ended September 30, 1988, File No. 0-0164); and (Exhibit 4(d) and 4(e) to Post- Effective Amendment No. 1 to Form S-8, File No. 33-15868). *10(a) Coal Supply Agreement dated May 12, 1975, between Wyodak Resources Development Corp. and the South Dakota Cement Commission (Exhibit 5(d) to Form S-7, File No. 2-57661). Extension of Coal Supply Agreement dated June 2, 1980, and First Supplement dated February 8, 1983 (Exhibit 10(c) to Form 10-K for 1983). Second Supplement to Extension of Coal Supply Agreement dated June 1, 1985 (Exhibit 10(c) to Form 10-K for 1985). Third Supplement to Extension of Coal Supply Agreement dated July 14, 1986 (Exhibit 10(c) to Form 10-K for 1986). Fourth Supplement to Extension of Coal Supply Agreement dated December 1, 1987 (Exhibit 10(c) to Form 10-K for 1987). Fifth Supplement to Extension of Coal Supply Agreement dated March 12, 1992 (Exhibit 10(a) to Form 10-K for 1992). *10(b) Agreement for Transmission Service and The Common Use of Transmission Systems dated January 1, 1986, among the Company, Basin Electric Power Cooperative, Rushmore Electric Power Cooperative, Inc., Tri-County Electric Association, Inc., Black Hills Electric Cooperative, Inc., and Butte Electric Cooperative, Inc. (Exhibit 10(d) to Form 10-K for 1987). *10(c) Restated and Amended Coal Supply Agreement for Neil Simpson Unit #2 dated February 12, 1993 (Exhibit 10(c) to Form 10-K for 1992). *10(d) Coal Supply Agreement and First Amendment dated September 1, 1977, between the Company and Wyodak Resources Development Corp. (Exhibit 5(g) to Form S-7, File No. 2-60755). Second Amendment to Coal Supply Agreement dated November 2, 1987 (Exhibit 10(f) to Form 10-K for 1987). *10(e) Coal Lease dated May 1, 1959, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 5(i) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(h) to Form 10-K for 1989). *10(f) Coal Lease dated April 1, 1961, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 5(j) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(i) to Form 10-K for 1989). *10(g) Coal Lease dated October 1, 1965, between Wyodak Resources Development Corp. and the Federal Government, as amended (Exhibit 5(k) to Form S-7, File No. 2-60755). Modified coal lease dated January 22, 1990, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(j) to Form 10-K for 1989). *10(h) Participation Agreement dated May 16, 1978, and various related agreements dated June 8, 1978, including, without limitation, Lease Agreement, Amended and Restated Coal Supply Agreement, Coal Supply System Agreement and Security Agreement, and Real Estate Mortgage (all relating to the lease financing of the Wyodak Plant and the dedication by Wyodak Resources Development Corp. of coal deposits with respect thereto) filed pursuant to item 6(b) of Amendment No. 1 to Registrant's Current Report on Form 8-K for June 1978 and located in Commission File No. 2-4832. Further Restated and Amended Coal Supply Agreement dated May 5, 1987 (Exhibit 10(k) to Form 10-K for 1987). *10(i) Coal Supply Agreement dated August 24, 1978, between Wyodak Resources Development Corp. and the City of Grand Island, Nebraska (Exhibit 5(l) to Form S-7, File No. 2-64014). Restated and Amended Coal Supply Agreement dated March 4, 1983 (Exhibit 10(l) to Form 10-K for 1983). First Amendment to Restated and Amended Coal Supply Agreement dated October 29, 1987 (Exhibit 10(l) to Form 10-K for 1987). *10(j) Power Sales Agreement dated December 31, 1983, between Pacific Power & Light Company and the Company (Exhibit 7(b) to Form 8-K for January 1984, File No. 0-0164). *10(k) Coal Supply Agreement for Wyodak Unit #2 dated February 3, 1983, and Ancillary Agreement dated February 3, 1982, between Wyodak Resources Development Corp. and Pacific Power & Light Company and the Company (Exhibit 10(o) to Form 10-K for 1983). Amendment to greement for Coal Supply for Wyodak #2 dated May 5, 1987 (Exhibit 10(o) to Form 10-K for 1987). *10(l) Coal lease dated February 16, 1983, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(p) to Form 10-K for 1983). *10(m) Coal lease dated September 28, 1983, between Wyodak Resources Development Corp. and the Federal Government (Exhibit 10(q) to Form 10-K for 1983). *10(n) Indenture of Trust dated as of August 1, 1984, City of Gillette, Campbell County, Wyoming, to Norwest Bank Minneapolis, N.A. as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(r) to Form 10-K for 1984). Indenture of Trust dated as of June 1, 1992, City of Gillette, Campbell County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(n) to Form 10-K for 1992). *10(o) Loan Agreement dated as of August 1, 1984, by and between City of Gillette, Campbell County, Wyoming, and the Company (Exhibit 10(s) to Form 10-K for 1984). Loan Agreement dated as of June 1, 1992, by and between City of Gillette, Campbell County, Wyoming, and the Company (Exhibit 10(o) to Form 10-K for 1992). *10(p) Loan Agreement dated as of June 1, 1992, by and between Lawrence County, South Dakota and the Company (Exhibit 10(p) to Form 10-K for 1992). *10(q) Indenture of Trust dated as of June 1, 1992, Lawrence County, South Dakota, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(q) to Form 10-K for 1992). *10(r) Loan Agreement dated as of June 1, 1992, by and between Pennington County, South Dakota and the Company (Exhibit 10(r) to form 10-K for 1992). *10(s) Indenture of Trust dated as of June 1, 1992, Pennington County, South Dakota, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(s) to Form 10K for 1992). *10(t) Loan Agreement dated as of June 1, 1992, by and between Weston County, South Dakota and the Company (Exhibit 10(t) to Form 10-K for 1992). *10(u) Indenture of Trust dated as of June 1, 1992, Weston County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(u) to Form 10-K for 1992). *10(v) Loan Agreement dated as of June 1, 1992, by and between Campbell County, South Dakota and the Company (Exhibit 10(v) to Form 10-K for 1992). *10(w) Indenture of Trust dated as of June 1, 1992, Campbell County, Wyoming, to Norwest Bank Minnesota, National Association, as Trustee (Black Hills Power and Light Company Project) (Exhibit 10(w) to Form 10-K for 1992). *10(x) Restated Electric Power and Energy Supply and Transmission Agreement and Restated Seasonal Non-Firm Power Sale Agreement both dated December 21, 1987, both by and between the Company and the City of Gillette, Wyoming (Exhibit 10(t) to Form 10-K for 1987). *10(y) Reserve Capacity Integration Agreement dated May 5, 1987, between Pacific Power & Light Company and the Company (Exhibit 10(u) to Form 10-K for 1987). *10(z) Firm Capacity and Energy Purchase Agreement between Tri-State Generation and Transmission Association, Inc. and the Company dated May 11, 1992 (Exhibit 10(aa) to Form 10-K for 1992). 10(aa) Firm Capacity and Energy Purchase Agreement between Sunflower Electric Power Cooperative and the Company dated October 11, 1993. *10(bb) Compensation Plan for Outside Directors (Exhibit 10(bb) to Form 10-K for 1992). *10(cc) Retirement Plan for Outside Directors dated January 1, 1993 (Exhibit 10(cc) to Form 10-K for 1992). *10(dd) Pension Equalization Plan of Black Hills Corporation dated January 1, 1990 (Exhibit 10(dd) to Form 10-K for 1992). 10(dd) Amendment #1 to Pension Equalization Plan of Black Hills Corporation dated April 27, 1993. 10(ee) Black Hills Corporation 1994 Executive Gainsharing Program. 10(ff) Black Hills Corporation 1994 Results Compensation Program. *10(gg) Pension Plan of Black Hills Corporation as amended and restated effective October 1, 1989. First amendment to the Pension Plan of Black Hills Corporation dated September 25, 1992. Amendment to the Pension Plan of Black Hills Corporation dated December 4, 1992. Amendment to the Pension Plan of Black Hills Corporation dated February 5, 1993 (Exhibit 10(ff) to form 10-K for 1992). *10(hh) Agreement for Supplemental Pension Benefit for Everett E. Hoyt dated January 20, 1992 (Exhibit 10(gg) to Form 10-K for 1992). *10(ii) Agreement for Supplemental Pension Benefit for Dale E. Clement dated December 19, 1991 (Exhibit 10(hh) to Form 10-K for 1992). 13 Annual Report to Shareholders of the Registrant for the year ended December 31, 1993. 22 Subsidiaries of the Registrant. 23 Consent of Independent Public Accountants. _________________________ * Exhibits incorporated by reference. (b) No reports on Form 8-K have been filed in the quarter ended December 31, 1993. (c) See (a) 3. above. (d) See (a) 2. above. _________________________________________________________________ REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Black Hills Corporation's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, 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. The schedules listed as a part of Item 14.(a)2. in this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic 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. Minneapolis, Minnesota, January 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. BLACK HILLS CORPORATION By DANIEL P. LANDGUTH Daniel P. Landguth, Chairman, President, and Chief Executive Dated: March 11, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. DANIEL P. LANDGUTH Director and Principal March 11, 1994 Daniel P. Landguth (Chairman, Executive Officer President, and Chief Executive) DALE E. CLEMENT Director and Principal March 11, 1994 Dale E. Clement (Senior Vice Financial Officer President - Finance) GARY R. FISH Principal Accounting March 11, 1994 Gary R. Fish (Controller) Officer GLENN C. BARBER Director March 11, 1994 Glenn C. Barber BRUCE B. BRUNDAGE Director March 11, 1994 Bruce B. Brundage MICHAEL B. ENZI Director March 11, 1994 Michael B. Enzi JOHN R. HOWARD Director March 11, 1994 John R. Howard EVERETT E. HOYT Director and Officer March 11, 1994 Everett E. Hoyt (President and Chief Operating Officer of Black Hills Power) KAY S. JORGENSEN Director March 11, 1994 Kay S. Jorgensen CHARLES T. UNDLIN Director March 11, 1994 Charles T. Undlin ___________________________________________________________________________ The Company's short-term borrowings consist solely of notes payable to banks. See Note 4 in the consolidated financial statements for additional discussion on notes payable to banks. The average amount of short-term borrowings outstanding during the year represents an average of daily balances. The weighted average interest rate during the year was based on a weighting of interest rates associated with these balances. ___________________________________________________________________________ APPENDIX BLACK HILLS CORPORATION The following items, appended hereto, are incorporated into the Form 10-K from the 1993 Annual Report to Shareholders: PART II Pages Item 5 Market for Registrant's Common Equity and Related Stockholder Matters . . . . . . . . . 32 Item 6 Selected Financial Data. . . . . . . . . . . . 29 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operation. . . . .12-18 Item 8 Financial Statements and Supplementary Data. . . . . . . . . . . . . . . . . . . .20-29 EXHIBIT INDEX EX-10.aa Firm Capacity and Energy Purchase Agreement between Sunflower Electric Power Cooperative and the Company dated October 11, 1993. EX-10.dd Amendment #1 to Pension Equalization Plan of Black Hills Corporation dated April 27, 1993. EX-10.ee Black Hills Corporation 1994 Executive Gainsharing Program. EX-10.ff Black Hills Corporation 1994 Results Compensation Program. EX-13 Annual Report to Shareholders of the Registrant for the year ended December 31, 1993. EX-22 Subsidiaries of the Registrant. EX-23 Consent of Independent Public Accountants.

4447_1993.txt

4447_1993

1993

4447

ITEM 1. BUSINESS Amerada Hess Corporation (the "Registrant") was incorporated in 1920 in the State of Delaware. The Registrant and its subsidiaries (collectively referred to herein as the "Corporation") are engaged in the exploration for and the production, purchase, gathering, transportation and sale of crude oil and natural gas and the manufacture, purchase, transportation and marketing of petroleum products. EXPLORATION AND PRODUCTION The Corporation's exploration and production activities are located primarily in the United States, Canada and the United Kingdom and Norwegian sectors of the North Sea. The Corporation also conducts exploration and/or production activities in Abu Dhabi, Egypt, Gabon, Namibia and Thailand. Of the Company's proved reserves (on a barrel of oil equivalent basis), 32% are located in the United States, 52% are located in the United Kingdom and Norwegian sectors of the North Sea, 12% are located in Canada and the remainder are located in Gabon and Abu Dhabi. Worldwide crude oil and natural gas liquids production amounted to 215,390 barrels per day in 1993 compared with 224,187 barrels per day in 1992. Worldwide natural gas production was 887,309 Mcf per day in 1993 compared with 924,961 Mcf per day in 1992. At December 31, 1993, the Corporation has 670 million barrels of proved crude oil and natural gas liquids reserves compared with 652 million barrels at the end of 1992. Proved natural gas reserves were 2,653 million Mcf at December 31, 1993 compared with 2,640 million Mcf at December 31, 1992. The Corporation has an inventory of drillable prospects primarily in the United States, Canada and the United Kingdom and Norwegian sectors of the North Sea. UNITED STATES. The Corporation operates principally offshore in the Gulf of Mexico and onshore in the states of Texas, Louisiana and North Dakota. During 1993, 33% of the Corporation's crude oil and natural gas liquids production and 57% of its natural gas production were from United States operations. The table below sets forth the Corporation's average daily net production by area in the United States: CANADA. The Corporation, through its wholly-owned Canadian subsidiary, Amerada Hess Canada Ltd., conducts operations in the Provinces of Alberta and British Columbia. The Corporation's crude oil and natural gas liquids production in Canada amounted to 13,492 net barrels per day in 1993 compared to 13,509 net barrels per day in 1992, and its natural gas production increased to 167,839 net Mcf per day in 1993 from 137,680 net Mcf per day in 1992. UNITED KINGDOM. The Corporation's activities in the United Kingdom are conducted by its wholly-owned British subsidiary, Amerada Hess Limited. During 1993, 39% of the Corporation's crude oil and natural gas liquids production and 21% of its natural gas production were from United Kingdom operations. The table below sets forth the Corporation's average daily net production in the United Kingdom by field and the Corporation's interest in each at December 31, 1993: Crude oil production commenced from the Scott and Hudson Fields in the third quarter of 1993. Natural gas production commenced from the Everest and Lomond Fields in mid-1993. The Angus Field ceased production in June 1993. NORWAY. The Corporation's activities in Norway are conducted through its wholly-owned Norwegian subsidiary, Amerada Hess Norge A/S. The Corporation's Norwegian operations accounted for crude oil and natural gas liquids production of 27,820 and 31,305 net barrels per day in 1993 and 1992, respectively. Approximately 60% of this production is from the Corporation's 28.09% interest in the Valhall Field. GABON. The Corporation has a 5.5% interest in the Rabi Kounga oil field onshore Gabon. The Corporation's share of production from Gabon averaged 8,136 and 6,660 net barrels of crude oil per day in 1993 and 1992, respectively. REFINING AND MARKETING The Corporation's refining facilities are located in St. Croix, United States Virgin Islands and Port Reading, New Jersey. The Purvis refinery operated throughout 1993 but was mothballed in early 1994. Total crude runs in 1993 averaged 351,000 barrels per day. Approximately 12% of the Corporation's crude runs was supplied from the Corporation's production directly, or indirectly under exchange arrangements with other producers. The balance comes from various suppliers under contracts of one year or less and through spot purchases on the open market. Approximately 85% of the petroleum products marketed in 1993 was obtained from the Corporation's refineries. The Corporation purchased the balance from other companies under short-term supply contracts and by spot purchases from various sources. Sales of refined products averaged 386,000 barrels per day in 1993 compared with 377,000 barrels per day in 1992. HESS OIL VIRGIN ISLANDS REFINERY. The Corporation owns and operates a petroleum refinery in St. Croix, United States Virgin Islands through its wholly-owned subsidiary, Hess Oil Virgin Islands Corp. ("HOVIC"). In 1993, refined products produced were approximately 50% gasoline and distillates, 20% refinery feedstocks and the remainder principally residual fuel oil. In addition to crude distillation capacity, the refinery has a fluid catalytic cracking unit which commenced production in the fourth quarter of 1993 and has increased gasoline production. The refinery also has catalytic reforming units, vacuum distillation capacity, visbreakers, a sulfolane unit, a penex unit, distillate desulfurizers, vacuum gas oil desulfurizers and sulfur recovery facilities. The refinery has approximately 30 million barrels of storage capacity. The refinery has the capability to process a variety of crude oils, including high-sulfur crudes. The refinery has a 60-foot-deep harbor and docking facilities for ten ocean-going tankers at one time. The refinery's harbor accommodates very large crude carriers after a portion of their crude oil cargo is lightered at the Corporation's storage and transshipment facility in Saint Lucia, which has a 90-foot-deep harbor. The Saint Lucia facility has approximately 10 million barrels of storage capacity. PORT READING FACILITY. The Corporation owns and operates a fluid catalytic cracking facility in Port Reading, New Jersey, which processes vacuum gas oil and operated at the rate of approximately 50,000 barrels per day in 1993. The Port Reading facility primarily produces gasoline and heating oil. PURVIS REFINERY. In early 1994, the Corporation mothballed its 30,000 barrel per day Purvis, Mississippi refinery. MARKETING. The Corporation markets refined petroleum products principally on the East and Gulf Coasts of the United States to public utilities, industrial and commercial users, governmental agencies, wholesale distributors, commercial airlines and the motoring public. At December 31, 1993, the Corporation has 535 HESS(R) gasoline stations of which approximately 83% are operated by the Corporation. Most of the Corporation's stations are concentrated in highly-populated, urban areas, principally in New York, New Jersey and Florida. 147 of the Corporation's stations have HESS MART(R) convenience stores. The Corporation owns in fee approximately 75% of the properties on which its stations are located. The Corporation also has 44 terminals located throughout its marketing area, with aggregate storage capacity of approximately 46 million barrels. COMPETITION AND MARKET CONDITIONS The petroleum industry is highly competitive. The Corporation encounters competition from numerous companies in each of its activities, particularly in acquiring rights to explore for crude oil and natural gas and in the purchasing and marketing of petroleum products. Many competitors are larger and have substantially greater resources than the Corporation. The Corporation is also in competition with producers and marketers of other forms of energy. The petroleum business involves large-scale capital expenditures and risk-taking. In the search for new oil and gas reserves, long lead times are often required from successful exploration to subsequent production. Operations in the petroleum industry depend on a depleting natural resource. The number of areas where it can be expected that hydrocarbons will be discovered in commercial quantities is constantly diminishing and exploration risks are high. Areas where hydrocarbons may be found are often in remote locations or in offshore water where exploration and development activities are capital intensive and operating costs are high. In addition, low crude oil prices have reduced the number of areas from which hydrocarbons can be economically produced. The major foreign oil producing countries, including the Organization of Petroleum Exporting Countries ("OPEC"), exert considerable influence over the supply and price of crude oil and refined petroleum products. Their ability or inability to agree on a common policy on rates of production, oil prices, and other matters has a significant impact on the oil market and the Corporation. In recent years, the futures markets have become increasingly important in influencing the prices of crude oil, natural gas and petroleum products. The Corporation cannot predict the extent to which future market conditions may be affected by OPEC, the futures markets or other external influences. Market conditions continue to affect the Corporation's earnings. The Corporation's refining and marketing results were affected in 1993 by weak refining margins caused, in part, by product prices falling faster than crude oil costs. Residual fuel oil prices continued to be weak because of oversupply and competition from other forms of energy. Results of refining and marketing operations will be negatively affected in the future if conditions comparable to those prevailing in 1993 continue. The Corporation's exploration and production operations were profitable in 1993, but are impacted by volatility in the selling prices of crude oil and natural gas. The low worldwide crude oil selling prices which existed in 1993 have continued in the early part of 1994. The balance between supply and demand for natural gas in the United States improved in 1993 and the selling price increased; however, there is no assurance that these conditions will continue. OTHER ITEMS The Corporation's operations may be affected by federal, state, local, territorial and foreign laws and regulations relating to tax increases and retroactive tax claims, expropriation of property, cancellation of contract rights, and changes in import regulations, as well as other political developments. The Corporation has been affected by certain of these events in various countries in which it operates. The Corporation markets motor fuels through lessee-dealers and wholesalers in certain states where legislation prohibits producers or refiners of crude oil from directly engaging in retail marketing of motor fuels. Similar legislation is periodically proposed in Congress and in various other states. The Corporation, at this time, cannot predict the effect of any of the foregoing on its future operations. Compliance with the various environmental and pollution control regulations imposed by federal, state and local governments is not expected to have a materially adverse effect on the Corporation's earnings and competitive position within the industry. However, the cost of such compliance has been increasing in recent years and is expected to increase in the future. Capital expenditures for facilities, primarily to comply with federal, state and local environmental standards, were $28 million in 1993 and the Corporation anticipates comparable capital expenditures in 1994. These amounts do not include capital expenditures incurred in connection with the upgrading of the Corporation's St. Croix refinery to produce gasolines required under the 1990 amendments to the Clean Air Act. In addition, the Corporation expended $14 million in 1993 for environmental remediation, with at least a comparable amount anticipated for 1994. The number of persons employed by the Corporation averaged 10,173 in 1993 and 10,263 in 1992. Additional operating and financial information relating to the business and properties of the Corporation appears on pages 9 and 10 under the heading "United States Exploration and Production," on pages 13, 14 and 17 under the heading "International Exploration and Production," on pages 19 and 20 under the heading "Refining and Marketing," on pages 23 through 27 under the heading "Financial Review" and on pages 28 through 53 of the accompanying 1993 Annual Report to Stockholders, which information is incorporated herein by reference.* - -------------------------------------------------------------------------------- * Except as to information specifically incorporated herein by reference under Items 1, 2, 5, 6, 7 and 8, no other information or data appearing in the 1993 Annual Report to Stockholders is deemed to be filed with the Securities and Exchange Commission (SEC) as part of this Annual Report on Form 10-K, or otherwise subject to the SEC's regulations or the liabilities of Section 18 of the Securities and Exchange Act of 1934, as amended. ITEM 2. ITEM 2. PROPERTIES Reference is made to Item 1 and the operating and financial information relating to the business and properties of the Corporation, which is incorporated in Item 1 by reference. Additional information relating to the Corporation's oil and gas operations follows. 1. OIL AND GAS RESERVES The Corporation's net proved oil and gas reserves at the end of 1993, 1992 and 1991 are presented under Supplementary Oil and Gas Data in the accompanying 1993 Annual Report to Stockholders, which has been incorporated herein by reference. During 1993, the Corporation provided oil and gas reserve estimates for 1992 to the Department of Energy. Such estimates are compatible with the information furnished to the SEC on Form 10-K, although not necessarily directly comparable due to the requirements of the individual requests. There were no differences in excess of 5%. The Corporation has no long-term contracts or agreements to supply fixed quantities of its crude oil production. Approximately 80% of the Corporation's 1993 natural gas production was sold under long-term contracts to various purchasers. Contractual commitments in 1994 (which are expected to be comparable to 1993) will be filled from the Corporation's production and from contractual purchases. 2. AVERAGE SELLING PRICES AND AVERAGE PRODUCTION COSTS Note A: Includes inter-company transfers valued at approximate market prices and the effect of the Corporation's forward sales activities. Note B: Production (lifting) costs consist of amounts incurred to operate and maintain the Corporation's producing oil and gas wells and related equipment and facilities, including severance and other related production taxes. The average production (lifting) costs per barrel of production reflect the crude oil equivalent of natural gas production converted on the basis of relative energy content. The foregoing tabulation does not include substantial costs and charges applicable to finding and developing proved oil and gas reserves, nor does it reflect significant outlays for related general and administrative expenses, interest expense and income taxes. 3. GROSS AND NET DEVELOPED ACREAGE AND PRODUCTIVE WELLS AT DECEMBER 31, 1993 Note A: Includes multiple completion wells (wells producing from different formations in the same bore hole) totaling 290 gross wells and 155 net wells. 4. GROSS AND NET UNDEVELOPED ACREAGE AT DECEMBER 31, 1993 5. NUMBER OF NET EXPLORATORY AND DEVELOPMENT WELLS DRILLED Note A: Excludes 1 exploratory well in 1992 and 4 in 1991 which have encountered hydrocarbons, but are not expected to be used for production. 6. NUMBER OF WELLS IN PROCESS OF DRILLING AT DECEMBER 31, 1993 7. NUMBER OF WATERFLOODS AND PRESSURE MAINTENANCE PROJECTS IN PROCESS OF INSTALLATION AT DECEMBER 31, 1993 -- FIVE (ONE NET) -- UNITED STATES - -------------------------------------------------------------------------------- ITEM 3. ITEM 3. LEGAL PROCEEDINGS On September 29, 1992, Region II of the United States Environmental Protection Agency ("EPA") commenced an administrative proceeding under Section 113(d) of the Federal Clean Air Act against Amerada Hess (Port Reading) Corporation, a wholly-owned subsidiary of the Registrant, alleging violations of Sections 111 and 114 of the Federal Clean Air Act arising out of this subsidiary's alleged failure to comply with certain monitoring and reporting obligations under regulations relating to new source performance standards. The proceeding seeks penalties totaling approximately $198,000 for the alleged violations. The Registrant's subsidiary is actively engaged in settlement discussions with the EPA but is also prepared to vigorously defend this action. The Registrant is currently the subject of an investigation by United States Attorneys for federal judicial districts in New Jersey and the U.S. Virgin Islands and by the EPA with respect to possible violations of federal environmental and other laws and regulations in connection with hazardous waste handling at the HOVIC refinery. The investigation apparently focuses on whether or not certain spent catalyst generated at the HOVIC refinery should have been managed as a hazardous waste under the Resource Conservation and Recovery Act. It is not possible at this time for Registrant to state what the outcome of the investigation will be, or, if any proceedings arising out of the investigation were to be commenced against the Registrant or HOVIC, what claims would be asserted or what relief would be sought. On April 27, 1993, the Texas Natural Resource Conservation Commission ("TNRCC", then known as the Texas Water Commission) notified the Registrant of alleged violation of the Texas Water Code as a result of alleged discharges of hydrocarbon compounds into the groundwater in the vicinity of the Registrant's terminal in Corpus Christi, Texas. Penalties provided for these violations include administrative penalties not to exceed $10,000 per day. The Registrant has undertaken a groundwater assessment and an interim correction measures program and is formulating other appropriate responses to these allegations. The Registrant expects to enter into an agreed order with the TNRCC that will address any remediation of the soil or groundwater that may be required. The TNRCC has not proposed a penalty amount to be assessed in conjunction with the issuance of such an order. Management does not currently expect that the outcome of this proceeding will have a material adverse effect on the financial condition of the Corporation. The Corporation periodically receives notices from the EPA that the Corporation is a "potentially responsible party" under the Superfund legislation with respect to various waste disposal sites. Under this legislation, all potentially responsible parties are jointly and severally liable. For certain sites, EPA's claims or assertions of liability against the Corporation relating to these sites have not been fully developed. With respect to the remaining sites, EPA's claims have been settled, or a proposed settlement is under consideration, in all cases for amounts which are not material. The ultimate impact of these proceedings, and of any related proceedings by private parties, on the business or accounts of the Corporation cannot be predicted at this time due to the large number of other potentially responsible parties and the speculative nature of clean-up cost estimates, but is not expected to be material. The Corporation is from time to time involved in other judicial and administrative proceedings, including proceedings relating to other environmental matters. Although the ultimate outcome of these proceedings cannot be ascertained at this time and some of them may be resolved adversely to the Corporation, no such proceeding is required to be disclosed under applicable rules of the Securities and Exchange Commission. In management's opinion, based upon currently known facts and circumstances, such proceedings in the aggregate will not have a material adverse effect on the financial condition of the Corporation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matter was submitted to a vote of security holders through the solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT The following table presents information as of January 15, 1994 regarding executive officers of the Registrant: * All officers referred to herein hold office in accordance with the By-Laws until the first meeting of the Directors following the annual meeting of stockholders of the Registrant, and until their successors shall have been duly chosen and qualified. Each of said officers was elected to the office set forth opposite his name on May 5, 1993. The first meeting of Directors following the next annual meeting of stockholders of the Registrant is scheduled to be held May 4, 1994. Except for Mr. Schreyer, each of the above officers has been employed by the Registrant in various managerial and executive capacities for more than five years. Prior to his employment with the Company in July 1990, Mr. Schreyer was a partner with the accounting firm of Ernst & Young. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Information pertaining to the market for the Registrant's Common Stock, high and low sales prices of the Common Stock in 1993 and 1992, dividend payments and restrictions thereon and the number of holders of Common Stock is presented on page 27 (Financial Review), page 35 (Long-Term Debt) and on page 50 (Ten-Year Summary of Financial Data) of the accompanying 1993 Annual Report to Stockholders, which has been incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA A Ten-Year Summary of Financial Data is presented on pages 48 through 51 of the accompanying 1993 Annual Report to Stockholders, which has been 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 is presented on pages 23 through 27 of the accompanying 1993 Annual Report to Stockholders, which has been incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, including the Report of Ernst & Young, Independent Auditors, the Supplementary Oil and Gas Data (unaudited) and the Quarterly Financial Data (unaudited) are presented on pages 27 through 47 of the accompanying 1993 Annual Report to Stockholders, which has been 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 Information relating to Directors is incorporated herein by reference to "Election of Directors" from the Registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 4, 1994. Information regarding executive officers is included in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is incorporated herein by reference to "Election of Directors-Executive Compensation and Other Information", other than information under "Compensation Committee Report on Executive Compensation" and "Performance Graph" included therein, from the Registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 4, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information pertaining to security ownership of certain beneficial owners and management is incorporated herein by reference to "Election of Directors-Ownership of Voting Securities by Certain Beneficial Owners" and "Election of Directors-Ownership of Equity Securities by Management" from the Registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 4, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information relating to this item is incorporated herein by reference to "Election of Directors" from the Registrant's definitive proxy statement for the annual meeting of stockholders to be held on May 4, 1994. ------------------------ 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 The financial statements and schedules filed as part of this Annual Report on Form 10-K are listed in the accompanying index to financial statements and schedules. 3. EXHIBITS 3. EXHIBITS (continued) * These exhibits relate to executive compensation plans and arrangements. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the last quarter of Registrant's fiscal 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, ON THE 24TH DAY OF MARCH 1994. AMERADA HESS CORPORATION (REGISTRANT) By /s/ JOHN Y. SCHREYER ............................ (JOHN Y. SCHREYER) 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. AMERADA HESS CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES * The financial statements and notes thereto together with the Report of Ernst & Young, Independent Auditors, on pages 28 through 42, the Quarterly Financial Data (unaudited) on page 27, and the Supplementary Oil and Gas Data (unaudited) on pages 43 through 47 of the accompanying 1993 Annual Report to Stockholders are incorporated herein by reference. ** Schedules other than those listed above have been omitted because of the absence of the conditions under which they are required or because the required information is presented in the financial statements or the notes thereto. CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Amerada Hess Corporation of our report dated February 14, 1994, included in the 1993 Annual Report to Stockholders of Amerada Hess Corporation. Our audits also included the consolidated financial statement schedules of Amerada Hess 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 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 set forth therein. We also consent to the incorporation by reference in the Registration Statement (Form S-8, No. 33-39816) pertaining to the Amerada Hess Corporation Employees' Savings and Stock Bonus Plan, of our report dated February 14, 1994, with respect to the consolidated financial statements incorporated herein by reference, and of our report included in the preceding paragraph with respect to the consolidated financial statement schedules included in this Annual Report (Form 10-K) of Amerada Hess Corporation. /s/ ERNST & YOUNG ERNST & YOUNG New York, N.Y. March 24, 1994 SCHEDULE V AMERADA HESS CORPORATION AND CONSOLIDATED SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------------------------------------------------------------------------------- (a) Includes cost basis adjustments and transfers to and from other accounts. (b) Reflects decreases of $134,869 in 1993, $884,254 in 1992 and $27,696 in 1991, resulting from foreign currency translation adjustments under FAS No. 52 (see Notes 1 and 7 to the consolidated financial statements contained in the accompanying 1993 Annual Report to Stockholders). (c) Includes an increase of $126,915 due to the addition of a capital lease. The methods of computing depreciation, depletion and amortization are described in Note 1 to the consolidated financial statements of the accompanying 1993 Annual Report to Stockholders. SCHEDULE VI AMERADA HESS CORPORATION AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION, AMORTIZATION AND IMPAIRMENT OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------------------------------------------------------------------------------- (a) Includes cost basis adjustments and transfers to and from other accounts. (b) Reflects decreases of $66,163 in 1993, $396,902 in 1992 and $23,791 in 1991, resulting from foreign currency translation adjustments under FAS No. 52. SCHEDULE IX AMERADA HESS CORPORATION AND CONSOLIDATED SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS OF DOLLARS) - -------------------------------------------------------------------------------- (a) The short-term borrowings have varying terms some of which are payable on demand and others at fixed terms with maturities of less than one year. (b) The average amount outstanding during the period is based on the average daily outstanding short-term borrowings. (c) The weighted average interest rates were determined by dividing total interest expense by the related average daily outstanding short-term borrowings. SCHEDULE X AMERADA HESS CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) EXHIBIT INDEX - -------------------------------------------------------------------------------- * These exhibits relate to executive compensation plans and arrangements.

36161_1993.txt

36161_1993

1993

36161

ITEM 1. BUSINESS DESCRIPTION OF BUSINESS General First Chicago Corporation (the "Corporation") is a multibank holding company incorporated in Delaware in l969. The principal asset of the Corporation is the capital stock of The First National Bank of Chicago ("FNBC"). The Corporation also owns all the outstanding capital stock of American National Corporation ("ANC") and FCC National Bank. ANC is the holding company for American National Bank and Trust Company of Chicago ("ANB"), American National Bank of Libertyville, and American National Bank and Trust Company of Wisconsin. FCC National Bank is a Delaware-based bank primarily engaged in the issuance of VISA and MasterCard credit cards. Together with these banking organizations, the Corporation, directly or indirectly, owns the stock of various nonbank companies engaged in businesses related to banking and finance, including venture capital and leasing subsidiaries. In November 1993, the Corporation and Lake Shore Bancorp., Inc. ("Lake Shore") signed a definitive agreement providing for the purchase of all outstanding shares of Lake Shore by the Corporation for approximately $323 million of the Corporation's common stock. Lake Shore, a Chicago area bank holding company with eight offices in the Chicago metropolitan area, owns Lake Shore National Bank and Bank of Hinsdale. Each share or share equivalent of Lake Shore common stock will be exchanged for common stock of the Corporation valued at $31.08. The exchange ratio will be determined based on the average closing price of the Corporation's common stock during a 20-day period ending just prior to the closing of the transaction, with a minimum price of $37 and a maximum price of $53 per share. The transaction is subject to approval of Lake Shore's stockholders and various bank regulatory authorities, and is expected to close in mid-1994. In addition to its equity investments in subsidiaries, the Corporation, directly or indirectly, raises funds principally to finance the operations of its nonbank subsidiaries. A substantial portion of the Corporation's annual income typically has been derived from dividends from its subsidiaries and from interest on loans to its subsidiaries. The Corporation's business strategy focuses on three major sectors: corporate and institutional banking, consumer banking and middle market banking. Each of these businesses is supported through the organizational structures of the Corporation's banking and nonbanking subsidiaries, as described below. The Corporation's U.S. offices and international facilities are listed on page 69 of the Corporation's 1993 Annual Report to Stockholders, and such listing is expressly incorporated herein by reference. Corporate and Institutional Banking Corporate and institutional banking encompasses the broad range of commercial and investment banking products and services that FNBC, along with the subsidiaries referenced below, provides to domestic and foreign customers. The principal focus of corporate and institutional banking activities is the delivery of corporate financial services and noncredit services and the extension of credit to commercial, financial and governmental customers. Serving the larger business marketplace within the United States, Canada, Europe, the Middle East, Africa and the Asia-Pacific regions, corporate and institutional banking provides products and services to industries including: retailing, commodities, banking, finance, insurance, transportation, securities, real estate, mortgage banking, communications, utilities, and petroleum and mining, as well as health, education and service organizations, and municipalities. Upper middle market customers within the Midwest are also served by corporate and institutional banking. In the global financial marketplace, corporate and institutional banking is responsible for FNBC's investment activities in U.S. government securities, municipal money markets, fixed income securities, federal agency securities, foreign exchange and the futures markets. Risk insurance products, such as foreign exchange options, interest rate options, and interest rate and currency swaps, are also provided. A separate subsidiary of the Corporation, First Chicago Capital Markets, Inc. ("FCCM"), is a primary government bond dealer and, as such, reports its positions daily to the Federal Reserve Open Market Committee Trading Desk. FCCM also is responsible for activities in the securities of states, municipalities and other governmental entities, and certain corporate entities, including trading, sales, underwriting, research, and maintenance of an active secondary market with national sales distribution. Certain financial products and services such as global merchant banking, private placement of debt securities, merger and acquisition advisory services, subordinated debt investments, highly leveraged transaction financings, asset sales and distributions, loan syndications, and financial advisory services to troubled companies are coordinated with corporate and institutional banking. These products and services are provided through FNBC, through nonbank subsidiaries of the Corporation, and through international banking subsidiaries of FNBC. Corporate and institutional banking also develops, markets and delivers cash management, operating, clearing and other noncredit products, both overseas and domestically. These include money transfer, collection, disbursement, documentary, remittance, trade finance, international securities clearing, custody, corporate trust and shareholder services. Corporate and institutional banking includes the operations of three subsidiaries of the Corporation and FNBC: First Chicago National Processing Corporation, which provides noncredit clearing services, including lock box processing, on a nationwide basis; First Chicago International, which provides clearing and documentary services; and First Chicago Trust Company of New York, a New York state-chartered trust company, which provides custody, corporate trust, special agency, stock transfer, and securities issuing, paying and clearance services. In addition, the First Chicago Clearing Center in London is that city's principal depository for certificates of deposit and other short- term securities. Consumer Banking The consumer banking business consists of two principal business groups: Community Banking and First Card. Community Banking has primary responsibility for developing and marketing diversified financial services to individuals and privately held businesses located in the Chicago metropolitan area. These services include traditional deposit and loan services, investment advisory and trust services, discount brokerage, mutual funds, annuities and mortgage loans. Consumer banking services are distributed through more than 70 consumer banking facilities and more than 370 automatic teller machines ("ATM"s), and through Bank-by-Mail, Bank-at-Work and computer home-banking programs. In 1993, the Corporation continued to consolidate and streamline its community banking operations by merging its remaining local community banking subsidiaries into FNBC. ATM services are provided to consumer banking clients in the Chicago market through a shared network called CASH STATION and through the CIRRUS system nationwide. First Card has primary responsibility for developing and marketing the Corporation's credit card services to individuals nationwide using direct response, telemarketing and other techniques that do not require a local physical presence. While VISA and MasterCard accounts are the primary products sold by First Card, other services include check-accessed lines of credit and certificates of deposit. The majority of the Corporation's credit card accounts are owned and administered by FCC National Bank ("FCCNB"), headquartered in Wilmington, Delaware. First Card operations centers are located in Wilmington, Delaware; Elgin, Illinois; and Uniondale (Long Island), New York. During 1993, First Card continued to expand, primarily through marketing programs offering FCCNB's proprietary First Card line of VISA and MasterCard accounts. The Corporation's subsidiaries in the aggregate rank among the largest issuers of bank credit cards in the United States. Middle Market Banking Middle market banking is conducted primarily through ANC, which, through ANB and ANC's other subsidiaries, offers a wide range of banking and financial products and services, with primary emphasis on the middle market corporate customer in the Chicago metropolitan area. ANB has 15 Chicago and suburban branches, including its main office in downtown Chicago and a new office in Matteson, Illinois. Other suburban branches are located in Arlington Heights, Bensenville, Deerfield, Des Plaines, Elgin, Lisle, Melrose Park, Skokie and Willowbrook. ANB maintains one foreign branch in Grand Cayman. ANC also owns American National Bank and Trust Company of Wisconsin and American National Bank of Libertyville, whose activities are coordinated with those of ANB. ANB is organized into three major lines of business: Banking, Trust and Investment Management. There are also four support divisions within ANB: Financial Services, Auditing, Marketing and Personnel. The Banking Department comprises Commercial Banking, Correspondent and Institutional Banking, International Banking, Personal Banking, Corporate Finance, Banking Operations and the Treasury Division. The Banking Department provides services to commercial and correspondent bank customers, including commercial loans, demand deposit and time deposit accounts, commercial finance and real estate mortgage loans, cash management services, financial advisory services and investment services. The department also provides personal banking services, including personal consumer loans, deposit services and safe deposit facilities. The Trust business is composed of Corporate Trust Services and Personal Trust and Investment Management. Corporate Trust Services acts as trustee and performs other services related to the issuance of public debt. Personal Trust and Investment Management provides estate planning, fiduciary management and investment management services to individuals, particularly business owners, executives and professionals. The Investment Management business is conducted through ANB Investment Management & Trust Company, a wholly owned subsidiary of ANB, which provides investment management and related administrative services for employee benefit and retirement plans and for other tax-exempt funds. ANB Investment Management & Trust Company manages a wide array of equity and fixed income funds, actively managed equity and fixed income funds, and balanced funds. This subsidiary manages approximately $18 billion of assets for clients in the Chicago area and throughout the U.S. Other Subsidiaries In addition to the banking subsidiaries described above, the Corporation owns subsidiaries that are engaged in businesses related to banking and finance, including leasing real and personal property; providing specialized financing that supplements FNBC's commercial lending activities; and engaging in certain permissible investment banking activities. First Chicago Financial Corporation raises funds to finance the operations of its subsidiaries: First Chicago Leasing Corporation, First Chicago Investment Corporation and FCCM. First Chicago Leasing Corporation provides advice on, and invests in, leases for commercial aircraft, facilities and other major industrial equipment. First Chicago Investment Corporation provides various forms of equity financing for acquisitions, management buyouts and growing businesses. FCCM engages in certain permissible securities distribution and trading activities as described on page 3 of this Form 10-K. First Capital Corporation of Chicago, a small business investment company licensed under the Small Business Investment Act of 1958, offers equity financing for small business ventures. Financial Policy The Corporation's Policy Committee maintains ultimate responsibility for the establishment of financial policies and strategies which are consistent with the Corporation's overall business objectives. The Policy Committee is responsible to the Board of Directors for reporting such policies and strategies. The Finance Committee oversees the implementation and execution of policies established by the Policy Committee relating to the financial management of the Corporation, specifically: liquidity management, interest rate risk management, investment accounts, tax planning, and accounting risk. The Finance Committee is chaired by the Corporation's Chief Financial Officer. Credit Strategy and Market Risk Policy The Credit Strategy Committee is responsible for providing strategic direction and senior management oversight for the credit risk management process. This process includes identifying, measuring and managing potential credit risk inherent in loans, leases, letters of credit, and other product offerings such as interest rate and currency risk insurance products, service products, securities placement products and trading products. The Market Risk Committee is responsible for providing strategic direction and senior management oversight for the market risk management process. This process includes identifying, measuring and managing potential capital, balance sheet and income effects associated with interest rate, exchange rate and other market risks. Staff Departments Staff support for FNBC, the Corporation and certain of their subsidiaries is supplied by the Administration, Audit, Corporate and Community Affairs, Corporate Strategy, Credit and Market Risk Policy, Economic Forecasting, Human Resources and Law Departments, and the Finance Group. EMPLOYEES As of December 3l, 1993, the Corporation and its subsidiaries had approximately 17,355 employees on a full-time-equivalent basis. COMPETITION All phases of the Corporation's activities, including banking, are highly competitive. The Corporation's banking subsidiaries (the "Banks") compete actively with money market mutual funds, national and state banks, mutual savings banks, savings and loan associations, finance companies, credit unions and other financial institutions located throughout the U.S. For international business, the Banks compete with other U.S. financial institutions that have foreign installations, and with other major banks and financial institutions throughout the world. In addition, the Corporation's subsidiaries are subject to competition from a variety of financial and other institutions that provide a wide array of products and services. MONETARY POLICY AND ECONOMIC CONTROLS The earnings of the Banks and, therefore, the earnings of the Corporation, are affected by the policies of regulatory authorities, including the Board of Governors of the Federal Reserve System (the "Board"). An important function of the Board is to promote orderly economic growth by influencing interest rates and the supply of money and credit. Among the methods that have been used to achieve this objective are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against bank deposits. These methods are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, interest rates on loans and securities, and rates paid for deposits. The Board's monetary policies strongly influence the behavior of interest rates and can, therefore, have a significant effect on the operating results of commercial banks. During the second half of 1993, economic growth accelerated. If growth continues to be strong, inflationary pressures will begin to develop. Given such circumstances, the Board has begun to tighten credit conditions, pushing up interest rates. The effects of the various measures used by the Board on the future business and earnings of the Banks and the Corporation cannot be predicted. Other economic controls also have affected the Corporation's operations in the past. The Corporation cannot predict the nature or extent of any effects that possible future governmental controls or legislation may have on its business and earnings. SUPERVISION AND REGULATION Bank Holding Company Regulation The Corporation is a bank holding company as defined under the Bank Holding Company Act of 1956, as amended (the "Act"), and is registered as such with the Board. Under the Act, bank holding companies are prohibited, with certain exceptions, from engaging in, or from acquiring more than 5 percent of the voting stock of any company engaging in, activities other than banking, or managing or controlling banks, or performing services for their subsidiaries. The Act authorizes the Board to permit bank holding companies to engage in, and to acquire or retain shares of companies that engage in, activities that the Board has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Board has determined that a number of activities meet this standard. Among the activities so approved are: making and servicing loans; performing certain fiduciary functions; leasing real and personal property; underwriting and dealing in government obligations and certain money market instruments; underwriting and dealing, to a limited extent, in corporate debt obligations and other securities that banks may not deal in; providing foreign exchange advisory and transactional services; acting as a futures commission merchant; and owning, controlling or operating a savings association if the association engages only in deposit-taking activities, lending and other activities that are permissible for bank holding companies. The Board, from time to time, may revise and expand the list of permitted activities. The Act also prohibits bank holding companies from acquiring more than 5 percent of the voting shares of any bank that is not already majority-owned without the prior approval of the Board. No application to acquire shares of a bank (as defined in the Act) located outside the state in which the operations of the applicant's banking subsidiaries are principally conducted may be approved by the Board unless such acquisition is specifically authorized by a statute of the state in which the bank whose shares are to be acquired is located. At present, nearly all states have adopted legislation permitting some form of acquisition by an out-of-state bank holding company of the shares of an in-state bank. In some of these states, only banks with limited powers may be established; in other jurisdictions, the laws permit only specific out-of-state bank holding companies to acquire in-state banks. Some states permit emergency bank acquisitions by out-of-state bank holding companies. In addition, the laws of some other states permit an out-of-state bank holding company to own a bank within their state only if a bank holding company within such state would be permitted to own a bank in the state of the out-of-state bank holding company. Certain reciprocal statutes are limited to specific regions of the country, and the U.S. Supreme Court has sustained the constitutionality of certain of these regional interstate banking statutes. Additional developments by state and federal authorities, including federal legislation, with respect to interstate banking may occur in the future. The impact of any such developments on the Corporation and the Banks cannot be predicted at this time. The Illinois Bank Holding Company Act (the "Illinois Act") provides that any out-of-state bank holding company whose principal place of business is in a state that grants Illinois bank holding companies reciprocal authority may acquire control of an Illinois bank or bank holding company. The approval of the Illinois Commissioner of Banks and Trust Companies is required to complete such an interstate acquisition in Illinois. The Illinois Act also permits intrastate acquisitions throughout Illinois by Illinois bank holding companies. All interstate and intrastate bank acquisitions by the Corporation are subject to the approval of the Board. The Corporation is required to file with the Board annual reports and such additional information as the Board may require pursuant to the Act. The Board periodically examines the Corporation and its nonbank subsidiaries, and is authorized to impose reserve requirements and interest rate limitations on certain debt obligations issued by bank holding companies. As a bank holding company, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit or providing property or services. The Board has adopted risk-based capital guidelines for bank holding companies that require bank holding companies to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) of 8%. At least half of total capital has to be composed of common stockholders' equity, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less disallowed intangibles (primarily goodwill) ("Tier I capital"). The remainder ("Tier II capital") may consist of subordinated debt, other preferred stock, certain other instruments and a limited amount of loan loss reserves. At December 31, 1993, the Company's consolidated Tier I capital and total capital ratios were 8.8% and 13.6%, respectively. In addition, the Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier I capital to total average assets, less disallowed intangibles (primarily goodwill) (the "leverage ratio") of 3% for bank holding companies that meet certain specified criteria, including those having the highest regulatory rating. All other bank holding companies generally are required to maintain a leverage ratio of at least 3% plus an additional cushion of 100 to 200 basis points. The Corporation's leverage ratio at December 31, 1993, was 8.0%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Board has indicated that it will consider a "tangible Tier I capital leverage ratio" (deducting all intangibles) and other indicia of capital strength in evaluating proposals for expansion or new activities. Banking Regulation The Corporation and its nonbank subsidiaries are affiliates of the Banks within the meaning of the Federal Reserve Act. The Corporation and its nonbank subsidiaries are subject to certain restrictions on loans made by the Banks to the Corporation or such other subsidiaries, on investments made by the Banks in their stock or securities, on the Banks taking such stock and securities as collateral for loans, and on the terms of transactions between the Banks and other subsidiaries. The Corporation and its subsidiaries, including the Banks, are also subject to certain restrictions with respect to engaging in the issuance, flotation, underwriting, public sale or distribution of securities. There are various additional requirements and restrictions in the laws of the U.S. and the State of Illinois affecting the Banks and their operations, including the requirement to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made by the Banks, and restrictions related to investments and other activities of the Banks. The Banks are subject to regulation by the Office of the Comptroller of the Currency (the "Comptroller"), the Board and the Federal Deposit Insurance Corporation ("FDIC"). As national banks, they are examined by the Comptroller. FNBC's and ANB's operations in other countries are subject to various restrictions imposed by the laws of such countries. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") significantly expanded the regulatory and enforcement powers of federal banking regulators and has important consequences for the Corporation, the Banks and other depository institutions located in the U.S. A major feature of FDICIA is the comprehensive directions it gives to federal banking regulators to promptly direct or require the correction of problems at inadequately capitalized banks in the manner that is least costly to the federal deposit insurance funds. The degree of corrective regulatory involvement in the operations and management of banks and their holding companies is, under FDICIA, largely determined by the actual or anticipated capital position of the subject institution. FDICIA established five tiers of capital measurement for regulatory purposes ranging from "well capitalized" to "critically undercapitalized." FDICIA requires banking regulators to take increasingly strong corrective steps, based on the capital tier of any subject bank, to cause such bank to achieve and maintain capital adequacy. Even if a bank is adequately capitalized, however, the banking regulators are authorized to apply corrective measures if the bank is determined to be in an unsafe or unsound condition or engaging in an unsafe or unsound activity. Depending on the capital level of an insured depository institution, the banking regulatory agencies' corrective powers can include: requiring a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to reduce total assets; requiring the institution to issue additional stock (including voting stock) or to be acquired; placing restrictions on transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election for the institution's board of directors; requiring that certain senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; prohibiting the institution's parent bank holding company from making capital distributions without prior regulatory approval; and, ultimately, appointing a receiver or conservator for the institution. If an insured depository institution is undercapitalized, the parent bank holding company is required to guarantee that the institution will comply with any capital restoration plan submitted to, and approved by, the appropriate federal banking agency in an amount equal to the lesser of (i) 5% of the institution's total assets at the time the institution became undercapitalized or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with the capital restoration plan. If such parent bank holding company guarantee is not obtained, the capital restoration plan may not be accepted by the banking regulators. As a result, such institution would be subject to the more severe restrictions imposed on significantly undercapitalized institutions. Further, the failure of such a depository institution to submit an acceptable capital plan is grounds for the appointment of a conservator or receiver. FDICIA also contains a number of other provisions affecting depository institutions, including the creation of additional reporting and independent auditing requirements, the establishment of safety and soundness standards, the changing of FDIC insurance premiums from flat amounts to a new system of risk- based assessments, as described below, a review of accounting standards, and supplemental disclosures and limits on the ability of depository institutions to acquire brokered deposits. FDICIA will likely result in increased costs for the banking industry due to higher assessments and more limitations on the activities of all but the most well-capitalized banks. In addition to FDICIA, there have been a number of legislative and regulatory proposals designed to strengthen the federal deposit insurance system and to improve the overall financial stability of the U.S. banking system. These include proposals to increase capital requirements above presently published guidelines, to place special assessments on banks to increase funds available to the FDIC, and to allow national banks to branch on an interstate basis. Bank regulators continue to indicate their desire to raise capital requirements applicable to banking organizations beyond current levels. Each of the Banks and the Corporation were in compliance with applicable minimum capital requirements as of December 31, 1993. The management of the Corporation, however, is unable to predict whether higher capital requirements will be imposed and, if so, at what levels and on what schedule. The Banks are subject to FDIC deposit insurance assessments. FDICIA provides that FDIC deposit insurance assessments change from flat rate premiums to a new system of risk-based premium assessments. In June 1993, the FDIC adopted final rules effective January 1, 1994, for the implementation of the risk-based assessment system. Under this system, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. Under the FDIC's risk-based assessment system, the prior flat assessment rate of 0.23% per annum on the amount of domestic deposits has been changed to a rate based upon classification of a depository institution in one of nine risk assessment categories. Such classification is based upon the institution's capital level and upon certain supervisory evaluations of the institution by its primary regulator. The assessment rate schedule adopted creates a 0.08% spread in assessment rates, ranging from 0.23% per annum to 0.31% per annum, between banks classified as strongest and weakest by the FDIC. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), among other things, provides generally that, upon the default of any bank of a multi-unit holding company, the FDIC may assess an affiliated insured depository institution for the estimated losses incurred by the FDIC. Specifically, FIRREA provides that 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. "Default" is defined generally as the appointment of a conservator or receiver. "In danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. All of the Banks are FDIC-insured depository institutions. Additionally, there are certain regulatory limitations on the payment of dividends to the Corporation by the Banks. Dividend payments by a national bank are limited to the lesser of (i) the level of "undivided profits then on hand" less the amount of bad debts, as defined, in excess of the allowance for credit losses, and (ii) absent regulatory approval, an amount not in excess of its "net profits" for the current year combined with the "retained net profits" for the preceding two years. As of December 3l, 1993, the Banks could have declared additional dividends of approximately $445 million without approval of the Comptroller. The payment of dividends by any Bank may also be affected by other factors, such as the maintenance of adequate capital for such Bank. In addition, the Comptroller has authority to prohibit a national bank from paying dividends if, in the Comptroller's opinion, the payment of dividends would, in light of the financial condition of such bank, constitute an unsafe or unsound practice. FNBC and ANB are registered with the Comptroller as transfer agents and are subject to the rules and regulations of the Securities and Exchange Commission (the "Commission") and the Comptroller with respect to their activities as transfer agents. Certain organizational units within FNBC and ANB are registered with the Commission as municipal securities dealers. These units are subject to the applicable rules and regulations of the Commission and the Municipal Securities Rulemaking Board with respect to transactions in municipal securities performed in a municipal securities dealer capacity. FNBC also is a regulated government securities broker and dealer under the Government Securities Act, and is subject to regulations issued thereunder in connection with the conduct of its U.S. government securities business. In addition, First Chicago Investment Services, Inc. ("FCIS"), a discount brokerage subsidiary of FNBC, is registered as a broker-dealer with the Commission and is a member of the National Association of Securities Dealers ("NASD"). The brokerage activities of FCIS are subject to the applicable rules and regulations of the Commission and the NASD. Also, FCCM is registered as a broker-dealer with the Commission and is a member of the NASD. The securities distribution and trading activities of FCCM are subject to the applicable rules and regulations of the Board, the Commission and the NASD. First Chicago Futures, Inc. ("FCFI"), a subsidiary of FNBC that conducts a commodities brokerage business and is a market maker in foreign currency options, is registered with the Commission as a broker-dealer and with the Commodity Futures Trading Commission ("CFTC") as a futures commission merchant, and is a member of the National Futures Association ("NFA"). FCFI is subject to the applicable rules and regulations of the Commission, the CFTC, the NFA, and certain commodities and securities exchanges of which FCFI is a member with respect to its activities as a foreign currency market maker and a futures commission merchant. FINANCIAL REVIEW Additional information responsive to this Item 1 is set forth in the Corporation's 1993 Annual Report to Stockholders on pages 17-37 of the "Financial Review" section and is expressly incorporated herein by reference. CERTAIN STATISTICAL INFORMATION In addition to the statistical information set forth on the following pages of this Form 10-K, the information set forth in "Selected Statistical Information" on pages 64-67 of the Corporation's 1993 Annual Report to Stockholders is expressly incorporated herein by reference. INVESTMENT SECURITIES - -------- (1) Includes venture capital portfolio and Federal Reserve stock. As of December 31, 1993, debt investment securities had the following maturity and yield characteristics. - -------- *Yields for obligations of states and political subdivisions are calculated on a tax-equivalent basis using a tax rate of 35 percent. LOAN COMPOSITION - -------- (1) December 31, 1989, amounts exclude real estate-related loans. FOREIGN OUTSTANDINGS The Corporation's cross-border outstandings to countries where such outstandings exceeded 1.0 percent of the Corporation's total assets ($526 million as of December 31, 1993, $493 million as of December 31, 1992, and $490 million as of December 31, 1991) are shown in the table below. They consist of loans (including accrued interest), acceptances, interest-bearing deposits with other banks, equity investments, other interest-bearing investments and other nonlocal currency monetary assets. - -------- *Outstandings less than 1 percent. At year-end 1993, the only country for which cross-border outstandings totaled between 0.75 percent and 1.0 percent of the Corporation's total assets was Korea; such outstandings totaled $489 million. At December 31, 1992, the countries for which cross-border outstandings totaled between 0.75 percent and 1.0 percent of the Corporation's total assets were Korea and the United Kingdom; such outstandings totaled $962 million. At December 31, 1991, the only country for which cross-border outstandings totaled between 0.75 percent and 1.0 percent of the Corporation's total assets was Korea; such outstandings totaled $405 million. HIGHLY LEVERAGED TRANSACTIONS The Corporation originates and syndicates highly leveraged transactions (HLTs). Policies and procedures are maintained for the management and reporting of HLT exposure. The Corporation continues to disclose this exposure using the HLT definition previously established by federal banking regulatory agencies. HLT CREDIT EXPOSURE HLT exposure continued to decrease during 1993, due mainly to the delisting of credits originally designated as HLTs. These reductions were made in accordance with the federal banking regulatory agencies' delisting criteria. Credit exposure to communications-related industries represented the only significant HLT concentration. This concentration represented approximately 33 percent of HLT credit exposure at year-end 1993, compared with 35 percent a year earlier. Net charge-offs of HLT loans totaled $6 million in 1993, $46 million in 1992 and $77 million in 1991. Nonperforming HLT loans totaled $1 million, or less than 1 percent of total HLT loans, at December 31, 1993, compared with $82 million, or 6 percent, at December 31, 1992. During 1993, the Corporation originated HLT transactions for 18 customers, representing total credit exposure of $317 million. At year-end, $225 million of this exposure was outstanding. While the Corporation's activities related to HLTs contribute to its ongoing results, a total cessation of such activities would not have a significant impact on its ongoing profitability. The Corporation's venture capital subsidiaries have invested in companies that have substantially higher leverage than would normally exist in their industries. At December 31, 1993, this portfolio consisted of 43 HLT investments with a carrying value of $397 million. At December 31, 1993, gross unrealized gains related to HLT investments totaled $66 million, while gross unrealized losses were $82 million. At December 31, 1992, the carrying value of HLT investments in the venture capital portfolio totaled $531 million. Unfunded commitments related to the HLT segment of the venture capital portfolio totaled $2 million at December 31, 1993. At December 31, 1993, $5 million of the venture capital investments was classified as nonperforming, compared with $12 million at December 31, 1992. There were no credit charge-offs related to subordinated debt positions in 1993. MATURITY DISTRIBUTION AND INTEREST RATE SENSITIVITY OF LOANS The following table shows a distribution of the maturity of loans and, for those loans due after one year, a breakdown between those loans that have floating interest rates and those that have predetermined interest rates. The amounts exclude domestic consumer loans, residential mortgage loans and domestic lease-financing receivables. LOANS 90 DAYS OR MORE PAST DUE AND STILL ACCRUING INTEREST Loans to troubled borrowers that were restructured during 1993 but continued to yield an effective market rate totaled $58 million at December 31, 1993. INTEREST SHORTFALL ON NONPERFORMING LOANS Interest at original contract rates (based on average outstanding balances) and interest actually recorded for those periods at December 31 was as follows. At December 31, 1993 and 1992, the Corporation was committed to lend additional funds of approximately $12 million and $40 million, respectively, in connection with nonperforming loans and nonperforming loans in the accelerated asset disposition portfolio. ANALYSIS OF ALLOWANCE FOR CREDIT LOSSES - -------- (1) 1989 excludes real estate-related loans. (2) 1992 amounts include $12 million defined as commercial real estate. (3) As of January 1, 1991, the Corporation no longer charges off unpaid interest and fees on credit cards to the allowance for credit losses but instead reverses them against their respective income statement lines. Charge-offs and the provision for credit losses decreased by $21.0 million in 1990 and $16.0 million in 1989. (4) Primarily reflects the reclassification of reserves related to securitized credit card receivables to other assets for all periods presented. ALLOCATED ALLOWANCE FOR CREDIT LOSSES While the allowance for credit losses is available to absorb credit losses in the entire portfolio, the tables below present an estimate of the allowance for credit losses allocated by loan type and the percentage of loans in each category to total loans. - -------- (1) Includes allocation for potential losses not specifically identified in the commercial segment of the portfolio. (2) Includes financial institutions, lease-financing and other. (3) Includes $699 million related to troubled-country debt in 1989. (4) Adjusted to exclude reserves for securitized credit card receivables. DEPOSITS The following tables show a maturity distribution of domestic time certificates of deposit of $100,000 and over, other domestic time deposits of $100,000 and over, and deposits in foreign offices, predominantly in amounts in excess of $100,000, at December 31, 1993. DOMESTIC TIME CERTIFICATES OF DEPOSIT DOMESTIC OTHER TIME DEPOSITS FOREIGN OFFICES The following table shows the breakdown of deposits on an average basis for the past three years. DEPOSITS--AVERAGE BALANCES FUNDS BORROWED Federal funds purchased, securities under repurchase agreements and commercial paper are other major nonretail sources of funds. Details on the outstandings and rates of these instruments during the past three years follow. The maturities of other funds borrowed as of December 31, 1993, were (in millions): *In 1992, earnings (as defined) were insufficient to cover fixed charges. The coverage deficiency was approximately $201 million. ANALYSIS OF CHANGES IN NET INTEREST MARGIN The following table shows the approximate effect on the net interest margin of volume and rate changes for the years 1993 and 1992. For purposes of this table, changes that are not due solely to volume or rate changes are allocated to volume. - -------- (1) Excludes other real estate held for accelerated disposition. ITEM 2. ITEM 2. PROPERTIES The Corporation and FNBC occupy space in a 60-story combined bank and office building at One First National Plaza, Chicago, Illinois. One First National Plaza is master-leased by FNBC from an owner trust that purchased the building from FNBC's wholly owned subsidiary, First Chicago Building Corporation, in May 1993, pursuant to a leveraged lease financing transaction. The building has approximately l,850,000 square feet of rentable space, of which the Corporation occupies approximately 59% and the balance is sub-leased to others. It is located on the north half of a block in the heart of the Chicago "Loop," the entire block being owned by FNBC. The south half of the block includes a plaza, parking and restaurant facilities, and a general-purpose auditorium. In addition, the Corporation, or its subsidiaries, own or lease more than 130 bank locations throughout the Chicago metropolitan area and occupy leased office space in various other locations as required for the conduct of business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information required by this Item is set forth in Note 18 on page 61 of the Corporation's 1993 Annual Report to Stockholders and is expressly incorporated herein by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT - -------- *Has served as an officer of the Corporation or a subsidiary for at least the past five years. Officers of the Corporation serve until the annual meeting of the Board of Directors (April 8, 1994). PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this Item is set forth in the fourth paragraph on page 9 of this Form 10-K, and in the Corporation's 1993 Annual Report to Stockholders in the "Five-Year Summary of Selected Financial Information" on page 18, the "Common Stock and Stockholder Data" table on page 64, the "Quarterly Earnings and Market Price Summary" table on page 65, the "Consolidated Summary of Quarterly Financial Information" table on page 65, and under "Corporate Information" on page 70; such portions of the Annual Report are expressly incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is set forth in the "Financial Ratios" table on page 18 of this Form 10-K, and in the Corporation's 1993 Annual Report to Stockholders in the "Five-Year Summary of Selected Financial Information" on page 18 which is expressly 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 is set forth in the Corporation's 1993 Annual Report to Stockholders on pages 17-37 of the "Financial Review" section and is expressly incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is set forth under "Certain Statistical Information" on pages 10-19 of this Form 10-K, and in the Corporation's 1993 Annual Report to Stockholders in the consolidated financial statements and the notes thereto on pages 38-61, the "Report of Independent Public Accountants" on page 63, and in the "Selected Statistical Information" section on pages 64-67; such portions of the Annual Report are expressly 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 required by this Item pertaining to executive officers of the Corporation is set forth in Part I of this Form 10-K under the heading Executive Officers of the Registrant. The information required by this Item pertaining to directors of the Corporation is set forth on pages 2-6 of the Corporation's definitive proxy statement dated March 4, 1994, and is expressly incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is set forth on pages 11-19 of the Corporation's definitive proxy statement dated March 4, 1994, and is expressly 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 on pages 10-11 of the Corporation's definitive proxy statement dated March 4, 1994, and is expressly incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is set forth on pages 8 and 19-20 of the Corporation's definitive proxy statement dated March 4, 1994, and is expressly incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS (See Item 8 for a listing of all financial statements). (2) FINANCIAL STATEMENT SCHEDULES. All schedules normally required by Form 10-K are omitted since they either are not applicable or the required information is shown in the financial statements or the notes thereto. (3) EXHIBITS. (b) The Corporation filed the following Current Reports on Form 8-K during the quarter ended December 31, 1993: - -------- *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE CORPORATION HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, THIS 11TH DAY OF FEBRUARY, 1994. First Chicago Corporation (Registrant) /s/ Richard L. Thomas By___________________________________ Richard L. Thomas 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 CORPORATION AND IN THE CAPACITIES INDICATED, THIS 11TH DAY OF FEBRUARY, 1994. /s/ John H. Bryan - ---------------------- John H. Bryan Director /s/ Dean L. Buntrock - ---------------------- Dean L. Buntrock Director /s/ Frank W. Considine - ---------------------- Frank W. Considine Director /s/ James S. Crown - ---------------------- James S. Crown Director /s/ Donald V. Fites - ---------------------- Donald V. Fites Director /s/ Donald P. Jacobs - ---------------------- Donald P. Jacobs Director /s/ Andrew J. McKenna - ---------------------- Andrew J. McKenna Director /s/ Richard M. Morrow - ---------------------- Richard M. Morrow Director /s/ Leo F. Mullin - ---------------------- Leo F. Mullin Director /s/ Earl L. Neal - ---------------------- Earl L. Neal Director /s/ James J. O'Connor ---------------------------------------- James J. O'Connor Director /s/ Jerry K. Pearlman ---------------------------------------- Jerry K. Pearlman Director /s/ Jack F. Reichert ---------------------------------------- Jack F. Reichert Director /s/ Patrick G. Ryan ---------------------------------------- Patrick G. Ryan Director /s/ Adele Simmons ---------------------------------------- Adele Simmons Director /s/ Roger W. Stone ---------------------------------------- Roger W. Stone Director /s/ Richard L. Thomas ---------------------------------------- Richard L. Thomas Director and Principal Executive Officer /s/ David J. Vitale ---------------------------------------- David J. Vitale Director /s/ Robert A. Rosholt ---------------------------------------- Robert A. Rosholt Principal Financial Officer /s/ William J. Roberts ---------------------------------------- William J. Roberts Principal Accounting Officer EXHIBIT INDEX

3000_1993.txt

3000_1993

1993

3000

ITEM 1. BUSINESS - ------------------ a) General Development of Business ------------------------------- Airborne Freight Corporation (herein referred to as "Airborne Express" or the "Company", which reference shall include its subsidiaries and their assets and operations, unless the context clearly indicates otherwise) was incorporated in Delaware on May 10, 1968. The Company is an air express company and air freight forwarder that expedites shipments of all sizes to destinations throughout the United States and most foreign countries. The Company holds a certificate of registration issued by the United States Patent and Trademark Office for the service mark AIRBORNE EXPRESS. Most public presentation of the Company carries this name. The purpose of using this trade name is to more clearly communicate to the market place the primary nature of the business of the Company. ABX Air, Inc., the Company's principal wholly-owned subsidiary (herein referred to as "ABX" or the "Airline"), was incorporated in Delaware on January 22, 1980. ABX provides domestic express cargo service and cargo service to Canada. The Company is the principal customer of ABX for this service. b) Financial Information about Industry Segments --------------------------------------------- None c) Narrative Description of Business --------------------------------- Airborne Express provides door-to-door express delivery of small packages and documents throughout the United States and to and from most foreign countries. The Company also acts as an international and domestic freight forwarder for shipments of any size. The Company's strategy is to be the low cost provider of express services for high volume corporate customers. Domestic Operations - ------------------- The Company's domestic operations primarily involve express door-to-door delivery of small packages and documents weighing less than 100 pounds. Shipments consist primarily of business documents and other printed matter, electronic and computer parts, machine parts, health care items, films and videotapes, and other items for which speed and reliability of delivery are important. The Company's primary service is its overnight express product. This product, which comprised approximately 68% of the Company's domestic shipments during 1993, generally provides for before noon delivery on the next business day to most metropolitan cities in the United States. The Company also provides Saturday and holiday pickup and delivery service for most cities. The Company offers a deferred service product, Select Delivery Service ("SDS"), which provides for next afternoon or second day delivery. The SDS product expands the Company's product offering and introduces new customers to air express services. SDS service generally provides for shipments weighing five pounds or less to be delivered on a next afternoon basis with shipments weighing more than five pounds being delivered on a second day basis. SDS shipments, which comprised approximately 31% of total domestic shipments during 1993, are generally lower priced than the overnight express product reflecting the less time sensitive nature of the shipments. While the Company's domestic airline system is designed primarily to handle express shipments, any available capacity is also utilized to carry shipments which the Company would normally move on other carriers in its role as an air freight forwarder. Pickup and Delivery - ------------------- The Company accomplishes its door-to-door pickup and delivery service using approximately 9,900 radio-dispatched delivery vans and trucks, of which approximately 3,600 are owned by the Company. Independent contractors under contract with the Company provide the balance of the pickup and delivery services. The Company's facilities are linked to FOCUS, a proprietary freight tracking and message computer system which permits monitoring of overall system performance and allows the Company to ascertain the status of a specific shipment. FOCUS receives information in several ways including drivers' use of hand-held scanners which read bar-coded information on shipping documents. FOCUS provides many major customers direct access to the status of their shipments 24 hours a day through the use of their own computer systems. Because convenience is an important factor in attracting business from less frequent shippers, the Company has an ongoing program to place drop boxes in convenient locations. The Company has approximately 7,300 boxes in service. Sort Facilities - --------------- The Company's main sort center is located in Wilmington, Ohio. As express delivery volume has increased, the main sort center has been expanded. The sort center currently has the capacity to handle 830,000 pieces during the primary 2-1/2 hour nightly sort operation. On average, approximately 600,000 pieces were sorted each weekday night at the sort center during December 1993. In addition to the sort facilities, the Wilmington location consists of a Company-owned airpark (including airport facilities); maintenance, storage, training and refueling facilities; and operations and administrative offices. The Company also conducts a daylight sort operation at Wilmington. The day sort services SDS shipments weighing in excess of five pounds that are consolidated at certain regional hub facilities and either flown or trucked into or out of Wilmington. The operation of the Wilmington facility is critical to the Company's business. The inability to use the Wilmington airport, because of bad weather or other factors, would have a serious adverse effect on the Company's service. However, contingency plans, including landing at nearby airports and transporting packages to and from the sort center by truck, can be and have been implemented to address temporary inaccessibility of the Wilmington airport. In addition to the main sort facility at Wilmington, ten regional hub facilities have been established primarily to sort shipments originating and having a destination within approximately a 300 mile radius of a regional hub. In December 1993, approximately 65% and 13% of total shipment weight was handled through the night sort and day sort operations at Wilmington, respectively, with the remaining 22% being handled exclusively by the regional hubs. Shipment Routing - ---------------- The logistical means of moving a shipment from its origin to destination are determined by several factors. Shipments are routed differently depending on shipment product type, weight, geographic distances between origin and destination, and locations of Company stations relative to the locations of sort facilities. Shipments generally are moved between stations and sort facilities on either Company aircraft or contracted trucks. Certain shipments are transported airport-to-airport on commercial air carriers. Overnight express shipments and SDS shipments weighing five pounds or less are picked up by local stations and generally consolidated with other stations' shipments at Company airport facilities. Shipments that are not serviced through regional hubs are loaded on Company aircraft departing each weekday evening from various points within the United States and Canada. These aircraft may stop at other airports to permit additional locations and feeder aircraft to consolidate their cargo onto the larger aircraft before completing the flight to the Wilmington hub. The aircraft are scheduled to arrive at Wilmington between approximately 11:30 p.m. and 3:00 a.m. at which time the shipments are sorted and reloaded. The aircraft are scheduled to depart before 6:30 a.m. and return to their applicable destinations in time to complete scheduled next business morning or next afternoon service commitments. The Wilmington hub also receives shipments via truck from selected stations in the vicinity of the Wilmington hub for integration with the nightly sort process. For the daylight sort operation, three aircraft return to Wilmington from overnight service destinations on Tuesday through Friday. These aircraft, and trucks from six regional hubs, arrive at Wilmington between 10:00 a.m. and noon, at which time shipments are sorted and reloaded on the aircraft or trucks by 3:00 p.m. for departure and return to their respective destinations. The Company also performs weekend sort operations at Wilmington to accommodate Saturday pickups and Monday deliveries of both overnight express and SDS shipments. This sort is supported both by Company aircraft and by trucks. Aircraft - -------- The Company acquires and utilizes used aircraft manufactured in the late 1960s and early 1970s. Upon acquisition, the aircraft are substantially modified by the Company. At the end of 1993, the Company's in-service fleet consisted of a total of 90 aircraft, including 26 DC-8s (consisting of 10 series 61, 6 series 62 and 10 series 63), 53 DC-9s (consisting of 2 series 10, 37 series 30 and 14 series 40), and 11 YS-11 turboprop aircraft. The Company owns the majority of the aircraft it operates, but has completed sale-leaseback transactions with respect to six DC-8 and six DC-9 aircraft. In addition, approximately 50 smaller aircraft are chartered nightly to connect small cities with Company aircraft that then operate to and from Wilmington. At year end 1993, the nightly lift capacity of the system was about 2.8 million pounds versus approximately 2.4 million pounds and 2.1 million pounds at the end of 1992 and 1991, respectively. Over the past several years the Company's utilization of available lift capacity has exceeded 80%. In response to increased public awareness regarding the operation of older aircraft, the Federal Aviation Administration ("FAA") has mandated additional maintenance requirements for certain aircraft, including the type operated by the Company. These maintenance requirements were substantially completed by December 1993 for the Company's DC-8 aircraft. As of the end of 1993 the Company had completed this required maintenance on 48 DC-9 series aircraft. This maintenance is required to be completed by September 1994. The Company believes these maintenance requirements for remaining aircraft can be accomplished without materially impacting operations or the financial position of the Company. However, the FAA may, in the future, impose additional requirements with respect to maintenance procedures and practices for aircraft and engines of the type operated by the Company or interpret existing rules in a manner which could have a material adverse effect on the Company's operations and financial position. The Company is periodically required to retrofit certain aircraft equipment and subsystems in accordance with mandated FAA requirements. Presently, the Company is seeking a waiver from the FAA with regard to the date by which installation of certain instrumentation on its YS-11 aircraft must be accomplished. If the FAA denies the Company's request, the Company believes it can comply with the FAA requirement without disrupting the Company's flight schedules. In accordance with federal law and FAA regulations, only subsonic turbojet aircraft classified as Stage 2 or 3 by the FAA may be operated in the United States. Generally, Stage 3 aircraft produce less noise than a comparable Stage 2 aircraft. As of December 31, 1993, 26 of the Company's turbojet aircraft (16 DC-8 and 10 DC-9 aircraft) are Stage 3 aircraft, the balance being Stage 2 aircraft. In 1990, Congress passed the Airport Noise and Capacity Act of 1990 (the "Noise Act") which, among other things, requires turbojet aircraft weighing in excess of 75,000 pounds and operating in the United States (the type DC-8 and DC-9 aircraft operated by the Company) to comply with Stage 3 noise emission standards on or before December 31, 1999. The Company's YS-11 turboprop aircraft are not subject to these requirements. The Secretary of Transportation may grant a waiver from this provision to allow up to 15% of an air carrier's Stage 2 fleet to be operated until December 31, 2003. In accordance with the Noise Act, the FAA, acting under delegated authority, has issued regulations establishing interim compliance deadlines. These rules require air carriers to reduce the base level of Stage 2 aircraft they operate 25% by December 31, 1994; 50% by December 31, 1996; and 75% by December 31, 1998. Under limited circumstances, the Secretary of Transportation may grant an operator a waiver from these interim compliance deadlines. As of December 31, 1993 the Company accomplished a reduction of its base level aircraft of approximately 24% and expects to meet or exceed the compliance percentage at the first interim compliance deadline of December 31, 1994. In addition, the Noise Act and the implementing FAA Regulations prohibit a U.S. air carrier from importing into the United States and thereafter operating Stage 2 aircraft unless the aircraft were under contract prior to November 5, 1990. The Company believes that most, if not all of the aircraft which were subject to contracts executed prior to November 5, 1990 and placed into service after the passage of the Noise Act will be permitted to be operated as Stage 2 aircraft subject to the interim and final Stage 2 aircraft phase-out compliance deadlines. In addition to FAA regulation, certain local airports also regulate noise compliance. See "Business - Regulation". The Company, in conjunction with several other companies, has developed, tested and received certification of noise suppression technology known as hush kits for its DC-9 series aircraft, which meet FAA Stage 3 requirements. Both of the Company's DC-9-10 series aircraft and eight of the Company's DC-9-30 series aircraft meet Stage 3 requirements. The estimated capital cost for Stage 3 hush kits is approximately $1.1 million for each DC-9 series aircraft. The Company has installed hush kits designed to satisfy Stage 3 compliance requirements on all of its DC-8-62 and DC-8-63 series aircraft. In early 1994, firms under contract to the Company obtained FAA certification for hush kits and other required modifications designed to meet Stage 3 noise standards for the Company's DC-8-61 aircraft. The estimated capital cost for these hush kits and related hardware is approximately $4.0 million per aircraft. International Operations - ------------------------ The Company provides international express door-to-door delivery and a variety of freight services. These services are provided in most foreign countries on an inbound and outbound basis through a network of Airborne offices and independent agents. Most international deliveries are accomplished within 24 to 96 hours of pickup. The Company's international express service is intended for the movement of non-dutiable and certain dutiable shipments weighing less than 99 pounds. The Company's international freight service handles heavier weight shipments on either an airport-to-airport, door-to-airport or door-to-door basis. The Company's strategy is to use a variable-cost approach in delivering and expanding international services to its customers. This strategy uses existing commercial airline lift capacity in connection with the Company's domestic network to move shipments to overseas destinations. Additionally, exclusive service arrangements with independent freight and express agents have been entered into to accommodate shipments in locations not currently served by Company-owned operations. The Company believes there are no significant service advantages which would justify the operation of its own aircraft on international routes or significant investment in additional offshore facilities or ground operations. In order to expand its business at a reasonable cost, the Company continues to explore possible joint venture agreements, similar to its arrangement with Mitsui & Co., Ltd. in Japan, which combine the Company's management expertise, domestic express system and information systems with local business knowledge and market reputation of suitable partners. The Company's domestic stations are staffed and equipped to handle international shipments to or from almost anywhere in the world. In addition to its extensive domestic network, the Company operates its own offices in the Far East, Australia, New Zealand, and the United Kingdom. The Company's freight and express agents worldwide are connected to FOCUS, Airborne's on-line communication network. The Company is capable of providing its customers with immediate access to the status of shipments via FOCUS almost anywhere in the world. Customers and Marketing - ----------------------- The Company's primary domestic strategy focuses on express services for high volume corporate customers. Most high volume customers have entered into service agreements providing for specified rates or rate schedules for express deliveries. As of December 31, 1993, the Company serviced approximately 356,000 active customer shipping locations. The Company determines prices for any particular domestic express customer based on competitive factors, anticipated costs, shipment volume and weight, and other considerations. The Company believes that it generally offers prices that are competitive with, or lower than, prices quoted by its principal competitors for comparable services. The Company has historically marketed the overnight express service as its primary domestic product. However, the Company believes its SDS product represents an attractive opportunity to expand its customer product offering and generate incremental revenues utilizing its existing network. SDS is a lower yielding product than the Company's overnight product and could result in conversion of certain shipments which may have otherwise been handled on an overnight basis. Internationally, the Company's marketing strategy is to target the outbound express and freight shipments of U.S. corporate customers, and to sell the inbound service of the Company's distribution capabilities in the United States. Both in the international and domestic markets, the Company believes that its customers are most effectively reached by a direct sales force, and accordingly, does not currently engage in mass media advertising. Domestic sales representatives are responsible for selling both domestic and international express shipments. In addition, the International Division has its own dedicated direct sales organization for selling international freight service. The Company's sales force currently consists of approximately 290 domestic representatives and approximately 80 international specialists. The Company's sales efforts are supported by the Marketing and International Divisions, based at the Company headquarters. Senior management is also active in marketing the Company's services to major accounts. Value-added services continue to be important factors in attracting and retaining customers. Accordingly, the Company is automating more of its operations to make the service easier for customers to use and to provide them with valuable management information. The Company believes that it is generally competitive with other express carriers in terms of reliability, value-added services and convenience. For many of its high volume customers, the Company offers a metering device, called LIBRA II, which is installed at the customer's place of business. With minimum data entry, the metering device weighs the package, calculates the shipping charges, generates the shipping labels and provides a daily shipping report. At year end 1993, the system was in use at approximately 5,500 domestic customer locations and a number of selected international customer locations. Use of LIBRA II not only benefits the customer directly, but also lowers the Company's operating costs, since LIBRA II shipment data is transferred into the Airborne FOCUS shipment tracking system automatically, thus avoiding duplicate data entry. "Customer Linkage", an electronic data interchange ("EDI") program developed for Airborne's highest volume shippers, allows customers, with their computers, to create shipping documentation at the same time they are entering orders for their goods. At the end of each day, shipping activities are transmitted electronically to the Airborne FOCUS system where information is captured for shipment tracking and billing purposes. Customer Linkage benefits the customer by eliminating repetitive data entry and paperwork and also lowers the Company's operating costs by eliminating manual data entry. EDI also includes electronic invoicing and payment remittance processing. During 1992, the Company introduced a software program known as Quicklink, which significantly reduces programming time required by customers to take advantage of linkage benefits. The Company offers a number of special logistics programs to customers through its Advanced Logistics Services Corp. ("ALS") subsidiary. This subsidiary, established in 1993, operates the Company's Stock Exchange and Hub Warehousing and other logistics programs. These programs provide customers the ability to maintain inventories which can be managed either by Company or customer personnel. Items inventoried at Wilmington can be delivered utilizing either the Company's airline system or, if required, commercial airlines on a next-flight-out basis. ALS' Central Print program allows information to be sent electronically to customer computers located at Wilmington where Company personnel monitor printed output and ship the material according to customer instructions. The Company also offers a Regional Warehousing program where customer inventories are managed by the Company at any of over 40 locations around the United States and Canada. In addition, the Company's Sky Courier business provides next-plane-out service at premium prices. The Company has obtained ISO 9000 certification for its Chicago, Philadelphia and London stations and its Seattle Headquarters. The ISO 9000 is a quality program developed by the International Standards Organization ("ISO"), based in Geneva, Switzerland. This organization provides a set of international standards on quality management and quality assurance presently recognized in 91 countries. The certification is an asset in doing business worldwide and provides evidence of the Company's commitment to excellence and quality. The Company expects to certify additional facilities over the next several years. Competition - ----------- The market for the Company's services has been and is expected to remain highly competitive. The principal competitive factors in both domestic and international markets are price, the ability to provide reliable pickup and delivery, and value-added services. Federal Express continues to be the dominant competitor in the domestic express business, followed by United Parcel Service. Airborne Express currently ranks third in shipment volume behind these two companies in the domestic express business. Other domestic express competitors include the U.S. Postal Service's Express Mail Service and several other transportation companies offering next morning delivery service. The Company also competes to some extent with companies offering ground transportation services and with facsimile and other forms of electronic transmission. The Company increased rates in March 1993 by approximately 5% on domestic business that was not under a time-definite contract, resulting in an overall yield improvement of approximately 2%. This was the first domestic rate increase in four years. Although still very competitive, the domestic pricing environment improved during 1993 resulting in relatively stable yields. The Company believes it is important to maintain an active capital expansion program to improve service and increase productivity as its volume of shipments increases. However, the Company has significantly less capital resources than its two primary competitors. In the international markets, in addition to Federal Express and United Parcel Service, the Company competes with DHL, TNT and other air freight forwarders or carriers and most commercial airlines. Employees - --------- As of December 31, 1993, the Company and its subsidiaries had approximately 9,500 full-time employees and 6,300 part-time and casual employees. Approximately 4,100 full-time employees (including the Company's pilots) and 2,800 part-time and casual employees are employed under union contracts, primarily with locals of the International Brotherhood of Teamsters and Warehousemen. Labor agreements for the Company's ground personnel are for three-year terms with most agreements expiring in 1994. The Company's pilots are covered by a contract which is amendable in 1995. Subsidiaries - ------------ The Company has the following wholly-owned subsidiaries: 1. ABX Air, Inc., a Delaware corporation, owns and operates the Airline. Its wholly-owned subsidiaries are as follows: a) Wilmington Air Park, Inc., a Ohio corporation, is the owner of the Wilmington airport property (Airborne Air Park). b) Airborne FTZ, Inc., a Ohio corporation, is the holder of a foreign trade zone certificate at the Wilmington airport property. c) Aviation Fuel, Inc., a Ohio corporation, purchases and sells aviation and other fuels. d) Advanced Logistics Services Corp., a Ohio corporation, provides customized warehousing, inventory management and shipping services. e) Sound Suppression, Inc., a Ohio corporation with no current operating activities. 2. Awawego Delivery, Inc., a New York corporation, holds trucking rights in New York and Connecticut. 3. Airborne Forwarding Corporation, a Delaware corporation doing business as Sky Courier, provides expedited courier service. 4. Airborne Freight Limited, a New Zealand corporation, provides air express and air freight services. Regulation - ---------- The Company's operations are subject to various regulations including regulation by the United States Department of Transportation ("DOT"), the FAA, the Interstate Commerce Commission, and various state, local and foreign authorities. The DOT, under the Federal Aviation Act, grants air carriers the right to engage in domestic and international air transportation. The DOT issues certificates to engage in air transportation if the carrier is a U.S. citizen, as defined by the Act, and possesses the financial and managerial fitness necessary to hold such certificates. The DOT has the authority to modify, suspend or revoke such certificates for cause, including failure to comply with the Federal Aviation Act or the DOT regulations. The Company believes it possesses all necessary DOT-issued certificates to conduct its operations. The FAA regulates aircraft safety and flight operations generally, including equipment, ground facilities, maintenance and communications. The FAA issues operating certificates to carriers who possess the technical competence to conduct air carrier operations. In addition, the FAA issues certificates of airworthiness to each aircraft which meets the requirements for aircraft design and maintenance. The Company believes it holds all airworthiness and other FAA certificates required for the conduct of its business, although the FAA has the power to suspend or revoke such certificates for cause, including failure to comply with the Federal Aviation Act. The federal government generally regulates aircraft engine noise at its source. However, local airport operators may, under certain circumstances, regulate airport operations based on aircraft noise considerations. Prior to passage of the Noise Act, certain airports adopted regulations including restrictions on aircraft operations, such as curfews during late night and early morning hours, noise budgets or mandatory use of Stage 3 aircraft, many of which are grandfathered under the Noise Act. Other airports have proposed and may adopt similar noise restrictions. The Noise Act provides that airports proposing restrictions on Stage 2 aircraft operations must provide interested parties a minimum of 180 days advance notice of such regulations and the opportunity to comment thereon. Thereafter, the airport may impose such noise regulations subject to the requirements of existing federal law. The Noise Act further provides that airports that fail to provide the required notice and opportunity to comment will be deemed ineligible for federal airport grant funds or the authority to impose passenger facility charges. With respect to Stage 3 aircraft restrictions, the Noise Act provides that no such restrictions may be imposed unless the airport either obtains the consent of all aircraft operators serving the airport or obtains FAA approval to impose such restrictions. Noncompliance with these rules will also result in the loss of federal funding and eligibility to impose passenger facility charges. The Company believes the operation of its aircraft either complies with or is exempt from compliance with currently applicable local airport rules. However, if more stringent aircraft operating regulations were adopted on a widespread basis, the Company might be required to expend substantial sums, make schedule changes or take other actions. See "Business - Domestic Operations - Aircraft." The Company's aircraft currently meet all know requirements for emission levels. However, under the Clear Air Act, individual states or the Federal Environmental Protection Agency (the "EPA") may adopt regulations requiring the reduction in emissions for one or more localities based on the measured air quality at such localities. The EPA has proposed regulations for portions of California calling for emission reductions by the year 2005. There can be no assurance that if such regulations are adopted in the future or changes in existing laws or regulations are promulgated that such laws or rules would not have a material adverse effect on the Company. Under currently applicable federal aviation law, the Company's airline subsidiary could cease to be eligible to operate as an all-cargo carrier if more than 25% of the voting stock of the Company were owned or controlled by non-U.S. citizens or the Airline was not effectively controlled by U.S. citizens. Moreover, in order to hold an all-cargo air carrier certificate, the president and at least two-thirds of the directors and officers of an air carrier must be U.S. citizens. The Company has entered into a Rights Agreement designed, in part, to discourage a single foreign person from acquiring 20% or more, and foreign persons in the aggregate from acquiring 25% or more, of the Company's outstanding voting stock without the approval of the Board of Directors. To the best of the Company's knowledge, foreign stockholders do not control more than 25% of the outstanding voting stock. Two of the Company's officers are not U.S. citizens. The Company believes that its current operations are substantially in compliance with the numerous regulations to which its business is subject; however, various regulatory authorities have jurisdiction over significant aspects of the Company's business, and it is possible that new laws or regulations or changes in existing laws or regulations or the interpretations thereof could have a material adverse effect on the Company's operations. Financial Information Regarding International and Domestic Operations - --------------------------------------------------------------------- Financial information relating to foreign and domestic operations for each of the three years in the period ended December 31, 1993 is presented in Note L (Segment Information) of the Notes to Consolidated Financial Statements appearing in the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES - -------------------- The Company leases general and administrative office facilities located in Seattle, Washington. At year end the Company maintained 232 domestic and 22 foreign stations, most of which are leased. The majority of the facilities are located at or near airports. The Company owns the airport at the Airborne Air Park, in Wilmington, Ohio. The airport currently consists of a runway, taxi-ways, aprons, buildings serving as aircraft and equipment maintenance facilities, a sort facility, storage facilities, a training center, and operations and administrative offices. The Company has in progress a significant expansion of the airpark which includes construction of a second runway, taxiways, two roadway tunnels under the taxiways and several other facilities. This expansion should be substantially completed during 1995. Information regarding collateralization of certain property and lease commitments of the Company is set forth in Notes E and F of the Notes to Consolidated Financial Statements appearing in the 1993 Annual Report to Shareholders and is incorporated herein by reference. The Company believes its existing facilities are adequate to meet current needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - --------------------------- None ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------- None ITEM 4a. EXECUTIVE OFFICERS OF THE REGISTRANT PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED - ---------------------------------------------------------------- STOCKHOLDERS MATTERS - -------------------- The response to this Item is contained in the 1993 Annual Report to Shareholders and the information contained therein is incorporated by reference. On February 28, 1993 there were approximately 1,497 shareholders of record of the Common Stock of the Company based on information provided by the Company's transfer agent. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - --------------------------------- The response to this Item is contained in the 1993 Annual Report to Shareholders and the information contained therein is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------------------------------------------------------------------------- RESULTS OF OPERATIONS - --------------------- The response to this Item is contained in the 1993 Annual Report to Shareholders and the information contained therein is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ----------------------------------------------------- The response to this Item is contained in the 1993 Annual Report to Shareholders and the information contained therein 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 response to this Item is contained in part in the Proxy Statement for the 1994 Annual Meeting of Shareholders under the captions "Election of Directors" and "Exchange Act Compliance" and the information contained therein is incorporated herein by reference. The executive officers of the Company are elected annually at the Board of Directors meeting held in conjunction with the annual meeting of shareholders. There are no family relationships between any directors or executive officers of the Company. Additional information regarding executive officers is set forth in Part I, Item 4a. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - --------------------------------- The response to this Item is contained in the Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Executive Compensation" and the information contained therein is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------- The response to this Item is contained in the Proxy Statement for the 1994 Annual Meeting of Shareholders under the captions "Voting at the Meeting" and "Stock Ownership of Management" and the information contained therein is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - --------------------------------------------------------- The response to this Item is contained in the Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Board of Directors and Committees" and the information contained therein is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------- (a)1. Financial Statements -------------------- The following consolidated financial statements of Airborne Freight Corporation and its subsidiaries as contained in its 1993 Annual Report to Shareholders are incorporated by reference in Part II, Item 8: Consolidated Statements of Net Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Independent Auditors' Report All other schedules are omitted because they are not applicable or are not required, or because the required information is included in the consolidated financial statements or notes thereto. (a)3. Exhibits - ----------------- A) The following exhibits are filed with this report: EXHIBIT NO. 3 Articles of Incorporation and By-laws - ------------------------------------------------------ 3(a) The Restated Certificate of Incorporation of the Company, dated as of August 4, 1987 (incorporated herein by reference from Exhibit 3(a) to the Company's Form 10-K for the year ended December 31, 1987). 3(b) The By-laws of the Company as amended to February 1, 1988 (incorporated herein by reference from Exhibit 3(b) to the Company's Form 10-K for the year ended December 31, 1987). EXHIBIT NO. 4 Instruments Defining the Rights of Security Holders - -------------------------------------------------------------------- Including Indentures - -------------------- 4(a) Indenture dated as of September 4, 1986, between the Company and Peoples National Bank of Washington (now U.S. Bank of Washington), as trustee, relating to $25 million of the Company's 10% Senior Subordinated Notes due 1996 (incorporated by reference from Exhibit 4(c) to Amendment No. 1 to the Company's Registration Statement on Form S-3, No. 33-6043, filed with the Securities and Exchange Commission on September 3, 1986). 4(b) Note Purchase Agreement dated September 3, 1986 among the Company and the original purchasers of the Company's 10% Senior Subordinated Notes due 1996 (incorporated by reference from Exhibit 4(d) to Amendment No. 1 to the Company's Registration Statement on Form S-3, No. 33-6043, filed with the Securities and Exchange Commission on September 3, 1986). 4(c) Indenture dated as of August 15, 1991, between the Company and Bank of America National Trust and Savings Association, as Trustee, with respect to the Company's 6-3/4% Convertible Subordinated Debentures due August 15, 2001 (incorporated herein by reference from Exhibit 4(i) to Amendment No. 1 to the Company's Registration Statement on Form S-3 No. 33-42044 filed with the Securities and Exchange Commission on August 15, 1991). 4(d) Indenture dated as of December 3, 1992, between the Company and Bank of New York, as trustee, relating to the Company's 8-7/8% Notes due 2002 (incorporated herein by reference from Exhibit 4(a) to Amendment No. 1 to the Company's Registration Statement on Form S-3, No. 33-54560 filed with the Securities and Exchange Commission on December 4, 1992). 4(e) Rights Agreement, dated as of November 20, 1986 between the Company and First Jersey National Bank (predecessor to First Interstate Bank, Ltd.), as Rights Agent (incorporated by reference from Exhibit 1 to the Company's Registration Statement on Form 8-A, dated November 28, 1986). 4(f) Certificate of Designation of Series A Participating Cumulative Preferred Stock Setting Forth the Powers, Preferences, Rights, Qualification, Limitations and Restrictions of Such Series of Preferred Stock of the Company (incorporated by reference from Exhibit 2 to the Company's Registration Statement on Form 8-A, dated November 28, 1986). 4(g) Form of Right Certificate relating to the Rights Agreement (see 4(e) above, incorporated by reference from Exhibit 3 to the Company's Registration Statement on Form 8-A, dated November 28, 1986). 4(h) Letter dated January 5, 1990, from the Company to First Interstate Bank, Ltd. ("FIB"), appointing FIB as successor Rights Agent under the Rights Agreement dated as of November 20, 1986, between the Company and The First Jersey National Bank (incorporated by reference from Exhibit 4(c) to the Company's Form 10-K for the year ended December 31, 1989). 4(i) Amendment to Rights Agreement entered into as of January 24, 1990, between the Company and First Interstate Bank, Ltd. (incorporated herein by reference from Exhibit 4(d) to the Company's Form 10-K for the year ended December 31, 1989). 4(j) Third Amendment to Rights Agreement entered into as of November 6, 1991 between the Company and First Interstate Bank, Ltd. (incorporated herein by reference from Exhibit 4(a) to the Company's Form 10-K for the year ended December 31, 1991). 4(k) 6.9% Cumulative Convertible Preferred Stock Purchase Agreement dated as of December 5, 1989, among the Company, Mitsui & Co., Ltd., Mitsui & Co. (U.S.A.), Inc., and Tonami Transportation Co., Ltd. (incorporated herein by reference from Exhibit 4(b) to the Company's Form 10-K for the year ended December 31, 1989). 4(k)(i) Amendments to the above Stock Purchase Agreement irrevocably waiving all demand registration rights, relinquishing the right of Mitsui & Co., Ltd. to designate a representative to Airborne's Board of Directors, and resignation of T. Kokai from said Board (incorporated herein by reference from Amendment No. 1 to Schedule 13D of Mitsui & Co., Ltd. Intermodal Terminal, Inc. (assignee of Mitsui & Co. (USA) Inc.) and Tonami Transportation Co., Ltd., filed with the Securities & Exchange Commission on December 21, 1993). 4(l) Certificate of Designation of Preferences of Preferred Shares of Airborne Freight Corporation, as filed on January 26, 1990, in the Office of the Secretary of the State of Delaware (incorporated herein by reference from Exhibit 4(a) to the Company's Form 10-K for the year ended December 31, 1989). EXHIBIT NO. 10 Material Contracts - --------------------------------- Executive Compensation Plans and Agreements - ------------------------------------------- 10(a) 1979 Airborne Freight Corporation Key Employee Stock Option and Stock Appreciation Rights Plan, as amended through February 2, 1987 (incorporated by reference from Exhibit 10(d) to the Company's Form 10-K for the year ended December 31, 1986). 10(b) 1983 Airborne Freight Corporation Key Employee Stock Option and Stock Appreciation Rights Plan, as amended through February 2, 1987 (incorporated by reference from Exhibit 10(c) to the Company's Form 10-K for the year ended December 31, 1986). 10(c) 1989 Airborne Freight Corporation Key Employee Stock Option and Stock Appreciation Rights Plan (incorporated herein by reference from Exhibit 10(d) to the Company's Form 10-K for the year ended December 31, 1989). 10(d) 1994 Airborne Freight Corporation Key Employee Stock Option and Stock Appreciation Rights Plan (incorporated herein by reference from the Addendum to the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders). 10(e) Airborne Freight Corporation Directors Stock Option Plan (incorporated herein by reference from the Addendum to the Company's Proxy Statement for the 1991 Annual Meeting of Shareholders). 10(f) Airborne Express Executive Deferral Plan dated January 1, 1992 (incorporated by reference from Exhibit 10(b) to the Company's Form 10-K for the year ended December 31, 1991). 10(g) Airborne Express Supplemental Executive Retirement Plan dated January 1, 1992 (incorporated by reference from Exhibit 10(c) to the Company's Form 10-K for the year ended December 31, 1991). 10(h) Airborne Express 1993 Executive Management Incentive Compensation Plan. 10(i) Employment Agreement dated December 15, 1983, as amended November 20, 1986, between the Company and Mr. Robert G. Brazier, President and Chief Operating Officer (incorporated by reference from Exhibit 10(a) to the Company's Form 10-K for the year ended December 31, 1986). Identical agreements exist between the Company and the other six executive officers. 10(j) Employment Agreement dated November 20, 1986 between the Company and Mr. Lanny H. Michael, then Vice President, Treasurer and Controller (incorporated by reference from Exhibit 10(b) to the Company's Form 10-K for the year ended December 31, 1986). Identical agreements exist between the Company and 25 other officers of the Company. In addition, the Company's principal subsidiary, ABX Air, Inc., has entered into substantially identical agreements with seven of its officers. Other Material Contracts ------------------------ 10(k) $240,000,000 Revolving Loan Facility dated as of November 19, 1993 among the Company, as borrower, and Wachovia Bank of Georgia, N.A., ABN AMRO Bank N.V., United States National Bank of Oregon, Seattle-First National Bank, CIBC Inc., Continental Bank N.A., Bank of America National Trust and Savings Association, The Bank of New York, NBD Bank, N.A., as banks and Wachovia Bank of Georgia, N.A., as agent. 10(l) Letter dated December 5, 1989, to the Company from Mitsui & Co., Ltd. ("Mitsui"), relating to Mitsui's commitment to provide the Company and ABX Air, Inc., a $100 million aircraft financing facility, as modified by that certain Supplement thereto entered into as of March 15, 1990 (incorporated herein by reference from Exhibit 10(b) to the Company's Form 10-K for the year ended December 31, 1989). 10(m) Shareholders Agreement entered into as of February 7, 1990, among the Company, Mitsui & Co., Ltd., and Tonami Transportation Co., Ltd., relating to joint ownership of Airborne Express Japan, Inc. (incorporated herein by reference from Exhibit 10(c) to the Company's Form 10-K for the year ended December 31, 1989). EXHIBIT NO. 11 Statement Re Computation of Per Share Earnings - --------------------------------------------------------------- 11 Statement re computation of earnings per share EXHIBIT NO. 12 Statements Re computation of Ratios - ---------------------------------------------------- 12 Statement re computation of ratio of senior long-term debt and total long-term debt to total capitalization EXHIBIT NO. 13 Annual Report to Security Holders - -------------------------------------------------- 13 Portions of the 1993 Annual Report to Shareholders of Airborne Freight Corporation EXHIBIT NO. 21 Subsidiaries of the Registrant - ----------------------------------------------- 21 The subsidiaries of the Company are listed on page 10 & 11 of this report on Form 10-K for the year ended December 31, 1993. EXHIBIT NO. 23 Consents of Experts and Counsel - ------------------------------------------------ 23 Independent Auditors' Consent and Report on Schedules All other exhibits 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. (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 Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AIRBORNE FREIGHT CORPORATION By /S/ ROBERT S. CLINE ---------------------------------- Robert S. Cline Chief Executive Officer By /S/ ROBERT G. BRAZIER ---------------------------------- Robert G. Brazier Chief Operating Officer By /S/ ROY C. LILJEBECK ---------------------------------- Roy C. Liljebeck Chief Financial Officer By /S/ LANNY H. MICHAEL --------------------------------- Lanny H. Michael Treasurer and Controller 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 Company and in the capacities and on the date indicated: /S/ ANCIL H. PAYNE /S/ HAROLD M. MESSMER, JR. - ---------------------------------- ---------------------------------- Ancil H. Payne (Director) Harold M. Messmer, Jr. (Director) /S/ ROBERT G. BRAZIER /S/ RICHARD M. ROSENBERG - ---------------------------------- ---------------------------------- Robert G. Brazier (Director) Richard M. Rosenberg (Director) /S/ ROBERT S. CLINE - ---------------------------------- Robert S. Cline (Director) AIRBORNE FREIGHT CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY AND EQUIPMENT (In thousands) AIRBORNE FREIGHT CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT (In thousands) AIRBORNE FREIGHT CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (In thousands) AIRBORNE FREIGHT CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in thousands) Balances outstanding under the Company's Money Market lines of credit arrangement generally have maturities ranging from one day to one week. Average amount outstanding during the period is computed by dividing the total of daily outstanding principal balances by 365 or 366 days as applicable. Weighted average interest rate during the period is computed by dividing the actual short-term interest expense by the average short-term borrowings outstanding. AIRBORNE FREIGHT CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) Note: Depreciation and amortization of intangible assets, taxes (other than payroll and income taxes), royalties, and advertising costs are each less than 1% of consolidated revenue in 1993, 1992 and 1991. EXHIBIT INDEX A) The following exhibits are filed with this report: EXHIBIT NO. 3 Articles of Incorporation and By-laws - ---------------------------------------------------- EXHIBIT NO. 4 Instruments Defining the Rights of Security Holders Including - ---------------------------------------------------------------------------- Indentures - ---------- EXHIBIT NO. 10 Material Contracts - ---------------------------------- Executive Compensation Plans and Agreements - ------------------------------------------- EXHIBIT NO. 11 Statement Re computation of Per Share Earnings - -------------------------------------------------------------- EXHIBIT NO. 12 Statements Re computation of Ratios - --------------------------------------------------- EXHIBIT NO. 13 Annual Report to Security Holders - ------------------------------------------------- EXHIBIT NO. 21 Subsidiaries of the Registrant - ---------------------------------------------- EXHIBIT NO. 23 Consents of Experts and Counsel - ----------------------------------------------- All other exhibits 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.